Operating in an industry that we all benefit from but never give much thought to, Watsco (WSO 0.90%) is a leader in heating, ventilation, air conditioning, and refrigeration (HVAC/R). While this may not be the most exciting corner of the stock market, sometimes businesses that support the essentials of modern life make outstanding investment opportunities.
Over the course of its history as a public company, Watsco has been a massive winner, with its total return up more than 39,000% since its IPO. To put that in perspective, a $10,000 investment in 1963 would now be worth $3.9 million. Yet what's important to investors today is whether Watsco makes a good investment moving forward. I'd argue it does, so let's dig in to see why.
Strong growth as demand reverts to the mean
Since the pandemic began in 2020, Watsco has seen above-average demand for the products it distributes. Consumers with money to spend, as well as more time spent in their homes, spent on upgrading their HVAC units, benefiting Watsco.
What's impressive is that even as this demand has begun to slow, the company has continued to put up strong results.
Watsco's second quarter of 2022 showed the strength of its business. Revenue for the quarter was a record $2.1 billion, representing year-over-year growth of 15%. Same-store sales jumped 14%, and gross margin improved 210 basis points.
Profitability also accelerated, with earnings per share hitting a record $4.93, good for a 33% increase over Q2 of 2021. Operating margin also expanded to a record 13.5%, up from 11.7% in the year-ago quarter.
2023 and beyond
Management has been transparent about the expected slowing of growth as the industry reverts to historical levels of sales. This could mean a return to the high-single-digit revenue growth the company experienced prior to 2020. However, some upcoming regulations are expected to spur new growth.
Beginning in 2023, the minimum efficiency standard of all HVAC units sold will be raised, which will in turn increase the sales price for each unit. Because Watsco is a distributor and not a manufacturer, this will lead to more revenue.
Additionally, 2025 will see a transition to new refrigerants. In the past, these kinds of changes led to higher cost of repair, and therefore an increase in the purchase of new systems to replace them. Again, this would be accretive to Watsco's business.
While all companies in this industry would stand to benefit from these tailwinds, Watsco believes that deriving the core of its business from the Sun Belt will be a benefit. Management sees the products it distributes as essential for those who live in these warm climates. Most customers are not likely to ignore a broken air conditioning unit during August in Arizona or Florida.
A strong balance sheet
The HVAC industry is very fragmented, with approximately 6,700 distributors worldwide. Watsco has grown by building its business, but also by buying other market leaders in order to either gain additional market share or to expand into new geographies.
Watsco's success in acquiring companies is dependent on a strong balance sheet. Over the past two years, the company has increased its working capital (the amount of money available for immediate expenses) 44% to $1.56 billion. This gives Watsco the financial flexibility to pounce on acquisition opportunities.
The cash on the balance sheet has also allowed Watsco to pay a dividend for 48 consecutive years. At recent prices, Watsco's dividend yield is 2.9%, easily outpacing the S&P 500's yield around 1.7%.
While not exactly cheap for its industry, Watsco's recent price-to-sales ratio over 1.5 is only slightly above its five-year average of 1.4. Considering the company has grown revenue 73% and net income 196% over that same time frame, some premium should be expected.
The expected industrywide tailwinds, combined with Watsco's track record of results and attractive dividend yield, make it a compelling choice for those looking for some stability in their portfolio.