Watsco: Time To Cool Off

It is hard to believe, but I have not covered Watsco (NYSE:WSO) on this platform before, a shame as the business has a great long-term track record, judging by the share price performance in the long haul.

The sound share price performance has been backed by a great operating performance, although that the share price advancements as of late have far surpassed the operating performance, pushing up the price for this quality play a bit too much. This results in a non-compelling risk-reward in the short- to medium term, as Watsco certainly deserves a place on my long-term watch list.

An Intro

Watsco helps homeowners and contractors to fix broken or failing A/C units at home or their business, operating nearly 700 locations throughout North America. This dense branch network, and sufficient inventory availability, makes it the go-to place for many contractors to get the required units and components. Scale and breath is what has granted Watsco the leading position in what still is seen as a highly fragmented industry.

The business generates 90% of sales in the US, complemented by smaller Canadian and Mexican operations, with about two-thirds of sales derived from the residential sector, and the remainder of sales split pretty evenly between new housing and commercial customers.

The company has benefited from long-term trends which includes a spectacular increase in the installed base of A/C units, which has grown from some 20 million units early in the 1980s, to more than 80 million units as of recent, with shipment volumes surpassing 10 million units alone in 2022.

A mere $64 million business in 1989, based on 16 locations, has grown at a 15% CAGR to $7.2 billion on a trailing basis, with similar growth seen in terms of profitability and the share price performance as well. In fact, the company proudly claims that is part of an elusive group of shares and companies which have seen +18% CAGR over the past 3 decades, being part of a select group of less than 1% of the stock market.

Picking Up Coverage

Pre-pandemic, Watsco was a $170 stock, as shares quickly rose to the $300 mark in 2021/2022 amidst a roaring housing market and rebound in the economy. Shares rallied to a high of $380 this year in June, marking fresh all-time highs, even as there are wobbles in the housing market. This comes as the housing market is perhaps holding up better than thought given the interest rate trends. It is ironic that the impact of climate change increased demand for A/C units, despite its negative impact on climate, as this was again a hot summer (at least in many parts of the continent).

In February of this year, Watsco posted a 16% increase in sales to $7.27 billion as operating profits rose by 32% to $832 million while operating margins rose from about 10% to 11.4% of sales. Amidst minimal interest expenses and a lower tax rate, net earnings to investors rose by 43% to $601 million, with earnings per share up by similar percentages to $15.41 per share. Note that corrected for some tax benefits relating to vesting of stock earnings came in at $14.20 per share.

On top of this earnings power, the company operated with a modest net cash position. While the company did not provide a 2023 outlook, the company looked forward to the year with confidence. Ironically, this was due to stricter environmental regulations which favor more efficient solutions, potentially driving another round of capital spending.

Despite this backdrop, Watsco only posted a 2% increase in first quarter sales to $1.55 billion in April, with operating profits of 10.6% actually being down by 60 basis points, with earnings of $2.83 per share being down seven cent on the year before. Despite the solid growth, which suggests a need to invest capital, Watsco is a significant dividend payer. After having paid out dividends for 49 consecutive years, Watsco now pays out as much as $2.45 per share, as the near $10 per share payout actually works down to a reasonable yield of 2.8% at prevailing levels of around $255 per share.

Early in August, Watsco reported a 6% fall in second quarter sales to $2.00 billion, although that operating margins of 13.3% were down just twenty basis points compared to this period last year.

Ironically, it has been the tighter regulations which hurt results, as some OEMs which supply Watsco had availability issues, hurting sales in the first half of 2023 by an estimated $120 million, as otherwise sales would come in rather flattish. In contrast to a net cash position by year-end 2022, the company has taken on a net debt load of $275 million, far from an issue given the profitability of the business here.

A Bolt On Deal

After a sluggish first half of 2023, the company announced a bolt-on deal post the summer to ignite some growth from here onwards. The company has reached a deal to acquire the Gateway Supply Company.

Founded in South Carolina, the company adds 16 locations and $180 million in sales, adding some 2-3% to pro forma sales, likely sufficient to halt revenue declines. While no further financial details have been announced, the purchase is a truly bolt-on deal and will not move the investment case significantly, but is exemplary of the potential in this fragmented industry, and the potential to further consolidate operations.

Concluding Remarks

With earnings power trending around $14 per share, the quality of Watsco is priced at about 25 times earnings, amidst a largely unleveraged balance sheet, although modest net debt has been taken on following some capital deployed so far this year.

In fact, shares have risen from $250 to $355 year to date, while operating performance is dead flat, marking significant valuation multiple inflation, which is never a great sign.

Given this backdrop, I am glad that I have gotten introduced to what appears to be a great long-term business. And while I think that this quality comes at a price, it has seen flattish operating performance year to date and a 40% run in the shares, which makes today not the time to get involved with the stock.

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