ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Forward-Looking Statements
This
Quarterly Report on
Form 10-Q
contains or incorporates by reference statements that are not historical in nature and that are intended to be, and are hereby identified as, forward-looking
statements as defined in the Private Securities Litigation Reform Act of 1995. Statements which are not historical in nature, including the words anticipate, estimate, could, should,
may, plan, seek, expect, believe, intend, target, will, project, focused, outlook and variations of these words and
negatives thereof and similar expressions are intended to identify forward-looking statements, including statements regarding, among others, (i) economic conditions, (ii) business and acquisition strategies, (iii) potential
acquisitions and/or joint ventures and investments in unconsolidated entities, (iv) financing plans and (v) industry, demographic and other trends affecting our financial condition or results of operations. These forward-looking statements
are based on managements current expectations, are not guarantees of future performance and are subject to a number of risks, uncertainties and changes in circumstances, certain of which are beyond our control. Actual results could differ
materially from these forward-looking statements as a result of several factors, including, but not limited to:
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general economic conditions;
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competitive factors within the HVAC/R industry;
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effects of supplier concentration;
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fluctuations in certain commodity costs;
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new housing starts and completions;
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capital spending in the commercial construction market;
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access to liquidity needed for operations;
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seasonal nature of product sales;
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insurance coverage risks;
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federal, state and local regulations impacting our industry and products;
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prevailing interest rates;
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foreign currency exchange rate fluctuations;
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international political risk;
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cybersecurity risk; and
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the continued viability of our business strategy.
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We believe these forward-looking statements are reasonable;
however, you should not place undue reliance on any forward-looking statements, which are based on current expectations. For additional information regarding other important factors that may affect our operations and could cause actual results to
vary materially from those anticipated in the forward-looking statements, please see the discussion included in Item 1A Risk Factors of our Annual Report on
Form 10-K
for the year ended
December 31, 2016, as well as the other documents and reports that we file with the SEC. Forward-looking statements speak only as of the date the statements were made. We assume no obligation to update forward-looking information or the
discussion of such risks and uncertainties to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except as required by applicable law. We qualify any and all of our forward-looking
statements by these cautionary factors.
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The following information should be read in conjunction with the condensed consolidated unaudited financial
statements, including the notes thereto, included under Part I, Item 1 of this Quarterly Report on
Form 10-Q.
In addition, reference should be made to our audited consolidated financial
statements and notes thereto and related Managements Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on
Form 10-K
for the year ended
December 31, 2016.
Company Overview
Watsco,
Inc. was incorporated in Florida in 1956, and, together with its subsidiaries (collectively, Watsco, or we, us or our) is the largest distributor of air conditioning, heating and refrigeration
equipment and related parts and supplies (HVAC/R) in the HVAC/R distribution industry in North America. At September 30, 2017, we operated from 562 locations in 37 U.S. States, Canada, Mexico and Puerto Rico with additional market
coverage on an export basis to portions of Latin America and the Caribbean.
Revenues primarily consist of sales of air conditioning, heating and
refrigeration equipment and related parts and supplies. Selling, general and administrative expenses primarily consist of selling expenses, the largest components of which are salaries, commissions and marketing expenses that are variable and
correlate to changes in sales. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts, and facility rent, which are payable mostly under
non-cancelable
operating leases.
Sales of residential central air conditioners, heating equipment and parts and
supplies are seasonal. Furthermore, results of operations can be impacted favorably or unfavorably based on weather patterns, primarily during the Summer and Winter selling seasons. Demand related to the residential central air conditioning
replacement market is typically highest in the second and third quarters, and demand for heating equipment is usually highest in the fourth quarter. Demand related to the new construction market is fairly consistent during the year, subject to
weather and economic conditions, including their effect on the number of housing completions.
Joint Ventures with Carrier Corporation
In 2009, we formed a joint venture with Carrier Corporation (Carrier), which we refer to as Carrier Enterprise I, in which Carrier contributed
95 of its company-owned locations in 13 Sun Belt states and Puerto Rico and its export division in Miami, Florida, and we contributed 15 locations that distributed Carrier products. In July 2012, we exercised our option to acquire an additional 10%
ownership interest in Carrier Enterprise I, which increased our ownership interest to 70%; and, on July 1, 2014, we exercised our last remaining option to acquire an additional 10% ownership interest in Carrier Enterprise I, which
increased our controlling interest to 80%. Neither Watsco nor Carrier has any remaining options to purchase additional ownership interests in Carrier Enterprise I or any of our other joint ventures with Carrier, which are described below.
In 2011, we formed a second joint venture with Carrier and completed two additional transactions. In April 2011, Carrier contributed 28 of its company-owned
locations in the Northeast U.S., and we contributed 14 locations in the Northeast U.S. In July 2011, we purchased Carriers distribution operations in Mexico, which included seven locations. Collectively, the Northeast locations and the Mexico
operations are referred to as Carrier Enterprise II. On November 29, 2016, we purchased an additional 10% ownership interest in Carrier Enterprise II, and, on February 13, 2017, we again purchased an additional 10% ownership
interest in Carrier Enterprise II, which together increased our controlling interest to 80%.
In 2012, we formed a third joint venture, which we
refer to as Carrier Enterprise III, with UTC Canada Corporation, referred to as UTC Canada, an affiliate of Carrier. Carrier contributed 35 of its company-owned locations in Canada to Carrier Enterprise III. We have a 60% controlling
interest in Carrier Enterprise III, and UTC Canada has a 40%
non-controlling
interest.
Critical
Accounting Policies
Managements discussion and analysis of financial condition and results of operations is based upon the condensed
consolidated unaudited financial statements included in this Quarterly Report on
Form 10-Q,
which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of
these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the condensed consolidated unaudited
financial statements and the reported amount of revenues and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. At least quarterly, management reevaluates its judgments and
estimates, which are based on historical experience, current trends and various other assumptions that are believed to be reasonable under the circumstances.
Our critical accounting policies are included in our 2016 Annual Report on
Form 10-K,
as filed with the SEC on
February 21, 2017. We believe that there have been no significant changes during the quarter ended September 30, 2017 to the critical accounting policies disclosed in our Annual Report on
Form 10-K
for the year ended December 31, 2016.
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Recent Accounting Pronouncements
Refer to Note 1 to our condensed consolidated unaudited financial statements included in this Quarterly Report on
Form 10-Q
for a discussion of new accounting standards.
Results of Operations
The following table summarizes information derived from our condensed consolidated unaudited statements of income, expressed as a percentage of revenues, for
the quarters and nine months ended September 30, 2017 and 2016:
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Quarter Ended
September 30,
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Nine Months
Ended
September 30,
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2017
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2016
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2017
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2016
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Revenues
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100.0
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%
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100.0
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%
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100.0
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%
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100.0
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%
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Cost of sales
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75.9
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75.7
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75.6
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75.6
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Gross profit
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24.1
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24.3
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24.4
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24.4
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Selling, general and administrative expenses
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14.9
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14.7
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15.8
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15.7
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Other income
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0.2
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0.1
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Operating income
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9.3
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9.6
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8.7
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8.7
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Interest expense, net
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0.2
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0.1
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0.1
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0.1
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Income before income taxes
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9.1
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9.5
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8.5
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8.6
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Income taxes
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2.6
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3.0
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2.5
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2.7
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Net income
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6.5
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6.5
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6.1
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5.9
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Less: net income attributable to
non-controlling
interest
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1.2
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1.4
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1.2
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1.3
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Net income attributable to Watsco, Inc.
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5.3
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%
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5.1
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%
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4.9
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%
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4.6
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%
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Note: Due to rounding, percentages may not add up to 100.
In the following narratives, computations and other information referring to same-store basis exclude the effects of locations acquired or
locations opened or closed during the immediately preceding 12 months unless they are within close geographical proximity to existing locations. At September 30, 2017 and 2016, 34 and 17 locations, respectively, were excluded from
same-store basis information. The table below summarizes the changes in our locations for the 12 months ended September 30, 2017:
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Number
of
Locations
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September 30, 2016
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568
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Opened
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2
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Closed
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(5
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)
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December 31, 2016
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565
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Opened
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12
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Closed
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(15
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)
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September 30, 2017
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562
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Third Quarter of 2017 Compared to Third Quarter of 2016
Revenues
Revenues for the third quarter of 2017 decreased
$11.6 million, or 1%, including $8.2 million from locations closed during the preceding 12 months, offset by $1.9 million from locations opened. On a same-store basis, revenues decreased $5.3 million, or were flat, as
compared to the same period in 2016, reflecting flat sales of HVAC equipment (68% of sales), a 4% decrease in sales of other HVAC products (27% of sales) and a 4% decrease in sales of commercial refrigeration products (5% of sales). The decrease in
same-store revenues reflects disruptions from natural disasters which impacted certain of our largest markets during August and September 2017. More than 300 locations experienced some impact with 190 temporary location closures, including locations
in key markets in Florida, Texas, Georgia and Puerto Rico.
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Gross Profit
Gross profit for the third quarter of 2017 decreased $6.3 million, or 2%, primarily as a result of lower revenues. Gross profit margin for the quarter
ended September 30, 2017 declined 20 basis-points to 24.1% versus 24.3% for the same period in 2016, primarily due to a shift in sales mix toward HVAC equipment, which generate a lower gross profit margin than
non-equipment
products.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the third quarter of 2017 remained flat as compared to the same period in 2016. Selling, general and
administrative expenses as a percent of revenues for the quarter ended September 30, 2017 increased to 14.9% versus 14.7% for the same period in 2016. On a same-store basis, selling, general and administrative expenses increased 3% as compared
to the same period in 2016. The increase in selling, general and administrative expenses was primarily due to our inability to leverage fixed operating costs as compared to 2016.
Other Income
Other income of $2.3 million for the
third quarter of 2017 represents our share of the net income from our investment in Russell Sigler, Inc. (RSI), in which we purchased an approximately 35% ownership interest in June 2017.
Interest Expense, Net
Net interest expense for the third
quarter of 2017 increased $1.1 million, or 113%, primarily as a result of an increase in average outstanding borrowings and a higher effective interest rate for the 2017 period, in each case under our revolving credit facility, as compared to
the same period in 2016.
Income Taxes
Income taxes
decreased to $32.3 million for the third quarter of 2017 as compared to $37.8 million for the third quarter of 2016 and are a composite of the income taxes attributable to our wholly owned operations and income taxes attributable to the
Carrier joint ventures, which are primarily taxed as partnerships for income tax purposes. The effective income tax rates attributable to us were 32.8% and 36.8% for the quarters ended September 30, 2017 and 2016, respectively. The decrease was
primarily due to higher share-based payment deductions in 2017 as compared to the same period in 2016.
Net Income Attributable to Watsco, Inc.
Net income attributable to Watsco for the quarter ended September 30, 2017 increased $1.9 million, or 3%, compared to the same period in
2016. The increase was primarily driven by other income and income taxes, as discussed above, and by a reduction in the net income attributable to the
non-controlling
interest related to Carrier Enterprise II
following our purchases of additional 10% ownership interests in both November 2016 and February 2017.
Nine Months Ended September 30, 2017
Compared to Nine Months Ended September 30, 2016
Revenues
Revenues for the nine months ended September 30, 2017 increased $70.5 million, or 2%, including $3.5 million from locations opened during the
preceding 12 months, offset by $19.1 million from locations closed. On a same-store basis, revenues increased $86.1 million, or 3%, as compared to the same period in 2016, reflecting a 3% increase in sales of HVAC equipment (67% of sales),
a 1% increase in sales of commercial refrigeration products (5% of sales) and flat sales of other HVAC products (28% of sales). The increase in same-store revenues was primarily due to demand for the replacement of residential HVAC equipment.
Gross Profit
Gross profit for the nine months ended
September 30, 2017 increased $18.2 million, or 2%, primarily as a result of increased revenues. Gross profit margin for the nine months ended September 30, 2017 remained consistent at 24.4% as compared to the same period in 2016.
Selling, General and Administrative Expenses
Selling,
general and administrative expenses for the nine months ended September 30, 2017 increased $15.6 million, or 3%, primarily due to increased revenues. Selling, general and administrative expenses as a percent of revenues for the nine months
ended September 30, 2017 and 2016 increased to 15.8% versus 15.7% for the same period in 2016. On a same-store basis, selling, general and administrative expenses increased 4% as compared to the same period in 2016. Selling, general and
administrative expenses included $0.6 million of additional costs for 2017 in excess of 2016 for ongoing technology initiatives.
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Other Income
Other income of $2.3 million for the nine months ended September 30, 2017 represents our share of the net income from our investment in RSI, in which
we purchased an approximately 35% ownership interest in June 2017.
Interest Expense, Net
Net interest expense for the nine months ended September 30, 2017 increased $2.0 million, or 65%, primarily as a result of an increase in average
outstanding borrowings and a higher effective interest rate for the 2017 period, in each case under our revolving credit facility, as compared to the same period in 2016.
Income Taxes
Income taxes decreased to
$82.9 million for the nine months ended September 30, 2017 as compared to $88.4 million for the nine months ended September 30, 2016 and are a composite of the income taxes attributable to our wholly owned operations and income
taxes attributable to the Carrier joint ventures, which are primarily taxed as partnerships for income tax purposes. The effective income tax rates attributable to us were 33.0% and 36.0% for the nine months ended September 30, 2017 and 2016,
respectively. The decrease was primarily due to higher share-based payment deductions in 2017 as compared to the same period in 2016.
Net Income
Attributable to Watsco, Inc.
Net income attributable to Watsco for the nine months ended September 30, 2017 increased $11.7 million, or 8%,
compared to the same period in 2016. The increase was primarily driven by higher revenues and other income, as discussed above, and by a reduction in the net income attributable to the
non-controlling
interest
related to Carrier Enterprise II following our purchases of additional 10% ownership interests in both November 2016 and February 2017.
Liquidity
and Capital Resources
We assess our liquidity in terms of our ability to generate cash to execute our business strategy and fund operating and
investing activities, taking into consideration the seasonal demand for HVAC/R products, which peaks in the months of May through August. Significant factors that could affect our liquidity include the following:
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cash needed to fund our business (primarily working capital requirements);
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borrowing capacity under our bank line of credit;
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the timing and extent of sales of Common stock under our
at-the-market
offering program;
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the ability to attract long-term capital with satisfactory terms;
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acquisitions, including joint ventures and investments in unconsolidated entities;
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capital expenditures; and
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the timing and extent of common stock repurchases.
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Sources and Uses of Cash
We rely on cash flows from operations and borrowing capacity under our revolving credit agreement to fund seasonal working capital needs and for other general
corporate purposes, including dividend payments, if and as declared by our Board of Directors, capital expenditures, business acquisitions and development of our long-term operating and technology strategies.
As of September 30, 2017, we had $66.7 million of cash and cash equivalents, of which $54.0 million was held by foreign subsidiaries. The
repatriation of cash balances from our foreign subsidiaries could have adverse tax consequences or be subject to capital controls; however, these balances are generally available without legal restrictions to fund ordinary business operations of our
foreign subsidiaries.
We believe that our operating cash flows, cash on hand, funds available for borrowing under our revolving credit agreement and
funds available from sales of our Common stock under our
at-the-market
offering program will be sufficient to meet our liquidity needs in the foreseeable future.
However, there can be no assurance that our current sources of available funds will be sufficient to meet our cash requirements.
Our access to funds
under our revolving credit agreement depends on the ability of the syndicate banks to meet their respective funding commitments. Disruptions in the credit and capital markets could adversely affect our ability to draw on our revolving credit
agreement and may also adversely affect the determination of interest rates, particularly rates based on LIBOR, which is one of the base rates under our revolving credit agreement. Disruptions in the credit and capital markets could also result in
increased borrowing costs and/or reduced borrowing capacity under our revolving credit agreement.
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Working Capital
Working capital increased to $978.5 million at September 30, 2017 from $925.3 million at December 31, 2016, reflecting higher levels of
accounts receivable and inventories, primarily due to the seasonality of our business.
Cash Flows
The following table summarizes our cash flow activity for the nine months ended September 30, 2017 and 2016:
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2017
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2016
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Change
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Cash flows provided by operating activities
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$
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184.7
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$
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146.3
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$
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38.4
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Cash flows used in investing activities
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$
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(77.3
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)
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$
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(8.3
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$
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(69.0
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)
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Cash flows used in financing activities
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$
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(98.3
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$
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(137.4
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$
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39.1
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The individual items contributing to cash flow changes for the periods presented are detailed in the condensed consolidated
unaudited statements of cash flows contained in this Quarterly Report on
Form 10-Q.
Operating Activities
Net cash provided by operating activities increased primarily due to the timing of payments for accounts payable and other liabilities and from a
buildup of inventory in anticipation of future demand related to the restoration and replacement activities after the natural disasters experienced in certain of our largest markets during August and September, partially offset by a lower increase
in accounts receivable primarily driven by timing of collections during the nine months ended September 30, 2017.
Investing Activities
Net cash used in investing activities increased primarily due to the purchase of an ownership interest in RSI for $63.6 million and an increase in capital
expenditures in 2017.
Financing Activities
Net cash
used in financing activities decreased primarily due to higher borrowings under our revolving credit agreement, lower distributions to the
non-controlling
interest, $12.7 million in proceeds from the
non-controlling
interest for its contribution to the purchase of an ownership interest in RSI and $5.4 million in proceeds from the sale of common stock, partially offset by the purchase of an additional 10%
ownership interest in Carrier Enterprise II for $42.7 million and an increase in dividends paid in 2017.
Revolving Credit Agreement
We maintain an unsecured, syndicated revolving credit agreement that provides for borrowings of up to $600.0 million. Borrowings are used to fund seasonal
working capital needs and for other general corporate purposes, including acquisitions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases and issuances of letters of credit. The credit agreement
matures on July 1, 2019. Included in the credit facility are a $90.0 million swingline subfacility, a letter of credit subfacility and a $75.0 million multicurrency borrowing sublimit. On January 24, 2017, we entered into an
amendment to this credit agreement, which reduced the letter of credit subfacility from $50.0 million to $10.0 million and modified certain definitions. At September 30, 2017 and December 31, 2016, $284.7 million and
$235.3 million were outstanding under the revolving credit agreement, respectively. The revolving credit agreement contains customary affirmative and negative covenants, including financial covenants with respect to consolidated leverage and
interest coverage ratios, and other customary restrictions. We believe we were in compliance with all covenants at September 30, 2017.
Purchase
of Additional Ownership Interest in Joint Venture
On November 29, 2016, we purchased an additional 10% ownership interest in Carrier
Enterprise II for cash consideration of
$42.9 million, and, on February 13, 2017, we purchased an additional 10% ownership interest in
Carrier Enterprise II for cash consideration of $42.7 million, which together increased our controlling interest in Carrier Enterprise II to 80%. We used borrowings under our revolving credit agreement to finance these acquisitions.
Investment in Unconsolidated Entity
On June 21,
2017, Carrier Enterprise I acquired an approximately 35% ownership interest in RSI, an HVAC distributor operating from 30 locations in the Western U.S., for cash consideration of $63.6 million, of which we contributed $50.9 million
and Carrier contributed $12.7 million. Carrier Enterprise I entered into a shareholders agreement (the Shareholders Agreement) with RSI and RSIs other shareholders. Pursuant to the Shareholders Agreement, RSIs
shareholders have the right to sell, and Carrier Enterprise I has the obligation to purchase, their respective shares of RSI for a purchase price determined based on either book value or EBIT, the latter of which Carrier Enterprise I used
to calculate the price paid for its investment in RSI. RSIs shareholders may transfer their
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respective shares of RSI common stock only to members of the Sigler family or to Carrier Enterprise I, and, at any time from and after the date on which Carrier Enterprise I owns 85% or more
of RSIs outstanding common stock, it has the right, but not the obligation, to purchase from RSIs shareholders the remaining outstanding shares of RSI common stock. We believe that our operating cash flows, cash on hand and funds
available for borrowing under our revolving credit agreement will be sufficient to purchase any additional ownership interests in RSI.
Acquisitions
We continually evaluate potential acquisitions, including joint ventures and investments in unconsolidated entities, and routinely hold discussions
with a number of acquisition candidates. Should suitable acquisition opportunities arise that would require additional financing, we believe our financial position and earnings history provide a sufficient basis for us to either obtain additional
debt financing at competitive rates and on reasonable terms or raise capital through the issuance of equity securities.
Common Stock Dividends
We paid cash dividends of $3.35 and $2.55 per share of Common stock and Class B common stock during the nine months ended September 30, 2017
and 2016, respectively. On October 2, 2017, our Board of Directors declared a regular quarterly cash dividend of $1.25 per share of Common and Class B common stock that was paid on October 31, 2017 to shareholders of record as of
October 16, 2017. Future dividends and/or changes in dividend rates will be at the sole discretion of the Board of Directors and will depend upon such factors as cash flow generated by operations, profitability, financial condition, cash
requirements, future prospects and other factors deemed relevant by our Board of Directors.
At-the-Market
Offering Program
On August 23, 2017, we entered into a sales agreement with Robert W.
Baird & Co. Inc. (the Agent), which we refer to as the Sales Agreement, pursuant to which we may issue and sell shares of our Common stock, from time to time, having a maximum aggregate offering price of up to
$250.0 million through the Agent. Sales, if any, may be made in one or more negotiated transactions or transactions that are deemed to be at the market offerings as defined in Rule 415 under the Securities Act of 1933. The
offering of shares in accordance with the Sales Agreement has been registered pursuant to our automatically effective shelf registration statement on
Form S-3
(File
No. 333-207831).
We intend to use the net proceeds, if any, from the sale of shares pursuant to the Sales
Agreement for general corporate purposes, which may include, without limitation, the acquisition of complementary businesses, the repayment of outstanding indebtedness, capital expenditures and working capital. The Sales Agreement contains customary
representations, warranties and covenants. We believe we were in compliance with all covenants at September 30, 2017.
During the quarter and nine
months ended September 30, 2017, we sold 35,000 shares of Common stock under the Sales Agreement for net proceeds of $5.4 million. Direct costs of $0.3 million incurred in connection with the offering were charged against the proceeds
from the sale of Common stock and were accounted for as a reduction of
paid-in
capital. At September 30, 2017, $244.6 million remained available for sale under the Sales Agreement.
Company Share Repurchase Program
In September 1999, our
Board of Directors authorized the repurchase, at managements discretion, of up to 7,500,000 shares of common stock in the open market or via private transactions. Shares repurchased under the program are accounted for using the cost method and
result in a reduction of shareholders equity. No shares were repurchased during the quarters ended September 30, 2017 or 2016. In aggregate, 6,370,913 shares of Common and Class B common stock have been repurchased at a cost of
$114.4 million since the inception of the program. At September 30, 2017, there were 1,129,087 shares remaining authorized for repurchase under the program.