Pool Needs a Refill

I love it when a past winner falls from grace. That means I might get a shot at buying a great company for a bargain price.

I was hoping Pool Corp. (Nasdaq: POOL) might be one of those swimming situations that I could swan-dive into. Now I'd have to say I'd be setting myself up for a belly flop.

It's not because of the struggle for sales growth during the first quarter. Unless your pool is indoors, it's not being used. So 7% sales growth, with 4% comps, is pretty good during a known down quarter. It's also not because of the falling margins leading to a big drop in earnings for the quarter. The company spent more on opening new stores as well as expanding and relocating others so that they can all be ready to lead the swimming-pool industry as the summer months roll around.

Pool Corp. isn't in a weak position, either. Quite the contrary. It's a big supplier and consolidator in a fragmented industry. That bodes well for its future. I don't think that companies such as Wal-Mart (NYSE: WMT), Home Depot (NYSE: HD), Lowe's (NYSE: LOW), Target (NYSE: TGT), or Sears Holdings (Nasdaq: SHLD) are really much of a threat to Pool Corp. despite their size and reach. It's your pool; you don't necessarily want to buy strictly on price.

And let's not forget that pools are money pits requiring constant maintenance. That translates into constant streams of revenue for Pool Corp. if owners are to have their fun in the sun. (It's also a big reason that a cheapskate like me isn't ever likely to own his own pool.)

So what's keeping me from taking the plunge? Even though the stock price fell 25% off its 52-week high, it's still not cheap. In fact, I calculate that the company would need to grow its free cash flows at about 25% per year for a long time to justify the current price. Since it hasn't been able to do that in the past, how is it going to be able to do it in the future? It could happen, but I have my doubts, since sales growth would need to explode and margins would need to expand considerably.

Here's something else that makes me wonder how clean the Pool really is. Its net income has been outpacing cash flow from operations, a situation that raises earnings-quality concerns. Since this is essentially a distributor and a retailer combined, it spends lots of money on working capital. That means net income overstates the company's earning power of the company.

Pool Corp. looks tempting on many levels, but I am not diving in. In fact, I'd be more tempted to rate it an underperform in Motley Fool CAPS. At these levels, it's going to take a big, long refill of cash flow to justify its current price.

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Retail editor and Inside Value team member David Meier sees that the pool in his new neighborhood is finally done and that the parking lot is being paved. Sweet! He does not own shares in any of the companies mentioned. He is currently ranked 980 out of 27,270 investors in the Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.