Watsco Inc (WSO.B) 2006 Q3 法說會逐字稿

Good morning, my name is Terrance. At this time I would like to welcome everyone to the Watsco Third Quarter Earnings Release Conference Call.

[OPERATOR INSTRUCTIONS]

Mr. Nahmad, you may begin your conference.

Good morning, everyone. This is Al Nahmad, and I'm the President of Watsco. With me is Barry Logan who is the company's Senior Vice President. This conference call; we're going to cover our operating results for the third quarter and the nine months that ended on September 30, 2006. But first let me read a cautionary statement. Please remember that this conference call has forward-looking statements as defined by SEC laws and regulations and are made pursuant to the Safe Harbor provisions of the various laws. Ultimate results may differ materially from the forward-looking statements.

Now on for the quarter. The company's doing a great. We had another solid record breaking quarter, adding to our best year ever. Important financial metrics reached record levels, even with significant and unusual challenges. What are some of these challenges? Well first, we were caught against a very strong quarterly comparison from a year ago. Last year same-store revenues grew 16%, HVAC equipment sales were up 22% and EPS in the third quarter climbed 49%.

Second, getting product from our OEMs during the 13 SEER transition proved difficult. Roughly half of our sales and inventory converted from the 10 to 12 SEER family to the 13 plus SEER family. Deliveries from the OEMs were erratic, late, incomplete and at times affected our ability to provide products to our customers. In response to this challenge we increased inventories and physically moved product within our network to fulfill orders. It has been an advantage to have the financial wherewithal and the network that Watsco does have to do these things, but it has not been easy. The good news is that most of these difficulties are over. Lead times have improved and our inventories are declining.

Despite these challenges this has been the most profitable quarter in our history. And I want to repeat that. This has been the most profitable in our history. Earnings per share increased 19% to a record $1.05 per diluted share, net income improved 19% to $29 million, revenues increased 6% to $507 million or 5% on a same-store basis, sales of unitary equipment, which is 28% of our sales, experienced a 4% growth with average selling prices increasing 22% while unit sales declined 18%. Sales of commercial refrigeration products, which is about 11% of our revenues, expanded 30%. That's a great execution by our team.

Gross profit grew 11% to $133 million with gross margins improving 110 basis points to a record 26.3%. Price realization on the new products at higher margins as well as improved margins across our other product lines speaks well of the discipline of our selling organizations. SG&A expense increased 7% or $5.9 million. SG&A reflects cost at new locations, extra costs to respond to OEM delivery issues and stock options costs associated with the accounting standard. Operating profit increased 18% to $47.4 million. Operating margins expanded 90 basis points to a record 9.3%.

We continued to expand our network and added 20 locations over the last 12 months. New locations, add local service, training and support to our contractor customers and caters to the time sensitive needs of the replacement market. This activity also develops market share for ourselves and our OEM partners. We see substantial opportunities increasing the rate of adding new locations. New locations generated $10 million of revenue in the quarter and 23 million for the nine months, that's 23 million of revenues for the nine months, and are profitable. We expect further profit expansion on these new branches as they mature.

Now on a year-to-date basis, revenues were up 12% to $1.4 billion with same-store sales growing 11%. Gross profits increased 15% to $366 million with gross margins improving 70 basis points to 25.9%. SG&A increased 10% and as a percentage of sales have decreased 20 basis points to 17.7%. Operating profit increased 25% or $23.3 million to a record $116.4 million. Operating margins expanded 90 basis points to a record 8.2%. Net income rose 27% to $71 million, still another record. EPS was up 26% to a record $2.54. As for cash flow, $10 million has been used in operations for the nine months reflecting the increase in inventory. We expect significant positive cash flow as we close out 2006.

For accounts receivable, DSOs finished the quarter at 42 days, a slight improvement from the same period a year ago, showing continued quality and discipline. Regarding dividends, we paid 67% more cash dividends to shareholders and will evaluate our present dividend rate after the closing of the year. As for stock repurchase activity, $15.3 million of Watsco shares have already been bought back during 2006.

Now for the outlook. Our fourth quarter is also up against a significant comparable last year. Same-store growth then, that's last year, was 16%, equipment sales were over 20% and EPS more than doubled last year. This year we expect flat or single-digit sales growth and higher margins to combine to produce earnings growth in the fourth quarter, in spite of the comps. For 2006 this adds up to another year with EPS in the range of $3.07 to $3.10. That's our outlook for '06.

We're looking forward to a very exciting 2007, and plan to have another great year. But even going beyond that, I want to remind everyone that our long-term goal is to build a network of locations that provide the finest service and product availability for contractors. We assist them and support them as they serve the country's homeowners and businesses. This big point here, let's not forget that there are 120 million homes that exist in the United States and most use central cooling and heating systems. They require service and replacement. Today we possess only a 7% share of this large $27 billion HVAC market at the distributor level, and we have ambitious plans to grow well beyond our present size.

With that, we'll be happy to take any questions.

[OPERATOR INSTRUCTIONS]

Your first question comes from David Manthey with Robert Baird.

Robert Baird.

Good morning. In terms of the OEM issues that you had in the current quarter, were there any sales that you feel you missed out on because of these shortages? And if so, who would have been able to pick up the slack?

The answer is we do feel sales were lost and we don't who picked them up, there are 1,300 distributors competing in this market.

Okay. Were there allocation issues? If you weren't able to get the product, why would the smaller competitors be able to get it?

There are seven different manufacturers, some perform better than others. We got partial shipments in some cases while others may have, in a particular market, received complete shipments.

Okay. So you think there might have been some shifting on the customer level as it relates to the specific OEMs?

I do.

Okay.

I don't think that shift is permanent. I think it's all coming back.

Okay. And then, Al, I think going into this year with the 13 SEER transition there were fears that consumers might change their behavior and opt to repair rather than replace their HVAC units. Was there in your mix that would confirm or refute that thesis?

We're seeing demand for higher efficiency equipment, not only at the 13 SEER level, but it's actually starting to go beyond that to 14 SEER and above. So, I would say the consumer likes what he sees. I think they enjoy the savings from higher efficiency and I think this is a long-term trend that's going to go on for a long time, and I think we're going to be one of the principal beneficiaries of that trend, but so will the homeowner as he saves on energy costs. So I think every person in the industry is going to be a beneficiary of that trend.

Dave, the other evidence of that is --.

[multiple speakers] pick up in terms of your replacement motors or compressors or repair parts relative to the somewhat weakness you saw on the unit side?

Barry, did you have something you were going to say?

Just going back here to your previous question, Dave, I mean the other evidence is that if a consumer has a problem, the contractor's the one that hears it and then we're the ones that hear it from the contractor. And the fact that the products have come out much higher prices and our margins in particular on those products are also higher speaks to the acceptance of the products.

Okay. All right. And then another issue that's top of mind for everyone is new residential construction. Could you just characterize, to the extent you can tell where your products are going, could you characterize those markets? How they work for you in terms of again year-over-year kind of change?

Well we continue to have a mix of about 25% hedged towards new construction that continues to perform. But overall our strategy is to focus on the 120 million homes, residential homes, that use central cooling and central heating systems and like commercial buildings. That's a replacement market, that's the biggest part of the industry, will always be, will always continue to be and that's the most profitable. And that's why we're performing so well. We've said it over and over again that we've grown through housing cycles in the past, we're doing it again and I don't see any change of that in the future. Staying in the replacement segment is very healthy and it's very large and we're only a small share of it. The largest distributor, we're still holding a small share of that market.

So that's the 75%, on 25 though, were the trends there worse than in the 75? Should we assume that's the case?

Well everybody knows that housing has got a little softer. But once again, Dave, we've had housing cycles in the past, we've grown right through them and that's what we're doing now.

Okay.

You know you don't make that much margin in new housing, that's a very compressed margin business. But we do very well because we provide a great level of service in the replacement markets. And you do that by building a very high dense network of branches where your contractors find convenience and technology support so that when they're replacing and repairing central cooling and heating systems in peoples' homes, we're there for them. That takes an extensive network and a lot of investment and we do it better than anyone else.

Okay, thanks very much.

Your next question comes from Curt Woodworth with JP Morgan.

Good morning, Curt.

Hi, good morning, how are you?

Thanks.

A question on the gross margins this quarter, once again very strong. Can you help us understand the sustainability of this improvement? I mean how much of it is run by a mix benefit versus overall improvement in the base business? And then thinking out to '07, what are the key drivers you're looking at? Do you feel that maybe some of the scarcity value on the 13 SEER product may go away a little bit and that the margins become more compressed? Or do you feel like this is kind of a step function up and you can only go forward?

What we see today is that the production has caught up with the demand and we see no price erosion in the market. We don't see any now. And I think that that speaks well of the acceptance of the product by not only the contractor, by the end consumer. These are desirable products, and as I've told you, the efficiency level seems to be moving well beyond 13 where you have even higher prices and also higher margins. So I like the trend, the margin trend.

Okay. So would it be fair to assume that, looking into '07 when you get the full mix shift here, that that can only be additive to the gross margin in '07? Or are there offsets that you would see?

No I would agree with that premise.

Curt, just to add some color to it, there's been over 600 product lines first of all in our business. And equipment product lines as we've talked about, is about 45% of what we do. And the non-equipment line is where the 600 vendor relationships also reside. And this year the trend shows that actually the margin improvement is higher, even in the non-equipment lines than the equipment lines. So it's really an across-the-board thing, it's not a one -- because we got the launch of a new product line, it's really something we're seeing across-the-board.

It's service based. We're just doing a better job and when you're doing a better job you can get a slight premium.

Okay. And then how many new locations did you guys open in '05? And how many are you planning to open in '07? And can you talk about, in terms of thinking about SG&A and leverage going forward, I mean historically that's been the key driver of your margin expansion in the past four years, this year it's been a little different. Do you think you're going to see a resumption of that in '07? Or do you think you're going to open that many new stores say in '07 where you're going to have some of the continued --?

Yes. That's a very good question. We're finding our experience with opening new locations very positive when we Greenfield. We find that in aggregate they produce profits within a year so we're very definitely going to step up the opening of new branches. But we're also going to step up, as we have the opportunity to buy, make acquisitions which also add branches to the network. But to answer your question, we're definitely going to step up Greenfielding because of our -- its going to do more of what we already know how to do well.

Do you think the acquisition environment is improving relative to maybe where you were a year ago?

Well it's always hard to predict, but we do see more people interested in us. I mean there's never been a lack of interest, but we do see some owners that are moving closer we think. You never know for sure, but yes I'd like to think that families are moving closer to deciding that we're the right people for them to join.

Great. And just one last question, on the equipment side this quarter, what was your mix of 13 SEER versus below 13? I assume it probably mostly 13.

Barry, do you have that breakdown?

Yes. So just that the unitary products, the 10 to 12 was under 10%, and to Al's point earlier, the over 13 was 16%, which is again a nice acceptance of not just the 13 SEER but something beyond 13 SEER.

Yes think of that, Curt, consumers are demanding and getting 14 plus SEER product, they're skipping the entry level in the high efficiency. I mean they're not doing it 100%, but they're doing it in large enough numbers that it's showing up.

If you were to just look at your equipment business in aggregate, what percent of that would be 14 SEER and above right now?

Well this is a good time to re-emphasize this, all of our compressor bearing business is only 28% of the business. And then if you add the other air handlers, the other components of the system, plus other equipment that isn't residential orientated, you're up to 45% of our mix. And what was your question?

Just looking at the compressor bearing units, I'm just curious know what --.

27%.

Of that if you say just 100% of that, what percent would be 14 SEER? You know just to get a sense for how [much] is the adoption of --?

Yes we have that for you, Barry?

If you look at just the new products, it's over 20%.

Okay, wow. Okay great, thank you.

If you look at the new families, it's over 20%.

Okay your next question comes from Jeffrey Hammond with KeyBanc Capital.

Hi, Jeff.

Thanks, good morning. Can you hear me?

Yes, sir.

Okay. I guess the magnitude of the decline in the compressor bearing units surprised me a little bit, can you just walk through how the quarter progressed in terms of unit shipments? And then maybe an early look into how that's progressed into October?

Well we knew that coming into the third quarter we could not sustain the 20% growth rates in units that we experienced in the second half. That's way above anything that anybody could expect to continue. Generally it's a 5% increase so we were traveling at four times that rate in the second half of last year. So a decline of units of 18% is not a surprise compared to the prior year, Jeff.

Okay. What I was trying to get to though is July and August, from a weather standpoint, were pretty favorable and I just want to understand did that decline accelerate through quarter? Is it now stabilized down at that level into October?

I would say, as we indicated in our earlier remarks, we're up against the same comps for the fourth quarter, that's why we're expecting flat to single-digit growth in the fourth quarter, which I would say is not different than what we've experienced in the third quarter.

Okay.

Although we got a 5% same-store in the third quarter. I'm not saying we're going to get 5% in the fourth quarter, but it's somewhere between flat and I would say that number.

Okay. And then on the parts side of the business you called out commercial refrigeration, but can you just give us overall what the parts business was up in the quarter? And what would have been price within that?

Sure. But I think that we should really better explain that because there's a mix that we call parts, there's a mix that we call refrigeration and what we reported on was commercial refrigeration. Barry, do you want to explain that?

Sure. Jeff, on the parts side, well you say parts specifically, it's not something that is that dissected in what we do, we look at the equipment versus non-equipment.

Right. Yes I guess what I'm asking is non-equipment.

Yes. I mean if the equipment is 4% and the overall is 6, that would leave 8% growth for the non-equipment.

Okay. And how much of that was price?

Not something we necessarily track down to the unit data. I mean if its duct tape, we're not tracking unit versus volume on duct tape.

Okay. And then --

And there are 600 product lines in that family of products.

Okay that's fair. In terms of free cash, can you just give the free cash flow dynamics, cash flow from operations, CapEx? And then maybe within that, talk about working capital expectations for the year? You know it's been a pretty significant use and I wanted to understand a little bit better how much of that turns around in the fourth quarter?

Are we speaking for the quarter or for the year?

Just give us free cash flow year-to-date or cash flow from operations year-to-date less CapEx?

Okay. In the conference call we talked about $10 million of cash use year-to-date and CapEx is $7 million.

So how do you think the year comes out in terms of free cash?

Well that's a horse race in terms of inventory reduction. As Al mentioned, the inventory is headed south, it's also a seasonal period where we're collecting a lot of money on receivables. At this point it would be a guess to give you, but suffice it to say it will be a significant cash flow as the quarter goes on.

If you look at '06 and '07 together I mean your goal has been to get free cash flow equal to net income. Understanding that there's a bit of a transition period in '06, but if you put '06 '07 together, are you kind of getting back to that one-to-one goal?

Yes and I'm glad you asked the question because by the nature of your question you understand that this transition has complicated the cash flow world that we live in. We had always produced cash flow equal to net income or higher and that's what we intend to do as things normalize in the transition. And I very much expect that. In the meantime, we had to put our cash into the inventory, which we could do better than most people can because of balance sheet, in order to take partial shipments.

You know sometimes the OEMs would send condensers but not air handlers and we took the condensers and then waited for the air handlers, or they couldn't give us coils until later. Those are things that we had the ability to do and that's all normalizing now and you'll see sharp reductions in inventory and I think you'll see sharp increases in cash flow and you'll see the one-to-one you're speaking about.

Okay perfect. Thanks, guys.

your next question comes from David Mills with JDM Capital Management.

Good morning. I'm wondering, back on the 18% decline in unit shipments, can you identify a point where you think that those units will begin to go positive again?

'07.

First quarter of '07?

Yes.

Okay. And about how much of the 18% decline in the third quarter was attributable to the failure of the OEMs to deliver correctly?

It's a good question, but it's not something that we can identify. You know it was just too big a task to try to ask a bunch of sales people that question, so we just know it occurred, but we cannot quantify it in the way you asked the question.

And finally the inventory of unsold homes is pretty high nationally and I assume it's probably even higher in Florida. Do you see that being a significant problem to unit shipments going forward in '07?

Well I think that, as we said earlier, new home construction does run cycles but our focus is the replacements. And if you look at 120 million homes that have air conditioning and heating systems, that's just equipment that needs service and repair and replacement. That's our focus and that's just a steady and steady up every year. So that's our sweet spot.

Okay, but 25% of your business is still related to new construction right?

Yes that's correct.

So that 25 could be impacted pretty severely by the --?

We don't see any signs of a severe impact.

Okay. Thanks.

Your next question comes from Jeff Germanotta from William Blair.

Jeff Germanotta.

Hello. Thank you. All my questions have been answered.

Okay your next question comes from Keith Hughes with SunTrust Robinson.

Thank you.

Thank you. First of all, congratulations on a good year in what's been a tough environment for you.

Thank you.

The one question I had was on your suppliers. Going into the fourth quarter, are you seeing any kind of price action from your equipment suppliers either up or down? Or attempts to move them up or down?

So far, Keith, we've only seen one announced price increase January 1, which is Carrier. They're announcing an average of 5% increase in their equipment effective in January.

January 1, '07?

Yes.

All right thank you.

Your next question comes from Holden Lewis with BB&T.

Great thank you, good morning, guys.

Good morning, Holden.

I guess with this whole 13 SEER thing, I guess my original thought was that you were going to have your average selling prices go up. And, if one assumes that the gross margin on units was roughly equivalent when it all washes out, that the real opportunity to boost the profitability of the company was going to come because you were going to be able to lever the SG&A by quite a bit given the higher ASPs. And I guess Q1 that seemed to happen though there was a relatively small mix of 13 SEER plus there and then Q2 and Q3 there really hasn't been much leverage, even as that mix has improved. Can you talk a little bit about why we're not getting more leverage on the SG&A the past couple quarters, despite the rising mix of 13 SEER units and the rising ASPs?

We thought we had, but we certainly can cover that once again. The need for us to move equipment around our locations is very costly because, when you do not have normal delivery times from the OEMs and you have customer demand, you've got to move what you've already got in the system and move it around. And that's very expensive.

Okay. So you believe that the lack of leverage was entirely a function of the differently --?

No I say that's a contributing factor and also I think, as you saw in our press release, we explained that we have a stock option cost in SG&A this year that we didn't have last year.

Okay plus the new stores I guess?

Plus the new stores, yes.

Okay.

You know these new stores are going to become more profitable. They were profitable in year one, but their profitability will continue to increase.

Okay. So it seems reasonable, I mean next year the option cost at the anniversary presumably you'll have the delivery stuff and you'll add new stores, but that's kind of rolling. So it seems reasonable to expect next year that we'll begin to see some better leverage of SG&A than we've seen this year?

Well year-to-date we're 20% better leverage, 20 basis points in SG&A.

Yes.

But I like to think it more in terms of an EBIT performance, which includes your gross profit margin and your operating expenses. And we have I think consistently delivered 50 basis points or better each year in improvement and I'd like to think that we can sustain that sort of performance, 50 basis points or better at the EBIT line.

Sure. And on the gross margin, I think if I remember the trends correctly, it seems like, in terms of your body language and tone, that first quarter you saw a pretty good premium on gross margin on the 13 SEER units and maybe that premium came down a little bit in Q2 but was still there. It sounds like maybe the premium on the 13 SEER units has held up, maybe even gotten better in Q3, can you either confirm or deny that? And then if it's true, I think this gets back to an earlier question, now that the product shortage are gone, were you able to sort of get some gross margin in this quarter simply because parts availability was relatively low and therefore in Q4 it's going to ease back a little bit?

Barry, I wasn't sure I followed that, did you?

No, Holden, I don't think so. I think the premium, if you will, margin in 13 SEER has stayed fairly steady and where we saw an improvement beyond that is in all the other products that we sell. I mention again over 600 other lines that we sell. The non-equipment margin growth rate, if you will, was actually higher than equipment during the quarter so that's speaking to again an entire sales organization that is incentivized, compensated and otherwise directed to get a better margin for everything they sell every day.

And as Al said, it's a very service intensive business on that side of the business and refrigeration especially is service intensive. So that's what we better do and that's what we want to do in terms of growing the margin, and that opportunity is there every day.

Okay so in the gross margin you've seen really no erosion in the margin of the 13 SEERs? You know that premium that's sort of been steady and at this point you would expect that to stay, so you're going to continue to have some mix benefit I guess, now that that represents a higher part of the mix. But I guess you're saying that the improvement that you saw, a lot of that was really more on the supply than everything other than the 13 SEER?

I wouldn't say that. I don't think he was saying that. I was saying we're experiencing margin improvements across the non-equipment as well as the equipment.

Okay.

Don't forget, as we said earlier, I love this trend that consumers are moving above and beyond the 13 SEER, they're moving to 14 SEER and above, that's very positive.

Right. But that means that your gross margin is benefiting from mix so it sounds like the gross margin on your 13 SEER units has remained steady, it's just that, as it's grown in the mix, that's improving the gross margin?

Correct. Correct. I would agree with that.

Okay. So any incremental improvement in the gross margin has really come more because of mix as well as real improvements elsewhere in your business?

Correct.

Got it. Okay. So, that all seems reasonably sustainable?

Yes, sir.

Okay. Great, thank you.

At this time there are no further questions.

Well great. Good to talk to all of you and we'll speak to you after the end of the fourth quarter.

Thank you for participating in today's third quarter earnings for Watsco, you may now disconnect.