Watsco Inc (WSO.B) 2006 Q2 法說會逐字稿

Good morning. My name is Lawana and I will be your conference operator today. At this time, I’d like to welcome everyone to the Watsco, second quarter earnings conference call. [OPERATOR INSTRUCTIONS]

Thank you. Mr. Nahmad, you may begin your conference.

This is Al Nahmad. We’re going to have the second quarter earnings conference call. I’m the President of Watsco. With me is Barry Logan, who is a Senior Vice President.

Let me read the cautionary statement. Please remember that this conference call has forward-looking statements, as defined by SEC laws and regulations that are made pursuant to the safe harbor provisions of these laws. Ultimate results may differ materially from the forward-looking statements.

As stated in the press release, this is our most outstanding quarter in our history. Fast on the heels of a great quarter, the company’s just doing great. We experienced strength in our company across the board. Double-digit unit increases for unitary equipment, improving sales mix from the introduction of new, higher-efficiency HVAC systems, which have been well accepted by contractors and consumers. Also, in the pipeline are additional products that will be introduced to offer an even more comprehensive offering of higher-efficiency systems.

We also achieved growth in our non-equipment products, including commercial refrigeration. So let’s go over the numbers for the second quarter. Revenues improved 16% to $512 million. Same store sales grew 15%. Gross profit grew 19% to $132 million with gross margins improving 70 basis points to 25.9. Operating profits increased 27% to [$42 million] dollars versus $37.1 million dollars last year. Operating margins expanded 80 basis points at 9.2%. Net income was up 28% to $28.8 million, and earnings per share increased 27% to record $1.03 versus $0.81 last year.

Now as far as the year-to-date results go, revenues were up 15% to [$906 million] for the first six months of this year. Same store sales so far have grown at 14%. Gross profit increased 17% to $233 million, with gross margins being 50 basis points to 25.7%. Operating profits increased 30% or $16.1 million to a record $69 million. Operating margins increased 90 basis points to 7.6%. Net income rose 32% to an all-time high $41.8 million from $31.6 million in 2005.

EPS, earnings per share, was up 32% to a record $1.50 versus $1.14 last year. As for cash flow, we have used cash of $19 million in the first half of 2006. We did this to maintain a healthy inventory position. In other words, we have put our balance sheet to work to gain a competitive position during the transition that has taken place to the higher-efficiency equipment.

Year-to-date, we have paid 63% more cash dividends to shareholders, and so far have repurchased $15.3 million of Watsco shares. As for our outlook, we expect that Watsco will have another record year and sustain our 20% EPS growth rate in line with our historical ten-year EPS growth rate.

And finally, a reminder. Our long-term goal is to build a network of locations that provide the finest service and product availability for contractors, assisting these contractors and supporting them as they serve our country’s homeowners and businesses. With that, Barry and I will be happy to take questions.

[OPERATOR INSTRUCTIONS] Your first question comes from Curt Woodworth, JPMorgan.

Good morning. It’s actually Alex Johnson for Curt. The first question is can you tell us the mix of 10 and 12 SEER this quarter?

10 and 12. All right. Barry?

Well, for the quarter, let’s define first what we’re talking about. About 30% of our scope is what we call unitary products, and in that mix for the quarter, about 60-70% of that was the 10 and 12 SEER product. I’m sorry, it was the 13 and above SEER product, the remainder being 10 and 12. So we continue to flush out the 10 and 12 SEER products. There continues to be demand for them, needless to say, but the mix certainly got richer during the second quarter versus the first, and that will continue to happen in terms of the mix getting richer for the new products as we go through the rest of the year.

Okay, thanks, and the following question. SG&A as a percent of sales was flat year over year, and given the strong top line, I was wondering if you could just commend on that.

Sure. Let me make a non-quantitative statement about that. We are building a network of locations to serve our contractors. We like to acquire businesses because they give us established relationships, and we also like to build branches, greenfield them, and in this last year, the last 12 months, we’ve started 23 locations. And that is a good reason why our SG&A percent is not peforming-- dropping as the percentage of sales as fast as you would assume, and that’s because we’re building a network and investing our money in those locations, primarily. That’s not the only reason, but that’s the big reason.

Thank you.

Your next question comes from Jeff Hammond, KeyBanc Capital.

Hi. Good morning, gentlemen.

Good morning.

Can you hear me?

Now I can, yes. How are you?

Doing well. Barry, maybe you could run through similar to last quarter what your—if you look at the equipment side, what was unit growth, what was price and what was mix in the quarter, and then also conversely, what you saw in the non-equipment side in terms of revenue growth?

Sure, Jeff. Again, on the unitary product side, 12% is the unit growth. The pricing in terms of the overall average selling prices is up over 20% for unitary products. On the non-equipment side it’s also double-digit growth rate and the revenues of non-equipment. So it’s really across the board in terms of what we’re seeing. As I mentioned, when I talk about average selling prices that includes the mix of the 13 SEER and above, and the continued selling of the 10 and 12 SEERs. As the pricing gets richer, it’s really trending the way we expected it to.

So if you look at just the equipment side of the business in total, what was that up?

Unitary equipment was up 12% on units.

Right. But I guess what was your total price benefit? The 20%, you would have gotten 6% on price based on 20%.

No, no, no. 12% on units, an additional 22-23% on price.

Okay. And then, can you just talk about kind of sequential momentum into the third quarter? A lot of discussion about new housing and I just wanted to get a sense of what you’re seeing there, what you’re seeing in terms of what’s been largely favorable weather trends, and then you know, maybe a little bit more color on how much of a benefit you get on a sequential basis as you shift more of this to 13 SEER?

Well, business is good. It’s solid, and that’s why we expect to reach another record performance for the year. This transition to 13 SEER continues. It’s a positive thing for the industry, all the way, I said earlier, from consumers to producers. And that’s a wonderful, positive trend and we’re in a position since we’re the largest distributor to enjoy those benefits. And I don’t see this as something that’s going to end this year. That’s going to be going on for several years. More and more high-efficiency product is going to be introduced during this year and next to provide even a more comprehensive offering to contractors and homeowners. Given the high energy costs, I think that our industry is providing some relief to home owners to switch over to higher efficiency and lower their electrical bills. Those are very great, strong, fundamental trends, and we’re enjoying those benefits, and I think we’ll continue to.

And how would you characterize your business to new housing and maybe you can speak regionally as well, within that?

Well, new housing from what we read is softening in markets, but our business has always been based primarily on the serving the 120 million homes that already have central air conditioning and central heating. And their demand for what we do is going to be necessary because this equipment wears out. It either has to be repaired or replaced, so even though we participate somewhat, I would say 20-30% in the new housing market, the overall performance of our company is primarily dependent on the ability to service our replacement market, and that’s one thing we’re doing better all the time. I’m not too concerned about the new housing trends one way or the other because of that mix in our revenues. But we have, as we’ve indicated before, we’re a participant in the refrigeration industry and that means that supermarkets and other places that use refrigeration equipment, that’s a steady business [in that]. I think it accounts for something like 15% of our overall revenues.

I guess back to the SG&A line. Can you, I guess, one, quantify what the impact would have been from opening the new branches where you might not have gotten the sales benefits, and then also, you know, Al, I think in the last quarterly conference call you talked about, you know, most of the margin improvement is going to come from SG&A leverage over time going forward. I guess, when do we start to see that SG&A leverage start to re-emerge looking out?

I think you want it to keep opening branches and that’s what we’re going to keep doing because for building a network, and we’re very small position in what I consider the ultimate network will be. I mean, we’re under 400 branches and I think it’s going to be substantially larger than that, so I don’t think we’re going to stop doing that, but revenue growth rates, we also hope we’ll exceed growth of operating expenses and that’s a trend that we’ve had going for a while and I think the trend will continue. The increase in gross profit margin is a result of providing a higher mix of higher efficiency equipment. I think that hopefully will continue. It’s a competitive driven thing. We’ll see how that shakes out, but we took some benefit from the second quarter and I’m hoping that will continue.

You mentioned some share re-purchase activity for the year-to-date in this quarter. Given the stock’s been under some pressure, how are you thinking about that going forward?

Well, we like stock repurchase. We have bought shares all year long. We do it in opportunistic places. We also remember our primary goal is to build a much larger network, and so it’s a balancing act, but we do like the stock repurchase and think you’ll see, hope to see, more of that in the future.

And then just finally, there seems to be maybe more of an emphasis or re-emphasis on accelerating your branch openings. Is that a function of you’re seeing fewer acquisition opportunities out there, or maybe just characterize the acquisition?

Not at all. We have a wonderful reputation in this industry for what happens after an acquisition. We’re builders of organizations. We’ve been doing it for such a long time that our name is synonymous with quality transactions and we are in constant contact with the country’s best distributors. They know who we are. Our reputation helps us with that, but it has always been difficult to predict acquisitions and we know that. And so we still have to continue building the network and since we can’t determine the timing of acquisitions we’re just building the network, greenfielding it, and I think that’s what we should do. Especially when I think that the network has a lot further to go. And so I hope that explains to you what’s on my mind. Build a network. Acquire it, greenfield it.

That’s helpful. Thank you, Al.

Your next question comes from David Manthey, Robert W. Baird.

Morning, guys.

Chicago or Milwaukee today?

In Milwaukee and it’s been unseasonably warm here for a while. Not that you guys care about that specifically, but someday you might be up here, right?

You bet.

Based on the guidance that you’ve given here, the 20% plus, which is sort of a standard level, which is actually a little bit higher than I think you were previously guiding, $2.90 to $2.95. This would imply something a little over $3.00. You know, I’ve been wondering about the second half relative to the first half. This would imply sort of 10% growth in the second half of EPS. What organic growth is that level of guidance, in just in the second half based on? Could you talk about units versus pricing that you expect in the second half?

Gee, David, I know that you would like for us to do that, but we don’t try to provide that information. That’s something that you guys have to figure out. We are builders of a network, and we had a long view. What we like to provide guidance on is whether we can sustain what we’ve done historically. If we’ve been earnings per share for 20% a year, compounded for the last ten years, we take a look at that as the year develops and say, can we sustain that? And then we comment on that, but no, we’re not able to, nor do we wish to, get into that sort of a question.

[CROSSTALK]

It’s always an unpredictable impact, temporarily, I should say, because eventually the equipment that’s in place in these 120 million homes wear out, so weather affects that. So that sort of thing moves demand from one month to another, from one quarter to another, so those are the sort of shifts that occur, and that’s why we try not to get involved in anything other than what annual trends are.

Okay, to put it another way, when we look at the second half of ’05, could you give us what you think happened there in terms of 16% overall growth, same store sales growth? I mean, what were some of the factors that were there and how we can compare that to the second half of ’06, and Al, the reason I mentioned that, I just think that is the key point that people are focused on today and that they’re confused about. If we could get some clarity around that, I think it would help.

Well, we had a very strong second half. The industry did, and as the largest distributor in the industry, we enjoyed that. I don’t see any reason why we’re not going to have another strong second half this year, especially that we have good acceptance of higher efficiency equipment, which does reduce homeowners’ and businesses’ energy bills. I’m just very positive on this industry. We don’t see any reason to have any concern about it. I know that ARI is publishing numbers that would show a different picture, but that’s at the manufacturing level. Maybe there’s an inventory situation going on for them, but we’re in contact with our contractors, so we’re way down the channel. We can see what’s going on. We have some 38,000 contractors as customers, and what’s going on is very good. It’s terrific. And eventually, not only will it impact us, it is impacting us, but it’ll impact the manufacturers, so I just think it’s very healthy all the way around. I don’t see any clouds in our industry, and I certainly don’t see any clouds for distributors in terms of what’s going on. So, good second half last year and I expect a good second half this year.

Okay, then the final question is, a number of items, but I hope you can just touch on them. With the increase in the number of stores, the 23 last year and 20 this year, how fast will those ramp and what kind of ontribution to growth do you see, let’s say, from the 23 last year in this year’s numbers, and then if you can just touch on private label and indoor air quality.

Barry? I’ve been doing all the talking, let’s get you in.

Well, the branches, David, just to kind of quantify some of this, just to give some credence to what we’re talking about. There’s about ten basis points in a quarter related to the new branches. Remember, we also have some stock-based compensation in the quarter that we didn’t have a year ago. In terms of going forward and looking forward, private label, most of that product fits in one of our subsidiaries, and that’s our strongest subsidiary to date this year. So it’s not just private label driving our growth, but it’s across the board for them too. That’s a coast-to-coast business, so what they have seen all year is growth really in all of their equipment product lines. It’s where, again, the private label has contributed on equipment. We’ve also introduced private label in terms of non-equipment. You saw some of that product when you visited us, and that continues. The numbers are small, but in terms of their rate of increase, it’s increasing, and we’re spending more time and the margins and product acceptance of what we’re sourcing globally now has been very well accepted and that continues. That trend is going to help, certainly beyond even this quarter and this year. That’s something that has been a nice addition to what we’re doing.

So, again, I think the other comment I would have about going forward is product availability during the second quarter was still not all it could or should have been, and that’s curing itself and that will continue to help the sale of the new products. The sales mix, the pricing, the margins that we see in the second quarter, as Al said, we’re hopeful that continues in terms of continued margin expansion going forward. So I don’t see a crack in this sitting here in the middle of summertime. It is nice and hot outside, certainly, around the country and some of the SG&A leverage that you don’t see in the second quarter also relates to how we compensate, really, our sales force. Our sales force is not compensated on, or commissioned on, how they sell. They’re commissioned on the margins that they generate. So part of the story in SG&A this quarter is stronger gross profit is shared with a commissioned sales force. That’s how we want them to think about it, not how much they sell, but how much they bring in margin dollars. So, just some random thoughts for you from my perspective, David.

Thanks, I appreciate that. Thanks, guys.

Hey, the only thing I want to end with is that once again, tell you that this industry that we serve is at $25 billion a year at the distributor level, is just a great place to be given that energy costs are escalating and, you know, our industry has solutions for that. You can save on gas furnaces, you can save natural gas, and with air conditioners you can save on your power bill, and you can save substantial amounts of money, so we are part of that trend to move to energy conservation, and I don’t think that’s—

Well, in any event, I was just saying, David, it’s a great, great industry. Great future, because the things that we’re providing for home owners and for businesses are very useful. Not only do we do what we’ve always done is replace equipment that wears out, but we’re providing equipment that helps to save enormous amounts of energy, and I think that’s why I’m so optimistic about what we do and what the industry does.

Your next question comes from Holden Lewis.

Good morning, Holden.

Good morning. Thank you. You talked about maybe some of the knock-off effects of the conversion over to the 13 SEER. Are you seeing, in terms of fulfillment, are you seeing now that we’ve gotten, perhaps, the majority of sales [through in summer under our belt]. I mean, is it costing us any more or less to sort of fulfill these larger footprint units? That sort of thing, are we seeing perhaps a better mix of higher than 13 SEER type units than maybe would have existed in sort of the previous?

That’s a terrific question. We are seeing a demand for over 13 SEER, and that’s a wonderful trend because the higher the efficiency the less the electrical bill, and the more the energy conservation. Barry, do you actually have those numbers? I think we can give you excellent numbers on that, Holden.

Yes, Holden, and again, those products were later to the party in terms of their introduction and having said that, for the quarter, that business is up about 40% year over year, in terms of beyond 13 SEER.

And we think that’s a trend. It’ll take hold even more, Holden, as we go on.

Right because I think in sort of the old regime it was what, 90% was 10 SEER or something like that? And then the rest was everything above? I mean, are you sort of expecting to see us settle into 90% at 13 SEER and the rest is above, or are we going to see some different mix when it all settles down? What sort of a bet based on what you’ve seen?

It’s hard to give you, we’d be really guessing, but no matter what the outcome, it’s better than it’s been, whether it settles in at 90% 13 or 80% 13 or 70% 13 and above, the rest above, it’s all good. Either one of those outcomes, but it’s very difficult to tell you where that’s going to settle.

Where it’s going to settle is the hard part. I can tell you where it is for a short period of time, which is always dangerous to project, but it’s already at 10%.

The non-13 SEER is already 10%?

Right. If I just look at the new products mix, just new products mix, it’s already at 10%, so let that be a year’s trend, not a quarter’s trend, but so far so good.

Now on the fulfillment side, are you finding that fulfilling these larger units is creating any challenges or has gone pretty seamlessly and incrementally cost-free?

Now that’s another great question. The unit cost is, of course, higher and therefore from a distribution point of view, it requires more dollars to keep the same [equipment number] of units, and so you’ll see distributors having to carry more, have to invest more in the dollars of the inventory and then space-wise, these are larger units and they require more of that. To my way of thinking, that’s good for us, our company. We have a great balance sheet, we’re able to take on these more expensive and larger pieces of equipment at much easier rates than our competitors, so those are also trends that I like going forward.

Sure, but when you talk about, like, looking at the SG&A trend, I mean, are you seeing that maybe you need more truckloads, for instance, or is there anything just in the 13 SEER conversion itself which may be boosting the SG&A and undercutting leverage a little bit? Anything that you’re seeing in that regard?

It’s early to say that. The two principle causes that we’ve spoken about are that we’ve opened up the new locations and you invest in SG&A so they make a contribution. And the second one is the way we incentivize our sales force, which there are 750 salesmen by the way, and we pay them on gross profit dollars, and their comp is up, which I’m pleased to see. But these things will settle in to a nice way. I’m very optimistic about where all these trends are going. I really don’t see anything that’s concerning me, one way or the other, it’s just good news.

And then lastly, in terms of the margin related to 13 SEER, I think last call you sort of said that you were also optimistic that any improvement you’ve seen on the 13 SEER gross margin might be sustainable, but it was a question of whether or not it was, or whether it was a function of supply. What are you seeing in terms of the gross margin trends on the new units versus what you saw in Q1?

Well, we’ve reported an increase in gross profit margins. So far, the OEMs have pretty good pricing discipline. Nobody’s trying to reduce prices as the method to gain share, and part of that, Holden, is because commodity costs are higher and so that discipline is easier for them to enforce, and that’s a healthy thing, and if that continues, I think you’ll see the same thing continue that you saw in our second quarter in terms of our own margin.

Okay, thank you.

We did see higher gross profit improvement on the equipment side versus the non-equipment side, Holden. So that gives you some depth to that comment.

Your next question comes from Keith Hughes, Robertson Humphries.

Yeah, thanks. This question follows on what Barry said earlier. You had talked about problems on getting some of the 13 SEER product. American Standard had mentioned that on their call as well. What kinds of problems were happening in the market and what improvements have you seen in the last month or two?

Well, there are two that I want to mention, and Barry, you may add to this. There was an unexpected surge in demand for air handlers at the indoor unit, and the OEMs had to ramp up for that, and are just now, some of them are catching up. You know, you have the condenser outside and the air handler inside, so it’s been, there have been shortages of air handlers. Secondly, the high price of natural gas has driven a demand for heat pumps unexpectedly. So the OEMs are ramping up to meet that demand. So those are the two principle items that OEMs are racing to catch up with. Some of them are catching up faster than others, but to Barry’s point, we would have even done better if we’d had those sorts of items in the inventory to the scale that we needed. This is a major transition. It’s been going on in the industry and they’ll be ironed out. I think that this quarter, the quarter that we’re in, I’d be very surprised if these sorts of delivery shortages exist after the third quarter.

Particularly if we have a good third quarter, it seems to be we’re off to a good start with weather. Do you think most of your under 13 SEER product will be gone by the end of the third quarter?

Well, we have about $25 million into 12 and under. Five million of that is 12 SEER and most of that is committed to home builders that want that product, they’re just waiting to take delivery of it. You know, air conditioning is one of the last things that you put into a home, and then 20 million is 10 SEER and I’ve consistently said that I’m glad we have a position in 10 SEER because there are consumers that ask their contractor for a 10 SEER. It’s less expensive and what they want to do is replace what they’ve got, they don’t want to go through the expense of a higher efficiency. I think it’s an asset and it’s not a large amount of money given our overall balance sheet.

And the inventories for the quarter, they’ve been up for the last couple of quarters, but I assume you took advantage with some of the price increases of the HVAC producers in the last three months. I guess there’s been two rounds here. You took advantage of some of that to pre-buy. Is that part of the inventory story?

Well, pre-buy was a little difficult because they weren’t able to deliver, so we took, in the fourth quarter of last year, we took plenty of the 10 and 12s because that was our strategy, to have product for our contractors. And then as we entered the first quarter, we also wanted to keep the contractor well-equipped and so we took in unusually large numbers of the new products. The combination of the two has increased our historical inventory level and I see it as an interim issue that, as the year winds down, we’ll normalize more in that inventory level, but I think these are steps that because of balance sheet and our strength, we were able to do, and that sort of stuff breaks us from our competitors

There’s probably very few other competitors that could have done that in the last nine months. Is that fair to say?

Yes, sir.

Okay. Thank you.

Your next question comes from Jeff Bernstein, Manhasset Capital.

Hi. Congratulations on a nice quarter.

Thanks very much.

Somebody asked the question earlier, but you didn’t get to it. Just regionally, obviously you know, we know the housing market has slowed a bit, Florida is one of the areas that had a lot of growth and it’s seen some slowing, but places like Texas never really had the boom but seem to be doing pretty well now. Can you just give us a little bit of color on your distribution network and then within it where you’re seeing strength and weakness on the new housing front.

We really don’t comment on regional areas for a number of reasons. It’s not something we’ve done in the past and don’t wish to do. I want to emphasize again that our business is dependent on two things, basically. The replacement market and the commercial refrigeration business, and those markets are strong and the new construction market, from what we read and from what we experience, has softened, but again, we’ve always, always focused on replacement. That’s what we [are] the best in the country in.

Just to follow up on that. Obviously, the housing cycle here has been good for a number of years and the housing stock has grown significantly, which means that there’s going to be replacement demand. Can you give us a feeling for sort of how many years in do you start to see, you know, replacement demand after a new home is built?

Well, there are all kinds of estimates on that, depending on the usage, but, you know, certain Sun Belt markets, the life of the equipment is much less than it is, say, in places like Boston. But eight to 12 years on a condenser, an air conditioning system. And as I said earlier in our comments, you’ve got 120 million homes in the United States, most of which have central cooling and heating.

Thanks very much. That’s great.

Just a reminder, too, 90% of what we do is sitting in the Sun Belt and all the population migration that’s happened over the last ten to 15 years, you’re right, all the housing stock that’s been established over the last ten to 15 years to support that growth, you know, it’s a good place to be.

Your next question comes from [Sean Boyd, West Fifth Capital].

Good morning. Just a couple of quick questions. I want to make sure I understand, earlier on the percentage of sales from systems versus service, did you say 30% in systems?

Barry?

Yeah, there’s no service element to our business. The split of our business is first termed equipment and non-equipment, and then part of our equipment business is termed unitary equipment, which is basically the condensing units, the heat pumps that sit outside of the house. And that’s the component of our industry that’s tracked by the industry, by a thing called ARI. So we talk about our business and comparing it to that, about 30% of our business is called unitary systems. There’s no service side to our business. We’re selling products, we’re not performing services.

Okay, so out of the equipment that’s not unitary systems, that’s how much?

Another 20% is other types of equipment, and then another 50% is what we call non-equipment, which is air movement products, commercial refrigeration and a host of other product lines that the contractor buys from us.

Got you. Okay, and to clarify on the unitary equipment, that’s where you had 12% unit growth and pricing in the low twenties?

Over 20, yeah.

For the quarter. So that piece was up, you know, 35% year over year?

Correct.

I see. Okay. The other question is down on the [housing]. I understand that it’s certainly not a huge driver relative to the replacement market and of course refrigeration. It’s 20-30% revenue, so that is material. When you talk about being in the Sun Belt, that includes California and Florida?

Yes.

Okay. And from what you’re seeing, you haven’t seen any weakness in those market yet, or in just your home building revenues overall?

What was the question?

Are you seeing any weakness on your home building revenues yet? Revenues from new home construction?

All our markets, or to my knowledge, are experiencing some impact on housing. All of that is affecting the business that we do, but it is not what drives our growth. It is the replacement business, and the commercial refrigeration business.

Right. Okay, and you stated earlier, you know, air conditioning is one of the last things you’re going to put in the new home. So it’s going to be, there’s not going to be very much lag.

I want to be very strict about the data on this. You’re data driven, I can tell, and I want to give it to you so you understand it perfectly. The industry last year shipped 8.6 million units and they built about 2 million single family homes, including multi-family. Typically, we’re not a large multi-family, if it’s over four or five stories, we’re not in that industry. Separate industry. But for the moment let’s say it’s about a 25% new construction business. I put that into dollars, not units, it’s even more tilted toward, let’s say it’s 80-20 at that point. 10% slowdown in new construction would mean 2%, which is relatively immaterial in my mind to the side of the industry. We participate in it, but the driver in terms of margins, sales, growth, the Sun Belt, is driven by the replacement market.

Got you. I appreciate that, and that’s a great way to look at it. The other thing I was wondering about just from all the experience in the past, when spending does get a little tighter, you know, my gut is that if you’ve got to replace the existing system you’ve got to replace it, but it’s not exactly a small-ticket item, either. So do you ever see with consumer spending on the discretionary side slowing down a bit that it causes people to push out those purchases at all, or is that just not something you do?

It’s hard to push out cooling in a hot summer or heating in a cold winter. What you may have is a little more towards repair. That can happen, but the argument for replacement is that with the new higher efficiency equipment you can repay the cost of what you’re doing in three years or less, depending on the proposal that you get.

Right. Okay, and then just one last thing on the SG&A. You’re paying your sales force on gross margin dollars, you indicated earlier?

Yes, dollars and margins, right.

So we should, any time we see a really good boost in sales, then we should just factor in the additional SG&A to get to that level?

Barry, did you know did he meant by that?

I’m not sure what you mean?

Well, I guess what I’m saying is that any gross margin improvement is essentially offset by the increase in SG&A.

No. I think we’re fairly more ambitious than that in how we look at the model. There’s a portion of our costs that are fixed. Rent, for example. Someone asked the question before about extra costs to carry this inventory. We’ve not had to add space to carry this inventory, so rent, for instance, is a relatively fixed expense. That’s our second largest line item behind head count. So in terms of leveraging the operating costs, we certainly seek to do that. I mean, our margins over the last five years, and let’s go beyond the quarter here, margins over the last five years have gone from the fours to the sevens, and that was done so through a combination of both SG&A leverage and gross profit increases, which is what you want. You want those, but no, I wouldn’t [fit in] simply model on one quarter what you said. You look at the year-to-date, we’re up 40 basis points in terms of SG&A as a percent of sales. Within quarters, we can get real analytical about it, but in the long term, which, look back and how we look forward, is to have a combination of both.

Okay, thank you.

You have a final question from the line of Jeff Hammond, KeyBanc Capital.

Hi, guys. Al, you know, you’ve spoken, you know, over the long term your target is free cash flow equaling net income. I guess given the moving pieces with the transition in inventories, is that still something you think you can do this year?

That’s a great question, and that is our goal.

Okay.

[CROSSTALK]

I’m sorry, Barry, go ahead.

No, we haven’t really talked about cash flow during the quarter. There was positive cash flow, actually, during the second quarter, and you can typically look back and see how the cash flow behaves in the second half, which is generally a positive period as well.

Jeff, his observation is that we are carrying unusually large amounts of inventory, by design, and so, yes, we’d like to have it normalized during the second half, or get close to it and therefore meet our goal of cash flow equals or exceeds net income.

Okay, and then, last quarter I had asked the question about 10 and 12 SEER inventory. I thought you had given a number of your inventory remaining was 25-30 million, and I think, Al, you cited a similar number, and I was just a little confused by that.

Well, you should be. Barry and I discussed it. He told me he had mentioned that to you. He had made an error. We were at 40 million at the end of the first quarter, not 25.

Okay, and is there any issue, or are you having any challenges moving the 10 and 12 SEER equipment, or--?

The 12 SEERs that we have are spoken for by contractors that want it for their home building cycle. It specifies that, and the 10 SEER, as I said, I’m glad that we have it. There are consumers that would rather just replace what they have and not get involved with a more expensive system.

And can you just talk about pricing dynamics on that remaining 10 SEER?

We are able, we think, to continue to get a premium over what we have historically because it is a valuable thing to have in inventory.

Okay, great. Thanks, guys.

Your next question comes from Alok Chopra, Oppenheimer.

Hi. A question on pricing on the 13 SEER. I know it’s at a premium to 10 and 12, but has anyone raised prices so far this year because of, we keep hearing about higher raw material costs, and I’m just wondering, or is it too early to get that sort of price increase through?

There have been several price increases during the year by [some OEMs] are announcing second and third price increases, and at this point, the market is absorbing those price increases.

Okay. Yeah, that’s more of what I was--I didn’t phrase it right. I mean, are the price increases sticking on 13 SEER?

Yes, they are.

Okay, thanks.

Your next question comes from [Arthur Weiss], Bank of New York.

Yes, just a few clarification questions. One, the higher SEER air conditioners, do they require any additional equipment that you also sell, or is it the same equipment as the lower SEER products?

They do require, a 13 SEER condenser and above, does require a change out also of the inside unit, the air handler. And that is what’s creating unusual demand for that air handler. In the past, if you replaced a 10 SEER condenser, the outside unit, you would generally, may or may not be a need to replace the one on the inside, the air handler, but with this new technology and this new higher efficiency, a complete system requires a replacement of both when there’s a breakdown. Both the inside and the outside unit, and that bodes well, of course, for revenue.

Right. Okay, and do the units generally break down faster in the Sun Belt than they do in other parts of the country? I mean, is an eight-year life for the country or is that for your area?

No, what I was saying earlier that, obviously this is pretty straightforward stuff, but the more you use a piece of equipment, the sooner it wears out. In the Sun Belt is where the greatest use of cooling exists, and therefore the lives of equipment in the Sun Belt will tend to be shorter than they are perhaps in the northern markets.

Right.

Because you use more. Then you get into gas furnaces. You know, they use more up there, so we sell those, too.

Okay. And then finally, what had the trend been in new home construction for, there certainly had been a lot of larger homes that had more than one unit. Did that affect demand in any way? Is there a trend towards more homes with multiple units or you’re not quite-- you don’t keep your eye on that one?

No, we don’t track that. I mean, just thinking off the top of my head, the larger the home, the more cooling and heating the requirements are and the more demand there are for our products. I think that’s a good corollary to keep in mind.

Okay, terrific. Thanks a lot.

Thank you. At this time there are no further audio questions.

I enjoyed our conversation. Thank you and look forward to the next quarter.