September 13, 2011

Watsco, Inc. 

 

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business, which offers a huge opportunity for incremental revenue—most of which also sells at 

higher-than-average gross margins. The Company has made good progress to date, bringing the 

mix down to 72% equipment versus 24% parts and 4% supplies. Attractive opportunities for 

additional gains remain, and management believes they can get supplies to a 15%-20+% share 

and equipment closer to 50% of sales.   

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  Additional Revenue Synergies—Leveraging existing contractor client relationships across the 

expanded product lines for both legacy Carrier and Watsco stores. 

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General and administrative expense leveraging. 

Attractive Acquisition Price 

The initial Carrier Enterprise acquisition significantly increased Watsco’s scale in the attractive Sunbelt 

region and brought Watsco economically and strategically valuable exclusive distribution agreements with the 

premier Carrier brands. Importantly, the acquisition was also transacted at what we view as extremely 

attractive valuation multiples. Watsco’s purchase of the 60% interest in the joint venture was valued at 

approximately $181 million, including the issuance of 3.1 million shares (~11.5% dilution) with a then-current 

market value of $151 million plus the contribution of 15 stores valued at $23 million and $7 million in working 

capital adjustments. Carrier stores generated approximately $1.2 billion in revenue in 2009, implying a 

purchase price of only 0.25x sales after backing out UTC’s 40% retained interest. Based on full Carrier 

Enterprise operating margins of 2.4% in 2008, Watsco paid a relatively modest 10x operating income. 

However, the real economics of the deal become evidence once factoring in the performance improvements 

Watsco has been able to generate from the acquisition. Based on Carrier Enterprise’s 2010 net income, 

Watsco paid a bargain-basement 4.0x forward earnings (net income) for the acquisition. Carrier Enterprise’s 

margins are already up to 6.5% and as Watsco continues to execute the strategic initiatives, we are optimistic 

the Company can continue to grow Carrier Enterprise revenue and approach if not achieve its 10% EBIT 

margin goals—especially if we see any material uptick in replacement demand and/or home construction.  

Carrier Enterprise Sunbelt Transaction Analysis 

Acquisition Cost: 

 

3,080,469 WSO shares @ $49.05 

 $ 151,097  

+ 40% in 15 Watsco Stores @ book value 

 $   23,217  

+ Working Capital Adjustments 

 $     7,201  

 

 $ 181,515  

Transaction Multiples: 

 

2008 Revenue, Contributed Carrier Stores 

$ 1,233,425 

Price/Sales multiple, 60% Interest 

0.25x 

 

 

2008E Operating Income @ 2.4% margins 

$ 29,602 

Price/Operating Income multiple, 60% Interest 

10.22x 

 

 

2010 Actual Net Income 

$ 77,405 

Price/ 2010 Earnings, 60% interest 

3.91x 

 

Not surprisingly, we would have preferred to see Watsco pay UTC in cash rather than diluting 

shareholders at <$50 per share—although according to Watsco’s management, UTC requested stock-based 

payment (UTC still held 3.0 million shares as of April 2011 according to Watsco’s latest proxy statement). It 

should also be noted that additional accretion should come from the exercise of Watsco’s option to increase its 

stake in the JV to 70% in July 2012 and 80% in July 2014. The upcoming July 2012 option has an exercise 

price estimated at approximately $50 million payable in cash or WSO shares at the Company’s discretion, 

while the July 2014 option should come at a modestly higher price tag based on performance-linked 

adjustments. Given the JV’s current profitability and performance trends, we anticipate Watsco will exercise 

these options at similarly attractive valuations as the initial deal. 

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Watsco, Inc. 

 

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Carrier Enterprise Northeast 

Watsco completed a second 60/40 joint venture with Carrier on April 29, 2011 covering Carrier’s 

Northeast distribution centers. Carrier contributed 28 Northeast centers, while Watsco contributed $35.7 million 

in cash plus the Company’s 14 Northeast locations valued at $14.7 million. The contributed Carrier Northeast 

stores had approximately $210 million in annual sales and EBIT margins <5%. This implies a purchase price 

for Watsco’s interest of only 0.4x sales or 9x trailing EBIT. As Watsco initiates similar strategic initiatives in this 

business as the Carrier Enterprise Sunbelt operation, this acquisition price should look increasingly attractive.  

Carrier Enterprise Mexico 

Most recently, on August 1, 2011 Watsco announced the completion of a third 60/40 joint venture with 

Carrier covering Carrier’s 6 distribution centers in Mexico. The stores generated approximately $80 million in 

revenue over the trailing twelve months ended June 30, 2011, while profitability statistics have not yet been 

released. Watsco paid $9 million in cash, or only approximately 0.2x revenue for its share in the JV. Watsco 

plans to expand parts and supplies sales at these locations as well as to add additional stores in Mexico in the 

coming years. The Company estimates this is a $2 billion addressable market, and although the business has 

been hit by the recession in recent years, Carrier remains the #1 HVAC brand in Mexico. 

Additional Long-Term Growth Drivers 

In addition to the Carrier Enterprise acquisitions, pent-up replacement demand, and new home 

construction, we believe Watsco is well-positioned to capitalize on several additional long-term opportunities, 

both industry-wide and Company-specific. 

Sunbelt Exposure 

Prior to accounting for the recently-completed additional Carrier JVs, Watsco derives approximately 

90% of revenues from the Sunbelt region, including close to 50% of sales from Florida and Texas. Historically, 

the Company concentrated on expanding in these regions due to numerous favorable characteristics including 

strong immigration trends from retirees as well as Hispanics; a longer hot season reducing seasonality and 

increasing demand for air conditioning systems; higher repair/replace demand given more frequent running of 

air conditioning systems; and additional demand from 2

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 home construction given the region’s vacation 

attractiveness. Alongside California, Florida was probably the most overbuilt state during the housing bubble, 

which should keep demand from new construction and home expansion/remodeling depressed through the 

medium term. On the other hand, Texas has suffered relatively modestly in recent years and continues to see 

strong positive benefits from migration and the more recent oil and gas boom locally. Regardless, in the longer 

term the aforementioned factors should continue to make the entire Sunbelt region a particularly attractive 

operating region. For example, the U.S. Census Bureau estimates Florida and Texas will experience the #3 

and #4 population growth rates, respectively, among all states between 2000-2030.  

Energy/Environmental Efficiency Mandates 

Environmental and energy efficiency regulations add an additional layer of complexity to the domestic 

HVAC industry, generally to Watsco’s benefit. Heating and cooling accounts for approximately 56% of the 

energy consumed in a typical home, which is leading to increased focus on HVAC energy conservation by 

regulators. The U.S. Department of Energy has developed ‘SEER’ (seasonal energy efficiency ratio) energy 

efficiency standards for central air conditioners and heat pumps. As of 2006, all new and replacement systems 

must meet at least the 13 SEER standards, which are 30% more energy efficient than the previous SEER 10 

standards. The federal government has also recently offered additional tax credits for higher energy efficiency 

purchases. Federal tax credits offered have included up to $1,500 in 2010 and $500 in 2011 for replacement of 

HVAC systems/parts with SEER ratings of 15-16 or higher depending on the specific item. Watsco estimates 

approximately 50% of the central air market is now at 13 SEER, 30% at 14 SEER (‘Energy Star’), and a small 

but nicely-growing portion at the ultra-premium 16+ SEER. Additional regulations include the phasing-out of 

R-22 ‘freon’ refrigerants (high in ozone-depleting CFCs) commonly used in residential air conditioning systems 

and heat pumps.  

Not surprisingly, premium energy efficiency products command premium prices—to Watsco’s benefits. 

However, federal government and/or utility subsidies, plus energy savings, typically make upgrades an 

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