Summary
- Watsco is expected to benefit from a mix shift toward higher-value products due to various regulatory tailwinds.
- Margin improvement over the last few years should be sustainable due to fundamental factors such as mix shift and higher markup realization driving it.
- Valuations are attractive.
Investment thesis
Watsco, Inc. ( WSO ) is poised to benefit from favourable regulatory trends such as the new SEER2 requirement and various rebate and incentive programs, which should drive demand for higher-value products in the HVAC industry. Additionally, beginning in 2025, the industry is expected to experience another regulation for refrigerants, further fueling demand for higher-value products. This trend should continue in the future due to ongoing regulatory requirements and increased emphasis on energy efficiency. Furthermore, I believe that the increase in margin post-pandemic is sustainable. The increase was driven by fundamental factors such as a shift in product mix and higher markup realization. Despite the recent run-up, Watsco currently trades at a valuation lower than its 5-year average P/E multiple. Hence, I believe WSO Stock still offers a buying opportunity.
Q4 2022 Earnings
Watsco recently reported mixed 4Q22 results. The company posted $1.51 billion in revenue which grew ~4.5% year-over-year growth but fell short of the consensus estimate of $1.61 billion. However, the adjusted earnings per share rose by 16% year-over-year to $2.35 (excluding a $1.20 per share tax benefit), beating the consensus estimate of $2.12.
Watsco reported a 10 basis points increase in gross margin to 27.4% and an 80 basis points increase in adjusted operating margin to 8.9%. The company experienced an 8% decline in volume during the quarter, primarily due to lower in-stock availability of some SKUs as the company transitioned to new SKUs to comply with SEER2 mandates. The company’s lead time with manufacturers also increased in 4Q22. However, the situation is now improving. Despite the volume decline, the company was able to post good revenue growth driven by pricing increases as a result of a shift in product mix towards higher-value products. This was a result of the SEER2 transition and a higher demand for heat pumps and other ductless systems. The company reported a 22% increase in sales of ductless systems in 2022, outpacing the overall 13% growth in HVAC equipment sales.
Revenue Outlook
Watsco has witnessed significant revenue growth since the pandemic. The company reported Y/Y revenue growth of ~6%, ~24.3%, and ~15.8% for 2020, 2021, and 2022, respectively. The strong increase in revenue can be attributed to robust replacement demand and a shift in product mix towards higher-value items.
WSO Revenue Growth (Company data, GS Analytics Research)
The revenue growth outlook for FY2023 and beyond also looks solid. The HVAC industry is undergoing a structural transition from lower-efficiency products to higher-efficiency products, thanks to regulatory tailwinds such as the SEER2 framework which was implemented on January 1, 2023. The SEER2 framework aims to phase out older, less efficient HVAC systems, leading to increased replacement demand for higher-value products. I believe the new framework should help Watsco with a higher average selling price for its product, improving its sales mix toward higher-value products. Moreover, several OEMs are expected to increase prices to continue offsetting inflationary headwinds which should also benefit the average selling price for Watsco.
In addition to SEER2-related tailwinds, the HVAC industry was also expected to benefit from rebate and tax credit scheme under IRA. However, the lack of a clear definition for unit qualification made the tax credit scheme under the IRA ineffective until now. I believe as more clarity emerges going forward, the tax credit and rebate program under the IRA should start yielding any benefits from next year. Several municipalities and regions, such as Northern California, New York, and parts of Canada, are also pushing harder to adopt higher-efficiency products due to increasing awareness around climate change. This coupled with the IRA benefits should help the average selling price for Watsco’s products in the coming years.
Apart from IRA benefits, the HVAC industry should benefit from SEER2-like transition in refrigerants. From 2025 the HVAC industry is set to phase out old refrigerants currently used in older HVAC systems. Historically, refrigerant transitions have led to an increase in the cost to service and repair older HVAC systems, encouraging consumers to replace old products. So, this transition should also serve as a catalyst for Watsco’s sales in 2024 and 2025.
In addition to industry-related tailwinds, Watsco has significant headroom to grow and consolidate market share. The company currently has ~15% market share in the ~$50 billion HVAC distribution industry. According to management, the industry is highly fragmented with about 1,300 family-run businesses. As the industry leader, Watsco is 2.5x the size of the next largest competitor and enjoys preferential pricing and terms from various HVAC OEMs. The company can easily pursue bolt-on acquisitions by acquiring small family businesses and bringing them under the same pricing and terms that Watsco enjoys, which should enable it to quickly realize synergy benefits from the acquisitions. Over the past three years, the company has expanded its footprint by 67 locations, primarily from six acquisitions, and now operates in 673 locations. With no long-term debt and a cash balance of ~$147 million, I believe the company should be able to pursue more acquisitions in the future.
Watsco Versus Competitor Sales (WSO Investor Presentation)
Margin Analysis and Outlook
Watsco has experienced significant margin expansion since the pandemic, with its adjusted operating margin increasing from 7.9% in 2020 to 11.5% in 2022. Excluding technology investment, the adjusted operating margin increased from 8.6% in 2020 to 12.2% in 2022. The improvement in adjusted operating margin was driven by higher gross margins, partially offset by higher SG&A expenses as a percentage of revenue. Watsco's gross margins expanded from 24.2% in 2020 to 27.9% in 2022 due to a favourable pricing dynamic resulting from a shift in product mix towards higher-value and higher-margin products such as heat pumps. However, SG&A as a percentage of revenue deteriorated from 15.3% in 2020 to 16.1% in 2022 (excluding technology investment) due to higher inter-store transportation costs resulting from lower product availability, and higher bonus expenses for employees.
WSO Gross margin and SG&A as a percentage of revenue chart (ex. technology investments) (Company Data, GS Analytics Research)
During 4Q22, the company reported a 10 basis point increase in gross margin to 27.4% and a 20 basis point decrease in SG&A expense as a percentage of revenue. Many investors and sell-side analysts were expecting gross margin to moderate given the moderation in inflation, but margins proved to be resilient. Moreover, SG&A as a percentage of revenue was reduced owing to lower variable compensation expenses and lesser inter-store transportation costs.
The company is expected to benefit from lower transportation costs in 2023 as inter-store transportation is expected to decrease due to better availability of products, and lead times for various goods are expected to normalize in the coming quarter. In addition, the company should benefit from the ongoing mix shift toward high-value and high-margin products like ductless HVAC systems, primarily heat pumps. Moreover, after the SEER2 mandate implementation, the company is expected to operate with fewer SKUs, resulting in operating efficiency.
I believe that the post-pandemic margin growth is due to structural factors like mix shift and higher markup realization, rather than just being driven by inflation. While some bears are betting on margin contraction as inflation moderates, I don't believe that margins will witness any meaningful reversion and expect the company to keep posting good margins in the future as well.
Valuation and Conclusion
The stock is currently trading at a forward P/E of 22.84x based on the FY23 consensus EPS estimate of $13.41, which is lower than its five-year average of 26.39x. The company has a good growth outlook due to favourable industry tailwinds and resilient margins. Further, the company’s strong balance sheet should enable it to use the current macro slowdown in its favour to do accretive M&As and drive shareholder value. Hence, I have a buy rating on the stock.
For further details see:
Watsco: Good Growth Prospects Despite Challenging Macros