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

All right. Thank you, everybody. Very happy to have Rick Gomez, VP of Corporate Development at Watsco, with us today. Hi, Rick. How are you?

How are you? Good to see you.

I'm doing good. Happy to be here.

Likewise.

I guess maybe starting off high level. There's a lot of distributors in the market. Watsco continues to win. What's the differentiator? What's the driver of the success?

Sure. What's the secret sauce, I guess? Well, first, thank you. I love the big-picture question and delighted to be here. We love this conference. We love partnering with Morgan Stanley, and it's a great setting, obviously. So thank you for the invitation and happy to be here. I think there are several key ingredients to that answer. And I could probably take a full day to answer it, but I'll try to distill it to -- I think it's the essentials. The first is the heart of our business is serving 150,000 local contractors. They could be your child's little league coach, they could be a neighbor, they could be a relative. And so you get the picture, right? We're not selling to Fortune 500 companies. We're selling to very savvy, very entrepreneurial local businesses. And we think that the best way to [ service ] that customer is through a very entrepreneurial culture that pushes decision-making and that decentralizes as much as we can. And that means that I think we're a more nimble, responsive organization to these customers. Remember that when you as the homeowner have a need, if it's August in Phoenix and you have a problem with your air conditioning system, you are demanding a response in hours, not days, not weeks, hours. And so what that means is that there's an imperative to helping the contractor in a local way, in a fast and responsive way. So this entrepreneurial decentralized culture that we have, I think, is a key ingredient as to why we've been so successful over the years. It is also, I think, a key ingredient as to why we've been a partner of choice for so many HVAC distribution businesses and family-held businesses in our space. So we've acquired about 70 family-held businesses over the last 30 years -- 35 years when we entered distribution in 1989. If I take a shorter-term lens there over the last 5 years, we've acquired 10 or so wonderful family businesses in our industry. And I'm happy to say that those leaders, those owners, those management teams, they're all there. The names are still there, the legacies are still there. And that's important because ultimately, we're serving that local contractor and these businesses that we've invested in and partnered with have long-standing legacies. And so if there are 700 locations across Watsco, not one of them say Watsco on it. not one. They all say the name of the distribution business that we've invested in or acquired, and that's how we go to market. So that's, I think, a second important ingredient is as to why we've been successful, is we've partnered with a lot of great family )held independent distributors over the years. The third is there is an equity culture that sustains a lot of that and that perpetuates a lot of that. So about -- not about, more than 50% of the associates at Watsco are shareholders of the company in some way, shape or form. We've got branch managers, truck drivers, warehouse associates, sales -- the goal has been to create this long-term thinking that comes with being an equity owner of something. And in our case, that equity culture is hugely important. Every one of our major P&L leaders, every one of our major -- not major, every one of our business unit leaders, key functional leaders, key salespeople, they are a part of this equity culture that we believe is important in helping sustain that entrepreneurial spirit over a long period of time. Lastly, the thing that I'll say that I think has been an important ingredient to growth and competitiveness over the last 10 years or so has been the technology that has been invested in and deployed in the markets. I would need 36 hours to distill it, but we've developed what I think is the industry's leading digital ecosystem where today, more than 50,000 users are living and breathing our digital tools. It has led to now more than 35% of our business being digital. And it is also what we can see in -- is that we have certain markets that are operating well above that, 50%, 60%, 70% of certain markets, and certain businesses are now digital. The results of that are important, especially if you're underwriting our story over a long period of time. The first is that when customers become digitally enabled, they begin to grow faster with us. The second is they also become better longer-term customers, i.e., they attrit less and they attrit meaningfully less. So I'm in a group of investment managers, and the analogy I'll use is if I could stem your outflows by 60% to 70%, how much more profitable would all your businesses be? And that's what we've managed to accomplish with the subset of customers that are active users of our technology. We see attrition go down by about 60%. And that's meaningful over the long term as we think about growth rates -- organic growth rates. And the third thing we're now working on is there should be also a lower cost to serve for that digitally enabled customer. That work is still ahead of us, but we have a line of sight into how to get there. So those are the key ingredients. It's a great question, and it entails a long-winded answer, but there's a lot to it. And I think what matters to us is that there's a lot of people invested in the long-term success of this business, and we would have it no other way.

No, I very much appreciate that. When you look at your competitors, it's fragmented. They're generally smaller. Are they developing tech initiatives? Or is that ability to invest capital like really a widening moat for a company of your scale?

I think certain businesses in our industry are attempting it and with varying degrees of success. We're not the only ones, but I think we have a tremendous advantage, and we're investing to grow that advantage. We didn't just start this 2 years ago, we really started this 10 years ago. And we started with the foundational element of it all, which is data. It's data about our customers, our products, our vendors, our peers in the industry. And so we call that Master Data Management, and we have pools of data that now can be leveraged across multiple platforms and can influence things in a very different way than they could 10 years ago. But we started with just that, right? How do we start amassing data about everything in our business? And how do we make things more real-time for our business unit leaders? And that data then allowed us to invest in a digital ecosystem, which I think today is by far the best digital platform in the industry for HVAC contractors. And so to do it justice, you really have to put yourself in the shoes of a contractor. What do they do every day? What is their daily cadence like? What's the first thing they have to do when they show up at your doorstep? It's -- they have to know what system they're working on, they have to check if it's under warranty, they need to understand the bill of materials, technical support, a host of different feature and functionality that helps that contractor be better and faster at what they do when they're in your backyard, at your kitchen table, in your attic or your basement, hopefully not in the summer. And again, it's about their speed to market. It's about them fulfilling your demand as the homeowner better, faster, more efficiently and ultimately, saving time in their day so that they can do more and be more productive. So a whole lot of data, an incredibly robust digital platform to help 50,000 users at the moment and growing. The third leg of that technology stool is our own operating excellence. It's how do we become a better distributor? How do we become a better supply chain company? I mean that is what we do in some senses. We buy a lot from a lot of vendors, we store it in many different places, and we sell it to local contractors. So that -- there is a whole lot of math and science that can be applied there. And things like our pricing technology, our demand planning, our forecasting, our inventory optimization tools have started to make a difference there. And just very quickly, the fourth element of that is, in some ways, the most interesting, which is everything I've just described; is about us and our customer. But what if we could influence how our customer interfaces with you, the homeowner? I.e., what if we develop tools and solutions that enable our customers to grow faster than their peer set? And so that's what we've done with platforms like OnCall Air. OnCall Air is a digital selling platform that has seen wonderful growth, and it is allowing a contractor to become a 21st century salesperson at your kitchen table. And again, I could spend a lot more time on it, probably not do it enough justice. But those -- the collection of those things is very hard to replicate overnight. The collection of those things has taken us 7, 10 years to get right, and we're still perfecting it. It's by no means perfected. But I like where we sit. I like the moat that exists around the business today. I like the same customer behaviors that we're seeing. And I like that other distribution businesses are hearing about it from their customers as well.

I appreciate that. I think it's very clear that how the digital platform drives share gains for you. If you can make the technician or the installer more efficient, they can turn more jobs, they give you more of their wallet. How does that flywheel ultimately drive margins higher for Watsco? Is it just through volume leverage? Or are there other drivers as well?

Yes. If we can get them to grow faster, there's some implied margin benefit there, obviously. But there are other drivers. For instance, it has always been the case that, that digitally enabled customer, they -- the technology is very good at suggesting other things and complementary items that should accompany whatever system they're buying that day. And so one of the things that we have consistently seen is that line items per order are 20% to 25% higher for that digitally enabled customer when they order through our digital channel versus the average customer that isn't taking advantage of those digital tools. And so that is good for margin. It's good for the customer relationship because we're reminding them and helping them. We are a more complete solution to them as a distribution partner. And yes, it's good for margin outcomes at the end of the day. The other, I think, implied margin benefit to all of this is, I mentioned the lower attrition. That is good for margin in the long term. More stable customers, growing faster, buying more from you and attriting less, that, I think, is a good recipe for how one can sustain and grow margins over time and use the digital channel as a means to do that.

No, I appreciate that. Maybe turning over to the market. The resi market, after many quarters of pressure, saw a nice turn in Q2. It seemed like there was support from the -- [ weather ] was a tailwind, maybe better visibility on policy. When you look at resi, do you feel like the cycle is turning? Or do you feel like maybe some of those drivers uplifted Q2 and maybe those shouldn't be extrapolated, going forward?

Yes. It is -- let's go back 3 years in time or 4 years in time. We saw 2 years of incredible growth in units, and we've seen 6 or 7 quarters of normalization. So where are we now, right? 4 years later, where are we? And what I'll suggest is that a good way to underwrite this is to look at long-term averages. And long-term averages tell us that the industry grows at somewhere around 3% to 4% in units every year. So when in doubt, go there because it's the best evidence we have of underlying industry growth, is 3% to 4% unit volume growth. And on top of that, you also have to, I think, factor in the markets in which we operate. So about 60% to 70% of our business and our network sits in very stable, slightly faster-growing markets, the Carolinas, Florida, Texas, et cetera. And so where you are matters in terms of whether you're above that 3% to 4% or below that 3% to 4%. And I'd like to think that we sit in relatively good markets for that long-term growth. So I think we are in the later innings of normalization. Q2 was a nice data point. We've seen, since then, I think, continued modest growth to units, and that's encouraging. And we'll see how the rest of the year plays out. The -- our -- we tend not to think of our business in quarterly increments very much. We tend to think of them in quarter centuries. So someone asked me about the 25-year model.

I guess we've heard from some of the OEMs today on the upcoming refrigerant changeover. What does it mean for you guys as a distributor?

Yes. It's -- first, we are very lucky to operate in an industry where regulatory trends are generally positive. They mean something that's up and to the right. And usually, we're debating the magnitude of that, but not the direction of that. And so we've been through, I think, a very busy period over the last several years as it relates to that regulatory change, and we're about to undertake a very meaningful one now starting January 1. It's a 1 in 15-year event. The last time that there was a refrigerant transition was in 2009. And every 10 to 15 years or so, you see that sort of regulatory tailwind benefit our industry. So what it means is a couple of things. It means, one, we are spending a great deal of time training our customers. When things like this happen, there's no call 1-800-OEM. There's call your local salesperson, call your branch manager, call your technical support person. I think that's one of the most underappreciated aspects of what a distributor does, is educate and train and support contractors. And so we're in the midst of training 150,000 customers on what the new products will look like next year. We're also planning for that inventory transition and the conversion of that later this year, early next year. And that is a massive undertaking, and our folks in the field are now busy planning for it and executing on that. And ultimately, what it means is that we, as a distributor, will support a lot of customers as they undertake this transition in the first half of next year. And we will expect to see some measure of price that will benefit the channel and benefit the whole industry next year. And that's what it means for us. It's training, it's planning for inventory and then ultimately executing on that across 700 locations in our network.

So is the expectation that you guys will build inventory into year-end to prepare for this? Or is it that you're maybe placing the orders earlier than you normally would with the expectation you maybe won't take delivery until early next year?

Yes. I think most distributors have been asked by most OEMs to think about and plan for in slightly longer horizons than we normally do, leading up to this transition. So this is not business as usual. It's not ordinary course. So what we've done is an exercise where market by market, leader by leader, business unit by business unit, you develop a view of what you think you need towards the end of the year and the beginning of next year. And then all of that sort of coalesces and aggregates up to what results in inventory and what results in ordering at the end of the day. But there is no real view, so to speak, of what it should be at the end. This is 700 branch managers, 800 sales professionals, 40 or so P&L leaders figuring this out locally in their markets. And what's different about it now is that normally, if you have lead times that are x, you tend to order and you tend to forecast more or less around those lead times. And a product transition that is a once in a 15-year product transition requires you to take a slightly different approach. So yes, we are looking a little bit later on and say, what can -- what do we think the balance of the year looks like? And a lot of that is really to support our OEM partners make that a smooth and efficient transition from their perspective. They're looking to us to help them plan how much production of what they need to make towards the end of the year and earlier this year. We, in turn, are going to our customers saying, what do you think? And again, this is sort of 1 million data points that get aggregated up and -- but not something that gets [ set ] or decided top down.

Appreciate that. Do you feel like -- if there's a period of time where we'll be selling the two different products, do you need a higher overall level of inventory to do that?

I think if there is, it will be modest and it will be short-lived. I don't think -- these product transitions usually require some investment before and some investment after. And I like the fact that if we turn inventory 4 times a year and hopefully more over a longer period of time that whatever that investment is, it's something that can be dealt with reasonably quickly afterwards. And so I don't think it will be a fundamental shift in anything. I think it will just be a -- to the extent it happens, it will be transitory in nature.

Have you guys talked about or -- how you expect that unit mix to evolve between the 410A and the 454B this year into next year? And I guess the second part of that is, do you think customers will continue just to buy the 410A as long as they can because of the price?

Yes. It's the parlor game of the day, I suppose. And I remind everyone that these decisions are not -- the OEMs are hugely important. The distributors are hugely important. The actors in the channel that will dictate all of this will be the contractor and you. So if your system, if your furnace, if you're a heat pump or if your air conditioning breaks next March, what is that contractor going to recommend? What are you as a consumer willing to accept? And therein lies the driver of how much 410A versus A2L will exist next year. So if you can tell me what that kitchen table conversation looks like, I can tell you, here's what I -- so no, we've not prognosticated and we've not proffered a view on that. I think our view is we want to have the right amount of inventory of each to satisfy the demand in local markets that we think will be there. And the deciding agent, the deciding factor in that calculus, it will not be us and it will not be the OEM. It will be you and your contractor making a decision on what you want to do if there's a problem with your system. And lastly, I'll just say that I think what we're really talking about is a phenomenon that will be with us for 3, 4, 6 months next year. I think it will be that short-lived in the grand scheme of things. And I don't -- I think the channel, the contractor base and the OEM community [ with ] large is eager to get on with the transition, and I would include us in that.

Appreciate that. Maybe I'll just stop real quick and see if there's any questions from anyone in the audience they would like to ask. All right. I guess moving to inventory levels, not on the 410A versus [ 43B ], just more in total; how do you think inventory levels sit today? We've obviously gone through a pretty long period of destock. Do you think things are normal, a little light? How would you frame it?

Yes. The distributor will normally think about inventory as it relates to turns. And I will say that we've made progress over the last 6 to 9 months. I think there's much more progress to go. We started this in a position where the supply chain disruptions really wreaked havoc on our ability to optimize inventory. And thankfully, with those supply chain disruptions behind us, with more technology in the hands of our field leaders, with more technology in the hands of our business units, I think we are -- we've made progress in sort of reestablishing what is a [ 4 ] turns a year sort of industry inventory dynamic. The real mission is more. The real mission is we think that 5 turns is achievable. And we've got the technology, we've got the wherewithal to do that. And doing that and undertaking a product transition at the same time, easier said than done. But that is really the -- not the near term, not the long term, but I'll say the medium-term vision is can we progress beyond 4 turns of inventory and make it 5. And as I said, I think we've got the tools in place to do that already. And that journey begins next year once the product transition is behind us in some ways.

I appreciate that. HVAC, like a lot of industries, has pushed a lot of price over the last 4 years in response to inflation. I guess, one, is there any pushback to the price increases that you guys are seeing in the market? And then second, when you look out next year, what are your expectations for price?

Yes. I mean we operate in a very competitive space. There's a lot of contractors. There's a lot of distributors and a good number of OEMs. But -- and so it is a competitive market and -- as it should be. And it's been that way for a long time. I'm not sharing something that is a new phenomenon or a new development, which is to say that the contractor and you, the homeowner, will always keep -- you will keep the contractor honest and the contractor will keep us honest, and then we work with our OEM partners collaboratively to try to make that happen. Is that pressure greater today than it's historically been? Not discernibly. Remember, at the end of the day, there's very little discretion that you as a homeowner exercise in -- if your system breaks and if it's February in Chicago or July in [ Tucson ], you're going to act. The question is how are you going to act, but there's no really deferring of that demand. And so I don't think that the industry is any different today around the elasticity of that than it's been historically. It's always been competitive and it's always been a dynamic price environment, I'll say. As far as next year goes, most OEMs have signaled some amount of price increase for next year as it relates to A2L product. We think that is achievable. We think that high single-digit, low double-digit realm of price increase is achievable. We will blend into that as the year progresses, obviously, because it will not start with 100% A2L products. And there are costs and investment and feature and functionality that now exists in these systems that did not exist when we went through this last refrigerant transition, obviously. So it is a price regime and a price environment that I think is going to be constructive here over the next 12 months.

I appreciate that. When you guys look at the demand trends, just the unit volumes that you guys are moving in the market, has there been any noticeable shifts between high-efficiency products and low-efficiency products? And -- because on one hand, higher electricity prices would support the higher efficiency. But on the other side, consumers have been under some pressure, so maybe they're looking for cheaper alternatives.

Yes. Well, I mean, the market today is essentially 80% -- I'll round it, it's about 80% entry-level product. And 2 years ago, we went through another regulatory transition, where the definition of efficiency changed a little bit. And not to get too granular, but the way that one calculates SEER changed, and that effectively redefined what the entry level in the mid-tier of the market looked like. So we're at 80% of it not because the consumer degraded to 80%, but simply because as a result of that transition, more stuff is called entry level. So I think the opportunity, going forward, is kind of like reestablishing that base mid-tier, high-tier dynamic that existed prior to the 2023 transition. I think that the consumer, in our eyes today is, still relatively healthy. Thank goodness, they're not deferring air conditioning. Thank goodness, they're not deferring heating. Again, the elasticity of that is not the same as other distribution verticals that you guys might invest in. And so you should get the sense that really the beta around our industry, the beta around demand and the beta around our performance, at the end of the day, is something less than it would be for the broader macro and certainly other distributors and other verticals.

Maybe if I could just squeeze one last one into the last 10 seconds. You started off by saying that it's great to be in an industry where policy is kind of always driving things up and to the right. When you look at all the policy that's out there, which one stands out to you as being most impactful?

Yes. I think this moment in time that we're in is pretty impactful. Again, we only go through these refrigerant transitions once every 10 to 15 years, and it's impactful. There are other ones down the line in terms of step down in the production. Available of legacy refrigerants, going forward, that will step down. There are some interesting regulatory dynamics as it relates to water heaters and heat pumps that will influence our channel and other channels beginning in 2029. I think the one we're in right now, the one we're living and planning for and talking about is a pretty big deal.

Yes. Well, exciting times ahead. We're up on time. Thank you so much, Rick.

Great. Thank you.

Appreciate you being here. I love the conversation. Thank you.