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

Good morning. We are here with the 10:30 session at the Jefferies Industrials Conference. We're with Watsco. Today -- I'm Chirag Patel. I'm on the machinery team here with Steve Volkmann covering the space, and we're happy to introduce Rick Gomez the Vice President of Corporate Development here today for us. I think Rick has some opening comments, and then we'll jump right into the fireside chat.

Good morning. Thank you, Chirag. You're a good stand-in for Steve. So great to be with all of you, and nice to be at one of these in person and actually interact with folks and get back to, hopefully, some sense of normalcy here. Keeping it true fireside fashion. We have no slides. So I'm going to just introduce say a few words about the company and we'll turn it over to Q&A. So first, Watsco is the largest distributor of HVAC/R equipment supplies and parts in all of North America. We are a company run by entrepreneurs and built by entrepreneurs. Our Chairman and CEO has been there for 50 years. We've acquired about 70 market-leading businesses during that period of time. And in the vast majority of the cases, particularly in the recent ones, all of those entrepreneurs have -- are part of our senior management and our senior leadership team today. So those 70 acquisitions have given us a scale that is unrivaled in the industry. We have 673 locations in the U.S., Canada and Latin America. We sell products for all the major OEMs in our industry, both domestic and international. We have the most diverse and broadest product array of any distributor on planet Earth in HVAC distribution. And our business and, really, the industry is powered by an installed base of about $110 million residential systems, all of which have to be serviced, repaired and eventually replaced. And in our investor presentation, you see what the trends are in term -- in that installed base -- and I'll spoil the fun. It only tends to go up and especially the markets in which we are in. About 2/3 of our business is in the Sun Belt. These are structurally higher growth markets. They have seen both an expansion of residential new construction as well as new inflows of residents from other parts of the country. And so we like the markets that we're in. We love the products that we sell. And keep in mind that generally speaking, what is driving the need for our products is a homeowner that has had a critical failure in their heating or cooling system. And so there's very little discretionary replacement. There's very little waking up one morning and decide that you need a new system. What really powers our industry and our market share development as a distributor is the churn and the reality of 110 million systems in the U.S., all of which need to be, as I said, serviced, repaired or replaced at some point. And what's also interesting, I think, about our industry and our role within it is that, historically speaking, regulatory change has been a benefit, has been a positive. We have 2 important regulatory changes coming up, one in 2023, one in 2025. I'm sure Chirag will ask a few questions about them, so I won't go into too much detail here. But just know that those changes have historically been supportive of demand in our industry. And then the last thing I'll say is I think, a fundamental thread of our success the last several years and what we gauge to be a critical differentiator going forward is a technology platform -- various technology platforms that we have built to bring the industry and contractors who serve you, the homeowner, into the 21st century. The homeowners are largely there. Distributors and contractors are not yet fully there. And so we've developed technology platforms that make it more productive for those contractors to do what they do, which is ultimately to satisfy our homeowners need. And we've also developed a technology that helps them interact with consumers and homeowners and do their jobs, as I said, more efficiently and grow faster. So today, we have roughly 30,000, 35,000 active users of that technology. The results are terrific so far, and it's emboldening us to do more. And I think -- it is not an understatement to say that we take ourselves out to be changing the way an industry operates with some of this technology. So that's a bit about us, and happy to start Q&A.

Absolutely. All right. So I guess we can just start with the -- what we're seeing currently. We're one month in to the summer, a very hot summer. And just kind of getting your feel for whatever we're seeing currently through July. I think A.J. had talked about high -- a mid- to high single-digit growth in volumes here. Just, what do you see on the residential side? What do you see on the light commercial side? Take us through your current state of affairs.

Sure. Well, for those of us who don't live in the Northeast, it's been longer than a month in summer. It certainly feels that way for us in Florida. And so yes, for those of you who don't know the story, our -- we do operate in a seasonal business where the second and third quarter are the seasonal peaks. And then first and fourth quarter tend to be the heating season, which matters a little bit less to us. But yes, the second and third quarter are really our season. And we have to say we're encouraged by what we see. July ended pretty much exactly as we described on the conference call. Units were up in that high mid-single-digit area. And pricing is still very much intact, which is to say that the pricing actions that our OEMs have undertaken have been successfully passed through the channel. And residential demand, at this point, appears to be holding up quite well. We do have a healthy consumer that backstops all of this. And it is that consumer that decides, really, when demand is created and, really, how that demand gets fulfilled with what types of products, et cetera. With the contractor, obviously, being an important ingredient there. So I think most of you know, what we sell is not something that a homeowner can easily do themselves. And so the power that the contractor has an immense influence over what gets sold, when it gets sold, how it gets installed, et cetera. And so that distributor-to-contractor relationship is incredibly important because, generally speaking, the homeowners don't have a sense of how to go about repairing or replacing their systems. And so the trends so far are good. You asked about light commercial, light commercial is also trending positively. It has been slightly more impacted of late by more of the supply chain challenges that all the OEMs have called out. And so -- but it's still in positive territory. And there is demand there that we'll have to get fulfilled at some point. And so it'll -- one of the interesting things about, I think, our space, and this is not just true to Watsco, but true to the entire industry is usually, demand can only be deferred for so long. I don't know too many people that will defer cooling in the summer and heating in the winter. And so again, back to the elasticity and the nondiscretionary element of what we do, it mutes volatility and it also -- it helps performance overall.

Very good. And then, I guess, as we're thinking through the next iteration of what's happening here in the overall idea. Just trying to get your thoughts on the cycle itself. We've had 2 very strong years of residential. What are your thoughts with regards to volumes as we're getting into '23? There's a [ CO2 ] change happening, we're going to hit on that in a second as well. But can you just walk through the thoughts on the cycle, basically, and how you guys kind of think about it as we move forward?

Sure. Well, a lot of ink has been spilled on this subject. And -- we're all looking into a crystal ball and trying to hazard a guess. I think the first thing I would suggest is that we should not think of it as one cycle. I'm not sure there is such a thing as one residential replacement cycle. There are many cycles happening throughout the country depending on where you live. Average useful life is not 1 average, it's the sum of a lot of different regional variants that influence that equation. So in Florida, for instance, which is our biggest market, our largest single market, average useful life in Florida is probably 12, 13 years. And so if peak housing was 2005 or 2006, then it stands to reason, we've probably seen the bulk of that impact already. And you can look back at our financials, nothing cratered. Doomsday did not show up. We managed through it and volumes flattened for a period of time. They never went down materially. Why is that? It's because -- well, today, there's millions more homes in Florida than there was during 2005, even though we had the Great Recession and the Housing Crisis, Florida has been a high-growth state. Texas has been a high-growth state. The Mid-Atlantic have been high-growth states. And in those 3 regions, I've just outlined the majority of Watsco's business. So where you are matters in terms of how you think about the replacement cycle, demographic flows matter in terms of how you think about the replacement cycle. And if we are in a dynamic where more consumers are spending more time at home, I don't know about you, but no one that I know is back in the office 5 days a week if you work in a traditional corporate office. It means that maybe we shouldn't rely as much on historical models that -- to influence the future. And then you mentioned rightly, the regulatory change, all of that, too, influences, really, the trajectory and the cadence of when units are repaired or replaced or not. And in the case of our industry, we have, as I said, 2 upcoming regulatory changes that will be meaningful. And so I -- the replacement cycle matters, yes. 80% to 90% of what we sell is due to some sort of emergency or critical failure at the homeowner or the business owner level. But that doesn't mean that drives 100% of the demand that we see. Things like existing home sales also influence demand. As I said, population flows, residential new construction, et cetera. So it's an important factor. It's not the "end-all be-all," in what drives demand.

And you talked about the idea -- well, the majority of your sales are in that Florida, Texas, Mid-Atlantic, can you be a little more specific, kind of ballpark as 2/3? 1/3? How are things kind of shaking out between the regions?

Yes, that's exactly it. It's 2/3 of our revenue are in the Sun Belt. That's how we describe it. That includes the Southwest and Southern California. That's where 2/3 of our revenue lies. That's where we historically grew up as a company. And of late, by the way, we're still not in all 50 states. I think we're represented in 40, 43 of those -- of the 50 great states. And so when we aggregate our presence and our market share, it's about 15% in residential units and 20% of the markets that we are in, which is to say there's a lot more to do, both organically in the markets that we serve and inorganically in the markets where we're not in today.

And I guess we talked a little bit on the cycle with the idea of volume, but the other aspect of this is all that pricing that we've seen. And it's been a significant amount in residential. How should we be thinking about that potential carryover impact in pricing as we move into next year? Are there other additional pricing actions that are being taken on the residential side this year? Or is it more like commercial? Just kind of walk us through what's next on that front.

Sure. Yes. Like most industries, we've seen inflationary levels that we haven't experienced as an industry before. And the cadence of price increases throughout the year has been incredible really. And so that's really been introduced by the OEMs who are trying to defend against higher commodity costs, rightly so. And so I'd like to say that an OEM will always think about margin and price in percentage points. A distributor thinks about it in basis points. We don't have a factory margin. We have something less than that. And so margin and pricing is critically important to us as a distributor. And so there has been price that has helped any distributor. I don't care what vertical or industry you're in. Inflation has helped all distributors. We sell -- if we sell the same number of units for a higher price, and that's good for earnings, obviously. And not everything in SG&A reacts at the same time. And so you're able to harness some earnings leverage in that scenario. So this year, there has been positive price. Last year, there was positive price. The OEMs have begun to announce pricing increases for 2023 as a result of the regulatory transition and all signs point to there being additional realization as a result of that in 2023. And then you have to look again at 2025 and start to peer through and imagine what might happen with the refrigerant change and what that will entail for units and pricing. So Again, back to the threat of -- the regulatory environment is generally positive for our industry. One of the ways in which that manifests itself is that there is a slight upward bent to pricing in our industry and rarely, rarely is there ever deflation in the channel. And as I said, the distributor will be the last to introduce deflation in the channel because we think of -- we think of things in basis points where --we don't have a factory margin to help us. We've got smaller margins that we need to get by on. So it matters at the distribution level. And we're very protective of price.