All right. Moving right along here with Barry Logan , EVP of Watsco. I don't know, Barry Logan, thanks for being with us. I don't know if you have a couple slides you wanted to go through first, and then, and then we'll go from there.
Sure. That'd be fine.
Okay.
Or, you know, I mean, I don't really wanna be too robotic about it. Just rather be interactive with you, which is fine. Let's see. I'm not gonna read that. Just kidding. Maybe that's all I have, is this if I receive it.
That's good content.
Oh, there's 20 minutes on that?
Yeah. No, that's okay. So, maybe we'll just start with, I think everybody kinda knows who you guys are. Maybe to start with, you guys reported recently. What have you kinda seen since then? How are you feeling about how the year's starting out? Obviously acknowledging that January and February really aren't that important months, but how are you guys feeling about things relative to when we last spoke?
Sure. Just some context, I think, is always needed, in a company, just to, you know.
Yep.
Lay a foundation for an answer to that. Again, we just finished our fiscal year. We ended the year about $7.3 billion in sales. Our first year in distribution was 1989, it was $60 million. So, you know, we've had growth through 35 years. I think 2023 was one of the three years in 35 years that didn't grow in relative terms. And partly because the two prior years had grown 25%, you know, percent plus for two years. We sell air conditioning products. We sell heating products. We sell any products that a contractor would walk into someone's home or business and fix, repair, replace, upgrade, sustain, add to any kind of air conditioning, heating system anywhere in North America.
Obviously, during the COVID period, our industry, our contractor, our business, our OEMs, their suppliers benefited from kind of the you know, people spending more money on their homes. So really, for the last, I would say, 18 months, the shipment of products by distributors into the contractor channel has had declines in units, almost again for the first time that we can count, if we look back in time. And pricing and regulatory measures that have been flowed through the market and higher efficiency products that have flowed through the market have helped kind of sustain an offset to lower unit volume. Last year, we finished the year again roughly flat in revenues, down in earnings, I think 4% or 5%, something like that, if my memory's right. And I've characterized that as bowling 290, which is a pretty ridiculous statement, I'll admit.
But I always wanted just wanna put things in context. Watsco's revenues. I'm sorry. Watsco's EPS doubled since 2019, again, after having an 18% compounded growth rate for 30 years. Put that in perspective. It doubled in the last four years and until 2023. So that's what a down year looks like, 2023. That's how I would characterize it. And so the Q4 and the Q1, which is what's a little bit what Stephen Tusa is inferring, tell us how it's going despite the fact that it's the slowest time non-seasonal period of the year. And so I'll give it a shot. That's my foundational, you know, rambling and abstract thoughts building up to an answer, to your.
Good context.
To your straightforward question.
Yep. All good context. All good context.
So the concept really is that, again, the consumer had slowed down beginning 18 months ago in terms of just relative reality, right? That was just going to happen. And, I think we've held on pretty well in terms of margins and growth rates. So we're in a period now where, it certainly, we characterized it in the Q4 as stabilizing as opposed to further destabilization. We said the consumer is stabilizing pricing, margin. Things seem to have been stabilizing over the last half of last year. I would say the same thing, sitting here in the middle of March. I'm not commenting on the Q1 because March is half the quarter. We begin a real seasonal ramp right now through the summertime. Our business is 30%-40% larger 60 days from now in terms of just pure seasonality.
And in fact, July's, you know, EPS is double March's. So, you know, this is a very seasonal business in relative terms. And any commentary I make now, you cannot project into the summertime. But again, succinctly, more stable versus unstable.
I guess from a volume perspective, how do you guys see the year playing out at this stage of the game? Maybe just break down price, volume, and mix as we look out to 2024.
Sure.
If we're not talking about the Q1 here.
Sure. Again, context. So it's in the slides that I could show you, the 30-year, 40-year, or maybe even 50-year compounded growth rate of units of this industry I can't remember how many years I put on the slide for the point of drama is somewhere around 3.9%. That's the compounded rate of units for, again, 30 years, 40 years, 50 years, whatever I put on there. And I mentioned the last 18 months is down. And that's, again, a relative, strange period of time to even talk about, relative to anything in the past. And so if I look forward, you know, I'll say I'm not any smarter today in the middle of March than we in the middle of February when we did our conference call to suggest unit growth this year.
We're not at a point where we can project that. I would say I'll be very smart in 60 days and can be, you know, more conversant about it. But I think our assumption is relative flat unit growth this year just to organize ourselves and organize our mindset properly in terms of how we price products, how we look to capture the price increases the OEMs have going on, the way we're looking to manage our operating costs, looking 'cause frankly, if it's flat units or down units, we're doing less transactions in the field. That's an SG&A operational efficiency opportunity, for example, after wild circus acts over the last, you know, two or three years. So we're looking to reduce operating expenses, you know, especially over the remainder of this year.
And as it also affects how we deal with our top 10, frankly, manufacturers. They're not just equipment OEMs. They're all types of OEMs. You never ask about Manitowoc. I don't know if you've covered them or not. That's where they're largest customer too, for example. So that's an example of a vendor where we've been given more territory. We're going to have more sales. We're going to build their brand in more markets. And we're already, again, their largest customer. So this is the time where we can go after really our top 10 large relationships, our mega relationships, and ask, "How do we build share? What can we do together? Here are our 52 ideas. What are your 62 ideas?" And let's prosecute that in the market.
And so again, I hope this year expect this year to have some market share gains, just through that energy that's flowing into the market. I mean, Dover spoke earlier about distribution cost of capital being 8%-9%. Our competitors are financing their business at 8%-9%. He's right. Watsco has no debt. Our cost of capital is zero to conceivably finance our business. So I like it. I like zero b ut no debt is a good thing to be in this posture right now of how we're gonna grow and what can we do and what companies can we acquire and so on. It's a good offensive position to be in.
As far as the price flow-through this year and the mix impact, at least in resi, what do you guys see from that perspective?
Yeah. The manufacturers, again, as a community, you know, came out this year, I would say the range of the composite range across OEMs was a 4%-6% price increase. That's largely residential products, some light commercial products in that mix. The other products we sell, about 30% of Watsco is 80 other product lines, not really affected by what I just said. But 70% of Watsco is equipment. And that I'll call that the aspirational pricing range that the OEMs are looking for. I've said, you know, somewhat historically, if it's half of that, that's probably reasonable to consider as a range of price, in the big picture. Some pricing actions came in later this year in April and I'm sorry, in March and April. So the benefit is more April, you know, March and April beyond.
Then the other mixed discussion is this, that, you know, last year, 2023, the minimum efficiency of equipment changed to be, you know, a new base layer, if you will. And that base layer today is about 85% of the market. And that's an unconventional position to be in 'cause usually, it's a richer mix of higher efficiencies in this industry. So as that re-regulation occurred, it tended to settle the mix, if you will. Maybe not a headwind, but certainly, the mix is at a very low point in the long-term cycle of mix. I would expect mix to have a bigger impact on and that means selling higher efficiency systems throughout the channel.
That means contractors going to your home and telling you, "You should really put in 16s here, not 14s here, and here's why." That's a 10%-12% higher price when a contractor successfully does that and buys it from us. So mix overall is, I think I hate the word tailwind, headwind. I don't know what else to say at the moment. But it's a benefit that can occur, as I see it over the next few years, because we're at the baseline of minimum efficiency at this point.
Are you seeing anyone at all, you know, from a timing perspective or, you know, maybe not timing, get aggressive at all on, on price? I mean, their volumes are down. They have added capacity. Anybody at all putting promotions out there to try and get you guys to take on some inventory or anything like that?
Yeah. Well, that's good. It's a good analysis. So yes, we do want to, again, defend our product availability as we enter this season. We wanna use our balance sheet. We want to compete in some measure with our balance sheet. So inventories have been built, as we've started the year. I would say nothing that's outrageous or material in the sense of, but we did wanna take a stand this year as we entered the market. Let's just get a, you know, maybe have a little better price as we enter the season. But I wouldn't characterize it as buying forward. I would characterize it as building inventory this year. We're not in the same position availability a lot as last year. It helps price.
But mostly, it helps the competitive condition as we push this through the channel this season.
You're saying what do you mean by a little bit more aggressive on price? You know, you wanted to get a little bit better price from the OEMs.
That's correct.
Early on.
Or, avert the price increase. As I said, if something's affected April 1st, we're making a decision in the Q1.
Right.
As to what we take delivery of. And we can, you know, have either a more competitive average weighted average cost or a more profitable weighted average cost in our pocket as we go through the season.
Right. That makes some sense. Are all the suppliers now, you know, on a level footing when it comes to the products that they introduced last year? I know Rheem had some, you know, challenges delivering. Are all these products now on a more even footing? Or is there still some dislocation in where they are with their technology?
No. I would say there was equal footing since last October.
Okay.
So, you know, six months later, I visited our largest Rheem location a couple days ago in Miami. And, some of, I don't know if any of you were there on one of the other analyst field trips or not. But there was adequate and absolutely beautiful inventory sitting in what is a $70 million store selling our products. And an average Home Depot is around $45 million. So, in perspective, we have some very large stores in Florida selling that brand and very well-positioned with inventory.
Okay. So they're much more on even footing now. As far as the commercial market is concerned, some, you know, pretty still robust shipment numbers, backlogs maybe normalizing a bit, but perhaps some dynamics in the second half around the refrigerant transition, school funding rolling down. How do you view the light commercial markets for you guys?
You know, for us, we're in a few businesses. The businesses are primarily smaller commercial, light commercial, small you know, smaller businesses, smaller applications, rooftop units. It's around 15%-20% of what we do, again, to put it in context. And for us, it's probably been a 10%-12% compounding growth over probably the last three years if I, you know, neutralize the highs and lows in that in that analysis. Probably half price, half units. So I, I think there's still an inventory build that needed to occur last year in, in the distribution channel to serve the aftermarket, to serve the replacement market, to serve the backlog that had been built. I, I would say it's smooth and steady, nothing choppy or out of the ordinary. And in that business, I again, it seems like business as usual, Stephen Tusa.
I don't think again, I keep it simple. Is it volatile or stable? It seems more stable than volatile at this point. We're also in the VRF business. VRF is ductless commercial products. Mitsubishi would be, for example, one of our, you know, largest vendors, top 10 vendors that makes that product for us. It's been a 10%-20% grower for I feel like the last 10 years. And not because of just Watsco selling it, but because the contractor acceptance, the architect community specifying it, engineering community specifying it. It's almost been irrelevant what schools or data centers or other verticals are doing. It's simply a more accepted product, over time. And we've expanded that relationship to Gree in China.
We've expanded that relationship with throughout our Carrier network, as they look at Toshiba potentially as a product group within that. That's, that's a long-term another brand that we could conceivably sell. It's not again, not just 'cause of what we're doing. It's the acceptance of those products throughout the channel.
Great. Pat Baumann from my team does all the distributors. I don't know, Pat Baumann, if you had anything for Barry Logan at all.
Yeah. Maybe just switching really quick to the HVAC product segment. I know it's 30%-30% of what you do. So the Ferguson reported last week, and they talked about, you know, that parts and supplies business growing 15% from them in the quarter. They're seeing, you know, good growth in that aspect of the business as they're seeing some consumers opting for, you know, more repair versus replace. Just curious if you're seeing any of that in your business. It's hard to tell always, like, what's volume, what's price.
Sure.
You know, in that side of the house for you guys.
Sure. Well, 30% of, again, of what we do is non-equipment. Let's call it that. Everything but equipment. It's the grocery store. If you came into one of our stores where there's 80 different product lines, thermostats, copper tubing, tools, refrigerant, you know, we're Nest's largest distributor other than Amazon and Home Depot, for example. So that non-equipment product is everything but equipment. And there's two kind of families of products within that. Replacement parts would be one. Replacement parts for Watsco, somewhere between 5%-6% of what we do in total. And that would be an example where in Miami, we might have 25 competitors selling motors or compressors or something to fix an air conditioning system.
And I would say, again, looking at the data and knowing the data, Pat Baumann, I don't see we have, we've said this, you know, many times in, in recent, discussions. We don't see any large conversion of, or let's say growth in our parts business, replacement parts business versus, new systems. That's not something that, we necessarily expected to see because of all the regulatory change in, in front of, of what's going on. Contractors would still rather not repair an old system and keep it going. It has to also depend on what the homeowner wants to do. But again, in the data, we're not seeing any, any big migration or, you know, change one way or the other in, in that segment of our business.
Where we see the greater kind of volatility and I don't, you know, I don't know what Ferguson's sales are of other building products, for example. It could be insulation products. It could be ductwork. It could be anything going into the building trade or the commercial building trade or the industrial building trade. I would suspect that's being discussed there. I don't know for sure. I would say we're less proportionate in that environment than they are in terms of the business mix. I would say we're probably more residential-oriented when it comes to those types of products. I don't know. But again, I would say the trends are better than versus being worse than what we saw as we entered the year.
Pricing and some of the irritants that affected that business last year seems to be less. But again, it's early in the year.
and then.
But don't just, for example, I would say 95% of what we sell is to contractors, somebody in your house or business doing the work versus, you know, I would say other competitors would be more in an industrial channel, a facilities management channel, almost a different channel than the pure contractor channel. So there's some business differences in the comparison.
Understood. And then, everybody's favorite topic on gross margin.
It is my favorite topic.
Can you just talk about the confidence you have in this year being at 27%?
Sure.
From the Q4? That was, you know, the 25.8% that you reported. What gave you that confidence?
Then maybe just talk about how you see that sequentially kind of moving through the year, that trend.
Sure. Again, context. So 10 year-20-year average gross profit at Watsco, somewhere right around, you know, 24.5%-25%. And it's a very fair analysis to ask the question. During COVID, it ran up to 27%-28%, I think, even 1Q , pushing 29%. And, you know, 300 basis points or 400 basis points of gross margin expansion in a distribution business that started out with 8% EBIT in that analysis, it's a pretty important question, right? I'm not gonna, like, mess around with this very much. It's an important analysis. And so, the components of what benefits occurred to derive a higher margin, are they sustainable? Are they structural? Are they temporary? Or dare I say transitory? I feel like saying that word. And of course, like any business, like your own portfolio, it's all of the above, right?
I wouldn't, again. This needs to be a balanced concept. So for us, what's the structural side of it is we did deploy in 2019 a massive campaign, a massive piece of software, a massive cultural change to improve pricing without having any clue that even that, you know, all the aspects of COVID was about to occur. I'm glad we did it because it helped us prosecute pricing throughout a super high-volume number of changes in the market across 200,000 SKUs, across 1,000 vendors that were raising price or changing price multiple times per year instead of once or twice. So in that environment, there is a structural benefit to what is essentially a structural piece of software and a cultural change to accomplish that. I can't really put a number on that.
It's helped us bolster our mindset when we communicate, you know, 27% as the target margin for us, not retreating back to where it was pre-COVID. Another part of the structural mindset is working with our customers, working with our OEMs, converging really pricing on both sides of that equation to gain share, really on behalf of ourselves to help our OEMs gain share and also help our contractors gain share. It's our job to do that. Our job isn't just to grow Carrier's business. It's to grow our customer's business, that we benefit from that, through the channel. If pricing and margins were not enough, essentially, to invest enough in that, it affects the growth rate.
I would say, you know, four years or five years ago, we really went on a good campaign to kind of change the mentality or change some of the dynamics, and now I'm going to be abstract when I say that, to help improve margins so that we could invest in more growth. And we did. And again, that's a half-hour answer condensed into 30 seconds. But it helped margin structurally. So that's how we bridge, Pat Baumann, getting on an annual basis from where we were to the 27%. There's also a technology story within our technologies. And again, it's a long answer.
What's transitory, what's temporary, what's risky, what's tricky is what every other distributor you cover and you ask them the same question, and you get a variety of answers, I'm sure, still over what are the what are the effects of inflation? 'Cause distributors like inflation. We can raise price ahead of pricing increases, ahead of our cost increases, and, and gain a little bit of margin that way. If it's a if inflationary environment, we can try to, raise price with the market and maybe not incur as much of a cost increase through our OEM community. We can be merchants, in other words. And, and to the extent there's less inflation going on, we have less opportunity to do that. And there'll be some impact on margin. So I hope those broad thoughts make sense. Call me if they don't make sense. It's an important answer.
It's an important analysis in talking about Watsco. So when we're below 27%, you know, as we were in the Q4, it's because there's really the absence of those inflationary kind of benefits that we see. We talked about that in the Q4. It was 100 basis point of quarter-over-quarter change in gross profit was because there really was no inflationary benefit to the Q4 as there had been in the year prior. And those waters are much smoother today than they were over the last 24 months.
The way we would expect to prosecute margins higher than 27% the rest of the year is because of the timing of a lot of these price increases that the OEMs have put in and then our own blocking and tackling, our own technology, our own cultural things, our own, you know, things we're trying to accomplish to raise margin. So I'll leave it at 27% for now, Pat Baumann. I think, in the short term, the absence of pricing actions is would be less than 27%. The presence of pricing actions makes it more than 27% as a composite. You know, that's our target for this year.
So I guess, though, Q1 relative to Q4 and then that sequential ramp, I mean, like, is it an inflection in Q2 'cause you're getting these price increases?
Yes.
An inflection. So it's gonna be.
An inflection.
It's possibly above 27% in Q2?
Yes.
Okay. Any other questions? I think we're at time here. They run on the clock differently this year. So, Barry Logan, thanks a lot for your time.
Okay. Thank you.
Thank you.
Thanks, Barry Logan.