Watsco, Inc. (WSO) Q3 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to the Watsco Third Quarter 2022 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.

Good morning, everyone. Welcome to our third quarter earnings call. This is Al Nahmad, Chairman and CEO, and with me is A.J. Nahmad, President of the company; Paul Johnston, Barry Logan and Rick Gomez. Before we start our 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 quarter. We delivered another record quarter. Sales grew 14% to a record $2.04 billion and operating income increased 14% to a record $236 million. This third quarter performance builds on what we believe will be a record year for our business. So far nine month sales increased 19% to a record $5.7 billion and nine months operating profits increased 37% to a record $694 million. Year-to-date cash flow also improved increasing 12% to $359 million. Now, given our earnings growth, cash flow expectations and our confidence in the business, we announced today at 11% increase in our annual dividend to $9.80 per share effective in January of 2023. Thought I might comment that we believe the last two years have been among the most challenging and also the most gratifying periods in our history. Our growth and stability speaks for the fundamental necessities of the products we sell and to the value that our industry provides homeowners and businesses. Given our long-term focus, Watsco has also invested over the past two years in people, technology and infrastructure and we do these things to build market share in our $50 billion market. As industry demand and supply chains normalized, it is the right time to expect more productivity and we have challenged our leadership to improve operation efficiencies across our network. We're also working closely with our OEM partners to develop forward-looking growth initiatives. Watsco does maintain good relationships with virtually every domestic and international industry manufacturer. We believe collaboration with the manufacturer is all the more important given the industry changes taking place in the coming years. Many views of our company fundamentals are in this morning's press release. I really do urge investors to read that release and understand why we believe we have an exciting future. We have an immense technology advantage and we're investing to grow that advantage. These technologies bring in new customers. They help our existing customers grow and they reduce attrition of customers and most important they help us gain market share. Our active technology user community has grown 21% this year to more than 45,000 users. And OnCall Air, that's a platform that reaches into homes, keeps growing. During the quarter contractors has presented quotes to approximately 66,000 households. That is a 39% increase in households over last year and generated $269 million in sales for our contractor customers. That is a 47% increase. Watsco's diversity of products and brands is an important competitive advantage that allows us to serve contractors in any economic environment. We also have a leading market share position in Sun Belt markets, where both population migration is greatest and the necessity of HVAC products is the most absolute. You got to have cooling and heating if you live in the Sun Belt. In addition, there are several important catalysts for growth that will play out in the next few years. For HVAC equipment, the minimum federal efficiency standards will increase in 2023 across the entire United States. Price points associated with these higher-efficiency products will increase and should benefit our 2023 results. Federal mandates are now in place to phase out high global warming potential refrigerants used in millions and millions of existing systems. But in 2025, we'll mark the introduction of new HVAC systems that will incorporate lower-GWP refrigerants. We also see a strong movement towards electrification of heating systems through the use of more heat pumps, which generally come at a higher price; higher margins; and in the long run, a shorter replacement cycle. Our sales of the heat pumps grew 27% in the first nine months and interesting 32% during the quarter, outpacing overall sales growth rates. The new Inflation Reduction Act, which takes effect next year, also provides tax credits and incentives for qualified efficiency upgrades and electrification. All of this provides the basis for homeowners and businesses to upgrade systems that will, over time, be more efficient and more environmentally friendly. And all of this is good for climate change and good for Watsco. We certainly believe our scale, technology and financial strength position us to capture these new market opportunities. Finally, we always concern ourselves with our balance sheet so that we are in a position of financial strength. And today's balance sheet remains in pristine condition to invest in growth opportunities in coming years. I'd like to say that we can fund almost any size of investment to grow our business. With that, let's go on to Q&A.

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Tommy Moll of Stephens Inc. Please go ahead.

Good morning.

Good morning.

Good morning, Al. Thanks for taking my questions.

Of course.

Wanted to follow up on your comment regarding finding more operating efficiency in a more normal business environment. If we go through a period where industry volumes are pressured, I presume that still applies. But can you actually continue to show leverage on SG&A? And to the extent you can, is it intentioned with market share opportunities that you might otherwise be able to go after in a period of pressured industry fundamentals? Is there a natural tension there that we should think about, how you might reconcile?

I think that's an excellent question, and I'm going to have Barry Logan and Paul Johnston answer that and A.J. Nahmad. You're going to get a trifecta here.

The last part first, Tom, and just to give some sense of product and brand and OEM and manufacturing and general conceptual stuff. Really been two years where I can attest to you that going to OEMs and saying, how are we going to grow, was met with the response of supply chain difficulty. OEMs have capacity, but yet, they have to have supply chain constraints. And in that environment, it's almost kind of bizarre, honestly, to go to our OEMs and say, how do we grow, what do we add, what brands can we go to market with, what incrementally can we do with you to help you grow and to be told you'll have to wait. So now we have that opportunity ahead of us in the next couple of years to play offense. We think the supply chain is better. There's still more to do. We're going through a big product transition as we head into next year. But that's a very unique and important opportunity that doesn't have much to do with our discussion on efficiency. It has everything to do with how do we use our balance sheet and how do we use our presence, how do we use our structure, how do we use our technology, to go grow brands and grow our relationships beyond where they are. So I think I would put that aside as a discrete strategy. And on the efficiency side, it's again a very kind of simple story to tell. We have to go prosecute and execute the strategy, but it has been a wild two years. There has really been nothing customary, nothing that's been ordinary in dealing with both the strength of the market, the real difficulties by the supply chain, you have a lot of inflation going on, you have really a fire drill going on to serve customers. And we were at no time going to look at cost as the critical item in serving customers in this environment. We were going to do anything it took to serve customers in this environment. So we're out of season as we head into the shoulder season here in the fall, and the message is very clear to our leadership, Al has made that message extremely clear, about stepping back from the business, looking at cost, looking at cost to serve, looking at efficiency, looking at technology and challenging them to be more productive as we get into the next environment. Paul, anything?

Yes. It's – the supply chain disruption obviously caused a dysfunction in our productivity, and that was basically around being able to match up systems, having an outdoor unit in one warehouse and an indoor unit in another warehouse. So it did stretch our people to be able to satisfy the customer and make sure that we were able to put the pieces together so that they could complete the job that they were on. And so that did create some dysfunction, as I said, in our ability to improve the efficiency with all the tools that we provided to our people. The second thing that we're going to be going through now is, as we go through the transition to the new product line, it's obviously going to reduce the number of SKUs. It's going to hopefully simplify the supply chain. And hopefully, we'll have a long-term benefit from that going into 2023 and beyond.

A.J.?

Yes, I'll just add some figures to give you some sense of scale. We process and fulfill roughly 7 million customer orders every year. That's product going out. Product coming in, receiving of product coming in, there's also millions of receiving touches that we have to do with the products. And then we move product around our 700 or so locations with 800 or so vehicles and lots of forklifts and lots of humans and lots of touching of the product various times. And like Barry said, given the supply chain challenges and not necessarily receiving product when we hope to receive them or in the locations we hope to receive them or in the quantities have – we'd like to receive them, and the surge in demand, there's a lot of scrambling going on. And the policy – or not the policy, but the – our heart was to fill customer orders, take care of our customers. Well, now as things start to calm down, if you will, a little bit in the supply chain, and we expect them to continue to "normalize", we'll have more opportunity to improve our processes, improve our technologies, improve our ability to smoothly receive all those products, move products around less, because we'll have products in the right place at the right time and the right quantity, get customer orders filled accurately and on time and efficiently. So I'm just trying to give you some sense of scale of the operation and the chaos that ensued. And now as the chaos calms down, we can really drive some productivity and efficiency through the system.

All very helpful, thank you and as a follow-up I wanted to hit on technology investment. Is it safe to assume that, that's a separate discussion here, and that you'll remain forward-leaning, I guess, we could say, on technology investment? Any view you could give us there for the coming quarters would be helpful. And just to throw out a couple of data points that maybe you could discuss. I just – I noted the contractor-assist users were up meaningfully quarter-over-quarter. OnCall Air quotes were down meaningfully quarter-over-quarter. I realize there's a lot of noise in those KPIs that you give us every quarter. But to the extent you want to clarify any of those trends, it would be helpful as well. Thank you.

I don't think that last specific is accurate. Right, Barry? OnCall Air quotes?

When you say quarter-over-quarter, you're talking about second quarter versus third quarter, or sequentially? Is that what you're looking at?

Correct.

Yes. We had to look at it year-over-year because there is seasonality in the business. But I mean, starting with OnCall Air – yes, go ahead, Barry.

No. I would say there is a seasonality aspect to that answer. Yes.

Right. But no, OnCall Air is thriving. And the customers of ours that are using it, which is a growing number, their performance with us, I mean, their sales growth rate with us is significantly higher than non-users. They're winning more times in the marketplace and that leads to more purchases from our business units. As for technology in general, will we continue to lean in and be a technology-driven company? The answer is yes. I'd like to say maybe it's become cliché now that we are a technology company that just happened to sell HVAC products. And technology, we really use that as an umbrella term. It really means modernizing the company, including people's skill sets, our processes, our systems, how we operate and how we are able to impact our customers as far as their experience and their ability to find the products they need, get orders delivered or fulfilled quickly and accurately. And really, technology touches all parts of who we are and what we do, and it's all customer-focused, and it's appreciated. The customers that are using our technologies are better customers. Their attrition rates are much lower and their growth rates with us are significantly higher. So those numbers continue to grow as far as customers using our tools. And we continue – we believe it's made an impact in our ability to take market share from our customer – from our competitors who don't have nearly the breadth or depth of the technology offering that we do.

Thank you both. I will turn it back.

The next question comes from Nigel Coe of Wolfe Research. Please go ahead.

Good morning, Nigel.

Thanks. Hi, hi. How is it going? So, yes, thanks for the question. Just wondering how we should think about your inventory levels as we go into year-end. And it sounds – it looked like third quarter, we're kind of back on a more seasonal path of lower inventories in 3Q versus 2Q. But just wondering how you're managing inventories into year-end and of course curious about the 14 SEER versus 15 SEER dynamic as well.

Those are two great questions. All I can generalize is inventory will be lower, and we hope not to have any or very few units that wouldn't qualify in the South given the efficiency mandate in the South. We're very conscious of that, but let me give you more in-depth that would be Paul.

Yes. Nigel, we monitor the straight-cool units in the South to make sure that we have a smooth landing at year-end when those units become basically obsolete in the South. So we feel we're on the right trajectory there. We're going to beginning to receive the new products, hopefully, in late October, early November. So we'll be set up to be in business on January 1st. The new product will be more expensive than the existing products we have. But generally speaking, the inventories are a little bit restrained right now in certain product areas. And in other product areas on heat pumps, for instance, we have sufficient product to guide us through at least the fourth quarter and into the first quarter.

Great. Thanks Paul. And then just my follow-on is really around, I don’t know if you want to throw out the price mix impact in HVAC products this quarter in residential.

Yes, we did.

You do that like you do sometimes.

Yes, we did do that.

Sorry. Okay. I'll go back to that. I missed that one. I'm sorry.

It's in the press release Nigel.

Okay, got it. Got it. My eyesight is terrible. But if we think about, you mentioned the hurricane obviously a tragedy for Florida, but just wondering what impact you saw in the quarter? And what opportunity do you see from the rebuild as far as HVAC is concerned?

This is Paul. I live in Fort Myers, so I'm right in the middle of the of the hurricane zone here. And I've been out visiting our branches and I was very proud to say that our branches were open within 24 to 48 hours after the hurricane passed. And taking tours of them we had one branch that was missing 160 feet of its wall, and there were 10 trucks lined up outside, and we had – our staff was there doing their job and filling orders. What did we lose in the quarter? It's an estimate, I would say, somewhere between $16 million and $18 million worth of business was probably pushed either into Q4 or perhaps is going to be lost. However, we've got a very strong market share presence in the three counties that were impacted. We've got 12 branches. It's a marketplace which is about equivalent to the size of the state of Louisiana. So, obviously as the work begins, we expect to see some upside in this marketplace. It's tragic that creates business, but we are here to help everybody get their lives normal again.

Yes, I would say just add color to that, we had about 40 locations under hurricane warning that had an irritation during the quarter, another 200 under hurricane watch that I'm sure there was some distraction. As that plays out into the fourth quarter there is some short term, immediate requirements to fix systems. What we have seen in other markets where there is destruction like this is and just conceive of a $20 billion insurance claim collectively in aggregate flowing capital into a market like this. And some portion of that $20 billion is our stuff that is part of either rebuilding, remodeling, or retrenching, or new building in that case. So there is a longer tail than just one quarter, but it's one of those events where we are witnessing the old destruction. And again, to some extent that's an opportunity for those markets within our business.

Right. Okay. Thanks.

I'm happy to add that none, no serious injury to any of our employees, which we care a lot, quite a bit of – who were employed during the areas of the hurricane.

Oh man, Thank you very much.

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

Hey, good morning guys.

Hey, good morning.

So just wanted to come back on Nigel’s questions on inventory. Maybe just speak to what you're seeing from your OEMs and parts suppliers around lead times and just, I think, Al you said inventory is going to be lower in the fourth quarter. And I don't know if that's a seasonal comment, but we've just seen some aggressive destocking in other kind of building products area, not so much HVAC. And I'm just wondering as you see lead times, what's the kind of the want and willingness to kind of bring inventory levels more normal?

Well I would say generally speaking the manufacturers did the best they could, but in more cases than not, they were not able to deliver either on time or a complete order they would send the out outdoor unit, but not the indoor unit. And so we had the inventory something we weren't going to be able to sell until they fulfill the second part of the order, that sort of thing. And since they are catching up, we're going to be getting complete systems, especially with the new products that are coming out towards the end of the year. And that's why, I think, that not only will the inventory come down, but the cash flow will come down because everything is going to get better in the point of view of investing in inventory, and improving the mix of what's in the inventory. Anybody want to add to that?

Yes. I think I indicated this earlier; the one good feature about the change to the higher efficiency products is a fairly large reduction in the number of SKUs that we have to handle. And what our hope is obviously is that as the number of SKUs come down, that makes it more efficient for us to be able to have the right inventory and a lower inventory at the same time, should also make it a simpler manufacturing process we hope for our manufacturers so that they will be able to provide us the products that we need. So, we're still having some problems. There still is sporadically something will go haywire at the manufacturing plants and we'll have a shortage of something. We're experiencing increasing demand as we indicated in the press release on heat pumps, we're seeing increasing demands on commercial products and we have a continuous demand increase that we've seen over the last several years on ductless products.

Well, from what can see in October the numbers throw strong growth, which is another reason why I feel good about the inventory?

Okay, great color. Just on gross margins I know there has been a lot of questions on that. I think Barry last couple calls you kind of talked about some of the structural improvements and kind of a new target of 27% gross margins. I think you are there this quarter. I'm just wondering if that's a reasonable target for kind of 4Q and into 2023 or if we start to maybe dip below that as some of the inflation normalizes. Thanks.

Barry you are on?

Yes, I am. Jeff, just to give some color first in the quarter, let's speak very narrowly about the quarter, the key business, component of gross profit in the business is what we simply call selling margin. What is our price cost effectiveness during the quarter and during the third quarter that was raised about 80 basis points. So we were still seeing higher margins in that kind of raw margin aspect of us selling products that will – there is not a reason to think that will change much as we play out the rest of this year. And so that's the positive. The negative was part of gross profit also is how we pay vendors when we pay vendors to the extent there is volatility and paying vendors. And there are cash discounts, there are vendor incentives, there are rebates that flow in that equation. And that volatility in a quarter that took away some of the gross profit profitability this quarter. So that's a short term one quarter conversation. Longer term, the good news is the price cost selling margin actually increased meaningfully this quarter.

The selling margins, there you go again. That's the healthy part of our business.

Okay, that's great color. I appreciate it guys.

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

Good morning, Ryan.

Hey, good morning. Good morning. So I wanted to pick up on the gross margin questions. So just to clarify, year-over-year you are saying that there was a positive 80 basis points of positive price costs, but that was offset by what rebates being lower?

Yes.

And if that’s the case, why would rebates be so much lower in one quarter? I don't recall ever seeing that in the past.

It's because of the level of purchasing activity and receipt activity a year ago versus this year. And that's where the chunk and the funkiness of inventory receipts that have kind of have been volatile play out a year later. So I would say a year ago there was a benefit in gross profit relative to the timing of receipts of inventory a year later a bit of an air pocket. We're talking about 30 basis points to put that in perspective.

Got it. Okay. And then gross margins were flat year-over-year, so what was the other part that offset the positive price cost?

Freight, inter-branch freight where we moved products around was negative in the quarter for all the reasons that we're talking about when we talk about freight and moving products around that's an inefficiency in gross profit year-over-year.

I got it. Okay. So how do we think about the trend then? I would presume that the positive price cost situation will be with us for a bit. And then what about those other pieces? How do you think those will evolve in the next couple of quarters?

Yes, it does go back to the purchasing patterns. And again, inventory as we reduce inventory seasonally, which is normal through the rest of the year versus what we did last year; there could be a small amount of volatility in that. I would have to go back and look at a year ago, but I don't think to the same extent as what we saw in the third quarter. And as far as moving inventory around, I think, that is better, but still an irritant. And it's probably one of those a year from now opportunities to actually improve margin.

Okay.

So, I would still stick with our target of 27% as a baseline. And some of those volatility that we're talking about this quarter flattens out or goes away as we get into next year.

Got it. Okay. That's what I was driving at. So thanks for that Barry. And then my last question, I just want to go back to the price mix impact in 2023 from this year change. So, I think what we're hearing is a lot of the OEMs are up sort of mid-teens for price increases on new base units, and I think there is actually some out there up 20. Are those the right numbers? And I think the mathematics would be price mix next year could be 6%, 7%, 8%, with carry over price from this year. Is that right?

I would say you are a little high. Everybody announces some of these price increases but, I think, what we're going to see is it probably, and this is a guess on my part, it’s probably going to settle somewhere around the 10% to 15% range.

I see. Okay. Great, thanks for that. Appreciate it.

The next question comes from David Manthey of Baird. Please go ahead.

Good morning, Dave.

Hey, good morning Al. Good morning everyone. So playing off of that that pricing question, I apologize if I asked this before, but could you remind me the percentage of your parts and supplies products that might be more subject to commodity deflation, like steel ductwork and copper tubing and that sort of thing?

Good question. Paul?

Yes, it is copper tubing, it is steel. We sell a lot of steel. It's used in the production of ductwork. Refrigerant is another area that we look at, which is generally for us it's mostly 410A which, I think, is going to have upward price pressure throughout the next four to five years. And then our general parts business which is compressors and motors representing the largest portion of it. On the supply side it's everything from the ductwork that goes up there, the flex duct to insulation products, grills, registers, we've got gosh probably a couple hundred thousand SKUs when you get into that product.

But when you look at that Paul just thinking about the types of products that are very sort of commodity heavy like copper tubing and steel, what percentage of your mix does that represent given that equipment and refrigerant are obviously seeing inflation, inflation, what components might see some deflation as commodity prices retrench?

It would be, I would say, just hazard, I'd have to give you an exact number, but it would be south of 5%.

Okay, yes.

Yes, I agree with that. I don't have to hazard it. I'm looking at the numbers. It is under 5%. Refrigerant, which is again, we label a commodity which has had nothing but inflationary reality was going on, is there, but as a group, that commodity group is still even with refrigerant right around 5% of sales.

Okay. Okay, thank you for that. And then a second, I hate to get too granular on this, but could we talk about the operating expense investment that you've been making here? And I'm looking at the OpEx level this quarter relative to a $2 billion revenue number. I'm just trying to understand, are all of those investments kind of at a full run rate in the third quarter? And then as we get the shoulder periods, some of your variable costs might come off a bit that the $3.22 million SG&A this quarter is a high watermark for the next couple of quarters, or were you implementing those programs during the quarter and we can actually see more of flatness or higher SG&A going forward? I'm just trying to understand the timing and what more we should expect as we look to the next couple quarters here.

Yes, I would say David first when we talk about 400 people, it's not recently, it's over the last couple of years. So that's just giving a big picture view that during what's been a tumultuous time, we've invested heavily to not just realized today's results, but investing, some of the future results that we're expecting. So, I would say it's a pretty mature looking number at this point in terms of what you see in a quarter. There are a lot of variable costs which moderate over time in terms of just moderating to what the top line and margins are doing. Gross margins are still up, over 25% this year that means every commission salesperson that sells off of gross profit, their income is up 25% this year. I wouldn't expect, I would like it, but I wouldn't expect that level of growth rate – I wanted to, but it's not going to sustain at that level obviously. So that would be a variable cost that moderates simply by the business, in terms of the scale of the business, changing, something like freight where it's a $60 million, $70 million number that's up 40%, 50% over the last 18 months, I would expect that to moderate for all the reasons that we're talking about. But also you have 675 branch managers that decide every day, how many people do I need? How many hours are we going to spend? How much overtime do I need? How much temporary help should I add? How many trucks should I own? And so when we talk about efficiency, it's going out to, and bringing data to the equation and culturally in the shoulder season and challenge kind of the thinking on what's going on in that regard. It's a lot of moving pieces.

That's perfect.

It’s a lot of moving pieces. A lot of moving pieces all of which have not been easy to manage the last two years and obviously become simpler to manage and obviously more critical to manage in terms of urgency over the next two years.

Fair enough. Okay, Barry, thank you.

Robert Baird is thinking about those kind of discussions right now.

The next question comes from Stephen Volkman of Jeffries. Please go ahead.

Hello. Good morning everybody. Thanks for taking the question. I'm wondering if we can just focus a little bit on kind of what you're seeing from the volume perspective, and I guess I'm sort of backing into volumes were kind of flattish this quarter, but I think maybe we started the quarter better than that. Did volume sort of decelerate through the quarter and Al you made a quick comment on October, I wasn't sure if that was a volume quarter or something specific, but we'd just love to hear what you're seeing there?

Yes. We haven't mentioned, I don't believe that there is a product mix going on which also elevates the pricing. I think Barry talked about that, I think that's probably the more significant – one of the more significant things that's going on. The product mix is changing and now as I think that's a plus, you only see is not unit sales as you otherwise would, but you see the sales that do occur, they occur at a higher price in the marketplace.

Right. Well, just to answer your question Steve, just on volumes, volumes were up – we're up in July. We reported that when we reported it in July. There was some moderation since then and, and pretty flat for the quarter and probably wanted the or probably would've been up a little bit if I try to account for some of the hurricane activity. But that's been kind of the way it's been now for six months. That's not a new trend. It's kind of been flattish unit growth now for really six months. What Al was speaking of is, what about everything else in terms of the business? And so obviously there's still a measure of inflation we're capturing in the market, but when we use the term heat pump and discuss that it's up 32% in a quarter and that's substituting for straight-cool units that are probably 10%, 15% less in price; that's mix, that's a price achievement in mix. And to the extent that trend simply continues, it's a permanent opportunity to have higher average selling prices. Also the SEER mix increased during the quarter and it's been going on now for about 11 years. You have contractors making recommendations, bringing solutions to the homeowner with confidence. We have technology in place that's triggering that opportunity in a much more professional way. And we're seeing another quarter of strong growth and energy efficiency mix and the government mandate next year makes that even more automatic. So when we use the word the term price and mix there's a lot of subtlety in that discussion and the heat pump discussion and this synergy mix – energy efficiency mix discussion, I think accounts for a lot of what we're talking about in price right now, not just inflation. Paul you can add color, I'm not sure there were any OEM pricing actions this quarter.

No, there really outside of some commercial pricing actions, we didn't have any residential pricing actions that really affected the quarter. And as Barry indicates the heat pump growth was something that's been happening sequentially over the last three quarters and we saw it accelerate in Q3, expectation is for it to continue to grow as that grows, it does have a material impact on revenues and residential products.

That's super helpful. And Al you anticipated my follow-on was on mix actually, because I've heard some channel checks sort of complaining that some of the high end units were hardest hit by supply chain issues and therefore were constrained. What's your view, does mix get even better because things normalize in 2023 or are we sort of stable?

I certainly think that it gets better for us. Every trend that we see and anticipate is that many factors are contributing to consumers wanting to own higher efficiency products. And as Paul keep pointing out in a north where they were gas furnaces we expect them to be replaced by heat pumps because they're more efficient when they operate and they emit less CO2 when they're used. These are all very positive trends in the short- and the-long term. We are in the right place at the right time. I just like everything we're doing. To meet what has occurred and better yet, what's coming we just have some fabulous capabilities that no one else has, who can afford $48 million in technology investment a year than growing. Or if they can't afford if they're not committed to it as we are. And that continue – will continue our edge in terms of staying the leader in gaining share. So I can't think of anything at the moment that I would warn you that we see something negative in the early future. Everything I see is positive. Can you guys add to that A.J., Barry, Paul?

Yes. We're seeing another trend that's starting to occur and that is where straight-cool units in the mid-south and the north are starting to be replaced by heat pumps as opposed to a straight-cool unit. And what that trend recognizes is a term that we call dual fuel, where the unit will operate as a heat pump down to a certain temperature, and then when the temperature drops below that point, it'll switch over to the gas furnace, not replacing the gas furnace just replacing the outdoor unit to provide non fossil fuel heating. And we've seen that growing and now it's starting to accelerate. We haven't – we have not talked about the tax credit and what impact that will have on the high efficiency product going into next year and beyond. There's still some adjustments to be made as far as what the efficiency has to be to qualify for it. Once that's clear, I think we'll have a clearer idea of what the opportunity's going to be with the – with the Inflation Recovery Act.

All right. Thank you guys. Appreciate it.

The next question comes from Jeffrey Sprague of VRP. Please go ahead.

Thank you. Good morning everyone. Could you just remind us now just really kind of following on from the mix discussion, what percent of your sales in 2022 would've been at the prevailing minimum SEER level? And therefore is kind of subject to kind of the mandatory regulatory list in the 2023?

Paul, go ahead, on the equipment sales.

Yes. Its minimum efficiency in the quarter was approximately half on just the outdoor units.

And that'd be a pretty good number for the year also, I suppose.

Yes. It – that hasn't really changed that much. There's been a little bit of mix up in it because of the supply chain, but generally speaking that's a pretty good number.

And just back to heat pumps, the numbers do seem particularly strong even before the IRA that come into play. I mean, are you proactively educating, like in many respects, I would think the average consumer doesn't know a straight air unit from a heat pump unit from air handler, right? So is there really a very proactive selling effort going on around heat pumps driving...

I think there is a proactive among our contractors. Obviously it's their responsibility, they're the ones in the home. We've got on-call which assist them as far as making that presentation to the consumer. So I think that's a plus that Watsco has and Watsco's contractors have. But also there's been an awful lot of discussion. Bill Gates wrote a book on it. California now has passed the law, which states that you can have – they're going to be fossil fuel heating by the year 2030, you won't be able to buy a gas furnace and install it. There's been also motions in New York state parts of Canada that are starting to phase this out. The Department of Energy also has a, what they call a contest to come up with a low temperature heat pump and that's been led by the state of Minnesota. So I think the word is getting out to consumers. Heat pumps are not new, heat pumps have been around since the since the mid-1950s. It's just that it's taken a while for these things to really catch on for the technology to be able to provide a comfort heating situation for the consumer. And so what we're seeing is we're seeing the frost line if you will used to be the end of where you could sell a heat pump. And now we're seeing that extending up into Pennsylvania, New Jersey and even Massachusetts. And the science of these heat pumps is improving. They're doing more things that dealing with more extreme temperatures than the old ones used to.

I was going to say that also, it's probably 10 years ago ductless was a fraction, a much smaller fraction of the market than it is now. And most every ductless residential unit or heat pumps, so if it's Mitsubishi or someone like that selling 20 SEER ductless systems, 95% of those are heat pumps.

Great, Thank you, Paul.

[Operator Instructions] And our next question will come from Steve Tusa of J.P. Morgan. Please go ahead.

Good morning, Steve.

Hey guys, how you doing?

Great.

So just on the, I guess just the forward look here; do you expect the fourth quarter to be kind of like normal seasonality for you guys on an EPS and sales basis? Just from a, I guess that would be sell through, I mean, what, you said it's up in October. How good is it in October and just how should we be thinking about the fourth quarter trend?

I'll give you a general comment. I think fourth quarter is going to be very strong. Barry detailed?

Yes. Steve, I mean the same kind double-digit. Yeah, I mean you've seen double-digit growth over the last two quarters and October, there's no interruption in the double-digit trend and kind of leave it at that. I think it is a shoulder season as we get into off season and so it can be a bit more consumer oriented in the sense of that, but we also are seeing the very strong commercial volumes flowing through the business. So yes, now that looks a lot like the trends of recent months.

I guess with all the cross currents around demand, the regulatory changes coming up and I guess your focus on destocking some, like what's the inventory trend in into 4Q? There's just a lot of moving parts here because it is a shoulder season. So I mean is that going to be kind of up, quarter-to-quarter in preparation of next year, like just maybe just a little color on the inventory?

Well, that's a good question. I don't think they are going to be higher; they are going to be lower. But anybody fill in the blanks on that.

Yes, of course, our goal is to end up lower. A lot of it's going to depend once again, on the supply chain as far as how quickly we can restock with the new M1 product, or is the majority of that going to fall in Q1? Obviously, that's a higher price product than what we currently have. We're also seeing strong demand as a lot of the – on the new construction side, a lot of these builders have to have the system operating under the old standard. They have to have the system operating in the home, the new home that they're building before your end. So we're seeing a little bit of a rush from that sort of standpoint. And I think it's going to be – I think we're going to be down, our plan is to be down. And we're working – we've got inventory management system that allows us to have complete visibility of it. So we're not surprised at the end of the quarter by where our inventories are.

Let's just be careful of those words. We think our inventory is going to be down, not our business.

Yes.

That's what I said. Yes.

Yes. So, inventory is a percentage of sales down a little bit. But I was just wondering from an absolute perspective. And then Barry, you mentioned these promotions or these rebates I guess, you call them. What's the expectation for that in Q4? And then just any color on the gross margin in Q4?

Again, the selling margin that I mentioned which is simply the price cost equation of selling products is we're seeing that continuing to trend better in October. Let's say it that way. And again, I don't think there should be any real disruption in the fourth quarter in that respect. The other stuff again, it's algebra on when we order products, when we receive them, when we pay for them, depending on which product line. And I think there could be a small measure of irritation just knowing the inventory is coming down but not to the same extent as what we saw in the third quarter. So net-net, I think, nothing disruptive in terms of trend of gross profit in the fourth quarter.

Sorry, one last one for you. What's your market call on next year? What's your most up to date? You didn't have anything in the release this time around kind of the market outlook. What's your guess on the market for next year for resi units?

I don't think…

Resi on the overall market?

Yes, overall resi unit market up, down, sideways.

I don't think that we, unless you have industry forecast by the associations, maybe Paul, do you?

No, I think you would have to talk to the OEMs who look at it a national basis. Our forecast that we do internally which is our proprietary system is only for the states in which we do business. So, I would look to the industry for that.

Okay, great.

Nevertheless, our planning is for another record year.

Yes, growth. You guys are planning to grow no matter what.

Oh, yes.

Yes, Okay. All right.

We've got too many advantages that are going to continue to expand our share in this business. And we're going to extend and invest more in those advantages.

Yes, that's clear. Thanks guys.

All right.

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

Well, thanks for your interest in our company. We appreciate it very much. And we welcome visitors to hear our more detailed explanation of the technology, which is obviously an important part of our future. And come to Miami or do a Zoom or whatever takes just to learn more. We're happy to do that for you. And once again, have a nice day. And see you the next quarter. Bye-bye.

The conference is now concluded. Thank you for attending today's presentation and you may now disconnect.