This little-known stock benefits from unstoppable trends – is it a buy?

Operating in an industry from which we all benefit, but which we never place much importance on, watsco (BSM -3.55%) is a leader in the field of heating, ventilation, air conditioning and refrigeration (HVAC/R). While it may not be the most exciting corner of the stock market, the companies that support the essentials of modern life sometimes offer exceptional investment opportunities.

Over its history as a public company, Watsco has been a huge winner, with its total return up more than 39,000% since going public. To put that into perspective, a $10,000 investment in 1963 would now be worth $3.9 million. Yet what matters to investors today is whether Watsco is making a good investment going forward. I’d say yes, so let’s dig in to see why.

Strong growth as demand returns to average

Since the start of the pandemic in 2020, Watsco has experienced above average demand for the products it distributes. Consumers with money to spend, as well as more time at home, have been spending upgrading their HVAC units, to Watsco’s benefit.

What’s impressive is that even though this demand started to slow down, the company continued to show strong results.

Watsco’s second quarter of 2022 showed the strength of its business. Revenue for the quarter hit a record $2.1 billion, representing 15% year-over-year growth. Same-store sales jumped 14% and gross margin improved 210 basis points.

Profitability also accelerated, with earnings per share reaching a record $4.93, good for a 33% increase from the second quarter of 2021. Operating margin also increased to a record $4.93. 13.5%, compared to 11.7% in the prior year quarter.

2023 and beyond

Management has been transparent about the expected slowdown in growth as the industry returns to historic sales levels. This could mean a return to the single-digit revenue growth the company enjoyed before 2020. However, some upcoming regulations are expected to spur further growth.

From 2023, the minimum efficiency standard of all HVAC units sold will be raised, which in turn will increase the selling price of each unit. Because Watsco is a distributor and not a manufacturer, this will lead to more revenue.

Additionally, 2025 will see a transition to new refrigerants. In the past, these types of changes resulted in higher repair costs, and therefore an increase in the purchase of new systems to replace them. Again, this would be accretive to Watsco’s business.

While all companies in this industry could benefit from these tailwinds, Watsco believes drawing the core of its business from the Sun Belt will be an advantage. Management considers the products it distributes essential for those living in these hot climates. Most customers aren’t likely to overlook a broken air conditioning unit in August in Arizona or Florida.

A solid balance sheet

The HVAC industry is highly fragmented, with approximately 6,700 distributors worldwide. Watsco has grown by expanding its business, but also by buying other market leaders in order to either gain additional market share or expand into new geographies.

Watsco’s success in acquiring businesses depends on a strong balance sheet. Over the past two years, the company has increased its working capital (the amount of money available for immediate expenses) by 44% to $1.56 billion. This gives Watsco the financial flexibility to pursue acquisition opportunities.

The cash on the balance sheet has also enabled Watsco to pay a dividend for 48 consecutive years. At recent prices, Watsco’s dividend yield is 2.9%, easily exceeding the S&P500‘s yield around 1.7%.

While not exactly cheap for its industry, Watsco’s recent price-to-sales ratio above 1.5 is only marginally above its five-year average of 1.4. Given that the company has increased revenue by 73% and net income by 196% over the same period, some premium should be expected.

Expected industry-wide tailwinds, combined with Watsco’s earnings track record and attractive dividend yield, make it a compelling choice for those looking for some stability in their portfolio.

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