Summary
- Watsco reported Q4 earnings last week.
- The company had a record FY 22 with all relevant metrics growing.
- Inventory concerns are subsiding.
- I summarized my 3 main takeaways from the earnings report and call.
Last week Watsco ( WSO ), the leading North American distributor of HVAC products, presented earnings. The market reacted very favorably to the results, shooting the stock up more than 10% before selling off a bit again with the general market. I have been a shareholder of Watsco and an active buyer over the last half year and found three key takeaways from the earnings release and call. I covered Watsco twice in the past and the stock is up 30% and 23% since the articles were released. If you want to learn more about this wonderful business, I encourage you to check those articles.
Watsco Earnings pop (Google)
Watsco keeps growing
Watsco had a strong quarter to round out the year:
- EPS was up 76% in GAAP to $3.55 and 16% in non-GAAP to $2.35; Investors should look at non-GAAP in this case because Watsco had a $1.2 tax benefit from restricted stock vesting.
- Sales and gross profit increased by 5%, with gross margins rising ten basis points to 27.4%.
- SG&A expenses only grew 3%, resulting in an 11% increase in operating income to $137 million or $141 million on an adjusted basis.
- Operating Cash flow came in strong at $213 million.
Overall, FY22 saw a substantial increase in every aspect of the business:
- EPS increased 32% to $14.2 (adjusted for the tax benefit)
- Sales increased by 16% and gross profit by 22%.
- SG&A expenses grew by 15%, leading to a 32% increase in operating income to $832 million.
- Operating Cash flows increased 64% to $572 million.
Let's talk about cash flow in particular. Throughout the year, cashflows were all over the place for Watsco. In March 2022, Operating cash flow dropped to $285 million, leaving Free cash flow around $250 million after subtracting CapEx. This was not enough to cover Watsco's $302 million in dividends paid at the time. What some people took as a red flag was primarily a result of changes in inventories. As shown in the picture below, Watsco had a -$273 million change in inventories in the same quarter, pushing operating cash flows down under the dividend payout. This brings us to the first point I want to talk about.
Watsco Cash flows (Koyfin)
The Inventory transition
The HVAC industry is currently undergoing a transition to a higher SEER standard. I talked more about this in my first article ; in short: New units sold need to have higher energy efficiency. This led to a transition where old SKUs had to be sold out (distributors are still allowed to sell off its existing stock, but they can't order new) while new SKUs already had to be purchased. This led to an increase in Inventory, but the company believes that this transition and the resulting reduction in the number of SKUs available will increase efficiencies and inventory turnover over the long term. This will have a positive effect on cash flows over the following years.
And also adding to Barry's point, as we move into the new inventory, we're going to have a reduction in the number of SKUs that we have to handle on the equipment side, which we think will result in better efficiencies and higher turnovers in the inventory.
Paul Johnston, Executive Vice President of Watsco at Q4 22 earnings call
Another critical point is that Inventory increased a lot, but this is not due to Watsco being unable to sell units; Watsco is in a unique position where it is a truly national company that can move Inventory around to sell it if necessary. The majority of the increase in Inventory is driven by price, which is up meaningfully, while volume is only up mid-single digits. The company also expects to be able to remove $200 million of Inventory from the equation now that the new SEER standard is in place.
That kind of makes Watsco unique because we're a national north south east west company. Nothing has ever stranded because, as AL indicated, we've got a large business that we do in the northern tier of the U.S. plus Canada where we were able to move very little inventory actually, but we did move the inventory to make sure it's available to sell.
Paul Johnston, Executive Vice President of Watsco at Q4 22 earnings call
Refrigerant transition as another catalyst
Another catalyst for Watsco is the new US regulations pushing a new refrigerant beginning in 2025 . This is just a tiny part of Watsco's business at 4% of sales, but it's growing at a fast 24% clip for the year and 19% in the quarter. The company estimates that this will further increase the cost to service and repair old HVACs, providing the need for more parts and, ultimately, business for Watsco.
A continued focus on the long-term
The last point I want to stress about Watsco is their continued focus on the long term. This again was evident in the earnings call, and it just is a pleasure to hear the management talk about their business with foresight and only the long-term in mind. A testament to this is Watsco's continuous investment into technology to differentiate itself from competitors not just on the outside but also on the inside, with enterprise systems enhancing the speed and precision of their ability to serve the customer. Technology spending grew by 14% to $49 million for 2022.
Watsco is getting expensive
I have been a buyer of Watsco for the last half year via monthly dollar cost averaging and a few larger purchases. The stock represents nearly 5% of my portfolio, but it's starting to get expensive. It is right on its average historical PE, cheaper on an FCF basis and more costly on an EBITDA basis. I believe that Watsco stock is still a light buy, so I'll keep my rating at a buy because I also keep DCAing into it.
For further details see:
3 Key Takeaways From Watsco's Q4 Earnings