Watsco Closes Out a Record Fiscal 2022; Shares Expensive

Shares of Watsco surged intraday on Feb. 16 after the narrow-moat-rated distributor of heating, ventilation, air-conditioning (or, HVAC), and refrigeration products reported another record quarterly financial performance. Fourth-quarter revenue increased approximately 5% year over year (but sales of $1.58 billion fell about 2% shy of the FactSet consensus estimate), adjusted operating margin remained well above prepandemic levels (8.9% compared with fourth-quarter 2019′s 4.9%), and adjusted EPS increased 16% year over year to $2.35 (beating consensus by approximately 11%).

HVAC original equipment manufacturers we cover expect residential HVAC shipments to decline by a mid- to high-single-digit percentage this year. For example, Carrier, Watsco’s largest supplier, sees the potential for a high-single-digit volume decline about offset by favorable price and mix. Our own projections see shipments down 7% year over year in 2023. However, Watsco’s management struck a more bullish tone, with aspirations of both favorable volume and price/mix growth in 2023. We think this is an aggressive near-term outlook, and we instead model 0.5% revenue growth in 2023.

Management also continues to see a 27% gross margin (compared with the 2015-19 average of 24.5%) as the new base level of normalized profitability for the firm. We agree that Watsco’s digitalization and other investments will likely support stronger customer retention and pricing. However, we continue to believe that Watsco’s recent record gross profit margins have benefited more from inflation than structural operational improvements. Instead, we think Watsco’s long-term gross margin will settle in around 25%-25.5%.

Nevertheless, we’ve raised our fair value estimate approximately 7% to $212 per share due to our upward-revised near-term profit margin outlook (primarily due to better selling, general, and administration expense management) and the time value of money since our late update.