Thoughts on Watsco and some businesses like it

A deep local presence can confer competitive advantages in industries with low entry barriers.  Rollins typically commands the largest share in its markets, allowing it to service more houses per technician outing than competitors, resulting in greater labor productivity and scale economies on marketing and branch overhead.  Fastenal clusters its stores near customers, permitting steady access to a wide range of mission critical SKUs on short notice.

Pool Corp., a wholesale distributor of swimming pool equipment, parts, and supplies, also combines local presence with broad selection to efficiently meet customer needs, aggregating 200k+ SKUs from a fragmented vendor base across a store footprint that is supposedly larger than those of the next 56 competitors combined.  Its 100k+ US contractors can visit a nearby site and be reasonably sure they will find everything they need, which saves them time and lets them finish more jobs.  The productivity gains that a contractor realizes from one-stop shopping at a conveniently located branch more than offsets the somewhat higher costs that Pool Corp charges, costs that are probably just passed on to the pool owner anyways. 

60% of Pool’s revenue comes from (somewhat) non-discretionary maintenance spend – things like pool chemicals, pumps, and filters¹.  In the residential market, which encompasses over 5mn in-ground pools vs. 80mn single family homes, Pool has 40% share of an $8bn market; on the commercial side, where business is less price/more time sensitive (resort pools need to running at all times), less seasonal (more indoor pools), and equipment is far more specialized and complex², Pool has just 10% of a $1.5bn opportunity. 

One gets the sense that management measures everything – the idle time on its delivery fleet and wait times in its call centers – down to the minute and explicitly translates those minutes to pennies. By rolling out self-service kiosks outside their facilities and setting up regional call centers, they have reduced service times and freed store employees up to address more complex needs. Each stores’ expenses and productivity are benchmarked against high-performing sales centers with similar unit volumes, pressuring underperforming managers to improve profitability to get off the “focus list”.  And so, even as Pool has consistently taken share on both the residential and commercial sides of the market, they have done so while keeping opex growth at 60% of gross profit growth and targeting 24% pre-tax returns on new store openings.

This is born out in the financials:        

(you’ll notice that gross margins haven’t moved much at all over the last 7 years, which I surmise is the result of higher mix from lower-margin new construction revenue (during the crisis, gross margins ticked higher as revenue from new in-pool construction fell off a cliff) and greater internet-induced price transparency offset by a growing mix of higher-margin private label products)

SiteOne³, a wholesale distributor of landscaping supplies to the residential (56% of revenue), commercial (31%), and recreational (13%) sectors, is similar to Pool in that it procures a wide range of product from lots of suppliers and distributes across a nationwide network of branches strategically located close to its 230k customers⁴, most of whom replenish inventory on an ad-hoc basis. 

Materials run between 10% to 25% of a landscaper’s costs, which is not so small that SiteOne’s customers don’t notice but not so large that they vigilantly re-bid supplies (notably, even as volumes decelerated to low-single digits in 2019, SiteOne still reported mid-single digit organic revenue growth as pricing picked up the slack). What landscapers care about more than getting the best price on fertilizer and irrigation supplies is reducing the time required to complete a job and controlling labor costs, so there’s value in offering technical support⁵ and stocking everything a landscaper could plausibly need. 

To grow into a convenient one-stop shop for its customers, SiteOne has been using all its free cash flow and levering its balance sheet to roll up leading local distributors of key products (fertilizers, herbicides, irrigation systems) at 5x-6x pre-synergy EBITDA, building towards 60%-65% share for every category in a local market⁶ ⁷.  For whatever reason, the company hasn’t seen much competition and, at least as of a few years ago, most of its deals had no other bidders.

It’s gotten to around 12% national market share, which is small on absolute basis but 4x larger than the next largest competitor.  Among smaller landscapers – according to management, 45% of landscape contractors do less than $250k in revenue – who might automatically source at Home Depot or Lowe’s because they don’t know about SiteOne, the company’s share is more like high-single digits, but revenue here is growing faster vs. larger customers as SiteOne generates more awareness through marketing campaigns (though, frankly, the value proposition of offering high service levels and lots of SKUs across multiple categories is more relevant for mid/large-sized landscapers who manage multiple crews and take on more complex projects). 

The bet is that management will roll up, at reasonable prices, leading distributors that have built strong relationships with local contractors while also a/ centralizing back-end IT, finance, and sourcing functions; b/ building density across its hub-and-spoke logistics networks; and c/ funneling volume to fewer preferred suppliers to procure goods at advantaged prices.  Basically, they acquire local leaders and realize regional/national scale economies.

I’m not going to argue that SiteOne is a terrific business.  With $5bn of capital, you could probably replicate it over 5 to 10 years.  But the idea is that by the time a competitor gets to that point, SiteOne will be enjoying superior unit economics through scale. Assuming management continues to put capital to work at ~17%-20% pre-tax returns, realizes procurement synergies, scales logistics, and accelerates working capital conversion, even shareholders who pay 27x EBITDA for SiteOne today will probably be rewarded.