Investors Should Watch Watsco With Caution

Summary

• Watsco sells HVAC equipment and parts.
• Watsco proves quite capable in generating organic revenue and net income growth.
• Watsco’s free cash flow has declined for three years straight.

It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. Right now let's talk about Watsco (NYSE: NYSE:WSO).

1.) What does the company do?

When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. Watsco is the largest company in North America to distribute HVAC parts and equipment, making it a market leader in a highly fragmented industry.

2.) What do the fundamentals look like?

Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains.

Over the past five years Watsco grew its revenue and net income 47% and 116%, respectively. However, its free cash flow declined 24% during that time (see chart below). Watsco's revenue increased due to a mixture of same store sales increases, price increases expansion and acquisitions. Same store sales increased four of the past five years, with the exception of 2011, serving as an indication of healthy demand increases. The company also demonstrates a tendency of keeping costs under control, contributing to the healthy growth in net income. However, I am a little concerned about Watsco's decrease in free cash flow, which is adversely impacted by accounts receivable, inventory and capital expenditures over the past three years.

WSO Revenue (NYSE:TTM) data by YCharts

Watsco shows similar fundamental patterns in FY 2015. The company saw its year-to-date revenue and net income increase 5% and 21%, respectively, year-over-year in the most recent quarter. However, its free cash flow deficit widened 25% vs. the same time last year. Accounts receivable showed a larger deduction on the statement of cash flows. However, inventory showed a smaller deduction.

Watsco's balance sheet is ok. In the most recent quarter, Watsco possessed $22 million on its balance sheet, which equates to a miniscule 2% of its stockholder's equity. I like to see companies with cash amounting to 20% or more of stockholder's equity, giving them cash to self-finance things like acquisitions and product innovations. However, as a counterbalance its long-term debt only equates to 37% of stockholder's equity. I like to see companies with long-term debt amounting to 50% or less. Its year-to-date operating income exceeds interest expense by 57 times. The rule of thumb for safety resides at five times or more.

Watsco does pay a dividend. I like to see companies pay out less than 50% of their full year free cash flow in dividends and retain the rest for other purposes. Last year, Watsco paid out 56% of declining free cash flow in dividends. Currently, the company pays its shareholders $2.80 per share per year translating into a yield 2.2%.

The stock market, impressed with Watsco's growth in revenue and net income, rewarded its shareholders with a 181% total return vs. 104% for the S&P 500 as a whole over the past five years (see chart below).

WSO Total Return Price data by YCharts

3.) How much management-employee ownership is there?

Investors should always look for businesses where managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance the share price and their personal wealth along with the wealth of shareholders.

According to the company's latest proxy, Watsco's President and CEO, Albert H. Nahmad, owns 86% of the company's class B shares, giving this individual 54% voting power. Barry S. Logan, Senior Vice President and Secretary, owns 2.5% of the company's class B stock, giving him 1.7% of the voting power. Aaron J. Nahmad, Vice President of Strategy and Innovation own 2.1% of the company's class B shares, giving him 1.3% of the voting power. It's definitely in the best interests of these individuals to see the company succeed.

4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?

Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. During its most recent audit, Watsco's auditors gave its financial statements an unqualified opinion and said that the company maintained effective internal controls.

5.) What types of risk does it have?

It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning and market price risk. Watsco does operate globally, meaning that political risk is there. The company is a market leader in a fragmented industry, which gives them an edge in terms of economy of scale. Watsco can profitably sell items at a cheaper price. Watsco trades at a P/E ratio of 23 vs. 19 for the S&P 500, meaning that its run up over the past five years created some market price risk.

6.) What does its forward analysis look like?

In the most recent quarter, Watsco upped its stake in Carrier Enterprises and hired 100 additional people to facilitate the company's increased focus on customer service. This should lead to continued sales and net income growth. However, I would like to see the company turn its free cash flow decline in the opposite direction. I would also like to see a lower valuation before investing. Finally, investors may want to keep an eye on this company, but tread cautiously.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Edward J. Roche]

Great company, would like a slightly better price. Could benefit from global warming and trend to move to the south.

[great run investor]

WSO has been in my portfolio a long time. Over the years it dramatically out performed everything else and done so consistently.
The biggest risk is that Mr Nahmad controls the company with well over 50% of the voting shares. Fortunately he and his team have done a great job.
It is my largest holding because it has performed so well. The dividend performance is amazing. It could find my entire retirement if I needed it to.