Watsco Inc (WSO.B) 2010 Q2 法說會逐字稿

Good morning. My name is Melissa and I will be your conference operator today. At this time I would like to welcome everyone to the second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (Operator Instructions.) Thank you. Albert Nahmad, CEO, you may begin.

Good morning, everyone, and welcome to our conference call for the second quarter of 2010. My name is Albert Nahmad. I'm the CEO. With me is Barry Logan, Senior Vice President, and Paul Johnston, Vice President.

First, our normal cautionary statement. This conference call has forward-looking statements as defined SEC laws and regulations that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements.

It feels great to report today that this was the best quarter in Watsco's 63-year-old history. We delivered record sales, strong earnings growth, and considerably higher margins, with record cash flow.

Record growth was driven by an increase in sales of replacement HVAC systems, with a continued progression of high-efficiency systems. Sales and margins in our legacy business units improved dramatically. And Carrier Enterprise, now a part of Watsco for a year, made considerable progress, with a sales growth generating operating profits and margins more than double compared to last year.

SG&A remained flat throughout our network, with additional selling costs being offset by reductions in other costs. Our record cash flow exceeded net income and our balance sheet remains in pristine condition.

Here are our highlights of the quarter. Diluted earnings per share grew 93% to $1.08. Sales increased 114% to a record $865 million. This includes $400 million added by the new Carrier Enterprise locations.

Same-store sales increased 14%, including 25% growth in sales of HVAC equipment, which breaks down to 21% unit growth plus 4% better pricing from sales mix. Most importantly, we believe we gained meaningful market share during the quarter. Other HVAC products increased 3% and commercial refrigeration products increased 5%.

Gross profit increased 99% to a record $201 million, with gross margins of 23.3% versus 24.9% last year, reflecting lower margins at Carrier Enterprise. Same-store gross profit margins declined 30 basis points to 24.7% due to a strong growth in HVAC equipment, which historically has a lower gross profit margin than non-equipment products.

Operating income increased 170% to a record $71 million, and operating margins expanded by 170 basis points to 8.2%. Same-store operating income grew 45% to $38 million, with operating margins improving 180 basis points to 8.4%.

SG&A expenses were $130 million and, as a percentage of sales, declined 330 basis points to a record low of 15.1%. Excluding new locations, SG&A was flat, a meaningful achievement in comparison to the 14% growth in same-store sales.

In summary, profit enhancement initiatives executed over the last few years have combined with sales growth to produce substantial earnings growth.

Let me also say happy first anniversary to Carrier Enterprise, which joined us on July 1st of last year. We are delighted with their progress and performance. A more entrepreneurial culture is in place. New products are continually being added, and the migration of technology and systems from Carrier Corporation was completed this quarter.

Over the last 12 months, EBITDA and EBIT margins have more than doubled and cash flow has exceeded the joint venture's net income. For the quarter, Carrier Enterprise's revenue increased 19% on a pro forma basis, and operating income more than doubled to $32 million on operating margins of 8%. A terrific quarter all around.

Now, first half results. Sales increased 97% to a record $1.4 billion. This includes $625 million added by the new Carrier Enterprise's locations. Same-store sales increased 7%. Gross profit increased 85% to a record $324 million.

Gross profit margins was 23.5% versus 25.2% in 2009, reflecting lower margins at Carrier Enterprise. Same-store gross profit margins improved by -- improved, that is, by 10 basis points to 25.3%.

Watsco's consolidated operating income more than tripled. Let me say that again. Watsco's consolidated operating income more than tripled to $80 million, with operating margins expanding 220 basis points to 5.8%. Same-store operating income increased 70% to $43 million, with same-store operating margins expanding 220 basis points to 5.8%.

SG&A expenses increased 62% to $244 million and, as a percentage of sales, declined - that's declined - 390 basis points to 17.7%. Excluding new locations, SG&A declined 5%, or $7.4 million, compared to last year. Obviously, we believe this demonstrates terrific discipline given that SG&A was reduced 5% while same-store sales grew 7% so far in 2010.

For the first half of 2010, Carrier Enterprise's revenue increased 12% to $625 million on a pro forma basis. Operating income increased 215% to $36.2 million, and operating margins improved 370 basis points to 5.8%.

Carrier Enterprise has added approximately $0.30 in diluted earnings per share so far this year to Watsco. Diluted earnings per share was $1.20 compared to $0.52 a year ago.

Our operating cash flow -- we're still talking about the second -- the full first half, but operating cash flow was $57 million during the first half, well in excess of net income. We believe this is especially impressive given the strong sales growth and the working capital requirements that is generally required when you're in a growth mode.

Accounts receivable quality and inventory quality have both improved during 2010.

Our balance sheet remains in pristine condition. Debt was $20 million and cash on hand was $88 million, and our debt-to-cap ratio was 3%.

Dividends remained and importantly as a share in cash flow success with shareholders. We raised our quarterly dividend 8% in April to $0.52 per share. 2010 will be our ninth consecutive year of paying increased dividends and signals our confidence to consistently generate cash.

Now, let's look ahead. There are several long-term fundamentals of our business that I want to emphasize. First, it is a simple fact that HVAC systems use more energy in a home than anything else. As a result, the movement toward high-efficiency systems over the last several years has been a consistent theme and an opportunity for us and our industry.

Government legislation, consumer awareness, enhanced selling skills by contractors, involvement by utilities, OEM-sponsored incentives, and tax credits have all contributed to what has been a long-term catalyst for homeowners to upgrade existing systems.

Further, energy efficiency, coupled with the 2010 mandate for more environmentally sensitive R410a systems has added to homeowners' needs to upgrade existing systems. Sales of high-efficiency R410 unitary product have increased over 60% in recent quarters, and the sales of matching indoor systems, a requirement for upgrading both efficiency and compliance with the new R410a systems, have accelerated in 2010.

Also, according to two industry studies, there is evidence of pent-up demand for replacement of HVAC systems, which is predicted to unfold over the next three to four years as the economy improves. Said another way, the installed base of HVAC systems exceeds 100 new units. And as the largest player in the industry, we are excited about the long term, given that all 100 million existing system will inevitably be upgraded and replaced to new and better systems.

Homebuilding has also been crushed over the last few years, with only a slight recovery in recent months. And long term, more activity in home construction will provide more revenues and profit and enlarge the install base for future replacement.

And lastly, commercial equipment spending has been affected by the economy. Carrier Enterprise has added a family of light commercial products to our sales mix. These products, along with our commercial refrigeration business, is now showing growth and should expand further as the economy recovers.

As for acquisitions, we continue to look for opportunities and certainly have the balance sheet in place to achieve almost any size transaction.

Looking at the rest of 2010, we are certainly encouraged by second quarter trends, while remaining cautious and disciplined in terms of how we are managing our business.

Our outlook for 2010 is earnings per share in the range of $2.35 to $2.45, and this considers historical seasonality and current trends.

With that, Barry, Paul and I would be happy to answer questions. Melissa?

(Operator Instructions.) Your first question comes from the line of Matt Duncan. Your line is now open.

Good morning, guys, and congrats on a great quarter.

Thanks, Matt. It feels good.

I imagine it does, Al. So, the first question I've got for you is, if I look at your revenue growth this quarter, do you have any way of figuring out how much of that might have been heat driven given the extremely hot May and June we saw across the South, versus sort of underlying demand improvement?

Well, obviously, anytime there's a temperature extreme, it either gets too cold or gets too heat -- too hot, it does impact our business. But I don't believe -- Barry, unless you or Paul have an idea what that increment might be.

It's really -- and this is Paul. There isn't a great way of predicting that. But generally in the Sun Belt, states that we're in, Florida and North Carolina, Texas, it was hot but it wasn't extreme heat that we've seen in the past. It pretty much lines up close to what's normal or what we had last year. I think when you look at the heat in the Midwest, where we're not, I think it probably had a great impact.

Or up in the New York area.

Yes. I mean--.

Yes, we're not in these markets.

Sure.

But for us it was hot, okay, it was hotter. So, I don't think it had that great an impact, but we calibrate that.

Yes. Well, that's helpful. The next thing I want to talk about is Carrier Enterprise. I think we were probably all pleasantly surprised by the strength that you've shown in that business, especially from a margin perspective. An 8% operating margin there, up almost 400 basis points is pretty impressive this early on. Can you talk about sort of what you guys have done to drive that much profitability improvement in just a year? And how much of that is maybe a shift to -- and the sales mix towards the supplies products that we know you guys have been adding to that footprint?

Barry, I think you're best to answer that.

Yes. Well, last thing first, Matt. The supply business certainly did grow, but it's still an immaterial part of their business. So, it's not what's driving the margin over the last year. And it's been consistent improvement over the last four quarters.

But that's still ahead of us, Matt. The impact of the supply is still ahead.

Okay.

That's correct. And the big picture, CE, Carrier Enterprise before Watsco did a great job of really getting costs and SG&A lower. They've been through a strong campaign of getting SG&A down. Their SG&A is down year to date. And so, that's really helping the margin to have meaningful sales growth, a great deal of meaningful sales growth, with flat SG&A. So, that hard work on the cost structure is something they had done.

When we mentioned in Al's comments the completion of the technology movement from Carrier and UT to a standalone platform for Carrier Enterprise, that was finished this June. And we do expect some savings and some capabilities to come from that, and that's ahead of us. So, I get a lot of questions on that -- in that regard about further savings from the technology shift and that's ahead of us, and that's being calibrated as we speak on a going forward basis.

The rest, I think, goes back to the simple culture of asking great managers to simply find ways to produce more profitability, incentivize them. Many of the key executives there are equity holders in Watsco, so we have them thinking that way. And I think it's just part of what we've done for many, many years; asking for performance, incentivizing performance. And all the metric sales and all the different product categories, gross profit margin, SG&A, have behaved well over the last 12 months.

Okay. And then, I guess if I look at the guidance that you guys just provided, would I be safe in assuming that the second quarter's probably going to be your high-water point for the year for earnings on a quarterly basis? Maybe driven partially by the seasonality of Carrier Enterprise which, if I remember correctly, that 2Q is their seasonally strongest quarter, correct?

That's correct, Matt.

Okay. And then the last thing I've got and then I'll jump back in the queue here is, if I look at your sales growth for replacements versus new construction in the quarter, do you have a sense how fast your replacement sales grew this quarter? And then also for new construction.

I think new construction is still bouncing along the bottom, Matt. I don't think that we can account for virtually any sales growth from that perspective. When we see 21% unit growth and better pricing, better sales mix, that's mainly the replacement market and having a very strong beginning to the selling season.

Okay. So, the replacements were probably up greater than 20% and that's -- some of that's probably this pent-up demand beginning to shake loose.

Again, hard to calibrate, but we think so.

Okay. Thanks, guys. Appreciate the answers.

Your next question comes from the line of Robert Manthey from R.W. Baird. Your line is now open.

Yes, hi. It's Dave Manthey.

Good morning, Dave.

Hi. Just a quick question on the federal rebate. Number one, do you think that it will be extended or replaced at the end of this year? And then, number two, as you're thinking about your own sales of high-efficiency equipment, do you have an estimate on what percentage of your equipment sales are qualifying for the rebate today?

I'm going to let Paul answer that because I think he's the most up to date to what's coming in terms of regulations -- or in terms of tax incentives.

Certainly. Certainly, Dave, we hope that the credit will be extended and we feel there's a couple ways that could happen. But obviously, I'm not going to try to estimate or guess what Congress is going to do in an election year.

There's three ways right now they're looking at. There's an extender potential at the end of the year where they could extend the credits into next year to the degree of our $1,500 credit. There's a Small Business Employment Act that's being circulated on the Hill right now which would incorporate the Home star program, which obviously would help us, even greater than the $1,500 credit.

Right now, I think we're at -- kind of at the crossroads of not knowing exactly what Congress is going to do. I think the indications, though, that we've had in conversations with the OEMs, as well as some government people, is that everybody is pretty happy with the performance of what this energy credit has created. It really has been able to drive through and be a successful part of the Recovery Act as far as generating more efficient sales for the consumer, or more efficient products for the consumer.

So, we're optimistic. And like I say, everybody--.

How about the Florida (inaudible)?

That one is not out yet. We're hoping to get something on that in August, where there's going to be a cash for clunkers program in the state of Florida to upgrade to higher-efficiency products. So, there's a lot of things going on out there. As well as the other aspect of it is the OEM manufacturers are -- have created incentives in the second quarter to even further enhance what the government's offered.

And so, as we look into 2011, we're also looking at what is going to be provided by the utilities, what could be provided by the state governments, and what could be provided by the OEMs in the way of incentives to keep this momentum going.

As far as determining what percent of these units, I would say it's been a very strong market for us in the high-efficiency products. And I'm sure a lot of it was driven by the $1,500 credit. I can't calibrate at this point what percent of it, but I would have to say it would be mystery all around.

Well, Paul, then maybe could you give us the breakdown of your, say, 13 SEER and then 15-plus maybe?

Let me get back to you on that one.

Dave, just to add some color to it--.

It's up 60%, I think.

To add some color to it, Dave, I think if we looked at five years of data, energy efficiency has increased as a mix every year. And if we look at the five years of data from a pricing perspective, that sales mix has been up 1% to 2% in terms of price for those five years and, right now, we're running more like a 4% to 6% range over the last three or four quarters in terms of sales mix.

So, somewhere in that algebra is the benefit coming from probably what's been accelerated benefit from high-efficiency. And tax credits is not the only driver. There are -- OEMs are putting money into the game now, direct to consumer. Utilities have bumped up some of their rebates to consumers. And certainly, the whole industry is advertising and promoting, and we're doing a lot of training on contractors on how to up-sell. And also, all the OEMs now, all of them, are in the high-efficiency market. That was not necessarily always the case historically.

So, there are a lot of moving pieces to this beyond tax credits and it is difficult to splice it all up into pieces. But going back to the pricing, this was probably was a 1% to 2% plus historically and now it's in the 4% to 6% range. How that falls out in let's say next year is still something to be seen. But that probably frames it the best way.

Okay. And what was price mix this quarter, Barry?

Up 4% for both the Watsco legacy and Carrier Enterprise in terms of sale mix benefit.

Okay. Great. Thanks a lot, guys.

Your next question comes from the line of Jeff Hammond from Key Capital Bank. Your line is now open.

Hi. Good morning, guys.

Good morning, Jeff.

Hey, just wanted to understand a little bit better from your perspective. And maybe it's a little bit of the housing, new housing market, but walk me through the disparity between HVAC equipment up 25% and non-equipment up 3%.

That's a new construction story, but Barry or Paul?

Paul, go ahead.

Okay. As far as the non-equipment side being up 3%, I think we basically have hit the bottom. And so, what we're seeing right now is--.

Bottom in new construction.

In new construction.

Yes.

And basically we're at that floor right now. So, a 3% increase is just some noise I think at this point. Obviously, when that market starts recovering, we're very exited about that because that obviously has a richer margin to it than the equipment side of our business.

But if--.

(Inaudible) as I can make it, Jeff.

Yes. But I guess if you look at the non-equipment piece, I mean, what do you think the mix is today of new versus replacement? Because it seems like similar to the equipment side, new -- the new piece has been under a lot of pressure.

The new equipment piece has been under--?

The new construction.

Yes.

It's very small.

Yes.

And that's indicated by the 3% supply increase. There's not much of an increase, which--.

Yes. I--.

If you just turned that around, you can say that if the equipment business is growing at 20 units, at 20 -- over 20% and supply is only a 3%, the difference is in replacements.

Because on a replacement job you're not going to have to be setting ductwork. A lower percentage of the time that you're going to be replacing the thermostat. You're not going to require a pad. Sometimes they're replacing the lines and sometimes they're not. You're not going to have the drop box coming off. So, it's -- on a replacement job, you just don't get the mix of supplies that you do on a new construction job. It's not even close.

Okay. And then just taking into account a pretty strong downturn here, you guys took out of a lot of cost. Doing a great job, certainly on the SG&A line. But as you get more comfortable with this recovery and the sustainability of it, how should we think about temporary costs coming back in that SG&A line? I mean, is this something we should think about as permanently taken out, or do we see some temporary costs leak back in?

Well, some of that is selling cost, which will increase. But you put your finger on our focus, which is we do not want to lose the efficiency that we have gained. And our key managers incentivize to keep that efficiency, and if not increasing the efficiency. But you'll see dollars increase simply because selling expenses, delivery expenses will go up. But I would hope that -- our goal is to continue to decrease SG&A as a percentage of overall revenues, and we've been pretty good at that and I expect that to continue.

Okay. And then just a clarification on the guidance, the $2.35 to $2.45. Does that include this income allocated to non-vested restricted stock? And if so--.

Yes.

So what does that line look like for the full year?

The answer, it does. It does, Jeff. And in terms of the full year, you can look at the tables in the press release and double it. It's pretty ratable cost. So, that would be--.

So if it was $0.10 in the first half, it should be $0.10 back half.

That's correct.

Okay. Okay, perfect. And then just a last question. Any sense as you look into July, just pace of business? Have we seen any real change or have we seen kind of that continued pace of the plus-25 HVAC equipment?

Well, we are experiencing growth in July, but I would say not the same rate of growth that we were experiencing in June. In early July, at least, we're not. But that doesn't change our optimism that it will be a terrific quarter in the third quarter.

Okay. Perfect. Thanks, guys.

Your next question comes from the line of Ian Zaffino from Oppenheimer. Your line is now open.

Hey, guys. It's Brian in for Ian. Congrats on the quarter.

Thanks.

Now, you talked about some market share gains. What do you think the growth rate for the rest of the industry was? You guys are about 14%. Where do you think everyone else is at?

Well, that data is not published but, Paul, go ahead. It hasn't been published yet--.

Yes, it hasn't been--.

It will be published--.

I guess my question is, how much market share do you think you've gained in--?

Until we get that data, we won't know that.

Yes.

Okay. Well, how about--.

We know we grew greater than the industry but, until we get the data, we aren't going to be able to tell where the market actually had the shipments, what states, what markets.

And I guess a follow-up to that is why? What are you guys doing that is allowing you to--.

Oh, come on. We're doing a lot of good things. You've got -- it starts with the employees. They're doing a great job of satisfying customers. And there is increasing demand for all the reasons we've just mentioned. And I don't see that -- I see that as a very long-term trend. And our ability--.

A long-term trend of taking market share.

Yes, both. A long-term share of taking market share and a long-term trend of growing.

Alright. Alright.

We're in great -- with over 500 locations serving 50,000 contractors, we're in a great spot. As the energy conservation and environmental issues continue to get focused by the American consumer and the American regulators. I love the spot we're in.

Thanks for taking the questions. Congrats again.

Thanks.

Your next question comes from the line of Keith Hughes from SunTrust. Your line is now open.

Thank you. Just marrying back on the guidance again, are you assuming in the second half of the year we go back into kind of the mid-single-digit run rate we'd expect from you in the past? Or just any kind of metric you could put around the back half of the year would be very, very helpful.

I think, Keith, we're certainly still on level with the second quarter. As far as being in love for the rest of the year, we're going to be cautious in how we state and what we think, just given what we see and what we've seen. The reason message here is, if you look at the 10 to 15 years of Watsco data, the first half of the year is roughly equal to the second half. So, we want to kind of give you our convictions about that big picture statement. And in terms of growth rates, that's going to play itself over the rest of the year. And we're not going to get beyond an earnings outlook at this time.

On margins, as we anniversary the Carrier deal, would -- in a growth scenario, I would assume overall margins for the Company, of historic Watsco and Carrier, will be moving up. Is that correct?

Yes.

Oh, yes, we expect that.

Okay. Okay, that's all for me. Thank you.

Your next question comes from the line of Steve Tusa from JPMorgan. Your line is now open.

Good morning, Steve.

Hi, good morning. So, I'm not sure I heard that correctly earlier on. Was it the third quarter that you said was going to be inline with the second quarter? Somebody made a comment about a high-water mark. Was that the second or the third quarter?

No, Steve. The second half we said generally equals the first half if you looked at historical Watsco data. We're not--.

But then, I think somebody asked earlier about a "high-water mark." Was that in reference to the third or the second quarter.

That was in reference in Carrier's second quarter being its high-water mark.

Oh, gotcha. Gotcha. So, okay. So, you're not -- so the third quarter should be down from the second quarter. I mean, that's what you guys are saying.

Yes.

Yes, okay. I'm trying to reconcile the 25% growth that you guys had in HVAC equipment with the OEMs' growth rates. I mean, Carrier is out there saying they did mid-teens. Trane hasn't reported yet, but I think some of the other guys are going to come in with similar numbers. We know -- what's the difference there in the growth rates?

One is the -- this is Paul. The manufacturers, obviously, are reporting their shipments to distributors who in turn would be selling to contractors. We're reporting what we have sold to contractors. So, there's always going to be a disconnect--.

Right. So, that would -- that would imply--.

Our improvement, yes.

Right. That would imply that you guys are selling out inventory, but it doesn't look like your inventory went down that much. So, I'm -- or if that's just (inaudible) explanation. I'm just trying to kind of -- I mean, that's a pretty wide gap between you guys and them.

Between the OEMs and -- well--.

A 10% difference--.

--Don't forget there's an R.22 impact earlier this year where the OEMs were shipping -- were not shipping R.22 while we had inventoried it.

Right.

A larger than usual inventory levels coming into the new year. And that is -- I think we started with about $50 million of R.22 inventory, which is gradually selling down.

Right.

That's an unusual event in this year.

Right.

So, when you say the inventory change hasn't been that great, that's because it started off unusually high.

I gotcha.

And also because we were planning on, as the season -- we got into the season, we saw the demand picking up and we ordered more. But I think the way to look at it, it's just my own view, is that sales to contractors is more relevant to what's going on in the end market than it is sales to the distributor. So, if you really want to know what's going on, look and see what distributor sales are as distinct from what OEM sales are. Because the OEM that you have to figure out what's going on with. OEM shipments you have to figure out what's going on with inventories, whereas the distributors are selling, it's going to the end user.

Right. So, I mean, so you're saying the inventories are still pretty lean relative to what you're seeing out there on sales.

Yes. I think -- yes. We're in pretty good shape. And we're slightly growing our turns, too, Steve.

Right.

So no, we're in good shape for that.

Will there be any -- I wouldn't -- I don't know if unusual is the right term, but will there be any extra, a bit of restock if the demand kind of continues at the trend? Or do you guys feel like you're in pretty good shape to supply the contractors with their current level of inventories?

Well, we're certainly not experiencing shortages. The OEM is very responsive and they have lowered their delivery times. But Paul, do you have some specifics on that?

No, I think that's something that each one -- that's -- the organization of Watsco is such that the operating subsidiaries are responsible for managing that inventory flow to their customer. And to Al's comment, we're not hearing anything from our subsidiaries where they're having to buy forward any material -- any great amount of--.

The lead times are much shorter, yes.

The lead times are fine and our guys seem to be operating without having stock out. So, that's something we've always prided ourselves on, we don't have a centralized inventory management system. We have individual operations out there who are actually managing--.

Closer to the local markets.

Right.

Gotcha. Just one more question. Any signs of life -- I know commercial's not a big piece of the puzzle, but any signs of life on like light commercial that you guys are hearing out there?

Yes. We're seeing growth; small growth, but we're seeing growth. We may be at the bottom.

Okay. Excellent.

That's encouraging.

Great. Thanks a lot.

You bet.

Your next question comes from the line of Joe Gagan from Atlantic Equity Research. Your line is now open.

Yes, hi. I just have a couple of questions. How much was the revenue contribution from the Carrier part of -- merger from last year for this quarter?

In the face of the press release, $400 million in the quarter.

$400 million. Okay. And as far as the percentage that you've cut the number of employees per branch since the recession started, roughly approximate what percentage? Is it like 10% less employees per branch, or how much--?

We haven't provided that information, nor will we.

Okay. And as far as the SG&A being lower, besides removing employees, what other cost reductions are in there? So, what other things have you done to lower costs? Can you mention a few of those things?

Sure. I mean, this is three years of conversation that's well documented at this point, but we're talking about fewer locations in terms of having the pro forma locations closed. It -- we're talking about fewer and spending for advertising and marketing, which lines up with sales. Less commissions, less lineup with sales over the last few years. And what I would call infrastructure costs, which would be technology, telecom, a lot of blocking and tackling type exercises to reduce the fixed costs of the business.

Okay--.

Credit losses.

Okay.

And bad debt has traveled lower as well.

So the bad -- so bad debt expenses -- on other words, people are paying you better than before?

Oh, yes.

Yes.

And what do you -- that's very interesting. What do you attribute that to?

A healthier industry.

Okay. So--.

The industry as a whole is healthier than it was the last couple of years.

So, the HVAC industry contractors are in better shape than three years ago.

Yes.

They're making more money and they're okay, right?

They're paying better. That would be good evidence that it's being well managed, as well as a healthy industry.

Okay. And then just one last question. What are you plans now that you've had these great revenue increases as far as adding employees per branch or in your main offices? Are there any plans on that, or you're just going to keep it the way it is?

That's a decentralized decision down to the branch level, of which we have over 500 branches. We couldn't give you answer for that. That happens when it happens by the managers of the branches.

So, it's going to--.

And the regional managers. I couldn't -- we'd have no sense for that.

Okay. So, you have no sense as far as when you increase revenues, how many employees you're going to increase--.

No.

Okay. Alright. Thank you very much.

Your next question comes from the line of Holden Lewis with BB&T Capital Markets. Your line is now open.

Thank you. Good morning.

Good morning, Holden.

Your gross margin, when you sort of look at how the gross margin has performed between sort of base Watsco and Carrier this quarter, the base Watsco gross margin has come down it seems a bit from the Q1 levels, whereas the Carrier, I guess, enjoyed -- it's really I think its third or fourth consecutive increase. It increased in Q2 over Q1.

Can you talk a little bit about what it is -- why you had a difference in the movement? And I would think that the same sort of mix trends and such that might be impacting the base Watsco would also impact the Carrier JV. So, I guess I'd just like to get a little bit of color why you're seeing a little bit of a step down at base Watsco and why, and why Carrier's moving the other direction.

Sure, Holden. Well, there's two -- there are two different answers because there are two different things going on between the Watsco legacy business units and Carrier Enterprise. And it won't be a permanent difference. It's something that's going on because Carrier Enterprise is young in its cycle to improve gross profit.

But Watsco first. The 30 basis point decline that you see year-over-year is strictly due to the strength of equipment growing 25% and the non-equipment products not growing at the same proportional rate. And the gross profit on equipment is simply lower. It always has been. It's one of the basics of what we do. And it's a mix change that affects gruff profit; again, algebraically.

As far as Carrier Enterprise, I mean, one of the big opportunities there has been for them to realize gross profit for all the products they sell, and how they incentive salespeople, how they grow the business, what they target in terms of margin in the marketplace. As well as getting Watsco programs to help them for all the non-equipment stuff they sell, which has a considerably higher margin at this point than they had historically.

So, I think there is a gap, a big gap between Carrier and Watsco in terms of gross profit. You know that coming into it. And there's been progress in closing the gap. It's still -- the gap is still there and it will take a few years, I think, for that gap to fully close. So, there will always be some difference in trying to compare the two at this point.

Okay. And so, if I'm hearing correctly, Watsco, it's just a function of mix. When you look at the gross margin of the supplies versus the--.

Yes.

Equipment, there's no -- that's been consistent and steady.

That is it, yes.

Yes.

Okay. And then at Carrier -- so there's been a gap, but they would presumably see the same mix changes. But you're saying that they're taking advantage of Watsco purchasing deals and things like that is eclipsing what looks like a pretty significant mix.

Well, they have not traditionally been in as much non-equipment as our -- the legacy business and they're moving in that direction. That's a very positive move. As more of that occurs you should see increasing margins.

Got it. Okay. Yes. And so--.

And Holden, without -- Holden, just to be -- for everyone's sake, the 19% that Carrier -- and we talked about in terms of revenue growth, that's fairly consistent across its product lines. So, it's growing all of its product lines at a pretty healthy clip. And that kind of mix that you see in Watsco is not relevant to Carrier Enterprise.

Right. So actually, the fact that Carrier has historically sold mostly equipment, not non-equipment--.

That's right.

The mix within mix question actually benefits it because the high efficiency is going to have a much more favorable impact to their headline number than it would to your given your non-equipment. Is that right?

Right.

Okay, great. And then I guess the other sort of math question I was trying to wrestle with is your guidance of $0.27 in earnings coming out of the Carrier business. I sort of -- you give the EBIT at $32 million. And to get a $0.27 number would sort of be at $8.3 million in net income. Knowing interest expense is nothing and minority interest is about 13.2, I guess it's sort of assuming a tax rate of like 33% for the Carrier business. And I thought that tax rate was quite a bit lower to get to that $0.27. Am I missing something in the math?

I don't see it, Holden, where you're missing something in the math. I think the only other denominator in this are the shares, the fact that we issued 3 million shares. And that's certainly in the accounting when we compute the diluted -- the accretion of Carrier Enterprise.

Right. And yes, we're sort of using that. But would it be -- would a 33% tax rate be reasonable for the Carrier business? I thought it was lower than that?

Yes. I'd have to check your math, but it's 60% of 38% is the tax rate applicable to Carrier Enterprise.

Okay. Maybe we'll take it -- we'll take this offline and sort of go through it, if we could. Alright. Thanks, guys.

Your next question comes from the line of Jeff Hammond from KeyBanc Capital. Your line is now open.

Hey, guys. Just to follow-on on the Carrier Enterprise's progress. I mean, margins this quarter are pretty much at parity with the base business, and you really haven't gotten the system savings and you haven't gotten really the benefit of the higher margin non-equipment. So, is it maybe too early to say that as you get deeper into this Carrier JV, maybe the margin opportunity's even greater than the base business?

Even greater than the Legacy business?

Um-hmm.

That's good, Jeff. Well, who knows. I would hope so because of their -- they also have -- in the three brands that they -- that we sell from Carrier, we're also repositioning the middle brands in a way that it could also contribute to higher margins. I mean, there are a lot of things in play. But I don't know that Carrier Enterprises would make more margin out of non-equipment sales than the legacy business. I don't think that more is -- I can't see that. I can see it coming along at the same rate, but I don't see it exceeding for any particular reason. Do you, Paul?

I really don't. You know, I -- I'm like you, Al, I see it coming up to what the Legacy business has been.

Yes.

But I can't see it ever coming above what the Legacy business--.

Within their equipment business I think that repositioning the Bryant line might contribute to margin expansion as well.

And then a separate question on the regulatory front. I think you and Trane have put out in your presentation some details about regional energy efficiency standards. And I just wanted to get a better sense of what you're hearing from your industry contracts, the EPA, regarding the likelihood that those go through as they're kind of presented.

Well, Paul was in -- with the EPA this week. So, the lead EPA person regarding this industry. So, maybe he can give you some fresh information.

Well, unfortunately, I don't have any fresh information on the regions. But I -- everybody's feeling still pretty good about the regional efficiencies becoming effective. It's got support from pretty much across the board from the OEMs. It's also the ARI, the HRI group. It also has a lot of support from a lot of the environmentalists. So, it doesn't have a lot of roadblocks within the industry in front of it right now. So, we're still feeling good about it.

But the head of -- at EPA that oversees this particular industry is a very -- what -- how do we say, very positive about the industry and I think very receptive to ideas that come from without -- from outside of EPA. I thought we were impressed very much with her.

Yes.

Okay, great. Thanks, guys.

So, that's a good thing, I think. Because if somebody who's listening, it's more likely that regulations will come out the right way.

Your next question comes from the line of Keith Hughes from SunTrust. Your line is now open.

Yes, just one follow-up question. Could you just remind us again, the $2.1 million, the distribution and non-vested common stock, just exactly where that comes from and what it's regarding?

That's -- you want to deal with that accounting question Barry?

Yes. The dividends that are paid on restricted stock are deducted. And the numerator from net income to get to net income available to common shareholders, it's one of the accounting changes made last year, and it's simply that the dividends that are paid on restricted stock.

Okay. Thank you.

Your next question comes from the line of Holden Lewis from BB&T Capital Markets. Your line is now open.

Thanks. Thanks again. I guess I wanted to expand on Jeff's question there a little bit earlier. If you look at sort of the legacy Watsco operating margin and the Carrier operating margin in the first half, they're identical, which is great. But, you're talking about being able to expand the gross margin at the Carrier JV as you take advantage of mix and things like that.

As -- if you grow the gross margin -- in other words, if you can get another 100 to 200 basis points of gross margins of Carrier JV, that would still lag your base Watsco. But at the SG&A they operate at, I mean, that would suggest margins higher at the Carrier JV than at base Watsco.

Is there some reason that investment at the SG&A line at Carrier needs to go up and maybe spending needs to rise to offset that increase in the -- or to achieve maybe that increase in gross margin? It just seems like we're already at parity between the two business and you have more low-hanging fruit at Carrier JV than at legacy Watsco to continue to drive that up.

Well, two thoughts, Holden. One is accounting and one is conceptual. On the accounting side, we do have Watsco corporate expenses and our same-store margin. But we're going to compare Watsco's legacy business units this quarter to Carrier Enterprise. They're still operating about 120 basis points higher than Carrier Enterprise. It's not on parity.

The conceptual thought you have on SG&A at Carrier Enterprise, they're working everyday to be more efficient, to save money, to lower costs. At the same time, from a density point of view, they did not have the number of branches, they did not have the number of products that the rest of Watsco has, all of which would apply some pressure and -- because it's the opportunity to add some SG&A dollars while growing the top line.

Now, that's a three or four year conversation. That's not quarter over quarter. But long-term, the spending that will be needed at Carrier Enterprise to grow its network, to grow its product group, they're looking to offset that with more efficiency and more savings, but that's a long-term conversation, not something that we can dissect in a quarterly conversation.

Okay. So basically, Watsco -- legacy Watsco is still operating about 120 basis points better if you strip out the impact of all the corporate, which it fall all into legacy Watsco?

That's correct.

Okay. And then, we would not -- it would not be prudent then to assume that SG&A as a percent of sales for Carrier declines over time as volume goes up, because you anticipate spending on branch density and training for broader products and things like that. So, we could assume that SG&A over time as a percentage of sales actually rises at Carrier relative to where it is today. Is that sort of the message?

Yes.

Okay. Great. Thank you.

(Operator Instructions.) There are no further questions at this time. I'll turn the call back over to the presenter.

Thanks very much for listening and we'll talk to you again in the next -- end of the next quarter. Bye.

This concludes today's conference call. You may now disconnect.