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

Well, thank you, everybody. I'm Chris Snyder, U.S. multi-industry analyst. Super excited to have Barry Logan up here with me from Watsco. Thank you for coming, Barry.

Thank you.

Maybe starting off high level and kind of open ended. We've had a lot of resi HVAC updates this week, both from the OEMs, some industry data. There's a lot of like cross currents going on in the market. Can you just kind of talk about what you see out there?

Sure. Well, first of all, I started my day at 7:00 a.m. So 9 hours and 50 minutes later, I'm here. So I've talked about all day. I'm either well-rehearsed or I'm tired of talking about it.

Probably both.

So just to do a little bit of therapy about it. So yes, there can always be an every year be a disconnect where a product change has gone on to the extent that it has, right? So played back a year ago. A year ago, we knew 410A was leaving the building. We knew that OEMs had a deadline in which we could order the products. We knew customers wanted the product. And as distributors, we decide to build inventory to take care of our customers. And our customers do not like change very much. They'll take change when they have to, but not necessarily well ahead of time. So I think our fellow brethren of distributors, not just us, built 410A inventory in the fall last year. It was reflected in the industry numbers. I think industry shipments were up 22% last July, probably near 20% for the next couple of months. And a year later, everything I just said is irrelevant, right? So a year later, we have no special need, no deadline, no special transition going on. That inventory has been sold out for the most part. And a year later, it's part of the calculus that you should consider in why the OEMs would be reducing their thoughts on inventory levels. And I think now it's -- that's part of -- certainly a material part of the discussion is the comparison of a year ago, shouldn't be obviously ignored. Secondly, as new products came out early this year, and again, we're talking about taking almost 60% of our product volume emptying out our stores of the old product and bringing in new products. Imagine -- I mean we have a store in Miami that has $70 million of Rheem product, average Home Depot does $45 million.

Really? Wow.

So let's take 70% of the inventory in that store, sell it off and bring in new product. Let's fix the price, let's make sure the margin is right. Let's make sure customers are happy. Let's make sure they know what they're doing. So the distributor level of cost commitment, fortitude was to transition an enormous amount of product beginning this year. And you had lead times extending out. You had lead time uncertainty beyond those extended lead times playing out. And as distributors, our lead time is 1 hour. If you order the product this morning, I want to have it to you in an hour. Not next Tuesday, not when I can get it from carrier, not when Mitsubishi delivers it to me, an hour from now. So to always hedge the risk of product availability and uncertainty like we just experienced this year, we build inventory. We build safety stock. We build -- we use our balance sheet. And distributors use their balance sheet, not just us, to be in a good position for the season with product, right? So there is an element of safety stock that's been carried all year that every distributor now has out of season to move out of their locations. Oh, there's a third one. You see I've done this today. The third one is the reality that the demand structure this year isn't what any of us would have thought going into the year. So we said in our second quarter call in our 10-Q, units were down 12% year-to-date. I would say that's a very consistent percentage and concept for what we're seeing right now. So no change -- no real change in trend or behavior as we got through the summer, positive or negative. What we said in July was our revenue dollars were flattish. I would say the same thing sitting here in September. Our earnings were up slightly in the second quarter. I would say we have that opportunity for the third quarter. So everyone should have some sense of feeling that consistency has gone on in our market to the contractor. I say that with objectivity. And more of what the OEMs are sensing or seeing or saying is really this huge inventory reality. And part of that reality, the third reality is demand is less than we thought. And if we're building replenishment, where we think units are flat and instead, they're down 10%, 12% in a market, we're going to replenish at lower levels as time goes on. So part of the -- again, the calculus going out of season is to position inventories to reflect the demand environment we're seeing. And when units are down, we will replenish at lower levels. So those are the 3 factors. And there's probably more nuances beyond that. But that's where the disconnect is, I think, between what I'm saying is a fairly stable kind of contractor market. We'd like it to grow. We'd like it to be stronger, but what we saw in terms of trends has been pretty consistent.

I appreciate that. I think coming into the year and in the early part of the year, I think you guys had been saying that the intention was to have extra inventory to accommodate the transition. But then it seemed like that inventory position continue to increase or even deteriorated from like a turns perspective. And is that just essentially a function of the demand got worse as the summer went on?

Yes. I think that's one part of it and maybe an equal or greater part of it is the safety stock that was really needed to build into our availability in season. So for example, we don't buy a box from a Rheem factory and sell the box. To make a system work in my home in Miami, I'm buying 3 different components from Rheem, made in 3 different factories. And I'm converting that into truckload quantities into a store in Miami. And what I just said, it was typically a 20-, 30-day lead time reality, it became 60- to 90-day lead times across all OEMs. And again, building those matching systems, building that matching set of components became far more complex over the last 12 months. It's simpler today. And getting it right, getting the mix right, getting the matching right is where inventory gets built. And as that unwinds as lead times and kind of the pattern and consistency of what we're seeing, we lower inventory. So demand plays a role in that, I would say, the safety stock discussion and lead time inefficiency discussion had as much to do with inventory is coming out at this point.

If I understood your earlier comments, it sounds like you were kind of saying -- I know you guys said on the conference call, July was flat. It sounds like it's been similar as Q3 progressed from a sales perspective. So we're kind of thinking about volumes maybe down in the 10-ish percent range or something. What -- is that a function -- like is that a function of consumers' uncertainty on the consumer? Is it -- is there a risk that the industry has just reached a price point that is just driving demand destruction? Like what -- is it weather? I mean no one wants to blame weather, but we know that does have an impact, like...

Sure. Well, two things. You mentioned price just to like mop that up a little bit. Everything we're selling now on these new products we needed to do two things under our control, get the price right and get the margins protected from a historical basis. And right now, the price trend on those products is around 12%. That's a combination of introductory price, plus the price increases since then. And that's been holding very steady, and we're very comfortable with what's been achieved and at higher margins. So that we can't control and so far, so good. I think the -- your question is, is this -- why did the units decline? Source of it?

Why -- yes.

Just call it simple. About 60% of the decline this year in units is either new construction, new housing construction, multifamily housing construction, our multifamily kind of facility management type customers that buy a special prices, we identify them. We know who they are. We buy at a different cost from our manufacturers to support that group. In Florida, in particular, it's down almost 20%. And that -- and Florida is 20% of Watsco. And I think single-family housing completions is a good benchmark to keep it simple, which are down about 16% through July year-to-date. So I've not talked about homebuilding in 15 years since 2010. I've not mentioned like homebuilding, as either a positive or a negative until this year. And it is about 15%, 20% of what we sell. And it's part of the unit decline, probably more material than any other category of product. The rest of the unit decline is obviously then consumer-driven. So why? And by the way, we can compete market share down to counties and states and brands and markets. We don't see our market share impact this year. A market like Florida, we're in 30%, 40% of the market for our Carriers. So we're not going to have market share chiseled away in big markets. But we do see -- because every business is cyclical. If you sell something and collect money, your business is cyclical, which my definition means every business is cyclical. But how much risk is there? So this year, clearly, the consumer is heavier. The contractor sets the price of these products. I don't, Carrier doesn't, Trane doesn't, Rheem doesn't, Lennox doesn't. The contractor sets the price of these products in the market. And if the contractor doesn't have the full swagger to go in and close a $10,000 installation and default to something that keeps the business but has a lower rate or perhaps a band-aid instead of a replacement or a lower brand versus a different brand or replacement refrigerant and fixing a leak instead of a new system, I keep it simple. I think people are spending less money on their homes this year. And if you look at -- if you glance at Home Depot, same-store sales were up 1%. That would tell you units are probably down in all the stuff they sell, just a basic proxy. So it is a heavier year. Is it rates? Is it economy? Is it a sense of concern? Always. And so our job is until like fret about it, our job is, again, to sustained price margin market share as we head into next year, if we have lower rates, great, that will help some of this underlying heaviness. Existing home sales is a component of that consumer discussion. That's down 15%, 20% in some markets. So okay, it's a heaviness that's going on. I don't want to complicate it by any more articulate answer than that. People are spending less money on their homes. And -- but those cycles typically don't last. And I think at this point, the industry shipments this year, just my guess, will be very close to what they were in 2019. And we know there are 15% more installed units today than in 2019. And if some conventional churn of replacement or systems show up in the next several years, its growth against the market this year that's down and probably at the contractor level, probably down 10%, 15%. So I'll take that as a vision of improvement. We don't see it yet, but 35 years of experience tells us that this could be a bit of a trough in what the consumer is doing. And it's really not so much the consumer has with the contractors recommending and doing. And so that's where we're putting a lot of energy and technology and some market share thoughts with some initiatives, some incentives, how do we get the contractor to have kind of the swagger to go replace more units next year and not necessarily count on what the economy is doing.

I appreciate that perspective, maybe kind of turning from the market more towards Watsco. In the second quarter, you kind of talked about the inventory. I think inventory is up 24%, sales were down 4% or 5%, if I remember correct. I guess what's the time line for you guys getting that back? It's kind of a normalized level? Because with volumes still negative here, it's obviously a tougher job.

Yes. It really goes back to our order book with our various OEMs. There's about 600 total vendors in Watsco, by the way. It could be Owens Corning, could be Resideo, it could be Mueller could be a variety of companies that we buy products from 3M duct tape, Avery Dennison duct tape. There's not a single one of those vendors as well as those at this conference, that isn't feeling a lower order book as -- again, as we can kind of get through an inventory cycle that should be lower and should be more productive for kind of our teams. But the opportunity is then to use that capacity and buying power as we head into next year in a very effective way. If it's making deals, making programs, making some kind of collaboration to grow the business next year and kind of use our balance sheet as a way to do that. And as we build inventory into next year, be a very good partner to those that need to grow and sell products. So I'll leave that as abstractly the way I've just left it, but kind of use some of our market share capacity and capital as a way for OEMs to take advantage of and grow with us. And we haven't been able to have those conversations with that level of theory in the last couple of years given all the product changes. And now it's a simpler business to look forward to, and we see that as an opportunity. But I think the -- your question of timing, I think we can certainly own less units at the end of this year versus last year. And the question is proportionately how much less. And so we'd like it to be kind of conformed to what we see in the market. And the price of those products today, as I said, at least in the equipment side, is about 12% higher. So dollars will add to the equation. But units, I would say, 90% of our heavy lifting can be done this year. And if it lingers into next year, it's because we're not going to just cut inventory for the sake of it. We're going to still serve customers. And -- but we'll see. I think the intent is to have less dollars and certainly less units than a year ago by the end of this year.

I appreciate that. If we -- the HVAC resi has a really strong track record of price from the OEMs. Obviously, distribution as well. You guys have a great pricing track record. Is this market so unique in that the price action is so choppy, that people are on different footing. The demand is -- or the flow of activity is catering to a degree that, that is starting to change a little bit?

Yes. I think that's always a worry and part of the common sense is to go back to kind of how things work transactionally. So just to have fun with numbers. So an OEM makes something for $2,000. I think this is pretty accurate, by the way. The average system price that OEM sells to us is around $2,000 for that matching pair of systems. In turn, I'm not -- you know what their gross margins are. You know what their EBIT margins are. We sell it for probably $3,000 and make 26% margin. You know what our gross margin, EBIT margin is. What we sell for -- what we buy for $2000 -- I'm sorry, what an OEM makes for $2,000, they sell to us for $3,000. What we buy for $3,000, we sell it for $4,000. Well, the average ticket price installed in a home is -- for that system is $9,000.

A lot of layers.

So why is that? And who's making the most margin? Is it an OEM? Is it Watsco or a contractor? That's why I'm saying the contractor plays a greater role in this entire conversation than any of us. If the contractor can set the price at $9,000 and have a great business and make ends meet. And again, we're going to, as a distributor, help him do that and do that every single day. That's where our service lies, it's a good business. Now if the price goes up 5% because tariffs, inflation, commodity prices, labor, transportation from China, whatever, the price goes up 5% to -- now my price went up to $3,150. My selling price went up to $4,200. Does that really change the $9,000 very much? Does the guy go to $9,200? Is it going to push back on me? So that's where pricing, I think, has the opaqueness of that changes and also common sense you only buy one of these things twice in your lifetime. And you didn't know 10 years ago, it was $6,700. All you know today is that's $9,200. So I think we worry less about price friction when there's a little bit of inflation going on. What I worry more about is, is there a consumer that just can't afford $9,000 and tell the contractor can you just fix the leak and get me by for a period of time. And I'll come up with -- I think that's more a macroeconomic reality in our industry, then can we continue to pass on 5% price, if there's inflation going on.

Yes. No. Interesting perspective. The other kind of dynamic that's been going on in the market is obviously the 410 to 454. You guys pivoted over to 454 earlier than some others. It pressured your sales in the -- at least in the first half of the year. I don't know if you disagree.

Yes, more so in the first quarter than the second quarter, but yes.

Okay. And I guess, do you guys have any sense of how much 410A is left in the market? Is it gone at this point?

Yes. I think, well, in our case, I think we were around $100 million of inventory left. We started the year with about $1 billion in 410A inventory. And I think Lennox said here's where we are, which was very consistent, I think, with that. What we see in the channel now is very little kind of competition for that 410A business. Yes, I don't think there's a lot left in the channel. I mean there's an artificial reef risk if you own too much of it heading into next year. We're allowed to sell the product only in components, not as systems. And so going along on 410A might have been a benefit in the first quarter or second quarter, but became an artificial reef write-off risk if you had too much of it. And that's why we were conservative about it. And why I think most distributors have been -- are not holding on to a long amount of 410A inventory at this point.

Kind of talking about that time line, the EPA has talked about a possible extensions of that 410A selling window. I guess do you guys have any perspective on that? And I guess if that were to happen, like what would it mean for you and the industry at large?

I think there's maybe two layers to extending something. One is the ability for our contract to install systems beyond this year. Right now, the deadline is a contractor to install a system that's 410A, it has to be this year, it can't be next year. If that were extended, it would take some of the pressure off of maybe distribution to try to sell out of all of it. I don't think it would be an incentive or even a thought for a manufacturer to make more of it into next year. Again, I thought Dave Gitlin said it well, there'd be a cost to that. You have component makers that have moved on, you have OEMs that have moved on distributor inventory that we're not looking to own two different product lines either and every part of the industry has said, it's not -- doesn't make sense to us. That doesn't mean it doesn't happen. But I think there are other parts of the industry that use refrigerants, be it frozen containers or frozen buildings or frozen grocery stores that have that concern that if we chop off availability this year, it is going to cost us a fortune in the long term, but we're talking about converting a grocery store that's got to spend $2 million on that. So those industry associations are, I'm sure, the ones lobbying. I'm not sure anyone in our industry is lobbying for that kind of extension.

I appreciate that. Maybe going over to the light commercial side of the market, where the updates certainly more positive on the resi side. What are you guys seeing over there?

Yes. Again, consistency with what we've reported year-to-date, probably units are down a little bit. Pricing is up consistent with 410A. I mean, with the 410A transition because -- or A2L transition because those products are affected there, too. I would say consistency again, I think light commercial, in our view, is someone's CapEx, it's a $10,000 machine on top of a retail store in a shopping mall. So the economy, I think, could have some weight on that, but it maybe has, but I don't think it's material. I think there's still an interest rate of a part of the economy that has been restrained in spending some CapEx, you would see that across your universe of -- and light commercial, I think, can benefit from either a stronger economy or lower rates to uncork some of the restrained CapEx that's gone in the market. But it's not, I would say, better or worse. It's been pretty consistent as we see it.

Appreciate that. And you think interest rates are kind of the tailwind to kickstart that more than anything?

Yes. I would never say more than anything. I would say it's a component of the discussion. I think business confidence and abstractly whatever that means, is probably more to do with it. Watsco's CapEx budget is probably more restrained than what we'll spend next year if we feel the economy is picking up, and we're not the only company that probably would say those words. So it's conservatism, I think, that versus interest rates.

I appreciate that. There's obviously a big focus this week on the resi sell-through and kind of some of the headwinds that's being faced there. Is it possible that there's more downstream inventory at the dealer installer level than everyone thought in that, okay, maybe end demand is actually better than we're seeing, but that's just kind of eating away at the sell-through data?

Yes. We certainly manage bulk sales to customers carefully for two reasons. We're taking credit risk if we do that. And there's always a thought of rebalance where they say, well, I bought too much, can I bring some back? So I would say the days of stocking of dealers for us and our business model has diminished and is de minimis at this point. I can't speak for others that if we have 107 locations in Florida and we do, and we have competitors that have 12 branches in Florida that are at this conference, or 20 branches instead of 107. I have the product. I don't need to put inventory in a small town in Florida to get somebody product timely. They can come get it and they don't have to own it. So a lot of the other business models where there are fewer branches in markets and part of pushing finished goods into the market is to have contractors take it. And I would say it's extremely de minimis in our company because we have the branch network that supports the customer.

I appreciate that. We haven't talked about R-32. I guess you're kind of talking earlier about the price on the homeowner. R-32 from our understanding is cheaper than 454. Is that -- are you seeing that have an impact on that maybe the installers are looking to those products?

Sure. Well, the R-32 is installed by Daikin at the factory when they make the product. So if it's cheaper for Daikin to make that product, then that's their profitability to either enjoy or use in the market. We don't see any real change in and we're -- I think we're a Goodman's third largest customer. There's no like price competition that's been introduced as a Goodman distributor in the market because of that. We're not looking to introduce, frankly, deflation into the market and try to grow with a lower price. There's really not a long-term benefit to that. What we see with Goodman and Daikin, importantly, is they have product in the channel in mass this year. That wasn't the case this time last year for reasons that have been well publicized. And guess what, if you have less product in the market to sell, you'll sell less. If you have more, you'll sell more. So I think they've done a good job of -- and have been a great supplier to get product in our channel to grow it this year. Our Goodman business, Daikin businesses has absolute growth this year. But again, I think it's more of a consequence than distributors having product to sell and be active in the market this year versus last and has little to do -- if nothing to do with any kind of price advantage of some kind. I mean I think Daikin also is an innovative company where they've come out with new products, they've come out with higher efficiency products. They want to innovate beyond just -- and I think it's help their business this year and again, it's an important partner to us.

I appreciate that. One question that we've gotten on Watsco is that, obviously, with the industry headwinds, the pace of the company's earnings growth in '25, and I mean, I guess, we'll see about '26, but '25, obviously, under pressure. I guess anything that we should think about on the dividend. You guys have a really long history of steady and quite material increases. Like is that tied to EPS growth? Like how should we think about that?

Yes. I would say it's -- well, first, just for everybody's sake, we paid a dividend for 50 years. I would say, the last 15 years or so, it's been about a 10% compounded rate, maybe 11%, whatever the math is. And it's more of a consequence of what we see in cash flow than EPS. So let me play with your head. So let's say, our business is down 10%. What happens to working capital? It goes down 10%. We have more cash flow in a lower earnings environment and conceivably can raise the dividend well beyond an EPS because the cash is there. So today, Watsco has no debt. One of 3 Fortune 500 companies that can say those words, Google it. It's only 3. And so the affordability of dividend isn't just having the cash, it's having the cash flow. And EPS actually is not a -- I'm not saying we ignore it or we pretend to ignore it. I'm saying our cash flow is really what drives the dividend. And with almost no CapEx really material to speak of free cash flow and operating cash flow is relatively the same. And 51 years, we'll raise the dividend again.

No, really interesting point that it almost seems like distribution is a great business. I guess, only a minute left here. I guess kind of just to wrap, it seems like from our perspective that you guys feel like you're obviously taking a lot of inventory, maybe a little bit to go next year, but really the heavy lifting is done this year. And you -- it seems like you think the industry could have a solid setup into next year, and you guys might be, I don't want to say aggressive, but in the market looking to build inventory into that next year?

Yes. I think the inventory will follow the strategy, right? So Carrier here yesterday and they talked about growth, they want growth. It's our biggest partner, like by 5x. So just to talk about that for a second as an example, I mean Carrier is a great partner. It has been, I would say, an exceptional partner over the last 5 years because in their independence and their own entrepreneurship and their own need for growth and desire to grow, they become exponentially easier to do business with to say, what should we do? And so I guarantee you, in this environment, after all this product stuff is done and we're like catching our breath and kind of sitting down and saying what's next? They've very aggressive growth plans with our -- with all of our partners, but I'll pick the biggest one. And it's not just open to ideas. It's a complete open-mindedness to say what can we do? So we're really looking forward to that for next year and do that with other big partners of ours. But that one in particular, is strategic, and we're strategic for each other. And it's actually pretty exciting in terms of things that we're conceiving of and working on and collaborating on very closely to achieve. So that's conversations we didn't get to have at the same level of freedom, given all the product changes that have gone on and now we can.

Well, we are up on time. I appreciate you sharing all your decades of knowledge with that. So thank you.

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

Thank you.