Watsco (NYSE:WSO) Q4 2020 Earnings Call

0:00 Good day and welcome to the Wasco fourth quarter 2020 earnings conference call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.

0:27 Good morning, everyone. Hope everyone is healthy and safe, and welcome to Wattsco's Fourth 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, also Executive Vice President. Now, as we normally do, before we start, here is our cautionary statement. The conference call has... forward-looking statements as defined by SEC laws and regulators that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statement. Now on to our financial report.

1:13 Wasco produced another record year with sales, net income, and earnings per share reaching record levels. We generated record cash flow of $534 million during the year, well in excess of our goal of generating cash flow greater than net income. This further strengthened our balance sheet, which is now debt-free and provides us the capacity to make almost any size investment to grow our business. We also announced this morning a 10% increase in our annual dividend to $7.80 per share. That reflects our confidence in our business. 2020 results were driven by steady growth with market share gains in our U.S.

2:02 residential HVAC equipment business, which grew 10% for the year and 17% during the fourth quarter. Homeowners continue to invest in their homes as replacement sales at higher efficiencies remain strong from early summer Looking long term, we see opportunity to be a significant participant and contributor in efforts to address climate change. Sales of high-efficiency products have long been a component of our business and have grown steadily in our sales mix over the past decade. This is an interesting data point. There are over 110 million installed HVAC systems in the United States, many of which are operating under old efficiency standards that resulted for the user in higher energy use and cost to them.

3:05 It's important to note we will explore and evaluate impactful opportunities to make progress in our marketplace. We believe the combination of Wattsco's technology platforms, industry-leading scale, access to capital, customer relationships, and unrivalled OEM relationships provide a strong foundation and long-term benefit for all stakeholders involved. We also continue to invest in our industry-leading technology platforms, leading to Greater adoption, new customer acquisition, and market share gains. User growth on WatchGo's e-commerce platform, a good indicator of overall tech adoption, was up 20% during 2020.

4:01 This is important as sales growth rates for customers that are active users uppace growth rates of non-users. Also, customer attrition among active users is a fraction of non-users, another good indicator of effectiveness. Now, some more detailed examples of our progress. Weekly users of our mobile apps increased 27% in 2020 with over 120,000 downloads. The number of e-commerce transactions grew 20% this year to 1.2 million, Online Orders. Our annualized e-commerce sales run rate is 33% versus 31% at the end of last year. In certain markets, it's over 50%.

4:54 Our curbside or dockside pickup services expanded to more locations and now includes no contact payment functionality. The technology has only been available since this summer and already over 22,000 orders were fulfilled by more than 3,000 unique users. Two of our newer innovative platforms gained momentum in 2020. We call them On-Call Air and Credit for Comfort. These platforms help digitize the relationship between contractors and homeowners when buying and financing replacement HVAC systems.

5:41 On-call air is growing exponentially. Contract has provided digital proposals to over 109,000 households using the tool during last year and generated nearly $350 million in gross merchandise value for our customers, an 89% increase over last year. and Credit for Comfort processed 40% more digital financing applications in 2020 versus 2019, resulting in more than 180% increase in third-party funded loans. This tool helps homeowners afford much-needed HVAC systems. Investments in inventory management software have also benefited the company, yielding lower inventory, improved turns, in contributing to our record cash flow and operating efficiency.

6:37 These examples are exciting. We believe it's still early in terms of reaching the full potential of our technology investments. As always, feel free to schedule a Zoom call with us and we can further explain our technology and its progress. Now, one very important thought as we end this prepared remarks. Our 2020 results are a testament to the efforts of our valued employees across the Weltsco network. We deeply appreciate their commitment. With that, AJ, Paul, Barry, and I are happy to answer your questions. Elizabeth? We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone.

7:22 If you are using a speakerphone, Please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question today comes from Steven Volkman of Jefferies. Please go ahead.

7:43 Good morning, Steven. Hi. Good morning, guys. Thanks for taking my question. I guess maybe just to kick off, I mean, obviously 2020 was an extraordinary year in lots of ways in terms of the stay-at-home spending and your market share gains and improvements in e-commerce, et cetera. But of course, that sets us up for what is potentially a difficult comparison in 2021, especially as the year progresses. So I'm wondering, Al, maybe you can give us your thoughts about how you think the market will kind of be unveiled in 2021 relative to the opportunities for continued growth?

8:26 Well, I'll start with an answer, and then I'll turn to Paul Johnston to talk about the industry. I'll talk about ourselves. I think that we are set up to continue to grow over a number of years. We've talked about technology adoption. We've talked about our financial strength, which allows us to continue our active M&A program. We have a lot of things we can do to continue our growth, regardless of what happens to the industry. And we feel very confident in that statement. Paul, you want to talk about the market?

8:59 Yeah, the market in 2021, you know, it's tough to make a comparison, obviously, to 2020 because we had so many ups and downs and ebbs and flows and inventory issues and such. However, I think it's fair to say that the industry will remain strong during the year. New construction remains strong. Replacement demand, we're still seeing that following through. It's where we ended last year. We're beginning this year on the right footing. I think there's another phenomenon out there that's helping and changing the replacement dynamics, and that is we're seeing homeowners stay in their homes. for longer periods, and I don't mean because of the pandemic.

9:46 I mean they're not flipping houses as they were in the early 2000s. We're seeing them stay in their homes 13, 14 years, which is a good indicator that, you know, when something does happen to your air conditioning system, you're probably going to replace it as opposed to repair it. You'd have more of a tendency to repair if you were planning to sell your home. So I'm bullish on that. Secondly, I'm also bullish on the idea that we have markets where we have very good market share and we have markets where our market share isn't as high as we think it should be. So we still have market share gains that we're striving for and going for and we have great partners working with us on the OEM side to help make that happen.

10:34 Good, Paul.

10:36 Okay, thanks so much, and my house is, we're going on year 20, actually, so I get your point. Quick follow-up, if I could, I was really surprised by the inventory levels. You guys just did a really good job of keeping that under wraps as we ended the year, and I'm curious whether that's just more, you know, the strong demand in the industry, and you might have even preferred to have them a little higher, or is that actually, you know, kind of the new normal with all the information technology kind of benefits that you've added to your inventory management?

11:11 That's a great question. Let me turn to AJ for the answer.

11:16 Sure. It's a combination of all of the above. There were supply chain constraints in the industry. There was strong demand, and our technology enabled us to fill customer orders and take market share and show sales growth in that environment. as well as gave us new insight and tools to attack what we call non-performing inventory, inventory that's probably been in our shelves for too long. So with more detail and more talent focused on it, we were able to move some of that old product out of the network as well. So it's a mix and a confluence of all three factors, and certainly those efforts are going to continue going into 2021 and beyond.

12:01 Okay, thank you. I could add one more thing to that, and that is, you know, that AJ did a great job of not only getting the technology that we needed with the system side of it so we had a visibility all the way through to what the inventory should be, but also we were able to, fortunately for us before the pandemic, add people from different walks of life in the purchasing and inventory management systems. People from retail, from different commodities mixed in with our group of people that knew the HVAC industry. So I think it bode well once we got into the pandemic that our people had varied backgrounds and capabilities and were able to work hand in glove with our OEMs and our other suppliers to make sure that we had a proper cadence of inventory received.

12:51 You're so right, Paul.

12:53 Sorry, you're so right, Paul. We use technology as really shorthand. It's really people, process, and technology. Technology just enables great people to put in great processes and create change and increase profitability.

13:09 Yeah, just to add a layer of numbers to it, the reduction year over year is around $120 million, which is a pretty astounding number. And I think part of the question is how much of that is temporary versus permanent, right? We kind of cut through the conversation some. And well more than half, I would say, is permanent reduction from the point of view of technology and recalibrating how our stores actually operate in stock products and real-world products with plenty of products. So it's certainly more than half, and I would call it a permanent reduction.

13:47 That's perfect. Thank you, guys. You bet. The next question is from David Manthe of Baird. Please go ahead.

13:55 Good morning, David.

13:57 Hey, good morning.

13:58 Hi, everyone. I hope it's not too cold where you are.

14:02 No, in Tampa.

14:04 That's the heat of the Super Bowl.

14:09 We're absolutely fine. Actually, a little warm yesterday in the 80s. But as always, hoping you can disaggregate the organic equipment growth units versus price mix. there, and then your outlook for 2021 as it relates to pricing.

14:26 Barry, you want to take a shot?

14:29 Sure. Well, Dale, first, if you look at the full year, which I think is a responsible way to look at it, the potential business up 10%, almost all unit growth, very little price, if any, a slight benefit on mix, but mostly unit growth this year, and for the quarter, Again, I would say a very similar circumstance, almost all unit growth, almost no price, and a slight amount of mixed benefit.

14:59 Okay. And with copper and steel and everything being up, should we expect that 2021 we could actually see a positive impact there? All right.

15:10 Well, there are two groups in that discussion. There's what the OEMs make products and what their cost inputs are, right? So almost all the OEMs already announced pricing actions, price increases for 2021, and that will flow through the inventory cycle and into the season this year. So I don't think we're ready to call it. It's a crystal ball, but there has been pricing announced, and we'll see how that shifts through the market this year. We do sell non-equipment products that consist of metals, right? And there is inflation going on in that, and those prices have been increasing and accounts for some of the fourth quarter's benefit that you see in the non-equipment growth.

15:57 Paul, you're more encyclopedic than me about that, but I think it's some helpful price increases heading into 2021.

16:07 Correct. Got it. Okay. And just to stay on that theme of the other HVAC products, assuming there was some volume there, I know you had a major initiative that you were working on, and I'm assuming that some of that growth was early returns from that program. Could you just talk about the trends that you're seeing and the early returns from the initiative relative to other HVAC products?

16:38 I guess we can take a shot at it, Paul, without... Yeah, I don't think a lot of it was from the early parts of our initiative. I just think a lot of it was a little bit of pent-up demand with some of the equipment spotting that we had that equipment wasn't available, so people had to repair their product, had to repair a furnace. That's been probably the tightest market for everybody right now. As far as price increases, a lot of the steel and copper prices that Barry mentioned did occur in the fourth quarter. They had a benefit, but really not material in the overall scheme of Wattsco's revenues for the quarter. I think more of that's going to bleed into perhaps in the first and second quarter of this year. We'll have a better idea for what's going to happen price-wise with those commodities.

17:33 Good to hear. All right. Thanks for the update, guys.

17:36 Sure. The next question is from Jeff Hammond of QBank Capital Markets. Please go ahead.

17:44 Hey, good morning, everyone. Just on good color on the U.S. Res HVAC, can you just kind of update us on whether it be the quarter or full year, what you saw from the businesses outside the U.S., which still seem to be a headwind, and then just Commercial Trends, 4Q, and into 2021.

18:09 Barry.

18:11 Hi, Jeff. Well, first, the U.S. market, we speak to that pretty directly in the press release. Our international businesses really split into two other markets, Canada, which actually looked a lot like the United States at the end of the day, a good market, a commercial market, underperforming residential, but on whole. Canada grew its sales and profits in 2020. So that's Latin America. That's in our Latin American business, which we do publish in our 10K. You can glean some data from it. That's mostly a commercial business, and that's the business that went down in sales and profits this year, probably to the tune of about $0.20 a share if I look at the full year.

19:00 So when we speak about our results, again, put a placeholder for Latin America, which we expect a recovery this year, and after costing us about 20 cents this year. Again, largely a commercial market, and like you're seeing in everyone's discussion, commercial market is improving but still lagging, and 2021 can be your recovery that can have some benefit We'll wait and see it and talk about it as it happens, but that gives you a sense of 2020.

19:32 Okay, that's helpful. And then just on the SG&A line, can you just talk about maybe put some takes, as you think about that, into 2021? Certainly good incrementals, very good incrementals in the back half, but it seems like a lot of companies tamped down costs. in 2Q, and then demand kind of came back quickly. So just how are you thinking some of those tamp down costs or temp costs start to come back and impact SG&A? Thanks.

20:08 Go ahead, Barry.

20:10 Yeah, again, three factors, I think, in the answer, Jeff, to kind of unbuttle it. So 2020, you're right, an early spring reaction to all the knives that were falling helping with cost reduction and provoking cost reduction for good reasons. Second was interesting, the need to deal with double-budget demand thereafter for the next eight months. So certainly some costs needed to come back to the equation as 2020 played out. And then third, technology. What did we do, can we do, can we continue to do relative technology, which is one of the whole outcomes of technology is to improve cost, especially the efficiency gain of all the technology that's intended in that.

21:06 So that's nice and abstract answer. If I look at 2021, I would say this. Half our SG&A are people. And commission growth, growth in incentive pay, We want that to happen. We would expect that to happen next year. So the SG&A increases, for example, in that category. Rent, which is about 15% of SG&A, is, I think, flat this year. That's an accomplishment. Our teams went to the landlords and dealt with the realities of what was going on in the market, and this year's rent is flat, what was otherwise intended to or likely to increase.

21:51 I think some of those savings will be kept and sustained into next year. So if I try to summarize it without another 10 minutes of explanation, we would see some SG&A growth next year just in the realities of what happened in 2020. We are making investments in our distribution network in 2021 with people and locations and We see the opportunity. We have really OEM partnership in many of those efforts, and we're going to go out and expand our network some next year, and there'll be some SG&A growth for that. Otherwise, technology will help pinch those increases.

22:39 And again, I would expect not the same performance, but a moderate increase next year.

22:47 Okay, thanks for the call, guys. The next question is from Chris Dankert of Longbow Research.

22:56 Go ahead. Good morning, Chris. Hey, good morning, guys. Thanks for taking the question. I guess just kind of looking into 21, I mean, great, great performance on the gross margin in the back half of 20. Definitely got things stabilized. I guess, you know, Latin America is a moving piece. I know there's some mixed dynamics going on, but how do we think about, you know, gross margin into the new year? Just any puts and takes you'd call out, anything to kind of bear in mind besides just the typical

23:25 Well, it's something that we're focused on, and whatever improvements you saw this year or last year, I should say, we continue to believe this year will show improvement as well because of our focus and because of the ability to do something about it through our own internal systems and approach to the marketplace.

23:53 I do assume Latin America was a piece of kind of what the headwind was kind of late 19, early 20, though. 19, 20. Barry, if you understand that, go ahead and answer it.

24:06 Yeah, go ahead. Ask your question again. So what are you getting to?

24:12 Yeah, sorry. So the gross margin is just kind of on a year-over-year basis in the latter half of 2019, early half of 2020. were facing some year-over-year headwinds. I'm just curious how much Latin America was playing a role in that gross margin decline earlier in 2020.

24:30 Oh, no, not at all. The margins internationally look like the U.S. margins, gross margins. So there's no algebra that affects the mix in some sort. It's really the blocking and tackling of getting pricing in the market. With technology, there's a big pricing initiative going on to improve We'll see you next time.

25:10 Something we haven't touched on lately, just any update on Russell Siegler, either in terms of investments being made there, kind of what's required in terms of investments, the likelihood of further consolidation of ownership, just anything you can share there would be great.

25:25 Well, we can't share much. We're in a minority position, and we're very supportive of anything they want from us. And that's all I can say. We have no idea what their intentions are in terms of divesting more ownership.

25:42 Yeah, even in terms of, I mean, how are they pulling on, you know, some of the technology tools, you know, are they fully integrated in terms of how they can use on-call air, that type of thing?

25:50 What we can tell you is that we're very pleased with their performance.

25:55 Understood. Yeah.

25:57 Thanks so much, guys. The next question is from Jeff Sprague of Vertical Research. Please go ahead.

26:05 Morning, Jeff. Hey, good morning, everyone. Thanks for the question. I guess maybe somewhat following up on that last point, I just wonder if you could speak a little bit to what you are seeing in the potential M&A landscape. And I imagine there's a little bit of tug of war. Business is good, so perhaps people aren't eager to sell. But by the same token, it does seem like the technology changes maybe are kind of increasing the pressure on some of the smaller guys. So just the state of play there, should we expect You know, other M&A that happened in 2021, maybe some color on the, you know, the activity in your pipeline.

26:47 Well, I'll make a general statement, then Barry, who leads our M&A, can provide more information. Wattsco is an acquirer, and that's part of our overall strategy. We have a $5 billion revenue and a $40 billion industry, so our share has a lot of room to grow, and we use our balance sheet to support M&A. And we are active, and we do think, there's no promise, but we do think we'll have M&A this year. And I do think that the reputation for our culture, we're a different kind of an acquirer. We're not disruptive. We're supportive. And all the other things that we add, the capital, the equity for the key people in our organization, our 401K, which is Our donations are in Watsco shares.

27:42 That sort of thing is culturally attractive, I believe. And as I said, lots of opportunities since we're only $5 billion out of the $40 billion. And some of them are very small, but it doesn't matter to us. We just try to bring in people that want to continue working and continue building what they have with our support. And Barry?

28:09 Yeah, Jeff, just first, Jeff, welcome back. Yeah, two things I think to remind everyone of is the focus of M&A is the regional superpower businesses that are in this industry. We're not attempting to roll up a fragmented industry. We're focused on the largest of targets that will drive growth and share and then platforms to build on and invest in. The second big picture fundamental is we would rather invest in businesses when they're growing and reaching greater strength. We're not turnaround experts. We're not looking for a dip in the market to buy. We're looking to invest in strengthening businesses.

28:55 So I think this environment, after everyone has been through a lot this year, net is stronger now than it was a year ago. So I would say that presents us opportunity and certainly gives us confidence in where the good businesses are. Having said that, for 2021, I'll never be able to predict a thing other than to say some of the targets that were technology discussions were the reason for the discussion along with performance. I think that rekindling of that effort can happen now that we're through some of the weirdness and and, again, the foundations are stronger today than they were a year ago.

29:40 So I would expect some great conversation. Whether there's great transactions or not is still to be seen.

29:47 Oh, there's going to be great transactions, Barry. Get off the fence here. We're very optimistic about that. No guarantees, but we're very optimistic.

30:00 Great. Well, thank you for that, Culler. Yeah, good to be back on the beat, Barry. Thanks. The next question is from Steve Sousa of JPMorgan. Please go ahead.

30:12 Hello, Steve. Hey, guys. How's it going? Doing good. Come visit. I'd love to. It's a little snowy up here. Question for you on Carrier said their backlog in residential was up 3x year over year. Backlog's not typically the type of thing we talk about in residential, especially not in December. Did you guys get out in front of some of these price increases or availability concerns and order a bunch that they'll deliver to you guys in the first half here?

30:52 What a question. Who wants to volunteer for that answer?

30:57 I will. No, we did not do huge pre-buys. We did several buys just to make sure that we were refilling the inventory that we lost, that we still had a deficit in. Very selective. One thing that we did during the entire pandemic is even when everybody else was canceling orders, we maintained a cadence of putting in orders and maintained our order board throughout the entire pandemic. We had shortages, yes, but we didn't have these yo-yo type inventory movements like a lot of people did. We feel that we finished the year in good shape on inventory. Yes, we have a concern going into 2021 that we'll be able to maintain that status, but we're working diligently with our OEMs on a daily and weekly basis to make sure that we're getting the fulfillment we need on what we have on order.

31:55 Yeah, I guess that wouldn't be an inventory, right? If it was backlogged for them, that's something they would kind of ship to you guys, you know, in the first half or whatever. Yeah. So, I mean, it's kind of unusual that you'd be allowed to just kind of like, you know, place a paper order and get terms and, you know, and they would essentially be holding, you know, whatever whip they have or finished goods they have. So none of that activity?

32:24 Like I said, we've got our orders. We put our orders in the way we always have. We have a pre-buy like we always do. We're not trying to be unusual here. Most of the manufacturers, I think, continued building product during the off-season where they normally would have shutdowns. I think that was pretty much universal across

32:45 the OEMs. Speaking of the OEMs, I think it's pretty clear that Goodman lost some share, whether it was their fault or not. Are you seeing any kind of, do you expect any kind of swings? I mean, you pretty much, you know, serve them all, so it's not like it's a negative or a positive for you guys either way. Do you see any kind of swings back this year, you know, between the guys that kind of won and lost in 20?

33:16 I guess that's the $100 question, you know, that everybody has, you know. Will the dealers go back to the brands that they were loyal to that they couldn't get availability or they lost and they went to other brands? And I guess that's what everybody's marketing plans are all about, is being able to maintain the share gains that they picked up in prior year.

33:40 And then just one last one. I've noticed Goodman's acquiring a few distributors recently. I think it's been selective and mostly around their Daikin brand. and we also understand Ferguson is kind of looking to be a bit more aggressive here. They put out some pretty publicly aggressive targets. Anything you've noticed on kind of around the block, if you will, about a little bit of an increase in competition?

34:07 Competition is always strong. And the one you mentioned and others, it's a very fragmented industry that we think we have advantages that others don't have. and we've had that for a number of years as evidenced by the growth that we've had. I don't see any reason why that's not going to continue. I think we're actually getting stronger. I'm more optimistic about the future than anything we've done in the past. We're on a roll.

34:39 Right. Clearly the digital stuff has worked out for you guys, so congrats on that. Yes, it has, and it's just beginning. Great. Thank you so much.

34:47 Sorry, to that end, this is AJ. Going back a question to the market share, which ties right into what the conversation was now, is that we saw huge new growth in new customers buying from the Wasco companies, which is exciting. And at the same time, we're seeing all-time low attrition rates of customers. So I think what that tells you is that customers are finding – Thanks, guys. I appreciate it. Good to talk to you. Ken, if you have a question, please press star, then one.

35:48 The next question is a follow-up from Chris Sankert of Longbow Research. Please go ahead.

35:54 Hi, Chris. Hey, guys. Just one more from me. I guess we talked about your inventory, OEM inventory. Let's go down one level. I mean, what are you seeing at the customer level? I mean, are they still stocking a bit more than normal, still kind of skittish about being able to get product on time? What are you hearing back from customers and what their inventory position looks like? Paul, why don't you take that?

36:15 Yeah, most of the dealers and contractors we do business with really don't maintain any inventory, just base inventory in parts and supplies. So that really isn't an issue. Some of the larger contractors do carry some inventory, but they really rely, on the most part, the industry relies on the distributors' supply inventory. Do we think there's some contractors who may have have been concerned about the shortages of last year, and they're trying to put some inventory in place. Yes, I think there is some of that happening. To what extent, I really wouldn't have a read on that right now.

36:53 Got it. Thanks so much.

36:55 It also remains true. The vast majority of our customers rely on us for their inventory. Yeah, that's right. Yeah.

37:02 Yeah, I mean, an example, we have one of our business units called Baker. is probably pushing a billion dollars in terms of revenue as part of what's go. I would say 99.9% of what they sell today was ordered within the last six hours. None of their customers are out drawing from inventory and replenishing with us. If I said de minimis, that's overstating it. That's 95% of the market.

37:30 Dealers carry motors and capacitors and some line sets, some copper tubing, refrigerant, but generally not equipment. Got it. Yeah, thanks so much. This concludes our question and answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

37:55 Well, thanks for listening, and I'll talk to AJ about his raise. We appreciate your interest. I just want to Thank you for joining us today. and we'll talk at the next quarter. Bye-bye now.