2 Lesser-Known Stocks Investors Should Have on Their Radar

Financial media and even Wall Street analysts tend to favor certain companies. As a result, there are great stocks out there flying under the radar of most investors.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma focus their attention on two of these lesser-known companies: Pool Corporation (POOL 1.31%) and Spectrum Brands (SPB -0.70%). 

Tune in to find out why these overlooked consumer goods businesses might have a place in your portfolio.

A full transcript follows the video.

This video was recorded on March 6, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, March 6th, and I'm your host, Vincent Shen.

We've heard your feedback for 2018, Fools, and we're going to continue with our coverage of lesser-known sectors and companies in the consumer and retail world. Today, we have a couple of mid-cap stocks for you. Mid-cap typically includes companies with market caps between $2 billion and $10 billion.

Joining me for this discussion via Skype is senior Motley Fool contributor, Asit Sharma. Hey, Asit! Hope all is well!

Asit Sharma: All is well on this end, Vince, except that I heard we had another two weeks of cold weather in Raleigh, North Carolina. So I'm particularly excited to be talking about the first of these two companies today.

Shen: I will ask, with some of the crazy weather recently, did you guys get hit by a lot of wind the past week?

Sharma: Yeah, I had to struggle to keep my toupee on about a week ago.

Shen: [laughs] Alright. Both of the companies you pitched to me, Asit, I'm really glad that you brought them onto our radar. The first one is Pool Corporation, ticker POOL, very fitting. Let's jump right into it. What is Pool, and how did they end up on your radar?

Sharma: I run screens, Vince, as I'm sure you do and many of our listeners do. You can find screening software on Yahoo Finance or Google Finance. I like to look at companies that have a quiet but steady trend upward. And I was doing screen filtering for mid-cap stocks. You gave the definition at the beginning of the podcast, those typically have market capitalizations between $2 billion and $10 billion. And this one popped up. I wasn't very familiar with Pool Corporation, although I know it to be a steadily growing business, and I like those businesses which, over time, inch up, because that takes some of the volatility out of your investment.

I'll jump right in and talk a little bit about Pool. It was incorporated in 1993 and had an IPO in October in 1995. This is a company which has a market capitalization of about $6 billion, and $2.8 billion in annual sales. It's the world's largest distributor of swimming pool supplies, equipment, and related leisure projects. It claims to be one of the three largest distributors of irrigation products in the United States. 

This is an interesting industry, because it's very fragmented. There are a ton of manufacturers who make everything from chemicals to keep your pool clean to repair substrates, when you have to gum over the tiles in swimming pools. This company has 351 sales centers across North America, Europe, South America, and Australia, to which it sells its products to very small companies. These are everything from mom and pop pool repair shops to retail supply stores. So it has come into an industry with no real solid competitor just because, from what I've been speaking about, it's extremely fragmented. All in all, an extremely interesting under the radar company.

Shen: Yeah. I'll say, both of the companies that we're going to talk about today don't get nearly as much attention. This includes through Motley Fool coverage but also across Wall Street and the investment community, in terms of, for example, the number of research analysts covering these companies. It's always nice to bring companies like this flying under the radar to the attention of our listeners. 

What you mentioned, in terms of the fragmented space, is really important here. Pool definitely enjoys some major scale and network effect benefits as the biggest player in the space. With their suppliers, for example, they can place the biggest orders. Their customers, which are mostly small businesses, they have 100,000 retail and commercial customers in total, these customers can turn to Pool as essentially their one-stop-shop for a lot of different products to fill their own inventory, which has been very beneficial for this company. 

Adding some more detail to that with these numbers, they sell 180,000 products across 500 products lines and 50 product categories. Just to note, the biggest one of those is pool and spa chemicals, with about 12% of the company's revenue in 2017. Then, the large, large majority, 98% of their customers, are these really small businesses, and we really have an 800-pound gorilla for this industry here.

Breaking down a little bit more in terms of their business and their revenue, Pool has a very seasonal business, as you can imagine. Their peak activity is from April through September. Something that's really important to note here is, though you might think of pools as being generally a luxury, discretionary thing that consumers have access to that they'll spend money on, adding it to their homes. A significant portion of the revenue for the company is tied to routine maintenance and repairs, which are much more stable and dependable. With 60% or so of customer spending tied to maintenance and repairs, that's much more non-discretionary. 

You can kind of see this come through during the Great Recession. This company, like many across the entire economy, took a hit. But you'll see that their maintenance and repair revenue rose to about 70% of their sales during that period. So again, still some consistency there. Then, another 25% of their top line comes from replacement and refurbishment. This is helped, because the overall age of installed pools in this country, they're aging, so they need more replacement, they need more repairs and refurbishment, which is definitely another benefit for the company. Then, the remaining 15% of revenue for Pool comes from construction. 

Keep in mind, only a small base, only about 11% of the 80 million homes in the U.S. that can house a pool, have one. So there's an opportunity there. We'll also speak to how the current construction and installation of new pools is at lower levels compared to historic levels. Let's get a little bit more into some of their customer relationships, also the management team and the progress they're making. What kind of things have stood out to you, Asit?

Sharma: I wanted to expand a little bit on the statistics that you just grabbed, because it talks about the opportunity that Pool has going forward. The Great Recession, which Vince mentioned, in 2008 and 2009, really hit this industry hard, as you might imagine. The company has rebounded with the industry, but since 2008 and 2009, management says that new pool construction is still only at 50% of pre-recession levels. They see a lot of growth opportunity. Most of the industries that we cover have rebounded, and the recession is in the rearview mirror. But it's still very much in the front of companies which do the infrastructure for pools. 

Now, I'm taken by this statistic. I don't personally own a pool, but we had one when I was growing up. I was so surprised to find what Vince mentioned, that only 15% of consumer spending is on new pool construction. But if you own a pool, or ever owned one, you know that the real money comes in buying those chemicals and doing the repairs. Then, there's landscaping, which is another side revenue business that this company has. 

If you look at where the highest concentrations of swimming pools are in the U.S., these are also some of the fastest growing economic areas -- 94% of this company's sales are in the U.S., and that breaks down to 50% of sales in four states. And I don't think this will surprise anyone listening today. Those states are: California, Florida, Texas, and Arizona. If you think about the metropolitan areas in each of those states, these are among the fastest-growing metros in the U.S. And it's a great place if you're in an industry which is growing, to be able to be concentrated in these markets. 

I talked about 95% being a concentration of revenue in North America. I'm also enthused by the fact that the global market, if the U.S. is growing at 2% to 4%, the global market is growing at an estimated compounded annual growth rate of over 10%. As developing economies in the world are starting to accelerate, there's a lot of consumer income splashing around, as we talk about often on the show, in places like Europe but especially Latin America and Asia. There's a wide ramp of revenue for a company like Pool, which has learned the gig of providing pool supplies and equipment here in the U.S., to translate that into some of these other continents. These are the things that really get me excited over the long term about this company.

Shen: I'll also note, it's really important what you mentioned, how the demand for the new pool installations is down 50% from historical levels, I believe something like 65% from their peak levels previously before the recession, so really significant there. That's why I think it's really important with this company, generating a lot of their revenue from that more non-discretionary routine repairs. But then, the side business in terms of their irrigation business, the landscaping that they do, is going to be a little more closely tied to new home construction. And there's that opportunity there as more people decide to, for example, move to warmer states, with retirees and things along those lines, if they choose to install new pools, that's definitely an area of potential growth for them.

I just want to note, too, on the management side, the CEO, Manuel Perez de la Mesa, he's held that position since 2001. Very stable leadership here at the company. Management has done a good job at consistently expanding their operating and net income margins. The online channel, another opportunity, represents just 5% of industry sales. With some of those improved margins, the inventory turnover for the company, I think the business is pretty well executed and run.

And going more into the growth initiatives, you've mentioned a few of those, Asit, something else that they talked about a lot in some recent presentations and investor calls is their private label. The company is relying on what they call private label and exclusive product offerings, or PLEX. These improve profitability, since PLEX products, these private label products, offer about 7.4 percentage point stronger margins than the OEM non-private label products. The company thinks, at some point, that they could hit, in terms of a long-term goal, think 10 to 15 years in the future, about 40% of their revenue, the products that they sell, could be in this category, so increasing their profitability and their margins over time. 

Then, something else that they've mentioned in terms of another opportunity is the commercial market. Pool has a much smaller presence here and market share, less than 10%. An interesting number that they touted in an investor presentation is that there's 65 billion gallons of treatable water in this part of the industry, the commercial side. Keep in mind again that the largest product category for them is the pool and spa chemical treatments. For the U.S., the market amounts to about, I believe, $1.5 billion in new construction, renovation, and maintenance on the commercial side. There's been 18% five-year compound annual growth for this market, so another area that the company is focused on, moving in to seize an opportunity there.

Final topic before we roll onto our next company, of course, to talk a little bit about their stock performance and valuation. Can you take it from there, Asit?

Sharma: Absolutely. This company has returned to investors 231%, that's total return, over the last five years. And those are great numbers. In doing so, it's pushed the forward P/E ratio up. And on the show, I often talk about two different measures for this industry, distributors, I think forward P/E or price to earnings ratio is a good gauge, and we can compare that to the broader market sector.

This company now trades at a forward P/E ratio of about 27x. It's 27x forward earnings versus the consumer discretionary sub-sector of the S&P 500, which is currently trading around an aggregate of 21x forward earnings. The little wrinkle in there is, as Vince mentioned, although this is a consumer discretionary stock, it has such a built-in revenue stream from that recurring maintenance need. Vince thinks of this sort of as a consumer staples stock, I think, and he's right to do so.

Shen: Yep.

Sharma: It trades at a premium to this market, but if you look at the revenue potential, it's probably justified. Pool has returned 9% revenue growth and 13% net profit growth between the 2015 and 2016 period. And in the last year, the company exhibited 8% revenue growth and 28% net profit growth. Those are great numbers. It has a net profit margin of around 7%, which for a distribution company, that's pretty solid. Typically, you see those a few percentage points lower. So you're paying for growth, and you're paying for the prospect of improved profitability in those areas that Vince mentioned, the ability to go to private label, to branch out into irrigation. So I don't think this is an overvalued stock. It's probably fairly valued. If you're looking to get into this, do your research, of course, don't just take our word for it. But maybe take a gradual entry point in 2018. I like this company a lot.

Shen: I'll just add to that, given that this stock has pretty handily outperformed the broad market, the S&P 500, over one, five, and 10-year timeframes, it's up 11% just year to date. This can be considered by some people as more of a mundane industry, not quite as flashy as some of the other companies we talk about, other sectors. But given the way they've been growing their earnings, as you mentioned, Asit, and the five-year forecast for their bottom line growth is about 17% per year, quite robust, I think that helps justify a little bit of that premium on the P/E valuation, as you mentioned. 

The company cites a few long-term trends that they think will be a tailwind for their business. I want to talk about a few of those before we wrap up here. For example, one I mentioned a little earlier about the retirees, baby boomers are moving south to warmer climates for retirement. That often means more pools being built, and also more maintenance and upkeep. For example, 10,000 Americans are estimated to enter retirement every day at the moment. In 2016, which is the latest data I could find, 600,000 Americans moved from the Northeast and Midwest regions farther south. Some of those major retirement centers in South Carolina and Florida saw the most growth among all metro areas in the country. Pretty compelling story there. Also, in general, homeowners are spending more on their outdoor spaces, whether that's for leisure or for relaxation overall. Again, this can speak to that 50% deficit right now in terms of where installations are across the country. 

The last thing, and management spoke to this a little bit, too, is the kind of products that are selling really well with consumers when they have their pools built, when they're maintaining them. It's different now, because consumers often want more automation, they want higher tech for their filters, their heating, their robotic vacuums and filters. And these things all often raise demand for other pool products and often command better prices, and that can benefit the small businesses that supply them, and then in this case, Pool, who supplies those businesses. 

The company has repurchased about $650 million worth of shares in the past five years. They pay a consistent dividend, the payout ratio is very reasonable, like 30%. Given that yield, the stock buybacks, the stable portion of their revenue, which is a pretty significant part of the top line, and then also the very dominant market position in a very fragmented industry, if you believe in some of those long-term tailwinds I just mentioned and some of the opportunities that we've talked about so far, I think this is a pretty compelling story. I agree with you, Asit. Next up, we'll turn our attention to the consumer products conglomerate, Spectrum Brands. 

Our next company is Spectrum Brands Holdings, ticker SPB. We're going to spend some time looking at this mid-cap stock. The company has announced a flurry of deals and major changes to its business just in 2018, the past couple of months. Before we dive into all that stuff, though, Asit, can you give us a quick overview of this business, what they're known for?

Sharma: Absolutely. Spectrum Brands mirrors some of the larger conglomerates that we talk about. It has its fingers in a number of different businesses. It has a market cap of nearly $6 billion. It's organized into five major segments. These are: global batteries and appliances, hardware and home improvement, global pet supplies, home and garden, and global auto care. 

Now, we're going to put global batteries and appliances to the side, although we're going to talk about that a lot in this segment. This is now a discontinued operation, because the company has announced the sale of this business to Energizer Holdings for $2 billion in cash.

Within this segment that it sold, global batteries and appliances, it has a number of appliance brands which it's now looking to sell to a number of other buyers which have not been disclosed. These brands on the appliance side within this one segment include George Foreman, Black & Decker, Juiceman, and Breadman. I want to say, sell everything but the George Foreman brand. George Foreman can sell anything. He can sell anything for Spectrum Brand Holdings. In this next phase, they're looking to get rid of the appliance brands within this segment that they call global batteries and appliances.

I know that's a lot to absorb. I'm going to repeat these segments again so we'll have a handle on them: global batteries and appliances, of which the batteries has just been announced to have been sold, hardware and home improvement, global pet supplies, home and garden, and global auto care. Now, I'd like to briefly talk about some of the brands that are in the other segments.

Shen: Please do.

Sharma: These are great staple brands. These include the Kwikset lock business; Pfister, which is in the home segment; Tetra fish products, which many of you will remember from when you were growing up, buying those products; the Dingo pet brands; Spectracide and Black Flag in home and garden; and Armor All and STP in the auto business. These are some really strong household names, very well-known labels that can be exploited, and they have higher margins than the business that's just being sold, the battery business. I'll flip it back to you, Vince. That's a brief overview of this company.

Shen: Battery business is going to Energizer for about $2 billion. There isn't a final buyer yet for the appliances business, but they say they're currently in talks with potential buyers doing some of their due diligence and in discussions for that. They expect proceeds from the sale of that business to be about $1.5 billion to $1.7 billion, so total proceeds from these divestments: over $3.5 billion. These are on top of three years of exits that the company has made from other smaller businesses that accounted for about $100 million of sales, so much smaller, but this is a climactic effort in terms of an ongoing multi-year strategic change. 

On top of that, as if that wasn't enough, this huge restructuring for this company, Spectrum Brands is also combining with HRG Group (NYSE: HRG). That's a holding company that controls about a 60% ownership stake in Spectrum Brands. Spectrum is going to be merging with HRG Group. The way they position it and explain it to investors, it's better governance, broadened the base of holders for the stock, which they generally see as a beneficial move for the company.

But if we focus in terms of the business itself and some of management's priorities -- they're getting all this money, $3.5 billion or so, from these sales. They've noted that they want to use the proceeds to reduce their debt, repurchase shares, and also look into acquisitions that will help them expand their remaining business segments, the ones that you mentioned, Asit. The way the CEO described it, he said more channels, more categories, and more countries. So wanting to expand into new geographic areas. The focus, of course, here, getting rid of those two other segments, is to focus on the more profitable ones and seeing what kind of opportunities they can find there. After the sale of the battery business and I believe the appliances business, North America will make up about 85% of sales for the company, so you can understand why they see those new geographic areas, those countries, being somewhere they can expand to a little bit more. 

Going forward, it seems like management is going to have a much larger risk appetite to pursue higher growth and higher-margin businesses. With the divestments, the company's EBITDA margin should improve pretty significantly, I believe going from 17% in fiscal 2017 to 21% in 2018, according to analyst estimates. More on the financials side, cash flow in the year after the various restructuring will remain pretty consistent at about $630 million. The two metrics that management really seems to focus on based on the calls I was reading and the presentations they give are their adjusted EBITDA and their free cash flow figures. 

We'll talk a little bit more about their stock trading valuation, as well, and some other opportunities they're looking into. What else has jumped out to you in terms of the stock and this story, Asit?

Sharma: This story isn't quite as rosy, to date, as the Pool Corporation story. The stock has given a decent return to investors. Over the past five years, it's returned exactly 100%. That's not a bad return. However, it's seeing some of the same challenges that its larger peers are experiencing. The strategy that this management team is taking, vis-à-vis the more aggressive risk profile, is a combination of what we've discussed on the show, two of our favorite companies to talk about, Procter & Gamble and Unilever. It's taken strategies from both of their playbooks. Procter & Gamble sold its own Duracell battery business to Warren Buffett's Berkshire Hathaway in 2016. Nobody wants to be in this battery business. It's a low-margin business. In fact, batteries dragged down the operating margin of this segment to 11%, while other segments, such as the home segment, generate operating margins of 22% for Spectrum Brand Holdings. So it's getting rid of a low-margin business, taking that money that's been set, and it's going to buy some faster-growing businesses in more promising sectors. 

First item of business, of course, is to take care of that debt, as Vince mentioned. It's a little highly leveraged. It has a debt to EBITDA multiple of about 5x, which is a bit high. That'll come down after it gets this infusion of cash. Looking at Unilever, what Unilever has done, which we've talked about on the show, they've been very aggressive in buying up small companies in what it deems to be promising sectors. Like P&G, divest the stuff that isn't making money, and like Unilever, spend that cash for bolt-on acquisitions in the areas like home improvement and pet care, and perhaps even some more of these products such as the Black Flag and the auto Armor All, STP, that we talked about. The company wants to leverage its financial structure after it pays down debt, we've seen this before with consumer goods companies. 

The bottom line is, like its larger competitors, so far, Spectrum Brands, if you look at their most recent quarter, has 2% organic revenue growth. It's just in line with that bigger sector. But it's a smaller, tinier company than a company like Unilever. So the path to growth is a lot smoother if they buy the right businesses. That's the magic. It's not just going out and spending when you're flush with cash. It's identifying the ones which are a good fit for your business and your management team.

I think it's at sort of an inflection point here. Although that stock chart doesn't look quite as attractive as Pool Corporation, I think going forward, they have the tools to spark some revenue growth and some operating income growth, which may lead to a higher valuation, which I'll talk about in just a second. What are your thoughts on the strategy and valuation, Vince?

Shen: I'll just add a little bit of detail about some of the things you said. For example, on that debt side, 5x, I agree, that's definitely higher than where management wants to be. They have over $4 billion of debt on their balance sheet. But management has also said they're not going to dedicate too much of the proceeds that they're getting from the sales of their appliances and batteries business to reduce that level. They're thinking something in a range of maybe 3.5x to 4x, something more sustainable. Then, the bolt-on acquisitions, definitely something the company is looking at, it's something they have emphasized in their communications to the investment community. 

And every company is, of course, always working on this, but they're also trying to work on better marketing and product innovation, and crossing some of the current businesses that they're in into new categories, as you mentioned. More channels, more categories, more countries. On those first two, for example, it might be expanding, in terms of their Armor All auto care business into air fresheners for the car, and for pet foods, for example, getting into mass channels and improving the distribution for these products. 

In terms of valuation, the stock has taken a beating in the past year, down 25%. Though, looking out further to about 5 to 10 years, it's managed to outperform the broad market. In terms of valuation, this is a little bit difficult because of all the changes that are going on at the company. That battery business was 40% of the top line previously. It was considered the core of Spectrum Brands, the company. If you look back five or seven years, it was by far the biggest part of the company. Now, for them to exit it, I think it surprised a lot of investors. 

The stock trades about 23x forward estimates. There's still some uncertainty in factoring how things change with that merger with HRG, too. This one was really tough on the valuation front and looking out into the future, for me to grasp everything that's going on. I don't know how you felt about it, Asit.

Sharma: Yeah, it's complex. There are a lot of moving parts and pieces. Some of the things which hit the stock in the past year included restructuring charges that the company took on some of those lower-growth businesses, as well as consolidating its footprint for its Auto business in Dayton, and also consolidating its Hardware and Home Improvement distribution in Kansas. Those were some one-time events that really pushed the stock down a little bit. But then, with this merger, that makes it a little bit more difficult to value. Although, the merger, as we said, is with their major stockholder, which already owns 60%. 

I want to point out one thing about that merger. The company which now will be the combined entity by merging, has an insurance company that they've picked up, an insurance arm. I think this will be something that gets divested in a few years. This is a $10 billion deal, as we mentioned. The insurance company is called Front Street Re, it's based in Delaware. That's owned by HRG, the majority shareholder. It's not a great fit with this combined consumer goods business. That could lead to a little bit of a bounty a few years down the road. We've seen sometimes, when we see consumer goods companies shuffle the deck and play cards and trade pieces back and forth -- that one piece that doesn't fit tends to get spun off in a few years, which rewards shareholders.

One last thing from my side to add, I do like the idea of these brand expansions. As you mentioned, Vince, they have a number of opportunities in the global side of things, and maybe employ something like Coca-Cola's model, which Coke calls "lift and shift". That's lifting a domestic brand and shifting it onto another continent. Spectrum is doing that with the Iams pet food, which is very popular in the U.S. They're lifting that and shifting it to Europe. That's just one example.

All in all, don't plunge your whole portfolio into this company. But definitely keep it on your radar screen. As I said, I think it's at an inflection point. If we see a few quarters of good performance, let these acquisitions settle, this might be a very interesting play in the mid-cap space which would grow faster than its peer competitor conglomerates that we talk about, like the P&Gs and Unilevers, which only stay 1% to 2% above the market over the long term.

Shen: Thanks, Asit! I'll just add to that in terms of, if you take a position, it's definitely a case where you have to believe in the story that management's telling regarding the new direction of the business. This decision to spin off the battery business and small appliances, and their strategy in terms of how they're going to leverage the remaining segments, those businesses, and grow them, whether that's with new channels or into the new countries with that strategy you just mentioned, Asit. Otherwise, thanks for listening, Fools! And thank you, Asit, for joining us again!

Sharma: Absolutely!

Shen: Austin Morgan is the producer for Industry Focus. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks again for listening and Fool on!