Watsco, Inc. — Q2 2020 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2020. Unaudited results; dollar amounts below are in millions unless noted. Watsco distributes HVAC/R equipment and related products through 603 locations. Its business is seasonal, with residential air-conditioning demand typically strongest in the second and third quarters.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Revenue | $1,355.4 | $1,371.9 | $2,363.5 | $2,303.1 |
| Gross profit | $319.2 | $328.0 | $566.8 | $561.7 |
| Gross margin | 23.6% | 23.9% | 24.0% | 24.4% |
| Operating income | $129.2 | $134.4 | $174.5 | $189.5 |
| Consolidated net income | $104.2 | $107.9 | $140.5 | $151.7 |
| Net income attributable to Watsco | $86.6 | $90.2 | $117.1 | $125.2 |
| Diluted EPS | $2.26 | $2.40 | $3.02 | $3.34 |
- Margins and expenses: SG&A was $194.1 million in Q2 (14.3% of revenue) and $397.4 million in the first half (16.8%, versus 16.4%). Q2 operating margin was 9.5%, compared with 9.8%; first-half operating margin was 7.4%, compared with 8.2%.
- Cash flow: First-half operating cash flow was $261.3 million, versus $68.4 million a year earlier. Investing activities used $8.0 million and financing activities used $247.3 million. The operating-cash-flow improvement was primarily attributed to lower inventory; working-capital movements materially influenced cash generation.
- Liquidity and debt: June 30 cash was $79.6 million, including $60.0 million held by foreign subsidiaries. Working capital was $992.6 million, down from $1,085.0 million at year-end 2019. Revolver borrowings were $33.4 million, down from $155.7 million; borrowing capacity was increased to $560 million in April 2020. The facility matures December 5, 2023, and Watsco reported covenant compliance.
- Other balance-sheet metrics: Total assets were $2,636.7 million and total shareholders’ equity was $1,736.1 million. Current assets were $1,631.5 million and current liabilities were $638.9 million.
- Dividends: First-half dividends were $3.375 per share. The board declared a $1.775-per-share quarterly dividend on July 1, paid July 31; future dividends remain at the board’s discretion.
Changes versus prior comparable periods
- Q2 revenue fell 1%; same-store revenue declined 6%. Acquired locations contributed $66.5 million, partly offsetting weaker comparable sales. Residential HVAC equipment sales were flat, while commercial HVAC equipment sales fell 20% on a same-store basis.
- First-half revenue rose 3%, but same-store revenue declined 3%. Acquisitions contributed $127.5 million. Same-store commercial HVAC equipment sales fell 14%; residential HVAC equipment sales increased 1%.
- Management attributed weaker comparable sales principally to pandemic-related disruption, particularly in commercial HVAC, other HVAC products and commercial refrigeration. Gross margin declined in both comparison periods, chiefly due to a sales mix shift toward lower-margin HVAC equipment; first-half margin also reflected a lower benefit from supplier pricing actions.
- Watsco’s attributable net income declined 4% in Q2 and 6% for the first half. Lower revenue and gross profit affected Q2; higher SG&A, primarily related to acquired locations, was the principal first-half pressure. Lower interest expense partly offset these effects.
- First-half SG&A rose 6% overall, while same-store SG&A declined 2% as the company reduced costs and discretionary spending. Interest expense declined 77% in Q2 and 46% in the first half, reflecting lower average borrowings and interest rates.
Outlook, risks and notable items
- COVID-19: Watsco said the pandemic significantly affected Q2 operations. Some branches had short-term closures or diminished capacity; locations were operating at the filing date with restricted public access and contactless services. The company cited continuing uncertainty, potential renewed restrictions, supply and delivery disruptions, staffing issues, customer-payment risk, and possible shifts toward repairs, value-oriented equipment, and away from new construction and commercial demand. It said the potential financial impact could be material and could not be reasonably estimated.
- Management response: Cost controls included reductions in fixed-cost compensation, rent abatement, changes to vendor terms and limits on discretionary spending. Management described liquidity and leverage as strong and stated that operating cash flow, cash and revolver access were expected to meet foreseeable liquidity needs, while cautioning that available funding cannot be assured.
- Guidance: The filing provides no numerical earnings or revenue guidance. Management noted uncertainty around pandemic duration and effects; results are seasonal and interim performance is not necessarily indicative of full-year results.
- Supplier and related-party exposure: Carrier and its affiliates represented 63% of inventory purchases in Q2 and 60% in the first half. Net amounts payable to Carrier affiliates were approximately $139 million at June 30, up from $86 million at year-end. Watsco said transactions were on arm’s-length terms.
- Contingency: Under the RSI shareholders’ agreement, Carrier Enterprise I has an obligation to purchase shares if RSI shareholders exercise sale rights. The estimated contingent purchase amount at June 30 was approximately $170 million. Watsco stated it believed cash, operating cash flow and revolver capacity would be sufficient to fund any purchase.
- Legal and controls: Watsco reported ordinary-course litigation and did not expect known claims to materially affect financial condition or results, based on information available. Management concluded disclosure controls were effective; acquired businesses’ internal controls had not yet been assessed.
Key facts for investors to verify
- Whether COVID-19 restrictions, supplier availability, customer demand and commercial-market weakness affect subsequent sales and gross margins.
- How much of the strong first-half operating cash flow reflects sustainable earnings versus seasonal and working-capital movements.
- Carrier-related supplier concentration, the increased payable balance, and any changes in commercial or contractual terms.
- Potential timing and funding needs associated with the approximately $170 million RSI contingent purchase obligation.
- Dividend sustainability and liquidity under weaker operating conditions, including access to the revolving credit facility and foreign cash availability.