Description

At recent price's I believe the market has sufficiently priced in risks related to the housing downturn while allowing for significant upside due to several factors that lean in Watsco’s favor over the short-term. I hope this can add to the prior WSO writeup as COVID sales gains appear stickier than expected and the not-so-transitory inflationary outlook is an added benefit for strong distributors. There are now potential catalysts near-term such as 2023 price increases, an eventual rebound in new construction, and the weak GFC HVAC installed base fading from relevance in the replacement cycle.

WSO operates in a highly recurring and stable replacement industry that provides a modern necessity in air conditioning. The majority of sales occur due to failure which gives inventory breadth, proximity, and rapid fulfillment higher importance over price, allowing for attractive returns on capital to the best network and operator. With WSO’s scale, density, and technology capabilities, they allow their professional contractor customers to spend less time getting supplies and more time completing jobs. This brings a customer's life back to normal faster while also making the professional installer more money. WSO excels in this dynamic, and I suspect their advantages are widening for two reasons:

1. The supply chain craziness of 2020/2021 allowed the best distributors to take significant market share, and WSO was no exception.

2. WSO’s scale (2.5x the size of their next competitor) affords them to spend large sums on ecommerce technology which is furthering their benefits to contractors while optimizing their inventory capabilities

Being a distributor of a housing-related big-ticket consumer product (HVAC), the market is concerned about deteriorating consumer balance sheets at the same time as a housing correction from the COVID era boom that led many housing sector companies to over-earn. While this will certainly have some impact on demand for WSO, there are reasons to believe significant earnings risk is limited:

• Only 10-15% of WSO revenue is tied to new home construction. Housing starts are projected to decline up to 20% in 2023 which would be a negative impact of 2-3% to WSO's topline, or possibly 4% if starts deteriorate more than expected in their core southern regions. Because new construction sales are planned, rather than failure related and time sensitive, this revenue is lower margin and is a lower share of profits.

• Of the other 85-90% of revenue, 80% of those sales are failure related (air conditioner stops working), which creates urgency to replace (few people will tolerate no AC in a Florida home in the summer) making a significant share of revenue “fulfillment-critical” and essentially non-discretionary in nature, which reduces the effects of a worsening housing market and consumer finances.

• This leaves another 10-20% of revenue potentially labeled “discretionary” such as remodel related revenue or consumers deferring replacements with repairs. 2023 remodel spending is forecast to be flat to slightly down y/y, which would have minimal impact to WSO. Management has stated that the cost to repair has inflated more than the cost to replace, making it less economic to repair given the superior efficiency of new systems against old AC systems at a time when monthly budgets are tight and energy bills can be high. Contractors prefer and favor replacements in their advice to consumers, which makes it unlikely to see an extreme shift towards repairs. But in that event, repair related sales are higher margin than replacement sales which minimizes the impact to profits. WSO has also rolled out a financing program to improve consumers' ability to pay.

• There is a risk to a negative mix shift towards lower priced HVAC systems. This impact should be muted by the fact that the highest priced systems have been the most supply constrained during 2022 and are now seeing improvement. WSO was not able to grow as much as they would have liked the last two years due to OEM supply chain challenges. This doesn’t support the case for WSO materially over-earning recently.

• To date, sales have continued to grow double-digits despite eight straight months of decline in home sales

• There is a risk to operating margins on SG&A deleverage as WSO has been earning record margins. This has been limited to an extent due to WSO overinvesting in SG&A during 2020-2021 in order to capture tremendous sales opportunities while supply chains were disrupted. WSO is now focusing on operating efficiencies as the market normalizes. Much of the benefit to operating margin has been due to gross margin expansion which management views as sticky. I view SG&A deleverage risk to be limited due to mgmt’s current SG&A discipline. The street is already modeling a reversion to 9% operating margin in 2023 compared to 10% in 2021, whereas management believes 10% is now a sustainable profit level.

Portions of revenue could be deferred or decline on lower spending lapping elevated savings from stimulus, which may be starting to show in shipment data as October shipments of air-conditioners and heat pumps declined 4% y/y compared to 1% and 3% increases in Sept and Aug. If as much as a half of this share of revenue were cut due to consumer pullback, it would likely reduce total profits by less than 7%. The shipment data is useful to keep an eye on.

All in all, this subjects topline to likely less than a 12% negative impact from the combination of a new construction decline plus the potential of a 50% haircut to the discretionary share of WSO’s revenue, with the impact to profit being even less as these are lower margin sales.

In the short-term, there are positives to offset these potential adverse impacts:

• 2023 minimum efficiency SEER regulations go into effect Jan 1st, which require systems sold at higher efficiency that sell for higher prices. Management expects this to benefit price mix by mid-single digits in 2023.

• The aforementioned improved supply of higher priced, higher efficiency systems should benefit sales mix as these have been outgrowing the broader HVAC industry.

• Higher efficiency systems can reduce month-to-month energy costs and environmental impact at a time when energy policies and supplies are a top global concern. This supports the decision to replace instead of defer.

• Regulations allow for more simplified inventory which should improve turnover and working capital for WSO.

With such a significant portion of WSO sales being failure related and fulfillment critical to return life back to comfort, it’s unlikely to expect a material decline in the current sales level for WSO. A worsening construction and consumer outlook may effect revenues by LDD, but these sales are lower margin and will be offset by MSD price increases due to coming regulations. Unless 2023 is significantly worse than forecast it is difficult to underwrite revenue and gross profit down much more than MSD with rising ASPs and the vast majority of sales being non-discretionary. Were 2023 revenues to decline 6% and operating margin to de-lever further to 8.5-9%, EPS would come in near $12-13 and put today’s price at 19-21x forward which is a small premium above the market on cyclically low earnings, offering low downside considering the long-term growth factors described below.

Long-Term Growth Runway

Whether you believe ESG is silly or not, WSO is an ESG friendly play and actually has good business economics. Beyond the near term-economic outlook, WSO has several long-term secular factors that will allow them to grow at an above average rate.

• Upgrading efficiency of HVAC systems

  • HVACs are the number one consumer of household energy, creating strong incentives to upgrade efficiency levels over time. Higher efficiency systems have higher prices and government subsidies support replacement demand.

    • By upgrading efficiency households can lower energy costs and reduce emissions. Government is supporting these consumer purchases with tax credits in the Inflation Reduction Act.

    • The current political climate increases the cost of emissions which benefits the economics of replacing over repairs.

  • Most units replaced today are below current minimum efficiency standards

• We are near a trough in the HVAC replacement cycle which will turn to rising replacement shipments for several years

  • In WSO’s core southern regions, the average lifespan of an AC system is shorter at 10-15 years. 

  • Assuming most systems replaced in any given year are 10-15 years old (some outliers outside of this) makes today’s core replacement cohort being units installed in 2008-2013, when shipment volumes were suppressed by the GFC housing crash. During those six years, 33.5 million AC and heat pump units were shipped.

  • Since that time, annual shipments have steadily risen. Eventually we will be replacing the 2017-2022 cohort of shipments which amounts to 54.4 units. This is a volume increase of 62% between equal cohorts. 

    • This should support a 4% annual increase in failure replacement units over the next decade as we move from replacing GFC era units to replacing the significantly higher shipment volumes of the last several years. 85-90% of industry volumes are driven by replacement.

• Sunbelt region exposure will benefit volumes long term

  • The sunbelt’s share of the population is projected to grow to 55% in 2030 from 50% today and has captured 75% of population growth in the past decade

• Housing shortage should support new construction demand beyond near-term outlook

  • New construction demand is heavily debated, however many studies show that we are short 3-4m homes in the US which should support the current level of housing starts or higher several years into the future and boost the portion of WSO sales to new construction.

• Increasing scale and inventory turns may benefit working capital and FCF conversion

  • SEER regulations are simplifying the SKUs in inventory while WSO has a clear opportunity to grow volumes per warehouse and further optimize its investment in inventory

• SG&A efficiency

  • Volumes and revenues likely to grow faster than the total # of warehouse locations

    • This should result in increasing SG&A efficiency and the ability to spread fixed technology and warehouse costs over a larger revenue base

  • Opex has been inefficient lately due to supply chain receipt mismatches, inefficient inventory/warehouse routing, and general scrambling to fill customer orders and gain market share. Now in a normalizing environment, operating managers have been informed to seek ways to right-size costs and efficiencies as the supply chain is more balanced. This should support recent operating margin levels around 9-10% or higher.

  • Mgmt goal is to get to 15% EBIT margin over time… in the past this goal was 10% which has been achieved.

• New ecommerce program is growing rapidly

  • Has lower customer attrition and improves the productivity of contractors which allows them to take on more jobs which is a material benefit in a labor constrained industry, unique value only a scaled operator like WSO can maximize

  • Scale allows them to invest over $40mil and 300 employees in technology which may lead to more consolidation - smaller distributors can’t afford this

  • Higher line items per order, more parts and supplies which are higher margin… Potential to increase customer loyalty, fulfillment efficiencies, sales and margins

Over the next decade, these tailwinds are likely to result in above average growth:

• Units needing replaced set to grow by 3-5% annually with potential for added growth in new construction demand

• Further SEER efficiency requirements and growing heat pump (higher ASPs) mix likely to grow ASPs at least 3-4% annually or above inflation as WSO is able to pass through price hikes

• Continued acquisitions and unique techonology capabilities to enable market share capture from LDD to HDD or 1-2% annually

• Opportunity to expand operating margin on improving operating efficiency and scale, with optimized inventory and turnover can add 1-2% EBIT and FCF growth annually

WSO is likely to grow EBIT at least 7% annually and in a more favorable outcome WSO has a runway to compound EBIT at LDD for several years ahead, combined with a growing 4% dividend at today’s price. There is also opportunity to increase FCF conversion through higher margins and reduced working capital thanks to simplified SKU’s and growing volumes/warehouse. WSO’s strong position in a stable and growing industry providing a critical product increases long-term forecastability despite today’s macro concerns.

WSO is less than 19x 2023 estimates and offers a 4% capital return unlikely to be cut but rather likely to grow HSD to LDD in the coming years. This is a business with expanding competitive advantages with top-tier management and proper incentives. Many signs point to WSO being an above average company which I expect to be 2-3x bigger in ten years that provides a greater capital return than the S&P 500 and just over one turn earnings multiple premium. The non-discretionary nature of sales and end market certainty is not being appreciated in light of the strong growth runway available to WSO, creating an asymmetric risk to reward setup. 

Management

• Family run business: the founder CEO owns over $1bil of stock and still actively manages with son

• Unique LT restricted equity award program for over 100 employees that only vests at retirement after age 62 encourages retention and long-term owner’s mentality - total RSUs worth around $200 million

  • Almost half of employees own WSO stock in some form (401k, ESPP, option awards)

• Capital allocation is rational with the majority used for acquisitions to acquire smaller distributors or paid out in dividends

Risks

• New construction and discretionary demand worsens significantly which could cause some operating deleverage for WSO

• Key man risk: Albert Nahmad has run WSO for fifty years. With his son also in the business and most top officers with tenure of 10-20 years or more, plus the long-term RSU program, I think this risk is limited

• A large acquisition that proves difficult to integrate. As most of WSO’s M&A is smaller deals, I see this as unlikely

Catalyst

- 2023 SEER regulations and government subsidy programs supporting replacement demand and higher prices

- Housing sentiment rebound

- Rising replacement units