Watsco

Watsco released disappointing results compared with last year. Revenue increased only 2% to $2.1 billion, operating income decreased to 12% (11.3% margin), and EPS fell 12% to $4.00.

Why it matters: Similar to its peer, Lennox, which also reported July 29, HVAC distributor Watsco disappointed investors with anemic performance, sending the shares down as much as 15% intraday. Management conceded that its core residential HVAC activities have seen significant volatility in recent years owing to covid and supply chain disruptions causing significant demand pull-forward along with regulatory changes to refrigerants. However, Watsco doesn’t give forward guidance, leaving investors confused how to benchmark where we might be in the cycle. Management acknowledged weakness in new construction but offered it was seeing 4%-5% organic growth in units in July. Recall 70%-80% of HVAC demand is replacement.

Long view: Watsco is a high-quality company in a very fragmented market, but it certainly appears that recovery in residential HVAC markets is more muted and will take longer than previously anticipated.

The bottom line: We are decreasing our fair value estimate for narrow-moat Watsco to $433 per share from $449 on the more uncertain outlook and weaker margins. Perhaps most concerning to us was management arguing Watsco’s 2025 gross margin may have been unusually high based on OEM pricing actions, and the current 27.5% is more reflecting of current market conditions. The company is targeting 30% gross margins, and there is elevated uncertainty here. Despite July 29’s share price correction, Watsco shares aren’t particularly cheap at 25 times our 2026 EPS. However, the shares are certainly cheaper than they have been in some time.

Our $433 per share fair value estimate equates to about 33 times still subdued 2026 EPS, which is reasonable in the historical context, given the company’s growth and returns. Operating results have been under pressure, given weakness in residential construction and housing starts. The company issued new long-term guidance at its 2025 investor day, which appears credible, particularly given peer commentary and Watsco’s various technology solution launches. Watsco’s new ambitions are to achieve $10 billion in revenue, 30% gross margins, and 5 times inventory turns.

We model a 6% revenue CAGR, with sales reaching approximately $10 billion in 2028. Given Watsco’s unique positioning, this seems reasonable. We project 300 basis points of gross margin expansion, achieving 30% gross margins in 2030. Given operating leverage and productivity enhancements from technology, we believe this is sensible. With minimal capital expenditures at 0.5% of sales, Watsco generates substantial free cash flow and allows management broad latitude to pursue growth initiatives.

Our Stage II forecast period incorporates an estimated investment rate of 28%, an earnings before interest growth rate of 7%, and perpetual growth of 3%. An 8.9% weighted average cost of capital is derived from the market-average cost of equity and the firm’s current capital structure.

We assign Watsco a Morningstar economic moat rating of narrow because we believe the firm's exclusive distribution rights (an intangible asset) and economies of scale (cost advantage) are durable competitive advantages that should continue to support economic profits for at least the next 10 years. The company’s returns have been improving and are meaningfully in excess of weighted average cost of capital. We believe these competitive advantages also explain Watsco's stronger profit margins relative to smaller distributors. Average small- to medium-size HVAC distributors typically earn low- to mid-single-digit margins, while Watsco's operating margin has expanded into the low double digits.

We believe Watsco enjoys an intangible asset moat stemming from its perpetual, exclusive right to distribute Carrier products in 30 US States, Canada, Mexico, and the Caribbean. Carrier's residential and light-commercial HVAC products hold a leading market share in the US and command a price premium. The US residential HVAC original equipment manufacturing market is rather consolidated, with six firms—Carrier, Goodman (Daikin), Rheem, Trane, York (Johnson Controls now Bosch), and Lennox—accounting for 90% of US HVAC shipments. The HVAC market remains competitive, and market leaders such as Carrier, Rheem, Trane, and Lennox typically command a 20%-30% premium on their brands. Despite Watsco’s outsize exposure to Carrier, the company hasn’t experienced channel conflict and has increased its presence with other OEMs.

Exclusive distribution can be mutually beneficial to suppliers and distributors. Exclusivity reduces price competition for distributors and gives suppliers greater control over marketing efforts and end-market pricing. Furthermore, we believe a more concentrated, independent distributor channel is more efficient for suppliers, both in operating costs and working capital, which supports Carrier North America’s best-in-class operating margins. The other leading OEMs demonstrate varying mixes of third-party versus direct distribution. Lennox would stand in stark contrast to Carrier/Watsco, with an overwhelmingly direct distribution focus. Trane, Rheem, and others have a more balanced mix of direct and independent distribution. We see no risk of Carrier reverting to a company-owned distribution model.

The North American heating, ventilation, air-conditioning, and refrigeration distribution market is highly fragmented, with over 2,000 distributors competing in an estimated $75 billion market. As the largest HVAC/R distributor with a low-double-digit market share, we believe Watsco benefits from multiple scale-driven cost advantages over the many small distributors in the fragmented market. First, the firm can leverage its scale to negotiate better pricing from suppliers and earn volume-based rebates and other sales incentives. Second, we believe Watsco has better fixed-cost leverage than competitors with much smaller revenue bases. Watsco can also carry a broader array of products than a competitor with a direct sales approach. For example, a Watsco distributor carrying multiple OEMs, located closer to the contractor customer, implicitly has an advantage over a direct Lennox sale in many cases, because the contractor may have to spend more time choosing Lennox rather than another OEM offered through Watsco. These advantages are all evident via Watsco’s robust top-line growth and, more importantly, its margin expansion. We believe it's Watsco’s density and other OEM relationships that highlight cost advantage as a driver of growth and margin expansion, rather than simply growing alongside Carrier, which would speak more to the advantage from intangible assets.

The company achieves a larger market share, either through organic growth (expanding its store/distribution footprint) or through acquisitions. The market is highly fragmented, so an M&A-driven growth strategy has a long runway.

The company is pursuing more exclusive arrangements with other OEMs, similar to its agreement with Carrier, which suggests that independent distribution is superior to direct sales.

Implementing more digital solutions leads to even greater margin expansion.

OEMs disintermediate third-party distributors to capture more control/economics. We see that industry leaders pursue a wide range of strategies, and it is unclear which is the “best” approach.

Independent competition prevents further margin expansion, signaling that Watsco’s scale isn’t sufficient to maintain economic rents, given that this business is ultimately local and has low barriers to entry.

The company can’t maintain above-category growth as its OEM relationships mature.