Watsco: Compounding Growth in the HVAC Industry.

Watsco is the largest distributor of HVAC/R products in North America, with deep supplier relationships, steady replacement demand, and a growing digital presence. Its total shareholder return ranks among the top 20 of all U.S. public companies over the past 30 years - one of only 24 to deliver 19%+ annualized returns. The question is: Should this quiet compounder earn a spot in your portfolio?

This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

For full disclosure, I should mention that I do not own any shares in Watsco at the time of writing this analysis. If you would like to copy or view my portfolio, you can find instructions on how to do so here. If you want to purchase shares or fractional shares of Watsco, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $50.

The Business

Watsco, founded in 1956 and based in Florida, is the largest distributor of air conditioning, heating, and refrigeration equipment, as well as related parts and supplies (HVAC/R), in North America. The company operates from nearly 700 locations across the United States, Canada, Mexico, Puerto Rico, and parts of Latin America and the Caribbean, serving over 130.000 active contractors in both residential and commercial markets. Watsco is a pure distributor - it does not manufacture products but acts as a vital link between OEMs and the contractors responsible for installation and service. Most of its customers are small, independent contractors who lack the infrastructure or resources to carry large inventories. These businesses rely on Watsco as a just-in-time inventory partner. With its extensive warehouse network, deep inventory, and high product availability, Watsco ensures that contractors can access what they need, when they need it. This logistical support is especially critical in the replacement market, where timing is essential. What sets Watsco apart is its scale. In a highly fragmented industry, Watsco leverages economies of scale to offer a broader range of products, maintain higher service levels, and negotiate favorable terms with suppliers. Its size has also enabled it to form exclusive distribution relationships, particularly through joint ventures with Carrier Global Corporation, which account for a significant portion of its revenue. These partnerships provide access to premium HVAC brands and allow Watsco to address underserved contractor segments by tailoring inventory, pricing, and programs to local demand. The company’s long-term mindset is reflected not only in its investment strategy but also in its ownership culture. Thousands of employees are shareholders through equity plans designed to promote retention and long-term alignment. This ownership mentality reinforces Watsco’s service-driven approach and supports operational excellence throughout the organization. In an industry with more than 2.000 distributors, Watsco’s competitive moat lies in its unmatched scale, exclusive supplier relationships, and commitment to service. These strengths have created a durable advantage and positioned the company for continued growth and market share gains.

Management

Albert H. Nahmad serves as Chairman and CEO of Watsco, a role he has held since 1972. Remarkably, he is also credited as the founder of Watsco in its current form, having led its transformation from a small manufacturing business into North America's largest distributor of HVAC/R equipment, parts, and supplies. Albert H. Nahmad holds a Bachelor of Science degree in Mechanical Engineering from the University of New Mexico and a Master of Science degree in Industrial Administration from Purdue University. Over more than five decades of leadership, Albert H. Nahmad has been the driving force behind Watsco’s long-term strategy, entrepreneurial culture, and sustained growth. He pioneered the company’s transition into distribution in 1989, a pivotal shift that laid the foundation for decades of compounded shareholder returns. Since that transition, Watsco has achieved a total shareholder return CAGR of over 19%, placing it among the top long-term compounders in the S&P 500 over the past 30 years. Albert H. Nahmad is known for his conservative financial philosophy, disciplined capital allocation, and unwavering focus on long-term value creation. Under his guidance, Watsco has expanded through a steady stream of strategic acquisitions, established strong partnerships with leading OEMs, and cultivated an ownership-driven culture across the organization. He has long emphasized scale and local autonomy as central to Watsco’s operating model, promoting entrepreneurial thinking at the branch level and across its network of joint ventures. Beyond his corporate role, Albert H. Nahmad is actively involved in philanthropic initiatives and has served on the boards of several educational and charitable organizations, reflecting his broader commitment to community and civic engagement. While he maintains a low public profile, his tenure, strategic clarity, and consistent execution speak volumes about his capabilities as a leader. Given his unique combination of technical expertise, entrepreneurial mindset, and shareholder-first approach, Albert H. Nahmad remains a cornerstone of Watsco’s success. His leadership provides both continuity and credibility, and his influence will likely continue to be a key asset as Watsco navigates new opportunities in a fragmented and evolving industry.

The Numbers

The first number we will look into is the return on invested capital, also known as ROIC. We want to see a 10-year history, with all numbers exceeding 10% in each year. The company has delivered solid financial performance over the past decade, maintaining a ROIC above 10% every single year. There are several reasons behind this consistent outperformance. Watsco is a pure distributor and does not manufacture its own products, which means it avoids capital-intensive investments in factories or R&D. This asset-light model naturally supports stronger returns on capital. In addition, Watsco has formed strategic joint ventures - most notably with Carrier - where it holds a controlling interest. These partnerships give Watsco access to large markets and premium product lines without requiring full capital outlays, further boosting capital efficiency. Watsco also maintains a strong focus on capital discipline, high-return growth, and long-term shareholder value creation. These priorities are closely aligned with the principles behind ROIC. Given this approach and the company’s consistent execution, I expect Watsco will continue to generate high returns on invested capital in the years to come.

The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. To put it simply, equity is the part of the company that belongs to its shareholders – like the portion of a house you truly own after paying off part of the mortgage. Growing equity over time means the company is becoming more valuable for its owners. So, when we track book value plus dividends, we’re essentially looking at how much value is being built for shareholders year after year. Watsco has managed to increase its equity every year, which is very encouraging. This consistent growth comes from running a steady, profitable business and managing its money carefully. Since Watsco doesn’t need to invest in expensive factories or equipment - because it’s a distributor rather than a manufacturer - it keeps more of the money it earns. Even while paying a solid dividend, it still retains part of its profits, steadily building up the company’s value. On top of that, Watsco makes smart, low-risk investments through partnerships, such as its joint ventures with Carrier. All of this contributes to stronger equity year after year and reflects a business focused on building long-term value for its shareholders.

Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising to note that Watsco has consistently generated positive free cash flow every year for the past ten years. In 2024, Watsco delivered record free cash flow and achieved its second-highest levered free cash flow margin to date, which is very encouraging. Management has expressed confidence in this trend continuing, emphasizing that Watsco’s strong financial position is an important differentiator in the industry. Watsco uses part of its free cash flow to reinvest in the business - either organically or through acquisitions. Management has stated that the record level of free cash flow gives them the flexibility to pursue large opportunities that can accelerate growth and help the company gain additional market share. In addition, Watsco allocates a portion of free cash flow to dividends. The company has increased its dividend at a compounded annual growth rate of 21% since 1989, and as free cash flow continues to grow, investors can reasonably expect continued dividend growth. Currently, Watsco’s free cash flow yield is below its ten-year average, which suggests that the stock is trading at a premium valuation. However, we will revisit valuation later in the analysis.

Debt

Another important aspect to consider is the level of debt. It is crucial to determine whether a business carries manageable debt that could be repaid within a three-year period. This is calculated by dividing total long-term debt by earnings. After reviewing Watsco’s financials, I found that the company currently carries no debt. Therefore, debt is not a concern when investing in Watsco. It is also worth noting that over the past 20 years, Watsco’s long-term debt has never exceeded 0,32 years’ worth of earnings. This long track record of conservative financial management suggests that debt is unlikely to ever pose a significant risk for investors in Watsco.

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Risks

Customer concentration and supply chain risk is a concern for Watsco. In 2024, 85% of Watsco’s purchases came from its top ten suppliers, including 62% from Carrier and 9% from Rheem. While these strong supplier relationships provide advantages such as exclusive distribution rights and access to leading HVAC brands, they also create a high level of dependency. Any significant disruption - such as production delays, regulatory changes, or supply shortages - could temporarily affect Watsco’s ability to serve customers and impact financial results. Many of Watsco’s key suppliers source components or assemble products in Mexico and China, which exposes the company to geopolitical risks and potential trade barriers. If tariffs were to increase or import regulations changed, Watsco could face higher product costs, putting pressure on margins or forcing price increases that might result in lost sales. There is also product risk. Watsco’s performance depends on the ongoing market acceptance and regulatory compliance of the HVAC systems supplied by its partners. As the industry shifts toward more energy-efficient systems and environmentally friendly refrigerants, any delay or misalignment by a key supplier could negatively affect Watsco’s growth and reputation. Although management believes it could secure alternative products if necessary - thanks to Watsco’s scale, distribution network, and relationships - such a transition would likely result in short-term disruptions. For instance, one supplier-related issue in a recent year led to a temporary margin impact of about 30 basis points. Therefore, Watsco’s high supplier concentration and reliance on a global supply chain present risks that investors should consider, particularly during periods of regulatory change, trade tension, or broader supply chain instability.

Competition is a risk for Watsco due to the highly competitive nature of the HVAC/R distribution industry. Watsco not only competes with a large number of independent distributors but also faces competition from HVAC equipment manufacturers that operate their own distribution networks in certain markets. This means that in some regions, Watsco is competing directly with the very companies that supply its products. In any given geographic market, competition is driven by several key factors: product availability, pricing, customer service, and perceived quality. If a competitor offers lower prices, better service, or faster delivery, it could put pressure on Watsco to lower its prices or invest more in service and infrastructure to maintain market share. This could lead to margin compression or increased operating costs. Moreover, if customers perceive competitors' offerings as superior - or if manufacturers prioritize their own distribution channels over third-party distributors like Watsco - there's a risk that Watsco could lose market share. A loss of market acceptance, either from pricing pressure or a shift in customer loyalty, could negatively impact sales, cash flow, and profitability. In short, while Watsco benefits from scale and strong supplier relationships, it still operates in a fragmented and competitive industry where customer expectations, pricing dynamics, and supplier strategies can shift. These competitive pressures represent a real risk to future performance, particularly if Watsco is unable to differentiate itself or respond quickly to changing market conditions.

Macroeconomic conditions pose a risk for Watsco because the company’s performance is closely tied to the broader economic environment, including consumer spending and the financial health of both its customers and suppliers. In the event of a broad economic slowdown, demand for HVAC/R products may decline, especially in the new construction segment, which tends to be more cyclical and sensitive to rising interest rates, lower housing starts, or delayed commercial projects. When uncertainty increases, developers often postpone or cancel construction plans, reducing the need for heating and cooling systems. At the same time, cost-conscious consumers may delay non-essential upgrades or repairs to HVAC systems, further softening demand on the residential replacement side. Many of Watsco’s customers are small, independent contractors who often rely on short-term credit or loans to run their businesses. If credit becomes harder to access, these contractors might struggle to afford the equipment and parts they need. This could lead to fewer orders or delayed payments on existing purchases. As a result, Watsco may face increased risk of unpaid invoices, which would put pressure on its cash flow and require additional resources to manage outstanding accounts.

Reasons to invest

A large and growing installed base of HVAC systems is one of the most compelling reasons to invest in Watsco. Since 1980, the installed base in the United States has increased every single year. Today, there are over 120 million HVAC units in service across the country. This long-term trend provides a steady and predictable tailwind for Watsco’s core replacement business, which is primarily focused on the residential market. The replacement cycle for HVAC equipment is driven by age, usage, and energy efficiency. Units typically last between 8 to 20 years depending on climate and how frequently they are used. Today, more than 100 million systems have been in operation for over a decade. Many of these older units fall short of modern energy efficiency standards and are nearing the end of their useful lives, which supports consistent demand for replacements. Watsco is well positioned to benefit from this, as it supplies not only new HVAC systems but also the parts and components required to service and repair them. Importantly, the growth in the installed base is not just about size - it’s also about how the mix of systems is evolving. The market is shifting from gas furnaces, which last 25 to 30 years, to electric heat pumps, which are used year-round for both heating and cooling. Because they operate more frequently, heat pumps tend to wear out faster and require more maintenance. This shift is increasing the frequency of replacements and driving higher demand for parts. Watsco has already seen the effects of this trend, reporting double-digit growth in both equipment and parts sales in recent quarters - an indication that both replacement and repair activity are rising at the same time. Another encouraging factor is that only about 12% of industry HVAC shipments are tied to residential new construction. The vast majority of demand is for replacements, which are typically non-discretionary. When a system breaks, it must be replaced - regardless of broader economic conditions. This gives Watsco a level of resilience that many other industrial or construction-related businesses lack.

Acquisitions have been a central part of Watsco’s growth story since it began its HVAC/R distribution strategy in 1989. The company follows a disciplined “buy and build” approach that has proven highly effective over time. Through this strategy, Watsco acquires well-established, often family-run distributors and then invests in them to support long-term performance. This approach has helped transform Watsco into the largest HVAC/R distributor in North America, driving substantial growth in both revenue and profitability. The “buy” side of the strategy focuses on acquiring market leaders that either strengthen Watsco’s presence in existing territories or expand it into new geographic regions. Watsco is highly selective, targeting businesses that meet strict financial and strategic criteria. Since 1989, the company has completed 70 acquisitions, many of which now operate as core subsidiaries. What sets Watsco apart is its relationship-driven approach. Management has spent decades building trust with multi-generational family businesses, which has created a strong pipeline of future acquisition opportunities. There are still dozens of HVAC distributors in the U.S. with over $100 million in revenue, many of which are family-owned and may choose to partner with Watsco when the time is right. The “build” side of the strategy involves helping acquired businesses grow by expanding product lines, opening new locations, improving pricing programs, and sharing operational best practices across the organization. These companies also benefit from Watsco’s scale, which allows them to offer better service and more competitive pricing to their customers. Watsco continues to see attractive opportunities ahead. The HVAC/R distribution industry remains fragmented, and management believes there are still 50 to 100 large, family-owned businesses that could be compelling acquisition targets.

Watsco’s long-term investment in technology is a major reason to consider the company as an attractive investment. While Watsco is best known as a distributor of HVAC/R equipment, it has also become a leader in modernizing the HVAC industry through digital innovation. This transformation is not just about improving internal efficiency - it is changing how contractors operate, enhancing the customer experience, and creating entirely new revenue opportunities. Over the past several years, Watsco has built a strong culture of innovation, investing in digital tools, e-commerce platforms, mobile applications, and data-driven systems. The company now employs around 300 technology professionals and continues to upgrade its infrastructure to support scalable, customer-facing technologies. These tools are designed to make it easier to do business with Watsco - anytime, anywhere. Customers can search for products, place orders, track deliveries, process warranties, and even access financing directly from their phones or tablets. The result is faster, more efficient service, reduced friction, and stronger customer loyalty. Watsco’s e-commerce business is now a major contributor, generating over $2,6 billion in online sales, which represents about 35% of its total revenue. These transactions are growing faster than overall sales and have been shown to reduce customer attrition - meaning fewer customers stop doing business with Watsco - by nearly half compared to traditional sales methods. The company’s flagship innovation, OnCall Air, is a digital sales platform that helps contractors present professional proposals to homeowners, complete with pricing, product options, and financing. This platform powered over $1,5 billion in proposals in the most recent year, a 25% increase. Contractors using OnCall Air are closing more deals, selling at higher margins, and offering a better experience to their own customers. Watsco also offers OnCall Air Finance+, which provides simple financing options, making it easier for homeowners to move forward with projects and helping contractors grow their businesses. These technologies not only make Watsco more efficient and profitable - they also help contractors become more successful. Technicians can complete more jobs in a day, improve their close rates, and operate more profitably. This strengthens Watsco’s relationship with its customers, reduces churn, and makes the company a more essential partner in the daily operations of HVAC businesses.

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Valuation

Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators for free.

The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 13,30, which is from the year 2024. I have selected a projected future EPS growth rate of 9%. Finbox expects EPS to grow by 9,4% in the next five years. Additionally, I have selected a projected future P/E ratio of 18, which is double the growth rate. This decision is based on Watsco's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $140,09. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Watsco at a price of $70,05 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 773, and capital expenditures were 30. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 21 in our calculations. The tax provision was 167. We have 37,645 outstanding shares. Hence, the calculation will be as follows: (773 – 21 + 167) / 37,645 x 10 = $244,12 in Ten Cap price.

The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With Watsco's free cash flow per share at $19,74 and a growth rate of 9%, if you want to recoup your investment in 8 years, the Payback Time price is $237,30.

Conclusion

I believe that Watsco is a great company with exceptionally strong management. Watsco has built a moat through its unmatched scale, exclusive supplier relationships, and commitment to service. The company has consistently achieved a high ROIC, and given its continued focus on capital discipline, high-return growth, and long-term shareholder value creation, I believe this performance will continue. Watsco delivered record-high free cash flow in 2024, and management has expressed confidence in this trend going forward. Customer concentration and supply chain risk is a concern for Watsco, as a large portion of its purchases come from just a few key suppliers, creating a high level of dependency. Any disruption in these relationships, supply delays, or regulatory changes could impact Watsco’s ability to serve customers, increase costs, and temporarily affect financial performance. Competition is another risk, as Watsco operates in a fragmented and highly competitive industry. It faces pressure from both independent distributors and HVAC manufacturers with their own distribution networks. If competitors offer better pricing, service, or delivery - or if suppliers prioritize their own channels - Watsco could lose market share, which may result in lower margins and reduced profitability. Macroeconomic conditions are also a risk. Economic slowdowns can reduce demand for HVAC products, especially in new construction, and lead consumers to delay non-essential replacements or repairs. On the positive side, a large and growing installed base of HVAC systems supports steady, recurring demand for replacements and repairs - an area where Watsco is strongly positioned. As older systems reach the end of their useful lives and the market shifts toward shorter-lived heat pumps, Watsco benefits from increased sales of both equipment and parts. Acquisitions are another key reason to invest in Watsco. The company has a long history of acquiring well-run, often family-owned distributors and helping them grow through its scale, capital, and operational expertise. Watsco’s long-term investment in technology has also transformed the company from a traditional distributor into a digital leader in the HVAC industry. Its tools and platforms improve efficiency, enhance customer loyalty, and unlock new growth opportunities, giving Watsco a lasting competitive advantage. I believe Watsco is a fantastic company operating in an underrated industry, and buying shares at $390 - representing a 20% discount to the intrinsic value based on the Ten Cap price - would be a solid long-term investment.

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