Buy Watsco Stock. The Air-Conditioning Stock Is Ready to Heat Up.

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The temperature is rising, but shares of air-conditioning distributor

Watsco

have cooled off. That’s created an opportunity for investors to buy the stock.

Summer should be a great time for Watsco (ticker: WSO). The heating, ventilation, and air conditioning, or HVAC, distributor operates about 670 stores across the country, from which it sells tens of thousands of products to hundreds of thousands of contractors. Its wares include new AC units, replacement parts, refrigerants, and even Nest thermostats.

It’s a stable business, one that leads to consistent earnings and sales, and it should be attractive to investors looking to play defense while benefiting from the heat.

Instead, Watsco shares have responded as if winter were coming. Its stock has dropped 21% this year, a touch more than the

S&P 500
index’s 18% decline. That’s largely a result of the downturn in the housing market, which appears to be accelerating as mortgage rates rise. New houses, after all, need new air conditioners.

Worries about a possible recession also linger over a stock that depends on people having enough money to spend.

Watsco’s business is more stable than that. While selling new ACs is part of its business, repairs and replacement parts account for 85% of its sales. At the same time, it’s nearly impossible to trade down for cheaper parts, given that they’re available only in stores and not online. “[You] can buy Gillette razors through Amazon,” adds Barry Logan, Watsco’s vice president of planning and strategy. “There’s almost no capability of buying our products, historically, through any means digitally.”

That all makes Watsco’s business defensive, but investors don’t have to sacrifice growth for relative safety. Watsco’s sales and operating profits have risen at average annual rates of 8% and 13%, respectively, over the past five years, and Wall Street projects that they’ll continue to grow at about the same clip through 2024.

That’s helped by government regulations, which mandate that air conditioners get more efficient over time as older refrigerants are phased out for newer, less environmentally harmful ones. Shifting populations also help, as the need for air conditioning rises as people migrate south.

Watsco also helps keep the growth coming by making small acquisitions in the fragmented HVAC distribution landscape. The company added three businesses in 2021 and now controls about 13% of the roughly $50 billion market for distributed HVAC parts, making it the go-to option for mom-and-pop shops.

Those deals, however, are small and are funded out of cash flow, not debt. Watsco carries about $250 million of net debt, but is expected to generate about $476 million in free cash flow in 2022.

“They have a bulletproof balance sheet,” says Motley Fool Asset Management’s chief investment officer, Bryan Hinmon. Watsco is the largest position in the

Motley Fool Mid-Cap Growth
exchange-traded fund (TMFM) and the third-largest in the

Motley Fool Global Opportunities
ETF (TMFG).

And yet Watsco finds itself strangely out of favor. Only a quarter of the analysts covering the company rate it Buy, well below the 58% average for stocks in the S&P 500. That may be because of inflation—though not in the way it impacts most companies. Distribution businesses tend to like a little inflation because it makes inventory purchased a few months ago at old prices become more valuable. Those higher prices have helped push Watsco’s gross profit margin up two percentage points, to 28%, over the past 12 months, but it could come back down as inflation cools.

Watsco, however, has the means to protect its profit margin—both with its Watsco Ventures unit, which uses automation and other technologies to make buying and selling more efficient, and by cutting other costs, if necessary. The company is targeting a margin of 27%, according to Logan.

If that’s the case, Watsco stock is starting to look cheap, at least on a relative basis. At a recent $248, it trades at 17.8 times estimated 2023 earnings per share of $13.94. That’s a 14% premium to the S&P’s 15.6 times, but Watsco grows faster than most companies and usually trades at a premium of almost 50%, based on its five-year average. Returning to that level would put its valuation at 23 times, or about $320 a share, up about 30% from Thursday’s close. That’s right where Hinmon believes the stock should trade.

In the meantime, Watsco pays a nice dividend. Right now, it sits at 3.6%, above the 3.1% weighted average for the

Russell 2000
and the 3% yield on the 10-year Treasury note.

What’s more, Watsco is particularly dedicated to dividends, which it’s offered for 48 consecutive years. Over the past decade, the company has spent roughly 75% of its free cash flow on the payout, and it has raised the dividend every year since 2013. That provides stability as shareholders wait for upside.

Not a bad way to beat the heat.

Write to Al Root at [email protected]