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)
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