All right, good morning. We're gonna keep things rolling here on day two with Watsco. I am joined on stage by Watsco Senior Vice President, Barry Logan. A fixture of the company for a long time, synonymous with Watsco, I think, for most folks here. Barry, good to see you. Pleasure to have you, as always. Maybe if you just wouldn't mind, you know, give us kind of an overview of what you're seeing out there, maybe the lay of the land. I know Watsco has a lot of, you know, sort of strategic initiatives that have been in focus, particularly the last few years. If you could just talk through at a high level, sort of what people should be focused on for that, and then, you know, maybe we dive into some questions.
Sure. Again, we'll do some basics for 60 seconds, the elevator pitch here real quick. Watsco's been around about 70 years. Our current CEO, Chairman's been with us 50 years. In 1989, he moved the company toward distribution of HVAC products by buying a $60 million distributor in Miami, or in South Florida, I should say. So since 1989, we've gone from that $60 million single acquisition to a little over $7 billion. We have almost 700 locations. We announced earlier this month, an acquisition in South Carolina that adds $180 million to our business. And what we've done for those years, you know, 34 years thus far, is really build through acquisitions of family businesses, other businesses that have been in the air conditioning and heating business for a long time.
There are brands, there are territories, there are legacies, there are affinities that have been built up in these markets. In scaling the company, it provided us some good benefits, some of which we are especially seeing over the last few years. First, we could scale our partnerships. There are about 8 or 10 U.S. OEMs. There are about 4 or 5 Asian-based OEMs. They make about half the products for the industry, and we represent about 20-25 brands within that community of OEMs. We marry those products with about 600 other manufacturers that sell us products, and all this converges into a contractor who puts it into your home. Over the last few years, and I'll catch up to your answer.
Over the last few years, we really saw incredible demand for products because people were spending money on their homes. Contractors did very well. Watsco did very well. Manufacturing community also is building, you know, 20%, 20% more units than they built four or five years ago. The industry has also seen an unprecedented level of regulatory change over the last 18 months, all of which is pushed through price or new products or new efficiencies. On the horizon, there's new refrigerants coming that will even potentially be even a stronger thread being pulled through the industry in terms of how these products are sold, what they're sold for, what contractors recommend in someone's home. So just some broad, random thoughts to start. What we're seeing is somewhat of, I'll call it Bowling 290.
Over the last two years, again, because of the consumer environment and the home environment, we were bowling 300 games. The last 2021, 2022, Watsco had terrific growth. A little bit of a reset this year in terms of how the consumer is spending money on their homes, needless to say, and you can't bowl 310 anyways. So we see this year, unit, you know, unit declines of around 10% this year in our markets, year to date. Thankfully, we see pricing and the regulatory threads and the higher efficiencies being sold offsetting most all of that. In this quarter, we're seeing certainly dollar growth this quarter. So that's what Bowling 290 to us kind of looks like. We see single-digit declines in profitability thus far this year.
We'd like to close that gap and exceed that gap as we finish the year, and that would be the reset year. That's what a reset year would look like. And over the next 12 months, and I'm sure it's on your questions, there's really another layer, another level of change coming that the industry is beginning to talk more about. They've talked about it at your conference here, and I'm sure we'll talk about it.
Excellent. I wanna follow up on a few points you made here about, you know, sort of the 2Q in 2023. I think inventory has been of particular focus. I think on the last call, you mentioned the units were down. A lot of the growth that folks are seeing is really in price. But to your best sense, you know, how would you characterize Watsco inventory, you know, sort of industry inventory, to the extent you have a window into that? Or are we at healthy levels, or is there still sort of destocking that should be done based on where demand is today?
Yeah. Well, again, I need to paint a picture, so because it's not been business as usual for two or three years-
Right
and if it was business as usual, then I could give a business as usual answer. I can't do that. Because really, two-thirds of the products we sell are entirely new platforms and new products that the OEMs had to invent, certify, produce on scale, ship, and transport to our stores, so we can sell them with a one-hour notice to our customer. And that last phrase, what we sell, we sell with basically one-hour notice from our customer. So serving a customer with all the products they need in that store with one hour's notice is what we're about. We don't have backlog, we don't have you know, long product, long delivery cycles, we have one-hour pickup, or less than that, if we can achieve that.
And so just consider what then in the inventory challenge of, if lead times go from 2 weeks to 60 days, the way they had a couple of years ago, what does that do to our inventory? What do we, what do we put in inventory, if the replenishment is that different and that kind of disrupted, which had gone on? And so we talked about supply chain challenges with manufacturers, and they talked about supply chain challenges for 2 years. But the bigger event, the last 12 months, was this entire product change, from all the new products that were brought into the channel, mixing and matching and, and having all the conforming systems in place in every branch for what, 1-hour notice period. So what am I saying? I'm saying that all of that disruption and all that change causes us to build inventory.
So I think the destocking is almost like this mythical negative, when all it really is, is bringing lead times into the right, you know, kind of place. Us building the right safety stock instead of what we've had to do. Having calmer waters, as opposed to choppier waters, to navigate this. And I'll say it's getting better all the time. And over the next 6 months, I think this, you know, reduction in inventory has a lot, has more, again, more to do with what I've just said in terms of safety stock and kind of getting the inventory balanced and right in all of our stores. And so I think there's probably, you know, again, a 3-to-6-month period that's ahead of us to get that serenity that we're looking for in all of our locations right.
I know weather tends, at points in time, to shoulder a lot of the blame, and maybe over the course of most seasons, tends to even out. 2Q was more of an irritant. The summer still ended up being one of the hottest on record. With that swing factor, did that provide sort of the normalization we would have expected, or was weather maybe not as big of a driver in 2Q as folks thought in real time?
No, I think it came late in our markets, in our big Sun Belt markets. I mean, I would say if you drew a triangle between Dallas and D.C. and Miami, that's probably two-thirds of Watsco in that triangle, and double the size of other businesses you can report on, in terms of scale. So the concept of, you know, where's the weather? We're in favor of the weather, certainly. It came more in late June in those markets than a nd I think the year before, it had come earlier. So in my next lifetime, I wanna be a six-month reporter of air conditioning-
You'll be Europe.
-sale. I wanna be British next time, so we're not talking about seasonality between seasons, second and third quarter. And so, you know, we're seeing the pickup come in the third quarter versus the second this year. And last year, it was a little bit of the inverse of that.
Understood. I want to pivot to gross margins if we can. Obviously, you know, huge, you know, source of positive momentum over the last couple of years. Yeah, I know Al said on the last call, you know, kind of a longer term target around 30%. I think a lot of Watsco targets in the past sort of come undated, or just, "Hey, we're grinding towards this over time. We can see the potential." But help me with, you know, either sort of internal benchmarking that you can say, "Here's how our best branches perform," or something that if we extrapolate a product opportunity across the portfolio, what do you see that gets you from, you know, current state to 30%? Like, what is that anchored to?
Well, like everyone in the room, we operate a portfolio, too, right? Not everyone's stock, you know, stock picking is performing exactly at the same level. Not all of our stores operate at the same EBIT level. Not all of our business units operate at the same level. So when we talk about 30% as an aspirational goal, it's because some of our business units are near that. Not pulled out of thin air or some, you know, again, some myth. It's something that we see within markets, we see within business units that are performing near that level. And Al's challenging, on our conference call, our leadership, as much as he is telling you that. And so that culturally, our portfolio, you know, is pulling in that direction toward what we think is outperformance.
I could say the same thing for EBIT. For many years, we said we wanted to get to 8% EBIT. We got to 8% EBIT, and, and, then we said 10, because we needed a new goal. We were past 10, and now, we, you know, we've said 15 as a, as a goal. Well, why would we even bother with that? Why even say it out loud? It's because we have outperforming business units near that. I'm not saying they're past that, I'm saying they're near that.
I think one of the interesting things, I think it's interesting, is across the distribution space, if it's Fastenal, Watsco, Grainger, Pool, it doesn't matter which one of us, we're all kind of figuring this out and proving it a little bit better each year, and those aspirations have tended to play out pretty well, updated, as you said. But I think distribution has a focus benefit to it that many of us have really done well with. If you would've invested in any of the names I just said over the last 10 or 20 years, you know, it would've been a proven thing, and I think we're still figuring it out and we're still introducing technology to influence it.
We're still going through some of the cultural shift and the need for cultural shift to improve margin or improve profitability or improve share or improve our partnerships. In some ways, we still feel young at doing this, despite where we are, and our 82-year-old leader is the youngest brain of all that says, "We're not even close to where we wanna be." Once in a while, he'll tell you what's on his mind, like a 30%-
Once in a while?
And that's the entrepreneur, that's entrepreneurial culture speaking on our conference call. So but again, it's, it's rooted in the idea that we're near that performance in some respects, and we want our portfolio to outperform at that level.
Understood. Not to dive into sort of heavy forensic accounting, it's certainly not my background, but it's a question that comes up just since margins have expanded so much over the last couple years.
Sure.
You know, if we look at inventory on the balance sheet, you know, as I think you noted on the last call, units are down, so price mix has to form that kind of mid-teens year-over-year delta. Price in the P&L, I think, was up only high single digits. Is that telling us that the costs that are gonna flow through the P&L are gonna be higher than price? Like, does that set up a margin squeeze, or is there some other important piece that we're missing?
No, we buy products on weighted average cost. So if I buy 10 of something and they're $100, my cost is $100. I wanna sell it for $130 and $135 and make a margin. It's almost not more complex than that. The only thing that is more complex is if I sell to a large contractor, maybe my price is $125, but I get a lower cost from my manufacturer to match against that. Because the pricing systems that we share, that we are architecturally collaborative with our OEMs, all the OEMs, is this matching system of my selling price matching with a different cost. And then, so it's a very real. My point is, it's a very real-time selling margin, as we would call it.
There's not a lot of accounting capability involved in that equation. If we're buying a product at a hundred different prices, conceivably, and selling it at a hundred different prices, conceivably, there's no accounting. That's just. In fact, it's algebra passing through system. I think the trickiness in analyzing it today, in that respect, is you have higher pricing, you have higher mix, you have higher average selling price because of the higher mandates of efficiency. Some of that touches gross margin, some of it doesn't. In the way, again, that prices that flows through our system. But, that selling margin is 95% of what is our gross margin, and there's not a lot of accounting going on that can influence it, in any material way.
Got it. You talked about a few sort of important industry-
I'm sorry.
Go ahead.
It's what retail would call a markup. You know, what is the markup on your products? It's that simple. It's algebra at the end of the day.
Got it. You mentioned a few industry, you know, sort of milestones that we're hitting over the next couple of years, on the regulatory front. 2025 with R-454B, obviously, the big step down refrigerant next year, and IRA kind of lingering in the meantime. I think it'll be hard to maybe tease out individual impacts, but it sounds like for next year, prices go up because refrigerant prices go up and the OEMs need to pass that on. Maybe some more replacement, just 'cause the cost of repair goes up.
Help us kind of unpack, you know, how you see some of these, some of these drivers playing out, and, and maybe just for context, for those in the room, or if you barely didn't get to catch it yesterday, I think the OEMs are pointing to something in the neighborhood of over the next two years, maybe 15 or even 20 points of price from the various, you know, regulatory elements around refrigerant. Do those things sound consistent with how you see it, and is there anything else we should keep in mind?
Well, since more than one has said it, then I'll believe that what they're saying in terms of their cost and what they need to build and their sourcing, what the requirements are, they're having, as I understand it, a need to recertify and retest everything and run everything through their labs because the refrigerant is slightly flammable. Either flammable or it's not flammable.
I take issue with that.
There, you know, whether there are sensors or monitors or leak detectors, things like that, that have to be built in. It will be a different product. It'll be a different compressor. It'll be higher pressures in those products a year from now. So if the OEMs are beginning to say, "Boy, there could be a 10%-20% price change because of those things," okay, that's, you know, my cost will go up 10%-20%. My selling price will go up 10%-20%. And quite selfishly, my rent won't go up very much. And EBIT margin generally behaves well in those types of price changes, which we almost just went through the same thing over the last 18 months.
Right.
So those are generally good things that the industry pulls off, so long as all the OEMs are kind of affected in the same way, and I think they are. The second phase of that, though, is where our job begins. Okay, now we own a product that's conforming to the new standard, what is our next opportunity beyond even the OEM environment? And that is, our contractor has to go in a home and say: "Here's what I recommend you do, and here's how much it costs." Are they going to recommend repairing a 12-year-old machine? They shouldn't. Are they gonna recommend just changing the outdoor unit and not the indoor unit, and letting it sit there for another 3 or 4 years? They won't be able to do that with the new refrigerants.
The new refrigerants will not work with the old components. Will they go into the home and say: "I wouldn't bother with this old system that's 20% less in cost, because I may not be able to repair it or keep it under warranty for the time period we're talking about, so let's go ahead and upgrade it now." So the subtlety, the abstract discussion, begins with the contractor channel, which is our job to train, to teach, to bring technology, to educate. There's local permitting and zoning nuances maybe in this. Florida may treat this differently than Texas. That's our job, is to get all that momentum into the contractor community. And you can tell we're very excited about it because it should help, and last time around did help, the rate of replacement in the end market.
Again, the OEMs are not in your home. I'm not in your home. Our software can be in your home, if the contractors adopted it.
I think it was, actually.
So that's where the groundswell for us is going on now until next year, is how do we get the contractors fully engaged? And if there's a tax credit or a rebate under IRA or a local utility rebate or electrification payment, how do we lace that into our daily life with the contractor's knowledge? And so we're working a lot on that side of it ahead of what's going on next year.
The next year has some, I think, particular nuance for folks like yourselves, who have to shepherd the contractor base and help them communicate to the homeowner. Buying an R-410A unit next year might make more sense than trying to repair something, just given the cost of repair will go up. But now I have this unit that will become very hard to service before even the warranty expires. How do you plan to approach that? I mean, we've heard some sort of inverse buy forward, where they're trying to pull in R-454B early. I don't even know how, you know, feasible that'll be at a market level, but do you have sort of a preliminary strategy on how to navigate, you know, some of that longer term risk the contractor or homeowner may face?
Sure. Well, I mean, we would like the new products sooner than later and not have to go through any kind of big transition in inventory. Just when it's available, begin to stock it and sell it. And we're in the Sun Belt, again, primarily, where the payback of all this stuff is quicker, and where the sort of the replacement rate is higher. Replacement rate is higher in Florida than in Minnesota. We replace them more often, and it's where the population migration obviously has come the last, you know, 20, 30 years. So in the Sun Belt markets, Josh, I think, our goal is to get things transitioned as soon as the product is available and not sit on old stuff that it becomes uncertain, to your point, as to whether it can be serviced or whether...
Because refrigerant is not covered under warranty.
Right.
The labor it takes to change out the refrigerant is not covered under a warranty. So three years from now, you don't know if that cost of that refrigerant is gonna be $1,000 or $3,000. And if you're a homeowner buying the system today and you're told that, to your point, you might go ahead and upgrade to the new product, if it's available, even though it's 20% more expensive.
Right. If-
You know, I guess 10%-20% has been the range thrown out.
If it's not fully available at sort of a widespread level, do people just hold off and try to wait and Band-Aid things? Like there's. I guess the season makes a difference. No one wants to sit in a hot house, but there's also sort of a practical application.
Yeah. I don't think we've seen, in the last time, if there's a chronic failure, that someone in Florida is not gonna wait six months-
Right
to get something. So I think the 410A products will be in stock, or will be available, and sold with a measure of uncertainty. But I don't think a stockpile will be built to defer the new products being introduced.
Right.
So I think that's what's critical. A year from now, I think, inventory in the channel will largely reflect the new products and diminishing amounts of the old products.
Got it. Maybe just pivoting over to IRA. I feel like we had a similar discussion a year ago, a lot of enthusiasm. Heat pumps were sort of the free bingo square for conversations like this and with your OEM partners, and no one really knew anything yet.
Right.
Fast forward 12 months, it still seems like there's a lot of ambiguity out there, but $2,000, even at the low end, is an awful lot of money. How do you see this skewing the heat pump mix for yourselves or industry or any other perspective you'd have?
Sure. Well, first, the first layer of the IRA was the tax credit.
Yep.
And so government will pay you $2,000, a $2,000 tax credit if you do this system, and this system was not defined. So now we have-
Not good policy.
Right. So let's, let's, let's allocate the money, but we don't know how to spend it yet. So that finally, that clarity, that definition finally was made clear about a month ago, and this, the individual SKUs that we carry in inventory, we know which ones qualify for the tax credit. So we go to our contractor and say: "Here are the ones where you have a, a sales pitch to make to the homeowner. We'll put that into, again, our, our, our technology platform for you to see and, and recommend each time you sell one," and go sell more, and they are. So how material is that? You know, I'll tell you in December, for the last half of the year.
But, it's a good thing because we will sell more inverter-driven products, be it ductless or ducted, over the last, you know, third of the year here. Again, materiality is probably more of a factor next year than this year, but at least we have clarity for the $2,000 tax credit. The rebate for electrification, which is a richer part of, potentially part of IRA, has been even more obscure in terms of how it works and who gets it and what do they get it for.
Oh, by the way, in my first example of the tax credit, so yeah, if I have a $1,000 gas furnace I'm selling and there's no tax credit, and the contractor puts it in for $2,000 and gets you a new furnace for the next, you know, 10 years of your life, or can put in a new heat pump system, get the tax credit, that's probably a $3,000-$4,000 sale for us. That's probably a $6,000-$8,000 sale for the contractor, and with a $2,000 tax credit, it helps the homeowner pay for it, and you get a 10-year improvement of electricity, you get improvement, you know, on all the things we're talking about. And there are some utilities adding dollars to that equation.
So we like the tax credit for just, let's sell more high efficiency. We like the tax credit just to offer more in heat pump electrification opportunities versus the gas furnace. And the third one, this is the most complex thing we've ever had in our careers to talk about. I guess it's good to talk about it, but is rebates for what would essentially be qualifying homeowners for qualified products that upgrade toward electrification, and that can be an $8,000. I think the number is $8,000. And but it's a state-by-state spend, that the states are getting money from the U.S. And like Florida right now is saying: "We don't know if we want the money or not.
We don't know if we want to spend it or not." So talk about lack of clarity. But a market like California, a big market for us, California is gearing up. They've got the dollars, they're going to figure out how to allocate them. They're going to figure out what bureaucracy is to pay the homeowners, and then we'll train our contractors on how to lace it all together. I think it's more of, again, more of a next year event at best than something that is helping this year. On the commercial side, there's more. I know some of the OEMs at the conference here have talked about the commercial side. And again, that's infrastructure spending, that's budgets, that's CapEx. Someone's CapEx is our revenue.
We would see that more on the unitary product side than the applied product side-
Sure
just based on what we sell. Again, I think it's more get rich slow than get rich quick. But that's okay. You know, all these things help sell products, I think.
But with the slight improvement in clarity that we've gotten over the last month or, you know, even over the last 12 months since we first started talking about this, I think something that I certainly get the question a lot, and a lot of people in this room wonder about, is $2,000 enough to bridge the gap between a cooling-only system and sort of the comparable qualifying heat pump? Like, does, is the homeowner basically getting a heat pump at the price of a cooling system that they probably would have had to buy anyway because it was failing?
Yeah. Well, we've seen an increase in heat pump versus straight cooling, growth rates without a tax credit.
Yep, probably like 20 years in a row now.
So again, that's the contractor making the sale and convincing the homeowner, "Here's what you should do." And so with the tax credit should help the higher end of that, because again, the attachment is on not just selling a heat pump system, but a higher efficiency heat pump system.
Mm-hmm.
But it's been a mega trend for, again, 10, 15 years, as you said. And if anything, it's accelerating because of awareness as well. It goes back to the contractor again. The contractor's the one saying: "Here's what you should do." And they're getting the confidence, they're getting momentum in the products, especially up north, now that the products can actually heat a home reliably. That's been part of the change. And then the growth in ductless, 'cause around the world, that's how you heat a home, is through heat pumps. The part of that proliferation is now happening here, and we're part of that market as well, obviously.
I think all those things probably come with shorter useful lives since you're spending that compressor 11 or 12 months out of the year, too.
Yeah. And I would say the warranty rate is probably higher too, by the way, on heat pumps for the OEMs. So that's a cost they need to capture in what they're selling for, too. And so the answer is yes.
Understood. I see we're at time. Barry, really appreciate you making the trip out. Good to speak to you as always.
Great. Thank you very much.