Content Published Last Week

1. IP ANALYSIS: Watsco: Gross Margin and Return Predictability

2. Watsco, Carrier, & History of HVAC Distribution

3. NVR Inc & US Land Development

4. Watsco: SEER Pricing Changes and Gross Margin

5. Naked Wines: Operational Changes & Strategic Opportunities

6. The Hut Group: Myprotein & Nutrition Division

Watsco, Fastenal, Addtech & B2B Distributors: Predictable Returns

When we study mature companies, we first aim to understand the persistence of returns. We want to grasp the predictability of the company’s earnings power. After laying out the 20-year financials on excel, one variable we focus on is gross profit.

A stable gross profit margin suggests the company is consistently adding value in its industry over time. It’s a cleaner measure of the underlying business fundamentals, excluding overhead efficiency, management salaries, leverage, taxes, etc.

Low gross margin variability is one of the main reasons we’re interested in B2B distributors like Watsco, POOL, Fastenal, Addtech, etc.

Source: In Practise, Filings
Source: In Practise, Filings

The table below shows the coefficient of variation, the variation of each year’s gross and ebit margin from the 20-year mean, for each distributor. The lower the variability, the greater the predictability of gross margins. A 3-4% variation in the gross margin is incredibly predictable for any industrial business.

Source: In Practise
Source: In Practise

But a stable gross profit margin isn’t enough; the absolute gross profit dollars needs to be high enough to cover operating costs and drive a return on the capital employed. Another metric we eyeball is gross profit relative to capital employed. How much gross profit is generated from $1 of assets. This is a quick indication of the underlying industry unit economics.

The table below shows that each distributor earns ~$1 in gross profit for every $1 of capital employed with little variation over the last 20 years. A high GP / Cap Employed ratio helps drive consistently ~20%+ ROIC.

Source: In Practise
Source: In Practise

This combination of low margin variability and high gross profit / cap employed is an indicator of predictable, high-returns for B2B distributors. As long as management can maintain a lean cost structure, the question becomes about growth: how much capital can distributors allocate to acquire companies or drive organic growth?

These are the core reasons we follow distributors like Watsco closely.

In the last 9 months, WSO has hit record gross and EBIT margins. We interviewed two Former Watsco executives to understand whether the margin improvement is structural or temporary. We also published our analysis exploring SEER regulation, impact of tax credits, and WSO’s operating leverage. In short, FY25 estimates could prove too low given SEER structural premiumisation and WSO SG&A leverage.

The full write-up is available for members only here.

NVR Inc & US Land Development

A Former VP at KB Home and current land developer in Florida shares insight into typical NVR’s land contract structures:

We've only started working with them, but during a good market they're a hard company to work with because of the way they do business. We're working on a deal with them in one of our communities and it's been a drawn out process on the land contracts. Once you get through your first one or two it's an easier process, but if you're allowing them to do takes, it has a lot more provisions in the contract than you would normally deal with. They're harder to get the first deal inked with, because as the seller, you're always wondering why all of these provisions are there. Is their intention to go forward or is this their way to weasel out of something, but that's how they do business.
Years ago, I was a trustee for a bankruptcy in Ohio, and NVR was going to buy lots from me and insisted on a rep and warranty that I typically would not give, but I gave it because as the trustee, I had immunity from that rep and warranty through the bankruptcy court. They pushed for reps and warranties and, as a land seller, you want to give as few reps and warranties as you possibly can. You want the buyer to do their own due diligence and to rely upon third party tests and not look to you as the land seller for the liability, because the liability is not just in the land. If they have a problem with soil compaction, you have house issues that buyers will look back to you as the party who did that rep and warranty to NVR.

Naked Wines: Operational Changes & Strategic Opportunities

We're searching through all the beaten-up ecommerce midcap names globally; those great garpy-investments that are now special sits with Naked being top of the list! A Former VP of Naked explores the opportunity to reignite growth. In short, it's a lot of work but the quality of the service is still intact. Top priorities are to strengthen its management team and board, find new marketing channels, and cut G&A costs whilst maintaining its current customer base.

From a culture perspective, it's always worrying when you think you're something that you're not. I even see it in their investment case, entrepreneurial, nimble, quick to market. A lot of it is to do with technology. They have a humongous weight around their neck because we built a lot of the tech ourselves in 2008, because there was no Shopify or a Software-as-a-Service industry. There is no documentation and everybody has left. They are terrified of changing anything in fear of it breaking. When you're not performing, all of a sudden, we had better not go further backwards and change this, because if we squeeze this part of the balloon, we don't what will happen over here. Look at how much cost they're carrying; their G&A is nuts.

Selling Aus or the UK and focusing on US could also be an option:

That is the strongest barrier to entry for any competitor in the US; Naked has wine maker talent. They love it but are concerned looking at the performance of the business, which is also playing into the culture because nobody likes to see poor performance...The difference in the US market to Australia and the UK is that price perception is much more of a factor in the US. In the UK and Australia, consumers want to pay as little as possible for a great bottle of wine, which is not the case in the US. People are embarrassed by the price of the wine. It is a status symbol like having the Rolex, car or house, if you come around and say I paid $11 for this bottle of wine, people are like, I’m not drinking it.

But who will run the US business?

The Hut Group: Myprotein & Nutrition Division

THG has enjoyed an even tougher ride than WINE and is down 90% since IPO last year. A Former THG Executive explores the quality of each division:

[Beauty] a much harder business [than nutrition]. Own brand versus resellers, as a reseller in the market, you’re selling other people’s products. The value in growth in beauty is if they can get their own brands, the ones they own to sell, rather than something like LOOKFANTASTIC. LOOKFANTASTIC is a big player in the market, and sells many brands, but you're so at the behest of anything else to happen. If Estée Lauder decides to reduce their distribution to their own channels, there's nothing you can do about it. There is always this inherent risk of third-party retailers, but they might need you as much as you need them. It seems like it could be more of a risk long term, but I’m not sure.