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Analyst Blog

On Jul 9, Zacks Investment Research downgraded Watsco, Inc. (WSO - Analyst Report) to a Zacks Rank #2 (Buy) from a Zacks Rank #1 (Strong Buy). Although the company will benefit from a raise in its stake in the joint venture with Carrier Corporation and strong replacement demand, we are worried about the volatility in housing starts and lack of potential acquisitions.

Why the Downgrade?

Watsco recently raised its stake in Carrier Enterprise LLC, a joint venture with Carrier Corporation, to 80% from 70% for about $90 million. Carrier is a leader in high technology heating, air-conditioning and refrigeration solutions. It is a unit of United Technologies Corp. (UTX - Analyst Report), a leading global provider to aerospace and building systems industries. This, along with other joint-ventures with Carrier not only added new products to Watsco's portfolio, but also marked the company’s entry into the international markets with the addition of Latin American and Caribbean sales operations.

Notably, the market for residential central air conditioning, heating and refrigeration equipment and related parts and supplies in the Americas is worth approximately $35 billion. Watsco now owns 10% of the market and has immense potential to increase its market share as no other competitor can match Watsco's geographic footprint.

Further, Watsco will continue to benefit from demand in the replacement market as old units get replaced by more energy-efficient units in the coming years. There are approximately 89 million central air conditioning and heating systems installed in the U.S. that have been in service for more than 10 years. Moreover, higher efficiency units mean higher pricing and in turn higher margins for the company.

In the long term Watsco expects to increase revenues to above $10 billion and margins above 10%. These are expected to be driven by organic growth initiatives, including new product offerings, geographic expansion, and logistical, productivity improvements, in addition to continued consolidation of the North American HVAC industry.

However, the company has been inactive on the acquisition front lately. This puts the company’s strategy of growing though acquisitions at risk. Moreover the volatility in housing starts remains a concern for the distributor of air conditioning, heating, and refrigeration equipment.

Other Stocks to Consider

Some other stocks in the same sector that warrant a look include Nordson Corporation (NDSN - Snapshot Report) and Kennametal Inc. (KMT - Analyst Report). Both the stocks hold a Zacks Rank #2 (Buy).