Good morning and welcome to the Watsco First Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, Chairman and CEO. Please go ahead, sir.

Good morning everyone from SETI Florida, where I have a really bad cold. But nevertheless, let's go on with our conference call. This is Albert Nahmad, Chairman and CEO, and with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Senior Vice President. As always, the cautionary statement; this conference call has forward-looking statements as defined by SEC laws or 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 delivered record sales and net income in the face of strong year-ago comparisons and varying seasonality across our markets. Sales improved toward the end of the quarter and April trends have accelerated to double-digit growth. We have added approximately 150 new customer-facing employees last year over year – let me say that again – we have added approximately 150 new customer-facing employees year-over-year, expanding our capacity to sell products and serve customers. They have a short-term impact on profits and margins, especially during a lower-volume period like the first quarter. Strategically, these are long-term investments to drive growth and build market share for our vendor partners. We are pleased to increase our dividend to an annual rate of $5 per share, beginning in July, supported by a strong cash flow and continued confidence in our business. Our balance sheet remains conservative with a debt-to-EBITDA of under 1x and we continue to look for M&A opportunities. We cannot predict whether transactions will occur, but rest assured is an important focus of the Company. Results also reflect continued investments in several innovative technologies to transform our business and that of our customers. The annual run rate for tech spending is approximately $23 million. As a reminder, we have launched three primary technology platforms; first, e-commerce and apps using the industry's most data-rich catalog of product information; secondly, business intelligence to enable more insightful decision-making throughout our organization; and lastly, supply-chain/warehousing optimization to improve speed, create efficiency and reduce operating cost. We are seeing progress with our technology, but we know it will take a lot more time to get traditional customers and employees to adopt and become fully immersed in what are truly [indiscernible] technologies for our industry. Now onto financial results; sales increased 2% to a record $872 million, or 3% growth on same-store basis. HVAC equipments increased 3%, other HVAC products increased 1% and commercial refrigeration products increased 5%. Gross profit increased 3% to a record $219 million, reflecting a 10 basis point expansion in gross margin. SG&A increased 5%, reflecting an increase in tech spending, the new headcount mentioned earlier. Earnings per share was flat at $0.71. Now as it has been our practice, we will not provide at this time a specific outlook for the year due to the seasonality of our business. We do however expect 2017 to be a record year for Watsco. With that said, A.J., Paul, Barry and I will be happy to answer your questions.

[Operator Instructions] The first question comes from Robert Barry of Susquehanna. Please go ahead.

So just wanted to clarify the double-digit growth, is that for the Company overall?

Yes.

And so equipment would be tracking higher than that?

We didn't give a breakout between equipment and sales and any other things.

Got you. I was just curious how things tracked during the quarter, because I think when you reported 4Q, you said, Jan, Feb, to-date were tracking up mid-single, [indiscernible] are kind of slow and then reaccelerate?

That's the good question because it deals with the principle that this is a very seasonal business and it's very difficult to sort of decide by quarters what the value of the performance is. We've known that for years. The analysts don't seem to care. They seem to put up their own estimates. But we know that seasonality can change quarter to quarter, year after year.

What was the seasonal headwind this quarter? Was it warmth in the North or how would you characterize it?

We have not characterized it. We've said, in various markets, seasonality has come late in terms of demand and it's just one of the things of the industry, I don't think we are the only ones, particularly since we are in the aftermarket mostly. New construction participants in the industry have a more steady pulse on it.

Got you. Maybe just one more from me on the SG&A and how you expect that to track, I mean I have to go back a few years in the model to see SG&A growing 5%, I think you're perhaps lapping the toughest comp of adding or making the incremental IT spend, but how should we think about that SG&A growth tracking, at least in the near-term?

I think we've demonstrated that's where we are now. I mean we're always going to look long-term, and if there is more investment in technology or more investment in hiring people to take care of our customers, we're going to do it. But for now, we see this going as it is.

Got you. Is the IT spend steady now this year? I think you referenced 23, which I think [indiscernible]

Yes, that's up $1 million for the quarter.

Got you. Okay, thank you.

The next question comes from Matt Duncan of Stephens. Please go ahead.

I hope you feel better soon. On the topic of April, my recollection is that last year you guys got a little bit of a late start to the selling season. So want to make sure, we don't get carried away and extrapolate that double-digit growth rate out if we shouldn't. What is the comparison like in the month of April year-over-year and is it going to get a little tougher as the quarter goes on?

Barry?

No, I think April again in context is the smallest month of the quarter. So you are right, we shouldn't get too far ahead of ourselves, but I thought it was important to report the trend. Also, I think given the way what we would see in May and June, we do have to wait to see how it plays out, but my memory is, April a year ago was just okay. And so I think it's good progress so far this quarter.

Okay, that helps. On the sales force additions, you called out that those are happening to help market share and drive growth, and it's part of why your SG&A obviously outgrew sales this quarter. Can you talk about what those salespeople are targeting? Is this maybe part of a larger plan to help drive market share along with the technology investments, and now that you've got the mobile apps in place, are these people going to go out and work on educating the contractor base in these markets and help explain the advantages of using Watsco with your distribution partners [indiscernible]?

Yes, that's part of it. But there's generally also the idea that we want more hands to deal with customer needs. But yes, this adoption of our technology is not going to be easy. When you figure we have about 88,000 customers, these are companies and each of them has several employees doing installation or repair work out in the field, you can imagine that's hundreds of thousands of people that we have to get into the adoption, and we're going to be patient about it but we're investing as you said in people to help that process as well as everything else that the customers need.

That makes sense. And the last thing from me, cash flow remains very good, you took the dividend up again, a nice 19% increase there. I think on the last call, a lot of us felt like you sounded, you Al, sounded more positive in terms of the potential for M&A. Does the increase in dividend change that in any way or [indiscernible]?

No, absolutely not, no, no. I mean when your EBITDA is just less than 1x, or the other way around, it's really a very powerful balance sheet. No, we believe that we can take on any transaction of any size in this industry. Now if you get out of the industry, who knows, but in this industry we can handle anything and we'll always be postured to do that.

And Al, does that run the gamut from another distribution business, another JV perhaps, or maybe even buying manufacturing with that?

No, I wouldn't start buying – not manufacturing, we're not going to do that, and I do think that we have – I don't want to speculate on this because I'm just being misleading – if something comes along in a similar pattern of manufacture distributor, dealer customer, our technology is very appropriate for that, and we had to look at it carefully. But we're not going to do anything like that unless it's of some size.

Okay, makes some sense. Appreciate it. Thank you guys.

The next question comes from Chris Dankert of Longbow Research. Please go ahead.

I guess first thing is thinking about SG&A again, at or about $2 million in the quarter, that's a good run rate. Is that the run rate going forward we should think about or did those kind of hires kind of roll on, so the number could be a bit higher in the rest of the year?

Barry?

No, it will not be $2 million per quarter. It's something that if you look back, some of these people were hired last year, and just from a comparison point of view, this quarter the $2 million is probably the full amount that we'll see.

Got you. Thanks. And then I guess if we could get A.J. in the mix here. Just any comment on the app adoption rates? I think last quarter you kind of highlighted some of the user increases, the online transaction increases. Any more color around that?

Only that the trends have continued. The app usage and e-commerce usage continues to increase. As mentioned before, as we are talking about a large scale here with 90,000 contractors and all our contracting businesses and all the employees in those businesses, so still early days, but usage is increasing and where there is usage amongst our apps and e-commerce, it's very positive for the Company and for our customers.

Got you. And then just one last if I may, the additional hires, was part of that fueled by kind of having greater analytics and a sharper view on the Company as part of what drove the hiring?

That's an interesting question. Barry, you want to deal with that, or Paul?

Sure, Chris, I can. I think first, the way a distributor adds capacity to its business is what Al mentioned, that's by having people serve customers, either sell things or help in any way customers' growth, and in this case, in our case, develop technology with our customer in mind. So I think all that is part of the strategy, is the capacity to do more of those things in our local markets. As far as the people that we don't tell you about is where is the analytics helping us save money or gain efficiencies in our branches, in our business, that's going on in the background as well, but that won't mature that kind of operational efficiency side of this technology equation. It probably won't mature until sometime much later. But for now, it was important to get in front of customers with technology, with products, and as I say, add capacity to what we do every day.

Got you. Thanks so much, guys. Feel better, Al.

The next question comes from Ryan Merkel of William Blair & Company. Please go ahead.

So first question for me, can you break out the sales performance in the U.S., Canada and Latin America, if you have it handy?

I don't think we do that in that much detail, but I think we can give you international versus domestic. Barry?

Ryan, it was a very narrow range of growth rate. So if you look at the overall growth rate and break it into pieces of international/domestic, even commercial/residential, it's in a very narrow range of what was reported.

Okay. And then, parts and supplies, obviously it's been soft for some time now. Is there any hope that we can get that back to mid single-digit growth? I know [indiscernible].

You nailed it right there. There is always hope, and yes, we're very focused on it and the improvement is slower than we'd like, but it seems like we're improving.

Ryan, I'm going to set that trap for ourselves, which I don't want to do, but if I take the non-equipment, the 1% growth rate in other HVAC products, part of seasonality is replacement parts sales. Seasonality meaning if it's a warm winter, we are going to sell less replacement parts for furnaces, and that did occur this quarter. So if I take the 1% growth rate and break it into parts, replacement parts versus supplies, which means everything else, there actually was a nice growth rate in supplies, I would say progress in supplies. The part sales were lower and tempered the growth rate that you see in the press release.

Got it, okay. Is there anything you're doing Company-specific to try to accelerate the growth in non-equipment?

We are very focused on it. We're motivating and incentivizing for growth and we are working with the vendors very closely, because the vendors want us to grow in that area. So, it's a focal point.

Okay. And lastly for me, a lot of questions on SG&A, but I'm just wondering, are you going to be able to return to delivering year-over-year operating margin expansion as early as 2Q or is it going to take a little longer for these new salespeople to start to deliver a return?

See I think that's too much in the future to forecast that. I mean, obviously we like to be optimistic, but it would be a pure guess. Let's see how it develops.

How long does it take for the new customer service people to break even?

I've never had a question like that. Paul, you're pretty good at this hypothetical.

[Indiscernible] All these salespeople are not just selling equipment, they are focused on different elements of our marketplace. So you've got people that are focused on parts supplies and equipment. So it would vary based on what their individual forte was.

This is A.J. I'll just add that with our new technologies, we have a lot of visibility and insight into performance at an individual level and we could be much more proactive in making changes or additions and subtractions as needed.

Okay. Thank you.

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

So this quarter you called out the $0.06 of headwinds. So it sounds like, Barry, from your comment that that goes down to something closer to $0.02 with continued spend as we move forward. I just want to understand how much of a headwind we see going forward.

I mean the way to look at it Jeff is, if it costs us $2 million in the quarter, the overall cost is $8 million for the full year. That's the point of the question. And the answer is, no. I mean some of this was added progressively over the course of last year, and comparatively this quarter it's probably the largest it will be. I don't know what it will go down to but it won't be an $8 million impact in this year.

Okay, but it's something you will continue to call out in terms of incremental spend, where it gets [indiscernible]?

We will see how material it is. Obviously in a quarter like this, any kind of incremental spending shows up pretty – is pretty visible in the slowest quarter of the year. So I thought it was important to call out this quarter, and we'll look at it each quarter for materiality.

Okay. And then just on the headcount spend, is a lot of that really tied back to the tech initiatives or where particularly is some of this headcount add going, because I know you've gotten a lot of questions on kind of the supplies, I just want to understand where some of the headcount is being added?

Jeff, I'll answer it this way. One market, I won't tell you what market it is, but one market in particular has been an 8% to 10% growth rate in sales for the last few years, EBIT margin is well above the Watsco average. How does that leader continue to grow, continue to add capacity, continue to add sales and share to an extremely successful business? And in his case, about 17 of the people we are talking about is in a single market. So it is us giving encouragement to our leaders to go out and develop markets beyond the current performance, and that incremental spend does not show up in incremental income that day obviously, but it's important for us to continue to do that, especially reward performance like that. Now there's always now a technology thread going through that conversation because those sales guys need to be in front of customers talking about it and teaching it, but it's really a bigger picture in terms of again adding horsepower and capacity to our markets.

Okay. And then some of our checks are picking up some share dislocation with Carrier. I just wanted to hear your read on that, and then just more broadly, how that plays into price, where do people start to get more price competitive or do you see better discipline with some of the inflation? Thanks.

Barry.

Jeff, I think first, there is a market share story that is difficult to tell or see if you split it between the replacement market and new construction. New housing obviously is growing. It's something that can be targeted as an individual market with aggressive pricing that can matter to market share. For us, that's not our preference. Our preference is to grow our replacement business, its higher-margin, its more repeat business long term, and we don't have the advantage of, let's say, lower input cost in a deflationary environment to take advantage of that. As that firms up, obviously we can begin to compete in that space. But more importantly, as things firm up in terms of commodities and things like that, we can get inflation, we can get price increases through the market. I would say in the first quarter, there was some progress toward pricing that needs to sustain itself through the selling season for it to be an opportunity. But for us, we can't be the hold into a new construction market as what is a high margin business that we operate. But we do like the idea that there is a bias toward inflation and selling to take advantage of, especially in our aftermarket.

Okay. Thanks guys.

The next question comes from David Manthey of Baird.

Speaking of other competitors, it seems like these parts plus locations is helping Linux gain share relative to the market overall, and I just don't know if you're seeing any impact from those locations. Just conceptually, I believe that Baker started out without any equipment whatsoever, and I'm wondering if it makes sense for you to offensively open locations in new geographic markets that are just parts and supplies, or would the manufacturers not go for that?

It's not what they want, the manufacturers, it's what we think best serves the customer, and certainly we like selling everything that a contractor needs in a single location. That's always been our policy. I don't know why you even suspect it would be different.

I'm just wondering, while they put limits on your ability to sell equipment out of the same location, they wouldn't have the same restriction on [indiscernible].

No, no. I mean think of it from the contractor's point of view. Does he want to go to different places to get parts and supplies and a different place to get the equipment? That's the way it used to be quite a while ago when I first got started with this, but the convenience factor of having what he needs in one location to us is the big idea, and we're good at it, we are probably better at it than anybody else.

Okay. And then the theory around the apps, was that in the future, in the long term, that you would need fewer people because the technology would help alleviate some of that? And Al, your comments about things taking longer for traditional customers to convert, does that imply that the uptake isn't as strong as you thought it would be or [indiscernible]?

No, we always knew it's going to be long-term, always. We have tried to tell you, this is years before adoption. But that doesn't stop us from continuing to improve the software and the apps that we do. But we believe that the economy is becoming digital more and more. That's not a new thought. But we think in our space, it's very important for us to lead in that since we have the capability of doing that and improve our competitiveness, but we're not looking at short-term results, we're just looking at long-term. We're just not that focused on short-term, although we've had records, record after record, which is nice. But really, this is a long-term game for us.

Okay.

This is A.J. I mean that theory of our customer-facing technology to remove people from our organization, that's not really it. It's about being better service providers for our customers, having more product information at their fingertips, making them more efficient in the field, making easier to do business with us and outcompeting anybody else in this space, so they only want to do business with us. It's more about driving sales and taking out cost on the customer-facing side.

All right, fair enough. And then on the tax rate, I assume you adopted ASU 2016-9 this quarter and what effective tax rate should we be looking at for the remainder of the quarters this year?

Barry, I hope you got this on your fingertips.

I do. Where that applies to us, Dave, is it impacts the tax rate by almost 100 basis points for the year, and it relates really to the dividends that are paid on restricted shares and the tax deductibility of those dividends in our earnings.

Great. Thank you very much.

The next question comes from Robert McCarthy of Stifel. Please go ahead.

Sounds like I'm a little better than you, but I think I've got the same thing.

Where are you, physically?

I'm in Boston, so I'm not going to be held by the weather. In any event, I wanted to just touch base perhaps on kind of what you're seeing in terms of the health of the consumer overall with the kind of traditional metrics around delinquencies and also just any of the – you look at Home Depot sales, you look at other things, [indiscernible] in the quarter, how you're feeling about the health overall of how the consumer in the context of the replacement market?

Why don't we let Paul answer that, Paul Johnston.

As you know, we don't sell to the consumer. We sell through the contractor to the consumer. I guess anything that we would have it with reference, that would be general things that you would also read in the papers. As far as existing home sales are off the chart, inventories of existing home sales available for sale are at one of their historic lows. That would indicate to us that if people are still buying existing homes, that's a good sign for replacement market for us. So right now, we feel really good about them.

I guess as a follow-up in terms of M&A activity, Al, do you think this current environment with maybe some creeping policy uncertainty is going to delay some enemy activity for you as people get a better [indiscernible]?

I hope not. I'm very eager to do M&A and I'm out there and we never look at calendar issues, I mean unless they are real serious. No, we have the ability and we have the desire to increase our M&A and just keep your fingers crossed for me.

Yes. And then the last question is in thinking about, and this hopefully is pedagogical and somewhat pedantic, but I think it's important to the investors, is maybe you just contrast kind of your model versus traditional industrial distribution in terms of the threat of e-commerce and what Amazon represents and why it's so different and why the barriers are so much higher, because it just seems across so many industries today the eruption of e-commerce is such a selling trend and maybe you could just talk about why your model is so differentiated?

I'm going to let A.J. answer that, but I can tell you this, that nobody has the data that we have in this industry, and it's taken years to prepare, and I think having the data with products which can be so helpful to the customer and the way we do business is the key, but I'll let A.J. deal with that.

Certainly. Bringing 600,000 SKUs now [indiscernible] our space. I don't think anybody comes close to that and that's a continuous effort of continuing to master more and more products and maintain that database is a full-time challenge for a lot of people here. We certainly think about the threat of Amazon and others a lot and make sure that we're well-positioned. One note is on the distribution side. Today, and I know this can change tomorrow, is that Amazon does not like to handle the size of products that we handle. 5-ton condensing unit is not delivered very easily by drone, or by FedEx or UPS for that matter. That thing is a little bit of comfort, at least for today. Another is that these are technical products. We do business with 90,000 customers and contractors and many of them, if not all of them, require our input on design and engineering and technical advice in diagnosing these products, which that data, expertise is valued in a big way by our customer base, and I don't think that's going away anytime either. So it's certainly something that we are aware of and that we watch and that we play offense against, but today I think those factors contributed to a little bit of a breathing room there.

And I was going to add one thing to that, just out of some common sense to that, is we're spending a lot of money in our warehouses outfitting it with product fulfillment software that lets our guys pick, pack and ship in 8 minutes. We want the customer to call us and then have the order ready in 8 minutes, and they can come by or pick it up or whatever it might be. So to A.J.'s point, a technical order, a diagnosis that was required to even create the order, and by the way we want to get it to you in 8 minutes, and the fulfillment of that whole stream I'm not saying is ever impossible, but that's the reality of any competitive environment for that kind of order.

Is it also just the OEM and the exclusivity around that? I mean obviously private equity has been hit, there's been a constraint on them getting involved in your space. So you think that applies to Amazon as well in terms of just distribution as a whole?

Sure, I think brands are a big deal. I mean where we do business with the brands of equipment that we do business, it's our brand, it's not available to Amazon or anyone else. And the Rheem brand, the Carrier brand, the Goodman brand, I mean these things are very valuable, and I don't know how somebody overcomes that but I agree that we should be constantly aware of such threats, and we are. But brand is a big deal.

This is Paul. Not to beat this thing to death, but there is two other aspects to it also. And that is local code. It's not just about the equipment and what the specifications have to be to meet the local governmental codes, but also on all the other components that we sell. It's different and unique in different parts of the country, it's different and unique within a state and a municipality as far as some of this equipment can't even be delivered to a customer unless they have a license to handle a refrigerant or they have to have an actual permit that they represent to us that they have permitted this sale with the city. So there's a lot more to it than just moving a box from a warehouse to a homeowner.

And just to follow up on my first question, maybe you just speak, Barry, to the relative health in terms of delinquencies with respect to the dealer network or any kind of metrics you track there?

Sure. Again, it's something we look at a quarterly basis over a long period of time, and the current quarter and the current profile of our customer paying us is actually well below any long-term average in terms of risk. So it's very healthy. You'll see in our filing, bad debt expense is down year-over-year quarter over quarter, so that speaks to that.

Thanks for your time.

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

Thanks very much for your interest in the Company. We look forward to speaking to you again in the next three months. Bye now.