Watsco: Heating Up For Profits (NYSE:WSO)

Introduction

It’s no secret I love a good compounder. I especially love them when I can buy them at the right price. This brings me to Watsco (NYSE:WSO), a company that I am waiting for a pullback before buying shares. As I delved into their operations and growth trajectory, I can’t help but be impressed by their consistent track record of growing revenues and earnings per share through remarkable expansion.

Through its’ “buy and build” strategy, Watsco has been a consolidator of the HVAC distribution market, acquiring smaller industry players and amalgamating them into their business. Its acquisition strategy consists of buying businesses to create density or expand into new geographic markets to further to company’s network of distributers.

Today, Watsco serves end markets with attractive long-term growth prospects driven by an undersupplied U.S. housing stock, higher repair and remodel spending, and positive changes to the regulatory landscape like energy efficiency standards, which require homeowners, businesses, and governments to focus on better air conditioning, heating and refrigeration equipment.

Business Overview

Watsco is a distributor of HVAC equipment, meaning that when air conditioners and heating equipment breaks down or stops working, a contractor is needed to come in and either replace or repair the unit, be it at a home or business. Contractors look to Watsco to buy equipment, parts, and supplies, ordering them through their store or ecommerce site to complete the repair or replacement.

By segment, about 65-70% of Watsco’s business is existing residential, with new housing accounting for 10-15% and commercial accounting for an additional 15-20%. By geography, nearly all of the company’s revenues comes from the United States (91%) but the company also has a presence in Canada (5%) and Latin America.

Over the last four decades, the installed base of central A/C units has increased over four-fold to around 85 million units, representing about a 3.4% CAGR over the period. For industry shipments, roughly 10.5 million shipments were shipped in 2022 (only 15% new construction) and this number has been increasing at a 4.5% CAGR since 1980.

Business Strategy

One of the first things I found interesting about Watsco was its acquisition strategy. In the late 1980’s the company began a “buy and build” strategy, whereby the company invested its profits from cash flows to buy other operators in the HVAC distribution space in an effort to consolidate the industry. By acquiring market leaders in new geographies to expand into adjacent markets, Watsco looks to better serve their customers by enhancing its technology stack, building out networks, and developing synergies between acquired businesses.

Through its conservative approach to M&A, Watsco operates a decentralized model where acquired companies retain their brand name, building off of the brand and trust developed by acquired companies. Watsco only makes improvements by sharing best practices with management teams and allowing acquired companies to have access to their capital resources and supplier relationships, benefiting from economies of scale from 1200+ OEMs on the cost side and also allowing for cross selling opportunities and expanding product lines.

Another point of differentiation for the company is that unlike smaller competitors who are much less capitalized, Watsco has a significant physical presence with over 670 locations across North America and Latin America. This allows the company to maintain a wide range of products and, perhaps more importantly, maintain inventory, parts, and supplies of equipment. According to Watsco, unlike factory-operated distribution networks that don’t usually maintain the same breadth of supplies and supplies that Watsco does, the company benefits from its extensive network by having the ability to quickly respond to market needs and customer demands.

With its strategic distribution network, significant presence, and strong inventory of parts and supplies, I believe these are factors customers would consider as important in choosing Watsco as their primary distributer for their HVAC needs. By selling its products across multiple geographies coast to coast, and also through digital mediums leveraging technology, the company also gains valuable insights into market trends. Its digital technology ensures that ordering and pickups are done faster, more profitably, and more proactive and consultative rather than simply being an order take. This convenience leads to better customer loyalty as it ensures technicians can do more jobs per day.

Financials

When looking at Watsco’s financials, since 1990 the company has grown revenues and EBITDA at a 13.8% and 15.5% CAGR, respectively, with growth rates of 9.0% and 14.5% over a five year period. This track record is impressive in my view, as the company has proven it can profitably grow its business and create value for shareholders. Since 2017, its also steadily grown its EBITDA margins nearly 300 bps as a result of higher revenues from its ecommerce platform.

While we should expect to see Watsco’s Q4 results early next month in February, let’s take a look at the most recent quarter announced in February to get a better overview of the recent financial performance of the company.

From a balance sheet perspective, as of its most recent quarter, Watsco had $175 million of cash on its balance sheet and $106 million in total borrowings, with a Debt/Equity ratio of 9.3% and Net Debt to EBITDA of 0.17x.

These low ratios indicate that the company doesn’t need to use a lot of debt in its capital structure to manage its operations. As an industry consolidator rolling up the HVAC distribution industry, it also suggests that it doesn’t need to rely on capital and debt markets to fund its acquisition strategy and can do so with the cash flow earned from its current operations.

Over the last five years, its capex and acquisitions have never made up more than 25% of unlevered free cash flow, allowing for cash to be returned to shareholders via dividends. In October 2022, Watsco increased its annual distribution for 2023 from $8.80 to $9.80, which represents a dividend yield of about a 2.5% at the current price. As its been a little over a year now since the increase, and Watsco has a history of regularly increasing its dividend, I wouldn’t be surprised to see Watsco increase their dividend next month as quarterly numbers come in or later this year. Since 1989, its increased its dividend at a 21% CAGR.

When looking at the recent quarterly performance for Watsco, the company announced revenues of $2.13 billion and net income of $200.6 million. While gross margin did miss, this was likely as a result of less higher margin HVAC revenues and more commercial HVAC sales.

Considering recent outsized demand for HVAC systems during the pandemic, which caused a tough prior year comparison as a result of a strong 2022, its likely that we are now seeing the maturation of the HVAC replacement cycle, given that we are seeing a small down year for shipments this year (down 16% year over year).

Despite this, revenues were still up 4% year over year, which is all the more impressive when we consider that 60% of the HVAC systems the company is now selling represent new products. With a drop of 80 bps in SG&A during the quarter, we can see how a single digit increase in revenue followed by cuts in costs as a result of efficiency can meaningfully improve profitability (diluted EPS up 7.9% year over year). In addition, when we looked at last quarter where product availability challenges linked to the energy efficiency standard changeover impacted sales by about $75-80 million, we can see that those headwinds have now subsided, as 400,000 SKUs were added, thousands of technicians were trained, and the company’s breadth of products have expanded.

So this energy transition in my view, while it could have been considered a temporary setback, has likely been a positive for the company’s market share. As all other HVAC distributers are much smaller, it would be significantly more challenging for them to navigate the transition. While management hasn’t provided specific commentary on market share gains, I wouldn’t be surprised if this event created by regulators to make various HVAC products more energy efficient to be a net positive for Watsco long-term.

As well, on the profitability front, gross margins are still 3% above their 10-year averages (source: S&P Capital IQ). So while many companies talk about how they implement technology into their business, it seems that the ecommerce investments Watsco has been making have been paying off as the company is experiencing higher margins overall. Longer-term, I expect modest improvement in margins to continue as a result of industry pricing power as the company becomes an established leader in the space, securing better supplier pricing and leveraging its network distribution scale.

Valuation

Based on the 9 sell-side analysts with one-year target prices on Watsco’s stock, there are 3 buys, 5 holds, and 1 sell rating on the stock. Aggregating the analysts target prices, the average target price is $413.75, with a high estimate of $500.00 and a low estimate of $350.00. From the current price to the average price one year out, this implies about 5.4% upside, suggesting analysts see minimal upside for the stock in the near term. However, we should also consider that the broader equity markets have risen as a result of lower interest rates, pushing the prices of almost all stocks since October.

When looking at its historical EV/EBITDA multiple, Watsco is trading slightly above its 5-year average multiple of 17.8x EV/EBITDA with the current multiple around 18.5x. For a company expected to generate mid-single digit returns over the next few years, this might seem like an expensive multiple to pay for shares at the current price.

This is not inherently expensive for a high quality distributer with attractive end-markets, especially when we consider the large runway for growth for the company. As the company has said in the past, they may get into other services one day beyond HVAC like in roofing, electrical, plumbing and solar, but for now the runway for growth in HVAC is still very large.

However, investors might consider waiting for a potential pullback before establishing or adding to their positions. While the current EV/EBITDA valuation provide insights into the company’s worth, it’s important to account for market dynamics and potential fluctuations that could create more favorable entry points. We’ll discuss some of these risks and catalysts in the next section.

Catalysts and Risks

According to a report conducted by the Air-Conditioning, Heating, and Refrigeration Institute, shipments of ACs and furnaces in the United States have increased at a 5% CAGR since the trough of the great financial crisis. Meanwhile, Watsco grew revenues at an 11% CAGR over this period (6% organic growth and 5% from acquisitions), suggesting that there is potential to grow faster than industry by consolidating the market. When asked about the long-term strategy for investing in new businesses last quarter, CEO Albert Nahmad had this to say:

And we might invest more. I think we will. We’ve been investing more every year. This company is very focused on long term. I know an analyst asked us last year some time, when are you going to stop investing? And I said, “Well, we’re never going to do that. This is our advantage, and we’re going to continue to increase our advantage.”

Another key catalyst for Watsco is favorable industry regulation with continued regulation around the climate and clean energy, more investment and focus is being given to government programs like heat pumps. On the earnings call, CEO Albert Nahmad emphasized that this is a tailwind for the company going forward. With heat pumps exceeding gas furnace sales last year making up 40% of the total market, I expect new regulations will amp up the need to replace old equipment with newer, more efficient and environmentally friendly ones. Regarding favorable regulation, Watsco’ EVP Paul Johnston said:

We’ve also got 2 other things that are hitting us, and that is there’s going to be an increase in the minimum of efficiency for gas furnace to a minimum of 95%. We feel pretty confident that that’s going to occur. And there’s a potential of an additional refrigerant change, where the government could reduce the global warming potential down from 750 down to 500. So anytime there’s a changing market, I think there’s an opportunity for an upside in gross profit for Watsco.

One of the risks for Watsco going forward is that the HVAC cycle is maturing so revenue growth could slow down, especially coming off the back of an extremely strong 2021 and 2022. In a case where inflation moderates and HVAC demand slows, this could hurt gross margins in the near term.

Another risk to watch for is supplier concentration. Being the largest HVAC distributer in the industry, Watsco has a certain level of pricing power it enjoys as being the market leader. However, the company has few suppliers with Carrier and Rheem making up almost 70% of shipments supplied. This possess concentration risk for Watsco, not just on the pricing power side, but also on the reliability and availability of supplies. If either Carrier or Rheem face financial difficulties, production issues, or decide to change their business strategies, it could significantly impact Watsco’s ability to source products, fulfill customer orders, and maintain its competitive position.

Conclusion

In summary, Watsco is market leader in the HVAC distribution space with an expansive network in North America and Latin America. The company follows a “buy and build” strategy, acquiring smaller industry players to create density and expand into new markets. With an impressive track record for growth and profitability, the company takes a disciplined approach to M&A and leverages its significant presence, digital ecommerce platform, and wide range of parts and supplier to be a distributer of choice for its clients. However, at 18.5x EV/EBITDA, I’d wait for a pullback before buying or adding to shares. For more advanced investors, consider selling covered calls if you already own shares to protect against downside risk. For investors waiting to buy shares at a lower price, consider selling covered puts to generate income while you wait.