Considerable Margin Deterioration Makes Leslie’s Stock A Miss (NASDAQ:LESL)

Investment thesis

Our current investment thesis is:

• LESL’s valuation, which we consider far too high given the current risk profile, appears to price in a strong recovery in the near term. We believe there is limited visibility as to the company’s normalized margin levels, although are confident it will not return to its FY22 levels.
• Further, LESL’s weak performance currently fundamentally challenges the qualities of its commercial profile, which we have heavily praised. This creates uncertainty as to whether it can achieve attractive risk-adjusted returns over the course of a cycle.

Company description

Leslie’s (NASDAQ:LESL), founded in 1963, is a leading specialty retailer and service provider for swimming pool and spa care, offering a comprehensive range of products and services. With over 900 stores across the United States, Leslie’s serves residential and commercial customers, providing solutions for pool maintenance, repair, and renovation.

Share price

LESL’s share price performance has been disappointing since the stock was listed, losing over 50% of its value while the S&P has soared. While this has been a difficult period for markets in general, LESL has struggled financially, seeing its fundamental profile change.

Commercial analysis

Presented above are LESL’s financial results.

LESL’s revenue has grown well since FY18, with a CAGR of +9% into the LTM. EBITDA is the problem, however, declining at a rate of (1)% during the same period.

Business Model

LESL is a specialty retailer that focuses on the sale of swimming pool supplies, equipment, and related products. This specialism has allowed the company to develop a brand in this segment, becoming a preferred supplier due to its perceived expertise.

LESL offers a wide assortment of products catering to pool owners’ needs, including chemicals, cleaning equipment, pool accessories, pumps, filters, heaters, and maintenance tools. This comprehensive product range allows LESL to serve both residential and commercial customers at scale.

LESL prioritizes customer satisfaction by providing a broad range of products (which many broadline retailers will not stock), expert advice, and solutions tailored to individual pool requirements.

The company has developed a strong private label brand offering for various product categories, giving customers high-quality alternatives at competitive prices. These private-label products contribute to higher-than-average margins and greater customer loyalty.

LESL has a strong omnichannel presence, with a network of retail stores across the United States complemented by an e-commerce platform and a network of distributors. This omnichannel approach allows customers to shop conveniently, with broad access to its brands.

Competitive Positioning

LESL is the undisputed market leader in the US with over 1,000 locations, which is more than its 20 largest competitors combined. This considerably reduces barriers to its customer’s purchasing, while also maximizing its marketing reach. This infrastructure allows LESL to be within 20 miles of 80% of the pools in the US, an impressive statistic.

This has been underpinned by a strategic expansion strategy focused on opening new stores in high-growth markets and expanding its footprint in existing markets. The company has spent over $150m on acquisitions since FY18, while capex has consistently remained within 3% of revenue.

LESL has developed an attractive loyalty program, which at a high-level keeps customers returning in order to benefit from promotions. This said, the data collected is far more important long term, allowing LESL to understand key trends and areas of demand, while also positioning its private-label products preferentially.

This is partially the reason for its strong sales through the online channel, with its digital sales 5x higher than its competitors. The unit economics of e-commerce are superior, contributing to margin strength.

LESL is led by an experienced management team with deep industry knowledge and a proven track record of driving growth and operational excellence. Being a historically PE-backed business, the company has seen strong investment in its leadership and operational capabilities.

Pool and Spa Care Industry

The industry is described as highly fragmented, valued in the region of ~$23b. It is expected to grow at a CAGR of ~7% into FY34, driven by a combination of growth in travel and hospitality, as well as wellness tourism.

The fragmented nature is the key factor here. LESL is a big fish in a small pond, priming the company well to incrementally acquire its peers, taking a larger share of this ~7% growth rate.

The demand for swimming pool supplies and equipment remains strong, driven by factors such as homeowners investing in backyard renovations and increased spending on outdoor living spaces. Importantly, however, its demand is robust due to its maintenance nature and affluent target audience. Management describes this as an “annuity-like” demand.

Growth progression

Whilst LESL’s position in its industry is strong and demand is expected to be consistent, it has experienced a noticeable drawdown since FY22. Management attributes this to a number of reasons, including unfavorable weather, increased consumer price sensitivity, and pool owners with elevated levels of chemicals carried over.

While we do believe these factors are important, the key here we feel is that the company appears more sensitive to economic conditions than expected. In its most recent quarter, the company experienced a decline in sales of (11)%, with margins considerably down vs. FY22.

Consumers are seemingly responding negatively to economic conditions, significantly reducing discretionary spending (for which the Q3 decline was -19%), while others are more likely to seek cheaper options. It is worth highlighting that the company has maintained market share, although is disappointing nevertheless.

Management’s response to this has been to increase prices considerably and focus on marketing efficiency. This has yet to impact margins but is worsening the company’s growth trajectory.

Overall, LESL has found itself in an incredibly messy situation, seemingly in a freefall that Management cannot easily right. Focus should have been on margin preservation but it is far too late now.

We expect economic conditions to weigh on the business in early 2024 while rates remain elevated, with scope for economic expansion in late 2024 and into 2025. With a considerable drawdown already, we could realistically believe the “bottom” has been reached.

Margins

LESL’s margin decline is driven by a combination of a decline in GM% (-5ppts) and an increase in S&A costs as a % of revenue (+3ppts). The fact both have moved negatively makes it incredibly difficult for LESL to return to its prior levels.

For a retailer, even one with the market leadership LESL has, to boast an EBITDA-M of 18%, the threat of erosion was always present.

Balance sheet & cash flows

LESL is heavily indebted, with a ND/EBITDA ratio of 4.8x. While rates were low, this was easily Manageable but now, interest payments comprise 5% of revenue, restricting FCF and the scope for distributions.

While this will not cause a solvency issue, this is an inefficiency that will contribute to a strain on shareholder value in the short term.

Outlook

Presented above is Wall Street’s consensus view on the coming years.

Analysts are forecasting mild growth in the coming years, with a CAGR of +4%. Alongside this, margins are expected to improve, although comfortably below its FY22 peak.

These forecasts appear reasonable. We expect a return to growth in FY25F, with the company slowly building up toward an annual growth rate of ~7%.

Further, we remain skeptical about the sustainability of its FY22 margins, with a normalized level of ~13-16% being far more reasonable.

Beats and Misses

LESL’s recent performance relative to analyst estimates has been poor, with considerable misses at a margin level suggesting a clear underperformance.

Industry analysis

Presented above is a comparison of LESL’s growth and profitability to the average of its industry, as defined by Seeking Alpha (18 companies).

If this view was taken in FY22, LESL would likely have been a market leader. Since then, it has declined considerably, now falling below the average in both growth and margins.

We do believe LESL has a higher scope for improvement, particularly in margins, while acquisitions and industry growth could allow it to broadly track its peer-average.

Valuation

LESL is currently trading at 18x LTM EBITDA and 13x NTM EBITDA. This is a small discount to its historical average.

A small discount appears insufficient in our view, owing to the considerable decline in margins while its perceived resilient demand has been non-existent. Much of what investors priced into the long term will not occur, requiring a rerating. At a FCF yield of 3.6%, the company is at a premium of ~2.2ppts, far too high we feel.

Further, the company is trading at a premium to its peers, across both LTM and NTM metrics. While the company has greater scope for long-term value, there is considerable risk associated with this and so for much of this to be priced in, we feel the stock is overvalued.

Analysts appear to concur with this, with a target downside of ~10%.

Key risks with our thesis

The risks to our current thesis are:

• Considerable margin progress through pricing action initiated.
• Given the fundamental need for stock such as chemicals, LESL could enjoy “pent up” demand, improving investor sentiment.

Final thoughts

LESL has all the hallmarks of a solid long-term compounder. It has a market-leading position, a diversified business model with multiple value levers, and a healthily growing industry. These factors have not gone away, and will thus likely contribute to outperforming going forward.

This said, there are risks associated with this and we must also consider the relative position. LESL could see EBITDA-M improve to 13%, which is greater vs. today but a disaster compared to FY22.

With its current valuation and our belief that it cannot get close to its FY22 levels, we rate LESL a sell.