Overview
My recommendation for Watsco, Inc. (NYSE:WSO) is a hold rating, as my target price is currently at WSO’s traded share price. WSO has reported strong performance in its recent quarter, even when it is facing tough comparisons to the previous year. This growth is driven by a combination of factors: expanding market share, strong sales in segments like heat pumps, and a commitment to technological innovation that enhances the customer experience. Their commercial sector continues to thrive, with sales of ductless systems highlighting the evolving demands in the HVAC market. Despite facing supply chain disruptions, WSO has shown resilience, with recovery evident by the third quarter. Strategic acquisitions, such as those of Gateway Supply, further emphasize WSO’s growth trajectory. However, when benchmarked against industry peers, WSO’s financial metrics still have room for improvement.
Business
WSO specializes in distributing air conditioning, heating, and refrigeration systems, along with their corresponding parts and accessories. Their offerings include residential air conditioners with and without ducts and various types of furnaces like gas, electric, and oil. They also supply commercial HVAC systems and other distinct equipment.
From 2018 to 2020, WSO consistently reported a modest yet stable revenue growth rate of approximately 5%. However, in 2021 and 2022, the company experienced a surge in growth, reporting rates of 24% and 16%, respectively. This significant uptick was primarily driven by price increases that WSO implemented in response to inflationary pressures, leading to increased revenue. Additionally, supply chain disruptions played a role. I perceive these factors as temporary drivers of revenue growth. Once inflationary concerns and supply chain disruptions subside, I anticipate that prices will return to more normalized levels.
Recent results & updates
For the most recent third quarter of 2023, WSO reported impressive results, especially when compared to their strong third quarter result of the prior year, which was referred to by management as exceptionally strong. For the third quarter, the company reported EPS of $4.35, an 8% year-over-year growth. WSO’s reported revenue of $2.13 billion, a 4% year-over-year growth. Despite third quarter 2022 being a tough comparison period, WSO reported growth for both its top and bottom lines.
WSO’s commercial business is continuing to show robust growth, reporting a healthy double-digit rate increase during the quarter. The company is also maintaining a backlog of projects that is extending into the following year, indicating sustained demand. Sales of ductless systems, which are becoming an increasingly important component of WSO’s business, were also growing at a double-digit rate during the quarter. This growth is underscoring the rising demand for ductless solutions in the HVAC market. The company is observing a trend where gas furnaces are transitioning towards heat pumps. Notably, heat pumps generally have higher average selling prices, which could be positively impacting revenue. WSO’s non-equipment business is experiencing mixed performance. While there is a 6% growth in HVAC equipment, there is a 4% decline in other HVAC products. This decline is being attributed to deflation in commodities such as refrigerant, copper tubing, and sheet metal products. However, the pricing of these commodities is showing improvement as the quarter progresses.
In the previous few quarters, WSO was experiencing disruptions in its supply chain, a challenge that many businesses are facing. However, by the third quarter, the impact of these disruptions will diminish. The company is reporting that its locations are becoming fully stocked, indicating a recovery in its supply chain operations. In addition, WSO’s original equipment manufacturer partners are making significant improvements in their supply chains to help WSO meet the needs of their customers. This collaborative effort is ensuring that customer demands are being met despite the disruptions. However, this supply chain disruption recovery as well as OEM support is expected to normalize price as supply will no longer face constraints moving forward.
WSO emphasized that M&A remains a significant contributor to their growth strategy. During the third quarter, they made a notable acquisition by bringing Gateway Supply, a family business based in South Carolina, into the WSO family. Gateway Supply is described as a legendary company in its Sunbelt markets. This acquisition provides WSO with the opportunity to partner with Gateway’s leadership to grow beyond their current $180 million sales run-rate. Furthermore, WSO expressed its commitment to partnering with more entrepreneurs and businesses. They highlighted that WSO is an excellent home for entrepreneurs in the HVAC space. The company is known for sustaining the culture of the businesses it acquires, investing in its people, and providing technology to secure and build upon the legacies of these businesses.
Valuation and risk
According to my model, WSO’s target price is $347.30, which matches its current trading share price. This target price is based on my growth forecast of low single-digit growth for both FY23 and FY24, aligning with its 2018 to 2020 growth rate. This is due to a challenging comparison with FY22, which management cited as an exceptionally strong year, driven by the recovery from the COVID pandemic. Despite these tough comparisons, WSO is still expected to grow, but at a low single-digit rate, which is in line with market consensus.
This assumption is influenced by several factors: Firstly, WSO had an impressive quarter where it reported strong year-over-year growth in both its top and bottom lines, driven by robust growth in its commercial business. This growth is supported by a backlog of projects that extends into the following year, indicating sustained demand for FY24. Secondly, the headwinds from WSO’s supply chain disruptions have subsided, which is expected to continue driving revenue growth since there are ample goods available for sale. This aligns well with the sustained demand WSO anticipates. With the potential for increased profits, WSO will have the financial resources to further their M&A initiatives, which they have emphasized as a significant contributor to their growth strategy. Their recent acquisition of Gateway Supply underscores their commitment to pursuing more M&A activities.
Author’s valuation model
Currently, WSO’s forward P/E is trading at 23.59x, which is below its peers, such as Fastenal Company (FAST), which has a P/E of 27.32x. This comparatively lower multiple can be linked to WSO’s lower margins relative to its competitors. Specifically, WSO has a net margin of 8.2%, which is almost half of its peer’s margin of 15.5%. Additionally, WSO’s projected growth rate for the next 12 months (Y2/Y1) is 5%, which is less than FAST’s 8%. Given these factors, WSO’s lower forward P/E seems justified, and I don’t anticipate any expansion in its forward P/E, especially when considering its weaker financial metrics compared to FAST. Based on WSO’s current forward P/E, my target price suggests no return potential. Therefore, I recommend a hold position on WSO until it can enhance its financial performance metrics relative to industry peers.
Author’s valuation model
Risk
The downside risk to my hold rating includes, but is not limited to, the following scenarios: Should WSO’s performance in the upcoming quarter surpass the market’s consensus, which currently anticipates a low single-digit growth rate due to a tough 2022 comparison and a lack of management guidance, this could be due to successful M&A activities or because the anticipated demand proves to be stronger and more sustained than what management has projected. If this happens, WSO’s share price might appreciate as its projected growth rate for the next 12 months (Y2/Y1) approaches that of its peers.
Summary
In conclusion, WSO has showcased a commendable performance this quarter, demonstrating resilience and growth even when compared against a strong prior-year quarter. Key drivers include consistent market share expansion, robust sales in specific segments, and a commitment to innovation. Their commercial business remains a growth engine with the rising demand for ductless solutions and the transition from gas furnaces to heat pumps. While there are challenges in the non-equipment segment, there’s optimism as commodity prices stabilize. Supply chain disruptions, a prevalent issue, are being mitigated through collaborative efforts with their OEM partners. Strategically, WSO’s M&A activities, like the acquisition of Gateway Supply, underscore their growth ambitions. However, when analyzing WSO’s valuation metrics, particularly its forward P/E in comparison to peers like FAST, there’s a noticeable disparity. This is attributed to WSO’s lower margins and projected growth rate. Given these financial metrics, the current valuation seems appropriate, and I don’t foresee significant P/E expansion in the near term. My recommendation for WSO is a ‘hold’ rating. Until it can improve its financial metrics in line with peers, I see no potential upside for WSO at its current share price.
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