Watsco Inc (WSO) 2007 Q1 法說會逐字稿

Good morning. My name is Cynthia, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Watsco first quarter 2007 earnings conference call. [OPERATOR INSTRUCTIONS].

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

Good morning, everyone. Welcome to our conference call covering Watsco's operating results for the first quarter. I'm Al Nahmad, President and CEO. And with me on this call are Barry Logan, Senior Vice President; and I've added for the first time Paul Johnson, Vice President of Business Development. Paul's been at Watsco five years, and part of that he was with Carrier and United Technologies and helped them develop global strategy.

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.

Also, a reminder that our first quarter is historically the seasonal low point of the year. This year's first quarter follows the record 2006 first quarter, and two well known factors are worth mentioning again. First, tough comps from unusually strong demand last year, up 16%, driven by 10 and 12 SEER unit sales that took place prior to the introduction of the new, more expensive 13 SEER split systems; second, weaker volumes in the new construction market this year. That market is a larger component of industry sales during the first quarter, since this is the off season for the cooling replacement market.

I also now want to go in and point out important highlights. Pricing for the new, high efficiency systems is a positive, up more than 20%. Our selling margins have improved in highly competitive market conditions. Sales mix for the new, higher SEER system is trending well in [advance of the replacement system].

Regarding inventory, from time to time, we enter programs with manufacturers which help them level production and provide us with benefits. Such programs accounted for approximately $20 million in additional inventory at quarter end. In addition to that, another $15 million worth of inventory has been invested in our new branches.

Having said that, we are also enjoying positive cash flow during a first quarter. That's a first for the Company and bodes well for great cash flow this year.

On an industry basis, unit volumes continue to be unlike and inconsistent with historical trends of around 5% annual growth, causing tough comps that should begin to have a lessening effect as the year goes on and we enter the historically more dependable replacement market.

We have continued expansion of sales to the refrigeration market, which again grew double digits during the quarter.

We have an aggressive posture towards using our balance sheet to make meaningful acquisitions, although we certainly cannot control when an owner decides to sell. Suffice it to say we want to make significant investments in the current business environment.

Cash dividends were raised during the quarter by 32% to an annual rate of $1.32 per share. We think this is a meaningful and very direct way of enhancing returns to the shareholders.

Finally, if you consider a long term view of our first quarter performance - that is, to look at first quarter over a five-year period - growth rates and trends are intact and comparable to historical trends.

Now, on to the numbers. Earnings per share was $0.39 per diluted share on net income of $11 million versus $0.47 on net income of $13 million. These results include $9 million of revenues and $0.02 of earnings per share dilution from 27 new locations. Again, the early part of the year is especially low, and we expect profitable performance from new branches as the year moves on.

Our sales and gross profit dollars for the quarter decreased 4%, with our gross profit margin increasing 20 basis points from 25.4% to 25.6%.

Our sales of unitary products, which is 27% of our overall sales, showed 20% higher pricing and 29% lower unit volume than last year. Although far from historical trends, this is a sequential improvement over the fourth quarter.

Operating expenses were flat, and, excluding the effects of the 27 new locations, declined 3%. Interest expense declined 44% on lower average borrowings and higher interest income.

A record of $7 million in operating cash flow was generated in the quarter compared to $30 million used last year; in other words, a $37 million swing. Cash flow should prove to be a significant opportunity this year, and we continue to refine inventory now that the transition is behind us.

Average daily borrowings declined 20%, and our debt to cap ratio improved to 7% from 10% a year ago. We have about $40 million of cash on hand, which is more than sufficient to pay down remaining debt of $30 million due later this year.

As far as outlook goes, as stated in the press release, our earnings outlook has been revised to $3.25 to $3.35 per share. Growth rates for the rest of this year are consistent with historical rates.

That concludes my comments. At this time, we will be pleased to answer your questions.

Thank you. [OPERATOR INSTRUCTIONS]. Your first question comes from Michael Cox with Piper Jaffray.

My first question is on the uptake on above-13 SEER equipment. I was wondering if you could comment if you continue to see the consumer response to greater energy efficiency.

Yes. Our mix right now is running about 12% over-13 SEER in the first quarter. So, that's a good indication because that means consumers appreciate the efficiency level that's now available since it reduces their consumption of electricity in their homes.

As we look at the comparisons that you face through the balance of the year, it looks like second quarter will continue to be a tough comparison. As we look at the earnings growth as the year unfolds, should we expect stronger earnings growth in the second half of the year relative to 2Q?

Yes, Michael. I think, again, the calendar didn't suddenly flip April 1, and some of the things we're talking about ended. It will still be a tougher second quarter, and the second half eases.

And then my last question is on the acquisition environment. I was just wondering if you comment on what you're seeing there.

I can tell you, as I just commented, that we have probably-- I'm sure of it. We have our strongest financial position ever and we are able to do larger transactions than we've contemplated, and I'm in the market. But we cannot control when owners decide they want to do something.

Okay. Great. Thank you very much.

Your next question comes from [Michael Novak] with Frontier Capital.

My first question is how much do you typically save when you consolidate a branch on the SG&A line? What's the range that you've historically saved?

Barry, do you have that sort of detail, or do you want to talk to him after the call?

Michael, it's not something we look at that way. What we've talked about before is that business units in Watsco at one time numbered 17 business units, and the margin for Watsco was down in the 4s. That's been integrated several years later now to six business units, and margins have come up over 300 basis points. There's not a simple answer to your question because there's 50 things that go into not just cost savings but improvement in the leadership, improvement in the pricing, improvement in the margin, improvement in many other disciplines that are part of our business. So, what I suggested is that this year by the end of 2007, we're going from six to four. It's just part of that simple progression that we've been doing and part of the margin expansion opportunity that's in front of us.

My next question is - assuming you were just to greenfield growth going forward, how fast do you feel you could sustainably grow the top line of the Company. And, I understand that when you open greenfield units there's a maturity curve associated with that, and it takes a while for those to ramp up. Could you talk about the timeline that that occurs over and how long you'd feel the pressure from these 27 new locations?

Well, the 27 locations we also talked about in the fourth quarter, and we talked about some dilution in the fourth quarter as well. And it is primarily an off-season exposure. Once we get into the season this year and they mature a year, we expect breakeven or better, certainly after a year. And, in year two, we certainly expect profit margins that start to climb into the average branch and, in year three, something higher than that. So, the first year, breakeven; second year, some profit; third year, start to look like our other branch profits.

Okay. Great. And in terms of the growth rate, assuming that you are going to be greenfielding your growth going forward?

I guess the growth rate that-- I should say it this way. The new branches is something that we do to basically extend service and local markets. We're not trying to make Watsco a national company per se by opening up several hundred greenfield locations over the next several years. That would not be a conservative strategy; that would be a more difficult strategy. So, the conservative strategy for branching is to add locations and better serve customers that we serve today, mostly in the markets that we are in. So, it's a safer bet, first of all. And, second of all, we have the relationships with those customers as we do it. It's just providing better service. So, as far as growth rates go, the last, really, 18 months has been the most we have done in our history in terms of having about 10 new greenfielded new branches. The remaining new branches are acquisitions. And, growth rates should add something to the growth rate, but it's not what's going to drive-- let's say, the long term expansion acquisitions will have to help that as well.

Thank you very much.

Your next question comes from Curt Woodworth with JP Morgan.

Barry, you broke out the unit volumes for [unitarian] and commercial refrigeration, which is almost 40% of the business. Can you give us a sense for how volumes look for the parts and supplies in the indoor units this quarter?

Again, Curt, as I said before, if it's duct tape, we don't track how many rolls of duct tape we sell to the market. I would say this, though-- that, if you look at a 5% decline in overall volume for Watsco, that's consistent with both non-equipment and equipment products.

A 5% decline in volume? Is that what you said?

Well, the revenue decline is in the neighborhood of 4.5% for the quarter.

Right.

Okay. But the pricing benefits wouldn't be as significant in the parts and supplies.

That's correct.

Nowhere near as significant. Right.

So, is it fair to say that the parts and supplies business has less exposure in terms of unit volumes to the pre-buy and the residential housing [inaudible], because it seems like the unit volumes would have had to have declined by a lower amount, just to make the math work.

There's no question that the unit volume in parts and supplies did not decline as the unitary products did. Pricing is really-- I don't think pricing has been a factor in the first quarter. I think, when we talk about a 4% or 5% decline, that's probably indicative of units.

Okay. And then in terms of the outlook for the year on the guidance, can you give us a sense for what your volume growth expectations are now and give us a sense for what you're assuming for the residential new construction mix?

I don't see yet any improvement in new construction, Curt. It is not-- I mean, a lot of people are looking at that. In what we do, we don't see any turn. So, we're providing outlooks as best we can based on what our business units are telling us they can accomplish. In the overall market, and, of course, we're just entering the most important part of the year, which is the replacement market for the cooling season, and this is what we see - those growth rates that we indicated in the press release.

Yes. So, would it be fair to say that you think the market-- the industry could be down in terms of volumes about 5% to 10%, given the start to the year? I'm just trying to get a sense for your industry view.

I understand. Unless you-- Barry, do you have an answer to that? I can tell you that OEMs think it's going to be worse than that, Curt, but that's at the production level. I just think that the demand for units in the cooling season is the big thing to watch for in this year because you've got 120 million homes. They don't care what's going on in housing. Those homes are already in place. They have central cooling systems that are operating. As they always do, some have to be replaced, and some have to be repaired. That's just a fact of life. It doesn't pay attention to what's going on in housing. So, I'm pretty-- I feel pretty good that that's what we participate in.

Okay. And a last question on the second quarter. It's another very difficult comp, 14% in a same-store [inaudible], as we saw in 1Q, but the aftermarket [hitting] that you didn't have in the first quarter. Can you give a little guidance on--? Do you think that quarter's going to look-- probably resemble more 2Q of last year?

We don't ever comment on quarters because of the seasonality impact. But, Barry's already mentioned that April doesn't look different than March. There's no switch that's turned. We take the long view of what's going to happen in the year as best we can do, because it's so early, Curt. We're just starting in the season.

Right. I know. June's obviously-- Okay. Thank you.

Your next question comes from David Manthey with Robert W. Baird.

First of all, I was wondering if you could just clarify-- you touched on inventories here. I'm trying to understand why your inventory turns have been declining for some time. The days in inventory on hand are very high. That should be, at this point, related to cost of goods sold more directly. So, given that that number, on a relative basis to your cogs, is so high, I'm wondering if you could talk about the dynamics there.

Well, I'm going to let Barry answer most of that, but I'm going to open by saying our inventory turns are improving. I don't know what data you're looking at. Maybe it's skewed by what we said by what we said earlier - that OEMs do participate with us in programs because we do help-- because of our size, we can help level production. And, of course, we have benefits, and that's the reason we do it. Barry, have you got anything else on that?

Sure. The three things-- two things we mentioned in the press release, Dave, is, again, the $20 million buy that we made; also about $15 million added for new branches. Also, if you look at this March versus March a year ago, about a third of our inventory, meaning the 13 SEER and above products, have about a 20% or 25% higher price tag per unit. Actually, for that population-- for unitary products today, we have fewer units on hand than we had a year ago. So, if you look at a blend of average inventories, let's say, for the last year-- if you look at the blend of that, we've also had during the last 12 months almost two sets of inventories on the equipment side, 10 and 12 SEER product that we needed to maintain that we also built, opportunistically. But, we also needed to maintain basic availability as OEMs transition. Once the transition occurred, we needed to sell out of the old inventory, bring in the new. So, inventory has been heavy for the last 12 months in that sense. For this quarter, if we go back to the short term perspective this quarter, if I add up the numbers, it's probably about another $20 million investment from the special buys to $15 million for the new branches and about another $20 million in average unit price, if you will, for the unitary products. It's nice to be able to afford this. I don't think our competitors are as easily able to do that. If you look at [technical difficulty] for some of this activity and accounts payable, you'll find it and part of the thought process. But I get the question a lot about inventory, as Curt asked. I think generally doing a channel check with us-- I've said the lead times have been longer than they have been historically. For the last several months, all the OEMs have assured us that that has improved and will improve. As we get faith and confidence in that, I think inventories can certainly go down from here.

Okay. Do you have a target or something? Your inventory turns are--

We'd like to move towards-- we're moving towards six times. I wouldn't write that up as a near term thing; that's our goal. That will have a further dramatic impact on our cash flow and other things.

Well, in terms of the near term, though, Barry, just to follow up on the point-- in terms of your pre-buys last year, I don't think this is an unusual event this year. Clearly, you had some pre-buy last year, not only--

The product was not available last year, Dave, from that perspective. The product was not available. We couldn't have ordered. We complained last year that we didn't have enough product during the early part of the year.

But you just said you had duplicate inventories.

Sorry?

You said you had duplicate inventories.

In this time of year last year, we did not have adequate supply of the new products.

Okay. As we look at this year, maybe just-- Al, the 6% is sort of a long term target.

You mean six times. Yes.

Can you talk about this year? As things normalize here, do you think you can get back to 4.5 or 5?

We do, Dave.

Okay. Then, in terms of furnaces--

We agree with you; there's opportunity there.

Right. Okay. Thank you. In terms of furnaces in the quarter, it seemed like the temperature variances might have impacted that in the first quarter as well as the fourth quarter. Could you talk a little bit about that and just your thoughts on the weather this early in the season?

Let's get Paul Johnson in on this.

On the furnaces? First of all, furnaces-- because of our location in the Sun Belt, furnaces have not historically been a big piece of our business. It's a fairly small percent.

Or heat pumps, for that matter, Paul.

Heat pumps-- we roll those up with our regular compressor bearing units, the split systems. I don't have a precise number on our split right now between heat pumps sales versus regular, straight cool sales. We could get that to you. But, basically, the first quarter was a very normal weather event. It wasn't unusually warm or cold any place, basically, where we do business. There obviously were spikes in the temperature as you went around the country, and I'm sure if you were in one of those, it felt like it was unusual. But, on a population-weighted basis, it was a fairly standard quarter weather wise.

Got it. Okay. Let's see here. The last question I have is - when you talk about your expectations for earnings for the rest of this year being more normal, does that also imply that, once we clear out these tough comps in the 13 SEER and everything else, that you're talking more about a normal sort of 5% or 6% units, and then you're gaining share, plus or minus pricing, etcetera. Is that sort of where you plan on being for the rest of the year?

We do.

Okay. All right. Thank you very much.

Your next question comes from Jeff Germanotta with William Blair.

One housekeeping item; then a couple of questions. Same-store sales and same-store operating profit?

Same-store sales 7. And ask your next question, and I'll give you an answer on the same-store operating profit.

Okay. My next couple of questions actually relate to the pace of branch development going forward. The drag on those 27 new branches in the first quarter-- what was the financial impact? And, then, how does that reverse itself as we head into the peak season in the second and third quarter?

Barry, in the press release, we mentioned the $0.02 impact - negative impact.

That's correct.

-- in the first quarter. And, as we go in season, Jeff, we expect [most] branches to be profitable.

Same-store operating profit was down 15.

Same-store operating profit was down 15?

Right.

One housekeeping item; then a couple of questions. Same-store sales and same-store operating profit? Was most of that downward direction due to the drag of the portion of the 27 branches that were just a year old, or what would be contributing to that?

The inefficiency of a sales decline on a fixed cost structure and, really, a slow time of year where that fixed cost structure is in place. And as a sales decline hits, the earnings would be more exposed during that type of time period. The new branches are excluded from everything I've just said.

And, on a go-forward basis, what are you thinking in terms of branch development for 2007 and going into 2008?

I think that we've started all the new branches we probably-- there may be under five, a small number through the end of the year. But I think-- We like to start them early. We may start some more in the fourth quarter so that we're in place for the next season. But I think, from a greenfielding, most of the lifting is done for this year.

And, last question. Can you give a little color on the acquisition pipeline?

Well, I can sort of repeat what I said earlier. Watsco has a-- I've been here for a long time. I've never seen the credit markets better. I've never seen our own financial strength stronger. I have an appetite for very large transactions. I cannot control what owners-- their timing. We have a good reputation in the market. People that have sold us their business are good reference points for us because they like what we do after the acquisitions. I think the one word that describes us and our culture is persistent. We're very persistent with these owners. And I can't tell you the timing, but we're there with a lot of financial strength.

Thank you.

Your next question comes from Keith Hughes with [Robertson] Humphrey.

I just had one question on pricing. I believe there was a pricing action by the HVAC manufacturers in the first quarter. If you could give me some sort of an update on that, and are there any increases coming, given the moves in copper and scrap steel and things like that you know of in the second quarter?

Paul, let's get you in on that one.

Okay. We had price increases from several of the major OEMs and suppliers towards the end of the fourth quarter and beginning of the first quarter. I would say, for the most part, that the pricing actions have held - that we've been able to implement those price increases. Obviously, there's pockets where the market has a different competitive edge to it, where we've had to do some things in conjunction with our OEMs in pricing measures. But, so far, I would say it's held out good. I think going forward it's going to be difficult, and it has been difficult, in this market environment to have any sort of a price increase again. With the price of copper and--

You mean at the OEM level.

At the OEM level. Yes.

If there is an increase, Keith, we feel, as we always have, comfortable that we can pass that on. As you can tell from our gross profit margin, we're holding up pretty good in the pricing environment. We had a slight increase in [inaudible].

And a final question. Paul, I know you buy a lot of other different materials and not just HVAC units. Are you generally seeing increases in the majority that you buy or announced increases, or is it more stable to that as we speak today?

I would say it's been very stable on the non-equipment side. Obviously, copper has moved up. That has a direct bearing - copper tubing and fittings and that type of product. But I would say the rest of the products have been very stable as far as pricing has been concerned.

All right. Thank you.

Your next question comes from Jeff Hammond with KeyBanc.

I guess to follow on with the acquisitions, I just wanted to get maybe a better sense of-- as you look at the pipeline, is it more biased towards kind of small bolt-ons versus larger type deals? And, then, as a follow on within the acquisition environment, is there a point in time during the year where maybe some of these opportunities fall through, and you maybe consider share repurchase?

You are persistent. Let's say that the-- let's answer the question, the first parts of it. As Barry indicated earlier, we are now four subsidiaries operating in '07. Each of the four subsidiaries have a capability and a competence to make bolt-on acquisitions, and they do that as a method of expanding the network that they're managing. I think that will go on, as far as I can tell, for a very long time. What I try to do here at the corporate office is to look at the larger transactions. That's my focus and the corporate office focus is the larger transactions. And, I'm repeating myself, but we are in the market. People know that. We want to do large transactions. We can do larger transactions. We're waiting for willing sellers to participate on that. I don't want to color it one way or the other because I can't predict what owners will do. But I can say that we are the preferred buyer because of our reputation for what happens to great companies that sell to us and what happens after the acquisition. We just have a great reputation in that.

In terms of stock repurchase, the data shows that we have bought back 15% of our stock over-- what period of time, Barry, is it?

About the last seven or eight years.

Seven or eight years. It's not a priority of ours. I think what we're trying to do in Watsco is build a much larger network. I want to reserve the strength of our financial position to use that to build a network, through acquisition, primarily. I just think that if we can continue to raise dividends and hopefully make some very large investments in companies that would expand our network, that would be my preference.

It would just seem, with your balance sheet capacity, even with the larger type deal, you'd have the capacity to do all three.

You just don't know how many large deals I'm looking at.

Okay. You also mentioned in terms of investments product opportunities. Can you just talk about new product opportunities, maybe either on the parts side or where you're getting the new vendor authorizations?

Good question. I'm going to ask Paul to participate in that.

We're seeing some pockets-- I would almost call them niche markets right now-- of products such as what we call a duct-free split system that's growing very, very rapidly, although it's a small piece of our business. We're also seeing other products on the supply side which are new to the marketplace, which allow us an entry level niche that we otherwise wouldn't have. So, it's been an interesting first quarter as far as the new products are concerned because, obviously, those have a different growth curve on them. But, unfortunately, the base right now is very small.

Okay. How about new vendor authorizations - anything to speak of?

Really, I don't think that I should disclose anything like that right now.

Okay. And, then, you've had the target of free cash flow equal to net income. Can you talk about kind of free cash flow expectations for the full year and how that might be different in light of the changing demand environment and kind of your added investments in the last couple years?

Again, Jeff, I think the main use of working capital has been used by building the inventory to what it needs to be with the new systems and building new branches, which is already in the numbers. So, from this point forward, as I said before and as Al suggested, inventory should actually behave quite well. Credit, which is the other big part of accounts receivable, is a big part of working capital. DSOs are now at 36 days for the last 12 months, so there's been some positive movement there in working capital. Payables days have been extended as part of these programs. So, to answer your question more directly, all of our key managers are incentivized for cash flow to exceed net income. You can do the math with our EPS guidance in terms of converting that into cash flow guidance. That opportunity is there this year to meet that type of goal. You use the word free cash flow. We see nothing new on CapEx this year, which should be in the $5 to $10 million range, if you want to get to free cash flow and what I've said.

Okay. Perfect. Thanks, guys.

Your next question comes from [Jason Castleman with Stonebrook Funds].

Actually, you kind of addressed most of my questions. I wonder if I could just kind of follow up on some questions around the balance sheet and acquisitions. Just to get a sense, because you guys are now a bigger company than you used to be, a large acquisition now would be $100 million deal or a $500 million deal? What would sort of qualify in terms of the large deal you'd be looking at?

We've never done $100 million acquisition purchase price, but we might. We might try to do more than [$100 million].

Maybe there's a second way to ask this. Just given the stability that you guys proved, even through this downturn in the business with the replacement cycle and the like and the free cash flow, what do you think is the optimal balance sheet for shareholders in terms of a debt/equity mix to kind of optimize your cost of capital?

Yes. That's a good question. Historically, I don't think we've ever exceeded 50% debt to cap. I was comfortable with that. I think you've described the foundations of the business pretty well. It's pretty stable and pretty predictable. I know we've been at 50% before, and my comfort level is very high that we could be there or perhaps even higher.

But it would take several-- given the free-- you have no net debt. I'm trying to think it through. You have no net debt. You're going to generate free cash flow something like your net income or maybe even more. [Inaudible] to get a general sense. That would seem like it's $100 million of cash on the balance sheet, plus--

That's a lot of investment possibility. One thing I may not have mentioned is that we are a very, very ambitious company, and we have very large goals. It is not unusual-- it would not be unusual is a better way to say it-- that we could leverage the Company in the way you're describing and do some very large deals.

I'm sorry. It would seem like you've got $400 or $500 million of [inaudible].

I wouldn't disagree with you.

Well, to your earlier point then, and the last question, having [worked] in M&A before, you never know when these things will happen or if they will happen, even when you think you're towards the end. Does it make sense to, along the lines of Jeff's question, just have some kind of a buyback in place, where if just nothing falls, you don't collect cash on the balance sheet?

That's a lot of what-ifs. I don't know what to say about that. We've stated that our primary goal is to build a network. And we believe that there are enough large gems out there that do what we do that we'd like to be able to offer them very attractive prices in cash or stock, depending on what they may want. So, we believe that that should be the first goal, and that should be the goal that we preserve. Now, I also believe, because of all the reasons you stated, that we should have increasing cash dividends. And we do that. The stock repurchase program-- we have purchased 15% of our outstanding over the last few years. But those are the priorities that I see. First-- You know, I'm sort of repeating myself. But use your capital to build a network. We've got much more growth we think we can achieve, considerably larger growth. I think we can be much larger than the size we presently are. That's the number-one goal we want to preserve. I'm not a particularly reckless guy when it comes to the balance sheet.

No. All that makes sense. I was really just kind of, along the comment that you make, that you never know when and if these things kind of fall. But the 15% you guys bought back of the Company prior actually turned out to be a pretty good buy.

Thank you. I think it was too.

Okay. Thanks very much.

At this time, there are no further questions. Are there any closing remarks?

No. We enjoyed it, and thank you. We look forward to meeting with you all on a conference call at the next quarter. Bye now.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.