Watsco, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Watsco distributes HVAC/R equipment, parts and supplies; results are seasonal, with residential air-conditioning demand typically strongest in the second and third quarters. Amounts below are in millions except per-share data.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $1,296.0 | $1,229.6 | $3,555.3 | $3,377.6 |
| Gross profit / margin | $319.0 / 24.6% | $295.9 / 24.1% | $870.6 / 24.5% | $824.7 / 24.4% |
| Operating income | $122.3 | $114.5 | $313.6 | $292.5 |
| Net income attributable to Watsco | $79.2 | $65.0 | $203.3 | $165.0 |
| Diluted EPS | $2.11 | $1.82 | $5.43 | $4.62 |
| Net cash from operating activities | — | $70.1 | $189.4 |
- Revenue increased 5% in both periods; same-store revenue also grew 5%. Q3 same-store HVAC equipment sales rose 7%, including residential growth of 6% and commercial growth of 9%.
- Q3 gross margin expanded 50 basis points, while SG&A rose 9% to $200.4 million and increased to 15.5% of revenue from 14.9%. Nine-month SG&A was 15.9% of revenue versus 15.8%.
- Watsco attributed earnings growth to higher sales, improved margins, lower interest expense and lower income taxes. Effective tax rates attributable to Watsco declined to 23.3% for Q3 and 23.6% for the nine months, primarily reflecting the federal corporate tax-rate reduction.
Liquidity, debt and cash flows
- At September 30, cash was $67.6 million and working capital was $993.0 million. Current assets were $1,501.8 million and current liabilities $508.8 million.
- Revolver borrowings were $116.4 million, versus $21.8 million at year-end 2017. The $300 million unsecured facility matures July 1, 2019; Watsco classified the borrowing as current and said it expects to refinance on similar terms. The company reported covenant compliance.
- Nine-month operating cash flow fell $119.3 million year over year to $70.1 million. Management cited the timing of payments for accrued expenses and other liabilities and higher receivables, partly offset by lower inventory growth and higher net income. Receivables used $126.2 million and inventory used $50.6 million of cash.
- Investing cash outflow was $22.3 million, including $5.8 million cash consideration for the Alert Labs acquisition and $3.8 million for an additional RSI interest. Financing cash outflow was $59.8 million; dividends paid were $155.0 million.
Changes, outlook and risks
- Other income was $8.5 million for the nine months, versus $2.3 million, primarily Watsco’s equity-method share of RSI earnings. Its RSI interest increased to 36.3% in June 2018.
- Watsco acquired Alert Labs, a Canadian technology company, in August for $5.9 million cash and 47,103 shares valued at $8.2 million; the pro forma impact was not significant.
- No numerical full-year earnings or revenue guidance is provided in the supplied filing text. Management said cash, operating cash flow and revolver availability should meet foreseeable liquidity needs, while noting refinancing and funding are not assured.
- On October 23, the board approved increasing the quarterly dividend from $1.45 to $1.60 per share beginning with the January 2019 payment.
- Key exposures include seasonality and weather, economic and construction conditions, competition, commodity costs, liquidity and refinancing, foreign exchange, insurance, cybersecurity and regulation. Purchases from Carrier and its affiliates represented 64% of Q3 inventory purchases and 63% for the nine months.
- The company said known litigation is not expected to have a material adverse effect. It expects the January 1, 2019 lease-accounting adoption to materially increase balance-sheet assets and liabilities, but does not expect a material income-statement impact.
Important facts for investors to verify
- Whether Watsco refinanced the $300 million revolver before its July 2019 maturity, and the resulting terms and borrowing capacity.
- Whether operating cash flow recovered as seasonal receivables and inventory converted to cash, given the year-over-year decline in nine-month cash flow.
- Whether margin gains and expense leverage persisted after Q3, and how much earnings growth depended on lower taxes and RSI equity income.
- Carrier supplier concentration, the economics and funding implications of the RSI investment and related purchase obligations, and Alert Labs’ subsequent contribution.
- The eventual balance-sheet effect of lease adoption and the sustainability of the increased dividend.