Watsco (NYSE:WSO) Q2 2020 Earnings Call

0:00 Good morning and welcome to the Wattsco, Inc. Second Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press stars and one on your telephone keypad. To withdraw your question, please press stars and two. Please note that this event is being recorded. I would now like to turn the conference over to Albert Nahmad. Please go ahead, sir.

0:31 Morning, everyone. Welcome to Wattsco's second quarter earnings call. 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. Before we start, our cautionary statement. This conference call is forward-looking statements as defined by SEC laws and regulations and are made in pursuit of the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. First and foremost, I hope all of you and your families are healthy, safe, and managing well. I'm pleased to say Watchco is experiencing a very busy summer selling season.

1:19 There are many heroic people in our company making an exceptional effort to serve and protect customers by protecting themselves. Our most sincere thanks to them. We also want to express our appreciation to our OEM and vendor partners who have done extraordinary things to react to the accelerated ramp-up in demand. Since our last call in April, a steady recovery began in May, and acceleration to double-digit growth occurred in June and continues into July. The growth occurred across our footprint and was driven by our U.S.

2:05 residential HDAC equipment business, which experienced 20-plus percent growth rates in June with similar trends in July. Homeowners are clearly investing in their homes as sales of replacement systems at higher efficiencies are accelerating. Sales of commercial HDAC refrigeration products, which were soft early on in the quarter, are now recovering. I'm also glad to report that our industry-leading technologies are contributing to our results and driving market share gains. Adoption and use of our mobile apps and e-commerce platforms have increased significantly as more customers use our technology.

2:50 Our best measurement of impact is that customers that use our technology generally are growing faster than non-users of our technology. Examples of our progress. Mobile app weekly average users has grown 34% over last year to more than 22,000, with 100,000 total downloads. New processes were introduced to provide rapid onboarding of e-commerce sales. So far this year, the number of e-commerce users has grown 14% in the number of transactions up by 12%. Our e-commerce sales run rate in June was 33% versus 29% in December 2019. And in certain markets, our e-commerce run rate is now over 50%.

3:45 It kind of shows the potential of this e-commerce platform. We also intensified the promotion of two other innovative platforms. They are called On-Call, I'm sorry, let me say that again, On-Call Air and Credit for Comfort. These two platforms provide digital support for contractors and homeowners and connect proposals for buying product and for financing replacement systems. Our contractors' fulfillment activities which we refer to as curbside or dockside pickup expanded to more locations and soon will include contactless payment functionality.

4:34 It is early, it's in the early days that adopting and growth has been terrific to this point. As always, feel free to schedule a Zoom call with us and we can further explain our technology in progress. We believe these capabilities provide a differentiated customer experience by engaging with us digitally in every way. We also believe a new standard for contractor service has been established, which will serve us well in the long term. Also during the quarter, we improved operating efficiency by reducing costs. Saints Store SG&A declined 7% with few store closings and loss of business across our network.

5:21 Our financial position is evidenced by our balance sheet strengthened during the quarter. We generated operating cash flow of $216 million, the highest of any quarter in our history. Over the last 12 months, we've generated $529 million in cash flow versus net income of $285 million. Dividends have been increased, and we have no debt at this time. Further financial analysis of our second quarter is provided in our press release. And now with that, AJ, Paul, Barry, and I are happy to answer your questions. Thank you. We will now begin the question and answer session. To ask a question, you may press stars and one on your touchtone phone.

6:08 If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press stars and two. At this time, we'll pause momentarily to assemble our roster. and our first question will come from Josh Pokrowinski with Morgan Stanley. Please go ahead.

6:29 Morning, Josh.

6:31 Morning, Al. Hope everyone's well. So I guess, you know, clearly some stimulus payments there, you know, help put up a very good quarter relative to maybe the broader macro. But, you know, any regional commentary from Paul that you can share, you know, either at the Watsco level or, you know, maybe industry observations that can help square up that performance?

6:55 We don't like to share reasons for competitive reasons, but Paul, what's the second part of the question?

7:02 Have we seen any other trends in the industry? Well, obviously, demand is high, and we're constantly focused on trying to make sure that we can maintain the inventory to satisfy our customer needs. That's been a battle for the last 60 days, obviously. Pretty much, you know, demand has been strong on the replacement side and picking up again on the supply side right now. And we hope it continues through the quarter.

7:40 Okay, thanks. And then just on the technology initiatives, you know, Al or A.J., I think most contractors, at least kind of the bigger, more stable ones, tend to use a couple different brands but are fairly sticky in that and not rotating around a lot. I guess does that mean with the share gains or outgrowth or however you want to track the technology, is it just doing more business with customers that are already doing something with Watsco and just can do more, or is it really causing folks to bring on a new distributor relationship?

8:21 Asia, you want to answer that? Yeah, sure. It's both. I mean, we touch a lot of contractors in North America. Some of them buy lots of products from us every day. Some of them buy just a little bit of product from us every once in a while. But those are all targets to get visibility and see the technology in action and what it can mean for their businesses. and that outreach to customers, whether they're small customers of ours or not customers at all, getting them exposure to the tech, helping them understand how different it is doing business with our companies versus our competition is moving the needle. So I guess to say it more succinctly, there are small customer of ours doing more business with us, and there are customers coming on board for the first time, and the technology is driving a lot of those conversations.

9:15 Another way to look at it might be, Paul, can you discuss share?

9:19 Yeah, I mean, for the second quarter, we definitely had market share increases. As you guys recognize, the industry shipments were probably down in the 10% range. for the second quarter, and our residential sales were flat, so that's a pretty monumental move towards an increase in market share. And in the front half of the year, the same numbers apply. You know, the market was down mid-single digits, and Wattsco basically was slightly up, you know, given what we did in the first quarter. So we're gaining share there. Proud to say we're gaining share in Canada.

10:05 Those numbers come out faster than the U.S. numbers, so we're becoming a force in Canada again. So I'm very happy to see everything that's happening from a sheriff's perspective.

10:18 That was a tough call. I'll pass it on. Our next question will come from Steven Vulcans with Jefferies. Please go ahead.

10:28 Morning, Steven. Hi, guys. Thanks for taking the question. I'm curious if you could comment a little bit around gross margin. I think that was a little better than some of us were expecting, especially given I think your mix is shifting a little bit more towards equipment, which I would have thought would be a margin headwind. So what's going on in gross margin? How should we think about that sort of going forward as business remains strong? Barry or Paul, somebody jump in with that one?

10:59 Steven, good morning. You're right. As equipment grows at a much faster rate, algebraically, our gross profit margin is impacted by that in terms of what you see optically on the face of the income statement. Also, as we get through a selling season and a busy time and making the efforts to sell products, price and margin and cost is an everyday, market-by-market, local competitive landscape. There's not one answer. There's 50 answers. There's 50 variables that are playing out every day. So this year is showing some improvement over last year in terms of trend, but still there's a lot of work to do on margin, a lot of work to do as we get through this select season and look into next year and beyond.

11:52 Okay, thanks, Barry. Is there any reason to think the second quarter was, you know, unusually a little bit better than it would be? Or, you know, how do we think about the trajectory going forward?

12:03 No, there's nothing remarkable or unremarkable about the second quarter, Steven, that would need commentary.

12:10 Okay, thank you. Our next question will come from David Manday with Beard. Please go ahead. Hello, David.

12:23 Hey, good morning, guys. Al, I believe that you said June and July month-to-date, the June all-in and July month-to-date were up 20% year-on-year. First, did I hear that right? And second, did you put that in the context of same-store daily sales for us?

12:45 That was good. I enjoyed that. Barry?

12:49 Sure. Well, Dave, yes, you heard right. And when we do comment on trends, we are adjusting for sales, Dave. Those are, you know, average selling day trends that you're hearing and the remarks.

13:04 Okay, and organic. And that was based on residential air conditioning size. Yeah, that wasn't based in total, no.

13:15 And the press release, you read double-digit growth in June. and Al's Remarks, you hear residential up 20. That's what you're hearing.

13:26 Got it. And that's same store daily sales. Okay. Second, looking at the operating expenses from the first to the second quarter, the reduction was impressive, probably the most impressive we've seen in Wattsco's history sequentially like that. You basically did $350 million more in revenues on $9 million lower op-ex sequentially. I know the company is very decentralized, but are there any major cost buckets you can talk about that drove that decline? I mean, that's really unusual and a big drop. All right.

14:10 Hey, David. Well, again, I can't invite you to our Friday Zoom call with 35 core managers across Wattsco. If I could, what you'd hear is what you said, decentralized challenges to constantly react to what's going on in the market. So it was not a Wattsco pen and paper session. It's 35 managers going out and prosecuting what they believe is important to take care of customers, employees. We had markets where revenues were untouched that needed to deal with a cost structure in that respect. We had other markets that were more heavily impacted. They cut costs and dealt with costs very aggressively in the short term. And so the good news is this was all a local lead and reaction to what's going on in the marketplace that drove the costs.

15:02 As a parent company, we certainly had the conversation, but it's all driven in the field.

15:07 Yeah, this is AJ. I just have to add, those 35 leaders or so have just been tremendously impressive during this whole period, and the 5,000, 6,000 people that work for them, just unbelievable effort and spirit, and they deserve all the credit.

15:27 Yeah, it's really impressive. Good luck, guys. Thank you.

15:32 And just to add, I mean, the corporate cost of Wapsco, corporate expenses, is under 5% of SG&A. So for any level of reductions going on in the field, you know, any reductions that you're seeing optically in terms of performance is all driven by them. So, again, once again, the credit belongs there. and our next question will come from Jeff Hammond with KeyBank Capital Markets, Inc. Please go ahead.

16:05 Hi, Jeff.

16:06 Morning. Hey, good morning. So, Paul mentioned, you know, inventory, you know, being a challenge. Just talk about, you know, we picked up on our check some of the OEMs, you know, kind of struggling to get product out the door and certainly, you know, maybe the expectation was demand was going to be weaker than it is. So, can you just speak about Your ability to get product, how quickly that kind of normalizes and how you're able to kind of keep up with these strong demand trends.

16:37 Well, we can't speak for the OEMs, but I can tell you they're doing their best. It's complicated to get their supply lines to accelerate. But they've done it. They're doing a pretty good job. And I... I don't think they're going to lay off. They're going to continue to support the demand, and God bless them. They're just great suppliers.

17:07 And not just the OEMs, but also the regular vendors. We've kept up a continuous cadence of orders, even in the down times of April and May. We continued replenishing the inventory. We didn't cancel any orders. We followed through with it. We have daily discussions with our primary OEMs. We have weekly discussions with our vendors. We're talking to them constantly about what their problems are and giving them lead time and a look at what we're doing and what our needs are going to be. Also, Barry and AJ are mentioning the A more cohesive opportunity that we've had, you know, with 35 senior managers talking every Friday and going through what their issues are.

17:56 We're seeing more and more intra-company movement of inventory as one part of the country gets hot and the other one cools down on sales. We're able to move inventory intra-company, but also a new feature that we've been able to do with our new technology on inventory is intra-Watchville inventory, where we're actually moving orders or inventory amongst the Wattsco companies. So it's tough. It's still tough. You know, we've had to do some substituting the product from time to time. But once again, I'm very, very proud of what our OEMs and our vendors have been able to provide us to date. And we just hope they can continue all the way through the season.

18:39 Every one of our OEMs has come to this. to the party. They're functioning as best they can, and we're very grateful for that.

18:50 Hopefully those aren't pool parties in Florida that they're coming to.

18:55 Oh, my.

18:57 That's mean. Cheap shot, man. Cheap shot. Just on the – you talked about the residential trends. Can you just talk about the commercial piece of the business – and, you know, any signs that as, you know, markets kind of open back up, you're seeing some stabilization there?

19:19 Well, I commented on that, but I'll let Paul go ahead.

19:23 Yeah, second quarter obviously was absolutely brutal, you know, on the commercial side. However, as states began to open up, we started to see some upticks. We're not back to zero yet, obviously. on the commercial rooftop side of our business. Applied has remained strong. And even commercial refrigeration, we've seen good life in that in the month of July, as a matter of fact.

19:52 Okay, and then just last one. Can you give us the tech spend in the quarter, either in total or year on year, or how much you expect that to be up for the year?

20:03 It's just running the same. Okay. and it will change from time to time as we see opportunities. So don't think this is the end of it. I know that's a persistent question of yours. We're going to add as much as needed. Anything that we see, we're going to invest in. Some of it will work and some of it will not, but that's the business we're in, innovation. That's what WatchGo is, an innovative business, and we have the financial means to invest in it. but there hasn't been any dramatic change from recent spending.

20:41 Okay, great. Thanks, guys. And our next question will come from Brett Lindsay with Vertical Research Partners. Please go ahead.

20:53 Hey, good morning, guys. Hey, could you just update us on the efficiency mix trends in the quarter? Any noticeable change, whether it be Mix up, mix down, buy homeowners. Just a little bit of color there would be great.

21:07 Buy homeowners. You see any new data on that?

21:11 Yeah, we've seen some data on that. It's, you know, we've seen a mix up, you know, where we've seen a bit more on the 16-seer, 18-seer front. It's not a remarkable change. I guess the thing that's been the most amazing to me this year This second quarter was I didn't see any material change in system change-outs, that people were replacing the entire system. They weren't just replacing the outdoor unit. So the consumer would never have guessed this was acting fairly normal as far as what we've seen historically.

21:53 Just sorry, Barry. I'll add real quick. DataPoint on our technology. You mentioned OnCallAir and the prepared remarks. That tool is about helping contractors sell into homes, into building owners, and it provides a very modern, very feature-rich platform to provide a beautiful, modern experience in the sales process. And without getting too specific in its early days with the tool, high-efficiency sales are much higher on that tool than without the tool. In other words, it's helping sell bigger tickets, higher margin products, and higher efficiency systems.

22:37 Interesting. Yeah, thanks. And then maybe just shifting to price, what are you seeing from a pricing standpoint? Any intra-quarter July price increases given the strength of the market here? Have you seen any?

22:52 No, there really haven't been any price increases on the equipment side. There's been some commodity moves, which are normal this time of the season, but nothing on the equipment side and nothing on the finish bid supply and parts side. Okay, great. Thanks, guys. I'll pass along. And our next question will come from Chris Dankard with Longbow Research. Please go ahead.

23:20 Morning. Hey, morning, Al. Morning, guys. Kind of circling back to SG&A for just a moment, again, really impressive, as David pointed out. I guess, just out of curiosity, how quick does some of that spending have to turn back on? I know the mantra is we're investing for the next 10 years. So, again, I was also very surprised to see SG&A come down to the magnitude it did. Just any comments on hiring, on what it takes to kind of maintain this level of growth you've seen in June and July here?

23:52 Wow. So, Barry, you're the futurist. Give him the crystal ball as best you see it. Gosh.

24:06 Well, I mean, the big picture, obviously, is that we're a labor-driven company. If you visited our stores, you'd find, you know, 5 to 20 people helping customers, and The extent that business is roaring, we will have more resources, more costs dealing with that issue. So that's a good problem to have where much of our labor can be variable or discretionary in a way that can be tied to the sales trend. So that will occur, and we will see SG&A spend creeping up as business volume drives it. That's part of being a distribution company and inherent in the distribution model. But we've also challenged the 35 leaders to look at under every rock over the last two or three months and determine what they can really change in terms of mindset or sacredness or how they react to the technology flow that's going on, really challenging their status quo. That's where, as a parent company in our culture, we can have an impact is challenging that status quo in all these markets.

25:15 So that is going on as well. I would expect there to be efficiencies that we can sustain well beyond just this temporary state that we're in. How much and how material, we'll find out as we get through this year. And as far as being a futurist, I know that we're a better company today, you know, 60, 90 days into this. And the cost structure is a portion of that improvement that we've made. We'll see how much of it once we get into next year. I wouldn't want to try to hazard a guess right now.

25:49 Yeah, fair enough. Fair enough. Thanks for the color there. And then, again, both your labor force and your customers' labor force is a little more specialized, skilled. But, again, we have seen some issues with guys not being able to show up or being kind of enticed away from certain jobs. Is any difficulty in labor availability either for you or your customers as having any meaningful impact?

26:14 You don't know what our customers are having issues that way or not, but I can tell you that our workforce has been just terrific. And we're keeping up with demand, and we're very appreciative, and we expect that to continue.

26:32 Sounds good. Well, congrats on the quarter, guys, and thanks for the detail. Great. Again, if you have a question, please press star, then 1. Our next question will come from Steve Tusa with J.P. Morgan Securities. Please go ahead.

26:48 Hi, Steve. Hi, Steve. Hey, guys. Good morning. Congrats on the execution and kind of a ball of a quarter here. I'm just trying to put the pieces together. Did you have any significant difference in, you know, the performance of your suppliers on the equipment side, Rezzy?

27:09 No. They're all just doing the best they can. And they're all know what's going on. They're very supportive. And we're not their only customer. They're supporting this entire work, their entire customer base. And they're just doing a great job. I just couldn't say enough about them, every one of them. Yeah, we call them true partnerships.

27:32 And you guys don't sell a ton of Lennox, right?

27:36 No. No, but we sell any. Yeah. Unless you have some ideas, we'll consider it.

27:45 I don't have any ideas right now. It's a little bit confusing. So I guess if your kind of major brands are gaining share, I mean, is there like an outlier in the industry that's really struggling to kind of deliver product that you guys don't sell? Because Lennox already reported, and, you know, they're claiming to have gained share. You guys are flat. They were down six. I'm just trying to kind of – is everybody all in the same boat, do you feel like, or are there some that are, you know, struggling more than others?

28:18 Well, I would say that all major equipment brands that we have are doing well.

28:23 Yep.

28:24 I mean, the issue is how quickly can they produce and get the product to us. Right. But they're all doing well, and they're all very supportive and couldn't be happier with it.

28:34 Right. How do you guys look at the inventory situation? Where do your inventories stand today? And then how will you kind of play that out in the back half of the year?

28:49 That's a very good question because the inventory has come down. But part of that is the tools that our technology group has come up with. Very good technology. I don't know how much detail you want to get into that, but we're happy to. Well, Asia, go ahead and talk about this.

29:09 Sure, sure. So some of the, or a lot of the inventory reduction is because of supply chain constraints and the, not excessive, but extreme demand. But also to the broader point of we are doing better managing inventory. We have new tools and technology, better teams, better systems. Better focus and daily effort on what we call non-performing inventory, moving low performers, you know, shoes that don't sell in one place, moving them around. And I would say a significant portion of the inventory reduction we've seen is about getting our inventory positioned healthier. And that should be sustained and continued over the next time period.

29:58 So you're kind of using these tools to maintain kind of a lean inventory position while you're delivering, and when you get to the back half of the year, there's not some need for a big kind of load-up heading into next year. You feel comfortable with what you have.

30:16 Yeah, I wouldn't say lean. I would say healthy, right? Having the right product at the right place at the right time is the key.

30:24 The term we use is inventory effectiveness as opposed to inventory terms. How effective is our inventory? Before we had these tools, can you imagine trying to manage hundreds of thousands of SKUs and try to regulate or try to figure out where they should be in 600 branches? The math hurts your head. The new tools that we have, we're We have meetings every day with our senior inventory management teams for every one of the Wasco companies, and sharing their information, sharing data among those people has been just invaluable. When I look at the technology gains that we've made, for me personally, the inventory systems are just magnificent.

31:11 And they're going to get better because we haven't implemented the tools throughout the company yet. We just... partially through.

31:21 Yeah, yeah, okay. Great execution. Congrats.

31:25 Thanks, Steve. This concludes our question and answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks. Please go ahead.

31:39 Well, let me just close with what's on everybody's mind, a pandemic. We truly wish all of you to stay healthy and safe. We are staying home here as much as we can and just want everybody to have the best possible outcome from this terrible virus right now. Thank you for attending. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.