Riding the HVAC Industry tailwinds: An Investment Analysis of Watsco Inc.
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1. Key Facts
Description: Watsco Inc (“WSO”, “Watsco”, and “Company”) is a leading distributor of air conditioning, heating and refrigeration equipment (“HVAC/R”), related parts and supplies in North and Latin America. The Company operates through a network of 673 locations and employs over 7,200 people as of December 2022. Watsco serves over 120,000 customers and has established itself as the largest distributor of HVAC/R equipment in the region.
Key Financials: Over the period FY12 to trailing twelve months (“TTM”) Q1 FY23, the Company depicted a revenue Compound Annual Growth Rate (“CAGR”) of 7.6% and operating income CAGR of 13.2%, reaching a TTM revenue of c. $7.3B and operating income of $804 million (margin of 11%). Watsco has cash and cash equivalents of $141 million compared to total debt and lease liabilities of $529 million.
Price & Market Cap (as of 24th April 2023): Its market cap is $12.1 billion with a 52-week high of $356.6 and a 52-week low of $220.68, whereas it currently trades at $338.6.
Valuation: Watsco trades at a TTM EV/EBITDA of 15.4 (10 Year average of 14.8) and a TTM EV/Sales of 1.8 (10 Year average of 1.3).
The rest of the write-up includes the following sections:
2. Business Overview
5. Financial Analysis
6. Competitive Advantages, Opportunities and Risks
8. Concluding Remarks
2. Business Overview
“Our growth and stability speaks to the fundamental necessities of the products we sell and to the value that our industry provides homeowners and businesses.” CEO, Albert Nahmad
Its history in brief
Watsco Inc. has a long history dating back to its incorporation in 1956. Initially, the Company focused on manufacturing parts, components, and tools used in the HVAC/R industry, whereas in 1989, the Company underwent a significant shift, transitioning to a distribution-only business model. This move proved to be instrumental in the Company's success over the years.
Since the transition, Watsco has grown through organic expansion and through a successful acquisition strategy which enabled the Company to add locations and introduce new products. The Company has acquired around 70 businesses, adding value through Watsco’s network, capital, and technology. The majority of the acquired entrepreneurs remained as part of Watsco's team, contributing to the Company's continued success.
Watsco's growth story is impressive, with revenues growing from $64.1 million in 1989 to $7.3 billion in 2022, while the annualized 30-year total shareholder return stood at 18%.
Source: Watsco, Inc. 4Q22 Investor presentation
At the helm of Watsco is the Chairman and CEO, Albert Nahmad, along with a management team that runs the Company for decades. Nahmad has been leading the Company for an impressive 50 years.
The HVAC/R industry has a long history and OEMs (Original Equipment Manufacturers) have been using independent distributors to distribute their products, add markets and connect them with contractors for the majority of the last 100 years.
Barry Logan, Executive Vice President, highlighted that the current estimated distribution market size is approximately a $50 billion of which approximately $40 billion is independent distribution.
Watsco's primary source of revenue comes from the replacement market for heating and cooling equipment. This means that the demand for Watsco's products is driven by households experiencing failures in their HVAC systems.
“What really powers our industry and our market share development as a distributor is the churn and the reality of 110 million systems in the U.S., all of which need to be, as I said, serviced, repaired or replaced at some point.” Rick Gomez, Vice President of Corporate Development
The Company distributes products from OEMs to a fragmented base of contractors who in turn service the end customer. Contractors play a critical role in the supply chain, as they make recommendations to the end customer and take decisions on what products to use. Therefore, the distributor-to-contractor relationship plays an important role on the success of the business.
While Watsco also serves the new construction market, this makes up only 10-15% of its business, making the Company more durable against macroeconomic headwinds. It is worth mentioning that Watsco demonstrated resilience during the Great Financial Crisis, experiencing only a single-digit reduction in revenue during FY07 and FY08. However, its profitability during that period deteriorated. Nonetheless, the possibility of future recessions or economic downturns should still be considered a risk for the Company.
In the higher-margin replacement market, customers demand immediate and reliable service. When someone's HVAC system breaks down, they call a licensed contractor who advises the consumer on whether to repair or upgrade their system. The contractor then visits a Watsco location or buys equipment, parts, and supplies from Watsco's ecommerce site to proceed with the replacement or repair of the equipment.
Source: Watsco, Inc. 4Q22 Investor presentation
Watsco's value proposition to contractors comprises of product availability, a high density of locations to enable fast order fulfilment, support, and technology to enhance customer service.
Markets and Sales Mix
Watsco disaggregates its revenue into three major product categories; HVAC Equipment, Other HVAC Product and Commercial Refrigeration Product.
Source: StockOpine Analysis, Stratosphere.io
HVAC Equipment Revenue which consists of residential and commercial air conditioning and heating equipment systems gained share in the sales mix in the past ten years as we continue to see a trend towards replacement versus repair. This trend was driven from the ageing of the installed base, movement towards electrification of heating systems, as well as regulation which continues to evolve towards more energy-efficient models.
This also justifies the relative decline of Other HVAC product revenue in the mix as it primarily relates to repairs.
Source: Watsco, Inc. 4Q22 Investor presentation
Watsco’s consumer revenue consists of residential and new housing which account for approximately 80% of total revenue while commercial revenue accounts for approximately 20%.
In terms of geographic distribution, approximately 90% of revenue is derived from US, 5% from Canada and 5% from Latin America and Carribean. The Company has dominant position in the Sun Belt markets (approximately 2/3 of the business) where there is a high reliance on HVAC/R products. These markets tend to benefit from the hot weather as air conditioning is considered a necessity, from the shortening of useful life of equipment given the significant hours of operation, the expansion of residential new construction as well as the population migration.
Watsco still builds its network in other markets which indicates more room for growth.
“We're still not in 10, 15 states. We still don't have representative market share in all the big markets that we would like. Where we've been the longest, Florida, we have a very dominant market share position with a very strong presence and profitability.” Barry Logan, Executive Vice President
On the demand side Watsco serves more than 120,000 active contractors with no single customer accounting for more than 2% of revenues. The fragmented consumer base provides the Company with pricing power as it can pass price increases from OEMs to customers. Additionally, the large number of customers and the critical distributor-to-contractor relationship built over the years provide the Company with an edge over competition.
“Watsco's diversity of products and brands is an important competitive advantage that allows us to serve contractors in any economic environment” Albert Nahmad, CEO
Source: Watsco’s website
Approximately 90% of all air conditioning and heating equipment units shipped in US are manufactured by 7 major companies. Watsco has a strategic relationship with 5 of those, namely Carrier, Rheem, Daikin, Trane and Lennox. Other key suppliers of Watsco are shown in the above image.
Consequently, Watsco has significant concentration on key suppliers as the top ten suppliers accounted for 84% of its purchases, including 60% from Carrier, and 8% from Rheem for 2022. This creates a significant risk, as any interruption in the operations of the key suppliers or any deterioration in their relations can affect product availability and ultimately Watsco’s results. It shall be noted that Carrier, Rheem and Mitsubishi provide Watsco with exclusive distribution rights in specified territories without an expiration date.
We believe that the risk is mitigated due to the long-standing relationships with the OEMs, especially with Carrier, which maintains a non-controlling interest of 20% in three joint ventures formed between the two companies and 40% in a fourth company. This strategic relationship dates back to 2009. The joint ventures with Carrier are significant for Watsco as combined they represented 54% of revenues for 2022.
Additionally, OEMs stand to benefit from Watsco’s scale and network of contractors, and as a result, for many, Watsco is their largest customer.
“So today, Watsco at $6 billion, $7 billion in size is the largest customer of Carrier, Honeywell, Johns Manville, Mitsubishi, Manitowoc, others that make air conditioning and heating equipment and parts and supplies. And that scale means something in terms of those relationships and how we serve these local contractors that need product right away.” Barry Logan, Executive Vice President
Recent regulation changes provide the catalysts for future growth that stand to benefit the HVAC/R industry in the years ahead. The new regulations stand to incentivize the movement towards electrification and the replacement of aging HVAC systems in favour of more energy-efficient systems to address the impact of climate change and global warming. The key regulatory changes are the new federal mandate for minimum efficiency standards, the Inflation Reduction Act and the introduction of new refrigerant standards.
The new federal mandate for efficiency standards which is effective from 2023 requires the upgrade to higher efficiency HVAC equipment across the entire United States. Those standards will drive replacements and result to higher average selling price of equipment sold in 2023 and beyond, boosting the bottom line of Watsco.
“half of our products are transitioning to a higher SEER level by mandate, half of our products. That's just a mix change that's selling something more expensive every day at the baseline of what we sell. The manufacturers talked last year about yielding a 10% to 15% price requirement on those new products, assuming that their cost was going up 10% or 15% to make them.” Barry Logan, Executive Vice President
New refrigerant requirements that will become effective in 2025 will result in new HVAC systems that will incorporate lower global warming potential (GWP) refrigerants. How does this affect Watsco? Those type of changes have historically increased cost to service and repair existing equipment and thus drive more demand for replacements.