Earnings Call: Q2 2019

Jul 18, 2019

Welcome to the Watsco second quarter 2019 earnings conference call. I would now like to turn the conference over to Albert Nahmad, CEO and Chairman of the Board. Please go ahead, sir. Thank you, Marco. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, President, Paul Johnston, Executive Vice President, and Barry Logan, our Senior Vice President. As always, before we start 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. Now let's get on to the quarter. Watsco produced another record quarter. Today, we also announced our agreement to purchase Peirce-Phelps, a longstanding HVAC distributor based in Philadelphia. The company was founded in 1926 and has been Carrier's sole distributor in Pennsylvania, New Jersey, and Delaware for 75 years. This acquisition will expand our network into these markets. Peirce-Phelps' current annual sales are approximately $206 million, serving more than 9,000 customers from 19 locations in a wide product offerings of equipment, parts, and supplies. As important or more important, this business is led by four Peirce brothers who are third-generation owners. We look forward to working with them as they continue to operate the business, and we apply our quote, "buy and build," unquote approach. Here's what that means. We start with buying or joint venturing a great business. We keep the name, the team. We honor the culture and empower the leadership. We ask leadership for an aggressive growth plan, and we help them achieve it. We motivate the team with long-term equity and build an ownership culture, and we collaborate with big ideas, technology, capital, M&A opportunities, and provide support in any way needed. In addition to the Peirce transaction, we also completed a number of transactions during the quarter as summarized in the press release. These are all positive incremental steps to grow our business and put our capital to work. Looking at the long term, we believe it is an opportune time for M&A as the technology wave in our industry builds momentum. We offer successful owners, like the Peirce brothers, the most complete spectrum of technology tools to modernize their business. Now, in terms of results for the quarter, sales and earnings strength during the first 2 months of the quarter were disrupted in June by cooler, wet-wetter weather, and that's something, wetter weather in certain markets. July growth trends have improved, and we believe growth rates in the second half of the year will improve and produce another record year for our company. Operational efficiencies continue in the quarter, as evidenced by our moderate SG&A growth rate in existing locations. We also continue to make investments. We opened 8 locations during this last year to add density to existing markets, and we have continued to develop, launch, and drive adoption of a variety of customer-focused technologies to better serve our contractor customers. Over the long term, we believe these innovations will transform the way business is done in our industry. Moving on to our balance sheet and cash flow. Our financial position remains conservative and strong with a ratio of 12% debt to total capitalization. That's again, a 12% debt to total cap. We generated record cash flow during the first half, and we again target cash flow to exceed net income in 2019. In terms of analysis of our financial results, our press release provides important detail about our performance. I will not recite those details in my prepared remarks. We'll be happy to provide more color during Q&A. One last thing is our renewed 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 and visit and learn more. With that, A.J., Paul, Barry, and I are happy to answer questions. Thank you. We will now begin the question and answer session. Today's first question comes from Brett Linzey of Vertical Research Partners. Please go ahead. Morning, Brett. Hey, good morning. Hey, just wanted to come back to some of the key Sunbelt states, obviously a barometer for the growth of the total business. How did some of the key states perform, particularly Florida in the quarter? Then, any big outliers with, you know, within that mix? We don't wanna alert the competition to too much, but Barry, go ahead and give it a shot. Sure. Well, first, you know, as we said in the press release, there was cooler weather in certain markets. What that really means is between the Mississippi and Rockies, we have a big presence in Texas North, and just call it that region of the country is where we saw the particular weakness. If I go to our largest market, you know, we mentioned in the first quarter we had growth. That growth accelerated in the second quarter, and we're seeing stronger growth since. Just to have some fun, the flamingo is still very much alive and well and growing. That really is the story in the quarter is that geography between the Mississippi and Rockies. It is what it is. Again, it has an impact on short-term performance, certainly not long-term performance. Okay. Maybe just shifting gears to the Peirce-Phelps, Inc., just really about the strategic rationale. I mean, is this an asset that Watsco believes has a similar margin profile some of the Carrier JVs did? Maybe just separately, how has the Peirce-Phelps locations been growing organically for the past, you know, three to five years? Thanks. Barry, you wanna take that? Sure. Well, first it, I would say a better than average margin versus what we had experienced 10 years ago when we acquired Carrier Enterprise. That's part of it, being an independent distributor and simply thinking that way as entrepreneurs. Better than average than the past. Certainly opportunity to improve margin to the Watsco levels that we have achieved since then. Somewhere in between, let's put it that way. From a growth point of view, boy, we were given a 20-year chart of organic growth and very strong growth rates over the years. Again, highly entrepreneur group of 4 brothers. It's only, you know, as we say, buy a great company. The evidence is in the long-term growth rates that they've had. Okay, great. Thank you. Our next question today comes from Ryan Merkel of William Blair. Please go ahead. Morning, Ryan. Hey, morning everyone. First, let's dig into the other HVAC products and the commercial refrigeration, you know, down again. It's been weak, I think, for a couple quarters. Just what's going on there, and more importantly, any signs that that could start to improve and grow again in the second half? Let's go to Paul Johnston. Yeah. Okay. Hey, Ryan. Yeah, it was when you look at the individual components of the non-HVAC equipment categories that we sell in, a lot of softness in some of the commodities, more related to demand as on some of the slowdown that Barry indicated that were happening between west of the Mississippi and the Rockies impacted some of the install products that we would normally sell. There is a softness that we experienced in the first quarter, continued in the second quarter, but it's leveled out on some of the refrigerant. A lot of different reasons why that the price is soft right now, but at least it's stabilized at this point. You know, longer term, I don't see this as being a, you know, a continuous trend, when you look at beyond the commodities. When you look at the parts sales, parts sales were strong in the second quarter, and we were heartened by that. Okay. Just a quick follow-up on the commercial refrigeration. Are you saying that it's refrigeration prices that are primarily the issue? It's, you know, the equipment and the parts that you sell in that business, is that actually growing? The equipment pricing is stable and has grown. The commodity side of it is the weakness, yes. Okay. Then, just a follow-up on gross margins, you know, down year-over-year. I'm guessing that's a function of lower equipment selling margins and possibly mix, but maybe provide some color there, if you would. Yeah. Barry, you covered that, and you're writing it to me. Go ahead. Sure. Well, selling margin, which is simply our markup on all products, is flat year-over-year, and equipment up slightly. That speaks to the pricing and margins on equipment, you know, still ticking up. So that's a good sign. Some of the weakness is in the non-equipment, you know, which Paul described, and you can hear the little bit of the angst in the voice short term about pricing of refrigerants and things like that. Overall, if equipment is growing at a faster rate than non-equipment, there's a little bit of mix just simply in how that algebra works out. When you said mix of equipment, again, mix of equipment has been up all year long, fractionally, not materially. That trend continued in the second quarter. It's really the mix of equipment versus non-equipment that's in the algebra. Got it. All right, thanks. I'll pass it on. Our next question today comes from Stephen Volkmann of Jefferies LLC. Please go ahead. Morning, Stephen. Good morning, guys. Thanks for taking my question. Maybe just back to the M&A, I'm curious about, you know, you've obviously stepped that up a little bit. I'm curious if the pipeline is more full, if there's some reason you think more deals, you know, can get done in this type of environment. We have expressed such an attitude in the prepared remarks. We do have more interest from sellers, potential sellers from great companies. That's driven by sort of a desire for getting on board with the technology, or is there something else in their businesses that's feeling more challenging to them? Well, hard to answer the last part of that question, but I can tell you that from our perspective, there are two things that should attract a great company. That is, first, our culture. We don't disrupt great companies, quite the opposite. We're not cost cutters. We're not, you know, gonna flip anything in five years. None of that exists in our culture. We're very respectful of people that sell us or joint venture with us. That's also unusual in the M&A world. Now, with respect to technology, well, there's not a secret in the industry anymore. We lead it, the innovation. The adoption, we've expressed over and over again, will take a long time, but we're in it for the long term. If a successful distributor wants to take advantage of what we have, we certainly afford it to them. I think that will be a continuing attraction. Culture and technology should be a continuing attraction and stepping up. Al, just to add to that, Al, I think, you know, with Peirce, we can't have Brian on the phone with us this morning, Brian Peirce being the leader of the company. A 94-year-old company decided to sell to us, and, you know, I think a big motivator was technology and is technology moving forward. And, you know, again, at a point in time where we can open things up, I think it'd be good to get some perspective of someone like Brian Peirce, who, by the way, is the current chairman of HARDI. From a leadership point of view, we have an industry leader making that decision. Families still have to decide it's the good time for the family. But certainly- Well, I'm gonna hold you to that, Barry. Since you run around with me, you better get more done. This is A.J. I'll just add that, you know, we've been talking about technology for a long time. You guys ask good questions about it, but I really encourage you to come see us in Miami, spend time with us. Let us take you through the fundamentals. Because when you do that, when you meet the team, you understand how big of a deal this is and how impactful it is being and how much it ensures our viability going forward. Those are the conversations that we're having with some of these targets, like the Peirce brothers, who understand that technology is a real thing, that it's something that they need for their business, that they are gonna have to be very challenged to do on their own, but a nice landing place to do it with Watsco, and not only because of technology, but because of the culture. Again, I encourage you to come down and see it firsthand to anybody on the call. I wouldn't come in August, though. No, that's not a good time to come. Hot and humid. Humidity. Yeah. Thanks, guys. With that, I guess I'll pass it on. Thanks. Our next question today comes from David Manthey of Baird. Please go ahead. Hi, David. Good morning, guys. First off, you provided the same-store sales figure of +1% versus a 3% reported revenue number. I was wondering if you could give us that same same store figure by each of the three product segments. Barry, do you wanna do that? Yeah. David, I think it's a very similar relationship in terms of the overall to each of the pieces, you know. Okay. All right. Apply the same math. Okay. Second, should we assume that price mix is a low single digit type contributor to the overall growth? Yeah. Barry? Yes, there is price in the market still. If you look at the residential pricing, which is the primary driver, was up 3%. A moderate amount of price and a moderate amount of unit growth. Got it. Okay. When you say the momentum rebounded in July, I'm wondering if you can be a little more specific on what things looked like in the month of June for you and then sort of month-to-date, July growth rate. No, we're not gonna disclose that. We're just giving you a sense of things. We're not gonna put any numbers on it or rates or anything. We're just giving you a sense. Right. I had to ask, though. I like that. It seems like I've been getting more questions from investors on SG&A leverage. Can you just broadly talk about the major actions you've taken on OpEx? As you look at the $196 million of SG&A, is there any way you can talk to us about how much of that is kind of same store versus the contribution from acquisitions, greenfields, et cetera, just to give us an idea of where that, where that number is shaking out year-over-year? Well, we've reported previously that we're getting more efficient with the employees. That continues, the cost of employment. Don't get too stuck on growth of SG&A, especially the investment in technology. Because we are who we are, the industry leader, not only in size, but in technology, a lot of people are coming and knocking on our door with fascinating innovations. As the guy who runs the technology, A.J. Nahmad, has said, we have no desire to limit our investment in technology. Things are gonna change, and they could change dramatically in terms of spending for technology. I also believe that we're getting more efficient with the non-technology costs, and I hope we reflected that in the numbers. If you need more color on that, Barry can add to that. I would say looking at the year to date, David, we're looking at a longer period just to evaluate your question, up 1% on a same-store basis for year to date. Technology spending accounts for much of that. You can certainly imagine there's still inflationary risk going on with facilities and rent and some of the other line items offset largely by the productivity stuff that we've talked about. That's how I would, you know, talk about 3 variables with a 1% year-to-date increase in SG&A. It is a sea change over the last 3 or 4 years if we, you know, put it in context. There's definite progress all at once or doing something silly we're not going to do, but we wanna make progress, and we obviously have. If you do the again, the math between the SG&A growth rate without new stores versus new stores, you can impute, you know, the cost of the new stores and Dasco being part of that equation too. Yeah, makes sense. Thanks very much, guys. Ladies and gentlemen, as a reminder, if you'd like to ask a question, please press star then one at this time. Today's next question comes from Jeffrey Hammond of KeyBanc Capital Markets. Please go ahead. Morning, Jeff. Good morning, gentlemen. Just on the new store openings, I didn't see a mention last quarter. Are those kind of all new, kind of running through this quarter? You know, it seems like a step up. You know, how should we think about that, you know, perspectively? Where are you know, adding stores? Well, we won't answer the last part of the question 'cause of competition, but we will tell you that's the last 12 months, the 8 stores that we have greenfielded, but we've added quite a few through acquisition of DASCO and now with Peirce-Phelps. Jeff, we did certainly talk about same store SG&A in the first quarter. There was a discussion of that in the quarter. Just to be clear, the 17 new stores, 9 are acquired and 8 are greenfield? That's correct. Just, I noticed, you know, at least in my model that the minority interest number was materially lower than how I was thinking about it. I just didn't know if there's anything going on within the Carrier Enterprise business that they might have been seeing a little more margin pressure, you know, dropping through. Yeah, Jeff, the answer is no. If you look in the quarter, the actual reported results, minority interest is down about $600,000. That is where the benefit of owning Homans 100% shows up. As we purchased the 20% in Homans Associates that we didn't own, that was early in June, that's where the benefit of that, of that transaction shows up. When did Homans Associates close? Beginning of June. Great. Just last question. Certainly you've done, you know, DASCO Supply and now Peirce-Phelps and a couple of these other maybe smaller ones. Is there a way to think about, you know, the accretion opportunity, you know, as you look over the next 12 months and roll these in? You know, clearly you're bringing good businesses in at, you know, and your financing costs are low. That'd be helpful. Thanks. Well, Barry Logan, you wanna look at the future? Sure. Well, we certainly, they certainly are accretive on their face in terms of, you know, just historical EBIT. You, you mentioned the word smaller. Brian Peirce would take offense to that 'cause they're number 15 out of 1,300 in the industry. Just to put it in perspective, for that transaction. The real accretion, if you will, is not just the math at the day of transaction. It's what we talked about in the Watsco way. How can we help the Peirce brothers double the size of the business and help the Dasco team double the size of the business? That's where we've seen the benefit of, you know, really the acquisition itself. Yes, the math works today, but it's really the next step over the next few years that's very critical to what's going on. Okay. Yeah, I was actually referencing the, you know, Sigler and the Homans as the smaller ones. I appreciate it, guys. Thanks. Thanks, Jeff. Our next question today comes from Robert Barry of Buckingham Research. Please go ahead. Morning. Hey, guys. Good morning. I guess I wanted to just circle back to an earlier question about SG&A and really just broaden that to ask you about op margin. I mean, I think you've acknowledged in the last few quarters that given some growth investment, there hasn't really been much op margin expansion in the last few years, but it seemed like there was going to be a more concerted effort to get some this year. I mean, what's the latest thought there? I know you want to still grow the business or invest to grow the business, but do you think that you can expand the operating margin this year? Mr. Logan. Well, again, every distribution model of every kind, forevermore is gonna be dependent on a measure of sales growth to produce long-term margin expansion. Otherwise, they're probably cutting their business up short term for short-term reasons. The sales growth year to date, obviously same-store sales growth of 1% didn't achieve that result of higher EBIT margin. Again, for the rest of the year, we certainly see improved growth. We see improved, you know, we only have visibility to really the month of July. We have some confidence about the rest of the year in terms of expanding margin. In longer term, it will still take reasonable sales growth to drive, you know, the longer-term margin expansion that, you know, everyone looks for. The rate of investment in technology is still going to increase, but not at the same rate that it did the last 3 or 4 years. That opportunity is still there. Short term, we can wring our hands over it. Longer term, we're not. Got it. This growth in adding stores just organically outside of acquisitions, is that something that you'd see picking up or moderating? Well, it gives me an opportunity to discuss how we deal with that. Watsco is a very decentralized model and meaning that opening locations is not considered or even decided at headquarters. People in the field decide what they need, and they implement it. Wherever they see a need, they just do it. Can we forecast what they might be doing? We can't because they're not making those decisions for them. They're just doing it on their own, and they're very opportunistic orientated. We do like our methodology being very decentralized because that gives them an opportunity in the field that we at headquarters could not see. Got it. Got it. I just had 1 last 1, kind of a minor item on the SG&A front. I think last year in third quarter, you actually had a spike in SG&A growth because there was a variable comp true up. I think that was worth about $6 million. Is it fair to assume that would not reoccur this year and maybe we could even see same store SG&A down in 3Q? I wouldn't forecast the future, but Barry, go ahead and answer the past. Sure. Yeah. There were some second half hits and, you know, that are in the SG&A that were disclosed. Again, time will tell in terms of performance. Performance-driven comp, we want it to go up in the third quarter because it will be driven by performance, in fact. Yeah, I wouldn't get too, you know, surgical about whether SG&A is up or down. I think it's an opportunity to have a better third quarter. You know, I think predicting some type of decline is probably not the right thing. Got it. Fair enough. All right. Thank you. You bet. Our next question today comes from Chris Dankert of Longbow Research. Please go ahead. Morning, Chris. Hey, morning, guys, and thanks for taking my question. I guess back to start off the year, Paul had kind of somewhat, you know, previewed that you were working with suppliers on some, you know, growth initiatives internally. I guess, you kind of mentioned once you got into the selling season, you were already on the beaches. You could talk about that a bit more. You know, is that part of the DMI you announced or just any other color there would be, we'd really appreciate. Sure. Mr. Johnston? Yeah, I guess, rephrase your question for me again, if you would, so I can clearly understand what you're asking. Sure, sure. Just the start of the year, you guys were talking about doing more with suppliers to try and help take share, just any kind of color on those initiatives would be great. Oh, yeah. That's just, that's just our DNA working with our suppliers to try to increase share. We had a number of programs in the first quarter. We continue it in the second quarter. Unfortunately, the weather in the didn't cooperate with us quite the way we wanted to, and hopefully in the third quarter, we'll start seeing some fruits of those efforts. Are we talking about more like advertising, marketing, things along those nature, or is it more again, on the tech side of things? It's on all of the above. It's on whatever the customer is. It's getting very customer-focused, looking at market segments, looking at specific customers, national accounts, builders. Looking at the advertising is pretty much across the board, depending on what the product category is. Got it. Got it. Then just, you know, secondly here, any update on Latin America? I know that was a bit of a struggle in the first quarter. Is there any update there would be, would be helpful. Yeah, I think we can do that. Barry, tell him about the second quarter performance. Sure. Again, we got into mid-single digit growth in Latin America for the second quarter. Say it again. Mid-single digit growth. Mid-single digit growth in the second quarter. Again, progress as the year has gone on for sure. You know, the second half of the year where, you know, there's an opportunity probably for some profit growth, where last year was rather severe in terms of results. Got it. Glad to hear we've turned the corner there, guys. Thanks so much again. You bet. Our next question comes from Blake Hirschman of Stephens Inc. Please go ahead. Yeah, good morning, guys. Just a quick one for me. There's been more and more distributors pointing to incremental price cost issues, kind of looking forward. It doesn't seem like it's been much of a factor for you guys, but just wanted to get a quick update there. Thanks. Barry, can you field that? Sure. Again, selling margin, as I mentioned earlier, is the purest, you know, determination of that question. Are we marking up products in an efficient way year-over-year with a lot of price actions and a lot of moving pieces that have gone on? Again, in the quarter and year-to-date, we've seen a slight tick up in selling margin. That's a good feeling given all the price actions that have gone on. Thanks for that. I'll turn it over. Our next question comes from Patrick Baumann of JPMorgan. Please go ahead. Morning. Hey, good morning, guys. Thanks for taking my call. Just had a few questions. I apologize if some of these have been asked. I dialed in just a little bit late. Could you comment on your regional sales trends if certain regions were stronger than others? Well, we commented when we saw the wet and cool markets. Barry, you wanna advise them about that? Yeah, we did comment earlier, and the commentary was that, again, this kind of stripe between the Mississippi and Rockies is where we had the big weather impact in June. If I look Florida and East Coast, again, positive growth, unencumbered by any kind of wet weather. It's really that central part of the country that was impacted. Yeah. With Texas, for example, is a big market for us. That's where the short-term impact, you know, probably affected us the largest. Understood. That makes a lot of sense. Did you comment on price mix contributions as part of that 3% HVAC equipment growth? Yeah. We said earlier there's a little bit of both. Okay. That's helpful. On Pierce-Phelps, it sounds like it hasn't closed yet. Is that right? Also, did you disclose how much you paid and anything on margins? I'm just trying to nail down expected accretion to net earnings and the related timing of that. There are consents and approvals that are required in order to close. We expect that to happen in the 3rd quarter. We commented that the margin profile is better than, let's say, the historical joint venture margins that we started with 10 years ago with Carrier, but still less than Watsco's, somewhere in between. Opportunity, you know, to grow. Just remind me, what were those historical JV margins? I don't recall. That was before my time. Sorry. You'll find 8-K. You'll find an 8-K and you'll find an 8-K in 2009 that says 3% margin was what we acquired when we acquired Carrier Enterprise. That was good though. Okay. That's all right. I like that. Sorry about that, guys. You know, on the inventories on the balance sheet, looked like up in the second quarter. Anything unusual? I mean, I guess they're always up in the second quarter, seemed like they were up a little bit more. Anything unusual there? We just wanna be ready. There were some freight, there were some delivery issues, and we've got the strength with our balance sheet to take it in earlier in order to be ready for the season. Oh, there are delivery issues this year or you're talking about last year? There were earlier this year. Oh, understood. Understood. Last one for me. Sorry, I had a bunch of random questions. I apologize for taking all the time. It's all right. Take your time. We're in no hurry. Take your time. The SG&A growth for the year, do you still expect it to be slower than the rate of sales growth, I guess? Well, maybe in the second half maybe, or for the year, however you wanna comment on it. I mean, I believe last quarter you talked about it growing at maybe half the rate of sales, but obviously this quarter was, you had some issues in June with the top line, which were not your fault, but just curious if you had an update on that. Mr. Logan. I'm sorry. I lost you at some point, so go ahead and repeat it. Well, the main question. You know, you don't have to be in a hurry. Just relax, and we'll give you all the time you want. Thanks so much. Thanks. The main question is on SG&A growth for this year. Do you expect the growth rate in SG&A to be at slower than the rate of growth in sales still? About how much would you kinda target? Well, again, one we're in control of. One is how much money are we spending? The first half of the year, SG&A on a same store basis is up 1%. Any level of sales growth in the second half beyond that will derive that equation that you're asking about, but sales growth has to occur for that to happen. I think there's some confidence there, but it's still dependent on the sales growth, as I said earlier. Okay. I'm sorry, I do have one last one. Just in terms of the competitive situation from other distributors, there, you know, Lennox had some issues with their plant in Marshalltown earlier, well, last year. Just curious if you're seeing any change in like competitive behavior with regard to them trying to, you know, recapture market share that maybe they lost because of- Well- You know, production going down. I see if I can give you my thoughts on that. Lennox is a great company, and the leadership has done outstanding since they joined the business. Are they taking share back? I couldn't tell you. I can tell you fundamentally they're a great company. Okay. Makes sense. Thanks a lot. Congratulations on the acquisition, guys. Good luck. Say hello to Stephen Volkmann. Will do. Ladies and gentlemen, this concludes your question and answer session. I'd like to turn the conference back over to Albert Nahmad, CEO and Chairman of the Board for any closing remarks. Rocco, thanks for monitoring this. Are you gonna be back the next quarter too? Let's hope so. All right. Thanks, everybody, for listening and look forward to talking to you in the next quarter. Bye bye now. Thanks. Today's conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.