September 13, 2011

Watsco, Inc. 

 

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decade trying to persuade United Technologies to sell the business until they finally agreed after a strategic 

review in 2009. As detailed earlier, the results of the JV to date are excellent and Watsco was also able to 

obtain a very attractive price given the acquired operations’ struggles, ‘non core’ status to UTC, and lack of 

potential strategic bidders with sufficient scale apart from Watsco. Several other OEMs have company-owned 

store networks, and according to management, Watsco is now using the evidence of Carrier Enterprise’s 

success to more vocally make the case for divesture of distribution centers to these OEMs. While it is difficult 

to gauge how likely Watsco is to successfully convince the OEMs to divest, in our estimation the extensive 

synergies and operational improvements executed at Carrier Enterprises would be replicable across other 

OEM stores and such acquisitions would most likely represent very attractive investment of capital.      

Key Man & Corporate Governance Issues 

Dual Class Shares 

As long-time Asset Analysis Focus subscribers may remember, we have previously discussed the 

pitfalls as well as potential opportunities associated with dual class shares (including in our summer 2005 

double issue). In Watsco’s case, longtime Chairman and CEO Mr. Albert Nahmad owns an approximately 13% 

economic interest in Watsco but a controlling 55% voting interest through the holding of Class B supervoting 

shares,  which also include the right to nominate 75% of the Board of Directors.  Mr. Nahmad is 70 years old 

and has directed the Company all the way through its transition into the leading domestic HVAC distributor. 

Although all indications are that CEO Nahmad remains very actively involved in Watsco’s operations and has 

no plans for anything otherwise, nonetheless this creates a major key man risk. In terms of succession, 

Watsco’s Senior Vice President and Secretary, Mr. Barry Logan (age 48; 1% economic ownership), who has 

served various key roles with the Company since 1992, appears to be very active in daily operations (including 

key relationships) and would be an obvious replacement. On the other hand, CEO Nahmad’s 29 year old son 

Aaron Nahmad has served as Director of Global Business Development since 2005 and was recently 

promoted to Vice President of Strategy and Innovation in 2010. Alternatively, as we have frequently highlighted 

in the past, succession/control issues associated with dual class shares and aging patriarchs often create 

catalysts for unlocking shareholder value.    

Corporate Governance Issues 

Mr. Nahmad’s control of Watsco extends to the Board of Directors, the members of which appear to 

have questionable independence and oversight capacity. The Lead Director, Mr. Paul Manley (age 74), was 

elected to the Board in 1984 and has been retired since 1991. He previously served as Vice President of 

Planning at Sensomatic Electronics from 1982-1987 and Executive Director of the law firm Holland & Knight 

from 1987-1991. Mr. Manley also serves as Chairman of the Compensation Committee and Co-Chairman of 

the Audit Committee—roles for which he received $52,250 in fees in 2010. Mr. Manley and the Board have 

authorized an incentive compensation plan for Chairman/CEO Nahmad which we view as outrageously 

structured. In addition to an annual salary of around $1 million, Mr. Nahmad has a performance-based plan 

linked to annual increases in WSO share price and EPS, without a highwater mark.  

 Salary 

Incentive Award 

per $0.01  

EPS Increase 

Incentive Award 

per $0.01/Share 

Annual Stock 

Price Increase 

(0%-15%) 

Incentive Award 

per $0.01/Share 

Annual Stock 

Price Increase 

(+15%)* 

Restricted  

Stock 

Awards  

(Shares) 

Grant Date  

Fair Value of 

Stock Awards 

Estimated 

Share 

Dilution 

2010   $1,045,000  

 $65,250  

 $1,200  

 $1,800  

301,052  

 $19,300,500  

1.0% 

2009   $   990,000  

 $65,250  

 $1,200  

 $1,800  

76,635 

 $3,808,760  

0.3% 

2008   $1,100,000  

 $65,250  

 $1,200  

 $1,800  

 –  

– 

 

 

* Threshold was 20% in 2008 

 

Note: Mr. Nahmad entitled to receive incentive awards in cash or 2x cash value in long-term restricted Class B stock (vesting 

length and some additional restrictions vary by period) 

 

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Watsco, Inc. 

 

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Last year’s plan called for a $65,250 bonus for every $0.01 increase in EPS versus the prior year, 

which Mr. Nahmad may elect to convert to double the value in Class B, 12-year restricted stock (doubled to 

supposedly account for discounting associated with the 12 year vesting period). Although EPS would not be 

our preferred performance measure, in a typical year this plan would produce not entirely unreasonable 

compensation levels by market standards. Mr. Nahmad received no bonus in 2008 due to the declines in WSO 

stock price and EPS, while he received $3.8 million in performance pay in 2009 based on the increase in 

WSO’s share price during the year. However, as a result of the sharp drop in EPS to $1.40 in 2009 followed by 

the rebound to $2.49 last year, in 2010 Mr. Nahmad was granted approximately 301,000 shares of restricted 

stock with a market value of $19.3 million (undiscounted)—equivalent to roughly 17% of the entire Company’s 

net income in 2010. While we believe this is an exorbitant level of compensation, we are as much or more 

dismayed by the overall structure of the compensation plan. The plan not only measures performance based 

on an unreasonably short window and using less than preferable metrics, but the plan essentially rewards 

earnings volatility and allows Mr. Nahmad to earn compensation on the same earnings gain multiple times.     

The Board composition and incentive pay structure are serious corporate governance issues which we 

would argue are deserving of vocal resistance from Watsco shareholders. Nonetheless, we have highlighted 

attractive investment opportunities in significantly more dubious management situations in the past 

(e.g. Cablevision, Dow Jones, Playboy, etc.). While we would like to see unfair dual class share structures 

abolished and always must approach such situations with caution, in many cases we have also observed over-

penalization by the market creating attractive long-term investment opportunities. In the case of Watsco, we 

would note that Mr. Nahmad has an impressive three-decade history of conservatively managing the Company 

and generating outsized returns for all shareholders, including returning plenty of cash to shareholders via 

dividends. Of course, we would like to see meaningful Board oversight and view the performance metrics used 

in calculating performance pay as seriously flawed. Nonetheless we would note that even in the most 

egregious case in 2010, Mr. Nahmad’s payout still represented approximately 1% shareholder dilution, which, 

viewed in combination with minimal additional corporate expenses/stock-based compensation, is actually less 

than the levels observed at a large percentage of public companies. The use of 12-year restricted stock as 

currency also further aligns Mr. Nahmad’s interest with long-term shareholders.  

Valuation 

Watsco has recorded tremendous operational performance over the past decade, increasing EPS at a 

remarkable 14% CAGR and free cash flow at a 13% CAGR between 2000-2010 in the face of what was 

essentially a ‘lost decade’ in the stock market and only marginally better from a macroeconomic perspective. 

Watsco shareholders have certainly been beneficiaries of this performance, with WSO shares up 388% over 

the past 10 years in addition to the 33% CAGR on the common dividend since 2000. Despite the historical 

outperformance, we believe Watsco shares still offer a compelling long-term investment value. In our view 

Watsco shares have long traded at a discount to intrinsic value due to some combination of a general lack of 

investor familiarity with the name; investor misunderstanding of Watsco’s leading position and competitive 

moat in a seemingly undifferentiated business; lack of recognition of the attractiveness of the recent Carrier 

Enterprise joint ventures; a generally negative outlook toward stocks linked to the domestic housing market; 

and corporate governance issues associated with Chairman/CEO Nahmad’s controlling interest in the 

Company.  

Watsco shares currently trade at approximately 9x EV/TTM EBITDA (closer to 11x after backing out 

our estimate of the contribution from UTC’s interest in the Carrier Enterprise JV), at the lower end of the 

Company’s historical trading multiple range of 9-12x EV/EBITDA. However, we would note that shares look 

much cheaper on a free cash flow basis (13.5x 2010 free cash flow) given the low capex requirements, excess 

amortization of intangibles, and a focus on working capital improvements. Additionally, in our view several 

extremely attractive opportunities are not imbedded in the near term trading multiples: (1) Additional upside 

from further integration of the Carrier Enterprise Sunbelt JV, which continues to post impressive margin 

expansion. (2) Exercise of Watsco’s options to increase its Carrier Enterprise Sunbelt stake by 10% in each of 

2012 and 2014 at what should be highly accretive cost bases. (3) The Carrier Northeast and Mexico JVs, just 

completed in late April and September, respectively. (4) Possibility of additional accretive acquisitions/JVs with 

Carrier and/or other OEMs as well as the acquisition of smaller competitors. And last but not least, (5) Historic 

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