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

Thank you. So we'll get -- we'll start with the Wolfe Industrials and Transportation Conference with Barry Logan, EVP of Planning and Strategy at Watsco.

Good morning, Nigel.

Barry, thanks for coming in from Florida.

Thank you.

So good to see you in person, in the flesh. Barry, I know you've got some great perspectives on the market. So before we get into Watsco and some of the news on Watsco, maybe just talk about kind of how you see the market, residential markets, and how Watsco is performing in that context.

Sure. Well, again, Watsco has been around in the industry for almost 35 years. And so we have a good perspective over cycles, over time, over growth, over all the relative issues. So the last 2 years have been among the most interesting of my career. I've been here 30 years. And the market really has really surprised us in some respect, in that consumers 2.5 years ago, I mean, we all wondered what will happen to the consumer. 2.5 years later, we have a good sense of it. Consumers simply spent more money on their homes. It's in the Home Depot numbers. It's been in some of the other categories. And air-conditioning is unique, in that you don't really buy it because you want it, you buy it because you have to have it. You buy it when yours breaks. You buy it because you're uncomfortable, and you don't want to be uncomfortable for more than a day. It's also unique that you don't buy it yourself or do it yourself. You're entirely reliant on a contractor, who, in many respects, has the power in the channel, not an OEM, not Watsco, a contractor is the one that really makes the prescription, makes the recommendation, cost of money, does the work, creates the quality in the home that the homeowner is actually looking for. So it's been, again, a fascinating couple of years because the contractor empowerment, the contractor wherewithal, really has been unwavering. And it's been very critical of how this industry has sold products for the last 2.5 years. A lot of industries have been disrupted or in many cases, prevented in selling and providing services or just disrupted. And our industry has done actually very, very well in the last couple of years. Inflation continues. These products are made out of metal steel, get transported in containers, are made with labor, have foreign content so currency can matter. And all the inflationary dynamics that OEMs have faced have been passed through to us to gain in the market, and distributors, in general, like inflation. Our margins tend to stay the same or are listed. And our rent doesn't go up 15%, so the algebraic equation to EBIT margin and growth and profitability can be very efficient in these conditions. So I would say, the state of the market now is almost the same, I would say, certainly double-digit trends this year, even after the strength of the last couple of years. Inflationary benefits are helping the top line. But that doesn't mean there isn't unit growth. There still continues to be unit growth this year thus far. The technology investments we made over the last 5, 6 years, having to explain them in aspirational details, in the last 2.5 years, that we calculate having gained about 250 basis points in market share. And it's among brands, it's among OEMs, it's -- we're not just selling 1 or 2 products. We're selling 10, 15 different brands of equipment. And so I think OEMs have benefited and are investing in the relationship in ways, in the last couple of years, but is feeding that growth and feeding that market share expansion. We're about twice the size of our next competitor. So if you're a manufacturer in this industry doing business with us, your charter to growth has to include a very aggressive partnership with Watsco to grow. So I think those partnerships also, to talk about the state of the market, is profoundly probably more important even 2.5 years -- than 2.5 years ago because there's been so much that's gone on in the market. With supply chain and pricing and so on, the OEMs and our relationship cannot be stronger.

That's great. You mentioned it's been an extraordinary couple of years. Nobody would have seen the kind of market we've had back in April 2020. It does feel that the consumers come in a bit more strained, maybe the inflation impact, but also this transition back towards services, people traveling more, et cetera. Are you seeing any threats emerging in the consumer?

I think threat is a strong word. I think the idea of moderating spending is probably inevitable in any business that's outgrown its long-term trend. I don't think we're going to be immune from a consumer thinking about what they're spending before they buy a system for $4,000 or $5,000. What we saw in 2010 though, for example, which was probably no less of an impact on the consumer than what we're even projecting today, is we saw regulatory changes come in, in 2009. We saw efficiency changes come in, in 2009. And go back and look at same-store sales growth in 2010, it was double digits. And so really, the notion of this industry being impacted in what would be heavily discretionary-type spending, if you're buying kitchen cabinets right now, if that was on your agenda, and it cost $5,000, would you spend that first or would you spend $5,000 on your heating and cooling system when it's 97 degrees outside in Texas? So I like our -- where we are in that spectrum of discretion. What we would see and expect to see is -- and again, the contractor is the one that actually makes the sale, not Watsco, not Carrier, not Emerson, a contractor in your kitchen table is making the sale. They're judging you. You're judging them. You're figuring out where should I be on the spectrum of price, where should I be on the spectrum of what I can spend. And that's why offering multiple OEMs, multiple brands in a market like Florida, where our market share is certainly much greater than anyone else's, it's because of our multi-brand, multi-OEM approach in the market. So if someone wants to spend $500 less, they can with us. If somebody wants to spend $1,000 more in the highest efficiency, they can with us. Not every competitor in Florida has that, again, that aperture they can open and close as easily in the market. So it's just one of our strengths. And so the consumer does slide up or down that pricing scale. I'm certain our price, our margin, our profitability will not be impacted -- would not be impacted as significant as if you're just selling a brand and a factory store, let's say.

Right. Right. Have you seen that slide and scale happening yet, the mix down? Any replaces, repair changes?

We're always -- always, yes, there's 3 subtle layers to that discussion. There's the energy efficiency, where 16 SEER costs more than 14 SEER and 18 SEER costs more 15 SEER. That has not budged for 11 years in terms of that mix improving. We have a regulatory change coming in next year that will, again, algebraically cause it to continue to occur. So on that spectrum, no. And there's about a 10% price difference between each of the kind of the rungs in the ladder, that I just mentioned, of efficiency. Then there's brand, brand mix. If I ask you, Nigel, would you rather buy Kenstar or Carrier, which would you rather buy? They're made in the same plant in Mexico by Carrier. One costs 10% more than the other. I'll gamble, not knowing their numbers, that they cost the same thing to make for Carrier. So Carrier has a brand mix as well, so does Trane, so does Lennox, so do others. And -- but the margin contribution, if you will, on the different brands is very similar. I'm not sure that's true for the OEMs. It's true for us. And so if someone is trading at all in brands because, again, the contractor is saying to the homeowner, "Well, if you want to spend a little less, I have these 2." And again, that's why if you come to the Miami store, we have a Miami store that sells 7 different brands of normal equipment, about 10 more brands of niche equipment. And that branch has $60 million in revenue, more than a Home Depot. So we like that kind of capability, where, again, competitively, I think others would be here, this is then, is to that. The third, believe it or not, we love all this pricing craziness because there's no Internet site, there's no dot-com. This is all very local, very personal to the contractor, very unique to each job the contractor is doing. The pricing truly has the snowflake type of existence really for our business. The third kind of pricing is, is it a large customer, is it a small customer, is it a big job, is it a small job, is it a builder, is it a guy working on a Saturday and paying cash at our counter. So we're also managing price every day based on even more variables than just cost or price or inflation or brand or efficiency or mix. We have customer mix even. And a lot of our technology initiatives, and our biggest source of new customer acquisition, are what had been small customers of ours that are someone else's large customer. So this is a market share gain too, as we talk about growth and so on. And pricing and margin of those new customers in our technology platforms is higher than if we just try to shoot the whale. And shooting whales has a cost, and getting some of these smaller customers to join us has been very lucrative.

Okay. You mentioned price increases, which I think is a good way of describing what we have seen in the last 12 months especially. Do you think that we're now getting back to recovering to maybe one single annual price increase effective Jan 1? Is that where we are now based on what you can see today?

Yes. I think it's so hard to tell until you really, I think, when you get through this season. And the OEMs are also -- are launching. Basically, half the industry is recalibrating to a higher efficiency. And it's not just rebadging a system that they already make. Many of the OEMs are making new systems for this new efficiency layer that's happening next year. So Nigel, I think, in many cases, they're working through those issues, that new production, that reproduction of new products. And I'm not sure they have price and margin fully in a confident mind yet of what they're doing. So I would like normalcy, but I don't know if it's normalcy at this point. Okay. I think if the commodities start backing up, the copper, aluminum, steel, transportation, freight, fuel even, and also labor will back up, then that becomes a bit of maybe kind of a honeymoon period for the OEMs to make their margin. Our honeymoon is enjoyed when we're raising prices in the market. And because it's oligopoly, price is never really that volatile in terms of either deflationary risk or disruptionary-type risks with pricing. OEMs tend to be pretty, again, predictable in these conditions. So I don't know if it's normal yet.

Yes. So it doesn't sound like we've seen any big break in the consumer yet. But if we do, if the consumer becomes unstrained, vis-à-vis spending mix down, perhaps copper gets back to $2.50; aluminum, below $1; raw materials come down a lot, do you think there's a risk that, this time, you could see the price get up in the industry?

Yes. I think it's always a scrum, if you will, at these large account, national account, builder-type level. So Lennar is going to build 100,000 homes and want a quote on 100,000 systems, and I move that, trading the number, it's not that many, then, yes, there is a competitive price quotation going on for Lennar. If it's the average Joe contractor in Fort Lauderdale, Florida, who needs a product 20 minutes from now, it is not a pricing exercise. It is you, "Hi, can you get it to me in 20 minutes or not?" So that replacement market, in our minds and certainly in our career, and the data would show, there's really not this shadow cast from deflationary-type actions. But for the OEMs that do well or specialize or enjoy the large national account business, large builder component, large builder-type componentry, that's probably more at risk than my average Joe contractor that I serve in a market like Miami.

Right. Okay. Do we have any questions in the room?

Yes. Right. Maybe you could talk a little bit about your acquisition strategy, particularly just wondering to what degree you integrate or don't the acquisitions that you do and why you choose that particular path.

Sure. Well, there are about 1,300 independent distributors in the country today and I would say, a couple of hundred that are more than $100 million in size, maybe 50 that are $200 million or more in size. And all of them, I don't think there's any exception, are second-, third-generation family-owned businesses that have become famous within their local markets, building companies and building affinity. No one in Chicago knows Watsco. Every contractor has known what TEC is in Chicago for the last 80 years. And one family owned the Carrier territory in Chicago, Chicago land for 80 years. So that's what we're acquiring, is the affinity, the relationships, the legacy of that. And we have a very low-risk mindset to say, "Just don't screw it up. It's a great business. It's been around forever. It's profitable. We've paid a great valuation for it." We've promised sales force -- we promised the sales force, we promised the leadership that it's your business. You're going -- you're in charge of growing it. We're in charge of helping you invest in it. We'll bring technology to it. We'll support it. So it's really, the first phase of all that is risk mitigation, to take care of a very good thing that's been around for a very long time and then try to incentivize it to grow, bring equity to employees, where maybe the family didn't bring equity ownership to the key employees. And the Phase 2 is, over time, figure out what to do with the collection of these things. So today, we have roughly 10 business units, the 4 in Watsco, a large network that sells Carrier, a large network that sells Rheem, a large network that sells Goodman, for example. And in some cases, they're still called -- in most cases, they're still called what they were called over the last 40 or 50 years for locations themselves. So now, we're going from just risk mitigation, to scale. How do you bring -- if a successful company had 20 branches, what about 120? And now, we're scaling the business and putting capital behind it. And the third phase was really, now, let's bring technology to it, let's invest in ways that a competitor couldn't even consider investing on scale for some of the technology. So that's a different 2-hour meeting, not a half-hour meeting today, but really changing the way a contractor rolls out a bed and runs his business with 10 employees. How do we influence the behavior of the daily life of a contractor who is running a small business? And rather than doing it in a haphazard or seat of the pants way, a very professional way with software we've built for him to run his business on -- not just do business with us, but actually help him run his business on it. And so those are kind of the phases that we're on. So today, it's roughly 60 acquisitions, 10 business units, 4 or 5 brand-centric networks. A company like TEC is still run by Skip Mungo, who -- whose father founded it 80 years ago. He's in his 60s. There were no third-generation leaders that emerged who wanted to sell the business for the sake of his kids, grandkids, nieces and nephews. They're then securing their wealth and knowing that our style, our approach, would see the TEC outlive into the third or fourth generation. We have some businesses that we bought from the second generation, and the fourth generation is working there because now, we've owned it 30 years. So that kind of mindset also -- is also met. But a lot of this is just friendly stuff. We've never been in an auction. We've never paid a fee, never hired a banker, building almost a $6 billion, $7 billion company, doing a lot of acquisitions, really because the relationships have been built then. And also, OEMs still have either power with who can buy these things. We can make a collection in the room, go try to buy the Trane guy here in New York. Trane would have to say yes or no. Yes, so there's still a little bit of a, I won't call it a moat, I would say, a little bit of a hurdle even for private equity or others to do what we're doing. And -- but no one else has the long-term horizon that we've been deploying here.

Great. Any more question?

You talked about the price craziness and just sort of how wild the market has been in the last couple of years. Just curious for what you're seeing in terms of just product availability and sort of inventory, where you've gone through the sort of hand-to-mouth type environment for a while. You said the contractor, we're going to get a product within 20 minutes, that sort of drives the pricing decision that was near impossible a year ago. Just kind of the latest on what you're monitoring in terms of your sort of your inventory turns or sort of inventory that's out there, just generally on product availability.

So that's been the puzzle, right, as to how, so a product everyone needs locally, we don't have distribution centers. We have stores basically that receive goods from direct from the factory and sell them. So we didn't have a stockpile. We didn't have a mountain somewhere that we could draw on. So no, I would say, 2 years ago was exceptionally horrible. The last 12 months have been better because really, the OEMs have started figuring out how to deal with these issues. I think, again, we're operating in the largest of markets for the industry, and the OEMs will have -- it's not a matter of just getting preference, it's having to do it to salvage their own growth. So I think it's better. I would say it's still disrupted at the very high end of the market for their electronics and chips and variable speed and communicating thermostats, things like that. No different than a Lexus automobile might be. And so that's 5%, 10% of the units in the market. It's not predominant. So I would say, again, it's -- inventories are still a bit longer than normal because lead times are still a bit longer than normal, but I would say a far better condition. And I said earlier that the industry is going through a kind of a recalibration of new products going into next year. And so I think, again, inventories will tend to be a bit deep as we conclude the year because we're hedging against availability of new product now, not just getting the old products. And so I think it's -- it will be a working capital investment, either this year and next year. Again, hard to tell, I would say, if unit growth tends to normalize next year and we get through the product transition this year, inventories will, I would say, will likely be lower next year than where we are today.

Okay. That's super helpful. Maybe we can just maybe finish up, with a few minutes to go here, on margins. Gross margins have been spectacularly strong. As the industry normalizes, obviously, investors are concerned as we go back to normal levels, 25% or so, to 29%. Where do you see that playing out today?

Yes, it's a good question. I think it's one of -- it's probably the biggest variable of improvement, that now where are we, where are we on that spectrum of performance. So gross margin in a distributor really has a simple component. Cost of sales is almost cost of goods. So there's not a lot of other overhead variances. There's no labor variances. It's what is the cost of the good, what do we sell it for. That's 98% of the equation of gross profit. So yes. Well, first, we did implement technology 3 years ago, which matured very nicely in good timing in terms of how we implement price and sustain price and creatively adopt price across different markets, different customer types, different product groups. And so some of it is certainly very permanent beyond the historical metric of 25-point something or whatever the long-term average had been. We also absolutely went to OEMs a couple of years ago, anticipating, frankly, a flat market, right? 2 years ago, we thought the market might be flat. And we needed very aggressive campaigns from our OEMs to grow. Well, that means margin. I have to be on a live chat here saying we asked for higher margins because we were willing to invest more in the market in terms of more branches, more people, more things to grow share, and that's precisely what's happened. And so it was margin well spent at the OEM level. It's in our numbers. It's in their numbers in terms of market share development. And it's ongoing. That's not a temporary condition. That's a permanent condition. So the other part of margin expansion has come from this idea of passing on price ahead of the cost catching up to it. It's worth about 1/4 of value. But over the last couple of years, we've probably seen 3 or 4 quarters of price increases. So there's -- it's not every quarter, but many quarters of benefit. And that's where we need to become a merchant next year. If we don't see the same level of price increases, either that's a risk factor in our gross profit margin, or we figure out another way or we become better merchants at it. So there is some risk. And every -- I don't care if it's Fastenal, Watsco, Grainger, POOL, all of us have enjoyed some inflationary benefit in our margin. And in our case, there are some other fundamental sustaining items beyond just the inflationary benefit that's occurred.

So it's a combination of structural and also price/cost benefits for the duration of the business.

That's correct.

That's very clear. Well, Barry, I think this is the stop. So thanks very much for your time, and great to be back here in the flesh.

Thank you. It is nice to do it in person. So thank you.

Yes. Thank you.

Thanks, everybody.