This write-up was first published on my website: http://topcornerinvesting.com/2023/04/19/watsco-inc/

Watsco is the largest distributor of HVAC/R (heating, ventilation, air conditioning & refrigeration) equipment and parts in North America. The business was incorporated in 1956 as a manufacturer of air conditioning parts before switching to its current distribution strategy in 1989. At the time of the strategy switch, Watsco was valued at a market cap of $22 million. In 2011, it became a 100-bagger at $2.2 billion. Today Watsco is valued at about $12 billion, up 545x since 1989.

Watsco’s customers are typically contractors and technicians who repair or install HVAC/R systems for their respective customers (typically residential, commercial or new housing). In 2022, the sales mix was as follows:

To serve its customers, Watsco operates 673 locations across 42 U.S. States, Canada, Mexico and Puerto Rico where contractors/technicians can buy equipment, supplies and tools. Watsco generally expand its store footprint (chart below) from M&A activity; for example, Watsco increased their presence in the Midwest and the South through 3 key acquisitions that brought them 56 new locations in 2021. Similarly, Watsco formed three different joint ventures with Carrier between 2008 and 2012 which expanded the businesses into Canada and new geographical areas. To read more about Watsco’s past and future acquisition activity, I highly recommend this memo from Andy (@bizalmanac on Twitter).

However, they are slightly dilutive to shareholders. For example, Watsco issued ~4.25 million new shares to fund the joint ventures with Carrier. Shares outstanding has increased by about 2% on average annually since 2008.

Distribution businesses like Watsco, Pool Corporation and W.W. Grainger have all delivered outstanding long-term shareholder returns. In Watsco’s case, this business model works well for a few different reasons - The HVAC/R industry is fragmented with no large direct competition. As the largest distributor, Watsco has reached a scale that allows the company to take advantage of its large network to support and serve customers faster and better than competitors. As mentioned earlier, the scale also allows them to acquire other businesses that will add new products and locations - Watsco has expanded into Canada, Mexico and Puerto Rico over the years and further expansion will be an important source of growth going forward as well. Watsco's size also gives them some purchasing power from its suppliers which in turn could drive margin expansion.

Further, Watsco’s business is benefitting from the growing installed base of A/C units. These units will need regular maintainance and service over the next 10-15 years until it needs to be replaced with a new one. Per Watsco (take the ESG angle for what it’s worth) there will also be a significant need for more energy-efficient HVAC systems to meet new efficiency standards:

“Our company and our customers are all capable of driving change that is good for the consumer, good for the environment, and good for our business. The products we sell have a direct and meaningful impact on overall energy consumption and CO2 emissions. As consumers replace older existing systems, particularly with high-efficiency systems, consumers save on energy costs and reduce greenhouse gas emissions. Upcoming federal regulatory changes will influence what products consumers choose from and how contractors present innovative solutions to homeowners.” (Watsco 2021 10-K)

(Image from Watsco 2023 Investor Presentation)

Part of the success can also be attributed to the ownership culture. Watsco’s compensation structure is fairly unique in that key or high-potential employees are rewarded a large number of restricted shares (about 130 employees own close to 3 million restricted shares as of 2022). The owners can vote and collect dividends with the restricted shares but the shares do not vest until “retirement age” at 62 or later. If you leave Watsco you also leave those shares behind. The goal is to create a long-term ownership mindset where management makes decisions that are good for Watsco in the long run:

“I tell our leaders all the time that we’re a public company, it’s important to have good quarters, but what we’re really after here is good quarter centuries, right?” -A.J. Nahmad, Watsco President

Watsco’s revenue growth has accelerated rapidly over the past three years compared to the last decade. Between fiscal years 2020 and 2022, revenues increased at 20% annually versus ~7.5% between 2013 and 2022 (and 15% annually since 1989). Furthermore, Watsco more than doubled its net income over the same three-year period and expanded profit margins from 5.3% to 8.3%.

Revenue growth will undoubtedly slow down as we move on from an environment which strongly benefitted anything home improvement related (companies such as Watsco, Home Depot and Pool Corp were arguably all pandemic winners). The question is if the profit margin also will revert back to its long-term average of ~5%. The argument as to why margins could permanently remain at 7-8% is because Watsco has taken market share over the past few years - per company reports, Watsco’s market share has increased from 12% in 2018 to 15-18% at fiscal year-end 2022. The company also used the pandemic to improve its technology platform to the benefit of customers (online ordering is more efficient, allowing contractors to complete more jobs) and Watsco itself (more platforms to sell from at any time of the day). On the other hand, reduced demand from a housing downturn could eat into margins if Watsco has to clear out inventory at lower prices. While this might be short-term I think it's reasonable for investors to think about the mean reversion from some of the pandemic gains.

Over the past 20 years, Watsco has spent $802 million on acquisitions and $288 million on capex. Watsco has also distributed $2.4 billion as dividends to shareholders over the same time period. With incremental ROCE at about ~40% for the past decade, one could probably wish Watsco would re-invest more of its capital in the business and not pay it out as dividends to shareholders.

I think this partly goes back to the ownership culture in the way that Watsco wants to reward its restricted shareholders and employees that own shares in the business by paying out a dividend on a quarterly basis. Another reason could be that Watsco doesn’t want to aggressively acquire other companies; Watsco wants to be seen as the right “home” for family-owned HVAC businesses that are looking to sell for various reasons. In many cases, these small businesses are happy to be acquired by Watsco rather than private equity because of Watsco's track record. Nevertheless, Watsco has significantly increased its cash pile over the last few years and likely in a good position to strike if any opportunities should arise.

Below is my current earnings model for Watsco

The underlying assumptions are that revenue growth slows to 10% in FY 2023 and 5% for 2024 through 2027, profit margins stay slightly above the long-term average and the annual dividend grows at 10% per year.

I find it fairly difficult to forecast Watsco’s earnings over the next few years for a couple reasons:

(i) Management doesn’t provide guidance. The only certainty we have is that the annual dividend (paid quarterly) will be raised for $9.80 for the 2023 fiscal year.

(ii) Watsco’s business is correlated to the housing market. I don’t have any edge in forecasting the housing market but it might be there is a chance that housing (new housing development, home transactions or similar) will slow down compared to prior years. This will hurt Watsco’s revenues but it’s difficult to say to what extent.

The current price of 23x forward earnings does not seem to provide much margin of safety given Watsco’s exposure to housing/real estate. I think a fair value in the range between $230-$250 is more reflective of the current business (for the record, Watsco was trading at $240 in July 2022) and the challenges it faces over the next few years.

I consider Watsco a great business and I’m adding it to my list of excellent companies (similar to companies like Hershey and O’Reilly that I have written about before) that I will be ready to purchase if Mr. Market provides me the opportunity.

Thanks for reading!