Watsco Inc (WSO) 2008 Q3 法說會逐字稿

Good morning. My name is Dominique and I will be your operator today. At this time, I would like to welcome to the third-quarter 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) Thank you. Mr. Nahmad, you may begin your conference.

Good morning, everyone. Welcome to our call. This is a beautiful South Florida day. My name is Albert Nahmad. I am President and CEO. With me is Barry Logan, Senior Vice President, and Paul Johnson, Vice President.

First, I want to read the statement and 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.

First, I would like to comment and highlight what has occurred. Our organization has responded well to the revenue environment, which was impacted by comparatively cooler temperatures during the quarter in the Southeast, which is a large market for us, as well as the impact of new housing, especially out West, particularly in California. The good news is that gross profit margins during the quarter reached an all-time high, up 150 basis points in a down market. And that is a remarkable accomplishment, in our view.

We again lowered SG&A year-over-year. As a result, operating margins during the quarter on a same-store basis remained constant at 8.1% -- that is 8.1% -- in the face of a 12% same-store sales decline. Sales results also reflect higher pricing and the richer sales mix of high-efficiency systems.

We have also produced more cash flow in 2008 than 2007, despite adding $38 million in inventory of new 410A equipment.

We will use our financial strength competitively to offer broad product availability at the local level to best serve the replacement market. This is one of our key strengths, our ability to use our financial strength to provide product availability to our contractor customers.

We expect 2008 to be another year of achieving our stated goal of producing cash flow greater than net income, and I stated in the press release we have raised dividends in 2008. It is our intent and hope to maintain our track record of providing increasing dividends each year. Dividends in 2008 increased 34% over 2007 and are now at an annual rate of $1.80 per share, a meaningful yield against our stock price.

Our balance sheet remains strong. Our net debt as of today is $30 million and availability under our revolving credit agreement, which is in place through the year 2012, remains well over $250 million at a cost -- let me emphasize that -- at a cost of just over 3%. Again, we consider this a competitive weapon in the current market environment and we are actively seeking investment opportunities in our normal disciplined manner.

Now for the specifics of the third-quarter performance. Sales were $475 million, and on a same-store basis declined 12%. Gross profit was $127 million, with gross profit margin improving 150 basis points to a record 26.7%. Same-store gross profit margin improved 160 basis points to 26.8%. SG&A was down 4% on a same-store basis. Operating profit was $38 million on operating margins of 7.9%. Same-store operating margins was equal to 2007 at 8.1%. Again, we really believe this is terrific performance relative to the change in revenues. Earnings per share declined 8% to $0.84 per diluted share on net income of $23 million.

Now for the nine-month period, sales were flat to last year at $1.37 billion and are down 9% on a same-store basis. Gross profit improved 3% to $356 million and gross margin improved 70 basis points to a record 26.1%. Same-store gross profit margin increased 80 basis points to 26.2%.

The SG&A was down 4% on a same-store basis. Operating profit was $93 million on operating margins of 6.8%. Same-store operating margins were 7.2% versus 7.3% in 2007.

We continue to produce record cash flow. Year-to-date, operating cash flow was $37 million versus $35 million in 2007, and this includes a 2008 $38 million inventory investment in the new 410A air-conditioning systems, which we have stocked in advance of an environmental mandate that takes effect in 2010.

Why are we doing this? Because many contractors have started to actively sell and market these new products well in advance of the mandate and we are in a strong position to respond to their needs. The combination of high-efficiency solutions matched with these new greener products bodes well for the replacement market, as both contractors and consumers will have attractive solutions to upgrade their existing systems.

Over the last 12 months, we have generated cash of $109 million, well in excess of our established goal of cash flow exceeding net income. As I said earlier, 2008 should be no exception in terms of exceeding this goal. Debt ended the quarter at $48 million and a debt-to-total-capitalization ratio of 8%. Today, our net debt is about $30 million and we have $300 million of total capacity under our credit line that expires in 2012. Not to mention that our cost of debt today is just over 3%. We are in a great position to invest in our business and are actively seeking opportunities to build our network.

As stated in the press release, we are revising our outlook for 2008 earnings per share to $2.22 to $2.26 per diluted share, reflecting current market conditions that we expect to extend into the fourth quarter.

Before I get into answering questions, it is important to again look at the long-term story of our company. We only think long-term, and think only in terms of maintaining a disciplined approach of building a much, much larger company, using the same conservative principles that have gotten us this far. Our 20-year record as a distributor shows revenues have grown at a compounded annual rate of 20% and the market capitalization of the company has increased more than 60 fold to well over $1 billion.

But an important reminder, our market share is just 8%. That's 8% of the estimated $26 billion market for HVAC/R products, and we intend to grow our leading market position substantially in coming years. Why do we think we can achieve this and why is our confidence high? That is because we have already achieved double-digit market shares in certain key states where the competition is fierce.

With that said, Barry, Paul, and I will be happy to answer your questions.

(Operator Instructions) Matt Duncan.

Good morning. The first question I've got, Al, do you have the numbers in front of you for the percent change in your replacement and new construction sales year-over-year?

Barry, do you have that?

Yes -- on a year-to-date basis?

Just in the quarter, Barry, if you've got that.

On the replacement side, there's low single digits decrease in replacements. New construction would be around 7% of the 12%. And then the commercial businesses would be a 1% difference.

Then Barry, looking at that replacement business being down in the quarter, how much of that would you attribute to the cooler August and September temperatures and also maybe to hurricanes?

I will be happy to send out the data. It's public data from the weather center. There's about a 20% to 30% difference in cooling degree days in just August and also we saw some of that in late September. And if I try to do sum imputation of that, it's about 4% to 5% of the 12% is sitting in that dynamic.

Okay, so replacements -- so it sounds like you think replacements probably would've been up call at 1% or 2% without the cooler weather.

Yes, and that would've been a year-to-date trend as it turned out from the first half of the year.

Sure. And then if we look at units, then, units versus price, I guess, it looks that you have done a good job capturing higher prices, as evidenced by your very nice gross margin improvement. So if you had to talk about maybe looking at volume versus price, how do you think the business is doing there?

As you know, the OEMs have been pushing through price increases all year, and the composite across our business is somewhere around 4% or 5%, and that's what has been captured through the nine months.

Okay, fair enough. Are you guys seeing any changes right now? I guess with the economy clearly looking like it's teetering on the edge and getting worse, are you seeing any changes in sort of how people are repairing or replacing a broken A/C unit? In other words, are you seeing any shift towards repair as the economy gets tougher or is that dynamic still about what it has been in the past?

Well, it's been almost two years that we have had some of these dynamics going on. And what we see in the Sunbelt is some consistency in replacing systems. As you get out of the Sunbelt, it takes a little more of a discretionary item, discretionary purchase. So as you go north, it's something we see and have been seeing. I wouldn't say it's more acute at this point than it has been.

Okay. Then last couple of things, then I'll jump back in queue. First of all, on the price increases, do you feel like you guys are going to be able to maintain these higher prices as things get tougher in the economy and therefore be able to maintain your gross margin percentage at these new levels?

We do. We believe that we compete fiercely on service and no one does as good a job as we do. The high density of branches that we have is an extremely high service function for the contractor. So he has to travel less to reach the products that he needs to repair and replace cooling and heating systems. It's the fundamental strength of the company.

Al, as you look at acquisitions now in a more difficult credit environment, you guys obviously have a lot of borrowing capacity. If I remember correctly, your revolver is about $300 million.

Correct.

What are your plans for acquisitions now that the economy is tougher and credit environment is tightened? Are you going to pull back on the reins any there or are you still --?

No, just the opposite. We believe that, for example, cash per share is about $3.89, well in excess of the earnings per share. And we believe that's just a trend that's been continuing as we manage our working capital better and better all the time. So we are hungry for the largest transactions, and we believe that this environment may create more opportunity.

But we are very conservative. But we mask the conservatism with our appetite. The bigger, the better, and we know that we can finance almost anything in the industry that comes our way if we had to acquire it. There's nothing that's too big that we can't acquire.

Okay. Thank you for the insights, guys.

Ian Zaffino.

Great, thank you very much. Just a quick question here, just as far as the cost-cutting. It looked like a lot of the cost-cutting had come on the gross profit side. I would have expected it to come more on the SG&A side. Does that mean there's just going to be a lot more SG&A cuts to come, or how much of that has been realized versus your gross profit initiatives? Thanks.

Yes, Ian --

Didn't you issue that either in the press release or --?

Sorry?

Go ahead. I'm sorry.

Ian, as we came into the program for implementing all the cost savings, about a third of the initiative is in gross profit and the rest is in SG&A. And SG&A is something that takes a slower grind, a longer time to execute. And there is more to come. The $8 million to $12 million that we talked about in the press release certainly has some SG&A in it that will come out over the next three quarters. And obviously, in a big seasonal quarter is an increase in gross profit has a very direct, immediate, and very quick reaction to the earnings.

So it looks like right now that a lot has come from SG&A -- from gross profit because we just went through our biggest seasonal period. But there is certainly more SG&A that can [come] over the next few quarters. And that is primarily what is -- in terms of going through the annualization of a lot of those changes that have happened throughout '08, not at the start of '08.

Okay. Then the second question would be is how do you think about your cash and your cash flow? I know we're in a terrible market as far as financing. I don't know if you want to use all your dry powder. But how do you view acquisitions versus share repurchases versus dividends?

And what it is really the sustainable dividend? What can you really, truly increase that to on a sustainable go-forward basis? Obviously $1.75 is -- you could pay more than that. So just wondering what you are thinking.

We agree with you, and that's why I said in my prepared comments that we intend and hope that we can increase dividends every year, and this year is no exception. But our first priority is to build a network, the national network, and we do that very efficiently by acquiring businesses that already have branches and a good customer base.

So while we are very hungry to acquire distributors, we also feel that our cash flow is more than adequate to finance acquisitions as well as to increase dividends. And then I would put share repurchase at a third priority, between acquisitions, increasing dividends, and lastly, share repurchase. But our cash flow is very large for our business, so we think we can do the first two, and may not do -- or at least not do much of the share repurchase.

I would think with the stock down sharply here you might want to do something, but --. Okay. All right, thank you very much, guys.

[Tom Hayes].

Good morning. This is Tom Hayes for Michael Cox. Just wanted to see if we could talk a little bit about -- you had mentioned $38 million of an increased inventory to meet the new demand for the 410A equipment. I was just wondering is that -- are you seeing a demand spread across all your geographies or are there some areas that may be moving a little quicker than others?

Let me put Paul into this conversation.

Yes, we are seeing demand all across the US for this. It's not just in one geography. We have had different manufacturers that have been introducing the 410A product at different points, so it hasn't been uniform throughout the entire organization at Watsco. But at this point, we have all manufacturers in all locations pretty much stocked with 410, and we are seeing demand in just about every part of the country.

Having said that, we are also still seeing demand for R22 products, which is the reason why we're maintaining both inventories to make sure we are satisfying all of our contractor needs.

Great. Then just one clarification, on the $8 million to $12 million of future cost saves. Did you say about a third of that was tied to SG&A, you would expect?

Yes, that's about right.

Okay, thank you.

Curt Woodworth.

Good morning. So I have a follow-up question on the SG&A idea that was discussed earlier. And I understand that it's probably more relevant to relate it to gross profit than total sales, given the way the compensation structure is done. But if you look at year-to-date gross profits at $361 million, last year you were at $351 million year-to-date. So you are up $10 million year-on-year, but your SG&A is up $15 million.

And I know that ACR did have a higher SG&A as a percent of sales, but it just -- it feels like there isn't that much SG&A benefit relative to maybe some of the cost targets you announced beginning the year. I'm just trying to figure out is that wrong to think that? And then potentially, optimally where should SG&A be as a percent of gross profit or however you look at it?

Curt, I think -- a way to look through your question and answer it objectively is year-to-date there is a 9% decline on same-store sales and the change in SG&A on a same-store basis is 4%. So obviously, optimally that should match each other in terms of being able to react as aggressively as possible. And so there is more heavy lifting. There is more work to do in SG&A clearly.

And I have to also say that the trends running into the third quarter on sales were better, and we ran into, again, what was a much weaker August with the weather and we have to react to that. So there certainly is some things we've done to formalize our process for the rest of the year and going into next year in terms of SG&A.

Curt, I think you should -- just to repeat, you know, we've kept our EBIT margin the same as it was in the prior year, even though our revenue declines were the size that we mentioned. I think that's quite a performance, to have increasing gross profit margins and decreasing SG&A and maintaining an EBIT margin with what's happened in the market.

Another thing that we probably haven't indicated yet -- at least I'm not aware of it -- is that the markets are particularly soft in the West. California has entered a period of -- first of all, California is a very high new construction market relative to replacements. And we can see in the industry and our own performance there, that is the weakest of all. I would say, go one step further, that if California had performed as it normally would for us, we would have met and exceeded the earnings-per-share estimates that are out there.

Okay. Is there a way you can, I guess, guesstimate what the sales impact was this quarter from what was pretty poor weather in September and August?

It's a range I would give you somewhere between $20 million and $30 million in sales, which would be about a 6%, 7% change on revenues from last year, of the 12% we're talking of. So about half, Curt.

Okay. And just last question on the gross margin performance. Phenomenal performance. How -- you know, maybe not that year-on-year change delta, but how sustainable is, I guess, maybe forward momentum in terms of increasing gross profit margin going forward for the company? And how much of the increase would you characterize as potentially mixed benefit versus maybe pricing benefit versus just better management of rebates and billing margin activity? How do you kind of characterize or disaggregate that improvement?

First is we track several items in cost of sales. The lion's share is what we pay for a product versus what do we sell it for. And that's just simply called selling margin. And that is where all the benefit in gross profits has come from. There may be some benefit in that fore the simple fact that new construction, as it comes out, replacement is a higher margin.

There's some benefit from higher efficiency. It's not what's driving it. It's a small component of it. A lot of it is just a lot of discipline, a lot of detail work going on at the counter and our sales force and so on in terms of raising profitability. And there is a sense of permanence that can come from that.

The other items that are outside of that, rebates, discounts, things like that, have actually worked against gross profit this year as purchases have come down. So the good news is that most of it is sitting in the merchandising of our product, and it's terrific performance.

Great. Then in terms of the commodity deflation we are seeing, have you heard anything from the OEMs regarding price decreases on equipment?

Not yet.

No? Do you think that's likely in '09?

A question for them. Paul, have you heard anything on this?

We've seen obviously -- yes, I think what you are talking about, Curt, is we've seen copper go to what -- [220 to 225]. We've seen aluminum stabilize. And those were the reasons why the price was going up, as well as freight costs. Obviously, the manufacturers are slower to reduce price than they were to raise them.

I don't think we are going to see much. You'd have to ask the OEMs what they are going to do. We so far have not seen manufacturers coming at us with across-the-board price decreases. Selectively, yes. Spot prices, yes. But nothing across the board yet.

Great. All right, thanks so much.

(inaudible)

Good morning, guys. Just talking about momentum through September and into the early part of October, have you guys seen any impact from kind of this broader macro slowdown that we've seen related to the credit markets, or would you attribute most of the weakness there to simply weather?

Well, that's a very perceptive question and it's very difficult to separate the two. But I would say that if it's one of repair versus replacement, that's a short-term action, because eventually that equipment will have to be replaced. So you might argue there is pent-up demand waiting for consumers to feel better. But I would say it's hard to separate that from the weather pattern.

There are very good financial return reasons why consumers should replace the stock equipment that's out there because it's old efficiency levels and they could, just by simply taking whatever they have, working or not, systems-wise and replace it with today's high efficiency, they are going to have material reductions in their electrical bill. And that is a fact, and we have the products to do that.

So eventually, we think that that will come in, no matter what happens to the weather, no matter what happens -- well, I would say not no matter what happens to the consumer sentiment, but certainly what happens to the weather. And then probably when the consumer has a little more confidence, he'll upgrade into higher efficiency because he has a direct return on his investment.

Right, to the extent they are able to finance that purchase.

Yes. And we do help with that. We provide third-party financing.

I guess in the same vein there, have you seen any change over the past couple of months in your past due receivables?

A very good question. We are very, very focused on that, on credit and collections, and very disciplined on that. And I'm happy to say that we are performing very well on that. That's one of the reasons cash flow is growing at record levels. We are improving our inventory turns and I think we could still improve our inventory turns. And that the ages of the receivables are still good, and we are very focused on keeping them good.

Okay. Thanks, guys.

Keith Hughes.

I had a question on acquisitions. You talked about your appetite earlier. Usually Ferguson is one of your biggest competitors for any potential deals out there. Have you seen their stance on acquisitions change in the market, given some of the things going on [inside] Wolseley Corporate?

Only what I have read, and I don't believe they are active in acquisitions today.

In HVAC?

That's right.

Okay. Second question -- and this might be hard to answer -- but if you remove the weather aspect from your demands, perhaps in areas where the weather was a little more consistent in the quarter, was there a falloff in demand in September, given the headlines that we were seeing in the US?

Paul, do you have any of that data?

Yes, it's not really data, Keith, and unfortunately it's more anecdotal at this point, as far as what's happening out there. And anecdotally, yes, there was a slight slowdown as consumers started worrying about their savings accounts and their 401(k)'s.

We have seen some reflection of increased part sales, but once again, the movement isn't to a point where I would say that consumers are all out replacing versus -- excuse me -- repairing versus replace. So it's too early, I think, to come up with a good answer to that question.

We do believe that fundamentally the business we are in is as close to necessity as can be. You can't live in the Sunbelt without air-conditioning. Then in the winter, we do have to be able to warm up the houses, the homes -- and the businesses. So this is not a particularly deferrable item. You might do a little bit more repairing than replacement, and all that does is build up more demand down the road for replacement, because you can't repair forever.

So this is not a particularly deferrable item, Keith. That's why we like it. That's why we're building our whole -- this large network throughout the United States with -- right now we have 440 branches to -- because we like the quality of that demand. And the fact that we are engaged and the industry is engaged in producing ever-improving products to conserve energy and reduce electrical costs to people's homes and businesses.

Final question. The higher --

It's not like deferring a garment, you know, that you go to retail. You can do that. But you cannot defer cooling and heating in businesses and in residences. You have to keep those systems going.

I understand. I live in the Sunbelt, too. I'd die without it. The higher efficiency items, can you give us a rough guide on what percentage of sales that is, or -- whether it's higher efficiency or the new coolant, however you want to characterize it?

Sure, Keith. On the high-efficiency side, it's about -- it's between 20% and 25% of our unitary equipment sales at this point. And last year, it was in the teens. And as far as the 410A products, that's not just high-efficiency; that captures the whole array of product. That's now about, let's see, about 15% of our equipment sales and growing -- growing substantially.

And last year that was single digits. Is that correct?

That is correct.

All right. Thank you.

[Eric Sobotka].

Hi, guys. Good morning. I just had a quick follow-up question on the dividend, and just sort of how you guys are -- more so how you are thinking about it as opposed to sort of what the dividend levels are. You know, you guys are doing, just on your guidance, doing roughly $2.25 earnings this year, and the dividend's going to be roughly $1.80. Just how do you think going forward about your dividend in the context of doing potential acquisitions and your willingness to draw down on that revolver that you guys talked about? And just maybe just sort of the rationale on how you think about that a little bit more.

Well, don't forget that cash per share is $3.89.

Right. But a lot of that is from working capital, right? So over time, I don't know if that is at the same benefit that you get the following year, etc.

Well, as I said earlier, we believe that our inventory turns have a lot more to go. So we don't see any end to improving our performance in working capital, especially on the huge investment that we carry in inventory. And we also like being able to do both, finance acquisitions and every year increase our dividends. I don't see any reason why we can't continue that.

Just to add some color to that, if we look beyond just the last couple years, look at -- go back to the beginning of 2000, cash flow in the Company has been $500 million while earnings have been $400 million. So it didn't take a slower market to produce some working capital gains. It's something that we have been doing over a sustainable period, and that effort is continuing.

So if we raise dividends from this point let's say 10% or 20%, we are talking about $5 million to $10 million of cash that is being returned to shareholders out of what is an increasing amount of cash flow that is now in the $80 million to $100 million range. So it's something that is easy to look at and consider, and it needs to put in context over a longer period of time.

So in theory, to your point, in the event of a further downturn, you feel like that just, particularly on the inventory side, there's a larger chunk that could keep going, if that trend continued, to generate incremental free cash flow.

Yes, we do. That's well said.

And there's inventory opportunity in that market as well.

And we are seeing a lot of efforts by some of our major manufacturers and vendors who want to get involved with this, as far as looking at working together to improve the inventory turns so that they have better visibility into what our demand is from them. So it's integrating the channel a little bit more to manage inventory even better, and that's finally reaching our industry.

Lastly, any other -- any changes to sort of the terms of your revolver? I forget when that comes due and sort of what's --

2012.

2012. Okay, so --. And it's floating rate. Okay, great. Thank you.

You bet.

Matt Duncan.

Just a couple of follow-ups. First of all, on R410A -- maybe, Paul, this is a question for you - -you guys say it's about 15% now. As you move through 2009, how do you think that percentage will change? And then remind us what the price differential is between a similar 410A and R22 unit?

We expect it to continue to obviously move towards 410. As far as how fast it goes, that's an estimate right now. We are seeing it grow substantially with -- as the price basically has come down -- to almost meeting the R22. It is 3% to 5% more expensive right now, for 410 versus the R22. As that price continues to go down, I think we're going to see the 410 demand continue to pick up.

So -- and several of the manufacturers are indicating that they would like to convert over to 410A completely. So I wish I could give you a precise percent as far as when it's going to happen, but that would just be a guess.

Okay, fair enough. Then as you look at your cost-cutting plan, it's now about $25 million of the original kind of $30 million to $40 million. And I guess it sounds like a lot of what you've done so far is on the gross profit side.

Barry, maybe you can give us some insights into kind of what's left on the SG&A side. What are some of the things that you guys are working on trying to cut back on?

Again, I went back and looked after the beginning of the call, and about half the year-to-date savings have come from the gross profit; the other half from SG&A, just to add some accuracy to what I said earlier.

It's really again, starts at the facilities and works in through branches and works in through branch management and works at the very detailed level. We have fewer branches today than we had at the beginning of the year, and that's going to annualize itself throughout really the beginning of next spring. So that's branches that have been either consolidated or simply being serviced out of local branches nearby.

There is variable costs that are influenced by sales, obviously, like commissions and incentives and bonuses and so on, and that's something -- that's somewhat of a mechanic that reduces itself as sales happen.

Don't forget our delivery system.

And we are down in freight this year, which is, again, a Herculean task. Really, our branch managers and regional managers have done a good job of reducing freight costs in the face of the market and there is more to come, simply because those initiatives have been taking place incrementally every month and there's more to come.

Obviously, something like fuel costs, as they come down, is something that will also have a benefit. So it's -- as we have kind of been answering this question all year, Matt, it's a lot of little things. There's really no restructuring, there's no big swings, there's no big burst. It's really a lot of little things that are going on and still going on.

Okay. And then last question, just a housekeeping item. Barry, what was D&A and CapEx both in the quarter?

CapEx for the quarter was $1.4 million, and depreciation and amortization was $3.3 million for the quarter.

Okay, thank you.

David Manthey.

Hi. This is actually Kyle O'Meara on for Dave Manthey. A quick question on the refrigeration side, Barry. I think you said it was down a couple percentage points. Could you talk about -- albeit against a pretty difficult comp last year -- could you talk about what you are seeing in the refrigeration end market and kind of your expectations there?

I should say this to be very clear, is in the 12% same-store sales decline, there is a 1% impact from refrigeration. If I [include] that, refrigeration is down about 10% in the quarter. And a lot of that has to do with some of the copper pricing that has come down during the third quarter. If I isolate that, the rest of the refrigeration business is closer to flat.

Year-to-date, again, it's basically a flat business of what had been some growth year-to-date. And it simply has flattened out, would be the color I would add.

Thanks.

(Operator Instructions) There are no further questions at this time. Do you have any closing remarks?

Well, thanks for listening and we look forward to conferring with you at the end of the fourth quarter. Thank you.

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