Watsco Long-Term Story Positive, Near-Term Headwinds Remain
On Dec 5, 2014, we issued an updated research report on Watsco Inc. (WSO), a leading distributor of air conditioning, heating, and refrigeration equipment as well as related parts and supplies (HVAC/R) in the United States.
Watsco reported record third-quarter earnings of $1.56, an 18% increase year over year, led by share gains in the United States and Canada, a stronger sales mix of high efficiency HVAC, higher gross margins and improved operating efficiencies. Total revenue in the quarter increased 5% year over year to a record $1.13 billion.
Sales of HVAC increased 7%, while sale of other HVAC products remained flat with the year-ago quarter. U.S. residential HVAC equipment sales increased 8% with gains in market share while commercial refrigeration products sales increased 14%.
The market for residential central air conditioning, heating and refrigeration equipment and related parts and supplies in the Americas is worth approximately $35 billion. Watsco now owns 10% of the market and has immense potential to increase its market share as no other competitor can match its geographic footprint.
Watsco will continue to benefit from demand in the replacement market as old units get replaced by more energy-efficient units in the coming years. There are approximately 89 million central air conditioning and heating systems installed in the United States that have been in service for more than 10 years. Moreover, higher efficiency units mean higher pricing and higher margins for the company.
Watsco’s joint venture with Carrier Corporation, a wholly owned subsidiary of United Technologies Corp. (UTX), has been successful and continues to generate profits. In Jul 1, 2014, Watsco exercised its second option to acquire an additional 10% ownership interest in Carrier Enterprise I in the Sun Belt region.
Watsco now holds an 80% controlling interest in Carrier Enterprise I. In the U.S., the most significant markets for HVAC products are in the Sun Belt. This increased stake will be accretive to Watsco’s earnings by 20 cents to 25 cents over the next 12 months.
Watsco has made several investments over the past one year to increase its market share – adding 200 people in sales, marketing, product specialist and store personnel roles; eight locations have been opened in the past year with 20 more expected to open in the next 12 months. The branches will improve network density as well as the ability to service customers locally. Watsco maintains its long-term plans to increase revenues to above $10 billion and margins above 10%.
Watsco is now aiming to capitalize on the growing trend of ductless systems in the U.S. The duct-free systems and VRF technologies are growing at an annual rate of 20% and taking share from traditional unitary and applied systems. The company was an early adopter of duct-free systems and feels that it is well positioned with the right partners for success in VRF.
Moreover, EPA’s recent decision to significantly reduce the allowed production levels of R-22 gas, beginning in 2015, due to environmental concerns, is a positive for Watsco. R-22 was the primary cooling agent used in air conditioning equipment for decades until the industry officially switched to R-410A several years ago.
Despite the switch, OEMs are still producing equipment that runs on R-22 today. This will lead to higher R-22 prices and would support continued growth in replacement demand, and is therefore considered a positive for the HVAC industry.
On the flip side, international sales (which contributed 12% of total sales) have been reportedly weak so far in 2014. Sales, though flat in the first quarter, declined 4% in the second quarter due to foreign exchange losses in Canada and challenges in its Latin America/Mexico/Caribbean regions. Despite an increase of 4% in international sales, in the third quarter, Canada continues to be a tough market with a weakening Canadian dollar.
The upcoming regulation change, which bans the installation of 13 SEER HVAC equipment in the Southern regions from Jan 1, 2015, will not have a material effect on Watsco. The company stated that it has taken a conservative approach to pre-buying 13 SEER inventory ahead of the change. It also noted that higher efficiency units are already being preferred in the Sunbelt region.
Moreover, Watsco has been historically acquisitive and its growth strategy mainly focuses on geographic expansion through new market acquisitions, subsequently increasing revenues and profits from a combination of greater number of locations, products, services and improved management practices. However, the company has been lately inactive on the acquisition front.
Other Stocks to Consider
Watsco currently carries a Zacks Rank #3 (Hold). Some better-ranked stocks in the sector include GigOptix, Inc. (GIG) and Universal Electronics Inc. (UEIC), both of which hold a Zacks Rank #1 (Strong Buy).
Read the Full Research Report on WSO
Read the Full Research Report on UTX
Read the Full Research Report on UEIC
Read the Full Research Report on GIG
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