Watsco, Inc. — Q2 2017 Form 10-Q
Business context and reporting period: Watsco distributes HVAC/R equipment, parts and supplies across North America. This unaudited filing covers the quarter and six months ended June 30, 2017, compared with the same 2016 periods. Results are seasonal, with residential air-conditioning demand typically strongest in the second and third quarters.
Financial performance
| Metric | Q2 2017 | Q2 2016 | First half 2017 | First half 2016 |
|---|---|---|---|---|
| Revenue | $1,275.9 million | $1,214.4 million | $2,148.0 million | $2,065.9 million |
| Gross profit | $310.3 million | $291.9 million | $528.8 million | $504.3 million |
| Gross margin | 24.3% | 24.0% | 24.6% | 24.4% |
| Operating income | $129.3 million | $117.6 million | $178.0 million | $168.3 million |
| Operating margin | 10.1% | 9.7% | 8.3% | 8.1% |
| Net income attributable to Watsco | $73.8 million | $64.6 million | $99.9 million | $90.2 million |
| Diluted EPS | $2.07 | $1.82 | $2.80 | $2.54 |
- Revenue and earnings: Q2 revenue rose 5% year over year, with same-store sales up 5%; first-half revenue rose 4%, with same-store sales up 4%. Watsco-attributable net income increased 14% in Q2 and 11% in the first half.
- Drivers and costs: Management attributed sales growth mainly to residential HVAC replacement demand and a richer mix of higher-efficiency systems. Gross margin improved year over year in both periods. SG&A rose 4% in both periods; first-half SG&A included $0.6 million of additional technology-initiative costs. Net interest expense increased 56% in Q2 and 42% in the first half, primarily from higher average borrowings and effective rates.
- Cash flow: First-half operating cash flow was $32.2 million, down from $41.9 million. Investing cash outflow was $73.8 million, including the $63.6 million RSI investment; financing provided $35.9 million. Cash declined $5.0 million to $51.0 million.
- Liquidity and debt: Working capital was approximately $1.0 billion at June 30, up from $925.3 million at year-end, primarily reflecting seasonal receivables and inventory growth. Revolver borrowings were $379.3 million versus $235.3 million at December 31, 2016; the facility provides up to $600 million and matures July 1, 2019. The company reported compliance with financial covenants. Cash included $47.6 million held by foreign subsidiaries, whose repatriation could have adverse tax consequences or be subject to capital controls.
Material changes, outlook and risks
- Watsco acquired an additional 10% of Carrier Enterprise II in February for $42.7 million, taking its ownership to 80%; the lower non-controlling interest contributed to growth in Watsco-attributable earnings.
- In June, Carrier Enterprise I acquired a 35% equity-method interest in HVAC distributor Russell Sigler, Inc. for $63.6 million. Watsco contributed $50.9 million and Carrier $12.7 million. Under the shareholder agreement, RSI shareholders have sale rights that Carrier Enterprise I is obligated to purchase under specified pricing terms; the filing says Watsco believes available liquidity can fund possible additional purchases.
- The board declared a regular quarterly dividend of $1.25 per share on July 3, 2017, payable July 31 to holders of record July 17. First-half dividends paid were $2.10 per share, versus $1.70 in 2016. No share repurchases occurred in the quarter.
- No specific full-year earnings or revenue guidance is provided. Management said operating cash flow, cash on hand and revolver availability should meet foreseeable liquidity needs, while cautioning that funding sufficiency is not assured.
- Key risks cited include seasonality and weather, economic and housing conditions, competition, supplier concentration, commodity costs, liquidity and credit-market access, interest and foreign-exchange rates, regulation, insurance and cybersecurity. Carrier and affiliates supplied 62% of inventory purchases in both comparable periods.
- A shareholder derivative suit concerning executive incentive compensation was dismissed with prejudice after the appeal was dismissed in May 2017. The company said known litigation is not expected to materially affect its financial condition or results, while noting outcomes cannot be predicted with certainty.
Important facts for investors to verify
- Whether seasonal demand, weather and product mix sustain revenue growth and gross-margin improvement in subsequent quarters.
- Working-capital conversion and operating cash flow, given the seasonal inventory build and increased revolver borrowings.
- The terms and potential cash implications of RSI shareholders’ sale rights, and the performance of Watsco’s RSI investment.
- Exposure to Carrier as both a major supplier and joint-venture partner, including related-party purchasing and sales arrangements.
- Dividend sustainability and available liquidity after debt-funded ownership purchases and other capital uses.