• At first glance, Watsco’s business appears boring and staid - its numbers and prospects are nothing but! Watsco is the leading commercial and residential air-conditioning (HVAC) distributor in the U.S. though it still only accounts for 12% of a highly fragmented $40B market - a market that is growing organically at about 6%-7% a year. Its an undisputed leader in this space, with admirable distributor networks, local presence and customer loyalty. Watsco has generated shareholder returns in excess of 20% per year over the last 20 years. The principal charm of this investment opportunity is WSO’s sizable bottom-line growth potential. Significant new growth could result from an industry consolidation, from imminent regulatory measures driving new replacement cycles, from more JVs with OEMs and from market share gains from acquiring fragmented mom and pop players. New products and substitutes could also shine from use of WSO’s well-established customer platform.

• Air conditioning is a necessity of modern life in most parts of the country and WSO fills a critical role in the supply chain. WSO has grown steadily for three decades by building a reputation for proven reliability and customer service in the wholesale-distribution business. The company has 589 stores, primarily focused on the Sun Belt states, which sell a wide array of HVAC equipment and supplies. WSO generates around $4B in annual revenues at around 7% operating margins (which management believes will get to 10% over the next few years) and has a $3B market cap with $332M in Net Debt and sports a 2.6% dividend yield.

• If your HVAC unit breaks down in July in Miami, you need it repaired (or replaced) fast. Your repairman or contractor places an order with the local Watsco affiliate, and the replacement parts (or an entirely new system) will be available in less than 2 hours. In key Sun Belt markets, WSO has the densest network of retail and warehouse locations to meet customer demand. This network density allows WSO to offer faster service, and crowds out local competition. Quick lead times (< 2 hours), a broad product selection, and superior customer service, have allowed WSO to build lasting relationships with local contractors and provides a wide moat around each local business that would be difficult for a new entrant to displace.

Significant Growth Drivers

• Replacement - A typical residential HVAC unit has a useful life of 8-20 years, depending on how often it’s used. Replacement rates over the last 5 years have averaged less than 5M units per year. There are currently 89M installed units in the U.S. that are over 10 years old. If 10% of those units (9M units) need to be scrapped each year, it would vastly exceed the current replacement rate of 5M units per year. Homeowners often face a decision to either repair or replace a broken unit. Since WSO sells both supplies and entire units, the company stands to benefit either side of the repair/replace decision. But, in terms of driving top-line growth, the total dollar value of selling a replacement unit for $5K certainly outweighs a $200 order for new parts. We’re seeing the early stages of a replacement cycle marked by 6%-11% growth in replacement units, versus only 2%-6% growth in parts and supplies. 

• Recent legislation has made it increasingly expensive to repair certain classes of older equipment, boosting sales of replacement units. Since 2004, a popular refrigerant used in air conditioning, R22, has been gradually phased out due to harmful environmental side effects. In January 2015, the U.S. is required to reduce total R22 consumption 90% from a baseline set 10 years ago. By 2020, all R-22 production in the U.S. will be banned. Homeowners looking to repair a broken R-22 unit face tighter supply of the refrigerant over the next 5 years. This drives up the cost of repair and tilts the repair/replace decision toward the purchase of a new, 410-A unit. Any R-22 unit is at least 5 years old (new production was banned in January 2010), so an upgrade also brings substantial savings in operating efficiency. There are roughly 60M units in the U.S. that use R22, many of which should be upgraded to 410-A models over the next few years.

• In addition to the R-22 mandate, a new EPA standard for energy efficiency will be phased-in starting in January 2015. HVAC units are issued SEER ratings based on energy efficiency. Most residential units fall in the SEER-13 and SEER-14 categories; with SEER-14 representing a higher level of energy efficiency. Beginning January 1, 2015, all new HVAC appliances sold in the Sun Belt states must meet the SEER-14 standard. The EPA gave the industry a generous 18-month window to meet the requirement; meaning full compliance isn’t required until July 2016. An average SEER-14 unit is priced at a 10%-15% premium to a comparable SEER-13 unit. We believe this will support a natural increase in annual selling prices for WSO over the next 24 months, given the company’s focus on the Sun Belt states targeted by the new regulations.

• WSO also sells into the new home construction market, which currently contributes about 10% of the company’s sales. In 2006, this reached as high as 35%, but fell with the housing crisis. Housing starts of 900K are still below the long-term average of 1.5M. If new construction returns to normalized levels it would be a plus for WSO, but we don’t see this as a near term driver for the stock. 

• An additional longer-term trend to follow is the move to ductless HVAC systems in U.S. Rather than having a central unit blowing cool air to the entire house via a network of ducts, a ductless unit has a coil and blower dedicated to each room, or set of rooms. The central unit sits outside and controls the flow of refrigerant to each of these smaller units. Of the 90 million split system HVAC units sold globally last year, 85 million were ductless; and virtually all of those ductless units were sold overseas. The market for ductless units in the U.S. in well under 1M units annually, though growing at 18% per year.  While these systems have higher up-front costs, they offer lower energy use, smaller footprints, and a better user experience. To make up for lost time in the development of ductless products, most of the leading U.S. OEM’s have teamed up with Asian manufacturers (Carrier/Toshiba) to offer these systems. Market share for ductless units in the U.S. is expected to steadily grow over the next decade, supporting higher average selling prices for WSO.

• The WSO distribution network is an underutilized asset that can support additional product lines and categories. Existing product lines like commercial refrigeration (5% of sales) can better leverage the network to grow sales, while new categories, like smart-home products (Nest Thermostat) need a proven distribution channel to reach customers. Nest took the thermostat, previously a $20-$30 product, and created a hub for the SmartHome, priced at $250. WSO has the platform, and customer relationships, to bring a wide array of similar products to the end customer.

• The HVAC distribution business in the U.S. is ripe for consolidation with the largest player (WSO) only controlling 12% of the total market. There are hundreds of family-run businesses with strong local presence that could easily be integrated into WSO. At the Wells Fargo Conference in May, CFO Barry Logan described the opportunity,
  
  “Just to put it in a little bit of context, there’s probably 50 distribution companies in the industry that have revenues of $100 million or more. So that would be the primary audience for our energy. Some of them are $200 million or $300 million in size and they own great market share in certain regions of the country. There’s no national player. There’s no superpower next to us that we can acquire. It’s really going into these regions. And all 50 are owned by second, third generation families, I’m not sure there’s a first generation there.
  
  …We’ve never hired a broker, never paid a fee, never been in (an) auction, yet we’ve done about 60 transactions.
  …I’m not really aware of even a private equity transaction in our space for certainly the last 10 years, which is probably unique for almost any industry.”

• In addition to these tuck in acquisitions, WSO has also acquired a significant portion of Carrier’s (HVAC OEM) direct distribution channel in North America. Carrier has spent years winnowing down its distribution footprint by either selling, or partnering with distribution specialists like WSO. WSO and Carrier set up three separate JVs in 2009, 2011, and 2012, each covering specific regions (Sun Belt, Northeast, Canada, Mexico, etc). Both companies contributed distribution assets in each region, with WSO also making a cash payment to Carrier. Initially, each JV was set-up with WSO owning a 60% controlling interest. The first JV (Carrier Enterprises, set up in 2009) offered WSO the option to buy an additional 20% stake over two installments in 2012 and 2014. WSO exercised both options and now owns 80% of Carrier Enterprises (Sun Belt and Puerto Rico). The most recent 10% stake was purchased for $90M cash in July 2014. We believe Carrier Enterprises did $136M in EBIT over the last 12 months, implying a 6.6x EBIT multiple for this portion of the deal. For comparison, WSO currently trades at 12.4x EBIT. The terms on the option were set in 2009, which helps explain the attractive multiple. Management has alluded to additional deals may be available with OEMs looking to divest distribution assets, but none have materialized since 2012. At only 12% market share, WSO has plenty of headroom to do more deals before its size becomes a concern for the OEMs.

Shareholder Value Creation

• One of Warren Buffett’s favorite tools for measuring the effectiveness of management is the $1 rule. He explains the $1 rule in the Berkshire Hathaway Owners Manual…
  
  “We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.”
  
  When taken over a 10 year time period, this simple, yet effective test captures both the effectiveness of management and the attractiveness of an industry. WSO management has added over $5 in cumulative market value for every $1 increase in retained earnings since 2004. This business model doesn’t need much invested capital to continue growing, and can support regular dividend increases without sacrificing growth. Another way to illustrate WSO’s superior economics is Return on Invested Capital, which has averaged 18% over the last 4 years, far above its  less than 5% cost of capital.

• WSO has shown discipline in controlling costs while still growing the top-line at an impressive rate. Over the last 4 years, operating expenses have grown at 12% annual rate, while sales have risen at an 18% rate. We see WSO maintaining a similar ratio of sales/op-ex growth, driving 15% - 20% EPS growth over the next 3 years.

Management Invested, Owner-Operators

• Al Nahamd has been Chairman and CEO since 1972 and owns 53% of the voting shares through his Class B super-voting shares. SVP Barry Logan (1.8% stake) and CFO Ana Menendez (< 1% stake) have been with the company since the ‘90s. Bottom line, the management team that has overseen two decades of spectacular growth remains in place. For a more thorough look at management, we encourage you to listen to the Analyst Day webcast (available on the Watsco Investor Relations page) where several of the division level managers gave presentations.  All together, management owns 57% of the voting shares, but a smaller economic stake. We don’t like the super-voting share classes, but draw some confidence from the large economic stakes held by United Technologies (14%), BlackRock (9%) and Vanguard (5%).

Valuation

• WSO is a terrific business with a wide economic moat protecting its dominant local distribution businesses. The business is currently trading for 18x our $5.11 estimate for 2015 EPS. Consensus estimates for 2015 were $5.23 before the recent earnings announcement, and have now come down to $5.07. Q2 earnings came in slightly below estimates, and management’s initial 2014 guidance was below the Street. Nothing in the current quarter suggests that the near-term growth trends have slowed. In fact, the core business of HVAC equipment sales was up 8%. The upcoming regulation changes (R22, SEER-14), potential acquisitions, and the natural replacement cycle should support 7%-9% sales growth every year. With some modest operating leverage, earnings should grow at a 15% - 20% rate for the next 3 years and we expect the stock price to keep up with this earnings growth rate. We expect WSO to be at least $125 (at 20x our forward 2016 EPS estimate) in 12 to 18 months for a total return of 40% from current levels.

• WSO is ideally positioned to profit from the early stages of a strong residential HVAC replacement cycle. The cycle is driven by pent-up demand, government mandated upgrades, and more efficient new designs.
• As the largest player in a highly frangemented distrubution market, WSO has gained share thorugh accretive acquisitions. We expect this trend to continue with WSO's clean balance sheet and dozens of attractive acquisition targets.
• New product lines like ductless HVAC systems, and smart home devices (Nest thermostat) will drive revenue growth and better leverage the distribution network.