Markets & Finance

A Stock Worth Diving Into


By Markos Kaminis Thanks to a smart acquisition strategy, SCP Pool Corp. (POOL), the largest independent distributor of swimming-pool supplies and related products in the U.S., has been able to fatten its margins and gain market share in a highly fragmented industry. And it has a top-flight management team. That's why we at Standard & Poor's rank

the shares 5 STARS (buy), our highest investment recommendation. We believe the company's strategy will continue to pay off as future acquisitions help SCP Pool achieve ever-greater economies of scale.

Founded in 1981 and incorporated in 1993, SCP now distributes about 60,000 national brand and private-label products to around 38,000 customers, including pool remodelers and builders, independent retail stores, and pool-repair and -service companies. One its great strengths is that SCP doesn't rely heavily on any single customer, and none accounts for more than 1% of sales. As of February, 2002, SCP operated 173 service centers in North America and Europe, but approximately 98% of 2001 revenues were generated in the U.S.

The company's growth has been sparked by acquisitions -- it has made 12 since 1997 -- and through the net addition, less closures, of service centers, with roughly 14 established since that year. However, S&P believes SCP Pool can find additional growth opportunities.

SUNBELT GROWTH. The installed base of swimming pools has grown steadily over the past 10 years, due to demographic trends and other factors. The average age of a swimming pool owner is 45 to 50, so the industry has certainly benefited from the aging of baby boomers. In 2002, an estimated 83 million people will be members of the club of 45- to 74-year old Americans, compared to 66.8 million in 1995.

Another plus for the pool industry: The rapid growth of the Sunbelt region. SCP has a high concentration of service centers in Florida, California, Texas, and Arizona, though it faces a tougher competitive environment in those states.

A strong housing market and an increasing degree of home ownership among Americans have also helped drive pool ownership. In addition, many of the world's markets present expansion opportunities for the company. Europe, in particular resembles the U.S. market in terms of industry structure, though to a smaller degree. The European market is estimated to be approximately one-fourth the size of that of the U.S.

ECONOMIES OF SCALE. SCP competes mainly with small distributors. The top four distributors control 50% of the U.S. market, while 170 local and regional distributors control the other half. Professional retailers like Home Depot compete mainly in the sale of chemicals. But chemicals make up just 18%-20% of the company's sales -- so it only goes head-to-head with giant discounters in a modest portion of its business. SCP Pool's main customers, as measured by percentage of annual revenue: Pool remodelers and builders (40%), repair and service companies (30%), and retail pool stores (30%).

The company has gained economies of scale through its acquisitions, and that shows in its steadily improving return on capital. SCP's margins have widened substantially over time as its increasing heft gives it added leverage over suppliers and pricing strength with customers. It also has a competitive advantage over smaller players due to the greater breadth and availability of products it offers as well as a higher level of service. SCP can maintain competitive pricing and offer consistency and stability in its client relationships.

We think SCP Pool's management team is exceptional. Just take a look at the company's drastically improved returns over the years: Return on equity grew to 26.5% in 2001 from 13.1% in 1996. In the recent past, management has increased the sale of complementary products, such as pool toys, to fuel same-store growth. The company's leadership has sought to establish greater consistency of pricing across service centers.

OFF-SEASON BUYS. In addition, SCP has implemented a preferred-vendor program under which service centers are encouraged to purchase products from a smaller number of vendors to make purchasing and inventory management more efficient. The company has found better payment terms by purchasing from suppliers during the off-season, helping suppliers to smooth their income stream and strengthening those relationships, while at the same time improving SCP Pool's own margins.

Although an extended recession could weaken its operational results, much of this risk is mitigated by the fact that 60% of the company's revenue is derived from supplies necessary for the general upkeep of a swimming pool. Roughly 80% of revenue is earned from pool maintenance, repair, and equipment replacement. Just 20% of sales is related to new pool construction.

SCP reported in its fourth-quarter 2001 conference call that backlog at pool construction companies remained strong. In a higher interest rate environment, S&P would become concerned that sales into the construction market could weaken. However, interest rates are expected to remain at relatively low levels through 2002.

SNAPPY APPRECIATION. We have been impressed with SCP's operational track record. Revenues have advanced at a compound annual growth rate (CAGR) of 29% over the five-year period ended December, 2001. Earnings per share increased at a CAGR of 45% over the same five-year period, driven by a 222-basis point improvement in net margins. Operational return measures reflect these exceptional results, as return on assets improved to 11.8% in 2001, from 4.8% 1996.

And the company's share price has reflected its operational strength. SCP Pool's shares provided an average annual return of 46% over the five-year period ended December, 2001. The shares appreciated 37% in 2001, compared to a 5.7% rise in the S&P Small-Cap 600 index.

In 2002, we forecast revenue growth of 15%, driven by acquisitions and same-store expansion. Same-store sales are anticipated to rise in the mid-single digits, benefiting from recurring requirements of pool-maintenance and complementary product offerings at service centers. Gross margins should continue to widen, as leverage over pricing, supply costs, and payment terms, due to improving economies of scale, overcomes any impact from a weakened U.S. economy.

CORE HOLDING. Selling and administrative expenses are expected to decrease as a percentage of sales over time, as SCP brings the costs of less profitable acquired operations into line. The company has been able to boost its operating margins over the years, and this should continue in 2002 as it gains leverage on existing service center operations. We forecast EPS growth of 19% in 2002, to $1.58, from $1.33 in 2001.

Standard & Poor's recommends the shares as a core holding for long-term growth in diversified portfolios. Recently trading at a price-to-earnings multiple of 19 times our 2002 EPS estimate, the stock is only modestly valued vs. our forecast of 19% EPS growth in the period. Our valuation of forecasted free cash flows puts the shares' intrinsic value at approximately $35 to $37, or about 20% above recent market value. Kaminis is an equity analyst covering small-cap and emerging growth stocks for Standard & Poor's


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