Watsco: Primed For Market-Beating Returns Following Q3 Earnings

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Watsco reported mixed Q3 results, but sees a stabilizing HVAC equipment market and reason for optimism.The company expects pricing and volumes to increase due to new regulatory requirements.Watsco's ...

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(NYSE:WSO) reported mixed Q3 2024 results, but the company sees an improving market opportunity on the horizon. The company expects the shift to A2L refrigerants to drive both pricing and demand tailwinds through the next phase of the HVAC equipment repair and replacement cycle. WSO believes it has gained market share, which, I believe, is likely to continue thanks to the strength of the company's moat. Watsco's moat comes from its leading position in the HVAC distribution market, economies of scale, valuable relationships with OEMs and contractors, as well as its tech platform that prevents most competitors from being able to take market share from WSO. Earnings Review Watsco reported mixed results in the third quarter amidst some HVAC market challenges, achieving all-time high sales but witnessing a decline in gross margin and EPS. On the positive side, WSO maintained overall steady profitability while the HVAC market showed signs of stabilization. The company's revenue increased by 1.6%, setting a new high at $2.16 billion. Same-store sales were flat, and its gross profit was $566.2 million, slightly down YoY. WSO's 26.2% gross margin was negatively impacted by 30 bps from supply chain and product disruption by an OEM and down from 26.7% in Q3 2023. The OEM affected by supply chain issues was not directly named by WSO, but it is generally known to be Carrier Global Corporation (CARR). Operating income declined 2.5%, and operating margin contracted by 50 basis points, coming in at $250.2 million, and 11.6%, respectively. Expenses rose slightly higher than revenue, with the cost of sales increasing by 2.2% and SG&A increasing by 2.1% YoY during the quarter. Net income attributable to Watsco was flat YoY stable, at $171 million, and EPS fell by 3.0% to $4.22. Operating cash flow increased 49.7% to $394.2 million for the nine months ended September 30, 2024. Free cash flow was up 55.7% YoY during the nine-month period. The table below summarizes Watsco's last three third quarters. Note that cash flows are for the first nine months of each year to better reflect performance and smooth out timing issues. Watsco (WSO) Q3 2024 Earnings Summary (Author-Generated (data from SEC filings and press releases)) HVAC equipment sales, WSO's largest segment, 71% of total revenue, grew by 1%, while sales of other HVAC products, 25% of total revenue, declined by 2%. Commercial refrigeration product sales fell by 4%, reflecting continued challenges in this segment. Positives From The Third Quarter Watsco's markets showed signs of stabilization, and management stated that it experienced a healthy start to October, with mid-single-digit sales growth driven by volume improvement. With unit growth leading the way, rather than price, I'm positive about WSO's forward outlook. The company sees catalysts for price increases in the near future, and volume is the most critical thing to watch out for as economic uncertainty increases, in my opinion. In 2025, there will be a mandated shift towards A2L HVAC equipment. As a reminder or primer for anyone, A2L is a shift towards lower-global-warming-potential (\"GWP\") refrigerants required by the U.S. EPA. A2L adoption is already in the works and appears to be safe from any political changes that may or may not happen soon, once technology changes are adopted by an industry, they aren't undone easily. Pricing increases for A2L systems are expected to be in the 8-10% range, prior expectations were for a 10% to 15% increase. WSO expects the A2L shift to drive higher sales volume overall, as it will require the replacement of full systems rather than just single-unit replacements due to the different refrigerants and additional safety components required to monitor A2L systems. Management believes it gained market share based on industry data and shipment trends, yet another sign that WSO's moat remains, and the future continues to look bright. As for the disruptions from Carrier, the two companies are co-investing to recover business and gain new customers. This partnership involves strategic investments to grow volume and market share, particularly in large markets like Florida, Texas, and California. Challenges From The Quarter Gross margin fell short of expectations, but some of this was due to the disruptions mentioned above. The long-term trend shows WSO is headed in the right direction, and it remains focused on improving margins with a stated goal of 30% still on the table. Other factors, including geographic, product, and customer mix, also contributed to the decline in gross margin. Inventory management was discussed during the call. WSO is actively working to improve inventory turns and has been stocking 410A products as the transition to the A2L product line by 2025 occurs. There is a manufacturing grace period for non-A2L equipment until 2016, and the full transition may take several years to complete, so it looks as if WSO is ensuring it has adequate supply to manage this transition. This is one contributor to increased inventory levels, and lower inventory turns for WSO. WSO Inventory (FinChat) Inventory turns have improved sequentially, however. Showing the company might already be on the right track in this area. Watsco's Inventory (Quarterly) (FinChat) Watsco Has Beaten The Market Executive VP and Secretary of Watsco, Barry Logan told a story at the William Blair Growth Stock Conference in June 2014: \"The first time I did this, it was at an investor conference in the Plaza Hotel Ballroom. I followed Nokia, and of the 500 people listening to them, 497 people left, and three people listened to me.\" This quote sums up why I believe WSO is still a market-beater going forward. It is still underfollowed and not fully understood. However, any wise analyst is aware of this company due to its incredible track record. I don't even know the date of this event, but I can confidently say WSO has crushed the S&P 500 since then. WSO is one of the top-performing stocks over the last 30 years. Only 24 companies returned a CAGR of 19% or greater during that timeframe, and WSO is ranked #16 of the bunch. Going back to 1999, it's easy to see why the stock has taken off and delivered such great returns. Margins have expanded significantly while revenue has grown at a 7.6% CAGR. Watsco's Long Term Margin Chart (Author-Generated (data from filings)) The operating leverage that has expanded OCF and FCF margins can be seen in this chart. WSO has grown OCF at a 12.0% CAGR, and FCF at a 12.5% CAGR, since 1999. These rates are 17.1% and 17.8%, respectively, since 2005. Capital expenditures have only grown at a CAGR of 7.0% since 1999, and 10.2% since 2005. Author-Generated (data from filings) How Watsco Can Continue To Beat The Market First off, Watsco has experienced a lot of growth thanks to its company culture. WSO's ownership culture is incredible, almost every employee receives restricted stock-based compensation, and those shares do not vest until they turn 62 years old or upon their death. This means the success of the long-term wealth of many WSO employees is contingent upon the company's success, and all employees will be enriched by the company's success. Only 8% of shares have gone unvested, and about 58% are still outstanding, meaning those employees still work for WSO. Taking Market Share The North American HVAC equipment distribution market is extremely fragmented, with WSO leading the way with a 12% market share. It doesn't even operate in all regions within North America, and its highly acquisitive nature means it can continue to pick away at the market over the next 30 years. WSO makes small accretive acquisitions, usually of family-owned, small distributors. It then rolls up these companies into its network, provides the businesses with better resources than they had on their own, and makes more money from them than they would have made on their own. Watsco's ROIC has climbed steadily over the last ten years, with a spike during COVID, which has normalized but is still much higher than in 2014. ROIC is one of my magic numbers for tracking WSO's success. As long as ROIC is maintained or increased and WSO continues to bolt-on distributors through strategic M&A, the company is likely to continue taking market share, growing free cash flow at impressive rates and beating the market. Watsco Return on Invested Capital (FinChat) I don't see any reason why these types of acquisitions will slow down, meaning WSO can continue to roll up companies and deliver excellent shareholder returns. As it does, we should see a continuation of its trend of increasing revenue per share with even faster, EPS and FCF per share growth improving at a much greater rate. The following shows WSO's operating leverage and efficiency as dollar-per-share metrics. EPS and FCF per share are growing significantly faster than revenue per share. Watsco Per Share Financials (FinChat) The company continues to deliver total shareholder returns, including growing its dividend per share at a CAGR of 18.3% since 2014. The payout ratio is quite high, at 78.9% over the last twelve months, but remember that free cash flow per share has been growing at a CAGR of 17.0%. FinChat I think WSO's dividend growth rate is pretty safe, given the healthy FCF growth, continued acquisitions with high ROIC and the opportunity WSO has to grow its top line in the coming years due to a continuation of HVAC demand and the A2L catalyst expected to hit in 2025 and 2026. Watsco's Moat Watsco's moat comes from being the largest distributor in North America. It has relationships with the largest HVAC OEMs in the market and thousands of contractors. This market isn't easy to disrupt, as there are many barriers to jumping into HVAC distribution and HVAC contracting. Distributors need to invest significant capital to get started and grow, and OEMs will only do business with distribution partners they can rely on, who can pay their bills, and who can reliably get their products out to consumers. As for contractors, HVAC equipment repair and replacement requires skill, resources, and licensing. Not anyone can jump into the business and compete away pricing power from entrenched players. Stability in WSO's customers is a good thing for its business. With its scale, the company has massive amounts of data and a technological advantage created by building out its ERP platform. This platform allows Watsco greater insight into pricing dynamics and a greater ability to distribute its products to contractors on demand. Helping contractors do more jobs per day has both direct and indirect benefits to WSO. As sales increase, WSO's customers are happy to remain with them. The contractor is the core of WSO's business, and they understand that dynamic. Technological Advantages In a fragmented industry dominated by thousands of mom-and-pop distributors, WSO has a huge advantage because while it spends $50 to $60 million a year on its technology, most of its competitors can't spend even half that amount on any capital improvements or R&D. This acts as an advantage in retaining contractors, growing sales, in increasing efficiency and pricing power, and as a catalyst for strategic M&A because acquired companies stand to benefit from inclusion into WSO's network. WSO has internally developed its own ERP and e-commerce platforms. ERP WSO internally developed its own ERP platforms, inputting millions of SKUs to enhance its control over pricing inventory, and logistics. The system improves WSO's insight into product pricing. In the past, WSO would have relied on about a thousand salespeople haggling with customers. Insight into its pricing dynamics would have required waiting for a monthly P&L, but now the company can strategically adjust pricing to account for market dynamics. Rather than giving salespeople the latitude to discount products to make sales, WSO can adjust pricing depending on the market's supply and demand patterns. These adjustments can be dialed into specific regions, increasing efficiency and profitability of pricing, and have helped the company realize a roughly 300 basis point improvement in gross margin since incorporating its ERP. The tech platform has also helped WSO improve warehouse operations and customer outreach, including order updates and other key information. E-Commerce Platform Watsco's e-commerce platform, Watsco Ventures, has helped its customers streamline the ordering process, check inventory, place orders, and manage transactions. With OnCall Air, Watsco's contractor customers can create customized proposals and design configurations for clients, among other features that help them do their jobs more effectively. It has also boosted retention. While WSO's historical attrition rates are about 10%, the company has only a 2% attrition rate through e-commerce, and this part of the business is growing faster than its non-e-commerce rate. Risks Management described the impact of hurricanes Helene and Milton as not significant enough to affect the overall business materially. Insurance payouts related to storm damage could boost sales in affected areas in the coming quarters. Despite the expected tailwinds from the A2L refrigerant shift, WSO's growth outlook may suffer if the price gains realized from the shift fail to materialize for any reason or if consumers hold off on repairs and replacements due to increased costs. I see this as more of a near-term risk, as the HVAC repair and replacement cycle is unavoidable though prone to some cyclicality and economic sensitivity. Valuation As mentioned, WSO has grown free cash flow at a CAGR of 12.5% since 1999, and a 17.8% CAGR since 2005. Since 2014, FCF per share has grown at a CAGR of 17.0%. The company is taking market share and rolling up smaller distributors with great success. I anticipate the company will benefit from the A2L shift which is expected to increase both price and volume in the HVAC equipment market. These factors provide confidence that WSO can continue to grow its top-line in the mid to high-single digits for the long run and free cash flow at a greater rate. To consider the valuation of WSO, I am using a reverse discounted cash flow model with assumed forward FCF growth rates. The company has a long runway for growth, and I believe a 10-year model is too short a time. Therefore, I am using a 20-year model with a declining FCF growth rate that includes a 3% terminal rate. A 3% terminal rate is sufficient for a company in a growing industry that appears to have long-term tailwinds, due to climate change. A growing market in Mexico may also provide WSO with another long-term opportunity for GDP-plus growth. WSO has grown FCF at a rate greater than 18% for ten years, so I have modeled 18% FCF growth for years 1-5, 13.0% for years 6-10, 9.0% for years 11-15, and 6.0% for years 16-20, before reaching its 3% terminal rate. This might even be a conservative projection for the first ten years. The hurdle (discount) rate used is 13.0% which both discounts the cash flows to present value and provides a theoretical stock return expectation given the inputs. Watsco Reverse DCF (Author-Generated Reverse DCF Model) Based on this model, WSO could deliver a 13.0% stock return if it can grow FCF at about 10.9% CAGR over twenty years. It's important to note that intrinsic valuation estimates are prone to error, dependent on inputs that cannot be relied on completely, and are a theoretical concept. However, my model shows that WSO has a path to market-beating returns with reasonable growth expectations. Conclusion  Watsco delivered mixed results during Q3 but sees potential for a return to its historical growth. The tailwinds of the HVAC market, the A2L shift, WSO's leading position in the North American HVAC distribution market, and technological superiority over competitors have the company well-positioned to be a market-beating stock going forward. I rate WSO a buy and will be looking to add to my position slowly in the coming weeks and months, particularly on any further selloffs.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2480571070"}