2024-01-16 14:57:30 ET
Summary
- Watsco is the largest distributor of HVAC equipment in North America and is expected to increase its market share through its strong balance sheet and strategic acquisitions.
- The company has competitive advantages due to its scale and market leadership, as well as its focus on technological innovation.
- Watsco has a solid balance sheet and growth prospects, with the potential for high single-digit revenue growth and strong bottom line and free cash flow growth.
- Waiting for a better share price may be prudent for investors looking for outsized returns.
Investment Thesis
My investment thesis for Watsco ( WSO ) is that the company is already the largest distributor of HVAC equipment in North America and that it will continue to increase its market share thanks to its rock-solid balance sheet, scale advantages, strategic acquisitions, and potential for sustained growth.
The HVAC/R market is expected to grow at a healthy rate both Worldwide and in North America, and Watsco is positioned to continue growing faster than the industry itself. With its history of incredible shareholder returns, I believe that investing in Watsco is as simple as buying at the right time and letting the company do the hard work for you.
Winners Keep Winning
One of the main criteria I look for when screening for stocks is whether or not a company has a history of outperforming the market. I believe that winners tend to keep winning and that identifying companies with a track record of great shareholder returns that still have strong fundamentals and competitive advantages is a recipe for future success. WSO has significantly outperformed SPY ( SPY ) for three decades, and there is reason to believe that may continue. However, I believe WSO's current valuation is too rich to expect outperformance, and I want to identify a multiple that offers a better margin of safety.
Watsco's Track Record and Financial Profile
Looking at WSO's last ten years of financial data, we can see how much operating leverage the company has. The positive impact of the COVID era has dramatically increased its EPS growth rate. That growth has begun to normalize. An absolute decline or slowing of growth in revenue should lead to a greater decline in EPS. If this happens, a re-rating of the stock will likely occur. If and when this happens, it will be important to have a guideline for purchasing the stock, rather than letting emotions dictate one's investment.
Watsco has operating leverage. (www.FinChat.io)
How Watsco Keeps Winning Going Forward
Competitive Advantages
WSO enjoys a significant competitive advantage thanks to its scale and market leadership. As the largest distributor in the $50 billion North American HVAC/R industry, WSO benefits from economies of scale and exclusive distribution rights with suppliers. Combined, this creates quite a barrier to entry that will be difficult, if not near impossible, for competitors to overcome. With a roughly 15% market share in a highly fragmented industry, the company can operate more efficiently and profitably than its competitors.
Innovation
Technological innovation has also become a main focus of the company. Despite growing revenue and net income by 7% and 17%, respectively, over the last 10 years and returning 19.4% annualized for shareholders, WSO has refused to rest on its laurels, investing in its e-commerce technology to improve its operations and customer service. Its e-commerce platform has enabled its customers (contractors) to benefit from the use of its mobile app to increase operational efficiency. This allows these businesses, many of which are owner-operated small businesses, to benefit from WSO's scale. When contractors utilizing WSO's platform benefit from this advantage, WSO also benefits. Its e-commerce platform also provides an immense amount of data, allowing WSO to improve customer experience and its own operational efficiency by adjusting inventory, pricing, and logistics as demand shifts.
Solid Balance Sheet
WSO has a rock-solid balance sheet. Strong financial performance and a solid balance sheet provide the resources for continued investment in growth and resilience during cyclical or economic downturns. WSO has a net debt-to-equity ratio of 0.3, a current ratio of 3.1, $175m of cash and equivalents, and only $105m of total long-term debt. The only risk I see on the balance sheet is that inventory has grown at twice the rate of revenues since 2020, but management has stated that its backlog of projects extends out into 2024. Some of this inventory buildup may be a result of supply chain disruptions; as the company continues to work through backlog orders, it should continue to reduce inventory levels in the range of $200m (~12%) for full year 2023, as management has stated in its last earnings call. WSO's robust balance sheet and operational performance allow it to continue to grow organically and by acquisition.
Growth Prospects
Strategic acquisitions are a signature part of WSO's playbook, and the company does this very well. Not only has WSO expanded its geographic footprint and market share, but it could also be expanding its product line with its most recent acquisition of Gateway. During the Q3 2023 earnings call , management was not willing to go into specifics, but Gateway is a supplier of both HVAC and plumbing equipment. Expanding into the plumbing equipment market could be another source of growth for WSO.
Secular Trends provide a base level of growth for the company. The market for WSO's products is expected to continue growing for many years. Global heat pump sales grew by 11% in 2022, U.S. Air conditioner shipments grew at a 5.7% CAGR between 2010 and 2021, Heat Pump shipments grew at a 7.6% CAGR over the same period. With industry growth expected to continue into the foreseeable future, and with WSO being the dominant player in a fragmented distribution industry ripe for further consolidation, it presents the company with an opportunity to grow revenues in the high single digits for years to come. With operating leverage, WSO should be able to grow the bottom line and free cash flows well beyond that rate.
Valuation Matters, Even For Serial Outperformers
Past performance may not guarantee future results, but buying wonderful companies at reasonable prices usually does. Therefore, I have examined the past ten years of returns and valuation for Watsco to look for the best historical times to buy WSO stock. Assuming that the business fundamentals remain strong, this historical trend can be an indicator of when to consider adding to my position in the future. Since 2014, purchasing the stock when it was at or below a 14.5x EV/EBITDA multiple has delivered significantly greater returns than simply dollar-cost averaging at even amounts and intervals into the stock. Given this, I believe it is prudent to wait for a better entry point for WSO.
Watsco has returned an incredible 19.1% CAGR for shareholders since its IPO, outperforming SPY by 9.1%. (www.Finchat.io)
Since 2014, WSO has also outperformed SPY by a wide margin. Investing into WSO at any point since 2014 would have beaten the market, so an investor couldn't go wrong with simply dollar-cost averaging into the stock. WSO meets my criteria of being a long-term outperformer.
However, I believe there is tremendous value in utilizing an enhanced DCA or selective DCA approach when investing in great companies. In the case of WSO, selectively dollar-cost averaging into the stock, at attractive valuation multiples, since 2014, would have significantly improved one's returns.
During the last 10 years, Watsco has outperformed SPY (www.FinChat.io)
Below, you can see comparisons of two different investing strategies. The first strategy (simple DCA) is to simply DCA into WSO, $100 on the first trading day of every month. The second strategy (selective DCA) is only to invest $100 into WSO when the EV/EBITDA multiple is 14.5x or less. No matter the strategy, the investor would have soundly beaten SPY. However, the selective DCA strategy returned a significantly greater CAGR than the simple DCA strategy (24.7% vs. 22.7% when investing in WSO). It also would have returned far better results versus investing in SPY (selective DCA had an 11.0% CAGR alpha over SPY vs. a 9.9% alpha in the simple DCA strategy). This strategy might have worked particularly well if an investor was selectively allocating funds between WSO and other stocks depending on valuation.
The WSO selective DCA strategy outperformed a simple DCA strategy, and grossly outperformed SPY. (Author Generated Chart.)
Note: My calculations include dividends received but not reinvested dividends, as I had to hand-construct a spreadsheet for this analysis, and reinvested dividends at the proper prices would have been too time-consuming. Being that WSO has outperformed SPY consistently, I expect that reinvested dividends would further enhance the returns of investing in WSO with the selective DCA approach.
In order to normalize these results with the same cost basis and gain a clear visual on how much more profitable the selective DCA strategy is compared to the simple DCA strategy, I have adjusted the selective DCA cost basis for each month invested so that the total cost basis invested equals the same amount as the simple DCA strategy ($12,000). We can see that the ending dollar amount using the selective DCA strategy is $4,493 greater than the simple DCA strategy.
The selective DCA strategy would have returned an additional $4,493 over the simple DCA strategy. (Author Created Chart)
Below is a chart showing the periods of time the selective DCA strategy would have kept one from investing in WSO. The red-shaded boxes are no-buy zones, and purchases would be made each month outside of the red boxes.
Monthly purchases of WSO outside of the no buy zones would have enhanced shareholder returns over a simple DCA strategy. (Image from www.app.Koyfin.com. Image edited by author.)
Because valuation is an art rather than a science, there are many other variables that must be considered when investing in a stock, including forward valuation multiples, macroeconomic issues, as well as current and forward-looking business fundamentals. Additionally, a backward-looking analysis like this can be problematic due to selective bias. However, this study illustrates how critical valuation can be when trying to maximize returns. This exercise gives us a benchmark to consider as a potentially good buy point for WSO in the future.
Because past returns cannot guarantee future returns, and future results may differ from the past, I hesitate to believe that investing in Watsco at any price is the best way to handle an investment strategy for the company. I will start to get more interested in adding to my WSO position as the stock nears a 15.0x EV/EBITDA. At that point, another analysis can be done to see if the business fundamentals support purchasing at that time or if it is more prudent to wait for my 14.5x buy range. Having this plan laid out in advance will make the decision easier when the market is likely falling and negative emotions start to take hold of investors.
In order for Watsco to trade at a 14.5x multiple, given its current LTM financials, the stock would have to trade at roughly $312 per share. A 15.0x multiple would represent a share price of $323.
A 14.5x multiple represents a share price of $311.83 based on LTM financials. (Author created chart)
To further examine the current valuation and a potential strong buy price for WSO, I used a reverse DCF analysis. Assuming a full-year 2024 GAAP EPS of $15.14 (based on analyst estimates), a 12.0% discount rate, and a terminal rate of 3%. I have modeled a rather high discount rate, considering WSO pays a dividend. The terminal rate appears reasonable to me, as the secular trends driving HVAC/R industry growth should continue to support growth for WSO for years to come.
Seeking Alpha Growth Estimates Point to EPS Growth Estimates of 9.03% to 11.99% (www.seekingalpha.com)
In my base case scenario, I used Seeking Alpha's forward EPS LTG rate of 9.03%, modeling a reduction in growth in years 7-10. This growth rate is well below the company's past EPS growth rate.
My base case reverse DCF shows that WSO may be overvalued by 22%.
Watsco Reverse DCF Analysis (DCF Inputs by Author. Calculator adapted from www.Brianferoldi.com (used with permission))
In my bull case, I used Seeking Alpha's estimated forward EPS GAAP growth rate of 11.99%. Even this growth rate could be conservative due to the operating leverage that WSO has.
In my Bull case, Watsco is undervalued by nearly 4%, with a fair price of $423.
Risks
The aforementioned operating leverage that WSO holds is a double-edged sword. With accelerating revenue growth due to COVID and inflation, earnings growth has grown even faster. A main risk to shareholders is if sales growth continues to decelerate or even declines due to a cyclical or economic downturn, earnings decline at an even greater rate. Additionally, past shareholder returns are great, but WSO must continue to operate efficiently and capitalize on its acquisitions to deliver great returns going forward. If the playbook it has used in the past is no longer as accretive to its business, then shareholder returns for WSO may be more dependent on buying at low multiples or when there is a dislocation between future potential and the price of the stock.
Conclusion
Watsco remains positioned as the leader in its industry growth in the North American HVAC/R installed base will remain a tailwind that can push growth for Watsco. Its strong balance sheet and scale advantages make accretive acquisitions a viable path to future returns. I believe this to be a company that can continue to grow for many years and deliver great shareholder returns. Now, more than ever, it appears important to be selective when investing in the company.
Based on my Reverse DCF Base case scenario fair value price of $331, and my 14.5x EV/EBITDA price of $311, I would label WSO a very strong buy price around the $321 level. I believe a purchase at these levels provides for a reasonable margin of safety in any macroeconomic environment and the possibility of 15% annualized returns or greater (discount rate + dividend yield).
For further details see:
Watsco: A Simple Thesis For A Great Company