Watsco, Inc. — Q1 2017 Form 10-Q
Reporting period: Quarter ended March 31, 2017; unaudited results compared with Q1 2016. Watsco distributes HVAC/R equipment, parts and supplies, operating 561 locations across the U.S., Canada, Mexico and Puerto Rico. Results are seasonal and can be affected by weather; residential replacement demand is generally strongest in the second and third quarters.
Financial performance
Amounts are in millions, except per-share data and percentages.
| Metric | Q1 2017 | Q1 2016 | Change / context |
|---|---|---|---|
| Revenue | $872.1 | $851.4 | Up 2%; same-store revenue up 3% |
| Gross profit / margin | $218.6 / 25.1% | $212.4 / 25.0% | Profit up 3%; margin up 10 bps |
| SG&A / revenue | $169.9 / 19.5% | $161.8 / 19.0% | Expense up 5%; ratio increased |
| Operating income / margin | $48.7 / 5.6% | $50.7 / 6.0% | Operating income down 4% |
| Net income attributable to Watsco | $26.2 | $25.5 | Up 3% |
| Basic and diluted EPS | $0.71 | $0.71 | Unchanged |
| Operating cash flow | $34.3 | $41.9 | Down $7.6 |
| Capital expenditures | $4.1 | $2.7 | Higher year over year |
Same-store sales growth reflected increases in HVAC equipment (3%), other HVAC products (1%) and commercial refrigeration products (5%). Management attributed growth mainly to replacement demand for residential and commercial HVAC equipment. SG&A included $0.9 million of additional technology initiative costs; management also cited higher sales- and service-related headcount. Net interest expense rose 27% to $1.3 million, primarily due to higher average borrowings and a higher effective rate.
Comparability note: The filing’s income statement reports Q1 2016 net income of $34.2 million and taxes of $15.5 million. A note explains that adoption of share-based payment guidance adjusted Q1 2016 results to net income of $35.0 million and taxes of $14.7 million (and diluted EPS of $0.74), versus the originally reported figures. Investors should account for this difference when comparing periods.
Liquidity, debt and capital allocation
- At March 31, 2017, cash was $47.4 million, accounts receivable $481.6 million and inventory $751.5 million. Working capital was $921.6 million, versus $925.3 million at year-end 2016.
- Revolver borrowings were $280.3 million, up from $235.3 million at December 31, 2016; Mexican subsidiary short-term borrowings were $1.6 million. The unsecured revolving facility provides up to $600 million and matures July 1, 2019. Watsco reported compliance with its covenants.
- Cash declined $8.6 million to $47.4 million. Financing cash use was $38.9 million, including $37.4 million in common-stock dividends and $42.7 million to acquire another 10% of Carrier Enterprise II, partly offset by increased revolver borrowings. Watsco’s interest in that joint venture rose to 80%.
- Management said operating cash flow, cash on hand and available revolver capacity should meet foreseeable liquidity needs, while cautioning that funding access and borrowing costs could be affected by credit-market disruption. $47.2 million of cash was held by foreign subsidiaries and may face tax consequences or capital controls if repatriated.
- Quarterly dividends paid were $1.05 per share, versus $0.85 a year earlier. After quarter-end, the board approved an increase to $1.25 per share beginning with the July 2017 dividend. No shares were repurchased in the quarter.
Outlook, risks and other notable matters
- The filing gives no quantified earnings or revenue guidance. Management emphasized seasonality, with HVAC/R demand peaking in May through August, and stated that quarterly results are not necessarily indicative of full-year results.
- Key disclosed risks include economic and competitive conditions, supplier concentration, commodity costs, housing and commercial construction, weather, seasonal sales, liquidity and interest rates, currency movements, regulation, insurance and cybersecurity. Carrier and affiliates supplied 62% of inventory purchases in Q1 2017, versus 61% in Q1 2016.
- A shareholder derivative suit concerning CEO incentive compensation was dismissed; the plaintiff appealed. Watsco said it considers the claims without merit and does not expect the matter to materially affect financial condition or results.
- Foreign-currency contracts included $46.5 million notional designated as cash-flow hedges and $15.1 million not designated as hedges. The company expected an estimated $0.2 million pre-tax hedge loss to be reclassified into earnings over the next 12 months.
- Watsco expects revenue-recognition adoption in 2018 to leave recognition timing generally similar. It expects lease-standard adoption in 2019 could materially increase balance-sheet assets and liabilities, but does not expect a material income-statement effect.
Investor verification points
- Reconcile Q1 2016 reported results with the share-based payment guidance adjustments disclosed in the notes when assessing year-over-year earnings and EPS.
- Track whether revenue growth converts into operating profit, given higher SG&A as a share of sales and lower operating income despite improved gross margin.
- Monitor seasonal inventory and working-capital needs, revolver usage, interest costs and covenant headroom as peak selling months approach.
- Assess the sustainability of the higher dividend alongside acquisition spending, cash generation and foreign-held cash availability.
- Follow Carrier-related supplier concentration, the appealed litigation and the financial effects of increasing Watsco’s ownership of Carrier Enterprise II.