Pool's Valuations Can Only Stay Afloat For So Long

| About: Pool Corporation (POOL)
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Summary

At current valuations, Pool Corporation (POOL) is priced like a company expected to see significant profitability improvements on a sustained basis.

However, POOL’s business is cyclical, currently at cyclical peaks, and markets are expecting ROA' to reach and sustain, levels never before seen.

Even in a Retail industry that is expensive in aggregate, POOL stands out as significantly overpriced compared to peers.

Given such high expectations, the firm could see substantial downside should they see any hiccups in execution, or should the global macroeconomic outlook worsen.

Performance and Valuation Prime™ Chart

Pool Corporation (NASDAQ:POOL) is the largest wholesale distributor of pool supplies and equipment and other related leisure equipment, with over 300 sales centers across North and South America, Europe and Australia. Considering its end markets and global exposure, the firm has historically seen cyclical profitability, with peaks and troughs occurring in line with trends in the economy, with greater discretionary spend in boom years leading to greater profits, and recessions leading to reduced spend for leisure-related purchases.

Coming out of the internet bubble in the late 90s, POOL saw UAFRS Adjusted ROA (ROA') fade from 20%+ levels to 17% in 2002, before seeing it rebound to 19-22% levels from 2003 through 2006. However, this recovery was somewhat short-lived, and starting in 2007, as the world entered the Great Recession, and any companies exposed to homes, as a pool supply company is, suffered, ROA' began fading and would eventually reach just 11% in 2009. Since then, profitability has slowly, but consistently recovered, reaching 18% in 2015, representing the low end of cyclical highs.

Meanwhile, the firm has significantly slowed growth in its Uniform Adjusted Asset (Asset') base lately, with growth pre-recession ranging from 8% to 49%, but only ranging from -4% to 6% since 2008, as the firm has managed its Assets' to improve profitability.

For context, the PVP chart below reflects the real, economic performance and valuation measures of POOL Corporation after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.

POOL Performance & Valuation Prime

The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

Performance Drivers - Sales, Margins and Turns

It can be helpful to break down ROA' into its DuPont formula parts, Adjusted Earnings Margin (Earnings' Margin) and Adjusted Asset Turnover (Asset' Turns), which are the cleaned up margins and turns metrics used to calculate ROA'. The chart below details both Earnings' Margin and Asset' Turns historically, to help us better understand the drivers of the firm's profitability and performance.

POOL Sales, Margins & Turns

Cyclicality in ROA' has been driven by cyclical trends in both Earnings' Margins and Asset' Turns. Earnings' Margins improved from 5% in 2000 to 6% in 2005, before bottoming at 4% in 2009. Since then, Margins have recovered back to previous cycle highs of 6%. Meanwhile, Asset' Turns faded from peak 3.9x levels in 2000 to just 2.5x in 2009, and have similarly recovered, but not back to previous highs, reaching 3.0x in 2012 where they have remained since.

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.

POOL is currently trading at a 33.1x V/E', which is historically high. At these levels, the market is pricing in expectations for ROA' to expand well past previous cyclical highs, to 36%, accompanied by Asset' growth of 3%, in line with levels seen since 2008.

However, analysts have much more modest expectations than the market, projecting ROA' to remain around cycle-average 17% levels, with 10% Asset' growth in 2016.

Peer Analysis

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. To this end we have included a scatter chart below, that plots POOL against its peers in the retail space based on their Adjusted Value-to-Assets ratio (V/A') and ROA'.

Looking across industries, markets, and time, there has been a very strong relationship between a company's ROA' relative to the corporate average (6%) ROA', and the multiple the market will pay above the value of the company's adjusted Asset' base, in terms of Adjusted Enterprise Value relative to Assets (V/A' or Value to Assets'). A company that generates a 6% ROA' will tend to trade at a 1.0x V/A', and company that generates an 18% ROA' will trade at a 3.0x V/A', etc. However, as outlined in our recent Seeking Alpha article on the Retail Industry, nearly every one of POOL's peers looks expensive.

Retail Quality to Valuation Scatter

Nonetheless, even in an industry full of overvalued names, POOL stands out as aggressively priced relative to its potential profitability. At a 6.1x UAFRS-based P/B (V/A'), not a single company with a similar market cap in the US Retail industry has a richer valuation than POOL with only QVCA and FIVE valued at a greater than 4.0x V/A'.

Moreover, the firm is not generating an ROA' significantly greater than peers, with nearly half generating an ROA' of 10%+, and POOL only expected to generate an ROA' of 17% in 2016. Lastly, this rich valuation may be warranted if POOL were expected to generate significant Asset' growth compared to peers, but with an average annual Asset' growth rate of sub-2% since 2008, this is unlikely to be the case as well.

Valuation Matrix - ROA' and Asset' Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for POOL at various levels of profitability (in terms of ROA') and growth (Asset' growth). Prices that are in excess of 10% equity upside are highlighted in black and prices representing an excess of 10% equity downside are highlighted in red.

POOL Valuation Matrix

In addition to appearing relatively overvalued compared to already expensive peers, at current valuations, the market has set the bar far too high. To justify current prices, POOL would need to start growing its Asset' base at levels not seen in over ten years, while also maintaining ROA' at the higher end of cyclical averages, or the firm would need to drive ROA' to levels 1.5x greater than any prior cyclical peaks. Given management's historical inability to reach 30%+ ROA' levels, these expectations are far too aggressive. As current valuations are also at peaks, with both V/E' and V/A' at historically high levels, should the firm miss the market's lofty expectations, multiple compression and material equity downside may be warranted.

To find out more about Pool Corporation and how its performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

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.