2023-05-03 12:34:57 ET
Summary
- WSO is a great business with an industry leadership position, capable management, and industry-wide tailwinds.
- The company also has an opportunity to consolidate its market share in the highly fragmented HVAC distribution industry.
- I believe the Street is underestimating WSO’s margin prospects.
- Valuations are attractive.
Business Overview
Founded in 1956 in Florida, Watsco ( WSO ) is North America's largest distributor of heating, ventilation and air conditioning ((HVAC)) equipment. The company serves 673 locations in the US, Canada, and Mexico.
The North American HVAC industry primarily consists of 7 major players which together account for 90% of all units shipped every year. These manufacturers distribute products through a combination of factory-owned locations or independent distributors like Watsco which in turn supply these products to contractors and dealers that sell to the ultimate consumers.
The end market mix is primarily weighted toward the residential end market constituting the residential segment with 65-70% of revenue, the new housing segment comprising 10-15% of total revenue and the commercial segment includes 15-20% of the total revenue. Furthermore, 80% of both commercial and residential end market (total revenue except new housing) is repair and replacement demand which is immediate in nature. So, the revenue for WSO is pretty stable and the majority of the demand is urgent need rather than discretionary spending.
Strong Management and Entrepreneurial Culture
Watsco is run by Albert Nahmad ((CEO)) for the last 50 years and has a stake in WSO of over $1.4 billion in the company and has a combined voting power of greater than 50% thanks to his and his son's class B stock holding. I believe the significant holding and control of the CEO in the company's shares aligns his interests and grants him the power to direct efforts toward shareholder value maximization. Under the visionary leadership of Mr. Nahmad, the company had far outpaced the S&P 500 index and other relevant benchmarks with total stock return growing 18% CAGR and dividends growing 21% CAGR for the last 30 years.
Watsco's Total stock return (TSR) as compared to benchmarks
In addition to the strong management, the company greatly focuses on creating an entrepreneurial culture on the branch level among talented employees. The employees are incentivized through stock incentive programs at the branch level making their interests align with shareholders and promoting the core value of long-term growth at grassroots levels.
Industry Tailwind
According to the Department of Energy, heating and air conditioning account for roughly half of the household energy consumption in the US. Therefore replacing less efficient HVAC systems with higher efficient systems is one of the most meaningful ways to reduce household carbon footprint.
The replacement of old lesser efficient HVAC systems with higher efficiency systems has been a focus area for not only the US government but all governments around the world. As such, the US government has recently enacted regulation to increase the minimum SEER requirement beginning in 2023. Moreover, the government should also provide tax credits under the IRA 2022 to promote the replacement of old HVAC systems with higher-efficiency heat pumps. The act also set aside $4.3 billion for a state-administered rebate program designed to promote energy saving.
WSO has been prioritizing the sale of high-efficiency products. These products offer a more favorable sales mix and higher margins for the company. In addition to these near-term tailwinds, the industry is set to undergo another regulation to phase out old refrigerants. This refrigerant transition has historically resulted in higher costs to service and repair old HVAC systems which should further benefit WSO.
Market Consolidation Opportunity
Watsco competes in a highly fragmented distribution industry with ~6500 individual distributors which are mostly family-led. Often times these businesses lack successors for the business and that's where WSO comes in. Over the years WSO acquired 68 such businesses at very low valuations of 3-5x EV/EBITDA. These acquisitions help WSO to expand its geographic coverage and increase market share where it already exists. Upon acquisition, the acquiree firm gets the benefit of Watsco's established vendor relationship, favorable terms and conditions on orders, and an expanded array of product lines. Watsco's leading position in the HVAC distribution industry simply puts it at the top spot to consolidate this highly fragmented market which the company had been doing for quite some time and is expected to continue in the future also.
Recent Earnings
The Street seemed skeptical about WSO's margin resiliency prior to the fourth quarter of 2022 and the consensus was that the company should witness margins normalize as the COVID-related demand boost and pricing benefits wanes in 2023. Although margins did retrace a bit till 3Q22 the company posted better than expected margins in both 4Q22 and 1Q23 quarters. This in turn resulted in a nice bottom-line beat of 23 cents and 44 cents in 4Q22 and 3Q22 respectively.
This better-than-expected margin performance was due to the bargaining power of WSO in the industry due to its scale and benefits from pricing-related tailwinds in recent years. Both of these tailwinds are expected to remain quite resilient because 1. WSO's leadership position isn't going to be challenged anytime soon 2. Pricing-related benefits should continue with the rollout of new high-efficiency products, rebate programs, and upcoming refrigeration phase-out in the long run 3. Supply chain-related inefficiency should wane in the coming quarters. I believe the sell-side analysts are still underestimating Watsco's margin expansion prospects. The company's management is even targeting to grow margins from here in the long run which I believe won't be hard for WSO to achieve due to their incentive structure and industry tailwinds.
Barry S. Logan -- Executive VP of Planning & Strategy and Secretary at Watsco, Inc.
And you've heard 27% as a target. Our entrepreneurial CEO would tell you it's an interim target because we have greater expectations than that.
Valuation
After the recent run up in the stock price of WSO the stock is trading at an EV/EBIT ((TTM)) of 16.04x which is slightly above the 15.8x sector median. I believe a stock like WSO should trade at a higher multiple than the sector median given its market share consolidation opportunity and strong and capable management.
On a historical basis, the company is trading near the EV/EBIT level of pre-covid which seems to be pretty attractive to me as the company has considerably improved its EBIT margin after the pandemic and is expected to at least maintain it, if not improve it.
WSO's historical EV/EBIT ratio
WSO's historical EBIT margin
Risk
Albert Nahmad has served for 50 years as CEO of WSO it is highly possible that he retires and appoints someone else as a new CEO for the company which may not be as effective as Albert Nahmad who set a high benchmark of strong culture and performance for the successor. Although Albert Nahmad has his son Aron J. Nahmad in the company, it would be hard to replicate the former's leadership.
Takeaway
WSO is a great company with a great track record and culture. Its leadership position in the HVAC distribution industry posies it to benefit the most from ongoing regulatory tailwinds in the near as well as long term. While the stock has recently run up post its 1Q23 earnings, there is still quite some room left for the stock given its attractive valuations. Therefore I am bullish on the stock, however, I won't be buying into the stock all at once but in a staggered manner as I believe the stock can cool down a bit after a recent run-up.
For further details see:
Watsco: Up 33% Year To Date, More Likely To Come