Earnings Call: Q4 2020

Feb 11, 2021

Good day, welcome to the Watsco 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. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead. Morning, everyone. Hope everyone is healthy and safe. Welcome to Watsco'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. As we normally do before we start, here's 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. On to our financial report. Watsco 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. 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 through today. 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 U.S., many of which are operating under old efficiency standards that resulted for the user in higher energy use and cost to them. It's important to note we will explore and evaluate impactful opportunities to make progress in our marketplace. We believe the combination of Watsco's technology platforms, industry-leading scale, access to capital, customer relationships, and unrivaled 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 Watsco's e-commerce platform, a good indicator of overall tech adoption, was up 20% during 2020. This is important as sales growth rates for customers that are active users outpace 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%. 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 OnCall Air and Credit for Comfort. These platforms help digitize the relationship between contractors and homeowners when buying and financing replacement HVAC systems. OnCall Air is growing exponentially. Contractors 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. Credit for Comfort processed 40% more digital financing applications in 2020 versus 2019, resulting in more than a 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, and contributing to our record cash flow and operating efficiency. 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 these prepared remarks. Our 2020 results are a testament to the efforts of our valued employees across the Watsco 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. At this time, we will pause momentarily to assemble our roster. The first question today comes from Stephen Volkmann of Jefferies. Please go ahead. Morning, Stephen. 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 year market share gains and improvements in e-commerce, et cetera. Of course, that sets us up for, you know, what is potentially a difficult comparison in 2021, especially as the year progresses. 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. Well, I'll start with an answer. 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. We feel very confident in that statement. Paul, you wanna talk about the market next? 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. 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. You know, with where we ended last year, we're beginning this year, you know, 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. 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 gonna replace it as opposed to repair it. You'd have more of a tendency to repair if you were planning to sell your home. 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. 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. Good, Paul. Okay. Thanks so much. 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. 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. 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? That's a great question. Let me turn to AJ for the answer. Sure. It's a combination of all the above. There were supply chain constraints in the industry. There was strong demand. Our technology enabled us to fill customer orders and take market share and show sales growth in that environment, as well as it gave us new insight and tools to attack what we call non-performing inventory. Inventory that's probably been on our shelves for too long. 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. It's a mix and a confluence of all three factors. Certainly, those efforts are gonna continue going into 2021 and beyond. Okay. Thank you, all. Can I add one more thing to that? That is, you know, A.J. did a great job of not only getting the technology that we needed, but the system side of it, so we had a visibility all the way through to what the inventory should be. 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. 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 receipts. You're so right, Paul. Sorry, Barry. 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. Yeah, just to add a layer of numbers to it. You know, the reduction year-over-year was around $120 million, which is a pretty astounding number. I think part of the question is how much of that is temporary versus permanent, right? We've had 3- Yes. Kind of cut through the conversations on. Well more than half, I would say, is permanent reduction from the point of view of technology and recalibrating how our stores actually operate and stock products and reorder products, replenish products. It's certainly more than half and is I would call it a permanent reduction. That's perfect. Thank you, guys. You bet. The next question is from David Manthey of Baird. Please go ahead. Hey, David. Hey, good morning. Hi, everyone. I hope it's not too cold where you are. No, in Tampa now. That's the heat of the Super Bowl. Yeah. We're absolutely fine. Actually, a little warm yesterday in the 80s. 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. Barry, you wanna take a shot? Sure. Well, David, first, if you look at the full year, which I think is a, is a responsible way to look at it, the residential business up 10%, almost all unit growth, very little price, if any, a slight benefit on mix, but mostly unit growth this year. For the quarter, again, I would say a very similar circumstance, almost all unit growth, almost no price and a slight amount of mix benefit. Okay. With copper and steel and everything being up, should we expect that 2021, we could actually see a positive impact there? Barry? There are two groups in that discussion. There's what the OEMs make products and what their cost, you know, cost inputs are, right? Almost all the OEMs have already announced pricing actions, price increases for 2021, and that will flow through the inventory cycle and into the season this year. I don't think we're ready to call it, actually, it's a crystal ball, but there has been pricing announced, and we'll see how that sifts through the market this year. We do sell non-equipment products that consist of metals, right? There is inflation going on in that, and those prices have been increasing and accounts for some of the 4th quarter's benefit that you see in the non-equipment growth. Paul, you're more encyclopedic than me about that, but I think it's some helpful price increases heading into 2021. Correct. Got it. Okay. Just to stay on that theme of the other HVAC products, assuming there was, you know, some volume there, I know you had a major initiative that you were working on, 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? I guess we can take a shot at it, Paul, with that. I don't think a lot of it was, 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 spot, spotting that we had that equipment wasn't available, so people had to repair their product, had to repair a furnace. You know, that's been probably the tightest market for everybody right now. As far as price increases, you know, 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, you know, the overall scheme of Watsco's, you know, revenues for the quarter. I think more of that's gonna bleed into perhaps in the first and second quarter of this year. We'll have a better idea for what's gonna happen price-wise with those commodities. Good to hear. All right. Thanks for the update, guys. Sure. The next question is from Jeffrey Hammond of KeyBanc Capital Markets. Please go ahead. Morning, Jeff. Hey, good morning, everyone. Just on good color on the U.S. res HVAC. Can you just kind of update us on, you know, 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 Q4 and into 2021. Hey, Jeff. Well first, you know, the U.S. market, you know, we speak to that pretty directly in the press release. Our international business is really split into two other markets, Canada, which actually looked a lot like U.S. 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. That leaves Latin America. That's where, in our Latin American business, which we do publish in our 10-K, 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. When we speak about our results, you know, again, put a placeholder for Latin America, which looks like the recovery this year, and after, you know, costing us about $0.20 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 could be a year of recovery that can have some benefit. We'll wait and see it and talk about it as it happens. That gives you a sense of 2020. Okay, that's helpful. Just on the SG&A line, can you just talk about maybe puts and takes as you think about that into 2021? Certainly good incrementals, very good incrementals in the back half. It seems like a lot of companies, you know, tamp down costs in 2Q, you know, demand kinda came back quickly. Just how you're thinking some, you know, some of those, you know, tamp down costs or temp costs start to come back and impact SG&A. Thanks. Go ahead, Barry. Well, again, three factors, I think, in the answer, Jeff, to kind of unravel it some. 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-digit demand thereafter for the next 8 months. Certainly some costs needed to come back into the equation as 2020 played out. And then third, technology. What did we do, can we do, can we continue to do well with technology, which is, you know, the whole outcomes of technology is to improve costs, especially, the efficiency gain of all the technology that's intended in that, in that. That's nice and abstract answer. If I look at 2021, I would say this: half our SG&A are people. Commission growth in incentive pay, we want that to happen. We would expect that to happen next year. There would be 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 when it was, you know, otherwise intended to or likely to increase. I think some of those savings will be kept and sustained into next year. 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. We see the opportunity. We have really OEM partnership in many of those efforts. 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. Again, I would expect not the same performance, but a moderate increase next year. Okay, thanks for the color, guys. The next question is from Chris Dankert of Longbow Research. Please go ahead. Morning, Chris. Hey, morning, guys. Thanks for taking the question. I guess just kinda looking into 2021, I mean, great performance on the gross margin in the back half of 2020. Definitely got things stabilized. I guess, you know, Latin America is a moving piece. I know there's some mixed dynamics going on. How do we think about, you know, gross margin into the new year? Just any puts and takes you'd call out or anything to kind of bear in mind besides just the typical price volume mix? Well, it's something that we're focused on. 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. I do assume Latin America was a piece of kind of what the headwind was kind of late 2019, early 2020, though. 19, 20. Barry, do you understand that? Go ahead and answer it. Yeah, go ahead. Ask your question again. What, what's what are you getting to? Yeah, sorry. Gross margin, just kind of on a year-over-year basis in the, you know, 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. No, not at all. The margins internationally look like the U.S. margins, gross margins. There's no algebra effects that mixes in some sort. It's really the blocking and tackling of getting pricing in the market. There's technology, there's a big pricing initiative going on to improve how we, you know, price our products go to market. We talked earlier about inflation, and there's a lack of inflation in 2020. The opportunity of inflation might help. We'll see. We don't know until we get into the season. Those are the larger moving pieces. Got it. Got it. All right. I guess something we haven't touched on lately, just any update on Russell Sigler, either in terms of, you know, investments being made there, kind of what's required in terms of investments, you know, the likelihood of kind of further consolidation of ownership. Just anything you can share there would be great. Well, we can't share much. We're in a minority position, and we're very supportive of anything they want from us. That's all I can say. We have no idea what their intentions are in terms of divesting more ownership. 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 OnCall Air, that type of thing? What we can tell you is that we're very pleased with their performance all across. Understood. Yeah. Thanks so much, guys. The next question is from Jeff Sprague of Vertical Research. Please go ahead. 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. I imagine there's a little bit of tug of war. Business is good, so perhaps people aren't eager to sell. By the same token, it does seem like the technology changes maybe are, you know, kind of increasing the pressure on some of the smaller guys. Just the state of play there. Should we expect, you know, other M&A to happen in 2021? Maybe some color on the, you know, the activity in your pipeline. Well, I'll make a general statement, and then Barry, who leads our M&A, can provide more information. Watsco 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. We are active, and we do think, there's no promise, but we do think we'll have M&A this year. I do think that the reputation for our culture, we're a different kind of an acquirer. We're not disruptive. We're supportive. All the other things that we add, the capital, the equity for the key people in their organization, our 401K, which is our donations are in Watsco shares. That sort of thing is culturally attractive, I believe. As I said, lots of opportunities since we're only $5 billion out of the $40 billion. Some of them are very small, but it doesn't matter to us. We just try to bring in people that wanna continue working and continuing building what they have with our support. Barry? Yeah, Jeff, just, first, Jeff, welcome back. 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, you know, growth and share, and then platforms to build on and invest in. The second, I think 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. I think this environment, after everyone has been through a lot this year, net is stronger now than it was a year ago. 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 where 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. Again, the foundations are stronger today than they were a year ago. I would expect some great conversation. Whether there's great transactions or not is still to be seen. Oh, there's gonna be great transaction, Barry. Get off the fence there. We're very optimistic about that. No guarantees, we're very optimistic. Great. Well, thank you for that color. Yeah, good to be back on the beat, Barry. Thanks. The next question is from Steve Tusa of JPMorgan. Please go ahead. Hello, Steve. Hey guys, how's it going? Doing good. Come visit. I'd love to. It's a little snowy up here. A question for you on Carrier said their backlog in residential was up 3x year-over-year. Backlog's not typically the type of thing, you know, we talk about in residential, especially not in December. Did you guys get out in front of, you know, some of these price increases or, you know, availability concerns and order a bunch that, you know, they'll deliver to you guys in the first half here? Wow, what a question. Who wants to volunteer for that answer? I will. No, we did not do huge pre-buys. We did several buys just to make sure that we were refilling, you know, 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 really didn't, we had shortages, yes, but we didn't have, you know, 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, you know, going into 2021 that we'll be able to maintain that status. 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. Yeah, I guess that wouldn't be an inventory, right? If it was backlog for them, that's something they would kind of ship to you guys, you know, in the first half or whatever. Yeah. I mean, are they allowed? It's kind of unusual that you'd be allowed to just kinda like, you know, place a paper order and get terms and, you know, and they would essentially be holding, you know, whatever WIP they have or finished goods they have. None of that activity? You know, like I said, we've got our orders. We put our orders in the way we always have. Okay. We have a pre-buy like we always do. Yeah. to be unusual here. Okay. Yeah. Most of the manufacturers, I think, continued building product, you know, during the off-season where they normally would have shutdowns. Right. I think that was pretty much universal across the OEMs. Speaking of the OEMs, I think it's pretty clear that, you know, Goodman lost some share, whether it was their fault or not. 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 2020? I guess that's the hundred dollar question, you know, that everybody has, you know. Will the dealers go back to, you know, the brands that they first worked that they were loyal to, that they couldn't get availability or they lost and they went to other brands? I guess, you know, 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. One, 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. 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? Competition is always strong. The one you mentioned and others, it's a very fragmented industry, but we think we have advantages that others don't have. 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 gonna 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. Right. Clearly, the digital stuff has worked out for you guys, so congrats on that. Yes, it has. It's just beginning. Yep. Great. Thank you so much. Appreciate the time. Sorry, just to add on, this is AJ. To go 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 Watsco companies, which is exciting. At the same time, we're seeing all-time low attrition rates of customers. I think what that tells you is that customers are finding it's very good to buy product from the Watsco companies. We're good partners to these contractors. It's, we try to make it easy for them to do business with us. We try to help them grow their businesses, and that's getting more and more valued and appreciated. Right. It sounds like, AJ's up for a raise, Al, so, you know. Well, I agree with that. Thanks, guys. I appreciate it. Good to talk to you. Again, if you have a question, please press star then 1. The next question is a follow-up from Chris Dankert of Longbow Research. Please go ahead. Hi, Chris. Hey, guys. Just one more from me. You know, 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, you know, stocking a bit more than normal? Still kind of skittish about being able to get product on time? Just what are you hearing back from customers and what their inventory position looks like? Paul, why don't you take that? It's, most of the dealers and contractors we do business with really don't maintain any inventory, just base inventory and parts and supplies. Some of the larger contractors do carry some inventory, but it's, they really rely on the most part, the industry relies on the distributors to supply inventory. Do we think there's some contractors who may 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. Yeah. Thanks so much. Yeah. It also remains true the vast majority of our customers rely on us for their inventory. Yeah, that's right. Yeah. I mean, an example, we have, one of our business units that, you know, called Baker, is probably pushing a billion dollars in terms of revenue as part of Watsco. I would say 99.9% of what they sell today, was ordered within the last six hours. None of their customers are out fucking drawing from inventory and replenishing with us. If I said de minimis, that's overstating it. Yeah, and that's- Some of the- That's 95% of the market. I mean, 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. Well, thanks for listening, and I'll talk to AJ Nahmad about his raise. We appreciate your interest. I just wanna give you the confidence level that I have that we're really on a roll here. I think we're very strong and gonna get stronger. I think business is solid at the start of the year, and I hope that continues. Take us up on our offer. Call us about learning more about the technology initiative. It's a game changer. Other than that, I wish you all to stay safe and stay healthy, and we'll talk at the next quarter. Bye-bye now. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.