Tariff Concerns And A2L Transition Will Drive Market Recalibration

Key Takeaways

• Proposed tariffs and OEM pricing strategies introduce significant uncertainty, potentially affecting sales in Canada and Latin America and applying pressure on revenue and profitability.
  
• Transition to new systems and supply chain issues may cause short-term sales volatility and impact revenue growth despite eventual benefits to margins.
  
• Watsco's transition to efficient systems, robust financial position, and strategic OEM partnerships drive growth, resilience, and profitability in a dynamic market.

Catalysts

Engages in the distribution of air conditioning, heating, and refrigeration equipment, and related parts and supplies in the United States, Canada, Latin America, and the Caribbean.

• The potential impact of proposed tariffs introduces significant uncertainty about future pricing and demand fluctuations, particularly affecting the 9% of sales derived from Canada and Latin America. Such external pressures could negatively impact revenue and profitability as adjustments in pricing by OEM partners are anticipated.
  
• The transition to the new A2L system represents both a challenge and a potential disruption to the business. While this move is expected to benefit sales and margins eventually, the current market uncertainty and supply chain difficulties, including container shortages for refrigerants, may create short-term sales volatility and potentially squeeze net margins.
  
• There is a notable absence of flexibility in pricing given that most OEM pricing actions have been implemented as permanent price increases rather than surcharges. This could put additional pressure on consumer demand and lead to potential decreases in revenue should the market resist these price hikes.
  
• The slow adoption of 454B systems highlights potential near-term disruption risks. Even though a significant portion of sales is transitioning, the pace of market acceptance may hinder the expected ramp-up in sales, impacting revenue growth and operating margins.
  
• Dependent on the strength of macroeconomic factors, particularly housing and construction activities, the company's stance on not leaning into 410A inventory has had effects on first-quarter sales. If demand for replacement and repair does not materialize as expected, this could lead to a more modest performance, challenging both revenue growth and gross margins relative to industry peers.

Watsco Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Watsco compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Watsco's revenue will grow by 5.1% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 6.5% today to 7.8% in 3 years time.
• The bearish analysts expect earnings to reach $682.8 million (and earnings per share of $17.46) by about July 2028, up from $491.6 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 23.2x on those 2028 earnings, down from 37.5x today. This future PE is greater than the current PE for the US Trade Distributors industry at 20.1x.
• Analysts expect the number of shares outstanding to grow by 0.75% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.52%, as per the Simply Wall St company report.

Watsco Future Earnings Per Share Growth

Risks

• Watsco's transition to the new A2L system is expected to impact around 55% of total sales, enhancing sales and profitability due to more efficient and sustainable solutions, thus positively affecting revenue and net margins.
  
• The introduction and realization of new pricing in the market, coupled with higher volumes and a richer mix of high-efficiency systems, have led to a 10% increase in the core HVAC replacement business, supporting revenue growth and improved gross margins.
  
• Watsco has reported a strong balance sheet with $430 million in cash, no debt, and over $3 billion in equity, enabling potential reinvestment for growth and stability in earnings.
  
• The collaboration with OEM partners on pricing actions and the ability to react quickly to changing market conditions suggest that potential tariffs may not severely impact profitability, sustaining net margins.
  
• The company’s leadership in a growing and necessary product market, combined with long-standing collaborative relationships with OEMs and a unique ownership culture, positions it for continuing strong revenue performance and profitability.

Valuation

• The assumed bearish price target for Watsco is $335.92, which represents two standard deviations below the consensus price target of $468.18. This valuation is based on what can be assumed as the expectations of Watsco's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $550.0, and the most bearish reporting a price target of just $333.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $8.8 billion, earnings will come to $682.8 million, and it would be trading on a PE ratio of 23.2x, assuming you use a discount rate of 7.5%.
• Given the current share price of $487.11, the bearish analyst price target of $335.92 is 45.0% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.