Qualivian Investment Partners recently released its Q3 2020 Investor Letter. In Q3 2020, the fund was up 9.3% and 9.1% on a gross and net basis versus the S&P’s 8.93% increase, outperforming by 0.3% and 0.2%. In October, we published an article revealing our exclusive interview with Qualivian Investment Partners’ co-founder Aamer Khan. You should check out Qualivian Investment Partners’ top 3 stock picks for investors to buy right now, which could be the biggest winners in 2021.
In the Q3 2020 Investor Letter, Qualivian Investment Partners highlighted a few stocks and Watsco Inc (NYSE:WSO) is one of them. Watsco Inc (NYSE:WSO) is the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies in the United States. Year-to-date, Watsco Inc (NYSE:WSO) stock gained 26.2% and on November 30th it had a closing price of $227.36. Here is what Qualivian Investment Partners said:
“We would like to revisit Watsco (briefly discussed in our Q2 2019 letter). Watsco is the largest HVAC distributor in North America. We like the HVAC distribution business because it is a steady, predictable, and recession-proof business with predictable demand for HVAC equipment driven largely by a replacement cycle. This typically accounts for greater than 80% of shipments, with another 10-15% driven by new house construction. The remainder is accounted for by demand for refrigeration in specific commercial markets.
Our Thesis on Watsco…
Within the HVAC markets, we like Watsco as a candidate for the fund because:
1) It is the #1 HVAC distributor with 15% market share. It is two and a half times larger than the next largest player.
2) It has high returns on invested capital and is relatively asset light.
3) It benefits from a long growth runway arising from its predictable end market demand as well as its consolidator role in the HVAC market.
4) Is extending and widening its already formidable competitive advantage due to a) its scale and b) its investments in its technology infrastructure. This leads to our differentiated view that Watsco will have higher EPS growth than consensus due to higher revenue growth and better EBIT margins.
5) Has a founder-led management which ignores short term earnings swings and is focused on long-term value creation and allocates capital accordingly, engaging in economically accretive consolidation.
#1. Dominant Competitor in HVAC Distribution…
In the US, HVAC distribution is a $35bn industry. $25bn of revenue is spread among 1300 local independent distributors. There are 50 distributors which do between $100mm and $1bn in sales. Another $5bn in revenue is accounted for by OEM-owned distribution. The remaining $5bn is Watsco, the largest independent HVAC distributor in the country. Watsco has almost 2.5X the market share of the next largest competitor. It serves 90K+ contractors in its key markets and with 600+ locations across the US, Canada, and Latin America. Watsco has concentrated its locations in the sunbelt states, where the need for cooling is omnipresent throughout the year. Florida represents its largest market and Texas its second largest market.
#2. High Return on Capital and Cash-Generative Business…
Watsco’s distribution model and scale have created a lucrative cash-generative model with low reinvestment needs. This leads to impressive returns on assets and invested capital. Watsco had about $673 million of capital invested in the business ten years ago. Currently, there is about $1.6 billion invested (we are defining invested capital as net working capital plus net fixed assets). During this decade, operating income grew from $166 million in 2010 to $372 million in 2019. This implies solid cash on cash returns in the low 20% range. Mid-teen ROIC and low-20% Cash Return on Invested Capital (CROIC) on a steadily growing revenue and capital base have allowed this management team to make the necessary investments in the business to expand organically and via a very disciplined acquisition strategy, discussed below.
#3. Recession-Proof Durable Business with Long Growth Runway…
The installed base of HVAC units has grown at a 3.6% CAGR since 1980. The US has ~115 million installed A/Cs and furnaces, 92 million of which are over 10 years old. Systems last 10-204 years suggesting a solid replacement runway. The primary replacement markets are in less weather-sensitive geographies where HVAC use is more frequent and consistent, which is why Watsco focuses on the Sun Belt (~60% of North America).
In addition to its durable and predictable end-market demand, Watsco’s growth runway is further enhanced by its role as the natural consolidator in the fragmented HVAC distribution market. This is enabled by its scale and its superior technology infrastructure. This is widening its competitive lead with smaller, less well-capitalized competitors who end up selling to Watsco to access its superior technology and its purchasing leverage with the Original Equipment Manufacturers (OEMs). Of the 1,300 independent HVAC distributors in North America, 99% are family owned. On average, these businesses are doing maybe $30-$50mm in revenue per year. This is Watsco’s target for acquisitions.
Watsco has benefited from value enhancing M&A, acquiring a little over 60 HVAC distribution businesses since 1989 without ever hiring a banker. Watsco buys smaller distributors for 5-9x trailing EBIT and improves their EBIT margins over the next few years. Watsco trades around 17x EBIT5 so the acquisitions create economic value. It is interesting to note that private equity has not been active in consolidating the fragmented HVAC distribution business and as a result, transaction multiples have not been bid up by financial buyers. This is because OEMs typically have a clause with their distributors giving them a veto power over whether the distributor can continue to sell their product if the distributor is sold. OEMs typically do not like private equity players because they feel that their focus on cost cutting negatively impacts customer service. This has a negative effect on how the OEM brand is perceived.
#4. The Case of the Ever-Widening Competitive Moat…
Watsco’s size has enabled it to invest in its technology infrastructure that its small, fragmented competition cannot afford. The company has been expensing roughly $35-$40 million a year for the last four years in building out its eCommerce platform, on-line sales tools, inventory management and warehouse management systems to transform antiquated industry practices.
Traditionally, it might have taken a contractor hours to diagnose a customer’s repair, call the local Watsco distribution center (DC) to see if they had the needed equipment/parts, drive to the DC and often wait for the parts to be picked and loaded on to his truck. If not available, he would go back in 1-2 days to get the needed parts, before returning to the customer’s home to finalize the repair. Today, the process is seamless. The contractor is able to access online tools to diagnose the problem at a customer’s site, look up parts availability, order and pay for the needed parts/equipment in a manner of minutes, and drive up to the Watsco DC for contactless delivery of the order, and be back at the customer’s site same day to finish the job. This allows contractors to materially improve their revenue productivity with Watsco product versus the competition.
For Watsco, the benefits are clear. Contractors who use the new digital tools tend to be repeat customers, driving market share gains for the company. Furthermore, Watsco is able to better forecast demand for different SKUs, deliver better fill rates to its customers, and ultimately it will be able to reduce overall inventory levels and warehouse square footage as it fine tunes its systems. This has the potential to deliver accelerating revenue, lower costs, and reduced working capital. This is in turn will likely improve its FCF generation and further enhance its ability to pull away from the competition and consolidate the industry. The flywheel effect is illustrated below:
We think COVID has been an accelerant of contractors’ adoption of WSO’s digital tools, and in Q2 and Q3 of this year, Watsco posted 0% and 8% organic growth rates, when industry shipments were down 10% and flat respectively. Watsco reported that 20K of its 90K+ contractors are now using its digital tools, up from the 12K at the end of 2019. We believe that Watsco’s fundamentals are on the verge of improving.
#5. Founder-Led Management Team with Focus Firmly Planted on Long-Term Value Creation…
Finally, we are big fans of Watsco’s founder-led management team. While the founder and CEO, Al Nahmad, and the President, his son AJ (in charge of the technology investments), own 12% of the company, they control 54% of the voting shares, allowing them to run the company much like a private company. They are squarely focused on generating long-term value creation by growing organic market share and consolidating the industry. They are not swayed by short-term earnings results. “We care about the next quarter century not the next quarter.”
Valuation
Optically, it may look like Watsco is trading expensively at 32.5X forward earnings. However, its NTM P/E7 relative to the S&P is currently 1.5X, which is in-line with its 10-year historical average. Furthermore, we believe that the company’s fundamentals are in the early stages of inflecting upwards. Its revenue growth rates are likely to rise from mid-single digits to 6%-8%. Operating margins should increase from the current ~8-9% level closer to 10%, because of the cost efficiencies that their technology investments will begin to deliver over the coming years. All-in, we think Watsco will be able to deliver annualized mid-teens+ EPS growth over the coming years, up from the 9% level the company has achieved over the past 5 years.”
Andrey_Popov/Shutterstock.com
In Q2 2020, the number of bullish hedge fund positions on Watsco Inc (NYSE:WSO) stock increased by about 5% from the previous quarter (see the chart here), so a number of other hedge fund managers believe in Watsco’s growth potential. Our calculations showed that Watsco Inc (NYSE:WSO) isn’t ranked among the 30 most popular stocks among hedge funds.
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Disclosure: None. This article is originally published at Insider Monkey.
