Watsco, Inc. — Q2 2016 Form 10-Q
Business and period: Unaudited results for the quarter and six months ended June 30, 2016. Watsco distributes HVAC/R equipment and related products, operating 563 locations across the U.S., Canada, Mexico and Puerto Rico. Results are seasonal and can be affected by weather, with residential air-conditioning demand typically strongest in the second and third quarters.
Key financial results
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $1,214.4m | $1,223.4m | $2,065.9m | $2,032.4m |
| Gross profit / margin | $291.9m / 24.0% | $295.2m / 24.1% | $504.3m / 24.4% | $499.5m / 24.6% |
| Operating income / margin | $117.6m / 9.7% | $124.9m / 10.2% | $168.3m / 8.1% | $171.9m / 8.5% |
| Net income attributable to Watsco | $64.6m | $65.4m | $90.2m | $88.5m |
| Diluted EPS | $1.82 | $1.85 | $2.54 | $2.51 |
- Q2 revenue declined 1%; same-store revenue fell $3.3m, reflecting lower residential HVAC demand. HVAC equipment sales fell 1%, other HVAC products fell 3%, and commercial refrigeration sales rose 8%.
- First-half revenue increased 2%, including a 2% same-store increase. Same-store HVAC equipment sales rose 2%, other HVAC products were flat, and commercial refrigeration sales rose 7%.
- Q2 SG&A rose 2% to $174.3m; SG&A as a share of revenue increased to 14.3% from 13.9%. First-half SG&A rose 3% to $336.1m. Technology initiatives added $1.0m of year-over-year Q2 costs and $2.5m for the first half.
- Net interest expense declined 35% in Q2 and 32% in the first half, primarily due to lower average borrowings. Effective tax rates attributable to Watsco were 34.7% for Q2 and 35.4% for the first half, down from 36.8% and 37.0%, respectively.
Cash flow, liquidity and debt
- Six-month operating cash flow was $41.9m, compared with an outflow of $74.1m in 2015. Management attributed the improvement mainly to a smaller seasonal inventory build, inventory effects from the 2015 regional-efficiency-standard transition, and payment timing for accrued expenses.
- Investing cash outflow was $5.0m versus $14.0m; capital expenditures were $5.6m versus $14.6m. Financing cash outflow was $41.7m versus $85.8m of inflow, reflecting higher repayments, dividends and distributions to non-controlling interests.
- Cash was $30.5m at June 30, 2016, including $20.3m held by foreign subsidiaries. Working capital was approximately $1.0bn, up from $911.0m at year-end 2015, primarily due to seasonal receivables and inventory.
- Revolving-credit borrowings were $267.3m under a $600m unsecured facility maturing July 1, 2019; approximately $332.7m of capacity remained before other facility uses. Watsco reported covenant compliance. Mexican subsidiary short-term borrowings were $0.8m.
- Total borrowings were approximately $268.1m; cash less borrowings was approximately $237.6m. Management said operating cash flow, cash and available credit should meet foreseeable liquidity needs, while noting there can be no assurance and that access depends partly on the lending syndicate.
Material changes, outlook and risks
- Q2 operating income fell 6% and attributable net income fell 1%; first-half operating income declined 2% while attributable net income rose 2%. Gross margin contracted 10 basis points in Q2 and 20 basis points year to date, with management citing lower realized margins on residential HVAC equipment for the first-half decline.
- A $2.3m benefit from early adoption of share-based payment accounting guidance reduced income-tax expense and increased 2016 net income. The filing also shows the adjustment to Q1 2016 results; the benefit is not necessarily recurring.
- No numerical revenue or earnings guidance is provided. Management described ongoing technology initiatives and continued evaluation of acquisitions and joint ventures. The Board approved an increase in the quarterly dividend from $0.85 to $1.05 per share beginning with the October 2016 payment.
- Key stated risks include economic and competitive conditions, supplier concentration, commodity prices, housing and commercial construction activity, seasonal demand and weather, liquidity access, interest and foreign-exchange rates, regulation, insurance and cybersecurity risks.
- Carrier and affiliates accounted for 62% of inventory purchases in both first-half periods; approximately $101m was payable to Carrier and affiliates at June 30, 2016. A non-cancelable purchase order with a key supplier totaled approximately $129m.
- A shareholder derivative suit alleges excessive CEO incentive compensation and seeks unspecified damages. Watsco said it considers the claims without merit and does not expect the matter to have a material effect, but the outcome is uncertain. The filing also describes self-insurance reserves of $4.1m.
Important facts for investors to verify
- Whether residential HVAC demand, gross margins and same-store sales recover after the Q2 decline, and how weather affects seasonal results.
- How working-capital needs, inventory levels and receivables affect operating cash flow and revolver usage through the peak season.
- The impact of Carrier supplier concentration, the large supplier payable and purchase commitment, and the economics of Carrier joint ventures.
- How much of reported earnings improvement reflects the $2.3m share-based-compensation tax benefit, and whether future tax rates differ.
- The sustainability of the increased dividend alongside seasonal financing needs, debt covenants and planned technology spending.
- Developments in the shareholder litigation and any changes in contingent liabilities or self-insurance estimates.