Thesis
This article provides an analysis of Leslie's Inc.'s (NASDAQ:LESL) latest financial results for fiscal Q2 2023, highlighting the company's return to pre-pandemic levels in an industry where pool owners spend significant amounts on general upkeep and supplies. The article examines Leslie's approach to inflation and supply chain issues, as well as its M&A strategy for capturing more market share. While the company faces risks and headwinds, the article concludes that Leslie's proactive pricing approach and optimism for a higher gross margin return on investment make it a stock worth holding for investors.
Q1 2023 Key Takeaways
In terms of product availability and customer behavior, Leslie's Inc.'s latest financial results reflect a return to pre-pandemic levels in an industry where general upkeep and supplies, pool owners can expect to spend $1,200 to $1,800 per year. Based on the latest conference call, the company's optimism seems backed by an expected typical purchase cycle for pool owners, with historical trends suggesting a 25-75 sales contribution ratio between the first and second half of the year. If this hold true, then the company should either achieve or exceed its full-year projection, since customers are buying based on need rather than hoarding due to supply chain issues. Also, management referenced pre-pandemic sales data from 2019, in which the first and second half sales split was that 25% to 75%, with EBITDA of minus seven and 107, respectively, and claim that by applying similar splits to the company's first half numbers puts them squarely inside their projection range.
Inflation
According to a Goldman Sachs report, based on last year's chlorine prices, they've increased by 58% compared to 2021. Therefore, like many other companies, Leslie's Chemicals is no stranger to inflation and has implemented a proactive pricing approach to combat it by testing and increasing prices as needed, which seems to be working. According to management, during the first half of the year, the firm effectively boosted pricing in their Chemical sector, notably on the residential side. Adding more color to this issue, CFO Steve Weddell noted:
Based on the omnichannel approach, we've got more consistent pricing. Pricing will deviate when we go on promotion, but it's typically more consistent across the country. We've been very proactive, raising prices, testing into prices. But one of the comments we made back in November as well, was that our expectation was that prices would increase. But if they don't, we've got the ability to compete, and that's what we're doing. So taking a very tactical approach as you say, market by market to ensure that we are not where price leaders on the way up, not on the way down, but making sure that we remain competitive in the markets in which we operate.
Trichlor
Overall, Leslie's has managed to maintain a consistent margin for Trichlor and is likely to maintain price uniformity throughout the country in spite of a range of factors that has led to tight supplies, including the rise in demand in the pool industry, temporarily reduced supply, and a notable chemical plant fire in 2022. However, although they hope to keep prices stable, the company did seem to hint at raising its prices as the pool season begins to march towards seasonal peak, so with higher pricing, it may result in better profitability.
Leslie's also anticipates that PRO Trichlor price would rise owing to increased expenses, but that pricing will stabilize over the season. Based on last year's prices, a 35-pound bucket of trichlor tablets, which is typically enough to last the average owner of a midsize pool an entire summer, cost $199 at Leslie's Inc.'s pool-products stores before any promotions, up from $149 in 2021 and $99 in 2020. All in all, despite inflation and supply chain issues, Leslie's has maintained high inventory levels, and to paraphrase management, this was done to control its own "destiny" and assure enough supply to satisfy demand which seems like a fair strategy in an environment where high inflation rates encourage companies to keep a high level of inventory, thus utilizing the Mundell-Tobin effect. In other words, according to Saylor Academy's Principle of Finance:
If inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Therefore, high inflation encourages companies [like Leslie's] to keep a high level of inventories.
Additionally, with the adoption of new inventory and merchandise financial planning tools to help with procurement, buying, and analytics at both the category and SKU levels, the company is optimistic for a higher gross margin return on investment which will be welcome in light of a gross margin rate that was down 410 basis points. Specifically, the company reported:
In total, 210 basis points of our gross margin decline was related to deleverage of fixed costs resulting from our comp sales decline. Adjusted EBITDA for the quarter was negative $8 million and adjusted diluted earnings per share were negative $0.14.
M&A
According to management, with over 900 retail stores in 35 states Leslie's continues to concentrate on capturing more market share which has been a significant growth driver, and the firm has continuously shown its capacity to do so via its M&A strategy, accounting for $14 million in non-comp sales.
Although poor weather and a return to a historically regular seasonal rhythm reduced Leslie's revenue by 12% in the first half of the year, the company's pool opening schedule for the second half is up by 48%, showing a reversal in consumer purchasing habits. Management noted that they're optimistic about this side of the business and expect to regain the majority of lost revenues (down 36% versus the prior year) in the second half of the year.
And finally, sales of high-ticket durable products such as hot tubs and above-ground pools fell 11% in the first half of the year; however, the business expects sales to rebound in the second half as financing rates fall.
Risks and Headwinds
Firstly, the decline in sales of above-ground pools and hot tubs, as well as smaller chemical sizes like Trichlor, has led to a concerning 8% drop in average order basket. This, combined with potential weather-related challenges and changing consumer preferences, could make it difficult for Leslie's to maintain consistent performance.
Moreover, Leslie's Chemicals has seen their product margins deteriorate from Q1 to Q2 due to increased product costs, and this trend is likely to continue throughout the year. It's my assessment that the company's attempts to raise prices while maintaining market competitiveness may result in further margin erosion. This delicate balancing act could become even more difficult as the pool season progresses, with potential impacts on the company's bottom line.
Although the company is optimistic about inflation, their proverbial crystal ball is as good as mine. Therefore, the uncertainty surrounding the extent of inflation and the efficacy of the company's new inventory systems could further exacerbate these issues, leading to potentially higher inventory carrying costs and lower inventory turnover.
Leslie's growth strategy also raises some doubt. Their heavy reliance on mergers and acquisitions (M&A) to drive market share gains raises questions of its long-term sustainability, especially as economic downturns, like we appear to be heading for, could pose serious difficulties that could erode sales and market share.
And finally, the higher inventory levels and uncertainty surrounding Trichlor prices add to my concerns surrounding Leslie's financial health. Should the company fail to utilize its sizable inventory balance effectively or experience a downward revision in pricing, it could face additional financial pressures.
Takeaway
My final take is that despite facing inflation and supply chain challenges, Leslie's, Inc.'s appears poised for better profitability as pool season approaches its peak. Therefore, with the company's proactive pricing approach and optimism for a higher gross margin return on investment, I believe that Leslie's, Inc. makes for a stock worth holding.
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