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

Good morning. Thanks for joining us again at the Wolfe Transport Investors Conference. My name is Nigel Coe. I cover the multi-industry sector. Today is May 27, the third day at the conference. And we're continuing with the investment track with Watsco. New coverage for us at Wolfe, but a company that I have known for a long time, and I'm very pleased to have Barry Logan, the SVP. Not sure exactly what your term is, Barry, but you're very senior and you have very long tenured at Watsco. But Barry, very pleased to have you with us again. And let me hand over the mic to you for to make some remarks and then we will dive into Q&A.

Yes. Thank you, Nigel. Again, thank you for all the hard work for your team and you on getting the report out. I thought it was a very balanced concept that was communicated. And so we appreciate the hard work. First, again, Watsco has been around since the 1940s. Our Chairman and CEO, joined the company at age 32 in 1972. And so do some math there, almost 50 years ago. Distribution began 1989, I will fast forward. After about 10 years, we reached $1 billion in size, and after another 10 years, we reached $2 billion in size. And within 30 years, became a $4 billion company and now over $5 billion. So very much a growth orientation. And in that storytelling really is about our culture, how we approach the market, how we approach acquisition targets, how we partner with vendors, how we look at our own distractions. We've not been distracted. We've stuck to HVAC and refrigeration now for all these years. Company's legacy is steeped in in the industry. And when something can be done this long, this consistently, we think, with a sustained culture. And yet, we only have about 15% of the total marketplace. There is still 1,300 independent distributors. There are still markets where we're 0. There are still OEM relationships that we are nurturing to build more on. We don't sell all products for all people. We only sell some products for some people. So we want to, over time, diversify and grow and have even greater opportunity for what we're doing. Yet in markets where we have great density, great product depth, great OEM relationships, deep brand selection, commercial, residential and so on where market share is very high and extremely diverse, it's our most profitable markets. So Florida would be one example of that where we started 32 years ago. And so we know the business model. Again, it's a matter of effort, time, capital, relationship building, in some cases, the eccentricities of family businesses going through generational ownership cycles. And I have not yet mentioned the word technology. And technology, we had to decide, 7, 8 years ago, what would that even mean? It used to mean more phone lines. That's how we would add technology would be, to add more capacity in our phone system. And of course, 10, 15 years later, it really means a broad portfolio of mobile-enabled apps and technology and processes and cultural movement towards really generating commerce and generating knowledge digitally 24 hours a day, not just when our branches are open. So that's still -- and after the early stages of adoption and early stages means we've captured the initial adopters, the progressive customers that wanted technology in the first place, and embraced it immediately and saw the benefits of it immediately. So now that's about 1/3 of our business. But the 2/3 that's not is this wide variety of other customers. Large customers that haven't tried it yet, small customers that are someone else's large customers, that we're focused on to migrate more of their business to us. And of course, the next stage in technology was it begin to influence how homeowners began to acquire these services or buy these products. And I'll say 10, 15 years ago, that was blasphemy to even suggest that the distributor would be involved in helping a homeowner or business owner acquire goods and services in our industry, enable them to acquire those services. And so that's what's been interesting is to get beyond just our contractor channel and begin to help our customer with their end customer, which is the homeowner. And so I'll leave it at that. That's the company in general terms. And I know there are some good questions. So let's go.

So Barry, you said a minute, I knew you'd blow that budget. So that's a good thing. You mentioned -- obviously, acquisitions are a big part of the story for Watsco. You've closed 2 or 3 deals in the last 12 months or so. Couple of things here. I mean, I keep asking the question to other companies. Do you think cap gains tax increases is going to accelerate some of these second, third-generation owners to kind of fold their cards and sell?

I think it helps our conversation. And there are certainly people that I think are looking at it in earnest, are still waiting a little bit to see what will evolve with the tax law, but it's been a catalyst in the past. And these are all family businesses we're dealing with, many of them S corporations that have 2 or 3, maybe 3 or 4 siblings that own businesses. And the gains they would make being taxed on higher rate is an ingredient that they'll focus on. We're already seeing it some, but that's not the only one, of course, part of it is technology. If you ask the people at TEC that we just acquired, why they sold to Watsco, I think the tax law threat was probably the #7 item. It was on their list but it was about generationally preserving what they're doing for more generations when this generation is becoming a little more aged, I guess, in the sense of maturity. They wanted technology, they wanted our backbone with Carrier and some of the other vendors they do business with, and backbone, meaning the perpetual relationship that we have, the benefits that we have, given our scale with Carrier in their case. But there are Rheem distributors, there are Goodman distributors, there are Manitowoc distributors that are our friends and long-term relationships also that we offer that same capacity as to the brand, another generation and relationship with their business through these key vendors. So those are the ingredients that we really focus on. The tax can help and as we get closer to when something might actually happen, I think there's an opportunity there.

Okay. Good. It just seems that if you're willing to sell in the next 2 or 3 years, that's a 20-point step-up in capital gains taxes, it'd certainly get my attention. Maybe I'm a little different. The other thing on this is you mentioned your market share is 15%. But if you look at the Sun Belt states, some of your more mature markets, your market share is certainly well above that. To what degree are you running into limitations, be it perhaps even market share distribution or OEM friction in some of these more mature territories for Watsco?

Sure. Well, again, we have some markets that are multi-brand, multi OEM. And we've been given more territory and given more product opportunity in those markets, because of the scale, because of the density. I don't think we've ever felt threatened or at some ceiling in that respect, nor that has been communicated to us in any way. I think part of that is this 30-year track record of being partners as opposed to some type of adversary or using our scale to somehow gain leverage or price or muscle or what have you. As a distributor, if we don't have products, we can't grow. Or we sense the limitation or angst, we need to solve that in order to grow. So again, it's been -- I can't think of an example where we've had a tough conversation like that that we've had to overcome at this point. And part of that, too, is different sales forces sell different brands. The customer wants a distinctive experience, too, by the way. The OEM wants a distinctive experience for their brands, but the customer wants the same. Contractor wants energy flowing to his business when they commit to the brands we sell. And so as long as that is the style, I don't see limitations or ceilings on what we're doing.

Okay. That's very clear. And the technology platforms you have in place, the apps, if you will, seems to be a real differentiator versus some of the moms and pops out there. They simply can't spend the $30 million that you're spending to develop these. So that seems to be a clear share driver for you. But to what extent are you sort of yielding these benefits to your efficiency, your internal efficiency? And do you think there's scope to maybe see that coming through a better SG&A efficiency levels going forward?

Well, the first goal, as you suggested, was to get customers using it and to get customers enjoy using it -- to enjoy using it, and speed up their processes every day for their businesses. And that speed as we're working to yield market share and margin, frankly. We had to be faster, too, in terms of pick packing, shipping, delivering, communicating, fulfilling. We needed to be as fast on our side for the promise on the front end that we were delivering. And by the way, that makes us more productive, more efficient. And some of our processes evolved to be more modern, and we could take out some costs or at least do more business with the same level of daily commitment and branches and yield some financial results. So we're finally seeing that. I think in 2020, we really did see a full year of benefit, not because we were looking to cut costs, but because efficiencies eventually flowed through all the business processes that had to change to really speed up our side of the equation with our customers. And COVID had a way of cinching that even more tightly in our stores just because of manpower and requirements that were needed to serve customers in that environment. So in some ways, a little bit of trauma a year ago at this time, produced, I would say, even a more efficient company. And now our challenge is how do we get even more customers using it. We're taking advantage of it, frankly.

Perfect. And maybe one more question before we get on to market conditions. Your operating leverage in the last 2 or 3 quarters has been very impressive. Obviously, you benefited from very strong volumes, but do you think there's a path towards 9%, 10% margins in the medium term?

I mean that's been the goal for a while to get to 10%. And our aspiration to do that is really predicated on the fact we have business units today that are over 10%. So if Watsco today is at 8% and change and absent corporate expenses is closer to the 9% -- not quite 9%, but absent corporate expenses, it's 8.5%, 9% today. 10% is not -- we don't have to go to the next galaxy to get that performance. But what we need is growth. Every distributor wants to leverage fixed costs, every distributor wants to yield higher gross margins in that equation to help attain higher margin. We're -- we just launched a pricing platform technology in Watsco to begin to address gross profit beyond just the blocking and tackling that we do in our markets. And so the reason, going back to the fundamental, the reason why business units are well over 10% is, again, market share, brand diversity, a market like Florida, where I suggested before, our margins are above that level. I'll tease in a public forum that our primary competitor is -- competitors is Trane Factory Direct, Lennox Factory Direct, YORK Factory Direct and Goodman Factory Direct in Florida. So this business model of diversity and density and technology, works. And so 10% really has been the aspiration. We just need to do that in more markets. So Texas would be an example where we're not at 10%. We're not at the same market share level as we are in some other markets. So that would be an example where there is a good amount of strategy as well as acquisition orientation to try to help that medium term to use your words.

Yes, scale is certainly important. You mentioned growth is key. And right now, you've got plenty of growth. When we do our replacement demand models, we can't get anywhere close to where current market levels are. And I'm sure there's a variety of factors. But I'd be interested in your perspective on what do you think is driving the current outsized trend? I'm not talking about the year-over-year, I'm talking about the absolute level of units being shipped right now in the market. And how do you think that shakes out over the next 12 months?

Sure. Well, I think, again, the contractor is really the one -- the party and the channel who matters most and the answer to that question, not the biggest distributor, not the largest OEMs, but a lot of the answer lies in the contractor itself that is walking to somebody's home, diagnosing a problem, giving a few recommendations and hopefully getting a replacement sale. I don't think people are proactively calling contractors to say, can you come by and take a look, I think I want to replace this. We fantasize about that day, and it's never come. There still has to be a problem with the system. Contractor makes the recommendation and increasing -- with an increasing amount of confidence right now that contractor is getting replacement business. Less band-aids being put on, more new systems being sold. And if that's -- if that's -- the consumer confidence to spend money on the home or a health consciousness or some type of other dynamic going on you can see it in Home Depot's same-store sales, which are up consistently now, 20% or more it seems. So you have this -- a little bit of this money flow, energy flow, comfort flow, health flow coming into the home. I think we're all participating in that clearly. It's unique. I haven't experienced it in my career. And if the question is, how long does it last? Not forever is the answer. How soon? We don't know. We know what normal is. Normal is around 6% growth, not 16% or 18% or 20%. So I think our job is to try to get a year ahead of this a year from now and work with our manufacturers that have the same issue, they want growth, they want to fill their factories. They're eager to get beyond the stage 2 of catching up and so on. And so I would say between technology and really our vendor kind of energy that's flowing right now, this has to become a market share gain probably a year from now. And we're -- it's how we're approaching all of that today for next year's strategy and tactics in that vein. I mean we're already thinking and acting and strategizing the tactics that will be needed for next year.

So Barry, I think you might have seen my questions here because my next topic was actually market share. So that's a great segue. Obviously, you're very much aligned with Carrier. It seems like Carrier has been gaining share, as have you, in the markets. And just number one, just touch on how the relationship with Carrier has changed since Carrier has been an independent company? That would be my first point. And secondly, how has market share changed or shifted in the last 12 months? We've seen some supply chain challenges for certain OEMs. Are you still seeing that market share dynamic playing out through this year?

It's interesting. Just some context with Carrier just to level set. We've been with Carrier in some measure of relationship for 24 years. We've been through a variety of CEOs at UTC, a variety of CEOs at Carrier. We're the same people here, but we've been building a relationship for all these years and have them now be independent. And a renaissance really occurring in terms of their orientation, their commitment, their stress, their desire to grow has been refreshing over the last year, to say the very, very least. It is a true partnership in the sense of we've got to figure this out together to grow, listening, acting, reacting, counteracting has been at a speed the last 12 months that we haven't experienced in most of the years we've been doing this. So it is a tribute to really to their culture, trying to become more intense and more quick in terms of growth. So we appreciate that. We do sell 7 different brands that Carrier makes somewhere. It's the most diverse OEM we sell products for, it's the largest and concentrated, but it's almost misleading to say it's concentrated because we actually sell 7 different brands they make somewhere. I think market share gains where that diversity has been placed, the last 12 months has helped them because they can sell against the high end, they can sell against the value segment that where Goodman, for example, had supply chain issues last year. Not every OEM could have benefited with that opportunity if they weren't diverse across those product segments, for example. So I think the relationship to kind of summarize it, again, as energize and far more entrepreneurial in the sense of looking and acting and reacting opportunity. And I use the term counteracting competitive dynamics. And we just invested again together in TEC. It's over $100 million purchase price, we put in 80%, they put in 20%. It's a great company, 80-year old business. It's got a growth plan to double the size of their business over the next several years. The team stayed. The owner is filled with energy. One day, we'll have an Investor Day in Chicago. I want to have him speak about the Watsco culture, not us old timers. I think it's going to be a fascinating Investor Day. And so from that perspective, I think market share has come from that energy flow, from that diversity that I mentioned that has -- it doesn't raise all boats, it raises some boats that I think have that competitive condition. And in our -- in our case, we have to be endlessly slightly unhappy and find ways to -- for market segments, product segments to keep growing, and we've communicated all of those. And again, the reaction time is far better than it ever was. So I think we're energized, as you can tell by my -- sometimes you can't tell, but by my energy that's flowing in the answer, it's -- we're feeling very good about it.

Good. That's great. Maybe a couple of more -- maybe 2 or 3 more questions, Barry, in the time we've got available. Are we still -- we've been seeing a nice mix up on efficiency and of course, we've got the step-up coming through in the next couple of years in both Northern and Southern states. But are we continuing to see positive mix coming through as we go through 2021?

Yes. We have. And it's been every quarter since 2010, by the way, if I measured every -- measure almost 45 quarters of data, it's been that consistent now for that period of time where the mix has increased. Again, that goes back in the context right now today, of that contractor confidence walking into a home and saying, "Here's what I recommend you do." And contractors incentivized to upgrade. We're incentivized to help them. The homeowner has a benefit. And yes, the OEM and Copeland making compressors gets a benefit. But it starts with the contractor confidence that, again, builds that recommendation. And we built a platform called OnCall Air, that is our version of a point-of-sale device for contractors to propose good-better-best solutions. And it literally says, base efficiency, high efficiency, almost like a Tesla model, ludicrous efficiency. And the mix within our platform is double high-efficiency at a normal rate. So just the fact that we're professionalizing what a consumer is experiencing and seeing is adding to the mix in our business. So -- and so yes, the government mandate that will come will help and will add another layer of support to that. But I think this consumer/contractor relationship that we're seeing now is at a different level than what's been typical in the past.

So Barry, you said the mix is 2x what you normally see. Is that correct?

Right. I think the industry standard is pretty much 2/3 base efficiency, 1/3 high-efficiency in the industry. On our platform, it's the reciprocal of that, 2/3 is high-efficiency and 1/3 is base efficiency.

That's incredible. Inventories, you've been rebuilding inventories as we've recovered from COVID. Are you now at a level, I'm talking here about through the quarter, where you're happy that inventories are now sort of more aligned with demand. And do you think the industry is there as well?

Well, we're happier in terms of lead times and consistency of those lead times being achieved in our mix of what we sell. I would say we're not entirely happy because there's still a demand structure going on that's challenging every average OEM and probably some more than others, but we -- it's a nice problem to have, I guess. So we're in much better shape today than I would say last summer in terms of both fulfilling orders, lead times we can count on and not having to hedge our inventory for failed lead times or risky deliveries. So there's more confidence flowing. But I think the industry is still catching up. And part of that is the demand flow hasn't changed at all. And probably still is catching everyone a little bit by surprise in terms of, again, important working or the consistency of the demand flow not just the level of demand, but the consistency has been really something.

Yes. Certainly, your friends at Carrier talked about April being very strong as well. So that makes sense. And then just on -- finally, on price increases. We've now had 2 price increases put through the channel. Your industry stands out as just very strong pricing power. And I know that the OEM prices are a fraction of the total installation cost. But is there any friction with contractors on the price increases?

Again, I would say the concept, again, is that an OEM issues a price increase. As distributors, we go out and implement as much as we can. It's in our best interest to do that. And then protect or push back or in some cases, we isolate customers who receive no price increase because that's what the customer relationship kind of demands. So I would say there's less of that breakage going on because I think, again, most customers are very busy. There's been pretty universal timing and amount of price increases across OEMs and when that occurs, generally speaking, it's simpler to get price. So I would say, last year, there was very little price. My guess in the first half of this year, there's probably a couple of percent in equipment price increases. Some aspirations for a second half price increase, which we'll see -- I would say, this year is a little better than average. Again, not because we went out and got it. It's because there was consistency amongst the OEM community of kind of sticking to it in both the amount and the timing of those price increases. That simply tells me they all have the same risks going on that they have to manage. That's what that...

That's good to hear that there's consistency amongst the OEMs. Barry, I think we're out of time there. So we'll draw a line. By the way, your background is a lot better than my background, my white wall. So it looks a lot nicer down in Florida. But again, thanks Barry for the time. Glad to be back up and running on coverage and look forward to catch up soon.

Thank You. Appreciate it very much. And always call or always tell us if you need more information, we hope it will be helpful.

Thanks, Barry. Take care.

Thanks.