HVAC/R Market Remains On Track And So Does Watsco Inc.

| About: Watsco, Inc. (WSO)

Summary

HVAC/R market largely relies on the housing market where growth trend is steady and the momentum is building up to a boom situation.

Watsco has an established position in this industry and benefits from having a long-term relationship with its vendors.

Moreover, the depression in Watsco Inc.'s cash flows is only on the back of built-up of working capital in expectation of higher sales in the coming periods.

Based on this thesis, the stock is currently trading at a discount of 8% and therefore deserves a Buy recommendation.

Introduction

Watsco Inc. (NYSE: WSO) was founded in 1956 manufacturing refrigeration and heating equipment and related parts, collectively known as HVAC/R, in North America. As the business grew, the company's focus shifted to distribution in connection to which it made certain acquisitions of distributors of other manufacturers. Over time, distribution became the main focus of the company, and in 1998, manufacturing was sold off to International Comfort Products, which was later acquired by Carrier Corporation with which Watsco has three joint ventures focused on HVAC/R distribution. The company, as it stands today, is a comprehensive distribution company with 567 locations in U.S., Canada, Mexico and Puerto Rico, along with export reach into Latin America and the Caribbean. The company's primary vendor is Carrier Corporation and its affiliates which, combined, account for around 60% of its total supplies. It sells this product primarily to residential consumers where demand arises from new construction and replacement sales in a seasonal pattern as is the nature of the product. Company's products are also sold to commercial consumers.

Financial Analysis

Revenues of the company have been growing over the past five years as the company maintains its distribution strength experiencing bursts of growth in CY10 and CY12 when it completed its joint venture with Carrier Enterprise, adding 95 locations in CY10 and further 70 in CY12. As of 9MCY15, the company operates through 567 locations which is compared to 572 locations reported in CY14 as the company closed down slow-growth locations in an effort to reduce costs. CY14 revenue growth has slowed down to 5% compared to 9% in CY13 as the company's capacity reaches its cap while demand from residential and commercial consumers is on a steady growth path. Higher demand is derived from residential consumers which increased by 8% during CY14 followed by commercial at a distant second posting 3% growth and a 2% increase in the HVAC equipment demand. Higher component of the revenues is derived from complete HVAC units forming around 64% of the revenues and 31% is comprised by related products. The remainder 5% of revenues comprises of refrigeration units where demand largely comprises of commercial consumers growing by 7% during CY14.

Revenues continue to climb in the 9MCY15, growing by 5% compared to the corresponding period last year, largely supported by the HVAC units' growth making up a larger percentage of the revenues, while there was slower growth in other areas of the business. Major portion of this growth came from residential demand which continued steadily but were also contributed towards by the higher priced improved air conditioning and heating system. Seasonal demand pattern indicates further growth in revenues in the outgoing year as demand for HVAC equipment increases during winter months. New construction in the US market is expected to continue to grow in the coming year, even if the pace has slowed down and is supported by the availability of credit leading to expectation of growth in the HVAC/R market.

Gross margin of the company has remained stagnant at 24% over the past five years, and the same has continued into the 9MCY15, indicating steady vendor relationships. The company also enjoys certain rebates from its vendors, based mainly on the volume of purchases which it has maintained given the level of revenues resulting in slight improvement in the cost of sales. Operating margin of the company has improved to 8% during CY14 after maintaining at 7% over the period CY11-13 as the company experienced better absorption of fixed costs despite increase in headcount. In the 9MCY15, the operating margin of the company has improved further by a percent at 9% as the company improved its fixed cost to revenue structure by shutting down some locations. This improvement was achieved despite incurring additional cost for new technology initiative. The company utilizes a long-term revolving line of credit for its working capital requirements and other corporate purposes which includes acquisitions, dividends and repurchases. There is no other regular short-term borrowing except for the outstanding in CY14, which has been obtained by its Mexican subsidiary for a period of one year to finance its corporate requirements.

The company's debt utilization is traditionally low and recent utilization has been to finance the purchase of shares in its joint venture with Carrier; however, financial costs remain low and steady, averaging 0.14% over the past five years and at that level in the 9MCY15. PBT margin, therefore, remains largely unchanged from the operating margin line while taxes take away another 2% to 3%, resulting in a net margin of 5% in CY14, unchanged from the previous year and a percent higher in the 9MCY15 following from a higher operating margin. After adjusting for non-controlling interest (NCI) profit margin attributable to Watsco shareholders is only a percent down at 4% in CY14 compared to 3% in CY13 as Watsco held 10% less of Carrier Enterprise I leading to lower share in the income of this joint venture. A percent of total income is attributed to non-controlling interest in 9MCY15, resulting in a net margin post NCI of 5%.

The company's operating cash flow has been under pressure over the prior three annual periods, which may be attributed to increasing revenues as the company has piling up receivables and increasing inventory balances. The same has been offset to some extent by holding back payables; however, operating cash flows remain depressed continuing into the 9MCY15. Operating cash flows adequately cover its maintenance CAPEX demand while acquisition-related expenses have been financed through debt. Debt repayment has been regular, and shareholder value is returned through dividends. Closing cash balance is historically low but increasing over the prior 21 months.

in millions USD

CY10

CY11

CY12

CY13

CY14

9MCY15

Revenues

2,845

2,978

3,432

3,743

3,945

3,209

Revenue growth

42%

5%

15%

9%

5%

5%

Basic EPS

2.49

2.75

2.70

3.69

4.33

4.16

Basic EPS growth

75%

10%

-2%

37%

17%

14%

CAPEX/revenue

0.24%

0.59%

0.42%

0.38%

0.51%

0.62%

Depreciation & amortization/revenue

0.38%

0.39%

0.46%

0.47%

0.45%

0.44%

Source: Company 10-Ks

Valuation

The HVAC/R market in the US is to a large extent reliant on the housing market where the growth trend is steady and the momentum is building up to a boom situation where easily available credit is supporting further demand increments. This leads to an almost 7% growth expectation in the HVAC/R market over the next five years fuelled by residential demand for more efficient systems which come at a higher price. Demand for efficient systems will also drive replacement demand as homeowners look for more eco-friendly and energy saving systems. This trend is also depicted in non-residential market, but its pace is expected to be slower than residential markets which are expecting a growth spurt in the coming years.

Growth in the HVAC/R market is expected to be faster outside US, specifically China, where demand is focused on efficient systems which is driving new purchases as well as replacement demand. Watsco has an established position in its industry and benefits from having a long-term relationship with its vendors. Further, in a bid to improve margins, the company has been cutting down on fixed costs by shutting low revenue generating locations while it continues to post growing sales supported by other means of selling points such as mobile apps and its website which it continues to develop and expand upon to divert more buyers to these portals.

The company is set to benefit from the growing demand of efficient systems and growth in housing markets. Higher sales are expected in the last quarter of the year on the back of winter months, which leads to expectation of a higher EPS for the year close. Revenues are expected to continue to grow at a steady pace within the current infrastructure, supported by sound market fundamentals with growth expenditure expected two years down the line. The company's income margins are also expected to improve given its cost cutting efforts; however, they may be capped, leaving it to revenue growth to provide the growth in EPS. This leads to a stock value steadily rising to USD121.66 at April close.

in millions USD

CY15E

CY16E

CY17E

CY18E

CY19E

CY20E

Revenues

4,140

4,378

4,674

5,036

5,477

6,011

Revenue growth

5%

6%

7%

8%

9%

10%

Basic EPS

5.31

5.62

6.00

7.44

8.09

8.88

Basic EPS growth

28%

6%

7%

24%

9%

10%

CAPEX/revenue

0.48%

0.45%

0.45%

2.30%

2.28%

2.26%

Depreciation & amortization/revenue

0.49%

0.49%

0.50%

0.82%

1.10%

0.99%

Conclusion

The stock had been losing steam over the past several months on the back of results which were not up to market expectations; however, there was improvement over the previous year and the depression in cash flows is only on the back of built-up of working capital in expectation of higher sales in the coming periods. In latest development, the stock has posted an instant jump of USD4.34 on 29-Jan-16 as the buying interest built on the stock, which may be fuelled by the recent purchase of a 6.8% interest by the BlackRock, Inc. (NYSE:BLK). While this pace of momentum may not be sustained, the direction is expected to continue, as higher earnings are expected for the outgoing year and market fundamentals continue to support further growth.

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.

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