September 13, 2011

Watsco, Inc. 

 

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Watsco derives approximately 59% of revenue from HVAC equipment such as furnaces, split systems, 

air handlers, and evaporator coils. Parts and supplies account for another 34% of revenue, and consist of over 

50,000 SKUs. Watsco’s goods are sold to a highly fragmented customer base of over 50,000 contractors, with 

end-users primarily residential units as well as some light-commercial buildings. Watsco also derives 

approximately 7% of revenue from commercial refrigeration products. This includes light commercial 

refrigerators and ice making equipment and related parts sold to grocery stores, restaurants, hotels, etc. 

Watsco only significantly entered the light commercial refrigeration business around 10 years ago but has 

experienced solid growth from both market share gains and favorable regulatory (energy efficiency and 

pollution regulation) tailwinds.  In terms of suppliers, in 2010, Watsco purchased approximately 72% of 

products from its top 4 suppliers including 52% from Carrier. Prior to the Carrier Enterprise joint ventures, 

Watsco purchased approximately 48% of goods from its top 4 suppliers including 13% from Carrier in 2008.  

Historical Performance 

Looking back over the past 10-plus years, Watsco has consistently posted impressive operational 

performance. The Company increased annual revenue at an 8% compound annual growth rate (CAGR) 

between 2000-2010, while EPS increased at an even stronger 14% CAGR. Favorable industry dynamics 

including a growing install base, regulatory/energy efficiency guidelines, and new home construction helped 

fuel this growth, as did solid expense controls and opportunistic acquisitions. Despite the concentrated 

equipment supply chain, Watsco has consistently maintained gross margins around the 24%-26% range, 

indicative of the Company’s strong ability to pass through OEM and other supply cost increases. Watsco also 

maintains a lean corporate structure; there are still only ~20 employees at its Miami headquarters. The 

Company relies on 9 regional managers to oversee operations in various store clusters, with the managers’ 

compensation heavily based on performance incentives. Given the nature of the business, Watsco’s 

advertising and marketing costs are also minimal; advertising expense totaled only $26.6 million or 0.9% of 

sales in 2010 and $12.1 million or 0.6% of revenue in 2009. Total SG&A expenses averaged a relatively 

modest 17.9% of sales in 2010.   

Historical Operating Performance  ($thousands) 

 

1H 

2011 

1H 

2010 

2010 2009 2008 2007 2006 2005 2004 

Revenue  

$1,417,887  $1,374,560  $2,844,595 $2,001,815 $1,700,237 $1,758,022 $1,771,214 $1,658,249 $1,294,715

Gross Margin % 

24.56% 

23.55% 

23.67%

24.02%

26.00%

25.43% 25.82% 25.24%

25.77%

Operating Profit  

$92,239 

$79,784 $165,572

$81,060

$98,608

$111,154 $135,394 $117,283

$84,094

Operating Margin % 

6.51% 

5.80% 

5.82%

4.05%

5.80%

6.32% 7.64% 7.07%

6.50%

Diluted EPS  

$1.33   

$1.20   

$2.49  

$1.41  

$2.09  

$2.27   

$2.86   

$2.52  

$1.79  

 

Recovery from Recession 

Watsco suffered 17% and 10% declines in same store sales in 2008 and 2009, respectively, due to a 

combination of the drastic decline in new home construction and deferral of HVAC repairs/replacement by 

retrenching consumers. Operating income (EBIT) declined to $81 million in 2009 from a peak of $135 million in 

2006. However, in our view the Company has prudently managed the decline. While EBIT margins declined 

from a peak of 7.7% in 2006 to 4.0% in 2009, Watsco remained profitable due to the Company’s relatively low 

fixed cost structure. Cost savings initiatives implemented over the past four years cut approximately 

$120 million in SG&A expenses, which declined to 17.9% of revenue from 19.1% in 2007. Same store sales 

rebounded 11% in 2010 including a 16% increase in HVAC equipment sales, driven by pent up demand for 

replacement heating and air conditioning units, including higher-priced more energy efficient units. While same 

store revenues have increased only 1% in 1H11, the Company expects to achieve record EPS this year, driven 

by margin expansion and the Carrier Enterprise acquisitions. Management is targeting improvement in EBIT 

margins (which are still depressed by the recent addition of below-average margin Carrier Enterprise 

businesses, as described on pages 68) to 10%, although this may require a recovery in same store revenues 

to around the prior peak—roughly 10%-15% above current levels. As detailed below, we believe pent-up 

demand and a recovery in new home construction could support this revenue growth over the next few years. 

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Watsco, Inc. 

 

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Attractive Recurring Revenue Business Model 

We are attracted by the solid underlying demand and recurring revenue nature of Watsco’s primary 

business. There are roughly 120 million homes in the U.S. with existing central air and/or heating, and this 

HVAC install base has consistently grown year in and year out. Growth from new home construction has been 

enhanced by increased penetration rates for central air conditioning and heating; for example central air is now 

installed in ~90% of new U.S. residences versus under 80% 25 years ago. Increased penetration of existing 

homes as well as home renovations or expansions (which may require the addition of a second HVAC unit) 

also offer additional unit growth. This growing install base provides Watsco with a relatively stable source of 

revenue from repairs and replacements. Watsco currently generates approximately 75% of revenue from the 

repair and replacement of existing HVAC systems. The Company estimates replacement unit sales have 

increased at an approximate 3%-4% average growth rate per year (prior  to price increases) over the past 

15-plus years. 

Not surprisingly, Watsco has observed unprecedented belt-tightening among existing install base 

customers since the housing downturn and recession struck. Residential consumers have tended toward 

repairs and more minor replacements over full unit replacements at unusually elevated levels. For example, 

customers have increasingly elected to replace HVAC compressors rather than replacing entire condensers or 

the full HVAC systems. According to industry data, unitary system sales to the residential market declined by 

between 8%-16% annually from 2006 through 2009 (2006 includes an unusual decline related to the expiration 

of SEER 10/13 upgrade mandates). Although this is primarily attributable to plummeting new home 

construction, nonetheless replacement sales are estimated to have declined by approximately 15% between 

2007-2009.    

 

 

Source: Lennox International presentation, August 2011 

 

On the plus side, Watsco has not seen a huge decline in overall revenue from the HVAC install base 

as deferred replacement demand has migrated toward greater parts and supplies sales. Importantly, these 

repairs also generally represent temporary patchwork and the full replacement of aging units can be delayed, 

but not deferred indefinitely. Some recovery of pent-up replacement demand is already kicking in. Industry-

wide unit sales rebounded approximately 4% in 2010, according to Lennox International. According to Air 

Conditioning and Refrigeration Institute (AHRI) data, residential central air conditioners and heat pump 

shipments are up 11% year-to-date through July (final sales are likely to significantly lag shipments as depleted 

inventory is being rebuilt). Nonetheless, an estimated 1-2 years or more of pent-up replacement demand 

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