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 (EPS) for all 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.

2012 FINANCIAL OVERVIEW

Financial Results

Solid performance in 2012 produced record results, surpassing our objectives. Net sales increased 9% compared to 2011, including a 7% increase in base business sales. Base business sales growth was driven by market share gains, continued improvement in consumer discretionary expenditures, growth in the installed base of pools and some price inflation, partially offset by unfavorable currency fluctuations of approximately 1%.

Gross profit increased 7% compared to 2011, while gross profit as a percentage of net sales (gross margin) decreased 60 basis points to 29.0%. This decrease reflects unfavorable product and customer mix changes and competitive pricing pressures. Gross margin in 2012 was also comparatively lower than 2011 gross margin due to the benefits realized in 2011 from opportunistic inventory purchases.

Selling and administrative expenses (operating expenses) for 2012 increased 3%, with base business operating expenses essentially flat year over year. Decreases in employee incentive costs, lower bad debt expense and the impact of currency fluctuations were offset by higher professional fees and increases in wages and employee insurance.

During the third quarter of 2012, we recorded a non-cash goodwill impairment charge of $6.9 million, equal to the total goodwill carrying amount of our United Kingdom reporting unit. This impairment charge had a $0.14 negative impact on diluted EPS for the year ended December 31, 2012. Since this goodwill impairment charge was not deductible for tax purposes, our effective income tax rate for the year ended December 31, 2012 was higher than normal. During the fourth quarter of 2011, we recorded a non-cash goodwill impairment charge of $1.6 million resulting from our annual goodwill impairment analysis. This impairment charge had a $0.03 negative impact on diluted EPS for the year ended December 31, 2011.

Operating income for the year improved 16%, while operating income as a percentage of net sales (operating margin) increased 40 basis points to 7.4%. Excluding goodwill impairment in both years, adjusted operating income for 2012 increased 20% and adjusted operating margin increased 70 basis points to 7.8% for the year ended December 31, 2012. Net interest expense decreased $1.5 million due to the impacts of changes in estimated interest expense related to uncertain tax positions and foreign currency translation gains and losses.

Net income increased 14% compared to 2011, while earnings per share was up 16% to $1.71 per diluted share. Adjusted net income for 2012 increased 21% and adjusted EPS was up 23% to $1.85 per diluted share.

Financial Position and Liquidity

Cash provided by operations of $119.1 million in 2012 was $30.2 million more than adjusted net income and, combined with $83.6 million in net proceeds from our revolving line of credit and $20.2 million in proceeds from stock issued under share-based compensation plans, helped fund the following:

• payments of $4.7 million related to acquisitions;

• net capital expenditures of $16.3 million;

• quarterly cash dividend payments to shareholders, which totaled $29.1 million for the year;

• share repurchases in the open market of $77.0 million; and

• the payoff of our $100.0 million Floating Rate Senior Notes at maturity.

Total net receivables increased 4% compared to December 31, 2011 due primarily to an increase in current trade receivables as a result of December base business sales growth, higher vendor receivables and a slight reduction in the allowance for doubtful accounts. Days sales outstanding (DSO) improved between periods to 28.8 days at December 31, 2012 compared to 29.9 days at December 31, 2011.

Inventory levels were up 3% to $400.3 million at December 31, 2012 compared to levels at December 31, 2011. Excluding inventory of approximately $4.0 million from recent acquisitions, inventories increased 2% year over year. Our inventory turns, as calculated on a trailing twelve month basis, accelerated to 3.4 times at December 31, 2012 from 3.2 times at December 31, 2011.

Total debt outstanding was $230.9 million at December 31, 2012, a decrease of $16.4 million compared to December 31, 2011.

Current Trends and Outlook

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 2012, construction levels are still down more than 70% compared to peak levels in 2005 and down approximately 60% from what we consider normalized levels.

Our base business sales growth in 2012 and 2011 was driven by market share gains, but also reflected continued improvement in consumer discretionary expenditures and higher replacement activities given our estimated industry growth of 3% to 4% each year. Although general external market factors including consumer confidence, employment, housing, consumer financing and economic growth have improved, we believe the current economic environment remains uncertain, especially in Europe due to lingering sovereign debt and economic issues.

Looking ahead, 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 will continue to improve, enabling further recovery of replacement, remodeling and new construction activity to normalized levels over the next 7 to 10 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 5% annual growth over the longer term. 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 outlook for 2013 is very similar to 2012 with regard to the macroeconomic environment, industry growth levels and opportunities for us to realize additional market share gains. We anticipate 5% to 7% base business sales growth, including our expectation for average inflationary product cost increases of 1% to 2%. We believe that unfavorable product and customer mix changes and competitive pricing trends will continue in 2013, therefore improved purchasing and pricing discipline will be key to realizing any gross margin improvement in 2013. As such, we expect that our gross margin will remain relatively flat for the full year with quarterly gross margin comparisons versus 2012 varying by 30 or more basis points.

Base business operating expenses were essentially flat versus 2011, as decreases in employee incentive costs, lower bad debt expense and the impact of currency fluctuations were offset by higher professional fees and increases in wages and employee insurance. Overall, we anticipate more normalized levels of expense growth in 2013, including inflationary increases and some incremental costs to support our sales growth expectations with operating expense growth at about half the rate of sales growth. We expect base business results will generate operating profit growth as a percentage of base business sales growth (contribution margin) at or approaching 20% in 2013.

Based on these expectations, we project that 2013 earnings per share will be approximately $2.13 to $2.23 per diluted share. We expect cash provided by operations will exceed net income for fiscal 2013 and anticipate that share repurchase activity will be similar to 2012.

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 for 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 the accounts receivable aging ranging 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 0.3% of net sales annually. Write-offs as a percentage of net sales were 0.1% in 2012, 0.2% in 2011 and 0.3% in 2010. Write-offs in 2010 were higher than our long-term historical average of approximately 0.2% of net sales due to the negative impacts on some of our customers' businesses from the challenging external environment between 2007 and 2010. Based on significant reductions in our past due receivables aging categories due to gradually improving external market trends, heightened collection efforts and creditworthiness evaluations, net write-offs improved significantly in 2011 and 2012. We expect that write-offs will be approximately 0.1% of net sales in 2013.

If the balance of the accounts receivable reserve increased or decreased by 20% at December 31, 2012, pretax income would change by approximately $1.1 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, 2012).

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:

Class 0      new products with less than 12 months usage (or 36 months for tile
             products)

Classes 1-4  highest sales value items, which represent approximately 80% of net
             sales at the sales center

Classes 5-12 lower sales value items, which we keep in stock to provide a high
             level of customer service

Class 13     products with no sales for the past 12 months at the local sales
             center level, excluding special order products not yet delivered to
             the customer

Null class   non-stock special order items

There is little risk of obsolescence for products in classes 1-4 because products in these classes generally turn quickly. We establish our reserve for inventory obsolescence based on inventory classes 5-13, which we believe represent some exposure to inventory obsolescence, with particular emphasis on SKUs with the least sales over the previous 12 months. The reserve is intended to reflect the value of inventory 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.

If the balance of our inventory reserve increased or decreased by 20% at December 31, 2012, pretax income would change by approximately $1.5 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, 2012).

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.

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.

As of December 31, 2012, 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 9 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. We generally make bonus payments at the end of February following the most recently completed fiscal year.

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.

Impairment of Goodwill

Our largest intangible asset is goodwill. At December 31, 2012, our goodwill balance was $170.0 million, representing approximately 22% 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 are required to test goodwill for impairment annually 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 has fallen below their 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, 2012, we had 209 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 by utilizing a present value model that incorporates our assumptions for projected future cash flows, discount rates and multiples. In order 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.

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 and the depressed economic conditions in the United Kingdom. Our results for the nine months ended September 30, 2012 were significantly lower than our 2012 sales, gross profit and operating profit estimates for the United Kingdom reporting unit that we used in our 2011 annual goodwill impairment test. We updated our 2011 impairment analysis for both our actual 2012 year to date results and our updated growth estimates for future years based on expectations for a more prolonged economic recovery period in the United Kingdom. Our updated projections had a significant impact on our projected future cash flow calculation and resulted in a much lower estimated fair value for our United Kingdom reporting unit. Consequently, we recorded a non-cash goodwill impairment charge of $6.9 million equal to the total carrying amount of our United Kingdom reporting unit.

In October 2012, we performed our annual goodwill impairment test and did not identify any goodwill impairment at the reporting unit level.

Based on the combination of their higher goodwill balances and the overall economic conditions and uncertainty in Europe, we identified our Spain and Italy reporting units as the most at risk for goodwill impairment. We believe that our domestic reporting units most at risk for goodwill impairment are the three Horizon locations in Texas that had a recorded goodwill impairment in 2011. Other domestic reporting units considered at risk for goodwill impairment include two additional Horizon locations in Texas, one Horizon location in Nevada and one Superior location in New Jersey that each had marginal results in recent years, but improved profitability in 2012. As of December 31, 2012, our European at risk reporting units had an aggregate goodwill balance of $6.4 million and our domestic at risk reporting units had an aggregate goodwill balance of $9.5 million.

If our assumptions or estimates in our fair value calculations change, we could incur additional impairment charges in future periods, especially related to the reporting units discussed above. Additional impairment charges would decrease operating income and result in lower asset values on our balance sheet. We performed a sensitivity test for the two key assumptions in our 2012 annual goodwill impairment test and determined that an increase in our estimated weighted average cost of capital of 50 basis points or a decrease in the estimated perpetuity growth rate of 50 basis points would not have resulted in any calculated goodwill impairments.

Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board issued new guidance to give more prominence to items reclassified out of accumulated other comprehensive income (AOCI). The new standard requires companies to disclose the effect on each income statement line item due to the reclassification of an AOCI component into net income, or if the reclassification does not impact net income, the applicable accounting guidance and related financial statement effects. This standard is effective for reporting periods beginning after December 15, 2012. We expect that the adoption of this guidance will impact our financial statement disclosures, but will not have a material impact on our financial position or results of operations.

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