Watsco Inc (WSO) 2015 Q3 法說會逐字稿

Good morning and welcome to the Watsco, Inc. third-quarter 2015 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad. Please go ahead.

Good morning and welcome to our third-quarter conference call. This is Albert Nahmad, President and CEO. With me is Barry Logan and Paul Johnston, Executive Vice President.

First a cautionary statement. The 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.

Watsco delivered another solid quarter. We achieved record sales, profits, and earnings-per-share while continuing to make significant investments in our business. The most notable, which are investments in technology.

We also produced the highest level of operating cash flow for any quarter in our history. Given our cash flow and continued confidence in our business, we announce today a 21% increase in our annual dividends to $3.40. This dividend increase will be reflected in our payment in January of next year.

I will discuss more about our technology and strategy, but first let me go over the financial performance. For the quarter, sales increased 4% to a record $1.2 billion and increased 5% on a same-store basis. HVAC equipment increased 5%, including an 8% increase in the United States, and came from share gains and a continued movement towards higher efficiency systems.

Other HVAC products increased 3%. And commercial refrigeration products increased 2%. EPS for the quarter increased 5% to a record $1.64. Operating income grew 5% to a record $111 million. Our operating margins expanded 10 basis points to 9.4%. Gross profit margin improved 10 basis points, and SG&A as a percentage of sales was flat.

Now for the nine months. Sales increased 5% to a record $3.2 billion. HVAC equipment increased 7%. Other HVAC products grew 2%, and commercial refrigeration products increased 2%. EPS for the nine months increased 14% to a record $4.16. Operating income increased 11% to a record $283 million. Operating margins expanded 50 basis points to a record 8.8%.

Gross profit margins have improved 30 basis points, and SG&A as a percentage of sales decreased 20% to a record low. Operating cash flow for the quarter was a record $174 million. For the nine months, operating cash flow was $100 million, compared to $42 million last year.

Our balance sheet remains conservative with a debt-to-EBITDA ratio of under 1X. We expect to further reduce debt by the end of the year as fourth quarter is a seasonally period for positive cash flow.

Now Watsco's revised outlook for 2015 diluted earning per share is in the range of $4.85 to $4.90, representing a prospective growth rate of 12% to 13% over 2014.

Now let's move on to the technology discussion. These are exciting times at Watsco. Over the last 25 years, we have scaled our business to become the leader in the industry and have achieved great results for our shareholders. Over this period, market capitalization has grown from under $50 million to over $4 billion. Stated in terms of total shareholder return, which measures capital appreciation plus dividends, Watsco's 25-year compounded annual growth rate is 20%, which ranks number 28 out of all public companies that have a market cap of over $2 billion.

Watsco's scale has allowed us to compete with capital. Giving it more fulfillment centers and products available than anyone. It also allows us to attract and retain the industry's best talent and to partner with OEM suppliers from a strategic long-term point of view.

We're looking to use our scale and size to bring technology and innovation to our business and our industry. Our investments have been in the development stage over the last two years and are now in various implementation in our business units.

We have grown from under 60 technology employees three years ago, to over 170 at present. Our current annual run rate for technology related costs is approximately $20 million.

Here are some examples of what we're doing in technology. We have launched mobile apps in eCommerce to enable customers to buy from us 24 hours a day, every day, using the industries largest source of digitized product information, which is presently over 300,000 SKUs.

We have instituted data-driven culture by developing business intelligence and data analytics capabilities to provide insider's report for greater decision-making by our 700 profit and loss managers. We are implementing software and other tools to optimize our supply chain to improve service levels with less investment. In the long run, we are targeting a material reduction in infrastructure cost, which will provide the opportunity to increase operating margins as our business grows.

Now we are conducting investor and analyst meeting on December 18 in Miami Beach to discuss our technology strategy in greater detail. Please let Barry Logan know if you like to join us. With that said; Barry, Paul, and I will be happy to answer your questions.

We will now begin the question-and-answer session.

(Operator Instructions)

Jeff Hammond with KeyBanc Capital Markets.

Morning, Jeff.

Good morning, guys. Really wanted to better understand the guide down. It looks at the a midpoint you can down $0.22. I just wanted to understand what surprised you in the quarter? How much of it was where top line came in versus expectation? Maybe speak specifically to these technology investments, and if you are accelerating investment or if you came in much higher on the spend curve? Can you hear me guys?

Yes.

One moment. There has been an interruption. I will reconnect the speaker. Just a moment. Mr. Nahmad has been reconnected. Please continue with your question, Mr. Hammond.

Did you guys get my question? Or do you want me to go through again?

I wish you'd go through it again, if you don't mind.

Sure. Looks like the guide came down $0.22. I just want to understand within the guidance revision what surprised you guys in the quarter? Outlook both on the top-line. And then speaking on the cost side, and specifically around technology investments. And maybe where you are accelerating some of that cost.

Sure. Barry, do you want to take a look at that?

Sure. Jeff, in terms of the fourth quarter, we're looking at a growth rate in the fourth quarter similar to the third quarter. Really to just reflect a little bit of softness of what we see in Canada. Canada, in particular, was the one market out of all the markets that had a little bit of a change in trend in the third quarter. It had less of an impact on earnings then on sales. Canada cost us about $0.03 in the quarter. But it's time to be a little bit conservative about that market. The only thing I would caution is it's about 6% of our sales, and as I said, cost us about $0.03 in the quarter. So that is one component of it.

The other component is the technology spend which actually a greater component of this discussion. We have been ramping up, moving beyond the development stage into the implementation stage on all of these platforms. I thought it was worthwhile to go ahead and start to talk more about that, because it does affect some of the earnings that we are seeing this year. Again, probably a 4% to 5% cost this quarter. A bit more next quarter as we're ramping up those expenditures. I wouldn't say there's any other real surprises, Jeff, in terms of that. I think it's time to be a little bit conservative as we go into the off quarters, the off-season quarters. And when we talk about the outlook.

Okay. I think you mentioned a $20 million run rate for technology investments. Is that where you think you are going to be at for this year?

I would say that -- go ahead, Barry.

In terms of this year, it will be just shy of that. The run rate is $20 million. It will end up being more in the $18 million range this year. I would tell you that things have been ramping up a little bit more as we have gotten deeper into this year.

When we go into future years, where you do see that number peaking? Is it '17, '18, where you see that number start to come down? Or is that built into the numbers on a go forward basis?

That's a good question, but it's difficult to answer because we are very long-term oriented, Jeff. As opportunities arise, for example, we have Watsco Ventures, which is essentially starting new ideas for technology we can employ in the industry. So at the very minimum I think we will be increasing as opportunities come up. I think the return is long-term orientated. It may cost us some earnings per share in the future. But since we are in for the long-term I am not concerned about it.

Okay. Great, guys. I will get back in queue and see you in December.

Matt Duncan of Stephens Inc.

Good morning, guys.

Good morning.

Good morning, Matt.

Al, the first question I've got is on the sales trend slowing a little bit. Barry, you commented on this some. It sounds like it's maybe it's just Canada. I noticed of the equipment sales have slowed a little bit, the growth there was 8% in the first quarter, 7% in the second quarter, and now 5% this quarter. Can you address what is going on there?

I will let Barry fill in, but the overall that I saw was that in September seems like we had an early in compared to last year to the season. September itself was flat. The quarter, of course, grew well.

Al, is October tracking better than that flat number?

Barry?

Yes, it is, Matt. The growth rate so far this month is pretty much like what you -- what you are accustomed to in the year to date in terms of being mid- single digits. So yes.

Just to add some color to that the season did seem to end a little bit early in our markets after what had been very strong performance all year. If you look at the year to date numbers, very consistent performance with what we have been seeing for the last couple of years. Canada, the market there even ends sooner in terms of seasonality. I think that's part of that discussion.

We're seeing a heating season begin there which [does not] have the same consequence of what we saw in the third quarter. I think overall the US market being up 8% in the quarter. Again, that's pretty strong. I wouldn't say there is any real message in the quarter performance for the US. The season did end a little bit early it seems. That's not the case as we look at October, at least. Canada, in particular, was the one market, as I mentioned, which had more softness.

Very helpful. The last thing for me, Barry, if you can give us a little detail on the price volume mix equation in your sales growth. How much is price helping the up shifting to higher efficiency systems? How much is that helping and then what is the underlying volume?

In the US market, again, the volume -- the revenues are up 8% in terms of volume. It's about two-thirds of that is volume and then a third of it is price and mix.

Okay. Very helpful.

That's, again, been pretty consistent all year. There's really not a change in that trend.

Okay. Thanks, guys.

David Manthey of Robert W. Baird.

Good morning, David.

Good morning. Hi, Barry. On the bridging from the midpoint [$5.10 down to the $4.85, $4.90]. I think, Barry, you talked about $0.03 Canada, maybe $0.04 or $0.05 technology. In the current quarter, there was probably some impact from those things and some continuing impact going forward. Can you talk about that bridge? If you talk about the shortfall in the current quarter, and then does this $0.03 and $0.04 to $0.05 -- do those reflect what is going on in the fourth quarter? Am I reading that right?

Yes, it's the big picture that we saw in the third quarter, Jeff. It's hard to pinpoint that in a very direct way. I know you want a very direct answer, but the bigger picture is we saw gross profit flatten out a bit this quarter. I think that is relevant to looking at the rest of the year. The SG&A spend that we see in technology is what it is. It has a bigger consequence in an off quarter than during the third quarter. The spending is not seasonal in terms of technology. A little bit of top-line conservatism that I think is important given what we saw as we concluded this quarter. So it's more of a big picture answer, Jeff, than a pinpoint answer.

Dave, Barry.

Sorry, Dave.

It's all right. I am used to it. Could you talk about the FX impact? You mentioned Canada percent of sales at 6%. Could you discuss what percent other international is? Is it your export markets? I guess that wouldn't really have a -- maybe it does have a currency impact. Could you outline local currency growth and US dollar growth in both Canada and other international?

Sure. First Latin America, which is actually a slightly larger market than Canada, grew mid-single digits along with the US. So currency does not influence that market. We sell in US dollars. And we buy in US dollars, so it is that simple. In Canada, it's actually more of a unit volume issue in Canada because -- really probably the overall economy than currency because we raised price, we protected our gross profit in Canada. I would say currency is less of an impact in Canada versus the unit volume impact from what the economy is doing.

Okay. Lastly, if I could get one more in here. Could you describe your stance on selling into the new residential construction market? When you see the other HVAC products being somewhat slow growth, I'm wondering has there been any change in your approach or in the competitiveness of that market versus recent history? Residential construction?

No. This is Paul. No. They're hasn't been any change in our approach into that market. We are continuing to sell products, the non-equipment products into residential new construction, and depending on the type of equipment that we are selling brand wise, we continue to see some lift in new construction.

But it's never going to be a significant part of our overall product mix. We still believe that our position in the marketplace is the aftermarket. We like the fact that there are 89 million units out there installed. Ducted systems that we will eventually have to replace. We love the consistency and the stability of that, as distinct from new construction which goes up and down.

Got it. Thank you very much.

Ryan Merkel of William Blair.

Good morning, Ryan.

Good morning. Wanted to follow-up on the comment that the season ended a little bit early. Can you give a bit more color? Is it weather issue? Is it weaker consumer? Is it a tougher comparison? Any color there?

Good question. As always, you have good questions. It is hard to say. It just flattened out in September. But then again in October, it's growing again.

Right. That's the way monthly sales comps can be. Okay. In the equipment category, what was the residential growth rate? And what was the commercial growth rate, if you have it there?

I don't think we split that. Do we, Barry?

No. I would say it's very consistent, Ryan. We don't see any divergence between residential versus commercial.

Okay. Last one if I could, have we started to see benefits from the technology investments yet? Or would you say we're more incurring costs right now and the benefits will come a bit later?

The latter is the emphasis. We are incurring costs. We will continue to incur costs, but we expect big-time, long-term benefits.

All right. We will wait for the investor day to try to quantify what big-time means, Al, but appreciate it.

I hope you come. I think it will be very interesting.

I will be there.

This is the most exciting part of my career here. The idea that the digital age is here and that we have the size and the scope to invest more money than anybody else that we compete with. I don't care whether it's in the industry or some of these online companies. We have such a fulfillment capability with all the locations that we have, and we certainly have the capital to invest in technology and compete with anybody. This is a very exciting time. This will separate us more and more from everybody else.

And thank God we have the size and ability to invest increasing amounts of money. But we will change Watsco. Watsco will be a very efficient -- with itself and provide a lot of efficiencies to our contractor customers. We will open up channels of distribution online that haven't existed in the industry before. It's just very exciting.

Okay. Looking forward to learning more. Thanks.

Keith Hughes of SunTrust.

Good morning, Keith.

Hey, how are you all doing? Question on the gross margin. It was up 10 basis points. If you can give any puts and takes you saw, I assume energy efficiency with a gain, if there were any offsets to that in the results?

Barry, do you want to take that?

Sure. Keith, first the equipment growth rate is obviously higher than non-equipment which has a gross margin consequence to it. Equipment being slightly lower than non-equipment. That is a bit of a sales mix issue. Also, we did make the decision to move 13 SEER product through our channel aggressively this season. A little bit of gross profit that is influenced in that decision really lets us convert our marketplace, convert our big Sun Belt markets into the 14 SEER phase for next year. That's part of the decision-making that was made as well this season.

How was pricing overall of that gross margin in the quarter?

Pricing has been holding very well. We haven't seen any collapsing or deterioration yet in the 14 SEER price coming down. Everybody had plenty of supply through the second and third quarter on 13 SEER products. Everybody stayed in their lane. For right now, I'm very happy with the pricing.

We've seen a lot of commodities trade off. So that much is just pure commodity items. Are they playing on the gross margin at all in the quarter?

Commodities are not a big portion of our business either. We do copper. We do steel. We do refrigerant. And, yes, there has been some commodity deterioration in the price of the product but also the cost of the product has come down.

Thank you.

Walt Liptak of Seaport Global.

Good morning, Walt.

Hi, thanks. Good morning, guys. I wanted to ask about the cash flow which was really impressive. What do you attribute the improvement to during this quarter?

I am going to let Barry answer that. Somebody asked me earlier what the benefits of some of this technology spend will be. I think probably where we'll have a sooner rather than later impact will be in cash flow, because the tools that we are using now for inventory management are just being implemented. That gives us a lot of optimism in terms of our ability to lower our investment in inventory and turn it more frequently and produce more cash flow. Barry?

On the cash flow, Walt, first, our cash flow really has two components to it, receivables and inventory. And receivables tend to grow along with our sales but the opportunity this year has been on the inventory side. We started the year and built some inventory early this year really in anticipation of this transition in product.

And as I said, it was important for us this year to move that product through the channel and not just to sell things but also to turn that investment into cash, which is what is happening as this year goes on. So it's been a good opportunity all year. It is showing itself and there will be more in the fourth quarter in terms of positive cash flow.

Okay. Great. Going back to that IT benefit. I want to make sure I'm clear on this. Are you saying that you may be, or you are, seeing a benefit on inventory management during the quarter? Or is it something where you -- (multiple speakers)

It just started. It just started because we just implemented the tool in one of our business units. The most important tool. It's just starting one of our units, and then we have to install it in the other units. I expect the benefit to come later. Not this year. But that's the one I think we will see the soonest benefit from.

Okay.

Which is terrific. If we can improve our inventory one time, one inventory turn, that pays for a lot of this technology.

Yes. Understood.

Let's do the algebra quickly. One turn is around $150 million in inventory in our Company. How long does it take and what will it take? It will take time. It will take effort. But that's the kind of opportunity we are looking at.

Okay. A follow-on with the increased IT spending. This year, to calibrate this, is a pretty large increase in IT spending this year. I think the comment was next year would increase. Are we seeing the biggest increase this year and we're at a base level that might grow? Or with Watsco Ventures do you envision similar incremental spending in 2016?

Again that's a very good question. But so difficult to answer because we're trying to revolutionize what we do in technology, and some of this is going to be opportunities as they come up. We are very much into the software world. We go to conferences. We have people visit us. And when we see a good idea, we pursue it. I don't know how to answer it. I do say that long-term, which is the way we look at it, I can't imagine a greater opportunity for us and that we can afford it because of our scale.

Okay. Very exciting. Thank you.

Josh Pokrzywinski of Buckingham Research.

Hi, guys.

Morning, Josh.

It's Kevin on for Josh. How are you?

Kevin.

A follow-up on another question. How would you guys characterize 14 SEER versus 13 Sun Belt mix now? Is the region mostly converted from your perspective? What are you guys hearing on inventory availability?

Yes, I would say we pretty much have reached the end of our 13 SEER transition. Most of our inventory has been sold through, and we are seeing our sales mix switching to 14 SEER.

Got it.

And 16, we are growing 16 too. Go ahead. I'm sorry, Josh.

That's okay. Anything else and what you're hearing as far as availability of inventory?

There is no availability issues.

All right. Thanks, guys.

(Operator Instructions)

Justin Maurer of Lord Abbett.

Morning, guys.

Good morning.

Just to beat the IT dead horse, sorry. You guys have talked about in prior calls that this is, and to your point, Al, an ongoing evolution of the Company and that this spend [is there]. Would you argue that it's more incremental at this point than you might have thought three, six, nine months ago?

Incremental? I'm not sure I understand.

I know others have asked you in prior calls about IT spend. You've said, hey, this is the culture of the Company. We're always looking to do that and it's more called out this time as to --

Oh, I see what you mean. Yes. Our approach to technology has been don't rush into software or tool or some idea. Be very slow about it. And that's probably the first couple of years of this technology effort. We weren't really spending a lot. We were really studying it. So, yes, I think it is scaling up because we have done that. We have taken a lot of time to see what it was that we could do. Some of the software we designed and code ourselves. Some we buy. It's been very slow at the beginning, and that's why I'm saying now, we think we have a great direction.

Of course, this will change from time to time because new stuff will come in front of us. We were very slow at the beginning and wanted to be to make sure that we understood what we were getting into. AJ Nahmad, who's the guy that leads this effort for us, he is a very deliberate manager, and that's the way he's done it. I think he has done it the right way.

And would you -- I'm sure this is a tough one too. How would you think to categorize the spend or the benefits going forward in terms market share and visibility for you and your -- both customers as well as suppliers? So it will take maybe longer for it to manifest itself into numbers that we see versus productivity improvements and labor savings for the guys in the field and other things that will be more visible in the next couple of years in terms of benefits?

You said that perfectly.

You did.

I think we want to have you present.

If you can, I really suggest you come down to the tech conference. There would be certain things we can't answer like when do the major benefits come? How is the spend going to change one way or the other? I don't think the spend is going to reduce. I do believe that there is just so much opportunity out there. There's so many things that we can do. I think that everybody is going to benefit. There is no one that is not going to benefit starting from the customer down to the Company's efficiency itself and ultimately to the shareholders.

The reason I like about it is it's such a huge opportunity and we are the guys in this industry that are on the innovative edge. The reason we know that is we talked to our OEMs, because they have to cooperate with it, and we see that we are leading it. They are cooperating with us as we ask for their data and that sort of thing. I am sorry that we're so vague about when is the opportunity coming or when is the spend going to start slowing. We just don't know, but it is a good thing.

I'm sure you can appreciate from our perspective it is tough when money is being spent and you are actually doing it to the long term as you articulate to the benefit of the business over time. Obviously, from our perspective the ROI --

Absolutely. I understand you have to do your models. We'll try to be helpful as we go.

One other quick one on the industry shift, on the efficiency side. Are you guys -- in terms of what you would have guessed this year of folks having three decisions, one, either replace the existing equipment with 13 or higher versus just maintain and just throw some dollars at their existing unit. Has that unfolded this year as you have thought? As you look to next year, obviously, their ability to find 13 is not going to be there, so it's going to be a mix up? But in terms of replace versus fix, has it gone like you thought?

Paul?

Yes, I would say it has gone pretty much in line with what we thought it was going to do. We continue to emphasize, obviously, all three channels: one, repair and upgrade to a higher SEER efficiency product, or maintain it with what is going to be a 14 SEER going forward. I don't think you can predict which way the consumer is going to go. Like I say, our strategy has always been to be strong in all three areas. I think in 2016 we are going to see that same dynamic going on that we have seen for the last four or five years.

I would add two points just as color. First, how is the consumer doing, is important to our business. And the transition has been nice for our business, but we are also seeing outsized growth in even the higher efficiency 16 SEER and above systems. So for us, at least at present, that is a good trend. That is a good sign of what is going on underneath our economy and our business.

The other, which I never get asked about but it's relevant, is we have 50,000 plus customers that owe us accounts receivable, and the quality of that portfolio is really at a quality that is probably the best we have seen in our careers. The quality of what is going on with our customers seems to be very strong. So those are good trends.

Just, Barry, one last one on the 13. The inventory you guys took on earlier this year and sold through, I think you've said that that's had negative gross margin implications for this year. So as that clears out, that is a tailwind for you guys next year? Is that true?

That's what's impacted some of our gross profit this year. Is it a tailwind? We will see when we get into next year.

Fair enough. Thanks.

Samuel H. Eisner of Goldman Sachs.

Good morning, everyone. Just a quick question on market share, particularly at the OEM level. If you look from what has been reported thus far through third quarter, it looks as though Ingersoll and Lennox growing in roughly the 13% range or low teens. I think Carrier was closer to around [7%, 8%]. Your growth rate seems to be matching up with that in North America. I'm just curious if you can talk a bit about what you are seeing with regards to OE market share in the industry. Any shifts that are going on there that we should be mindful of?

Sam, I'm going to let Paul answer that. But don't forget our consistency. Some of these other businesses have had ups and downs. We're just consistent in a growth level. Maybe some of these others had bad previous sales, and now, of course, they're catching up. Go ahead, Paul.

Sam, that's a real tough question, trying to compare what goes into the channel versus what Watsco. Everything Watsco reports is a sale to a consumer or contractor or an end user. Whereas when you're talking the OEMs, you're going to have to ask them the question directly whether or not -- how much of it is going into channel load or channel fill versus how much of it is actually sold all the way through to the consumer. I don't know that answer. Only they would know. I think we are a good indicator of what the market is. I think, looking at what our sales volume has been and what the industry numbers that have been reported, I feel pretty confident that we've gained share on the sell-through side.

If you look at your business, whether it's any particular brands, do you see any changes on a year-on-year basis or nine-month basis with regards to sell-through of any particular brands?

I don't think we want to comment on particular brands.

Understood. Maybe just overall in the M&A environment, obviously you guys are increasing your dividend by 20% plus on a go-forward basis. Perhaps you can talk a bit about capital allocation and the opportunities for M&A? Thanks.

Sam, let me deal that one. We are very cognizant that we want to do further M&A activity. Now, we've had some frustration in recent past because -- it's not that we don't want to do them, but we just couldn't get sellers to want to sell. I am hoping that as the industry is recovered that will change, and so we want to keep our balance sheet very strong and capable of doing any size transaction. It's not a lack of desire to do it. It is hoping that as the industry has recovered that more sellers will come to us. We certainly are going to do every bit of M&A that we can.

Appreciate that. We'll see you down in Miami in December.

Good.

Jeff Hammond from KeyBanc Capital Markets.

Good morning, guys. Just a couple quick follow ups. It sounds like pricing holding up as you thought. What are you hearing from OEMs about 2016 pricing? How do you expect to react to that?

Really not hearing much OEMs on 2016 SEER pricing right now. Everybody's been pretty much focused on the 14/13 SEER transition state that we have been going through, and seeing what sort of support the 14 SEER pricing would have. If that, obviously, is going to be relevant the 2015, 2016 and 2018 SEER product pricing going forward.

Paul, I was actually asking about just have you gotten price increase announcements heading into 2016 in general?

No. Not yet.

Okay. It looks like the JV income is roughly flat, and I think someone mentioned Carrier growing 7%. I know you don't break that out. Is there anything on the cost side where you're not necessarily seeing the leverage in the JV near term?

Boy, I would have to see your math, Jeff. We did see growth in EBIT in the JV. Canada would be the exception to that in the quarter, which I've kind of quantified for you.

Okay. Thanks, guys.

This concludes our question-and-answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

Thank you again for your continued interest in our Company. I look forward to bringing guys up to date as we progress. Bye now.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.