Watsco to Bear the Burden of Weak International Markets

On Aug 8, 2014, we issued an updated research report on Watsco Inc. (WSO), a leading distributor of air conditioning, heating, and refrigeration equipment as well as related parts and supplies (HVAC/R) in the United States.

Watsco’s second-quarter 2014 adjusted earnings increased 8% year over year to $1.60 per share aided by robust unit growth, a stronger sales mix of high efficiency HVAC equipment, improved selling margins and operating efficiencies. Total revenue increased 4% year over year to a record $1.17 billion.

The market for residential central air conditioning, heating and refrigeration equipment and related parts and supplies in the Americas is worth approximately $35 billion. Watsco now owns 10% of the market and has immense potential to increase its market share as no other competitor can match Watsco's geographic footprint.

Watsco will continue to benefit from demand in the replacement market as old units get replaced by more energy-efficient units in the coming years. There are approximately 89 million central air conditioning and heating systems installed in the United States that have been in service for more than 10 years. Moreover, higher efficiency units mean higher pricing and higher margins for the company.

Watsco’s joint venture with Carrier Corporation, a wholly owned subsidiary of United Technologies Corp. (UTX), has been successful and continues to generate profits. In Jul 1, 2014, Watsco exercised its second option to acquire an additional 10% ownership interest in Carrier Enterprise I in the Sun Belt region. Watsco now holds an 80% controlling interest in Carrier Enterprise I. In the U.S., the most significant markets for HVAC products are in the Sun Belt. This increased stake will be accretive to Watsco’s earnings by 20 cents to 25 cents over the next 12 months.

Watsco has made several investments over the past one year to increase its market share – it added 200 people in sales, marketing, product specialist, and store personnel roles; eight locations have been opened in the past year with 20 more expected to open in the next 12 months. The branches will improve network density as well as the ability to service customers locally. Watsco maintains its long-term plans to increase revenues to above $10 billion and margins above 10%.

International sales (which contribute 12% of total sales) were flat in the first quarter and declined 4% in the second quarter due to foreign exchange losses in Canada and challenges in its Latin America/Mexico/Caribbean regions. Watsco issued its 2014 earnings per share guidance at $4.20-$4.40 – the lower-than-expected forecast reflects weaker international markets and non-HVAC equipment sales, as well as incremental internal investments.

Moreover, Watsco has been historically acquisitive. The company’s strategy mainly centers around geographic expansion of its HVAC business through new market acquisitions, subsequently increasing revenues and profits from a combination of greater number of locations, products, services, and improved management practices. However, the company has been lately inactive on the acquisition front.

Other Stocks to Consider

Watsco currently carries a Zacks Rank #4 (Sell). Some better-ranked stocks in the sector include Garmin Ltd. (GRMN), Research Frontiers Inc. (REFR) and Universal Electronics Inc. (UEIC). All of these stocks hold a Zacks Rank #2 (Buy)