Watsco Inc (WSO) 2016 Q3 法說會逐字稿

Good morning and welcome to the Watsco third-quarter 2016 earnings conference call. All participants will be in listen-only mode.

(Operator Instructions)

After today's presentation there will be an opportunity to ask questions.

(Operator Instructions)

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

Hello. Good morning and welcome to our third-quarter conference call. This is Al Nahmad, Chairman and CEO. With me is AJ Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Senior Vice President.

As I always do, I like to read the cautionary statement. This conference call has forward-looking statements as defined by SEC laws and regulations, that are made pursuant to the Safe Harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements.

Now, for the news. Watsco delivered solid third-quarter performance. Growth trends improved after a slower-than-typical start to our selling season.

We achieved record sales, profits, operating margins, and earnings per share, while continuing to make significant investments in technology. Over the last 12 months, we generated terrific cash flow, or $268 million, which is equivalent to $8.22 per share, far exceeding our net income. As a result, we have reduced debt over last year by $86 million, and recently increased our annual dividends by 24% to $4.20 per share.

As mentioned earlier, we've continued to invest in several innovative technologies to transform our business, and more importantly or as importantly, and that of our customers into the digital age. The annual run rate for tech spending remains at approximately $23 million. During the nine months, incremental tech spending had a $0.06 impact on our results, and $0.01 for the quarter.

We see early progress on technology as our customers in our organization adapt to our new technologies. Examples are, an increase in the number of customers that are using our apps and using our e-commerce to gain speed and efficiency. We also continue to build the largest source of digitized HVAC product information, which now holds over 400,000 SKUs, mastered in our database.

Our supply chain initiatives have helped inventory terms as evidenced by our cash flow. More of our 568 locations implemented technology to fulfill orders more efficiently and save our customers time. Using our business intelligence platform, our employees are using data analytics to gain more insight into operations.

Now, we are excited about what is happening. The spirit of creativity and innovation at Watsco is at an all-time high.

We want to remind everyone about our second annual technology conference. It is a meeting for institutions and analysts in Miami, on December 9 of this year.

AJ and his team will provide a technology overview and update. We hope you will join us in person or by webcasts. Let Barry Logan know if you would like to attend.

Let's get on to our results. For the quarter, sales increased 5% to a record $1.24 billion, 6% on a same-store basis. HVAC equipment increased 7%, including the continued movement towards higher-efficiency systems.

Other HVAC products increased 2%, and commercial refrigeration products increased 7%. Earnings per share for the quarter increased 9% to a record $1.78. Operating income grew 8% to a record $119 million.

Our operating margins expanded 20 basis points to a record 9.6%. In SG&A as percentage of sales improved 20 basis points, an all-time low. For the nine months, sales increased 3% to a record $3.31 billion.

HVAC equipment increased 4%. Other HVAC products grew 1%, and commercial refrigeration products increased 7%. Earnings per share increased 4% to a record $4.32, and operating income increased 2% to a record $288 million.

Operating cash flow for nine months increased 47% to a record $146 million. Debt was reduced $48 million during the quarter, and $86 million over the last 12 months. As a result, our balance sheet remains conservative with a debt to EBITDA ratio of under 1 times.

We expect a further reduction -- let me say that again, we expect further reductions of debt by the end of the year as the fourth quarter is a seasonal period for positive cash flow. Now, to our outlook. Our outlook for the full-year 2016 is earnings per share to be within the range of $5.15 and $5.20.

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

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

(Operator Instructions)

Matt Duncan, Stephens Inc.

Good morning, Matt.

Hey, good morning, guys, this is Will on the call for Matt. Can you talk about your sales trends throughout the quarter, and what changed in the market from the end of July, when sales were trekking up roughly 10%, and what happens through to the end of the quarter?

Generally, we don't like to talk about month to month, but we can give you a sense for the quarter and how it trended. Paul?

The quarter started out very strong and then we just saw some -- a little bit of a slowdown in September where things started to just back off a little bit. Nothing serious, nothing dramatic, it just didn't sustain itself throughout the entire quarter the way it started out in July.

Were there any geographies or regions that were noticeably weaker than others that might have stood out to you?

No. Not really. Obviously, there are differences between regions, but nothing material.

Okay. And on the pricing front, on 14 SEER remains steady in June, did that continue throughout the quarter as well?

Yes, Sir. We're not seeing any deterioration right now in pricing. We're seeing it withhold itself.

Okay. Great. Thanks, guys.

Hopefully, we'll see some price increases.

Appreciate it.

Jeff Hammond, KeyBanc Capital Markets, Inc.

Good morning, Jeff.

Good morning, guys. So, I think you're continuing to talk about a $23 million kind of annual run rate, so does that put us up like $3 million or $4 million year on year, is that the right way to think about incremental cost in 2016?

Didn't I report that number? The incremental spending for the year? Remind me, Barry.

For nine months, it's around $2.9 million, so I would peg it right around $3 million, Jeff.

And then is that a number that you think is up incrementally again in 2017, or do we start to level out or even see it back off?

Well, this question has been asked in prior calls, and my answer to that is that we will not set ourselves a certain figure, but more set ourselves according to the opportunity. We just think that there is a dramatic change going on in the entire United States economy, but we want to lead it in the HVAC distribution industry. So, we will focus on opportunity that we think will have a proper return.

Right, but as you look at the pipeline of opportunities, does that --

(multiple speakers)

It changes all the time. We have, for example, Watsco Ventures, and if any one of those things -- well, I don't speculate too much, but we are very excited about the possibility, and I emphasize possibility, of a breakthrough in Watsco Ventures.

Okay, and then just stepping away from that -- I mean, it sounds like, in general this year, mix has been favorable, and I think the industry has at least been able to get some price. But even if you back off some of these tech spending, your leverage on your sales growth is coming in a little bit less than normal. Maybe just help me understand what's going on there.

I will give it a try. I don't know that I agree with your conclusion but Barry?

Jeff, first of all, there are some investments that go beyond just technology. You know, there's a commercial product, VRF, that has been launched, and it has required hiring of people and a team, and market coverage and brand support across, really, all the Sun Belt markets for Watsco. Would be one example of some SG&A that is being invested in products.

There are also five new branches this quarter, for example. There's SG&A that applies to that initiative, that's expanding the network. And so, investment is not just technology story, there is also some, certainly, some business investments going on.

And, Jeff, just going back to your technology question, at last year's investor conference we had 15 minutes of conventional discussion and two hours of technology discussion. And laying out the opportunity, laying out the initiatives was its purpose last year, and this year we'll lay out the same concepts and develop it even further. So, not to put you off on answering your question, but obviously we'll spend a lot of time and you'll get a lot of substance out of the Investor Day.

Jeff, it's warm here in December.

(Laughter)

But I also want to point out, Jeff, I read something in your report this morning, in terms of new residential construction. I've said it in the past, and I continue to say it, we are an aftermarket business by focus, and the new construction business runs 10% if not less. So, let's not get carried away with new construction. For example, I believe higher interest rates eventually will come up, that's why you see us retiring debt, that's why you see us focusing on the aftermarket. That's what we've always been.

Okay, just a quick one. Any impact, favorable or unfavorable, near term, medium term from Hurricane Matthew?

Well, it used to be when you had a hurricane, it would materially move the needle for us, but that doesn't happen anymore. Because the Company is so big and spread out over the United States. Of course we will have some benefit of replacing the systems that need replacement, but overall, given our size, I wouldn't think it's going to move the needle that much.

Okay. Thanks, guys.

Jeff, congratulations on Cleveland tonight.

Thanks so much. Go Tribe.

Ryan Merkel, William Blair & Company.

Good morning, Ryan.

Good morning. So the first question I had is, it looks like the big issue for the quarter was the non-equipment, the parts and supplies, the growth rate was only 2%, and that follows, I think it was down 3% in the second quarter. So, just talk about what the puts and takes are there, and why didn't we see a bigger lift in the growth rate for that part of the business?

Go ahead, Barry. Or Paul.

Of course, Ryan, in the US, there was a stronger market, because of the 2%. And we saw some international weakness in that market, and I think that's just the timing in terms of how that business operates in international markets.

So, US was a stronger market. And I think in some of the potential inflation that we might see in that market is something maybe in front of us versus what we saw in the third quarter, and so those products, again, have not broken out in terms of, I would say, pricing the way that maybe the equipment business has.

The last thing I would say is on parts, whenever we have a growing equipment business, the parts business itself has some weakness in it, which we do not mind given the strength of the equipment margin in total dollars and so on, so there is about 120 product lines, 600 vendors in that category, so, a lot of moving pieces. That would give you some color.

Okay, and just a followup. The international weakness, is that primarily Canada? What else would you include there?

We have really two businesses, we have Latin America, primarily export in Mexico and Canada. I would say it's really spread equally across those two markets.

Okay. And then organic sales this year looks like it's going to be up 3%, 4%, which is the slowest we've seen in about four years.

So, I'm wondering, do you think this reflects that kind of demand is potentially running out of steam, or is this just rough comparisons after a few good years of growth? How do you think about that?

Let me start with, and then I'll turn it over to the two of them. The established systems in people's homes is $90 million.

Those are machines. They will wear out. And they will need to be replaced or repaired.

And the refrigerant is changing, which means there will be more replacement. There are all kinds of huge force factors causing this replacement cycle to continue, as far as I can tell, for years to come. I don't believe there is any better place to be than in the replacement market of air-conditioning and heating.

That is not the same with new construction. But as I said earlier, we are in the aftermarket, and that's our focus and we're getting better at it. So, I would not see any lack of opportunity long term in aftermarket.

I would see a strong ongoing opportunity. And Paul or Barry, do you want to add to that?

Yes, I think on the resi equipment side, at least, we have a little bit of a tough comparing than last year, we were still showing the dry charge 22 units. And to Al's point, when I net out that old business, it's -- basically it's gone away, and I look at our 410 sales, up double digits, low-double digits, which bodes well for the replacement market going forward, I think.

Okay, so as far as you can tell, it's steady as you go, cycle is not running out of steam --

Not at all. Not at all.

Just lastly, and I'll pass it on. A few of the HVAC OEMs have announced increased price increases for 2017, are you seeing this, and do you think that price increases stick?

Paul?

Yes, we are seeing the same price increases that the OEMs are announcing, we represent most of them. Do we hope they stick? Obviously, we hope they stick.

It has always been kind of a wait-and-see as far as we're concerned, whether or not they hold or not. Right now, everything looks very good.

Okay. Very good. Thank you.

Sure.

David Manthey, Baird & Company, Inc.

Hello, David.

Hey, Al, how are you? Good morning.

It sounds like the strong cash flow that you saw this quarter is not just a timing issue but your technology tools and other improvements are leading to more lasting change there. Could you talk about longer term, do you have any working capital goals that you could share with us?

Well, we have a -- an inventory software system that last time I think I reported on, it was into this part of our business. It still continues to be in part of our business, because the installation and the adoption takes time, and I think that will continue to impact cash flow. Do we have a goal in mind?

I don't know, Barry. Do we have a goal in cash flow?

Our standard goal has always been (inaudible) over net income. Do we have anything beyond that?

Yes, we've stated as inventory terms historically, been around four times, and the interim goal after technology was five times. Which is 20%, 25% reduction in inventory, and as we've said in the call, a 30 basis-point improvement against the 100 basis-point goal that we have. And as Al mentioned, it's not fully implement across all of Watsco's business units and locations.

So, it is nice progress that the cash flow story long term, also long term can become a cost story, where what cost associated with carrying less inventory can we achieve in terms of reduction. So, that's probably a longer-term story, and it's certainly part of the potential and part of the intent through all this new initiative.

Okay, and as it relates to the refrigerant, I guess this HFC thing is, it seems like it's out there a few years, and I guess R22 pricing continues to push higher. Looks like your placement trends are very strong right now. Any reason to believe that, that trend shouldn't remain intact, or maybe even get more -- I know you answered that question earlier, but I just want to reiterate. It sounds like (multiple speakers) are lining up for replacement, continue to outpace repair in the near term. Is that (inaudible)

Let's give it to Paul Johnston, since you've heard from Barry and I.

Yes, I think the trend is going to continue long term. We definitely have seen not only seen the pricing of 22 to go up, but also the availability of 22 going down. So, with this vast population of R22 in our installed base, obviously I think it's going all have to be replaced with 410. I feel very, very bullish about the replacement market -- at least for the next four to five years.

Last question, if I can. Despite the incremental tech investment that you're making here, which seems to be on a year-over-year basis diminishing in terms of magnitude. If you grow to mid-single digits, give or take in 2017, should Watsco return to double-digit earnings growth?

Well, it always has. We leverage our sales into a higher growth rate of either, and I don't see why that should not continue, and then of course the offset to that can be the incremental technology spending. As I said earlier, and as I said in prior conference calls, everything we think about is long term.

So, we're going to take this technology thing and change -- change what we do, help our contractors be much more efficient and more loyal to everything that we're doing and that's just the goal. It's a long-term goal. So that's the variable -- how much are we going to spend for that.

Eventually, these things that we spend produce -- produce something. Right now, we're seeing the benefits in cash flow. We're seeing the benefits to our contracts as they are getting and picking up their products much quicker.

They're ordering anytime they want now, seven days a week, 24/7 on e-commerce. There are all kind of things that are in the initial adoption, so that's the only caveat. I just think that we have got to continue to look long term on investment spend and just follow the opportunity.

All right. Thanks, Al.

Robert Barry, Susquehanna.

Good morning, guys.

Morning.

Nice to see the IT investments start to read out into the cash flow.

Yes, I think that is going to continue.

I wanted to start by just following up on a point I think Paul made earlier. Did you say that the, X the R22, the 410 sales were up low double digits? Was that in the quarter?

That was in the quarter, yes.

So, like, several points plus of headwind on HVAC equipment from that R22 comp.

Just when you make the comparison from prior year. I'd consider it to be very strong that it's up double digits -- the 410 is, all by itself, year over year.

Yes, me too. And I guess a little surprised to think that the lap in the R22 could have such an impact on slowing it down in the quarter. But, okay.

I had a big picture question, so externally, a lot of us look at this Hardy data, and I know you guys are not in Hardy and a lot of the big players are not in it. Those little guys seem to be growing very quickly.

In the quarter I think they were up about low teens and year to date it has been quite strong as well. So, just curious, from an industry perspective if you had some comment on reconciling what appears to be very strong growth among a lot of these little players versus what you are seeing at Watsco.

Go ahead, Paul.

I haven't spent any time even trying to reconcile. I don't know what their database is, what their geographic locations are. You know, it's wonderful that they've grown, but Watsco is a national company.

We have our consistent financials that we have to report year after year. So, it just isn't something that we follow. I don't know what the sales mix is of those people.

Yes, okay. I could follow up with you online in more detail. Quick question, a housekeeping item on your outlook, your EPS outlook. Does it include the tax benefit this year from the FASB change, and how much is in there -- is it $0.06 or $0.08?

Again, the answer is yes, Robert, for the quarter, for the fourth quarter, there's very little benefit to, so most of what you've seen year to date is what it will be.

Got you. And then just finally on the parts and supplies business, R22 availability, refrigerant availability, there was some talk of some other vendors of not having it at weighing on growth. Was that a factor at all impacting that part of the business?

No, it wasn't. There is a couple of drop-in replacements for R22 that are available from the three big refrigerant manufacturers, so you can get it. It has a slight degradation as far as the capacity and the efficiency of the equipment, but it is available.

(multiple speakers)

A year ago, we had a short period to sell R22 product before manufacturers wouldn't make it anymore, and we did have a real nice bump from refrigerant-free equipment last year, and that's the comparison this year, that's what Paul is saying. We grew double digits in equipment sales this year, but when you compare it to the prior year that had refrigerant-free equipment, that we could sell before the deadline, we didn't have that repeating this year. But fundamentally, if your equipment sales are growing at double digits, that's a very healthy thing, we believe.

Yes. Agreed.

I'll see you in December. Thank you.

Great.

Chris Dankert, Longbow Research.

This is actually Josh Nelsen sitting in for Chris. Of the equipment sales growth, how much of that was volume versus pricing in the quarter? Thanks.

Paul?

Most of it was volume. We had some price pickup, obviously, as we switched over to the 14 SEER, but we also had a lift in unit sales.

All right, perfect. Thanks.

Walter Liptak, Seaport Global.

Thanks, good morning, guys.

Morning.

I wanted to ask about the tech spending, and the $23 million that you're spending in the smaller incremental for this year. I've done some work, and it looks like the rule of thumb is like tech spending of 1% to 2% of revenue, which means that you are under spending, kind of (Laughter)

I think AJ really likes that.

(inaudible)

Do you bucket it differently, is there an innovative IT spend that is in that $23 million, and maybe branch spend that might be more like ERP system or software implementation that's a different bucket?

Why don't we have AJ answer that?

The answer is yes, of course, we have visibility into exactly where dollars are being allocated. And the growth in spending over the last several years has been on new platforms, new technology to enhance the customer experience and help make our operations more efficient and more profitable, and hope to create some new profit streams through these Watsco Ventures programs, which are going to have a little more speculative at this point. But yes, we have visibility to that, of course.

Okay, but I guess the question is, does the $23 million is that just the innovative corporate IT spending, and if there is other spending at the branch level, how much are you spending -- is there an incremental spend going on there?

It is not just the new programs, but the spending at the branches and in the ERPs are now of course influenced by the new programs and technology, so, they should be looked at as a whole because development is part of ongoing programs.

Okay, great. All right, thanks, guys.

Joshua Pokrzywinski, Buckingham Research.

Good morning, Joshua.

This is Matt on for Josh. Just wondering if you could help us understand your equipment growth to 7% a little bit more, given that Carrier just reported 11% growth in residential.

Barry or Paul?

I have no idea what Carrier reported.

There is a global sales anyhow I presume.

Yes. We're just talking domestic.

I saw in their slides, at least, North American residential up single digits, so that's the reference point that I saw in there in their disclosures this morning.

Okay, I guess we'll follow up with you on a call later.

(Operator Instructions)

Robert McCarthy, Stifel.

Morning, Robert.

Good morning, how are you doing? A couple of questions.

One, just thinking about from a messaging standpoint, you came out with articulating your guidance for the full year in the third quarter in years past. You've done it as soon as the first quarter or second quarter, depending. Was it something specific about this year that may have made you reluctant --

Yes, that's a good question. Yes. We noticed, it doesn't happen very often, that late season it didn't occur in the second quarter. So, we were very conservative and said so at the last conference call that we were not going to provide outlook until we got a better fix on it.

We didn't know whether it was a late season or something different than that, and as it turned out, it was only a late season because the (indiscernible) very strong beginning of the third quarter. And now that we have a better feel for things, we're providing [to date]. We don't like to reach out there unless we have a good sense of it.

Right, so that'll be the driving factor going forward, how I would think about it, in terms of the cadence of when you give your full-year guidance.

Yes, I would say, generally speaking, around the second quarter, yes. Good question though.

Obviously, listen, underlying demand and sales sound pretty good, particularly given that in the context the R22 compares and we've kind of picked over the bone around the trends of the quarter.

I guess, longer term, in terms of the technology spend, could you comment on -- are you doing anything on the sensor side with basically trying to create intelligence in the products you sell into the home from that perspective? Because we've heard that some big box retailers and also some component suppliers are actually looking into that, to basically get a better sense of the installed base by the idea of would be putting in something that would wake up the Wi-Fi and then all of a sudden you would have a much better sense of the use of life, whether the machine was -- or the equipment was put in properly, getting a lot more data around that --

You know somebody working in our company that's giving you our information?

(Laughter)

I'm going to laugh. Hardy har har. But I guess anything you could talk about that, or anything along the lines of what you're doing with the utilities that is kind of innovative.

AJ. Go ahead, AJ.

Yes, that's the real fun part of the Watsco Ventures vehicle that we've created is that we get to dream, we get to explore, we get to learn about what others are doing, we get to try some things internally and of course, IoT, the Internet of Things, is very much on our minds. I'll answer this question a little generically in that if and when, I think it really is a when, all of the HVAC systems in the country or the world are connected and there is visibility into the data and the health of the systems and the ability to measure and monitor and meter those systems, it can only be a good thing for us.

Because we are very well positioned to leverage that data and build business models on top of that data for all stakeholders. So, yes, we love that idea. Some of our OEM partners already have some of that measuring and monitoring technology in their highest-end equipment, and there is some fun stuff happening in the Watsco Ventures portfolio where we are also thinking of taking a deep dive into that.

I'll leave it there for now.

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

Well, once again, thanks for your interest in our company, and we'll speak to you at the end of the year when we have our year-end numbers ready for you. Bye.

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