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

All right. Great kicking off day 2 of the conference here. We've got the guys from Watsco. Barry Logan, Executive VP; and Rick Gomez, VP of Corporate Development.

It's just initials by the way, it doesn't actually stand for Executive Vice President.

These guys just do everything. They do it all. Pat is also up here. Pat covers the distributors for us at JPMorgan. Guys, thanks for being here. And we're going to tag team a little bit on this one.

But just wanted to first start off. I know it's March, I think, 12th. It was a little bit warm out yesterday here in New York. It's a little bit chillier this morning. What are you guys seeing so far? Anything evolving since you guys reported from an early selling season indication perspective, obviously, it's a little bit too early to be definitive, but anything in the channel that you're seeing that's interesting on the ground as a start.

All right. I read some tea leaves early in the season. So yes, I mean, we had obviously a blowout fourth quarter. Blowout meaning that overall residential businesses were up in the teens. The overall market was up for us at 9%, a nice drop-through to the bottom line and so on. I would have expected a bit of a return to more conventional growth rates, but stable. And I would say that's what we have seen quarter-to-date. March is half the quarter. March is critical to this time of year, but not necessarily an indicator of what we see going into the season. But we're seeing growth. We're seeing margins behave well. I'll have a better answer in May, June, July, when our business is 30% or 40% larger than it is today. But so far, so good. I don't know if you have any color to that?

Now just to note that it was as cool yesterday morning in South Florida as it was this morning up here. So we've enjoyed a little bit of spring time ourselves. The only thing I would add to what Barry said is that there is we are obviously in the middle of an important product transition that's impacting the whole channel. It's impacting the whole market. That seems to be unfolding as planned. And first quarter is that 90- to 120-day period where you have to convert $1 billion of inventory across 700 locations and get that as precisely right as you can so that you've got availability to support your customers come selling season. So we are in the midst of all that right now. Obviously tracking it very closely, and we are seeing good uptick and good acceptance of the new product in the channel, and it's starting to now become some element of our sales here in March. But as Barry said, I think the real -- the real test of all of this will be coming the selling season and we'll all be smarter at that point, I think.

Anything with regards to -- I'm not going to use the term prebuy because I think it's been used now enough. Anything that's evolved in the channel that you look at and you say, "Oh, that's interesting kind of post year-end that you've gotten a little more information on from an inventory in the channel perspective, whether it's contractors or not, and then also just on the pricing that's going on out there competitively with the various OEMs and different strategies. Anything surprised you in the last few weeks here as things evolve?

I can't think of anything on the inventory side that surprised us or has been tricky. It's going to be tricky to get, as Rick said, $1 billion of inventory out of the system over the last 120 days and new products into the system over the next -- and go through that with a measure of precision. It means our branch managers are having awesome 10-, 12-hour days over the last 60 days to really set the table for the season. I can't think of anything that's happened or going on that's any different than we thought or had wanted. That doesn't mean it's simple. It's a big, complex machine that's turning over a product really for the selling season coming up. On the pricing side, we wanted to be and can be a merchant during these times. We can look to optimize price and margin and what we're selling out of. I think we've done that and doing that. We also have the opportunity to look at $1 billion of new product that we're about to sell and set price and margin. And when I say that, that's not just talking to customers, that's talking to our vendor community as well as to their price coming into the market that we're then passing through. Now we have some science and math and technology to help us do that. We didn't have that 3 or 4 years ago. And so I think margins and pricing in general, I would say, again, is a positive because of those kind of 2 bodies of work going on.

And from an inventory perspective, is it being managed pretty smooth where it's kind of a normal seasonal level and your churning underneath? Or is it going to be lumpy where you're going to get a bunch of this stuff in because it's available and that's their ship date to you, like how smooth is this process on inventories -- inventory churn?

It is not smooth, and it is a bit of a wave that flows in. And as a distributor, of HVAC stuff, we only have one goal with inventory. That's to have it for our customer an hour from now. Our lead times are not next week or 2 days from now, our lead time promise is an hour from now. So where we hedge risk of inventory is to have more of it if we feel like the channel or the supply chain is tricky. So I could see us early part of this year being heavier on the new inventory to assure that and to assess that -- to address that risk. And we get out of season and we get out of season towards the fall and end of the year rebalance that and there should also be, obviously, a more serene supply chain going on 6 months from now.

So you're saying there's a bit of a prebuy of the A2L?

I wouldn't say prebuy, I would say, a building of inventory because lead times and so on aren't what they're going to be in 6 months. I don't like the word prebuy as if we've decided to take part of our balance sheet and buy a ton of new product. That's not Watsco is or does. This is a purchasing manager in Houston buying for 15 stores, adding a bit of inventory into his market and it may be a different calculus and a different equation in Central Florida. It's not a Watsco pushdown of strategic petroleum reserve by -- not that. This is a very regional, very market-driven, very brand-driven and going back to that local contractor that needs a product in an hour. So any thoughts to that?

No, just to have a little fun with Steve that you can't call it a prebuy during the year. You can only call it if you're crossing a year. I think...

Well, we think in the quarters. Maybe it's a first quarter prebuy, for the second quarter -- but the point is you're trying to mitigate the risk by taking on a little bit more of this stuff as opposed to really managing it tightly to a band or at least that's your sense of what your guys are doing on the ground?

That's correct. And again, it's a learning process, right? The manufacturers are learning how to get this new stuff out of their factories and plan for it and logistics and push it out in pairs. Again, we sell products in pairs, made in different factories. So we're actually converging product in our stores and having -- so it's like a double edge equation. I'm not just buying from a factory, we're buying from multiple factories and then merging that, converging that into our stores. And so that's the trickiness. And everything I just said is not simple in these transitions. And that's where the phobia of lead times and on-time delivery and things like that derive a bit higher inventory, which is what we should be doing in terms of playing offense with our balance sheet. But it's not buying -- allocating capital to buy products ahead of time. I don't define it like that.

Right. And then just last one for me and then I'll pass it over to Pat for a couple. Just on the pricing that's coming out for these guys. Any interesting movements on that front? I know most -- a couple of guys have been out with like letters about tariffs and pushing that through. Has that actually been triggered yet? Or is that still kind of TBD?

Well, I think some have moved forward with pricing -- new pricing in March to get something going because they're already incurring inflation absent tariffs. And then the tariff discussion adds a layer of risk and reality to the overall equation for the OEM. And what the question is, what's reality, right? So I think there's a little bit of that consternation on the fence, waiting to see what really happens. And their question for their meeting is, how is that going? And we'll listen to it and be the benefactor of it in some ways. But I think those Phase 1 has kind of occurred and Phase 2 is contingent on what's happening with the tariff situation.

Right. Okay. Pat, you want to follow-up here?

Yes. I just wanted to peel back the comment you made on price optimization with respect to the older inventory that you now have -- so you're not obviously getting OEM price increases for that. But it sounds like you're going to maybe try to get a little price on that stuff. Maybe just peel that back a little bit?

Yes, it's more past tense at this point than future tense with 410A product. When we started the year, our business units felt they could gain some price on 410A products. And if there's a scarcity value that is created from that, then that should -- that's a value we should be able to obtain in the market. We'll talk about the materiality of that when we have the numbers all the way through the quarter. But that's been a thinking and a process really beginning probably in December of last year. It's more past tense than future tense.

Meaning that past tense meaning that you executed in the fourth quarter?

I mean part of the benefit was in the fourth quarter. And most of the benefit with that particular narrow concept is in the first quarter, but it's not something that builds on itself or adds to itself. Once we get into the A2L product, then it's a new product with that second phase of what I said, which is how do we have a good merchant execution on all new products that we'll be selling on scale as we get into the season.

And so I guess, just magnitude wise, that we should think about it that as not double digit, more kind of mid-single digit?

I don't know what that means?

Not a double-digit price increase more of like a mid-single-digit price increase?

I think -- if you're referring to 410A product...

Yes. Yes, the step-up on 410A, the sliver that you're selling through?

No, I think, look, it's -- in the absence of some OEM initiated pricing action in the market at scale. It's hard to be that aggressive. And so you tend to be more measured than aggressive in that scenario. And so the reason why it's hard ex ante to really size the magnitude of this is that there is no single lever at Watsco that says, here, let's change price by X. We're talking about 40 to 60 P&L leaders and 700 locations and 130,000 customers. So it really is a bit of a sum of the parts in terms of what we derive at the end of it, which is why looking forward or trying to size it in real time is difficult. But yes, I would characterize it more in that low single-digit world because that's the -- and plus, we didn't have as you saw on our year-end balance sheet, it wasn't -- we weren't starting with an inflated inventory position of 410A product to begin with. So I think our bent and our focus has been more on getting on with the transition sooner rather than later, and not lingering with legacy product in the channel, which does come with its risks at the end of the year if you have too much of it. So it's threading a needle of how much do you think you should have for the customers and measuring lead times on new products for the OEM community. And as I said, we're kind of in that crossover point here in March and April, and we'll tell you more about it after season.

It's in basis points, Steve. If I do the algebra on the overall margin. It's not percentage points, but it's more than 0, which is good.

Yes, I think there was -- some of the OEM discussions, there was a narrative that like you just would basically take your 410A, and like market up to your A2L product and move along. So just wanted to make sure we -- I had an idea of the magnitude?

I'll really say it this directly. There is 0 opportunity for that to happen. It's basis points and it's single-digit percentage points.

In terms of the volume dynamics last year and how that plays through to '25, so Watsco grew volumes mid-single digits in residential equipment last year. I think the market was generally kind of flattish, so pretty good relative performance. Can you talk through some of the dynamics that as we roll into '25, might be a little bit different. And I'm thinking about you had some probably volume coming back from one of your big vendors Rheem. I said it, you didn't say it. And then there was the issues at Goodman, which I don't think is a huge vendor for you, which may be benefited volumes for some of your other vendors. And as you think about that in '25, how does that kind of play through in your thinking?

Yes. I'll try to put things in perspective, and this is 10-K material, so you can get a sense for it. First, Carrier is by far our largest vendor. I want to say large, it's again in the 10-K about half of what we buy, therefore, more than half of what we sell. What's unknown -- I won't say unknown, what's underappreciated is, that's 7 different brands. It's not just the Carrier brand. It's multi-branded. It's multifaceted. It's covering different parts of the waterfront. The most sophisticated thing we sell or the cheapest thing we might sell is made by Carrier. So it is a bandwidth of products and a spectrum of products. And that is, I would say, 5 years ago with the spin-off, their investment, their understanding of that asset, their dependence on distribution to serve well to go out and prosecute growth and market share expansion is where they've done a very good job. I think a year ago, not a year ago, maybe 6 months ago, they said on a conference call, we listen to our customers, and here's what we're doing, that's us. I didn't hear that phrase 6, 7 years ago. Maybe they listen, but they didn't necessarily have the capacity or the investment from their parent to go do it. So I would say especially in the last 2 years, as things have settled down a bit on product in the post-COVID kind of thing, that's a powerful partner that's kind of the table and listening to the strategic objectives and investing in those objectives and helping us go sell product and grow the market. You look in our numbers, the Carrier Enterprise, profit sharing that we share with them has doubled in the last 5 years. It's over $100 million or close to $100 million. And that's a benefit to that relationship that is a 2-way street. We've grown our business, and they've grown theirs. So I'll leave that. Let's park that there because it is an ongoing market share and development campaign. We're not done. We're not happy. We're not content. We're not complacent. We meet every 90 days with the senior leaders and go through a strategy of how we're going to do that. And I'll leave it at that. So that's part of last year's growth. It's the intention going forward in a material way because it's our, by far, our most material supplier. Rheem is about $0.5 billion manufacturer to us. So that's roughly 6%, 7% of our business. I wanted to grow 10%, 20%, 30% because it's shrunk 5%, 10%, 15% a year ago, and that's an opportunity to regain share, to regain business. We did some of that last year at a lower margin. We intend to do more of that at a higher margin this year with this change in products. But you got to put the materiality within the scope of what I just said of being 6%, 7% of our overall business. And Goodman is probably half of that. And so -- it's another great vendor. They've been probably the #2 player behind Carrier for our entire careers. I discount the materiality of that statement. We want to do more business with them in the markets. We have much of -- much of our Goodman business is in the deep Sunbelt. And yes, they've had a choppy period of changing over their products beginning last year. But I think when those cylinders finally kick in and hit, it's an opportunity for us. And the other 1,400 independent distributors than us will have to deal with a better Goodman set of distribution. Again, I think the materiality of it is diluted in that statement. But nonetheless, -- that's how the profile of the top 3. I could go tell another 0.5 hour story over the next 7, all of which is built on post COVID as the market flattened out, how do we gain share? What do we do as partners to gain share? It's all Mitsubishi story. I could tell a Gree story in China, I could tell a Carrier story about ductless products et cetera. But that's what's going on. And it's nice to have this pattern where we're not just figuring out this crazy circus of either COVID or post COVID, but now it's actually new product, things are more serene, certainly 6 months from now, even more so. And we kind of like how things are set up.

So I guess, though, the follow-up to that is Daikin on their call very visibly, said their market share was dropped to 19% and that they have initiatives called like win-back or something and they want to get 80% of that back, like in the near term. I guess the question is, is that -- are you starting to see some of that in the marketplace? Is there -- because that seems like more of a hammer approach than like they're going to -- that they're going to be very aggressive about this? Are you seeing anything out there in their supply, their behavior or anything like that?

I think, I mean my two cents on it is that Daikin is a far more strategic OEM than they are given credit for. They're very measured in their thinking and in how they do things. I'll take you back maybe 2.5, 3 years ago where they had massive supply chain disruptions in their facility in Houston, and the entire market was in the same state of wondering what they would do and how they would react. And they've done so in a very, again, measured, thoughtful way. So nothing seems disruptive, nothing seems overly aggressive at this point. Just to underscore something that Barry said is, I think they're more material and more long-term thinking than people give them credit for. And what their share is this quarter probably isn't to their satisfaction. I think their eyes are more focused on what it could be in 3, 5 and 10 years. So they've been a great partner. We've been a distributor of theirs for 20-some-odd years, maybe longer. And it's a partnership that we think has some latent growth potential. Another thread to the question, just to expand on what Barry said earlier, is that for the -- I'd say the last 18 months have been more "normal" as it relates to just supply chain availability, and I'm referencing specifically residential like commercial product. What that does is that it allows us to prosecute and go after organic growth initiatives that we historically are very, very good at. And there's one not too far from here actually right in this market. We have a business unit based in Boston, that has expanded their territory with their primary OEM. That's Mitsubishi. We have other initiatives with other OEMs going on. The smoothness of the supply chain allows for that kind of organic growth strategy, business unit by business unit, market by market and combine that with the digital strategy that is sort of how we lead with a lot of these growth initiatives. It means that market share that's gained has a better chance of being sticky, has a better chance of being higher growth, higher quality, higher durability market share going forward.

You mentioned Mitsubishi. So the talk of the market for you guys remind us how big as a percentage of units or revenue in residential equipment? And how that probably grew double digits last year. Is that kind of the outlook for this year as well?

It did. So yes, I think ductless overall was about 10%, 15% of total units that we sell. And part of that is commercial products as well. VRF goes beyond residential. VRF would be a material part of that -- actually, that Boston business we're talking about that's selling into this market as well. I'm not sure I can slice it in my head with residential versus commercial on ductless, but yes, I mean, again, there are probably 4 primary vendors we're doing business with. Mitsubishi is by far the largest in North America, and we're their largest customer, for example, Gree the largest in China where they're sole exclusive distributor for the North American market. And that's been a developing brand, now a 9-figure brand in the U.S. market through that relationship. And then Carrier has tried to solve its ductless needs for its distribution through partnerships and joint ventures with Midea, Toshiba, now that they own it. And that's playing catch-up really to the others. But you can't rule it out because I would say Carrier has the most advanced distribution to go sell that product, but it's a work in process and part of the equation too. And -- but those products have become more efficient, more accepted by contractors, more likely to be recommended by contractors. That was always the barrier of entry for those products, not the manufacturers, not the distributors, but the contractor, saying thing to a homeowner or a business you should do this. And so it will always be an ingredient of growth in the industry, but it will still be, I think, never disruptive to what the industry is doing.

Maybe we can -- well, sorry, one more question that's on the market. So flat last year, you guys grew mid-single digit, gained a decent amount of share. So this year, kind of the market grow a little bit faster and you guys don't have that much share gain. Is that the algorithm that you're thinking about?

We'll never, like say those words out loud. We're not looking for a lot of share gain. We're always looking for a lot of share gain...

That's a good number though, [5% versus] the flat.

Yes. The way I've always handicapped this conversation in my career is because in March, I don't have insight related to the season yet is that the long-term 30-year, 40-year, compound growth rate of unit growth is 4% rounded. It doesn't look like that? It's about all I can think of, right? And I don't see a reason why the market shouldn't be a conventional kind of market. And our job is to grow share against that, of course. I don't see a reason why the market can't grow and its long-term growth rate this year. Consumer is strong, employment is down, contractor credit has never asked about. It's our biggest leading indicator of what's going on and credit has been extreme low risk, extreme low write-offs. I mean 2 or 3 basis points of write-offs. I've done this job when write-off or bad debt is 250 basis points, 300 basis points. So when it's 10 basis points or less, it's a good market.

And just to double-click on one element of the answer there is, pure gains don't just magically happen. You have to work hard at those share gains. And so the question is what do we have that makes that a more compelling proposition to the contractor? And the answer is, is this digital platform that now exists within Watsco, that is a $2.5 billion part of our business that's in the hands of 60,000 contractors. It allows them to do things digitally and with us that very, very few distributors can offer those same contractors in the market. And so we need to couple, I think, if we go back in time, maybe 2.5 years, 3 years, in the markets that we're in, we can confidently say we've grown share about 200, 250 basis points over that horizon. We think market share is best gauged over that period of time because a 90- or 180-day period isn't always indicative of a whole lot of things beyond that. And so we like the long-term trajectory of that market share. It has magically coincided with a great uptick in our digital strategy and our e-commerce business. I don't think that's by accident. I think those are 2 very -- those things are tethered in the end. And if you think about who our customer is, it's largely a 3- to 4 truck small business owner operator. And they've never had access to the technology that we are now providing them. And it's helping them think differently about their business. It's helping them envision different possibilities within their 4 walls. And it's turning that owner operator into a more sophisticated actor in the channel. So those investments have been -- have paid off in spades. And I think it is the linchpin to why we think there's confidence beyond whatever the market gives us, whatever that long-term trajectory is of 3% to 4%, we think there's an upward bias to that over time because of the digital strategy.

And the scorecard, just -- now I'll exhaust the thought. But I think our 9% growth in the quarter in sales, the digital community was in the teens, nondigital community was less than 9. So what happens? Is it the more advanced, ambitious technology-driven contractor is growing at a faster rate, taking share from there? Could be. It could be an answer, right? It could be a share of wallet discussion with our user community, it could be a few different things. But we also know the attrition of that user community is a fraction of the attrition of our conventional old-school contractor that might want to go on train trip to Portugal this year instead of our trip to Mexico. Our industry still has customer trips going somewhere. You lose market share with a customer if they like someone else's trip better. Still happens by the way, it's not like 1970. That's -- we may be going to Portugal this year, I don't know, but I know which contractors are going to grow faster over time. And so that's why we really like this digital strategy. We always invite anyone to come down after our conference calls to like listen to that and hear it. It's a longer-term perspective. We get questions about AI, we get questions about what the manufacturers are doing and what our competitors are doing. And we've always believed that if we're there first with our customer to take them -- to basically run their business on our platforms, that's an advantage no one else can create. If we do it first. So that's where these investments are paying off, we think, also.

We want to ask, obviously, a question on gross margin. But before we do that, anybody in the audience have questions on the markets -- want to ask? No. Okay. So maybe just talk about how we should think about the gross margin performance -- 27% has been kind of your line in the sand for gross margin. Should we think about that as kind of what the expectation is for '25 as well because there's a lot going on this year with product transition or what have you should -- could be better than that. It could be higher than that?

Sure. I feel better than worse about answering that question, by the way. We pegged 27% a couple of years ago after increasing gross margin during COVID. And the fundamental question was, is it temporary or permanent? And I think Steve said in our office at a meeting. I think it was you and you asked, is there any risk of going back to where it was? I said there's no risk. And that's like a straightforward statement not often said in the meeting. And that's because we also felt very strong that the technology, the culture, the tools in the field, the -- if not just simply the people doing their job that had raised margin, we're going to keep pushing the boundary of what had been a 25% gross margin. And the other interesting analysis is, everyone in this room manages a portfolio. Everyone's portfolio last year went up 21%, and I'm making the number up. What's my point. My point is, inside that portfolio, you have underperformers, you have outperformers. What do you report as your investment return is an average, right, of your portfolio? So as our gross margin. When we say 27%, that is an average across 10 business units. We have business units that are at 30%, which then admits to you that we have business units less than 27%, and what are the attributes and what's the leadership and what's the technology use and what's the constant struggle, the constant improvement criteria you need to get to well beyond 27%. So I'm almost doing therapy about this now and answer your question, I could be a little more, again, straightforward maybe, but we see 27%, again, as today's stopping point. We see higher margins over time, assuming our portfolio of business units are adopting some of the technologies or better at those technologies of their peers that are already closer to that. It's also a product mix opportunity. Our business units that are higher have a bigger mix of parts and supplies. Those that are lower do not. When we sell parts and supplies, we're in the 30%, 35% to 40% margins for some product lines, equipment. Therefore, I'm telling you is less than 27%. So we want to grow our equipment business. It's more profitable when we do. But to our margin, the parts and supplies algebraically at least are -- is an upside to our current performance. So if I think real short term, again, where we have a measure of inflation going on this year, we have a measure of new product growth coming in this year. As of March 12, pretty stable market that we're -- we see ahead of us, I would expect to improve margin this year, not have margin risk, I'd say that March 12.

On that parts and supply side, there's been a bit of volatility on the gas front, 410A is down and kind of stable. But the 454B we've heard is it's either availability, some canister issues or they're raising price to offset the 410A weakness they didn't expect. Anything on that front that's a variable that's influencing your results here in the near term? Or maybe just an update on what you're seeing on that gas in the channel?

Sure. Well, first, refrigerant is a $200 million product for us. So again, 3% of sales, just like to scope the answer when before I give the answer or give some scope before I give the answer. There has been, I would say, deflation on average over the last 3 years in 410A, gas, which defies logic because it's become a more scarce product and -- but nonetheless, that's what it is. And as -- so I don't think there's a story to tell. Margins are fine in refrigerant. There's no price volatility per se. There's no more deflation going on. I don't think we're -- nor are we seeing the upside of greater scarcity that economically should occur. With 454, it's probably less than $25 million of revenue today. That will grow as contractors stock their trucks and get that infrastructure kind of in place, nothing early on that I would say is a trend or a signal that we see Steve. That's also an OEM question where they're buying railcars of it in a factory. It's a more material event at the OEM level. We're buying 25 pounds -- containers, one pellet at a time, and you should ask them that question. That's a broader dynamic.

Okay. Great. We're out of time. Thanks, guys.

Thank you, everybody.

Thank you.