Watsco Earnings: Second-Quarter Revenue Slips, but Impressive Profit Margin Continues

Considering recent outsize demand for HVAC systems (causing a tough prior-year sales comparison) and our view that the U.S. residential HVAC replacement cycle has matured, we’ve been expecting a down year for HVAC shipments in 2023. Nevertheless, Watsco’s WSO second-quarter revenue growth fell short of our expectations, falling 6% year over year. That said, product availability issues (related to the energy efficiency standard changeover) with a key original equipment manufacturer partner were likely to blame for much of the shortfall; management estimates that this supply issue reduced sales by $75 million-$80 million. We don’t believe this will be an ongoing issue.

Still, we continue to be impressed with Watsco’s sustained gross profit margin strength. Second-quarter gross profit margin expanded 20 basis points to 28.1%, which is roughly 300 basis points above the firm’s 10-year historical average. Operating margin compressed 20 basis points to 13.3% due to less selling, general, and administrative expense leverage.

While management has touted its technology transformation as the primary driver behind much-improved margins, we had been skeptical, thinking that unprecedented industry pricing power was largely behind the outperformance and that margins would moderate along with price. However, it’s now become clear that we didn’t give the firm enough credit for these initiatives, which have been monetized via more favorable supplier pricing and better pricing decisions, as well as improved operating efficiency. We now model Watsco will maintain about a 28% gross profit margin and 11%-12% operating margin over the next four years. We moderate our midcycle operating margin assumption to 10% to account for industry cyclicality and potentially increased price competition. These changes, along with the time value of money, caused our fair value estimate to increase 8% to $246. Even so, we still think Watsco’s stock is overvalued.