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Watsco Earnings Stay Hot, but Some Fear Cooler Times Ahead

By Dan Caplinger - Jul 21, 2015 at 9:31AM

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The HVAC specialist set new records but left some questions about its growth rate.

Watsco's ACDoctor information source. Image source: Watsco.

The heating and cooling business isn't an industry that most people think of often, even though they take advantage of its services every single day. HVAC-system distributor Watsco ( WSO 2.90% ) has done a good job of cashing in on demand for heating and air-conditioning systems, with new technology designed to make these systems more energy-efficient and spurring many customers to make switches from their older systems. Coming into Tuesday morning's second-quarter earnings report, Watsco investors were looking for the company to continue its run of strong results. Yet even though it reported record sales and earnings, some of Watsco's investors weren't entirely happy with its performance. Let's take a closer look at Watsco and how its quarter went.

Another set of records for Watsco
The tension among Watsco investors stemmed from the fact that despite its having set new records in key financial metrics, its results still fell short of what many of those following the stock had expected. Sales gained about 4.5% to $1.22 billion, and net income climbed nearly 17% to $65.4 million. Yet the consensus forecast among investors for Watsco's sales growth was closer to 6.5%, and earnings of $1.85 per share fell $0.04 short of what shareholders had wanted to see.

Despite what many considered lukewarm results, Watsco still continued its run of improving performance throughout its business. Operating income hit a new record of $125 million, climbing 11% on the strength of a big half-percentage-point increase in operating margins to a record 10.2%. On the expense side, Watsco continued to cut costs adeptly, reducing its selling, general, and administrative expenses by another three-tenths of a percentage point to hit a new all-time low. Watsco has made ongoing progress in becoming more efficient internally, and the company has kept seeing the benefits of its efforts quarter after quarter.

The same trends within Watsco's three main business units showed themselves this quarter, as the key HVAC equipment division led the way with 7% growth in sales. The Other HVAC Products division once again had the slowest growth at just 1%, while the commercial refrigeration category split the difference with a 3% gain in unit revenue. With the gains, the HVAC equipment business climbed above the two-thirds mark in terms of Watsco's overall revenue.

CEO Albert Nahmad highlighted the company's record performance, citing how the results "were driven by a combination of solid sales growth, better selling margins and operating efficiencies." Nahmad believes that Watsco is in a good position to keep doing well, saying that "We remain focused on our fundamentals -- gaining market share for our supplier partners, improving operating efficiency, and having the products and people in place to best serve our customers."

What's ahead for Watsco?
Watsco intends to keep pushing forward to take advantage of favorable conditions in the industry. In Nahmad's words, "Our technology investments, both in talent and capital spending, provide innovative capabilities to sell products and serve customers as well as provide greater insight into our business. We expect these investments to generate growth and further distance ourselves from the competition." Watsco has also added to its employee count, with salespeople, specialists in counter sales, and commercial HVAC experts helping to position the company as a leader in its field.

Still, despite the record results, Watsco didn't make any changes to its expectations for 2015. The company repeated its earnings guidance for $5 to $5.20 per share for the year, noting that those results would work out to a 16% to 20% improvement from the previous year's figures. Most investors expect Watsco to finish the year toward the high end of that range at $5.15, so this quarter's shortfall didn't necessarily give them everything they wanted to see.

From a long-term perspective, though, Watsco continues to have a huge opportunity. Tens of millions of existing HVAC systems have been in service for a decade or longer, and with various incentives and requirements for replacing those systems, Watsco is targeting a big piece of that growing pie.

Still, short-term traders weren't happy with the news, and they helped send Watsco's stock down about 2% in the first couple of hours of pre-market trading following the announcement. After such a big run higher for the stock, a small pullback wouldn't represent a major setback for Watsco. Long-term investors should instead focus on whether slightly slower growth is a one-quarter aberration or the beginning of a cooling trend that could eventually have a more sustained impact on the share price and Watsco's business prospects.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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