Watsco Inc (WSO) 2008 Q2 法說會逐字稿

Good morning. My name is Beverlin and I will be your conference operator today. At this time I would like to welcome everyone to the Watsco second quarter operating results 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.

Thank you. Good morning everyone, welcome. This is our second quarter earnings conference call. My name is Al Nahmad, President and CEO. With me are Barry Logan, Senior Vice President; and Paul Johnson, our Company's Vice President.

First let me provide the necessary cautionary statement. This is a reminder that this conference call has forward-looking statements as defined by SEC laws and regulations and are made pursuant to the Safe Harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Now, the highlights.

The second quarter performance was the second best in a 60 year history behind only 2006's blockbuster results. Obviously, much has happened in the general economy since then. We believe our performance this quarter is exceptional and speaks well of the fundamentals of our business and industry as well as our ability to react to these market conditions.

As expected, sales results showed improvement compared to the first quarter with the start of the replacement season. We estimate sales of replacement products in Watsco grew 8% during the quarter. It is also important to note that sales of high-efficiency systems, products above the 13 SEER level grew 22% over last year.

The richer mix helped sales and margins and speaks to the importance and relevance of these products particularly now in this high energy cost environment. We also saw continued growth in the sales of the new environmental friendly systems that use R410a refrigerants.

In 2010 the Montreal protocol will become effective for equipment manufactured in the United States. This means that 410a products will become the standard of the industry. The product transition is already underway and we have been actively training our customers on the merits and benefits of replacing systems with the 410a products well before the mandate takes effect.

It is great to be in a business with a built-in focus on two important issues -- high-efficiency products that can save meaningful amounts of energy and concern for the environment. There is no question that the new products provide great opportunity in the replacement market and provide higher price points and margin contributions for us and for our contractor customers. Consumers also receive long-term value and see an immediate reduction in their electrical bills.

Back to some analysis for the quarter, the quarter's performance includes actions taken to improve gross margins and reduces SG&A. We estimate approximately $6 million of pretax earnings were contributed during the quarter and an additional 20 to $25 million of earnings could potentially be realized during the next several quarters.

We generated record operating cash flow of $28 million during the quarter. Over the last 12 months we have generated cash of $129 million. That's also a record and as well in excess of our established goal of cash flow exceeding net income.

In per-share terms, this represents cash flow of $4.68 per share over the last 12 months. Watsco's dividend was raised 12.5% at the start of the second quarter to $0.45 per share. This shows our confidence in the Company's ability to perform and generate cash flow in the future. Now for the specifics on second quarter performance.

Sales were $510 million including $62 million from new locations. On a same-store basis, sales declined 5%. And I might remind everyone that in the first quarter, same-store sales had declined 9%. So the [train] is good.

Gross profit improved 10% to a record $131 million and gross profit margins improved 30 basis points to 25.7%. Same-store gross profit margins improved 50 basis points to 25.9%. SG&A was down 4%. That's down 4% on a same-store basis. Operating profit was $42.3 million on operating margins of 8.3%. Same-store operating margins increased 30 basis points to 8.7%.

Earnings per share was $0.94 per diluted share on net income of $26.1 million. During the quarter the addition of ACR added approximately $0.08 of EPS to the quarter. For the six-month period, sales increased 6% to $890 million and are down 7% on a same-store basis.

Gross profits improved 7% to $229 million and gross margin improved 20 basis points to 25.7%. Same-store gross profit margin increased 40 basis points to 25.9%. SG&A was down 4% on a same-store basis. That's for the six-month period.

Our operating profit was $55.2 million on operating margins of 6.2%. Same-store operating margins improved 40 basis points to 6.6%. We continue to generate record amounts of cash flow.

Year-to-date operating cash flow was a record $49 million. Debt ended the quarter at $23 million, its lowest level in 12 years and we have fully repaid debt incurred for the ACR transaction which was purchased last July and was our largest acquisition ever.

This is a great financial position to be in. At present our cost of debt is under 3% so we are in a great position to invest and are actively seeking acquisitions. Our outlook for 2008 remains the same -- earnings per diluted share of $2.35 to $2.40.

Lastly, I want to invite our listeners to go to the Internet and visit our ACDoctor.com website. This is our attempt to get consumers well-informed about what they can do to conserve energy as they replace their equipment into higher efficiency products. With that, Barry, Paul and I would be happy to answer your questions.

(OPERATOR INSTRUCTIONS) Matt Duncan, Stephens, Inc.

Good morning gentlemen and congrats on a nice quarter. The first question I've got, Al, you mentioned that replacements were up about 8%. Is that unit replacements or is that your total replacement related sales that were up 8% in the quarter?

That's revenues.

But I mean is that just equipment sales or is that everything?

That's everything.

Okay. What do you think is driving that? I know I guess June was a little bit warmer this year than normal. How much of it do you think was weather versus other factors?

Well, we are in season now so this is a typical demand curve that comes in in the second and third quarter. But what we are noticing is more attention being paid to the high-efficiency products. That's why we reported a 22% increase in over 13 SEER equipment. So this is just normal seasonal demand and we continue to emphasize that that this is our Company's -- primarily based and fundamentally into the replacement market which is always a pretty reliable -- provides a reliable demand no matter what the economy's doing or what interest rates are doing or anything else.

Sure. Just sticking with the normal seasonality, knowing that June is usually a seasonally strong quarter, if you were to look at the months, I know the quarter started a little cooler and got hotter as it went along relative to the norm. Did that have any impact on kind of a month-to-month or was this (multiple speakers)

We don't really look at that. We just know that things shift between the second and the third quarter. Sometimes there are dips and sometimes there are increases in the temperature across the Sunbelt and other parts of the country. But we just know that during that period we're going to have reliable demand and we just know that and expect that. Sometimes it comes a little later, sometimes it will last a little longer. But during the second and third quarter is when we experience our seasonal demand.

Sure. Al, if the new construction revenue then, if replacements were up 8% that would seem to indicate that new construction was down pretty substantially, maybe 50% or more. Is that accurate or am I off (multiple speakers)

Yes, that's very close. It was down 40%

It was down 40?

Yes, sir.

Thank you. And then last couple of things and I will jump back in queue. Looking at the balance sheet, your accounts receivable and inventories both jumped pretty significantly. I know part of that is seasonality. Was there anything else that played there or is that just the seasonality that caused that?

No, it's seasonality. We're actually gradually improving the inventory turns. That's why [we're] optimistic that this cash flow streams [we were] enjoying. We can do better.

Sure. Then on looking at the commercial refrigeration business, it was up 1% this quarter based on what was in the release. That's a little bit slower growth than what you have been seeing. Is there any change in that end market or anything going on there that we should be aware of?

I really cannot identify anything to answer that question. It's just you know it could be related to the commercial markets which it serves. But it's a pretty steady business and it's been growing consistently through this entire economic weakness. Maybe the rate of growth last year -- I haven't looked at it. Maybe it was exceptional in the second quarter. Berry, do you remember that?

Yes, it was double digits a year ago. So it (multiple speakers)

(multiple speakers) comps, yes.

Tough comps then.

Okay and then last thing guys and I will jump back in queue. If we look at your balance sheet you guys have done a great job paying off the debt from ACR pretty quickly and you're left with very little debt on your balance sheet. Al, you did mention that you guys would like to put that balance sheet to use. What is the acquisition pipeline look like right now and are you getting close to anything or is there anything you can kind of -- what is that acquisition environment look like for you guys right now?

Well, we don't like to report transactions until we have done them. But I can give you a sense that because of our strong position as you've just noted, we're seeing opportunities that I worked on for years that are showing interest in talking to us. So I am optimistic.

Okay, great. Thanks and congrats again, guys.

Curt Woodworth, JPMorgan.

Question on the third quarter in terms of the seasonality in the business. If you look back over the past, sometimes second quarter is better, sometimes third quarter is better. It seems like when the weather hits it's partly a function of that. Maybe, Barry, can you give us a sense of how you think that could play out this year? It seems like June was pretty strong so I don't know if maybe that pulled in a little from Q3 a little bit different than last year perhaps.

Well I will take a shot at it and I will turn it over to Barry. But I like what I see so far in the beginning of the third quarter. Go ahead, Barry.

We're really obviously -- we're almost like a retail business where we don't see backlog. We don't have a great visibility. We just can see consistency over a period of time. I think you're right. If you averaged 10 years, you see third quarters that end up being a lot like second quarters. There's no way to predict that obviously because it is again a day-to-day business. But as Al suggests, the trend -- so far, so good.

Can you give us a sense of what same-store sales growth has look thus far through the quarter?

You mean the third quarter? No, we don't want to do that. It's too early.

But July is the most important month.

I like to phrase it as I said -- I like it.

Okay, fair enough. In terms of ACR if you look at the margins, if you back out the margins from -- on a same-store basis it looks like it was about 40 basis points dilutive to the Company but it added $0.08 to the quarter which implies a net margin close to the Company average. So I'm just wondering can you provide us a little bit more color on ACR, what the margins look like and where you see that going near term?

I will give you an overview and then, Barry, you can perhaps add something to it. ACR is a great company with great people and great customers and we are very happy to have them as part of our family. And they are not untypical of acquisitions that we make.

When we first get involved with an acquisition the margins are below what we have accomplished historically and so they are following the same trend. When you scale it as we do, you always see a margin improvement. So every time you add an acquisition you're generally going to (inaudible) lower margin, it takes time to bring it in and use the advantages of our scale. And that's what has been happening at ACR and I think that will continue to happen at ACR and overall I believe that Watsco's margins overall still have a lot of ways to go in the future.

Okay, and just last question in terms of sort of sizing the impact of the mix shift to the higher efficiency as well as the (inaudible) ASP's from what is going on in passing through the raw material costs. Would you say that a mix benefit plus price realization would be close to 5% for the Company? Is that a fair guess?

Barry?

What we really study is the equipment side of our business. We don't really study let's say, duct tape. But on the equipment side of our business we saw about a 4% price increase versus units this quarter. And in terms of how much of that is mix versus inflation versus other factors is hard for us to splice. That gives you a big picture sense, about a 4% overall price from mix and inflation.

All right, great. Thanks very much guys.

Michael Cox, Piper Jaffray.

Good morning congratulations on a great quarter guys. I noticed that you closed a few branches here in the second quarter. Do you have any plans to close any further branches? And the branches you've closed thus far this year (inaudible) targeted any specific markets or any specific subsidiary company of yours?

Barry, you know the details to that? I just know that closing branches and opening branches is just a common occurrence. Partly we're always looking for opportunities to open new branches. We're always looking for opportunities when we think that it's not worth having a branch. But whether it involves any specific regions, do you have any feel for that, Barry? I don't.

I do. Part of the whole profit assurance plan to get to the 30 to $40 million was to look at branches where maybe something wasn't performing and could be supported by a nearby branch; in other words, just cut square feet out of the market but not have any loss of coverage in the market. So we have closed a net 12 branches this year. There are only a handful that are remaining so there's no -- most of the heavy lifting is done.

But of the 12, eight of the 12 are being serviced by local branches and we don't see a material change in revenues in that particular market. So that's all part of this year's plan. I think it's unusual that it's that many but it's all part of again getting to the profit goals that we have.

That's very helpful. And I think in some prior quarters you've given the percentage of unit volume that would be above 13 SEER. I'm just curious as to what uptake that has reached at this point and maybe relative to (inaudible) dating back several years but what you saw the last time around when the efficiency change was made.

Our equipment business itself, it's about 12% of our equipment business is above 13 SEER, above the baseline. The last time around when 12 and 14 SEER became what was considered high-efficiency above the 10 SEER minimum, the 12 SEER and above was over half the industry volume. So it is going to be a slow creep and in terms of how slow or how quickly obviously we like the dynamic of all the focus on energy because it should drive what is now 12% of our equipment business to something much greater. It was over 50% last time around, that high-efficiency stuff.

[Ian Zaffino], private investor.

Who is the call from?

It's Ian Zaffino from Oppenheimer. How's everything?

Really, really good.

Certainly. A little bit of an interesting question here is driving the growth above 13 SEER, can you just get into that a little bit more? Is that -- as people open up their electricity bills now and they see them probably double what they were last year, is there more of an incentive to go above 13 SEER? Is that what's driving a lot of this or is it just more (multiple speakers)

Higher cost of electricity we consider a primary driver for demand -- ongoing demand for higher efficiency equipment. Offsetting that of course is the cost of higher efficiency equipment to the consumer. But the data shows and it's government data, that generally speaking the 120 million homes that use central heating or central cooling, something over 50% is the cost of energy. So it's a major item.

Interestingly enough, there's not much press on this. You hear about lightbulbs and if you change your lightbulbs it makes a difference and you hear about higher efficiency refrigerators and things like that. But none of those categories added all together equal the electrical or energy demand in the case of gas furnaces. The percentage of the electrical bill is substantially higher for cooling and heating but the media hasn't caught up with that yet. We think they will because that would create even more demand for higher efficiency.

I think so too.

A couple of other points on your question is utilities obviously [are a big role] wanting the upgrade of air-conditioning and one of the functions they do is to give rebates to consumers as a way to incentivize. And those incentives only start at 14 SEER and above. So that's obviously a way to provoke some extra sales in a market is because of the incentives that are provided.

Also the warranties can generally be longer as you go up the SEER chain. Obviously the contractor makes more money because there is about a 20% price difference between a 13 and 14 SEER system. So there's a lot of incentive for everybody to go ahead and push for the higher (multiple speakers)

Barry, why don't you explain what we are trying to educate the consumer through ACDoctor so he -- we don't wait for the [medium]. We're trying to do it directly through the Internet.

Sure, well on ACDoctor something we've added that's very important is to let the consumer know about it and learn about it and educate them but more importantly to tell them and their local market what are the incentives, what are the rebates that utilities do provide. And even in some cases there's local financing available from the utility to upgrade the system at lower interest rates and so on.

So that's all brought to bear now and rather than having static Yellow Pages as a source of information, but rather having a rich source of information, that's what ACDoctor is about is to bring the consumer not just closer to our customer but closer to the information they need to make a better decision.

And this was launched about two weeks ago.

Okay, that's very helpful. Thanks again and good quarter.

Keith Hughes, SunTrust Bank.

Thank you. Two questions, one on 410a. How much are your equipment being sold now is using that refrigerant?

Let's get Paul into this because I haven't heard a peep from you, Paul.

I've just been sitting here listening and learning and all these good things. 410 for us has really popped big this quarter. And we're glad to see it because it's something that we really have been trying to push our contractors to move ahead of the curve and do this before the deadline which is in 2010.

Based to what we're seeing right now is roughly 25% which is pretty much in line with the industry of our equipment sales to move to the 410a product. And getting back to the prior question, that also drives us into a -- generally a higher SEER product contains the 410. You're going to go 14 SEER and above. There are several products in the 13 SEER category which are 410 but for the most part this is high SEER product.

What is the current [upcharge] on a 410a system versus R22 system?

You know it's hard for us to talk about an installed basis as you know because the contractor depending on what region of the country he's in has a different pricing matrix. But generally the pricing has gotten very close. It's within probably under 5% I would say to go 410 versus a R22 but the difficult point there is of course you're going to a higher SEER when get to 410 generally. So there's not a comparative R22 unit.

On equipment pricing we've seen numerous announcements of increases from the producers. Is there a pre-buy possibility here to take some margin advantage going into the second half of the season?

I would say very little.

Are the increases, are they sticking so far? Is there any trouble (inaudible - background noise)

I would say generally they are sticking right now.

(multiple speakers) profit margin we are -- we find ourselves in an inflationary environment when there is one that it doesn't have a negative impact on us, at least not as much as the OEM (multiple speakers)

Manufacturers, yes. Okay. Thank you very much.

David Manthey, Robert W. Baird.

Good morning.

Is it raining in Florida?

It's a little cloudy and (inaudible) a little bit of rain but it's plenty warm. Thanks for taking my question.

First off, could you talk about the percentage of your mix today that's new construction versus replacement? I don't know if you want to talk about just the pure residential business setting refrigeration and ice machines on the side or Watsco overall. But could you give us an estimate of what that is in the third quarter and then what you would expect it to be as we tail off seasonally into the fourth?

Dave, our estimate at the beginning of the year, it was starting around 25% and then working its way down to something under 20% by the end of the year just given the freefall that's been going on.

Okay would it be -- in the current quarter wouldn't it be something less than that though given that we're -- with the (multiple speakers)

Our estimate is 21% in the quarter.

21 in the quarter, okay. Thank you. And then your profit initiatives, maybe if you could discuss some of the areas where you're having the most success or the biggest bang for your buck here as you rollout these profit initiatives.

Paul?

Yes, I will take a stab at that. We're seeing it pretty much across the board I think. Barry described it best last year or earlier in the year in the first quarter when we first got into the initiatives that it's a whole laundry list. It's not just one thing that we're doing that magically all of a sudden creates cost savings.

But we're seeing definite opportunities that we have been able to take advantage of on everything from advertising, the normal travel supply type things. One that we've done a surprisingly great job at -- I've got to complement our operations (inaudible) -- we have actually seen a major decrease in our total freight expenses. Our people have been managing that with our manufacturers, trying to consolidate loads in order to save freight expenses, looking at their fleet utilization and retiring trucks early, working on pretty much everything involved in the freight side even though our fuel expense obviously has increased dramatically.

So, we continue to monitor this on a monthly basis. We review it on a quarterly basis with the CFOs and we still feel very, very very confident that our people are following through on all of the initiatives (inaudible) identified in the first quarter.

Great, thanks very much guys.

David Cohen, Midwood Capital.

My question has actually been answered. Thanks.

Jeff Hammond, KeyBanc.

Sorry, I did get kicked out of the call for a short period of time so if this has been answered or asked already I apologize.

Nobody asks questions as good as you do.

Just in terms of the guidance unchanged, I imagine that this second quarter number just given the traction on cost savings and the better same-store sales decline that it came in better then your internal expectations. What would it take -- what do you need to see into the second part of the selling season to want to revisit that guidance?

Well, more like what we saw in the second quarter and as I said, I like what -- it's early but the third quarter started off nice. So, (inaudible) the third quarter to look at the guidance again.

Okay and then clearly a lot of the OEMs have raised prices here toward the beginning of the selling season. What is the feedback you're getting in terms of those going through? Is there any kind of different level of pushback given the environment or are people kind of recognizing the inflationary pressures and just taking the increases?

It is a competitive market. The OEMs have a lot of capacity and you can't escape that. But I would say that consistently over the years our business can generally pass on inflationary -- in inflationary environment, price increases with acceptance at all levels; so the contractor and the consumer. And we are experiencing that again this year.

Matt Duncan, Stephens, Inc.

Just one real quick follow-up. It's just a housekeeping question. Barry, do you have the D&A expense and CapEx in the quarter in front of you?

For the quarter, CapEx is 1 million 1 and D&A is 1.8.

I'm sorry. I thought he was still answering his question.

Are there any other questions?

There is. We have three more questions.

Sure, well let's hear them.

(inaudible)

I had a question. Obviously the price increases from the HVAC OEMs are well communicated and are scheduled to take effect this month, I believe. Is it possible for you to disaggregate the demand impact that you may have seen in the June quarter from some of your customers wanting to buy ahead of those price increases?

No, I don't think contractors buy -- they do a little bit of that but I don't think it has a serious impact on anything.

I don't think it had any impact.

Or any impact, yes.

Holden Lewis, BB&T.

I think last quarter you had commented that the pricing was more -- the pricing mix combination was more in the 500 basis point range? And I thought that they had been putting in more price sort of ahead of the selling season and you're kind of stating that it's about 400 basis points this quarter. I guess I would have expected that to be at least as much of a contribution if not more. Are we seeing something drop out or why didn't we see maybe a little bit more of an acceleration on the price mix component?

Barry, did you follow that?

I don't think there's anything specific that gets to the answer of that. I think 4 to 5% is a very narrow range to be talking about. So there's nothing specific that I can think of.

And then can you talk about also the 50 basis point increase that you saw in the gross margin organically? Are you able to sort of breakout how much of that was a function of these profit initiatives that you're doing, how much of it was from sort of people moving up in terms of mix and how much of it was from price? Any way to sort of break that out or look at that?

I will give you a broad brush. Most of the increase is what we call selling margin which is simply part of the profit assurance plan was to go into our systems and look at the pricing to the market very carefully and make pricing disciplines that much more stringent and systematically. So most of what we see in gross profit improvement is that, is sitting in what we call the selling margin.

We don't really have many other components to our cost of sales other than rebates and cash discounts and freight as Paul mentioned. We did see reductions in freight as a component of cost of sales and the discounts and other items -- there's some benefit but the lion's share is sitting in what we call selling margin which is just merchandising, merchandising at a store level and making more money.

But you're not (inaudible) sort of look at that and determine how much of that was a function of just the mix versus the equipment pricing versus price on non-equipment pieces at all?

It's not something that can be spliced that easily, Holden.

Yes.

What can be easily identified is the SG&A side. And there's 25 line items that will show meaningful reductions as part of the profit assurance. The gross profit is a little bit more of an art form than an analytical process.

And then lastly, I think you commented in the release about your cost savings. You recognized about $11 million so far which means you have got $6 million more in the quarter. And then you said another 20 to $25 million over the next several quarters. Are you sort of refining the range to that 31, 36 or how should we sort of look at that? (inaudible) by midpoint of '09, right?

You answered your own question, yes. It is refining the range and it will take through the first half of '09.

Curt Woodworth, JPMorgan.

Thanks. Looking at the SG&A structure and I know that was definitely part of the profit initiatives plan at the Company, it seems just on the map that as a percentage basis on the margin for the Company it hurt you by about 40 basis points year on year going to 17.4 from 17. I was wondering is there anything else in that SG&A number? That simply a function of maybe investments that you've made that frankly you just weren't going to get the return on this quarter?

Frankly I don't understand you train of thought. Do you want to try again?

SG&A as a percent of sales year-over-year was up about 40 basis points.

On a same-store basis?

Total Company reported number. So that was a 40 basis point negative to the total Company margin. And I'm just wondering why you saw that type of maybe negative leverage on SG&A. I know on a same-store basis the absolute decline was less than the same-store decline on the topline. But the margin hit was a little bit greater than we were forecasting. I'm just wondering maybe how you are thinking about that. Was that to be expected?

First, ACR has a much higher SG&A as a percent of sales than the rest of Watsco so it has to somewhat be looked on on a same-store basis. On a same-store basis sales still went down about 5% so there's some pressure on the SG&A line to recover that.

So I think the best way to look at it is there's a 5% same-store sales decline, a 4% SG&A decline. So there's some of the explanation sitting right there in that delta. But it's a great improvement over what we saw last year if you were to look at that same or similar analysis.

I think the longer ACR (inaudible) lower that SG&A as a percentage of sales will perform. So it's again a matter of time before ACR catches up with the overall. That's been our experience through all the acquisitions we have done to date.

Okay, I understand. And then I guess this is somewhat of a hypothetical, but thinking maybe more out, further down the line in terms of your leverage going forward when inevitably topline will go positive on a same-store basis, conceptually how do you think about if you're same-store sales growth was up 5% you have the feel for what you think your SG&A would be up? I assume it would trend lower?

I see what you're saying. I think our internal (inaudible) we will always improve -- the gross profit margin, it will be incremental (inaudible) improvements but I believe the SG&A will show much better performance as we continue to scale up as a percent of sales if that's what you are asking and I think you are. That's why we see an overall trend which we were experiencing through '06 and then that trend coming back as the (inaudible) comes back. That trend is -- we always -- we've never lost sight that trend will start again. Scaling does bring you that (inaudible)

Make sense. All right, great. Thank you guys.

There are no further questions at this time.

Terrific. Well have a nice day and we will talk to you at the end of next quarter.

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