Watsco, Inc. — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018. Watsco distributes HVAC/R equipment, parts and supplies across North America, operating 568 locations. Results are seasonal; residential cooling demand is typically strongest in the second and third quarters.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Revenue | $1,332.7 million | $1,275.9 million | $2,259.3 million | $2,148.0 million |
| Gross profit / margin | $320.8 million / 24.1% | $310.3 million / 24.3% | $551.6 million / 24.4% | $528.8 million / 24.6% |
| Operating income / margin | $137.3 million / 10.3% | $129.3 million / 10.1% | $191.3 million / 8.5% | $178.0 million / 8.3% |
| Net income attributable to Watsco | $90.0 million | $73.8 million | $124.2 million | $99.9 million |
| Diluted EPS | $2.40 | $2.07 | $3.32 | $2.80 |
- Q2 revenue rose 5%; same-store revenue rose 4%. First-half revenue and same-store revenue each rose 5%. Growth was led by HVAC equipment, with higher sales of residential and commercial equipment; higher-efficiency system mix also supported sales.
- Q2 gross margin declined 20 basis points, attributed to a prior-year nonrecurring benefit in non-equipment products and lower vendor incentives due to purchase timing, partly offset by better HVAC equipment selling margins. First-half margin declined 20 basis points, primarily from a sales mix shift toward lower-margin HVAC equipment.
- SG&A was 14.0% of Q2 revenue versus 14.2% a year earlier, and 16.2% of first-half revenue versus 16.3%. Technology initiatives added $0.7 million of Q2 costs and $1.0 million of first-half costs versus the prior year.
- Effective tax rates attributable to Watsco were 23.8% for both periods in 2018, versus 32.9% in Q2 2017 and 33.1% in the first half of 2017, mainly reflecting the U.S. federal tax-rate reduction. Q2 net income attributable to Watsco increased 22%; first-half net income increased 24%.
Cash flow, liquidity and debt
- First-half operating cash flow was a use of $19.3 million, compared with $35.0 million provided in 2017. Increased receivables and inventory, reflecting higher sales and seasonal working-capital needs, were the primary drivers.
- Investing cash use was $8.7 million versus $73.8 million in 2017, when Watsco invested $63.6 million in RSI. Financing provided $20.8 million; dividends paid totaled $100.8 million.
- At June 30, cash was $72.0 million; current assets were $1,621.5 million and current liabilities $522.9 million. Working capital was approximately $1.1 billion. Cash includes $58.5 million held by foreign subsidiaries.
- Revolving-credit borrowings were $141.6 million, up from $21.8 million at year-end; an additional $1.5 million was drawn on a Mexican subsidiary credit line. The revolving facility’s capacity was reduced from $600 million to $300 million in February 2018 and matures July 1, 2019. Watsco reported covenant compliance and expected to refinance at or before maturity on similar terms.
Outlook, commentary and risks
- The filing provides no specific revenue, earnings or other numerical guidance. Management said operating cash flows, cash on hand and available revolver capacity should meet foreseeable liquidity needs, while cautioning that funding availability is not assured.
- Management cited strong replacement demand and higher-efficiency product mix. The business remains exposed to seasonality and weather, economic conditions, competition, supplier concentration, commodity costs, housing and commercial construction, interest rates, currency movements, regulation, cybersecurity and access to liquidity.
- Watsco’s 80%-owned Carrier Enterprise I investment in RSI generated $3.2 million of Q2 and $4.8 million of first-half equity-method income. Its ownership increased from approximately 35% to 36.3% in June; $3.8 million consideration was paid July 5, 2018. RSI shareholders have contractual sale rights that could require future purchases.
- Carrier and affiliates supplied 64% of Q2 inventory purchases and 63% for the first half; amounts payable, net of receivables, were approximately $152 million at June 30. This supplier concentration is a material dependency.
- Adoption of the new lease standard, effective for Watsco in 2019, is expected to materially increase balance-sheet assets and liabilities; management did not expect a material income-statement effect. The revenue standard adopted in 2018 had no significant overall financial-statement impact.
- Known litigation was not expected by management to materially affect financial condition or results. Disclosure controls were judged effective; no material change in internal control was reported.
Investor verification priorities
- Confirm seasonal working-capital trends and whether receivables and inventory convert to operating cash in the second half.
- Review refinancing progress, facility availability and covenant headroom ahead of the July 2019 revolver maturity.
- Assess gross-margin trends, vendor incentives and product mix against revenue growth.
- Evaluate dependence on Carrier as supplier and partner, including RSI purchase obligations and potential additional ownership transactions.
- Track the timing and balance-sheet effect of lease-standard adoption and the sustainability of dividends.