Watsco, Inc. — Q2 2019 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2019. Unless noted otherwise, financial figures below are in millions of dollars. Watsco distributes HVAC/R equipment, parts and supplies; it operated 585 locations across the U.S., Canada, Mexico and Puerto Rico. Results are seasonal, with residential air-conditioning replacement demand generally highest in the second and third quarters.
Financial results
| Metric | Q2 2019 | Q2 2018 | First half 2019 | First half 2018 |
|---|---|---|---|---|
| Revenue | $1,371.9 | $1,332.7 | $2,303.1 | $2,259.3 |
| Gross profit | $328.0 | $320.8 | $561.7 | $551.6 |
| Operating income | $134.4 | $137.3 | $189.5 | $191.3 |
| Net income attributable to Watsco | $90.2 | $90.0 | $125.2 | $124.2 |
| Diluted EPS | $2.40 | $2.40 | $3.34 | $3.32 |
| Gross margin | 23.9% | 24.1% | 24.4% | 24.4% |
| Operating margin | 9.8% | 10.3% | 8.2% | 8.5% |
Q2 revenue rose 3% year over year; same-store revenue increased 1%. First-half revenue rose 2%, also with 1% same-store growth. Management attributed residential HVAC equipment growth primarily to pricing, a richer mix of high-efficiency products and replacement demand. Q2 equipment sales increased 3% same-store, while other HVAC products declined 2% and commercial refrigeration declined 1%. For the first half, equipment sales rose 3% same-store; other HVAC and commercial refrigeration sales fell 2% each.
Gross profit increased in both periods, but Q2 gross margin declined 20 basis points, which management attributed primarily to a greater sales mix of lower-margin HVAC equipment. SG&A rose 5% in Q2 and 3% in the first half; SG&A as a share of revenue increased to 14.3% and 16.4%, respectively. Ongoing technology initiatives added $1.5 million of Q2 costs and $2.9 million of first-half costs versus 2018. Net interest expense increased 59% in Q2 and 50% in the first half, reflecting higher average revolving-credit borrowings and effective rates. Lower estimated foreign withholding taxes reduced the effective tax rate attributable to Watsco to 21.7% in Q2 and 22.0% in the first half, from 23.8% in each 2018 period.
Cash flow, liquidity and debt
- Operating cash flow: $68.4 million provided in the first half, versus $19.3 million used in 2018. Management said the improvement primarily reflected timing of payments for accrued expenses and other current liabilities. Working-capital investment remained substantial, including increases in receivables and inventory.
- Investing and financing: Investing used $30.8 million, including acquisitions and a further investment in RSI. Financing used $65.3 million, including $120.2 million of dividends and $32.4 million to buy an additional Homans interest; net revolving-credit proceeds were $84.4 million.
- Cash and working capital: Cash was $55.9 million at June 30, down from $82.9 million at year-end; $37.7 million was held by foreign subsidiaries. Working capital was $1,114.6 million, versus $1,084.2 million at year-end. Management said cash, operating cash flow and available borrowing capacity should meet foreseeable liquidity needs, while cautioning that funding access is not assured.
- Borrowings: Revolver borrowings were $219.6 million, up from $135.2 million at year-end, under a $500 million unsecured facility maturing December 2023. The company reported compliance with covenants. The balance sheet also included $60.8 million of current long-term obligations; this includes $59.6 million of current operating-lease liabilities following lease-standard adoption. Long-term operating-lease liabilities were $129.6 million.
- Dividends: $3.20 per share was paid during the first half, versus $2.70 in 2018. The board declared a further $1.60 quarterly dividend payable July 31, 2019.
Material developments, outlook and risks
- Watsco adopted the new lease standard on January 1, 2019. It materially increased reported balance-sheet assets and liabilities through recognition of operating-lease assets and obligations, but did not significantly affect income or cash flows; prior periods were not restated.
- In April, Watsco acquired seven-location distributor Dunphey & Associates for $16.8 million cash and $7.5 million in Watsco shares. In May, it acquired Carrier’s remaining 20% of Homans for $32.4 million, bringing Watsco’s ownership to 100%. In August, after quarter-end, Carrier Enterprise I acquired substantially all assets of 19-location distributor Peirce-Phelps; stated consideration included $10 million cash and Watsco shares valued at $58.6 million, with Carrier contributing $17 million to the joint venture.
- Carrier Enterprise I increased its RSI ownership to 38.1%. Under the shareholders agreement, RSI shareholders have sale rights and Carrier Enterprise I has corresponding purchase obligations. Watsco estimated its contingent purchase amount at approximately $138 million at June 30.
- Inventory was higher partly because of seasonal demand, acquired/opened locations, and purchases ahead of new residential furnace-fan energy standards effective July 3, 2019. Management identifies weather, seasonality, economic conditions, housing activity, competition, commodity costs, interest rates, foreign exchange, cybersecurity, regulation and supplier concentration as risks. Carrier and affiliates represented 63% of Q2 inventory purchases.
- Watsco provided no specific earnings or revenue guidance in the supplied filing text. It cautioned that interim results are not necessarily indicative of full-year results. Management said known litigation was not expected to have a material adverse effect, based on information then available. Disclosure controls were assessed as effective.
Important facts for investors to verify
- Whether modest same-store growth and the Q2 gross-margin decline persist through the peak selling season.
- Whether working-capital needs, including receivables and inventory, convert into cash as the season progresses.
- Revolver capacity, interest costs and covenant headroom after increased borrowings and the Peirce-Phelps acquisition.
- The potential timing, valuation and funding requirements of the approximately $138 million estimated RSI purchase obligation.
- Integration and financial impact of the Dunphey and Peirce-Phelps acquisitions, and ongoing dependence on Carrier as a supplier.