Press "Enter" to skip to content

Watsco: Dividend Aristocrat With A Touch Of Cool

Success, it is said, often results from the combination of a particular talent with a fortunate set of circumstances. This is the story of Watsco, a roll-up in the distribution side of the HVAC/R business fueled by a Berkshire Hathaway-like culture, and led by Albert H. Nahmad, a shrewd owner-operator with a bent for value-driven acquisitions.

The following paper aims at dissecting Mr. Nahmad’s blueprint — this, in order to help spotting other distribution businesses where it could be applied. A fitting example would be EVI Industries, a $350mil company formerly known as EnviroStar, now a burgeoning roll-up in the distribution of laundry equipment 62%-owned by Henry Nahmad, a nephew of Albert.

Henry is a former head of M&A at Watsco, where he learnt the buy-and-build playbook that has worked wonder for his uncle’s business. Interestingly, he is not the only Watsco-bred executive who started his own roll-up operation: former VP Manuel Perez de la Mesa also turned distributor Pool Corp into a breathtaking success.

The 32 features of Watsco’s proven blueprint are discussed below. Readers who’d like to get the full research report in .pdf should get in touch.

1. Focus on Core HVAC/R Distribution Business — PASS

Watsco has been involved in the climate control business since inception (in 1956) via its manufacturing operation of cooling and heating equipment. Adhering to the conglomerate model that dominated the following decades, it acquired several peers and diversified into unrelated industries, such as plastic tools and haircare.

In 1973, Panama-born Albert H. Nahmad seized control and assumed leadership after an executive career split between engineering (at W.R. Grace) and accounting (Ernst & Young) roles. Apparently an astute value investor, Mr. Nahmad divested the haircare business in 1982 and purchased an 8.5% stake in a Florida bank for $3mil; the latter was sold in 1984 for $8.5mil.

In 1988, Watsco bought two majority stakes (80%) in Florida’s largest residential air conditioning distributors, Gemaire Distributors, Inc. and Harry Alter Co., snapping up an immediate 16% market share in the Sunshine State. Always eager to use Watsco’s excess cash, Nahmad bought a staffing business late in the takeover mania that was raging in this era. (Wound down for a first time in 2001, Dunhill Staffing was finally divested in 2007.)

Albert Nahmad was inspired by the sequels of the Florida real estate boom in the 1970s. His distribution business continued to thrive even as the boom flattened because it sold replacement parts. In effect, used year-round in Florida, air conditioners wore out after about ten years; the replacement cycle was thus in full swing in the 1980s, even as new home construction slowed.

In 1990, Watsco definitely settled for its Sun Belt strategy and purchased a 50% interest in Heating and Cooling Supply, Inc., the largest air conditioning distributor in California and Arizona. Taken together, all these deals in the distribution business brought $150mil in additional revenue — a sevenfold increase. The manufacturing business prospered along, but it was the distribution segment that really carried most of the freight.

This is when Nahmad realized that a massive growth opportunity was laying before Watsco. The air conditioning distribution industry was largely fragmented but no one had yet undertaken to scale up. “There’s no one out there consolidating in the industry except us” he told the Wall Street Journal in 1994.

Within the next years, Watsco expanded into neighboring geographies and bought Rheem’s 20% minority interests in Gremaire and Harry Alter. It also purchased two distributions operations from Carrier, a subsidiary of United Technologies, and the world’s largest manufacturer of HVAC/R (heating, ventilation, air conditioning and refrigeration) equipment.

This rapprochement triggered the fruitful collaboration between Watsco and Carrier that exists up to this day. By the late 1990s, Watsco sold its manufacturing business and pushed its distribution enterprise into New England. In the process, it became a billion-dollar company as well as the largest independent distributor of residential heating and cooling equipment.

Nowadays, Watsco does $4.5bn in revenue, employs 5,200 staff and serves 300,000 contractors and technicians through 575 locations. Its corporate structure and HVAC/R distribution focus differ from its two closest challengers Johnstone Supply and Ferguson. The former is an employee-owned cooperative with 425 locations across North America and $2bn in revenue. With $20.7bn in revenue, of which $1.2bn derived from its HVAC/R segment in the United States, the latter is the broadly diversified, leading distributor of plumbing and heating products worldwide.

According to Albert Nahmad: “We believe that our singular focus on the HVAC/R marketplace enables us to adapt and respond to the market more quickly. Collaboration of our managers within the HVAC/R marketplace is unparalleled. This means that great ideas can be executed quickly.

2. Regional Moat — PASS

The economic advantage of a distributor is regional in nature. This explains why failure is common whenever they venture beyond conquered land, where the benefits of scale cannot be reproduced. Watsco understood this early and chose to consolidate Florida, then the Sun Belt before it took on expanding into the U.S. It now remains primarily focused on the domestic market (91% of revenue in 2018) and its southern states (~70% of revenue).

Since 2012, management has sought to expand in Canada and Mexico by acquiring majority interests in Carrier’s distribution arms in these countries. A short while after these deals were completed, Albert Nahmad declared that: “Our international markets, which are comprised of Canada, Mexico, the Caribbean and parts of Latin America, account for 16% of sales [10% related to sales in Canada and Mexico, 6% to the export business] and are an important source of future growth for Watsco. We’re very excited about our international business.

Six years later, however, pace of growth abroad has failed to catch up with domestic performance. Besides, there seems to exist a persistent discrepancy between management’s ambitions and reality, for Watsco apparently withheld its investment effort abroad.

[…] See .pdf report for complete figures.

In 2015, Nahmad kept repeating that: “The Mexican and the export businesses are very high growth businesses. The strong dollar is the only reason that explains weakness in the international business.” Yet sales and margins declined. According to Barry Logan, VP: “There’s really two risks internationally. It’s currency risk, meaning that what you sell becomes more expensive as the U.S. dollar strengthened. And the second risk, of course, is credit risk. We do see strength there. Write-offs are very low. It shows us and tells us that we’re managing it well. So it’s more about the currency risk.

In 2016, operating income for international locations fell by 14%. Rampant profitability issues in Canada remained unresolved. The international business wasn’t even discussed in Mr. Nahmad’s letter, nor during the earnings call. Neither was it discussed in 2017 and 2018. Surprisingly, management didn’t disclose the international business performance in their annual press releases, as they used to do before.

Nevertheless, Mr. Logan held until recently that: “Latin America remains a profitable market and has been growing exceptionally well.” If this is true, Watsco has yet to fully capture such potential, as evidenced by the slower pace of growth of its Mexican business.

A weaker dollar may boost export sales indeed, but conversely these gains could be erased by higher purchasing costs — even if Carrier (which supplies 62% of Watsco’s inventory) is an American corporation, it sources parts of its hardware from Asian suppliers, and would likely try to pass some of the additional expenses related to a weaker dollar to its distributors.

Barring neighboring Mexico, management has shown reluctance in venturing towards emerging markets. Per Mr. Logan during the Barclays 2013 Industrials Conference: “We may be curious, but we’re not trying that hard right in some of the, what they call, emerging markets. Too much risks.

These international issues put aside, as discussed in note 1, Watsco’s distribution business remains heavily focused on a very regional market — Florida, and to a larger extent the Sun Belt. In 2007, Mr. Nahmad used to say: “Our network is principally penetrated to the Sun Belt. We do have some branches North of the Sun Belt, but whatever we’re telling you about is really Sun Belt orientated.

In 2012, Florida accounted for 25% of total revenue, the Sun Belt for 80%. In 2018, Florida still regroups 20% of the company’s total locations. Of course, such geographic concentration entails both strength and risks. Mindful of this, management is used to blur the lines. As Mr. Logan declared in 2017: “We are careful not to give out specific local data per se, for competitive reasons and for other good reasons.

3. Owners-Operators in Control — PASS

Per latest proxy, father and son Albert and Aaron Nahmad jointly own 86.6% of class B common stock (11% of total equity capital) and control 54.3% of voting rights. Albert Nahmad has more or less maintained an equal stake in the company since 2008, when he owned 91.3% of class B common stock (11.4% of total equity capital and 58.1% of voting rights).

Albert Nahmad, 78, has served as chairman and CEO since 1972. He is credited with being the driving force behind Watsco’s impressive growth. His son Aaron, 37, joined the company as a business development director in 2005, was promoted VP of strategy and innovation in 2011, and became president in 2016. In these various capacities, he oversaw Watsco’s successful push into digital technologies (see note 27).

Neither Albert or Aaron Nahmad ever sold any of the shares they own.

4. Extreme Decentralization — PASS

A cornerstone of Watsco’s philosophy lies in its decentralized structure that keeps acquired companies’ management teams in place. Operated independently by “highly empowered” and equity-incentivized people, subsidiaries can better honor the history, legacy and long-standing relationships that have been established over decades with their partners, suppliers and customers — the HVAC/R contractors.

Living under Watsco’s discreet umbrella, they benefit from their parent company’s scale, financial position, superior technology capabilities, commitment to growth and collective know-how with — in theory — as little parasitic interference as possible. “Nothing is called Watsco” Barry Logan said at a Goldman Sachs conference in 2012. “Our stores are called what they’ve been called for those 40, 50 years. We try not to interrupt the progress or those relationships with a big corporate office. Our corporate office has 25 people in it.

Management teams at subsidiaries make decisions on their own, based on what they see in their local markets. “We encourage them not only to organically put up new stores, but also to look for acquisitions that complement their efforts” Nahmad said. “We like it that way. Decision making should be at that level.”

Opening locations is not considered or even decided at headquarters. According to Albert Nahmad: “People in the field decide what they need and they implement it. Wherever they see a need, they just do it. Can we forecast what they might be doing? We can’t, because we’re not making those decisions for them. We do like a methodology being very decentralized, because that gives them an opportunity in the field that we at the headquarters could not see.

5. Lean Salaried Workforce — PASS

An interesting feature of Watsco is the lean workforce it employs, even as revenue grew rapidly over the last two decades.

[…] See .pdf report for complete figures.

6. Longevity of Leadership — PASS

The top 5 executives have been with the company for an average of 25 years. The directors — including the five executives above, who all sit on the board — have been with the company for an average of 17 years. For the anecdote, Cesar Alvarez is a close confidante of high-profile value investor Bruce Berkowitz.

Watsco remains a family business — in its extended definition. The same tight group of people has successfully run the company throughout the years, which is a telling clue of Mr. Nahmad’s leadership skills. For Barry Logan: “The chemistry set that we’ve had in the last several years — you known, the difference in personalities that we have — that chemistry set has been successful and that’s what’s in place today and that’s what moves forward.

[…] See .pdf report for complete figures.

7. No-Nonsense Investor Relations — PASS

Management comes across as unusually forthright. On the limited disclosures: “We don’t like competition to know what we’re up to.” On business following the housing crisis: “We’re just going on by the idea that it’s going to remain flat. We’re not hearing anything that says that there’s going to be a recovery in the near term.

On investments undertaken to upgrade Watsco’s technology capabilities: “We don’t want to mislead anybody. It’s not going to produce margin increase. We don’t know what it’s going to produce. We just know it’s essential. It’s essential that we help our contractors. It’s essential that we focus on the digital age. It’s essential that we block any serious competition from us.”

Notably, there are zero adjusted figures in annual reports.

[…] See .pdf report for the full section.

However, not all claims resist a double check (see notes 2, 20, 24, 29 and 32).

8. Fair Incentives & Compensation — PASS

Executives at Watsco are incentivized by a unique share program — they are allotted restricted shares that they cannot cash in until retirement. If they leave the company beforehand, they forfeit these awards. Such program, in theory, ingrains a long-term mindset and incentives managers to act as owners, in the best interest of customers. Albert Nahmad’s restricted share awards will vest from 2022 to 2028. His son Aaron’s — bound to succeed him — will vest in 2043.

At the board level, directors solely receive small option awards — barring one exception, no fees are paid in cash. To a larger extent, the stock option program remains limited in scope. A maximum of 1.8 million equity securities may be issued under current compensation plan (vs. 42 million shares outstanding as at 2019). The 0.5 million equity securities to be issued in accordance with outstanding awards bear an exercise price of $152 (vs. a current share price of $160). Dilutive impact is thus negligible.

At the executive level, per latest proxy, 80% of compensation is performance-based, consisting of restricted stock with significant cliff-vesting periods. The Company began granting restricted stock awards to a variety of leaders in 1997. As it relates to executive officers, 97% of their restricted share awards have not yet vested. Interestingly, there exist no severance agreements or defined benefits program.

Base salaries and bonuses are kept in the bottom range of the industry averages. The most poignant — and unusual — proof of fairness are the regular salary reductions. In 2018, all executive officers accepted salary reductions in response to a broader company-wide effort to reduce overall costs. Albert Nahmad was no exception: his base salary was subject to “voluntary” 20% cuts in 2016, 2017 and 2018.

As revenue grows, so are the incentives — and vice versa. In 2013, Mr. Nahmad declared that: “We’d like to spend more on this side [compensation] because the bigger the incentive comp programs that we have, the better performance the company gets overall.”

9. Steady Market Growth — PASS

On the global stage, the largest market for HVAC/R equipment is the Asia-Pacific region. It accounts for half of the industry’s revenue worldwide, of which almost two-thirds are driven by Chinese demand. In the near future, India is expected to post the most rapid gains, with double-digit growth.

The Asian example, however, demonstrated that growth does not necessarily translate into higher profits for manufacturers and distributors. Due to intense competition, equipment prices declined by 8.2% between 2014 and 2018, and are expected to fall further over the next years. This pitfall has been avoided in North America because the industry is already consolidated.

In light of rising interest for more energy-efficient systems, product development remains a strategic priority for manufacturers, distributors, contractors and customers alike. Regulations drive HVAC/R industry trends and, in the case of cooling equipment, the use of more environmentally friendly refrigerants (see note 16). Increasing preference toward ductless air conditioning systems and advancements in connectivity technology represent additional growth drivers.

Of course, HVAC/R sales in the U.S. market have been impacted by the housing crisis (see notes 10 and 12). Nevertheless, in 2012, pressed by an analyst to give an estimate of Watsco’s growth rate over the next three to five years, Mr. Nahmad replied that: “Well, I don’t think that we put our double-digit goal in the back burner. I’m just saying that given the demand of the industry and our participation in it, we believe we are getting our share of the demand. The industry is not growing much but, in spite of that, we’re getting more efficient.

The 2012-2018 period turned out to be fairly good. Most industry participants reported record sales between 2015 and 2018. About 60% of the U.S. households are equipped with central air conditioning systems, so there is room to grow still. But nobody can tell at which pace. An independent research boutique projects that the HVAC/R industry will have a 4.3% compound annual growth rate through 2022. Other sources project compound annual growth rates between 3% and 7% till 2024.

In 2018 — by all accounts a a good year for HVAC/R professionals — combined shipments of central air conditioners and air-source heat pumps increased 6.7% in the first half of the year. But broken down, central air conditioner shipments increased 1.9%, while heat pump shipments increased a whopping 15% percent. So it is important to acknowledge that air conditioners sales may not necessarily track HVAC/R industry trends.

Goodman Global, a major domestic manufacturer recently acquired by Japanese corporation Daikin Industries, stated in its latest annual report that, on a unit basis, the HVAC/R industry has grown at a compounded annual growth rate of approximately 3.4% over the last twenty years. Carrier reported organic growth of 6% in 2018 and 4% in 2017. All in all, it thus seems difficult to confidently assess the magnitude of growth expected forward.

What is nonetheless pretty certain is that, in the past — which is no indication of the future — Watsco has overgrown its market by a sensible margin, with a revenue compound annual growth rate of 8.1% between 2001 and 2018. The outperformance is chiefly due to the 60 acquisitions it realized over the course of its history in the HVAC/R distribution business.

The other major factor has been the company’s focus on the replacement market. As Mr. Nahmad declared: “What drives the replacement market is the installed base breaking. And the installed base gets bigger each year.

As discussed above (see note 1), equipment cycles typically last ten to fifteen years, at which point machines wear out. This is what limits the HVAC/R industry’s dependency upon new constructions. The latter constitutes a small proportion — an average of about one-sixth — of HVAC/R contractors’ work. Nearly two-thirds of new HVAC/R units they install come to replace failed units, rather than being new installations.

These numbers corroborate estimates put up by Watsco’s management.

10. Resilient & Replacement-Driven — PASS

Mr. Nahmad has expressed unabated faith about his company’s strategic focus: “Replacement demand is going to happen whether the weather is normal or not. No matter what the economy is doing, what interest rates are doing, what geopolitical things are — you have to keep the cooling going on in 120 million homes. So one way or the other I think the replacement market is going to be good.”

The aftermarket comprises the vast majority of air conditioning sales — and Watsco is the leading player there. The refrigerants are also changing, which means more replacements for the years to come. In this respect, new constructions would only provide “a bit of a lift“.

Fortunately, end-users can’t escape the laws of durability. They might go the repair route and try to defer replacement as long as possible, but eventually they’ll have to give in, especially when repair costs outmatch replacement costs. “More repairing— all that it does is building up more demand down the road for replacement” says Nahmad.

To what extent are his claims true? Watsco’s history provides an interesting precedent: in the 1970s, the Sun Belt saw a boom in housing as many people migrated south; the latter flattened but Watsco continued to thrive because it sold replacement parts.

We’ve been through slow economies in the past” recalls Nahmad. “After 2008, we did see a slowdown of our business. But what we see in the Sun Belt is some consistency in replacing systems. As you get out of the Sun Belt it’s a little bit more of a discretionary item, so if you we north it’s something we’ll have to figure out [if replacement are sufficient to maintain sales].”

Another testimony to Watsco’s resilient model is the “monster year” — to cite Mr. Nahmad — the company delivered in 2008 in terms of cash-flow, which surpassed the 2007 records and enabled management to raise the dividend in the midst of a dreadful economic setback. Of course, distributors are set to liquidate their inventories whenever activity declines, in effect freeing up cash formerly mobilized to fund working capital, so the feat, albeit admirable, isn’t necessarily illustrative of long-term relevance in the marketplace.

Company secretary Paul Johnston offered his own take on hardship: “It brings opportunity in M&A, and it certainly brings a lot more cash flow.” Meanwhile, federal and state legislations provide strong fiscal incentives for residents to switch to higher efficiency air conditioning systems. In the 2008-2012 period, it did soften the blow, in particular thanks to the Weatherization Assistance Program enacted in 2009. “Energy efficiency is what drives the price. It’s what drives our sales mix” repeats Nahmad. “It is not fashion or luxury, but energy efficiency.” A demand-oriented stimulus may thus mitigate the impact of the next recession, as it did in the last.

The aftermarket also extends to the various supplies Watsco sells, which are the duct work, insulation hardware, and everything else that goes into the house other than the systems themselves. Per Nahmad, if the equipment business slows down while the replacement and parts businesses grow, “the tradeoff for lower revenues is higher profitability, so it’s not something we’re particularly
against.

The parts business obviously has lower expenses and higher margins than the equipment business. But what will make it grow is is an increase in new construction — generally, contractors do not replace ductwork, grills, registers, wiring, etc. when they put in a replacement unit. “That really is the driver behind the supply business” says Nahmad.

For instance, in a typical new house, there may be $1,500 worth of air conditioning equipment — Watsco sells that. But more importantly, there should be a few thousand dollars of other supplies that fulfill the rest of the system, such as ductwork or thermostats, copper tubing, etc.

11. Barriers to Entry — PASS

Beyond its scale (see note 18), broad offering (note 19), privileged relationships with manufacturers (note 20), capital advantage over smaller operators (note 23), good reputation (note 26) and technology edge (note 27), Watsco does well out of the staffing challenge all HVAC/R distributors and contractors have been dealing with forever. Competition isn’t only over customers, but over talents also — industry-wide shortage of the latter is a recurring issue.

In effect, selling is one thing, but installing is another one that requires qualified labor. For Tim Brooks, president at Lohmiller & Co: “This is not a plug-and-play industry. Distributors that add value on a consistent basis will always have a place in this market. I do not see a drone delivering a furnace or rooftop unit that was purchased online for a homeowner or building owner to find the labor to install.

Speaking of drone delivery and e-commerce, ubiquitous Amazon — the elephant in the room — still lacks the knowledge required to size, install, and distribute mechanical equipment. It is deficient when it comes to offering customized technical advice, holding personal relationships, connecting with manufacturers, offering warranties, etc.

In addition, HVAC/R distributors did not sit idle as other industries were permanently disrupted — all the big players have significantly improved their online capabilities to cope with the new paradigm. Watsco is a shining example, with 30% of its sales now processed online and a full set of digital capabilities (see note 27).

12. Limited Exposure to New Constructions — PASS

In the equipment business, management estimates that new constructions account for only 10% of revenue, “if not less”. The products that Watsco sells in the supplies business — spare parts and accessories — are required in new constructions, but later in the cycle, when homebuilders put in the ductwork, the grills, the air conditioning, the furnace, etc. Exposure is limited there, too. For Barry Logan: “20% of the supplies business is linked to new constructions, but that’s only a guess.

Still, health of the construction industry isn’t inconsequential to HVAC/R distributors. “Business has obviously been suffering as new constructions went from 2 million units to 0.5 million units“, Barry Logan said at the Barclays Industrials Conference in 2013. Conversely, when new constructions increased by 6% in 2017, all HVAC/R distributors were applauding — as shown in their triumphant press releases at the time.

On average, single family homes weight for 28% of the North American HVAC/R market. This share is precisely what drives Watsco’s business. “I wouldn’t include multifamily, which is where a lot of the growth has been in recent months in housing“, Nahmad warned in 2013.

Though management is adamant about being judged against the right benchmark — the HVAC/R residential aftermarket growth rather than the new constructions index — the remarkable population growth in the Sun Belt — where Watsco concentrates its business — and the accompanying construction boom has undoubtedly contributed to lift its business over the last decades.

13. Right Place, Right Time — PASS

In the early 1990s, Watsco’s surge of growth took place against a troubled backdrop. The country was in recession and housing suffered a steep downswing in Florida and California. New building starts were down, and yet Watsco thrived by selling parts and distributing equipment to contractors for replacement jobs.

In fact, the period coincided with peak demand for air conditioning systems replacements in both states — which corroborates management’s claims that their business is primarily driven by replacements, bearing little correlation with new constructions.

Of course, temperature-wise, the states targeted by Watsco are the hottest in the country. Seasonality has a strong effect on HVAC/R sales, but less so in the Sun Belt where climate is either arid or tropical year-round. Per Barry Logan: “We’re not going to be driven by winter or how cold it is, how freezing temperatures are. It’s really how nice it is in our big Sun Belt markets.

The Sun Belt — which stretches across the Southern and Southwestern portions of the country from Florida to California — has been the most dynamic region of the U.S. in terms of population growth. In 2005, the Census Bureau projected that approximately 88% of the nation’s population growth between 2000 and 2030 would occur there.

California, Texas, and Florida were each expected to add more than twelve million people during that time, which would make them by far the most populous states in America. Nevada, Arizona, Florida, and Texas were expected to be the fastest-growing states.

These projections were based on spectacular demographic developments already set in motion. For instance, Nevada’s population increased by a whopping 216% between 1990 and 2008. Arizona saw a population increase of 177%, and Utah grew by 159%. Southern California followed suit. These uncommon growth rates have cooled off since 2008, but the Sun Belt remains the fastest growing part of the country nevertheless, with the oil boom in Texas now attracting newcomers.

A similar dynamic could be observed in Florida — Watsco’s core market, which still accounted for 25% of revenue in 2012 — where a massive influx of retirees in the 1970s and the 1980s led to a vibrant growth of new constructions, and later on to a massive replacement cycle.

All in all, there was no better place and no better time to sell HVAC/R equipment in the U.S. than the Sun Belt from the early 1990s onward.

14. Natural Disasters Driving New Business — PASS

Though it is certainly tendentious, this feature could not be omitted. In effect, the company got a surge of business in the wake of Hurricane Andrew — the storm that devastated southern Florida in August 1992, damaging or destroying 90,000 homes. Naturally, the rebuilding effort required tens of thousands of new air conditioners.

The 2017 Atlantic hurricane season had a similar impact. In his earnings call, Mr. Nahmad confessed that: “I hate to say that something positive has come from the storms, but it has.

15. DIY Not an Option — PASS

Watsco’s customers aren’t the end-users, but the HVAC/R contractors that go to the end-users’ houses to set the systems and equipments — the guy in a pick-up truck running around town fixing, replacing, servicing, maintaining air conditioning systems. “HVAC/R is one of the only things in the house that you cannot do by yourself. You need a contractor”, explains Barry Logan.

Manufacturers’ warranty terms generally require a proof that past maintenance and repair was performed by a licensed HVAC/R contractor in order to qualify for warranty service. In addition, doing the job properly the first time often eliminates the need for repeated visits, and ensures the system will run at peak performance.

Since heating and cooling accounts for over half the energy consumed in the typical American home — in commercial buildings, HVAC systems consume 40% of the total power consumption — an optimal installation is critical.

Finally, handling the wiring, electrical needs and gas heating systems of HVAC/R systems requires adequate training; duct design and ensuring that the system is leak-free represent additional challenges. In the worst case, improper work performed by untrained personnel could pose an ongoing risk of fire or deadly carbon monoxide poisoning.

This is why the Environmental Protection Agency (EPA) regulations require that technicians who maintain, service, repair, or dispose of equipment that could release ozone depleting refrigerants into the atmosphere be certified in proper refrigerant handling techniques.

16. Government Support — PASS

There is no greater opportunity for homeowners to conserve energy than to improve the efficiency of their HVAC/R systems. This is especially true for homeowners whose systems were installed more than ten years ago — in 2010, Watsco’s management estimated that number to be over 74 million households — because equipment this old would not meet current government mandates for efficiency and environmental standards.

Proper insulation for a home or a building can improve HVAC/R efficiencies by up to 30% on its own. In that respect, contractors have observed that energy efficiency programs have a strong impact on the residential HVAC/R market. The distributors’ networks — especially Watsco’s, which is the largest nationwide — thus stand out as highly strategic to promote efficiency and customer awareness (see notes 18 and 20).

According to Barry Logan, SEER14+ — the latest norm of environment-friendly coolers — already represents well over 50% of his company’s business. No doubt the move towards greater energy efficiency will remain central to the industry growth.

The housing crisis and its aftermath proved the point. Growth has been weak in 2011 and 2012, but 2010 turned out to be a good year thanks to a fortunately timed tax credit. Back then, Albert Nahmad admitted upfront that the industry was deeply impacted by government support: “We think there’s an enormous amount of pent-up demand because of that [tax credits]. And when that gate opens up…”

The supply business has likewise been stimulated by federal spending, “Because $5 billion just go a long way in helping people insulate their houses better and we are a prime distributor of insulation.” (In 2009, the White House announced the $5 billion Weatherization Assistance Program.)

Mandating higher energy efficiency benefits the consumers, the utilities, the construction industry and the likes of Watsco, among others. “So over time, the government is our champion” said Logan at the 2012 Goldman Sachs Industrials Conference. Thus far it has been a reliable safety net for the HVAC/R industry to be in the business of capturing higher prices by promoting energy efficiency. ” It’s what drives our sales mix”, Nahmad reckoned.

Will it last? Long term, efficiency standards are likely to be increased, which should lead to healthy margins and replacement rates.

17. Favorable Credit Environment — PASS

Watsco funds a large part of its 88,000 contractors’ working capital. In 2018, those contractors owed the company $500 million, or $5,700 per contractor, an amount lower than five years ago when it floated above $8,000 per contractor. According to Barry Logan: “We are the bank for that guy in the pickup truck that runs into your house and sells you HVAC/R equipment and supplies.

Management has been upbeat about the credit portfolio, describing it as “The healthiest we have seen in our history.” Underwriting usually poses little risk because a documented record is maintained on every contractor. “There are 90% replacement contractors that shop at our place five to ten times a day“, explains Logan. Offered terms are excellent — “Below Visa” — and lender protection optimal: “We can legally tie up houses, tie up closing statements, tie up through liens and so on.” Those collaterals weren’t used in the heyday, but “Things have changed.

Receivables carried on Watsco’s balance sheet have proved a safe asset over the years. Since contractors rely on Watsco’s subsidiaries to finance their daily operations, high borrowing discipline is a must. This results in very low write-offs, even during the troubled 2008-2012 period.

The credit environment is also extraordinarily good for the consumer, which benefits Watsco when households decide to invest in maintaining or upgrading their houses — and more specifically their HVAC/R systems. However, banks have historically been reluctant to finance such spending. Consumers can borrow to buy furniture — oftentimes with no upfront sum and no payments for two years — but couldn’t do so to buy HVAC/R systems.

In 2012, Watsco tried to partner with a bank to offer credit to these consumers — “Bringing the same home-financed backbone that Home Depot or other retailers use to close a large ticket sale” — but it’s unclear whether the program eventually hit the market.

18. Way Ahead of The Pack — PASS

In 1989, Watsco had zero revenue in the HVAC/R distribution industry. In 2018, it made about $4.5 billion, whereas Ferguson made $1.2bn and Johnstone Supply $2bn. In 2012, Barry Logan boasted that: “We are by three times the largest.” The gap has narrowed but remains spectacular nonetheless.

Across its footprint of 575 locations, Watsco serves approximately 300,000 contractors and technicians, completes over 7 million transactions a year and covers about 30 states. Ferguson serves all 50 states but out of its 1,459 locations, 141 are for HVAC/R only, 130 are for HVAC/R and other, and 1,188 are for non-HVAC/R. Johnstone Supply operates 410 locations in 4 states across the U.S. — a smaller footprint but a very concentrated, likely fortress-like network.

With 50 locations across six states, the fourth largest player — Russel Sigler, in which Watsco owns a 35% stake — lags far behind.These numbers show that Watsco’s network is by far the most extensive, and that it could gain much in concentration through the acquisitions of small regional players. As a lead analyst from Barclays Research once observed: “Watsco became that 800-pound gorilla in an industry where I’m not sure any of us could name a 100-pound gorilla they compete against.

Watsco’s business is a very local business. The HVAC/R contractor who runs around town to setup or repair systems typically covers a 50-miles radius. This is where the company’s culture of entrepreneurial empowerment shines, for it makes it possible to leverage what management describes as “the largest but also the densest network in terms of serving local markets”.

However, while Watsco has been an active consolidator in the past — acquiring up to 60 businesses since 1989 — M&A is less likely to be a major factor in the future, as there aren’t many needle-moving deals to be done.

The possible acquisition of Johnstone Supply or Ferguson’s HVAC/R arm would be a game-changer — if the regulator could authorize it. Conversely, a merger of its two challengers would pose a major threat to Watsco, for their cumulated enterprise would do $3.3bn in revenue and compete aggressively in the race to consolidate the industry.

19. Broadest Product Offering — PASS

Watsco’s $900mil inventory comprises more than 300,000 SKUs — vs. Johnstone’s 70,000-100,000 SKUs — from over 1,000 suppliers, in addition of the industry’s richest depository of product information with 700,000 SKUs — such database helps contractors to find adequate spare parts for less commonly used systems.

This asset enables the company to deliver a timely service to contractors who always need everything fast. As Nahmad is used to say: “Contractors live in their trucks, going job to job. They are the definition of time-is-money.”

20. Privileged Relationships With Manufacturers — PASS

In most cases, Watsco is the manufacturers’ largest customer. The company has a particularly strong relationship with Carrier: the three joint-ventures they run together account for about half of what Carrier sells to the North American residential HVAC/R market. Watsco has progressively bought his partner out, increasing its stakes in the two joint-ventures in the Northeast and the Sun Belt.

According to Nahmad: “We constantly were after them to let us buy down to 80%.” Getting additional ownership added earnings and cash flow, and over the long-term should provide more value for the technology investments (see one 27). In the third joint-venture, which addresses the Canadian market, Watsco is still at 60%. Nahmad confessed that: “It’s a little more difficult there because of the currency issues.” (See note 1.)

The company is eager to develop this kind of partnerships with manufacturers. A key advantage is that it bounds the latter with the distributor, in effect aligning both parties’ interests — a common theme in Nahmad’s management style. “When we represent a brand of equipment, our highest goal with that partner is to increase their market share. And we have a very, very good track record with that“, Nahmad said.

Watsco is also Daikin’s and Goodman’s largest independent distributor. With the industry shift towards ductless and VRF (variable flow refrigerant) technologies underway, and the American market still undeveloped in that regard, Watsco comes across as an ideal partner for manufacturers to build momentum. “For Asian players looking for partners in the United States, with our scale and our size, we’re very attractive.

These new technologies address a $1bn market as of now. But it should grow fast, and Watsco is gearing up for it. Over the years, along with higher energy efficiency standards, “It’s going to be huge for us.” Manufacturers think no less. All but one of them have announced strategic alliances to win this new market and mutually share the gains, in a bid to avoid what happened in Asia, where prices declined in spite of spectacular growth (see note 9).

21. Healthy Balance of Power — PASS

However, manufacturers could attempt to overstep distributors, and run a larger part of their distribution operations by themselves. Carlton Harwood, vice president of HVAC/R at Ferguson, warned that: “The distribution industry will face the challenge of competing directly with manufacturers.”

Distributors already have little to no role in negotiating sales of equipment to national accounts. This occurs at a higher level, directly between the customer and the manufacturer. Some equipment associated with these sales will flow through distributors, with the installing contractor working with the latter to obtain the ordered stock units. In these instances, distributors are held to the fixed, discounted prices, in effect losing their own volume advantage.

Watsco’s management downplayed this issue: “What these guys [the national accounts] do very cleverly, they negotiate with the manufacturers to get a better price. And then we, the distributors, participate in the program it creates — it creates a demand for us when the OEMs do that. For example, Carrier, Rheem or whatever else we represent, they will negotiate national contracts with national builder, then we will do the fulfillment.”

Such contracts, however, must be lower-margins than sales contracts independently registered by the distributor itself.

In general, the manner in which customers source equipment depends of their size. Smaller customers — such as households or small businesses — tend to work with contractors who obtain the equipment from distributors. In contrast, larger customers — such as homebuilders or retail chains — tend to deal directly with manufacturers, securing a discount by themselves.

The supply chain models are different in both instances. The wholesale distributor uses a hub and stoke model — where hardware goes to the warehouse, then to the branch where the contractor picks it up — that suits deliveries under 25 tons. Here, the distributor and the contractor are the main decision makers; this design-build model has a shorter cycle, no bidding process and fewer parties involved.

The sourced-from-manufacturer model applies to deliveries above 25 tons, typically for customized and complex equipment. It’s a slower process that involves more decision-makers — such as architects and building owners — and in which distributors play a limited role.

So why would manufacturers still need distributors when they can sell directly to the customer? In fact, they do rely on qualified intermediaries with local knowledge to promote their product lines. Furthermore, availability — often at moment’s notice — to assist with troubleshooting, fulfillment, and maintaining a well-supplied inventory of spare parts, stock units, and other complimentary products remains essential to close a sale.

To replicate and consolidate those capabilities would require huge investments that manufacturers are not inclined to undertake, in addition of bearing significant operational risks.

According to a HVAC/R industry analyst we’ve talked to, but who asked not to be named: “Speaking of those I know, Lennox, Trane and Daikin all have their company-owned distribution networks to keep independent distributors honest. They need local distributors but cannot completely hand them the keys if they want to preserve their pricing power.

22. Safety in Supplier Diversification — FAIL

Watsco’s purchases from their top ten suppliers comprised 84%, 84% and 85% of all purchases made over the last three years. By itself, Carrier accounted for 62% of all purchases. In that respect, a significant interruption or change of contract terms by Carrier or any of the other key suppliers could deal a serious blow to Watsco.

The two companies remain bound by their three joint-ventures, but Carrier’s diminishing stakes may reduce alignment of interests. Carrier will soon be spun-off from United Technologies. As a separate entity, the new enterprise will be more aggressive in pursuit of market share, whereas they were formerly constrained as part of United Technologies because they had to sustain a certain margin profile.

Does it mean that Carrier plans to invest in its own distribution capabilities? Or that it will be able to better focus on product innovation? Answer is unknown, but there’s no doubt that Watsco will monitor the situation closely, for its fortunes are directly conditional on Carrier’s goodwill.

23. Capital Advantage Over Other Operators — PASS

Not only does Watsco uses its financial strength competitively to offer the broadest product availability — a feature that cannot be replicated by smaller distributors with limited funds and infrastructure — but it is also better tooled to acquire dominant regional players, consolidating its footprint and domination. Management think they’re the only ones who have the financial means to afford the most attractive properties if they ever come on sale, and one of the few manufacturers will allow their distribution rights to be transferred to.

With a market share between 10% and 15%, Watsco’s declared priority is to keep expanding its network. But the company needs large transactions — in 2013, management indicated that they had “changed their thinking” regarding small acquisitions. The problem is that not many deals can actually move the needle (see note 18). In that respect, the recent acquisition of a 35% stake in Russell Sigler may pave the way for a real game-changing deal, in which the first and the fourth join forces to consolidate their leadership.

Watsco’s management believe that competition — chiefly represented by Johnstone Supply and Ferguson — has stayed passive on the acquisition front. They supposedly lack the available capital to go out and buy other operators — a claim we dispute, in particular regarding Ferguson’s excellent financial standing.

In contrast, “There is no transaction that is too big for us when it comes to distribution assets in our industry”, Nahmad said. “And I might add that we’re probably the only ones who can say that in the industry because of our scale today.” Like all successful distributors, the way Watsco competes is by building a high-density network of branches in good markets. According to Nahmad, “The fact that no one else does it on a scale comparable to us is our number one competitive advantage.

The company does greenfield development from time to time, but management’s preference has been always been to acquire branches that already had a strong customer base, and who could use an injection of capital to increase the product offering and customer service capabilities. In the end, the goal is to better support the HVAC/R contractor — enabling him to make more money — and thus earn his fidelity.

24. Not Reliant Upon Acquisitions to Outperform — FAIL

Over the past six years, growth of revenue matched growth of same store sales — averaging ~5% per year — which indicates that Watsco isn’t necessarily dependent upon acquisitions to grow, albeit it likely is dependent upon the latter to grow its market share. It is impossible to assess whether these results outmatched smaller distributors. What can be observed is that they’re similar with Ferguson’s, Carrier’s, and other publicly-listed industry participants’.

Management claims that growing with the market is not going to be good enough for Watsco to be able to meet its targets and long-term goals. “I wouldn’t be happy with a 3% growth rate”, Nahmad said. This is why they track their share continually, looking for accretive acquisitions Watsco’s network remains underdeveloped, in particular through the Upper Midwest and Northwest. For Nahmad: “We have a lot more opportunities. We’re years away from reaching our goal as far as what our market penetration is.

As discussed above, Watsco is a very strong player in the Sun Belt, but market growth has been more spectacular in the Midwest as of late, with double-digit rates that sometimes reached 25% to 30% up around Michigan and Illinois. Excellent sales were also recorded throughout the Northeast and New England.

The reason for this differential between the Sun Belt and the northern parts of the country is the lower equipment rate in the latter, as it typically is a luxury for households to acquire an air conditioning system where the climate is cooler. Because its distribution network is much less dense in the north than in the south, Watsco will need to complete a series of acquisitions to fulfill its ambitious growth objectives.

Mystery still surrounds the export business and its potential impact on growth. With hot climate, population of over 110 million and the 11th largest economy in the world, Mexico represents a substantial opportunity. The strong brand equity of Carrier coupled with Watsco’s commitment to increase its market footprint and add additional non-equipment products could lead to above average organic growth, even if results have been disappointing thus far.

In short, per management’s admission, the HVAC/R industry has never evolved at a rapid pace. Through an astute mix of organic and external growth, Watsco delivered above average results nevertheless. But this performance has reached a plateau as of late. Barring a major acquisition, or success in Mexico, outmatching the industry should prove challenging from now on.

25. Highly Fragmented Industry to Consolidate — PASS

Fortunately, there is still significant runway for additional growth. With almost 600 stores in the U.S., Watsco covers about 30 states, so it isn’t a national company entirely yet. Management “passionately believes” that the company is still very much a work-in-process given its moderate share of the $35-$40bn North American market.

A lot of established and respected family businesses exist in the HVAC/R distribution industry, many of which were founded decades ago. They have been dominating their local markets for a while. In a similar fashion with Berkshire Hathaway, management thinks that it would be very gratifying for their owners to associate with Watsco and sustain their legacy.

Opportunities are abundant, with over 1,300 companies engaged in the HVAC/R distribution business. Of those, only three — or possibly four or five — have gone beyond the $1bn revenue mark.

[…] See .pdf report for complete figures.

Watsco has a 10%-15% market share, Johnstone Supply 5%, Ferguson 3%-4%. Its scale remains unrivaled. The recent acquisition of Peirce-Phelps — ranked 15th out of 1,300 distributors — will add $206mil to Watsco’s top line. A longstanding player in the industry, Philadelphia-based Peirce-Phelps will add a dense network in Pennsylvania, New Jersey and Delaware to Watsco’s existing infrastructure. The company was founded in 1926 and has been Carrier’s sole distributor in these states.

26. Natural Acquirer — PASS

Steady growth, good profit margins and recurring labor shortage — which creates its own issues but leaves practicing professionals with plenty of work — have turned the HVAC/R business into a very healthy industry for distributors and contractors alike. Owners don’t sell because of their anticipations on the economy, but because “something has happened to their personal needs”, Barry Logan explains. “Most of the brands in North America were established by family businesses over the last 110 years — since Willis Carrier invented this stuff [air conditioning]. Over that time, generations of families have owned businesses and reached crossroads. And that has been a big source of growth for us.”

I wish it was about money”, Albert Nahmad lamented. “But it’s usually not. It really is an emotional process, and having the right timing in dealing with a family.” The Peirce-Phelps business, for instance, is led by four Peirce brothers, who are themselves third-generation owners.

Family ownership often makes negotiation arduous, especially in challenged markets such as those experienced over the 2008-2012 period. Of course, Watsco’s management would be keen to deploy capital in such times. In theory, “Any kind of slowing economy gives us the opportunity to have our partners come to us and work with us to grow the market” Nahmad said. In practice, a family business making 30% or 40% less EBIT during a downswing would be worth 30% or 40% less, leaving owners reluctant to sell. “So it’s really more complicated than getting something done at the right multiple where there’s emotion — there’s family emotion.

These challenges notwithstanding, Watsco will continue to stand out as the go-to buyer thanks to their unparalleled scale and solid reputation — earned because of the way they responsibly handle the organizations they acquire post-transaction. “Our reputation among people that own businesses is very high”, Nahmad said. “I don’t think the economy, or what’s going on with interest rates, or anything affects us. It’s just people sentiment about what is the right time to sell.

Watsco prides itself for not disrupting great companies — quite the opposite. “We’re not cost cutters. We’re not going to flip anything in five years. None of that exists in our culture. And we’re very respectful of the people that sell us, or have joint venture with us.

Meanwhile, Watsco’s advanced technology capabilities (see note 27) should also be a continuing attraction for owners looking for a constructive exit. Smaller distributors see their industry going digital at full speed and understand it might be a good idea to benefit from Watsco’s unmatched investments in technology.

Those ring large with Nahmad’s commitment to “buy and build”, in effect not cutting cost, but propelling smaller players towards new avenues for growth. Watsco offers successful owners — like the Peirce Brothers — the most complete spectrum of technology tools to modernize their business and hit the next level. In some cases, this could act as a very strong incentive to sell.

Another neat advantage helping Watsco in its quest to consolidate the industry would be the structural unbalance between the number of buyers and the number of sellers. For any organization above $100mil in revenue, only a handful of buyers would qualify — among which Watsco ranks first.

27. Technology Edge — PASS

Watsco began investing in technology in the early 2000s, introducing an online service providing contractors 24-hours access to its distribution network. The company’s longstanding tradition in innovation is well alive and kicking, and its goal to be “the biggest and the best” in the digital economy backed by a spending run rate of about $20- $25 million per year. According to Nahmad, who mandated his son Aaron (see note 3) to oversee the transformation, “That is more money than anybody we compete with.

Interviewed by William Blair’s M&A consultants in September 2018, Watsco’s management team went as far as saying that there were first and foremost “a technology company that happens to sell HVAC/R systems.” Although a bit extravagant, this comment shows that there is no resting on laurels — management has been early in transforming its business into a modern, data-based powerhouse designed to perform in the digital era. “Right now, no one else is really doing it”, Logan claimed as early as 2012. “I think it will have a huge impact on the company going forward. We’re very comfortable with what we’re doing.

In short, the app technology enabled Watsco to bring its inventory database to the contractor’s mobile when he needs it the most — that is, when he’s working in the end-user’s backyard, or at his kitchen table. What separated Watsco’s management from their peers has been their early grasp that contractors were all using their mobiles as business organizers — something that sounds obvious today, but wasn’t so a decade ago.

Apps have been enriched with further business intelligence and e-commerce features since then. Management’s thesis is that being the easiest company for those contractors to work with is a critical determinant to earn their business; hence their goal is for contractors to enjoy a one-of-a-kind shopping experience with Watsco. For Aaron Nahmad, “In the next five years, there’s going to be the haves and the haves-not. And the differentiator is going to be technology. That’s going to be true at the distributor’s level and at the contractor’s level.

True to the contractors’ “time-is-money” motto, Watsco has developed an app that gives contractors better and faster access to information about spare parts, in-stock status and warranties, among other features, allowing them to better plan their work, cut out paperwork and — in plain words — make more money.

Technology investments also encompass order fulfillment functionalities and supply chain optimizations for the 300,000 SKUs (stock keeping units) available on-line. For instance, Watsco has implemented an integrated inventory management system that should allow it to reduce inventories by about 20%, saving around $150 million in working capital yearly (see note 29). All these investments are rooted in the belief that speed, productivity and efficiency will be ever more critical.

Another benefit of these technologies is the business intelligence capabilities they enable. Those give management valuable insights into their subsidiaries’ book of business, and into patterns of their customers’ purchasing behavior, opening new opportunities for sales. According to Aaron Nahmad, “There are several thousand people using business intelligence across the enterprise now. We’re able to measure how frequently each employee uses the tool. So we’re able to look at those that use it often. They are outperforming their peers who are using it less to the magnitude of 7x [inventory?] turns.”

Watsco is also stepping up its innovation capabilities under the Watsco Ventures’ umbrella. It recently acquired Alert Labs, with makes connected sensors aimed at protecting homes and businesses from “damage and unnecessary expenses”, for instance by monitoring indoor energy efficiency. Other projects include project management, billing or accounting tools, all designed to earn the contractor’s fidelity.

28. Excellent Financial Standing — PASS

We are risk averse, and therefore debt averse”, Nahmad repeats in almost every earnings call with analysts. “We are very conservative in terms of our balance sheet. Always have been, always will be.

In effect, his company defends a fortress balance sheet — total liabilities are covered twice by working capital alone — and has always maintained very low leverage ratios — typically less than x1 EBITDA (see Selected Financials below). Even in the early days, when they had to took on some leverage to expand, management never went beyond a net debt level higher than x2.5 EBITDA.

Given the scale it reached and the size of its acquisitions, Watsco would easily be able to fund growth out of its own cash-flows — at the expense of the dividend though. But if it had to take on some debt to finance a major deal in the near future, it would likely benefit from an extremely low cost of capital, as it happened in 2012 and 2018.

Another peculiarity of Nahmad’s management style is how he always eschewed share buybacks. “As I said, we’re not in the business of buying back shares because we want the capital to do transactions and to fund technology, and technology may escalate depending on what happens to the Watsco Ventures.

R&D projects may require a lot of investments and management intends to stand ready for those. “We’re a very stable business with a very strong balance sheet. I wouldn’t get too upset about fluctuations in one number or another. We know that we what we do [investing-wise] is very necessary.”

Another testimony of Nahmad’s financial prudence — and value investing bent — has been his anticipation of higher interest rates. The latter has yet to realize, but better being too early than caught short after all. In 2016, he declared that: “I believe higher interest rates eventually will come up. That’s why you see us retiring debt.

The next year, management very astutely raised equity capital, selling 1.5mil new shares for net proceeds of $248mil, or $165 per share — exactly the price level where it is currently trading at. The proceeds were largely used to repay outstanding debt.

This offering sheds light on management’s outlook about Watsco’s fair value. 2017 was a good year for the company, the industry and the capital markets in general. In that respect, notwithstanding the quality of the business and the people involved, $165 per share might be a little too rich for a risk-averse, margin of safety-focused value investor contemplating to acquire shares in Watsco.

However, as shown in the Selected Financials below, since 2007 shares have more or less always traded at about x25 earnings — also where they’re priced at today.

29. Efficient Management of Working Capital — FAIL

Previously, Watsco’s purchasing department was tasked to make procurement decisions largely based on experience and intuition. Now, as a result of the investments undertaken in technology, these processes revolve around “world-class” software that employs predictive analytics, in order to optimize inventory and simplify decision-making.

We have a piece of software that brings real math and science and algorithms and predictive analytics to how much of what items we should buy, so we have the right amount at the right place at the right time“, Nahmad claims. While it didn’t necessarily take slower markets for management to produce working capital gains in the past, things have changed since 2011, with revenue growth consuming large amounts of cash. This is particularly true in 2018, with record net investments in inventories and receivables.

Watsco’s ability to free up some cash thanks to technology improvements thus remains unproven, albeit it is true that management sometimes stocks bestsellers in advance to secure good discounts, in effect using their superior balance sheet capabilities to secure market share.

We’re going to become better inventory managers”, Nahmad promised in 2015. Historically, Watsco turned its inventory four times per year, with a peak near five times in 2014. “Our focus will be to continue to increase the multiples, the inventory turns which will thereby increase the cash flow.

Management argues that turning it five times per year would unlock $150mil in free cash-flow. It did not in 2014. In 2017 and 2018, the average is back to four times per year — so their ability to execute on these working capital improvements remains unproven as well.

30. Astute Capital Allocation — PASS

Albert Nahmad repeats that his priority is to invest in the business and grow the network, because a dense geographical grip feeds Watsco’s competitive advantage. However, over the 2007-2018 period, capital allocation has been primarily oriented towards distributions ($1.2bn), with acquisitions ($0.5bn) being funded by the issuance of debt and equity.

Of note: in a bold — but shrewd — call on the recovery, management issued $316mil of debt in 2012 to fund an exceptional dividend of $258mil.

[…] See .pdf report for complete figures.

Actual change of cash was actually positive once added the various non-cash items we have excluded from our free cash-flow calculations, such as provisions, deferred tax provisions, share-based compensation and contributions to 401(k) plans — which may be non-cash but remain actual expenses.

Under the leadership of Mr. Nahmad, Watsco’s annual total shareholder returns — the measurement of stock appreciation, including the reinvestment of dividends— on a compounded basis were 18.2%, vs 9.1% for the SP500. So there’s no doubt that is playbook is well thought out.

Some comments worth of interest by Mr. Nahmad on share buybacks: “Share repurchases, we’re not big fans of. […] We don’t believe in buying back shares to improve earnings per share. We believe that we should have a balance sheet to do whatever comes along, not only in the acquisitions field but also in technology.” On paying a growing dividend: “And we’re a pretty conservative company, so we know we want to pay a dividend, but we just don’t know or even can start to imagine at what rate. We do want to continue being a dividend-paying company. […] We intend and hope that we can increase dividends every year.

The ever-growing dividend has undoubtedly been a major factor of the continuing stock price appreciation, in particular against a backdrop of low interest rates. But growing distributions wouldn’t have been possible without equally growing earnings. This is where management’s talent comes to light — in reinvesting cash from operations and borrowed/issued capital at a good rate of return.

[…] See .pdf report for complete figures.

31. Opportunist Mindset in M&A — PASS

Nahmad’s value-oriented playbook was evidenced even before his foray into the HVAC/R distribution business — in 1982, when Watsco was still a diversified conglomerate, he acquired an 8.5% stake in a Florida bank for $3mil, which he sold two years later for $8.5mil. Later on, Nahmad pivoted into distribution by purchasing the Gemaire distributorship during an auction. He was the only bidder.

The mindset hasn’t changed for the next 60 acquisitions realized over the company’s history. Management regards bad times as providers of opportunities, for instance when competitors end up in trouble and become willing to sell. However, as of now, that doesn’t happen often — corroborating Nahmad’s comments about the “healthy market for distributors and contractors alike” and the “emotional process, rather than money-driven.” (See note 26). It should be noted that Watsco shied away from acquisitions in 2008 and 2009, akin Ferguson, so the “buy-when-blood-flows-in-the-street” may be easier said than done.

In 2012, as the industry just started to recover, Watsco invested $174mil investment in a Canadian joint-venture with Carrier for a 60% controlling interest. Bottom line of the Canadian venture is unknown, but total sales amounted to ~$400mil. The valuation multiple paid by Watsco was thus ~x0.7 revenue. In 2017, the 35% non- controlling interest in Russell Sigler — which sports a top line of ~$650mil — was acquired for $64mil, or ~x0.3 revenue.

According to Adam D. Wyden, principal at ADW Capital Management and a keen Watsco follower, in the early days Nahmad used to purchase assets at 4x-6x EBITDA. As of now, Watsco shares trade at x1.3 revenue and x15 EBITDA.

32. Operating Leverage — FAIL

Management claims that about two-thirds of the costs are fixed, so that, in theory, any sales growth and gross profit expansion would be very productive to earnings growth. In practice, over the past decade operating margins have expanded in sync with revenue — so the advertised operating leverage is everything but obvious. Some of the fixed costs were reduced over the last several years to accommodate the technology spending (see note 8).

On the variable costs side, regional managers have “done a good job at branch closing and reducing freight costs in the face of the market”, certainly safeguarding the consolidated margin profile. According to management, “the ability to quickly match expenses to market conditions has become a way of doing business at Watsco.”

While this may be true, difficult market conditions have yet to materialize and put such claims on trial.

APPENDIX. Selected Financials

[…] See .pdf report for complete figures.

©2019. All rights reserved.