Watsco Inc (WSO.B) 2005 Q4 法說會逐字稿

At this time I would like to welcome everyone to the Watsco, Incorporated earnings release conference call. (Operator Instructions). Thank you. I will now turn the call over to Albert Nahmad, Chief Executive Officer. Please go ahead sir.

Good morning, everyone. Welcome to our conference call covering Watsco's operating results for the fourth quarter and 12 months ended December 31, 2005. This is Al Nahmad; I'm the President and CEO. With me is Barry Logan, Watsco's Senior Vice President.

First let me read this cautionary statement. This is a reminder that this conference call has forward-looking statements as defined by SEC laws and regulations and are made pursuant to the Safe Harbor provision of these various laws. Ultimate results may differ materially from the forward-looking statements.

Now, on to our operating results for 2005. In all measures of performance, Watsco had another great year and, once again, our best ever. But before we discuss the specifics, I will comment on four general thoughts.

First, our most important goal is to build a national network. In 2005 we expanded our network by 35 locations, 27 from an acquisition and eight Greenfield locations. Growing our network continues to be our top priority, as our market share is only 7% of the United States HVAC market. We will continue this building process in the same concerted manner by making acquisitions and by Greenfielding locations in attractive markets. In 2006, for example, we have plans for an additional 20 Greenfield locations, and we will continue to be active in seeking acquisitions of high-quality, well-established distributorships.

Secondly, our strategy is to also continue to broaden our product offering. This helps increase same-store sales and meets another one of our goals, which is to have consistently double-digit sales growth each year.

Thirdly, a significant part of our strategy is also to increase profitability, primarily by driving revenue growth. In 2005 we controlled costs and generated double-digit revenue growth, which resulted in a 70 basis point jump in operating margins. More interestingly, over the last three years margins have improved 260 basis points, and we hope to continue this trend.

The last of my general thoughts is number four, and that's that the industry shift to higher-efficiency systems mandated by the federal government is well underway. This transition will play out more during the next few months and it remains a significant opportunity for us, the OEMs, contractors, and consumers alike, as everyone benefits from the higher-efficiency systems that are now in production and just now getting into the market.

Now for the specifics on 2005 performance. First, the fourth quarter. Diluted earnings per share increased more than -- I should say diluted earnings per share more than doubled to a record $0.50 on the 128% increase in net income. Revenues for the quarters increased 36% and improved 16% on the same-store basis. Gross profit dollars increased 35%, with gross profit margins decreasing by 10 basis points, and that small decline reflects the results of the recent acquisition. On a same-store basis, however, gross profit margins improved by 10 basis points.

Operating expenses were up 23% versus the 36% increase in sales, and as a percentage of sales, operating expenses declined 200 basis points and 19.4% during the quarter. Operating margins climbed 190 basis points to 5.6%. Interest expense declined 38% on lower borrowings and higher interest income, and net income reached a record $14.1 million. The fourth quarter was in all senses a terrific finish to an excellent year.

For the full year in 2005, diluted earnings per share increased 41% to a record $2.52. Revenues increased 28% to approximately $1.7 billion, and on a same-store basis revenues improved 11%. Gross profit dollars increased 26% to $423 million. Gross profit margins came in at 25.1% versus 25.6% last year, reflecting the East Coast acquisition, which historically has lower gross profits margins compared to our consolidated margins. However, this new transaction has already started to improve its margins during the year 2005, and I think that will continue as it catches up with the rest of the Company's consolidated margins.

Our operating expenses were up 20% versus the 28% increase in revenues. Let me say that again. Operating expenses were up 20% versus a 28% increase in revenues. As a percentage of sales operating expenses declined 120 basis points to 18.2% for the year. Operating profit climbed 42% to a record $116 million, with operating margins expanding 70 basis points to 6.9%.

Interest income declined 24% from lower borrowings and higher interest income, and [net] income dropped 46% to a record $70 million. Cash flow for the year was $34 million, and reflects three key working capital investments. First, towards the end of 2005 we decided to make additional investments in inventory in order to provide our contractor customers availability of product during the manufacturers' transition to the new minimum efficiency standard that's mandated by the federal government. Second, strong revenue growth rates during the quarter drove significantly-higher accounts receivable balances as of year end. And third, we used our cash to invest in new products and in new branches. Our debt declined 17% to $15 million, dropping our debt-to-cap ratio to 10% from 13% a year ago. On dividends, we once again raised our quarterly rate, raising dividends by 43% to $0.20 per share, and we also repurchased $17 million of Watsco stock last year.

Our initial earnings guidance for 2006 is for continued growth, consistent with our long-term growth rate of 20%, within the range of $2.90 to $2.95 per share. This estimate includes charges related to the new stock options accounting of $0.04 to $0.05 in 2006, and $0.06 in 2005.

That concludes my comments. And at this time, Barry and I will be pleased to answer your questions.

(Operator Instructions). David Manthey, Robert W. Baird.

My first question is in terms of the 13 SEER changeover, what are you seeing today as the new products are rolling out as far as the price differential between 10 and 13? And then, are there any availability issues, or are all of the OEMs now shipping the new 13 SEER machines?

I think you've got two questions there, maybe three. Let's take a shot at it. In terms of [PAC] availability, I would say that that -- there are mixed performances by the different manufacturers. I would say some are supplying and some are late. And overall, this transition, I believe, in 13 SEER will impact the industry primarily in the second quarter, not much in the first quarter.

In terms of pricing, 13 SEER pricing is holding steady, whatever is available. And I've even heard where one manufacturer and perhaps another will soon follow with price increases even beyond that which we thought was possible. So I would say from a pricing perspective, the discipline is very good.

Okay. And than as far as your growth goal, obviously, 2005 was a year of two distinct halves. Could you talk about the 20% and the double-digit growth goal that you have in terms of the first and second halves of 2006? And then I have one last question, Al.

I know that you asked the question because that's what you do, but we don't really look at our business [from the point of view] of quarters and halves. We look at it on an annual basis, and we look at it on the basis of what we can sustain. And the most important thing I've said in this whole conference call so far is that we are a work in process. We're building out a national network, and we think we've got years of growth because we're only 7% of a huge U.S. market. Other than that, I just want to say that we do what we've always done, provide annual guidance. And after that, I guess you have to do what you have to do.

Okay. And then last question, the number of branches today -- just so we have a basis for that 20 new Greenfield branches?

353 today.

Curt Woodworth, JP Morgan.

Congratulations on a great quarter. On the gross margin performance this year, you were down about 56 basis points. I know that that's partly driven by the addition of East Coast, which has lower margins. Can you talk a little bit about the other factors there, and was the decline all due to East Coast this year?

Barry?

On the yearly basis, the margins on a same-store basis were relatively flat. We saw some strength in equipment margins during the year, and our non-equipment margins were slightly lower, really because of some sheet metal activity that had gone on in 2004. That's perfectly stabilized now in terms of year-over-year comparisons. And if you look at the fourth quarter, we reported, as in the press release or in the conference call, that we saw gross profit pick back up about 10 basis points, which is -- if you look at several years, has been a long-term trend for us, is to improve gross profit little by little each year.

And if I could add, with the 13 SEER transition, at this pricing discipline that we are starting to witness, they say product availability is just coming on now, I think we've got a good shot at further improving gross profit margins.

On equipment and parts and services, or just equipment?

Good question. Our efforts are to improve across the board, but certainly I'm just pointing out part of our product mix is the -- will be the 13 SEER, particularly as we get into the second quarter. And I think it will have an impact there, too, as long as I see what I see now, which is very good pricing discipline.

Curt, just to be clear, what I said, which is important, is we did see some price increases this year, certainly not the magnitude that we'll see with the 13 SEER transition. But this year in '05, we did see higher equipment gross profit margins while the price increase was happening, so that's what we want.

Right. Okay, thanks. And on the same-store growth this quarter of the 16%, Al, I think last quarter you mentioned that the equipment was up over 20, and parts and supplies were over close to like 11 to 12. Is that a similar pattern this quarter, where the equipment was up pretty strongly?

Barry, do you want to answer that? I think that intuitively I feel that it was, but the percentages -- Barry, have you got that?

Yes. The equipment growth rates were around 20% again during the fourth quarter, and the remainder, which is still double digits, is in the parts and supplies.

And the 20% growth on equipment, when you look at the ARI data or the distributor volumes, they were up 60% in all October/November, 40% in December. Do you think that those are real numbers? I mean, if you're coming in well below that, how do we kind of reconcile that?

Another good question. We are not losing share. We believe we're gaining share. So I don't know what to say about that ARI data. They back into it by some change in inventory data. It's not as accurate as what we actually sell, you know, our business.

Andrew DeAngelis, KeyBanc Capital Markets.

Just a couple of quick fillers. Do you have staffing revenues and profit?

Staffing revenues and profit. Barry, do you have that breakdown?

Yes. This is something we will, obviously, put in our filings as well. For the year, 25 million in sales and breakeven in profit.

When you kind of look at the acquisition in that branch activity in the quarter, it looked to me that it was very strong. Could you comment on the East Coast performance and any net branch activity in the quarter?

I'd like to do that. East Coast has been performing brilliantly since January of '05, and I hope they're listening to this, how pleased we are with what they've done. They substantially improved their revenues at a double-digit rate and increased their earnings even at a faster rate than their revenue growth. And as I commented earlier, their operating margin are starting to move higher, which is what traditionally happens at Watsco companies as they first enter our system; they come in at a certain level, generally a much lower level in the consolidated basis, but over time they improve. And East Coast is certainly doing that. It's a great organization and they are growing very rapidly already into the first quarter of this year.

Super. You commented on a recent acquisition. Could you maybe give us a little bit more insight into that, and also what the pipeline looks like now?

Well, that is East Coast, when I said --

When you said the recent acquisition?

Yes. That is East Coast. In terms of the acquisition pipeline, we consistently are engaged with quality distributorships. I think we have a great reputation in the marketplace for what happens after an acquisition. We preserve organizations, we build on them. Owners like to talk to us when they get ready to sell their business, because of our historical past and how we handle their -- what they've created. So I'm optimistic that, as I've always said, it's just not possible to predict any activity until we actually engage in a final discussion. So there's nothing we can say to you now, other than this is what we're doing constantly, and we are engaged.

And I guess the last question, could you qualify or maybe even quantify the impact from the hurricanes in your business during the fourth quarter, and maybe what you expect going forward (multiple speakers)

I don't think we have a -- unless Barry has -- I know that the impact has been positive along the Gulf Coast and in Florida, but I can't say that in the scheme of 1.7 billion that that's a very significant part. I wouldn't want you to think that some sort of a surge is going to come in. It's good, it's positive, but so is everything else that we're doing. So I would just say it's just another activity that increases our business, and we are building more branches in the Gulf Coast area to support that sort of growth.

And you haven't seen any disruption at the same time?

Oh, yes. There was disruption, but those disruptions were four days only. And then after that we were up and running.

Michael Greenwald, BB&T Capital Markets.

Are you willing to break out the 16% same-store sales growth number? What aspect of that was from pricing and what was from volume?

Good question. Barry, have you got that (inaudible)?

The equipment side is really what we can see pricing, and it's about a 3 to 4% price increase in that the (technical difficulty) came all the way through in '05. (multiple speakers). Sorry?

Yes, it's about 20% of the 16% is in price changes.

And then your guidance, the $2.90 to $2.95 -- what does that assume on the 13 SEER pricing front? I know that you guys were expecting that to fall through -- flow through to maybe around the current 12 SEER pricing. But it sounds like that's holding firm. Where do you guys -- in your guidance, where are you guys envisioning 13 SEER pricing going?

I wish I could tell you that we have some sophisticated model considering what you're speaking to, but we don't, because we don't think it's necessary. What we think our priority is is to build a network, regardless of what happens with 13 SEER. I think what I'm suggesting is that it's very early to know what 13 SEER is going to impact in terms of prices and margins, because it really isn't a 13 SEER market yet. It's primarily a below 13 SEER market in the beginning of the year, so I think we'll have better views on your question by the second quarter, but not before.

Again, I'd like to emphasize that we are very long-term goal-orientated. You know, our earnings per share have grown at a compounded growth rate over the last 10 years of 20%, and that's on an 18% revenue growth rate. We think we can sustain these sort of things over the long-term, because our market share is only 7%. And the 13 SEER and other things like that, I think, are positive. And they're positive for every side of the channel, from the consumer all the way back to the manufacturer. That's just one of several things that are positive about the industry.

But it's safe to say that --

Well, [nobody's] going to be negative.

But it's safe to say where you guys stood at the end of Q3 pricing is coming out ahead of expectations it looks like?

So far, but I would not make a trend out of that, because it's just a few weeks, and it's just there's some availability is coming in. The manufacturers are not all there yet with all their models and all that they want to introduce.

Okay. And your buildup in inventory at the end of the year, was that mostly in 10 SEER? How long do you see that, most of that going (multiple speakers) in Q1.

(multiple speakers) should be sold by the end of the first quarter, and perhaps some part of it in the second quarter. But certainly. There will be no lack of demand for that product.

In these 20 branches that you're Greenfielding, are these -- is there one primary focus, an area of primary focus that you're working on? I know you mentioned (multiple speakers)

(multiple speakers) further extensions of the existing structure than we presently have.

, Okay. So they are tack-on and not new markets? Okay.

Yes.

Okay.

And Michael, when we talk about our market, 88% of it today is in the Sunbelt. And the 20 branches are all in the Sunbelt and looking to expand, really, the convenience that's there for customers. And this is not -- when we say Greenfielding, it's really to better serve and bring more density to our existing markets.

These are low -- what I consider low-risk openings of branches to further penetrate the existing market area.

[Mark Bauser], [Redstone].

Sorry to tread on ground we've already treaded on, but can you comment on your mix in the fourth quarter and maybe the full year? Did you see any meaningful transition from 10 SEER to 13 SEER, just because of energy cost considerations?

No. There was no transition of any consequence in the year 2005. It's beginning to occur here in 2006, and it's very small at the beginning.

And the inventory, 20 million or so, was that primarily 10 SEER, or was that a mix?

Yes, it was.

(multiple speakers)

Right. You mentioned the contribution or the drag from options, $0.04 to $0.05 in '06, and I missed the number in '05. But was that included in the 2.52 of earnings?

It was $0.06, and you would reduce the 2.52 by the $0.06 to get a comparable going into '06.

[Scott Uschec], Adage Capital.

My question has been answered. Thank you.

Keith Hughes, Robinson Humphrey.

As you look at 2006, is there any reason to believe we're going to have a significantly different unit growth in the year than we normally get out of the markets that you are in? Is the 13 SEER change going to have any impact there?

Well, you know that some of the industry players are saying they might have an impact. I think you have reported on that, or one of your has. Our view is that cooling is performed with machines, and those machines are going to break down no matter what efficiency levels that are being introduced into the marketplace. I mean, these are machines. They have a useful life and they wear out, and they will need to be replaced or repaired. So 13 SEER is just another thing that occurs in this replacement cycle. So, I'm optimistic as hell. I think we're going to do great in '06, and I don't know what to say about some of these OEMs that are somewhat concerned.

Now don't forget, we are at the distribution part of the channel. Some of these OEMs had great shipment years last year. For example, you saw our inventory grow at the end of the year. Maybe they are concerned about how they're going to deal with '06, but we are not. We're just very positive because of all the things I've just said. And we're also building -- continuing to build the network.

One final question. The pushdown of gross margin has lessened as '05 progressed, and I assume that speaks to the improvements at East Coast. Is it fair to say going into '06 we could see a little bit better year-over-year gross margin improvement (multiple speakers)

I'd like to think that, Keith, very much. That's what we plan to do and that's part of our overall strategy, is improvement constantly in gross profit margins as well as operating margins.

David Mills, JDM Capital Management.

You said you're not in a 13 SEER market as yet. Is that going to be a second half '06 event, do you think?

Well, I think it will happen by the second quarter of this year. It's already out there in the first quarter, but it's not the major part of the business yet.

But it will be by some time in the second quarter?

[That's what] the OEMs that we do business with. And as you know, we're large customers of these OEMs -- that's what our visibility is, that they'll be going strong by the second quarter. And of course, in the first quarter we'll be selling what we have, which is the 10 series all the way through the -- I mean we have 13 SEER in inventory and higher. We'll be selling that. But I think your question is will the mix move more toward 13 SEER in the second quarter. And my answer to that is we believe it will, 13 SEER and above.

And the average price (multiple speakers)

At the distribution level. Now, at the manufacturing level, they cannot make anything below a 10 SEER in the first quarter, since January of this year.

And the price differential between 10 and 13 is going to be what?

Well, that's the $64 question, and that's what was referred to earlier in the conversation. And right now we are seeing pricing disciplines that indicate there is a premium beyond what we expected. We expected the 13 SEER -- new 13 SEER to come down to the 12 SEER pricing level, but that has not occur yet. And the difference between a 12 and a 10 is somewhere between 15 and 20%.

Okay. So, if you're over 20% in the 13, between 10 and 13, and you've got your normal organic growth rate on top of that, and your gross margin is going to go up, you said, it seems to me that you've got a revenue increase that has to be well over (multiple speakers)

Sounds like the perfect storm, doesn't it?

(multiple speakers) your earnings per share estimate is simply an extrapolation of your long-term growth rate of 20%. It doesn't really fit with the model that you're painting.

What you're giving to you is commentary, and much of it is forecast. And so as we do constantly, we try to be conservative, we try to stick to our long-term growth rate, because we don't want to provide guidance until we see -- have -- much more specific guidance until we see more what's actually happening. After all, this is only January, the end of January that we've seen. And so we try to provide a conservative view of it. You're describing a perfect storm, and maybe it will occur. But you know, this is January; we've just ended January, I should say.

But you do believe that the gross margin on the 13 SEER business will be higher?

At the moment, it seems like the discipline in pricing is holding, and what you just said would appear to be true. But it's very, very early, and it could change. It probably will change.

Curt Woodworth, JP Morgan.

Just one quick follow-up. On the 7% market share you talk about, what would that percentage be relative to the group of independent distribution in the market?

You mean versus factory distribution?

Yes.

Barry, we did those numbers once. What is factory distribution of this (inaudible)? First of all, half of the 25 billion or 26 billion industry is not equipment, and there is no important impact by manufacturers on that half. And on the equipment side, how much of it did we estimate once, Barry, we thought was factory distribution?

About 4 billion.

4 billion of the balance.

Okay. And in terms of the mix shift this year, I know the first quarter was only like 20% of annual volume, roughly. What do you think -- your best guess in terms of 13 SEER and above? Do you still think that will be like maybe 70 to 80% of the total mix for the year, or would that be too high of an estimate right now?

It's going to have to move to those high numbers, because that's the minimum standard allowed to be manufactured. And once distributors' inventory sell through, primarily, I believe, in the first quarter, then in the second quarter -- sometime in the second quarter and beyond -- this is my forecast -- it's going to be distributors will be selling only what they can get from the manufacturers, which is 13 SEER and above. And that's the minimum standard, so that's where the volume and the percentage of the overall equipment business is going to flow to. And it will be a very high percentage of it.

And the second quarter -- how much 10 and 12 SEER do you think you will sell in the second quarter? Would it be less than 20% of the mix?

In the second? No, we don't have those estimates. I don't know. I'd like to think that by the end of the first quarter, most of our 10 and 12 will be gone.

Okay. That's essentially what I was trying to get at.

Going back to your first question about the size of the industry, what my estimate is is unitary products, just to keep that in. When we talk about our industry and the estimate I gave on the OEMs, that's just unitary products. We don't do commercial, and that's not in the numbers.

(Operator Instructions). Andrew DeAngelis, KeyBanc Capital Markets.

Just a follow-up on Q1. I don't know how your dealers' inventories work out, but are your dealers' inventories pretty clean right now from your viewpoint, that you sell into?

Hard to say. I would say that some are and some are not. I don't think it's going to be an issue, though, for our growth.

Okay. And then you talked about the mix availability from your manufacturers for 13 SEER product, so maybe that kind of skews the mix a little bit towards 10 and 12 in the first quarter. But have you seen any maybe orders delayed or pop out of the system due to the fact that you don't have the new 13 SEER product?

Absolutely. We've had several delays, important delays.

Michael Coleman, Sterne, Agee & Leach.

I was wondering if you could talk -- you mentioned that you had planned to open locations in the Louisiana hurricane-affected areas. I'm wondering if you could talk about how many locations you have in Louisiana, Mississippi and Alabama, and how many you think you could add in, say, the next year or so?

Barry, have you got that breakdown?

Yes. There are about 20 locations that surround kind of the Panhandle over to New Orleans, and going up into Alabama. And there are about three new locations that are a part of the 20 that are simply building out that network that's there. The remaining are everywhere else throughout the Sunbelt.

The 7% market share that you talk about, do you think your penetration or market share is higher in those regions than that 7% number?

Oh, yes. We built the Company primarily with a focus in the Sunbelt, and the 26 billion is a national number.

At this time there are no further questions. Are there any closing remarks?

No. Thank you for joining us. Look forward to the next conference call. Bye now.

Thank you. This concludes today's Watsco, Incorporated earnings release. You may now disconnect.