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

Hi, everyone. This is Cameron Soelberg from the Global Industrials Group at UBS. Appreciate you all joining us remotely today for our virtual conference. As just a heads up to make sure you're in the right place, this is the webcast for Watsco. Many of you may know, this is the largest distributor of heating, air conditioning, refrigeration-related parts and supplies in the U.S. With me on the line today is Barry Logan, EVP of the company, who will be making some remarks, and then we'll be moving to Q&A. [Operator Instructions] So with that, Barry, I'll turn it over to you.

Thank you, Cameron. I appreciate it. I hope everyone had lunch and is in kind of that like phase of biology where you kind of feel good and comfortable. I do. I just did the same thing. So my monotone random thoughts hopefully do not cause sleepiness, but we'll see. So good -- nice to hear everyone or talk to everyone from Miami today. It's hot and nasty and humidity and kind of rain this afternoon creates some more humidity. So we like the misery going on outside here in South Florida. Anyways, Watsco, as Cameron said, is the largest air conditioning, heating distributor in the United States, North America, for that matter. We have been around in this industry about 60 years; as a distributor, since 1989, so 31 years. And we've gone from 0 to where we are through really just a combination of philosophies. The first one is to acquire great businesses that had built legacy market share in markets. This industry started really in the post-World War II era. And manufacturers who have made products had distributors, independent distributors sell products throughout markets over time. The number of distributors remained over -- well over 1,000. And within those 1,000-plus distributors, there emerged regional leaders and regional superpowers. And over time, in our careers, we've gotten to know the families and know the people that have built them, many or most today are second-, third-generation family owners of businesses. So the first 10 years really was acquiring good businesses, figuring out how to acquire them safely, does it preserve legacies, preserve market share, gain confidence of OEMs who have veto power over who can buy distributors and just build relationships. So the first 10 years, we went to $1 billion, and that was nice. The second 10 years, we did something very similar and just kept the building-block process going, professionalized leadership, capitalized our company in a far different way given our public status, became really the first multi-brand distributor in markets, became a major player with all the OEMs of products in the industry. And after 20 years, built $2 billion of business and I think finished 2008 around $48 a share. So 2009 came along in the middle of the recession, and we had the opportunity to buy Carrier's distribution business, which it had assembled through acquisition about 10 years before, and 10 years later, decided to divest of what was then about a $1.5 billion distribution business, EBIT of roughly $30 million. We paid $180 million for 60% of it and -- basically 9x earnings. And today, it's well over $2 billion in size, over 8% EBIT. And we own the business today at under 3x its earnings, and it's been a home run for us. And with Carrier, they've built market share. They got a lot of cash from us. They have no bad debt expense anymore. They're a simplified higher-margin business and are good partners for us. So after 30 years, we became basically a 4 -- $4.5 billion business. And what we like most of all about the story and my punchline is it's still only $4.5 billion out of a $35 billion market in North America. So we're still not in several states. We're not in the Midwest U.S., for example, we're not in the Pacific Northwest. We still don't have representative market share even in the Sun Belt markets that we would like. So this idea of growing our network through acquisitions, adding branches, adding products, building strong relationships with OEMs is still a work in process. And through that time, we've obviously built a lot of value, have a strong dividend, have almost no debt today to speak of, all the debt capacity in the world to imagine how to grow and how to invest. And I think the principle that has helped us the most is we've dedicated all this capital and growth and strategy into one industry. We're not multiline distribution. I think for those of us that stayed in our category like POOL, like Fastenal and Grainger even and some others, kind of staying in our neck of the woods and developing a better company over a long period of time has worked well. And the latest iteration of that is technology. Contractors will replace, this year, somewhere around 7 million systems in people's homes. They will replace or repair or service millions of air conditioning systems in businesses. And every single contractor who does the work relies on distribution of some sort to get products every day, all day, throughout the day, to create that solution for the homeowner or the business owner. And tomorrow is a different day. Tomorrow is a different set of solutions. So that interactivity across millions of transactions is what we wanted to really revolutionize beginning 4 or 5 years ago and simply change the way a contractor might operate its business in the future state of technology. So something like mobile apps that let contractors find products, get products, find multiline-adding solutions, get technical knowledge, get warranty knowledge, get connectivity to, let's say, bill of materials at OEMs, all the data that used to be federated in the heads of our people answering phones 8 hours a day is now federated in technology in a much faster, searchable way that is really changing, again, the way a contractor can operate its business. E-commerce just happens to be one component of that technology. And today, e-commerce is -- well, it had been around 30% of sales at the end of last year, that's accelerating closer to 40%, given what's going on, and then the fulfillment of those orders in a touchless, curbside, pick-up-and-go expedited way is going on now. And so all this COVID stuff has done a lot of things for several companies. And one of those things for us is how do we fulfill orders, basically where a contractor doesn't even get out of this truck, how he drives by, get his stuff, drive away. And we can all do that with take-out pizza. Doing it with air conditioning systems that weigh 200 pounds and doing that in 600 stores throughout the country has been what we've been up to. And we think for the future, it's simply a cool advantage that we'll have, not just in protecting people but in speeding up the entire process. So that's the tip of the iceberg in this conversation of technology but just to give you a sense of things. The other last thing I'll say in general comments is the financial kind of capacity of the company has always been very important. A lot of companies in the last quarter talked about their balance sheet, talked about liquidity, wanted to demonstrate and reassure investors on the strength of their balance sheet. I can find an investor presentation that's 20 years old that talks about the aspiration of no debt, in our case, the hatred of leverage, the liquidity we need to grow our business, the debt capacity at investment-grade cost of capital that we seek, the dividend that we always want to raise a little bit each year to sustain a partnership feeling with investors, just to keep a very conservative posture when something good might come along. So in 2009, we're going to wait until 2020. 2009, a good example, again, where we doubled the size of our company in 2009 and '10 because of our conservative mindset toward debt and capacity on our balance sheet. And today is no different. Today, we're out talking to owners, pushing OEMs, asking for opportunities for investment because, again, we're in that position competitively where no one in our industry has our balance sheet, not the OEMs, not the independent distributors. I think Watsco has the capacity truly that no one else has, and again, inclusive of the OEMs in that conversation. So we're going to look and see and find and talk and discuss and hopefully get more M&A done, and may wait until some of the recovery begins more in earnest later in the year. But in the meantime, a lot of good conversations going on to position ourselves for that as things perhaps get a little more normal later in the year. So those would be my broad comments, and we'd be happy to go from there.

Okay. Great. Thanks, Barry. You touched on a variety of topics. Along the lines of what you were just discussing related to M&A, we had a question come in. I guess in the context of what you said in this environment, there's conversations going on, maybe waiting for things to become a little more normalized before you act from an M&A perspective. But I guess what -- along the lines of M&A, what are your priorities? How do you guys think about your opportunity? Are you focused on markets that you're in already and looking to expand market share there? Do you want to focus on territorial expansion? Do you just look at what's available? How do you kind of work through that strategy? What are the key points here of your M&A strategy?

Sure. The key was to build relationships that hopefully no one else has. And that's a super cliché thing to say. But there's 2 reasons for that. They're all family businesses in terms of the likely targets. Trane and Lennox and Goodman and JCI have factory networks that distribute their own brands in certain markets. I would guess that it adds up to about $4 billion or $5 billion collectively amongst those 4 companies and -- in terms of what we sell, residential, central conditioning in the United States. And that's $4 billion or $5 billion, at most, out of the $35 billion in the market. So will call them, badger them, remind them, but again, it's unlikely in the short term, unless there's a policy change about what they -- how they go to market. So our primary focus has been the families, the families that own the other $25 billion of distribution, and there are 1,300 of them. And the top 100 are probably $100 million or more in size, to give that a scope. So those relationships that go on with those families is a central focus, and we think that, for the most part, they would not want to sell to someone else because of our track record, our culture, our honoring of their business. And if anyone wants to read about it, read our annual report from 2019 that was just published because we acquired one of those type of businesses last year in August, a 93-year old family business in this industry. They were the first Carrier distributor in its market and the only one since Carrier invented air conditioning. And we had them write the story, not us, they wrote the story in our annual report of why they sold the business to Watsco. And I think it really speaks to the idea of why these relationships matter. The other is that OEMs have veto power over who can buy one. So there's always been a protection for us in terms of private equity or third parties that have capital just to come in and throw money around. And for that reason, if we have good relationships with OEMs, good relationships with owners, that's a way to kind of close the circles on the opportunity. So to this day, we've never been in an auction. We've never paid a broker, paid a fee, hired an investment banker. It's all been done through relationships. And obviously, that helps -- most likely helps valuation, but it also helps kind of getting things done. And so that's what we're doing all the time. And where we've accelerated those discussions is in larger targets, where that technology presence and the sophistication of that knowledge and federating throughout a network is important. We're not trying to acquire $10 million companies, to be honest with you. We're trying to acquire -- integrate $150 million businesses over time. And some of them are $300 million or $400 million in size. Again, all family-based, all multigenerational, all likely wanting to acquire advanced opportunity to -- and there really is not a strict policy on geography or even brands. We want to be diverse, both geographically and through brands, and -- but what we really are after though is a superpower regional distributor that maybe reaches a point with technology, with capital, family succession, whatever it might be, that reaches a point in time where they want to partner with us. And again, that's our success for over 30 years we've been doing that. So it's a little bit more of the same versus picking 1 market or picking 1 OEM. At the end of the day, we're in pockets of those things and simply want to build our network into a more national network.

Okay. Great. Coming back to some of your opening remarks, you mentioned technology, and I think this was also discussed a fair bit on your Q1 earnings call. Can you talk a little more about how technology is being implemented in the business, both at the branch level and from the customer point of view? And you mentioned e-commerce, and so maybe just expand on that a little bit because there's a follow-up question or 2 related to that topic.

Sure. Well, again, each year, on average, we process 7 million transactions with customers. All our contractors all have a problem they're trying to solve, and they want to solve it today. So the capacity of our industry in terms of distribution, as far as customer service would go, is how many people do we have that are great technical-service-know-how people answering phones when they ring. How often can our good salespeople get out, see customers, sit down with them and go through the latest-and-greatest stuff? How well can our forklift drivers, truck drivers, delivery drivers pick and pack and ship products to contractors and do that 7 million times? And so that -- in historical terms and competitive terms, those are all manual processes and only happen during business hours. And like everything else in the economy, if that's your intent is to do that forever, you're probably at risk at some point in your future if that manual process is the only thing you're doing. So we thought 4 or 5 years ago, if we get ahead of everyone else, ahead of the curve in helping all aspects of the contractor's daily life, scheduling jobs, finding jobs, scheduling with homeowners, going to homeowners and proposing on what to do, finding the solution, pricing the solution, fulfilling this solution, all the steps that are typical, if we can make that a digital process 24 hours a day with very modern capabilities on a mobile platform, because again, contractors are not on our website, they're in your backyard on a mobile device. How do we do that? And how do we -- where do we start? So building the platforms with product information, all the functionality, all the search capability, all the functional cross-referencing and capacity, OEMs who didn't have that data to give us had to get it and then give it to us, a mountain to climb. Again, today, all that is in the hands of customers. At the end of last year, we had 17,000 active users in our community of -- and active, meaning they use it. They use it to buy more than 10% of their products from us, just as a definition, as a way to draw a line. And today, that's expanded, as you might imagine, through just the life we're living these days, closer to 25,000 in a short period of time. And what we -- the data that supports the whole thesis of this is that those active users are growing -- grew last year at a double-digit rate. The active- user community with Watsco grew with us double digits. The market did not grow double digits. The overall business did not grow double digits, they did. And so our challenge and opportunity is how do we grow our user community beyond -- well beyond where it is. And that's what we're doing. So in the present state, salespeople, counter people that now have a different way to engage, a different means to engage with customers are doing so in a digital way. And out of pure happenstance, we're seeing this active-user community expand because of what we're going through. And then, ultimately, it changes the paradigm of more and more contractors who maybe won't go and shop in our stores, won't wait in line, won't eat popcorn that we've made for them, won't drink coffee that we made for them, we do all those things, by the way. So again, we'll see what's temporary and what's permanent. But our intention is to keep this level of adoption going. And the underlying growth rate of those modernized, aggressive, progressive customers are now growing at a much faster rate along with us. We're pulling them through into the technology channel, so to speak. And so what that leaves next is what else can we do to help them. So there are, again, there are some other technologies we've implemented that are growing to go beyond the transactional environment into the home and help the contractor actually sell stuff remotely to homeowners or business owners. So there's a product called OnCall Air. You can go to the website, oncallair.com. That is that progression of getting beyond distribution locations and into the home to help contractors complete and sell something without being there. And then we also launched consumer financing through that channel to help consumers pay for it in a digital, easy-to-use process. So again, if you were operating a $50 million -- if you were a $50 million competitor in Nashville, you're selling stuff today. The Nashville market isn't closed. Contractors are coming into that store and buying stuff. But what we're offering in Nashville is a completely separate experience and hopefully, we're growing faster because of all these things that we're doing. And I can tell you this, that there's much more customer engagement in Nashville today, teaching, telling, training, showing, demonstrating, because customer engagement is something that is going on at a 2x pace right now, and it's something we're trying to accelerate. So I hope that answers your question. The other natural question is what does it mean beyond it sounds good. What does it mean? What does it mean to the numbers? So we approached this first with having to spend $30 million that we didn't spend 5 years ago in SG&A to build, create, iterate, invent, launch, adopt, push, $30 million. It's really 200 people -- 200-and-something people that we didn't employ 5, 6 years ago. And so that's what it's meant, is a dilution to our operating margin because we're spending $30 million. That's what it's meant. What it is intended to impact going forward is market share, ultimately, gaining share with these higher-growth customers over time, reducing costs. We should not, over time, have the same cost structure to support the old-school nature of our business in a new-school format. And that cost reduction began last year and, needless to say, is accelerating this year just in this overall environment we're in. So we'll see how the cost structure behaves over the course of this year. But it's obviously one of the important outcomes that is needed to go through this. But at the end of the day, we were also investing -- what it means is you're investing to kind of preserve future state, which is, if you're not doing these types of things, 5, 10 years from now, you're probably at risk. And if we're the leader today and can lead these things ongoing, if we talk to owners, if we talk to OEMs, if we talk to customers, it's feeling from a point of view of strength long term, not weakness long term. So yes, and I hope that answers your question.

Yes. That makes a lot of sense. And one follow-up that came in. Was wondering, you talked about the number of contractors that you have onboarded, do you have a view or an idea of what that represents in terms of penetration in terms of your overall customer base? What percentage are using e-commerce or mobile tools today?

Yes. It's a -- we have about 90,000 contractors that do business with us. So if I said progression was 17,000 to 25,000 or so, that gives you an indication of the number of customers. In terms of dollar revenue, it's closer to 40% of revenue flowing through the platform. So if we do comparative algebra, we have a larger percentage of dollars than customers flowing through our platform, which would suggest that the larger customers are the ones buying from us, and that would be accurate. The smaller customer that historically would buy from us, and maybe buy from 2 or 3 other distributors in town, is the next phase that we've been doing with customer engagement. So many years ago, I went to a customer meeting. I asked them, "Why do you buy from 4 distributors?" This is a guy in Orlando. "Why do you buy from 4 distributors?" And they said, "Well, I get credit at all 4 of them. I can get a credit line from you, from your competitors, and I have more -- I can grow my business by having 4 different accounts." It's like having 4 different credit cards in a wallet. So I thought that was interesting. So we went through a process of upgrading how we grant credit, who we give credit to, how we ensure that credit and a more sophisticated mindset of offering credit as a service in our industry. The other thing he said was, "I like my salespeople. And if I buy enough, I get to go on a sales trip with them. And we're going to Costa Rica this year and Trane is going to Madrid and Lennox is going to Mexico, and I like those trips." So in the old-school world, oddly enough, ironically enough, we would compete on where our dealer trip was going to be. That's old school. So new school is a more sophisticated, almost professionalized channel in the form of contractors that still want to go on trips maybe, but to make money and accelerate their business and accelerate growth as technology began to really matter. So that story is now being told not to just the big customers but the small customers that, frankly, are probably someone else's large customer. And so in markets where we have high penetration of locations, the level of customer engagement about technology, about our offerings, about pricing, about functionality, we've picked the last 60 days to really do an unprecedented level of that and -- because salespeople could do it. They're not out driving around bringing donuts to our customers. They have time to do this stuff. So we'll see what plays out, but you're right in your -- the inference in the question is where are you in your development. I would say we have good penetration in our big customers, low penetration in our small customers. And that's where the energy is flowing right now. Because our $50,000 customer is likely someone else's $500,000 customer. And that's where this market share game, I think, can begin to really play out.

No, that's good. A related question that just came in, my understanding is that you've grown your -- a lot of your platform from a technology standpoint organically. But is this an area that's also an opportunity for M&A for you, just looking at technology and tools and incorporating those in the business?

Yes, we have. We've looked at either purchasing or partnering or investing different levels of this as a means to your question. We did acquire a company, for example, about 1.5 years ago, that is a leader in the space of IoT but not thermostats. There's enough thermostats that are smart thermostats being made. This was to be able to monitor systems, advise contractors how their customer systems are running. So that was an example of investing in a future state where we want our customers to be visibly engaged with all homeowners everywhere. And that way, it's not just a one-transaction thing. It's something that they're connected to over time. So there, we made an acquisition. In terms of partnering, for example, I mentioned before about scheduling, dispatching, communicating, payment collection with homeowners and consumers and then homeowners and contractors. There, we're partners with one of the platforms that does that. We didn't build it ourselves. We're partners and we're their exclusive channel for that product, their air conditioning contractors. So we will consider it. We will be -- we don't want to create a bunch of -- a mutual fund of start-ups at Watsco. That's not our intention because a lot of this is start-up-type community people. But we'll pick and choose. And for the most part, if we get exclusivities for our channel, then we'll do things in a partnership way instead of an acquisition way.

Makes sense. We've talked about a lot of big picture stuff, maybe just circling back to the near term and the current situation. You guys talked a bit in Q1 about how social distancing had impacted some of the installer customers that you have and the trends you were seeing. How have you seen, as certain states and geographies have loosened up social distancing rules, how has the business been performing over the last -- through April and May now? Have you seen a positive trend around certain markets?

Yes, I mean we -- the initial impact of communities closing and homeowners wondering and commercial sites being shut down and also up North, especially, where you have winter still going on and no summer yet, the business was impacted in April, as we said, meaning declines in total business. And I would say, every week since then has been better, not just stabilizing, but I would say digging out of the hole that had happened in April. And in some of the Sun Belt markets, where it is summertime, it is 80 to 90 degrees, not like where I'm sitting, I wouldn't call it business as usual, but I would call it an absolute avalanche of business because people will not live without air conditioning in a Sun Belt. So they -- if things -- what I've said many times in my career is the same number of machines are going to break, no matter what happens. The economy, pandemic, social unrest, the same -- the machines are indifferent. They're going to break at the same rate, and the same number will break no matter what. And the obvious other thesis is that people won't live without them. It's not like new kitchen cabinets. If the air conditioner goes down, it's summertime, you're not going to live without it. You're going to -- and contractors, distributors, OEMs, homeowners are going to reach a comfortable way to get that work done because it's another health issue if they don't. So that's what we're seeing in the Sun Belt is an absolute, I would say, absolute recovery of some of the gap that was disrupted in April, and each week has gotten a little better. We can't ring the bell yet because it's early June. June is a huge month this quarter, July is bigger than June. If I looked at the full year, June, July, August, September are all important, seasonal important months. But I would say, in most every market where it's warming up, the trend line has improved.

That's great to hear. Well, it looks like we've reached the end of our allotted time. Barry, thank you for your participation and comments. It's very much appreciated. And same, too, to the investors who are participating remotely, appreciate your engagement as well here at our conference.

Well, thank you again. Thank you. I always say at the end of these calls, come see us. And I guess we're all getting tolerant and good at Zoom. So don't come see us but Zoom us anytime, and we'll be happy to spend time.

Fantastic. Okay. Thanks very much.

Thank you.

Hope you have a great day.

Bye now.