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

All right. Moving right along here with Barry Logan, EVP of Watsco. I don't know -- Barry, thanks for being with us. I don't know if you have a couple of slides you wanted to go through first, and then we'll go from there.

Sure. That would be fine. I mean -- I don't really want to be -- do the robotic about it, just rather be interactive with you, which is fine. I'm not going to read that.

Good content.

Only 20 minutes on that.

That's okay. So maybe we'll just start with -- I think everybody kind of knows who you guys are. Maybe to start with, you guys reported recently, what have you kind of seen since then? How are you feeling about how the year is starting out, obviously, acknowledging that January and February really aren't that important months. But how are you guys feeling about things relative to when we last spoke?

Sure. Just some context, I think, is always needed in the company just to lay a foundation for an answer to that. Again, we've just finished our fiscal year. We ended the year about $7.3 billion in sales when our first year in distribution was $89 million. It was $60 million. So we've had growth through 35 years. I think 2023 was one of the 3 years and 35 years that didn't grow in relative terms. And probably because the 2 prior years had grown 25% plus for 2 years. We sell air conditioning products. We sell heating products. We sell any products that a contractor would walk into someone's home or business and fix, repair, replace, upgrade, sustain, add to any kind of air conditioning, heating system anywhere in North America. And obviously, during the COVID period, our industry, our contractor, our business, our OEMs, their suppliers benefited from kind of the people spending more money on their homes. So really for the last, I would say, 18 months, the shipment of products by distributors into the contractor channel has been -- has had declines in units, almost again for the first time we can count, if we look back in time. And pricing and regulatory measures that have been flowed through the market and higher efficiency products that have flowed through the market have helped kind of sustain and offset to lower unit volume. But last year, we finished the year again, roughly flat in revenues, down in earnings, I think, 4% or 5%, something like that, if my memory is right. And I've characterized that as Bowling 290, which is a pretty ridiculous statement, I'll admit. But I always just want to put things in context, Watsco's revenues -- I'm sorry, Watsco's EPS doubled since 2019, again, after having a 18% compounded growth rate for 30 years with that in perspective. It doubled in the last 4 years until 2023. So that's what a down year looks like, 2023. That's how I would characterize it. And so the fourth quarter and the first quarter, which is what's a little bit -- what Steve is inferring, tell us how it's going, despite the fact that it's the slowest time nonseasonal period of the year, and so I'll give it a shot. That's my foundational rambling and abstract thoughts, building up to an answer to your straightforward question. So the concept really is that, again, the consumer has slowed down beginning 18 months ago in terms of just relative reality, right? That was just going to happen. And I think we've held on pretty well in terms of margins and growth rates. So we're in a period now where it certainly -- we characterized it in the fourth quarter as stabilizing as opposed to further destabilization. We said the consumer is stabilizing pricing margin. Things seem to have been stabilizing over the last half of last year. I would say the same thing sitting here in the middle of March. I'm not commenting on the first quarter because March is half the quarter. We began a real seasonal ramp right now through the summertime. Our business is 30%, 40% larger 60 days from now in terms of just pure seasonality. And in fact, July's EPS is double March's, so this is a very seasonal business in relative terms. And any commentary I make now, you cannot project into the summertime. But again, succinctly more stable versus unstable.

So I guess from a volume perspective, how do you guys see the year playing out at this stage of the game, maybe just break down price volume and mix as we look out to '24 if we're not talking about the first quarter here.

Sure, I can context. So in the slides that I could show you, the 30, 40 or maybe even 50-year compounded growth rate of units of this industry, I can't remember how many years I put on the slide or the point of drama, is somewhere around 3.9%. That's the compounded rate of units for, again, 30, 40, 50 years, whatever I put on there. And I mentioned in the last 18 months is down. And that's, again, a relative strange period of time to even talk about relative to anything in the past. And so if I look forward, I will say I'm not any smarter today in the middle of March than in the middle of February when we did our conference call to suggest unit growth this year. I'm not -- we're not at a point where we can project that. I would say I'll be very smart in 60 days and can be more conversant about it. But I think our assumption is relative to flat unit growth this year, just to organize ourselves and organize our mindset properly in terms of how we price products, how we look to capture the price increases, the OEMs have going on. The way we're looking to manage our operating costs, looking -- as frankly, if it's flat units or down units, we're doing less transactions in the field. That's an SG&A operational efficiency opportunity, for example after -- [indiscernible] over the last 2 or 3 years. So we're looking to reduce operating expenses, especially over the remainder of this year. It also affects how we deal with our top 10, frankly, manufacturers. They're not just equipment OEMs, they're all types of OEMs. You never ask about Manitowoc. I don't know if you covered them or not. That's -- we're their largest customer, too, for example. So that's an example of a vendor where we've been given more territory. We're going to have more sales. We're going to build their brand in more markets and we're already, again, their largest customer. So this is the time where we can go after really our top 10 large relationships, our mega relationships and ask how do we build share? What can we do together? Here are our 52 ideas? What are your 62 ideas and let's prosecute that in the market. And so again, I hope this year, I expect this year to have some market share gains just through that energy that's flowing into the market. I mean Dover spoke earlier about distribution, cost of capital being 8%, 9%. Our competitors are financing their business at 8%, 9%. He's right. Watsco has no debt, or cost of capital is 0 to conceivably finance our business. So I like 0. No debt is a good thing to be in this posture right now of how we're going to grow and what can we do and what companies can we acquire and so on. It's a good offensive position to be in.

And then as far as the price flow through this year and the mix impact, at least in resi, what do you guys see from that perspective?

Yes. The manufacturers again, as a community came out this year. I would say the range of -- the composite range across OEMs was a 4% to 6% price increase. That's largely residential products, some light commercial products in that mix. The other products we sell about 30% of Watsco is 80 other product lines, not really affected by what I just said. But 70% of Watsco is equipment and I'll call that the aspirational pricing range that the OEMs are looking for. I've said somewhat historically, if it's half of that, that's probably reasonable to consider as a range of price and the big picture. Some pricing actions came in later this year in April -- I'm sorry, in March and April. So the benefit is more March and April beyond. And then the other mix discussion is this, that last year 2023, the minimum efficiency of equipment change to be a new base layer, if you will. And that base layer today is about 85% of the market. And that's an unconventional position to be in because usually, it's a richer mix of higher efficiencies in this industry. So as that regulation occurred, it tended to settle the mix, if you will, maybe not a headwind, but certainly, the mix is at a very low point in the long-term cycle of mix. I would expect mix to have a bigger impact on -- and that means selling higher efficiency systems throughout the channel. That means contractors go into your home and telling you, you should really put in 16 SEER, not 14 SEER, and here's why. And that's a 10%, 12% higher price. When a contractor successfully does that and buys it from us. So mix overall is, I think -- I hate the word tailwind, headwind. I don't know what else to say at the moment, but it's a benefit that can occur, as I see it over the next few years because we're at the baseline of the minimum efficiency at this point.

And are you seeing anyone at all from a timing perspective or maybe not time and get aggressive at all on price to mean their volumes are down. They have added capacity. Anybody at all putting promotions out there to try and get you guys to take on some inventory or anything like that.

Yes. It's good. It's a good analysis. So yes, we do want to again defend our product availability as we enter this season. We want to use our balance sheet. We want to compete in some measure with our balance sheet. So inventories have been built as we've started the year. I would say nothing that's outrageous or material in the sense of -- but we did want to take a stand this year as we entered the market let's just get -- maybe have a little better price as we enter the season, but I wouldn't characterize it as buying forward. I would characterize it as billing inventory this year. We're not in the same position availability as last year. It helps price. But mostly, it helps the competitive condition as we push this through channels and [ season ].

And you're saying, what do you mean by a little bit more aggressive on price, your -- you wanted to get a little bit better price from the OEMs early on?

That's correct or -- the price increase. As I said, if something is effective April 1, we're making a decision in the first quarter so what we take delivery of and we can have either a more competitive average -- weighted average cost or a more profitable weighted average cost in our pocket as we go through the season.

Right. That makes some sense. Are all the suppliers now on a level footing when it comes to the products that they introduced last year. I know [ REEM ] had some challenges delivering. Are all these products now on a more even footing or is there still some dislocation and where they are with their technology?

No, I would say it was equal footing since last October. So 6 months later, I visited our largest green location a couple of days ago in Miami and some -- I don't know if any of you were there on one of the other analyst field trips or not, but there was adequate and absolutely beautiful inventory sitting in and what is a $70 million store selling our products and average Home Depot is around $45 million. So in perspective, we have some very large stores in Florida selling that brand and very well positioned with inventory.

Okay. So they're much more even footing now. As far as the commercial market is concerned, some pretty still robust shipment numbers, backlogs may be normalizing a bit, but perhaps some dynamics in the second half around the refrigerant transition, school funding rolling down? How do you be the light commercial markets for you guys?

For us, we're in a few businesses and the businesses are primarily smaller commercial, light commercial, smaller businesses, smaller applications, rooftop units. It's around 15%, 20% of what we do, again, to put it in context. And for us, it's probably been a 10% to 12% compounding growth over probably the last 3 years, if I neutralize the highs and lows in that analysis, probably half price, half units. So I think there's still an inventory build that needed to occur last year in the distribution channel to serve the aftermarket, to serve the replacement market, to serve the backlog that had been built. I would say it's smooth and steady, nothing choppy or out of the ordinary. And in that business side again, it seems like business as usual, Steve. I don't think -- again, I keep it simple, is it volatile or stable? It seems more stable than volatile at this point. We're also in the VRF business. VRF is ductless commercial products. Mitsubishi would be, for example, one of our largest vendors, top 10 vendors that makes that product for us. It's been a 10%, 20% grower for, I feel like, the last 10 years. And not because of just Watsco selling it but because the contractor acceptance, the architect community specifying it, engineering community specifying it, it's almost been a relevant what schools or data centers or other verticals are doing, it's simply a more accepted product over time. And we've expanded that relationship degree in China. We've expanded that relationship throughout our carrier network. As they look at Toshiba potentially as a product group within that, that's a long-term another brand that we could conceivably sell. And it's not -- again, not just because of what we're doing, it's the acceptance of those products throughout the channel.

Great. Pat Baumann from my team does all the distributors. I don't know, Pat, if you had anything for Barry at all?

Yes. Maybe just switching really quick to the HVAC products segment. I know it's 30% of what you do. So the Ferguson reported last week, and they talked about that parts and supplies business growing 15% for them in the quarter. They're seeing good growth in that aspect of the business as we're seeing some consumers opting for more repair versus replace. Just curious if you're seeing any of that in your business. It's hard to tell always like what's volume, what price in that side of the house for you guys?

Sure. Well, 30% of again, of what we do is non-equipment, just call it that, everything but equipment. It's the grocery store. If you came into one of our stores, where there's 80 different product lines, thermostats, copper tubing, tools, refrigerant. We're next largest distributor other than Amazon and Home Depot, for example. So that non-equipment product is everything, but equipment. And there are 2 kind of families of products within that, replacement parts would be one. Replacement parts for Watsco somewhere between 5% and 6% of what we do in total. And that would be an example where in Miami, we might have 25 competitors selling motors or compressors or something to fix in air conditioning system. And I would say, again, looking at the data and knowing the data, Pat, I don't see -- we've said this many times in recent discussions, we don't see any large conversion of or, let's say, growth in our parts business -- replacement parts business versus new systems. That's not something that we necessarily expected to see because of all the regulatory change in front of what's going on, contractors would still rather not repair an old system and keep it going. It has to also depend on what the homeowner wants to do. But again, in the data, we're not seeing any big migration or change one way or the other in that segment of our business, where we see the greater kind of volatility. And I don't know what Ferguson's sales are of other building products, for example, it could be installation products, it could be ductwork, it could be anything going into the building trade or the commercial building trade or the industrial building trade. I suspect that's part of the growth that's being discussed there. I don't know for sure. I would say we're less proportionate in that environment than they are in terms of business mix. I would say we're probably more residential-oriented when it comes to those types of products. I don't know. But again, I would say, better -- the trends are better than versus being worse than what we saw as we ended the year. And pricing and some of the irritants that affected that business last year seems to be less. But again, it's early in the year. But just for example, I would say 95% of what we sell is to contractors, somebody in your house or business doing the work versus, say, other competitors would be more in an industrial channel, a facility's management channel, almost a different channel than the pure contractor channel. So there's some business differences and the comparison.

Understood. And then everybody's favorite topic on gross margin.

That's my favorite topic.

Can you just talk about the confidence you have in this year being at 27% from the fourth quarter, that was the 25.8% that you reported. And what gives you that confidence?

And then maybe just talk about the -- how you see that sequentially kind of moving through the year, that trend?

Sure. Again, contact. So 10-, 20-year average gross profit at Watsco, somewhere right around 24.5%, 25%. And it's a very fair analysis to ask the question during COVID, it ran up to 27%, 28%, I think, even 1 quarter, pushing 29%. And 300 or 400 basis points of gross margin expansion in the distribution business that started out with 8% EBIT in that analysis. It's a pretty important question, right? I'm not going to like mess around with this very much. It's an important analysis. And so the components of what benefits occurred to drive a higher margin, are they sustainable? Are they structural? Are they temporary? Or do I say, transitory. I don't feel like saying that word. And of course, like any business, like your own portfolio, it's all of the above, right? I wouldn't -- again, this is -- needs to be a balanced concept. So for us, what's the structural side of it is, we did deploy in 2019 a massive campaign, a massive piece of software, a massive cultural change to improve pricing without having any clue that all the aspects of COVID was about to occur. I'm glad we did it because it helped us prosecute pricing throughout super high-volume number of changes in the market across 200,000 SKUs, across 1,000 vendors that were raising price or changing price multiple times per year instead of once or twice. So in that environment, there is a structural benefit to what is essentially a structural piece of software and a cultural change to accomplish that. I can't really put a number on that. It's helped us bolster our mindset when we communicate 27% as the target margin for us not retreating back to where it was pre-COVID. Another part of the structural mindset is working with our customers, working with our OEMs, converging really pricing on both sides of that equation to gain share really on behalf of ourselves to help our OEMs gain share and also help our contractors gain share. Our job is to do that. Our job isn't just to grow carriers business, is to grow our customers' business that we benefit from that through the channel. And if pricing and margins were not enough essentially to invest enough in that. It affects the growth rate. And I would say 4 or 5 years ago, we really went on a good campaign to kind of change the mentality or change some of the dynamics and now going to be abstract when I say that to help improve margins so that we could invest in more growth, and we did. And again, that's a half hour answer condensed into 30 seconds, but it helped margins structurally. So that's how we bridge Pat, getting on an annual basis from where we were to the 27%. There's also a technology story within our technologies. And again, it's a long answer. What's transitory, what's temporary, what's risky, what's tricky is what every other distributor you cover and you ask them the same question, and you get a variety of answers. I'm sure still over what are the effects of inflation because distributors like inflation. We can raise price ahead of pricing increases, ahead of our cost increases and gain a little bit of margin that way. If it's inflationary environment, we can try to raise price with the market and maybe not incur as much of a cost increase through our OEM community. We can be merchants in other words. And to the extent there's less inflation going on, we have less opportunity to do that, and there will be some impact on margin. So I hope those broad thoughts make sense, call me if they don't make sense. It's an important answer. It's an important analysis and talking about Watsco. So when we're below 27% as we were in the fourth quarter, it's because there's really the absence of those inflationary kind of benefits that we see. We talked about that in the fourth quarter. It was 100 basis points of quarter-over-quarter change in gross profit was because there really was no inflationary benefit to the fourth quarter, as there had been in the year prior. And those waters are much smoother today than they were over the last 24 months. In the way we would expect to prosecute margins higher than 27%. The rest of the year is because of the timing of a lot of these price increases that the OEMs have put in and then our own block and tackling, our own technology, our own cultural things, our own things we're trying to accomplish to raise margins. So I'll leave it at 27% for now, Pat. I think in the short term, the absence of pricing actions is -- would be less than 27%. The presence of pricing actions makes it more than 27% as a composite. That's our target for this year.

So I guess though first quarter relative to fourth quarter and then that sequential ramp, I mean, like is it an inflection in second quarter because you're getting these price increases?

Yes.

An inflection. So it's going to be -- it's possibly above 27% in second quarter?

Yes.

Okay. Any other questions? I think we're out of time here. They're running the clock differently this year. So Barry, thanks a lot for your time.

Okay Steve. Thank you.

Thank you.

Thanks, Barry.