Weekly Update: POOLCORP, Heritage, Leslie's, & Pool Distribution

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2. Lectra: Selling CAD / CAM Equipment

3. Home Depot Pro vs DIY Customer Behaviour

POOLCORP, Heritage, Leslie's, & Swimming Pool Distribution

In 2018, Manny Perez retired as CEO of POOLCORP (POOL) after 20 years of leading the company. Prior to joining POOL, he worked at another high-quality B2B distributor: Watsco. In fact, Manny said he left Watsco because of more favorable dynamics in the swimming pool market, namely a more fragmented supply and demand and only a 10% penetration of pools of US single-family households.

Manny clearly had great judgement as in the 20 years to FY 2018, POOL’s sales and FCF per share compounded ~12% per year and the stock has returned 22.7% per year.

The pool industry still benefits from such favorable attributes, but we believe there are three more recent developments that could define a very different competitive landscape today.

We interviewed a Former POOLCORP executive with over 30 years experience in the swimming pool industry to explore potential competitive threats to POOL.

Succession planning for long standing CEOs is always difficult, especially for relationship-based service businesses like pool distribution. Although Peter Arvan, POOL’s current CEO, was hired and trained by Manny, it seems his management style is slightly different:

Peter Arvan is a different CEO from Manny Perez. Everything is more metrically-driven and he wants people of like mind versus people who know and understand the industry and all its nuances… Manny was an interesting guy who I got to know well. He had been there for 20 years until he retired, so that was his baby and not everything was black and white…It was a relationship business to him, whereas Peter Arvan is metrically-driven, so what works in Dallas should work in Syracuse and there's not a lot of conversation. - Former Regional Director at POOLCORP

As POOL continues to professionalize and focus on metrics, a PE-owned building products distributor has rolled up several well-renowned family-owned distributors to create the second largest pool distributor in the US.

We never thought, in a million years, that Bel-Aqua would sell. Their service levels are uber high; great pricing, great people. Everybody who works there loves to work there. The next thing you knew, it was three acquisitions in a row for Heritage, in the span of about five days. No one could believe it, but it makes sense. - Former Regional Director at POOLCORP

In 8 months, SRS Distribution, a company that Pete Arvan competed with in his previous role, has launched Heritage Pool Supply Group with ~90 sales centers. Although Heritage runs a fraction of the 286 POOL US pool branches, the speed at which the business has scaled is interesting. Heritage could pose the biggest direct threat POOLCORP has ever had.

The US Pool market is $10bn wholesale and $22bn at retail and POOL currently owns ~38% of the wholesale market. Over 30% of the market is purchased direct at retail and the other 35% is owned by smaller family-run distributors, those of which Heritage is rolling up.

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POOLCORP’s growth strategy focuses more on organic than inorganic growth. Before the Pinch a Penny acquisition, the company had only spent ~$365m on acquisitions in 20 years. Also, most of the acquisitions were pre-2000 as POOL was building scale. With over 400 pool and irrigation sales centers, POOL adds 8-10 greenfield sites per year to fill in gaps in the network.

This is how POOL breaks down components of revenue growth:

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A large part of POOL’s long-term growth is driven by organically growing existing and opening new sales centers. Over the last 20 years, POOL has 7x revenue whilst maintaining a very stable ~30% gross margin which highlights the superior positioning of POOL in the value chain.

Although the gross margin is stable, the driver of incremental profitability comes from increasing the absolute level of sales through the existing network. Over the last 15 years, POOL's conversion of gross profit to operating profit has increased from 30% to over 50%, highlighting the operating leverage in the business.

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POOL’s organic growth is crucial to fuel operating leverage. The speed and manner in which Heritage has rolled up quality assets is a potential headwind to POOL’s long-term organic growth:

When I worked for POOLCORP, there were many dealers who didn't want to buy from us because we were the 800-pound gorilla in the room, were publicly held and had a reputation as being a bully to our vendors. Now if they have a solid choice in an equally sized distributor, I assume many of them would prefer to stay with an independent distributor like the Heritage Group is, as opposed to put all their eggs in one basket with POOLCORP. As we saw a lot of scale back in our Atlantic City show, Heritage had a giant party with a Grammy winning country artist. - Former Regional Director at POOLCORP

PE-backed Heritage is attracting quality distributors by allowing them to maintain their culture and operating systems, the opposite approach of POOL:

Many dealers like it that Heritage allows them to keep their independents so the faces, names, operating systems and credit policies don't change. In our dealer's minds, they are still dealing with that mom-and-pop distributor, and the people that ran it are still in the same place, but it allows these independents to be part of something bigger and better than themselves with much more capital behind them. Now they can develop their own deeper marketing programs and offer dealers discounts or rebates. That will challenge POOLCORP's market dominance. - Former Regional Director at POOLCORP

This is what POOLCORP CEO thinks of the threat of Heritage:

Private equity has come in, and they bought some distribution businesses. The reality is, there is no new competition. They simply bought the existing businesses that are out there. There's new ownership. There's no new capabilities. So people say, has it really changed the competitive landscape? And the answer from our perspective is, no. There's many, many, many differences between how a business like that operates and how we operate in terms of tools and resources. - CEO POOLCORP, Investor Day, 2022

Is Heritage really not a threat because PE has simply purchased existing assets in the industry?

As with all distributors, scale and sales network density matters most to offer the broadest selection as quickly and cheaply as possible. POOL’s network is 3x the size of Heritage which puts it closer to the customers than smaller distributors:

Our competitive advantage is our sales center network. We are where the pools are, and we are going where the pools are going to be. 70% of our business is done at that sales center counter. Our customers are there in that sales center doing business. They expect them to have the products. Those teams have the product knowledge. They know how to help their customers at the local level. We continue to open sales centers as we grow. And we continue to widen our competitive advantage every single day as we open those sales centers. - CFO of POOLCORP, Investor Day, 2022

POOL stocks the broadest assortment and owns the most centralized fulfillment centers which supply products more efficiently than competitors. POOL’s Preferred Vendor Program also enables it to buy deeper and earlier from vendors, which drives cost savings for customers.

These may be advantages today, but a willing acquirer with deep pockets can replicate a similar infrastructure over time. And Heritage has proven it can make headway in just 8 months.

It’s not clear exactly what tools and resources Pete is referring to in the quote above. POOL360 is the B2B platform for customers to browse and place orders that are collected in the branch. The fact that only 10% of orders are placed via POOL360 and 70%+ is transacted at the counter highlights how it could be easier to enter the pool products distribution market compared to other industrial distribution sectors.

For example, Fastenal seems much harder to displace given they are literally fulfilling orders via vending machines or onsite facilities at the customer’s plant. HVAC has a more consolidated supply side with 7 OEM’s owning 90% of the market. Watso’s relationship with Carrier is an advantage for as long as it lasts. Also, 35% of Watsco’s orders are placed online which gives the company more room to add value to customers with better technology.

Over 65% of POOL’s revenue is “non-discretionary maintenance spend”, mainly chemicals, pumps or filters. These are simple, commoditized products where convenience and price matters most. If Heritage can attract more quality distributors and offer a similar range just as close to customers, POOL’s recurring revenue could be at risk.

This also leads us to the other threat to POOLCORP: Leslie’s.

Leslie’s is the leading US pool retailer with 1,000 stores and has recently targeted over 200 PRO store openings to serve POOL’s professional customers. In 2021, PRO sales grew 44% to $210m, 15% of Leslie's total sales. Although this is under 10% of POOL’s US revenue, it suggests that Leslie's is solving a problem for professional customers that POOL isn't addressing.

This was even more interesting from Leslie’s Q1 22 call:

During our last call, I noted that we had executed more than 1,000 PRO affiliate agreements and had targeted 1,500 plus for 2022. I'm encouraged to say that as of last week, we have surpassed that target number and that our PRO affiliate partner sales doubled in the quarter. - CEO of Leslie's, Q1 22

In Q1 22, Leslie’s surpassed the 2022 annual target for Pro Partners joining the Affiliate Program. Leslie’s Affiliate Program offers wholesale pricing for a limited range and leverages its retail customer base to generate new business for PRO Partners.

Just as POOL claims the density of its sales centers is an advantage, Leslie's argues that its store density offers even greater convenience to PRO customers for commoditised chemicals, pumps, and filter products:

Our stores are where the pools are and they work at the pool. So when they need something quick, they can go on their app, go to the PRO website, see what store or something is available in, pull up in the front, get in and out very quickly. We've compared it to fast food. And that convenience proposition, there's a lot of value in that as is the referral programs. - CEO, Leslie's, Q1 2022

POOLCORP CEO recently addressed the threat of losing chemical sales to Leslie:

If I go to David's pool, and I look in his pool, and I'm like, wow, you need some algecide, and I'm out of algecide on the truck. And there is a pool retail store that is half a mile from where I'm at or a mile from where I'm at, or I could drive 4 miles or 5 miles back to SCP. I don't kid myself to think that, that, that a service tech is going to drive all the way back to SCP if all he needs is a $15 bottle of algecide. He's probably going to go in there and buy it. I get it. It's a convenience thing. But are they going to have the parts? Or they going to have the whole goods? Or they're going to have the commercial-sized chemicals? Because remember, those are not bought in consumer size quantities. They're buying a case or cases at a time. Specialty retail, it's a completely different model. - CEO, POOLCORP, Investor Day, 2022

We wonder whether offering a large product size is a durable competitive advantage. As Leslie’s converts retail to PRO stores, more commercial-sized chemicals will be closer to residential pools. This saves the contractor time compared to driving to a SCP sales center. Also, if the Pareto 80/20 rule applies, Leslie’s doesn’t need to stock too many pumps or filters to serve the contractor. At 200 PRO stores, this could begin to impact POOL's recurring maintenance revenue organic growth.

There is no doubt POOL is one of the highest quality businesses in the US over the last few decades, but the dual threat of Heritage and Leslie's potentially defines a new competitive landscape for POOLCORP.

This threat could've influenced POOL's recent acquisition of Porpoise Pool and Patio.

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Porpoise Pool and Patio acquisition is three acquisitions in one: a traditional wholesale business, a chemical manufacturing plant, and Pinch a Penny, a franchise chain with 260 retail stores.

Although this acquisition only amounts to 5% of 2021 revenue, this seems like a pivotal strategic move. POOL is now fully vertically integrated; by owning Pinch a Penny, it controls wholesale pricing from manufacturing to retail for key products. It has more bargaining power throughout the value chain and, more importantly, POOL now has control over retail assets similar to Leslie’s.

POOL will leverage its distribution network to replenish Pinch a Penny’s more efficiently and with more products. Penny’s franchise network also increases the sales channel for POOL’s high-margin private label chemical sales and the franchise fee revenue is margin accretive.

The first typical response when vertically integrating is to question how the acquisition impacts existing customers.

POOL supplies ~13,000 mainly independent retailers that compete with Pinch a Penny. Before the acquisition, we estimate the retail channel makes up ~20-25% of POOL revenue.

Why would independent retailers continue to buy wholesale products from their distributor that effectively now competes directly with them?

The other distraction would be POOLCORP's purchase of Pinch A Penny. Once that settles in, it could upset the industry in a big way because now you have true vertical integration. If I were a retailer in Florida, the last person I would want to buy from would be a POOLCORP branch because Pinch a Penny is around the corner from me, so in essence I am buying from my competitor…Talking to friends at Hayward or Pentair, they are all on pins and needles as to what to expect. They know many Pinch A Penny franchisee owners and say there might be some backlash there, and as soon as their contracts are up, they could simply go independent, which could be a big blow to the brand if that happens. - Former Regional Director, POOLCORP

It’s unclear how often these risks actually play out. It’s also the first thing investors questioned when Carvana recently acquired ADESA: will auto dealers now move inventory to Manheim?

It’s common practice for retailers to vertically integrate backwards and offer private label products that compete with suppliers. Maybe distributors integrating at the demand side is a step too far, but if the selection, pricing, and service is excellent, independent retailers have little reason to switch away from POOLCORP.

Unless Heritage can step in with a competitive offering.

The combination of Heritage, Leslie’s PRO focus, and the potential backlash from the Pinch a Penny acquisition are factors worth paying attention to.

It will be a while until we see the real impact of these three developments; pandemic-led orders have booked out contractors until mid-2023 and POOLCORP has guided to ~18% revenue growth and 15% EBIT margin in 2022. If new installations and renovations have been pulled forward and materially decline from 2023, we could see operating leverage work in the reverse and EBIT margins will normalise.

POOL is a fantastic business in a fantastic industry and we will continue to follow the company and also cover the listed OEM's and retailers going forward.