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Executives

Mark W. Joslin - Chief Financial Officer and Vice President

Manuel J. Perez De La Mesa - Chief Executive Officer, President and Director

Analysts

David S. MacGregor - Longbow Research LLC

Ryan Merkel - William Blair & Company L.L.C., Research Division

Anthony C. Lebiedzinski - Sidoti & Company, LLC

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

Pool (POOL) Q3 2012 Earnings Call October 18, 2012 11:00 AM ET

Operator

Good morning, and welcome to the Pool Corp. Third Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Mark Joslin, Vice President and Chief Financial Officer. Please go ahead.

Mark W. Joslin

Thank you, Laura. Good morning, everyone, and welcome to our Third Quarter 2012 Conference Call. I would once again like to remind our listeners that our discussion, comments and responses to questions today may include forward-looking statements, including management's outlook for 2012 and future periods. Actual results may differ materially from those discussed today. Information regarding the factors and variables that could cause actual results to differ materially from projected results is discussed in our 10-K.

Now, I'll turn the call over to our President and CEO, Manny Perez De La Mesa. Manny?

Manuel J. Perez De La Mesa

Thank you, Mark, and good morning to everyone on the call.

After a relatively slow start to the quarter in July, August and September activity reverted to more normal growth levels. Clearly, the early start to the season pulled sales forward from June and July to the first 5 months of the year. This is best reflected in our largest product category, Chemicals, whose growth rate was 12% year-to-date through May, slowing abruptly to year-to-date 6% growth through June and now sit at 4.4% growth year-to-date through September.

For a little perspective, we estimate the industry's natural growth rate for chemicals, including any inflation, is 1% to 2%. Factoring a modest recovery in more discretionary product segments, we estimate that the industry's overall growth will be approximately 3% in 2012.

Adjusting for 1 less sales day and the impact of currency exchange, our Blue based business sales were up 5% in the quarter and 7.2% year-to-date. In the 3 largest markets, Florida had relatively stronger results while California and Texas were slightly below the company average. These variances are largely due to varying year-on-year comparisons, as well as modest differences in local execution.

Adjusting for the 1 less sales day, our Green base business sales were up 10% in the quarter and 8% year-to-date, consistent with our expectations.

Our sales growth in our strategic priority customer segment, Retail, is up 4.7% year-to-date, with this customer segment heavily weighted by chemical sales and there being very little inflation impact this year.

Our strategic priority product category, building materials, had a 15.1% sales growth year-to-date, primarily driven by market share gains with some recovery visible in remodeling activity.

At this juncture of the year, the pool season is virtually complete in many of the more seasonal markets. And we can conclude that we had another successful year with continued progress in every facet of execution, enabling us to continue to capture profitable market share.

We launched our 2013 season last week at our International Sales Conference with a record of approximately 1,200 participants, including managers and outside sales people from throughout the company, as well as representatives from our preferred vendors.

There was a lot of excitement about the many opportunities available to us despite the uncertainty in the macroeconomic environment.

Gross margins being down in the quarter was not a surprise given the inventory gains realized last year from the mid-season price increases. We also continued to experience the effect of adverse customer and product mix changes that are in part recaptured in proportionately lower operating expense.

An example of this is our selling a greater mix of higher priced, more energy-efficient products, which have a higher margin dollar per unit but are sold at a lower margin percent.

On the customer front, some of the larger customers are gaining share from smaller customers, with logically the larger customers typically having, on average, lower prices in their markets.

Fortunately, we have much more to offer than our competitors and are still able to grow share by providing a comprehensive suite of services and solutions to help our customers succeed. These programs also help us mitigate the competitive pricing pressures.

An item of recent interest given the difficult economic climate is our European business. It helps for prospective to note that Europe represents 6% of our total sales and 3% of our year-to-date profits. Despite all of the bad press regarding the European economy, our base business sales in Europe were down only 0.7% year-to-date through September in local currency versus a 5% increase in the same period of 2011, as we continued to gradually increase market share.

Just like in North America, our share gains are earned through superior execution based on our investments in talent development, technology, marketing and altogether, combined with the outstanding commitment of our people.

Another item of interest has been our Green business, that for perspective represents 8% of our total sales and has suffered as that market declined by more than 60% from peak levels with the collapse of new residential construction. While new construction appears to have stabilized and recovered, the progressive actions taken by our team together with the regional competitor going out of business, have translated into solid sales and market share gains and a $4.5 million increase in the year-to-date operating income.

Overall, and as mentioned previously, we are pleased with our operating results in 2012 as we captured sales -- captured share based on the value that we provided while leveraging infrastructure and best practices and we expect to realize approximately a 20% contribution margin on base business sales growth for the year.

Mark will fill you in on our expenses, receivables and inventories, but my one-word summary of these is that they are very solid.

To summarize the quarter, year-to-date and projected 2012 results, the key highlights are: We have to date, and should finish 2012 with, record dilutive earnings per share in a still challenging environment with new construction still down 70% from peak levels and with depressed discretionary expenditures. This will mark our third consecutive year of 20% or greater diluted earnings per share growth.

We have year-to-date and should finish 2012 with a 20% contribution margin on base business sales growth as we leverage infrastructure and realize continued share gains.

We have managed working capital efficiently to realize strong cash flows, which we have and will deploy to further strengthen our business, returning the balance to shareholders in either dividends or share repurchases.

Last week, we celebrated a number of individuals and teams for their success in 2012. And it is not without the commitment of so many in our company that worked very long hours to ensure that our customers are provided with exceptional service that make us the successful company that we are. Our people's commitment to our customers is unsurpassed. I am truly grateful for their efforts to provide exceptional value everyday and I am very proud of their accomplishments.

Now, I'll turn the call back over to Mark for his financial commentary.

Mark W. Joslin

Thank you, Manny.

I'll start by providing a little color on our expense performance in the quarter.

As noted in our release, our base business expenses were down 6% or $6.3 million in the quarter, which is a bit more than a 2% decline we reported in Q2. Lower incentive costs, which were down nearly $4 million in the quarter from last year was the biggest factor driving this.

For the full year, we expect incentive costs to be down about $6 million in 2012 from 2011, which leaves another $2 million year-over-year decline in incentive expenses for the fourth quarter.

Overall, as mentioned on previous calls, incentive expenses in 2012 reflect a more normalized expense level after the more extraordinary year we had in 2011. And the timing of expense accruals in 2012 reflects the relative better first half performance this year compared to the second half, which is opposite of what we saw in 2011.

As for our other expense declines in the quarter, collectively, the impact of the weaker U.S. dollar on nondollar denominated expenses, the shift in expenses to Q4 due to the loss of the sales day in Q3 and lower bad debt expenses, accounted for most of the remaining year-over-year expense decline with some offsets in other areas.

For the fourth quarter, while we expect to benefit from the $2 million projected incentive decline, we also expect cost increases in other areas, which including the impact of acquisitions, should give us expense growth in the 3% to 4% range for the quarter and modest expense growth overall for the year.

I'll take a moment here and walk you through the goodwill charge we recorded in the quarter, which reflected the full impairment of our business in the U.K. This business was acquired by the company in 1998 and at present has about $11 million in annual revenue.

Over the last year, we've seen some deterioration in the profitability of this business, which coupled with the current and expected continued depressed economic conditions in that market, resulted in our write-down of all of the acquired goodwill of nearly USD 7 million.

In terms of other potential goodwill impairments, we'll be doing our annual goodwill impairment evaluation in Q4 as we do every year but I don't expect further impairment charges in the foreseeable future.

The goodwill charge is not deductible for tax purposes, so you need to exclude this from our pretax income to calculate our effective tax rate in the quarter, which was just under 39%. Our year-to-date tax rate, excluding the impairment charge is just over 38%, which is also where we expect to end the year.

One other tax-related comment, which we referenced in our release was that because of hurricane Isaac, our federal tax payment in Q3 was pushed back to Q4, which favorably impacted our cash flow in the quarter by about $35 million.

Moving on to the balance sheet. Our 2 largest assets, accounts receivable and inventories, continued to reflect positive operating management. Our Trade-Air amount was up 6% year-over-year in line with our sales growth while the quality of this receivable improved as reflected in DSO or day sales outstanding, which was 29.0 days at the end of the quarter, down from 30.3 days 1 year ago. Likewise, a modest 3% growth in our inventory balance and 3% improvement in inventory turns reflect the positive management actions taking place here.

Cash flow improvements in the quarter from last year were discussed in our release. So to summarize, we're benefiting from a combination of ongoing operational improvements and favorable timing, which were reversed in Q4. For the year, we expect cash flow from operations to exceed net income and we are well on track to achieve that through 3 quarters.

Finally, I'll update you on our share repurchases and our share accounts. During the quarter, we repurchased 300,000 shares at an average price of $36.71, with no shares repurchased yet in October. This brings our year-to-date share repurchases to 1.5 million shares in current open-board authorizations to $115 million.

That concludes my prepared remarks, so I'll turn the call back over to our operator to begin our question and answer period. Laura?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from David McGregor of Longbow Research.

David S. MacGregor - Longbow Research LLC

Can you just talk about trends in the discretionary spending categories? I realize it's a smaller part of your business and it sounds like maybe up until now, it's been relatively light. But I'm just wondering if you're starting to see any -- anything encouraging there?

Manuel J. Perez De La Mesa

Yes. Just for a little perspective, we estimate that from, call it 2006 timeframe to the bottom in early -- or 2009, there was 35% to 40% reduction in terms of affecting the replacement remodeling activity in our business. And we began to see a little bit of recovery there in 2011 and we're continuing to see a little bit more recovery in that regard in 2012. And that's best captured, in our case, with those items that are involved again, in equipment replacement or the resurfacing or remodeling of the pool. So an example of some of that and -- is our growth in building material sales, where we're 15% year-to-date now and we know that we captured share in that space. But independent of our capturing share, certainly, the marketplace there is a little better than it would be overall.

David S. MacGregor - Longbow Research LLC

And then within the replacement business, is there anything going on with mix that's notable? I mean, are people buying higher quality products, do you get a sense there's a little more confidence being reflected in how people spend on replacement?

Manuel J. Perez De La Mesa

Well, that's a great question, David. The mix impact there is more geared not so much to a change in consumer behavior in the natural sense of spending versus not spending. But it's more reflected in energy-efficient products. For example, variable-speed pumps being sold instead of a single-speed pump. And there are significant energy efficiencies that the pool owner realizes by putting in a variable-speed pump, usually upwards to 70%, 80% savings in terms of energy consumption. But the upfront price is logically higher and we are seeing some shifting there of mix, and that's overall benefiting industry and our sales a little bit, certainly as that mix happens, although there is a small drag on margin as a result as well -- margin percent as a result.

David S. MacGregor - Longbow Research LLC

Percentage margins, right?

Manuel J. Perez De La Mesa

Yes.

David S. MacGregor - Longbow Research LLC

And finally, just can you comment at all on the outlook for 2013 vendor price increases?

Manuel J. Perez De La Mesa

At this juncture, the expectation would be that probably, overall, an inflation will be close to 2%. Certain manufacturers -- I'll call it on the equipment side, for example, have already announced increases, which will be fully effective sometime in the spring of next year and those are a little higher than 2%, in the neighborhood of 3% to 4%. But chemical is still very depressed and accessories, I don't anticipate anything significant there and in other product categories, they're still not yet announced. So overall, in all likelihood, the effective increase will be somewhere in the neighborhood of 2% for next year.

Operator

And our next question is from Ryan Merkel of William Blair.

Ryan Merkel - William Blair & Company L.L.C., Research Division

So I want to start with the organic growth outlook in the fourth quarter. It seems to me, I'm kind of reading between the lines, but it sounds like the pool market is maybe stabilized a bit after some of the pull forward we saw in the middle of summer?

Manuel J. Perez De La Mesa

You are correct, Ryan. If you worked through the periods, I mean, we were going gangbusters through May and then June and the first part of July, through about 3rd week of July was pretty much flattish year-on-year. And towards the end of July, year-on-year sales activity began to increase again and increased decently in August, September. So yes, I would expect, call it mid single-digit type increase for the fourth quarter.

Ryan Merkel - William Blair & Company L.L.C., Research Division

Got you. Okay, great. And then just moving to gross margins, Mark mentioned a few headwinds there. It sounds to me like that should continue into the fourth quarter.

Manuel J. Perez De La Mesa

Yes, that's correct. We expect those headwinds to continue. We had the mid-season price increases last year and those mid-season price increases that we bought into basically covered us for the balance of the year. So therefore, what happens is that as we realize pickups during the course of last year from, call it, May forward, that we have: A, an artificially tougher comp to wrestle against and especially given the fact that we did not have those types -- that type of activity this year. So that's that headwind that we have. And then the other headwind that we have is what I mentioned earlier in terms of -- in my prepared remarks, where we have a little bit of a drag from both customer mix as well as product mix, whether it be to product mix, to our selling of variable-speed pump, which sells at about 2.5x the price of the single speed pump but a percentage margin is lower or LED lights versus a regular light. That also sells at a premium price but a lower margin percent. Those are product type issues and customer issues. It's mainly some of the bigger guys in the market are gaining -- growing a little faster than smaller guys.

Ryan Merkel - William Blair & Company L.L.C., Research Division

Yes. The year-over-year vendor price increase, I get. What about sequentially though, did the decline surprise you?

Manuel J. Perez De La Mesa

No. I would have thought that it would have been maybe 10 or 20 bps different but nothing significantly.

Ryan Merkel - William Blair & Company L.L.C., Research Division

Okay. And then last one for me, I'll turn it over. Just given the upcoming dividend tax change at the end of the year, are you considering a special dividend? One of your peers did something recently. I'm just curious what you're thinking there.

Manuel J. Perez De La Mesa

Ryan, you ask very good questions. Dividends and that type of discussion is really something that's done at the Board level. And we're having a meeting with the Board in November and I am pretty positive it's going to come up. But I think it's a little premature, and in fact, I think, the other distributor did something, may have been a little bit premature, given the unknown outcome in a couple of weeks.

Operator

And the next question comes from Anthony Lebiedzinski of Sidoti & Company.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

A couple of questions. First, just looking at the gross margin, could you perhaps quantify what the impact was from just the competitive pricing pressures and the mix shift to some of these product categories that you just talked about?

Manuel J. Perez De La Mesa

Sure. Let me back up, Anthony, and give you the perspective that we believe that roughly half of the difference, right? And this is more art than science, although there is some science underneath it because we have all the mixes and everything else, but there's also geography that plays into it as well, different margin in different markets. But when you look at -- when it's all said and done, we believe that roughly half of that, of the shortfall year-on-year is due directly to the price increase benefits that we got last year that we did not get this year, are buying into those price increases. Okay? Last year, so that's about half the delta. The other half is the rest. And I would say the rest as product mix, customer mix and in a number of cases, a little bit more accentuated competitive pressures than perhaps in a normal year. So those are the -- and that competitive pressure is heavily weighted towards chemicals by the way. So those are the 3 pieces and it's hard to pin a number down but I'd say that those are 3 reasonably comparable type rationales or reasons for that -- the rest of the shortfall.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Okay. That is helpful. And where is your private label product penetration nowadays?

Manuel J. Perez De La Mesa

Last year, we finished between private label and exclusive products representing 25% of our gross profits in our U.S. business. We expect that to be a little higher when we tabulate the numbers for 2012 and that will continue to grow as time goes on.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Okay. And just looking at the maintenance piece of the business, could you perhaps quantify what your base business sales growth was in your maintenance or just overall nondiscretionary product area?

Manuel J. Perez De La Mesa

Sure. That would really follow very closely to our Retail customer segment. I mean that also would include the Service segment. But in the Retail segment, we're up 4.7% year-to-date through September. So I would say that it'd be very similar to that overall in terms of our sales to the maintenance and repair component of the business, close to 5%. And that would be where the industry is in that sector doing, probably, something in the neighborhood of 2%.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Okay. And lastly, do you expect any other service center additions this year and what's your outlook for 2013?

Manuel J. Perez De La Mesa

Yes. Not for so much for 2012, we're hoping something it will be like -- practically speaking, it won't matter in this year. Typically, we try to get those open before the preceding season, so they will be more targeted for first quarter opening. And we do have a few, let's say, at this juncture, 4, 5 sale centers, small sale centers that we're looking at opening for the 2013 season.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

And are they mostly in the existing markets or newer markets?

Manuel J. Perez De La Mesa

Oh, they would be more weighted towards existing markets where we are basically opening up satellite centers to get closer to the service and maintenance trade that perhaps we don't serve as well as we could because of just sheer traffic.

Anthony C. Lebiedzinski - Sidoti & Company, LLC

Got it. So you want to be more convenient to customers basically?

Manuel J. Perez De La Mesa

Exactly, right.

Operator

[Operator Instructions] And we do have a follow-up question from David McGregor of Longbow Research.

David S. MacGregor - Longbow Research LLC

I wonder if you could just talk a little bit about your expectations around housing sector recovery here? And my understanding was kind of the attachment rate was always maybe 10% to 15% from new pool construction with new homes. How might that change as we look at the next cycle?

Manuel J. Perez De La Mesa

Well a couple of things, David. The attachment rate, we wish it was 10% to 15%. It's nowhere near that. Most pools, most in-ground pools go in as home improvements and the attachment rate, if it's 10%, 15%, it would be single-family homes above a certain price threshold. So that's -- for perspective, that's I think it's important to note that. What we do see is a couple of factors. What we do see is 2 things: one is we see that new pool construction will lag the recovery of home values by probably 1 to 2 years. So as we have seen this year, in 2012, as anticipated by us and not just by us, but I think the general market consensus was that 2012 was going to be the turning point in terms of the housing market, in terms of valuations. As we see that happening, that is going to provide more confidence and there will be a -- we believe a 1 to 2 year lag before that increased confidence and that recovery of equity in their homes will result in meaningful increases in new pool construction. So we see that happening. New pool construction is up very marginally this year, in 2012, probably no more than 5,000 units on a national basis. But we do see that creeping up gradually over time. Frankly, we believe the bigger impact is going to be on replacement remodeling activity, as in your earlier set of questions. We believe that, that's an area that is -- first of all lower price points and there'll be greater inclination to do something there first.

David S. MacGregor - Longbow Research LLC

So how do you think about the growth potential around replacement remodeling activity then? Do you -- I mean, what do you correlate that with as you try to model it?

Manuel J. Perez De La Mesa

Well, what we've looked at there is primarily consumer confidence. Obviously, awaiting there with the housing market overall. I mean, people have to view their homes as an investment and not an expense. And then once they view that home as an investments, they'll be more willing to invest in their home whether it be in resurfacing the pool, replacing the equipment or, again, bigger leap of faith, putting in a new pool.

David S. MacGregor - Longbow Research LLC

Okay. And just to some extent, I guess, you could take a look at the install base and make some kind of an assumption about sort of life expectancy of various elements of installation and then try to model off that.

Manuel J. Perez De La Mesa

Exactly, in fact, we have that in our models.

David S. MacGregor - Longbow Research LLC

So what kind of growth do you get just from -- if all else being equal, all else being flat, what kind of growth do you get just from the replacement demand?

Manuel J. Perez De La Mesa

If you look at the numbers, we estimate that there is about close to $300 million of sales to us that we will, given our share of the marketplace, we will be able to capture or recapture in the case of replacement and remodeling activity and that will be realized over the course of the next 6 to 8 years.

Operator

[Operator Instructions] And our next question is from David Mann of Johnson Rice.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

Just a couple of questions. First of all, when you're talking about the pricing pressures you're seeing in the marketplace, how long do you think that's likely to continue? Or do you think that's just a function of sort of the strength in the market earlier this year just got people a little over-excited on their inventory buys?

Manuel J. Perez De La Mesa

First, yes. Certainly, there was some rebalancing of inventory taking place. I think the other reality, David, is what's happened over the course of time and we've been doing this for a number of years, we consistently grow share and we try to -- we do that by providing a full suite of services and solutions to help our customers grow and succeed in their business. And you, individually, are familiar with that given your knowledge of the company in terms of whether it be the technology tools or in the marketing that we do on behalf of our customers to drive traffic to them, whether it be retail store builder, remodeler or whatever, a lot of the training that we do for our customers. So we do a lot for our customers to help them grow and succeed, and that enables them, or that enables us to capture more of their business as they reward us with their business. Our competitors have, over time, chosen not to make those types of investments or at least not anywhere to the same degree as we have over the past 19 years now. So therefore, because of our investments that we've made and the value that we've created, the only tactic left in many cases is price. And therefore, as they see the market not really recovering in any significant way and they lose -- constantly losing traction, they resort to price. It's -- and therefore, that puts increasing pressure on us because while we have pricing at a premium usually, that premium can only be so much. So that's what affects us. But it's no -- I referenced it before as acts of desperation and that's what it sometimes is. And we just have to act smart as we respond to that in a case-by-case basis.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

I mean, given the way you're talking about that plus the fact that we may be seeing a continued mix related type of pressure, does that make you stand back from previous comments that you would see gross margin improvement on a longer-term basis?

Manuel J. Perez De La Mesa

Well, there is a point here. And I think that long term, we will continue to see gross margin improvements. But what I will also say -- the smarter competitors realize that reducing pricing doesn't give them anything. So that is really, I'll call it irrational behavior. So the more -- I would expect that the market on the competitive side will revert to more rational behavior and hopefully, they invest in some of the same things we've been investing in for years because that would help the whole industry, but -- and that would be better for the industry. But having said that, I think that overall, I mean, there's going to be some years of pluses and minuses, but I think the overall long-term trend is still going to be positive. And again, I've cautioned in the past that, that's going to be more like 10 to 30 bps a year in contrast to, I'd say, the 700 bps of improvement that we've realized over the past 14 years.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

Okay. A different question on the Green business. From a top line basis, it seems to be accelerating. Giving a nice EBIT contribution. Given what we're seeing out in the housing market in terms of the recovery there, especially on the new home side, how do you see those trends going into '13 in terms of the top line and EBIT contribution improvement?

Manuel J. Perez De La Mesa

Yes. I think that the irrigation space took a big hit, huge hit much more than the pool side because they're more closely aligned to new construction. And therefore, as that begins to recover or as that recovers to a more normalized levels, they will get a proportionately greater lift. So I mean, we fortunately had the maintenance repair portions of the Blue business and that was very resilient with chemicals sales, parts sales, et cetera, accessory sales growing every year through 2008, '09, '10 and '11, whatever. But that also is not going to grow at a rate much faster than the growth of the rate of the installed base. So that's the big picture. Now, the more variable pieces like irrigation and new pool construction that will kick in at a higher degree. Irrigation, because it's not necessarily a home-improvement like a pool, new pool would be, irrigation is more -- again, tied to new home construction, single home construction, so I think that will come back faster and that will be better and could very well see another high single-digit type level growth, if not greater next year.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

And is there the opportunity for similar EBIT improvement in '13?

Manuel J. Perez De La Mesa

Oh, yes, there's huge leverage. The same flow-through leverage of roughly 20% applies on the Green side as well as the Blue side.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Manny Perez for any closing remarks.

Manuel J. Perez De La Mesa

Thank you, Laura. And thank you all again for listening to our third quarter results conference call. Our next call will be on Valentine's Day, February 14, when we'll discuss our full year 2012 results.

Thank you for listening.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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