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We have recently downgraded our recommendation from Outperform to Neutral on Watsco Inc. (WSO - Analyst Report), the largest distributor of air conditioning, heating, and refrigeration equipment as well as related parts and supplies in the United States. Shares of Watsco currently retain a Zacks #4 Rank (short-term Sell rating).

Watsco reported second quarter earnings per share of $1.15, up 6% year over year and revenues of $1.01 billion, which increased 15% year over year. However, both fell short of the respective Zacks Consensus Estimates
 
We believe Watsco has immense potential in the replacement market of air conditioners and heating systems in the U.S as old units would 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 United States that have been in service for more than 10 years.
 
Among these, the older systems are operating below the government-mandated energy efficiency and environmental standards. Watsco is positioned to benefit from enhanced equipment replacement cycle. Moreover, higher efficiency units drive higher pricing and higher margins for the company.
 
The Architecture Billing Index of American Institute of Architects became positive in August after remaining in the negative territory for four consecutive months since April. The index increased 1.5 points from July to 50.2 in August, 2012. Any reading above 50 indicates an increase in demand for architect’s services.
 
The new projects inquiry index was 57.2 in August, up from 56.3 in July. We believe that the housing market is improving, though at a moderate pace, thanks to an increase in employment rates, higher consumer confidence and several years of pent-up demand. Watsco will experience an uptick in activity as the recovery continues to gain momentum.
 
Watsco recently announced a special cash dividend of $5.00 per share based on the current annual dividend rate of $2.48, which is equivalent to approximately two years of dividends. The special dividend will amount to a total payout of around $172 million. Watsco paid $41 million in dividends in the first half of 2012.
 
Earlier this year, Watsco’s board of directors approved a 9% increase in its quarterly dividend to 62 cents per share. Watsco has consistently paid dividends for over 35 years and has increased its dividend over the last 11 consecutive years. Cash and cash equivalents were $35.2 million as of June 30, 2012, compared with $18.1 million as of March 31, 2012. With debt-to-total-capitalization ratio at 16%, the company has substantial flexibility to make additional investments and pay dividends going forward. 
 
Watsco lowered its 2012 guidance to $3.15–$3.25 from $3.25–$3.40 to incorporate lower-than-expected earnings from the joint venture with Carrier in Canada. This business is experiencing some profit issues and Watsco is currently in negotiation with Carrier to rectify this. We expect these issues to impact profitability in the second half of fiscal 2012. 
 
Watsco’s business is subject to federal, state and local laws and regulations relating to the storage, handling, transportation and release of hazardous materials into the environment. These laws and regulations include the Clean Air Act, relating to minimum energy efficiency standards of HVAC systems and the production, servicing and disposal of certain ozone-depleting refrigerants used in such systems.
 
HVAC units use R-22, a refrigerant that has been identified as a contributor to ozone depletion. The EPA has mandated that all HVAC manufacturers cease production of R-22 refrigerant starting January, 2010 and then cease entirely by January 1, 2020. R-22 will be replaced with an environment-friendly and more efficient R 410A refrigerant, which will lead to incremental costs.
 
Watsco distributes residential and commercial air conditioners; parts such as replacement compressors, evaporator coils and motors; as well as supplies such as thermostats, insulation materials, refrigerants, grills, registers, sheet metal, tools, concrete pads, tape, and adhesives. Watsco distributes products through 542 locations to over 50,000 customers in 38 states, Puerto Rico, Latin America and the Caribbean.

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