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Watsco Inc. (WSO - Analyst Report) delivered a record third quarter both in terms of revenue and profits. Adjusted EPS in the quarter was $1.19, up 17% from the year-ago quarter earnings of $1.02, but missing the Zacks Consensus Estimate of $1.27.

Total revenue increased 12% to $1.02 billion, but lagged the Zacks Consensus Estimate of $1.05 billion. Same-store sales increased 1%, including a hike of 1% in air conditioning and heating (HVAC) equipment and a 16% rise in commercial refrigeration products, while sales of other HVAC products dropped 4%.
 
Cost and Margins
 
Cost of sales increased 12% to $778 million in the quarter. Gross profit was up 11% to $242 million. However, gross profit margin dropped 20 basis points (bps) to 23.8%, hurt by higher sales mix of HVAC products and commercial products, which generate lower margins than non-equipment products.
 
Selling, general and administrative expenses rose 8% to $157 million in the quarter. Income from operations increased 15% to record $86 million. Operating margin increased 30 basis points to 8.4%, aided by expansion in international markets and improved operating efficiency.
 
Financial Operations
 
Cash and cash equivalents were $46 million as of September 30, 2012, compared with $35.2 million as of June 30, 2012. For the quarter, operating cash flow was a record $124 million. For the first nine months ended September 30, 2012, Watsco generated operating cash flow of $64 million compared with a cash usage of $59 million in the comparable period last year.
 
Long-term debt for the company was $220 million as of September 30, 2012 compared with $236 million as of June 30, 2012. 
 
Watsco paid $62 million as dividends so far in 2012. Earlier in October, Watsco’s board of directors announced a special cash dividend of $5.00 per share. Even though the company intends to continue paying quarterly cash dividends, but hinted a moderation in the dividend rate in 2013, due consideration to its financial position, government tax policy and general economic conditions.
 
2012 Outlook
 
The company expects earnings in the band of $3.00 to $3.10 per share, down from the previous expectation of $3.15-$3.25 per share. This represents a growth rate between 9% and 13% over 2011.
 
Our Take
 
Watsco has immense potential in the replacement market of air conditioners and heating systems in the U.S, as nearly 89 million of them are more than 10 years old. Backed by its solid balance sheet, Watsco can continue to increase its dividend and make additional investments going forward. Watsco also stands to benefit from a recovery in the housing market.
 
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.
 
The company, which competes with Johnson Controls Inc. (JCI - Analyst Report), currently retains a short-term Zacks #4 Rank (Sell rating).

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