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

Everyone, why don't we get started? This is the Watsco presentation. I'm Ryan Merkel from William Blair's Research Department. Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website. With us today is Barry Logan, Senior Vice President. Barry, thanks for being here today. Watsco is the #1 distributor of HVAC and refrigeration products in North America. It operates over 670 locations and serves over 350,000 contractors. I often pitch Watsco as a buy-and-hold investment given the huge installed base of air-conditioning that's all going to break and you can't really live without it. So I stole a little bit of Barry's thunder, but let me turn it over to Barry.

Thank you, Ryan. You've been listening. I appreciate that. Again, I'm Barry Logan from Watsco. It's my 30th year at Watsco. I was the fourth employee. So we can have fun reminiscing or we can move forward and tell the story. It's a great story, I think. We're in Miami, if anyone ever wants to come down and see us and spend time now, we're opening back up and be happy to always spend time. We also -- I could give a half hour on just the technology discussion this morning. We're doing amazing things to really change the way contractors wake up in the morning and operate their business, the way they sell products to homeowners and the way homeowners are buying these products in the industry. We're in a $50 billion industry selling products. The contracting side of the industry is near $100 billion when these things get installed and serviced and maintained and so on. And we're having technology that's influencing all layers of that discussion. So again, not within the confines of 27 minutes and 50 seconds that are left, but there is a technology story here that we -- I'll touch on, but there's more to tell if you want to learn. Well, there is no presentation on the digital screen. So Barry will -- Barry will talk. Imagine a North American map for a second. Again, what we cover in terms of just general themes of investment, why invest in the company, why be a shareholder forever, why buy the stock and hold it forever? First, it is a company that's been around about 35 years in distribution. The company has been around 60 years. Our CEO has been here 50 years. Not many companies can say their CEO and Chair and Founder have been around 50 years. And the culture is proven, very basic concept. Secondly, it's a good industry. As Ryan said, everyone has air-conditioning. I am certain this June that we're sitting in, the precise number of units are going to break in the United States that otherwise would have that machines don't know the economy. They don't know what's happening in China. The exact precise number of machines will break and every machine will have to be fixed, repaired, replaced. And a contractor who is the one writing the prescription for the job is the one in charge, not Watsco, not Carrier, not Emerson, not anyone else. The contractor is the primary decision-maker when they recommend something to you. And you want it fixed today tomorrow, not 7 days from now, but within a matter of hours. So the fulfillment process, the technical knowledge, the product staging, the service capability, the delivery capability, all the nuances of how do you get products into people's homes with 10, 15 SKUs per job, but there are snowflakes. So distribution plays a super-critical role. Many years ago, one of our competitors hired a new CEO, and he promised that they would have products to contractors in 24 hours. I enjoyed that. It was exactly 23.5 hours too late. Contractors want the job in the next half hour. Good fundamental in terms of how the business operates. The third is capital, bringing capital to really an industry that today is super fragmented. There are still 1,300 independent distributors. Like Ryan mentioned, we sell over 300,000 installers contractors. There's more than 0.5 million in the United States. Because today, we don't sell to all markets, we're still building our network in other markets. And fundamentally, that capital has meant we get to sell more brands, more locations, make acquisitions, become better partners, bigger partners, scale partners to the OEMs we sell products for. So today, Watsco at $6 billion, $7 billion in size is the largest customer of Carrier, Honeywell, [indiscernible] Johns Manville, Mitsubishi, Manitowoc, others that make air conditioning and heating equipment and parts and supplies. And that scale means something in terms of those relationships and how we serve these local contractors that need product right away. If Carrier wants to grow, we buy about 1/3 of what they make globally, put that in perspective for the air conditioning side of their business. So it is a very -- it's a dance between us and the manufacturers to grow the market, and we love the fact that scale and capital matter against the fragmentation of the competition that we're dealing at. And for those that just walked in, there is no presentation, so Barry is winging at this point. The other concept obviously is the culture of our people. And we are the only public company in the space in terms of independent distribution. We've got about 7,000 employees. We compete against, again, primarily family businesses. And the culture is unique in that as public equity, we share it with leadership, employees, branch managers, truck drivers, what have you. And we did a lot of disclosure about it, and it's fun. But we just know that we do something very unique that you haven't heard before. And a lot of presentations will tell you something you haven't heard before, whether that's true or not. Well, this you haven't heard before because I can't find, I've looked. So in our case of equity, our key leaders, about 120 people get equity in Watsco, including myself, where it does not vest until somebody turns 62 at the end of their career. So you're 32, you've got 30 years to wait. If you leave, it's forfeited. If you get fired, it's forfeited. So today, we have, again, almost $400 million of equity owned by 110 people. And not the senior leadership, CEO and myself in that number. This is people running our company in the field. And over the last 10 years, we've had about $65 million of shares vest. And the -- in terms of people reaching that age at the end of their career, 9 out of 10 people stayed longer beyond that date, which is interesting. And today, we have about 94% of what we've ever issued, still issued and invested over the last 25 years. This plan started 25 years ago. So I won't go much beyond that other than to say when companies talk about ownership culture, it's something that's very unique and how we think and operate long term within our business. The other story to tell is the fundamentals of the business. So you have homeowners that own homes or operate -- people that own businesses, they call contractors. And then at the job site, there's probably 12 things that happen. Are you going to be there on time? Are you going to know what to look at? What product do I need? What technical know-how do I have to suddenly have, given the diagnosis of the job? Are parts in stock or this new equipment -- is the new equipment in stock? What's the configuration of new equipment that fits properly in the home? What other goods do I need to properly install it? What else can I sell the homeowner in terms of pitching something, a new thermostat, a new indoor air quality system, a new something, a new warranty, extended warranty, whatever it might be. So contractors have, again, are going to sell this year, about 8 million replacement systems. So 8 million times the contractor is trying to configure each and every job technically and then sell it to the homeowner. So over the last 4 or 5 years, our technology investments, and it's about $30 million to $40 million per year in SG&A over the last probably 7 or 8 years, where technology is built on that equation. How do we help the contractor technically do everything they do 8 million times. And then how we're going to help the homeowner procure those services and buy those services and products 8 million times. That's not just being a distributor. That's actually being a point of sale purveyor of these products to homeowners and businesses. It's an interesting layer beyond what we've typically done. So today, for example, 1/3 of our business runs through that first platform. The contractor buying, diagnosing, configuring, architecting jobs, buying the job from us, paying for it through his digital account. Us pick, pack and shipping it through a digital process, communicating with the contractor. And today, there's about 30,000, 35,000 contractor owners that are on that system. They employ about 8 people each, so about 250,000 people touching the technology throughout the day. But really, what we're helping is those owners operate their business, operate every aspect of their business. So that's fun. And what was mostly fun about it is the growth rate of that community, that's what it is a community, was near 30% last year. Overall, we were in the 20s if you go back and look at the numbers in terms of growth rates. So the community growing at a much faster rate and the attrition rate of that community is fractional. If you ever talk to a Grainger or Fastenal or a Pool, ask them, if you like the companies, were all great stocks and were all great companies, ask them what their attrition rate is for their customer base each year. Ask all your companies you talk to, how much of your revenue do you give up each year by the calendar flipping to a new page and assets under management attrition in your business. So in our distribution business, historically, it is around 10%. So think that if we wanted to grow our business 8% same-store sales, we had to overcome 10% attrition each year. It's a pretty remarkable number while attrition in the community is under 2%. And so this idea of not losing jobs, not losing customers, keeping customers, growing good customers, adding customers, it's pretty -- that is a remarkable scorecard on what's going on with technology. So the real key then is how do we get the hit rate or the adoption rate much higher and that's to spend more time and money. It's really getting the contractors in their everyday job to focus on it and jump on the platform. Second platform I mentioned is called OnCall Air. That's how do we begin to influence how a homeowner buys these products and services. Because heaven knows for the last 50 years, it's not a great experience. It's a contractor that you might trust, that you hopefully trust, giving you an office depot, preprinted one page thing, that says $4,800 on it, and you just want your air-conditioning fixed. Should you spend the $4,800 or not? You might ask 2 contractors. You probably won't ask 3 because that's going to take another day or two and all you have done is confused your decision. So that's been it for 50 years, selling -- contractors selling products over the last, again, 50 years. So OnCall Air is our influence on how that works. And it's a platform. It's another technology platform, point-of-sale device, it's software on an iPad or a laptop. Communicates what these specifications are to the homeowner in pictures and messages or videos, whatever it might be. There's a good, better, best aspect to the specification, would you want low efficiency, middle efficiency, high efficiency? We had a contractor that wanted to use the label government minimum efficiency, believing that homeowners really want to do a little better than that. A lot of psychology in the sales process. We're building pricing models for our customers. We're drawing on product data, availability data, technical data, permitting and zoning data, to help the contractor sit there and promise the job later today where before he couldn't promise. He had to go back to the distributor and made sure that we had these things in stock. Find out what its pricing was, so you could properly quote it and so on. So very interesting. This year, we'll sell $1 billion out of a $100 billion market on OnCall Air. So ways to go, but our content is about half of that. And last year, it was $650 million, to give you some idea of scale and growth. And again, just get the sense that taking an old school industry, super fragmented, mostly family-owned, contractor-driven and not just selling boxes at a higher margin and inflation helping. Yes, those things occur. A part of the innovation in the company right now is influencing really some of the historical means in which people buy these services. So again, there's more to the technology story. There's a pricing platform that we've introduced that's helped the margin and the pricing actions of the company. There's logistics technology that's been introduced for pick, pack and shipping more efficiently. All of this in the last 4 or 5 years. COVID had a way of accelerating adoption or accelerating the urgency of it because then we can serve customers much differently than them coming to our store or walking in, having a popcorn and coffee and shooting the breeze and having doughnuts on Friday. A lot of these technologies have helped the last couple of years' performance. We've gained share. And the margin gains are both a byproduct of inflation and structural changes to how we're doing pricing and margin development in the company. And again, those are 10-minute answers to the simple questions, which I'll be happy to give. We just get the sense of the innovation going on beyond just growing the business in the sense of the historical way of looking at it. There's a slide that I love that is interesting, wish I could show it to you, how do you imagine it, where many years ago, we wondered where our growth rate stood with total shareholder return. And again, I'll e-mail this or what have you. And because we've been telling this story this way, I'm the second IR person in 35 years to tell the story, I've been doing it for 30 of those. Manny Perez of Pool preceded me if you know Manny Perez. We still work together here. The company over those 30 years, total shareholder return is around 18% compounded. There's about 35 companies, including Pool in that community of companies. 5 years, it's 18%; 10 years, it's 18%; 20 years, it's 18%; 30 years, it's 18%. So we have a lot of noise, a lot of good questions, a lot of worry, a lot of instinct that we need to react to, given that the economy is probably going through some change. And that's fine. It's probably opportunity and risk, not just risk. So that's what's interesting for me is 5, 10, 15, 20, 25 years ago, we figured those things out and have kept our level of shareholder return very consistent. I think it's a good part of the story, a good part of the culture, a good part of this industry that we're in, where, as Ryan said, people won't live for very long without our products. The other thing I'll say is about capital structure. Again, the debt profile has never been more than 2x EBITDA in our careers ever. It's less than half a turn today of EBITDA -- of debt to EBITDA. If it was 0, that's fine with us, not because we're just debt-averse, but because we want to take big swings at large transactions when they come along. And in the middle of the recession, 13 years ago, for example, United Technologies came to us and said, "Would you like to buy our distribution business at Carrier?" We did so. And with no debt, a rising dividend and the largest transaction ever, our fiscal conservatism, if you will, meant something because we did those 3 things. We grew. We did the biggest acquisition ever. We doubled the dividend in a recession because as a distributor, you have that cash flow flowing out of your business in those circumstances. And so a little bit of the old school feeling of keep the bat on your shoulder and swing at good pitches. We must do that because acquisitions is still a component of what we do. And it'll be my last kind of concept to cover, but there are 1,300 family businesses in the industry. About [indiscernible] 100 are $100 million and larger. There are -- they are mostly second, third-generation family-owned businesses. I mean we have a target that's $1 billion in size as a third generation family business, for example, and 2 of them. And something we'll give. We don't know when or how or what it will take. But we've acquired about 60 of them over the last 30 years. We've never paid a bank -- never paid a fee, never hired a banker, never been in an auction. This is knowing those families, having a personal relationship. The manufacturer that they sell products for generally has veto power over who can buy it. So it's important for us to have great relationships with OEMs. And when those things come about, again, a strong balance sheet to make the owner content and happy about what they're doing. So we just bought a business a year ago in Chicago. I was there yesterday, here in Chicago. And the owner is second generation after about 70 years. He's in his 60s. It cannot have gone better. It is the prototype of what we want to do. If any of you are ever here in Chicago and ever want to dig a little deeper on Watsco, have coffee with this guy, Skip. You'll learn about the industry, you'll learn about our culture. You'll learn more. And Ryan, you're welcome to do that too and add some depth to this acquisition story. Because that's how Watsco becomes a $10 billion, $15 billion company, not just by growing 8% or 10% each year, but still by acquiring some of these great family businesses that are out there. And the technology enablement that I mentioned is very interesting to those owners because many of them can't see that they're doing it on their own. It's part of the interesting next 5 years or next 10 years, when I talk about this total shareholder return measuring stick that we have. So with that, any questions?

So Barry, let me start off. So there's 3 questions I'm asking on my company's. Talk about the health of the consumer, talk about inflation. Is it still rising? Are you seeing prices peaking out? And talk about supply chain. Do you have all the product that you need?

Sure. Well, the consumer -- again, this is a consumer product for us, about 75% of the time. We sell some products to the commercial market, the industrial market. But for the most part, we're selling to that replacement transaction. We certainly have seen no influence on either brand mix, efficiency mix, the pricing mix that drives revenue. We did see better-than-average unit growth for the last couple of years. Normal unit growth for the industry is in the 4%, 5% range. This last year for us was 9%. First quarter was 7%. There will be a moderation to some typical level of unit growth, but the pricing is the other side of revenue, calculating revenue, right? And we're still seeing 10%, 15% pricing benefit from the inflationary realities that OEMs have had to pass through to the market. And so I think if those were the only 2 variables, normal will look different a year from now. But thankfully, they're not the only 2 variables. We have a -- the industry is going through an energy efficiency transition next year. Consumers will pay 10% more for the base level efficiency. That's not inflation, that's a regulatory pass-through that will occur. We -- as I said earlier in my earlier comments, if the -- if Watsco is the largest partner of all the OEMs, growth next year comes as a collaboration, not just as a showing up in the market. There's a lot, lot that will go on. The second is inflation. I think it has been tempered some. And this is, again, this is the fire drill of manufacturers trying to catch up their price to protect their margin, given copper, aluminum, steel, freight, transportation, labor, even currency would play -- could play a role in that for them. And so they're still telling Wall Street about how they're capturing price and cost. As a distributor, we're just trying to capture price. Our costs do not change in terms of what we -- how we operate the business very much. So that -- again, that equation will level out. The gross margin benefit that some of that algebraic benefit that occurs will be tempered some. But structurally, we're sitting on much higher margins today than we were 2 years ago, largely because of the technology discussion that I had. Supply chain, yes, we buy $6 million of stuff or $75,000 fits in one container. And that's the OEMs and other manufacturers bringing us stuff in our stores. It is a huge math and science equation that was corrupted by slow lead times, by -- for some products where there's chips and other shortages, no availability. In the last year, that's improved almost every day. I would say it's 85% of where it should be. The good news is where we have, especially large presence in markets, we also own the most inventory in the market. So a smaller competitor was out of something or couldn't get something, we probably had it. And it's been good to have that multibrand, multi-OEM, multi-branch presence that we have kind of during these circumstances. So I would say it's 85% of getting to where it should be. So there are extra costs. There's some extra SG&A. There's some extra moving of product around. There's some inefficiency on our part that the rests in our SG&A that would mean lower SG&A next year in that respect if we see that improvement and less inventory and more cash flows next year.

And then the other question I wanted to ask for maybe folks in the room that are a bit newer to the story. How should we think about your long-term growth algorithm? Building it up, you mentioned 4% unit growth is the average for the industry. And then what long-term financial targets have you given that you can share with the room?

Sure. Well, again, if I unbundle my compounding for 30 years and look at the income statement, if you will, it's about a 7%, 8% revenue growth and about a 15% EBIT growth, and that's what's compounded for on average for 30 years. So I would say that's still a relevant bandwidth of what this industry and our business is kind of capable of on a same-store basis. Acquisitions are always chunky and never predictable, so that would be additive to that. Contribution margins in the 15% range, not the 20% plus range that we've been in for the last 2 years, but 15% over 7 years, doubles the value of the company. That's okay. And if I'm wrong, it will take 10 years, that's okay. And -- but acquisitions can again -- can be in the gaps of when there is some cyclicality going on. And the dividend, we pay about a 3% yield. We've paid a meaningful dividend and an increased dividend for a very long time. You can see it in the numbers. We want institutions to own the stock forever because they're getting it, partially a strong dividend they can count on. And -- but going back to the longer-term target is where we have market share fully developed, we're easily half the size we might be one day.

And then we just have 1 minute left. You mentioned that HVAC unit demand has been very strong in '20 and '21. What were the factors that drove that growth? And do you think it's sustainable?

Yes. Again, the driver is the contractor selling the product into the channel. And if homeowners decided to spend more money in their home, they made that decision with our contractor together. Home Depot sold 30% more into, I guess, people spending money on their homes. So that would -- there's probably an incremental benefit simply from maybe someone buying a new system instead of repairing their old ones. We saw our parts sales, for example, probably go down in units and replacement systems go up in units. That's again the -- that's not the homeowner deciding to do that, that's the contractor recommending it and the homeowner agreeing to do it. So you have the subtlety again of the contractors' influence on the end market. And so things like existing home sales can help. I think it's marginal. I think the still the bottom line is people are buying more efficient systems, more comfortable systems and a contractor is better at selling those products. And we're certainly enabling it for those that use our technology.

Great. Well, we're out of time. Thanks, everyone, for joining. Appreciate it.

Thank you.