Watsco Inc (WSO) 2006 Q4 法說會逐字稿

Good morning. My name is April and I will be your conference operator today. At this time I would like to welcome everyone to the Watsco Inc. 2006 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). Mr. Nahmad, you may begin your conference.

Good morning, everyone. Welcome to our conference call covering Watsco's operating results for the fourth quarter and for the full year ended December 31, 2006. My name is Al Nahmad; I'm the President and CEO. With me as Barry Logan, the Senior Vice President.

Before we get started I'd like to read what we always do, a cautionary statement, a reminder that this conference call has forward-looking statements as defined by SEC laws and regulations that are made pursuant to the Safe Harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Now on to our performance last year.

In 2006 Watsco had its best year ever. Let me just repeat that -- we had our best year ever, achieving record results in all performance measures such as revenues, margins, earnings per share and cash flow and we are now operating with the strongest balance sheet in our history. But before we discuss the specific results, let's look again at key goals and strategies.

First, our most important goal is to expand our network and we do that by acquisitions as well as by greenfielding new locations. Over the last four years we have grown our network 38% by adding 104 locations. In 2006 28 locations were added -- 19 by acquisition and nine from greenfielding. We will continue this building process and we have ambitious plans given our present national market share is only 7.4%.

Another goal is to constantly add to our product offering which helps increase sales per location as well as gain market share. We do that by purchasing and distributing products of over 600 manufacturers for which we provide access to the contractor serving the HVACR industry. By growing our network and product offering it is also our goal to continue to increase operating margins. To that end operating margins have increased 320 basis points over the last five years with contributions from improved gross profit and lower SG&A as a percentage of sales. We are focused on continuing this trend and are far from the goal we have set for ourselves.

It is also appropriate, and perhaps for the last time, to comment on the transition to higher efficiency air-conditioning equipment that was mandated by the federal government starting January 2006. That's the so-called 13 SEER product transition. The transition is now for the most part complete. In 2007 we expect working capital needs to be less onerous and result in lower interest cost as inventories decline to a more typical level. The transition has been costly in terms of SG&A.

If you can imagine half the products we sell in our 380 locations, that's almost 8 million square feet, being sold off, restocked, rebalanced in the face of inconsistent vendor shipments. Importantly however, the higher pricing called for by the most efficient products -- or the more efficient products -- has been accepted in the market given the value to the consumers from lower energy costs. Watsco, along with the rest of the industry, has terrific opportunities in 2007 and beyond with these higher efficiency products.

Now for the specifics on the 2006 performance; first the fourth quarter. Results for the quarter were consistent with our January 15th press release. The fourth quarter of 2005 was a blockbuster quarter having benefited from unusually strong sales volume of the less expensive 10 to 12 SEER equipment prior to the 13 SEER mandate, as well as market conditions in the heating season and residential construction.

But if you look at the fourth quarter from a longer-term, in other words look at the results in the context of the last five years; we had a very good quarter. Revenues for the quarter were $388 million; gross profit dollars were $97 million with gross profit margin improving by 10 basis points. Operating income was $19.2 million with operating margins of 5%. Diluted earnings per share was $0.42 on net income of $11.5 million.

For the full year 2006 diluted earnings per share increased 17% to a record $2.96. Revenues increased 7% to a record $1.8 billion or 6% on a same-store basis. Gross profit dollars increased 9% to $463 million; gross profit margin was 25.7%, its highest level ever. Operating profits climbed 16% to a record $136 million with operating margins expanding 60 basis points to a record 7.5%. Net income improved 18% to a record $82 million. Cash flow for the year was $69 million also a record. Debt ended the year at $40 million and our debt to cap ratio improved to 7% from 10% a year ago.

Regarding dividends, we increased dividends by 53% to $0.95 per share for the year. We also repurchased $15 million of our common stock. We covered our earnings outlook in our January 15th press release. As we stated, the dynamics affecting the fourth quarter last year continue to impact our first quarter to date, and we expect to return to historical growth rates as the selling season begins in earnest during the second quarter. That concludes my comments and at this time Barry and I will be pleased to answer your questions.

(OPERATOR INSTRUCTIONS). Jeff Hammond, KeyBanc Capital.

Good morning. Just wanted to revisit the guidance. You laid out some guidance of 15 to 20% earnings growth in '07. I just wanted to get a sense of how you're thinking about that versus one month ago and then maybe give us some detailed color in terms of how you're thinking about same-store sales growth, margin improvement, etc., within that?

We have not changed our outlook of 15 to 20% for 2007. We do believe that the trends that we started that you saw in the fourth quarter will continue in the first quarter, but I believe that our historical growth rates come back starting in the selling season in the second quarter and I thing we're going to have another great record year with increasing margins as we do year after year and increasing share gain and adding to the network -- and possibly some acquisitions.

And then speaking to acquisitions, can you just talk about how the acquisition pipeline looks, have the conversations changed at all in terms of dynamics given we've moved into a more uncertain or slower period near-term?

I think that that's a good way to describe it, Jeff; a very accurate way. I think that I'm more optimistic that we'll be able to do more things this year than we have in the past for the reasons you've just said. So I'm very bullish on acquisitions. And we have a fantastic balance sheet to do those transactions if we're fortunate enough to make the acquisitions that we want to.

And then a final question in terms of the balance sheet. I mean, you basically have no debt. There are certainly some larger acquisition targets out there. But seemingly you'd be able to do that with your balance sheet. How are you thinking about share repurchase versus acquisitions given that your stock price is still well off its highs?

That's a good question. Our cash flow is strong and I think it's going to be another great year in cash flow. We do believe we should have an increasing dividend policy and hope to have an announcement on that as the year progresses. In terms of share repurchase, we've always been opportunistic about that. I think I like dividends more than I do share repurchase. But most important is, Jeff, I like to keep the balance sheet strong for the acquisitions because some of the things that we look at are very substantial and I want to have our powder dry. So I like to do all three things and I like to do it with a conservative balance sheet, that's just a style that we've always had.

Okay, thanks.

Curt Woodward, JPMorgan.

Good morning. Al, you commented that this year due to the disruption in the supply chain you had some working capital headwinds as well as an SG&A impact from that as well as probably from some of the new branch locations. Can quantify that? What do you look for for working capital usage this year and can you comment on your expectations for getting greater SG&A leverage out of the business model this year?

I'm going to answer part of that and then ask Barry to chime in here. We try to achieve a 50 basis points improvement in EBIT margins annually, that's our goal and we've been pretty good at that. If there are any breakdowns of that, Barry, do you want to comment on that?

Yes. As far as this year goes, obviously the analysis of a gross profit was a terrific year of this share. More typically it's a 10 to 20 basis point improvement each year in gross profit and that's not one or two things contributing, that's 50 things just in terms of execution in the field and the way products are priced and sold and in turn purchased from our vendor community. So in that type of a goal looking forward, that's the type of range of gross profit improvement.

SG&A this year was the first year in four or five years where we did not see a material amount of improvement in SG&A again in a typical year from that perspective. And a lot of that is the cost sitting in the transition from this year; it's hard to generate an exact affect of this year, but that's certainly part of the story. So the rest of the 20 to 30 basis points of improvement historically has come from SG&A.

As far as new branches, this year new branches were neutral to earnings from an EBIT point of view.

You mean last year?

In '06. If you add cost of capital, which is about a $14 million investment, there's a couple of pennies of earnings per share spent on opening up the new branches. Acquisitions in '06 were made late in the year, so there's really again a neutral contribution from acquisitions.

Looking forward in '07, you're looking at all of those branches contributing profit and more meaningful profit, as well as returns on the working capital. Cash flow, if you look at the last 90 days, the cash flow for the Company, it approached $80 million in those 90 days. There is still more opportunity in the inventory in '07 and beyond. The turns are still not at a record level and still far from where our best business units are. So as far as financing new branches and so on, it is really something that can some from the cash flow and should not be any blip on the positive cash flow that you see.

So the $30 million of revenue incremental you got from the 28 locations, is it safe to say that maybe half or more than half of that was from greenfield locations versus the acquisitions that were made at the end of the year?

About two-thirds of it was greenfield and branches, two-thirds of the $30 million.

And how many locations do you expect to add in 2007?

Ten to 15 from a greenfield basis and acquisitions is always something we report at the time.

On the EPS growth target of 15% to 20%, what is embedded in that in terms of your view of the end-market growth? How do you see the replacement market growing relative to new construction for the year?

That is a good question. I think that the industry's first quarter will be soft compared to the prior year. It won't be soft at historical levels, just compared to the prior year. And then I think that the traditional industry growth rates of 5% is achievable in '07 in units, and of course that could have a higher impact of that on revenues because as you know, the higher efficiency products are more expensive and do provide higher selling prices as well as, we believe, higher margins. And that is why we are optimistic about '07 and beyond.

These products are great for saving energy for the 120 million homes that are installed with central cooling. As you know, central cooling in the replacement market is what our focus is, as distinct from new construction and other segments of the market.

Great, thanks.

David Manthey, Robert W. Baird.

A question in terms of gross margin. I'm wondering if you'd talk about --Barry, you touched on it a little bit. Last year some key positive factors that when into that number were clearly higher copper prices and the 13 SEER, the new units that were higher gross margins which I don't know if that is sustainable or not. And then mix, rebates, private-label, if you can talk about each of those items or touch on other ones that you think are important as we look forward here.

Barry?

So, David, certainly on the new product launch the ability to continue to improve margin on something like that is going to diminish over time. And ultimately what will have to happen is the 14 SEER and above products will filter in. That mix was higher than we expected in '06 and that bodes well for next year as well, because not all those products were even available all year long. But some of the new product launch sizzle, if you will, does diminish and why, again, I think the 60 basis points you saw through nine months is something that probably isn't sustainable on the new products. But there's still opportunity to keep some increase going.

In terms of private-label products, that is something that has been rolled out to virtually the entire Watsco network as of the end of '06. That was not so during the entire course of '06. Still something that has to obviously be pushed through the market in terms of sales and probably six months from now, to give you a better update on it, we just know it will be a lot more than what it was in terms of the number of branches selling and so on. So there is an opportunity, I wouldn't make it a huge number at this point, something we're being very careful about but still an upside opportunity.

Copper pricing, absolutely. The OEMs ate the new copper prices during '06, raised prices all year long and still have complained they've not captured the entire impact of copper pricing. So I still think there is a reason for a fairly stable equipment price and they're all very well analyzed by some of the people on the phone today and for the most part pricing has remained stable as we've entered into '07. So that's probably a neutral to gross profit at this point. Don't expect anything one way or the other in terms of where the copper pricing is. And that's primarily an affect that's embedded in our purchase price from our OEMs.

And then rebates?

Rebates, again, it's 600 vendors being discussed and debated and in terms of being a larger share of the Watsco network and getting more of our business each and every year, it's not one or two conversations, it is 600 conversations. So that's blocking and tackling, something we want to make more money at each year, that's just chipping away at, again, that 10, 20, 30 basis point improvement that we want each year. No headlines from that category.

Okay. And then in terms of the percentage of mix that were 13 SEER -- above 13 SEER, do you have a percentage for that?

It was 15% in '06.

So 15% of your sales were 14 and above?

Correct. On the equipment side of the business, not of the overall sales. And the equipment sales we were talking about was 30% of the overall mix last year.

Right, okay. And then just two final quick questions. One, could you quantify the negative impact from the warm weather on furnace sales? And then, if you could address indoor air quality, if it's something you can measure or talk about?

Barry, do you have that data? I don't believe we do on the warm weather impact.

It's hard to say what it is, David. We know our furnace business is off in the quarter, a little bit higher rate of decline than our overall was -- if that answers your question. On the [IAQ] that's not something we break out of our total volume and highlight.

Okay, thank you very much.

Ryan Merkel, William Blair Research.

Good morning, this is Jeff Germanotta. Just a couple of numbers and a couple of questions. Can you comment on what same-store sales and same-store operating profit were in the fourth quarter?

Barry, do you have that?

Same-store sales was minus 8.

And same-store operating profit?

Hang on one second -- minus 10.

Minus 10?

Yes.

And can you also comment on the capital expenditure outlook for 2007? I think you said you have about 10 to 15 new branches, what would that be in CapEx and what would be the other components of CapEx?

We never exceed $10 million, Jeff, for everything. And it's just general leasehold improvements and IT equipment and that sort of thing. But it's not a very large number.

So the $14 million you talked about investing in the branches in 2006, that's a combination of capital budget and income statement spending?

Yes, that would be your inventory and your Accounts Receivable.

And the CapEx would be a very small component of that, Jeff. It's primarily working capital.

Okay. And then regarding selling price inflation, what was selling price inflation in the fourth quarter?

Overall it would be -- what we're really measuring here, Jeff, are the equipment products that we sell. We don't measure duct tape and things like that on the other side of our business, but the mix-in price was up between 20 and 25% in the equipment products. That's reflecting the full mix of the 13 SEER products and above.

That's on 30% of our overall revenue.

(multiple speakers) unit pricing that's measured, Jeff.

And as you look forward to '07 what are your expectations in terms of that changing dynamic?

I don't think we're going to have much in price changes in that equipment business in '07.

So you think we'll be able to hold that price change flat and we won't go backwards?

Correct. I mean in the first quarter you'll see all kinds of things, but when things normalize I agree with what you just said.

And then lastly, can you comment a little about industry inventory levels and manufacturer supplies going into 2007 here?

I don't know that we can comment, but we can take a shot on the whole industry. I think that the manufacturers have plenty of inventory. We believe that because of the availability that we have for anything we want and that's across the board on equipment and non equipment guys. And I think that the supply bottlenecks that were experienced in '06 are history. I think it will be a very smooth channel now.

Thank you very much.

Keith Hughes, Robinson Humphrey.

I had a couple questions on the acquisition front. Even though we're heading into the season is it still possible we could see some deals coming in the spring and summer months?

We're sure going to give it a try, Keith.

Because historically that's been tough to do, has it not?

Well, it's hard to say one way or the other. Some of these conversations have been going on for so long that when it happens it sort of happens without any concern over the timing. So I'm just optimistic, it's not an assurance, but I hope we'll do something in the spring and summer.

On inventory you were down sequentially, still up year-over-year. Is that going to continue to trend down in the first half of the year?

I think so. I mean, some of it, because we're now selling and maintaining higher priced equipment with the 13 SEER mandate, will be permanent. But as Barry said earlier, we've got a lot of work to do in improving our inventory turns. So in the end I think that we'll be able to reduce our working capital over what you've seen in '06.

All right. Thank you.

Craig Schiffler, Basswood.

Good morning, guys. Just a follow up on one of your comments from earlier about preferring dividends to buybacks. Just curious, particularly where the stock is trading now, why that would be?

I think that if you have as a corporation an increasing dividend policy, meaning year after year you're increasing your dividends, I think that's a good thing to do to provide shareholder return. In terms of stock repurchase I think that's sort of opportunistic. We've always acted on a basis where we think things have just -- it's just irresistible. But I can't give you more of a scientific answer, we just like to have increasing dividends and we know that the dividend rate is attractive -- the tax rate that is -- and we like keeping our net worth and our balance sheet for purposes of transactions hopefully large transactions.

Okay, that's all. Thanks very much.

[Michael Martin], [Small Cap] Report.

Good morning. Two questions. First, can you give us a breakdown percentage between the heating and air-conditioning business?

Barry, do you have that?

Yes. For the year the heating business -- just one second. It was about 10% of our overall volume.

Okay, great. And the other question -- what do you consider the main risk to the '07 outlook?

As always it's whether, sometimes you have a summer that is below normal temperatures and mild summers, that affects the replacement demand. That to me is the single risk that we manage to. It is not an industry with great risk historically and I don't see anything different. We have some good things happening, we have further technology with the 410 refrigerant coming in. All of the products are getting updated constantly for efficiency and that's right in line with higher energy costs, I mean consumers will want more and more of what we do. That is just a long-term trend and I think will continue. But on short-term impact it's whether -- that it might impact the demand for replacement air-conditioning or replacement heating.

Thanks very much.

Jeff Hammond, KeyBanc Capital.

Just a couple follow-ups. Barry, have you tried to do any analysis in terms of how much it costs you -- how much the 13 SEER transition costs you in terms of product availability issues, added cost to kind of move things around, etc., that happened in '06 that would go away in '07?

Jeff, the list of things would be lost sales because we didn't have product; overtime for handling; delivery; freight; rebalancing; moving inventory around; third party freight carriers; extra labor -- the list would -- and then add the cost of capital on top of the extra inventory that was carried, which is material in terms of the number. So it's not an easy number to get and it's hard to bifurcate every cost and evaluate it that way. But we certainly know it was material to this year's results.

And that's why I feel good about what we did last year, Jeff, with an earnings per share increase of 17% -- given what we were up against.

Exactly. And then I just wanted to try to get a little more granular on first quarter. I mean, same-store sales in the first quarter down 8%. It looks like the comp is similar to maybe a little bit easier. Just wanted to maybe try to understand better how you guys are thinking about first quarter in terms of revenue, margins, kind of same-store sales declines, etc., just given the --?

Our visibility so far -- and don't forget that March is as big as the first two months, January and February and we're still in February -- but the same sort of declines you mentioned that you saw us experience in the fourth quarter are holding.

Okay, so that would support some year-on-year decline in the first-quarter earnings number?

Yes, in the first quarter, that's correct. About the same rate of decline at this date as we saw in the fourth quarter for both revenues and earnings.

Okay. And then I guess final question on this 4Q/1Q. Do you sense that, is this -- I mean is the surprise versus your original expectation, is it mostly weather, is it mostly the housing weakness is coming in and it's been more significant? Or is it just simply that you guys weren't fully appreciating the comparisons that you had in 4Q/1Q?

I think you said it very well, all three of those things. The comps are very difficult, more so than we thought. And the weather didn't cooperate and, lastly, the housing market conditions were not as good as they were in the prior year. But I would say the most difficult thing for us was the comp. We just blew the cover off the ball in the fourth and first quarter of the prior period.

I mean, we had an earnings per share increase of over 100% in the fourth quarter of '05 and you just can't sustain that sort of rate and I think we underestimated our ability to beat that comp. It went from $0.23 to $0.50. And that's -- for us, I think we underestimated our ability to go over $0.50 just on that comp basis, the other two were not factors, were not as serious.

Okay, thanks a lot, Al.

Curt Woodward, JPMorgan.

Al, you mentioned that you think that pricing is going to be relatively flat this year for the industry, but it seems like a lot of the OEMs have come out with first-quarter price increases. So can you just comment on are those price increases going through?

I don't think so.

You don't think they are?

No, and I think commodity prices for the OEMs have declined.

And then you mentioned large acquisitions as a possibility. Can you give us a sense of what are some of the bigger targets out there you're looking at. And can you comment on valuation targets? Have the multiples you're willing to pay changed and do you see any --?

And I don't blame you for asking, but -- and I don't want to mislead you that we have something that we're about to announce, that's not true. It's just that, as Jeff had said earlier, the environment we believe is better. Our reputation for what happens after an acquisition is very high, so owners of businesses like doing business with Watsco. And these distributors have had a great run. They've worked their earnings up and we're an earnings driven company. So I'm sort of hopeful, in terms of size they're all over the place. And I'd just rather not go into that sort of discussion because I might be misleading you.

Fair enough. And in terms of multiples paid, I think historically you've articulated a view of four to six times trailing EBIT.

Yes, that's what we've done historically, and I don't know that we need to do anything different, but if we do we will. Our goal is to build a much larger network of locations in the United States. I love doing acquisitions that's a faster way of building a network. And as I said, we've got a great balance sheet to do them with and we have a great reputation among the 1300 independent distributors that exist and the good ones that we want, I think we have great relationships with them. So it's just timing.

Understood. Thank you.

David Manthey, Robert W. Baird.

35 minutes, I think this is your longest conference call ever.

How are we doing?

Good, good, but normally they're under 20 minutes, so I'm surprised. But the question is, just as a follow-up, I think you said ASPs and equipment were up 20 to 25% on 30% of your overall revenues which would be your equipment what were the ASPs and the attached rate if you have it for air handlers?

The growth rate, Dave, for the indoor units and outdoor units was about the same.

In units?

Yes. And part of the indoor unit is the fact the furnaces are also down and it's, again, hard to know exactly what marries what in the field, but overall the growth rate is about the same. The pricing is not the same, pricing is not as significant but the units are pretty much tied together as this point.

Maybe it's a good thing to point out that one thing that is not affected by the 13 SEER mandate is the refrigeration business and that's now a healthy part of our company and that's growing at double-digit rates just consistently.

It was $0 nine ago and now it's about 10, 12% of our overall business and, as Al mentioned, growing at a much faster rate.

Okay, thank you.

At this time there are no further questions.

Terrific, thank you very much.

Excuse me. We do have a question from Holden Lewis, BB&T.

Wanted to extend your streak a little bit. I think it was David's question about sort of the gross margin. You gave a nice little synopsis of where you might be able to get your traditional 10 to 20 basis points of improvement, but just as interesting to me is it looks like you saw a pretty good drop in gross margin in Q4 relative to where you were Q2, Q3 and I think a bigger drop than is normal. Did we see some of those premium margins begin to erode into Q4 now that we have availability out there? And if so, does that essentially create a difficult comp where you're doing a lot of good things to get 10, 20 basis points in '07, but at the same time you're going to have a very difficult comp and therefore it's going to be difficult to match the '06 gross margin?

No, I don't think so. I think that we'll be okay on gross margins and I think we'll be where we historically have been. What Barry was trying to do is signal that we don't think 60 basis points is sustainable improvements. That's not sustainable.

Nor is it needed to achieve what we believe we can sustain is at a 50% -- 50 basis points, I should say, improvement in EBIT margins over a long period of time.

But I guess the question is, is the 60 basis points improvement you saw in gross margin in '06 -- I mean, can you hold onto all of that and build on it in '07 that there was probably some premium margin.

I understand the question. And I would say that given what's going on in the fourth quarter of last year and the first quarter of this year I would not expect to that, but beyond that I would.

Okay, great. Thank you.

You bet. Okay, thanks so much.

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