Good morning, everyone, and welcome to the Watsco Second Quarter 2018 Earnings Conference Call. All participants will be in listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad.
Please go ahead.
Good morning, and 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 A. J. Nahmad, President Paul Johnson, Johnson, 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 the 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 cost. 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 make 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 $1,200,000,000 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 $24,000,000 In summary, Watsco's transformation of our distribution channel continues. Now the 2nd 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 $90,000,000 including the benefit of lower income taxes. Debt has been reduced by $238,000,000 from a year ago.
Our gross margins reflect higher equipment selling margins that are offset by non reoccurring benefits last year related to refrigerant. 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 and HVAC equipment. And 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.
Now 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 7% increase in residential HVAC equipment. Operating income increased 7% to a record $191,000,000 Operating margins expanded 20 basis points to 8.5 percent and EPS increased 19% to a record $3.32 on net income of $124,000,000 Now one last comment before we move on to Q and 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 are 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, A. J, Paul, Barry and I are happy to answer your questions.
Thank you, sir. We will now begin the question and session. The first question will come today from Ryan Merkel with William Blair. Please go ahead.
Morning, Ryan.
Hey, morning.
Is this as warm there as it is here?
It's been warm in Chicago this summer, so it's got to help the HVAC industry, I would think. So a couple of 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?
Yes, Ryan, again, it was a spike in price that was temporary and short term last year and it was about a $4,000,000 impact on last year's earnings that did not recur this year.
Which is $0.09 per share, is it not?
That's correct, yes.
Got it. Okay. So that's sizable. And then 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. And again, that's a matter of timing of when we make purchases and when we pay vendors.
Okay. So then the important question is, as we look to the second half, it sounds like given the pricing environment and 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, they're moving pieces. I mean, Paul, you may want to comment on refrigerant, but I can take a stab at it. And 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, that should flatten out over the course of the year, something I think we just needed to deal with this quarter and this conversation. And pricing also has been introduced across most of our OEMs for the second half of the year.
And there's obviously, there was momentum in pricing and margin for equipment in the first half and it's an opportunity to do that incrementally in the second half. So 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?
Okay.
And most of the energy we talk about is on equipment, equipment being about 2 thirds of our business. And so if I dial in on the 6%, as Al's comments suggested, both unit volume, price and mix contributed to the 6%. And 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.
Good morning, David.
Good morning, Al. Good morning, everyone. So first off, on this refrigerant issue, I guess the $4,000,000 is the difference between the current price for R-twenty 2 of $11 or $12 versus something like $20 last year? And Barry, based on what you said, are we to assume that, that might be the case in the Q3 as well?
No, we're not suggesting that there's an overhang to this for the rest of the year, no.
Okay.
And this was all price, there was not some volume influx in the Q2 last year, it was just the price?
That's correct.
Okay. All right. And then on the price mix impact on equipment this quarter, you said it contributed to the 6%, but you're not saying how much. But we should assume that you'll pick up something in the Q3 based on the midyear price increases. Should we assume another percent maybe, 2%?
I'm just any idea as far as what the incremental might be from 2nd to 3rd quarter?
Paul, maybe you have some insight. I think, again, we said go ahead.
No, I mean, I can't calibrate exactly how much it is, only because the OEMs staggered their price increases across the board. So we had OEMs going up in June, July, May, August. And so it's going to be a difference for us in mix as well as 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 Q2 versus Q2 last year?
Yes. We don't we do not disclose that.
Okay.
All right. And just overall, I guess, you've over the past couple of years, you've not provided any guidance at this point in the year. But I think from, I don't know, going back to 2010 or even before, you normally give some level of guidance. Is there anything you want to provide or qualitatively discuss about the year at this point, Al?
Well, we're not going to quantify anything, but we do want to tell you we're expecting record performance, obviously.
Okay. Thank you.
The next question comes from Brett Linzey with Vertical Research Partners. Please go ahead. Yes.
Thanks. Hi, good morning. Yes, just wanted to come back to some of the technology strategy rollout. In terms of the business intelligence and the data analytics rollout, what percent of the next several quarters?
Good question. A. J?
Yes. The answer is 100% has the tools and the technology and data at their fingertips now, but the data and the insights and the dashboards and scorecards and reports and analytics will ever 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 actually see trends and patterns and opportunities. And so while everybody has it, the usage and the value creation and realization of the usage should continue to increase.
And then I guess just in terms of SG and A leverage, I mean how should we think about as that rollout or a big portion of that rollout is now live, how does SG and A leverage or SG and A as a percent of sales look into 2019 2020? What are sort of the expectations and targets there?
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. So I would not venture to say to answer the question directly, just that we just think we're going to continue to operate at record levels while we continue to make for us anyhow very large investments in technology because of the long term focus that we have.
And then I guess just in terms of the higher customer facing investments
Yes, that's a lot of people.
Yes, another year over year headwind in the quarter.
Well, that I can't answer. We've added, what is it Barry, 300 people?
In the last 2 years, almost 300, about 140 year to date.
I think that's top off.
And what was the drag from that in or you mean in the first half or in the quarter?
I don't know. Did you quantify that Barry?
Yes. It's also about $3,000,000 to $4,000,000 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.
Good morning, Chris. Hey, good 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 other owners there or kind of how you've been working with the guys in the ground? Just any commentary would be helpful.
Yes, we can add. Barry, tell him the small addition.
Well, first, we did close on a purchase to add 1.4% to our ownership. So we're at 36 0.4%. 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, Alan, I don't know what you want to cover beyond that.
They're doing very well. Their performance is very good. As it should be, it's a great company.
And then just thinking about on the ground, I mean, obviously, we see the price increases coming through from the vendors. But as far as the dealers you're working with and that kind of thing, how's acceptance been there? I mean, has the pushback been as severe as in years past? Or are they just kind of pushing it onto the customer at this point? Paul?
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 tariff change, with some of the freight issues that we're all running into to justify and rationalize an increase in pricing.
Got it. And just 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 on a year over year basis here?
Well, the hurricane affected all the parts of our market. I mean, obviously important parts, but that's a very hard question to quantify. I just think we're going to 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 think there's 2 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 Q4. The second word is destruction. And certainly was destruction in some limited markets in Florida and Houston. But we said many times now in the big picture, that's not a material thing to all of Watsco.
And that's a better explanation than mine. Thank you. My goodness.
Thank you, gentlemen. The next question will be from Jeff Hammond with KeyBanc Capital Markets. Please go ahead.
Good morning, Jeff. Hey, good morning.
Carrier mentioned in their call some issues in June with trucking shortages. Can you just speak to what you're seeing there and if that's impacting the momentum of the business?
That might reflect itself in the amount of inventory we're carrying, but go ahead, Paul.
Yes. There's been a lot of conversation in the press about truckers and the lack of drivers. And 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 into stock in anticipation of the trucking shortage. So to date, Watsco really hasn't been impacted by a shortage of inventory because of truckers.
Okay, great. And then just on margins, I mean, I understand the refrigerant dynamic, but we're certainly in a good environment. You seem to be getting price and mix. And I'm just wondering what might be holding back more meaningful improvement in the margins?
I'm not sure I understand the question.
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%. And it just seems like with price and mix, you would be able to hit that bogey?
Barry, I don't get it. Do you have an answer to that? Yes.
I mean, first of all, it's the first half of the selling season and we need to have a conference call to talk about our Q2. I think the whole of our selling season with the Q3 offers that opportunity to have better margin expansion. I think we called out a few items in the second quarter that did some
of that Excuse me for the interruption, but EBIT margin is at a record high. Were you aware of that, Jack?
I mean, I have margins down year over year and you had Ziegler and other adding to that, which was
FlashCo's EBIT margin is at a record high. It doesn't mean we don't have opportunity to get better, if that's what you're inferring. 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 and thank you for your interest in our company. Goodbye now.
And thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.