It turns out that avoiding buying Pool Corp. was a mistake, as shares have delivered a total return of 74.5% since. However, over this period, the company has made little operational improvements, while shares have disproportionately appreciated compared to future expected earnings.
Source: Google Finance
We believe that the stock’s ongoing rally is unjustified, and despite the company’s quality characteristics, investors are unlikely to see meaningful returns buying at its current valuation.
In this article, we will:
- Go over Pool Corp.’s financials
- Explain why capital returns are not enough to compensate for the current valuation
- Highlight some risks
- Conclude why we are still avoiding shares of Pool Corp.
The company’s historical growth has been phenomenal, with both the top and bottom line consistently growing. The company’s growth lagged during the Great Financial Crisis due to limited consumer spending and savings. However, despite the overall economic headwinds of the past few months, Pool Corp.’s performance has remained robust.
Last quarter, the company reported revenue growth of 14.2% YoY, marking record quarterly revenues of $1.28B, despite the ongoing challenges the pandemic has caused to the economy.
We believe that the company’s performance will remain strong since the demand for pools is usually coming from affluent customers, whose purchasing power is likely to remain solid even in times when the overall economy may be under pressure. We view Pool Corp. as a great way to get exposure to the luxury sector, in a niche market, while investing in the company with the largest distribution network and expertise in the sector.
Another investable characteristic of Pool Corp. is its gross margins, which have been incredibly stable, even in times of reduced demand (2008-2010), while its net income margins have been in a long-term expansion phase over the past decade amid economies of scale.
We believe that the company’s profitability is set to continue increasing, as management affirmed that there is a strong pool builder backlog, favorable weather trends, while undergoing a positive net income margin expansion.
Despite the company’s highly investable characteristics and growing financials, however, we fail to see how its projected future growth and capital returns can justify its current valuation.
Our primary concern when it comes to Pool Corp.’s future investor returns is its unjustifiably high valuation. Shares are currently trading at a decade-high P/E ratio of 46.5. Sure, the company had a great quarter, but similar growth levels had also occurred during 2012-2018, and the valuation never advanced past 35X earnings.
What such a high valuation means is that current investors have little to no margin of safety, even if the company successfully delivers on its projections.
The current valuation expansion should indicate the company’s future results are about to accelerate. However, based on management’s outlook, this isn’t exactly the case. Revenue growth is expected to be at similar levels to its five-year history, while gross margins are to remain stable, as they have done over the past decade. EPS is to grow in the mid-teens, as share repurchases should assist the underlying earnings growth, along with the favorable net income margins mentioned earlier.
Source: Investor presentation
Based on these projections, investment returns are barely enough to compensate for the current valuation risks. Let’s put that to the test.
We assume medium-term EPS growth of 15%, based on management’s “mid-teens %” growth outlook. Further, we assume DPS growth of 19.4%, which is exactly the company’s five-year DPS CAGR (compound annual growth rate). Pool Corp. has a meager payout ratio, so we are confident that dividends can comfortably be increasing at a faster rate than EPS in the medium term.
Based on these projections, future figures should look like the following:
Now here’s where the company’s decade-high valuation poses a total return risk. In the table below, we have calculated the total investor return potential based on our projections and different potential valuation multiples.
As you can see, if the stock’s valuation returns to its historical average of 25-30X earnings, investors should expect annualized returns of around 3.5% to 7.1% despite the company’s double-digit growth rates we have assumed.
The only way investors should continue seeing double-digit returns is if the company retains a valuation premium. However, our point is that based on its non-explosive future performance projections, such a high valuation is not sustainable and not justifiable. Further, at its current price of $326.21, the company yields around 0.71%, which makes for minimal tangible returns to keep investors attracted to holding its shares.
Finally, the company’s expected EPS growth is expected to be assisted by stock buybacks. However, we believe that shareholder value is being wasted by repurchasing shares at such a premium.
We believe that the company’s largest risk from an investor’s perspective is a reasonable valuation compression to its historical levels. However, there are a couple of additional risks to consider as well.
Firstly, the company’s sales are directly related to weather conditions. Around 81% of the operating income in FY2019 was derived from Q2 and Q3. These quarters have historically represented the peak months of swimming pool use, irrigation installation, remodeling, and repair activities.
While favorable weather conditions persisted in H1-2020, a potential unfavorable future weather outlook could hurt sales during peak months, and subsequently, a large chunk of Pool Corp.’s profitability.
Source: Investor presentation
Further, the company’s three largest suppliers, Pentair plc (NYSE:PNR), Hayward Pool Products, Inc., and Zodiac Pool Systems, Inc., accounted for nearly 40% of the company’s products sold last year. As POOL has highlighted in its latest 10-K report, if one of these suppliers decides to sell direct to consumers or through different channels, the company’s short-term operations will be adversely affected.
We believe that Pool Corp. is a fantastic growth story that has consistently grown its top and bottom line in a niche, luxury-based market. We are confident that the company will keep on expanding rapidly, in line with management’s expectations, as demand for pools can remain strong even during times of economic uncertainties, as the purchasing power of affluent consumers remains robust.
However, even with prosperous assumptions, the stock fails to deliver adequate returns to compensate for a potential return to its historical valuation levels. Investors are expected to enjoy significant returns only if Pool Corp.’s valuation levels remain disproportionately high to underlying earnings, which is a bet we are not willing to take. Thus we will keep avoiding Pool Corp. despite its otherwise numerous investable characteristics.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.