Watsco: Gross Margin and Return Predictability

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: IP

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

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.