Description

Thesis:

Watsco is a terrific little business out of Miami that is run by a hall of fame manager in Albert Nahmad. The company distributes HVAC products for five of the seven major HVAC manufacturers. HVAC tends to be a highly recurring industry because 80% of the industry revolves repair and replacement of the installed base of AC units.

Watsco is 2.5x the size of the next largest player in the industry and their scale has given them an opportunity to execute a repeatable M&A algorithm. Over the last 20 years the company has acquired 3 companies a year for a total of 60 transactions which has resulted in a share price that is up 100x. We believe the company is still in the early innings of the consolidation of the industry and should continue to compound their share price on this dynamic alone at a fast clip. However, we also think the business is at the precipice of a few market and internal dynamics which should accelerate growth and free cash flow profitability. We think see little downside and tons of upside in the business and think a below 20x FCF multiple is quite cheap for the opportunity.

Background / Industry Structure:

The HVAC industry was started 100 years ago when Carrier invented the first air conditioner. Since then, many players have entered and exited, but today only 7 players control 90% of the market in the US. Those manufacturers trade at hefty multiples largely because of the recurring nature of the HVAC industry and the benefit to manufacturing scale.

For the first 50 years, those players went direct to service technicians fixing / repairing broken AC units. This was a problem because AC repair parts are a “Just-in-Time” product that requires repair in under 24 hours. Otherwise, customers are often left in the middle of July in Florida in a 100-degree house while they wait for their repair. This dynamic gives a player with a local footprint a tremendous advantage and eventually pushed manufacturers to use third party distributors which is where most of the distribution sits today. Over the last 50 years most of these third-party distributor businesses have sat inside the same family and been handed from generation to generation. There has been very little institutional focus on this space and as such the industry is highly fragmented with 2,000 companies inside the US and no one besides Watsco having more than 5% share. Having said that, there is quite a bit of M&A happening in the industry at cheap multiples (3-6x EBIT). This generally takes place between the players as a succession tool when an owner does not have a family member to bequeath his/her business too.

The last leg of the value chain are the service technicians that come into a home / business and diagnose and then fix a problem. This industry is dominated by mom and pop with tens of thousands of businesses and over 100k contractors. Players like Bluedot tried to consolidate the industry in the 2000’s but failed and eventually went BK. There is a small business private equity mafia that appreciates the recurring nature of this business and the leverage-ability. As such, many private equity firms are focused on this space and multiples have increased dramatically (10 – 20x EBITDA).

Watsco Background:

Albert Nahmad has worked at Watsco for most of his career and his family owns ~$1bn of stock. He could easily be written about in the next chapter of the Outsiders because his track record has been phenomenal, and his disciples are running large businesses also (POOL, EVI). A large value creation lever was pulled in 2009 when Watsco acquired Carrier’s distribution business from Carrier. This gave them an exclusive right to distribute Carrier products in most of the US indefinitely. This is quite a spot to be in... Watsco is basically the only company that customers who want new Carrier units or need to repair their Carrier units can buy from in the US. That Carrier installed base will continue to break and Carrier customers will cointinually have one only option…which is Watsco. 

Watsco distributes for other manufacturers but Carrier is 60% of their revenue today. This very advantageous market positioning gave them the opportunity to grow rapidly and build scale.

Watsco M&A Algorithm:

In the HVAC distribution space, there are 2,000 players and therefore 2,000+ bespoke distribution agreements governing the pricing and terms between manufacturer and distributor. In other words, there is generally not template document and each commercial agreement is negotiated between the counterparties. The rule of thumb for this dynamic is that the bigger you are the better distribution agreement you will get. Watsco is the largest player in the industry by far and therefore commands the best pricing and payables and other terms with manufactuerers. This presents a highly scalable model through M&A.

Watsco goes out and internally connects with all the players in the industry (they have never used an investment bank). When those players are ready to sell, Watsco acquires their business and rips of their distribution agreement in favor of their own. This gives the acquisition target better pricing and more favorable terms in addition to leading edge systems that help move inventory quickly. Watsco think this dynamic gives their target the ability to double margins in just a few short years creating tons of value for the Company and often times the former shareholder who has rolled his equity. Watsco currently only has 15% market share, has limited debt and generates a tremendous amount of cash. Giving them the opportunity and the resources to continue to roll up the industry over the long term.

Other Factors at Play:

·       Growing Installed Base -  the industry is attractive because the installed base of AC units in the US has grown virtually ever year since they were invented. Around the time of the financial crisis construction slowed and shipments decreased. The units generally take about 12-14 years to break before a repair is required. That means the 2009 vintage of AC units are coming up for repair. The 2009 vintage was the catalyst of a significant 10 year new unit expansion in the industry leading us to believe that the next decade should be filled with more repair events than the previous one.

·       Working Capital Gains -  the business has done $500m in free cash flow LTM. That is almost 50% higher than any year previously. They were able to achieve this through solid operating performance and working capital gains. We think the working capital gains were some mix of operational wins and covid de-stocking. To the extent they have made significant working capital gains, the business could be much more profitable as there is an obvious enormous inventory build required to operate the business.

·       Technology Investment / Gains – the company loves to toute its technology gains. They have recently released products to help them optimize high margin / fast moving inventory and a web-based platform that helps contractors know their part is in stock. Watsco’s ability to earn higher margins gives them the opportunity to invest more dollars into growth avenues such as technology.

Catalyst

M&A

2009 Installed Base growth coming up for repair

Margin / Working Capital Gains