Watsco, Inc. (NYSE:WSO) Q3 2023 Earnings Call Transcript

Watsco, Inc. (NYSE:WSO) Q3 2023 Earnings Call Transcript October 19, 2023

Watsco, Inc. beats earnings expectations. Reported EPS is $4.35, expectations were $4.31.

Operator: Good day and welcome to the Watsco Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Al Nahmad, CEO. Please go ahead.

Al Nahmad: Good morning, everyone. Welcome to our third quarter earnings call. And this is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, President and Paul Johnston, Barry Logan and Rick Gomez. Before we start our normal 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. Watsco delivered a record quarter, which is all the more rewarding given a record performance achieved in the third quarter last year. Third quarter last year was a barnburner. And so I am so happy we are able to beat that.

Sales grew 4%, driven by 6% increase in HVAC equipment. Residential unit volumes steadily improved throughout the quarter and price realization continues to be strong. Commercial end markets also remain very healthy. As a reminder, we have navigated through immense product transition in 2023 following the step-up minimum efficiency standards mandated across the United States by the U.S. federal government. Approximately 60% of the HVAC systems we are now selling represent new products. Let me repeat that. 60% of the systems we are selling are new products. Thousands of customers have been trained. Our digital product library has been updated, adding over 400,000 new SKUs since the start of the year. As mentioned in our second quarter call, one of our primary OEM partners was disproportionately impacted by the product transition affecting product availability during the summer selling season.

That impact diminished during the third quarter and I am happy to share that our locations are now fully stocked. Sales growth has returned to the effective stores and our partner is aggressively investing and collaborating with us to drive growth. But the reality is that all our OEM partners were affected to some measure and all have improved their supply chain to help us meet the needs of our customers. Here are some other highlights. Our commercial business continued to grow at a healthy double-digit rate this quarter and our backlog of projects extend into next year. Sales of ductless systems, an increasingly important component of our business also grew double-digits during the quarter. We saw the continued trend of gas furnaces converting towards heat pumps, which sell at higher average selling prices.

SG&A as a percentage of sales decreased 80 basis points this quarter, a good start to what we feel is an important opportunity to improve productivity and overall efficiency. We are optimistic about driving more operating efficiencies across our network as supply chains improve and operating conditions return to normalcy. We have the tools, the technology and the most importantly, the entrepreneurial culture to achieve more, particularly as it relates to our internal productivity. We are focused on internal productivity. And of course, our balance sheet remains strong with a small amount of debt offset by cash, in other words, no debt. As always, the financial position improves – the financial position provides us the flexibility to invest in virtually any opportunity as we continue to grow our scale in a very fragmented $50 billion plus North American market.

M&A remains an important contributor to growth. This quarter, a great family business joined our family with acquisition – with the acquisition of Gateway Supply in South Carolina. I have spoken to the principles and you couldn’t ask for higher quality people. Gateway is a legendary company in its Sunbelt markets and provides us with the ability to partner with great leadership to grow beyond their current $180 million sales run-rate. We continue to look for more entrepreneurs and businesses to partner with. Watsco is a great home for entrepreneurs in our space. We sustain culture, invest in people and provide technology to secure and build under great legacies. Looking beyond the short-term, our press release provides critical details to support Watsco’s long-term growth strategy.

We have an immense technology advantage and we are investing to grow that advantage. Our mobile platforms and e-commerce channels have increased customer engagement, reduced attrition, created market share gains and supported our margin expansion in recent years. Watsco’s broad array of products and brand is a competitive advantage that allows us to serve contractors in any environment. We have a leading market share in Sunbelt markets that provide stability and higher growth rates over time. We have also made important technology investments with our business that will support margins and productivity in the years to come. In addition, there are several important regulatory and industry catalysts that are in effect, which are listed in today’s press release.

All of these catalysts will be good for the industry in the coming years and we believe our scale, technology and financial strength position us to especially benefit from these opportunities. With that, let’s go on to Q&A.

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Q&A Session

Operator: [Operator Instructions] The first question today comes from Tommy Moll with Stephens. Please go ahead.

Al Nahmad: Good morning, Tommy.

Tommy Moll: Good morning, Al. Appreciate you taking my questions.

Al Nahmad: Of course.

Tommy Moll: I want to start on the topic of gross margins. I don’t imagine you will get any more than a question or two on that today. But just to start the conversation, what can you tell us about the drivers, headwinds or tailwinds from your second quarter to your third quarter results? And then associated with those, if I look over the past few years, the margin rate tends to improve as you move into fourth quarter from third quarter. Is there any reason that should not be the case this year? Is there something else going on that you want to make sure we are aware of?

Al Nahmad: Well, I am going to turn that over to two persons, A.J., the President and Barry Logan, our Chief Financial Officer.

A.J. Nahmad: Good morning, Tommy. Yes, we had a bet going. Would it be the first question would be on margins or would it be every other [indiscernible].

Tommy Moll: For the first 10.

A.J. Nahmad: Exactly. So I’ll let Rick and Barry get into the details, but I wanted to spend a second in here and abstract as a layer and talk about the big picture. And start with reminding everyone what Barry usually reminds us of is that there are many components to our gross margin. There is the transaction margins or what we make on an invoice-by-invoice basis, on a markup basis if you will. There is cost changes that come from the 1,000 or 2,000 manufacturers that we buy products from. There is volatility in commodity items that we sell. There is internal pricing actions with our optimization tools that we are getting more fluent in. There are product delivery costs. There is product mix changes between commercial and residential equipment, supplies etcetera.

So there is action in all of these categories all the time. But what I want to get across is a reminder that we are a long-term company. And quarter-to-quarter, there is going to be noise and actions in all those categories, but we are focused on the signal. And as we have said, the long-term aspirational goal of margins is 30% and we see that within reach in time. And let me tell you why. And really, it starts with what we talk about a lot, which is our technology, but we should really call our continuous improvement culture. What the technology enables is our teams to be able to do analytics, to spot opportunities, enhance our capabilities, measure and track our successes in all parts of our business. Things like prospecting and winning new customers and changing and improving how customers engage with us with things like e-commerce and our apps, which eventually reduce our cost to serve those customers.

We can increase with the tech or the continuous improvement. We are increasing our productivity levels in the warehouses. We spend a ton of money moving cost in and out and through our network and our fleet and transportation, which is now another frontier how we can use technology to improve what we are doing there. Optimizing our inventory, we have talked about a lot, and there will be meaningful gains there. Marketing and sales is a new system that goes on and on and on. But that continuous improvement culture or what we call technology, so it’s a tool set to win in the marketplace and increase our – what we do and margins will be part of that. Higher gross margins will be part of our – is part of our DNA and more importantly will continue to grow profits and generate a lot of cash.