Watsco Earnings: Gross Margin Slips but Sales Rebound and SG&A Containment Drive Q3 Earnings Growth

According to the Air-Conditioning, Heating, and Refrigeration Institute, year-to-date (through August) shipments of air conditioners, heat pumps, and furnaces were 16% lower than last year. Nevertheless, we think Watsco WSO is on pace for flattish year-over-year revenue growth this year due to favorable price and product mix, and to a much lesser extent, revenue contribution from the September acquisition of Gateway Supply Company, with $180 million of annual sales.

Third-quarter revenue increased 4% year over year to $2.1 billion; heating, ventilation, and air conditioning equipment sales (70% of total sales) grew 6% and commercial refrigeration equipment sales (4% of total sales) grew 9%, but higher-margin HVAC products sales (26% of total sales) fell 3% year over year.

Watsco’s third-quarter gross profit margin narrowed 40 basis points year over year and 140 basis points sequentially to 26.7%, which is also below management’s 27% near- to mid-term target. We believe sales mix (less higher-margin HVAC product revenue and more commercial HVAC revenue) and price deflation for commodity products, such as refrigerant, copper tubing, and sheet metal (6% of sales), were primary factors behind Watsco’s lower gross margin. Nevertheless, disciplined selling, general, and administrative expense management drove operating margin expansion. Indeed, SG&A as a percentage of sales decreased 80 basis points and operating margin expanded 50 basis points to 12.1%.

We continue to be impressed with Watsco’s operational execution and capital allocation. We’ve raised our fair value estimate 7% to $264 per share, due to modest upward adjustments to our five-year revenue growth and profit margin outlook, along with the time value of money since our last update. Even so, we continue to believe Watsco’s stock is overvalued. In our view, the market has bought into management’s aspirational margin targets (that is 30% gross margin and 15% operating margin goal), but we remain skeptical.