2023-09-06 03:56:45 ET
Summary
- Watsco, Inc. is expected to benefit from improvements in product availability and easier year-over-year comparisons in the second half of 2023.
- Watsco also has the potential for margin growth through a shift.
- However, the stock's valuation is already reflecting its growth prospects.
Investment Thesis
Watsco, Inc. (WSO) is expected to benefit from improvements in product availability and easier Y/Y comps in the second half of 2023. The company’s medium- to long-term growth prospects also look encouraging, with continued market share gains and the benefit of favorable regulatory trends that would drive demand for its higher-efficiency products with high average unit price, improving the product mix. On the margin front also, the company should benefit from an ongoing mix shift towards high-efficiency products due to increased regulations and continued investment in its pricing technology. This, coupled with effective cost control across its operations and sales leverage, should help the company drive margin growth moving ahead.
However, the stock price has increased over 15% from my previous bullish article and I don't see a further re-rating of valuation multiples from these levels in the near term. The company’s growth prospects seem to be already factored into the current valuations. So, I am moving to the sidelines and rating WSO as neutral.
Revenue Analysis and Outlook
In the second quarter of 2023, Watsco reported a 6.1% YoY decrease in revenue to $2 billion. Sales of HVAC equipment (which accounts for ~69% of total sales) and other HVAC products (~27% of total sales) decreased 8% YoY and 7% YoY, respectively, while the sales of commercial refrigeration products (~4% of total sales) increased 1% YoY.
The second quarter's sales reflected lower sales volumes, due to product unavailability and a slowdown in the residential business, which were partially offset by moderate price increases and strength in the commercial business. The product shortages were caused by ongoing product transitions in the industry due to SEER2-related product changes at the company’s OEM partners. Moreover, the delayed arrival of the summer selling season further impacted sales growth. However, double-digit growth in the commercial business, driven by double-digit sales growth in ductless systems, partially offset the downtrend in the residential business.
WSO’s Revenue Growth (Company Data, GS Analytics Research)
Looking forward, Watsco's sales should return to growth in Q3 as the supply chain situation for the company's OEM suppliers improves. As mentioned earlier, over the last couple of quarters, the company's OEM partners faced supply chain troubles and issues with the availability of components for higher-efficiency systems. This in turn impacted the product availability at the company and, according to management , Watsco lost ~$125mn in sales in the first six months of this year due to this. I expect this headwind to ease moving forward and, as the situation improves, Watsco's sales should benefit in the back half.
Further, delayed summer this year also impacted Q2 sales while Q3’s weather is turning out to be normal. In addition, comparisons are also easing in the back half of this year, especially in Q4, which should also help. On its last earnings call , management mentioned that sales have returned to low-single-digit Y/Y growth in July and I expect it to continue improving as Q3 and Q4 progresses.
The company also has good medium to long-term drivers. The company is a secular market share gain story in the fragmented HVAC market and has been consistently gaining market share through both organic and inorganic routes. The company's digital sales platform OnCall Air (which I discussed in a previous article ) continues to gain traction among HVAC/R contractors as more and more customers engage digitally. Not only does the platform help gain more customers but the company also benefits the company by retaining those customers. The company is also well-positioned to gain market share through tuck-in acquisitions of small distributors.
Further, with new regulations continuing to require higher efficiency products, the company's Average Unit Price (AUP) should also improve. New regulations also help in improving the company's replacement sales. After a change in regulation, component availability for products complying with old standards reduces and it becomes difficult to repair them. This drives replacement demand for the company.
Overall, I am positive about the company's revenue growth prospects moving forward.
Margin Analysis and Outlook
During 2Q23, the company reported a 20 basis point YoY increase in gross margin to 28.1%, driven by favorable pricing dynamics brought on by a shift in product mix towards higher-value and higher-margin products such as heat pumps and ongoing investment in pricing technology. Moreover, SG&A expenses as a percentage of revenue decreased 40 bps YoY, primarily as a result of a 15% to 20% decline in variable costs and lower revenues. However, the operating margin declined 20 bps YoY to 13.3% due to volume deleverage in the residential business which more than offset the positive impact from gross margin expansion.
WSO’s Gross Margin and Operating Margin (Company Data, GS Analytics Research)
Looking forward, I expect the company to continue posting healthy margins. The company’s current gross margin is already above management's previously communicated long-term gross margin target of 27% to 28%. In the last earnings call , management indicated that they may revise the company's long-term gross margin target to 30%. They haven't mentioned a timeline or many details yet, but we can expect more discussion around it in the coming quarters. I believe continuously improving product mix towards higher efficiency products due to regulations and increasing customer's focus on sustainability should help mix as these products carry higher margins. The company should also benefit from the use of technology, especially its pricing platform, to optimize discounts and sales prices.
Further, the company is doing a good job in managing SG&A costs, and management is aiming to drive further operating efficiencies across the network. This coupled with sales leverage should help margins. Overall, I am optimistic about the company's ability to improve margins in the medium to long term.
Valuation and Conclusion
While I like the company's growth prospects, I cannot say so about the company's valuations. When I previously covered Watsco, it was trading at P/E multiple of the low 20s and I argued that the stock can trade in the mid-20s where it has traded on an average forward P/E basis over the last five years . The stock has already re-rated to these levels and is currently trading at 26.11x FY23 consensus EPS estimates and 24.90x FY24 consensus EPS estimates.
While I expect the company to continue growing, I don’t see a potential for significant re-rating in valuation multiple from these levels and believe the growth prospects are already getting reflected in the stock at current valuations. Hence I am changing my rating to neutral.
For further details see:
Watsco: Good Growth Prospects But Priced In