Watsco Inc (WSO.B) 2022 Q3 法說會逐字稿

Good morning, and welcome to the Watsco Third Quarter 2022 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Albert Nahmad, Chairman and CEO. Please go ahead.

Good morning, everyone. Welcome to our Third Quarter Earnings Call. This is Al Nahmad, Chairman and CEO. And with me is A.J. Nahmad, President of the company; Paul Johnston; Barry Logan; and Rick Gomez.

Before we start, our usual cautionary statement. 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 various laws. The ultimate results may differ materially from the forward-looking statements.

Now on to the quarter. We delivered another record quarter. Sales grew 14% to a record $2.04 billion, and operating income increased 14% to a record $236 million. This third quarter performance builds on what we believe will be a record year for our business. So far, 9-month sales increased 19% to a record $5.7 billion, and 9 months' operating profits increased 37% to a record $694 million. Year-to-date cash flow also improved, increasing 12% to $359 million.

Now given our earnings growth, cash flow expectations and our confidence in the business, we announced today an 11% increase in our annual dividend to $9.80 per share effective in January of 2023.

Thought I might comment that we believe the last 2 years have been among the most challenging and also the most gratifying periods in our history. Our growth and stability speaks to the fundamental necessities of the products we sell and to the value that our industry provides homeowners and businesses. Given our long-term focus, Watsco has also invested over the past 2 years in people, technology and infrastructure. And we do these things to build market share in our $50 billion market.

As industry demand and supply chains normalize, it is the right time to expect more productivity. And we have challenged our leadership to improve operational efficiencies across our network.

We're also working closely with our OEM partners to develop forward-looking growth initiatives. Watsco does maintain good relationships with virtually every domestic and international industry manufacturer. We believe collaboration with the manufacturer is all the more given the industry change that's taking place in the coming years.

Many views of our company fundamentals are in this morning's press release. I really do urge investors to read that release and understand why we believe we have an exciting future.

We have an immense technology advantage, and we're investing to grow that advantage. These technologies bring in new customers, they help our existing customers grow, and they reduce attrition of customers. And most important, they help us gain market share. Our active technology user community has grown 21% this year to more than 45,000 users.

And OnCall Air, that's a platform that reaches into homes, keeps growing. During the quarter, contractors has presented quotes to approximately 66,000 households. That is a 39% increase in households over last year and generated $269 million in sales for our contractor customers. That is a 47% increase.

Watsco's diversity of products and brands is an important competitive advantage that allows us to serve contractors in any economic environment. We also have a leading market share position in Sun Belt markets, where both population migration is greatest and the necessity of HVAC products is the most absolute. You got to have cooling and heating if you live in the Sun Belt.

In addition, there are several important catalysts for growth that will play out in the next few years. For HVAC equipment, the minimum federal efficiency standards will increase in 2023 across the entire United States. Price points associated with these higher-efficiency products will increase and should benefit our 2023 results.

Federal mandates are now in place to phase out high global warming potential refrigerants used in millions and millions of existing systems. But in 2025, we'll mark the introduction of new HVAC systems that will incorporate lower-GWP refrigerants.

We also see a strong movement towards electrification of heating systems through the use of more heat pumps, which generally come at a higher price; higher margins; and in the long run, a shorter replacement cycle. Our sales of the heat pumps grew 27% in the first 9 months and, interesting, 32% during the quarter, outpacing overall sales growth rates.

The new Inflation Reduction Act, which takes effect next year, also provides tax credits and incentives for qualified efficiency upgrades and electrification.

All of this provides the basis for homeowners and businesses to upgrade systems that will, over time, be more efficient and more environmentally friendly. And all of this is good for climate change and good for Watsco. We certainly believe our scale, technology and financial strength position us to capture these new market opportunities.

Finally, we always concern ourselves with our balance sheet so that we are in a position of financial strength. And today's balance sheet remains in pristine condition to invest in growth opportunities in coming years. I'd like to say that we can fund almost any size of investment to grow our business.

With that, let's go on to Q&A.

(Operator Instructions) And our first question will come from Tommy Moll of Stephens Inc.

Wanted to follow up on your comment regarding finding more operating efficiency in a more normal business environment. If we go through a period where industry volumes are pressured, I presume that still applies. But can you actually continue to show leverage on SG&A? And to the extent you can, is it intentioned with market share opportunities that you might otherwise be able to go after in a period of pressured industry fundamentals? Is there a natural tension there that we should think about, how you might reconcile?

I think that's an excellent question, and I'm going to have Barry Logan and Paul Johnston answer that. And A.J. Nahmad. You're going to get a trifecta here.

The last part first, Tom, and just to give some sense of product and brand and OEM and manufacturing and general conceptual stuff. Really been 2 years where I can attest to you that going to OEMs and saying, "How are we going to grow?" Was met with the response of supply chain difficulty. OEMs have capacity, but yet, they have to have supply chain constraints.

And in that environment, it's almost kind of bizarre, honestly, to go to our OEMs and say, "How do we grow? What do we add? What brands can we go to market with? What incrementally can we do with you to help you grow?" And to be told, "You'll have to wait."

So now we have that opportunity ahead of us in the next couple of years to play offense. We think the supply chain is better. There's still more to do. We're going through a big product transition as we head into next year. But that's a very unique and important opportunity that doesn't have much to do with our discussion on efficiency. It has everything to do with how do we use our balance sheet? And how do we use our presence? How do we use our structure? How do we use our technology, to go grow brands and grow our relationships beyond where they are. So I think I would put that aside as a discrete strategy.

And on the efficiency side, it's again a very kind of simple story to tell. We have to go prosecute and execute the strategy, but it has been a wild 2 years. There's really been nothing customary, nothing that's been ordinary in dealing with both the strength of the market, the real difficulties by the supply chain, you have a lot of inflation going on, you have really a fire drill going on to serve customers. And we were at no time going to look at cost as the critical item in serving customers in this environment. We were going to do anything it took to serve customers in this environment.

So we're out of season as we head into the shoulder season here in the fall, and the message is very clear to our leadership, Al's made that message extremely clear, about stepping back from the business, looking at cost, looking at cost to serve, looking at efficiency, looking at technology and challenging them to be more productive as we get into the next environment.

Paul, anything?

Yes. It's -- the supply chain disruption obviously caused a dysfunction in our productivity, and that was basically around being able to match up systems, having an outdoor unit in one warehouse and an indoor unit in another warehouse. So it did stretch our people to be able to satisfy the customer and make sure that we were able to put the pieces together so that they could complete the job that they were on. And so that did create some dysfunction, as I said, in our ability to improve the efficiency with all the tools that we provided to our people.

The second thing that we're going to be going through now is, as we go through the transition to the new product line, it's obviously going to reduce the number of SKUs. It's going to hopefully simplify the supply chain. And hopefully, we'll have a long-term benefit from that going into 2023 and beyond.

A.J.?

Yes, I'll just add some figures to give you some sense of scale. We process and fulfill roughly 7 million customer orders every year. That's product going out. Product coming in, receiving of product coming in, there's also millions of receiving touches that we have to do with the products. And then we move product around our 700 or so locations with 800 or so vehicles and lots of forklifts and lots of humans and lots of touching of the product various times.

And like Barry said, given the supply chain challenges and not necessarily receiving product when we hope to receive them or in the locations we hope to receive them or in the quantities have -- we'd like to receive them, and the surge in demand, there's a lot of scrambling going on. And the policy -- or not the policy, but the -- our heart was to fill customer orders, take care of our customers.

Well, now as things start to calm down, if you will, a little bit in the supply chain, and we expect them to continue to "normalize", we'll have more opportunity to improve our processes, improve our technologies, improve our ability to smoothly receive all those products, move products around less, because we'll have products in the right place at the right time and the right quantity, get customer orders filled accurately and on time and efficiently.

So I'm just trying to give you some sense of scale of the operation and the chaos that ensued. And now as the chaos calms down, we can really drive some productivity and efficiency through the system.

All very helpful. And as a follow-up, I wanted to hit on technology investment. Is it safe to assume that, that's a separate discussion here, and that you'll remain forward-leaning, I guess we could say, on technology investment? Any view you could give us there for the coming quarters would be helpful.

And just to throw out a couple of data points that maybe you could discuss. I just -- I noted the contractor-assist users were up meaningfully quarter-over-quarter. OnCall Air quotes were down meaningfully quarter-over-quarter. I realize there's a lot of noise in those KPIs that you give us every quarter. But to the extent you want to clarify any of those trends, it would be helpful as well.

I don't think that last specific is accurate. Right, Barry? OnCall Air quotes?

When you say quarter-over-quarter, you're talking about second quarter versus third quarter, or sequentially? Is that what you're looking at?

Correct.

Yes. We had to look at it year-over-year because there is seasonality in the business. But I mean, starting with -- yes, go ahead, Barry.

No. I would say there is a seasonality aspect to that answer. Yes.

Right. But no, OnCall Air is thriving. And the customers of ours that are using it, which is a growing number, their performance with us. I mean, their sales growth rate with us is significantly higher than nonusers. They're winning more times in the marketplace, and that leads to more purchases from our business units.

As for technology in general, will we continue to lean in and be a technology-driven company? The answer is yes. I'd like to say, maybe it's become cliche now that we are a technology company that just happened to sell HVAC products.

And technology, we really use that as an umbrella term. It really means modernizing the company, including people's skill sets, our processes, our systems, how we operate and how we are able to impact our customers as far as their experience and their ability to find the products they need, get orders delivered or fulfilled quickly and accurately.

And really, technology touches all parts of who we are and what we do, and it's all customer-focused, and it's appreciated. The customers that are using our technologies are better customers. Their attrition rates are much lower and their growth rates with us are significantly higher. So those numbers continue to grow as far as customers using our tools. And we continue -- we believe it's made an impact in our ability to take market share from our customer -- from our competitors who don't have nearly the breadth or depth of the technology offering that we do.

The next question comes from Nigel Coe of Wolfe Research.

Just wondering how we should think about your inventory levels as we go into year-end. And it sounds -- it looked like third quarter, we're kind of back on a more seasonal path of lower inventories in 3Q versus 2Q. But just wondering how you're managing inventories into year-end. And of course, curious about the 14 SEER versus 15 SEER dynamic as well.

Those are 2 great questions. All I can generalize is inventory will be lower, and we hope not to have any or very few units that wouldn't qualify in the South given the efficiency mandate in the South. We're very conscious of that.

But let me give you more in-depth. That would be Paul.

Yes. Nigel, we monitor the straight-cool units in the South to make sure that we have a smooth landing at year-end when those units become basically obsolete in the South. So we feel we're on the right trajectory there. We're going to beginning to receive the new products, hopefully, in late October, early November. So we'll be set up to be in business on January 1.

The new product will be more expensive than the existing products we have. But generally speaking, the inventories are a little bit restrained right now in certain product areas. And in other product areas on heat pumps, for instance, we have sufficient product to guide us through the -- at least the fourth quarter and into the first quarter.

Cool. Great. And then just my follow-on is really around -- I don't know if you want to throw out the price/mix impact in HVAC products this quarter in residential. You do [that] sometimes.

We did. Yes, we did do it.

Okay. I'll go back to that. I'll -- i missed that one.

I'm sorry. It's in the press release, Nigel.

Okay. Got it. Got it. Okay. My eyesight's terrible. But if we think about the -- you mentioned the hurricane. Obviously a tragedy for Florida. But just wondering what impact you saw in the quarter. And what opportunity do you see from some of the rebuild as far as HVAC is concerned?

This is Paul. I live in Fort Myers, so I'm right in the middle of the hurricane zone here. And I've been out visiting our branches, and I was very proud to say that our branches were open within 24 to 48 hours after the hurricane passed, and taking tours of them. We had one branch that was missing 160 feet of its wall, and there were 10 trucks lined up outside and we had -- our staff was there doing their job and filling orders.

What did we lose in the quarter? It's an estimate. I would say somewhere between $16 million and $18 million worth of business was probably pushed either into the -- into Q4 or perhaps was -- is going to be lost.

However, we've got a very strong market share presence in the 3 counties that were impacted. We've got 12 branches. It's a marketplace which is about equivalent to the size of the state of Louisiana. So obviously, as the work begins, we expect to see some upside in this marketplace. It's tragic that, that creates business, but we are here to help everybody get their lives normal again.

I would say -- just to add color to that. We had about 40 locations under hurricane warning that had [an irritation] during the quarter, another 200 under hurricane watch that I'm sure there was some distraction. As that plays out into the fourth quarter, there's some short-term immediate requirements to fix systems.

What we have seen in other markets where there's destruction like this is, just conceive of a $20 billion insurance claim collectively, in aggregate, flowing capital into a market like this. And some portion of that $20 billion is our stuff that is part of either rebuilding, remodeling or retrenching or newbuilding in that case. So there is a longer tail than just 1 quarter, but it's one of those events where we are witnessing real destruction. And again, to some extent, that's an opportunity for those markets within our business.

I'm happy to add that none -- no serious injuries with any of our employees, which we care a lot, quite a bit about, who were employed during the areas of the hurricane.

The next question comes from Jeff Hammond of KeyBanc Capital Markets.

So just wanted to come back on Nigel's questions on inventory. Maybe just speak to what you're seeing from your OEMs and parts suppliers around lead times. And just -- I think, Al, you said inventory is going to be lower in the fourth quarter, and I don't know if that's a seasonal comment. But we've just seen some aggressive destocking in other kind of building products area, not so much HVAC. And I'm just wondering, as you see lead times, what's the kind of the want and willingness to kind of bring inventory levels more normal?

Well, I would say, generally speaking, the manufacturers did the best they could. But more cases than not, they were not able to deliver either on time or a complete order. They would send the outdoor unit, but not the indoor unit. And so we had the inventory, something we weren't going to be able to sell, until they fulfilled the second part of the order. That sort of thing.

And since they're catching up, we're going to be getting complete systems, especially with the new products that are coming out towards the end of the year. And that's why I think that not only will the inventory come down, but the cash flow will come down. Everything is going to get better in the point of view of investing in inventory and improving the mix of what's in the inventory.

Anybody want to add to that?

Yes. Like I think I indicated this earlier, the one good feature about the change to the higher-efficiency products is a fairly large reduction in the number of SKUs that we have to handle. And what our hope is, obviously, is that as the number of SKUs come down, that makes it more efficient for us to be able to have the right inventory and a lower inventory at the same time. It should also make it a simpler manufacturing process, we hope, for our manufacturers so that they'll be able to provide us the products that we need.

So we're still having some problems. There still is, sporadically, something will go haywire at the manufacturing plants and we'll have a shortage of something. We're experiencing increasing demand, as we indicated in the press release, on heat pumps. We're seeing increasing demands on commercial products. And we have a continuous demand increase that we've seen over the last several years on ductless products.

Well, what we can see in October, the numbers show strong growth, which is another reason why I feel good about the inventory.

Okay. Great. Great color. Just on gross margins, I know there's been a lot of questions on that. I think, Barry, the last couple of calls, you've kind of talked about some of the structural improvements and kind of a new target of 27% gross margins. I think you're there this quarter. Just wondering if that's a reasonable target for kind of 4Q and into 2023. Or if we start to maybe dip below that as some of the inflation normalizes.

Barry, you on?

Yes, I am. Jeff, just to give some color. First, in the quarter, let's speak very narrowly about the quarter. The key business component of gross profit in the business is what we simply call selling margin. What is our price/cost effectiveness during the quarter? And during the third quarter, that was raised about 80 basis points. So we were still seeing higher margins in that kind of raw margin aspect of less selling products. That will -- there's not a reason to think that will change much as we play out the rest of this year. And so that's the positive.

The negative was -- part of gross profit also is how we pay vendors, when we pay vendors, to the extent there's volatility in paying vendors. And there are cash discounts, there are vendor incentives, there are rebates, that flow in that equation. And in that volatility in the quarter, that took away some of the gross profitability this quarter.

So that's a short-term, 1-quarter conversation. Longer term, the good news is the price/cost selling margin actually increased meaningfully this quarter.

The selling margins. There you go again. That's the healthy part of our business.

The next question comes from Ryan Merkel of William Blair.

So I wanted to pick up on the gross margin question. So just to clarify, year-over-year, you're saying that there was a positive 80 basis points of positive price/cost. But that was offset by, what, rebates being lower? And in that case, why would rebates be so much lower in 1 quarter? I don't recall ever seeing that in the past.

It's because of the level of purchasing activity and receipt activity a year ago versus this year. And that's where the chunk and the funkiness of inventory receipts, that have kind of have been volatile, play out a year later. So I would say a year ago, there was a benefit in gross profit relative to the timing of receipts of inventory. A year later, a bit of an air pocket. We're talking about 30 basis points, to put that in perspective.

Got it. Okay. And then gross margins were flat year-over-year. So what was the other part that offset the positive price/cost?

Freight. And our branch freight, where we move products around, was negative in the quarter for all the reasons that we're talking about. When we talk about freight and moving products around, that's an inefficiency in gross profit year-over-year.

I got it. Okay. So how do we think about the trend, then? I would presume that the positive price/cost situation will be with us for a bit. And then what about those other pieces? How do you think those will evolve in the next couple of quarters?

Yes, it does go back to the purchasing patterns. And again, inventory, as we reduce inventory seasonally, which is normal through the rest of the year, versus what we did last year, there could be a small amount of volatility in that. I'd have to go back and look at a year ago, but I don't think to the same extent as what we saw in the third quarter.

And as far as moving inventory around, I think that is better, but still an irritant. And it's probably one of those, a year from now, opportunities to actually improve margin. So I would still stick with the -- with our target of 27% as a baseline. And some of the volatilities that we're talking about this quarter flattens out or goes away as we get into next year.

Got it. Okay. That's what I was driving at. And then my last question, I just want to go back to the price/mix impact in '23 from the SEER change. So I think what we're hearing is a lot of the OEMs are up sort of mid-teens for price increases on new base units. And I think there's actually some out there are up 20%. Are those the right numbers? And I think the mathematics should be price/mix next year could be 6%, 7%, 8% with carryover price from this year. Is that right?

I would say you're a little high. That's -- everybody announces some of these price increases. But I think what we're going to see is it probably -- and this is a guess on my part. It's probably going to settle somewhere around the 10% to 15% range.

The next question comes from David Manthey of Baird.

So playing off of that pricing question, and I apologize if I asked this before. But could you remind me the percentage of your parts and supplies products that might be more subject to commodity deflation, like steel ductwork and copper tubing and that sort of thing?

Good question. Paul?

Yes. It's -- it is copper tubing, it's steel. We sell a lot of steel that's used in the production of ductwork. Refrigerant is another area that we look at, which is generally, for us, it's mostly 410A, which I think is going to have upward price pressure throughout the next 4 to 5 years. And then our general parts business, which is compressors and motors, representing the largest portion of it.

On the supply side, it's everything from the ductwork that goes up there, the flex duct, to insulation products, grills, registers. We've got, gosh, probably a couple of hundred thousand SKUs when you get into that product.

But when you look at that, Paul, just thinking about the types of products that are very sort of commodity-heavy, like copper tubing and steel, what percentage of your mix does that represent? Given that equipment and refrigerants are obviously seeing inflation, what components might see some deflation as commodity prices retrench?

It would be -- I would say, just hazard. I'd have to give you an exact number, but it would be south of 5%.

Okay. Yes.

Yes, I agree with that. I'm going to have to hazard it. I'm looking at the numbers. It is under 5% refrigerant, which is -- again, we label a commodity, which has had nothing but inflationary realities going on. It would be -- is there. But as a group, that commodity group is still, even with refrigerant, right around 5% of sales.

Okay. Okay. And then second, I hate to get too granular on this, but could we talk about the operating expense investment that you've been making here? And I'm looking at this -- at the OpEx level this quarter relative to the $2 billion revenue number. I'm just trying to understand, are all of those investments kind of at a full run rate in the third quarter? And then as we get to the shoulder periods, some of your variable costs might come off a bit, that the $322 million SG&A this quarter is a high watermark for the next couple of quarters?

Or were you implementing those programs during the quarter, and we could actually see more flatness or higher SG&A going forward? I'm just trying to understand the timing and what more we should expect as we look to the next couple of quarters here.

Yes. I would say, Dave, first, when we talk about 400 people, it's not recently, it's over the last couple of years. So that's just giving a big-picture view that, during what's been a tumultuous time, we've invested heavily to not just realize today's results, but investing some of the future results that we're expecting. So I would say it's a pretty mature-looking number at this point in terms of what you see in a quarter.

There are a lot of variable costs which moderate over time in terms of just moderating to what the top line and margins are doing. Gross margins are still up over 25% this year. That means every commissioned salesperson that sells off of gross profit, their income is up 25% this year. I wouldn't expect -- I would like it, but I wouldn't expect that level of growth rate to -- I want it to, but it's not going to sustain at that level, obviously. So that would be a variable cost that moderates simply by the business in terms of the scale of the business changing.

Something like freight, where it's a $60 million, $70 million number that's up 40%, 50% over the last 18 months, I would expect that to moderate for all the reasons that we're talking about. But also, you have 675 branch managers that decide every day how many people do I need? How many hours we're going to spend? How much overtime do I need? How much temporary help should I add? How many trucks should I own? And so when we talk about efficiency, it's going out to and bringing data to the equation, and culturally, in the shoulder season, and challenge kind of the thinking on what's going on in that regard.

It's a lot of moving pieces, all of which have not been easy to manage in the last 2 years, and obviously become simpler to manage and obviously more critical to manage in terms of urgency over the next 2 years.

Robert Baird is thinking about those kind of discussions right now.

The next question comes from Stephen Volkmann of Jefferies.

I'm wondering if we can just focus a little bit on kind of what you're seeing from the volume perspective. And I guess I'm sort of backing into volumes were kind of flattish this quarter. But I think maybe we started the quarter better than that. Did volume sort of decelerate through the quarter?

And Al, you made a quick comment on October. I wasn't sure if that was a volume quarter or something specific, but would just love to hear what you're seeing there.

We haven't mentioned, I don't believe, that there is a product mix going on, which also elevates the pricing. I think, Barry, talk about that. I think that's probably the more -- one of the more significant things that's going on. The product mix is changing, and I think that's a plus. So you won't see -- it's not unit sales as you otherwise would, but you see the sales that do occur. They occur at a higher price in the marketplace.

Right. Well, just to answer your question, Steve, just on volumes. Volumes were up in July. We reported that when we reported in July. There was some moderation since then, and pretty flat for the quarter. And probably would have been up a little bit if I try to account for some of the hurricane activity. But that's been kind of the way it's been now for 6 months. That's not a new trend. It's kind of been flattish unit growth now for really 6 months.

What Al was speaking of is, what about everything else in terms of the business? And so obviously, there's still a measure of inflation we're capturing in the market. But when we use the term heat pump and discuss that it's up 32% in the quarter, and that's substituting for straight-cool units that are probably 10%, 15% less in price, that's mix. That's a price achievement in mix. And to the extent that trend simply continues, it's a permanent opportunity to have higher average selling prices.

Also the SEER mix increased during the quarter, and it's been going on now for about 11 years. You have contractors making recommendations and bringing solutions to the homeowner with confidence. We have technology in place that's triggering that opportunity in a much more professional way. And we're seeing another quarter of strong growth in energy efficiency mix, and the government mandate next year makes that even more automatic.

So when we use the term price and mix, there's a lot of subtlety in that discussion. And the heat pump discussion and this energy mix -- energy efficiency mix discussion, I think, accounts for a lot of what we're talking about in price right now, not just inflation.

And Paul, you can add color. I'm not sure there were any OEM pricing actions this quarter.

No. There really -- outside of some commercial pricing actions, we didn't have any residential pricing actions that really affected the quarter. And as Barry indicates, the heat pump growth was something that's been happening sequentially over the last 3 quarters, and we saw it accelerate in Q3. Expectation is for it to continue to grow. And as that grows, it does have a material impact on our revenues on residential products.

That's super helpful. And Al, you anticipated, my follow-on was on mix actually. Because I've heard some channel checks sort of complaining that some of the high-end units were hardest hit by supply chain issues and therefore were constrained. What's your view? Does mix get even better because things normalize in '23? Or are we sort of stabilized?

I certainly think that it gets better for us. Every trend that we see and anticipate is that -- many factors are contributing to consumers wanting to own higher-efficiency products. And as Paul keeps pointing out, in the North, where they have gas furnaces, we expect them to be replaced by heat pumps because they're more efficient when they operate and they emit less CO2 when they're used. These are all very positive trends in the short and the long term.

We are in the right place at the right time. I just like everything we're doing to meet what has occurred, and better yet, what's coming. We just have some fabulous capabilities that no one else has. Who can afford $48 million in technology investment a year, and growing? Or if they can afford it, they're not committed to it as we are. And that continue -- will continue our edge in terms of staying the leader in gaining share.

So I can't think of anything at the moment that would warn you that we see something negative in the early future. Everything I see is positive.

Can you guys add to that, A.J., Barry, Paul?

Yes. We're seeing another trend that's starting to occur, and that is where straight-cool units in the mid-South and the North are starting to be replaced by heat pumps as opposed to a straight-cool unit. And what that trend recognizes is a term that we call dual fuel, where the unit will operate as a heat pump down to a certain temperature. And then when the temperature drops below that point, you'll switch over to the gas furnace. Not replacing the gas furnace, just replacing the outdoor unit to provide non-fossil fuel heating. And we've seen that growing, and now it's starting to accelerate.

We haven't -- we have not talked about the tax credit and what impact that will have on the high-efficiency product going into next year and beyond. There's still some adjustments to be made as far as what the efficiency has to be to qualify for it. Once that's clear, I think we'll have a clearer idea of what the opportunity is going to be with the Inflation Recovery Act.

The next question comes from Jeffrey Sprague of VRP.

Could you just remind us now -- just really kind of following on from the mix discussion. What percent of your sales in 2022 would have been at the prevailing minimum SEER level, and therefore, is kind of subject to kind of the mandatory regulatory lift into 2023?

Paul, go ahead on the equipment sales. Yes.

Yes. It's -- minimum efficiency in the quarter was approximately half on just the outdoor units.

And that would be a pretty good number for the year also, I suppose?

Yes. It -- that hasn't really changed that much. There's been a little bit of a mix up in it because of the supply chain. But generally speaking, that's a pretty good number.

And just back to heat pumps. The numbers do seem particularly strong even before the IRA has come in to play. I mean, are you proactively educating? Like in many respects, I would think the average consumer doesn't know a straight air unit from a heat pump unit from an air handler, right? So is there really a very proactive selling effort going on around heat pumps driving the performance...

I think -- yes, there is a proactive among our contractors, obviously. It's their responsibility. They're the ones in the home. We've got OnCall Air, which assists them as far as making that presentation to the consumer. So I think that's a plus that Watsco has and Watsco's contractors have.

But also, there's been an awful lot of discussion. Bill Gates wrote a book on it. California now has passed a law which states that you can have -- they're going to phase out fossil fuel heating by the year 2030. You won't be able to buy a gas furnace and install it. There's been also motions in New York State, parts of Canada, that are starting to phase this out. The Department of Energy also has a -- what they call a contest to come up with a low-temperature heat pump, and that's been led by the state of Minnesota.

So I think the word is getting out to consumers. Heat pumps are not new. Heat pumps have been around since the mid-1950s. It's just that -- it's taken a while for these things to really catch on, for the technology to be able to provide a comfort heating situation for the consumer.

And so what we're seeing is we're seeing the frost line, if you will, used to be the end of where you could sell a heat pump. And now we're seeing that extending up into Pennsylvania and New Jersey and even Massachusetts.

And the science of these pumps is improving. They're doing more things that deal with more extreme temperatures than the old ones used to.

I was going to say that also, it's probably 10 years ago, ductless was a fraction -- a much smaller fraction of the market than it is now. And most every ductless residential unit are heat pumps. So if it's Mitsubishi or someone like that, selling 20 SEER ductless systems, 95% of those are heat pumps.

(Operator Instructions) And our next question will come from Steve Tusa of JPMorgan.

So just on the -- I guess just the forward look here. Do you expect the fourth quarter to be kind of like normal seasonality for you guys on an EPS and sales basis, just from a -- I guess that would be sell-through. I mean, what -- you said it's up in October. How good is it in October? And just how should we be thinking about the fourth quarter trend?

I'll give you a general comment. I think fourth quarter is going to be very strong. Barry, details? [I mean, as much as you can...]

Yes, Steve, I mean the same kind of double -- yes. I mean you've seen double-digit growth over the last 2 quarters. And October, there's no interruption in the double-digit trend. I kind of leave it at that. I think it is a shoulder season as we get into off-season. And so it can be a bit more consumer-oriented in the sense of that. But we also are seeing the very strong commercial volumes flowing through the business. So now that looks a lot like the trends of recent months.

I guess with all the cross currents around demand, the regulatory changes coming up, and I guess your focus on destocking some, like what's the inventory trend into 4Q? There's just a lot of moving parts here because it is a shoulder season. So I mean, is that going to be kind of up quarter-to-quarter in preparation of next year? Like just -- maybe just a little color on the inventory.

Well, that's a good question. I don't think they're going to be higher, they're going to be lower a bit. Anybody fill in the blanks on that?

Yes. Of course, our goal is to end up lower. A lot of it is going to depend once again on the supply chain, as far as how quickly we can restock with the new M1 product, or is that going to -- or is the majority of that going to fall in Q1? Obviously, that's a higher-priced product than what we currently have.

We're also seeing strong demand as a lot of the -- on the new construction side, a lot of these builders have to have the system operating under the old standard. They have to have the system operating in the home, the new home that they're building, before year-end. So we're seeing a little bit of a rush from that sort of standpoint.

And so I think it's going to be -- I think we're going to be down. Our plan is to be down. And we're working -- we've got an inventory management system that allows us to have complete visibility of it. So it's -- we're not surprised at the end of the quarter by where our inventories are.

Let's just be careful of those words. We think our inventory is going to be down, not our business.

That's what I said.

Yes, yes. So inventory as a percentage of sales down a little bit. But I was just wondering from an absolute perspective. And then, Barry, you mentioned these promotions or these rebates, I guess, you call them. What's the expectation for that in Q4? And then just any color on the gross margin in Q4?

Again, the selling margin that I mentioned, which is simply the price/cost equation of selling products, is we're seeing that continuing to trend better in October. Let's say it that way. And again, I don't think there should be any real disruption in the fourth quarter in that respect.

The other stuff. Again, it's algebra on when we order product, when we receive them and we pay for them, depending on which product line. And I think there could be a small measure of irritation, just knowing the inventory is coming down, but not to the same extent as what we saw in the third quarter. So net-net, I think nothing disruptive in terms of trend of gross profit in the fourth quarter.

Sorry, one last one for you. What's your market call on next year? What's your most up to date? You didn't have anything in the release this time around, kind of the market outlook. What's your guess on the market for next year for resi units?

I don't think we...

The overall market?

Yes. Overall resi unit market. Up? Down? Sideways?

We -- I don't think that we -- unless you have industry forecast by the associations. Maybe Paul, do you?

No. I think you'd have to talk to the OEMs who look at it on a national basis. Our forecast that we do internally, which is our proprietary system, is only for the states in which we do business. So I would look to the industry for that.

But nevertheless, our planning is for another record year.

Yes. Growth. You guys are planning to grow no matter what.

Yes. Yes. We've got too many advantages that are going to continue to expand our share in this business. And we're going to extend our -- and invest more in those advantages.

This concludes our question-and-answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

Well, thanks for your interest in our company, we appreciate it very much. And we welcome visitors to hear our more detailed explanation of the technology, which is obviously an important part of our future, and come to Miami or do a Zoom or whatever it takes just to learn more. We're happy to do that for you.

And once again, have a nice day and see you the next quarter. Bye-bye.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.