Watsco, Inc. (NYSE:WSO) Q4 2023 Earnings Call Transcript

Watsco, Inc. (NYSE:WSO) Q4 2023 Earnings Call Transcript February 13, 2024

Watsco, Inc. misses on earnings expectations. Reported EPS is $2.06 EPS, expectations were $2.5. Watsco, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, and welcome to the Watsco Fourth Quarter 2023 Earnings 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.

Albert Nahmad: Thank you, and good morning, everyone. Welcome to our fourth quarter earnings call. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, Watsco’s President; and Paul Johnston, Barry Logan and Rick Gomez. Now before we start, our cautionary statement, as always, this conference call has forward-looking statements as defined by the SEC laws and regulations that are made pursuant to safe harbor provisions of these various laws. Ultimate results may differ materially from forward-looking statements. Now, Watsco delivered strong results in 2023 despite some market conditions which were somewhat inevitable after two extraordinary years in 2021 and 2022. While reflecting in the year’s results, I am proud of the accomplishments we delivered.

We achieved market share gain in markets we serve. We further scaled Watsco’s industry-leading technology platforms. We had a successful start driving down long-term productivity gains. I should say, we had a successful start driving long-term productivity gains. We expanded our network and product offerings by acquiring great businesses through our scale, and we fortified our balance sheet through inventory reduction and generated record fourth quarter cash flow. And once again, shareholders will receive a meaningful dividend increase in 2024, which is in April 2024. This is Watsco’s 50th consecutive year of paying dividends. 2023 was also a year of immense change in virtually all equipment products transition to new [indiscernible] systems.

In collaboration with our OEM partners, Watsco introduced new products and SKUs for over 25 brands of HVAC systems. Our teams executed well, and thanks to our scale and speed to market. We are confident that we gained share. We also trained thousands of customers on new products and our digital pilot library was updated with approximately 500,000 new SKUs. In this spring we will begin the next regulatory transition to new A2L products with lower GWP refrigerants. These regulatory transitions are positive for our industry and are good for Watsco’s business. They offer meaningful value to homeowners and businesses to upgrade systems that are more efficient and better for the environment. Watsco’s residential unit volumes, although still down, stabilized during the second half of 2023.

Commercial end markets remain strong across all markets. Our commercial business continued to grow at a healthy rate, and our backlog of products extends well into next year. Sales of ductless systems, an increasingly important component of our business grew double digits in the year, and offset declines in conventional residential business. SG&A as a percentage of sales on a same-store basis decreased for the year, indicating progress in driving more productivity across the company. We believe we are in early innings of a long-term opportunity to meaningfully improve productivity and overall efficiencies. We have challenged our leaders and provided them with tools and data to implement change. And most importantly, we possess an entrepreneurial culture to execute change in a responsible way.

Over the past year, we expanded our network through acquisitions with three terrific business joining the Watsco family, collectively their annual sales are around $200 million. These businesses will retain their culture, leadership teams and uniqueness in the market, consistent with our long-term practice of honoring and sustaining great legacies. Our industry remains highly fragmented, and we will continue to pursue other great companies to grow scale in our $60 billion North American market. We believe Watsco’s technology advantage, market-leading scale and the strength of our balance sheet are all great reasons to join the Watsco family. Now before getting to Q&A, as always, I want to emphasize that our core focus remains on the long term.

We believe our scale, the quality of our balance sheet and unique culture will continue to drive long-term growth and performance. We have an immense technology advantage, and we invested — investing to grow that advantage. Watsco’s broad array of products and brands is also a competitive advantage that allows us to serve contractors in any environment. And finally, our industry is fortunate to benefit from important regulatory and industry catalysts that should positively influence Watsco’s performers in the years ahead. With that, let’s go on to Q&A.

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Q&A Session

Operator: Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Tommy Moll with Stephens Inc. Please go ahead.

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

Albert Nahmad: You bet.

Tommy Moll: I wanted to start on gross margins, no big surprise there. Your fourth quarter — your fourth quarter gross margin percentage was a little bit below the long-term aspirations that have been discussed recently. So it’s a two part question really. One is just if you could unpack any of the factors there for us in the fourth quarter? And then if we think about the art of the possible going forward to start this year, is there a pathway near term, you can define that how you want, near term to recovering and moving back towards those longer-term aspirations in the high 20s or maybe 30?

Albert Nahmad: Very good question. As you know, I’ve stated earlier that eventually, our aspiration is 30%, and we have a ways to go. So I’m going to ask Barry Logan and Paul Johnston to deal with current events.

Barry Logan: Yes. Thanks, Al. good morning, Tommy. We’ve said all year long with some of the moving pieces with gross profit and also said two years ago or so now, the aspiration — short-term aspiration was 27%. And so, if I just focus on the year for a second, Tommy, just some important things to be grounded in looking at the year’s performance and then I’ll address the quarter and the shorter-term perspective. But for the year, the 27.4% million is what was achieved. And it’s — obviously, it’s better than it was two years ago, two years ago, historically, and a lot of the moving pieces that we’ve talked about to drive and sustain that higher margin, obviously, are in place as we look at the year’s perspective. If we look at a 60 business day perspective, which is the fourth quarter, in the off season, some of those variables have a greater impact in the short term.

So that would be my first bias I would try to talk about is we’re talking about 60 business days in the off-season in the fourth quarter and some of the moving pieces are more acute because of benefits of a year ago, not so much what’s happening short term. So if I unpack that a bit and not be quite as abstract about it, we have about $16 million of benefit in the prior year from pricing gains, from weighted average cost gains, from inflationary gains, however you want to define it, which is roughly 100 basis points in the year ago quarter. Some of that is equipment, a greater proportion is not equipment as there was a lot of inflation going on in some of our non-equipment products a year ago like refrigerant, like copper tubing, like steel products and probably 40 other product lines where an year later, those benefits are not there.

So that’s 100 basis points. That’s $16 million of consequence. And if I look forward to 12 months, instead of back 12 months, if I look forward 12 months, I don’t expect there to be that kind of headwind in those products, let’s say, a year from now. And it’s just one of those things that as the numbers are larger in the fourth quarter, the acuteness is higher, $16 million would not be as material to a second or third quarter. It’s more material to a fourth quarter. So that’s probably the biggest impact in the quarter if you look at things on a year-over-year basis. There are some other moving pieces, which we’ve talked about. One is that equipment products in fact, have a lower gross margin than non-equipment products. So in the quarter, you see a mix difference between the growth rate of equipment, which was pretty flat.

Non-equipment, which was down. So that’s algebra that affects the margins in the quarter by 20, 30 basis points, I would say. And there are some other smaller things that aren’t worth kind of going through. The bigger picture is this idea of inflationary gains that occurred a year ago. With less inflation, there’s less inventory gains to come by. And if we look in the next 12 months, I would expect a much smoother water, much more — less volatility in terms of this dynamic. I think we need to get beyond the first quarter to clearly see that if I look forward the next 12 months. But I would say a greater feeling of stability versus the volatility that you’ve been seeing this year. Paul, anything you would add to that?

Paul Johnston: Barry, you’ve really covered a lot of ground there, yes. Obviously, there’s going to be some price changes that we’re going to see in some of the commodities, especially refrigerant. We should start seeing some uptick in refrigerant pricing as we — as we’ve got the 30% reduction in allocations coming into effect January 1. Too early in the season to have really seen those yet in the first quarter, but obviously, those are expected. Secondly, we’re also seeing some recovery in steel. We’re seeing some recovery in some of the other products that we sell. So price increases are still occurring in the non-equipment side of the business, and we expect those to stabilize and perhaps grow as the year — as the demand picks up during the year.

Tommy Moll: Thank you both for those helpful answers. As a follow-up, I wanted to pivot to a volume conversation and knowing that you won’t give guidance, I’ll try to frame it in a way that provides for a constructive discussion. If we look at the trends for unitary HVAC systems in the year you just concluded, down, I think it was 8% in your material this morning that you provided. I think we would agree that’s an abnormal type trend. And so I’m just curious, if you look to 2024, is there anything abnormal that you see anything worth calling out now? Or does it feel more like a normal kind of environment off that lower base from last year?

Albert Nahmad: And it’s a great question. By the way, some of the OEMs, particularly large ones — now 30% unit volume drop in the fourth quarter. And we’re pleased that we’re doing a hell of a lot better than that. Paul, do you want to take a shot?

Paul Johnston: Yes. The obvious elephant in the room is going to be the — how fast the transition goes to the A2L product, which is being discussed in — among the OEMs is a perhaps a 10% to 15% increase or a lift in price and each one of the OEMs, obviously, has a different implementation schedule. So it’s not going to be a full year implementation that we’re going to see on that. We’re going to see some start coming in, in the second quarter and beyond. So I think that’s going to be one of the things that’s going to drive an increase. Secondly, obviously, a reduction in mortgage rates always helps. People buying existing homes although they don’t intend to replace the air conditioning system, that’s really when they’re at the prime period where they would do a replacement is within the first 90 to 180 days after acquiring an existing home.

So I think there’s some good news out there. We don’t — I can’t forecast out exactly how that’s going to overlay into the entire year. But I think there’s some positive things that we’re going to be seeing as the year goes on.

Albert Nahmad: Generally. Let me just say generally that if — I’ve obviously seen industry weakness as an opportunity for us. there are highly leveraged distributors in the business, and there are distributors that don’t have the — perhaps the balance sheet to deal with tougher times. We see that as an opportunity to join — have them join us with their culture. We provide capital, we insisted they keep their culture and their organization and we provide tools that no one else has — so I’m sort of well, I don’t — would not be very excited to have market industry data decline. If it happens, I’m also looking at opportunity to bring more wonderful companies to do partnership with us. Go ahead, Paul.

Paul Johnston: I was just going to add about the unit data. I listened to the question, and I asked myself the question about units. Do we feel better or worse? That would be my simple way of asking that question. And so the first half of 2023 units were down, I think, in the teens. And second half of the year, I think it’s — units are down 2% or 3%. So I think we feel better about units than worse. Of course, the crystal ball is — needs to play out next selling season in April to September when our business multiplies in size. But I think generally speaking, things again seem more stable as opposed to being volatile.

Tommy Moll: Thank you all. I appreciate the insight. And I will turn it back.

Operator: The next question comes from Ryan Merkel with William Blair. Please go ahead.

Ryan Merkel: Hi everyone. Good morning. My first question was on price and the outlook for ’24. What do you think in price will contribute given what you’ve seen from the OEMs?

Albert Nahmad: We have that information. Barry, Paul?

Paul Johnston: Yes, we’ve seen price increases announced already in the year on the existing equipment, and they range basically from 4% to 6%. So the equipment prices have already been announced. They’re going to be further supplemented again by the introduction, as I indicated in the last question, with the A2L introduction. And so we’re going to probably see some additional lift there. A lot of speculation around how big of a lift that’s going to be, so nobody has really disclosed anything on their anticipated price outside of that wide range that I think you all have heard 10% to 15%. On the other products that we sell, we’re also seeing, as I indicated, increased prices pretty much all of the copper products and all of the metal products that we sell and we experienced some softness on some of the insulation products last year.

Those appear to be stabilized now and we should start seeing those products not have any sort of price degradation in 2024. How much all that is going to add up to? I think it’s still a little bit of a question mark as far as being able to put a percentage against that against total sales, I think it will be clear in the second quarter as we start seeing what the rollout prices are going to look like for the A2L.

Ryan Merkel: Okay. Got it. And then I wanted to ask on SG&A. You’ve taken some actions there. Anything you can quantify for us in terms of how much is coming out in ’24 or what your kind of aspiration is for SG&A growth in ’24 either way?

Albert Nahmad: Mr. Logan?

Barry Logan: Good morning Ryan. Well, first, again, there’s two sides to that equation. And they’re all — it’s all being driven again through the field, through our stores, through our regions, through our business unit leaders in terms of — in their 2024 plans, reducing SG&A. And when I say reduced SG&A, it’s not just cutting SG&A, it’s finding out the opportunities for productivity after what had been also two years of wildness in terms of SG&A growth. Talk about the business performance of 2021 and 2022. It was also a very unproductive period of adding SG&A to serve what was going on. So that’s what we’re looking to improve and to some extent, simply get back to a little bit more normalized conditions in terms of how the branches operate and so on.

So this kind of single-digit declines that you’re seeing, Ryan, is a composite of two things. In recent quarters, it’s variable expenses coming down 10%, 15% fixed cost inflation moderating, but still there’s inflation in fixed costs like rent, for example. So it’s probably a slow grind or better improvement from what you’ve been seeing in the last few quarters? This is, again, not restructuring the corporation. This is improving the daily expenses, the daily productivity. But in that kind of better progress from what we’ve been seeing in the last few quarters is our expectation. I’ll have to leave it at that.