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Watsco (WSO) to Gain from Technology Development, Costs High

Zacks Equity Research

Watsco, Inc. WSO has been benefiting from ongoing investment in technology, higher HVAC equipment unit growth, and improved equipment pricing and sales mix. However, higher SG&A expenses and seasonal factors raise concerns.

Last month, the company reported fourth-quarter 2018 results, wherein earnings and revenues missed the Zacks Consensus Estimate by 3.8% and 1.9%, respectively. The poor performance was mainly due to extreme weather conditions and certain incremental costs.

Nonetheless, earnings and revenues increased 13.3% and 2.8%, respectively, from the year-ago level. The upside stemmed from higher unit demand in HVAC equipment, and improved pricing and sales mix. Continued investment in the technologies designed to revolutionize customer experience added to the positives.

Key Growth Drivers

Watsco has been investing in technology to improve customer experience through e-commerce, in a bid to improve speed, productivity and efficiency. Given the use of various technology platforms, the company’s e-commerce sales accounted for 29% of the total sales in 2018 compared with 25% a year ago.

It is poised to benefit from strong unit demand, higher pricing and sales mix. Sales of HVAC equipment (heating, ventilating and air conditioning; comprising 67% of sales) grew 6% in 2018, and that of other HVAC products (29% of sales) increased 5% from a year ago.

Watsco’s acquisition of Alert Labs, a technology company in Canada, in October 2018 will help it to grow its customer base and profitability. The buyout will also help the company in leveraging technology investment, enhancing productivity and reducing costs.

Meanwhile, consistent dividend payouts underscore the company’s financial strength and stability. During the fourth quarter, Watsco raised its annual dividend by 10% to $6.40 per share. Notably, 2018 marked the 45th consecutive year of dividend payment by Watsco.

Since 2000, the company’s cash flow was approximately $2.4 billion and net income totaled roughly $2.3 billion, meeting its stated goal of generating cash flow in excess of net income. The company continues to look for investments to grow network, and invest in acquisitions or mergers. Notably, it generated a 30-year compounded total shareholder return of 18%.

Major Headwinds


 

Shares of Watsco have lost 18.4% against its industry's growth of 3.7% in the past year. Earnings estimates for 2019 and 2020 have declined 0.7% and 0.4%, respectively, over the past 30 days, depicting analysts’ concern surrounding the company's bottom-line growth potential.

Higher SG&A expenses, lower vendor incentives and seasonal factors are pressing concerns for Watsco. The company’s digitization of business and incremental technology spending have been substantially increasing SG&A expenses over the past few years. In fact, incremental SG&A, which includes $9 million in field-level incentive compensation, $7 million in health-related costs and $4 million in incremental technology spending (including the acquisition of Alert Labs), impacted overall performance of the company in 2018.

Also, fluctuations in sales due to seasonal demand of residential air conditioners and heating equipment significantly hurt its profitability. Watsco’s profitability will be impacted favorably or unfavorably, based on the severity or mildness of weather patterns during summer or winter selling seasons.

Zacks Rank & Stocks to Consider

Watsco currently carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Some better-ranked stocks in the Zacks Construction sector include Quanta Services, Inc. PWR, Apergy Corp. APY, and Armstrong World Industries, Inc. AWI. While Quanta Services and Apergy sport a Zacks Rank #1 (Strong Buy), Armstrong World carries a Zacks Rank #2 (Buy).

Quanta Services and Armstrong World’s earnings for the next year are expected to increase 4.3% and 12.6%, respectively.

Apergy has a solid three-five year expected EPS growth rate of 22.5%.

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