Watsco is a market leader in the North American heating, ventilation, air conditioning, and refrigeration market. While heating, ventilation, air conditioning, and refrigeration may not sound as exciting as other markets, Watsco has delivered exceptional shareholder returns. Watsco's total shareholder returns rank 16th out of 1.600 public companies in the past 30 years, and it is one of only 24 companies that have returned more than 19% CAGR in the same period. Is it too late to invest in Watsco? It is what I am going to investigate in this analysis.
This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since attending the workshop with Phil Town, I have decided to make some changes to the layout of my analyses. I will perform additional calculations and also provide a brief explanation of why the company is significant to me. If you want to learn more about my company evaluation process, please visit the "MY STRATEGY" section on my website.
For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of Watsco. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. I do not own any stocks in any of Watsco's direct competitors either. Thus, I have no personal stake in Watsco. If you want to purchase shares or fractional shares of Watsco, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $100.
The Business
Watsco was founded in 1956 in Florida, United States. Watsco is the largest distributor of air conditioning, heating, and refrigeration equipment, as well as related parts and supplies (HVAC/R), in the HVAC/R distribution industry in North America. Watsco operates from 690 locations in 42 U.S. states, Canada, Mexico, and Puerto Rico. They also have market coverage for export to parts of Latin America and the Caribbean. Watsco serves over 125.000 active contractors and dealers who work in the replacement and new construction markets. Watsco is solely a distributor, meaning they do not manufacture their own products; they simply sell equipment and parts to contractors. Watsco makes 90% of its revenue in the United States, followed by 5% in Canada and 5% in Latin America. They generate the majority of their revenue from residential markets, which account for 65%-70% of their total revenue. Commercial markets contribute 15%-20% of the revenue, while new housing contributes 10%-15% of the revenue. In 2023, HVAC equipment accounted for 69% of revenue, other HVAC products contributed 27% of revenue, and refrigeration products contributed 4% of the total revenue. Watsco is the market leader with approximately a 15% market share. As a market leader, Watsco benefits from economies of scale, which provide exclusive distribution rights with suppliers. Hence, scalability is what gives Watsco its moat. This is supported by management, who have stated that they believe Watsco's scale, the quality of its balance sheet, and unique culture will continue to drive long-term growth and performance.
Management
The CEO is Albert H. Nahmad. Albert H. Nahmad is also the founder of Watsco, which is quite remarkable considering that Watsco was established in 1956. Albert H. Nahmad has been the Chairman and CEO since 1972. He received a Bachelor of Science degree in Mechanical Engineering in 1962 from the University of New Mexico, and a Master of Science degree in Industrial Administration in 1963 from Purdue University. He has been instrumental in shaping Watsco's entrepreneurial culture, expanding the business through acquisitions, and fostering strategic business relationships. Under his leadership, Watsco has grown from a market capitalization of $22 million in 1989, when Watsco's distribution strategy began, to $15 billion at the end of 2023. This growth represents a compounded annual growth rate of total shareholder return of more than 20%, demonstrating his exceptional leadership. He is known for his conservative, long-term focus and entrepreneurial spirit, often emphasizing that Watco's core focus remains on the long term, which is beneficial for shareholders. Besides being the CEO and Chairman of Watsco, he also plays an active role in several charitable organizations, which I believe speaks volumes about his character. I haven't been able to find much information about Albert H. Nahmad, but his tenure as the CEO and Chairman for over 50 years indicates his exceptional knowledge about the company and industry. Coupled with his outstanding results, I am confident in Albert H. Nahmad's leadership of Watsco moving forward.
The Numbers
The first metric we will investigate is the return on invested capital (ROIC). I would like a 10-year history demonstrating a minimum annual growth of 10%. Watsco has consistently delivered solid financial performance over the years, maintaining a Return on Invested Capital (ROIC) above 10% every year in the past decade. It is encouraging to see that Watsco has delivered a Return on Invested Capital (ROIC) above 20% in the past three years, and hopefully, this trend will continue. All in all, I am pleased with these numbers as they consistently exceed 10% in all years. There has been a steady growth from 12,8% in 2014 to 22,2% in 2023. Additionally, the Return on Invested Capital (ROIC) has remained above 20% for the past three years, indicating a positive trend that suggests Watsco may continue to deliver a ROIC above 20% in the future.
The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most significant of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. Watsco is a textbook example of how you would like to see equity evolve over the years. Watsco has managed to grow its equity every year in the past ten years. Few companies manage to do this, which is very impressive. Furthermore, it seems that growth has accelerated, as Watsco has achieved double-digit growth in the past three years.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising to note that Watsco has consistently generated positive free cash flow every year for the past ten years. It is positive to see that free cash flow has grown from 123 in 2014 to 526 in 2023, which represents a compound annual growth rate (CAGR) of over 15%. It is encouraging to see that Watsco has delivered its highest free cash flow in the past five years. Levered free cash flow margin has been higher than usual in three out of the past four years, which is another encouraging sign despite levered free cash flow margin decreasing slightly last year. However, the free cash flow yield reached its lowest point in 2023, indicating that the stock is not trading at a discount. We will delve deeper into this aspect later in the analysis.
Debt
Another important aspect to consider is the level of debt. It is crucial to determine if a business has manageable debt that can be repaid within a three-year period. We calculate this by dividing the total long-term debt by earnings. After analyzing Watsco's financials, I found that the company has 0,03 years' worth of earnings in debt. Hence, debt is not a concern when investing in Watsco. It is also worth noting that Watsco has not exceeded 0,32 years' worth of earnings in debt in the past 20 years. This suggests that debt should never be a significant concern when investing in Watsco.
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Risks
Based on my findings so far, I find Watsco to be an intriguing company. However, no investment is without risk, and Watsco also has its fair share of risks. One of the risks is supplier concentration. Watsco's top ten suppliers accounted for 86% of their purchases during 2023, with 65% from Carrier and 8% from Rheem. Given the significant concentration of Watsco's supply chain, particularly with Carrier and Rheem, any significant interruption by any of the key manufacturers or a termination of a relationship could temporarily disrupt Watsco's operations. Furthermore, Watsco's operations are dependent on the continued market acceptance and quality of these manufacturers' products, as well as their ability to manufacture products that are competitive, comply with laws related to environmental and efficiency standards, and align with shifting consumer preferences. Watco's inability to obtain products from one or more of these manufacturers, or a decline in market acceptance of these manufacturers' products, could have a material adverse effect on Watco's results of operations, cash flows, and liquidity.
Competition. Watsco operates in highly competitive environments. They compete with other distributors and several air conditioning and heating equipment manufacturers that distribute a significant portion of their products through their own distribution channels in specific markets. Competition within any given geographic market is based on product availability, customer service, price, and quality. Competitive pressures or other factors could cause Watsco's products or services to lose market acceptance or result in significant price erosion, both of which would have a material adverse effect on Watsco's results of operations, cash flows, and liquidity.
Seasonality. Sales of residential central air conditioners, heating equipment, and parts and supplies are seasonal, leading to revenue fluctuations for Watsco from quarter to quarter. Furthermore, profitability can be impacted favorably or unfavorably based on the severity or mildness of weather patterns during summer or winter selling seasons. Demand related to the residential central air conditioning replacement market is typically highest in the second and third quarters, while demand for heating equipment is usually highest in the first and fourth quarters. Demand related to the new construction sectors in most markets is fairly evenly distributed throughout the year. It largely depends on housing completions, as well as weather and economic conditions.
Reasons to invest
There are also numerous reasons to invest in Watsco. One reason is acquisitions. Acquisitions are a significant part of Watsco's growth strategy. When acquiring businesses, Watsco focuses on identifying the dominant players in markets. Over time, after acquiring these businesses, Watsco builds incredible franchises on top of the credible franchise that the owners have established. Watsco believes that if there is an industry weakness, it will be an opportunity for them, as many of its competitors are highly leveraged and may not have the balance sheet to deal with tougher times. Watsco sees this as an acquisition opportunity. This acquisition strategy will continue and has been very favorable to Watsco. Management believes that this strategy can double the size of Watsco over the long term.
Utilizing Technology to Transform the HVAC Industry. Watsco has developed a robust e-commerce platform for all its products. It involves building, partnering with, and investing in startups, both within and outside the company, that create solutions to benefit Watsco's business units or generate new revenue streams. One of these new revenue streams is to sell a Watsco-developed app to other companies. Watsco has implemented new technologies to optimize every aspect of its extensive supply chain, including warehouse stocking and truck route planning. These investments in technology have made it easier to do business with Watsco, making the company more efficient and profitable, improving speed to market, enabling new profit streams, and helping their customers grow faster.
The installed base continues to grow. The installed base of HVAC units in the United States has increased every year since 1980. A large and growing installed base indicates an increasing demand for replacement parts, leading to more recurring revenue for Watsco. Furthermore, the mix of the installed base is changing. With the transition from gas furnaces to heat pumps. A gas furnace lasts 25-30 years. Heat pumps generally do not have as long a lifetime because they operate not only in the wintertime but also in the summertime. So, more hours are being added to that piece of equipment. This implies that individuals will need to replace heat pumps more frequently than gas furnaces and may also need to purchase replacement parts more frequently.
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Valuation
Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 13,67, which is from the year 2023. I have selected a projected future EPS growth rate of 7%. Finbox expects EPS to grow by 6,8% in the next five years. Additionally, I have selected a projected future P/E ratio of 14, which is double the growth rate. This decision is based on Watsco's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $93,06. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Watsco at a price of $46,53 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 562, and capital expenditures were 35. I attempted to analyze their annual report in order to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 25 in our calculations. The tax provision was 156. We have 39,49 outstanding shares. Hence, the calculation will be as follows: (562 – 25 + 156) / 39,49 x 10 = $175,49 in Ten Cap price.
The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With Watsco's free cash flow per share at $14,30 and a growth rate of 7%, if you want to recoup your investment in 8 years, the Payback Time price is $156,99.
Conclusion
I believe that Watsco is an intriguing company with exceptionally good management. Watsco has delivered exceptional returns to shareholders, as evidenced by ranking 33rd in total shareholder returns. Watco's most significant risk is supplier concentration, as it heavily relies on its major suppliers, particularly Carrier. Nothing suggests that its largest suppliers should terminate the relationship with Watsco or its products should go out of favor, but it is still a risk worth monitoring as if any of these scenarios should happen, it would affect Watsco. Watsco is also facing competition in a highly fragmented market, and the largest risk from competition is if heating equipment manufacturers that distribute a significant portion of their products through their own distribution organizations will focus on growing their distribution organization at the expense of Watsco, but there is no indication that they will. Seasonality may affect Watsco in the short term, but I don't think it poses a significant risk for long-term investors. I appreciate that Watsco is a market leader because it gives them the advantage of scalability. As Watsco acquires more companies, this advantage will continue to grow. Watsco's focus on technological innovation should increase profitability in the future. As the installed base grows, the need for replacement parts also increases, leading to a rise in Watsco's recurring revenue in the future. This is a development that I truly appreciate. I would love to add Watsco to the portfolio if it reaches the intrinsic value of the Ten Cep price at $350.
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