Watsco, Inc. (WSO) Earnings Call Transcript & Summary

Welcome. And thank you for standing by. At this time, the call is being recorded, and if you have any objections, you may disconnect. This call is for JPMorgan Chase & Company personnel only. If you're not an employee or consultant of JPMorgan Chase & Company, you may disconnect at this time. [Operator Instructions] I'd like to introduce Steve Tusa. Sir, you may begin.

Great. Thanks, operator. Just one correction to that statement. That's really the first glitch we've had this entire conference here. But it is not for just personnel and JPMorgan employees, it's JPMorgan clients. So if you are a client, please stay on the line and listen in. Sorry for any confusion there. And sorry, operator, for not going through that preamble beforehand. But anyway, putting that aside, thank you, everyone, for joining us on day 2 here of this virtual conference. We're very pleased to start the day off with Watsco, and Barry Logan and Rick Gomez from Watsco. Guys, thanks for dialing in and being so flexible given the circumstances here.

Thank you, Steve. Good morning.

So just wanted to start at a kind of a high level. We are asking this question to everyone because we just want to make sure we check the box. But do you see any impacts from what's going on out there with coronavirus on your supply chain? Any feedback in the last couple of weeks from any of your contractor, customers on consumer nervousness or anything like that? Let's just kind of get that on the way. I know you guys are obviously certainly, probably at the bottom of the list of companies that would have direct exposure to what's going on with this thing. But just wanted to check the box on that question first.

Yes, Steve. Well, thank you again. Good morning. Well, first, from a supply chain point of view, we have the luxury of owning about almost $1 billion worth of inventory on average. And if you do the math, it's about 4 turns a year and -- which would be about 90 days' worth of inventory. And our supply chain behind us at the OEM level is also stocking many finished goods throughout the U.S. and in support of its distribution throughout the U.S. So we feel like from just at least a short-to-medium term point of view, there's a lot of built finished goods and part of our customer service, part of our customer support is to have inventory on a minute's notice, not hours or days or weeks. So a lot of inventories are built now. And we'll watch and see and listen and learn and adapt as we need to with our OEMs. But for now, finished goods inventory is pretty flush in our channel.

And is that stocking for the season, do you think, for the OEMs and for you guys? I mean does that kind of play out in January, February? Or is that something that -- I know the selling season typically starts kind of end of April, early May. Do you think that, that happens earlier in the year that, that supply chain kind of ramps to a point where, if things were shut down for a period of several weeks or a month that you would -- you guys would be able to -- or at least your OEMs would be able to kind of be ready for the season?

Yes. So first, in the Sunbelt, we're beginning the season earlier than what would be typical or on average throughout the U.S. So some of the inventories would already be in place. It's a 70-degree beautiful morning, it's going to be 80 by the end of the day and -- where I'm sitting. And we'll have inventory already ramping seasonally at this point. In terms of if we draw or build or buy forward, in some case, again, we're watching and listening. But right now, I'd say it's more business as usual, Steve.

Got it. And I know that Lennox yesterday talked a bit about the warmer weather impacting first quarter. You guys have a bit different geographic exposure. If you could talk about kind of what you're seeing so far. I know -- again, you guys are more southern part of the country. Maybe just a bit of an update on kind of what you're seeing quarter-to-date.

Right. Well, for the record, I'm in favor of warmer weather this time of the year, given in the Sunbelt where we have our large markets. And we have seen growth and stability thus far in the Sunbelt markets. And obviously, weather does impact the northern parts of the country. But on balance, again, I would call it a measure of stability through the early part of the year. As we speak today, as we speak now, of course, March is, from a materiality point of view, much greater, much more important relative to this time of year. We'll see how that plays out. But from a Sunbelt point of view, we love the stability and fundamentals of the Sunbelt. And so far, so good this year.

Got it. Okay. How do you see from a demand perspective -- how do you see -- what's kind of your view on the cycle? I know there's some debate around that and whether residentially track growth's 3% to 4%, or 0 or 5. I think at this stage of the game, given the context of the industrial economy we're dealing with, doesn't seem like that big of a deal relative to maybe a few months ago. But how do you see kind of the cycle here, the replacement cycle playing out over the next couple of years? Where are we in that replacement cycle?

Well, again, and if I look at the last 10 years, for example, in the Sunbelt in particular, you have a lot of population migration. You have a growing economy, and you have some irritation from this discussion about what happened with the homebuilding market 10 years ago filtering into the numbers now. But I think on balance, we've seen a strong consumer, as I said, strong economy. Ultimately, it's the collaboration of a contractor and homeowner sitting down and saying, "Here's what you need to do, here's what has to happen, here's what it costs," and contractor very motivated to replace systems and upgrade systems and the regulatory environment causing upgraded systems. So I think, again, on balance, there are more positives than negatives or irritants in that discussion. And of course, our job is to react to anything that we see that is irritating gain share and react to the market, and we're doing that. And again, I don't think we're seeing any disruptions that are harming the short term from that point of view, from some kind of cyclical point of view, really because of that collaboration and the strength of that collaboration that we've seen with contractor and homeowner.

So I guess, what is your view on the next couple of years? Are we talking low single digit, mid-single digit? What's your kind of -- what do your kind of models tell you on that front?

Well, Steve, if I think about it analytically, not emotionally or otherwise, the industry for 30, 40 years, the compounded growth rate in units is around 3%, 3.5%, with a measure of price. And our Watsco's 30-year compounded average is in the 4% to 5% range from a same-store basis. And so I think, if I look over the next 2 years, the question is, is that achievable? Or is it possible? Or what other factors are there? I think as long as the homeowner and consumer economy is continuing what it's doing, I don't know for sure, but I would be confident about continued growth rates.

Got it. I know that there was some chatter a year ago about the Florida market. How did you -- just remind us of how you guys saw the Florida market last year and whether that made you feel a little bit better or worse about things?

Well, I feel like, since the chatter, Florida has been a consistent grower of the market. So maybe we need to chatter about everything. I don't know, but we've seen, again, consistency and market share growth. And again, that consistency would be relevant through today. So I think the Florida market, in general, some of the worry was either overcome by performance or we should not have worried as much.

Got it. Okay. When we think about how you're aligned with some of the OEMs, can you talk about what you're seeing out there and how you evaluate which OEMs you generally align yourselves to?

Sure. Well, the 10-K disclosure says about -- there's about 10 vendors -- 10 primary vendors that account for the 60%, 70% range of our business. And -- but if you look through that, on the air-conditioning equipment side, there's probably about 10, 15 different brands in that mix of products. And if I were to extrapolate that to parts and supplies and so on, there's a few hundred thousand SKUs in all, 1,000 vendors in all. But the concentration, if that's the point of your question, is the primary U.S. OEMs. We presently do not sell any Lennox products or JCI products, but we sell a representation of the others.

Right. How do you choose which ones you want to be -- like, how do you go through that process? Or you don't really care?

Well, we certainly care. We certainly want to be diverse and as diverse as possible. And so probably the primary 30-year priority is to have partnerships either in the strict form or an emotional form, and what that word means, and feel like we're really building markets together, customer relationships together, market share campaigns together. And our partnership usually is documented, and distribution agreements, or in the case of carrier joint venture agreements, that sustain the distribution partnership for a very long time. Not for the sake of time, but for the sake of investment. A billion-dollar business in this industry needs about $300 million or $400 million of capital to sustain itself and grow and to commit over $1 billion in capital through a primary vendor. These types of long-term agreements give us a lot of confidence, give us a lot of backbone to invest more. It gives a lot of courage to go to the market and expand our business. So those will be the primary things that we've had in place with most of our partners now for 30 years. Current iteration that you're kind of inferring in your question is really just a building process of what we've started more than 30 years ago with another primary vendor.

Got it. You guys talked about the pricing dynamics in the channel on your conference call on earnings. Can you maybe just expand on what you -- what kind of a messaging was there in the market's pricing?

Sure. Well, I think there's some context of what pricing means and how it actually works. And so if we picture a Miami branch, where we have a $40 million, $50 million business and maybe 800 to 1,000 customers that might come every day, and they're buying 20,000 SKUs from us that are distinct to Miami, pricing, what it means is that every customer, every product, every situation, every job, every nuance of pricing is custom-made by customer. I don't think people really appreciate just how many snowflakes there are in the market from a pricing point of view. And to make it more interesting, we're also buying from the same vendors, products at different prices to conform to the end market or the end customer or the situation that we're dealing with. So imagine the iterations of price, both selling price and purchase price in just Miami, and now multiply that x600 stores. I will answer your question, but I want to put the backdrop in the sense that, as a merchant, we are constantly selling and conforming price into the market and then to sustain our margin, buying and purchasing in an array of prices that fit and, again, sustain our profitability. That's the real-life answer to a few hundred thousand SKUs, by the way. So to answer your question, when we have been through, I would say, a pricing cycle over the last couple of years, where you had really unprecedented levels of price increases in '18, a settling of the market in 2019, our job is to examine 2 things: what are the selling prices that are relevant in the market to sustain and grow share? And what are the purchasing actions and purchasing efforts we need to do to sustain margin? So really, after 2 years of what we call it volatility of both sides of that equation, we settle out, and we look at -- we look forward and we work with vendors to really calibrate what occurred, and given all the complexities. It's not an annual negotiation. It's not an arm wrestling match. It's not who's right and who's wrong. It's really navigating all the subtleties of what I'm trying to explain and working with our vendors to sustain and grow -- sustain and grow the business -- sustain margin and grow the business. So it's hard to find that level of detail in our inference in our first -- in our year-end conference call, Steve. But really, going back and working with vendors and working through that is something that was required given the volatility of the last couple of years.

Right. And I guess, are you getting pushback from contractors when it comes to price at that point?

Again, the point of sale of the contractor is, every job, every SKU all day long and really keeping competitive as well as keeping the contractor happy in terms of his or her profitability. I wouldn't call it pushback, I would call it simply adapting to whatever the end market pricing is.

Got it. Okay. So in -- how much are you embedding in price kind of -- for 2020? I know basically in the K, I think it was 2% from volume, 2% from selling price. How much -- what's that kind of profile looking like in 2020?

Yes. I think as we start the year, the OEM price increases across the board, look, a lot like the aspirational price increase of 2019. And as I use that word, it's all aspirational at this point. The season and the variability of the season will tell us what's yielded in the market. I don't think it's unreasonable to say this year can look like last year.

Got it. Okay. On market share, just talk about where do you think -- what do you think your market share is? I know it's a fragmented market globally, but when you earn nationally -- but when you look at where you guys target locally, what is kind of, do you think, your kind of market share entitlement in the local markets you're in?

Again, Steve, a nuanced answer. We don't publish market share really nationally. We do some math with our equipment business and try. But the real story, the way we look at it is we're in probably 30, 40 major markets, and market share within those markets is very diverse. A market like Florida, where we've been the longest, is very strong. It's not with 1 particular vendor. We sell 3 different vendors, probably 70 different brands in Florida. That diversity builds a lot of market share in a market like Florida. And so that diversity is what we've always worked on in other markets. The Northeast, for example, where we have expanded last year, we didn't just buy companies, we added new brands, new touch points, new locations, new market share development and are more diverse in the Northeast market now. So we really break it down in that way from a market point of view. From a customer point of view, there is a lot of customer segmentation. Generally speaking, most of us talk about 2 segments: new construction and replacement. Even within new construction, there are different segments. Even within replacement, there are different segments. So our job is to dissect that, find out where we're weak, find out where we want to be stronger, work with OEMs to target markets or target end markets or target customer types. And that's a lot of what we do now that we have the data really to do that with. I'm not sure 10 years ago we had the data, at least not in the same level of detail. And so market share is a nice, big picture thing to mention, but it's really a street level, granular thing that we all operate under.

Got it. Who do you see is some of your biggest competitors in these local markets? So I know that Johnstone is out there. Who are some of the bigger guys? And maybe talk about how you guys compete a bit differently.

Sure. Well, there are 2 kinds of competitors. There are independent distributors. There's 1,300 of them still. There's probably 100 that are between $50 million and $1 billion in size. Johnstone, you mentioned, is a composite of over 100 businesses that are part of a co-op. But some of our best competitors are those independents because you've had this sustained ownership by, let's say, a family that have really been strong in markets for 40, 50 years or more. Peirce-Phelps was an example of that, a 93-year old business, and they are dominant in Philadelphia. There are factory branches. There are other competitors. There's all kinds of stuff in Philadelphia. And Peirce-Phelps, owned by a -- 1 family for 93 years, was the market share leader in the market. So I think, for us, that independent channel, who are also our acquisition target list, are still very viable in the sense of having brand market share, customer service capabilities, long-term relationships, sustained loyalty in the market and affinity in a market that is very real. The factory -- so in Florida, if I said, "Who's the biggest competitor?" I'd have to name 3 people to you because there's a South Florida guy that's great, a Central Florida guy that's great and a Northern Florida guy that's great. The factory locations, let's say, in Florida, compete more in equipment business. Florida is a good example, where we have Trane direct, Lennox direct, Goodman direct and JCI direct. And we love our profitability and market share in Florida. So it's a testament to our discipline and our -- the obvious credibility, I would say, in distribution. But we have a few competitors that are, I would say, greater competitors from a broad point of view of selling all the products and having 50-year relationships that are in the market. So the factory is more of a -- factory locations are more of an equipment competitor and the independents are more full-service competitors where they're providing not just equipment, but everything a contractor might need.

Right. And when you think about the factories and the way they're competing, the kind of company-owned, do you see -- how do they compete differently when it comes to the equipment versus perhaps what -- how you guys would approach things?

Well, if I'd like just to go back and answer your question, the way we can -- the way we do compete is, obviously, more locations. So we have the most densest network in the markets that we have. I don't think we have any -- you can look at our 10-K and number of locations in our major markets. I don't think there's any competitor near those levels of investment in locations. More brands, the diverse brands is another way we compete. So we're covering not just a segment but an array of segments across the market. And then technology, obviously, over the last 5, 6 years, is meant to be a game changer and really simply creating a new way of life for contractors that want to be progressive with technology. And that new way of life is how we're competing for that future state where those progressive customers are going to be the most active and have more share than those who aren't using technology. So that's a very critical part of the long term. But where we're competing with factories is really, goes back to variety. And all the products, all the knowledge, all the relationships, all the things that we have in Miami, we have 12 miles away with a different set of customers in Hollywood, Florida, and 7 miles away from there, in Pompano Beach, Florida, and almost 100 branches in Florida [indiscernible] tell the same story about the Carolinas or Texas. And not just equipment, but all the products that are generic products and genuine products that contractors buy in markets that's part of their daily life, as I use that term. So that diversity and density and then technology is how we're competing against the factory locations. It's hard for them to imagine, I would think, selling multi-brands, multi-products, multi-manufacturers across 100 locations in Florida. That's a pretty substantial commitment or investment that would have to be made.

Can you maybe talk about some of the technology initiatives and what you're seeing out there with -- which ones are really top of the list and are resonating with customers and the benefits and -- maybe which ones you thought would resonate more, but are perhaps having a bit of a harder time gaining traction? Or maybe they're all just going great? Who knows? Can you talk about that? Because you guys are definitely differentiated on that front.

Yes. Well, it's -- I wouldn't call it early stage at this point for certain things, I would say we're still in the adoption phase in many respects. Adoption, meaning getting customers, more and more customers to use it every day. What we're happy about is the mobile platform that a contractor and its technicians can use every day in operating its business. It's not just e-commerce, it's helping a contractor to operate his daily business with his team in the field in someone's backyard with all the products, the SKUS, the warranty information, the bill of materials, the technical knowledge to match products properly, the permitting and zoning certificates they need to prosecute a job and so on, and call that a customer experience side. We've seen it grow, and it's nice that it's grown. But looking back a year or 2, the attrition of customers using it every day is a fraction, simply a fraction of what we would see in our conventional old-school answer-phone-lines-type of business. 10, 15 years ago, technology meant adding more phone lines and adding more people to answer them and to have a mobile platform that is growing in terms of use. The growth rate of customers using it is double digits. The attrition year-over-year of those customers is a fraction. And so our challenge is how do we get another 20,000 customers to use it. First 20,000 or so, we published this in our press release, that there's almost 20,000 users, while we have over probably approaching 100,000 customers. How do we do that? And so we've been investing in people and almost a unique type of sales force to go out and target and develop those digital relationships. With customers that buy from us, we didn't have to find them, they buy from us. And -- but if it's a 50,000-customer -- $50,000-customer of us, it's probably a $500,000-customer or more of someone else. And so that's where, over the last 12 months, we begin to add staff, add sales horsepower to that type of catalyst to get more customers using it. So that's what we're happy about. What's new is really the fulfillment of 7 million orders. If we sell for -- sell almost $5 billion, that means we fulfill almost $5 billion. And that fulfillment process used to be done with paper and clipboards and tick marks on using pens. And now that is a digital process that was not fully rolled out until 2019. And that fulfillment exercise to really change the speed and cost and manpower requirements of fulfilling those products is earlier stage, but this year and certainly next year is that next progression of impact, where now it could impact our manpower requirements or at least the time and materials it takes to fulfill orders, or the customer velocity that we can service every day with the same number of people. So that productivity is earlier stage, but we've seen some early returns in some of the older branches where we have it. And so the next 2 years will be important from that perspective. There's more, Steve. How much more time we have? But ultimately, the next goal and the technology curve was how do we help our customers get more jobs, sell more products at the home, how do we extend technology to the kitchen table that is our -- it's our proprietary platform that helps customers sell products and then tie that to the product information that we have, the inventory availability we have, the transactional capabilities we have. And now if we're at the kitchen table helping a contractor, that's another layer of importance and capability. And we've mentioned in our press release that, that technology, which is called OnCall Air, sold $198 million of revenue for our contractors at the homeowner level. And our industry is an $80-billion market or more at the consumer level. So it's a fraction, but it was 0, 2 years ago. So it's an interesting extension of what we're doing is to get even into the contractor/homeowner collaboration with technology.

Yes. You guys -- you're certainly out in front of this. No doubt about it. On, I guess, the flip side of that is kind of the degree of spending that's going on to support this. SG&A up again in 2019. Is that something kind of we should expect in the next couple of years? And what do you -- how do you envision SG&A playing out in 2020?

Well, we need to spend money on technology to keep the adoption curve growing. There's no doubt about that. And there's always a measure of spending to continuing to evolve the technology itself. We do much of this in-house. We have 200 people today that we didn't employ 5, 6 years ago. Because it's internally developed, it's all in SG&A. We -- there are more creative accountants out there. But in our case, very conservative in terms of how we -- this is an SG&A investment, and that's why we kind of kind of show you and tell you what it is so it can be part of the story. And so I think 2020, if I answer your question, we will see more spending. The adoption curve is where it's being spent. The, call it, the innovation curve, where we need to keep things evolving, is there. In terms of more, it's not much more. And SG&A in total, I think, again, 2019 same-store SG&A was up 1%. When every single SG&A line item had inflation in it, so 1% SG&A was a productive year for our SG&A. I think, 2020, we're asking our leaders for the same disciplines. What plays out? We'll know once we have better insight into our season. We have a lot of variable costs that will either go up or down based on the revenue of our business. But productivity has been a big theme over the last 18 months obviously. It was in the numbers last year, and we'll see how 2020 goes.

I guess that's interesting. What is that kind of inflation? Is that kind of a 2% inflation type of number and then you get a percent of productivity? I mean what is the -- how do you -- a lot of these companies that have been restructuring recently, these are manufacturing companies, are not quite like a different business model than you guys have. But they put out kind of these big restructuring numbers, but the drop-through on those restructuring benefits is a lot less, given the underlying inflation, which is something that I think it surprised people a bit. Even though there's always been inflation, it seems like, especially on the labor side, there's a bit more these days. What is that equation look like -- what does that equation look like for you guys every year?

Sure. The primary SG&A driver is 5,000 people that we employ and the wage inflation or incentive compensation or adding more people for capacity purposes. I mean those are the -- that's the biggest driver in a distribution business is the workforce that serves customers every day. And to the extent the consumer economy is growing, there will be a measure of probably GDP inflation on that -- those labor costs. And if our salespeople sell more, they'll make more money. And if our branches performed better, they'll be paid more incentives. So that's not inflation. Those are things that we, frankly, want to occur. But that's -- probably 60%, 70% of our SG&A is 5,000 people, probably 4,000 of which or more are serving customers. So there's really no such thing as restructuring, unless we want to have a smaller business because all that is capacity to serve customers, ultimately. So therefore, there won't be a restructuring in that sense of what others might be.

Yes, yes, yes. I'm just talking about how kind of the underlying inflation seems to be greater than most people have assumed. So the way they get at it is restructuring. The way you guys are getting at it is kind of a run rate of productivity in other areas, right?

And that's exactly right. And that's -- the other fixed cost, by the way, that's #2 in the payroll, is rent. We lease 16 million square feet in primarily 5-year leases. So 20% of our portfolio each year is subject to change. And so I think same-store rent last year was up 1%. And from a rental rate point of view, there was more inflation than that from a -- operating a portfolio of real estate with less square feet, that was accomplished in 2019. So luckily, those are the 2 primary drivers of SG&A. Everything else is much smaller, and I would say, a simpler business to manage from that respect.

One more question for me, just on the industry. In 2022, we're going to have DOE regs and then a refrigerant reg coming in. Did you see the potential for a prebuy at that stage of the game? And what's your take on the ducted hybrid product, that kind of mini split or the ductless product that's coming out and targeted at kind of traditional ducted replacement markets? What's your take on that technology going forward?

Well, first, for the record, we're in favor of everything you just asked. From a point of view of having a catalyst for really change in growth and replacement and upgrade and so on. And in terms of a prebuy, there are really 2 layers to that, I think. Well, distributors buy ahead in some way or protect inventory or protect themselves in some way of an inventory -- and buy forward and for some reason. I don't -- I think those days are gone from point of view of what used to happen maybe 10 or 20 years ago. I think the OEMs, as a group, are better at these transitions in terms of planning and navigating early. If we think that there's an opportunity, we'll act on that opportunity to have inventory that maybe a smaller competitor who can't own as a growth opportunity. But it's harder to anticipate that now 2 or 3 years ahead of time. The prebuy at the consumer level or the homeowner level is really, in our minds, I think, not a concept. These things usually break. That's when the contractor makes a recommendation. That's when they're replaced. So I don't think we'd expect to see volatility of a prebuy and then the next year, some kind of weirdness. I think the last 2 or 3 refrigerant changes and DOE changes have been pretty smooth in that respect. The refrigerant change here is a little more dramatic. But again, I don't think it affects how the consumer wakes up and decides to own an air-conditioner today.

Do you think there's a chance that they pivot more towards the ductless products?

Yes, let's head towards ductless. So Watsco, again, we are in the ductless game very early. And I don't want to give out market share, but I would say we have very strong share across really all -- many Asian brands, not simply one or the other or one partnership or another, but we're very -- we're probably as diverse in ductless as we are in ducted in terms of relationships and partnerships and exclusivities and things like that. So we're talking to -- not we're talking to, we talk all the time to all of our partners in the evolution of applications both on the VRF side. I would say, we're a substantial VRF player that's been growing at terrific growth rates where we have it. And from a ducted point of view -- or ductless point of view at the residential side, again, someone like Mitsubishi, where it's a major player with us, as they evolve, it's unique that we have a very powerful relationship with them as they think about it. And we cover some important markets with them, for example. But there are Chinese manufacturers that also we have those relationships with. And then our OEMs who have their own partnerships or collaborations is another source. We'll see, Steve. I think it's -- those things are never disruptive. I would say they're always slow-growth opportunities. And so ductless, splits and hybrid products make an entrance. It will be a slow-growth opportunity that brings some innovation that probably the industry needs.

I appreciate the comments, and thanks for spending some time with us here and being flexible in your schedule. And best of luck into the selling season. And most importantly, stay healthy.

Thank you, Steve, and I appreciate it very much. And we hope to see everyone next time. Like I said, it's 72 degrees now outside, and come see us. We love a visit once in a while. Thank you.

Great. Thanks, Barry.

This does conclude today's conference call. You may disconnect your lines. And thank you for your participation.