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

Thanks for joining us, everyone. Good afternoon. Before we get going, let me read the following disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. My name is Christine Yao. I am a member of the multi-industry team here. And on the stage, we're very pleased to have Barry Logan, Executive VP, and Rick Gomez, VP of Corporate Development from Watsco with us today.

So let's start with something high level maybe. Watsco has become a much larger business today. Where do you guys see the biggest benefits of Watsco's scale? And what can Watsco do that other players cannot simply replicate?

Well, thank you, Christine. Thank you for being here, everybody. It's the last session of the day, which also means, I guess, we can run a couple of hours if we want to, right? So just kidding. We are Southern storytellers, so we'll try to contain it. So scale is the question. So scale historically for us has been very acquisitive in the markets to have the capital, to have the relationships with OEMs, to know who the big players are, to have the credibility to discuss acquiring their company. And most of the time, when we say acquiring a company, it's a family business that has been around 50, 60, 70 years. So the personal chemistry, the credibility to talk to them, manufacturers who have to permit who can buy one of their distributors. Just the idea of having the scale to get things done at scale has been successful for us over almost 40 years now. That's old school, but still going on and still important to us. Scale also meant being a mega partner to the manufacturers that we represent. Manufacturers are not at your kitchen table when you buy these systems. We're not at the kitchen table. We are maybe through technology today, but the contractor who actually does the work, who gets paid, who pays us, who produces the unit volume, who gets things to happen at the homeowner and business level, our scale helps that. It helps with the number of brands we sell. It helps with the number of stores we operate. It helps with the complexion of all the goods we might sell in those stores. It helps with the number of employees we have serving the end market. A bit old school again, but that's part of what scale does. More recently, the word technology, which every company wants to describe as a moat around their business. Again, we're dealing with 100,000 contractors, 30,000 SKUs, 700 stores, infinite number of price points, an infinite number of customer interactions and all of which converges in the idea that everything everybody wants in our industry, they want an hour from now. Very much almost a retail trade business selling to contractors who order in real time, who want the product in real time and tomorrow it becomes a different day. So the last 10 years, how do we bring an ecosystem of technology that does that and operates in that fashion and provides that value, provides that speed and convenience, accuracy, completeness, all the things that technology can do versus just relying on historically old school, kind of the grumpy old man in our stores answering the phone. How do we make it a 24-hour business, not an 8-hour business. The scale has let us spend about $60 million, $65 million a year on building out the technologies that help the contractor every day that help the homeowners, how they source and buy products from our customer, how we can improve the operations of our daily life. I have 30 more minutes to answer the question, but you get the drift. But at the end of the day, it boils down to strong OEM relationships that are critical and material to them as part of the scale, the ability to innovate and deliver technology and the credibility to acquire some great businesses that have been around for decades that are interested in doing that with us.

For sure. Maybe, let's stay with contractor for a minute. As contractors become larger and more sophisticated, how does that change what they need from Watsco? Does greater customer scale change economics of the relationship? Or does it ultimately make Watsco's platform more valuable?

Well, I think it's -- the first reaction to something like that is you worry, you assess, you have to like try to figure things out. That's the near-term reaction. And about a year or so ago, we said, wait a minute, on paper, we are tailor-made for this trend. We have the scale that we just talked about. We have the industry's most advanced technology platform to go help these growing contractors win. We have the industry's best digital selling platform to help them execute better in the home and close more and higher price and higher-margin orders in the home. And so we decided to embrace the trend as they say, don't fight the tape. So we're not fighting the tape on this one. We decided to embrace the trend. And we announced at our Investor Day in December, the launch of something called SupplySync. And SupplySync is that single pane of glass that a large consolidating customer has to go procure and have the entirety of our PIM catalog at their disposal, the entirety of our business units' resources at their disposal, again, our scale and our technology. And so we think it's a win-win. We think it's a trend that we can do well with irrespective of what the near-term irritation of it might be. I think it's something that we can absolutely capitalize on. So it's core to what we're doing now, and the update is SupplySync is with its pilot customers, and we intend to scale that later this year and entering into 2027. There's both a volume and a margin opportunity that comes with that. The volume opportunity is that, today, those existing customers, we feel like we have less than our fair share of -- share of wallet. And so that's where the incremental volume can come from. And it's a margin opportunity at the same time in the sense that what we sell to those customers today is largely equipment. And again, by exposing the full totality of Watsco's inventory and PIM catalog, we think we do well with nonequipment with that customer segment over long periods of time. So it's a trend. We're prepared for it to persist. And I think we have, again, the scale, the technology and now the platform in SupplySync to make that successful.

That's very helpful. I appreciate it. We've covered some topics about value prop to the contractors. But maybe let's switch to talk about the OEM side. What is Watsco's value proposition to the OEMs?

Again, it's -- first and foremost, it's the contractor relationships that we have. Again, that's who is actually defining the product to be sold in the home, who specifies the product, it's who the contractor's the one there at the point of sale. And access to that contractor relationship is the critical element of how we compete, more contractors, more brands, more locations, more everything. And we think that that's the first access point of an OEM when you make stuff in a factory is how do I get access to that local market, and that's through our relationships, first and foremost. Secondly is, I think the last 10 years of -- when we use the word technology, is to drag our OEMs into that environment when none of the distributors necessarily were asking for it. We had to get Honeywell to give us their product information. We had to get Carrier to give us their bill of materials for everything they've made over the last 10 or 15 years. So now a Carrier dealer can sit in someone's backyard and know the right motor because we have the bill of materials sitting there on a mobile app that he can draw on to find the right motor. So again, I think there's been a lot of value and continued value and more innovation to occur of how do we bring and a manufacturer wanting to bring itself into the point of sale into the contractor relationship at a point of -- again, using the technologies that we've developed. And the other is capital. Working capital in this industry as a distributor is roughly 90 days worth. So if we were to grow a business from $200 million to $400 million, that requires that proportionate amount of working capital to put in the market. If Carrier, Rheem, Daikin, one of our OEMs says, how do we grow? They need to invest it at the factory, and we need to invest the working capital it takes to deploy that into a market, support it with credit, support with the inventory, support the know-how. And so in our joint venture with Carrier, for example, this is certainly on our books, more than $1 billion of capital is sitting in our balance sheet trying to sell more Carrier products each year. And several hundred million dollars of Rheem working capital is sitting there on behalf of Rheem. And again, if their factory grows 10%, 15% a year, they've invested 0 in that working capital. We've made that investment. And so it's collaboration that is obviously very important. But we can -- we're the investor of working capital in this industry to grow an OEM's business. And to the extent our wealth and our capability and our -- we're here to help you learn more about a growing public company, that is our charter and OEMs know that. We're not trying to protect the family's interest. We're trying to grow our business. And a few billion dollars of capital is in place to go do that. And so that's a few of the ideas that an OEM gets in partnering with us.

And I would just add very quickly to that, that there's -- we -- for those of you that are newer to the story, we operate in a $75 billion industry. We're the leader in that industry. The top 5 or 10 command what they command, but there's 2,000 other distributors that comprise the chunk of that, the majority of that $75 billion in TAM. So what I'm trying to convey is that the median distributor in our industry is not Watsco at $7 billion, it's $100 million, $200 million, $300 million distributor. And that fabric and that network of distribution, some are investing, some are not. And I think what we offer very strategically to our OEM partners is there's a balance sheet with no debt and there's every ambition to grow this business and invest in technology to do that. I'm not sure that's true everywhere in the distribution landscape. And so that's what I think we offer to more qualitatively and strategically is a -- we're thinking decades ahead in terms of how we invest. And I think that's rare when you go look at the average distributor in our space.

Maybe to further understand the dynamics and relationships with OEMs, if we see meaningful OEM share shifts or potentially new entrants gain traction in the market over time, does Watsco economically care which manufacturer ultimately wins? Or could greater competition among the OEMs actually increase your strategic value? What's your take?

Yes. Well, first, it's important to understand how we go to market as Watsco. In 700 stores of Watsco, there's not one named Watsco, by the way. And so why is that? Well, we acquired business units that have been great at building a brand before Watsco. So we have -- for example, we have a large business unit called Gemaire that sells Rheem throughout the Sunbelt. We have our joint venture with Carrier, where we're selling Carrier dedicated brand locations, selling billions of dollars of Carrier brand. We have a relationship with Daikin, where we have one of their historical 60-year-old distributors that we acquired 25 years ago, helping build the Goodman and Daikin brands in its markets. So my point is that we have very defined business units whose charter is to grow market share of the brands they sell. They're distinct with some measure of independence. We want to grow those customer relationships, and we want to build our company with that array of brands and opportunities. And the OEMs understand that. They respect that. It's how we've operated for, again, almost 40 years. And -- so very dedicated networks that are there to grow brands. And the question is how do we add more to it? So we've acquired a couple of Carrier distributors in the last 6, 7 years to build on our joint venture. We recently also acquired a Daikin distributor in Texas that is now dedicated under the Watsco philosophy to build its brand network within that. So OEMs understand that, and we don't grow if we ever substitute one product for the other. Our job is to be supportive of our business units, trying to do that. And that's where the relationships are really at the grassroots level is in the field within local markets. And again, I think our job at the Watsco level is to build great relationships to enable that. And then we're still not in 10 states. We're still not representative of all brands in the market. And we'd like to diversify over time because that reflects what the market is. But the horsepower and intent and conviction of a brand is for all the brands we sell, and our partners know that and know how it operates.

Appreciate that. I think that's a good segue into capital deployment. As Watsco has become larger, how has the acquisition opportunity evolved? And when you guys are acquiring, I wonder what can you guys offer that other people -- other companies cannot, for example, like larger strategic buyers or like PE owners.

Yes. I think, look, we've -- we are a collection of businesses that operate as one umbrella under Watsco. And Barry is right, there's nothing in the market that says Watsco, you'll never see a branch called Watsco. That's very intentional. That's very much by design. Part of that is because our M&A strategy has been to go buy market leaders that have built terrific businesses. And our job is to go help them build on what they have built. Our job is to help them. We go to work for them. It's not the other way around. So I'll get to what we offer them in a second. But I think the aperture for M&A and the opportunity for partnering with more terrific businesses, it's as great today as it was 10 years ago, 20 years ago. And I'll give you 2 proof points of that or just 2 data points to validate that. If we're, call it, $7.2 billion of sales prior to the 2 acquisitions that we've just announced that add about $750 million of volume to the business, by the way. And I just mentioned that the industry is about $75 billion in TAM, then that's one way of computing market share. Let's round that to 10%. So lots of opportunity to go, nowhere near anything that would be considered mature. And then the other way to measure market share is if you just look at traditional residential unitary shipments, we are 18% to 20% of the market. So in neither scenario, are we so capped out that M&A isn't an ingredient for growth. What we offer and what we attract these -- and what we -- I think is a point of attraction for many of these businesses is we are a forever home. That's what we are. We get calls all the time from bankers asking if we want to dispose of anything, and we don't answer those calls because we've never disposed of anything. And so for the entrepreneurs that have built great businesses that have taken something that in many cases is multigenerational, second, third, fourth generation in certain cases, and it's time for them to rethink ownership, we are that perfect home where we offer the stability of, again, our balance sheet, our capital, our OEM relationships, our technology orientation and the fact that they can continue as who they are, as what they've built, their legacy, their people, their name, their partnerships in the market, their customer relationships, et cetera. I think that's been hugely attractive to, again, these very entrepreneurial-minded owners in our industry. And that is the strategy going forward. And there are many, many more of those opportunities in the market that we can go after.

I think our timing was good or fortunate. Most of these businesses were built after World War II, where -- and especially in the Sunbelt, if I said Houston and Dallas and Miami and Orlando and Charlotte and Phoenix, these are all post World War II boom places where air conditioners made it possible to live there. And so now 50, 60, 70 years later, they're second, third-generation owners that say, now what? And so similar -- a good example of that is actually in Philadelphia, our business unit in Philadelphia is about a $300 million part of Watsco. It's sold Carrier since Carrier, I think, launched products in Philadelphia in like 1930. It's actually a 99-year-old family business. We've owned it for 7 years. The Pierce brothers, whose name is on the building, it's called Peirce-Phelps, run the business, and there are 6 cousins that are fourth generation in the business. And we paid roughly 9x $10 million in earnings for it. And now it's -- return on invested capital is 30% and the same brothers are running it and grew it. And they have a lot of Watsco equity that has gone from $140 to where it is today. And that's our spokesperson for acquisition strategy to other targets. We just announced a large deal a couple of days ago. The owner of that business spoke to owners of -- 4 prior owners of other acquisition targets that are part of Watsco. And that's a big credibility factor as we go around other families and talk to them. And so financially, it's worked out well. Culturally, it's managed risk well. And the idea is, again, succession plan for the manufacturers to whose distributors are in that situation. And so there's a comfort zone, I think, for them as well in this. So that's been our approach. And Rick and I, a couple of others of us have known the families well over our careers. And now we're dealing with some second generations that are now in place for third generations, and there's a lot more to do. The funnest part of our job.

It is.

Let's switch gears to talk about some of the current trends. There are obviously some moving parts in the market. And so it would be helpful to level set and see where demand stands. What have you been seeing quarter-to-date?