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

All right. Good afternoon, everybody. Welcome back. Next up, we'll hear from Watsco. On stage with me is Watsco's Executive Vice President and wearer of many hats, Barry Logan. So Barry, great to see you. Great to have you here in person again.

Thank you, Josh. Good to be here.

Before we get started, I do have to remind everybody, as always, if you have any questions about our research disclosures, please visit the research disclosure website or reach out to your salesperson. Barry, if you wouldn't mind just kind of giving us a little bit of a 30,000-foot view on what you guys are seeing and sort of who is Watsco. I mean I think everyone here is sort of familiar on the surface level of how the HVAC works, but you guys approach the market differently and kind of have your own growth vectors that you're focused on. So if you could just spend a few minutes kind of enlightening us on that, and we'll dive into some questions.

Sure, Josh. Thank you. Again, I've been doing this 30 years. And back when I first started, we had one conference a year we would go to. And sometimes there might be somebody listening, and sometimes there wasn't. So I appreciate, with humility, everyone coming and spending time. Yes. Watsco has been around more than 50 years. We've been in distribution for exactly 33 years. Our CEO has been with the company all this time, all that -- for that duration. In 1989, we bought our first distribution company in this industry. And we did well with that first acquisition. They introduced us to other peers of theirs. And fast forwarding, it took us about 10 years to get to $1 billion, took us 20 years to get to $2 billion. And over the last 13 years, we've grown to near $7 billion this year in revenues. So it's been a great growth story in terms of bringing together and professionalizing and adding capital to what's a very old-school industry. Air conditioning has been around 100 years. Carrier's here today, they invented this stuff more than 100 years ago. For most of the 100 years since, most of the OEMs have hired independent distributors to broaden their scope, to add capital, to develop local markets, to add contractors, have local know-how. And Watsco has done a good job of doing 2 things, really, acquiring a lot of great leaders around those markets, family businesses that have been built over 50, 60, 70 years. And then once we had scale, figuring out how to operate with scale, both in terms of growing the market, growing the business, adding products, adding technology. In recent years, last couple of years, beginning to bring the consumer and the homeowner into our circle of how we go to market and how we serve the market, which is interesting. A first for the industry, really. So the broad stroke is Watsco as both operating company in the sense of being a $7 billion company and about a $50 billion market in North America. We're acquisition-oriented still. We're still not in 10, 15 states. We still don't have representative market share in all the big markets that we would like. Where we've been the longest, Florida, we have a very dominant market share position with a very strong presence and profitability. And so there's -- we know what a mature market looks like, and we know what is in front of us where we don't have that level of maturity in all markets. To answer your question in terms of what's going on, really, COVID, when it started coming -- started happening a couple of years ago, we really didn't know what would happen. Would contractors be allowed in your house? Would contractors pay us on time? Would consumers spend money on their homes? What level of economic impact would there be on buying a $4,000 or $5,000 pair of machines for your home? So what's occurred in the last 2 years is almost the opposite of our not knowing, which is consumers spend money on their homes. And contractors who are the ones really that specify solutions and educate the homeowner on what they're buying and get the check and then pay us. Contractors have done a great job of growing their business in this environment. Our job as their supplier is to develop contractors' capabilities to do that, provide them capital to do it, provide them product know-how and technology of how to do it. And so unit growth rates over the last couple of years have been above average, if I look at a 30-year average, let's say. I think there's obviously a lot of optics on what the future might hold knowing that we've had strong growth rates over the last couple of years. The answer is we'll see. Our job isn't to wonder about it. Our job is to grow share, to collaborate with our manufacturers, to add more manufacturers and brands to the equation. Product has been hard to come by the last 2 years. It will be better to come by over the next 2 years, where we're looking to develop share, again, with our manufacturer partners. We've also -- it's a different half hour of conversation, which I'll be happy to have with anybody, where we've been investing in technologies that are beyond competitive in terms of our marketplace, highly innovative, very effective and still developing in terms of adoption and use by contractors. Masked with the unit environment that has been growing, we've also seen unprecedented inflation. And when I say unprecedented, for most of my career, we would talk about 3% or 4% price increases. Last quarter, our pricing gain was 14% during the quarter. And that's pretty much what it's been over the last couple of years as OEMs have faced higher costs, faced higher realities in their factories and in logistics and their own costs. We're more than able to pass that through the market and gain growth in sales and earnings as a result. So that's likely to moderate. None of us know exactly what inflation will look like over the next 12 months, probably more moderate than the last 12 months, right? So that will have some influence on comparisons and growth rates. But there are really 2 things that are going on that is a super, super important scorecard of what's going on. First is credit. No one ever asked about it. I've sat here in 25 meetings today. No one asked me yet, what does the credit profile of your customer look like? And the answer is, it's the healthiest we've ever seen it. Contractors are very liquid. There's almost no defaults, almost no bad debt. It is a very strong environment, telling us the contractors are still in very good shape to work with homeowners on what they're doing. And that doesn't mean there isn't moderation in front of us, but it means it's still an extremely healthy market. The other is mix. We sell consumer products 80% of the time. Someone's air conditioner breaks, they have choices to fix it, repair it, upgrade it. And we continue to see both a higher mix of products being sold in terms of price points, and we're seeing a continued trend towards replacement versus repair, which we can measure when we look at our repair parts business, which has gone on now for exactly 12 years. We've seen an improvement in both metrics for the last 12 years. So that's the present state. Future tense is be careful, be objective about what's going on in the economy. And then the other tact is some of our OEMs are here today. They're all hearing an avalanche of enthusiasm about how we can grow and what we want to invest, how we want to build larger partnerships. There's no exceptions to it. And what we're looking forward to is now they'll have product. I think they've been disadvantaged by not being able to think about growth, not having their own supply chains or their own production capabilities. That's changing. That will change extensively, I think, in the next 12 months, which is an opportunity for us to grow.

So you touched on a lot of interesting points there that hopefully we'll have time to unpack all of them. But maybe just starting off with that last point around availability and supply chain. I think if I look at your inventory or what we're able to tell from looking, hardly knowing it's kind of an imperfect data point, on one hand, inventories look high, but everyone is still sort of running short on product. How do we square those up? Is it too much of the wrong product or in the wrong place? Or is it just inflated by price? Like how do you marry those 2 concepts?

Sure. Well, obviously, if we have 14% higher sales price, it also means 14% higher inventory value sitting in the inventory. So that's part of the reality of it. The other part is lead times. I'll give you a real life example. So we have a $60 million store in Miami. It's bigger than any Home Depot, $60 million, just selling primarily air conditioning. Think about that. It's 10 truckloads of material a day that we sell one box at a time to contractors. That means we need to fulfill 10 truckloads per day to basically keep inventory in line for the next selling week. And if our vendor lead times are 10 days, we count on that. We build our safety stock. We build our inventory based on 10 days lead time. Well, what if it's 60? What is our inventory then? And what if it's only -- what if we can only have access to certain products, not all products, even with 60-day lead times? Then what do we do with inventory? We build it. And if it can't be built, we source it from our own stores and move products around. And the last 2 years, we built this immense LTL capability of moving products among our branches and spent a lot of money in a very unproductive cost way of doing so in order to take care of our Miami customers who want the product an hour from now. I mean that's the race. That's the -- that's how we gain share, is to provide that level of service. So what are some of the answers inside my story is lead times build inventory or lead times with that much uncertainty means we frankly build a mountain of inventory to protect that customer service. So that's what's been diminishing and improving over time, is lead times are more reliable, are less. Those were 2 different words, reliable and less, but not optimal and certainly not typical at this point still. So I would say that inventory will come out of the channel to the extent those lead times become reliable and less. Every distributor is going to have the same equation. In our case, we own more inventory than anybody in the channel. So this year, I think we're seeing improvement. We're seeing things that are better, but I think there's still some reality to come as lead times, again, become more reliable and less.

And you touched on the volume situation and sort of the surprise factor during COVID in terms of people replacing more and spending more on these units. And I guess we'll find out what that looks like in kind of the future state in terms of normalization. But what do you really attribute that to? I mean is it people wanted to replace because they were worried that repairs wouldn't take and it's hard to get a contractor or hard to get a unit? Like how much of it do you think was sort of psychology versus more units breaking?

Yes. I don't necessarily buy -- in our big Sunbelt markets, I don't buy the idea that people use our machines more. We didn't keep our thermostat on any differently.

I certainly don't.

Because of COVID, it stayed the same no matter what. So we even -- we're the next largest pro distributor partner. Amazon is bigger than us. We're behind Amazon, but we sell to the pros. The people actually install it. And they monitor the systems. They have data on usage, and they didn't see any drastic change in usage, and they're out there measuring it in terms of Google and Nest. So I think it really goes back to -- if I ask you the question, why did Home Depot's same-store sales grow 20%, 25%? Maybe it's a simple answer as people spent more money on their homes because they were there, and maybe it's that simple. In our case, typically, contractors are call only when something isn't working, right? It doesn't mean it's broken. I mean maybe it's not cooling right. Maybe it's leaking. Maybe it's frozen. Maybe it's off. Maybe it's not bringing it down the temperature properly. And contractors did use that opportunity to sell the systems. So I would say the hit rate, given the focus, given the climate, given the conditions and the simple fact that people were spending more money on their homes, I think, helped the replacement rates. I think it's that simple. Now if somebody would have repaired something instead, absent COVID, and maybe 2 years from now, the BAND-AID comes off and they have to replace it, I think it's that subtle. I don't think there's any real pattern of predictability or calculus that says here's what happened or what will happen in the next phase of this. I think -- I would expect some of the unit growth rate to have borrowed from future growth. I think it could be a 1-year period or a 5-year period depending on how long BAND-AIDs might have lasted. And the other thing that has gone on in the last year or 2 the cost of repairing anything has also had extreme inflation. The cost of labor for a contractor, the opportunity value of his time to repair something is worth more. And refrigerant, which is used in almost every repair scenario, has doubled in price. And the cost of repair of compressor now could be a couple of thousand dollars. That never would have been the number on the proposal. So I think, again, it's -- I argue the OEMs do not sell products. Watsco does not sell products. The contractor sells products at that homeowner level, and that's kind of where the commerce is really done. Our job is how do we empower, how do we bring service and technology and know-how to that equation at the kitchen table. And that's where I think we've gained share in the last couple of years, is being very good at that.

You mentioned sort of being clear-eyed to the economic possibilities of slowdown. What does that sort of like planning scenario look like to you? I mean we're coming off of pretty awesome growth and maybe lapping at this point some of the slowdown that we saw with the financial crisis. So 10 different models will tell you 11 different things in terms of replacement. I'm assuming you guys have your own view as well. Like how do you handicap that level of kind of peak to trough volatility?

We have to measure every market within markets, not -- certainly not a national scope. It's just like any portfolio. If unit growth was 7% this year, it was 11% somewhere and it was 2% somewhere, that's just the reality of a composite. So we look at all the markets. So Florida will be an example where I think we've been in a pattern of very steady growth over the last 4 or 5 years in terms of both price and units. And we look at Florida as how do we keep incrementally adding to our share in Florida. It's a market like the Northeast, where I think there is more exposure to this conversation, first of all, because also the effects of inflation and pricing is greater in the Northeast. There, we're pausing and saying, "Boy, there's probably a value category that we're not as well represented in, in the Northeast. How do we build that?" So that's the process we're in right now of, talking to OEMs to talking to our current partners, future partners to say, "This is a market opportunity that we sense in this market. How do we build that out?" So we recently were, for example -- a specific example, we're granted product in New York, New Jersey for Mitsubishi, the largest ductless provider of products in the U.S. They gave us that territory. It's now a $50 million business this past year in Mitsubishi products. We don't have conventional air conditioning in those locations. So that's an example where we'll talk to all the OEMs, let them evaluate the opportunity. A year ago, they told us, "We can't build product for you. We don't have it." A year later, that capacity restraint is better. And this coming season, we'll sell products in those locations alongside Mitsubishi and have business volume we didn't have this year. So that kind of market-specific discussion -- and for those OEMs that are listening, we're talking about you. And my point is that we have this opportunity coming into this year to really develop some brands and territories that have not been available to us in the absence of product in the last couple of years, and we're kind of looking forward to it.

The other thing that's been very topical lately on multiple fronts is the regulatory environment between SEER change and the tailwind from the IRA. I guess the SEER change stuff, a lot of the OEMs, and I think yourselves included, have sort of gone out there on record with 10% to 15% delta on impacted products, which I think in the cooling world or the AC world is, what, 60%, 70% of the market and maybe slightly less than that if you include things like furnaces. I guess, one, am I thinking about that the right way? And two, why is it so much bigger than the 2015 version of regional SEER standards?

Sure. Well, the big picture for everyone's sake is, first, air conditioning and heating uses about half the power in someone's home, universally. So that's always been a target of conservation. What do we do to improve energy use and given that fact? The more current other facet of this is electrification. If a large number of homes are heated by natural gas, in furnaces, or up North, you have boilers that boil water using natural gas to boil water, then circulate hot water in a home -- it sounds wildly inefficient when I think about it. Or oil, there's still furnaces that burn oil, for God's sake, and heat homes, how do we electrify that? So these are -- Europe is already 2 generations ahead of what we're doing here. And now our continent is finally advancing into some of these discussions. So in my career, we've always had 3 -- really 2 changes that have had a good regulatory thread from which pricing and profitability improves. The first is energy efficiency mandates. The government -- the Department of Energy mandating higher efficiency standards. That happened in 2015. I think it happened now 2009, I think. And it's happening in 2023, next year, where the base level of efficiency is going from where it is to a higher standard. What's bigger this time are 2 things. It's the whole market. In 2015, it was just the Sunbelt. And this is a national change in standards, which is obviously a broader opportunity. The second is that -- and don't ask me a question because I'll not give you an engineering answer, you can ask me, but I probably won't answer, I probably can't answer it, is the method of measuring efficiency has changed, where AHRI who sets the standard is basically going through a process of basically being more stringent about how energy efficiencies are met, not just at the base level, but at all levels. And manufacturers had to decide how to comply, recalibrate, either, create new products or modify existing products, all of which is free to Watsco, I'm happy to say, none of which is free to any of the OEMs because they need to spend the money to develop these products, all of which come out next year at a more stringent view where it used to be standard changes we could -- manufacturers had to stop making the product and then we could sell out of our inventory for whatever period of time it took. This standard, not all products, but for the most part, will entirely convert later this year into a new product group for all of next year. So simply a little -- the screws have been tightened a little bit tighter. And the OEMs can explain it better than me. But I think they've had to almost go through and recalibrate all their product offerings to meet these standards heading into next year. And the cost attached to that is embedded in what they projected as price increases, which -- so I've talked for like 4 minutes about one thing. The second thing is refrigerant. In my career in 2009, refrigerant changed from what had been ozone depleting to something better. That's now converting again in a couple of years. It's already started where all the refrigerant used for the most part in old systems -- not all, but most, is called R-410A. That's being phased out. The first phase-out year is this year, which is a 10% curtailment. The price of refrigerant has doubled in the last 12 months. The cost of every repair has gone up in the last 12 months. In 3 years, it will be curtailed another 30%, and OEMs can only make products that use new refrigerant beginning in 2025. If I add that to the efficiency change, we kind of like it. These things are reasons why contractors will go in and tell a consumer, "It's time to replace your system." The third is there's the new law. And these have never happened in this kind of short-term period. The third is government incentives that will underwrite part of the cost for everything I've just said. And it needs to be defined. It needs to be clarified. It needs to be made certain. But there are 2 sides to the law. There's a tax credit. So if you're a taxpayer and you install a qualified system, you get a tax credit, and it will help pay for part of the cost of that installation. The brackets around that sentence is in the phrase qualifying products. I think the industry has some work to do to basically define what that means to optimize the opportunity. Right now, I think it's very narrowly defined and a little bit prohibitive. So I think the industry will work through that and find some ground that can be meaningful. And that takes effect next year, January 1, '23. The second is more interesting in the sense of rebates. It's very rare that in our industry, a consumer rebate is offered by anyone to upgrade your air conditioning system. So the federal government has come up with a program to fund state governments who will, in turn, provide rebates in their local markets for our products, and not just our products but other products, to electrify. It could be water heaters. It could be -- the electrical panel itself needs to be upgraded. There's a rebate for that. So we'll see what it really means long term. But short term, it's a catalyst we haven't seen before, a state level, meaningful rebate. How much and who qualifies and for how much needs to be defined. I'm sure there used to be a bureaucracy set up somewhere in each state to administrate it. So there's no get rich quick here, but it should be, again, a good catalyst for and certainly a recognition of this industry. And our job as Watsco is how do we get every contractor we deal with to walk into somebody's home and be educated and smart and intelligent about how to convey it and sell product. So that's a technology story that, again, is for another day. But our technology is meant to push that into the homeowners' presence as well.

Excellent. So we're running short on time, but I do want to sort of pick your brain on one key aspect of the IRA. Do you think the incentives, whether tax credits or rebates, are sufficient knowing what we know now, there's still kind of more to be defined, to fund the difference between straight cooling and sort of the spiritually equivalent heat pump?

Yes. So in some markets, yes. In Florida, where we sell heat pumps every day, if we sell a heat pump instead of a straight cooling system, it will be very close in terms of somebody upgrading their heating source to a heat pump. That becomes trickier in Northern markets where you may still need a furnace to supplement a heat pump system. Everything up Northeast is more complex and more costly, it seems.

I attest to that.

So there, like the state of Massachusetts, for example, today has a rebate to basically -- they did it on their own, to underwrite upgrade to heat pumps. So I don't think it's just a reliance on what the federal government is doing. I think still California, places like Massachusetts, maybe not in Texas, but other markets like that will decide to provide their own catalysts for upgrading to heat pumps and get to the electrification equation faster.

Awesome. Well, we're at time. I appreciate you making the time and joining us up here, Barry, and for everyone in the room for giving us your attention here for a half hour. Thanks.

Thank you, Josh. Appreciate it very much. Thanks, everybody.