However, during my coverage of POOL, I often debated with Manny about the potential impact of a housing downturn, one I suspected would be inspired by higher interest rates. This later proved prescient, after I left Wall Street, and we are now in the midst of the result.
POOL’s team was always well prepared for this question, noting POOL’s steady revenue streams originating from the maintenance needs of swimming pools. You see, when people own a pool, they usually use it. As a result, some 60% of POOL’s revenue is derived from maintenance requirements. Another 20% from repair, and 20% from new pool construction.
This was reassuring, but I remained concerned that the 20% of revenue coming from construction might still be enough to set POOL’s stock off course. Here we are in the midst of a housing recession, and POOL just revised its full year 2007 earnings forecast lower to a range of $1.75 to $1.85, from $2.00 to $2.10, based on weakness in the construction segment.
POOL reported net sales for the second quarter below analysts’ consensus, and just 2.9% above prior year levels. The culprit turned out to be the effect of a construction slowdown, especially in the markets of Florida, Arizona and parts of California. Poor weather in Oklahoma and Texas were also partly to blame. During the conference call, Manny indicated that flaws in the Florida market were somewhat camouflaged in the past by the strength of the housing market, and those flaws have now been flushed out into the open.
POOL’s base business only grew about 1%, and sales otherwise benefited from the acquisition of the Wickham Supply operations and new center openings. While the offerings of complementary products have been a strong growth engine over the recent past, increasing from $3 million in 1999, to some $180 million in 2006, POOL may have overextended too far into housing related type items. Complementary product sales increased just 9% in the quarter, compared to 23% growth in the prior year period.
During the conference call, management mentioned that it would pursue expansion of some complementary products already within the system, while limiting others. Your favorite Greek here feels like the statement implies POOL might scale back its sales effort of items like fencing and other products closely related to housing. While the company has indicated that some 80%-90% of new pool construction is not directly related to new home starts, we still believe tighter lending restrictions and lighter home equity borrowing are impacting pool industry growth. Also, that 10% that is related to new home starts is not insignificant.
Margins narrowed, on less efficient sales efforts. Operating margin narrowed some 110 basis points, but management kept earnings per share stable through share repurchases. After buying back shares, EPS matched the prior year level of $1.12.
While POOL contends that given a normal external operating environment, it should grow EPS at a 15%-20% annual rate over the long-term, investors still have to contend with short-term cyclical fluctuations. We would like to see the company intensify its international expansion efforts in order to diversify economic risk like we see in today’s marketplace. At 19X the mid-point of its earnings guidance for this year (or $1.80 a share), the shares trade at the high end of POOL’s long-term growth expectations, or 20%. The problem is that we are in a period of declining estimates and cyclical downturn, and one might argue that such a period deserves a multiple near the low end of growth forecasts.
Compared to leisure industry and sporting goods peers, POOL shares fare relatively well. For instance, Callaway Golf (ELY) enjoys a P/E ratio of 32X, while Oakley (OO) trades at 38X earnings, but neither of these firms has exposure to housing or lending related weakness.
With difficulty finding close peers, we must look to intrinsic value metrics like the PEG ratio. With earnings estimate momentum not in the company’s favor, as it only just revised estimates lower, we would avoid the stock over the short term. However, with a high level of confidence in the management team, we expect the company will adjust to better adhere to its dynamic operating environment. Wall Street Greek would classify POOL now as a great company with an overpriced stock.