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

Hi. Good afternoon. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for a wrap-up session on day 2 of our Laguna Conference. Hope to see you all in -- live in person in Laguna next year. But for our last presenter today, someone who's already enjoying the sunshine in South Florida, we have Barry Logan and Watsco, Barry's Senior Vice President. Barry, welcome. Thanks for joining us. Before I hand it off, I do need to remind folks for any questions about our research disclosure, please visit the appropriate website at morganstanley.com/researchdisclosures. And for all other questions, please reach out to any Morgan Stanley salesperson. With that, Barry, thanks for joining. As always, good to see you. Let us know what's on your mind, what you guys are working on and what you see out there in the world.

Thank you, Josh. By the way, what's good about going last is that we can go on for like a couple of hours, Josh. This can go on for [indiscernible] night or so. No time pressure.

Speak for yourself, I've been here since 8:00 a.m. My L4 disc won't hold out that long.

Again, thanks. I'm sorry, we're not there. It's a great venue and a great place for even somebody who lives near water to go to. So it's a wonderful place. So again, Watsco, again, has been around more than 60 years. In distribution since '89, so 32 years. Largely the same management team together now for many years. I've been here 29 of them. Started to grow a distribution network and an industry, and so far successful. We're probably nearing the $6 billion annual run rate from being 0 in 1989. It's about a $40 billion market. There are still 1,300 independent distributors. There are still a lot of real estate in the nation where we have zero presence and still some OEMs that we don't represent broadly that we would like to develop markets for and both foreign and domestic. And as far as the contractors, we serve somewhere between 90,000 to 100,000 air conditioning contractors. They employ 4 or 5 people each. So maybe 0.5 million people can use our technology, use our apps, use our e-commerce, digitize their business in some way with us these days. And -- but again, as I said, a work in process. We're still not in all of the markets, and where we've been the longest is highly successful. So hopefully, much more real estate to cover through the years. So that would be some opening thoughts, Josh, in no particular order. I don't know if you can hear me, I cannot hear you.

Yes. Sorry. Can you hear me now? Excellent. So I appreciate those opening remarks. I think I would have said this a year ago as well, and the same holds true today. Clearly an exceptional year in residential that we've had over the past, call it, 18 months-plus now. Demand has been running pretty hot. I think there's a few things that we can point to as a result of that. How have you seen that unfolding on year-end? What sort of gives you the confidence on the elements that are more sustainable, less sustainable and how do you think the industry has changed as a result of what we've gone through during the pandemic?

Sure. Well, I think there's a couple of thoughts. First, I think there's 2 important players that do not go to conferences that don't get tested by institutional holders or analysts that matter a great deal in this. And the first are contractors. We're really seeing a health, a vibrancy, a merchant capability, a professionalism, I think, and a growth orientation with our customers that is truly special. Not just our customers, but I think the industry in general is seeing that. And as I mentioned, we sell about 90,000 contractors. The mix of products they're buying from us over the last 18 months is much higher in terms of efficiency. We're seeing more kind of complementary products being pulled through. Typically, if the replacement market is growing, the supplies business does not necessarily grow as fast. It is in many respects. So we're seeing kind of this pull-through of other products in ways that we didn't necessarily see as rich in the past. We're tracking that very closely in terms of complementary products and add-on products and kind of the hit rate of those products and the systems we're selling. And as importantly, accounts receivable. We don't talk a lot about it. We never asked about it. But I've said this for many years, that we have 90,000 customers that owe us $500 million. We can see the health of their business every day and how they pay us and maybe how they don't pay us. And default rates and past due rates and write-off rates are really at all-time lows. I mean absolute all-time, best health we've seen through our contractor kind of exposure in that way. I want to say it's great customer service, but it's also a very healthy customer group. So we think, again, the opportunity there being presented going to homes and have change and make change and make hay, so to speak. And offering these products, I think, is part of the dynamic that's going on. And of course, our job, more selfishly, is how do we empower more of it. And that's where we think our technology is making a difference for those that are buying from us because as strong as our growth rate is the technology user community is growing at an even faster rate with us. So it speaks to the value, but also speaks to the ability of the dynamic that are kind of a more empowered contractor makes a difference. I think the other is even a simpler answer, Josh, and it's the most abstract, and that is the consumer is spending more money. Home Depot is up 20% or more over the last 18 months. You have $100-something billion company, bigger than -- a factor bigger than all of us in this industry. If their revenues are up 20%, why? And the answer is people are spending money. So whether the consumer is more oriented, more comforted by spending money in this segment or they feel like they have to or need to or if it's run times or if it's just general health or just general awareness, as I said earlier, it's also a healthy contractor that's saying, here's what I think you should do. So I don't think that has a time life cycle to it. I think that's going to play out in some measure in the same way over the next several months. I don't see a reason for that to change. If the consumer is holding their head up and the economy expands some more, and liquidity is there, I see that kind of continuing. I don't see a reason why it wouldn't.

So if I had to break down kind of the different schools of thought driving the strength over the last year, I think there's a camp that would talk about run times, higher run times. I suspect that run time in South Florida in the middle of the day doesn't go down dramatically unless you want to spend the rest of the night cooling your house. But the nation is big. So maybe that's a piece of it. I've heard the R22 dynamic, that just the cost of refrigerant is so much higher that repair has become less palatable. The idea that the combination of weather and work from home has made people a bit more sensitive when there is a replacement, I got to do this now. I don't want to have a break another 2 weeks from now. Any one of those or ones I didn't mention stick out as sort of being the most acute? Or do you think they all kind of tug at the demand curve a little bit?

Yes, I think it starts to blend together a lot of these dynamics. I go back to my Home Depot reference where how did they sell 20% more in 2,000 stores in a very mature business. It's because they either took some share or maybe more importantly, the consumer, again, is channeling and prioritizing their home as a place to spend money. So I think it's some of that, too, if I think about it from a common sense point of view as a reference for them. But I think, again, it -- in our markets, we're disproportionately weighted in the Sun Belt, Florida. The life cycle of a unit is probably 8 or 10 years, not -- it's not a debate of 15 or 20. It's probably 8 or 10 years, and some of the churning that people project for other markets that's out there still has already played out in Florida. I don't think the replacement market changes very much in Florida. I think it's been 8 or 10 years from my entire career. And if there was a housing bump 13 years ago, 14 years ago that has some cataclysmic effect, it's already happened, and we didn't even perceive it in this sense. So I think, again, it's a compositive market and compositive variables. And I think there's 4 or 5 things going on in this discussion other than just 1.

Got it. So one thing that's come up and especially a lot today with some of the major OEMs presenting is the challenges around supply chain. We've heard that from several now. Some of them are your suppliers, some of them aren't. How is your own ability to get product sort of ebbed and flowed here over the last couple of months? I know we're getting to the end of the traditional season and maybe more tempered markets. But it seems like backlogs at the industry level are still long. Have you had any challenges that have gotten aggravated in the past, call it, 30, 60 days.

We have. We're no different than anyone else in a sense of making noise to our OEMs when we're asking for products because our customers are asking for products. But I would say that we're glad for a few things because I don't think the supply chain kind of risk has been as acute for us as anyone else. And I'll tell you what the few things are. I mean, first, we built inventory earlier in the year. I mean we -- our inventory in June this year was somewhere around 15%, 20% higher than the prior June. And a lot of that was driven by the demand structure that we were seeing in the market. We tend to order inventory based on demand flow and demand forecast. And we're glad we felt our convictions were strong for 2 reasons. It helped us build inventory; and secondly, it's let us keep up with demand because the demand, again, has been relatively consistent through the season. Secondly, and where we might have had a shortage or might have had a slow lead time or an irritation. It shouldn't be lost on anyone that we're the most diverse owner of inventory in the industry. We don't own one brand. We own inventory of probably 15 different brands. In a market like we have 100 locations, we sell, I think, 7 different brands, 3 different manufacturers and a highly diverse customer base. And there is not one location in Watsco that doesn't sell multiple brands. So that diversity and kind of that, I think, depth has helped us is if we ran into a supply issue or a delivery -- really more like a delivery issue, it is something we could source and fix in a very efficient way, either within the same warehouse or within the same region or within the same network without having to have a chronic issue. So we're not seeing, I would say, any chronic issues. I would say it's getting better as we're getting into September. I think the manufacturers are dealing with a lot of different dynamics that as their largest partner, we're helping them deal with in some way. I would say the cost to serve customers in this environment is costing more. We have to move product or find product or just deal with the demand that's going on. There is a higher cost to serve going out of our own, but we're seeing that in the pricing and the margin benefit that is flowing through the market as well. So I think in balance, I would say things are better, not worse in the last 60 days. I would say and why we built a cushion coming into the season, which has helped, I think, us compete. And when we're also glad we have a brand and OEM diversity that has -- helps deal with these kind of issues in a big picture way.

Would you say, given that we're getting to the end of the traditional season as it were with that backdrop [Audio Gap]

So because of demand, because of lead times, sustaining inventory investment for the foreseeable future, which we have the balance sheet to do. Today, we have no debt, cost of capital on building our inventory is exactly 0. And so it's kind of a good position to be in competitively.

And I guess kind of bridging off that competitive comment there at the end, I would imagine, given your pull in the industry, given the importance you are as a partner for a lot of these OEMs. You might not get first pick, but your demand is probably satisfied maybe for earlier than other smaller partners or certainly ones that are more episodic. That's probably given you some opportunity to take share if I had to wager. And maybe some the ability to hold on to that share relative to an OEM who's kind of traded back and forth with another. Is that your perception as well that this has kind of been a share gain opportunity based on your own availability? Or is there more at work than that?

No, I think there has been share gain opportunity not necessarily because we're the biggest of someone's customer book, it's more important than that. So our largest partner in the form of Carrier, for example, we have technology in place where they can see our sales. They can see our velocity through our stores. They can see it on a SKU level. It lets them more quickly, less bureaucratically and less old-fashioned ways, replenish inventory on a much quicker basis with real data. And so that's the advantage of having a relationship at that level, not just buying a ton of product but actually having the data that supports the flow to take care of customers. So that's an investment that we made a couple of years ago. It was really at the time, just improving the math and science of how we sell products and replenish products locally. And now 2 years later, we think it's a critical asset and giving insight into our velocity and a local level to our major partner. And we have something similar with others. And that's the advantage, not so much how big we are or how scaled we are.

Got it. So maybe a good segue into some of the technology investments as a whole. If we think where we're at in kind of the phase of -- the current phase of this journey, you guys have been on this for approaching a decade now, really. Can you talk about how the focus has shifted at points in time and sort of what the main thrust is today?

Well, 2 layers to the answer. First is we went to our best customers early and said, would you use this? And once they told us what they would use, we built it for them and really focused on a kind of the historical good customers covered by our historical salespeople that began to use all the features, if you will, of our Swiss Army knife. So phase 2 was how do we get someone else's large customer to be aware of it and begin to adopt it in their business. That's a harder equation. So maybe someone buys $50,000 from us but $1 million from somebody else, how do we begin to cultivate those relationships? So I would say the last year or 2, that's where energy has gone to educate, train, philosophize, evangelize technology to new customers. And COVID helped us do that in the sense of if we could offer some services that others couldn't, it was a way to tell the story and a way to gain adoption. So I think we've expanded the customer group, user group effectively. There's much more to do. But this kind of whole kind of dynamic we've been and has helped us do that. So that phase 1 is to continue to do more of that kind of evangelizing beyond the historical base and make our technology a way of life for some of these customers. The second was -- that's even more interesting is how do we help our customers sell more products, something distributors typically didn't necessarily extend themselves out to do. We used to design Yellow Page ads. We used to help design the Sunday newspaper ad. That was about it. But actually to have a sales platform now that's integrated into all of our technologies and actually present a homeowner choice A,B,C or D with risk data about the products, data about the pricing, data about the complementary products, ultimately financing that system through our technology, that's a little more important than Yellow Page ads had once been. So that's a younger stage technology, but is expanding very quickly. Again, we focused on customers that we know as a way to get it bedded and to build some momentum. And we've pointed out some of the numbers, but I think we'll approach about $1 billion run rate, essentially a retail sales, helping our customers sell something in the next 12 months. I don't know if we'll get there this year, but sometime next year, we'll reach a point where we've helped our customers sell $1 billion worth of stuff. It's higher margin. It's higher margin for them, for us. And is it market share? We'll see. We'll measure it as we go. But that's an interesting concept was actually getting beyond being a simple distribution model and actually helping the retail sale of these products.

Understood. Yes, I think the biggest innovation in the advertising side prior to that would have been whoever came up with the billboard that says, "Your wife is hot, call Bob's Heating & Cooling." So just going back to the first layer of that discussion, where -- what kind of, I guess, wallet share have you seen with the core customer group that was kind of the early adopter? Anyway -- I know you guys are very data-intensive around this stuff. So what is sort of the XY on what adoption of the technology has done for the percentage of products that you think that they're buying before and after from Watsco?

Sure. The key metric that we looked at, at first, was attrition. We said that's a simple question of the data scientists at the time was if we sell $5 billion last year, for example, how much of that doesn't show up in the year following? And what's the long-term average attrition? Every business has it. How you measure it and how you change it is important. So we measured attrition. And in some of the out years, it was as high as 10%. We would lose 10% of our business in a given year or the following year. It could be 10 or 15 different reasons. It was a big number, a big cost, so to speak, a hidden cost that -- so what we -- so with technology, we could then measure the user community and ask year-over-year, how much attrition do we see from our user community. And we've said publicly, enough times now, that it's a fraction. And when I say it's a fraction, I mean, it's a fraction of a percent in terms of attrition with the user community. Now there are still people that will go out of business. There are still people that will retire or people that will sell their business. And I'm factoring that into this discussion. So a fraction is coming from attrition. So that tells us 2 things is that contractors that want to be around for a long time are using the technology and with us for a long time because they're making an investment in the technology. And then secondly, it's a hidden cost that can be greatly diminished the more we can get people to be on the platform. So today, there's around 20,000, 25,000 contractors out of 90,000 that are touching our technology most days. There are some super users that they're running their business literally. Most of their orders, if not all their orders are running through the technology. And so again, I won't publish all data about it, but both lower attrition and higher growth rates is the consequence. So that's why I go back to the other point of how do we evangelize this to someone else's large customer in an effective way. And again, I won't build a rocket ship publicly on how we're doing that, but that's really the next big phase of kind of what's going on.

Understood. How has this changed the strategy around pricing? Presumably, you're getting a lot more insights and able to kind of stratify different customer types and their own demand. Does that result in sort of a sharper pencil on the pricing front or more differentiation there? Or is that not as much of the equation piece?

Yes. It's a somewhat separate dynamic pricing, and I'll say it this way. When we did the whole conversation with customers about the mobile platform and e-commerce and owning a Swiss Army knife and working with us that way, pricing was never a conversation of something we should play with or tinker with. The same pricing to a customer group was going to be the same, whether they called us, whether they faxed us, whether they e-mailed us or whether they bought it through the technology. We didn't want there to be any objection or funny feeling about launching something like this in terms of pricing. So the pricing and the margins and that dynamic has not been influenced really by -- from a structural point of view, from technology. But long term, we know that human intuition is important, but data supplying that intuition is probably even better. And what I mean by that is if we sell $200 million in 3 counties in Florida, we're selling several thousand customers. We have maybe 50 to 100 salespeople setting price. We have large and small, we have -- overall we're selling largely the same product groups to these customers in South Florida. And without a lot of insight into, let's say, the bandwidth of pricing for thermostats or the bandwidth on pricing for copper tubing or the bandwidth for product groups because the data was actually very hard to get. And so that's been one of our more recent initiatives on technology was a pricing technology piece of software that could assemble all that data and make it usable, visible and actionable so that someone setting price had more information at their fingertips, have more insight versus intuition. And so that was launched towards the end of last year. We're in the early phases of launch this year. I think there's some benefit in this year's pricing capacity to make those decisions. Next year will be a more important year because it will be more cultural, a little more kind of trusted across the network. But pricing, Josh, is kind of not trying to necessarily raise price, but trying to optimize price or trying to communicate what is the price. There's always possibilities where we're overpriced in some ways. And so it's a different technology and maybe in one of our Investor Days where we have some -- can spend 15, 20 minutes on this, begin to develop a more in-depth story and actually talk to the people that are doing it, not me. But pricing is more of a separate conversation for the long term using data that we typically didn't have at our fingertips.

Understood. I see we're out of time. I appreciate you taking the time, and good to see you as always. I hope to do it in person next year. And thanks to everybody for joining us. We'll see you back here again tomorrow morning.

So too, Josh. And thank you for the time, as always. Appreciate it.