September 13, 2011

Watsco, Inc. 

 

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pent up demand for HVAC replacements as well as an estimated 8%-12% upside to annual revenue from a 

recovery in new housing construction to long-term normalized levels.   

These dynamics could drive significant EBITDA and free cash flow growth for Watsco over the next 

few years even without assuming a full recovery in new home construction or pent-up replacement demand. In 

our base case scenario, we assume Watsco’s legacy (non-Carrier Enterprise) business sales grow at a tepid 

1% rate in 2011 and 2.5% in 2012 before a modest benefit from an improved housing/economic environment 

leads to 5% growth by 2013 and 8% in 2014, while the Carrier Sunbelt business exhibits stronger growth over 

the next 18 months from continuing product mix improvement. We also conservatively estimate base business 

EBIT margins expand only approximately 130 basis points over the next 3 years to 7% (~8% pre-corporate 

expense), well below the 8.6% levels achieved in 2006 and management’s target of 10% operating margins. 

Even in this scenario, we estimate Watsco can generate EBITDA greater than $290 million, or $257 million 

after deconsolidating UTC’s interest, by 2014. Applying a 9x EV/EBITDA multiple, we estimate Watsco’s 

intrinsic value at approximately $75 per share—implying approximately 31% upside from current levels. In the 

meantime, we estimate Watsco could increase the dividend over the next three years to $2.88/share (5.0% 

yield at the current share price) by 2014 while still paying out less than 55% of 2014E free cash flow.      

 

Watsco Valuation 

  

Value ($MM) 

2014E EBITDA (unconsolidated) 

$257  

Assumed Multiple 

    9.0x 

Enterprise Value 

$2,310  

Less 2014E Net Debt 

     $30  

  

  

Equity Value 

$2,339 

  

  

2014E Diluted Shares Outstanding 

31.3 

  

  

Estimated Intrinsic Value Per Share 

$74.74 

  

  

Implied Upside to Intrinsic Value 

31% 

 

The upside from a fuller, more timely recovery in new home construction and consumer spending/pent-

up replacement demand is compelling. As noted earlier, a recovery in new home construction to normalized 

levels could translate into an 8-10% boost to annual sales for Watsco. We estimate the impact of a run-down in 

pent-up HVAC replacement demand would be of similar magnitude. The contribution margin from these 

incremental sales should also be above-average given the opportunity for operating leverage. If such a 

scenario were to unfold by 2013, we model core revenue growth (ex-Carrier Mexico and Northeast) increasing 

up to 8% in each of 2013 and 2014 and core operating margins expanding to 8.5% by 2014. Under this 

scenario, we estimate Watsco could generate close to $305 million in EBITDA by 2014, which implies an 

estimated intrinsic value upwards of $90 per share based on the same 9x EV/EBITDA multiple. Notably, 

Watsco management has targeted significantly higher (10%) operating margins under a similar (actually 

somewhat more modest) revenue growth scenario. Additionally, we would not be surprised to see multiple 

expansion in such a scenario. Of course, we would be very pleasantly surprised to see such a scenario fully 

unfold by 2014 given the current macroeconomic picture. Nonetheless, we believe a recovery in home 

construction and consumer confidence is inevitable, and Watsco should ultimately see an outsized benefit 

whenever this eventually takes form.  

Investment Rationale 

Watsco is the largest independent distributor of residential and light commercial HVAC equipment, 

parts and supplies in the U.S. We view Watsco as a top operator and the only independent distributor of scale 

in an otherwise highly fragmented industry (1,300+ independents) with attractive barriers to entry. Although 

Watsco still only has ~10% market share (which we view as an opportunity), the Company has 20%-30% 

market share in its top regions, which are also concentrated in attractive HVAC markets in states like Florida 

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Watsco, Inc. 

 

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and Texas. The HVAC distribution business is also characterized by regional or state-wide, non-transferrable, 

often exclusive, distribution agreements with the various HVAC manufacturers (6 of whom have long 

dominated the industry). With a customer base of 100,000+ independent contractors, this business is also 

closely tied to longstanding local relationships while offering minimal customer concentration pressures.    

The domestic HVAC install base has consistently grown over the years to more than 120 million units, 

which offers an attractive recurring-type revenue source from repair and replacement sales. Annual industry-

wide replacement unit shipments have grown at a ~3.5% rate over the past 20 years. Upgrades related to more 

energy efficient units has also contributed ~2-3% to annual sales growth for Watsco via higher pricing and 

should continue to be a long-term tailwind given higher energy prices and increasing government focus 

(including mandates and/or incentives/rebates) on energy efficiency programs. These dynamics combined with 

selective acquisitions have enabled Watsco to slowly but steadily increase its scale and earnings power over 

the years, with the Company recording annualized revenue growth of 8% and EPS growth of 14% between 

2000-2010. While the housing downturn affected Watsco, the Company remained solidly profitable due to a 

combination of resilient underlying repair/replacement demand, the pass-through nature of the business, a 

minimal corporate structure and meaningful SG&A expense reductions. In fact, management expects to post 

record EPS (previous high was $2.85/share in 2006) in 2011. 

Watsco currently trades at 9x EV/TTM EBITDA (we estimate 10.5x-11x after backing out consolidated 

JVs) and 20x consensus 2011E EPS, which may not look particularly compelling on the surface. However, we 

believe the underlying valuation is significantly more compelling. Watsco’s low-capex (<0.5% of sales) 

business model and management’s prioritization of working capital improvements and strong free cash flow 

have produced 13% annualized growth in free cash flow over the past decade, and WSO currently trades at a 

more modest 13.5x 2010 free cash flow. Additionally, we see several huge tailwinds for Watsco going forward. 

Over the past 2 years the Company completed several 60/40 joint ventures with United Technologies to take 

over HVAC distribution centers for its leading manufacturer, Carrier Corp. This should contribute ~$1.3 billion in 

additional revenue in 2011 and based on early results from the initial 2009 JV covering Sunbelt region stores 

(operating margins already up 370 bps to date), a combination of Watsco’s superior operational practices, cost 

savings, and the introduction of a vastly expanded line of product offerings should drive substantial profitability 

improvements. The Carrier transactions were completed at extremely attractive multiples of only <0.2x-0.4x 

sales, including options for WSO to increase its stake in the largest Sunbelt JV to 80% by 2014. Watsco also 

has the potential to see tremendous operational upside over the next few years from the unwinding of pent-up 

replacement demand and a recovery in new housing construction—the latter of which historically accounted for 

25-30% of industry unit sales versus ~10% today. Even discounting a full recovery, we estimate Watsco has an 

intrinsic value of at least $75/share based on 9x 2014E EV/EBITDA.  

We would also note that longtime Chairman/CEO Mr. Nahmad’s controlling interest via class B shares 

presents some risk, but historically he has proved to be an excellent steward of capital. The Company is run 

with a conservative balance sheet (minimal to no leverage) and although acquisitions have been very 

successful, they accounted for the deployment of a fairly modest 24% of operating cash flow over the past 

decade. Watsco has consistently returned its free cash flow to shareholders via dividends to the tune of a 37% 

CAGR in the annual rate since 2001, including a 10% increase in February 2011 to $2.28/share offering an 

attractive 4.0% yield.  

Risks: 

Risks that Watsco may not achieve our estimate of the Company’s intrinsic value include, but are not limited, 

to an economic slowdown; extended deferral of the replacement cycle; lack of recovery in new home construction; 

failure to successfully integrate acquisitions; unfavorable supply disruptions or renegotiations; loss of key 

management personnel; and corporate governance issues associated with the dual-class share structure. 

Analyst Certification: 

Asset Analysis Focus certifies that the views expressed in this report accurately reflect the personal views of 

our analysts about the subject securities and issuers mentioned. We also certify that no part of our analysts’ 

compensation was, is, or will be, directly or indirectly, related to the specific views expressed in this report. 

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