Leslie’s: Taking A Dive (NASDAQ:LESL)

In November 2020, I concluded that I was not jumping in the shares of Leslie’s (NASDAQ:LESL) as the largest US pool and spas accessories supplier went public. Amidst sky high valuations, applied across the industry, I was wary of the timing amidst a boom following the outset of the pandemic.

While the business has seen solid growth post the offering, it is not getting hampered by a decline in demand, which coincides with declining margins, higher leverage and concerns from a financial point of view.

A Recap

Founded in 1963, Leslie’s has delivered on a very impressive consecutive revenue growth in each year, growing out to become a pure play in the care of pool and spas care and accessories. The company claims to have end relationships with more than 11 million customers, having a network density reportedly 20 times larger than its second-largest peer.

With more than 14 million pools and spas installed at the time of the offering, the category is very large as the costs and need to maintain these pools is high. Besides up keeping of the pools, Leslie’s aims to aid owners to spend less time on pool and spa maintenance.

The company sells these products through nearly a 1,000 locations as well as an online business as well. With an average life span of 25 years, a pool owner quickly spends about a $1,000 per year on maintenance, needed to avoid quick degradation of water, as well as equipment replacement, creating a total market size of an estimated $11 billion in 2019.

The pandemic provided a huge boom, but not just in terms of new equipment and pool sales (as the company does not sell actual pools). The pandemic provided a boom in the sense that more people used their pools, and in a more intense way, while focusing more on outdoor living and the quality of life at large. This made that they shopped for water chemicals, equipment, parts, cleaning and water testing gear.

Amidst these trends the company has tripled sales from about $300 million in 2000 to $928 million in 2019 (on which the company posted operating profits of $122 million) with revenues comfortably seen surpassing the billion mark in 2020. In fact, at the time of the offering sales were seen at $1.11 billion.

The company sold 30 million shares at $17 per share, raising over half a billion in gross proceeds with the offering. With 187 million shares trading at those levies, the company was awarded a $3.2 billion equity valuation, for a $3.7 billion enterprise valuation once net debt was included.

With sales seen around $1.1 billion in 2020, I pegged operating earnings at around $150 million that year, as EBITDA of $180 million worked down to a 3 times leverage ratio. Assuming a 4% cost on net debt and tax rates at 20%, realistic earnings were seen at $100 million, with earnings per share seen around $0.55 per share. Based on such earnings power, in generally a boom time, the company traded at 30-31 times earnings. That was expensive enough as it was at $17 per share, as valuations increased further to 38 times as shares rose to $21 per share on the first day of trading.

Taking A Dive

After shares rose to the $30 mark in the spring of 20201, as investors were more upbeat on the prospects for the firm and a strong market performance at large, it has been all downhill from there.

By the start of 2022, shares had fallen to the $20 mark and has steadily fallen to the $10 mark in July of this year, as shares lost 30% in response to the latest quarter results, now trading at $6 and change.

In November 2022, Leslie’s posted its annual results for the year as continued growth was seen. After 2021 sales already rose to $1.34 billion, sales rose further to $1.56 billion in 2022. Operating profits rose from $209 million to $239 million, with net earnings of $159 million coming in at $0.85 per share. This was up twenty-two cents compared to the 2021 results, and are better than expected at the time of the IPO. Net debt was reported at $675 million, although that adjusted EBITDA improved to $292 million, for a leverage ratio in the lower 2s.

The company guided for 2023 sales to come in rather flattish at a midpoint of $1.60 billion, with EBITDA seen at $295 million and adjusted earnings seen at a midpoint of $0.82 per share. Needless to say, with shares trading around the $13 mark at the time, the valuation came in at a fair market multiple around 16 times earnings, albeit that no growth was seen in 2023. That reduced multiple made me contemplate taking a position in December (as evident in this article), but I concluded to hold off.

In February of this year, Leslie’s posted first quarter sales of $195 million, up 5% on the year before, although that this is seasonally a soft quarter, with the full year guidance being reaffirmed.

The bad news arrived in May, with sales of $213 million being down 7% on the year before and despite this sales decline and larger losses (in a seasonally softer quarter) the company maintained the full year guidance. Net debt shot up to $948 million, pretty much entirely due to very poor working capital management (tied to larger inventory holdings).

While the company maintained the outlook, investors voted with their feet as shares fell to the $10 mark already. The bombshell reported arrived in July, as the company reported preliminary first quarter results and announced a CFO transition. The shortfall in the guidance is huge with sales seen down by $160 million (or 10%) to a midpoint of $1.44 billion. Adjusted EBITDA is now seen at just $175 million, a $120 million reduction on the back of a $160 million shortfall in sales, with earnings seen at just $0.30 per share.

With net debt having risen to nearly a billion alongside the second quarter earnings report, the issue is that leverage ratios will effectively shoot up from just over 2 times a couple of quarters ago, to about 5-6 times with EBITDA contracting so much.

With 183 million shares outstanding, the equity valuation has fallen to $1.2 billion, for a $2.2 billion enterprise valuation.

And Now?

The reality is that I am positively surprised by the operating performance of the business since the public offering, as revenues and margins have continued to grow, although 2023 is set to mark a violent trend break, notably with margins.

Hence, leverage issues might arrive, although that this is in a big part the result of poor working capital conversion, which could be fixed if the company adjusts to the new normal and manages to normalize inventory levels. BY now it is certain that something is happening as this will be the first year since its founding in which revenues fall on an annual basis, and quite frankly financial concerns arise.

That said, if the company can stabilize the situation, the long term appeal can be seen here. I believe that the business could fetch a decent and premium market multiple as I see no reason why earnings power should not come in around a dollar per share in more normal times. That, however, requires some execution, but moreover the avoidance of dilution and financial concerns here.

In the long run, we should furthermore factor in more limited growth of the pool base, certainly amidst water becoming more scarce with regard to climate change and drought.

While the current situation is very unclear, and I fear leverage a bit, I will keep a close eye on the working capital developments in Q3 to see if leverage might be under control and it might be time to dip my toes into the shares.