Earnings Call: Q2 2020

Jul 23, 2020

I would now like to turn the conference over to Albert Nahmad. Please go ahead, sir. Morning, everyone. Welcome to Watsco'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 has forward-looking statements as defined by SEC laws and regulations and are made pursuant to 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 Watsco is experiencing a very busy summer selling season. There are many heroic people in our company making an exceptional effort to serve and protect customers while 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. residential HVAC equipment business, which experienced 20%+ 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 HVAC and 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 in driving market share gains. Adoption and use of our mobile apps and e-commerce platforms have increased significantly as more customers use our technology. 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. Far this year, the number of e-commerce users has grown 14% and the number of transactions up by 12%. Our e-commerce sales run rate in June was 33% versus 29% in December 2019. In certain markets, our e-commerce run rate is now over 50%. It kinda shows the potential of this e-commerce platform. We also testified a promotion of two other innovative platforms. They are called OnCall Air and Credit for Comfort. These two platforms provide digital support for contractors and homeowners and connect proposals for buying product as 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. It is early. It's in the early days, but 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 and progress. We believe these capabilities provide a differentiated customer experience by engaging with us digitally in every way. We are also Excuse me. We also believe a new standard for contractor service has been established, which will serve us well in the long term. During the quarter, we improved operating efficiency by reducing costs. Same-store SG&A declined 7% with few store closings and loss of business across our network. Our financial position, as 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. Now with that, A.J., Paul Johnston, Barry Logan, 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 star then one on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we'll pause momentarily to assemble our roster. Our first question will come from Joshua Pokrzywinski with Morgan Stanley. Please go ahead. Morning, Josh. Morning, Al. Hope everyone's well. I guess, you know, clearly heat and some stimulus payments there, you know, helped put up a very good quarter relative to maybe the broader macro. 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? We don't like to share regional for competitive reasons. Paul, the second part of the question. Have we seen any other trends in the industry? Well, you know, obviously, you know, demand is high, you know, 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, you know, for the last 60 days, obviously. Pretty much, you know, demand has been strong on the replacement side, picking up again on the supply side right now, we hope it continues through the quarter. Okay, thanks. You know, just on the, on the technology initiatives, you know, Al or A.J., you know, I think most contractors at least, you know, kind of the bigger, more stable ones, you know, 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 wanna, you know, 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? A.J., you wanna 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 products 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. 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. 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 that, those conversations. Another way to look at it might be, Paul, can you discuss share? 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. That's a pretty monumental move towards an increase in market share. In the front half of the year, the same numbers apply. You know, the market was down mid-single digits, and Watsco basically was slightly up, you know, given what we did in the first quarter. We're gaining share there. Proud to say we're gaining share in Canada. Those numbers come out faster than the U.S. numbers, so we're becoming a force in Canada again. I'm very happy to see everything that's happening, you know, from a share perspective. Got it. That's helpful, Paul Johnston. I'll pass it on. Our next question will come from Stephen Volkmann with Jefferies. Please go ahead. Morning, Stephen. Hey, guys. Thanks for taking the question. 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. Just, you know, 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. Yes, Stephen. 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, you know, as we get through a selling season and a busy time and making the efforts to sell products, you know, price and margin and cost is an everyday market-by-market, local competitive landscape. There's not one answer. There's, you know, 50 answers. There's 50 variables that are playing out every day. This year is showing some improvement over last year in terms of trend. Still there's a lot of work to do on margin, a lot of work to do as we get through the selling season and look into next year and beyond. Okay, thanks, Barry. Is there any reason to think the second quarter was, you know, unusually a little bit better than it would be? you know, how do we think about the trajectory going forward? No, there's nothing remarkable or unremarkable about the second quarter, Stephen, that would need commentary. Okay. Thank you. Our next question will come from David Manthey with Baird. Please go ahead. Hello, David. Hey. Hey, good morning, guys. Al, I believe that you said June and July month to date were the June all-in and July month to date were up 20% year-over-year. First, did I hear that right? Second, could you put that in the context of same store daily sales for us? That was good. I enjoyed that. Barry? Sure. Well, Dave, yes, you heard right. When we do comment on trends, we are adjusting for sales date. Those are, you know, average selling day trends that you're hearing in the remarks. Okay, organic? That was based on residential air conditioning sales. Yeah. Yeah, when you heard- Yeah, that wasn't based in total, no. In the press release, you read double-digit growth in June. In Albert's remarks, you hear residential up 20%. That's, you know, that's what you're hearing. Got it. That's same store daily sales. Okay. Second, looking at the operating expenses from the first to the second quarter, the reduction, I mean, was impressive, probably the most impressive we've seen in Watsco's history sequentially like that. You basically did $350 million more in revenues on $9 million lower OpEx sequentially. I know the company's 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. Barry? Yeah, David. Well, again, I can't invite you to our Friday, Zoom call with 35 core managers across Watsco. If I could, what you'd hear is what you said, decentralized challenges to constantly react to what's going on in the market. It was not a Watsco, pen and paper session. It's 35 managers going out and prosecuting what they believe is important to take care of customers, employees. We have 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. The good news is this was all a local read and reaction to what's going on in the marketplace that drove the costs. As a parent company, we certainly have the conversation, but it's all driven in the field. Yeah, this is A.J. I just have to add, those 35 leaders or so have just been tremendously impressive during this whole period. The 5,000, 6,000 people that work for them just unbelievable effort and spirit, and they deserve all the credit. Yeah, it's really impressive. Good luck, guys. Thank you. Because and just to add, I mean, the corporate cost of Watsco, corporate expenses is under 5% of SG&A. 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. Again, once again, the credit belongs there. Our next question will come from Jeff Hammond with KeyBanc Capital Markets Inc. Please go ahead. Hi, Jeff. Good morning. Hey. Hey, good morning. Paul mentioned, you know, inventory, you know, being a challenge. Just talk about, you know, we picked up on our checks some of the OEMs, you know, kind of struggling to get product out the door. Certainly, you know, maybe the expectation was demand was gonna be weaker than it is. Can you just speak about your ability to get product, you know, how quickly that kind of normalizes and, you know, how you're able to kind of keep up with these strong demand trends? 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. They've done it, and they're doing a pretty good job. I don't think they're gonna lay off. They're gonna continue to support the demand, and God bless them. They're just great suppliers. Not just the OEMs, but also the regular vendors. You know, we've kept up a continuous cadence of orders, even in the down times of April and May. We continued replenishing 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 A.J. are mentioning a more cohesive opportunity that we've had, you know, with the 35 senior managers talking every Friday and going to what their issues are. We're seeing more and more intracompany movement of the inventory. As one part of the country gets hot and the other one cools down on sales, we're able to move inventory intracompany. Also, a new feature that we've been able to do with our new technology on inventory is intra-Watsco inventory, where we're actually moving orders or inventory amongst the Watsco companies. It's tough. It's still tough. You know, we've had to do some substituting the product from time to time. Once again, I'm very, very proud of what our OEMs and our vendors have been able to provide us to date. We just hope they can continue all the way through the season. Every one of our OEMs has come to the party. They're functioning as best they can, and we're very grateful for that. Hopefully, those aren't pool parties in Florida that they're coming to. Oh my. 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? Well, I commented on that, but I'll let Paul go ahead and. 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. Okay. Then just last one, can you give us the tech spend in the quarter, either, you know, in total or year-over-year, how much you expect that to be up for the year? It is running the same. It will change from time to time as we see opportunities. Don't think this the end of it. I know that's a persistent question of yours. We're going to add as much as needed as anything that we see, we're gonna invest. Some of it will work and some of it will not, but that's the business we're in, innovation. That's what Watsco is, an innovative business, and we have the financial means to invest in it. There hasn't been any dramatic change from recent spending. Okay, great. Thanks, guys. Our next question will come from Brett Linzey with Vertical Research Partners. Please go ahead. Hi, Brett. Morning. 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 by homeowners? Just a little bit of color there would be great. By homeowners? Sorry, Paul, you see any new data on that? Yeah. 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 2Q 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. The consumer, I would never have guessed this, was acting fairly normal as far as what we've seen historically. Yeah, I think. Sorry, Barry. I'll add real quick. Just an interesting data point on our technology. You mentioned OnCall Air in the prepared remarks. That tool is about helping contractors sell into homes and to building owners, it provides a very modern, very feature-rich platform to provide a beautiful modern experience in the sales process. Without getting into too specific, and it is 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. Interesting. Yeah, thanks. Then maybe just shifting to price, you know, what are you seeing from a pricing standpoint? Any intra-interquarter July price increases given the strength of the market here? Paul, have you seen any? No, there really haven't been any price increases on the equipment side. There's been some commodity moves, you know, which are normal this time of the season, but nothing on the equipment side and nothing on the the finished good supply and parts side. Okay, great. Thanks, guys. I'll pass along. Our next question will come from Chris Dankert with Longbow Research. Please go ahead. 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, you know, just out of curiosity, how quick does some of that spending have to turn back on? I know the mantra is, you know, we're investing for the next 10 years. 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? Barry, you're the futurist. Give us your Given the crystal ball as you see, as best you see it. Oh, gosh. 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, five to 20 people helping customers. The extent that business is roaring, we will have more resources, more costs, you know, dealing with that issue. That's a good problem to have. We're much of our labor Can be variable or discretionary in a way that can be tied to the sales trends. That will occur, and we will see, you know, SG&A spend creeping up as business volume drives it. That's part of being a distribution company and inherent in the distribution model. 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. 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. 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 made, and we'll see how much of it once we get into next year. I wouldn't wanna try to hazard a guess right now. Yeah. Fair enough. Fair enough. Thanks for the color there. Then again, both your labor force and your customers' labor force is, you know, a little more specialized, skilled. Again, we have seen some issues with guys, you know, 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 that's having any meaningful impact? We don't know whether our customers are having issues that way or not, but I can tell you that our workforce has been just terrific. We're keeping up with demand, and we're very appreciative, and we expect that to continue. Sounds good. Well, congrats on the quarter, guys, and then thanks for the detail. Right. If you have a question, please press star then one. Our next question will come from Steve Tusa with J.P. Morgan Securities. Please go ahead. 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. Thank you. Did you have any significant difference in, you know, the performance of your suppliers on the equipment side in resi? No, they're all just doing the best they can. Amen. They're all know what's going on. They're very supportive. 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'm just couldn't say enough about them. Every one of them is. Right. Yeah, we call it true partnerships. You guys don't sell a ton of Lennox, right? No. I don't know that we sell any. No, we don't sell any. Unless you have some ideas, we'll consider them. I don't have any ideas right now. It's all a little bit confusing. I guess if your kind of major brands are gaining share, and they're gain 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 6. 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? Well, I would say that all major equipment brands that we have are doing well. Yep. Okay. I mean, the issue is how quickly can they produce and get the product to us. Right. They're all doing well, and they're all very supportive and couldn't be happier with. Right. How do you guys, you know, look at the inventory situation? Where do your inventory stand today, and then? Well, yeah. will you how will you kinda play that out in the back half of the year? That's a very good question 'cause the inventory has come down. 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 wanna get into that, but we're happy to. Well, A.J., go ahead and talk about that. Sure. Sure. Some of the, or a lot of the inventory reduction is because of supply chain constraints and the not excessive, but extreme demand. Also, to the broader point of we are doing better managing inventory. We have new tools and technologies, better teams, better systems, better focus and daily effort on what we call non-performing inventory, moving low performers, you know, SKUs that don't sell at one place, moving them around. I would say a significant portion of the inventory reduction we've seen is about getting our inventory position healthier, and that should be sustained and continued over the next time period. Right. You're kind of, you know, using these tools to maintain kind of a, you know, a lean inventory position while you're delivering, and when you get to the back half of the year, there's not, you know, some need for a big kinda load up heading into next year. Yeah. You feel comfortable with what you have? Yeah, I wouldn't say lean, I would say healthy. Right? Yeah. Yeah. Having the right product at the right place at the right time is the key. Yeah. Right. The term we use is inventory effectiveness as opposed to inventory turns. You know, 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, you know, where they should be in 600 branches? You know, the math is The math hurts your head. Yeah. With the new tools that we have, you know, we have meetings every day with our senior inventory management teams for every one of the Watsco 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, I, for me personally, the inventory systems are just magnificent. They're gonna get better. Yeah. We haven't implemented the tools throughout the company yet. We're just partially through. Yeah. Yeah. Okay. Great execution. Congrats. 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. Well, let me just close with what's on everybody's mind, the 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. Bye now. Thank you for attending. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.