Pool Corp: Form 10-K for the period ended Dec 31, 2013

General

Based on industry data, Pool Corporation (the Company, which may be referred to as we, us or our) is the world’s largest wholesale distributor of swimming pool supplies, equipment and related leisure products and is one of the top three distributors of irrigation and landscape products in the United States. The Company was incorporated in the State of Delaware in 1993 and has grown from a regional distributor to a multi-national, multi-network distribution company.

Our industry is highly fragmented, and as such, we add considerable value to the industry by purchasing products from a large number of manufacturers and then distributing the products to our customer base on conditions that are more favorable than our customers could obtain on their own.

As of December 31, 2013, we operated 321 sales centers in North America, Europe and South America through our three distribution networks:

• SCP Distributors LLC (SCP);
• Superior Pool Products LLC (Superior); and
• Horizon Distributors, Inc. (Horizon).

Our SCP network includes nine domestic sales centers designated as National Pool Tile (NPT) locations. Our NPT locations focus on selling specialized products under the NPT brand including tile, decking materials and interior pool finishes. Our SCP network also includes 31 international sales centers.

Superior and Horizon are both wholly owned subsidiaries of SCP, which is wholly owned by Pool Corporation.

Our Industry

We believe that the swimming pool industry is relatively young, with room for continued growth from the increased penetration of new pools. Of the approximately 80 million homes in the United States that have the economic capacity and the yard space to have a swimming pool, approximately 12% currently have a pool. Significant growth opportunities also reside with pool remodel and pool equipment replacement activities due to the aging of the installed base of swimming pools, technological advancements and the development of energy-efficient products. The irrigation and landscape industry shares many characteristics with the pool industry, and we believe that it will realize long-term growth rates similar to the pool industry. As irrigation system installations and landscaping often occur in tandem with new single-family home construction, we believe the continued recovery in the housing industry also offers significant opportunities for the irrigation and landscape industry.

Favorable demographic and socioeconomic trends have positively impacted our industry and we believe these trends will continue to do so in the long term. These favorable trends include the following:

• long-term growth in housing units in warmer markets due to the population migration toward the southern United States, which contributes to the growing installed base of pools that homeowners must maintain;
• increased homeowner spending on outdoor living spaces for relaxation and entertainment;
• consumers bundling the purchase of a swimming pool and other products, with new irrigation systems and landscaping often being key components to both pool installations and remodels; and
• consumers using more automation and control products, higher quality materials and other pool features that add to our sales opportunities over time.

Approximately 60% of consumer spending in the pool industry is for maintenance and minor repair of existing swimming pools. Maintaining proper chemical balance and the related upkeep and repair of swimming pool equipment, such as pumps, heaters, filters and safety equipment, creates a non-discretionary demand for pool chemicals, equipment and other related parts and supplies. We also believe cosmetic considerations such as a pool’s appearance and the overall look of backyard environments create an ongoing demand for other maintenance related goods and certain discretionary products.

We believe that the recurring nature of the maintenance and repair market has historically helped maintain a relatively consistent rate of industry growth. This characteristic, along with relatively consistent inflationary price increases of 1% to 2% on average passed on by manufacturers and distributors, has helped cushion the negative impact on revenues in periods when unfavorable economic conditions and softness in the housing market adversely impacted pool construction and major replacement and refurbishment activities.

The following table reflects growth in the domestic installed base of in-ground and above-ground swimming pools over the past 11 years (based on Company estimates and information from 2014 P.K. Data, Inc. reports):

The replacement and refurbishment market currently accounts for close to 30% of consumer spending in the pool industry. The activity in this market, which includes major swimming pool remodeling, is based on the aging of the installed base of pools. The timing of these types of expenditures are more sensitive to economic factors that impact consumer spending compared to the maintenance and minor repair market.

New swimming pool construction comprises the bulk of the remaining consumer spending in the pool industry. The demand for new pools is driven by the perceived benefits of pool ownership including relaxation, entertainment, family activity, exercise and convenience. The industry competes for new pool sales against other discretionary consumer purchases such as kitchen and bathroom remodeling, boats, motorcycles, recreational vehicles and vacations. The industry is also affected by other factors including, but not limited to, consumer preferences or attitudes toward pool and landscape products for aesthetic, environmental, safety or other reasons.

The irrigation and landscape distribution business is split between residential and commercial markets, with the majority of sales related to the residential market. Irrigation and landscape maintenance activities account for approximately 40% of total spending in the irrigation industry, with the remaining 60% of spending related to irrigation construction and other discretionary related products. As such, our irrigation business is more heavily weighted toward new construction activities and the sale of discretionary related products compared to our pool business and is therefore more sensitive to economic factors that impact consumer spending. Our irrigation and landscape business has recently benefited from the continued recovery of single-family home construction as irrigation system installations and landscaping projects typically correlate with, but lag, new home construction.

Certain trends in the housing market, the availability of consumer credit and general economic conditions (as commonly measured by Gross Domestic Product or GDP) affect our industry, particularly new pool and irrigation system starts as well as the timing and extent of pool refurbishments and equipment replacement. We believe that over the long term, housing turnover and single‑family home value appreciation may correlate with demand for new pool construction, with higher rates of home turnover and appreciation having a positive impact on new pool starts over time. We also believe that homeowners’ access to consumer credit is a critical factor enabling the purchase of new swimming pools and irrigation systems. Similar to other discretionary purchases, replacement and refurbishment activities are more heavily impacted by economic factors such as consumer confidence, GDP and unemployment.

The economic downturn between 2007 and 2009 had a significant impact on our industry, driving an approximately 80% reduction in new pool construction in the United States compared to peak levels in 2005 and also contributing to more than a 30% decline in replacement and refurbishment activities. While we estimate that new pool construction has increased from a low of roughly 45,000 new units in 2009 to approximately 60,000 new units in 2013, construction levels are still down more than 70% compared to peak levels in 2005 and down approximately 60% from what we consider to be normal levels.

The rebound in our base business sales growth beginning in 2010 reflects continued improvement in consumer discretionary expenditures, higher replacement activities and market share gains given our estimated industry growth of 3% to 5% for 2010 to 2012. Improvements in general external market factors in the United States including consumer confidence, employment, housing, consumer financing and economic expansion helped support this growth. In 2013, we estimate industry growth dipped temporarily to approximately 1% to 2% given the impact of adverse weather on seasonal markets.

Going forward, we believe there is potential for a significant sales recovery due to the build-up of deferred replacement and remodeling activity and our expectation for gradually normalized new pool and irrigation construction levels. We also expect that market conditions in the United States will continue to improve, enabling further recovery of replacement, remodeling and new construction activity to normalized levels over the next 4 to 7 years. We expect that the industry will realize an annual growth rate of approximately 4% to 7% over this time period before reverting back to 3% to 4% annual growth over the longer term. As current economic trends indicate that consumer spending has begun to slowly recover and that construction activities will likely continue to gradually improve, we believe that we are well positioned to take advantage of both the eventual market recovery and the inherent long-term growth opportunities in our industry.

Our industry is seasonal and weather is one of the principal external factors that affect our business. Peak industry activity occurs during the warmest months of the year, typically April through September. Unseasonable warming or cooling trends can accelerate or delay the start or end of the pool and landscape season, impacting our maintenance and repair sales. These impacts at the shoulders of the season are generally more pronounced in northern markets in the United States and Canada. Weather also impacts our sales of construction and installation products to the extent that above average precipitation, late spring thaws in northern markets and other extreme weather conditions delay, interrupt or cancel current or planned construction and installation activities.

Business Strategy and Growth

Our mission is to provide exceptional value to our customers and suppliers, in order to provide exceptional return to our shareholders while providing exceptional opportunities to our employees. Our three core strategies are as follows:

• to promote the growth of our industry;
• to promote the growth of our customers’ businesses; and
• to continuously strive to operate more effectively.

We promote the growth of the industry through various advertising and promotional programs intended to raise consumer awareness of the benefits and affordability of pool ownership, the ease of pool maintenance and the many ways in which a pool and the surrounding spaces may be enjoyed beyond swimming. These programs include media advertising, industry oriented website development such as www.swimmingpool.com® (http://www.swimmingpool.com®), public relations campaigns and other online marketing initiatives including social media. We use these programs as tools to educate consumers and lead prospective pool owners to our customers.

We promote the growth of our customers’ businesses by offering comprehensive support programs that include promotional tools and marketing support to help our customers generate increased sales. Our uniquely tailored programs include such features as customer lead generation, personalized websites, brochures, direct mail, marketing campaigns and business development training. As a customer service, we also provide certain retail store customers assistance with all aspects of their business including site selection, store layout and design, business management system implementation, comprehensive product offering selections and efficient ordering and inventory management processes. We also act as a day-to-day resource by offering product and market expertise to serve our customers' unique needs.

Growth initiatives related to our various customer programs include our retail brand licensing program and our rewards program designed for pool service professionals. Under our brand licensing program, customers make commitments to meet minimum purchase levels, stock a minimum of nine specific product categories and operate within certain guidelines (including weekend hour requirements). Our rewards program aligns with our replacement parts growth initiative and provides customers with monthly coupons and other special discounts on parts product purchases. In addition to these programs, we also feature consumer showrooms in over 80 of our sales centers and host an annual retail summit to educate our customers about product offerings and the overall industry.

In addition to our efforts aimed at industry and customer growth, we strive to operate more effectively by continuously focusing on improvements in our operations such as product sourcing, procurement and logistics initiatives, adoption of enhanced business practices and improved working capital management. Other key internal growth initiatives include the continued expansion of both our product offerings (as described in the “Customers and Products” section below) and our distribution networks.

We have grown our distribution networks through new sales center openings, acquisitions and the expansion of existing sales centers. Given the more stabilized external environment, we have increased our focus on new sales center openings, including satellite locations that enable us to more effectively serve customers in existing markets. Since the beginning of 2011, we have opened 17 new sales centers (net of sales center closings and consolidations), including the 10 new sales centers opened in 2013. We expect to open between 7 and 9 new sales centers in 2014. Since the beginning of 2011, we have completed 7 acquisitions consisting of 13 sales centers (net of sales center closings and consolidations within one year of acquisition). The acquired locations include 2 sales centers added to our SCP network in 2013.

We plan to continue to selectively expand our swimming pool and irrigation distribution networks via both acquisitions and new sales center openings. We plan to make strategic acquisitions to further penetrate existing markets and expand into both new geographic markets and new product categories. For additional discussion of our recent acquisitions, see Note 2 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10-K.

We believe that our high customer service levels and expanded product offerings have enabled us to gain market share historically, including the period between 2007 and 2009 when our industry contracted. Going forward, we expect to realize sales growth higher than the industry average due to further increases in market share and continued expansion of our product offerings.

We estimate that price inflation has averaged 1% to 2% annually in our industry over the past 10 years. We generally pass industry price increases through the supply chain and make strategic volume inventory purchases ahead of vendor price increases. We estimate that annual price inflation was consistent with the historical average between 2011 and 2013, with 2011 price inflation closer to 2%. We anticipate price inflation will vary some by product lines, but will approximate the long term average overall in 2014.

Customers and Products

We serve roughly 80,000 customers, none of which account for more than 1% of our sales. We primarily serve five types of customers:

• swimming pool remodelers and builders;
• specialty retailers that sell swimming pool supplies;
• swimming pool repair and service businesses;
• landscape construction and maintenance contractors; and
• government, golf course and other commercial customers.

The majority of these customers are small, family owned businesses with relatively limited capital resources. The recent economic environment has had the greatest impact on swimming pool remodelers and builders and landscape construction companies. We have seen a modest contraction in our customer base in these areas over the last several years.

We conduct our operations through 321 sales centers in North America, Europe and South America. Our primary markets, with the highest concentration of swimming pools, are California, Florida, Texas and Arizona, representing approximately 52% of our net sales in 2013. In 2013, we generated close to 95% of our sales in North America, 5% in Europe and less than 1% in South America.

We use a combination of local and international sales and marketing personnel to promote the growth of our business and develop and strengthen our customers’ businesses. Our sales and marketing personnel focus on developing customer programs and promotional activities, creating and enhancing sales management tools and providing product and market expertise. Our local sales personnel work from our sales centers and are charged with understanding and meeting our customers’ specific needs.

We offer our customers more than 160,000 national brand and Pool Corporation branded products. We believe that our selection of pool equipment, supplies, chemicals, replacement parts, irrigation and landscape products and other pool construction and recreational products is the most comprehensive in the industry. The products we sell can be categorized as follows:

• maintenance products such as chemicals, supplies and pool accessories;
• repair and replacement parts for pool equipment, such as cleaners, filters, heaters, pumps and lights;
• packaged pool kits including walls, liners, braces and coping for in-ground and above-ground pools;
• pool equipment and components for new pool construction and the remodeling of existing pools;
• irrigation and landscape products, including irrigation system components and professional lawn care equipment and supplies; and
• other pool construction and recreational products, which consist of a number of product categories and include:
• building materials used for pool installations and remodeling, such as concrete, plumbing and electrical components and both functional and decorative pool surface and decking materials; and
• discretionary recreational and related outdoor lifestyle products that enhance consumers’ use and enjoyment of outdoor living spaces, such as spas, grills and components for outdoor kitchens.

We track and monitor the majority of our sales at the product level to provide support for sales and marketing efforts and for consideration in incentive plan programs. We currently have over 400 product lines and over 50 product categories. Based on our 2013 product classifications, sales for our pool and spa chemicals product category as a percentage of total net sales was 14% in 2013, 15% in 2012 and 16% in 2011. Chemical sales declined 1.5% in 2013, reflecting lower volume due to delayed pool openings compared to 2012, while chemical pricing remained relatively flat. While market share gains drove chemical volume growth of 4% in 2012 and 6% in 2011, chemical sales growth did not keep pace with our overall sales growth due to price deflation of approximately 2% in 2011 and lingering price deflation for certain chemical products in 2012. No other product category accounted for 10% or more of total net sales in any of the last three fiscal years.

We categorize our maintenance, repair and replacement products into the following two groupings:

• maintenance and minor repair (non-discretionary); and
• major refurbishment and replacement (partially discretionary).

In 2013, the sale of maintenance and minor repair products accounted for approximately 60% of our sales and gross profits while approximately 40% of sales and gross profits were derived from the refurbishment, replacement, construction and installation (equipment, materials, plumbing, electrical, etc.) of swimming pools. These components reflect a shift back toward more sales of major refurbishment and replacement products due to an ongoing recovery of these activities since levels reached a low point in 2009. Between 2005 and early 2010, sales of maintenance and minor repair products had increased to approximately 70% of our sales and gross profits due to the significant declines in new pool construction. Prior to this industry downturn, just over 50% of our total sales and gross profits were related to maintenance and minor repair products.

Since our acquisition of NPT in 2008, we have expanded the number of sales center locations that offer NPT tile and composite pool finish products from the original 14 locations to over 80 locations. These locations feature consumer showrooms where swimming pool dealers and homeowners can view and select pool components including tile, decking materials and interior pool finishes in various styles and grades. Another key product initiative has been the expansion of our replacement parts offerings. These product initiatives, along with the continued expansion of our Pool Corporation branded products, have contributed to gross margin improvements over time. However, throughout 2012 and 2013 we experienced product and customer mix changes, including a shift in consumer spending to higher value, lower margin products such as variable speed pumps, high efficiency heaters, LED lighting and irrigation and landscape equipment, which positively impacted our sales growth but negatively impacted our gross margin.

Discretionary demand for products related to pool construction and remodeling has been an important factor in our historical base business sales growth. While sales of these products declined between 2007 and 2009, we realized sales growth from 2010 to 2013 due to our ongoing expansion of these product offerings and the steady improvement in new construction, remodeling and economic trends. However, new pool construction remains approximately 70% below peak levels reached in 2005 and approximately 60% below what we believe to be normal levels. We continue to identify new related product categories and we typically introduce new categories each year in select markets. We then evaluate the performance in these test markets and focus on those product categories that we believe exhibit the best long-term growth potential. We expect to realize continued sales growth for these types of product offerings by expanding the number of locations that offer these products, increasing the number of products offered at certain locations and continuing a modest broadening of these product offerings on a company-wide basis.

Operating Strategy

We distribute swimming pool supplies, equipment and related leisure products domestically through our SCP and Superior networks and internationally through our SCP network, while we distribute irrigation and landscape products through our Horizon network. We adopted the strategy of operating two distinct distribution networks within the U.S. swimming pool marketplace primarily for two reasons:

• to offer our customers a choice of distinctive product selections, locations and service personnel; and
• to increase the level of customer service and operational efficiency provided by the sales centers in each network by promoting healthy competition between the two networks.

We evaluate our sales centers based upon their performance relative to predetermined standards that include both financial and operational measures. Our corporate support groups provide our field operations with various services, such as developing and coordinating customer and vendor related programs, information systems support and expert resources to help them achieve their goals. We believe our incentive programs and feedback tools, along with the competitive nature of our internal networks, stimulate and enhance employee performance.

Distribution

Our sales centers are located within population centers near customer concentrations, typically in industrial, commercial or mixed‑use zones. Customers may pick up products at any sales center location, or we may deliver products to their premises or job sites via our trucks or third party carriers.

Our sales centers maintain well-stocked inventories to meet our customers’ immediate needs. We utilize warehouse management technology to optimize receiving, inventory control, picking, packing and shipping functions.

We also operate five centralized shipping locations (CSLs) that redistribute products we purchase in bulk quantities to our sales centers or in some cases, directly to customers. Our CSLs are regional locations that carry a wide range of traditional swimming pool, irrigation and related construction products.

Purchasing and Suppliers

We enjoy good relationships with our suppliers, who generally offer competitive pricing, return policies and promotional allowances. It is customary in our industry for certain manufacturers to offer seasonal terms to qualifying purchasers such as Pool Corporation. These terms typically allow us to place orders in the fall prior to any seasonal price increases, take delivery of product during the off-season months and pay for these purchases in the spring or early summer.

Our preferred vendor program encourages our distribution networks to stock and sell products from a smaller number of vendors to optimize profitability and shareholder return. We also work closely with our vendors to develop programs and services to better meet the needs of our customers and to concentrate our inventory investments. These practices, together with a more comprehensive service offering, have positively impacted our selling margins and our returns on inventory investments.

We regularly evaluate supplier relationships and consider alternate sourcing to assure competitive cost, service and quality standards. Our largest suppliers include Pentair Water Pool and Spa, Inc., Hayward Pool Products, Inc. and Zodiac Pool Systems, Inc., which accounted for approximately 18%, 11% and 8%, respectively, of the cost of products we sold in 2013.

Competition

Based on industry knowledge and available data, management believes we are the largest wholesale distributor of swimming pool and related backyard products and the only truly national wholesale distributor focused on the swimming pool industry in the United States. We are also one of the top three distributors of irrigation and landscape products in the United States. We face intense competition from many regional and local distributors in our markets and from one national wholesale distributor of irrigation and landscape products. We also face competition, both directly and indirectly, from mass-market retailers and large pool supply retailers (both store-based and internet) who buy directly from manufacturers and, to a lesser extent, from other distributors.

Some geographic markets we serve, particularly the four largest and higher pool density markets of California, Florida, Texas and Arizona, have a greater concentration of competition than others. Barriers to entry in our industry are relatively low. We believe that the principal competitive factors in swimming pool and landscape supply distribution are:

• the breadth and availability of products offered;
• the quality and level of customer service;
• the breadth and depth of sales and marketing programs;
• consistency and stability of business relationships with customers and suppliers;
• competitive product pricing; and
• access to commercial credit to finance business working capital.

We believe that we generally compete favorably with respect to each of these factors.

Seasonality and Weather

For a discussion regarding seasonality and weather, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Seasonality and Quarterly Fluctuations,” of this Form 10-K.

Environmental, Health and Safety Regulations

Our business is subject to regulation under local fire codes and international, federal, state and local environmental and health and safety requirements, including regulation by the Environmental Protection Agency, the Consumer Product Safety Commission, the Department of Transportation, the Occupational Safety and Health Administration, the National Fire Protection Agency and the International Maritime Organization. Most of these requirements govern the packaging, labeling, handling, transportation, storage and sale of chemicals and fertilizers. We store certain types of chemicals and/or fertilizers at each of our sales centers and the storage of these items is strictly regulated by local fire codes. In addition, we sell algaecides and pest control products that are regulated as pesticides under the Federal Insecticide, Fungicide and Rodenticide Act and various state pesticide laws. These laws primarily relate to labeling, annual registration and licensing.

Employees

We employed approximately 3,600 people at December 31, 2013. Given the seasonal nature of our business, our peak employment period is the summer and, depending on expected sales levels, we add 200 to 500 employees to our work force to meet seasonal demand.

Intellectual Property

We maintain both domestic and foreign registered trademarks, primarily for our Pool Corporation branded products that are important to our current and future business operations. We also own rights to numerous internet domain names.

Geographic Areas

The table below presents net sales by geographic region for the past three fiscal years (in thousands):

7

The table below presents net property and equipment by geographic region for the past three fiscal years (in thousands):

Available Information

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge on our website at www.poolcorp.com (http://www.poolcorp.com) as soon as reasonably practical after we electronically file such reports with, or furnish them to, the Securities and Exchange Commission (SEC).

Additionally, we have adopted a Code of Business Conduct and Ethics (the Code) that applies to all of our employees, officers and directors, and is available on our website at www.poolcorp.com (http://www.poolcorp.com). Any substantive amendments to the Code, or any waivers granted to any directors or executive officers, including our principal executive officer, principal financial officer, or principal accounting officer and controller, will be disclosed on our website and remain there for at least 12 months.

Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995

Our disclosure and analysis in 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 future performance, statements of management’s plans and objectives, future contracts, and forecasts of trends 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,” “believe,” “will likely result,” “outlook,” “project,” “should” and other words and expressions of similar meaning. No assurance can be given that the results in any forward-looking statements will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.

Risk Factors

Certain factors that may affect our business and could cause actual results to differ materially from those expressed in any forward‑looking statements include the following:

The demand for our swimming pool, irrigation and related outdoor lifestyle products has been and may continue to be adversely affected by unfavorable economic conditions.

In economic downturns, the demand for swimming pool, irrigation and related outdoor lifestyle products may decline as discretionary consumer spending, the growth rate of pool eligible households and swimming pool construction decline. Although maintenance products and repair and replacement equipment that must be purchased by pool owners to maintain existing swimming pools currently account for approximately 90% of our net sales and gross profits, the growth of this portion of our business depends on the expansion of the installed pool base and could also be adversely affected by decreases in construction activities similar to the trends between late 2006 and early 2010. A weak economy may also cause consumers to defer discretionary replacement and refurbish activity. In addition, even in generally favorable economic conditions, severe and/or prolonged downturns in the housing market could have a material adverse impact on our financial performance. Such downturns expose us to certain additional risks, including but not limited to the risk of customer closures or bankruptcies, which could shrink our potential customer base and inhibit our ability to collect on those customers’ receivables.

We believe that homeowners’ access to consumer credit is a critical factor enabling the purchase of new pools and irrigation systems. The recent unfavorable economic conditions and downturn in the housing market have resulted in significant tightening of credit markets, which has limited the ability of consumers to access financing for new swimming pools and irrigation systems. If these trends continue or worsen, many consumers will likely not be able to obtain financing for pool and irrigation projects, which could negatively impact our sales of construction related products.

We are susceptible to adverse weather conditions.

Weather is one of the principal external factors affecting our business. For example, unseasonably late warming trends in the spring or early cooling trends in the fall can shorten the length of the pool season. Also, unseasonably cool weather or extraordinary rainfall during the peak season can decrease swimming pool use, installation and maintenance, as well as landscape installations and maintenance. These weather conditions adversely affect sales of our products. Drought conditions or water management initiatives may lead to municipal ordinances related to water use restrictions, which could result in decreased pool and irrigation system installations and negatively impact our sales. While warmer weather conditions favorably impact our sales, global warming trends and other significant climate changes can create more variability in the short term or lead to other unfavorable weather conditions that could adversely impact our sales or operations. For a discussion regarding seasonality and weather, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Seasonality and Quarterly Fluctuations,” of this Form 10-K.

Our distribution business is highly dependent on our ability to maintain favorable relationships with suppliers.

As a distribution company, maintaining favorable relationships with our suppliers is critical to our success. We believe that we add considerable value to the swimming pool and irrigation and landscape supply chains by purchasing products from a large number of manufacturers and distributing the products to a highly fragmented customer base on conditions that are more favorable than these customers could obtain on their own. We believe that we currently enjoy good relationships with our suppliers, who generally offer us competitive pricing, return policies and promotional allowances. However, our inability to maintain favorable relationships with our suppliers could have an adverse effect on our business.

Our largest suppliers are Pentair Water Pool and Spa, Inc., Hayward Pool Products, Inc. and Zodiac Pool Systems, Inc., which accounted for approximately 18%, 11% and 8%, respectively, of the costs of products we sold in 2013. A decision by several suppliers, acting in concert, to sell their products directly to retailers or other end users of their products, bypassing distribution companies like ours, would have an adverse effect on our business. Additionally, the loss of a single significant supplier due to financial failure or a decision to sell exclusively to retailers or end-use consumers could also adversely affect our business. We dedicate considerable resources to promote the benefits and affordability of pool ownership, which we believe significantly benefits our swimming pool customers and suppliers.

We face intense competition both from within our industry and from other leisure product alternatives.

We face competition from both inside and outside of our industry. Within our industry, we compete against various regional and local distributors and, to a lesser extent, mass market retailers, large pool or landscape supply retailers and internet retailers. Outside of our industry, we compete with sellers of other leisure product alternatives, such as boats and motor homes, and with other companies who rely on discretionary homeowner expenditures, such as home remodelers. New competitors may emerge as there are low barriers to entry in our industry. Some geographic markets that we serve, particularly our four largest, higher density markets in California, Florida, Texas and Arizona, representing approximately 52% of our net sales in 2013, also tend to be more competitive than others.

More aggressive competition by mass merchants and large pool or landscape supply retailers could adversely affect our sales.

Mass market retailers today carry a limited range of, and devote a limited amount of shelf space to, merchandise and products targeted to our industry. Historically, mass market retailers have generally expanded by adding new stores and product breadth, but their product offering of pool and landscape related products has remained relatively constant. Should mass market retailers increase their focus on the pool or professional landscape industries, or increase the breadth of their pool and landscape related product offerings, they may become a more significant competitor for our direct customers and end-use consumers which could have an adverse impact on our business. We may face additional competitive pressures if large pool or landscape supply retailers look to expand their customer base to compete more directly within the distribution channel.

We depend on key personnel.

We consider our employees to be the foundation for our growth and success. As such, our future success depends in large part on our ability to attract, retain and motivate qualified personnel. This includes succession planning related to our executive officers and key management personnel. If we are unable to attract and retain key personnel, our operating results could be adversely affected.

Past growth may not be indicative of future growth.

Historically, we have experienced substantial sales growth through organic market share gains, new sales center openings and acquisitions that have increased our size, scope and geographic distribution. Since the beginning of 2011, we have opened 17 new sales centers (net of sales center closing and consolidations) and we have completed 7 acquisitions consisting of 13 sales centers (net of sales center closings and consolidations within one year of acquisition). While we contemplate continued growth through internal expansion and acquisitions, no assurance can be made as to our ability to:

• penetrate new markets;
• generate sufficient cash flows to support expansion plans and general operating activities;
• obtain financing;
• identify appropriate acquisition candidates;
• maintain favorable supplier arrangements and relationships; and
• identify and divest assets which do not continue to create value consistent with our objectives.

If we do not manage these potential difficulties successfully, our operating results could be adversely affected.

Our business is highly seasonal.

In 2013, we generated approximately 66% of our net sales and essentially 100% of our operating income in the second and third quarters of the year. These quarters represent the peak months of both swimming pool use, installation, remodeling and repair, and landscape installations and maintenance. Our sales are substantially lower during the first and fourth quarters of the year, when we may incur net losses.

The nature of our business subjects us to compliance with environmental, health, transportation and safety regulations.

We are subject to regulation under federal, state and local environmental, health, transportation and safety requirements, which govern such things as packaging, labeling, handling, transportation, storage and sale of chemicals and fertilizers. For example, we sell algaecides and pest control products that are regulated as pesticides under the Federal Insecticide, Fungicide and Rodenticide Act and various state pesticide laws. These laws primarily relate to labeling, annual registration and licensing.

Failure to comply with these laws and regulations may result in the assessment of administrative, civil and criminal penalties or the imposition of injunctive relief. Moreover, compliance with such laws and regulations in the future could prove to be costly, and there can be no assurance that we will not incur such costs in material amounts. These laws and regulations have changed substantially and rapidly over the last 25 years and we anticipate that there will be continuing changes. The clear trend in environmental, health, transportation and safety regulation is to place more restrictions and limitations on activities that impact the environment, such as the use and handling of chemical substances. Increasingly, strict restrictions and limitations have resulted in higher operating costs for us and it is possible that the costs of compliance with such laws and regulations will continue to increase. We will attempt to anticipate future regulatory requirements that might be imposed and we will plan accordingly to remain in compliance with changing regulations and to minimize the costs of such compliance.

We store chemicals, fertilizers and other combustible materials that involve fire, safety and casualty risks.

We store chemicals and fertilizers, including certain combustible, oxidizing compounds, at our sales centers. A fire, explosion or flood affecting one of our facilities could give rise to fire, safety and casualty losses and related liability claims. We maintain what we believe is prudent insurance protection. However, we cannot guarantee that our insurance coverage will be adequate to cover future claims that may arise or that we will be able to maintain adequate insurance in the future at rates we consider reasonable. Successful claims for which we are not fully insured may adversely affect our working capital and profitability. In addition, changes in the insurance industry have generally led to higher insurance costs and decreased availability of coverage.

We conduct business internationally, which exposes us to additional risks.

Our international operations expose us to certain additional risks, including:

• difficulty in staffing international subsidiary operations;
• different political and regulatory conditions;
• currency fluctuations;
• adverse tax consequences; and
• dependence on other economies.

We rely on manufacturers and other suppliers to provide us with the products we sell and distribute. As we increase the number of Pool Corporation branded products we distribute, our exposure to potential liability claims may increase. The risk of claims may also be greater with respect to products manufactured by third-party suppliers outside the United States, particularly in China. Uncertainties with respect to foreign legal systems may adversely affect us in resolving claims arising from our foreign sourced products. Even if we are successful in defending any claim relating to the products we distribute, claims of this nature could negatively impact customer confidence in our products and our company.

For foreign sourced products, we may be subject to certain trade restrictions that would prevent us from obtaining products and there is also a greater risk that we may not be able to access products in a timely and efficient manner. Fluctuations in other factors relating to international trade, such as tariffs, transportation costs and inflation are additional risks for our international operations.

We rely on information technology systems to support our business operations, and any disturbance or breach of our technological infrastructure could adversely affect our financial condition and results of operations.

Information technology supports several aspects of our business, including among others, product sourcing, pricing, customer service, financial reporting, collections and cost management. Our ability to operate effectively on a day to day basis depends on a solid technological infrastructure, which is inherently susceptible to internal and external threats. We are vulnerable to interruption by fire, natural disaster, power loss, telecommunications failure, internet failures and other catastrophic events. Exposure to various types of cyber-attacks such as malware, computer viruses, worms, or other malicious acts, as well as human error, could also potentially disrupt our operations or result in a significant interruption in the delivery of our goods and services.

We have designed numerous procedures and protocols to mitigate these risks. We continually invest in information technology security and update our business continuity plan. However, the failure to maintain security and prevent unauthorized access to confidential customer information, or data belonging to us or our suppliers, could put us at a competitive disadvantage, result in damage to our reputation and subject us to potential litigation, liability, fines and penalties, resulting in a possible material adverse impact on our financial condition and results of operations.

A terrorist attack or the threat of a terrorist attack could have a material adverse effect on our business.

Discretionary spending on leisure product offerings such as ours is generally adversely affected during times of economic or political uncertainty. The potential for terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility could create these types of uncertainties and negatively impact our business for the short or long term in ways that cannot presently be predicted.

We lease the Pool Corporation corporate offices, which consist of approximately 53,000 square feet of office space in Covington, Louisiana, from an entity in which we have a 50% ownership interest. We own three sales center facilities in Florida and one in Texas. We lease all of our other properties and the majority of our leases have three to seven year terms.

As of December 31, 2013, we had 12 leases with remaining terms longer than seven years that expire between 2021 and 2027. Most of our leases contain renewal options, some of which involve rent increases. In addition to minimum rental payments, which are set at competitive rates, certain leases require reimbursement for taxes, maintenance and insurance.

Our sales centers range in size from approximately 2,000 square feet to 60,000 square feet and generally consist of warehouse, counter, display and office space. Our centralized shipping locations (CSLs) range in size from approximately 71,000 square feet to 115,000 square feet.

We believe that our facilities are well maintained, suitable for our business and occupy sufficient space to meet our operating needs. As part of our normal business, we regularly evaluate sales center performance and site suitability and may relocate a sales center or consolidate two locations if a sales center is redundant in a market, underperforming or otherwise deemed unsuitable. We do not believe that any single lease is material to our operations.

The table below summarizes the changes in our sales centers during the year ended December 31, 2013:

(1) Consolidated sales centers are those locations where we expect to transfer the majority of the existing business to our nearby sales center locations. During 2013, we consolidated three sales centers.

(2) We completed two acquisitions in the United States in 2013. We do not plan to close or consolidate either of these acquired sales centers.

The table below identifies the number of sales centers in each state, territory or country by distribution network as of December 31, 2013:

13

From time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. Litigation can be expensive and disruptive to normal business operations.

In 2012, a number of purported anti-trust class action suits were filed against us in various United States District Courts. The cases were transferred and consolidated before the Judicial Panel for Multidistrict Litigation, MDL Docket No. 2328, and are presently pending in the Eastern District of Louisiana. The plaintiffs include indirect purchaser plaintiffs, purporting to represent indirect purchasers of swimming pool products in Arizona, California, Florida and Missouri, and direct purchaser plaintiffs, who are current or former customers. Three additional defendants include Hayward Industries Inc., Pentair Water Pool and Spa, Inc. and Zodiac Pool Systems, Inc. The plaintiffs seek unspecified compensatory and enhanced damages, interest, costs and fees and other equitable relief. We believe the amended complaints are without merit and we intend to vigorously defend ourselves.

We are subject to regulation under federal, state and local environmental, transportation, and health and safety requirements, which govern such things as packaging, labeling, handling, transportation, storage and sale of chemicals. As previously disclosed in 2012, the Office of the District Attorney for the County of Riverside, California, made a monetary demand upon us for civil penalties, alleging noncompliance in the past with local and state hazardous waste handling, storage and transportation laws, fire and building code regulations and California Business & Professions Code Section 17200, primarily relating to liquid chlorine and muriatic acid. On August 30, 2013, the Office of the District Attorney for the County of Riverside, California, filed a complaint against us for civil penalties, alleging the same matters. Although we are unable to predict the outcome of this matter, based on information currently available to us, we do not expect this matter to have a material adverse effect on our financial condition, results of operations or cash flows.

While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters or other claims and litigation not discussed above will have a material adverse impact on our financial condition, results of operations or cash flows. Our view of these matters may change in the future as the litigation and related events unfold.

For a discussion of our base business calculations, see the RESULTS OF OPERATIONS section below.

In our discussion of results of operations below, adjusted operating income, adjusted net income and adjusted diluted earnings per share for the 2012 and 2011 periods exclude the Goodwill impairment line item on the Consolidated Statements of Income. We have provided these adjusted amounts because we believe it helps investors assess our year-over-year operating performance.

2013 FINANCIAL OVERVIEW

Financial Results

In 2013, we surpassed $2.0 billion in sales, a fitting accomplishment for our milestone 20th year. We achieved record results, including diluted earnings per share (EPS) of $2.05, despite persistent and challenging external factors. In our business, how we distribute products is as important as what products we distribute. We believe that our success reflects the totality of having the right products, available at the right time, coupled with exceptional service, complemented by innovative programs and tools resulting in the value-add we provide to the marketplace.

Net sales for the year ended December 31, 2013 increased 6% compared to 2012. Base business sales increased 6%, including a 6% increase from swimming pool product sales and an 11% increase from irrigation and landscape product sales. Base business sales growth reflects market growth, market share gains and the ongoing recovery of discretionary product sales, partially offset by weather driven declines in non-discretionary product sales, primarily in our seasonal markets. For 2013, net sales growth of 11% in our largest, year-round markets tracked well above the 2% growth in our seasonal markets, although this difference lessened as weather comparisons normalized later in the year.

Gross profit for the year ended December 31, 2013 increased 4% over 2012. Gross profit as a percentage of net sales (gross margin) decreased 60 basis points to 28.4% for 2013. Product, customer and geographic mix changes adversely impacted gross margin in 2013. Product mix changes reflected a shift in consumer spending to certain lower margin, discretionary products such as variable speed pumps, high efficiency heaters, LED lighting products, irrigation systems and landscape equipment, relative to higher margin, non-discretionary products generally associated with basic pool maintenance and repair activity. Additionally, due to the later start to the 2013 season, we experienced higher sales growth rates in our lower margin, year-round markets than in our higher margin, seasonal markets, which negatively impacted gross margins.

Selling and administrative expenses (operating expenses) for 2013 increased 2% from 2012. Base business operating expenses increased 2% year over year, as salary and other variable expense increases were partially offset by decreases in performance‑based compensation.

In the third quarter of 2012, we performed an interim goodwill impairment analysis for our United Kingdom reporting unit and recorded a non-cash goodwill impairment charge equal to the total goodwill carrying amount of $6.9 million, which had a $0.14 negative impact on diluted EPS for the year ended December 31, 2012.

Operating income for the year improved 14% over 2012 and increased 9% compared to adjusted operating income for 2012. Operating income as a percentage of net sales (operating margin) increased to 8.0% in 2013 compared to 7.4% in 2012. Adjusted operating margin was 7.8% in 2012.

Net income increased 19% compared to 2012, while EPS was up 20% to a record $2.05 per diluted share. Compared to adjusted net income for 2012, net income increased 9%, while diluted EPS increased 11% from adjusted diluted EPS for 2012.

Financial Position and Liquidity

Cash provided by operations of $105.1 million in 2013 was $7.8 million more than net income and, combined with $15.5 million in net proceeds from our revolving line of credit and receivables securitization facility and $21.4 million in proceeds from stock issued under share-based compensation plans, helped fund the following:

• quarterly cash dividend payments to shareholders, which totaled $33.8 million for the year;
• share repurchases in the open market of $94.3 million;
• net capital expenditures of $18.7 million; and
• payments of $1.2 million related to acquisitions.

Total net receivables increased 10% compared to December 31, 2012, consistent with our fourth quarter sales growth. Days sales outstanding (DSO) improved between periods to 28.1 days at December 31, 2013 compared to 28.8 days at December 31, 2012.

Inventory levels grew 7% to $429.2 million at December 31, 2013 compared to levels at December 31, 2012. Our inventory turns, as calculated on a trailing twelve month basis, were 3.4 times at both December 31, 2013 and December 31, 2012.

Total debt outstanding at December 31, 2013 was $246.4 million, an increase of $15.5 million from the balance at December 31, 2012.

Current Trends and Outlook

2013 marked the fourth year of the gradual pool industry recovery following the Great Recession. Despite the sluggish pace of recovery, pent up demand in North America for replacement and refurbishment of existing pools and pool components helped propel industry growth. This growth occurred despite inclement weather throughout many, primarily seasonal markets, which adversely impacted pool openings and demand for maintenance products. Irrigation and landscape markets also benefited from the continuing recovery of single-family home construction markets.

The economic downturn between 2007 and 2009 had a significant impact on our industry, driving an approximate 80% reduction in new pool construction in the United States compared to peak levels in 2005 and also contributing to more than a 30% decline in replacement and refurbishment activities. While we estimate that new pool construction has increased from a low of roughly 45,000 new units in 2009 to approximately 60,000 new units in 2013, construction levels are still down more than 70% compared to peak levels in 2005 and down approximately 60% from what we consider normal levels.

The rebound in our base business sales growth beginning in 2010 reflects continued improvement in consumer discretionary expenditures, higher replacement activities and market share gains given our estimated industry growth of 3% to 5% for 2010 to 2012. Improvements in general external market factors in the United States including consumer confidence, employment, housing, consumer financing and economic expansion helped support this growth. In 2013, we estimate industry growth dipped temporarily to approximately 1% to 2% given the impact of adverse weather on seasonal markets. Going forward, we believe there is potential for a significant sales recovery due to the build-up of deferred replacement and remodeling activity and our expectation for gradually normalized new pool and irrigation construction levels. We also expect that market conditions in the United States will continue to improve, enabling further recovery of replacement, remodeling and new construction activity to normalized levels over the next 4 to 7 years. We expect that the industry will realize an annual growth rate of approximately 4% to 7% over this time period before reverting back to 3% to 4% annual growth over the longer term. As current economic trends indicate that consumer spending has begun to slowly recover and that construction activities will likely continue to gradually improve, we believe that we are well positioned to take advantage of both the eventual market recovery and the inherent long-term growth opportunities in our industry.

For 2014, we expect the macroeconomic environment and the opportunities to realize additional market share gains will be quite similar to 2013. We also anticipate industry growth levels will benefit from an expected return to normal seasonal weather compared to 2013. We project 6% to 8% base business sales growth, including our expectation for average inflationary product cost increases of 1% to 2%. We expect that we will grow market share by providing exceptional customer service throughout our networks, expanding product lines and further penetrating underserved markets. We also expect to modestly expand our pool and irrigation networks by opening seven to nine new locations. We believe our sales growth will be more geographically balanced than 2013 and will continue to be weighted toward sales of discretionary products, resulting in negative to neutral gross margin trends for the full year.

Overall, we anticipate expenses will grow at approximately half the rate of our net sales growth in 2014, reflecting inflationary increases and incremental costs to support our sales growth expectations. We expect base business results will generate operating profit growth of 15% or greater in 2014.

Based on these expectations, we project that 2014 earnings per share will be approximately $2.35 to $2.45 per diluted share. We expect cash provided by operations will approximate net income for fiscal 2014 and anticipate that share repurchase activity will be similar to 2013.

The forward-looking statements in this Current Trends and Outlook section are subject to significant risks and uncertainties, including changes in the economy and the housing market, the sensitivity of our business to weather conditions, 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.

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
• those for which changes in the estimate 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. 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.

As our business is seasonal, our customers’ businesses are also 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 0.1% for amounts currently due 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 collectibility based on a combination of factors including:

• aging statistics and trends;
• customer payment history;
• independent credit reports; and
• discussions with customers.

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 0.2% of net sales annually. Write-offs as a percentage of net sales were 0.1% in 2013, 0.1% in 2012 and 0.2% in 2011. The recent improvement in net write-offs reflects gradually improving external market trends and heightened collection efforts and creditworthiness evaluations. We expect that write-offs will be approximately 0.1% of net sales in 2014. 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 reserve methodology is appropriate.

If the balance of the accounts receivable reserve increased or decreased by 20% at December 31, 2013, pretax income would change by approximately $0.9 million and earnings per share would change by approximately $0.01 per diluted share (based on the number of weighted average diluted shares outstanding for the year ended December 31, 2013).

Inventory Obsolescence

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 have lower velocity. Sales centers classify products into 13 classes based on sales at that location over the past 12 months (or 36 months for tile products).

All inventory is included in these classes, except for non-stock special order items and products with less than 12 months of usage. The table below presents a description of these inventory classes:

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 that we may not be able to sell at a profit. 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 relationship to historical sales by product, including inventory usage by class based on product sales at both the sales center and Company levels;
• changes in customer preferences or regulatory requirements;
• seasonal fluctuations in inventory levels;
• geographic location; and
• new product offerings.

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 reserve methodology is appropriate.

If the balance of our inventory reserve increased or decreased by 20% at December 31, 2013, pretax income would change by approximately $1.4 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, 2013).

Vendor Incentives

Many of our vendor arrangements provide for us to receive incentives of specified amounts of consideration when we achieve any of a number of measures. These measures are generally related to the volume level of purchases from our vendors and may include negotiated pricing arrangements. We account for vendor incentives 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 such incentives are recognized as a reduction of cost of sales in our income statement.

Throughout the year, we estimate the amount of the incentive earned based on our estimate of total purchases for the fiscal year relative to the purchase levels that mark our progress toward earning the incentives. We accrue vendor incentives 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 weather and changes in economic conditions. Changes in our purchasing mix also impact our incentive estimates, as incentive 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 incentive accruals 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 incentive arrangements are based on calendar year periods. Our estimates for these arrangements are updated 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 incentives received to the prior year vendor incentive balances. Based on our hindsight analysis, we concluded that our vendor incentive 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 gross margins for products purchased and sold in future periods.

Income Taxes

We record deferred tax assets or 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.

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.

As of December 31, 2013, we have not provided for United States income taxes on undistributed earnings of our foreign subsidiaries, as we have invested or expect to invest the undistributed earnings indefinitely. If these earnings are repatriated to the United States in the future, or if we determine that the earnings will be remitted in the foreseeable future, additional tax provisions may be required. Determining the amount of unrecognized deferred tax liability on these undistributed earnings is not practicable due to the complexity of tax laws and regulations and the varying circumstances, tax treatments and timing of any future repatriation.

We hold, through our wholly owned affiliates, cash balances in the countries in which we operate, including amounts held outside the United States. Most of the amounts held outside the United States could be repatriated to the United States, but, under current law, may be subject to United States federal income taxes, less applicable foreign tax credits. Repatriation of some foreign balances is restricted by local laws including the imposition of withholding taxes in some jurisdictions.

We have operations in 39 states, 1 United States territory and 10 foreign countries. The amount of income taxes we pay is subject to adjustment by the applicable tax authorities. We are subject to regular audits by federal, state and foreign tax authorities. Our estimate for the potential outcome of any uncertain tax issue is highly judgmental. We regularly evaluate our tax positions, assess the probability of examinations by taxing authorities 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.

Incentive Compensation Accrual

Our incentive compensation structure is designed to attract, motivate and retain employees. Our incentive 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, with a component based on management’s discretion. We calculate bonuses based on the achievement of certain key measurable financial and operational results, including budgeted operating income and diluted earnings per share.

Management sets the objectives for our bonus plans at the beginning of the bonus plan year using both historical information and forecasted results of operations for the current plan year. The Compensation Committee of our Board approves these objectives for certain bonus plans. We record an incentive compensation accrual at the end of each month using management’s estimate of the total overall incentives earned based on the amount of progress achieved toward the stated bonus plan objectives. During the third and fourth quarters and as of our fiscal year end, we adjust our estimated incentive 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.

Our quarterly incentive compensation expense and accrual balances may vary relative to actual annual bonus expense and payouts due to the following:

• the discretionary components of the bonus plans;
• differences between estimated and actual performance; and
• our projections related to achievement of multiple-year performance objectives for our Strategic Plan Incentive Program.

We generally make bonus payments at the end of February following the most recently completed fiscal year. Each year, we compare the actual bonus payouts to amounts accrued at the previous year end to determine the accuracy of our incentive compensation estimates. Based on our hindsight analysis, we concluded that our incentive compensation accrual balance was within a reasonable range of acceptable estimates and that our reserve methodology is appropriate.

Impairment of Goodwill and Other Indefinite-Lived Intangible Assets

Our largest intangible asset is goodwill. At December 31, 2013, our goodwill balance was $172.0 million, representing approximately 21% of total assets. Goodwill represents the excess of the amount we paid to acquire a company over the estimated fair value of tangible assets and identifiable intangible assets acquired, less liabilities assumed.

We perform our goodwill impairment test in the fourth quarter of each year or on a more frequent basis if events or changes in circumstances occur that indicate potential impairment. If the estimated fair value of any of our reporting units is below its carrying value, we compare the estimated fair value of the reporting unit's goodwill to its carrying value. If the carrying value of a reporting unit's goodwill exceeds its estimated fair value, we recognize the difference as an impairment loss in operating income.

Since we define an operating segment as an individual sales center and we do not have operations below the sales center level, our reporting unit is an individual sales center. As of October 1, 2013, we had 208 reporting units with allocated goodwill balances. The highest goodwill balance was $5.7 million and the average goodwill balance was $0.8 million.

We estimate the fair value of our reporting units based on an income approach that incorporates our assumptions for determining the present value of future cash flows. We project future cash flows using management's assumptions for sales growth rates, operating margins, discount rates and multiples. These estimates can significantly affect the outcome of the impairment test. To determine the reasonableness of the assumptions included in our fair value estimates, we compare the total estimated fair value for all aggregated reporting units to our market capitalization on the date of our impairment test. We also review for potential impairment indicators at the reporting unit level based on an evaluation of recent historical operating trends, current and projected local market conditions and other relevant factors as appropriate.

In October 2013, we performed our annual goodwill impairment test and did not identify any goodwill impairment at the reporting unit level. During the third quarter of 2012, we performed an interim goodwill impairment analysis based on our identification of impairment indicators related to our results through the end of the 2012 pool season. As a result of our interim impairment analysis in the third quarter of 2012, we recorded a non-cash goodwill impairment charge of $6.9 million equal to the total carrying amount of our United Kingdom reporting unit.

Based on the magnitude of their goodwill balances and the challenging economic conditions in Europe, we identified our Italy and Spain reporting units as the most at risk for goodwill impairment. Results for certain of our reporting units in Quebec, Canada fell below expectations in 2013, due to weather and other execution challenges, which prompted us to identify one reporting unit as at-risk. We believe our domestic reporting units most at risk for goodwill impairment include one Horizon location in Texas, one Horizon location in Nevada and one Horizon location in California. As of December 31, 2013, our at-risk reporting units in Europe had an aggregate goodwill balance of $6.4 million, our at-risk reporting unit in Canada had a goodwill balance of $0.7 million and our at-risk reporting units in the United States had an aggregate goodwill balance of $3.2 million.

If our assumptions or estimates in our fair value calculations change or if operating results are less than forecasted, we could incur additional impairment charges in future periods, especially related to the reporting units discussed above. Impairment charges would decrease operating income, negatively impact diluted EPS and result in lower asset values on our balance sheet.

To test the reasonableness of our fair value estimates, we compared our aggregate estimated fair values to our market capitalization as of the date of our annual impairment test. We expect that a reasonable fair value estimate would reflect a moderate acquisition premium. Our fair value estimates fell within 1% of our market capitalization. Our sensitivity analysis, which incorporated more conservative projected cash flow assumptions and fell close to 10% below our market capitalization, resulted in no calculated goodwill impairments.

We performed a second sensitivity analysis over our two remaining key fair value assumptions and determined that a 50 basis point increase in our estimated weighted average cost of capital or a 50 basis point decrease in the estimated perpetuity growth rate would generate fair value estimates significantly below our market capitalization, evidencing that our estimates for these assumptions fell at the conservative end of a range of acceptable estimates.

Recent Accounting Pronouncements

We are not aware of any recent accounting pronouncements that will materially impact our Consolidated Financial Statements in future periods.

RESULTS OF OPERATIONS

The table below summarizes information derived from our Consolidated Statements of Income expressed as a percentage of net sales for the past three fiscal years:

Note: Due to rounding, percentages may not add to operating income or income before income taxes and equity earnings.

Our discussion of consolidated operating results includes the operating results from acquisitions in 2013, 2012 and 2011. We have included the results of operations in our consolidated results since the respective acquisition dates.

Fiscal Year 2013 compared to Fiscal Year 2012

The following table breaks out our consolidated results into the base business component and the excluded components (sales centers excluded from base business):

(Unaudited)

(in thousands)

25

We have excluded the following acquisitions from base business for the periods identified:

(1) We acquired certain distribution assets of each of these companies.

We exclude sales centers that are acquired, closed or opened in new markets from base business results 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. There was one sales center opened in a new market that was excluded from base business as of December 31, 2013.

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 centers during 2013:

For information about our recent acquisitions, see Note 2 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10-K.

Net Sales

(in millions)

Net sales, as well as base business sales, increased 6% in 2013. The base business sales increase is comprised of a 6% increase from swimming pool product sales and an 11% increase from irrigation product sales. In local currencies, net sales in Europe were relatively flat compared to 2012, reflecting the impact of cold and wet weather conditions on results over the first half of the year, and the effects of the continued difficult economic environment.

The principal factors impacting our base business sales growth included the following (listed in order of estimated magnitude):

• market share gains attributable to continued improvements in customer service levels, sales growth rates for certain discretionary product offerings such as building materials (see discussion below), heaters, pumps and lighting, and higher base business sales growth for irrigation systems and landscape equipment due in part to the gradual recovery of the housing market in some of our key states;
• challenging weather comparisons in the first half of the year, resulting in declines in non-discretionary product sales, primarily in our seasonal markets, supported by continued growth in our largest, year-round markets and discretionary product sales (for the year, net sales growth of 11% in our largest, year-round markets tracked well above the 2% growth in our seasonal markets, although this differential narrowed throughout the third and fourth quarters as weather comparisons normalized); and
• inflationary product cost increases (estimated at approximately 1% to 2%).

Sales of building materials and tile grew by 20% in 2013 compared to 2012, although collectively these products only accounted for approximately 11% of our total sales. Chemical sales declined by 1.5%, reflecting lower volume due to delayed pool openings compared to 2012, while chemical pricing remained relatively flat.

We realized base business sales growth of 2% in the first quarter and 4% in the second quarter, compared to the prior year periods. Throughout the first half of 2013, comparatively difficult weather versus the first half of 2012 suppressed our sales growth. Sales through May of 2012 benefited from unusually favorable weather, especially across the Eastern half of North America. Record warm temperatures in the Northeast and Midwest United States spurred an earlier than normal start to remodeling projects and new pool construction in the 2012 season. In 2013, later than normal pool openings in our seasonal markets in North America and Europe further added to these challenging comparisons. Weather normalized in the latter half of 2013, leading to base business sales growth of 9% in the third quarter and 11% in the fourth quarter. See discussion of significant weather impacts under the subheading Seasonality and Quarterly Fluctuations beginning on page 32.

Gross Profit

(in millions)

Gross margin declined approximately 60 basis points from last year. This decrease is primarily due to unfavorable product mix, customer mix and geographic mix as well as competitive pricing pressures. Double-digit sales growth of higher value, lower margin discretionary products such as variable speed pumps, high efficiency heaters, LED lighting products, irrigation systems and landscape equipment positively contributed to sales and gross profit dollars but negatively impacted our margins. This growth outpaced our sales of higher margin, non-discretionary product lines generally associated with basic pool maintenance and repair activity. Additionally, as a result of the slower start to the 2013 season, geographic regions with generally higher margins contributed a proportionally smaller share of our total sales growth.

The following factors collectively impacted gross margin throughout 2013:

• changes in our product mix, as discussed in detail above;
• growth in sales to larger, lower margin customers, primarily those focused on remodeling and construction activities;
• higher sales growth rates in our lower margin, year-round markets compared to our seasonal markets;
• lower volume incentive rates from certain vendors;
• higher credit card fees as a percentage of net sales; and
• increased presence of Internet retailers who set low industry reference prices for certain products.

Year over year, gross margin comparisons fell below the prior year each quarter during 2013, with declines of 60 basis points in the first quarter, 50 basis points in the second quarter, 60 basis points in the third quarter and 90 basis points in the fourth quarter. These declines reflect the changes in product and customer mix discussed above, while geographic mix also contributed to the margin decline in the first and second quarters of 2013. The larger decline in the fourth quarter is due primarily to a more favorable impact on fourth quarter 2012 gross margins from certain vendor incentives.

Operating Expenses

(in millions)

Operating expenses, as well as base business operating expenses, increased 2% compared to 2012. Increases in overall compensation-related costs, driven by inflationary salary increases and headcount increases to support new sales centers, and higher professional fees were partially offset by a reduction in performance-based compensation.

Interest Expense, net

Interest expense, net for 2013 was consistent with 2012. Average outstanding debt was $256.1 million for 2013 versus $250.3 million for 2012. The weighted average effective interest rate declined slightly to 2.4% in 2013 compared to 2.6% in 2012.

Income Taxes

Our effective income tax rate was 38.80% at December 31, 2013 compared to 41.00% at December 31, 2012. Excluding the impact of last year's goodwill impairment charge, our effective income tax rate for 2012 was 39.80%. The impact on the provision from the change in our valuation allowance for foreign net operating losses was 0.57% in 2013 compared to 1.97% in 2012.

Net Income and Earnings Per Share

Net income increased 19% to $97.3 million in 2013 compared to $82.0 million in 2012, while earnings per share increased 20% to $2.05 per diluted share compared to $1.71 per diluted share in 2012. Excluding the $6.9 million ($0.14 per diluted share) impact from the goodwill impairment charge in 2012, net income for 2013 increased 9% over 2012 adjusted net income of $88.9 million, while diluted EPS increased 11% from adjusted diluted earnings per share of $1.85 for 2012.

Earnings per share for 2013 also included an accretive impact of approximately $0.02 per diluted share from the reduction in our weighted average shares outstanding due to our share repurchase activities during the year.

Fiscal Year 2012 compared to Fiscal Year 2011

The following table breaks out our consolidated results into the base business component and the excluded components (sales centers excluded from base business):

(Unaudited)

(in thousands)

For an explanation of how we calculate base business, please refer to the discussion of base business on page 26 under the heading "Fiscal Year 2013 compared to Fiscal Year 2012".

For purposes of comparing operating results for the year ended December 31, 2012 to the year ended December 31, 2011, we excluded acquired sales centers from base business for the periods identified in the table below. As of December 31, 2012, we also excluded four new market sales center that opened in 2012.

(1) We acquired certain distribution assets of each of these companies.

The table below summarizes the changes in our sales centers during 2012:

29

For information about our recent acquisitions, see Note 2 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10-K.

Net Sales

(in millions)

Net sales for 2012 increased 9% compared to 2011, including a 7% increase in base business sales and a 2% increase related to our recent acquisitions and sales centers opened in new markets. Our base business sales growth included a 7% increase on the swimming pool side of the business and a 10% increase on the irrigation side of the business. In local currencies, net sales in Europe declined approximately 1% in 2012, as modest sales growth in France, our largest European market, offset double digit sales declines in the United Kingdom and sales declines in Spain and Italy.

The principal factors contributing to base business sales growth included the following (listed in order of estimated magnitude):

• market share gains attributed to continued improvements in customer service levels, sales growth rates for certain product offerings such as building materials and chemicals (see discussion below) and higher base business sales growth for the irrigation side of the business, which included benefits realized from a regional competitor going out of business;
• double‑digit sales growth for higher value, lower margin products, such as variable speed pumps, motorized pool lifts, pool heaters and LED lighting;
• continued improvement in consumer discretionary expenditures, including some market recovery in remodeling activity;
• the impact of inflationary product cost increases (estimated at approximately 1% to 2%); and
• higher sales of non-discretionary products for the refurbishment of the aging installed base of swimming pools, which we estimate grew 1% over the past year.

Sales of building materials, tile and packaged pool products grew by 16% compared to 2011, although collectively these products only accounted for approximately 12% of our total sales. Chemical sales grew by 5%, with a small benefit overall from price inflation despite some lingering price deflation for certain chemical products.

These sales increases were offset by unfavorable foreign currency fluctuations of approximately 1%.

Our sales performance in 2012 was strongest in the first quarter with 13% base business sales growth, modest in the middle second and third quarters, and solid in the fourth quarter with 12% base business sales growth. Sales benefited from exceptionally favorable weather through May as record warm spring temperatures spawned an early start to the 2012 peak season. However, June and July sales were negatively impacted by unfavorable weather conditions compared to the same period in 2011 and the shift of business into earlier months. See discussion of significant weather impacts under the subheading Seasonality and Quarterly Fluctuations beginning on page 32.

Gross Profit

(in millions)

Gross margin decreased 60 basis points between periods, reflecting unfavorable changes in our product and customer mix, competitive pricing pressures and unfavorable comparisons to 2011, which benefited from opportunistic inventory purchases. As discussed above, customer demand shifted somewhat in 2012 to higher value, lower margin products. While this product mix change strongly contributed to 2012 sales and gross profit growth, it negatively impacted gross margin. Additionally, going into the 2011 season, we made greater early buy inventory purchases in advance of year-end vendor price increases and we made additional bulk inventory purchases in advance of mid-year 2011 vendor price increases. These strategic purchases benefited our gross margin throughout 2011. We made more modest early buy inventory purchases going into the 2012 season as vendor price increases were less escalated.

Favorable impacts on comparative gross margin included continued improvements in purchasing and pricing discipline and a 10 basis point increase attributed to lower debit card fees as a percentage of net sales as a result of the Dodd‑Frank Wall Street Reform and Consumer Protection Act.

Year over year, gross margin comparisons worsened throughout 2012, with declines of 30 basis points in the first quarter, 50 basis points in the second quarter, 70 basis points in the third quarter and 90 basis points in the fourth quarter. The gradual decline reflected the difficult comparison to 2011 due to the timing and amount of inventory purchases, combined with changes in product and customer mix during 2012.

Operating Expenses

(in millions)

Operating expenses increased 3% compared to 2011. Base business operating expenses remained essentially flat due to the following:

• a $3.7 million decrease in performance-based compensation;
• a $2.5 million impact on expenses from currency fluctuations; and
• a $2.2 million decline in bad debt expense, due to improved collection and write-off trends.

These declines were offset by increases of $4.1 million in salaries and wages and $2.1 million in employee insurance costs primarily due to a 3% increase in average headcount excluding acquisitions. Professional fees also increased by $2.5 million.

Interest Expense, net

Interest expense, net decreased $1.5 million due primarily to the impact of foreign currency transaction gains and losses, with gains of $0.1 million recognized in 2012 compared to losses of $0.6 million recognized in 2011. Interest expense related to borrowings declined approximately $0.3 million in 2012 due primarily to a decline in expense on interest rate swap contracts. Average outstanding debt was down 2% compared to 2011 and the weighted average effective interest rate remained flat at 2.6% between periods. In 2011, we realized a $0.3 million loss related to the early termination of interest rate swap contracts in the fourth quarter.

Income Taxes

Our effective income tax rate was 41.00% at December 31, 2012 compared to 38.70% at December 31, 2011. This slightly higher effective income tax rate reflects an increase in our valuation allowance and a small impact due to the temporary lapse of the controlled foreign corporation income exclusion, offset by benefits realized upon the expiration of statutes of limitations for our 2007 income tax returns.

Net Income and Earnings Per Share

Net income increased 14% to $82.0 million in 2012, while earnings per share increased 16% to $1.71 per diluted share. Excluding the $6.9 million ($0.14 per diluted share) impact from the goodwill impairment charge in 2012 and the $1.6 million ($0.03 per diluted share) impact from the goodwill impairment charge in 2011, adjusted net income for 2012 increased 21% to $88.9 million and adjusted earnings per share increased 23% to $1.85 per diluted share. Earnings per share for 2012 also included the following:

• an accretive impact of approximately $0.02 per diluted share from the reduction in our weighted average shares outstanding due to our share repurchase activities during the year; and
• an unfavorable impact of $0.01 per diluted share due to foreign currency fluctuations.

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 landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2013, we generated approximately 66% of our net sales and essentially 100% 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 2013 and 2012. 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)

(in thousands)

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.

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.

More normalized weather in the first quarter of 2013 sharply contrasted with the mild winter experienced in the same period of 2012. In the first quarter of 2012, above average temperatures surfaced throughout the Eastern half of North America, with record warm temperatures in the Northeast and the Midwest. More normal temperatures in 2013 resulted in delayed pool openings in comparison to 2012, which directly affected first quarter sales in most seasonal markets as evidenced by the sales growth variations between our year-round and seasonal markets. Our largest year-round swimming pool markets delivered growth of approximately 10% in the first quarter of 2013, whereas our more seasonal markets experienced close to 10% declines compared to the first quarter of 2012. Weather turned unfavorable in the second quarter of 2013 with unusually cool and wet conditions in our seasonal markets. We observed above normal precipitation across nearly the entire United States with the exception of California, Texas, the Southwest and the Rockies. Below normal temperatures in the Central and Southeast United States and in Europe differed significantly from the above normal temperatures experienced in the second quarter of 2012. These conditions resulted in even further delayed pool openings in comparison to last year, which directly affected our second quarter sales in most seasonal markets. Weather trends in our seasonal markets largely normalized in the third and fourth quarters of 2013, resulting in sales growth rates in our seasonal markets to more closely align with sales growth rates in our largest, year-round markets.

As discussed above, weather favorably impacted sales in 2012, particularly in the first quarter. Favorable weather trends continued in the beginning of the second quarter with much higher than normal temperatures across the United States, excluding the Pacific Northwest. The three month period between March and May 2012 was the warmest on record both nationally and for 31 of the 37 states east of the Rocky Mountains. The unusually mild winter and record warm spring led sales to shift into the first and early second quarter and resulted in the earlier than normal peak of the 2012 season. June sales were negatively impacted by weather due to below normal temperatures across the Southeast and cooler temperatures compared to 2011 in most markets excluding California and the Southwest. In the third and fourth quarters of 2012, weather conditions were favorable in most markets but comparable overall to the same period in 2011.

Weather also had a moderately favorable impact on our operations in 2011. Sales benefited from weather conditions in the Southeast and Southwest, including record high temperatures in Texas, although this impact was partially offset by unfavorable conditions throughout the year on the West Coast due to cooler than average temperatures. In the first quarter of 2011, our sales benefited from much more favorable weather conditions across the Sunbelt markets compared to the same period in 2010. Sales in our North Texas and Oklahoma markets were also positively impacted by repair and replacement activity for freeze damaged pool equipment. While our sales in the second quarter of 2011 benefited from above average temperatures across the Southeast, a slow start to the pool season in the Midwest (due to record precipitation levels) and closer to average temperatures across the Northeast resulted in some unfavorable comparisons to the same period in 2010. In the third quarter of 2011, we estimate that the weather impact on sales was neutral overall compared to both the same period in 2010 and long-term averages. Weather conditions were more favorable in the fourth quarter of 2011, with warmer temperatures across much of the Eastern half of the country compared to the fourth quarter of 2010.

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;
• acquisitions;
• scheduled debt repayments;
• dividend payments;
• capital expenditures;
• 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 bank 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 debt structure and returning money to our shareholders. Our specific priorities for the use of cash are as follows:

• maintenance and new sales center capital expenditures;
• strategic acquisitions executed opportunistically; and
• payment of cash dividends as and when declared by the Board.

As discussed further under the subheading Future Sources and Uses of Cash on page 35, we are required to comply with certain financial covenants under our debt agreements, including the maintenance of a maximum average total leverage ratio. Although more conservative than the maximum, we strive to maintain an average total leverage ratio of 1.50 to 2.00. While considering this metric, we also use our cash to repurchase common stock based on Board-defined parameters and to repay our debt.

Capital expenditures have historically averaged 0.5% to 1.0% of net sales. Capital expenditures were 0.9% of net sales in 2013, 0.8% of net sales in 2012 and 1.1% of net sales in 2011. In 2011, following two to three years of limited capacity expansion, capital expenditures were higher than the historical average because we began purchasing, rather than leasing, new vehicles and forklifts. Going forward, we project capital expenditures to be near the high end of our historical range due to our continued investment in new vehicles, equipment and technology.

Sources and Uses of Cash

The following table summarizes our cash flows (in thousands):

Cash provided by operations of $105.1 million in 2013 exceeded net income by $7.8 million. Compared to 2012, cash provided by operations decreased primarily due to normal seasonal timing differences in working capital. Cash provided by operations in 2012 exceeded net income by $37.1 million and increased over 2011 primarily due to the increase in net income from 2011 and improved working capital management.

Cash used in investing activities in 2013 declined compared to 2012 primarily due to lower acquisition payments. The decrease in cash used in investing activities in 2012 compared to 2011 is primarily due to higher capital expenditures of $3.2 million in 2011, which included a few large information technology upgrades.

Cash used in financing activities declined in 2013 due primarily to changes in our net borrowings, offset by repurchases of our shares in the open market. We had $15.5 million of net proceeds from our debt arrangements in 2013 compared to net payments of $16.4 million in 2012. In 2013, we repurchased $94.3 million of shares on the open market, up $17.3 million compared to 2012.

Cash used in financing activities increased in 2012 compared to 2011 due primarily to the change in net proceeds and payments on our debt arrangements. We made $16.4 million of net payments on our debt arrangements in 2012 compared to $48.6 million of net borrowings in 2011. The activity in 2012 for proceeds and payments on our debt arrangements included the payoff of our $100.0 million Floating Rate Senior Notes at maturity on February 12, 2012. Also, on October 19, 2011, we entered into a new $430.0 million unsecured syndicated senior revolving credit facility (the Credit Facility). Since the Credit Facility replaced and refinanced the outstanding balances under our $240.0 million unsecured senior revolving credit facility (the Previous Revolver), proceeds from and payments on revolving lines of credit in 2011 reflected the $161.5 million payoff of the Previous Revolver. In 2012, we repurchased $77.0 million of shares on the open market, up $6.0 million compared to 2011.

Future Sources and Uses of Cash

As amended on September 20, 2013, our Credit Facility provides for $465.0 million in borrowing capacity under a five-year 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 $540.0 million. The Credit Facility matures on September 20, 2018. We intend to use the Credit Facility for general corporate purposes and to fund future growth initiatives.

At December 31, 2013, there was $194.4 million outstanding and $267.4 million available for borrowing under the Credit Facility. We currently have five interest rate swap contracts in place that reduce our exposure to fluctuations in interest rates on the Credit Facility. These swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 1.185% on notional amounts totaling $50.0 million, 1.100% on a notional amount of $50.0 million, 1.050% on a notional amount of $25.0 million and 0.990% on a notional amount of $25.0 million. Interest expense related to the notional amounts under these swaps is based on the fixed rates plus the applicable margin on the Credit Facility. All five swap agreements will terminate on October 19, 2016. The weighted average effective interest rate for the Credit Facility as of December 31, 2013 was approximately 2.1%, excluding commitment fees.

Financial covenants on the Credit 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 December 31, 2013, 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 December 31, 2013, our average total leverage ratio equaled 1.40 (compared to 1.49 as of December 31, 2012) and the TTM average total debt amount used in this calculation was $263.3 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 December 31, 2013, our fixed charge ratio equaled 4.29 (compared to 3.90 as of December 31, 2012) and TTM Rental Expense was $48.9 million.

The Credit Facility also limits 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), 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.

Under the Credit 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 could result in penalty payments, higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.

On October 11, 2013, we and certain of our subsidiaries entered into a new, two-year accounts receivable securitization facility (the Receivables Facility) with a peak seasonal funding capacity of up to $120.0 million between March 1 and August 31 and up to $80.0 million between September 1 and February 28. An additional seasonal facility limit of up to $40.0 million may be available between April 1 and June 30. We decided to employ this arrangement because it provides us with a lower cost form of financing.

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 December 31, 2013, there was $52.0 million outstanding under the Receivables Facility at a weighted average effective interest rate of 0.9%.

As of December 31, 2013, we were in compliance with all covenants and financial ratio requirements. We believe we will remain in compliance with all covenants and financial ratio requirements throughout 2014. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10-K.

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 February 21, 2014, $70.4 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.

Contractual Obligations

At December 31, 2013, our contractual obligations for long-term debt and operating leases were as follows (in thousands):

For additional discussion related to our debt, see Note 5 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10-K. The table below contains estimated interest payments (in thousands) related to our long-term debt obligations listed in the table above. Our estimates of future interest payments are calculated based on the December 31, 2013 outstanding debt balances, using the fixed rates under our interest rate swap agreements for the applicable notional amounts and the weighted average effective interest rates as of December 31, 2013 for the remaining outstanding balances not covered by our swaps. To project the estimated interest expense to coincide with the time periods used in the table above, we have projected the estimated debt balances for future years based on the scheduled maturity dates of the Credit Facility and the Receivables Facility.

37

We are exposed to market risks, including interest rate risk and foreign currency risk. The adverse effects of potential changes in these market risks are discussed below. The following discussion does not consider the effects of the reduced level of overall economic activity that could exist following such changes. Further, in the event of changes of such magnitude, we would likely take actions to mitigate our exposure to such changes.

Interest Rate Risk

Our earnings are exposed to changes in short-term interest rates because of the variable interest rates on our debt. However, we have entered into interest rate swap contracts to reduce our exposure to market fluctuations. For information about our debt arrangements and interest rate swaps, see Note 5 of “Notes to Consolidated Financial Statements,” included in Item 8 of this Form 10‑K.

In 2013, there was no interest rate risk related to the notional amounts under our interest rate swap contracts for the Credit Facility. The portion of our outstanding balance under the Credit Facility that was not covered by our interest rate swap contracts and the Receivables Facility were both subject to variable interest rates. To calculate the potential impact in 2013 related to interest rate risk, we performed a sensitivity analysis assuming that we borrowed the maximum available amount under the Credit Facility excluding the accordion feature, and the off-season maximum amount available under the Receivables Facility. In this analysis, we assumed that the variable interest rates for the Credit Facility and the Receivables Facility increased 1.0%. Based on this calculation, our pretax income would have decreased by approximately $3.1 million and earnings per share would have decreased by approximately $0.04 per diluted share (based on the number of weighted average diluted shares outstanding for the year ended December 31, 2013). The maximum amount available under the Credit Facility is $465.0 million excluding the $75.0 million accordion feature and the maximum amount available under the Receivables Facility is $120.0 million excluding the $40.0 million seasonal increase in capacity available from April to June.

Failure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.

Currency Risk

We have wholly owned subsidiaries in Canada, the United Kingdom, Belgium, France, Germany, Italy, Portugal, Spain, Mexico and Colombia. Based on the functional currencies for these international subsidiaries as shown in the table below, changes in exchange rates for these currencies may positively or negatively impact our sales, operating expenses and earnings. Historically, we have not hedged our currency exposure and fluctuations in exchange rates have not materially affected our operating results. While our international operations accounted for only 8.9% of total net sales in 2013, our exposure to currency rate fluctuations could be material in 2014 and future years to the extent that either currency rate changes are significant or that our international operations comprise a larger percentage of our consolidated results.

38

The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of December 31, 2013, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of December 31, 2013, our disclosure controls and procedures were effective.

We maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Pool Corporation’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Any evaluation or projection of effectiveness to future periods is also subject to risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Pool Corporation’s management assessed the effectiveness of our internal control over financial reporting as of December 31, 2013. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the Internal Control-Integrated Framework (1992 Framework). Based on this assessment, management has concluded that, as of December 31, 2013, Pool Corporation’s internal control over financial reporting was effective.

The independent registered public accounting firm that audited the Consolidated Financial Statements included in Item 8 of this Form 10-K has issued a report on Pool Corporation’s internal control over financial reporting. This report appears below.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

We have audited Pool Corporation’s internal control over financial reporting as of December 31, 2013, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 Framework) (the COSO criteria). Pool Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on Pool Corporation’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Pool Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Pool Corporation as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows of Pool Corporation for each of the three years in the period ended December 31, 2013, and our report dated February 27, 2014 expressed an unqualified opinion thereon.

New Orleans, Louisiana

February 27, 2014