Watsco, Inc. — Q3 2013 Form 10-Q
Business context and period. Watsco distributes HVAC/R equipment, parts and supplies. This unaudited report covers the quarter and nine months ended September 30, 2013, compared with the same periods in 2012. The company operated 571 locations in 38 U.S. states, Canada, Mexico and Puerto Rico. Results are seasonal, with residential air-conditioning demand typically strongest in the second and third quarters.
Financial performance
Amounts below are in millions, except per-share data. Balance-sheet amounts compare September 30, 2013 with December 31, 2012.
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Revenue | $1,081.9 | $1,020.9 | $2,916.0 | $2,666.2 |
| Gross profit / margin | $258.6 / 23.9% | $242.5 / 23.8% | $700.7 / 24.0% | $631.6 / 23.7% |
| Operating income / margin | $95.5 / 8.8% | $85.7 / 8.4% | $231.1 / 7.9% | $191.5 / 7.2% |
| Net income attributable to Watsco | $45.7 | $41.0 | $110.4 | $88.6 |
| EPS, basic / diluted | $1.32 / $1.32 | $1.19 / $1.19 | $3.19 / $3.18 | $2.62 / $2.61 |
- Growth and drivers: Q3 revenue rose 6% and Watsco-attributable net income rose 11%. Nine-month revenue increased 9%, while attributable net income increased 25%. Same-store revenue grew 6% in both periods; management cited strong residential HVAC demand. Nine-month revenue included $87.4 million from Carrier Enterprise III locations acquired in 2012.
- Margins and expenses: Gross margin improved 10 basis points for Q3 and 30 basis points year to date. SG&A was 15.1% of Q3 revenue versus 15.4% a year earlier, and 16.1% year to date versus 16.5%, reflecting fixed-cost leverage. Nine-month 2012 SG&A included $1.1 million of acquisition costs.
- Cash flow: Nine-month operating cash flow was $51.2 million, down from $64.4 million. Investing cash outflow was $10.7 million versus $89.3 million, primarily because 2012 included $80.5 million of cash consideration for Carrier Enterprise III. Financing cash outflow was $84.7 million versus $54.8 million of inflow in 2012. Cash declined $44.5 million to $29.2 million.
- Liquidity and debt: Working capital was $850.0 million, up from $733.1 million at year-end, primarily reflecting seasonal increases in receivables and inventory. Revolver borrowings were $284.8 million, down from $316.2 million; the facility limit is $500 million. The company reported compliance with its debt covenants. Cash included $19.1 million held by foreign subsidiaries.
- Other financial items: Net interest expense rose to $1.8 million in Q3 and $4.7 million year to date, mainly due to higher average borrowings, partly offset by lower effective rates. The effective tax rate attributable to Watsco was 37.0% in both comparative periods. Dividends paid were $0.75 per share year to date; a $0.40-per-share quarterly dividend was declared after quarter-end.
Material changes, outlook and risks
- On July 1, 2013, Watsco amended its $500 million revolving credit agreement, extending maturity to July 1, 2018, reducing pricing and providing greater covenant flexibility for seasonal working-capital needs.
- Management said operating cash flow, cash on hand and borrowing availability should meet foreseeable liquidity needs, while cautioning that funding sufficiency is not assured and access depends partly on lender performance and credit-market conditions.
- No specific earnings or revenue guidance was provided. Management highlighted ongoing evaluation of acquisition and joint-venture opportunities.
- Principal risks include economic and competitive conditions, supplier concentration, commodity costs, housing and commercial construction activity, seasonal demand and weather, liquidity and borrowing access, insurance, regulation, interest rates and foreign-exchange movements. Carrier and its affiliates represented 62% of purchases in Q3 2013; approximately $96 million was payable to them at September 30.
- Management stated that known litigation was not expected to have a material adverse effect, based on information then available. Self-insurance reserves were $5.5 million; actual claims or adverse reserve development could require additional reserves.
- Foreign-currency translation produced a $8.4 million year-to-date other comprehensive loss. The company also reported a $203,000 fair value liability for foreign-currency forward contracts, which were economic hedges but not designated for hedge accounting.
- Disclosure controls were assessed as effective. Watsco had not yet assessed internal controls at Carrier Enterprise III’s 35 acquired locations, representing approximately 17% of consolidated assets and 8% of nine-month revenue.
Important facts for investors to verify
- Whether same-store residential HVAC demand and gross-margin improvement continue beyond the peak seasonal selling period.
- How much of year-over-year growth reflects underlying same-store performance versus acquired Carrier Enterprise III operations.
- Working-capital requirements, operating cash conversion and revolver utilization as the business moves into its lower-demand season.
- Ongoing dependence on Carrier as a supplier and the related-party purchasing and payable balances.
- Debt covenant headroom, variable-rate exposure and the availability of revolving-credit funding.
- Developments in self-insurance estimates, litigation and the financial reporting controls assessment for Carrier Enterprise III.