Watsco, Inc.
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business, which offers a huge opportunity for incremental revenue—most of which
also sells at
higher-than-average gross margins. The Company has made good progress to date, bringing the
mix down to 72% equipment versus 24% parts and 4% supplies. Attractive opportunities for
additional gains remain, and management believes they can get supplies to a 15%-20+% share
and equipment closer to 50% of sales.
Additional Revenue Synergies—Leveraging existing contractor client relationships across the
expanded product lines for both legacy Carrier and Watsco stores.
General and administrative expense leveraging.
Attractive Acquisition Price
The initial Carrier Enterprise acquisition significantly increased Watsco’s scale in the attractive Sunbelt
region and brought Watsco economically and strategically valuable exclusive distribution agreements with the
premier Carrier brands. Importantly, the acquisition was also transacted at what we view as extremely
attractive valuation multiples. Watsco’s purchase of the 60% interest in the joint venture was valued at
approximately $181 million, including the issuance of 3.1 million shares (~11.5% dilution) with a then-current
market value of $151 million plus the contribution of 15 stores valued at $23 million and $7 million in working
capital adjustments. Carrier stores generated approximately $1.2 billion in revenue in 2009, implying a
purchase price of only 0.25x sales after backing out UTC’s 40% retained interest. Based on full Carrier
Enterprise operating margins of 2.4% in 2008, Watsco paid a relatively modest 10x operating income.
However, the real economics of the deal become evidence once factoring in the performance improvements
Watsco has been able to generate from the acquisition. Based on Carrier Enterprise’s 2010 net income,
Watsco paid a bargain-basement 4.0x forward earnings (net income) for the acquisition. Carrier Enterprise’s
margins are already up to 6.5% and as Watsco continues to execute the strategic initiatives, we are optimistic
the Company can continue to grow Carrier Enterprise revenue and approach if not achieve its 10% EBIT
margin goals—especially if we see any material uptick in replacement demand and/or home construction.
Carrier Enterprise Sunbelt Transaction Analysis
Acquisition Cost:
3,080,469 WSO shares @ $49.05
$ 151,097
+ 40% in 15 Watsco Stores @ book value
$ 23,217
+ Working Capital Adjustments
$ 7,201
$ 181,515
Transaction Multiples:
2008 Revenue, Contributed Carrier Stores
$ 1,233,425
Price/Sales multiple, 60% Interest
0.25x
2008E Operating Income @ 2.4% margins
$ 29,602
Price/Operating Income multiple, 60% Interest
10.22x
2010 Actual Net Income
$ 77,405
Price/ 2010 Earnings, 60% interest
3.91x
Not surprisingly, we would have preferred to see Watsco pay UTC in cash rather than diluting
shareholders at <$50 per share—although according to Watsco’s management, UTC requested stock-based
payment (UTC still held 3.0 million shares as of April 2011 according to Watsco’s latest proxy statement). It
should also be noted that additional accretion should come from the exercise of Watsco’s option to increase its
stake in the JV to 70% in July 2012 and 80% in July 2014. The upcoming July 2012 option has an exercise
price estimated at approximately $50 million payable in cash or WSO shares at the Company’s discretion,
while the July 2014 option should come at a modestly higher price tag based on performance-linked
adjustments. Given the JV’s current profitability and performance trends, we anticipate Watsco will exercise
these options at similarly attractive valuations as the initial deal.
Watsco, Inc.
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Carrier Enterprise Northeast
Watsco completed a second 60/40 joint venture with Carrier on April 29, 2011 covering Carrier’s
Northeast distribution centers. Carrier contributed 28 Northeast centers, while Watsco contributed $35.7 million
in cash plus the Company’s 14 Northeast locations valued at $14.7 million. The contributed Carrier Northeast
stores had approximately $210 million in annual sales and EBIT margins <5%. This implies a purchase price
for Watsco’s interest of only 0.4x sales or 9x trailing EBIT. As Watsco initiates similar strategic initiatives in this
business as the Carrier Enterprise Sunbelt operation, this acquisition price should look increasingly attractive.
Carrier Enterprise Mexico
Most recently, on August 1, 2011 Watsco announced the completion of a third 60/40 joint venture with
Carrier covering Carrier’s 6 distribution centers in Mexico. The stores generated approximately $80 million in
revenue over the trailing twelve months ended June 30, 2011, while profitability statistics have not yet been
released. Watsco paid $9 million in cash, or only approximately 0.2x revenue for its share in the JV. Watsco
plans to expand parts and supplies sales at these locations as well as to add additional stores in Mexico in the
coming years. The Company estimates this is a $2 billion addressable market, and although the business has
been hit by the recession in recent years, Carrier remains the #1 HVAC brand in Mexico.
Additional Long-Term Growth Drivers
In addition to the Carrier Enterprise acquisitions, pent-up replacement demand, and new home
construction, we believe Watsco is well-positioned to capitalize on several additional long-term opportunities,
both industry-wide and Company-specific.
Sunbelt Exposure
Prior to accounting for the recently-completed additional Carrier JVs, Watsco derives approximately
90% of revenues from the Sunbelt region, including close to 50% of sales from Florida and Texas. Historically,
the Company concentrated on expanding in these regions due to numerous favorable characteristics including
strong immigration trends from retirees as well as Hispanics; a longer hot season reducing seasonality and
increasing demand for air conditioning systems; higher repair/replace demand given more frequent running of
air conditioning systems; and additional demand from 2
nd
home construction given the region’s vacation
attractiveness. Alongside California, Florida was probably the most overbuilt state during the housing bubble,
which should keep demand from new construction and home expansion/remodeling depressed through the
medium term. On the other hand, Texas has suffered relatively modestly in recent years and continues to see
strong positive benefits from migration and the more recent oil and gas boom locally. Regardless, in the longer
term the aforementioned factors should continue to make the entire Sunbelt region a particularly attractive
operating region. For example, the U.S. Census Bureau estimates Florida and Texas will experience the #3
and #4 population growth rates, respectively, among all states between 2000-2030.
Energy/Environmental Efficiency Mandates
Environmental and energy efficiency regulations add an additional layer of complexity to the domestic
HVAC industry, generally to Watsco’s benefit. Heating and cooling accounts for approximately 56% of the
energy consumed in a typical home, which is leading to increased focus on HVAC energy conservation by
regulators. The U.S. Department of Energy has developed ‘SEER’ (seasonal energy efficiency ratio) energy
efficiency standards for central air conditioners and heat pumps. As of 2006, all new and replacement systems
must meet at least the 13 SEER standards, which are 30% more energy efficient than the previous SEER 10
standards. The federal government has also recently offered additional tax credits for higher energy efficiency
purchases. Federal tax credits offered have included up to $1,500 in 2010 and $500 in 2011 for replacement of
HVAC systems/parts with SEER ratings of 15-16 or higher depending on the specific item. Watsco estimates
approximately 50% of the central air market is now at 13 SEER, 30% at 14 SEER (‘Energy Star’), and a small
but nicely-growing portion at the ultra-premium 16+ SEER. Additional regulations include the phasing-out of
R-22 ‘freon’ refrigerants (high in ozone-depleting CFCs) commonly used in residential air conditioning systems
and heat pumps.
Not surprisingly, premium energy efficiency products command premium prices—to Watsco’s benefits.
However, federal government and/or utility subsidies, plus energy savings, typically make upgrades an