Air conditioner and replacement parts distributor Watsco (WSO 0.39%) has seen its shares falter along with the broader market this year. While most investors may have never heard of the company, its track record of growth and its defensive business model should put the stock on just about anyone's radar. But is it a buy right now?
Knowing is half the battle
Watsco is the largest air conditioner parts distributor in the U.S. If you haven't heard of the company before, that's understandable. Air conditioner replacement parts don't garner a ton of attention. But heat waves do. When your A/C goes out during the dog days of summer, you call your landlord or your local repair person as fast as your fingers can dial. The repair person will visit you, diagnose the problem, and order replacement parts or refrigerants from distributors like Watsco.
Image source: Getty Images.
Customers' dependency on a comfortable environment in their homes is what keeps Watsco churning out sales and profits. About 85% of the company's revenue is derived from a steady flow of replacement parts, so it would stand to reason that the stock is defensive.
But it hasn't played out that way this year. Watsco's stock was down 12% for the year at Friday's prices, but that included a three-day rally after earnings -- as recently as Tuesday, it was down more than 20%. By comparison, the S&P 500 was down 13% for the year at Friday's prices.
So what was holding Watsco back? Investors might have been worried about the 15% of revenue the company derives from new air conditioning units. New units are typically sold to newly constructed homes. Rising mortgage rates this year could stall new-home construction, which has already shown signs of weakening.
But in its second-quarter earnings report, Watsco told investors that it achieved record revenue and operating margin of $2.13 billion and 13.5%, respectively. After a stellar year in 2021, management said that Watsco was doing even better, growing same-store sales (or sales growth minus acquisition and new stores) by 29%.
Buy the dip?
Watsco's steady growth goes back much further than last quarter. Since entering the air conditioning parts distribution arena in 1989, revenue has grown at a 15% compounded annual growth rate. More impressive is the company's 19% growth in operating income over the same time frame. This demonstration of performance over all types of economic environments should grab investors' attention.
The company has made several acquisitions over the years, including three in 2021 alone. As a distributor, acquisitions can be neatly tucked into Watsco's distribution network and increase both the geographic range of its network and the number of availability of parts. The company's strategy has lifted its market share from less than 1% in 1989 to an industry-leading 12% to 15% today.
Its dividend has grown even faster, at a 21% clip since 1989. Watsco stock now pays a handsome $8.80 annual dividend, which equates to a yield of 3.3%. Wall Street analysts expect the company to reach adjusted earnings per share of $14.63 for 2022. So, the dividend should be easily covered by earnings.
Looking out a little further, Watsco's stock is trading at a forward earnings multiple around 20, which is significantly below its five-year average of 27. Given the valuation and defensive nature of its business model, long-term investors may find value in buying on the dip of beaten-down Watsco shares.
