September 13, 2011

Watsco, Inc. 

 

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remains outstanding. Watsco estimates a whopping 74 million units are at least 10 years old. With the 

estimated average useful life of these units at approximately 12-14 years, these units will increasingly require 

significant repair or replacement. 

 

Historical U.S. Air Conditioner & Heat Pump Sales 

 

Source: Air-Conditioning, Heating, and Refrigeration Institute 

 

If the macro economy and employment environment continue to stagnate, consumers may continue to 

delay complete replacement. Nonetheless, compressors typically only last 3-4 years, so this will create steady 

repair demand. On average, parts and supplies sales are also higher margin for Watsco (although obviously 

lower ticket price) than unitary equipment. We would also note that compressors typically run at around 

$1,000/unit, plus additional labor and parts/supplies costs for the end-consumer, versus $3,000/$4,000 to 

replace the full system. Thus it is often in consumers’ economic interest to undertake a complete replacement. 

Given these dynamics, and especially if we see any substantial macroeconomic improvement in the interim, we 

believe a fairly strong pickup in full unit replacement demand over the next 2-5 years is a good bet.  

Upside from New Housing Recovery 

While the HVAC replace/repair market held up fairly well through the recent recession all things 

considered, demand from new home construction has been an entirely different story. Domestic new home 

construction plummeted from a rate of greater than 2 million homes/year in early 2006 to a current run rate of 

only approximately 600,000. As a result, the share of HVAC unit sales attributable to new home construction 

has also plummeted to approximately 10% today from a historical average of 25-30% in the decade preceding 

the recent downturn. Similarly, industry-wide shipments of unitary air conditioning and heat pumps have 

declined at the equivalent of a (4.0%) CAGR from 1992 levels to 2010 levels.   

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Watsco, Inc. 

 

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Source: Air Conditioning and Refrigeration Institute (AHRI) 

 

As further detailed in our introduction to this summer’s Asset Analysis Focus Double Issue, we 

estimate the longer-term run rate for new home construction to keep pace with new household formation is 

approximately 1.4 million homes annually. Numerous factors may keep new housing construction below this 

level for the next several years depending on macroeconomic developments, but we believe this represents a 

tremendous upside opportunity for Watsco. The Company estimates it generates an average of roughly $3,000 

in revenue per new home at above-average margins. A recovery to normalized home construction implies an 

incremental annual revenue opportunity of approximately $240 million or 9% incremental revenue for Watsco, 

assuming the Company’s current market share holds steady. The bottom-line impact should be significantly 

higher given the SG&A leveraging, and of course, every new home also has the long-term benefit of increasing 

the installed based and bringing on the associated repair/replacement revenue.      

Carrier JVs and Margin Expansion Potential 

After performing a strategic review that began in 2008, United Technologies Corp. (‘UTC’) decided to 

bring in an independent operator for the distribution centers of its HVAC OEM business, Carrier Corp. 

According to Watsco management, the Company had initiated discussions with Carrier about the possibility of 

a joint venture for 10-15 years prior to the idea taking hold in 2009. Watsco already maintained a  

good relationship with Carrier as its largest independent distributor. As the only independent distributor with 

sufficient scale as well as a solid long-term operational track record, Watsco was a natural partner. In July 

2009, Watsco completed the first of a series of acquisitions/joint ventures, incorporated as Carrier Enterprise, 

with Watsco to take over the management of Carrier’s distribution centers in the Sunbelt region. The Company 

recently completed two additional joint ventures covering Carrier’s Northeast and Mexico distribution centers. 

Based on our analysis, the deals represent extremely attractive investments with modest purchase prices 

combined with the potential for very significant improvements in operational profitability, as already being 

exhibited in the Sunbelt JV.  

Carrier Enterprise Sunbelt 

Watsco completed the first joint venture with Carrier in July 2009. The JV was structured with Watsco 

taking a 60% controlling ownership and UTC retaining a 40% interest. Watsco also received the option to 

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Watsco, Inc. 

 

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purchase additional 10% stakes in July 2012 and July 2014. In association with the JV, Carrier contributed 95 

distribution stores across 12 states in the U.S. Sunbelt and Puerto Rico. The stores also include a small Miami-

based export business that exports to Latin America and the Caribbean. Watsco also contributed 15 of its 

existing stores that primarily sold Carrier products in the Midwest. The combined business added 

approximately $1.2 billion in revenue, increasing Watsco’s pro forma 2009 revenue base by roughly 81% (prior 

to backing out UTC’s retained interest).  

Drastic Operational Improvements 

Under UTC, the Carrier Enterprise stores’ performance were most likely limited by lack of management 

focus, given their modest contribution to the $57 billion/year conglomerate’s bottom line; most of UTC’s Carrier 

distribution businesses were labeled ‘non-core’ following the 2008 strategic review. At the time the JV was 

formed, the businesses were operating with gross margins below 20% and EBIT margins of only ~2.8%. 

Watsco management has aggressively moved to improve operating performance, setting goals to bring the 

business in line with historical WSO gross margins at ~25% and EBIT margins up to ~10%. While the 

turnaround plan is still in the earlier stages, given we are only ~2 years in, nonetheless material improvements 

in operating performance under Watsco’s leadership are already evident at Carrier Enterprise Sunbelt. EBIT 

margins have expanded roughly 370 bps to 6.5% in 2Q 2011, despite the still challenging macro environment.  

 

 

Source: Company presentation, August 2011 

The major aspects of Watsco’s strategy for improving the Carrier Enterprise business include: 



 

Aligning Management Incentives—According to Watsco management, under UTC, store/regional 

managers were not sufficiency incentivized to maximize operational performance. Incentive pay 

was focused on revenues rather than profits, a policy which Watsco has reversed. This change 

combined with greater oversight, introduction of best practices at the store level, and a higher 

portion of incentive-based pay have already had a meaningful impact on gross margins and 

profitability. 



 

Expanded Product Offerings—Performance at the legacy Carrier stores was significant impaired 

by limited product offerings, primarily consisting of equipment under Carrier’s brands. According to 

Watsco, the contributed stores averaged approximately 90% equipment sales mix versus 10% 

from parts and supplies. Watsco has focused on expanding the stores’ parts and supplies 

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