Good day, and welcome to the Watsco Third Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touch-tone phone. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.
Good morning, and welcome to Watsco's Third Quarter Earnings Call. This is Albert 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 call, our cautionary statement. This conference call has forward-looking statements as defined by SEC laws and regulations that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Watsco produced another record quarter with sales, net income, and earnings per share all reaching record levels. In addition, cash flow for the nine months was also a record, and we expect cash flow to exceed net income for the full year. Our 2019 acquisitions, Dasco Supply and Peirce-Phelps, both contributed to the quarter and produced sales and profit growth over last year.
We remain very active in the industry, seeking great companies. We believe in investing in great companies and providing their leaders with resources to grow their business. These resources include capital, technology, equity incentives, and most important, encouraging the preservation of their own entrepreneurship culture. With the advent of modern technology, we believe it is a time for independent distributors to join the Watsco family since our resources can help them develop scale faster. In terms of results for the quarter, sales growth was driven by strength in residential HVAC equipment, with more consistent demand trends across the Sun Belt markets. 2018's third quarter gross margin comparison proved difficult, as last year's OEMs pricing actions did not reoccur in 2019. SG&A efficiencies were achieved during the quarter, that offset a good portion of the gross margin impact.
We continue to drive adoption of a variety of customer-focused technologies to better serve our contractor customers. That adoption has led to higher growth rates and lower attrition rates with customers who regularly use our technology. Over the long run, we are confident Watsco's innovations will transform the way business is done in our industry and will also influence and convince great companies to become a part of the Watsco family. Moving on to our balance sheet, our financial position remains conservative and strong, with a 9% debt to total capitalization ratio. This financial strength allows us to take advantage of almost any size investment opportunity. Our press release provides important details about our performance. I will not recite these details in my prepared remarks, but we'll be happy to provide more color during Q&A.
Finally, we renew our standing invitation to visit us in Miami and learn more about our technology journey. You will gain insight into our culture and many innovations that are underway. We hope you will come visit us and learn more. With that, A.J., Paul, Barry, and I are happy to answer your questions.
Thank you. We will now begin the question-and-answer session. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before you press any keys. To withdraw your question, please press star then two. Our first question comes from Jeffrey Hammond of KeyBanc Capital Markets. Please go ahead.
Morning, Jeff.
Hey, good morning, guys. How are you?
Thank you.
Yeah, 6% residential at, you know, was pretty impressive, and I know that, you know, some other folks were kinda complaining about the weather. Can you maybe just talk about, you know, where you saw particular strength and where there still may be pockets of weakness regionally?
I don't know that we get into that sort of competitive detail, but I'll let Barry deal with the question.
Morning, Jeff. Without giving, you know, data by state or data by market, I could say it this way, that really across our Sun Belt markets in particular, very consistent, narrow bandwidth of growth, consistent with what you see overall. In our minds, it was nice to see, you know, that consistency. Up north there, we have some strength in the residential markets and Latin America also grew during the quarter. Nice and plain and simple in terms of overall growth.
Okay, great. It looks like the carrying minority interest line was a little light versus my expectations, and I know, like Peirce and Homans were coming into the mix. You know, maybe speak to the gross margin, you know, pressure and how that might have gone through the Carrier side. Maybe on this gross margin dynamic you talked about, you know, do you expect that to carry into 4Q? Thanks.
Go ahead, Barry.
Well, Jeff, I think most of the change in the quarter for the minority interest line is Homans. We purchased 20% of Homans at the end of last quarter, and that's where the benefit of that 20% purchase flows is a reduction in minority interest expense year-over-year. As far as gross profit, looking in the fourth quarter, there were some price actions as well in the fourth quarter a year ago. There will be a measure of irritation, and then that should play out, you know, in the fourth quarter. Okay.
Our next question comes from Ryan Merkel of William Blair. Please go ahead.
Morning, Ryan.
Hey, morning, everyone. First off, back to the 4% equipment growth number, which is pretty solid. Do you think you're taking market share? Is the tech spending the big driver?
Well, who wants that one? Paul? I can take the first half of that. A.J., Barry. What?
Go ahead, Paul.
I can take the first half of it. You know, as far as, you know, the numbers aren't out in the third quarter yet, you know, from AHRI. You know, looking at the first two months of what came in the quarter, which would be the larger, months, you know, I think the, I think we definitely did grow some market share during the quarter on the residential side. I, you know, we were up. I think the market's gonna be flat to down slightly when all the numbers are tabulated.
Yeah. This is A.J. As for technology, yeah, It's hard to measure causation, but as far as correlation, what I can tell you is that the customers that are using technology and using it more regularly are growing out at a faster pace with us than the customers that are not, and their attrition is much lower than customers that are not using technology. Generally speaking, the customers that use it more often are stronger customers with us.
Got it. Okay. Then, on operating margins, just stepping back, it's been flat for a few years now. I'm just wondering, is expanding operating margins a priority for the company? What is it that you need to achieve that? Is it just better sales growth?
Don't forget, we're very long-term focused, and we believe that for the long term, we have to invest significantly in our technology. Even though it may hurt short-term results because we are spending more on technology, it's good for the long term. We have a big lead on technology. We wanna increase it. I think that's a part of the SG&A. Although overall, we sustained the same percentage levels as we did last year, so I'm pleased about that. Don't be surprised if we find opportunities in terms of technology and take advantage of it because we're not really focused on the short term.
Yeah.
Got it.
I'll say this too, I mean, the technology spending has been a big part of our business for the last three or four years, but this is not a short-term exercise, right? This is a journey. I mean, we're a big company in a big industry with a mature market. The investments we're making today will play out over a, you know, 10 - 20-year period probably. Why we can do that is because we're doing it from a position of strength, which is a nice place to invest from.
Yeah. I would just add that, you know, part of that, Ryan, in terms of the long term is, you know, what will OEMs think about doing with distribution over periods of time as things are evolving this way? We're already an immense partner to many or most of them, and we think that will only improve and deepen over time. Then there are 1,300 independent distributors that also are gonna face some sort of music about technology. Part of this investment, we're already seeing some benefits in attracting some age-old businesses that had never sold their business to anybody. In terms of completing transactions and conversations going on, it's a very deep part of what we're doing. That, that's a good feeling and I think there'll be more to come.
Okay. Appreciate the color. I'll pass it on. Thanks.
Our next question comes from Stephen Volkmann of Jefferies. Please go ahead.
Our next Stephen.
Good morning, guys. Maybe I'll just follow up on that, if I may, 'cause your revenue line was a little stronger than we were looking for, but so was your SG&A spending, I think. I'm wondering, you know, relative to your plan, obviously, we didn't know that, but did you find some additional things that you decided would be good investments during the quarter and sort of spent a little more than you thought? Was this in line with kinda your longer-term plan?
You mean in terms of technology spending?
Yeah.
Well, let's have the President answer that.
Yeah. There's nothing that stands out as a big spike in technology spending this quarter, no.
Okay. Yeah. I'm just trying to think about how you sort of plan that out.
I think year to date, we have a number of it over last year. Barry , do you have that number?
Yeah. For technology, year-over-year, it's up $4 million, about $0.10 a share. Most of that, a good portion of that, at least, is the acquisition of Alert Labs, which is an IoT company that we acquired to help with our IoT strategy, also a long-term investment. That anniversary is this quarter, so that influence will not be as great going forward. So there, that's not a spike. That's explanation for why it went up this quarter. Longer term, again, it's opportunistic. The plan is to keep driving adoption of what we've invested in for the last 4 - 5 years.
How do we get more customers every day making our technology their way of life? Obviously, there is spending going on to develop more and more customers and more and more usage across our network. Big spending, big tickets is not something that, you know, comes along. If it does, we evaluate it and make sense of it and decide if we wanna do it or not.
Right. The specific transaction you just mentioned, Barry, it's a development company. We knew going in that it would be losing money and it will continue to lose money, but we think that the outcome of that technology improvement, in the, in the long term will have a major impact.
Okay. Great. Thank you. If I can just pivot a little bit. We've heard through some channel checks that Carrier, I don't know that they would want to say it this way, but maybe is a little more focused on their end markets and, you know, a little more willing to get involved in marketing and so forth. Are you seeing any kind of changes from them in terms of their partnership with you?
Well, first let me say, I hope what you've heard is true. We're all for that. No, we've met their senior leadership, and they couldn't be more positive about their future in terms of being independently publicly traded. Of course, the word that applies to them now, as it does to us, is growth. To get growth, you have to do the things you're talking about, invest in products, invest in distribution. All the signs are positive that this is a good thing for Carrier and, therefore, a good thing for Watsco.
Okay, great. I'll leave it there. Thank you, guys.
Yeah.
Our next question comes from Robert Barry of Buckingham Research. Please go ahead.
Morning, Robert.
Hey, guys. Good morning. Just wanted to follow up on a few things. When you report the SG&A same store as flat, does that include that $4 million of IT spend?
Of course it does.
Okay.
IT, technology spending is in our SG&A.
Okay. Yep, just wanted to clarify.
Also, the losses are included in the P&L too.
Yeah.
I mean, it's not a profitable business, and we know that going in. Yes, that's all part of the main financial statement.
Right. I mean, I guess, just don't mean to beat a dead horse, but, you know, it seemed like the tone at the beginning of the year was, "Listen, we haven't delivered much margin expansion in recent years. It's gonna be more of a focus this year." There was some, you know, cost actions at the end of last year to kind of get you there, and SG&A has been flat same store. It seems like the responses to the earlier questions on op margin suggest that maybe the goal of op margin expansion is less of a priority now.
Well, we kind of explained that.
I'm curious how you'd characterize it.
Yeah, this is opportunistic. We don't look at things the way you outlined it. We look at what the opportunity is long term to keep growing the company and increase our competitive advantage. We're not numbers-driven. You know, why don't we do this because it's a budget or this and that, the other. This year, it was the one we just mentioned, Alert Labs, headquartered in Canada. Great products, not in the market yet, or they're coming to the market, and we believe strongly in them. Now we're supporting them, and we will continue to do things like that. Whether SG&A goes up or goes down, you know, that's a consequence of what we do. We're not so focused on numbers as we are the opportunities that we see.
Got it. I did also wanna just get a little more color on what drove the gross margin down. I mean, you mentioned the tough comp with the pricing.
Yeah.
How about?
Yeah, let's do that. Paul?
The deals or.
Yeah.
Yeah. We had a, as you know, last year was unprecedented as far as the number of price increases we had, and obviously that drove up our gross profit percentage. That was a big part of it. You mentioned that, gross profit, you know, drive is always in front of us as far as what we're trying to drive to increase the gross profit on our products. There is a market out there though, and we are competitive in that market and we maintain our competitive nature in that market. Sales, we try to balance sales growth and gross profit at the same time. We want both to grow.
Got it. Just, lastly, just to follow up on another comment. Sounds like, most of the markets we're tracking, in that 3% same store growth rate. Does that, include Florida and just any update on what's happening there and what the outlook is for Florida?
No, we're not gonna answer geographic questions. We don't wanna assist our competitors.
Yeah.
As you've heard earlier today, it's a mature market, very competitive, and we don't want to give anybody an idea where they can do better against us.
All right, I'll pass it on. Thank you.
Our next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead.
Hi, Josh.
Hi, this is Brandy on for Josh. Morning. Just wanted to look at inventory. One, it looks like inventory is elevated relative to the amount of sales that were added from the deals or just general growth. Can you talk about core Watsco inventory and if it's running higher than usual this season?
That's a very good question.
Any observations you have in the industry.
That's a great question. I think any of these could answer that. I think, Paul, do you wanna take a shot at that since you do all the buying? Just kidding.
Yes. This is all my fault. Yeah, inventory is up, you know, month-over-month from September or from August through September, and what we've seen is inventory has been increasing. One, we had price increases, compared to prior year comparisons, in the equipment that we do carry and in the parts and supplies that we carry. Secondly, there was a small buildup, that probably you'll see reflected across the industry with gas furnaces, where we had a cutoff in July, for furnace energy ratings changes. We built a little bit of inventory for that, but nothing that exciting that won't be sold out in the second half of the year.
Okay. That's helpful. Just wanted to follow up on the deals. Do you see any potential for synergies that can be extracted on the SG&A level?
Yeah. Yeah. I, we have a ready answer for that 'cause we give this a lot of thought. The reason we buy these great independent distributors is because they're very successful. We don't wanna take a risk, and we will avoid taking a risk trying to do anything to change their culture and their record of success. We don't look for synergies. That's up to them, these businesses that have done so well. We think we can grow them faster by what we said in the press release. We can capitalize them better. We can ask them to take more risk if they wish to. Basically, our culture and acquisitions is support the entrepreneurship that was there before we got there. We're not gonna mess around with trying to take some cost out because that's not what we do.
We're in for growth. What we wanna do is continue to build a network, and we don't want the risk of trying to tell them how to operate as an independent business. They're independent in terms of what they do, but they're part of Watsco, utilizing the resources of Watsco. That's a heck of a good combination which has helped us become the largest in the world in what we do. Synergy is not a word we use. Growth is the word we use.
Okay. I understand. Thank you.
Our next question comes from David Manthey of Baird. Please go ahead.
Hi, David.
Thank you. Good morning, y'all. First off, if you could talk about the breakdown of price mix versus volume in both equipment and the resi equipment numbers you gave us, that 4 and 6?
Barry?
Morning, David. Well, in the residential market, more unit growth than price if I dissect the 6%. For the commercial business, which makes up the rest to get to the 4% overall, it's not really a price cost conversation to have. Just slightly less growth in the U.S. on the commercial side, and I don't think price mix really had any consequence. On the residential side, though, it was probably better than expected unit growth.
Okay. A couple points there. Paul implied that there was also some price benefits in parts and supplies. I would guess that's fairly nominal.
If I did, I did not mean to do that. That, I did not say that, no.
Okay. Maybe I misunderstood that. Okay, then on overall organic equipment unit volume, so if you take price out of the equation, you just sort of think about the selling season in the second and third quarter, it looks somewhat flat this year with the second quarter down and the third quarter up. I know you talked about the cycle, and you didn't really wanna talk about it. Have you given any thought to just broadly, nationally, the HVAC cycle and any impact it might be having on the overall industry?
Paul?
Yeah.
Yeah.
Yeah, we've been looking at this. You know, you know, we've got a couple things that play into it. Obviously, you know, we still have the $80 million-$90 million install base on the residential side, which, you know, is going to be replaced over time. That hasn't changed. You know, it's been increased by probably an extra 1-1.5 million units this year. Secondly, as far as, you know, looking at it in total, it's kind of hard to come up with an exact number, but you're talking roughly 45%-50% of those units that are out there are still R22, and obviously we'll have replacement coming up, you know, sooner than later. The general replacement cycle nationwide, you know, is still a good market to be in and a good place to be positioned for Watsco.
Right. Okay. One more, if I could, on, when you mentioned industry unit shipments, you thought they'd be down for the full quarter. I'm just wondering why you think that given the quarter to date, shipment data that we've seen that implies it's up sort of 3+% right now.
I think I said flat to date.
Okay. Okay.
I just don't see where there was, there's gonna be a robust cycle of shipments in the month of September, that's all. It's, it's an estimate.
Okay. All right. Thank you very much.
Sure.
Once again, if you have a question, please press star then one. Our next question comes from Blake Hirschman of Stephens Inc. Please go ahead.
Hi, Blake. Morning, Blake.
Yeah. Good morning, guys. First off, did the hurricanes during the quarter, did they impact activity in the near term at all, and/or create any incremental repair work on the back end looking forward?
Paul?
Yeah, I don't think it had a material impact on the quarter for us, no.
All right. Back to the gross margins. Did the acquisitions that you guys have done year to date, did they create a drag at all? Or was it really just due to the tough comp and the price increases from last year?
Again, Paul. Barry?
No, the acquisition gross margin is at par with Watsco, there is no influence o n gross profit and from that perspective.
Okay. Yeah.
EBIT margin is where there's opportunity to improve, you know, long term. The change in gross profit, if you look at it a year ago, was up 50 basis points. Last year's third quarter gross profit margin was up 50 basis points strictly due to passing on relatively material OEM price increases midyear, which almost never occurs. A year later, that's the comp we're talking about. Again, as things have played through and we work through it becomes a more normal and stable circumstance going forward. This is really just a quarter for that type of, you know, occurrence last year, in terms of standing out.
All right. That makes sense. Thanks. I'll leave it there.
This concludes our question and answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.
Well, once again, thanks for your interest in our company. I'm glad you're involved. I really wish you would come down here and get a better handle on what we're doing with our major technology effort. Think about the winter. That's a good time to come down to Miami. Thanks again, and we'll speak to you at the end of this current quarter. Bye bye now.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.