Image: Watsco.
Innovations in the HVAC business have allowed users to save energy and provide comfortable conditions more efficiently and at lower cost. HVAC-system distributor Watsco (WSO 1.74%) has capitalized on the rising demand for energy-efficient systems, with impressive growth rates that have spurred the stock to record heights recently. Coming into Tuesday morning's third-quarter earnings report, though, Watsco investors wanted to see continued evidence of strong trends in the HVAC arena, especially in light of declines that industry giant United Technologies (RTX -0.18%) reported in its recent results. What they got instead was a clear growth slowdown that even a sizable dividend increase from the company wasn't enough to offset. Let's look more closely at how Watsco fared this quarter and why investors weren't happy with the results.
Watsco keeps setting records but misses the mark
As we saw to some extent last quarter, Watsco was able to keep its top and bottom lines moving in the right direction but not at the pace that investors wanted to see. Revenue rose 4% to a record $1.18 billion, but most of those following the stock had hoped for growth closer to 6% from year-ago levels. Similarly, a 6% boost in net income to $58 million reflected underlying strength in Watsco's business, but the resulting earnings of $1.64 per share was $0.13 short of the consensus forecast among investors.
Overall, Watsco kept executing in its efforts to make the most from its business. Records in earnings per share, operating income, and sales all pointed to solid conditions in the industry, and Watsco continued to post improvement in gross profit margins and operating margins, albeit at a slower pace than investors have seen in past quarters. The company managed to keep its overhead costs in check during the quarter as well.
Looking at the three main segments under Watsco's corporate umbrella, the HVAC equipment unit posted solid 5% revenue growth, with the U.S. market providing even healthier performance in pushing sales up 8%. Other HVAC products saw sales gains accelerate to 3%, while the small commercial refrigeration segment enjoyed a 2% rise in revenue. Those sales trends are generally consistent with how Watsco has performed all year.
CEO Albert Nahmad accentuated the positive aspects of Watsco's quarter. "We generated more cash flow this quarter than in any other quarter in our history," Nahmad said, and "we experienced healthy sales growth for residential HVAC systems in the United States from strong unit growth and the continued trend toward higher-efficiency systems."
Is Watsco cooling off?
Watsco hopes to maintain its leadership role in the industry by emphasizing technology. Overall, the HVAC specialist thinks it can use its scale and extensive network to serve more customers more effectively across its geographical footprint. The company's technology team has nearly tripled in size since 2012, and innovations that have tapped into mobile apps for e-commerce use, data analytics for smarter decision-making, supply chain optimization, and operational efficiency should pay off in higher customer satisfaction and greater productivity going forward.
Watsco is optimistic enough about its long-term prospects that it announced a big dividend increase as well. The HVAC specialist will now pay investors $0.85 per share on a quarterly basis. That's a 21% boost and gives Watsco stock a dividend yield of more than 2.5% based on where the stock closed prior to the announcement.
Yet Watsco gave investors some bad news as well. The company cut its guidance for 2015 earnings, now expecting diluted earnings to come in between $4.85-$4.90 per share. That represents growth of 12% to 13%, but it's still a substantial downgrade from the previous range of $5 to $5.20 per share, which is where most investors were expecting Watsco's eventual results to land. The expected slowdown in growth is consistent with some of the numbers that United Technologies posted, with the conglomerate seeing sales in its UTC Climate, Controls, and Security segment fall nearly 2%, hitting operating profit for the unit by 4.5%. Unlike United Technologies, of course, Watsco doesn't have other major businesses to protect it HVAC-related issues.
The mixed news led to a big drop for the stock in its immediate aftermath of the results, with Watsco's stock quickly falling as much as 10% in the opening minutes of the trading session following the announcement. With a fairly high valuation for a company in a cyclical business, Watsco is vulnerable to concerns from growth investors about its ability to keep producing attractive gains in revenue and earnings. If the HVAC industry continues to slow, then Watsco investors could see a lot more volatility in what until now has largely been a straight-up trajectory for the share price over time.
