September 13, 2011

Watsco, Inc. 

 

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economic choice for consumers. Watsco estimates higher pricing associated with improved products has 

historically contributed a very meaningful 2%-3% to annual sales. Given the increased focus on environmental 

and energy efficiency concerns of late, as well as unusually high energy price inflation, we anticipate Watsco 

will continue to benefit materially from these issues going forward.          

International Growth 

Watsco has historically been an almost exclusively domestic distributor. Prior to the Carrier Enterprise 

acquisitions, the Company owned no distribution centers outside of the continental U.S. However (in addition to 

the Carrier Mexico acquisition), the Company acquired via Carrier Sunbelt an approximately $200 million/year 

business exporting HVAC equipment and supplies from Miami to various countries in the Caribbean and Latin 

America. Watsco estimates this is a ~$3 billion addressable market, so plenty of room for additional growth 

from expanded product lines and market share gain is available.  

Cash Flow and Balance Sheet 

CEO Nahmad and Watsco’s management have historically run the business with a strong focus on 

cash flow. Watsco generated $851 million in operating cash flow between 2000-2010 versus $602 million in net 

income. Watsco generated $144 million in free cash flow in 2010, or an 8.5% free cash flow yield at the current 

share price. The strong cash flow has been driven by a focus on working capital in recent years. Inventory 

turns were up to 5.6x in 2010 versus 4.6 x in 2009 and 4.7x in 2008. Inventory lead times have been managed 

down to 7-14 days. Additionally, maintenance capex needs are very low for Watsco’s business—roughly 

$5 million per year historically and between $5-$10 million per year after the addition of the Carrier Enterprise 

joint ventures. Top management’s focus on cash flow has also been distilled down throughout the organization; 

for example, the Company’s recently-issued incentive based compensation plans for its 9 regional managers 

included a clause that operating cash flow must exceed net income.  

 

Cash Flow Summary  ($ millions) 

 

 

2010 2009 2008 2007 2006 2005 

Cash Flow from Operations 

$153  

$88 

$113 

$108 

$68 

$36  

Capital Expenditures 

$8  

$6  

$4  

$6  

$10  

$7  

Free Cash Flow 

$144 

$82 

$110  

$102  

$58  

$29  

Avg. Diluted Shares 

30.6 28.5 27.0 27.1 27.2 27.8 

FCF/Share 

$4.72  

$2.89  

$4.05  

$3.76  

$2.16  

$1.03  

Dividends 

$66  

$57  

$49  

$37  

$26  

$17  

Distributions to Non-

Controlling 

Interests 

$14 

 

$5 

 

– – – – 

Share Repurchases 

– 

– 

$5 

$9 

$15 

$18  

Net Cash Acquisition Costs 

$4  

$10 

$0  

$109  

$10  

$49  

 

As illustrated in the following chart, Watsco has also historically maintained a conservative balance 

sheet, operating with minimal or no net leverage. The Company currently has $46.4 million in net debt 

outstanding, or 0.25x EBITDA. In our view, if anything, the Company has historically been underleveraged 

given the consistent free cash flow generation and we would not object to seeing the Company take on 

moderate debt levels during low interest rate environments like today’s and/or to repurchase shares during 

periods of market dislocation. Nonetheless, we view the Company’s conservative capital structure as a positive 

buffer in this still-uncertain economic environment as well as an indication of the Company’s conservative 

approach to M&A considering its history as a ‘roll up’ of sorts, as detailed below.  

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Watsco, Inc. 

 

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Historical Year-End Leverage Ratios 

(0.70)x

(0.50)x

(0.30)x

(0.10)x

0.10x

0.30x

0.50x

1H 2011

2010

2009

2008

2007

2006

2005

2004

Net Debt / EBITDA (TTM)

 

 

Prudent Cash Deployment 

Not only is Watsco a consistent free cash flow generator, but in our view management have historically 

been prudent stewards of capital.  As illustrated in the following chart, between 2000-2010 Watsco returned the 

greatest portion of operating cash flow (32%) to shareholders via dividends. The Company also spent 

$100 million (12% of OCF) on share repurchases, primarily prior to 2006. Management has downplayed their 

inclination toward share repurchases in recent years, while emphasizing that a large dividend payout is 

‘fundamental’ to the Company. While the Company is inclined toward executing accretive acquisitions, Watsco 

put a relatively modest $207 million or 24% of OCF toward acquisitions between 2000-2010—which, again, we 

believe reflects the Company’s conservative approach to M&A.  

 

 

Source: Company presentation, August 2011 

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Watsco, Inc. 

 

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Attractive Dividend Looks Sustainable 

Watsco has an impressive record of returning cash to shareholders via common dividends. Watsco 

initiated a dividend policy in 1997 and the Company has raised the dividend rate 13 times since 2003 to the 

current annual rate of $2.28 per share (4.0% yield). The dividend rate has grown at an impressive 31% CAGR 

since 2000. The current dividend rate represents a payout ratio of approximately 87% of TTM diluted EPS, 

which may make some investors fear it is unsustainable. However, we would note that this represents a more 

modest 80% forward ratio based on the baseline of management’s forecast that 2011 EPS will exceed 2006’s 

record of $2.86, and represents only 49% of 2010 free cash flow (before accounting for cash earnings 

attributable to UTC). Furthermore, we anticipate Watsco’s low-capex model, minimal debt levels, and the 

incremental cash generation which should flow from the additional Carrier Enterprise ventures will provide 

ample support for the current dividend payout and future increases going forward. Management has also 

expressed their continuing commitment to the dividend and we would speculate that Mr. Nahmad, who is 70 

years old and appears to have the lion’s share of his wealth tied to Watsco stock, is likely very keen to keep 

those big dividend checks flowing every quarter.    

Cautious Acquisition Strategy Likely to Continue 

CEO Nahmad and Watsco management have expressed continued interest in executing acquisitions 

within the HVAC/R distribution industry. While we are typically cautious investors when it comes to ‘roll up’ 

strategies, several aspects of Watsco’s strategy help us to get comfortable with the execution risk. First of all, 

as illustrated above, the Company has historically been operated with minimal leverage and only allocated 

~24% of OCF toward acquisitions. Management has expressed their continued disinclination to take on a 

significant debt load in order to fund acquisitions. For example:  

“We’ve always [built the Company] on a conservative balance sheet. I don’t expect 

that’s going to change…we know [Watsco] is underleveraged, we like it that way…” 

 – CEO Albert Nahmad, 2Q 2011 earnings conference call, July 26, 2011 

Additionally, Watsco’s market-leading position combined with the industry’s highly deconsolidated 

nature (~1,300 primarily small, local, independent ‘mom and pop’ distributors) virtually eliminate the possibility 

of a single large-scale, transformative acquisition. Even the initial 2009 Carrier Enterprise joint venture, which 

was far and away the Company’s largest transaction and an acquired business which we believe was larger 

than any remaining North American competitors, was completed at a relatively modest $181 million price tag 

for Watsco. The deal was also structured for Watsco to contribute Company shares and distribution centers 

rather than cash/debt (although we would have rather seen some use of debt given the share price). 

Management has also expressed interest in only acquiring ‘top 50’ type distribution companies rather 

than bottom-tier companies. The Company’s extensive track record and dealmaking procedure also give us 

confidence in their due diligence process. Under the stewardship of Mr. Nahmad, the Company has completed 

57 acquisitions with no major stumbles along the road. Notably, the Company has never entered a bidding war 

or hired investment bankers in connection with acquisitions (including the Carrier transactions). Instead, 

management tries to wait patiently to find well-run operations where the families are looking to exit at a 

reasonable price.  

We built the Company over the last 22 years through what we call a buy and build 

growth strategy. We bought a lot of companies, a lot of family businesses. It takes a long time 

to buy a family business, sometimes 10, 15 years to get a family oriented to selling, then 

waiting to sell, then having a price to sell that is comfortable and a price that we are willing to 

pay that is comfortable. A very long process. We have done it very successfully, never hired a 

banker, never paid a fee, never been in an auction; just simply had a lot of good relationships 

with people that own these businesses.  

– Barry Logan, Watsco. Inc. Senior VP, JPMorgan HVAC Conference, June 06, 2011  

We are also attracted by the potential for Watsco to acquire additional manufacturer-owned store 

networks a la the Carrier Enterprise joint ventures. According to management, the Company spent over a 

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