Watsco, Inc. — Q1 2018 Form 10-Q
Business context and period: HVAC/R equipment and parts distributor operating 563 locations across the U.S., Canada, Mexico and Puerto Rico. This unaudited report covers the quarter ended March 31, 2018, compared with Q1 2017. Results are seasonal and are not necessarily indicative of the full year.
Financial performance
Amounts below are in millions, except per-share data and percentages.
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Revenue | $926.6 | $872.1 | +6% |
| Gross profit / margin | $230.8 / 24.9% | $218.6 / 25.1% | Profit +6%; margin -0.2 pp |
| Operating income / margin | $53.9 / 5.8% | $48.7 / 5.6% | Income +11% |
| Net income | $42.4 | $33.8 | +25% |
| Net income attributable to Watsco | $34.2 | $26.2 | +31% |
| Diluted EPS | $0.89 | $0.71 | +25% |
| Operating cash flow | $(41.6) | $34.3 | Down $75.9 |
- Revenue growth was primarily same-store (+6%), led by HVAC equipment sales (+8%); residential HVAC equipment rose 9%, commercial HVAC equipment 4%, other HVAC products 5%, and commercial refrigeration was flat.
- Gross margin declined as sales mix shifted toward HVAC equipment, which has lower margins than non-equipment products. SG&A was 19.3% of revenue versus 19.5% a year earlier, supporting operating-margin expansion.
- Net income benefited from higher revenue, improved operating margin, lower interest expense and lower income taxes. The effective tax rate attributable to Watsco was 23.8%, versus 33.6%, principally reflecting the reduction in the U.S. federal corporate tax rate.
- Operating cash use reflected seasonal working-capital needs, including a $49.9 million inventory cash outflow and the timing of payments for accrued expenses and other liabilities. Investing cash use was $3.4 million, primarily capital expenditures. Financing provided $23.3 million, including $69.2 million of net revolver proceeds and $46.6 million of dividends paid.
Liquidity, debt and balance sheet
- At March 31, cash was $58.1 million, current assets $1,371.7 million and current liabilities $377.7 million; working capital was $994.0 million. The filing reports $55.2 million of cash held by foreign subsidiaries.
- Revolver borrowings were $91.0 million, up from $21.8 million at year-end. Cash was therefore below revolver debt by approximately $32.9 million.
- The unsecured revolving facility’s capacity was reduced from $600 million to $300 million effective February 5, 2018; it matures July 1, 2019. Watsco reported covenant compliance and said cash, operating flows and available borrowing were expected to meet foreseeable liquidity needs, while noting that access depends in part on syndicate banks and credit-market conditions.
Changes, outlook and risks
- Watsco recognized $1.6 million of other income, representing its approximate 35% share of earnings from Russell Sigler, Inc. (RSI), an unconsolidated investment.
- The company adopted the new revenue standard on January 1, 2018; it reported no significant effect on consolidated results. It expects adoption of the lease standard in 2019 to result in potentially material right-of-use assets and lease liabilities, but not a material income-statement impact.
- No specific earnings or revenue guidance was provided. Management emphasized seasonal demand, with residential replacement demand typically strongest in Q2 and Q3, and heating demand generally strongest in Q4.
- Notable exposures include supplier concentration (Carrier and affiliates accounted for 62% of inventory purchases in both periods), weather and seasonality, competition, commodity costs, construction activity, liquidity and interest rates, foreign exchange, regulation and cybersecurity. The company said known litigation was not expected to have a material adverse effect; self-insurance reserves were $2.4 million.
Important facts for investors to verify
- Whether Q1 sales growth and margin trends continued through the peak seasonal selling quarters.
- Drivers of negative operating cash flow and the seasonal inventory build, and subsequent working-capital conversion.
- Revolver availability, covenant headroom and refinancing plans ahead of the July 2019 maturity, particularly after the facility-capacity reduction.
- Exposure to Carrier as a major supplier and joint-venture partner, and developments in the RSI investment or any potential additional purchase obligations.
- Foreign-currency effects: Q1 other comprehensive loss was $5.7 million, including a $6.6 million currency-translation loss.