Watsco, Inc. (WSO) Q3 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Watsco Third Quarter Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Albert Nahmad, President and CEO. Please go ahead.

Good morning, everyone. Welcome to our third quarter conference call. This is Albert Nahmad, President and CEO; and with me is Barry Logan, Senior Vice President. Paul Johnston, who's normally on this call, on these kind of calls, is unable to be with us today. First, let me read the 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. Watsco has achieved another record-breaking quarter. We're having a great year. We established new records for sales, operating income, net income, earnings per share and cash flow. Sales in the United States, which account for 86% of the revenues, outperformed international sales, with sales up in the United States of 8%, including 10% growth in both residential and commercial equipment products. Our trends toward system replacements and a higher mix of higher efficiency systems continues. We achieved record higher selling margins, and SG&A was, again, well-managed by our team. In summary, a solid quarter that continues what has been a terrific year for our company. Now on to the figures. First of all, the quarter's revenues grew 6% to a record $1.1 billion. Equipment sales were up 8% across all markets, and sales of other HVAC products were up 3%. Sales of commercial refrigeration products grew 1%. Gross profits increased 7%, and gross margin improved 10 basis points to 23.9%. SG&A increased only 4%. Operating profit improved 11% to a record $95 million, with operating margins expanding 40 basis points. And finally, earnings per share increased 11% to a new record of $1.32 per share, that is, diluted share. Now for the 9 months. Revenues grew 9% to a record $2.9 billion, up 6% on a same-store basis. Gross profit increased 11%. Gross margin improved 30 basis points, while SG&A increased just 2%, excluding new locations. Operating profit improved 21% to a record $231 million, with operating margins expanding 70 basis points to 7.9%. On a same-store basis, operating profit increased 19%, with operating margins improving 90 basis points to 8.1%. Earnings per share has increased 22% to a record $3.18 per diluted share during the last 9 months. Now for our cash flow and balance sheet. During the quarter, we generated cash flow of $128 million, which is a record for any quarter in our history. Positive cash flow will continue in the fourth quarter. Our target for 2013 remains the same as always, to generate operating cash flow in excess of net income. Debt at the end of the quarter was $28 million or just 1x trailing 12-month EBITDA. We ended the quarter with a debt-to-cap ratio of 20%, and we recently raised our dividend rate by 60% to $0.40 per share. Our goal remains to pay increasing dividends depending on our debt position and other prospective means for capital. Our outlook for this year, 2013, is within a range of $3.65 to $3.75 (sic) [$3.70]. This represents a prospective growth rate of 20% to 22% in earnings per share over last year. One last item before we take your questions. Watsco will be hosting an Investor Analyst Meeting on November 8 in Miami. We will send out a formal announcement in the next few days. Please send Barry Logan a note if you would like to attend. It will be a great event at a great venue. Members of our senior management will have fun telling you more about our company. With that said, Barry and I will be happy to answer your questions.

[Operator Instructions] First question comes from Ryan Merkel of William Blair & Company. Ryan Merkel - William Blair & Company L.L.C., Research Division: So the first question I had was, can you just talk about the cadence of sales growth by month in the quarter? My guess was July was strong, but things might have fallen off a little bit, and I'm just wondering what some of the drivers were.

Bryan (sic) [Ryan], we opened the -- our commentary -- actually, during the last quarter, somebody asked about July, and I said that it was strong, but we do not comment on monthly performance. So all I could say is July of the third quarter was strong, and you can take it from there. Ryan Merkel - William Blair & Company L.L.C., Research Division: Okay. And then your annual guidance implies that the fourth quarter EPS is a little better than I was thinking. So what explains this, because it looks like you're assuming EPS growth will accelerate year-over-year in the fourth quarter? I'm just wondering, was weather an issue in the quarter and that will turn around in the fourth quarter, or is there something else in the business you're seeing?

Well, I'll answer it and then let Barry answer it. We're just having a very strong year, and all the fundamentals, while not operating at peak performance yet, we're -- the performance is getting and better. And with respect to the fourth quarter, Barry, you want comment on that?

Sure, Ryan. I mean, again, the third quarter is really the end of the season, so to speak, the end of the cooling season, and as come into the off season, if you will, and into the heating season, it's really showing up, I think, as we expect it to. In fact, the whole year, really, if you go back and listen to our sentiments early on in the year, have been very much where we're ending up as we close out the year. So really, there's no big trend or anything to read into it, Ryan. Ryan Merkel - William Blair & Company L.L.C., Research Division: Okay. And then just last one quickly, gross margins were up sequentially. That was kind of surprising to me given the mix shift to equipment. So is this just driven by better selling margins across most of your product portfolio?

We did see better margins in our equipment sales, which is now about 2/3 of what we do. And Ryan, I think that's just good discipline and a healthy market and equipment business.

The next question comes from Matt Duncan of Stephens Inc.

I wonder if you can help us a little bit with the difference in equipment growth for residential and commercial. The total was up 8%, but how did resi and commercial differ?

Matt, especially in the U.S. markets, we saw a nice recovery in the commercial market. Both residential and commercial were up 10% in the quarter in the U.S. International had a little bit of a slowdown off of what had really been significant growth last year. But if I concentrate on our big business in the U.S., both residential and commercial were very healthy.

Okay. And then Barry, looking at the 3% growth in other HVAC products, I think there's probably a tale of 2 things going on there. The repair versus replace pendulum seems to have swung back to replacements. So can you talk about how much of a drag you had in those other HVAC products from maybe a decline in repair parts sales versus the parts and supplies you sell into the new construction market?

It's a -- the trend really towards replacement of systems as opposed to replacement parts began last year and that's continued this year. So that's a great long-term trend, and it's why you see the growth in the equipment side of our business, which obviously drives much bigger dollars. In the other types of non-equipment, supplies and not just things that go into housing, but refrigerant, for example, this year, we did see some lower pricing, which has impacted the revenue in that bucket. That has stabilized, the gross profit that we're realizing on those products is where it should be, but we are seeing -- we did see some lower pricing in some of those, what I'd call generic products, this year.

Okay. And then looking at sort of longer term, looking out to next year, how do you think the move from 13 SEER minimum in the Sunbelt to a 14 SEER minimum is going to impact the market next year? I guess in theory, since you guys have locations both in the Sunbelt and in the North, that ought to help you keep a 13 SEER product available in the Sunbelt when others may not be able to do that, so how do you think that's going to unfold as we move into next year?

Well, again, the standards are not -- do not take effect until the beginning of 2015, and the regulations that relate to those requirements are still being written. So Matt, I don't -- we don't have a clear picture yet on how that's going to play out in the marketplace.

But Barry, that is an install date as opposed to last time when we went from 10 to 13 SEER, that was a manufacture date, correct?

That's correct, yes. The difference is, and it is more onerous for the marketplace, is the installation date becomes the guidepost for the regulation. How that will be enforced, who will enforce it and what the consequences of that enforcement will be is what's being debated and worked out. So if it goes as written today, that transition of products should begin to happen sometime next year. And in 2015, again, as written today, the 14 SEER mix would improve and the price mix would improve.

Okay. The last thing, just a couple of housekeeping items. Do you have what depreciation, amortization and CapEx were in the quarter?

For the quarter, depreciation, amortization is $6.6 million, and CapEx is about $4 million.

The next question comes from Jeff Hammond of KeyBanc Capital Markets.

Just to clarify, on the guidance, so you took $0.10 out of the top end. Can you just -- is that top line coming in weaker, or a weaker third quarter or higher cost? How are you thinking about the guidance change?

Well, that's the thing about our business. That's why we don't like to anticipate by quarter, and we don't do that. We anticipate, when we think we can, the year. And it's a general feel that we're still going to have a fabulous year, but we may not reach the ultimate highs that we thought we were, but it's just a general feeling. Business is good, we like the year, we like the fourth quarter, so I don't know that I want to characterize it as either the way you want me to. I just generally can comment on it.

Okay. And then maybe to look at the other HVAC equipment a little bit differently. My understanding is that more of that run -- your -- more of your new housing exposure would run through there. Why are we not seeing that? And then the other thing is, I think early days, you had talked a lot about growing the other HVAC piece of -- non-equipment piece of the Carrier JVs, and maybe just update us on how that's going and why that may not be showing through more?

I'm not sure it's not showing through more, but go ahead, Barry. You want to take that?

Sure, that's fine. Jeff, the -- what drives our business is single family. I wouldn't include multifamily, which is where a lot of the growth has been in recent months in housing. But if we focus on single family, about 600,000 completions is the estimate this year that I see. Put that in a 5.5 million unit industry, it's still 11%, 12% of the industry. If it's growing 10%, 20%, it is in our numbers. But in terms of driving the numbers, that's not going to have a huge impact, unless that growth rate continues over, really, a longer period of time than just the last 12 months. On the non-equipment in Carrier Enterprise, we've said for a long time that because of their concentration in selling equipment and because of the opportunity to sell more products, that would take time and those products would be launched and they have been. I could say, I can have fun and say the business has doubled, and it has, but it's still only about 13% of their volume. So it's a slow growth story. We need people, and inventory, and know-how and market share of programs to wrestle that away. It's probably taking us longer than we might have predicted, but there is certainly still progress.

Okay, great. And then just final question. I know you don't typically break out the Carrier JVs from revenue standpoint, but can you just give me a sense of how would you characterize growth rates over the year or more recent quarters in the JVs versus, say, the legacy business?

You said we don't comment on that. There's no material difference between these business units. We don't like to break out because I don't want to imply that one brand is doing better than another brand in our network, because generally, they don't. But if you get into specific markets, that story could change. But overall, we represent the brands that we represent and we're doing the same for all of them, and all of them are performing about as well as they should be. Now somebody -- you asked the earlier question about where are some other opportunities, like in the joint venture, we can add other products, other HVAC products other than the equipment. But generally speaking, on the equipment side, we represent them all and we're doing well with all of them. I mean, we represent -- we don't represent all the brands, but the brands that we do represent, we're doing well with them. One is not outperforming the other is what I'm saying. Okay, clear?

Yes.

The next question comes from David Manthey of Robert W. Baird. David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: First off, the 10% growth in residential HVAC, could you disaggregate units versus the price mix contribution?

Barry?

There's a -- 1% to 2% is price and mix, and the rest would be units. So strong unit environment is what's -- is really what's driving the...

It's real growth. David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: Okay. And Al, you mentioned a couple of times in the release about how you're well positioned to make the right investments in the business. I was just wondering, when I look at the range of those, if you look at the acquisition landscape, eCommerce has become more important, any new products or private label, anything in there that you could just address or anything that's moving more rapidly to the surface today?

Well, I think you've touched on important things that I think about in my every day. We're very ambitious, we have an internal goal of tripling this business in size. And to do that, you have to do the things you mentioned. You have to consider further acquisitions, which we do, and you have to consider new product offerings, for example, like a ductless product, and you have to consider the geographic reach by opening up new branches. All of that goes together with a constant pressure to grow -- our internal pressure to grow. We are growing, our earnings per share this year at 20%, 22% growth rate. That's pretty good. I'd like to see that maintained over the next several years. So I hope I've answered what you were asking for. David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: Okay. So bottom line, you're thinking about all of those things?

Yes. And we're not without lack of opportunity, but we're a pretty conservative team here, we run a conservative balance sheet and we're going to do things when we think they're right. And we have the international scene that we've got our toe into, and there's a lot that can go on there in the future, but that doesn't diminish what we can still do in the United States. So there's just a lot of opportunity. Don't forget, we're only -- in the United States, only in the 10%, 11% share of market of this distribution market, so we've got a lot of room. David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: Right, okay. And Barry, you had mentioned the R-22, and the EPA's more liberal view of production of R-22 and the impact that had on pricing, and you had touched on it. I assume that you had higher cost inventory that became less valuable that might have had an impact on the sales and the profitability of that product. Was that something that was measurable, or was it -- I mean, not that I wanted you to single it out, but just -- was it something that was relatively meaningful, or was it just too small to talk about?

No, I mean, anything that, like that can -- has no big impact, but it has an irritation effect, certainly for the quarter. We did not see any gross profit consequence. We've done, I think, a great job in working with our vendors to protect that risk, and gross margin is very consistent in that environment. It's just been more of a price decrease that hit our R-22 products, it passes through and has some earnings consequence, but it's not a big event, Dave.

And more importantly, I think, David, is behind this. I think there'll be further and further restrictions by the government on the manufacture of that product, which bodes well in terms of maintaining price stability.

Please go ahead.

Are there any other questions?

Mr. Hughes, your line is open.

Two questions for you. I guess, one, were there any acquisitions or detail from historic acquisitions in the revenue in the [indiscernible] quarter?

No, there -- the same-store sales are equal to the numbers we had produced. There are no impact of acquisition that weren't there last year.

And number two, I know you don't like talking about the weather much, but I'll ask you a weather question. Just in general, the second quarter was not a very advantageous weather environment for HVAC manufacturers or distributors. In general, would you consider the third quarter the same? And I'm thinking more of next year about comparisons and how that will look as we model for next year?

Well, you're right, I don't like to talk about weather. But Barry, maybe you can put that out there.

Keith, it is in the numbers, it is in the analysis for the quarter, that in some of our markets, especially in the mid-South and mid-Atlantic states, which are good-sized markets for us, simply were not as intense as last year, and there's some correlation that we see in the numbers. So yes, we can -- again, I'll call it an irritation. It's not something I think has a dramatic impact, but it did have some irritation.

Final question. As you talk to your suppliers, is there any talk of price increases coming, either on HVAC equipment or the accessories?

It's a good question. I have not, Barry, have you?

No, no, we haven't.

The next question comes from Mark Douglass of Longbow Research.

So Al, discuss commercial, it's a pretty big turnaround from the last couple of quarters.

Yes, it is. That's absolutely right.

And do you think -- do you feel like it's sustainable? Is it just a catch up from pent-up demand? How are you reading that?

Barry?

We've said the last 2 quarters that 2012's first half was very strong and we had some tough comps, and that was our excuse, if you will. And we expected things to become a little more consistent, and they have, and 10% is the consequence, I think, of that conversation.

When you mentioned before that you thought the market was relatively flat the last couple of quarters, does it still feel flat, or was it more than just the comps got easier, that commercial...

Yes, Mark, we don't have market share data for our commercial business until, I think, December, so I can't give you a good sense of it. But I think, we -- my intuition would say, we gained some market share this third quarter.

Okay. And then, Al, you mentioned the mix is improving towards higher efficiency. Is that, is it real intermittent, significant trend kind of choppy? Can you discuss that a little bit more? Flesh that out?

Sure. I would say it's improving slightly, meaning it's getting slightly better. It's not, again, not a dramatic shift. I wouldn't call it choppy. It's been pretty consistent this year, but I would -- it's really just only a slight improvement at this point, very, very far away from the type of mix that we had 4 or 5 years ago.

The next question comes from Steve Tusa of JPMorgan. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: What -- you talked about the refrigerant. Any color around the compressor sales through distribution for you guys? Were those below or above the 3% in other products?

Excuse me real quick. I think we lost Al. Let me get him back on the line. [Technical Difficulty]

Sorry about that. I got cut off. I apologize.

Steve asked a question about compressors. Steve, ask again. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Yes, so you guys mentioned refrigerants had a kind of a tough comp because of price. What were the trends in compressors, non-equipment to supplies?

Down single digits, Steve. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Down single digits? Okay, that's helpful. And then I'm just still trying to reconcile the up 10% in resi and commercial, then the up 8% in equipment. I mean, given resi and commercial, I guess, in the U.S. are a significant percentage of sales, that implies that the rest of the business was down pretty meaningfully. Was that Canada? What's -- I wouldn't ask specifically about it if it wasn't such a big drag, but it seems to be a relatively meaningful drag, so I'm just trying to understand what's going on there so we can account for it when we look at next year's comparisons.

It's not Canada. We had some non-reoccurring issues occurring in Venezuela, where there's a change going [ph] there, and the same thing happened in Mexico. These are issues that come up that temporarily slow down the market. I'm not too concerned about it. In fact, I'm not concerned at all about it. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Right, okay. And then just...

[indiscernible] invest in our international business strongly. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Sure, sure, sure. That makes sense, and we'll take that into account for next year, of course. When -- in thinking about the resi dynamics, anything going on with outdoor versus indoor units in the SEER mix? Any kind of trend there that's worth calling out?

Well, Steve, as I mentioned, if I look at the growth rate of indoor and outdoor systems being double digit plus unit growth rates for the year, it's true for both indoor and outdoor, which means that systems selling is going on and it's robust. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: And the SEER mix?

The SEER mix is where -- again, we talk about mix and seeing a slight improvement, but a far cry from where it once was. So I think that's...

That's ahead of us.

Still a work in process. It's not anywhere near where it should end up in the next few years. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: And then one last question on pricing. You mentioned that you hadn't seen increases yet from the equipment guys. I think it's around this time of year, but they've come maybe a little bit later than -- I mean, does that -- do you view that as you'd expect to get them? What is kind of the -- what's kind of the tone in the channel around price? I mean, Grainger, kind of unrelated, came out today and said that they didn't get any price this quarter and they were less than optimistic around getting price for the first time in a couple of years. Would you characterize the lack of discussion on equipment price increases a little bit of a trend here going forward, or is this kind of usual that you wouldn't hear from them yet?

Well, again, Steve, we saw improvement in our gross profit, in our big -- certainly, in our big-ticket items all season, so I'll take that as a good segment of our -- of the business, which is our largest segment of the business. The OEMs usually come out in the fourth quarter, sometimes even in the first quarter, as far as next year seasonal pricing, and I wouldn't characterize it as being late, just something they, they decide to come out sometime in the fall. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Okay. So you would expect to see that in the fourth quarter is what you're saying? Okay, perfect.

That's what's typical, let's put it that way. Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Right. But there's no change in -- you don't think there's a real change in the market dynamic, where the industry is going to have maybe a little bit tougher time getting price? That's kind of what I'm getting at is, what's kind of the tone of the marketplace? Do you see this as any different than the last several years where these guys have pushed through a couple of points of price every year?

No, I think it's business as usual, that becomes... Charles Stephen Tusa - JP Morgan Chase & Co, Research Division: Okay, perfect.

The next question comes from Walter Liptak of Global Hunter Securities.

I wanted to ask about some internal initiatives, and maybe to start out with, you commented about fourth quarter cash flow. Was it down -- cash flow expected to be better just because of seasonal, or is there some special initiative or something that you're doing?

No, fourth quarter is always strong seasonal. There's nothing special going on. It's just general operating, where the season works. The 2 big quarters are the second and third quarter, and then as the season winds down, the cash flow increases.

Okay, got it. And I wonder if you talked about other initiatives, like the mobile app, any testing is coming out, like on that and when you think the rollout will be?

I can't hear him, Barry. Did you hear him, Barry?

Yes. He asked about the mobile apps and a little bit of the...

Yes, of course. We're constantly introducing improvements on it. We have our app out there for the -- each of the business units, and we have improved and issued new generations of it. And that is a very good question because I think we're going to lead and invest a great deal of money in the entire field of analytics and business intelligence. But the specific question on the app, yes, we have them out for each of the business units, and they have already had further improvements on them.

Okay. And the spending for the mobile app, is that already through the P&L, or are you having incremental costs that go through, like this quarter?

I think it's both. But Barry, you want deal with that?

Yes, Walter, there is certainly P&L flowing through -- costs flowing through the P&L for whatever we're doing on technology. There's also some capital spending on some longer-term projects that are in the CapEx that will, once they go into production, will be in the P&L. All this is a 2- or 3-year window of time in terms of looking forward, both in the benefit and the cost, and really, the innovations that are going on. Don't put any of this into a short-term picture. The app is simply a first chapter of a long-term viewpoint on really innovating our business and our industry.

[Operator Instructions] The next question comes from Josh Pokrzywinski of MKM Partners.

Just a couple of follow-ups here. On SG&A, I'm sorry if you already covered this, but it ticked up a little bit from last quarter on an absolute basis. Just trying to understand if we should think about any one-timers in there, or how to think about the run rate of 2Q, which was extremely solid, versus 3Q, which maybe looks a little bit closer to historical?

Well, Barry can give you more detail, but generally speaking, as our revenues grow, so will our incentive comp. And that's my guess that that's part of that answer. But Barry?

That is the answer for the quarter. If I answer it analytically, Josh, is we see the performance for the year, and a lot of it is over -- about 1,400 people in either commission or in earnings incentives, some type of performance-based compensation that gets accounted for and given the performance. It hurt this quarter's EPS, but obviously for the year, it's something that has been earned, and we're glad to -- that's the culture, so...

We'd like to spend more on this side of it because the more the incentive comp programs that we have, the better performance the company overall gets.

So there's about $0.04 in the quarter for that one discussion, Josh.

Okay. Would that be typical in the third quarter of a strong year, to see kind of a true-up come through?

Yes. We'll be...

There's nothing unusual here.

Okay. And then just secondarily, I know we've touched on mix a couple of times within equipment. But if you could just characterize 3Q versus 2Q in terms of high-efficiency adoption, it sounds like it's roughly the same, but any color you have, even qualitatively, on the pace of that recovery in high-efficiency equipment versus 2Q?

No, Josh, it's very consistent in both quarters. I mean, it's really one season, one cooling selling season, not 2 quarters, and the season was very consistent as we went through it.

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

As always, thank you for your interest in our company. We will continue to perform well -- try to continue to perform well for all of you, and we look forward to our next conference call. Bye-bye.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.