Earnings Call: Q2 2018

Jul 25, 2018

Good morning, everyone, and welcome to the Watsco 2nd quarter 2018 earnings conference call. I would now like to turn the conference over to Albert Nahmad. Please go ahead. Good morning, welcome to the Watsco second quarter earnings call. We're coming to you from sunny Miami, where it's very warm. This is Al Nahmad, Chairman and CEO, and with me is AJ Nahmad, President, Paul Johnston, Executive Vice President, and Barry Logan, Senior Vice President. As we always do before we start, the usual cautionary statement. This conference call has forward-looking statements as defined by SEC laws and regulations that are made pursuant to safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Now on to the report. Watsco achieved record second quarter results. Our performance includes record sales, profits, operating margins, net income, and earnings per share. Sales growth was driven by increased unit demand, price, and mix for replacement systems. Importantly, Watsco's results were achieved while continuing to make significant investments in our industry-leading technology platforms, as well as the addition of customer-facing employees to expand sales and service capabilities. As we mentioned in the release, we are challenging our employees to accelerate utilization of our innovation to build market share, develop more efficient processes, and reduce costs. A number of initiatives are underway, all with the goal of improving sales and profitability over the long term. During the quarter, we raised our annual dividend to $5.80 per share. 2018 marks the 44th consecutive year that we have paid dividends. Future dividend increases will be considered in light of investment opportunities, cash flow, our financial condition, and business conditions. Our balance sheet remains conservative with a debt-to-total cap of 8%. This positions us to take advantage of almost any size investment opportunity that may come along. As always, the second half of the year will be a strong cash flow period. We again targeted cash flow to exceed net income this year. On our very important game-changing initiatives, we continue to grow adoption and use of our various technology platforms. For example, more customers are using our apps and e-commerce to gain speed and efficiency in their business. More SKUs have been digitally mastered and added to our product information database, which is now over 650,000 SKUs. Given our progress to date, we believe our e-commerce sales could reach $1.2 billion this year and exit the year close to a 30% run rate. More of our locations have implemented order fulfillment technology to complete and ship orders faster and save customers time. More employees are using our data analytics to gain insight into operations and opportunities. Technology spending so far this year has increased 9% with an annual run rate of $24 million. In summary, Watsco's transformation of our distribution channel continues. Now the second quarter results. Revenue grew 5%, including a 6% in equipment sales. Operating income increased 6%. Operating margins expanded 20 basis to a record 10.3%. EPS increased 16% to a record $2.40 on net income of $90 million, including the benefit of lower income taxes. Debt has been reduced by $238 million from a year ago. Our gross margins reflect higher equipment selling margins that are offset by non-recurring benefits last year related to refrigerants. Gross margins were also impacted by the timing of the vendor-related incentives. The overall price environment for equipment remains positive. The first round of OEM price increases are reflected in our existing results. The mid-year price increases recently introduced are presenting us with a sales and profit opportunity during the second half of the year. Now results for the first half. Revenues grew 5%, driven by a 7% increase in residential HVAC equipment. I must now turn off this phone because it's interfering. The overall pricing environment for equipment remains positive. The first round of our OEM price increases are reflected in our results. The mid-year price increases recently introduced are presenting us with a sales and profit opportunity during the second half of the year. Results for the first half. Revenues grew 5%, driven by a 7% increase in residential HVAC equipment. Operating income increased 7% to a record $191 million. Operating margins expanded 20 basis points to 8.5%, and EPS increased 19% to a record $3.32 on net income of $124 million. One last comment before we move on to Q&A. This past May, Baird and Watsco hosted a technology summit to provide institutional investors greater insight into our long-term thinking. It was a great event, which you were invited to listen to on our website. As a follow-up, we are also happy to host institutions who wish to learn more about Watsco and learn firsthand how our technology platforms are redefining the industry. A visit to our Miami headquarters also provides a deeper understanding of our unique culture, which is critical to our long-term success. With that, AJ, Paul, Barry, and I are happy to answer your questions. Thank you, sir. We will now begin the question-and-answer session. To ask a question, you may press star then 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question will come today from Ryan Merkel with William Blair. Please go ahead. Morning, Ryan. Hey, morning. Is it as warm there as it is here? You know, it's been warm in Chicago this summer, so it's gotta help the HVAC industry, I would think. Yeah. A couple questions on gross margins, if I can. Firstly, can you quantify the year-over-year impact from the non-recurring refrigerant boost? Just wondering how big that was. Sure. Barry? Yeah, Ryan, again, it was a spike in price that was temporary and short term last year. It was about a $4 million impact on last year's earnings that did not recur this year. Which is $0.09 per share, is it not? That's correct, yeah. Got it. Okay. That's sizable. Secondly, the timing of vendor incentives, what was the impact there in the quarter? Again, it's driven by the timing of purchases, and it's probably a similar magnitude, Ryan. Again, that's a matter of timing of when we make purchases and when we pay vendors. Okay. The important question is, as we look to the second half, it sounds like given the pricing environment, maybe the timing of vendor incentives, should we expect that gross margins could improve year-over-year in the second half such that you might get to flat for the year? Obviously, there are moving pieces. I mean, Paul, you may wanna comment on refrigerant, but I can take a stab at it. First, we do think that's a temporary thing from last year and is somewhat not in the cards going forward. The purchasing side of vendors and rebates and discounts, things like that should flatten out over the course of the year. Something I think we just needed to deal with this quarter and this conversation. Pricing also has been introduced across most of our OEMs for the 2nd half of the year. There's, you know, obviously there was momentum in pricing and margin for equipment in the 1st half, and it's an opportunity to do that, you know, incrementally in the 2nd half. Where it plays out at the end of the year, I can't say, but, we like the general conversation of this. Okay. just lastly, and I'll turn it over, how much did price contribute to the 5% total company sales growth this quarter? Again, most of the energy we talked about is on equipment being about two-thirds of our business. If I dial in on the 6%, as Al's comments suggested, both unit volume, price, and mix contributed to the 6%. Generally speaking, we'll leave it at that. Very good. Thanks a lot. The next question will come from David Manthey with Baird. Please go ahead. Morning, David. Morning, Al. Good morning, everyone. First off on this refrigerant issue, I guess the $4 million is the difference between the current price for R-22 of $11 or $12 versus something like $20 last year. Barry, based on what you said, are we to assume that that might be the case in the third quarter as well? No, we're not suggesting that there's an overhang to this for the rest of the year, no. Okay. This was all price. There was not some volume influx in the second quarter last year. It was just the price? That's correct. Okay. All right. On the, you know, on the price mix impact on equipment this quarter, you said it contributed to the 6%, but you're not saying how much. We should assume that you'll pick up something in the third quarter based on the mid-year price increases. Should we assume another %, maybe? 2%? Any idea as far as what the incremental might be from second to third quarter? Paul, maybe you have some insight. I think, again. Go ahead. In the middle of a conversation. No, I mean, I can't calibrate exactly how much it is, only because the OEMs staggered their price increases across the board. We had OEMs going up in June, July, May, August. It's going to be a difference for us mix as well as, you know, when the timing of the price increase actually occurred. Very unusual. I've never seen a price increase in season before. Right. Do you know, Paul, the increase in the number of units you shipped this second quarter versus second quarter last year? Yeah, we don't, we do not disclose that. Okay. All right. Just overall, I guess you've over the past couple of years, you've not provided any guidance at this point in the year, I think from, I don't know, going back to the 2010 or even before, you'd normally give some level of guidance. Is there anything you wanna provide or qualitatively discuss about the year at this point, Al? Well, we're not gonna quantify anything, but we do want to tell you we're expecting record performance, obviously. Right. Okay. Thank you. The next question comes from Brett Linzey with Vertical Research Partners. Please go ahead. Yeah. Hi. Thanks. Hi, good morning. Yeah, just wanted to come back to some of the technology strategy rollout. Sure. In terms of the, you know, the business intelligence and the, and the data analytics rollout, what % of the footprint currently has those tools and is live, and what's the cadence of, you know, that penetration look like here, you know, over the next, you know, several quarters? Good question. AJ? Yeah. The answer is 100% has the tools and the technology and data at their fingertips now, the data and the insights and the dashboards and scorecards and reports and analytics will forever evolve, right? There's more data sets being added to the mix. There's new math and new dashboards and new ways to torture that data to derive insights and eventually see trends and patterns and opportunities. While everybody has it, the usage and the value creation and realization of the usage should continue to increase. Then I guess just in terms of, you know, SG&A leverage, I mean, how should we think about, you know, as that rollout or, you know, a big portion of that rollout is now live, you know, how does SG&A leverage or SG&A as a % of sales look, you know, into, you know, 2019 and 2020? You know, what are sort of the expectations and targets there? You know, it's hard to quantify that because we are open-ended with respect to technology investment. We are so long-term orientated. We're not a quarter-to-quarter sort of investor. I would not venture to say, to answer the question directly, just that we just think we're gonna continue to operate at record levels while we continue to make, for us anyhow, very large investments in technology 'cause of the long-term focus that we have. I guess just in terms of the higher customer-facing investments. Yeah, that's a lot of people. Yeah, another year-over-year headwind in the quarter. I know. Well, that I can answer. We've added, what is it, Barry? 300 people. In the last two years. Yeah. About almost 300. Yeah. About 140 year-to-date. I think that's topped off. What was the drag from that? You mean in the first half or in the quarter? I don't know. Did you qualify that, Barry? Yeah. It's also about $3 million-$4 million of impact in the quarter. In the quarter. Okay. Great. I'll pass it along. Thanks. The next question comes from Chris Dankert with Longbow Research. Please go ahead. Morning, Chris. Hey, morning, Al. Thanks for taking my questions, guys. I guess first off, just any kind of update on Sigler as far as the coordination with the other owners there or kinda how you've been working with the guys on the ground? Just any commentary would be helpful. Yeah. Yeah, we can add. Barry, tell him the small addition. First, we did close on a purchase to add 1.4% to our ownership, so we're at 36.4%. The concept and the process, the technology we designed with the family worked, and we've added a small piece to that. As far as the remaining ownership, again, it's up to the family of when and how and to what magnitude they want to sell. From the business perspective, Al, I don't know what you wanna cover beyond that. They're doing very well. Yeah. Their performance is very good. As it should be. It's a great company. Then just thinking about, you know, on the ground, I mean, obviously we see the price increases coming through from the vendors, but as far as, you know, the dealers you're working with and that kind of thing, how's acceptance been there? I mean, is the pushback been as severe as in years past, or are they just kind of pushing it onto the customer at this point? Paul? You know, the acceptance obviously has a little bit of a snarl to it, but generally speaking, the customers are accepting the increase. There's such strong and compelling evidence out there with the with the tariff change, with some of the freight issues that we're all running into to justify and rationalize an increase in pricing. Got it. Just the last one from me. Since we're kind of coming up on the hurricane comp from last year. I think it was $0.10, if I'm remembering correctly. Do you guys expect you've already recovered most of that repair damage over the past 12 months, or is that something that's still going to be a meaningful benefit, you know, on a year-over-year basis here? The hurricane affected only parts of our market. I mean, obviously important parts, but that's a very hard question to qualify. I just think we're gonna have a very good year, and it's hard to say how much of that comes from hurricane impact last year. Fair. Fair. Thanks again, guys. Again, if you'd like to ask- I'd like to add to that, Al. I think there's two words in the hurricane discussion. There's the word disruption, and that is what happened last September, and some of that business came back in the fourth quarter. The second word is destruction, and there certainly was destruction in some limited markets, you know, in Florida and Houston. We said many times now, in the big picture, that's not a material thing to the all of Watsco. That's a better explanation than mine. Thank you. Oh my goodness. Thank you, gentlemen. Again, if you have a question, please press star then one. The next question will be from Jeff Hammond with KeyBanc Capital Markets. Please go ahead. Good morning, Jeff. Hey, good morning. Hey, Carrier mentioned in their call some issues in June with trucking shortages. Can you just speak to, you know, what you're seeing there and if that's, you know, impacting momentum for business? That might reflect itself in the amount of inventory we're carrying. Go ahead, Paul. Yeah. There's been a lot of conversation in the press about truckers and the lack of drivers. To date, knock on wood, yes, there was a little bit of an issue that Carrier had. We compensated for it, obviously, by pre-buying the inventory and bringing it in to stock in anticipation of the trucking shortage. To date, Watsco really hasn't been impacted by a shortage of inventory because of truckers. Okay, great. Just on, you know, margins. I mean, I understand the refrigerant dynamic, but, you know, we're certainly in a good environment. You seem to be getting price and mix. I'm just wondering what, you know, what might be, you know, holding back more meaningful improvement in the margins. I'm not sure I understand the question. Yeah. Well, I mean, if you kind of pull out the Sigler, the incrementals were, like, 9% in the quarter, and I think you guys typically run 15%. You know, it just seems like with price and mix, you know, you would be able to, you know, to hit that bogey. Barry, I don't get it. What do you have an answer then? Yeah. I mean, First of all, it's the first half of the selling season, you know, we need to have a conference call to talk about our second quarter. I think the whole of our selling season, with the third quarter, offers that opportunity to have better and better margin expansion. I think we called out a few items in the second quarter that. I mean. some of that. Excuse me for the interruption, but even margin is at a record high. Were you aware of that, Jeffrey? I mean, I have margins down year-over-year, you had Sigler and the other, you know, adding to that. Watsco's EBIT margin is at a record high. It doesn't mean we don't have opportunity to get better, if that's your inference. Yes. Okay, thanks. This concludes our question and answer session. I'd like to return the conference back over to Albert Nahmad for any closing remarks. Thanks very much for your interest in our company, and we look forward to some of you visiting us in Miami to get a firsthand look at our technology platforms and our culture. We really wish you would come. Thank you for your interest in our company. Goodbye now. Thank you, sir. This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.