Watsco, Inc. — Q3 2023 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2023; unaudited. Watsco distributes HVAC/R equipment, parts and supplies, operating 691 locations across the U.S., Canada, Mexico and Puerto Rico, with additional export markets. Sales are seasonal, with residential air-conditioning demand generally strongest in Q2 and Q3.
Key financial results
| Metric | Q3 2023 | Q3 2022 | Nine months 2023 | Nine months 2022 |
|---|---|---|---|---|
| Revenue | $2,126.8 million | $2,035.8 million | $5,680.6 million | $5,693.1 million |
| Gross profit / margin | $566.9 million / 26.7% | $550.8 million / 27.1% | $1,577.7 million / 27.8% | $1,596.7 million / 28.0% |
| Operating income / margin | $256.6 million / 12.1% | $236.3 million / 11.6% | $687.1 million / 12.1% | $694.4 million / 12.2% |
| Net income attributable to Watsco | $171.0 million | $157.6 million | $453.8 million | $463.5 million |
| Diluted EPS | $4.35 | $4.03 | $11.60 | $11.86 |
| Operating cash flow | Not separately presented | Not separately presented | $263.3 million | $358.9 million |
- Q3: Revenue increased 4%; same-store sales rose 4%. Attributable net income rose 8% and diluted EPS rose 8%. HVAC equipment sales grew 6%, while other HVAC products declined 3%.
- Nine months: Revenue was nearly flat, while same-store sales declined 1%. Attributable net income fell 2% and diluted EPS fell 2%.
- Margins: Gross margin declined 40 basis points in Q3, mainly because sales mix shifted toward lower-margin HVAC equipment. For the nine-month period, gross margin fell 20 basis points, primarily due to less beneficial supplier pricing actions. SG&A as a share of revenue improved to 15.0% in Q3 and 16.0% year to date.
- Cash flow: Nine-month operating cash flow decreased $95.5 million year over year. Management attributed the decline primarily to timing of vendor payments and lower net income. Working-capital changes included $184.1 million of cash use from receivables and $143.7 million from inventory.
Financial position and capital
- At September 30, cash and equivalents were $175.0 million, including $152.6 million held by foreign subsidiaries. Current assets were $2.731 billion and current liabilities $887.6 million; reported working capital was $1.843 billion.
- Revolving-credit borrowings were $105.6 million, all classified as long-term. The unsecured revolving facility is $600 million and matures March 16, 2028; seasonal capacity was reduced to $500 million effective October 1. Watsco reported covenant compliance.
- Nine-month dividends were $7.35 per share, versus $6.35 in 2022. Cash dividends paid totaled $286.1 million. A quarterly $2.45 dividend was declared after quarter-end and paid October 31, 2023.
- Operating cash flow, cash on hand, available revolver capacity and remaining ATM authorization are management’s stated liquidity sources. Management believes these sources will meet foreseeable needs, while noting there can be no assurance they will be sufficient.
Material developments, outlook and risks
- Acquisitions: Watsco acquired Gateway Supply on September 1, issuing 280,215 common shares valued at $102.3 million and paying $4.0 million cash, net of acquired cash. Preliminary goodwill was $59.7 million. It also acquired Capitol District Supply in March. The acquisitions’ pro forma effect was not considered significant.
- Supply constraints: Management estimated limited inventory availability reduced revenue by approximately 1% in Q3 and 3% in the first nine months. Disruptions included component availability, labor and transportation constraints, compounded by the transition to higher-efficiency products.
- Demand and regulation: New minimum SEER standards took effect in 2023. Watsco expects IRA tax credits and state rebate programs to support demand for efficient products, but program details were still being finalized. The filing provides no quantified revenue or earnings guidance.
- Interest costs: Net interest expense increased to $1.9 million in Q3 from $0.5 million, and to $5.9 million for nine months from $2.2 million, primarily due to higher rates and average borrowings.
- Supplier concentration: Carrier and affiliates represented 67% of Q3 inventory purchases and 65% year to date; approximately $178 million was payable to them at September 30, net of receivables.
- RSI investment: Watsco’s share of RSI earnings is reported as other income. Under the shareholder arrangements, Watsco’s joint venture has an obligation to purchase shares when RSI shareholders exercise their sale rights. A July agreement allows up to 80% of qualifying purchases to be funded with Watsco shares and caps sales by the majority holders at $125 million in any rolling 12-month period. No such shares had been issued under that arrangement by September 30.
- Other risks and contingencies: Management cited economic conditions, competition, supplier concentration, commodity prices, housing and construction activity, weather, inflation, interest rates, foreign exchange, regulation and cybersecurity. Watsco said known litigation is not expected to materially affect financial condition or results, but outcomes cannot be predicted with certainty.
Important facts for investors to verify
- Whether HVAC product availability improves and the estimated sales impact from constraints changes.
- Whether residential unit volumes, same-store sales and gross margins stabilize after the product-mix and pricing pressures.
- Whether working-capital investment converts to cash as seasonal inventory and receivables normalize.
- How higher interest rates affect borrowing costs, and whether debt and covenant headroom remain adequate.
- Gateway’s integration, contribution to results and dilution from shares issued; also monitor goodwill and acquisition activity.
- Potential cash or share requirements related to RSI shareholder put rights, alongside the substantial reliance on Carrier as a supplier.