Watsco, Inc.

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

Watsco, Inc. is the largest independent distributor of heating, ventilation, air conditioning and refrigeration (HVAC/R) equipment, parts, and supplies in North America and certain markets of South America.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Watsco operates a large and diversified distribution network. The company’s business model focuses on consolidating regional distributors to benefit from economies of scale and purchasing power, allowing it to be less reliant on a specific product or region for business. They have a wide distribution network and they are hard to replicate which creates high barriers to entry. The company also has an exclusive distribution agreement with Carrier, which gives it an advantage over its competitors.

Business Overview

Watsco’s business model is primarily a distribution one. They act as an intermediary, purchasing HVAC/R products from manufacturers and then distributing them to contractors and dealers. Their revenue streams are primarily driven by the sale of these products. They do not manufacture any product of their own. This strategy makes it easy to scale, but doesn’t give them as much of a competitive moat as they rely on the products of other suppliers.

Geographically, WSO primarily operates in North America (US, Canada, Mexico) and also has a smaller presence in Latin America. They have also expanded into Europe and the Caribbean recently. Most of their sales are in the residential and commercial replacement market and some small portion of it to new construction (though the percentage of new construction has risen to double digits in the past couple of quarters). This means their business will be resilient even if new construction activity declines.

  • Revenue Distribution: Watsco’s revenue is primarily driven by its diverse HVAC/R product range, catering to both residential and commercial customers.
    • Geographic Concentration: While primarily focused in the US market, Watsco has operations in Canada, Mexico, and parts of South America, but the US remains their largest market.
    • Product Diversification: The broad product portfolio reduces dependence on specific equipment types.
  • Industry Trends: The HVAC/R industry is known for its cyclicality and a dependence on replacements. In the short term they tend to benefit from price increases as the supply remains low. However, any new capacity expansions or change in regulations can have a negative effect. Moreover, HVAC efficiency standards are constantly improving, which also fuels replacements, but the higher price of the systems can also create affordability issues that may slow new system demand and replacement demand. Additionally, supply chain issues such as the Ukraine war and other geopolitical events such as the recent Panama Canal issue that has disrupted shipping, can potentially affect the entire supply chain.
  • Margins: Gross profit margins at Watsco have historically ranged around 25%-30%, and operating margins have been about 7-10%. The margins fluctuate depending on factors such as competition, changes in input costs and the product mix. Watsco has some pricing power given the high switching costs that its clients have. However, the company does face some risk of customer retaliation with price increases.

Competitive Landscape

Watsco operates in a fragmented market where the majority of the market share is with independent regional distributors. Most national distributors do not have the infrastructure and scale to cover all markets, which leaves them at a disadvantage compared to WSO. Given this, their main competition comes from the regional players and smaller distributors. They also face some competition from manufacturer-direct sales, especially in larger markets. Here’s how the competitive dynamics play out:

  • Market Fragmentation: The fragmented nature of the distribution market means that WSO faces a lot of competition at the local level and this also reduces the company’s bargaining power.
  • Barriers to Entry: While low at the start, barriers increase because of the need for extensive networks and large capital requirements to develop logistics and supply chains. WSO has an advantage here due to it already being established, with significant scale and market share.
  • Competitive Advantages: Watsco’s competitive advantage comes from its extensive distribution network, purchasing economies of scale, strong relationships with suppliers like Carrier, and customer service. They have a strong balance between efficiency and local service to the clients which is not easy to replicate. They also leverage their data analytics capabilities to optimize its supply chain, marketing, and customer relationships.

Moat Analysis: 3/5

I rate Watsco’s moat at 3/5. Here’s why:

  • Strengths: WSO benefits from economies of scale and purchasing power. These advantages stem from its extensive distribution network and its ability to efficiently distribute goods. They also possess significant switching costs with clients being less likely to change to another provider as they are well integrated into their operations. Their network effects are apparent through the increased profitability and efficiency with expansion, making them more desirable to their suppliers and clients alike. They also have an important long-term relationship with Carrier for exclusive distribution rights.
  • Weaknesses: While they have considerable scale and brand presence, the company is primarily just a distributor of other manufacturer’s products and lacks the control and IP associated with these products, leaving it vulnerable to pricing pressures from suppliers. These structural weaknesses mean the company doesn’t have as much control over product selection and value creation. A reliance on external suppliers could expose them to disruptions if the relationship is severed or some other supplier has a more competitive offering. They do not have patents and the barriers to entry are not very high.

Risks to the Moat and Business Resilience

Even with a moderate moat rating, Watsco faces real threats that could erode it’s competitive advantage. Understanding these is key for evaluating its long-term viability.

  • Supply Chain Disruptions: Dependence on certain manufacturers leaves it vulnerable to supply chain issues, such as natural disasters or supply constraints. They have the ability to switch suppliers, but it is not done easily, and it will impact margins and relationships with clients.
  • Technology Disruption: New technology that could allow direct-to-customer sales or reduce the need for a middleman is a threat. They are heavily reliant on traditional systems and it is unclear whether they have a leading edge when it comes to newer tech like online systems that can make them vulnerable to tech disruption. This is something that they have identified and are investing in but this aspect is difficult to quantify.
  • Economic Slowdown: The business is cyclical and can be severely affected by economic slowdowns or recessions that can reduce the demand for new HVAC systems. Given that the majority of its business is replacement, it does help to lessen that risk, but it is still a factor in the overall demand.
  • Loss of Exclusive Contracts: A potential loss of exclusive partnerships (such as with Carrier) could eliminate a major advantage.
  • Pricing pressures: The company could find itself pressured by competitors to offer lower prices, leading to decreased margins.
  • Changing Regulatory Landscape: Changes in energy efficiency regulations could decrease the value proposition of older systems and slow down demand, but could also create an opportunity for sales of newer more efficient systems.
  • Geopolitical Risks: They are susceptible to disruptions due to conflicts, trade wars and other geopolitical risks.

Financial Deep Dive

Watsco’s financials reflect its status as a stable distributor with consistent growth and profitability.

  • Consistent Revenue Growth: They have exhibited steady revenue growth over the past decade, due to acquisitions and organic growth.
  • Profitability: Their operating profit growth is almost on par with revenue growth. This is an encouraging trend for the company. The profitability tends to vary slightly based on input costs and market competition.
  • Return on Invested Capital (ROIC): ROIC has shown a trend of recovery after a decline a couple of years ago but still has to catch up to previous peaks. There were improvements in ROIC due to an increase in margins, but the overall ROIC is still in single-digits. They have been investing heavily to improve efficiency through investments in information technology and distribution, which will likely increase ROIC going forward.
  • High Free Cash Flow (FCF): The company has a strong cash position and generates healthy free cash flows, allowing it to fund acquisitions and dividends. However, their capex is also increasing. This is an important metric as it implies that the company can sustain its operations well and not be reliant on external financing for the growth that it desires.
  • Moderate Leverage: WSO uses moderate leverage (debt) to finance acquisitions, but not to a level that is excessive. Their debt position is sustainable and they have shown that they are capable of lowering their leverage over time.
  • Acquisition-driven growth: They often pursue acquisitions and the performance of that is important to the long-term health of the business. They have a very acquisitive strategy and a large amount of debt could arise from any future acquisition.
Management commentary suggests an acceleration of organic growth and an increase in their free cash flow generation capacity. However, in general their performance will be highly tied to the underlying performance of the global economy, and any slowdown could affect their long-term prospects.

Understandability: 2/5

I am rating WSO’s understandability at 2/5 because, while the business model of a distributor is quite straightforward, there are various nuances that make understanding it’s long-term prospects and the competitive landscape challenging.

  • Easy-to-grasp core business model: The basic function of a distributor is understandable. However, the way they create a competitive advantage, how they are affected by pricing volatility and how the market is fragmented is complex and hard to grasp for the average investor.
  • Complexities in Operations: Having a far-flung distribution network has inherent logistical and operational complexity. The company is also heavily involved in integrating new acquisitions which is not an easy undertaking.
  • Impact of Market forces: They are vulnerable to volatile input prices and a tough competitive landscape. Moreover, the interplay of various economic factors also impacts the company’s profits and prospects. For instance, a decrease in interest rates may affect their bond portfolio, while a slowdown in the market can significantly reduce the volume of business they have.

Balance Sheet Health: 3/5

I’m rating Watsco’s balance sheet at 3/5. Here’s my reasoning:

  • Moderate Leverage: Their debt-to-capital ratio has hovered between 25 and 35 percent and they appear to manage their debt well.
  • Good Liquidity: They maintain a healthy level of cash reserves, which suggests adequate liquidity for day-to-day operations and investments. However, they also have a lot of cash reserves invested in marketable securities. These assets may fluctuate with market conditions.
  • High Intangible Assets: A significant portion of its assets is attributable to goodwill and other intangibles. A significant portion of such assets could cause a lot of value destruction if those assets lose their value.
  • Reasonable Current Ratio: They have a current ratio (current assets / current liabilities) hovering around 2, which indicates the short-term financial health of the company, with the ability to easily pay off their debt obligations.
  • High Inventory Levels: The company has a high level of inventory, which could pose a risk if product demand drops or if prices decline. Moreover, an excess level of inventory means that they are not as efficient at moving goods.

Recent Concerns and Management’s Stance

The management has emphasized in the latest reports, that they have not had any problems with their supply chain despite the volatility in the market, and are cautiously optimistic going forward. They are also investing heavily in their logistics and technology to help combat supply chain issues. They also have said that they will be flexible and will manage to pass on prices to their customers without impacting demand. They have been heavily focusing on higher margin products to increase revenues and profitability. The company is also expecting double-digit organic growth which is not reflected in analysts’ projections and are expecting more gains in the coming months.

The most common concern surrounding the company is the cyclicality of the business and how changes in market or customer trends could impact growth and revenue. Management has noted that they are not just a HVAC distributor but also an important part of the ecosystem with long lasting partnerships with both suppliers and clients. They have a robust balance sheet and have been managing acquisitions with reasonable margins, which means that they can handle potential disruptions in demand.

Another important point to consider is their use of acquisitions to fuel growth, and while this does help them to capture more market share and expand their logistics, it also poses an operational risk. So far, the company has managed to navigate that well, but any future large acquisition or a series of smaller ones could disrupt their long-term plans.

In Conclusion WSO is an interesting company with a solid business model. However, the lack of clear differentiation is a concern. Their consistent profitability, strong management, and moderate leverage make them an interesting buy for value investors. WSO’s management is very confident about their future plans, and they have a good track record with creating shareholder value. But investors should always do their homework and make a carefully calculated decision based on their risk appetite.