Watsco Inc (WSO) 2005 Q3 法說會逐字稿

Good morning. My name is Melanie and I will be your conference facilitator today. At this time I'd like to welcome everyone to the third 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 period. [Operator Instructions]

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

Good morning everybody. This is Al Nahmad. And with me is Barry Logan and we're pleased to bring you our conference call in spite of Wilma who did its best to cut down our communications. I'm not in Miami and Barry Logan is. And we are going to start. Barry, as you know, is a Senior Vice President. And we're going to report on the third quarter.

But before we do that, I'd like to go through the disclosure statement and please remember that this conference call has forward-looking statements as defined by SEC laws and regulations and were made pursuant to the Safe Harbor provisions of the various laws. Ultimate results may differ materially from the forward-looking statements. Now let's get on with our conference call regarding the earnings.

I would say that 2005 is shaping up as a phenomenal year for the Company. We are experiencing high rates of growth in sales, revenues, and we're also experiencing increases in cash flow.

Markets are strong. And we are successfully expanding our margins as our revenues continue to grow. Still, we are less than 7% (ph) of the market for HVAC products and we are very excited about our future growth opportunities.

Now let's go through the third quarter results in detail. Diluted earnings per share increased 49% to a record $0.88 versus $0.59 in 2004. That's on a 53% increase in net income. Revenues for the quarter grew 34% to $478 million with sales of HVAC products increasing 16% on a same store basis.

Gross profit increased 30% to $120 million with gross margins of 25.2%. The slight change in gross margin year-over-year primarily results from the addition of East Coast, which historically has had lower gross profit margins than our other business units.

Operating profit increased 50% to $40.2 million. Operating margins expanded 90 basis points to a record 8.4% and on a same store basis, our operating margins improved 110 basis points to 8.6%. As I said earlier, we are successfully expanding our margins as our revenue grows. SG&A as a percentage of sales decreased by 170 basis points to 16.7% during the quarter. That's quite a performance on our operating expenses versus our sales growth.

Now the results for the 9 months, diluted earnings per share increased 29% to a record $2.02 versus $1.56 last year. That's a 33% -- that's on a 33% increase in net income. Revenues for the 9 months grew 26% to $1.27 billion with sales of HVAC products increasing 9% on a same store basis.

Gross profits increased 23% to $309 million with gross margins of 25.9, sorry, 25.2% for the 9 months. Operating profits increased 32% to $93.1 million. Operating margins expanded by 30 basis points to a record 7.3%. And on a same store basis improved 50 basis points to 7.5%. SG&A as a percentage of sales decreased by 100 basis points. Operating cash flow was strong as the Company generated $39 million of cash from operations during the quarter.

Fourth quarter operating cash flow is expected to also be very strong due to the seasonality of our business. And for the year cash flow should, once again, exceed net income.

Now let me comment on the balance sheet, which continues to strengthen. Since the beginning of the year, Watsco's been able to reduce debt 17% and achieve a debt to total capitalization ratio of 10%. The strength of our balance sheet continues to allow us to develop unique strategies in the marketplace that our competitors simply cannot. And we look to make these advantages an important factor to us as we enter next year, especially given the 13 SEER transition.

A reminder that dividend policy has been an important objective and that is to pay increasing dividends over the long term. Earlier this month we announced a 43% increase in our quarterly dividend rate from $0.14 to $0.20 per share.

Also, we have said all year now how well East Coast Metals has been performing since its acquisition in January. And the third quarter continues their streak of double-digit sales and earnings growth as part of Watsco.

And finally our outlook for the remainder of 2005 or I should say for 2005. Given the strength of the quarter and the current trends, we are increasing our guidance for the year to approximately $2.30 in earnings per share for 2005.

Now with that opening statement, Barry Logan and I would be pleased to take your questions.

[Operator Instructions]

Your first question comes from David Manthey from Robert W. Baird.

Good morning, David.

Hi. Good morning. Congratulations.

Thanks a bunch.

First of all on the inventory days, they seemed very low for a third quarter. And I'm wondering were there any shortages or OEM issues? Any other details you can give us on that? Because given that I would imagine your reducing your exposure to 12 SEER and possibly ramping up 13 that the dollars in inventory should be rising disproportionately. So I'm wondering how you're able to keep those, the days in inventory so low this quarter?

I'm going to give you a general answer and then I'll ask Barry to see if he wants to contribute. First all, the premise is not that we should be increasing inventories of 13 SEER because that product is still not available.

What's happening, and the reason you're seeing those increase -- those decreases in inventory is that our business is so strong the manufacturers are having trouble keeping us supplied. Not all of them, but some of them. 13 SEER transition has not begun in terms of our distribution company. It's just strong sales and our, us pushing hard to achieve market share gains.Barry, you have anything to add to that?

I would say the same thing, Al. The 13 SEER product across the board is not - they've not begun shipping 13 SEER product, at least in the new platform environment that we'll have. That won't happen until later this year.

Okay. And then there's been controversy in the industry whether or not there's been a, what they're calling a pre-buy but I think it's more of a buying 10 SEER ahead of the transition in an attempt maybe to sell low cost units early next year and take some market share. I understand some of the OEMs are putting in surcharges right now on the 10 SEER product. But you're clearly not affecting that strategy. Are you seeing anyone else in your markets doing that right now?

Well I can answer for sure what Watsco's doing and that is that we are not pre-buying 10 SEER. We are simply trying to get supplied while the product or contractors are ordering. And as I said, from time to time some of the OEMs have to play catch up just to supply us with what we've already sold. And we are not pre-buying 10 SEER.

Okay. And so from the discussion of the shortage and things, do you have a significant backlog today or are you ...

I would describe it as not all of the equipment manufacturers but some of them have had to extend their delivery dates from a few weeks, out a few weeks. But they're cooperating. I'm not really complaining about that. I'm just saying that we're working hard just to keep our contractors, our customers supplied and our commitments to them.

Okay. Got it. Then my last question is on the 13 SEER. As we're getting closer to it and you're getting a look at the new products, the new format, 13 SEER products that are coming out. Is there any additional information you have in terms of where pricing is going to shake out or any other details as we make that transition?

Our view is that the 13 SEER transition mandated by the federal government is positive for everyone in the chain. The consumer because he has a higher efficiency product and therefore conserves on energy, the distributor because he has a higher unit price and is providing something more meaningful to the contractor and his customer, and the manufacturer I presume once he's made the large investments that he has to will benefit as well.

But I would say that in terms of pricing for 2006 on 13 SEER, I wouldn't say that there's any new development out there. Everyone expects the average unit price to increase because we're moving from a 10 SEER market, a heavily 10 SEER market to a minimum of 13 SEER market. And that by its very nature is going to increase the unit price.

So, Dave, I can't say there's anything new that we've learned other than there is a race in the industry just to keep us supplied now. I mean there's just a lot of demand to meet contractor needs. And frankly 13 SEER is not part of that. We're just trying to keep up.

Great. Appreciate it. Thanks very much, Al.

You bet.

Your next question comes from Jeff Hammond with KeyBanc Capital Markets.

Good morning, Jeff.

Hi, good morning. I wanted to just get an update on some of your internal growth initiatives. Can you talk a little bit more about how the private label branding is going? What you're seeing in terms of new branch activity? How you're executing there?

And then I think you had talked about some expanded regional footprints with some of your vendors. Maybe just give us an update.

Yes. I would say that our revenue expansion is coming from all of the things you just mentioned. Watsco is through its branches or through its subsidiaries opening up new branches. Watsco's adding branded product primarily to those branches and where needed is adding its own private label. And the footprint is increasing slowly as we build out national network of locations.

So it's more of the same, just blocking and tackling and developing a national network. And as I said we're still only something like less than 7% of the market. That's why I'm so optimistic about our ability to continue to build that footprint. And there's nothing unusual about it. That's what we do. And we're just going to continue doing it for years to come.

Can you give us a sense of where you stand in terms of branches open year-to-date? And I don't know if you quantify what level of revenues are from private label.

No, first we wouldn't quantify that but Barry, in terms of number of branches?

There are 4 new branches opened so far this year.

How many?

Four. And there's another 6 that will be opened by the end of the year is the schedule. Some of those may trickle into next year. But that's the current plan.

Okay. And then maybe to ask the pricing, 13 SEER pricing question a little bit differently. It sounds like the OEMs are coming out with their initial price books for '06 for 13 SEER product. Do you have a sense where the 13 SEER pricing is coming out relative to current 13 SEER pricing?

Well, sure. But I would say that whatever new 13 SEER pricing we're seeing doesn't mean anything now because there's some OEMs that have not announced any price for 13 SEER next year. So whatever is out there now I would say is not meaningful until the beginning of the year. At that point in time we'll see the real prices. But in all cases, in all cases, I would say they're certainly higher than the 10 SEER prices.

And this is not new. I think we've talked about this. At the beginning anyhow it looks like the 13 pricing, 13 SEER price will be at a 12 SEER pricing level. But until we see all the prices from all the OEMs, and we have not, that really cannot be set in concrete.

Okay. Great. And then you said that the 13 SEER product wasn't available. Can you give us a sense of your comfort level that your primary vendors are going to be fully prepared in terms of having 13 SEER product?

I certainly can. I mean I personally have traveled and talked to the presidents of our OEMs. And they're busy now just meeting demand, as I said. Industry demand is very high right now, or has been at least to the third quarter and continues to the fourth quarter. And we've seen product. We know their plans. And I feel very confident.

Okay. And then just with regard to your updated guidance and maybe a little more color on fourth quarter. Is there any impact in there for hurricane disruption, one, and 13 SEER disruption?

Yes, that's an excellent question on the hurricane. It just occurred, as you know, and Florida is a very strong market for us. And they will be rebuilding, which will come in the future.

In the interim, I do not fully yet know how many of our branches have been temporarily stopped from opening due to lack of power. The southern part of state of Florida right now is virtually without electricity. But I understand there are crews out there and they're gradually turning it back on.So I cannot quantify that for you. It's just occurred.

But in the short-term there may be some branches that are late to open up, late meaning days and I hope not weeks. But in the long-term the rebuilding will of course permit us to serve our contractors as they help the rebuilding process.

Is there any build in as far as any expected disruption from this 13 SEER transition?

That's just not a question that we have an answer for. I don't expect any disruption about anything. But I certainly, I mean other than what I mentioned, but I certainly don't see disruption in 13 SEER. I don't even know why there would be. If the product is available we're going to sell it.

Okay, good.

And the product will be available.

Great. Thanks, Al.

You bet.

Your next question comes from Curt Woodworth of JP Morgan.

Good morning, Curt.

Hi. Good morning. Congratulations on the nice quarter.

Thanks. I wish I could see the light. It's dark here where I am in California.

I'm glad you're safe and well. A question on the margin performance, looking at the operating margin improvement of about 94 basis points in spite of an 84 basis point decline on the growth side, which is obviously really strong. Can we just talk a little bit more about what's going on, on the gross profit side with that margin weakness in terms of maybe the impact of the East Coast or vendor rebates or generally what you're seeing in terms of the slowing margin?

Sure. I'm going to let Barry answer that call for you, Curt.

Curt, how are you?

Good, how are you, Barry?

Good. Well listen as we've said, most of the change, which is about 50 basis points, comes from East Coast being at its historical margin. It is including ...

The negative change, yes.

But it is improving its margin. But it's relative to where it comes in at Watsco, how it affects the mix of that has been quarter-by-quarter I think we've talked about. Something we did see this quarter is we saw very strong equipment business this quarter. And strong meaning over 20% ...

You're talking about for the whole company now Barry.

For the whole company, that's correct. We saw over 20% growth in our equipment side of the business when you look at same store sales, and equipment has a slightly lower margin than the overall mix than in versus non-equipment. So that's simply a very strong market for equipment. Our equipment margins are up this quarter and are up year-to-date. But when you mix it into the mix, it has an impact on the overall gross profit.

Okay, great. And then trying to think about 2006 and I expect that even if you continued to leverage on the SG&A line, but the past 2 years you've seen pretty good improvement in the gross margin. Can you talk at all about expectations there in terms of East Coast should be moving up the margin scale?

And I don't know what the dynamics of 13 SEER would be on the gross margin. I don't think they would be sitting at the comfort. Can you help us think about that?

Well I can jump in here. East Coast I've seen it starting to see their plans for expansion. They're going to open up several branches. Our overall philosophy as a corporation is revenue growth. And East Coast certainly is becoming a player in that. And I expect that they're going to improve their margins as they increase their revenues just like the rest of the Company.

So do I believe that our margins will continue to expand in the future I think is the bottom line of your question? The answer is most assuredly we believe that because if we can grow revenues at a faster rate than we can our operating expenses, that's what's going to happen. And we've been doing it as you suggest. But we believe we're going to continue to do that. Now don't ask me where this is going to end because I don't know. It just continues to get better.

Great.

And I think it's got a lot more room to go.

And just one final question looking at the SG&A spend per year. How much of that would you consider to be fixed verse variable?

Barry, have you got a sense for that?

Yes. It's about 60% variable, Curt.

Okay. Great. Thank you very much.

Your next question comes from Jeff Germanotta with William Blair.

Good morning, Jeff.

Good morning. Congratulations on a terrific quarter.

Thanks. How are things in Chicago?

A little cloudy but not as windy as elsewhere, thank God.

Okay.

My question relates to clarification regarding your 2005 guidance. You mentioned guidance of $2.30.

We use the word approximately because we just want to be in that area.

Okay. Because let me just frame the question and maybe get a little more color for you. Prior to today's announcement the consensus was $2.23 for 2005. You beat the Street by $0.11. That would take you to $2.34. My question is are we being conservative at $2.30? Or are there things in fourth quarter that you're trying to steer us to a lower number on?

No. Jeff, the culture of our management team is conservative. We try to always hold on to our long-term growth rate, which over the last 10 years earnings per share have compounded at 20% a year. And then when we move higher than that we just try to be conservative because it's new territory for us. So no, there's nothing in the quarter. I mean we've commented on the hurricane. Business is strong.

Thank you. And another question, could you comment on the degree to which selling price inflation drove sales growth in the third quarter and what your expectations are going forward on general selling price inflation?

Well on this I'm not going to give you a scientific approach, but generally speaking and Barry can amplify this if he wishes to. Price increases occurred this year to the tune of I would say in the net rate of 3%. We were actually able to increase our selling margins beyond that price increase. So in other words we successfully passed on whatever came from the manufacturers.

That's what we've done in the past. And we've done it again this year. And I think that will continue in future years.

Thank you. And last question. Can you comment on the acquisition pipeline? Historically the fourth and first quarters tend to be a more robust period of acquisition activity. Is that likely this year or is it difficult to predict?

Well, we - you always ask the good questions, Jeff. And we're very persistent people. Watsco has a wonderful reputation in the industry of what happens to well established companies once they've been part of Watsco. We work on that reputation. We do it with good deeds. These corporations that are nice enough to sell to us retain much of what their heritage. And we just help them grow. And that's something we've done successfully.

So we're very persistent. We're always in contact with great companies. But once again, we're unable to predict when we might do the next one. It's just impossible to predict and we never have and can't do it again.

I thought of one more question. As you look at hurricane activity year-to-date in 2005 and compare that to hurricane activity for the same period last year, given that Florida was particularly hard hit last year, do you think the disruption is greater or less than the comparable magnitude to last year?

Well let's take the Gulf Coast. In the Gulf Coast we estimate that the market for HVAC products is $325 million in the 3 states of Alabama, Mississippi, and Louisiana and annual revenues of $325 out of a $25 billion industry total. And we're roughly 10% of that market today. And we are seeing some substantial increases in the business that we have there. And we're going to be opening up more locations there.

But even if you double that, Jeff, it's from 10% to 20% it's - I mean it's positive. But obviously when we're should do about $1.6 billion this year, you do the arithmetic.

Now in the state of Florida that's a completely different picture. That's, there's a lot more population, much larger market. And it's too early to tell now what this particular hurricane, which has devastated Fort Lauderdale, the Broward County and Palm Beach and also caused some serious damages in parts of Dade County will impact in terms of our demand for HVAC products.

So I cannot answer what the Florida impact will be. Frankly don't even care about that. There's a lot of suffering going on right now and we want to make sure our employees are found and our employees - we support them getting through a pretty rough time. So that's the best I can do for you in that question.

No. Thank you very much and our best to you, your family, and your employees.

Thanks.

Your next question comes from Jeffrey Cooley (ph) with Westville Capital (ph).

Thanks. My questions have been answered.

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

Good morning, thank you. Perhaps I missed it, but what was the revenues attributable to East Coast in the quarter?

We don't break that out.

I thought -- hadn't you broken that out in past quarters?

No.

Okay. All right, fair enough. Related to the hurricanes, do you think that the impact in Q3 on your revenues was a net positive or a net? It sounds like you think that they were actually a net positive to the quarter.

In the third quarter it was not material one way or the other.

Okay. And that would include anything with regards to your manufactured housing side of the business, would that have been adversely?

Correct. Correct. I mean manufactured housing is much stronger but it's still the small part of the overall revenue of the Company.

Okay. Okay. And then I think that you were doing some spending in terms of putting lines into the Texas and Louisiana market and expanding their, I'm sorry, Texas and Florida, expanding there in Q2 and expending your resources. Has that continued or was there additional drag in the quarter from that?

No. We're continuing to add lines throughout our system and also as we add branches. None of that has slowed down.

Okay.

And none of that will slow down. The reason we do that is it's incremental.

Okay. But it's at a pretty steady level. It's not sort of higher than normal or lower than normal?

No. I would say that it's just steady.

Okay. All right. Thanks.

Your next question comes from Keith Hughes with SunTrust.

Yes, most of my questions have been answered, just one follow-up on pricing. I know we've got a lot going on with 13 SEER coming in. But when you look at some of the other products are your suppliers trying to put in more price increases as we enter the fourth quarter or is that?

You mean on the new 13 SEER platform?

No, not 13 SEER. If we move beyond 13 SEER to some of the higher efficiency rated units and we go into your accessory products. Is there still pricing pressure coming from manufacturers in those items?

No. For example in steel it's the other way around. Steel has been soft most of the year. And it follows the world commodity prices for steel and other metals. And the OEMs come under pressure as commodity prices go up. And when they decided to pass them on then we pass on to the contractors. But I don't see any strong trends either way up or down at the moment.

Okay. And in terms of the pricing of 13 SEER from your suppliers, will they start publishing those what, December or early January or when do you expect that?

Well it's a good question. Some of them are giving us numbers now, which we know are preliminary numbers cause they have to wait to see what their competitors are going to do. And there are some manufacturers that refuse to provide any numbers right now, any pricing numbers. And they're waiting for some time in the future.

So we really don't know exactly how things will sell. But we do expect that the average, well obviously it has to go up. The average unit price of equipment sold in '06 will be higher than the average unit price sold in '05.

If we go back to this year, what was the spread for most of this year between a 12 SEER and a 10 SEER on average?

Was that about 20%, Barry?

Yes, 15 to 20%.

All right, thank you.

15 to 20% I would say.

Okay, thank you.

At this time there are no further questions.

Very good. We enjoyed talking to all of you. Look forward to doing it the next 3 months. Bye now.

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