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Watsco Warms Up in a Hot Summer

In many parts of the U.S., air conditioning is a necessity during the summer months. For HVAC system distributor Watsco (NYSE: WSO), demand for air conditioners starts to climb during the spring, and those who follow the industry look to results from the spring months to gauge how successful of a year major players in the sector are likely to have.

Coming into Tuesday's second-quarter financial report, Watsco investors were expecting another solid set of financial results from the distributor. Watsco didn't live up to all of its shareholders' expectations, but it did produce record results that included solid gains in key product lines. Let's take a closer look at Watsco to see how it did and what's ahead for the HVAC specialist.

Image source: Baker Distributing, a unit of Watsco.

Another quarter in the record books for Watsco

Watsco's second-quarter report was a nice rebound from a sluggish first quarter. Revenue was up 5% to $1.28 billion, which was a bit less than the nearly 7% growth rate that investors were hoping to see. Yet net income jumped 14% to $73.8 million, and that produced earnings of $2.07 per share. The figure topped the consensus forecast among those following the stock for $2.04 per share, and both sales and earnings per share hit new record highs for the company.

Looking more closely at Watsco's numbers, a number of favorable factors contributed to strong bottom-line results. Operating income was up 10% from the year-ago period, rising to a record $129 million. Efforts to improve margin figures continued to pay off, with a rise of 0.4 percentage points in operating margin that came in part from more efficient sales practices and in part from lower overhead expenses as a percentage of total revenue.

Sales picked up quite a bit for the key HVAC equipment segment. Revenue from the division was up 7% worldwide, with an even stronger 8% jump for U.S. sales. That was more than double the growth rate that Watsco produced during the first quarter, marking the company's rebound during the spring. Sales of other HVAC products were up 2% from the year-ago period, and commercial refrigeration had a 3% rise in segment revenue.

Watsco CEO Albert Nahmad was succinct in his comments about the quarter. "Our second quarter performance produced the highest sales and profits of any quarter in Watsco's history," Nahmad said, and "earnings growth and margin expansion were driven by a combination of solid sales growth, improved selling margins, and operating efficiencies."

Can Watsco heat up even further?

Watsco believes that the future is even brighter, with opportunities to upgrade systems with existing customers and to poach business away from competitors with replacement systems. As Nahmad put it, "We believe technology changes progressing in our industry will accelerate, and our industry-specific focus, scale, and leadership position will serve us well." Moves like investing in scalable platforms for mobile apps, e-commerce, and business intelligence are part of that technology strategy. Watsco also expects to keep looking for acquisitions and other investments in order to keep growing to meet its customers' needs.

One example of such an acquisition is the recent purchase of a stake in HVAC distributor Russell Sigler. Sigler serves more than 10,000 customers in six Western states, selling residential and commercial HVAC equipment manufactured by Carrier, which is Watsco's partner in the joint venture that made the purchase. With sales of $650 million, Sigler should go a long way toward boosting Watsco's exposure to the industry, and the 35% stake cost Watsco just $50.9 million in cash for its contribution to the total purchase price.

Maintaining a healthy relationship with Carrier will be a key to Watsco's success. Some were concerned when Carrier parent United Technologies (NYSE: UTX) sold off Watsco stock earlier this year, but the move was motivated solely by accounting issues rather than any deterioration of the relationship between the two companies.

Even with the strong results, Watsco stock didn't react favorably, falling almost 1% in the opening minutes of the trading session following the announcement. Nevertheless, Watsco continues to find good opportunities for fundamental growth, and that should bode well for investors in the long run.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Watsco. The Motley Fool has a disclosure policy.