We came across a bullish thesis on Watsco, Inc. (WSO) on Seeking Winners’ Substack by Seeking Winners. In this article we will summarize the bulls’ thesis on WSO. Watsco, Inc. (WSO) share was trading at $500.25 as of Sept 19th.

An engineer inspecting a HVAC system, revealing the complexity of the products.

Watsco stands as a dominant force in the $42 billion North American HVAC distribution market, commanding an estimated 18% market share and serving over 350,000 contractors through nearly 700 locations across the U.S., Canada, Mexico, and Puerto Rico. With total revenue of $7.28 billion in 2023, Watsco ranks as the largest HVAC distributor, achieving a high return on invested capital (ROIC) of around 20% and generating substantial cash flow with minimal reinvestment needs. The HVAC market itself has shown steady growth, with a 3.4% CAGR since 1980, heavily driven by significant replacement demand due to aging systems, particularly in the Sun Belt region, which comprises approximately 80% of the market.

Watsco has effectively utilized an acquisition strategy, having successfully acquired 69 HVAC distribution businesses, primarily family-owned, without external financing. These acquisitions, typically valued around 6x EV/EBITDA, have been instrumental in enhancing revenue and profit margins. Furthermore, the company invests $35-$40 million annually in developing eCommerce and inventory management systems, now utilized by over 60,000 contractors, which significantly boosts operational efficiency.

Financially, Watsco has demonstrated robust growth metrics, with a revenue CAGR of 9% and same-store sales CAGR of 6% over the past five years. EBITDA, EPS, and free cash flow growth rates have surged by 17%, 18%, and 90%, respectively, from 2019 to 2023. The EBITDA margin has also expanded from 8% to approximately 12% (13.5% in Q2 2024), reflecting Watsco's effective management of operational costs and enhanced profitability. Net operating profit after tax doubled from an estimated $324 million in 2019 to $645 million in 2023, underscoring the company’s strong financial health.

Watsco's valuation indicates a fair value of $454.31 per share in a base case scenario, assuming a sales CAGR of 10% from 2024-2033 and an average EBIT margin of 15%. In a bull case, with a sales CAGR of 15% and an EBIT margin of 18%, the valuation remains the same. Conversely, a bear case scenario projects a fair value of $194.86 per share, based on a slower sales CAGR of 6% and a lower EBIT margin of 12%.

The company's strategic focus on technology and customer relationships enhances its competitive advantage, creating barriers for smaller competitors. Looking ahead, the U.S. HVAC market is projected to grow to $30.41 billion in 2023, driven by extreme weather, energy-efficient systems, and government incentives. While facing potential risks from seasonality and supply chain concentration, Watsco's strong capital allocation strategy and focus on acquisitions position it well for long-term value creation.