Balanced Risk Reward for Watsco - Analyst Blog

On May 29, 2014, we issued an updated research report on Watsco Inc. WSO, a leading distributor of air conditioning, heating, and refrigeration equipment as well as related parts and supplies (HVAC/R) in the United States.

Watsco's first-quarter 2014 adjusted earnings increased 23% year over year to 48 cents per share aided by higher sales, stronger selling margins and improved operating efficiencies. Total revenue increased 7% year over year to a record $763 million.

The market for residential central air conditioning, heating and refrigeration equipment and related parts and supplies in the Americas is worth approximately $35 billion. Watsco now owns 10% of the market and has immense potential to increase its market share as no other competitor can match Watsco's geographic footprint.

Watsco will continue to benefit from demand in the replacement market as old units get replaced by more energy-efficient units in the coming years. There are approximately 89 million central air conditioning and heating systems installed in the United States that have been in service for more than 10 years. Moreover, higher efficiency units mean higher pricing and higher margins for the company.

Watsco's joint venture with Carrier Corporation, a wholly owned subsidiary of United Technologies Corp. UTX, has been successful and continues to generate profits. In July, Watsco plans to purchase an additional 10% interest in the Carrier joint venture in the Sun Belt region. In the U.S., the most significant markets for HVAC products are in the U.S. Sun Belt. This will be accretive to Watsco's earnings.

Management outlined its long-term plans to increase revenues to above $10 billion and margins above 10%. This will be driven by organic growth initiatives, including new product offerings, geographic expansion, and logistical, productivity improvements, in addition to continued consolidation of the North American HVAC industry.

However, Watsco has been historically acquisitive. The company's strategy mainly involves geographic expansion of its HVAC business through new market acquisitions, subsequently increasing revenues and profits from a combination of greater number of locations, products, services, and improved management practices. However, the company has been lately inactive on the acquisition front .

Moreover, sales of residential central air conditioners, heating equipment and parts and supplies have historically been seasonal. Furthermore, profitability can be impacted favorably or unfavorably based on the severity or mildness of weather patterns during summer or winter selling seasons.

Other Stocks to Consider

Watsco currently carries a Zacks Rank #3 (Hold). Some better-ranked stocks in the building products – air/heater sector include GigOptix, Inc. GIG and Nortek Inc. NTK. Both the stocks hold a Zacks Rank #2 (Buy).

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