Watsco Inc. (WSO) reported fourth-quarter 2010 earnings per share (EPS) of 31 cents, in line with the Zacks Consensus Estimate and 48% above the prior-year quarter EPS of 21 cents.

Revenues increased 17% year-over-year to $657 million, ahead of the Zacks Consensus Estimate of $605 million. Air conditioning and heating (HVAC) equipment (contributing 63% of sales) grew 23% driven by strong replacement demand, market share growth and an improved sales mix of higher-efficiency replacement HVAC systems.

Sales of other HVAC products (31% of sales) went up 6% and commercial refrigeration products (6% of sales) surged 19%.

Cost of sales increased 17% to $503.2 million in the quarter and as a percentage of revenues, increased 30 basis points to 76.6%. Gross profit soared 15% to $154 million but gross margin dipped 30 basis points to 23.4%.

Selling, general, administrative and engineering expenses went up 11% to $132.2 million in the quarter whereas as a percentage of sales improved 100 basis points to 20.1%. Watsco’s operating income of $21.8 million in the quarter increased 17% year over year with operating margin expanding 70 basis points to 3.3%.

Fiscal 2010 Performance

Fiscal 2010 EPS was $2.49, a 78% climb over $1.40 in fiscal 2009 and above the Zacks Consensus Estimate of $2.45. Watsco’s revenues grew 42% to a record $2.8 billion beating the Zacks Consensus Estimate of $2.79 billion. Operating income more than doubled to a record $166 million and operating margin expanded by 180 basis-points to 5.8%. 

Financial Position

Watsco had cash and cash equivalents of $126.5 million as of Decmber 31, 2010, up from $99.9 million as of September 30, 2009 and  $58 million as of December 31, 2009. During the year, operating cash flow increased 73% to a record $153 million driven by a reduction of $47 million in operating assets and liabilities.

Through the 2000-2010 timeframe, Watsco’s operating cash flow was approximately $850 million compared with net income of approximately $600 million, in line with the company’s stated goal of generating cash flow greater than net income.

Debt-to-capitalization ratio improved further to 1% as of December 31, 2010 from 2% as of September 30, 2010 and 2% as of December 30, 2010.

Fiscal 2010 marked Watsco’s ninth consecutive year of increase. Dividends to shareholders in 2010 increased 16% to $66 million during the year. In February 2011, Watsco’s Board of Directors approved a 10% increase in the quarterly dividend rate to 57 cents per share, which will be reflected in the next regular dividend declaration in April 2011.

Outlook

The company expects a shift toward higher-efficiency and environmentally sensitive HVAC systems to continue as conservation efforts, consumer awareness and regulatory norms intensify. The residential installed base of HVAC systems is outdated and will necessitate replacement as older units become more expensive to repair.

Further, sales of commercial products have been promising in the last several months and are expected to recover further as capital spending continues to increase.

Our Take

Watsco continues to increase its market share through strategic acquisitions and through expansion of its product offering. The company’s joint-venture with Carrier not only added new products to its sales mix, but also marked Watsco’s entry into international markets with the addition of the Latin American and Caribbean sales operations.

Moreover, the company continues to benefit from the transition to higher-efficiency air-conditioning equipment.

However, decline in housing starts, reduction of the tax credit for homeowners for purchasing a high efficiency HVAC unit and higher costs of replacing with R410A refrigerant, remain concerns. We currently have a Zacks #4 Rank (short-term Sell recommendation) on the stock.

Watsco is the largest distributor of air conditioning, heating and refrigeration equipment as well as related parts and supplies in the United States. The company operates 508 locations serving over 50,000 customers in 36 states, Puerto Rico, Latin America and the Caribbean. Watsco competes with the likes of Johnson Controls Inc. (JCI), Gensco Inc and Gustave A. Larson Company.

 
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