Watsco (WSO) Q3 2025: Gross Margin Expands 130bps as A2L Transition Nears Completion

2025-10-29 | By EarningsIQ Research

Watsco delivered record cash flow and widened gross margin despite industry-wide HVAC volume declines tied to the A2L refrigerant transition. Management sees the worst of the regulatory disruption passing, with focus shifting to inventory normalization, technology-driven margin expansion, and acquisition optionality as the environment stabilizes into 2026. Investors should watch for a return to demand normalization and the impact of new digital tools on margin structure.

Summary

• Margin Expansion Amid Regulatory Volatility: Gross margin gains reflect pricing discipline and mix, even as unit volumes fell.
• Technology Investments Accelerate: E-commerce and digital selling platforms are driving higher engagement and sales efficiency.
• Balance Sheet Strength Enables Flexibility: Cash generation and inventory turns position Watsco for opportunistic M&A as industry stabilizes.

Performance Analysis

Watsco’s Q3 performance was defined by resilience in the face of a sharp industry transition. Total sales declined 4 percent, with US sales down 3 percent, as the HVAC sector absorbed the disruptive shift to A2L refrigerants, which impacted over half the company’s product portfolio. Despite this, gross margin expanded by 130 basis points to 27.5 percent, a function of double-digit price increases on new equipment, a favorable shift toward non-equipment and commercial refrigeration products, and the increasing impact of pricing optimization tools.

Operating expenses increased 5 percent, driven by transition-related inefficiencies and costs from new and acquired locations. However, record third-quarter cash flow of $355 million and a continued reduction in inventories underscore Watsco’s ability to manage working capital tightly during market upheaval. E-commerce penetration reached 34 percent of sales, with some US markets reaching as high as 70 percent, highlighting the company’s digital transformation momentum.

• Non-Equipment Outperformance: Parts and supplies, which comprise over 28 percent of sales, outpaced equipment, reflecting consumer price sensitivity and repair trends.
• Cash Flow Execution: Robust cash generation and inventory reductions provide strategic flexibility for M&A and investment.
• Unit Volume Weakness: Equipment demand remains subdued, with management confirming mid-single-digit revenue declines quarter-to-date in Q4.

Despite lower volumes and a challenging demand backdrop, Watsco’s focus on margin, cash, and technology adoption is positioning the company for a smoother 2026 as regulatory headwinds abate.

Executive Commentary

Strategic Positioning

1. Navigating the A2L Refrigerant Transition

Watsco’s operational focus in 2025 centered on managing the disruptive shift to A2L refrigerants, which affected 55 percent of its product mix. While this created short-term inefficiencies and demand volatility, management views regulatory change as a long-term tailwind, historically driving higher replacement cycles and margin opportunities. The company expects the transition to be “substantially complete” by year-end, setting the stage for a return to more normalized operations in 2026.

2. Technology-Driven Margin and Sales Model

Digital adoption is transforming Watsco’s go-to-market engine. E-commerce now represents over a third of sales, and the OnCallAir platform, a digital selling tool for contractors, saw a 19 percent increase in gross merchandise value to $1.7 billion. Notably, over 70 percent of OnCallAir transactions are for higher-efficiency systems, driving up average selling prices and margins. Pricing optimization tools and AI are being deployed to further support Watsco’s goal of exceeding a 30 percent gross margin.

3. Inventory and Cash Flow Discipline

Watsco is aggressively reducing inventory and improving turns, targeting a step-change in working capital efficiency. With inventory turns at 3.6-3.7 and a stated goal to reach five turns, management is leveraging scale and technology to push for faster OEM deliveries and daily replenishment. This discipline is directly translating into record cash flow, fueling both organic initiatives and potential M&A as industry conditions create new opportunities.

4. M&A Optionality and Capital Allocation

With a debt-free balance sheet and $600 million in cash, Watsco is positioned to pursue acquisitions as industry softness may bring new targets to market. While share repurchases are under consideration, management’s focus is on leveraging financial strength for strategic expansion, especially as smaller distributors face pressure in the current environment.

5. Non-Equipment Growth and Repair/Replace Dynamics

Non-equipment categories—parts and supplies—are outperforming equipment, reflecting both consumer price sensitivity and regional differences in replacement cycles. The Sun Belt, representing 75 percent of Watsco’s business, remains more replacement-driven, while northern markets skew toward repair. This mix shift, while not fully offsetting equipment weakness, is supporting gross margin resilience.

Key Considerations

Watsco’s Q3 underscores the company’s ability to protect earnings and invest in the future even as HVAC market demand contracts sharply. The focus on controllable levers—margin, cash flow, technology, and capital deployment—stands out as the company navigates the end of a historic regulatory transition.

Key Considerations:

• Regulatory Disruption Winds Down: The A2L transition’s drag on volumes is expected to fade, with management anticipating a simpler operating environment in 2026.
• Digital and AI Initiatives Gain Traction: E-commerce and OnCallAir adoption are not only driving sales but also shifting product mix toward higher-margin systems.
• Inventory Normalization Remains a Priority: Management is pushing for improved inventory turns and faster OEM replenishment, targeting five turns to unlock further cash flow.
• Capital Flexibility for M&A: With no debt and substantial cash, Watsco is prepared to pursue opportunistic acquisitions if market softness prompts smaller distributors to sell.
• Consumer Demand Remains Uncertain: Macro headwinds, including low consumer confidence and housing turnover, continue to weigh on replacement demand.

Risks

Watsco faces continued volume pressure from subdued consumer demand, especially as higher prices and macro uncertainty dampen replacement activity. Execution risk remains around inventory normalization and sustaining margin gains if demand remains weak into 2026. Additionally, further OEM price increases or supply chain disruptions could challenge the company’s ability to defend margins and working capital improvements.

Forward Outlook

For Q4, management indicated:

• Revenue pacing down mid-single digits quarter-to-date, with equipment volumes under particular pressure.
• Non-equipment sales expected to continue outperforming equipment, supporting gross margin stability.

For full-year 2025, management did not provide formal guidance but emphasized:

• Inventory reductions likely to exceed $500 million target, with year-end turns approaching historical norms.

Management highlighted several factors that will shape the next quarters:

• The completion of the A2L regulatory transition, restoring operational simplicity.
• Continued investment in technology and digital tools to drive sales and margin expansion.

Takeaways

Watsco’s Q3 demonstrates the company’s ability to defend profitability and cash flow despite a disruptive market environment, leveraging pricing, mix, and technology to offset volume headwinds.

• Margin Structure Proves Resilient: Gross margin expansion and cost discipline highlight Watsco’s ability to manage through regulatory and demand shocks.
• Digital Transformation Is a Material Growth Lever: Platforms like OnCallAir are shifting sales mix and supporting higher average selling prices and margins.
• 2026 Setup Hinges on Demand Recovery: Investors should watch for signs of HVAC demand normalization and the impact of new digital and AI initiatives on market share and profitability.

Conclusion

Watsco’s third quarter marks a turning point as the A2L refrigerant transition recedes and the company pivots toward normalized operations, with technology and capital strength as key differentiators. Margin and cash flow execution position Watsco for both organic and inorganic growth as the industry stabilizes into 2026.

Industry Read-Through

Watsco’s experience highlights the HVAC sector’s sensitivity to regulatory shifts and macro demand cycles. The outsized impact of the A2L transition, coupled with low housing turnover and consumer caution, is mirrored across the industry. Margin expansion through pricing, mix, and digital adoption is likely to become a sector-wide imperative, especially as distributors and OEMs seek to offset volume volatility. Watsco’s focus on inventory efficiency and M&A optionality signals a coming wave of consolidation, with well-capitalized players poised to gain share as weaker competitors face balance sheet strain.

WSO Industrials HVAC Digital Transformation Inventory Gross Margin Mergers Technology