Watsco (WSO)

Equipment distributor Watsco (NYSE:WSO) fell short of the market’s revenue expectations in Q1 CY2025, with sales falling 2.2% year on year to $1.53 billion. Its GAAP profit of $1.93 per share was 14.1% below analysts’ consensus estimates.

Company Overview

Originally a manufacturing company, Watsco (NYSE:WSO) today only distributes air conditioning, heating, and refrigeration equipment, as well as related parts and supplies.

Focusing on narrow product categories that can lead to economies of scale, infrastructure distributors sell essential goods that often enjoy more predictable revenue streams. For example, the ongoing inspection, maintenance, and replacement of pipes and water pumps are critical to a functioning society, rendering them non-discretionary. Lately, innovation to address trends like water conservation has driven incremental sales. But like the broader industrials sector, infrastructure distributors are also at the whim of economic cycles as external factors like interest rates can greatly impact commercial and residential construction projects that drive demand for infrastructure products.

Competitors in the HVAC industry include Carrier Global (NYSE:CARR), Lennox International (NYSE:LII), and Ferguson (NYSE:FERG).

A company’s long-term sales performance can indicate its overall quality. Any business can put up a good quarter or two, but many enduring ones grow for years. Thankfully, Watsco’s 9.4% annualized revenue growth over the last five years was solid. Its growth beat the average industrials company and shows its offerings resonate with customers.

Long-term growth is the most important, but within industrials, a half-decade historical view may miss new industry trends or demand cycles. Watsco’s recent performance shows its demand has slowed as its annualized revenue growth of 1.9% over the last two years was below its five-year trend.

This quarter, Watsco missed Wall Street’s estimates and reported a rather uninspiring 2.2% year-on-year revenue decline, generating $1.53 billion of revenue.

Looking ahead, sell-side analysts expect revenue to grow 8% over the next 12 months, an improvement versus the last two years. This projection is above the sector average and suggests its newer products and services will fuel better top-line performance.

Cost of sales for an industrials business is usually comprised of the direct labor, raw materials, and supplies needed to offer a product or service. These costs can be impacted by inflation and supply chain dynamics.

Watsco has bad unit economics for an industrials company, giving it less room to reinvest and develop new offerings. As you can see below, it averaged a 26.9% gross margin over the last five years. Said differently, Watsco had to pay a chunky $73.15 to its suppliers for every $100 in revenue.

In Q1, Watsco produced a 28.1% gross profit margin, in line with the same quarter last year. On a wider time horizon, the company’s full-year margin has remained steady over the past four quarters, suggesting its input costs (such as raw materials and manufacturing expenses) have been stable and it isn’t under pressure to lower prices.

Operating margin is an important measure of profitability as it shows the portion of revenue left after accounting for all core expenses – everything from the cost of goods sold to advertising and wages. It’s also useful for comparing profitability across companies with different levels of debt and tax rates because it excludes interest and taxes.

Watsco has managed its cost base well over the last five years. It demonstrated solid profitability for an industrials business, producing an average operating margin of 10.3%. This result was particularly impressive because of its low gross margin, which is mostly a factor of what it sells and takes huge shifts to move meaningfully. Companies have more control over their operating margins, and it’s a show of well-managed operations if they’re high when gross margins are low.

Looking at the trend in its profitability, Watsco’s operating margin rose by 1.7 percentage points over the last five years, as its sales growth gave it operating leverage.

In Q1, Watsco generated an operating profit margin of 7.3%, in line with the same quarter last year. This indicates the company’s cost structure has recently been stable.

Revenue trends explain a company’s historical growth, but the long-term change in earnings per share (EPS) points to the profitability of that growth – for example, a company could inflate its sales through excessive spending on advertising and promotions.

Watsco’s EPS grew at a spectacular 15.8% compounded annual growth rate over the last five years, higher than its 9.4% annualized revenue growth. This tells us the company became more profitable on a per-share basis as it expanded.

We can take a deeper look into Watsco’s earnings to better understand the drivers of its performance. As we mentioned earlier, Watsco’s operating margin was flat this quarter but expanded by 1.7 percentage points over the last five years. This was the most relevant factor (aside from the revenue impact) behind its higher earnings; taxes and interest expenses can also affect EPS but don’t tell us as much about a company’s fundamentals.

Like with revenue, we analyze EPS over a shorter period to see if we are missing a change in the business.

For Watsco, its two-year annual EPS declines of 7.9% mark a reversal from its (seemingly) healthy five-year trend. We hope Watsco can return to earnings growth in the future.

In Q1, Watsco reported EPS at $1.93, down from $2.17 in the same quarter last year. This print missed analysts’ estimates, but we care more about long-term EPS growth than short-term movements. Over the next 12 months, Wall Street expects Watsco’s full-year EPS of $13.01 to grow 15.7%.

If you’ve followed StockStory for a while, you know we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can’t use accounting profits to pay the bills.

Watsco has shown decent cash profitability, giving it some flexibility to reinvest or return capital to investors. The company’s free cash flow margin averaged 7.1% over the last five years, slightly better than the broader industrials sector.

Taking a step back, we can see that Watsco’s margin dropped by 2.4 percentage points during that time. If its declines continue, it could signal increasing investment needs and capital intensity.

Watsco burned through $185.1 million of cash in Q1, equivalent to a negative 12.1% margin. The company’s cash flow turned negative after being positive in the same quarter last year, suggesting its historical struggles have dragged on.

EPS and free cash flow tell us whether a company was profitable while growing its revenue. But was it capital-efficient? A company’s ROIC explains this by showing how much operating profit it makes compared to the money it has raised (debt and equity).

Although Watsco hasn’t been the highest-quality company lately, it found a few growth initiatives in the past that worked out wonderfully. Its five-year average ROIC was 29.8%, splendid for an industrials business.

We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. On average, Watsco’s ROIC increased by 2.6 percentage points annually over the last few years. This is a good sign, and we hope the company can keep improving.

Watsco reported $431.8 million of cash and $445.8 million of debt on its balance sheet in the most recent quarter. As investors in high-quality companies, we primarily focus on two things: 1) that a company’s debt level isn’t too high and 2) that its interest payments are not excessively burdening the business.

With $817.9 million of EBITDA over the last 12 months, we view Watsco’s 0.0× net-debt-to-EBITDA ratio as safe. We also see its $23.82 million of annual interest expenses as appropriate. The company’s profits give it plenty of breathing room, allowing it to continue investing in growth initiatives.

We struggled to find many positives in these results. Its revenue missed significantly and its EBITDA fell short of Wall Street’s estimates. Overall, this was a weaker quarter. The stock traded down 4% to $484 immediately following the results.

Updated: May 22, 2025 at 11:14 PM EDT

The latest quarterly earnings matters, sure, but we actually think longer-term fundamentals and valuation matter more. Investors should consider all these pieces before deciding whether or not to invest in Watsco.

Watsco isn’t a terrible business, but it doesn’t pass our bar. Although its revenue growth was solid over the last five years, it’s expected to deteriorate over the next 12 months and its flat same-store sales disappointed. And while the company’s stellar ROIC suggests it has been a well-run company historically, the downside is its diminishing returns show management's prior bets haven't worked out.

Watsco’s P/E ratio based on the next 12 months is 30.5x. This valuation tells us it’s a bit of a market darling with a lot of good news priced in - we think there are better investment opportunities out there.

Wall Street analysts have a consensus one-year price target of $478.82 on the company (compared to the current share price of $456.08).

Want to invest in a High Quality big tech company? We’d point you in the direction of Microsoft and Google, which have durable competitive moats and strong fundamentals, factors that are large determinants of long-term market outperformance.

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