Watsco Inc (WSO) 2019 Q4 法說會逐字稿

Good morning, and welcome to the Watsco, Inc. Fourth Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Albert Nahmad, Chief Executive Officer and Chairman of the Board. Please go ahead.

Good morning. This is Al Nahmad, Chairman and CEO. And with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Executive Vice President as well.

Now before we start, our cautionary statement as usual. The conference call have forward-looking statements as defined by SEC laws and regulations that are more pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements.

On to the report. Watsco produced another record year with sales, net income and earnings per share reaching record levels. We also produced record cash flow of $336 million, representing 114% of net income. Reflecting our confidence in our business and as supported by our strong cash flow and conservative balance sheet, we announced this morning an 11% dividend raise to $7.10 per share starting with our next regular quarterly payment in April of 2020.

We continued to invest last year in our industry-leading technology platforms. Interestingly, today we have nearly 20,000 customers that have embraced our technologies.

For our most active users, annual sales growth rates are higher with considerably less attrition over the year. We have intensified our efforts to drive greater use and widespread adoption and to develop new features and functionality that our customers are asking for. Technologies to improve operational excellence and to drive efficiency are now implemented across all of our legacy U.S. locations. These internal-facing platforms were built to increase the speed and efficiency of fulfilling over 7 million customer orders per year and to optimize our inventory and supply chains. To that end, we improved operating efficiency during 2019 as evidenced by same-store SG&A performance.

Our long-term goal remains the same to develop the industry's most attractive and customer-obsessed technology platforms, which revolutionize and transform our business is done. We again invite each of you to come to Miami, spend a day with us and learn more from our team.

2019 was also an active year with increased M&A activity. That is summarized in our press release that we published also today. We added 3 new operating companies to our family, DASCO Supply in New Jersey, Peirce-Phelps in Philadelphia and N&S in New York. These are wonderful companies, and we are honored they choose to become part of Watsco. It is Watsco's culture to empower each of these companies to operate under their historical leadership, same team and name with a deep respect for their entrepreneurial culture from us. What we ask for in return is growth. We provide the resources they request, including capital, technology, equity incentives and access to our vendor relationships. These companies contributed to 2019 performance and were accretive to our bottom line. We remain very active in the market and are in contact with other owners of great companies, and we do expect to accomplish more this year.

With the avid modern technology, we believe it is an opportunity -- or I should say, an opportune time for independent distributors to join the Watsco family since our resources can help them develop scale much faster. We also made large investments in areas of Watsco's culture and that are important to us in long term. We increased our 401(k) match and equity-based compensation to expect ownership -- to expand our ownership culture, promote continuity, retain talent and incentivize long-term thinking. As important, if not more important, we also enriched our employee wellness program to encourage good health and preventive care. These investments will help attract and retain the industry's best talent. Our press release provides important details about our financial performance. I will not recite these details in my prepared remarks, but we'll be happy to provide more color during Q&A.

With that, A.J., Paul, Barry and I are happy to answer your questions.

(Operator Instructions) Our first question comes from Jeff Hammond with KeyBanc Capital Markets.

Just on the SG&A line, it seemed like last year you had kind of a number of onetime items. So I was a little surprised that bumped. I know there's some M&A impact in there. Can you just speak to any kind of moving pieces that elevated that number?

Barry?

Sure. Jeff, well, you have to look at things on a same-store basis, and we do -- we show that in the performance data. So on a same-store basis, SG&A was up 1%. And so if you look at that in terms of the overall picture, still a very moderate growth rate despite some growth going on, some investments going on and so on. So I think, overall, we ended the year with the exact same percentage, up 1% on a same-store basis, including technology, including the investments that we highlight, including some transaction expenses for our M&A activities. So if we account for those and exclude them, I would say, the base business itself actually had pretty flat SG&A, both in the year and for the quarter.

Okay. And then I think a number of guys have talked about kind of weather headwinds into 4Q and maybe early into 2020. Can you just maybe speak on early trends into the year?

Paul?

Well, Jeff, it is really early to talk about early trends in 2020. Yes. The year is starting out like it finished in the fourth quarter. But January and early February really don't give us a strong indication of which way the market is going to blow for the entire year.

Okay. And then just last one. It looks like you guys raised the dividend. You're kind of bumping up against kind of a 100% payout of your free cash. And just maybe speak to the rationale of kind of moving that up and your comfort level, kind of given the payout ratios.

Well, Barry is our expert on that.

Sure. Well, Jeff, again, the source of dividend is our cash flow and it was record cash flow this past year. And if you look at free cash flow, there's still, obviously, room between the dividend we're going to pay this year and the free cash flow that we just produced. So as we really look at the past cash flow, the forward-looking cash flow, where I think we have opportunities to have another very strong year for free cash flow. And that's the objective and that's how we look at it.

The next question is from Ryan Merkel with William Blair.

So first off, what explains the big year-over-year decline in gross margin in the fourth quarter? I think mix is probably part of that answer, but maybe just walk us through that.

Well, spotting that, we have an issue going on with pricing from 2 large OEMs and we are engaged with them to see if we can have some action on pricing that might resolve that as well as what you stated.

Maybe you could dig into that a little bit more out, what's the issue with the large OEMs on pricing, exactly?

Barry, you want to deal with that?

Sure. Ryan, well, again, if you think about the last few years, we've had probably more pricing volatility in the market than ever. '17 into '18, '18 into '19, and now we look back and look at margins and look at the -- really the forward-looking margin profile that we seek to operate our business. So given all the volatility and the realities of the last few years, we take the data, we examine the data, we present the data, we act on the data with our OEMs. And that's what we're doing.

Okay. So I guess should we be extrapolating this weakness into 2020? Or is flat gross margin the goal in 2020?

Excellent question. But like I said, it's work in process, but we're very optimistic that our margins will be recovering, our gross margins.

Got it. Okay. Maybe just lastly, I just want to ask on Florida. What were industry shipments in 2019? What was the growth? And then what are you forecasting for 2020? That would be helpful.

Are you a forecaster, Paul?

No, I don't try to forecast. Just in the history, that's a fool's batman. But we do know what occurred in the prior year to the industry in total for the U.S., and it was a very flat year for the industry as far as what the industry shipments were, both on gas furnaces as well as residential splits.

Okay.

Just to add to it, Ryan, not to leave you hang completely on that. We said earlier in the year that really our Eastern markets, and Florida being the largest, have performed and behaved well from a sales and growth point of view. We'll measure market share when we have the data ourselves for our individual markets. But Florida, North all the way to the -- up to the Eastern seaboard had better than overall growth rates. And like we said, I think last quarter, really the middle part of the country was the more irritated market, but this idea of consistent irritation or whatever we said last year about Florida in 2019, we said we'd react to it. We said our -- we pushed our OEMs to come to the table and growth rates were, as I said, better than average in Florida this year.

The next question is from Robert Barry with Buckingham Research.

Just kind of curious, a little more color on why growth in the quarter was only one. Was that the middle part of the country pulling it down or the Northeast? Just a little more color there would be helpful.

Barry?

Sure. It is, Robert. It's -- again, eastern part of the country, stable and stronger; and middle part of the country, not as -- or obviously weaker in terms of the outgrowth.

Yes. And then middle part, is that just a weather factor? Or what's causing it to be weak?

Yes, we'll examine the data when we have it state by state. The industry hasn't sent that to us yet, so I can't comment on it. But all summer long, I think it was pretty tempered in Texas, which is our biggest market in that part of the country. And it is what it is at this point.

Got it. Just a follow-up on the gross margin question. When you talked about the issue with pricing, is that have to do with -- anything to do with rebates you're getting? Or would you like those OEMs to be more aggressive on pricing and they're not being as aggressive? Or just trying to see what you mean by that issue?

I think it's best not to comment on that since these are ongoing discussions and negotiations.

Got it. I guess just lastly from me, question on SG&A, same-store only 1%. So really good performance there. Just curious, as you think about going forward, whether you think that is sustainable? And if that's the goal?

Well, why don't we ask the President of the company because we're -- he has been told he has an opportunity to develop technologies as fast as he can and as complete as he can. And so much of this SG&A expenditure could come from him. A.J.?

Sure. I think Barry said it well earlier. And you said it well, there is good performance on the SG&A line in 2019. We do think that's a result of efforts we've taken in leveraging some of the tools and technologies that we put in our leaders' hands. But with that said, there is more investment to come as there's good opportunity for investment. We are a long-term company. We -- our investments today don't necessarily have a 12-month ROI. We're investing for the years ahead. And that's true with all this technology spending. This is not all just an offensive program. This is a, you can say, defensive program as well, where we are really shoring up the quality of the company we are with the latest and greatest in tools and technologies and people and processes. And while these may not have an immediate impact on our financials, we are a stronger company as a result of them. So where we see opportunities to invest more, we will.

Got it, got it. So just to make sure I'm hearing you correctly. It sounds like maybe same-store SG&A of only one is a little -- maybe too low given all the opportunities you see to invest on the technology front.

Well, it's hard to say because as these technology investments proliferate through the organization and have impacts on our efficiencies, we should see results as far as lower SG&A spend, but it may be offset by future investments.

The next question is from David Manthey with Baird.

So first off, relative to the question on free cash flow and dividends and acquisitions, could you just refresh us on the company's philosophical view on leverage? And is there an upper limit to net debt-to-EBITDA that you'd be willing to run with?

I can't give you numbers, we don't like that. We have moderate debt, and we intend it continue that way. If our M&A program requires large investment, we'll solve it with the appropriate debt and equity at that time. But we consistently keep a conservative balance sheet in order to be able to deal with anything that comes along of some size. If there is nothing of some size that more of the size you've been doing, you shouldn't see any change in our debt-to-equity and the leverage part.

Okay. And second, looking at the other HVAC products category, it's been inconsistent and maybe a little bit weaker more recently. I'm just trying to understand the makeup of that business. I know there's construction-related products as well as repair parts and supplies in there. With the housing market doing better in a lot of units in this mid-teens age cohort, shouldn't that category be doing better overall? And can you just discuss what's happening there?

Paul?

Yes. It's -- that's probably the most -- the category that fluctuates the most for us as far as commodity prices as well as demand -- seasonal demand. So I don't think there's anything strange going on there. I just think that as we unbundle some of the China tariffs and such, we're going to see some fluctuations back and forth on that.

I mean what I would add is, it's roughly 80 product lines, if I thought about it, 600 vendors and a lot of moving pieces. As Paul said, it's a grab bag of both new construction stuff, but it's also parts. Parts would be the largest of the product lines in there. And to the extent equipment is growing at a faster rate, that's going to drive equipment growth versus the parts growth. But as I said, that's one of only -- only one product line within the bucket. So a lot of moving pieces there.

Okay. And then last question, if I could sneak one in here. On the -- when you're talking about the price cost dynamic and thinking about the coming year, should we be thinking that if nothing changes, price would be 0 and if your negotiations are successful, you could have a positive price outcome? And I assume the manufacturers are pushing through moderate price as they typically do. Is that the situation? Or am I not seeing that clearly?

Paul, you're with the OEMs mostly. What are you hearing about price to say?

Yes. Everybody is pushing moderate price increases through right now. All -- basically, the 6 big players out there, Lennox, Carrier, Trane New York, Rheem, Goodman have all pushed through single-digit -- low single-digit price increases effective January, February. So we're just getting into the season now to roll those up and see what sort of the impact they're going to have on the market.

The next question is from Chris Dankert with Longbow Research.

This is Brian on for Chris. I assume you're looking at just the tax spend in 2020, now will that increase? And is it safe to kind of assume the normal growth of increase you guys have seen in the past couple of years there?

I'm sorry, then -- Barry, did you get the question?

Yes.

And increase, yes. Go ahead and answer.

Yes, Brian. This is A.J. I think I've been consistent in that answer, which is we certainly ramped up our technology spend over the last few years. And overall, it's, I would say, at a steady state. However, where and when there's opportunity to invest more than an ROI opportunity, we're going to invest more because this is a long-term company.

Got it. That's helpful. And then kind of switching gears to the inventory entering into 2020. I know you guys previously mentioned you'd be willing to start above seasonal average as long as the balance sheet remained healthy. Is that still the case? And how our inventory is looking heading into 2020?

A.J.?

As far as inventory, again, that's a major initiative as far as the tools and technology go. We now have modern platforms to ensure that we're having the right product in the right place at the right time to meet expected customer demands. And that's a slotting location by branch, by business unit, math equation. So now we have the right tools, we've got great teams that are using these tools and our fill rates -- our customer fill rates have jumped significantly. So that's the first step, make sure we have the right product in the right place at the right time and the right quantity to fill customer demand.

Secondly is to take product out of our network that has not sold or is underperforming to free up cash flow to make investments, return dividends to shareholders, et cetera. So overall, that remains a focus in parallel with that or in tandem with that is that the supply chain, in general, from OEMs and their vendors, especially with what's going on in Asia right now. There's always -- or I should say, it's not 100% reliable all the time. So it's and when we think it's necessary to bring in some extra inventory to make sure that our customers have the products they need, those are investments we can make. The focus is on our customer needs.

Got it. And then just quick one. Final one here is, are you able to provide the price mix versus volume and the equipment in resi?

A.J., I think you've got a question.

I think that's probably Barry or Paul. Barry maybe?

Yes. Again, you can see the growth rates for our equipment business and obviously far more units than price in 2019 for both the quarter and the year.

The next question is from Patrick Baumann with JPMorgan.

Most of the good ones have been asked, but I'll try to do a couple. On competition, there's been one OEM/distributor talking about trying to win back market share lost over the past year or so. And I'm just wondering whether you're seeing any more aggressive behavior from any of your competitors in the market.

That's a good question. I think they come and they go, cycles in and out. Paul?

Yes. It's -- I would say, I don't think anybody relaxes on their competitive juices as far as being in the marketplace. Everybody is trying to grow market share, everybody is working hard to try to develop sales and sales growth. So I can't see where it fluctuates up or down based on what somebody said on their earnings call. It's strong competition in this marketplace, and it always has been, and I'm sure it always will be.

Okay, makes sense. And no change to that stuff. Maybe on the acquisition revenue, so it looks like it's contributed -- I don't have the exact numbers, but at least half of your revenue growth over the past couple of quarters. So I'm just curious if there's any margin implications related to that revenue coming in? I don't know what kind of margins these deals come in at? And if it's a drag on gross margin or operating margin, just curious if there's anything there?

Barry?

Yes. So from a gross margin point of view, no, they're neutral and in terms of gross margin. So that's not really a conversation. From an EBIT margin point of view, the businesses do come in with a lower EBIT margin historically. And our challenge and our -- where we want to invest in growth in these businesses is to change that. We don't touch cost, we don't the organization. We ask them to grow. We ask them to take advantage of our OEM programs. We ask them to expand their business. And that's where the EBIT margin development comes from looking forward. So this first year will break out things on a same-store basis. They are dilutive to margin -- to EBIT margin in the short term. And the medium and long term, though, we look to have them grow and raise their margin to kind of the Watsco type margin.

Got it. And then last one for me on -- maybe back on pricing. Just curious, like do you have a view on whether we're getting closer to a point where price -- pushing prices harder where consumers might consider repair versus replace more? Like, what's your view on kind of the tipping point there for kind of that switch in the consumer behavior? Are we close to that? Or how do you view that?

Paul, from the data you showed me the unit sales are higher continuously.

Yes, our unit sales continue to grow. I think that's a really tough question to try to get data around only because it's a product that we sell for a given price and then each contractor dealers that we have would represent whatever their installation cost would be. So there's a lot more things that go into an installation and then just the equipment cost. So I don't see any real elasticity issues on the horizon right now, at least.

And I would say, in general, then the big picture, the consumer is strong. Consumer data is good. Unemployment is low. And I think those have always been in our residential business the most important correlation. So I think this is a consumer product, and it is something people have to have, and what they spend is going to be based on really the quality of the consumer, I think, at the end of the day.

I'll also add, this is A.J. I'll also add that I believe there are more consumer financing options coming online than ever before. So making it more affordable for our homeowners to actually buy new equipment.

(Operator Instructions) The next question is from Blake Hirschman with Stephens.

First one, I could have missed it, but did you guys say what same-store operating margins look like for the year? I heard the SG&A and I assume gross margin is pretty similar to the overall, but just wanted to check and see.

Barry, you want to take that?

Yes. I think it's right around 10 basis point difference, organic would be about 10 basis points higher.

Got it. And then on M&A, the most recent deal you guys did had some plumbing. Should we be thinking about that as an area you might look to expand in? Or is that more of kind of a one-off?

That's a great question. When we find a dual product distribution and examine the profitability and the growth, we will not hesitate because there is a theory that eventually there'll be a convergence, but that's not proven. But if we see a business that's well-managed with great principles of business, we will not hesitate because they're doing well, why would we not continued to do well and just help them grow faster than what they have with providing more capital in branches and whatever else that they need. But we would not do one. I think that sound like a double negative. But yes, very good observation.

Yes. It's me and I'll just add to that. It's a 74-year-old business, run by the same family that started it. It's part of their DNA, it's part of what they do in the market, it's how they address their customer and they're more like it. So that's the reason number one, enough is to, as we always say, keep the continuity of that. And from a product or technology or convergence down the line, that's nice. But at the end of the day, we're really after to keep this great company that's been around for so long, simply growing and doing more of what it does well.

Aaron maybe teaching us how to do things, we don't know how to do with plumbing.

Got it. And as a follow-up there, is it more often than not, it's the same contractor putting in the plumbing and HVAC that you're selling to? Or does it kind of vary based on where you're at in the country?

Who want to volunteer for that one?

Yes, it does vary around the country. Go north, you're going to find a lot more plumbing and air conditioning contractors. I mean you get down to the south, you find it's more an air conditioning person and a plumbing person. But to Al's point, we are seeing some convergence, some overlap spreading throughout the country.

But Blake, also sometimes a business opens up a branch in a small market, and they can't survive with just air conditioning or HVAC products. So they add plumbing because the revenue needs that in order to survive in the very small market. We see that model too, which is pretty interesting. We do both and be able to sustain the service level by having a very more convenient service to the customer.

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

Once again, thanks for your interest in our company. Once again, please come visit. It is gold up there, those of you that are in the North. And we'd love to see you and have you get a firsthand look at what we're doing here in Miami. Goodbye now.

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