Watsco Earnings: Solid Performance Amid Moderating HVAC Demand

Heating, ventilation, and air-conditioning demand appears to be normalizing following a period of booming sales during the pandemic. According to data from the Air-Conditioning, Heating, & Refrigeration Institute, year-to-date (through February) U.S. shipments of air conditioners and heat pumps were down over 15% year over year, and shipments of furnaces were down 19%.

Considering this backdrop, Watsco WSO, a leading distributor of HVAC systems and products, reported solid first-quarter results. In our view, the firm’s performance was good but not spectacular. Nevertheless, the market sent Watsco’s shares 8% higher on April 20 in reaction to its first-quarter results. The firm beat FactSet consensus EPS expectations by 18% ($2.83 versus $2.39 consensus), but revenue fell just shy of consensus. We think the market was encouraged by Watsco’s elevated profit margins despite declining volumes and normalizing original equipment manufacturer pricing. Recall that Watsco achieved record profit margins last year (27.9% gross margin and 11.4% operating margin). This was a marked improvement compared with the five years leading up the pandemic (2015-19) when Watsco’s gross and operating margins averaged roughly 24.5% and 8%, respectively. Management believes that a 27% gross margin is the new baseline due in part to technology investments that have improved the customer experience and support better pricing decisions.

In our view, the market is pricing in double-digit operating margins as the new norm for Watsco, but we remain skeptical that the firm’s recent profit margin strength is maintainable over the long run. That said, we now think elevated profit margins could persist longer than we had previously modeled. We’re now modeling a 10.5% average operating margin over the next four years with a 9.5% midcycle assumption (compared with a 9.7% four-year average and 9.0% midcycle margin previously). This adjustment increased our fair value estimate 7% to $227 per share.