Searching for Wonderful Businesses: Watsco
Warren Buffett seeks out wonderful businesses – either through purchasing shares of their common stock in these companies, or an outright acquisition. These businesses fall under two broad categories: the Consumer Monopoly or a Toll Bridge. A consumer monopoly is a dominant brand known in the marketplace, and is often synonymous with the product itself – including WD-40 or Kleenex. Toll bridge businesses require consumers to use the services or products of a business to get where they are going; hence paying the metaphorical toll. These toll bridges come in many forms. In order to issue bonds, investment banks need to obtain a rating from a bond rating agency. If you buy a house with a mortgage, you need title insurance. If you need to ship something quickly, you need to use Fedex (FDX) or UPS (UPS). To sell a valuable collectible coin, you need a PCGS certification.
Attractive competitive moats and consumer monopolies are only part of the story. Many of these wonderful businesses have highly motivated management, consisting of founders or their descendants, generate substantial amounts of free cash flow with very little or any debt relative to their peers, and gradually grow through bolt-on acquisitions. They also have vision, and to this end are unconcerned with quarterly or even yearly results and laser focused on long term performance.
In the public markets, Warren Buffett has often invested in companies that have iron-clad competitive moats – either through a consumer monopoly or toll bridge characteristics… or both. Buffett has also said that he will only make a substantial commitment when he knows “who is going to win.” Companies that Buffett knew were going to win were Gillette, Wrigley Chewing Gum and Coca-Cola (KO). The industry fundamentals of these companies were known, unchanging and attractive and their competitive positions in these industries were dominant.
One business in the public sphere that I firmly believe is going to win (and is now becoming attractively priced) is Watsco (NYSE:WSO), a distributor of HVAC and Refrigeration products. Though it may not be a household name, Watsco operates in an attractive industry and enjoys an already dominant competitive position. Under the stewardship of the Nahmad family, Watsco has also succeeded mightily – over the past three decades shareholders have enjoyed a thirty year annualized total return of 21%.
In addition to strong management, a corporate culture of excellence and operating in a business that remains ripe for consolidation; Watsco is also equipped to navigate an inflationary environment and exhibits a decentralized management structure that makes it dynamic and highly responsive to changes in the business landscape. The company also constantly innovates, and has made substantial investments in technology over recent years to expand its competitive moat. All these factors make this business attractive for long term investors.
What Watsco Does
Watsco (WSO) is the largest distributor of HVAC and Refrigeration products in the United States in addition to operating in Canada and Latin America and is headquartered in Coconut Grove, Florida. Founded in 1947 as the Wagner Tool & Supply Corporation, the real story of Watsco begins when the company’s majority shareholder and operator Albert H. Nahmad became the chairman, president and CEO of the company in 1972. In 1989 the company acquired 80% of Gemaire and refocused its business activities on distribution. Within a decade, Watsco would shed its legacy manufacturing business and focus entirely on HVAC and Refrigeration distribution. Watsco purchases large quantities of HVAC and Refrigeration units and parts from manufacturers and sells them to contractors
The company currently operates under a decentralized structure, with over 670 locations under numerous brand names including Gemaire Distributors, the Baker Distributing Company, N&S Supply and East Coast Metal Distributors. The company’s primary focus is HVAC, with only a minority of its business focused on Refrigeration. Watsco provides parts as well as entire systems and serves both residential and commercial customers.
Though a giant in the industry, the company is not a household name – this is because their primary customers are contractors and technicians who provide repair and installation services to the end consumer. Though operating far afield from the attention of most consumers, Watsco certainly has not escaped the attention of attentive long term investors due to its exceptional operating results year after year: Since focusing on distribution in 1989, Watsco’s share price has increased from $2.70 per share to $252.52 per share as of the time of this article’s writing.
The Numbers on Watsco
As of the time of this article’s writing, Watsco is currently priced at $252.52 per share. The company has a current P/E ratio of 20.29 and a forward P/E ratio of 17.63. With a market capitalization of $9.6 billion, the company is on the higher end of the mid-cap size range. Watsco typically operates with no or low debt, and currently has a debt to equity ratio of 0.21, a current ratio of 2.8 and a quick ratio of 1.1. The company also pays a steadily growing dividend, currently standing at $8.80 per share, or an annual yield of approximately 3.6%. With a book value of $48.81 it currently trades slightly under five times book value, a significant – though not undeserved – premium. The company’s earnings per share have also grown at a compounded annual rate of 19% over the past five years.
Watsco is organized under a dual class share structure, WSO and WSO.B, with control of the business resting with the Nahmad family. In addition to the CEO, Albert Nahmad, the second generation of the Nahmad family is actively involved in managing the business and contributing to the future of Watsco.
Watsco primarily operates in the Residential HVAC market, accounting for 65-70% of the company’s revenues. The remainder of the company’s revenues, 15-20% come from commercial customers as well as new housing construction, accounting for approximately 10-15%. From the perspective of geography, 90% of Watsco’s revenues are generated in the United States, with 6% in Canada and 4% in Latin America.
Attractive Industry Fundamentals
HVAC, particularly residential air conditioning, is an intrinsically attractive industry within which to operate. HVAC units are often difficult to maintain and if the air conditioning in a residential dwelling malfunctions, the HVAC repairman will likely be called quickly – particularly during the summer months. Refrigeration is also an essential business, particularly for businesses with perishable goods including food or pharmaceuticals that are sensitive to temperature.
Headquartered in Florida, the bulk of Watsco’s locations are located on the Eastern portion of the United States as well as the Southeast and Southwest – though the company has a national presence, particularly in areas where the climate is often hot. Air conditioning is essential for the population in these regions, particularly in Florida. There is currently a large and growing installed base of air-conditioning units in the United States and a significant impetus for modernization and replacement of this installed base, which are two long term tailwinds for Watsco’s business. In forty years, air conditioning has also transformed from a relative luxury to almost a necessity, with the installed base of Central AC units in residences increasing from approximately 20 million to over 80 million, per page 8 of the company’s most recent investor presentation.
Due to the effects of global climate change, air conditioning is more important than ever. In addition to ordinary wear and tear on this large installed base of AC units and rising temperatures, recent government energy efficiency requirements imposed on HVAC units represent a significant driver of replacement for this installed base. As energy inefficient legacy models are phased out, newer models will be required to replace these units.
The more parts and units that are needed for HVAC, the more that will be distributed and Watsco realizes more profit.
Buying and Building: Acquisitions and Joint Ventures
Watsco is currently the largest distributor of HVAC/R in the United States, with the company estimating it controls 12-15% of this highly fragmented and largely private market. Because of this degree of market fragmentation, the HVAC distribution market in the United States is also ideally given to consolidation. It consists of numerous family owned businesses and as these families grow and either seek to pass their businesses on or realize liquidity, ownership often becomes more fragmented – allowing Watsco to step in. Watsco has engaged in over sixty acquisitions since focusing on distribution in 1989, and has a long path ahead of it in its core market of the United States. These acquisitions have varied in size, and are either “Bolt-On” in nature, incrementally increasing overall profitability or strategic and intended to enter new sales territories – or both.
What is particularly notable about these acquisitions is the fact that Watsco does not attempt to heavily alter the corporate culture or strategy of the businesses it has acquired, and instead relies upon the capability of the in-place operators who retain a superior understanding of the dynamics of their home markets. In a similar manner to Berkshire Hathaway, Watsco’s decentralized operating structure makes the company highly responsive to changes in the marketplace and provides the company’s leadership with the opportunity to focus on larger strategic initiatives.
Watsco is perfectly situated as a natural acquirer in this space. The company provides owners with the opportunity to significantly grow their business through economies of scale and more sophisticated operating infrastructure. Watsco is also in no hurry to acquire these businesses, and will typically gradually purchase equity over a period of many years. A major hurdle is the 80% ownership threshold, at which point additional benefits regarding the tax treatment of profits are realized.
Apart from independent distributors, Watsco has also engaged in large Joint-Venture transactions with HVAC manufacturers. Though infrequent, these types of transactions can provide substantial benefit to both parties involved. One notable transaction of this nature has been with the Carrier Corporation (CARR), one of the largest producers of HVAC equipment in the world. Watsco began this relationship in with Carrier in 2009, with Carrier contributing 95 distribution locations while Watsco contributed cash, stock and 15 locations to this joint venture. Initially this joint venture was 60% owned by Watsco and 40% by Carrier, however Watsco has gradually exercised options to increase their equity ownership over the years and now currently has 80% ownership of this joint venture.
Employees Are Owners: Effective and Unique Equity Compensation Structure
To this investor, one of the most compelling features of Watsco is the company’s unique employee compensation structure that encourages broad based ownership and long term thinking among employees. In contrast to many other large publicly traded companies, at Watsco a large portion of employee wealth is derived from the appreciation of Watsco shares that are granted as compensation rather than high cash salaries and cash bonuses. These shares only vest at retirement age – turning employees into long term owners that are laser focused on growing their business and constantly identifying efficiencies in the company through the course of their career. Watsco also often issues shares when they acquire a new distribution business, ensuring an alignment of incentives between Watsco and the management of the businesses that they acquire. This compensation structure has firmly aligned incentives with public shareholders, to great effect over the years.
A Growing Moat: Technology Innovation
One of Watsco’s greatest strengths in recent years has been the emergence of its long term strategic investment in developing a technology platform. Watsco has digitized over 960,000 HVAC/R SKU’s and is now the single largest digital source of HVAC product information in the United States. The development of this eCommerce platform has been occurring over the course of many years and has required significant capital investment. In spite of drawing skepticism from Wall Street analysts, this long term initiative is now beginning to show extremely satisfactory results even in these early phases of its rollout, with this platform leading to higher line item orders and less customer attrition.
Watsco’s technology platform enables an HVAC technician or contractor in the field to use a smartphone to order parts or units quickly and have their order ready to be picked up from a nearby Watsco distribution warehouse. Engaging with this technology platform improves efficiency and increases sales for contractors in the field, making their business significantly more profitable. Easy to use on a mobile device, the management of Watsco’s articulated goal regarding the development of this platform has been to enable technicians to “go from doing two jobs a day to three” – though this may not sound like much, if fully realized this translates to an increase of 50% – potentially a massive win for both HVAC contractors using this platform and of course Watsco itself.
This platform is also something that provides immediate value to any privately owned HVAC distribution business that seeks to partner or sell a minority (or majority) stake to Watsco, as they gain access to this platform and can better drive sales in their own territory.
Watsco also benefits from access to and ownership of the data that is generated from activity on their technology platform, enabling the company to make strategic capital allocation decisions that can generate substantial savings or higher profits. One area of efficiency that the management has discussed is the potential for the further optimization of the real estate footprint of the company’s distribution facilities as a result of data driven inventory and location management. Watsco’s distribution facilities are leased rather than owned and the leases are staggered, with approximately 20% of the total location footprint running off every year, allowing the company to optimize this expense item in response to growth through acquisitions, consolidation, or increased inventory turns on an annual basis.
Though Watsco has survived and thrived over the past several decades, investment in the company is not without risks.
Cyclicality is something that is important to consider. Though Watsco does not derive a large amount of its revenues from homebuilding, it will nevertheless be sensitive to a decline in the broader housing market that may arise as a result of higher interest rates and higher prevailing prices for homes.
The question of valuation is also something important to consider. Watsco is a demonstrably high quality business and therefore its shares will typically command a significant premium in the marketplace. At current valuations, I believe that Watsco represents an attractive investment, particularly from a Price to Earnings perspective – however I also believe that is important for investors to gradually acquire shares over a long period of time, particularly given the nature of the prevailing broader market conditions.
A broad supply chain disruption is also something that could impair the ability of Watsco to operate at its fullest level. Supply chain issues with manufacturers such as Carrier, which Watsco enjoys a deep relationship with, could also create a significant issue for Watsco if the company is unable to maintain appropriate inventory levels.
Revenue concentration risk is also important to consider. In 2021, Carrier accounted for approximately 56% of Watsco’s distribution revenue, per page 8 of the company’s 2021 Annual Report. Conversely, Carrier being recently spun off from United Technologies can potentially expand and deepen the already significant relationship, as Carrier will be able to focus more significantly on its core strengths and potentially grow even larger as a standalone corporate entity. Because Watsco owns much of Carrier’s distribution, the more Carrier grows the more Watsco grows by proxy.
Inflation is also something important to consider. Watsco is able to purchase significant quantities of inventory in bulk at attractive prices at the beginning of a business year and gradually raise prices for its customers over the course of the year in order to combat inflationary pressure. However, it is important to realize that customer demand could eventually be significantly impacted as a result of higher prices and end-consumer behaviors could change, causing repairs or replacement to be deferred which would cause inventories to remain on shelves.
Conclusions: A Wonderful Business at a Fair Price
I believe Watsco is a wonderful business. The company has a strong culture of owner operators, a track record of profitable acquisitions intelligently conducted over a long period and operates in an essential though still highly fragmented industry that it is in the process of methodically consolidating. For investors that are interested in obtaining a growing source of cash income, I believe that Watsco is also particularly attractive. In contrast to many other superior businesses, Watsco pays a substantial dividend that has been significantly increased over the years. Though subject to some degree of cyclical pressure and often richly priced in the marketplace due to its manifest quality, I believe that Watsco is well situated to enjoy long term growth in scale and profitability for the next several decades and therefore merits a permanent place on any long term investor’s watchlist as this is an ideal business for permanent holding. Simply stated: I believe Watsco is going to win.