POOL CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2019 Annual Report on Form 10-K. For a discussion of our base business calculations, see the Results of Operations section below. Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995 This report contains forward-looking information that involves risks and uncertainties. Our forward-looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning. No assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including impacts on our business from the COVID-19 pandemic, the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2019 Annual Report on Form 10-K and in Part II, Item 1A. of this Form 10-Q. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. OVERVIEW Impact of COVID-19 Pandemic On March 11, 2020, the World Health Organization declared the novel coronavirus disease (COVID-19) a pandemic, and on March 13, 2020, the United States declared a national emergency. States and cities have taken various measures in response to COVID-19, including mandating the closure of certain businesses and encouraging or requiring citizens to avoid large gatherings. Most of our North American operations are and have been continuously open for business as we are designated as an essential business in almost all of our markets. In Europe, our operations closed for a short period during the first half of 2020 in France, Spain and Italy, in order to comply with local authorities’ orders. Our products are used to maintain and protect outdoor commercial, residential and municipal environments through chemically-balanced, virus and bacteria-free swimming pool water. We also supply products used in the prevention of runoff, flood, fire and other natural disasters. These products are essential to the health and safety of the general public. As a result, our supply chain remains intact, with our customers continuing to meet end-user needs. The health, safety and security of our employees has been, and remains, one of our highest priorities. We have adapted our operations and implemented a number of measures to facilitate a safer sales center environment for both our customers and employees, which includes following best practices and guidelines from the Centers for Disease Control and Prevention (CDC). We implemented enhanced hygiene and sanitation practices at our sales centers and at our corporate offices. In rare instances, we have had to close facilities in whole or in part as a result of government regulations, as well as positive or presumed positive results from COVID-19 testing. The direct impact of any closures to date has not been material to our operations. 14 Beginning in the middle of March, when stay-at-home orders related to the COVID-19 pandemic were initially issued, we experienced sales declines across most markets. However, as stay-at-home restrictions eased in late April through early May, our business not only rebounded, but accelerated, resulting in net sales of $1.28 billion for the second quarter of 2020. In the third quarter of 2020, we realized net sales of $1.14 billion, as our sales continued to benefit from elevated demand for residential pool products, driven by home-centric trends influenced by the COVID-19 pandemic. As families spend more time at home, our sales have benefited from greater swimming pool demand and usage, resulting in broad sales gains across our product categories and geographies. While the short-term impact of this trend has had a positive impact on our business, it is unclear what the long-term impact will be. In addition, governmental restrictions have had a material impact on some of our customers, limiting their ability to operate in certain geographies from mid-March into mid-May. While these restrictions were lifted, new stay-at-home orders or other government mandates could have a material impact on our results. Our balance sheet remains strong with low leverage and sufficient access to additional capital. Given the seasonality of our business, our warehouses were stocked with inventory in preparation for the upcoming peak season prior to the implementation of most stay-at-home orders. As a result, the limited vendor supply interruptions experienced to date have had a minimal impact on our business. Supply disruptions have largely been limited to categories with the greatest demand, including heat-related equipment and above-ground swimming pools. We continue to work closely with our suppliers to maintain the flow of essential products to provide customers with the materials they need to serve their communities. We began taking steps in April to reduce both capital expenditures and operating costs. Specifically, we reduced expenses for labor, fuel, utilities, advertising, meetings, travel and entertainment. As our business outlook and market trends have improved since the implementation of these cost-saving measures, we continue to assess our discretionary spending. We continue to reevaluate previously deferred capital expenditures and currently expect capital expenditures in 2020 to approximate 65% of 2019 capital expenditures and range from $20.0 million to $25.0 million. The impact of the ongoing pandemic on our business and financial results will continue to vary by location and depend on numerous evolving factors that we are not able to accurately predict. These factors include the duration and scope of the pandemic, global economic conditions during and after the pandemic, governmental actions that have been taken (or may be taken in the future) in response to the pandemic and changes in customer and supplier behavior in response to the pandemic. Financial Results In the third quarter of 2020, net sales increased 27% to $1.14 billion compared to $898.5 million in the third quarter of 2019. Our sales benefited from continued elevated demand for residential pool products, driven by home-centric trends influenced by the COVID-19 pandemic, as working from home became routine and families created and enjoyed safe social and entertainment alternatives in their own backyards. We realized broad sales gains across many product categories, as maintenance, replacement, refurbishment and construction activities across most geographies were strong. Gross profit increased 27% to $328.7 million in the third quarter of 2020 from $257.9 million in the same period of 2019. Gross margin increased 20 basis points to 28.9% in the third quarter of 2020 compared to 28.7% in the third quarter of 2019, with increased purchase volumes driving improvements in supply chain management. Selling and administrative expenses (operating expenses) increased 18% to $180.5 million in the third quarter of 2020 compared to $153.4 million in the third quarter of 2019, primarily reflecting a $20.1 million increase in performance-based compensation. Excluding performance-based compensation in both periods, operating expenses increased 5% due to growth-driven freight expenses and greater facility-related costs. As a percentage of net sales, operating expenses decreased to 15.8% in the third quarter of 2020 compared to 17.1% in the same period of 2019, as we continued to realize benefits from discretionary spending controls implemented earlier in the year. Operating income in the third quarter of 2020 increased 42% to $148.2 million compared to $104.5 million in the same period in 2019. Operating margin was 13.0% in the third quarter of 2020 compared to 11.6% in the third quarter of 2019. We recorded an $8.5 million, or $0.21 per diluted share, tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting , in the quarter ended September 30, 2020, compared to a tax benefit of $4.5 million, or $0.11 per diluted share, realized in the same period of 2019. Net income increased 50% to $119.1 million in the third quarter of 2020 compared to $79.5 million in the third quarter of 2019. Earnings per share increased 50% to $2.92 per diluted share in the third quarter of 2020 compared to $1.95 in the same period of 2019. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 47% to $2.71 in the third quarter of 2020 compared to $1.84 in the third quarter of 2019. 15 References to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations. Financial Position and Liquidity As of September 30, 2020, total net receivables, including pledged receivables, increased 19% compared to September 30, 2019, driven by our September sales growth and partially offset by improved collections. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 27.6 days at September 30, 2020 and 29.0 days at September 30, 2019. Our allowance for doubtful accounts balance was $5.3 million at September 30, 2020 and $6.2 million at September 30, 2019. Net inventory levels decreased 1% compared to levels at September 30, 2019, reflecting the strong pace of sales in the third quarter of 2020. The inventory reserve was $11.4 million at September 30, 2020 and $9.9 million at September 30, 2019. Our inventory turns, as calculated on a trailing four quarters basis, were 3.7 times at September 30, 2020 and 3.2 times at September 30, 2019. Accrued expenses and other current liabilities increased 79% compared to September 30, 2019, primarily reflecting increases in accrued performance-based compensation and unrealized losses on interest rate swaps. Total debt outstanding at September 30, 2020 was $339.9 million, down 38% compared to total debt at September 30, 2019, as we have utilized our operating cash flows to decrease debt balances. We have used debt proceeds over the past 12 months primarily to fund business-driven working capital growth, acquisitions, payments of cash dividends and share repurchases. Current Trends and Outlook For a detailed discussion of trends through 2019, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2019 Annual Report on Form 10-K. Based on our results to date and expectations for the remainder of the year, we expect 2020 diluted EPS of $8.05 to $8.35, including the impact of year-to-date tax benefits of $0.55 and the $0.15 impact of non-cash impairments recorded in the first quarter of 2020. Our previous 2020 earnings guidance range disclosed in our Second Quarter 2020 Quarterly Report on Form 10-Q was $6.90 to $7.30, including year-to-date tax benefits of $0.34 and the $0.15 impact of non-cash impairments. Our 2020 earnings guidance range assumes average weather conditions and no adverse impacts from a resurgence of COVID-19 and related government responses. We expect net sales growth for 2020 to approximate 18% to 20%. The majority of our business is driven by recurring revenue streams from the installed base of pools, and we believe that underlying demand for most discretionary products, including those serving the renovation and construction markets, remains strong. In addition, we believe that our sales for the fourth quarter of 2020 will continue to benefit from delayed projects, subject to our customers’ building capacity, including the availability of labor and favorable weather. At the same time, the impact of new stay-at-home orders or government mandates, as well as unfavorable economic conditions resulting from the COVID-19 pandemic and the resurgence of COVID-19 cases in some of our markets, could adversely impact our business, including an easing of demand for products dependent on discretionary spending. We expect gross margin for the full year of 2020 to decline modestly compared to gross margin for the full year of 2019 given the decline in gross margin through the first nine months of 2020. We expect gross margin for the fourth quarter of 2020 to be relatively flat compared to the fourth quarter of 2019. We expect base business operating expenses for the remainder of the year to benefit from actions taken by management in the second quarter of 2020 to reduce costs and to vary ratably with changes in sales performance. For the year, we expect operating expenses to increase 10% to 12% compared to 2019, primarily due to increases in performance-based compensation. 16 We expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2020 will approximate 25.5%, which is consistent with 2019. Our effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded a $22.6 million, or $0.55 per diluted share, tax benefit from ASU 2016-09 for the nine months ended September 30, 2020. We may recognize additional tax benefits related to stock option exercises in 2020 from grants that expire in years after 2020. We have not included any expected benefits in our guidance beyond what we have recognized as of September 30, 2020. We expect cash provided by operations will remain strong in comparison to net income for the 2020 fiscal year. We expect to continue to use cash to fund opportunistic share repurchases over the next year. We also expect to use cash for the payment of cash dividends as and when declared by our Board of Directors (the Board). The following summarizes our current expectations for 2021: • We expect sales growth in 2021 to be impacted by the following factors and assumptions: ◦ normal weather patterns; ◦ continued elevated demand for residential pool products, driven by home-centric trends influenced by the COVID-19 pandemic; ◦ a benefit from delayed projects depending on our customers’ building capacity, including the availability of labor, and weather; ◦ estimated 2% growth in the installed base of pools; ◦ estimated 4% growth from acquisitions completed throughout 2020; and ◦ inflationary product cost increases of approximately 2% to 3% (compared to our historical average of 1% to 2%). • We expect performance-based compensation for the full year of 2021 to normalize and decrease by $15.0 million to $20.0 million compared to the full year of 2020. RESULTS OF OPERATIONS As of September 30, 2020, we conducted operations through 381 sales centers in North America, Europe and Australia. For the nine months ended September 30, 2020, approximately 94% of our net sales were from our operations in North America. The following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales: Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of sales 71.1 71.3 71.2 70.9 Gross profit 28.9 28.7 28.8 29.1 Selling and administrative expenses 15.8 17.1 16.0 17.1 Impairment of goodwill and other assets — — 0.2 — Operating income 13.0 11.6 12.6 12.1 Interest and other non-operating expenses, net 0.2 0.6 0.3 0.7 Income before income taxes and equity earnings 12.8 % 11.0 % 12.3 % 11.3 % Note: Due to rounding, percentages presented in the table above may not add to Operating income and Income before income taxes and equity earnings. We have included the results of operations from acquisitions in 2020 and 2019 in our consolidated results since the acquisition dates. 17 Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019 The following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business): (Unaudited) Base Business Excluded Total (in thousands) Three Months Ended Three Months Ended Three Months Ended September 30, September 30, September 30, 2020 2019 2020 2019 2020 2019 Net sales $ 1,133,608 $ 895,489 $ 5,621 $ 3,011 $ 1,139,229 $ 898,500 Gross profit 326,692 257,525 2,006 406 328,698 257,931 Gross margin 28.8 % 28.8 % 35.7 % 13.5 % 28.9 % 28.7 % Operating expenses 178,773 152,630 1,692 761 180,465 153,391 Expenses as a % of net sales 15.8 % 17.0 % 30.1 % 25.3 % 15.8 % 17.1 % Operating income (loss) 147,919 104,895 314 (355) 148,233 104,540 Operating margin 13.0 % 11.7 % 5.6 % (11.8) % 13.0 % 11.6 % In our calculation of base business results, we have excluded the following acquisitions for the periods identified: Acquired Acquisition Date Net Sales Centers Acquired Periods Excluded Northeastern Swimming Pool Distributors, Inc. (1) September 2020 3 September 2020 Master Tile Network LLC (1) February 2020 4 July - September 2020 (1) We acquired certain distribution assets of this company. When calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers. We generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period. The table below summarizes the changes in our sales center count during the first nine months of 2020: December 31, 2019 373 Acquired locations 7 New locations 3 Closed/consolidated locations (2) September 30, 2020 381 18 Net Sales Three Months Ended September 30, (in millions) 2020 2019 Change Net sales $ 1,139.2 $ 898.5 $ 240.7 27% Net sales and base business net sales increased 27% in the third quarter of 2020 compared to the third quarter of 2019. Our sales benefited from continued elevated demand for residential pool products, driven by home-centric trends influenced by the COVID-19 pandemic, as working from home became routine and families created and enjoyed safe social and entertainment alternatives in their own backyards. The following factors benefited our sales (listed in order of estimated magnitude): • strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as equipment, building materials and above-ground pools and spas (see discussion below); • increased demand for residential swimming pool maintenance supplies due to increased usage, as evidenced by improvements in sales growth rates to retail customers (see discussion below); • market share gains, including those in building materials (see discussion below); and • inflationary product cost increases of approximately 1% to 2%. We believe that higher sales growth rates for certain product offerings, such as equipment, building materials and above-ground pools and spas evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the third quarter of 2020, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, increased 36% compared to the same period last year. Equipment collectively represented approximately 28% of net sales for the period. Sales of building materials, including sales from recently acquired Master Tile locations, grew 29% compared to the third quarter of 2019 and represented approximately 11% of net sales in the third quarter of 2020. Sales of above-ground pools and spas increased 60% in the third quarter of 2020 compared to the third quarter of 2019 and represented approximately 2% of net sales for the period. Sales to customers who service large commercial installations and specialty retailers that sell swimming pool supplies are included in the appropriate existing product categories, and growth or decline in these areas are reflected in the numbers above. Sales to retail customers increased 28% in the third quarter of 2020 compared to the third quarter of 2019 and represented approximately 14% of our consolidated net sales for the third quarter of 2020. Sales to commercial customers declined 10% in the third quarter of 2020 compared to the third quarter of 2019, driven by COVID-19 related closures and the decline in both business and leisure travel. Sales to commercial customers represented approximately 3% of our consolidated net sales for the third quarter of 2020. Gross Profit Three Months Ended September 30, (in millions) 2020 2019 Change Gross profit $ 328.7 $ 257.9 $ 70.8 27% Gross margin 28.9 % 28.7 % Gross margin increased 20 basis points to 28.9% in the third quarter of 2020 compared to 28.7% in the third quarter of 2019, with increased purchase volumes driving improvements in supply chain management. 19 Operating Expenses Three Months Ended September 30, (in millions) 2020 2019 Change Selling and administrative expenses $ 180.5 $ 153.4 $ 27.1 18% Operating expenses as a % of net sales 15.8 % 17.1 % Operating expenses increased 18% in the third quarter of 2020 compared to the third quarter of 2019, reflecting an increase in performance-based compensation of $20.1 million in the third quarter of 2020. Excluding performance-based compensation in both periods, operating expenses increased 5% due to growth-driven freight expenses and greater facility-related costs. Interest and Other Non-Operating Expenses, Net Interest and other non-operating expenses, net for the third quarter of 2020 decreased $3.6 million compared to the third quarter of 2019. The decrease reflects lower average debt levels and lower average interest rates between periods. Our weighted average effective interest rate decreased to 1.9% for the third quarter of 2020 from 3.4% for the third quarter of 2019 on lower average outstanding debt of $331.5 million versus $568.3 million for the respective periods. Income Taxes Our effective income tax rate was 18.7% for the three months ended September 30, 2020 compared to 19.8% for the three months ended September 30, 2019. We recorded an $8.5 million tax benefit from ASU 2016-09 in the quarter ended September 30, 2020 compared to a tax benefit of $4.5 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 24.5% for the third quarter of 2020 and 24.3% for the third quarter of 2019. Our third quarter effective income tax rate is typically lower compared to other quarters due to the timing of our accounting for uncertain tax positions, including the expiration of statutes of limitations. Net Income and Earnings Per Share Net income increased 50% to $119.1 million in the third quarter of 2020 compared to the third quarter of 2019. Earnings per diluted share increased 50% to $2.92 in the third quarter of 2020 versus $1.95 per diluted share for the comparable 2019 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 in the third quarter of 2020 and $0.11 in the third quarter of 2019. Excluding tax benefits in both periods, earnings per diluted share increased 47% to $2.71 in the third quarter of 2020 compared to $1.84 in the third quarter of 2019. 20 Nine Months Ended September 30, 2020 Compared to Nine Months Ended September 30, 2019 The following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business): (Unaudited) Base Business Excluded Total (in thousands) Nine Months Ended Nine Months Ended Nine Months Ended September 30, September 30, September 30, 2020 2019 2020 2019 2020 2019 Net sales $ 3,078,463 $ 2,601,801 $ 18,899 $ 15,482 $ 3,097,362 $ 2,617,283 Gross profit 885,002 759,858 6,805 3,017 891,807 762,875 Gross margin 28.7 % 29.2 % 36.0 % 19.5 % 28.8 % 29.1 % Operating expenses (1) 495,710 443,107 6,420 4,320 502,130 447,427 Expenses as a % of net sales 16.1 % 17.0 % 34.0 % 27.9 % 16.2 % 17.1 % Operating income (loss) (1) 389,292 316,751 385 (1,303) 389,677 315,448 Operating margin 12.6 % 12.2 % 2.0 % (8.4) % 12.6 % 12.1 % (1) Base business and total include $6.9 million of impairment from goodwill and other assets recorded in the first quarter of 2020. In our calculation of base business results, we have excluded the following acquisitions for the periods identified: Acquired Acquisition Date Net Sales Centers Acquired Periods Excluded Northeastern Swimming Pool Distributors, Inc. (1) September 2020 3 September 2020 Master Tile Network LLC (1) February 2020 4 February - September 2020 W.W. Adcock, Inc. (1) January 2019 4 January - March 2020 and January - March 2019 Turf & Garden, Inc. (1) November 2018 4 January 2020 and January 2019 (1) We acquired certain distribution assets of each of these companies. For a more detailed explanation of how we calculated base business results and a summary of the changes in our sales centers since December 31, 2019, please refer to the discussion under the heading Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019. 21 Net Sales Nine Months Ended September 30, (in millions) 2020 2019 Change Net sales $ 3,097.4 $ 2,617.3 $ 480.1 18% Net sales and base business net sales for the first nine months of 2020 increased 18% compared to the same period last year. During the first quarter of 2020, sales benefited from earlier pool openings, as mild weather combined with school closures drove greater early-season residential pool usage. As stay-at-home restrictions eased in late April through early May, families continued to search for safe, at-home leisure activities, resulting in broad sales gains across our product categories and geographies. In the third quarter of 2020, our sales benefited from continued elevated demand for residential pool products, driven by home-centric trends influenced by the COVID-19 pandemic. Sales were also favorably impacted approximately 1% by an additional selling day in the first nine months of 2020. The following factors benefited our sales (listed in order of estimated magnitude): • strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as equipment, building materials and above-ground pools and spas (see discussion below); • increased demand for residential swimming pool maintenance supplies due to earlier pool openings and increased usage, as evidenced by improvements in sales growth rates to retail customers (see discussion below); • market share gains, including those in building materials (see discussion below); • inflationary product cost increases of approximately 1% to 2%. We believe that sales growth rates for certain product offerings, such as equipment, building materials and above-ground pools and spas evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first nine months of 2020, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, increased approximately 26% compared to the same period last year. Equipment collectively represented 28% of net sales in the first nine months of 2020. Sales of building materials, including sales from recently acquired Master Tile locations, grew 18% compared to the first nine months of 2019 and represented approximately 12% of net sales in the first nine months of 2020. Sales of above-ground pools and spas increased 53% in the first nine months of 2020 and represented approximately 2% of net sales in the first nine months of 2020. Sales to customers who service large commercial installations and specialty retailers that sell swimming pool supplies are included in the appropriate existing product categories, and growth or decline in these areas are reflected in the numbers above. In the first nine months of 2020, sales to retail customers increased 22% and represented approximately 14% of our consolidated net sales. Sales to commercial customers declined 10% in the first nine months of 2020, driven by COVID-19 related closures and the decline in both business and leisure travel. Sales to commercial customers represented approximately 4% of our consolidated net sales in the first nine months of 2020. Gross Profit Nine Months Ended September 30, (in millions) 2020 2019 Change Gross profit $ 891.8 $ 762.9 $ 128.9 17% Gross margin 28.8 % 29.1 % Gross margin declined 30 basis points to 28.8% compared to 29.1% in the same period last year, primarily due to sales of lower margin, big-ticket items, such as in-ground and above-ground pools and pool equipment, which comprised a larger portion of our product mix in the nine months ended September 30, 2020 compared to the first nine months of 2019. 22 Operating Expenses Nine Months Ended September 30, (in millions) 2020 2019 Change Selling and administrative expenses $ 495.2 $ 447.4 $ 47.8 11% Impairment of goodwill and other assets 6.9 — 6.9 100% Operating expenses as a % of net sales 16.2 % 17.1 % Operating expenses for the nine months ended September 30, 2020 increased 12% compared to the first nine months of 2019. In the first quarter of 2020, we recorded impairment charges of $6.9 million, which included $2.5 million from a long-term note, as collectability was impacted by the COVID-19 pandemic, and non-cash goodwill and intangibles impairment charges of $4.4 million, equal to the total goodwill and intangibles carrying amounts of our Australian reporting units. Excluding impairment charges, operating expenses were up 11%, reflecting a $32.1 million increase in performance-based compensation, in addition to growth-driven freight expenses and greater facility-related costs. Interest and Other Non-Operating Expenses, Net Interest and other non-operating expenses, net for the first nine months of 2020 decreased $9.2 million compared to the same period last year. The decrease reflects lower average debt levels and lower average interest rates between periods. Our weighted average effective interest rate decreased to 2.2% for the first nine months of 2020 from 3.5% for the same period of 2019 on average outstanding debt of $439.4 million versus $631.1 million for the respective periods. Income Taxes Our effective income tax rate was 19.2% for the nine months ended September 30, 2020 compared to 18.0% for the nine months ended September 30, 2019. We recorded a $22.6 million, or $0.55 per diluted share, tax benefit from ASU 2016-09 in the nine months ended September 30, 2020 compared to a $21.1 million, or $0.52 per diluted share, tax benefit in the same period of 2019. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.2% for the nine months ended September 30, 2020 and 25.1% for the nine months ended September 30, 2019. Net Income and Earnings Per Share Net income increased 26% to $307.6 million for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. Earnings per diluted share increased to $7.53 for the nine months ended September 30, 2020 versus $5.97 per diluted share for the nine months ended September 30, 2019. Adjusted net income for the first nine months of 2020, excluding the $6.3 million, or $0.15 per diluted share, impact of non-cash impairments, net of tax, increased 29% to $313.9 million. Excluding the impact of non-cash impairments, net of tax, and tax benefits from ASU 2016-09 in both periods, adjusted diluted EPS increased 31% to $7.13 for the nine months ended September 30, 2020 compared to $5.45 for the nine months ended September 30, 2019. See the reconciliation of GAAP to non-GAAP measures below. 23 Reconciliation of Non-GAAP Financial Measures Adjusted Income Statement Information We have included adjusted net income and adjusted diluted EPS, which are non-GAAP financial measures, as supplemental disclosures because we believe these measures are useful to investors and others in assessing our year-over-year operating performance. We believe these measures should be considered in addition to, not as a substitute for, net income and diluted EPS presented in accordance with GAAP, respectively, and in the context of our other disclosures included within this Form 10-Q. Other companies may calculate these non-GAAP financial measures differently than we do, which may limit their usefulness as comparative measures. The table below presents a reconciliation of net income to adjusted net income. (Unaudited) Nine Months Ended (in thousands) September 30, 2020 Net income $ 307,565 Impairment of goodwill and other assets 6,944 Tax impact on impairment of long-term note (1) (654) Adjusted net income $ 313,855 (1) As described in our First Quarter 2020 Quarterly Report on Form 10-Q, our effective tax rate at March 31, 2020 was a 0.1% benefit. Excluding impairment from goodwill and intangibles and tax benefits from ASU 2016-09 recorded in the first quarter of 2020, our effective tax rate for the first quarter of 2020 was 25.4%, which we used to calculate the tax impact related to the $2.5 million long-term note impairment. The table below presents a reconciliation of diluted EPS to adjusted diluted EPS. (Unaudited) Nine Months Ended September 30, 2020 2019 Diluted EPS $ 7.53 $ 5.97 After-tax non-cash impairment charges 0.15 — Adjusted diluted EPS excluding after-tax non-cash impairment charges 7.68 5.97 Tax benefit (0.55) (0.52) Adjusted diluted EPS excluding after-tax non-cash impairment charges and tax benefit $ 7.13 $ 5.45 24 Seasonality and Quarterly Fluctuations Our business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2019, we generated approximately 63% of our net sales and 81% of our operating income in the second and third quarters of the year. We typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August. The following table presents certain unaudited quarterly data for the first, second and third quarters of 2020, the four quarters of 2019 and the fourth quarter of 2018. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends. (Unaudited) QUARTER (in thousands) 2020 2019 2018 Third Second First Fourth Third Second First Fourth Statement of Income Data Net sales $ 1,139,229 $ 1,280,846 $ 677,288 $ 582,234 $ 898,500 $ 1,121,328 $ 597,456 $ 543,082 Gross profit 328,698 373,481 189,629 162,050 257,931 330,314 174,631 160,442 Operating income 148,233 205,857 35,588 25,798 104,540 172,523 38,386 25,970 Net income 119,098 157,555 30,912 18,024 79,525 131,390 32,637 16,811 Balance Sheet Data Total receivables, net $ 366,412 $ 453,405 $ 345,915 $ 226,539 $ 307,798 $ 417,126 $ 313,127 $ 207,801 Product inventories, net 612,824 628,418 858,190 702,274 616,217 694,447 815,742 672,579 Accounts payable 268,412 346,272 517,620 261,963 214,309 342,335 472,487 237,835 Total debt 339,934 438,804 586,050 511,407 547,560 692,337 698,977 666,761 We expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends. 25 Weather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions. Weather Possible Effects Hot and dry • Increased purchases of chemicals and supplies for existing swimming pools • Increased purchases of above-ground pools and irrigation and lawn care products Unseasonably cool weather or extraordinary amounts of rain • Fewer pool and irrigation and landscape installations • Decreased purchases of chemicals and supplies • Decreased purchases of impulse items such as above-ground pools and accessories Unseasonably early warming trends in spring/late cooling trends in fall • A longer pool and landscape season, thus positively impacting our sales (primarily in the northern half of the U.S. and Canada) Unseasonably late warming trends in spring/early cooling trends in fall • A shorter pool and landscape season, thus negatively impacting our sales (primarily in the northern half of the U.S. and Canada) Weather Impacts on 2020 and 2019 Results Overall, weather conditions in the third quarter of 2020 were generally favorable, which benefited results. Much of the western United States experienced above-average temperatures, particularly in California, which was also plagued with the most active wildfire year on record. Precipitation was below-average in most of the western half of the United States and normal to above-average in the eastern half. Likewise, results in the third quarter of 2019 were positively impacted by above-average temperatures and below-average precipitation throughout most of the country. Weather conditions in the second quarter of 2020 were varied across the contiguous United States; however, results in the second quarter of 2020 benefited from generally mild weather conditions. Much of the western United States benefited from warmer weather, while the southeastern United States experienced slightly below-average temperatures. Southern California and the southeastern United States, including Florida, experienced more precipitation than normal. In contrast, results for the second quarter of 2019 were largely impacted by record rainfall and cooler temperatures in three of our largest markets, California, Texas and Arizona, particularly in the month of May, which was the second wettest May on record for the contiguous United States. In the first quarter of 2020, sales benefited from above-average temperatures throughout the contiguous United States, particularly in the southern United States. These favorable weather conditions contrast from the first quarter of 2019 when wetter and cooler-than-normal temperatures to begin the year hindered sales growth. 26 LIQUIDITY AND CAPITAL RESOURCES Liquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following: • cash flows generated from operating activities; • the adequacy of available bank lines of credit; • the quality of our receivables; • acquisitions; • dividend payments; • capital expenditures; • changes in income tax laws and regulations; • the timing and extent of share repurchases; and • the ability to attract long-term capital with satisfactory terms. Our primary capital needs are seasonal working capital obligations and other general corporate initiatives, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principle applies to funds used for capital expenditures and share repurchases. We prioritize our use of cash based on investing in our business, maintaining a prudent capital structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows: • capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; • strategic acquisitions executed opportunistically; • payment of cash dividends as and when declared by our Board of Directors (Board); • repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and • repurchases of our common stock under our Board-authorized share repurchase program. Capital expenditures were 1.0% of net sales in 2019, 1.1% of net sales in 2018 and 1.4% of net sales in 2017. Our higher capital spending in 2017 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Due to the deferral of capital expenditures earlier in the year to address the COVID-19 pandemic, we expect capital expenditures in 2020 to approximate 65% of 2019 capital expenditures and range from $20.0 million to $25.0 million. Sources and Uses of Cash The following table summarizes our cash flows (in thousands): Nine Months Ended September 30, 2020 2019 Operating activities $ 388,914 $ 243,253 Investing activities (41,552) (35,839) Financing activities (300,161) (187,734) Cash provided by operations of $388.9 million for the first nine months of 2020 increased $145.7 million compared to the first nine months of 2019. The improvement in cash provided by operations primarily reflects an increase in net income, a decline in inventory balances between periods and improvements in working capital management. Cash used in investing activities for the first nine months of 2020 increased compared to the first nine months of 2019 primarily due to the acquisitions of Master Tile Network LLC, which we completed in February 2020, and Northeastern Swimming Pool Distributors, Inc., which we completed in September 2020. The increase in cash used in investing activities due to acquisitions was partially offset by lower capital expenditures. 27 Cash used in financing activities was $300.2 million for the first nine months of 2020 compared to $187.7 million for the first nine months of 2019, which reflects a $52.2 million increase in net debt payments, additional share repurchases of $53.0 million and an increase in dividends paid of $6.8 million. Future Sources and Uses of Cash Revolving Credit Facility Our Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives. At September 30, 2020, there was $40.9 million outstanding, a $4.8 million standby letter of credit outstanding and $704.3 million available for borrowing under the Credit Facility. We pay interest on revolving borrowings under the Credit Facility at a variable rate based on the one month London Interbank Offered Rate (LIBOR), plus an applicable margin. The weighted average effective interest rate for the Credit Facility as of September 30, 2020 was approximately 1.1%, excluding commitment fees. Term Facility Our Term Facility provides for $185.0 million in borrowing capacity and matures on December 30, 2026. The Term Facility will be repaid in quarterly installments of 1.250% of the Term Facility on the last business day of each quarter beginning in the first quarter of 2020. The total of the quarterly payments will be equal to 33.75% of the Term Facility with the final principal payment, equal to 66.25% of the Term Facility, due on the maturity date. We may prepay amounts outstanding under the Term Facility without penalty other than interest breakage costs. At September 30, 2020, there was $178.1 million outstanding under the Term Facility with a weighted average effective interest rate of 2.1%. We pay interest on borrowings under the Term Facility at a variable rate based on the one month LIBOR, plus an applicable margin. Financial Covenants Financial covenants of the Credit Facility and the Term Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio, which are our most restrictive financial covenants. As of September 30, 2020, the calculations of these two covenants are detailed below: • Maximum Average Total Leverage Ratio . On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of September 30, 2020, our average total leverage ratio equaled 1.01 (compared to 1.26 as of June 30, 2020) and the TTM average total debt amount used in this calculation was $466.3 million. • Minimum Fixed Charge Coverage Ratio . On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of September 30, 2020, our fixed charge ratio equaled 7.10 (compared to 6.27 as of June 30, 2020) and TTM Rental Expense was $61.2 million. The Credit Facility and the Term Facility also limit the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility and the Term Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice. 28 Under the Credit Facility and the Term Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility and the Term Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt. Receivables Securitization Facility Our two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and May 31, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $120.0 million to $275.0 million throughout the remaining months of the year. The Receivables Facility matures on November 1, 2021. The Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due. The Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00. At September 30, 2020, there was $110.0 million outstanding under the Receivables Facility at a weighted average effective interest rate of 0.9%, excluding commitment fees. Interest Rate Swaps We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our variable rate borrowings. Interest expense related to the notional amounts under all swap contracts is based on the fixed rates plus the applicable margin on the respective borrowings. As of September 30, 2020, we had one interest rate swap contract in place, which became effective on November 20, 2019 and terminates on November 20, 2020. This swap contract was previously forward-starting and converts the variable interest rate on our variable rate borrowings to a fixed rate of 1.1425% on a notional amount of $150.0 million. Interest expense related to the notional amounts under this swap contract is based on the fixed rate plus the applicable margin on our variable rate borrowings. We have entered into forward-starting interest rate swap contracts to extend the hedged period for future interest payments on our variable rate borrowings. These swap contracts will convert the variable interest rate to a fixed interest rate on our variable rate borrowings. 29 The following table provides details related to each of our forward-starting interest rate swap contracts: Derivative Inception Date Effective Date Termination Date Notional Amount (in millions) Fixed Interest Rate Forward-starting interest rate swap 1 May 7, 2019 November 20, 2020 September 29, 2022 $75.0 2.0925% Forward-starting interest rate swap 2 July 25, 2019 November 20, 2020 September 29, 2022 $75.0 1.5500% Forward-starting interest rate swap 3 February 5, 2020 February 26, 2021 February 28, 2025 $150.0 1.3800% Forward-starting interest rate swap 4 March 9, 2020 September 29, 2022 February 26, 2027 $150.0 0.7400% Forward-starting interest rate swap 5 March 9, 2020 February 28, 2025 February 26, 2027 $150.0 0.8130% Compliance and Future Availability As of September 30, 2020, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility, our Term Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2019 Annual Report on Form 10-K and in Part I, Item 1 of this Form 10-Q. We believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions. As of October 26, 2020, $176.9 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities. CRITICAL ACCOUNTING ESTIMATES We prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as: • those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and • those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. Management has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2019 Annual Report on Form 10-K. See Allowance for Doubtful Accounts in Note 1 of Part I, Item 1 of this Form 10-Q for more information on our adoption of ASU 2016-13. We have not changed any other policies from those previously disclosed. Recent Accounting Pronouncements See Note 1 of “Notes to Consolidated Financial Statements,” included in Part I, Item 1 of this Form 10-Q for discussion of recent accounting pronouncements. 30