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

[Audio Gap] 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, Executive Vice President. Watsco is the #1 distributor of HVAC and refrigeration products in North America. It operates over 670 locations, serving over 350,000 contractors. HVAC is one of the best markets that I cover because there's a huge installed base of equipment that is all going to break and need to be replaced. With that, let me turn it over to Barry.

The first time I did this, it was at Investor Conference in the Plaza Hotel ballroom. I followed Nokia and the 500 people listening to them, 497 people left and 3 people listen to me. So I have that humility whenever I do this. I appreciate you being here and wanting to listen and learn and it's a great group here, so I appreciate that. I've done this job when no one was listening, so I appreciate it. First, just in general terms, Watsco has been around about 70 years. Our current CEO bought into Watsco at age 32, 52 years ago. I've worked with him for the last 32 years. Hardcore entrepreneur, raw entrepreneur, wonderful entrepreneur. And when he got to Watsco was doing about $4 million or $5 million of revenue, pivoted to distribution in 1989. So the zero state of Watsco started in 1989, and the story you hear is since then. And so here we go. The -- in terms of just the market itself, it's a very fragmented industry, about 1,400 independent distributors, selling about $60 billion of stuff in North America. We are the market leader. I'll give you some insight into kind of what means, what that looks like on the graph. But we've been the leader for a while at about 10 years to get to $1 billion, took us less than 10 years to get to the second billion. Fast forwarding, we're now about a $7.5 billion industry with 12% market share, and there are still markets where that are zero. We have markets still that we are looking to pioneer in our strategy. We just got to Chicago actually 3 years ago in our growth strategy. So I'll tell more about that. But yes, we're the leader, but still a very fragmented market and something we're going to keep building and don't have to change our tune or scope or culture or much just kind of keep pushing and shoving and trying to benefit from the scale that we've built. Part of that concept of evolution and scale has also come through technology. Much of our technology beyond ERPs was built in the last 5, 6 years. I'll talk about what that means, what it has meant so far. And again, a lot of stuff in front of us in terms of how our technology and scale and investment and innovation, all cliches play out but has pretty profound the last 4 or 5 years. And I feel like we're just getting started. Ownership culture, I'll describe to you what is a very unique way. We look at equity within our culture. We're unique is way overused. Unique means one of a kind. And what we do isn't one of a kind, and I'll show that, explain that and get -- you can get a sense of entrepreneurial culture when I describe it that way. In terms of being the scale leader in the industry, it also gives us access to OEMs. About 10 OEMs represent 70% of our business. There are about 900 others that we do business with. But that core group that large OEM, that large category kind of OEM in this industry is our largest partner and we're among their largest customers. So in growing and gaining share and investing, in co-investing, we're doing it amongst the leaders as the leader. And we see a particular advantage and moat built around that concept of truly collaborating and partnering with the large players in this industry. In terms of the track record, I'll give you a sense of our shareholder returns and what it looks like over a 30-year period. There's a good punch line at the end for stock pickers in the room, and I'll let that sit there. And our capital position, we have no debt, a lot of cash. We've built a great company. And when I say low leverage, I mean no leverage at this point. And so we can keep growing, keep thinking, keep imagining and have a powerful balance sheet to do most anything with. What do we do? We wait for air conditioners to break, it's like a cartoon here. I need to get a video of this. The installed base of air conditioning systems, Ryan's point, over $100 million, about $110 million to be exact. They're all going to break. Every homeowner is going to want it fixed right away. No homeowner can do it themselves, they must rely on a license contractor to go do the work. They want it fixed in an hour or 2, not -- no later than tomorrow. And the contractor gets probably 15, 20 things from us for every job they complete, and they need it all today. They need it later today. And again, if I start talking about technology as a ahead of time here, how do we help a contractor do that every day, how do we help them do 4 or 5 jobs a day, how do we help them run their business? How do we help them price their products? How do we help them get more business? How do we help our manufacturers have access to that in a more important strategic way. So the contractor is at the core of this industry. Watsco is not at the core. The OEMs are not at the core. The contractor is the core of the industry because that's the person that sells you the product, that makes you happy, that pays for it. That really is the catalyst for what happens, and they write the prescription for what happens in a home. So I like it that that's our customer. I like it that we're that close. I like that our technology is being infused in the daily life of that contractor. So yes, it's a cartoon, but it's a good point to understand really how we're approaching the market and where we're making investments. Where we are today, as Ryan mentioned, about 700 locations, mostly in the United States, a little bit in Canada. We export to Latin America. We have some stores in Mexico. We're happy with the election there. That's one of the highest growth, highest margin markets we have, albeit very small. And -- but it's something we represent and you can get a sense of density, especially in the Sunbelt, especially in the Southeast, Florida, for example, where we started in 1989 is about 20% of Watsco, over 100 locations, 3 or 4 different manufacturers, 10, 15 different brands, dominant market share. And I wish the rest of Watsco looked like Florida. But it's where we started, it's the most kind of mature example of what we can achieve in other markets. And again, we're building out our network far from where it should be. So despite the humility of that, this is the anti-humility slide, which says we're the biggest. And at least, I admit it. So again, well approaching $7.5 billion this year, next largest competitors, a few of them you've heard of, Lennox is there. They distribute their own products in this industry. Ferguson, actually reported their earnings today. They have a component of Ferguson, which is HVAC. And beyond the few of us at that level, it drops off pretty quick. And if I get beyond player 5, it is all family businesses. The next 1,400, if I could put 1,400 graph points on this slide, they would all be independent, family-owned, local businesses. Some of those local businesses do $300 million or $400 million, some do $30 million or $40 million. So that's our target audience for acquisitions. We've done about 65, 70 acquisitions over the last 30 years. I never hired a banker, never payed a fee, never been in an auction, never been in a process. This is going to the owners, building personal relationships. We bought the Carrier distributer in Chicago, for example, 3 years ago, a $200 million business that's now approaching $300 million. One family owned it for 90 years. Skip Mungo principal that we acquired it from still operates the business for us. Skip's our greatest advocate and talking to other owners. We keep the name, we keep the people, we keep the culture, just build on it. And we have a collection of really impressive and I think long-standing distributors that we own that come together as Watsco. It's a community of distribution that's called Watsco but all locations are called what they've ever been called for the last, again, 30 or 40 years. With scale, obviously, comes capital. With scale comes talent and wherewithal and the ability to invest and the ability to add technology. But scale also helps us with the manufacturing community. We're that much more important partner to the manufacturers who make products who want access to the market. And that's a critical partnership, critical collaboration and understanding this. So if any of our manufacturers want to grow, and have to grow, we can be their primary conduit with which to collaborate and do so. So it's very important just a point to make. Overall, it's still a peculiar industry because it's not very disruptable. And I put barrier to entry at the bottom of the slide. That's really a disruption editorial. Contractors are the only ones licensed to do the work. To be a contractor, you have to go get one. And you won't get a permit or zoning won't allow it or we won't sell it to you unless you have that kind of licensing in a market. Also to enter distribution, you've got to convince an OEM you can be one of their distributors. You can't show up with money and pay for it and be in business. OEMs have veto power of who could buy one of their distributors, if they want to continue the distribution rights or not. And we think there's a lot of affinity in this industry. Contractors buy from us because of our relationships with them, the affinity that's been built up. One of our business units called East Coast celebrated its 70th anniversary this year. There's a nice video on our website about it. We bought them on their 50th anniversary 20 years ago. There aren't many acquisition strategies that talk about sustaining legacies like that. And we built our company, attracted other sellers to join our family. And again, scale and barrier to entry, things like that are important things for you to know. Markets. We talked about the U.S. being the primary market from perspective, about 2/3 residential. The rest be residential replacement products, 10%, 15% new [ housing ] air conditioning or heating products into new homes and not just the equipment, but everything else that goes in to the home. Commercial, 15% to 20%. I would say commercial has been growing at a faster rate because some of the acquisitions we have made have a nice component of commercial to it. The Chicago guy that I mentioned that we acquired is probably 50-50 residential-commercial in this market. So that will be something that we progress based on how we acquire business in the market. But it's become more balanced overtime is my point. And as far as the end market goes, again, residential replacement, that 65%, 70%, that's probably 75%, 80% of the earnings we make. And that's those systems breaking one at a time and replenishing and helping contractors kind of do the work. My favorite slide -- maybe my second favorite slide. I like the stock picking in one later on. But this is the installed base. The installed base has never gone down. There will always be more people. There will always be more machines. There will always be more that break and conceivably more will be replaced over long periods of time. And I break out in the slide below industry shipments and housing, just to get a sense of over time, I used to get a lot of homebuilding calls in 2006 and '07, say, what's going on? And even then, maybe it was 20% of the market, now it's around 10% of the market. But the replacement market is where the money is at, where the energy flows and, obviously, where the stability lies in the slide. But at the bottom of the slide, I just want to cover this, 3.9% growth rate in shipments, in unit shipments, over 40-plus years. Again, that's that simply the population consuming these products. It's the Sunbelt migration that's going on for 30, 40 years. That's still going on, building markets that use air conditioning in every home. Again, a lot of good fundamentals, and this is an industry slide as much as a Watsco slide just to get a sense of that over a long period of time. Technology. So I mentioned that the prior slide shows about 8.7 million units were sold in the industry. We sold close to 20% of them, put that in perspective, okay? and every contractor went to homes to do that. Every contractor went to a business to close. Everything the contractor did was to get the job, to do the job well, to do the job accurately and do it quickly. And historically, technology meant more phone lines. We would have more people answering more phones to handle more contractors calling us. And when Nokia came out with the flip phone, remember that? For those of you that old enough, the walkie-talkie phones, it didn't need to be plugged into the wall. That was good. That was cool. And then cellphones, yes, let's get cell phones. So for much of my career, getting more -- I'm having fun, getting more phones and getting more people answering the phones was technology. And of course, with the cloud and with mobile and with this whole proliferation of technology that we use every day now, we had to find out how do we apply that to our business, how we apply it to our daily life. And so we started with just simply how we make it easier to do business with us. So we went to all our OEMs, our first idea was let's get product information on everything we sell. We want to create an Amazon-like experience for everything we sell. So we went to Carrier, Honeywell, DuPont, Owens Corning and said, give us the product information on every product you've made for the last 10 or 15 years. And we're going to put that into a database, make it searchable, help our customers find your products. Not one of them said they had it, and not one of them said they would give it to us. They did. So we had to create and this like and push and shove and finesse, and we couldn't threaten our manufacturers to give us that data. We have that data. There's over 1 million SKUs in it. We have the same quality of product information that you would find on any website for our industry, and no one else has it. It's not on a balance sheet. It was all SG&A driven by 40 people that built it, that maintain it, is the basis of serving our customer better every day because when we can take that and match it with pricing, match it with availability, match it with warranty. Match it with configuration, meaning what products go with which products. And we can make a contractor's job and order pattern and lifestyle and capability technically, we can do all that quickly on mobile apps. And you'll see the data about 2/3 -- about 1/3 of our business now flows through that platform when it was zero 7 years ago. And so that's just one example of helping our customer. Give you 10 other examples. I don't have time. But just take our -- that scale, take that wherewithal I'm talking about and then bring it to a customer group, where probably someone else can't. That simple. Second one was how we take our own business process and digitize that and just improve what we do. It's not just less paper, it's doing something better. So pricing would be an example. If you look at our gross margin in the last 4 or 5 years, you see about a 300 basis point increase in margin. A big chunk of that has come through that #2 slide, which is how do we help our business become more profitable through technology. And when we price products historically, the empowerment of pricing and margin movement and -- was largely federated in 1,000 salespeople. Give 1,000 salespeople the latitude to set price for their customer, and then watch it. How do you watch it? You watch it by printing a P&L out once a month. That's how you watch it. Because that's not productive and leading edge and technology-driven or data driven. It doesn't, right? So that's an example where we've invested in pricing technology, a culture that had to support it. You want another 20 minutes on this, I'll be happy to give you a sense of it on the call. How do we help our warehouse operations. How do we help tell a customer, your order is ready. We couldn't do that 5 years ago. Today, I can tell a customer, text, fax, your order is in process, your order is ready. It's ready to be picked up. We'll scan you in and out, don't even get out of your truck. Do that 7 million times because that's how many orders that we process. So we're on our way. We're not there. We're on our way, but good progress. Third was even more interesting, which is how do we help our customers sell something to you. With pricing and product information and videos and technology and 24-hour wherewithal, how do we help a customer do that. So we designed a mobile app or a platform for an iPad or a desktop. And a customer is going to walk you through our products with their profitability in mind and price things to you and configure it for you and help you buy it and help you finesse it, and really again, take customer experience beyond the customer into the home. We'll sell this year about $1.5 billion through that platform at higher margins, at a higher mix. It's only about $1.5 billion of the $10 billion we'd like to do through that channel. So far, so good. We're making some progress. I just want to skip a little bit here, go to some of the metrics. So I mentioned about 1/3 of the business is now running through e-commerce. That's 55,000 customers using it. It's about 150,000 in total. So again, that's the progress report. 28% of gross value of products growing through that third platform, which we call OnCall Air, that's the platform helping contractors sell stuff. And the other attribute that is in the numbers is I've never been to a presentation. I've never heard an investor ask ever, what attrition rate does your business have? Your $7 billion business, how much of it will you lose next year? So I dare you to ask you that question. Start asking that question. Every business has attrition, right? Ours approached 10%. So for me to grow 6% next year in old school Watsco, I had to replace somehow $700 million of business and grow 6%. That's a pretty astounding thing to say out loud, right? Attrition in the technology is less than 2%. So this whole technology discussion is also letting us not just recover lost customers or business. But actually, when we grow, it's a more efficient way to grow. And just like your own bank and mobile app, it's sticky, it creates a wherewithal that banks didn't have 10 years ago. So just some more data and some more thoughts. But if anyone ever wants to spend an hour on this, I'll get our technology team on a Zoom, spend as much time as you like. We spend about $50 million, $60 million a year on technology. If I go back to that slide showing the top 10 companies in our industry. I think there's maybe only 1 or 2 that can spend $20 million. And probably beyond that, this level of spending and innovation, and I'm giving you an inch out of the 12-inch ruler of how much we're actually doing to get a sensor technology. So anybody would like to do that, just contact me. I want to get to the ownership and then I'm going to get to the fun slide. I'll stop picking. I won't have anymore fun without -- I just think it's interesting to see. But our ownership culture, Barry started 32 years ago, I got my first stock grant 27 years ago, 1997, I have not yet vested. We have a restricted stock program that does not -- will not vest until our employee turns 62. If you're 32, you've got 30 years. And you get the dividend. Barry has a good W-2 with dividends in it. I appreciate that. But my true wealth is at risk every day working at Watsco. We have about 160 people in the plan. These are leaders across markets and companies. Over $400 million restricted stock outside of a corporate office that excludes people who have been around a long time. That's -- could be 30-year-olds, 40-year-olds, 50-year olds that have been with us. And we think it's remarkable. If you leave, it's gone. If you quit, it's gone. If you get fired, it's gone. If you pass away, your family has a life insurance policy because it vests. And so to have kind of a family, honestly, a family of 160 people feeling that and having that, experiencing that and pulling in one direction for that. It also lets us when we recruit people know who really wants to be part of it because it's almost maniacal to say you've got to wait 30 years to vest. But what's remarkable, I think, is that 92% of whatever we've granted, 59% is still outstanding, meaning people have stayed with us all those years and 33% have vested. 92% worked, 8% were forfeited. Over 27-year period. So we think that's pretty remarkable and when talking -- when people talking about being aligned with their shareholders, I think that's pretty aligned. On the balance sheet, you can do the analysis. If you go all the way to the right, you'll see again -- I'm sorry, not balance sheet, long-term track record. So this is what I want to focus on a little bit. If I look at the total shareholder return over 5, 10, 15, 20, 30 years, that's compounded growth rates. It's pretty remarkable that it's pretty similar. And I probably sat here 5 years ago and showed this and said, and somebody asked, how can you do this another 5 years. I said, we're going to work at it, and we're still working at it. But this is the long-term growth and long-term way of looking at Watsco. We're very proud of it. And through cycles, through infinite changes in OEM leadership teams, infinite changes in product and market cycles, and we think it's a good track record. Cash flow, you can -- I'll let you guys see cash flow net income, basically the same after 20, 30 years. Balance sheet. Again, nice cash, no borrowings, we'll keep at it. Not picking slide is funny, is this the fun one. And so I don't know how many of you guys own these companies or how many of you own Watsco, but I had some fun with the chart and said there are only 24 companies that have returned 19% or more total shareholder return over 30 years. That's it, 24 out of 1,600 and Watsco rankes 16. And I like some of them because I've never heard of them. And not to pick on them, but Ross Dress for Less is there, not Walmart, not Target, not -- and someone like HEICO, which is next to us in Miami, another like below the radar, but boy, what a quality company. And a lot of these share what we share, which is a lot of inside ownership, a lot of founder or family or just long sustained cultures. Apple has that. Aeon has that. If you know the company Aeon, I got asked about that earlier today, they sell commercial air conditioning, 1 CEO for 50 years. So these are cultural companies, not just good companies. They're companies that have sustained cultures for a long period of time. So that's my stock picking slide. Did you know? So any questions?

Can you just talk about the health of the contractor and [indiscernible]

Sure. Was it [indiscernible] health of the contractor and just general pricing dynamic and kind of what are we seeing. Well, so far, so good. I mean, the contractor was in a honeymoon period during COVID and enjoyed higher pricing, higher margins. So did we. And that collaboration led to an incredible growth rate. And in the last 18 months, I would say, was a little bit of a correction from that reality, which had to core to an extent. And as we start this year, we're beginning to see, I would say, absolute stability, number one, not volatility and some growth that is encouraging -- very encouraging early on. And I need to say those words, in October, when we're through our selling season. I mean, June is half this quarter and June, July, August is very material to the full year. So it's nice to feel encouraged. It's nice to feel upbeat. It's nice to feel good or better, feeling wonderful. We'll see, to be very balanced about the answer. But the contractor itself and what we see in the data beyond my abstract thought is we're seeing a better mix of products being sold. That tells us the consumer is still paying for these things. We're seeing absolute great credit risk with our customers who owe us $800 million in accounts receivable, that tells us how the end market is doing. It tells us what's going on, tells us how we're doing. And so credit, again, is a great leading indicator. And credit has been sound in this market. And the OEMs have all come out with new products for new refrigerant-based products over the next 12 months, that offers a price increase, but it also offers a replacement dynamic more so next year than this year. So our industry is not static right now. And she's going through a lot of change that will basically reinvent and bring in new products over the next 12 months that add another layer of why you should replace and at least in the metrics, at a higher cost.

[indiscernible]

The question is about warranty and kind of where are we in the channel. We're the agent for the manufacturer's warranty. So if Carrier or Train or Ream sell -- if we sell a product of theirs, it's their warranty that they're offering the homeowner. If something breaks in 4 years and a part is needed and the contractor goes out and installs it, we get paid by the manufacturer, as does the contractors. So there's no warranty risk per se for us. We're the conduit for manufacturing.

Thanks, Barry.

Thank you, everybody.