Watsco, Inc. — Q3 2017 Form 10-Q
Business and period: Watsco distributes HVAC/R equipment, parts and supplies across North America. This unaudited report covers the quarter and nine months ended September 30, 2017, compared with the corresponding 2016 periods. Results are seasonal and weather-sensitive; Watsco operated 562 locations at quarter-end.
Financial results
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Revenue | $1,229.6m | $1,241.2m | $3,377.6m | $3,307.1m |
| Gross profit / margin | $295.9m / 24.1% | $302.2m / 24.3% | $824.7m / 24.4% | $806.5m / 24.4% |
| Operating income / margin | $114.5m / 9.3% | $119.3m / 9.6% | $292.5m / 8.7% | $287.6m / 8.7% |
| Net income attributable to Watsco | $65.0m | $63.1m | $165.0m | $153.3m |
| Diluted EPS | $1.82 | $1.78 | $4.62 | $4.32 |
Q3 revenue fell 1%, while Watsco-attributable income rose 3%; lower revenue and gross margin were partly offset by equity-method income, lower taxes and a smaller share of earnings allocated to non-controlling interests. For the nine months, revenue rose 2%, attributable income increased 8%, and diluted EPS increased about 7%. The nine-month effective tax rate attributable to Watsco was 33.0%, down from 36.0%.
Cash flow, balance sheet and capital
- Nine-month operating cash flow was $184.7m, versus $146.3m; investing cash use was $77.3m versus $8.3m, including the $63.6m RSI investment; financing cash use was $98.3m versus $137.4m.
- Cash was $66.7m at September 30, 2017, including $54.0m held by foreign subsidiaries. Working capital was $978.5m, up from $925.3m at year-end 2016; management attributed the increase largely to seasonal receivables and inventory.
- Revolver borrowings were $284.7m, up from $235.3m at December 31, 2016, under a $600m unsecured facility maturing July 1, 2019. Watsco said it was in compliance with covenants.
- Watsco paid $3.35 per share in dividends during the first nine months, versus $2.55 in 2016. The board declared another $1.25 quarterly dividend, paid October 31, 2017.
Material changes and management commentary
- Q3 same-store revenue was flat. Natural disasters in August and September affected more than 300 locations; 190 temporarily closed, including sites in Florida, Texas, Georgia and Puerto Rico. Management cited disrupted activity and anticipated restoration and replacement demand.
- Nine-month same-store revenue increased 3%, primarily on demand for residential HVAC replacement equipment. Q3 gross margin declined 20 basis points, mainly because of a sales mix shift toward lower-margin HVAC equipment.
- In June, a Carrier joint venture acquired a 35% interest in HVAC distributor Russell Sigler, Inc. (RSI) for $63.6m; Watsco funded $50.9m and Carrier $12.7m. Watsco recorded $2.3m of equity-method income for the quarter and nine months. Under the agreement, RSI shareholders have specified rights to sell shares to the joint venture, which has a corresponding purchase obligation.
- Watsco increased its ownership of Carrier Enterprise II to 80% after purchasing an additional 10% for $42.7m in February 2017. Increased ownership reduced income attributable to non-controlling interests.
- Watsco began an at-the-market share offering program of up to $250m. It sold 35,000 shares for $5.4m net proceeds through September 30, with $244.6m remaining available.
Outlook, risks and contingencies
No quantified earnings or revenue guidance was provided. Management said operating cash flow, cash on hand, revolver availability and potential ATM proceeds should be sufficient for foreseeable liquidity needs, while cautioning that funding access is not assured. It continues to evaluate acquisitions and potential additional RSI ownership.
Risks highlighted include seasonal demand and weather, economic and construction trends, supplier concentration, commodity costs, liquidity and credit-market access, interest and foreign-exchange rates, regulation, insurance, cybersecurity and execution of strategy. Carrier and affiliates supplied 62% of inventory purchases in both comparison periods; amounts payable to them, net of receivables, were approximately $134m at September 30, 2017, versus $63m at year-end 2016. A shareholder derivative lawsuit was dismissed with prejudice in May 2017; Watsco said known litigation was not expected to have a material adverse effect. Self-insurance reserves were $2.8m. Management reported effective disclosure controls and no material change in internal control over financial reporting.
Investor verification points
- Assess the duration and financial effects of disaster-related closures and whether replacement demand materialized as expected.
- Monitor gross-margin mix, same-store growth, and the ability to manage SG&A and technology costs.
- Review seasonal working-capital needs, revolver usage, interest costs, covenant headroom and the 2019 facility maturity.
- Verify RSI investment performance and the potential cash impact of contractual shareholder sale rights or further purchases.
- Track Carrier supplier concentration and the scale and dilution implications of any further ATM share sales.