Inside Wall Street: This Air-Conditioning Company's Stock Is Heating Up

Gene Marcial's Inside Wall Street
Gene Marcial's Inside Wall Street

Wall Street's traditional and usually robust summer rally is quite overdue. But one weather-sensitive stock that has started to rise -- rally or not -- is Watsco (WSO), the largest U.S. distributor of air-conditioning, heating and refrigeration equipment. Its stock, down way back in February to a 52-week low of $47 a share, has heated up since, closing at $58 on June 18.

Is there more oomph left in the stock that hit an all-time high of $73 five years ago?

The answer very well could be yes. What could propel the stock to much higher levels is big pend-up demand for air conditioners and heating ventilation (HVAC) units in the replacement market, which has been in the doldrums in the past two years, says Matt Duncan, analyst at investment bank Stephens. Never mind the potentially huge need for HVACs when the depressed housing industry gets back on its feet. Replacement demand is soaring now, and that's enough to keep Watsco busy. Some 90% of current buying is coming from houses and buildings starting to replace their HVAC units, notes Duncan. .

"Very Encouraged"

First-quarter results came in below analysts' expectations because inclement weather hampered sales, "but sales trends continue to improve, and sales growth should be positive going forward," says Duncan. He has raised his 12-month price target for the stock, which he rates as outperform, to $73 a share from $67. He based it on an upward revision of his 2010 earnings forecast to $2.27 a share from $2.18.

Watsco's management said in a recent conference call with analysts that it was "very encouraged" by the strength of sales in April. As a result, it expects to deliver strong results for the remainder of 2010. The April sales had very little to do with improving housing starts. Rather, says Watsco, the replacement cycle has started kicking in. .

One game-changing event for Watsco, says Duncan, was forming a joint venture in July 2009 with Carrier, a unit of United Technologies (UTX), to sell its products in the U.S. Sunbelt region and in Latin America and the Caribbean. Watsco owns 60% of the venture with an option to raise it to 80%.

Carrier, a brand name in HVAC, contributed 95 locations to the venture and Watsco 15, all of which sell Carrier products. Duncan predicts that the joint venture will be "meaningfully accretive" both companies in 2010 and 2011 as Watsco "gains further traction on cost synergies and begins to cross-sell higher-margin parts and supplies at Carrier." Carrier contributed $225 million to sales in 2010's first quarter.

More Geographic Expansion Ahead

With the economy moving into a recovery, Watsco is facing stronger sales and earnings growth in the years to come. It should "post among the strongest earning per share growth during the next two years," predicts Jeffrey Germanotta, analyst at investment firm William Blair. He forecasts earnings will jump to $2.35 a share on projected sales of $2.7 billion in 2010 (up from 2009's $1.51 a share on $2 billion), and to $3.03 a share in 2011 on sales of $2.9 billion.

Over a longer-term period, Watsco should benefit as homes age and the large installed base of HVACs needs replacement, says Germanotta. With the company's strong balance sheet and cash flow, he expects it to continue its geographic expansion, mainly through acquisitions. Watsco operates 505 branches in 36 states, plus locations in Puerto Rico, Latin America and the Caribbean, and it counts 50,00 contractors and dealers as its main customers.

A key catalyst that should drive the stock higher -- apart from the weather -- would be better-than-expected results in the second quarter, scheduled to be released at the end of July. Weather data in the first quarter indicate it has been much warmer than normal in the South Atlantic U.S., says Scott R. Davis, analyst at Morgan Stanley, who rates Watsco as overweight. Weather is a key element of HVAC sales. The other factors, says Davis, include the last five to six years of pent-up demand, improving housing data and better-than-expected HVAC shipments.

Not Too Late to Buy In

Apparently, Wall Street has started to think positively about Watsco with the onset of summer: Seven of the 12 analysts who track Watsco now recommend buying the stock. None suggests selling it. Five analysts rate Watsco a hold. And a handful of the big institutional investors have added to their holdings, including Frontier Capital Management, which now owns 5.4% of the stock, and BlackRock Fund Advisors, which owns 8.2%. United Technologies remains the largest stakeholder, with 10.64%.

It may true, according to contrarian logic, that the time to buy summer straw hats is in the winter. Still, it may not be too late in the season to jump into Watsco's stock, which still looks a hot buy.