Watsco's Strategic Expansion
A Blueprint for HVAC Growth
Investment Thesis
Industry Leader with Substantial Market Share.
High Return on Invested Capital and Cash Generative Business.
Recession-Proof Durable Business with Long Growth Runway.
Widening Competitive Advantage.
Founder-Led Management Team with Aligned Focus.
Consistent Track Record of Delivering Value.
Industry Leader with Substantial Market Share
The North American HVAC distribution market is a $42bn industry. Watsco, with an estimated 18% market share, has almost 2.5x the market share of the next largest competitor. It serves 350K+ contractors and technicians in its key markets and has nearly 700 locations across the United States, Canada, Mexico and Puerto Rico with additional market coverage on an export basis to portions of Latin America and the Caribbean. 60,000 of these contractors are now linked to a Watsco e-commerce account as of June 30, 2024.
Watsco has concentrated its locations in the sunbelt states, where the need for cooling is omnipresent throughout the year. Florida represents its largest market and Texas its second largest market.
The top 30 HVAC distributors 2023 sales total was $19.8 billion USD. Watsco, along with Ferguson Enterprises, Winsupply Inc., and R.E. Michel Co., reported combined 2023 sales of more than $14.48 billion USD. Watsco is the largest with total 2023 revenue of $7.28 billion.
High Return on Invested Capital and Cash Generative Business
Watsco’s efficient distribution model and substantial scale have generated substantial cash flow with minimal reinvestment needs. This has translated into exceptional returns on both assets and invested capital. Over the past 5 years, Watsco's invested capital (defined as net working capital plus net fixed assets) has grown from 1,085.0 million in 2019 to $1,679.9 million today, while operating income soared from $367 million to $796 million. This impressive performance equates to a robust cash-on-cash return in the 20% range. With cash ROIC of 20% on a steadily expanding revenue and capital base, management has been able to strategically invest in organic growth and a disciplined acquisition strategy, as detailed below.
Recession-Proof Durable Business with Long Growth Runway
The HVAC market exhibits strong fundamentals. Since 1980, the installed base of HVAC units has grown at a steady 3.4% CAGR. With approximately 120+ million units installed in the US alone, and nearly 87 million of these over a decade old, the replacement market presents a substantial and enduring opportunity. Given the typical lifespan of 10 to 20 years, this replacement runway is solid. The Sun Belt, with its consistent HVAC usage, is a prime focus for Watsco, accounting for roughly 80% of the North American market.
Beyond a stable and predictable end market, Watsco's growth trajectory is amplified by its dominant position as a consolidator in the highly fragmented HVAC distribution industry. Leveraging superior technology infrastructure and scale, Watsco is widening the competitive gap against smaller, undercapitalized rivals. Many of these smaller players ultimately opt for acquisition by Watsco to access advanced technology and enhanced purchasing power from OEMs.
Of the ~2,200 independent HVAC distributors in North America, the vast majority (99%) are family-owned businesses generating annual revenue between $30 million and $50 million. These represent Watsco's primary acquisition targets. The company has successfully acquired 69 HVAC distribution businesses without external financial assistance and over the last five years, Watsco has acquired eight businesses that today generate approximately $1 billion in annual sales. These acquisitions typically command a valuation of ~6x EV/EBITDA. Acquired businesses have EBIT margins of 4-6% initially, expanding to 8-10% after a couple of years. Given Watsco's current market valuation of around 24x times EBIT (20x on a forward basis), these deals generate substantial economic value.
A unique factor contributing to Watsco's M&A advantage is the limited involvement of private equity in the HVAC distribution sector. This absence of financial buyers has prevented a bidding war for acquisition targets. OEMs often include clauses in distributor agreements granting veto power over ownership changes, deterring private equity firms due to their perceived focus on cost cutting, which can negatively impact customer service and brand perception. Watsco may be the only viable acquirer for certain distributors because of this.
Widening Competitive Advantage
Watsco's substantial scale has enabled significant investments in technology infrastructure, a luxury out of reach for its fragmented competition. Over the past five years, the company has consistently allocated $35-$40 million annually to develop an eCommerce platform, online sales tools, inventory, and warehouse management systems, revolutionizing a traditionally antiquated industry.
Historically, contractors faced a time-consuming process to diagnose issues, check parts availability, collect supplies, and complete repairs. Watsco's digital solutions have streamlined this process, allowing contractors to quickly diagnose problems, order necessary parts online, and collect them efficiently. This translates to significantly improved productivity and revenue for contractors using Watsco products compared to competitors.
Watsco reaps multiple benefits from this digital transformation. Increased contractor efficiency drives repeat business and market share gains. Enhanced demand forecasting, improved fill rates, and optimized inventory management are reducing costs and working capital. This virtuous cycle of accelerating revenue, lower expenses, and stronger free cash flow positions Watsco to further consolidate the industry.
The COVID-19 pandemic accelerated the adoption of Watsco's digital tools. The number of contractors using Watsco's digital platform has surged from 12,000 at the end of 2019 to 60,000 today.
Founder-Led Management Team with Aligned Focus
We strongly admire Watsco's founder-led management team. CEO Al Nahmad and President AJ Nahmad along with other named directors share a 12.28% ownership stake (4.947,823 out of the total 40,300,014 shares) but wield significant control with 55.1% of voting rights, enabling them to operate with the autonomy of a private company. Their unwavering focus is on long-term value creation through organic growth and industry consolidation. Unconstrained by short-term pressures, they embody a "quarter century, not quarter" mentality.
Consistent Track Record of Delivering Value
Over the past 34+ years, Watsco has delivered a total return of 42,980% (CAGR: 19.1%) compared to the S&P 500’s return of 2,059% (CAGR: 10.2%). In almost any time period you look at the company, the outperformance is similar:
