(EDGAR Online via COMTEX) -- Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
For a discussion of our base business calculations, see the RESULTS OF OPERATIONS section below.
2019 FINANCIAL OVERVIEW
We achieved favorable results in 2019 despite inclement weather throughout much of the first half of the year. Our focus on market share gains and capacity creation allowed us to capitalize on our competitive advantages and deliver solid results.
Net sales increased 7% to a record high of $3.2 billion for the year ended December 31, 2019 compared to $3.0 billion in 2018. Base business sales increased 5%, driven by our continued expansion in commercial and building material products as well as healthy demand for discretionary products, such as construction materials and products used in the remodel and replacement of in-ground pools.
Gross profit reached a record $924.9 million for the year ended December 31, 2019, a 6% increase over gross profit of $870.2 million in 2018. Gross margin was relatively flat year-over-year at 28.9% in 2019 compared to 29.0% in 2018, with base business gross margin at 29.0% in both years.
Selling and administrative expenses (operating expenses) increased 5% to $583.7 million in 2019, up from $556.3 million in 2018, with base business operating expenses up 3% over 2018. The increase in base business operating expenses was primarily attributable to higher growth-driven labor and freight expenses, as well as greater facility-related costs.
Operating income for the year increased 9% to $341.2 million, up from $313.9 million in 2018. Operating margin increased to 10.7% in 2019 compared to 10.5% in 2018, while base business operating margin improved 40 basis points to 10.9% in 2019.
We recorded a $23.5 million, or $0.57 per diluted share, benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, for the year ended December 31, 2019 compared to a benefit of $15.3 million, or $0.36 per diluted share, realized in 2018.
Net income increased 12% to a record $261.6 million in 2019 compared to $234.5 million in 2018. Earnings per share increased 14% to a record $6.40 per diluted share compared to $5.62 per diluted share in 2018. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $5.83 in 2019 compared to $5.26 in 2018.
Financial Position and Liquidity
Cash provided by operations was $298.8 million in 2019, which helped fund the following initiatives:
quarterly cash dividend payments to shareholders, totaling $83.8 million for the year;
Total net receivables, including pledged receivables, increased 9% compared to December 31, 2018, reflective of December sales growth. Our allowance for doubtful accounts was $5.5 million at December 31, 2019 and $6.2 million at December 31, 2018. Our days sales outstanding ratio, as calculated on a trailing four quarters basis, was 29.0 days at December 31, 2019 and 30.1 days at December 31, 2018.
Inventory levels grew 4% to $702.3 million at December 31, 2019 compared to $672.6 million at December 31, 2018, reflecting normal business growth and inventory from acquired businesses of $10.3 million. Our reserve for inventory obsolescence was $9.0 million at December 31, 2019 compared to $7.7 million at December 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.2 times at both December 31, 2019 and December 31, 2018.
Total debt outstanding of $511.4 million at December 31, 2019 decreased $155.4 million, or 23%, compared to December 31, 2018.
Current Trends and Outlook
Market conditions were generally favorable in 2019 tempered by unfavorable weather, which weighed on our results in the first half of 2019. We expect similar favorable market conditions to persist into 2020 and beyond, buoyed by a number of factors.
The post-recession market environment from 2010 to 2019 has been characterized by steady economic expansion, the cautious recovery of consumer spending, modest housing recovery and low inflation. However, in terms of homeowners investing in their existing homes, discretionary expenditures, including backyard renovations, have flourished over this time period with steady increases in home values and lack of affordable new homes prompting homeowners to stay in their homes longer and upgrade their home environments, including their backyard. We expect that new pool and irrigation construction levels will continue to grow incrementally, constrained by availability of construction labor, but we believe that consumer investments in outdoor living spaces beyond the swimming pool will generate continued growth over the next several years.
Although some constraints exist around residential construction activities, we believe that we are well positioned to take advantage of both the market expansion and the inherent long term growth opportunities in our industry. Additionally, recent regulation passed by the U.S. Department of Energy mandates all new and replacement motors and pumps for swimming pools must be variable speed by July 2021. This mandate, coupled with additional product developments and technological advancements, offers further growth opportunities over the next few years.
While we estimate that new pool construction was approximately 80,000 new units in 2019, construction levels are still down approximately 65% compared to peak historical levels and down approximately 50% from what we consider normal levels. Favorable weather plays a role in industry growth by accelerating growth in any given year, expanding the number of available construction days, extending the pool season and pool usage and positively impacting demand for discretionary products. Conversely, unfavorable weather impedes growth. Wetter and cooler-than-normal temperatures throughout the first half of 2019 delayed pool openings and led to lower construction and remodeling activity, although the latter half of the year benefited from relatively normalized weather patterns. In establishing our outlook each year, we base our growth assumptions on normal weather conditions and do not incorporate alternative weather predictions into our guidance.
We established our initial outlook for 2020 based on reasonable expectations of organic market share growth, ongoing leverage of existing investments in our business and continuous process improvements. For 2020, we expect the macroeconomic environment in the United States will be quite similar to 2019. We expect to continue to gain market share through our comprehensive service and product offerings, which we continually diversify through internal sourcing initiatives and expansion into new markets. We also plan to broaden our geographic presence by opening 8 to 10 new sales centers in 2020 and by making selective acquisitions when appropriate opportunities arise.
The following summarizes our outlook for 2020:
We expect sales growth of 6% to 8%, impacted by the following factors and assumptions:
We expect relatively neutral gross margin trends for the full year with lower gross margin growth in the first half of 2020 compared to 2019, which benefited from strategic inventory purchases we made in the latter half of 2018, and modestly positive gross margin growth in the second half of the year.
We expect operating expenses will grow at approximately 60% of the rate of our gross profit growth, reflecting inflationary increases and incremental costs to support our sales growth expectations, with greater growth in the first half of the year and more modest growth in the back half. The main challenges in achieving this metric include managing people and facility costs in tight labor and real estate markets. However, we continue to see significant opportunity to leverage our existing infrastructure to achieve this goal.
In 2020, we expect our effective tax rate will approximate 25.5%, excluding the impact of ASU 2016-09. Our effective tax rate is dependent upon our results of operations and may change if actual results are different from our current expectation. Due to ASU 2016-09 requirements, 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. Based on our December 31, 2019 stock price, we estimate that we have approximately $2.3 million in unrealized excess tax benefits related to stock options that expire and restricted awards that will vest in the first quarter of 2020. We may recognize additional tax benefits related to stock option exercises in 2020 from grants that expire in years after 2020, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the period that our employees will exercise vested stock options. We recorded a $23.5 million benefit in our provision for income taxes for the year ended December 31, 2019 related to ASU 2016-09.
We project that 2020 earnings will be in the range of $6.47 to $6.77 per diluted share, including an estimated $0.06 benefit from ASU 2016-09 during the first quarter of 2020. We expect cash provided by operations will approximate net income for fiscal 2020, and we anticipate that we will use $150.0 million to $200.0 million in cash for share repurchases.
The forward-looking statements in this Current Trends and Outlook section are subject to significant risks and uncertainties, including 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 and other risks detailed in Item 1A of this Form 10-K. Also see "Cautionary Statement for Purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995" prior to the heading "Risk Factors" in Item 1A.
CRITICAL ACCOUNTING ESTIMATES
We prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which requires 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
Management has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. We believe the following critical accounting estimates require us to make the most difficult, subjective or complex judgments.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts based on an estimate of the losses we will incur if our customers do not make required payments. We perform periodic credit evaluations of our customers and typically do not require collateral. Consistent with industry practices, we generally require payment from our North American customers within 30 days, except for sales under early buy programs for which we provide extended payment terms to qualified customers. The extended terms usually require payments in equal installments in April, May and June or May and June, depending on geographic location. Credit losses have generally been within or better than our expectations.
Similar to our business, our customers' businesses are seasonal. Sales are lowest in the winter months and our past due accounts receivable balance as a percentage of total receivables generally increases during this time. We provide reserves for uncollectible accounts based on our accounts receivable aging. These reserves range from 0.05% for amounts currently due to up to 100% for specific accounts more than 60 days past due.
At the end of each quarter, we perform a reserve analysis of all accounts with balances greater than $20,000 and more than 60 days past due. Additionally, we perform a separate reserve analysis on the balance of our accounts receivables with emphasis on past due accounts. As we review these past due accounts, we evaluate collectability based on a combination of factors, including:
aging statistics and trends;
During the year, we write off account balances when we have exhausted reasonable collection efforts and determined that the likelihood of collection is remote. These write-offs are charged against our allowance for doubtful accounts. In the past five years, write-offs have averaged approximately 0.07% of net sales annually. Write-offs as a percentage of net sales approximated 0.12% in 2019, 0.07% in 2018 and 0.05% in 2017. We expect that write-offs will range from 0.05% to 0.10% of net sales in 2020.
At the end of each fiscal year, we prepare a hindsight analysis by comparing the prior year-end allowance for doubtful accounts balance to (i) current year write-offs and (ii) any significantly aged outstanding receivable balances. Based on our hindsight analysis, we concluded that the prior year allowance was within a range of acceptable estimates and that our estimation methodology is appropriate.
If the balance of the accounts receivable reserve increased or decreased by 20% at December 31, 2019, pretax income would change by approximately $1.1 million and earnings per share would change by approximately $0.02 per diluted share (based on the number of weighted average diluted shares outstanding for the year ended December 31, 2019).
Product inventories represent the largest asset on our balance sheet. Our goal is to manage our inventory such that we minimize stock-outs to provide the highest level of service to our customers. To do this, we maintain at each sales center an adequate inventory of stock keeping units (SKUs) with the highest sales volumes. At the same time, we continuously strive to better manage our slower moving classes of inventory, which are not as critical to our customers and thus, inherently turn at slower rates.
We classify products into 13 classes at the sales center level based on sales at each location over the expected sellable period, which is the previous 12 months for most products. All inventory is included in these classes, except for special order non-stock items that lack a SKU in our system and products with less than 12 months of usage. The table below presents a description of these inventory classes:
Class 0 new products with less than 12 months usage Classes 1-4 highest sales value items, which represent approximately 80% of net sales at the sales center Classes 5-12 lower sales value items, which we keep in stock to provide a high level of customer service Class 13 products with no sales for the past 12 months at the local sales center level, excluding special order products not yet delivered to the customer Null class non-stock special order items
There is little risk of obsolescence for products in classes 1-4 because products in these classes generally turn quickly. We establish our reserve for inventory obsolescence based on inventory classes 5-13, which we believe represent some exposure to inventory obsolescence, with particular emphasis on SKUs with the least sales over the previous 12 months. The reserve is intended to reflect the value of inventory at net realizable value. We provide a reserve of 5% for inventory in classes 5-13 and non-stock inventory as determined at the sales center level. We also provide an additional 5% reserve for excess inventory in classes 5-12 and an additional 45% reserve for excess inventory in class 13. We determine excess inventory, which is defined as the amount of inventory on hand in excess of the previous 12 months' usage, on a company-wide basis. We also evaluate whether the calculated reserve provides sufficient coverage of the total class 13 inventory.
In evaluating the adequacy of our reserve for inventory obsolescence, we consider a combination of factors, including:
the level of inventory in relation to historical sales by product, including inventory usage by class based on product sales at both the sales center level and on a company-wide basis;
We periodically adjust our reserve for inventory obsolescence as changes occur in the above-identified factors. At the end of each fiscal year, we prepare a hindsight analysis by comparing the prior year-end obsolescence reserve balance to (i) current year inventory write-offs and (ii) the value of products with no sales for the past 12 months that remain in inventory. Based on our hindsight analysis, we concluded that our prior year reserve was within a range of acceptable estimates and that our estimation methodology is appropriate.
If the balance of our inventory reserve increased or decreased by 20% at December 31, 2019, pretax income would change by approximately $1.8 million and earnings per share would change by approximately $0.03 per diluted share (based on the number of weighted average diluted shares outstanding for the year ended December 31, 2019).
Many of our vendor arrangements provide for us to receive specified amounts of consideration when we achieve any of a number of measures. These measures generally relate to the volume level of purchases from our vendors, or our net cost of products sold, and may include negotiated pricing arrangements. We account for vendor programs as a reduction of the prices of the vendor's products and therefore a reduction of inventory until we sell the product, at which time we recognize such consideration as a reduction of cost of sales in our income statement.
Throughout the year, we estimate the amount earned based on our expectation of total purchases for the fiscal year relative to the purchase levels that mark our progress toward the attainment of various levels within certain vendor programs. We accrue vendor program benefits on a monthly basis using these estimates provided that we determine they are probable and reasonably estimable. Our estimates for annual purchases, future inventory levels and sales of qualifying products are driven by our sales projections, which can be significantly impacted by a number of external factors including changes in economic conditions and weather. Changes in our purchasing mix also impact our estimates, as certain program rates can vary depending on our volume of purchases from specific vendors.
We continually revise these estimates throughout the year to reflect actual purchase levels and identifiable trends. As a result, our estimated quarterly vendor program benefits accrual may include cumulative catch-up adjustments to reflect any changes in our estimates between reporting periods. These adjustments tend to have a greater impact on gross margin in the fourth quarter since it is our seasonally slowest quarter and because the majority of our vendor arrangements are based on calendar year periods. We update our estimates for these arrangements at year end to reflect actual annual purchase levels. In the first quarter of the subsequent year, we prepare a hindsight analysis by comparing actual vendor credits received to the prior year vendor receivable balances. Based on our hindsight analysis, we concluded that our vendor program estimates were within a range of acceptable estimates and that our estimation methodology is appropriate.
If market conditions were to change, vendors may change the terms of some or all of these programs. Although such changes would not affect the amounts we have recorded related to products already purchased, they may lower or raise our cost for products purchased and sold in future periods.
We record deferred tax assets and liabilities based on differences between the financial reporting and tax basis of assets and liabilities using currently enacted rates and laws that will be in effect when we expect the differences to reverse. Due to changing tax laws and state income tax rates, significant judgment is required to estimate the effective tax rate expected to apply to tax differences that are expected to reverse in the future.
We operate in 39 states, 1 United States territory and 11 foreign countries. We are subject to regular audits by federal, state and foreign tax authorities, and the amount of income taxes we pay is subject to adjustment by the applicable tax authorities. We recognize a benefit from an uncertain tax position only after determining it is more likely than not that the tax position will withstand examination by the applicable taxing authority. Our estimate for the potential outcome of any uncertain tax issue is highly judgmental. We regularly evaluate our tax positions and incorporate these expectations into our reserve estimates. We believe we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are made or resolved, or when statutes of limitation on potential assessments expire. These adjustments may include changes in valuation allowances that we have established. As a result of these uncertainties, our total income tax provision may fluctuate on a quarterly basis.
Each year, we prepare a return to provision analysis upon filing our income tax returns. Based on this hindsight analysis, we concluded that our prior year income tax provision was within a range of acceptable estimates and that our provision calculation methodology is appropriate. Differences between our effective income tax rate and federal and state statutory tax rates are primarily due to valuation allowances recorded for certain of our international subsidiaries with tax losses.
Performance-Based Compensation Accrual
The Compensation Committee of our Board (Compensation Committee) annually reviews our compensation structure to oversee management's implementation of maintaining a program that attracts, retains, develops and motivates employees without leading to unnecessary risk taking. Our compensation packages include bonus plans that are specific to each group of eligible participants and their levels and areas of responsibility. The majority of our bonus plans have annual cash payments that are based primarily on objective performance criteria. We calculate bonuses based on the achievement of certain key measurable financial and operational results, including operating income and diluted earnings per share (EPS).
We use an annual cash performance award (annual bonus) to focus corporate behavior on short-term goals for growth, financial performance and other specific financial and business improvement metrics. Management sets the Company's annual bonus objectives at the beginning of the bonus plan year using both historical information and forecasted results of operations for the current plan year. Management also establishes specific business improvement objectives for both our operating units and corporate employees. The Compensation Committee approves objectives for annual bonus plans involving executive management.
We also utilize our medium-term (three-year) Strategic Plan Incentive Program (SPIP) to provide senior management with an additional cash-based, pay-for-performance award based on the achievement of specified earnings growth objectives. Payouts through the SPIP are based on three-year compound annual growth rates (CAGRs) of our diluted EPS.
We record annual performance-based compensation accruals based on operating income achieved in a quarter as a percentage of total expected operating income for the year. We estimate total expected operating income for the current plan year using management's estimate of the total overall incentives earned per the stated bonus plan objectives. Starting in June, and continuing each quarter through our fiscal year end, we adjust our estimated performance-based compensation accrual based on our detailed analysis of each bonus plan, the participants' progress toward achievement of their specific objectives and management's estimates related to the discretionary components of the bonus plans, if any.
We record SPIP accruals based on our total expected EPS for the current fiscal year and earnings growth estimates for the succeeding two years. We base our current fiscal year estimates on the same assumptions used for our annual bonus calculation and we base our forward-looking estimates on historical growth trends and our projections for the remainder of the three-year performance periods.
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Feb 27, 2020
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