Welcome to the Watsco Second Quarter 2019 Earnings Conference Call. All participants will be in listen only mode. Please note today's event is being recorded. 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 and with me is A. J. Nahmad, President and Paul Johnson, 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 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. Let's get on to the quarter. Watsco produced another record quarter. Today, we also announced our agreement to purchase Pierce Phelps, a longstanding HVAC distributor based in Philadelphia. The company was founded in 1926 and has been carrier sole distributor in Pennsylvania, New Jersey and Delaware for 75 years.
This acquisition will expand our network into these markets. Pierce Felt's current annual sales are approximately $206,000,000 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 4 Pierce Brothers, who are 3rd generation owners. We look forward to working with them as they continue to operate the business and we apply our buy and build 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 asked leadership for an aggressive growth plan and we helped 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 and A opportunities and provide support in any way needed.
In addition to the Pierce transaction, we also completed a number of transactions during the quarter and 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 opportune time for M and A as the technology wave in our industry builds momentum. We offer successful owners like the Pierce 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 1st 2 months of the quarter were disrupted in June by cooler wetter weather and then 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 and 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.
Now 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 and 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. Good
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? And then any big outliers within that mix?
Well, we don't want to alert the competition too much, but Barry, go ahead and give it a shot.
Sure. Well, first, as we said in the press release, there was cooler weather in certain markets. And 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, we mentioned in the Q1 we had growth, that growth accelerated in the Q2 and we're seeing stronger growth since.
So just to have some fun, the fling to the Flamingo is still very much alive and well and growing. So that really is the story in the quarter is that geography between the Mississippi and Rockies. And it is what it is. And again, it has an impact on short term performance, certainly not long term performance.
Okay. And then maybe just shifting gears to the Pure Steel, 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? And then maybe just separately, how has the Pierce locations been growing organically for the past 3 to 5 years? Thanks.
Barry, you want to take that?
Sure. Well, first, I would say a better than average margin versus what we had experienced 10 years ago when we acquired CURE Enterprise. And that's part of it being an independent distributor and simply thinking that way as entrepreneurs. So better than average than the past, certainly opportunity to improve margin to the Watsco levels that we have achieved since then. So somewhere in between, let's put it that way.
From a growth point of view, we have a we were given a 20 year chart of organic growth and very strong growth rates over the years. And again, highly entrepreneur, group of 4 brothers. And so it's only, as we say, by a great company, the evidence is in the long term growth rates that they've had.
Okay, great. Thank you.
And our next question today comes from Ryan Merkel of William Blair. Please go ahead. Good morning, Ryan.
Hey, good morning, everyone. So first, let's dig into the other HVAC products and the commercial refrigeration down again. It's been weak, I think, for a couple of 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 Johnson.
Yes. Okay. Hey, Ryan. Yes, 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 some of the slowdown that Barry indicated that were happening between west of the Mississippi and the Rockies impacted some of the installed products that we would normally sell.
And then there is a softness that we experienced in the Q1, continued in the Q2, but it's leveled out And 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. So longer term, I don't see this as being a continuous trend when you look at beyond the commodities. But when you look at the part sales, part sales were strong in the second quarter, and we were heartened by that.
Okay. And just a quick follow-up on the commercial refrigeration. So are you saying that it's refrigeration prices that are primarily the issue? It's 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. And then just a follow-up on gross margins, 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?
Barry, you covered that in your writings 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. And so that speaks to the pricing and margins on equipment still ticking up. So that's a good sign. Some of the weakness is in the non equipment, 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.
And overall, if equipment is growing at a faster rate than non equipment, there's a little bit of mix to simply and 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 Q2. But 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. And our next question today comes from Steven Brookman of Jefferies LLC. Please go ahead.
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 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.
And 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?
Hard to answer the last part of that question, but I can tell you that from our perspective, there are 2 things that should attract a great company. That is, first, our culture. If you don't disrupt great companies, quite the opposite, we're not cost cutters, we're not going to flip anything in 5 years, none of that exists in our culture. And we're very respectful of people that sell us through her joint venture with us. That's also unusual in the M and 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. But if the distributor, a successful distributor wants to take advantage of what we have, we certainly afford it to them. And I think that will be a continuing attraction. Culture and technology should be a continuing attraction and stepping up.
And Al, just
to add to that, Al, I think with Pierce, we can't have Brian on the phone with us this morning, Brian Pierce being the leader of the company. But the 94 year old company decided to sell to us. And I think a big motivator was technology and is technology moving forward. And again, at a point in time where we can't open things up, I think it'd be good to get some perspective of someone like Brian Pierce, who by the way is the current Chairman of Hardee. So from a leadership point of view, we have an industry leader making that decision.
So it's something that is certainly part of the ingredients. Families still have to decide is the good time for the family. But
I want to hold you to that, Barry, since you run around in there, you better get more done.
This is Ajay. I'll just
add that we've been talking about technology for a long time and you guys asked 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. 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. And those are the conversations that we're having with some of these targets like the Pierce Brothers who understand that technology is a real thing, that it's something that they need for their business, that they are going to have to be very challenged to do on their own, but a nice landing place to do with Watsco, and not only because of technology, but because of the culture. So again, I encourage you to come down and see it firsthand to anybody on the call.
We didn't come in August though.
No, that's not a good time to go. Obviously, it's
humidity. Thanks, guys. With that, I guess I'll pass it on. Thanks.
And 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 plus 1% versus a 3% reported revenue number. I was wondering if you could give us that same store figure by each of the 3 product segments?
Barry, do you want to do that?
Yes. Dave, I think it's a very similar relationship in terms of the overall to each of the pieces.
Okay.
All right. The same math.
Okay. And second, should we assume that pricemix is a low single digit type contributor to the overall growth?
Yes, there is price in the market still. And if you look at the residential pricing, which is the primary driver, it was up 3%, a moderate amount of price and a moderate amount of unit growth.
Got it. Okay. And then 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 going to disclose that. We're just giving you a sense of things. We're not going to 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.
Finally, it seems like I've been getting more questions from investors on SG and A leverage. Can you just broadly talk about the major actions you've taken on OpEx? And then as you look at the $196,000,000 of SG and 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, etcetera, just to give us an idea of where that number is shaking out year over year?
Well, we've reported previously that we got we're getting more efficient with the employees that continues the cost of employment. But don't get too stuck on growth of SG and A, especially the investment in technology, because we are who we are, the lead industry leader, not only in size, but in technology, a lot of people are coming knocking on our door with fascinating innovations. And as the guy who runs technology, Ajay Naved has said, we have no desire to limit our investment in technology. Things are going to change and they could change dramatically in terms of spending for technology. But I also believe that we're getting more efficient with the non technology costs and I hope we reflected that in the numbers or if you need more color on that, Barry can add to that.
I would say looking at the year to date, Dave, so we're looking at a longer period just to evaluate your question and 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. So that's how I would talk about 3 variables with a 1% year to date increase in SG and A. And it is a sea change over the last 3 or 4 years if we put it in context.
So there's definite progress all at once or doing something silly we're not going to do, but we want to make progress and we obviously have. So if you do the again, the math between the SG and A growth rate without new stores versus new stores, you can impute the cost of the new stores and DASCO being part of that equation too.
Yes, makes sense. Thanks very much guys.
Today's next question comes from Jeffrey Hammond of KeyBanc Capital Markets. Please go ahead.
Good morning, Jeff. Good morning, gentlemen.
So just on the new store openings, did all I didn't see a
mention like last quarter. Are those kind of all new kind of running
through this quarter? Like last quarter. Are those kind of all new kind of running through this quarter? And it seems like a step up. And so how should we think about that prospectively?
And where are you adding stores?
Well, we want to answer the last part of the question because of competition, but we will tell you that's the last 12 months, D8 stores that we have greenfielded, but we've added quite a few through acquisition of DASCO and now with Pierceville.
And Jeff, we did certainly talk about same store SG and A in the last in the Q1. There was a discussion of that in the quarter.
Okay. So just to be clear, the 17 new stores, 9 are acquired and 8 are Greenfield?
That's correct.
Okay. And then just, I noticed, at least in my model that the minority interest number was materially lower than how I was Carrier Enterprise business that they might have been seeing a little more margin pressure dropping through?
Jeff, the answer is no. If you look in the quarter, the actual reported results, minority interest is down about $600,000 And that is where the benefit of owning homens 100% shows up. So as we purchased the 20% in Home and that we did know and that was early in June and there's a benefit to that's where the benefit of that transaction shows up.
Okay. And when did Home and Close?
Beginning of June.
Okay. Okay, great. Then just last question. Certainly, you've done DASCO and now Pierce and a couple of these other maybe smaller ones. Is there a way to think about the accretion opportunity as you look over the next 12 months and roll these in?
Clearly you're bringing good businesses in and your financing costs are low? That'd be helpful. Thanks.
Barry, you want to look at the future?
Sure. Well, we certainly they certainly are accretive on their face in terms of just historical EBIT. And you mentioned the word smaller, Brian Pierce would take offense to that because they're number 15 out of 1300 in the industry. So 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 Pierce Brothers double the size of the business and help the DASCO team double the size of the business? And that's where we've seen the benefit of really the acquisition itself. Yes, the math works today, but it's really the next step and over the next few years that's very critical to what's going
on. Okay.
Yes, I was actually referencing the Sigler and the Holman as the smaller ones. But I appreciate it. I
appreciate it, guys. Thanks.
Thanks, Jeff. And our
next question today comes from Robert Barry of Buckingham Research. Please go ahead. Good morning.
Hey, guys. Good morning.
I guess I wanted
to just circle back to an earlier question about SG and 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?
Again, every distribution model of every kind forevermore is going to 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. So the sales growth year to date, obviously, same store sales growth of 1% didn't achieve that result of higher EBIT margin. But again, for the rest of the year, we certainly see improved growth. We see improved we only have visibility to really the month of July, but 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 the longer term margin expansion that everyone looks for. And 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. And so that opportunity is still there. And 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?
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. Headquarters, people in the field decide what they need and they implement it. So wherever they see a need, they just do it. Can we forecast what they might be doing?
We can't because we're not making those decisions for them. They're just doing it on their own and they're very optimistic orientated. And 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 one last one, kind of a minor item on the SG and A front. I think last year in Q3, you actually had a spike in SG and A growth because there was a variable comp true up. I think that was worth about $6,000,000 Is it fair to assume that would not reoccur year and maybe we could even see same store SG and A down in 3Q?
I wouldn't forecast the future, but Mary, go ahead and answer the past.
Sure. Yes. Well, there were some second half hits and that are in the SG and A that were disclosed. And again, time will tell in terms of performance. Performance driven comp, we want it to go up in the Q3 because it will be driven by performance, in fact.
I wouldn't get too surgical about whether SG and A is up or down. I think it's an opportunity to have a better third quarter. But I think predicting some type of decline is probably not the right thing.
Got it. Fair enough. All right. Thank you.
You bet.
And our next question today comes from Chris Dankert of Longbow Research. Please go ahead.
Good morning, Chris.
Hey, good morning, guys, and thanks for taking my question.
I guess back to start off
the year, Paul had kind of somewhat previewed that you were working with suppliers on some growth initiatives internally. I guess, and 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. Is that part of the DMI you announced or just any other color there would be really appreciated?
Sure. Mr. Johnson?
Yes, I guess
rephrase your question for me again, if you would, so I can clearly understand what you're asking.
Sure. Just to start the year, you guys are talking about doing more with suppliers to try and help take share, but just any kind of color on those
increase share. We had a number of programs in the Q1. We continue it in the Q2. Unfortunately, the weather in the didn't cooperate with us quite the way we wanted to. And hopefully, in the Q3, we'll start seeing some fruits of those efforts.
Are we talking about more like advertising, marketing, things along those nature? Or we is it more again on the tech side of things? Just that you mean?
It's on
all of the above. It's on whatever the customers. 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. And then just secondly here, any update on Latin America? I know there was a bit of a struggle in the Q1.
Is there any update there would be helpful?
Yes. I think we can do that. Barry, tell me about the Q2 performance.
Sure. Again, we got into mid single digit growth in Latin America for the Q2.
Mid single digit growth.
Mid single digit growth in the second quarter. And again, progress as the year has gone on for sure. And second half of the year, where 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.
And our next question comes from Blake Hirschman of Stephens Inc. Please go ahead.
Hi, good morning guys. Just a quick one for me. There's been more and more
Thanks.
Perry, can you feel that?
Sure. Again, selling margin, as I mentioned earlier, is the purest determination of that question. And are we marking out products in an efficient way year over year with a lot of price actions and a lot of moving pieces that have gone on? And again, in the quarter year to date, we've seen a slight pickup in selling margins. So that's a good feeling given all the price actions that have gone on.
Thanks for that. I'll turn it over.
And our next question comes from Patrick Baumann of JPMorgan. Please go ahead.
Hi, good morning guys. Thanks for taking my call. Just had a few questions and I apologize if some of these have been asked. I dialed in, just a little bit late. The did 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 want to advise him about that?
Yes, we did comment earlier and the commentary was that again this kind of strike 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. And then and with Texas, for example, is a big market for us. That's where the short term impact probably affected us the largest.
Understood. That makes a lot of sense. And then did you comment on price mix contributions as part of that 3% HVAC equipment growth?
Yes, we said earlier there's a little bit of both.
Okay. That's helpful. And then on Pierce Phelps, it sounds like it hasn't closed yet. Is that right? And then 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.
Well, there are consents and approvals that are required in order to close. We expect that to happen in the Q3. 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. So opportunity to grow.
And just remind me, what were those historical JV margins? I don't recall. That was before my time, sorry.
You find an 8 ks in 2,009 that says 3% margin was what we acquired when we acquired Care Enterprise.
That was good. Okay. I like that.
And then on the inventories of the balance sheet, it looked like up in the second quarter. Anything unusual with regard I mean, I guess they're always up in the second quarter, but seem like they were up a little bit more, anything unusual there?
We just want to 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.
So there are delivery issues this year or you're talking about last year?
There were earlier this year.
Understood. Understood. And then last one for me. Sorry, I had a bunch of random questions. I apologize for
being over the years.
All right. Take your time. We're in no hurry. Take your time.
The so the SG and A growth for the year, do you still expect it to be slower than the rate of sales growth, I guess, maybe in the second half maybe or for the year, however you want to comment on. 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 have an update on that.
Mr. Logan,
I'm sorry, I really lost you at some point. So go ahead and repeat it.
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 and A growth for this year. Do you expect the growth rate in SG and A to be at slower than the rate of growth in sales still? And about how much would you kind of target?
Well, again, one we're in control of. One is how much money are we spending. The first half of the year SG and 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.
So I think there's some confidence there, but it's still dependent on the sales growth, as I said earlier.
Okay. And I'm sorry, I do have one last one. Just in terms of the competitive situation from other distributors, there Lennox had some issues with their plant in Marshalltown earlier, well, last year. And just curious if you're seeing any change in like competitive behavior with regard to them trying recapture market share that may be lost because of production?
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. But 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 Steve. Will do.
And ladies and gentlemen, this concludes your question and answer session. I'd like to turn the conference back over to Albert Nammad, CEO and Chairman of the Board for any closing remarks.
Rocco, thanks for monitoring this. Are you going to be back the next quarter or 2?
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, Andrew. 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.