Watsco Inc. (NYSE: WSO)

Watsco is North America’s largest distributor of heating, ventilation, air conditioning and related products (HVAC/R), owning > 10% of a $40 billion distribution market, 3x the share of the #2 player.

Watsco is a prime example of what it means to be a member of the Good Business Repository:

• They’re a leader in a relatively predictable industry that is not sensitive to the economy
• The model generates consistent returns above the cost of capital, producing cash flow that allows for acquisitions and a growing dividend
• Management has significant skin in the game with good long-term incentives in place

Watsco has 603 locations in 38 US states, Canada, Mexico, and Puerto Rico, with additional coverage via exports to portions of Latin America and the Caribbean. The company’s most significant markets lie in the “Sun Belt”, with the highest concentration in Florida and Texas – the largest HVAC markets.

Watsco is in the business of providing products and services to approximately 90,000 HVAC contractors employing 500,000 technicians who, in turn, serve homeowners and businesses. Watsco’s revenues in HVAC distribution have increased from $64.1 million in 1989 (when the company shifted its focus from manufacturing to distribution) to $4.5 billion in 2018, representing a 29-year CAGR of 16%.

Industry

Large, fragmented, replacement-driven markets provide the opportunity for steady long-term growth. The North American HVAC market is serviced by 1,300 independent distributors, the majority of which are second and third generation owned. Business is ~70% residential replacement, 20% commercial, and 10% new build. The primary replacement markets are in less weather-sensitive geographies where HVAC use is more frequent and consistent, which is why Watsco focuses on the Sun Belt (~60% of North America).

The installed base of HVAC units has grown at a 3.6% CAGR since 1980. The US alone has ~115 million installed A/Cs and furnaces, 92 million of which are over 10 years old.  Systems last 10-15 years and the current installed base took 40-50 years to build = solid replacement runway.

Heating and cooling account for 1/2 of the energy consumed in a typical US home. Older systems operating below government-mandated energy efficiency and environmental standards give Watsco opportunity to accelerate replacement at greater scale vs competitors. Big picture, HVAC systems are trending from centralized units toward ductless systems, and the US is well behind the rest of the world in this transition. Roughly 80 million of the 115 million systems in the US are centralized.

Demand for HVAC products is seasonal, with greater demand for residential air conditioning in 2Q and 3Q and greater demand for heating equipment in 4Q. Demand in the new construction market (small % for WSO) is fairly even throughout the year and depends on housing completions and weather conditions.

HVAC equipment is manufactured primarily by 7 companies that together account for ~90% of the US market: Carrier, Goodman Manufacturing, Rheem Manufacturing, Trane Inc., York International, Lennox International, and Nordyne. These manufacturers distribute their products through a combination of factory-owned locations and independent distributors who, in turn, supply the equipment and related parts and supplies to contractors and dealers that sell and install the products.

Watsco sells equipment from 5 of these major OEMs along with equipment from 15 other smaller vendors. They do not sell products from York International (Johnson Controls) or Lennox International. Watsco also sells a variety of non-equipment products from ~1,200 vendors and commercial refrigeration products from ~150 vendors.

Business Strategy

Watsco built its network of locations using a “buy and build” philosophy, which has produced substantial long-term growth in revenues and profits.

Watsco has benefited from the valuation multiplier effect of small M&A, acquiring 60 HVAC distribution businesses since 1989 without ever hiring a banker or paying a fee. Significant returns have been earned from valuation arbitrage, buying businesses for 5-7x trailing EBIT, while WSO has traded at > 10x EBIT since eclipsing $100mm in operating income.

Acquisition risk is low as Watsco is buying long-established businesses. Watsco simply provides the capital, relationships, and technology for growth.

“There’s always been a consequence, if you will, of the fact that OEMs approve who can buy a distribution company, there’s veto power over who has the sustained distribution rights in a transaction” VP Barry Logan, JPM conference March 2019 = significant barriers to entry.

Fueled by a Conservative Balance Sheet

“Our conservative mindset toward debt and maintaining a powerful balance sheet provides the safety and the flexibility to take advantage of any-size opportunity especially during periods of economic volatility” CEO Albert Nahmad, 3Q18 call.

Outstanding debt (excluding operating leases) is less than 0.5x EBITDA. It has never been > 2x EBITDA.

In July 2009, WSO formed a JV with Carrier (Carrier Enterprise I), purchasing 60% controlling interest + options to acquire another 10% in 2012 and 10% in 2014. Both options have been exercised. This has been the largest acquisition in the company’s history, right around max pain for the market. WSO has since formed Carrier Enterprise II and III with similar terms.

Watsco paid 9x $30 million profit for the Carrier JV. The JV now produces over $200 million in profit.

Carrier’s 2^nd largest customer behind Watsco is Russell Sigler, the 4^th largest distributor in the industry. In 2017, Carrier Enterprise I bought 34.9% of the company, and the JV has since inched up its stake to 38.1%. Watsco has the exclusive right to buy whatever remainder the family is willing to sell.  

Long Acquisition Runway

The HVAC business took off in North America following WWII with the advent of affordable central heating and AC systems for residential settings (credit Henry Galson). Such a boom has occurred in Latin American and Caribbean countries in recent years as residential HVAC has become less of a luxury and more of a necessity.  

See this article for a nice little history of air conditioning in the US.

Of the 1,300 independent HVAC distributors in North America, 99% are family owned. Because the industry is ~60-70 years old, many of these businesses are now second and third generation owned. On average, these businesses are doing maybe $30-$50mm in revenue per year. This is Watsco’s target.

Good Business? Yes.

The installed base increases every year, and “machines don’t care” when it comes to the economy, consumer sentiment, etc. Watsco has a relatively straightforward growth runway – do the same thing over and over. Selling the same product to the same customer type in new geographies suggests relatively high odds of growth materializing.

HVAC products and services are not DIY – contractors are the decision-makers and are not price sensitive. Watsco has close relationships with OEMs as they are the largest customer in most cases yet “still far from reaching [their] full potential in scale” Al Nahmad, 4Q18 call.

Watsco’s distribution model and scale have created a lucrative cash-generative model with low reinvestment needs, leading to impressive returns on assets and invested capital.

This has fueled a dividend that has grown at a near 15% CAGR since its initiation in 1985 ($0.0564 -> $6.40). Dividend growth continued through the financial crisis, and the last 10 year CAGR has been 13%.

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.” Warren Buffett. Watsco stock has added over $5 in cumulative market value for every $1 increase in retained earnings.

Good Management + Proper Long-Term Incentives

CEO Albert Nahmad has fostered an owner/operator management team and culture since 1972.

Nahmad’s de-centralized approach to acquisitions and management has led to strong positions in local markets. “We’re an M&A company…we don’t try to change cultures, we don’t try to change leaderships, we just want to support and to do more and provide capital and provide additional products and whatever and technology and whatever else they might need” Al Nahmad, 1Q19 call.

There’s very little private equity in HVAC distribution after a firm “destroyed one of [Watsco’s] peers about 15 years ago…they went to a very centralized, synergized business model where they bought a lot of eclectic local business, tried to assemble it into one thing and it went out of business…for Watsco, we bought 60 businesses, there’s not one of them that says Watsco” Barry Logan, JPM conference March 2019.   

Al’s son AJ is currently the President and has been with the company since 2005. Each of the top 30 employees has been with Watsco for an extended period, often greater than 20 years. The company has a unique equity inventive plan in that restricted stock granted to executive officers and 55 other key leaders does not vest until the employee is at the end of his/her career, usually 62 and older.

Among the executive officers, 97% of restricted stock awards have not yet vested. Al’s stock does not begin vesting until 2022, and AJ’s does not begin until 2043.

In all, Watsco’s long-term share-based incentive compensation plan has 230 participants. Insiders and employees together own almost 15% of shares outstanding.

Unique Board of Directors

Watsco is considered a “controlled company” by the NYSE as Al Nahmad controls 52.2% of the voting power. Because of this, Watsco isn’t subject to certain corporate governance policies such as majority independent directors. 7 of Watsco’s 12 board members are independent as they still do elect to maintain a majority. Regardless, this is something that proxy voting services would likely flag.

I have no problem with this. I’d prefer that the directors have some skin in the game when it comes to making decisions. Outside opinions are important, but you see many boards that are entirely independent. I think these boards are at risk of being too disconnected from the business.

Going Forward -> Investing in Technology

“I get asked often what will this industry look like in five years or so? And my answer is that there is going to be the haves and have nots and the differentiator is going to be technology, and that’s going to be true at the distribution level and at the contractor level” Al Nahmad, 1Q19 call.

Watsco’s size enables significant long-term investments that small fragmented competition cannot afford. Nearly half of the company’s capital expenditures are currently going toward computer hardware and software, and while increased technology spend has been reflected in little-to-no margin expansion, clear benefits have shown through this chart posted in 2Q18:

“We’re seeing customers that use our apps and technology grow at 3 times the growth rate of our customer that’s not using technology. We’re seeing attrition be a fraction year-over-year for users versus non-users” Barry Logan, William Blair conference June 2019.

Watsco works with approximately 90,000 contractors and notes just 12,000 active online/app users. The runway ahead is long.

These investments in the supply chain, mobile, and e-commerce will ultimately create stickier, longer-lasting relationships with contractors and their customers. If technicians can complete more jobs in a day, contractors will be more efficient and profitable, and contractor loyalty will increase.

I think Barry sums up the attractiveness for contractors and homeowners well:

“We bought a company in April in New Jersey called DASCO, $57 million company that is dominant in that market. The owner we’ve been in touch with for 20 years reached a point where he got the technology. He brought his team to Miami to hear it, and I believe it made the difference in joining after 45 years of independent ownership” Barry Logan, UBS conference June 2019.

These are the types of benefits that cannot be calculated but further justify a premium valuation.

What Might the Long-Term Model Look Like?

What I like most about Watsco is the relative predictability of the business. I think you can confidently model out a happy medium type scenario that could point to buying opportunities when the stock sells off (see end of 2018 / early 2019).

I feel obligated to answer the question…if Watsco is such a fantastic company, why did the stock sell off nearly -31% peak to trough to end 2018? (S&P 500 -20%).

Northern HVAC companies put up exceptional summer metrics on warmer-than-usual weather. The HVAC industry saw double-digit increases in the North, while the Sun Belt was rather flat. Add in a historically rich valuation with dampened near-term earnings growth, and shares traded down. The good news is that I believe this presented an opportunity to purchase shares of a best-of-breed business + management team in an economically insensitive industry.

On to the model, revenue growth should remain at GDP+ levels over cycles. Replacement runway exists (volume) and price should work in Watsco’s favor (trend toward more energy efficient systems + efficient equipment costs more + distributors easily pass price through to contractors). Longer-term, I envision a mismatch between the supply of labor and the consistent demand that will exist for contractor services. This, too, should be a positive for Watsco.  

“The only thing we’ve found over the last 30 years that we’re steady. Sometimes we grow at a faster rate and in other times, but we always grow…I wouldn’t be happy with 3% growth rate in revenue.” Al Nahmad, 4Q18 call.

Operating margin expansion was strong coming out of the financial crisis, and it’s clear that things have slowed down since Watsco began committing to technology investments in 2014/2015.

Watsco is starting to show flat same-store SG&A. The entire increase in 3Q19 SG&A ($11.5mm) was attributed to 35 new and acquired locations. Barry has said that historically 60% of SG&A is variable – my math suggests more like 75%, but I think he is talking about same-store while I am looking at the total number. Regardless, when looking at my projections, know that I am using 75% to project operating expenses.

Al’s long-term operating margin target is > 10%. Many locations are already there. Regions with smaller market share / newer locations are not. I don’t use anything close to 10% in valuing Watsco because I don’t have near that kind of foresight. I consider it potential upside.

Summary: What Makes Watsco Special?

• Leading distributor with significant benefits from scale – relationships + data + technology
• Economically insensitive industry – “machines don’t care”
• Family owned and operated + proper incentives – long-term focus
• Conservative balance sheet – always acquisition-ready
• Cash-generative model with low reinvestment needs – growing dividend

Risks

• Watsco’s top 10 suppliers account for 84% of the company’s purchases, with Carrier accounting for 62% and Rheem 9%. In calls management doesn’t seem too concerned about UTX spinning off Carrier in 1H20. The 10K states “It is too early to determine whether the proposed spin-off of Carrier will have any impact on us and our results of operations”. I don’t foresee any problems, but business is changing at Carrier…and Watsco does a lot of business with Carrier. This could actually turn out to be a positive as Carrier will have a new mandate for growth as an independent company. The existing JV agreement is perpetual and exclusive in 30 states + Canada, Mexico, and the Caribbean. Regardless, I don’t think Carrier will get into distribution:

• Directors possess 56% of the voting power. Family ownership combined with good long-term incentives across executive leadership suggest this is okay, but the past is no indication of the future. Prospective common shareholders may not like the lack of voting power.
• Equity dilution. Watsco does have a share repurchase program, but they haven’t used it since 2008. They tend to issue shares at the market to help fund acquisitions.  

Valuation

Promising numbers and commentary from last few quarters have the market once again baking in GDP+ growth and margin expansion, putting the stock back at or near an all-time-high valuation on many measures.

This isn’t alarming, but the market is clearly starting to bake in a positive future as you can see in the simplified DCF model below – revenue growth > GDP and operating margin expansion.

Also, notice how much of the DCF’s value is coming from the later stages – Stage 2 (years 6-20) and the Terminal Value (years 20+). This is the opposite of what you’ll commonly find baked into “deep value” stocks, where the market is pricing in little to no confidence in the terminal value = there’s a chance this company loses its competitive edge / goes extinct.

To the question “how much optimism is baked into the price”, my answer is “a good amount.” It’s enough to keep me from recommending the stock at today’s price.

That said, there are a few positive things to note:

1. Do remember that with a DCF model, if the future pans out exactly as predicted (it won’t), you can still expect to earn the cost of capital (7.5%) + dividend (~3.5%) annually. That’s not bad. Watsco’s business and management team have proven reliable. I have no problem buying a stock around “fair value”, particularly if I think the potential for an upside surprise outweighs the potential for a downside surprise.
2. If Watsco continues to grow organically + acquire smaller businesses, 3% FCF growth beyond 2023 will prove conservative. I’ve chosen 3% because it is a floor I believe I can count on, but I could be grossly undervaluing the company in the mid-term.
3. I trust that Watsco can hit 9% EBIT margins with time, I’m just not ready to make that call right now. 9-10% EBIT basically guarantees that Watsco has taken share and grown beyond $6 billion in revenue. Such a combination would likely send the stock above $200.  

Watsco is worthy of a spot on the Mount Rushmore of distribution companies. Stocks like these do not come cheap, and they are rarely “screaming buys”. I believe that homework on such companies is best done at all-time highs so that when things do get messy, I can confidently take action.

I am long shares of WSO and would be happy to add more, but I believe the opportunity cost is too high at the current price. I would start getting interested again in the mid $160s.