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Watsco Continues to Expand

13 Feb

Watsco, Inc. (WSO) continued to roll on its growth path this past year, growing earning per share by 17% while expanding operating margins and gross profit margins year-over-year.

This is a boring business, but a profitable one. Watsco distributes air conditioning, heating, and refrigeration equipment and related parts and supplies. The company is still small and operates in an industry where demographic trends are favorable for continued growth as the industry consolidates. The market is highly fragmented, with over 1,300 companies in the space. The company’s goal is to build out a national network and broaden its product offerings. In this industry, larger players will benefit from economies of scale in purchasing from a concentrated group of manufacturers, and the ability to spread higher revenues over a large fixed cost base – in distribution and store location infrastructure. Watsco is the largest player in the industry, yet commanded only 7.4% of the $26 billion U.S. HVAC market at the end of 2006.

Watsco is controlled by its CEO, Al Nahmad, so while interests of existing shareholders are not aligned directly with shareholders, you can believe he’s looking out for the company’s interest given the amount of net worth he’s got tied up. From a management perspective, I like that they don’t need to worry about dissident shareholders trying to take this thing over. Private equity loves highly profitable companies operating in niche markets with very little debt. All things considered, I’d say the control issue is a good thing for outside shareholders at the moment, because this business is protected from takeovers that should allow it to continue on its growth path.

The risks here relate to the economic cycle. Its products are durables that will be effected by a downturn in economic activity. However, 75% of the company’s revenues are derived from the service and replacement market, which is less cyclical. People still want their homes cool when they don’t have a job.

At current prices, Watsco appears fairly priced, trading at about 17 times forward earnings with a 1.8% dividend yield. For a projected growth rate of around 20% for the next several years, this doesn’t seem overvalued, either. If the stock pulls back to the mid-40s, as it did this past summer and again in late December, I’d think seriously about adding to positions.

Full disclosure: Clients own shares in WSO.

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Home Depot Rallies on Bad News

14 Nov

Home Depot (HD) shares were down this morning on the heels of an earnings release but ended up sharply higher by market close. Revenues, same store sales results, and earnings all came in below expectations. Yet the share price rose by over 4% today. What gives?

Low expectations have depressed the shares, but Home Depot’s financial position remains very strong. The company carries prudent levels of debt and generates very high investment returns. Management reported 22% returns on invested capital for the quarter (after considering operating leases the real number is in the high teens). These are admirable returns to post in this environment. Despite a slowing business climate, the company has been using its free cash flow to buy back shares. CEO Bob Nardelli knows a bargain when he sees one. Investors must have noticed.

EPS is still expected to grow by 4% and sales should be up around 12% for the full fiscal year. Frankly, I would expect worse. But the valuation is far from demanding: the shares sell at just around 12 times forward earnings and operating cash flow. For a premiere franchise like Home Depot, there seems to be a margin of safety built in to the current valuation, though not as much after the recent run-up.

One problem I had with their reported results today: no cash flow statement. It’d be nice to see a cash flow statement in the press release. This would help us gain a clearer picture of what went on during the quarter and first nine months of the year. Maybe next time, Bobby.


Disclosure: I own shares for clients as well as personally.

More on Dow Chemical

9 Oct

(continued from previous post)

The 4% dividend yield is a nice pad to total return. Over at least the past 17 years, the company hasn’t cut or reduced its dividend, which has grown at an annual rate of a little over 3%. The company is watching costs, having shut down more than 50 manufacturing facilities across the globe over the last three years amidst record profitability. And they’re using cash to pay down debt and buy back shares. Yet this has happened before, most recently from about 1994 through 1998, and from there debt levels and share count grew again.

We know the third quarter is likely to be a little rough, as the company will be taking about $600 million in charges for severance and asset writedowns as a result of plant closings. Look for earnings to be boosted in future periods, as this writedown will hit earnings in the third quarter of this year and not affect them in future periods. Don’t be fooled, though, as actual severance and plant shutdown costs will continue to impact the company’s cash flows into the future.

Let’s look at another metric, the current forward price-to-sales (P/S) ratio, which is around 0.75. This is near the lows of the past 10 years and most similar to the lowest forward multiples experienced in 1995-96 for the expansion years of 1996-97. Coincidentally (or not), the period most similar to now in level of margins and ROE was 95-96. The average forward P/S multiple during those years was under 0.90 (since 1995 Dow’s average P/S ratio is 1.00) , while Dow’s P/E ratio averaged 9.5, which looks strikingly similar to now. What does all this mean?

Purchased at the low prices of 1995-96, Dow would have returned about 8.6% annually to date (including the 10-yr average dividend yield of 2.6%). The S&P 500’s total return over that period is around 10% annually.

Historically, it has been more profitable to buy cyclical companies when P/Es are high and profits are bottoming. In this case, Dow has a low P/E ratio and its profits are (probably) at or near a peak.

If you think the stock has upside between now and January but don’t want to invest the cash, write a Jan 40 put and buy a Jan 40 call. Based on current prices, you’ll effectively own the stock at a little over $39 (slightly over market) but without any cash outlay. Be aware that you’ll need to have the cash to cover the trade in the event the stock is put to you come January.

A Look at Dow Chemical

5 Oct

Is Dow Chemical undervalued at $38 and change? At 9.5 times forward earnings, about 0.75 times sales, and a 4% dividend yield, on the surface it looks like a value.

This is a cyclical company that lacks an economic moat. In other words, it is largely not in control of its own destiny. It has high returns during economic expansion (when demand exceeds supply) and experiences poor returns during contractions (when demand weakens, or supply brought on during expansions exceeds demand). Roughly 50% of revenues come from specialty chemicals and plastics. These businesses are less cyclical than other, basic chemical lines but all segments remain sensitive to the economic cycle.

Especially in its North American operations, the company has little control over its resource costs and is only able to pass cost increases along to customers when demand is high. Thus, when economic activity slows and costs in increase the company’s margins get squeezed. Of course, this works both ways. Both oil and gas, which comprised almost half of Dow’s total costs in 2005, are down dramatically in price as of late. This is likely to lead to some margin gains and maybe even to an upside earnings surprise in Q4, perhaps even in Q3. But these gains may be fleeting.

Operating and net margins appear to be at cyclical highs (18.5% and 9.5%, respectively, versus a 14% and 5.2% 7 year average), as does return on equity (ROE), at about 26% currently, versus a seven-year average of 15%. The current numbers are direct evidence of pricing power during a period of high demand. Looking back as recently as 2001 and 2002 (recessionary conditions), Dow’s operating margins were near 10% and net margins were negative.

The market doesn’t capitalize peak earnings, so let’s use the above numbers to “normalize” Dow’s earnings over an economic cycle. That is, average out the swings in profitability that result from the cyclical nature of the business. Using the 7-year average ROE of 15% times the current (2Q 2006) book value of $17.52, I get a “normal” net income number of $2.63. Using the normalized net profit margin based on projected 2006 sales we arrive at about the same number. At today’s price, this puts Dow at nearly 15 times normalized forward earnings. This happens to be right around Dow’s average P/E since 1990.


(look for more on Dow in coming days)

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