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On Sep 17, we reiterated our Neutral recommendation on Watsco Inc. (WSO - Analyst Report), a leading distributor of air conditioning, heating, and refrigeration equipment as well as related parts and supplies (HVAC/R) in the United States.

Why Reiterated?

Watsco reported second quarter 2013 earnings per share of $1.48 and revenues of $1.12 million, both all-time records. In 2013, Watsco expects to generate earnings per share in the range of $3.65 to $3.80, reflecting an annual growth rate of 20% to 25%.

Watsco will continue to benefit from the demand in the replacement market as old units would get replaced by more energy-efficient units in the coming years. There are approximately 90 million central air conditioning and heating systems installed in the United States that have been in service for more than 10 years. Moreover, higher efficiency units drive higher pricing and higher margins for the company

Watsco’s joint venture with Carrier Corporation, a wholly-owned subsidiary of United Technologies Corp. (UTX - Analyst Report), remains successful and continues to generate profits.  Watsco has an option to purchase an additional 10% interest in the Carrier joint venture in the Sun Belt region, which becomes exercisable in Jul 2014. This option, if exercised, is expected to be accretive to Watsco’s earnings.

Watsco expects to meet or exceed its annual target of generating higher operating cash flow than net income in 2013. With debt-to-total-capitalization ratio at 27%, the company has substantial flexibility to make additional investments and increase its dividends going forward. The company also reiterated its plans to reduce near-term debt and evaluate increasing the dividend before 2013 end.

However, in June, housing starts unexpectedly fell to the lowest level in almost a year to 836,000 units. In July, housing starts recovered somewhat to 8,96,000 units, below expectations and also below the peak of just over 1 million in Mar 2013. Recent rise in mortgage rates in anticipation of the Federal Reserve tapering its massive bond purchase has made builders cautious about breaking ground on new projects. This puts a question on the expected recovery in the housing sector, which would have benefited Watsco.

Other Stocks to Consider

Other players that are worth a mention in the industry are. AAON Inc.  and Lennox International, Inc. (LII - Snapshot Report), both carrying a Zacks Rank #1 (Strong Buy).

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