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Watsco, Inc. (NYSE:WSO)

Goldman Sachs Industrials Conference

November 14, 2012 11:45 AM ET

Executives

Barry Logan – SVP

Analysts

Adam Samuelson – Goldman Sachs

Adam Samuelson

Okay. I think we’ll get started. Very happy to have Barry Logan and Watsco. Barry is the Senior Vice President at Watsco. (Inaudible) some brief opening remarks and we’ll go right into Q&A.

Barry Logan

I want to thank you for being here. Again, I’m Barry Logan. I have worked for Watsco over 20 years. The company has been around 60 years. And in 1989, we became -- entered into the distribution market for HVAC products.

So zero revenues in this industry in 1989 and now about $3.5 billion, 24 years later. That still represents only about 12% of the North American market which is where operate. Our business is, again, centric to air-conditioning and heating products; refrigeration also as a component of it.

And the customer really in our case is a guy in a pick-up truck or a truck that’s running around town fixing, replacing, servicing, maintaining air-conditioning systems. It’s one of the only things in your house you can’t do yourself. So these are product are not made available out of Home Depot, for example, on a do-it-yourself basis. You need a contractor. Your air-conditioner or heater doesn’t work, you want it fixed today, a contractor’s firm may ring 10, 15 times a day with problems and our stores are the ones that sell products that give the contractor the promise of doing it today, and the technical help and the credit and the capability of product and brands and, again, the technical help to do the work. So that’s the (inaudible) our business.

Of almost 600 stores in the U.S., we cover about 30 states. So we still are not a national company entirely yet. We cover Canada and Mexico and the northern part of Latin America and the Caribbean. The manufacturers who make this stuff, Carrier, York, Trane, Winix, Rheem, and then Honeywell and Emerson and other players in the market need distribution again to get to that local contractor. So we’ve built out our business on both brands and relationships with contractors. And again, a work in process with about 12% market share.

The financial side of the business, if you look at our 10- or 15-year chart, about a 15% earnings per share growth rate compounded for 15 years. Cash flow has been about 120% of our net income over the last 10 years, basically, no debt until recently when we paid a special dividend which I had [ph] mentioned [ph], which I’ll talk about. But we wanted to be a great dividend-paying stock, very conservative balance sheet. We’ve never had leveraged above 2.5 our EBITDA.

We wanted to build our business through acquisitions which we have, because much of the relationships that are established in the market are held by family businesses for example that have been in the market 40, 50 years. Nothing is called Watsco. Our stores are called what they’ve been called for those 40, 50 years. We try not to interrupt the progress or those relationships with a big corporate office. Our corporate office has 25 people in it. But we are the only public company in this space, as a distribution business.

We’re by three times the largest, and the most important part of that is we’re by far the largest partner to the OEMs who make the products. Carrier would be our largest single partner. They invented air-conditioning 110 years ago. And we sell about half of what they make in the North American market exclusively. So if anyone wants a Carrier brand products in those markets, those particular markets, they buy it from us. So it’s a big partnership. But we have other, again, with Rheem, Goodman, Emerson, Matholoc [ph], DuPont, Honeywell, other brands that are in the industrial complex so to speak; and charged with growing their brands and their market share as partners with us as well.

So that’s at least [ph] an opening comments. I guess, the only, the other thing I would cover is about two-thirds of what we do is at someone’s kitchen table, as a consumer who’s air-conditioning or heating is broken and a contractor sitting there recommending what it is they should do. So that’s about two-thirds of our business. The good news is no one will live without it. No one will live without it being 74 degrees in their house. The question is what do they spend when they have to do something. And energy efficiency is what drives that price. It’s what drives our sales mix; not fashion or luxury, but energy efficiency.

So over time, the government is our champion. In this case, through mandating higher energy efficiency levels. It benefits the consumer. It benefits the utilities that want conservation as part of what they do. It benefits the cost of owning a home. And so every few years, government raises those standards. There’s a standard coming in a couple of years that will be raised in the Sunbelt market of the U.S. Other countries in North America are catching on and we see some, at least, discussion of raising energy standards. And again, that usually means raising prices for what we sell.

So it’s been a good safety net for our industry to be in the business of capturing price because of energy efficiency. So it’s a, in a strange way, we are an energy play in the sense that these systems use half the power of home energy use in the country. And long term, we know that the standards will be increased, the value proposition is there and it’s good for our pricing margins and for the rate of replacement that goes on. And, again, in two years is the next milestone for such a standard change.

We also sell products that can heat up the environment because of refrigerant. And those standards have been changing. U.S. has been playing catch up to the European market and those standards also are evolving each year with another milestone coming in a couple of years that we would expect could provoke, again, further replacement requirements and at least replacement activity beginning in a couple of years.

So those are some of the big picture thoughts I can give you.

Question-and-Answer Session

Adam Samuelson

Sure. So maybe we can dig in to some of those and maybe just start, Barry, thinking about just the state of the market today, year-to-date industry shipments are up [ph], flat [ph], up low single digits, give or take depending on which measure you want to use, your sales performance versus that. And as we enter the heating season, I mean, what goes predominantly in the Sunbelt, but you do now have business into Canada and bigger presence in the North East with Carrier, maybe talk about how the heating season is starting to track if you can give any color there.

Barry Logan

Sure. What drives the replacement market is the installed base breaking. And we know one side for sure is the installed base has never gotten smaller. Installed base gets bigger each year. It’s really the rate of replacement when things break that causes our business to grow. The last couple of years, we saw consumer in some cases repairing more often than typical. We saw that start to change on the other way this year where I think as the consumer strengthen, part of our business is simply turns into replacement volume, and we’re seeing that.

We obviously haven’t had historical levels yet but it seems to be evolving at least in a positive way. Not enough to offset some of the price impacts we’re seeing from people buying the minimum efficiency they can buy. Again, that’s still a consumer economy issue of confidence and employment of what does someone spend when they replace their unit. Again, as the consumer economy improves, that will improve. That will help our top line and profitability.

And then, again, at a more dramatic way, the government standard is coming in 2015 will provoke that change more automatically. But year-to-date, we, our business in our Sunbelt markets, we see single-digit unit growth, pricing that’s come down a little bit this year. So our single digit revenue growth is there organically for us. We bought businesses. We’ve added to our network with Carrier. So our overall sales growth rate is in the team this year. But, in the organic way, it’s kind of a flat year, a little frustrating, a little bit enigmatic. We react by cutting SG&A which we’ve done this year. We’ll have 10%, 15% earnings growth this year.

But the fantasy of having both home building recover, the consumer recovery, the pricing recovery of sales mix is probably more in front of us than what we saw this year. But we don’t see anything destabilizing. We probably see more potential versus more risk at this point and in those conversations.

Adam Samuelson

And maybe on that last point, new construction, an end market that more broadly you do see signs that it is recovering, home starts on an annualized basis have continued to tick up through the year. You haven’t really seen it come through to your business yet, and probably, the supplies business would be where it would be most readily event, the contractors you’re buying supplies that go into the home. Maybe talk about what you think where that diversions is coming from and how are you thinking with that going into next year.

Barry Logan

Sure. The context of our new construction, residential new construction businesses is about 10% of what we do. It’s roughly 500,000 starts of single-family starts this year; multi-family is not necessarily an industry for us; the different application of air-conditioning. But we care about the good old-fashioned single-family building, and today, again, it’s 10%. And nationally, 500,000 units are sold into that market. So if it’s 1 million units, it’s 10% growth. It’s really linear for us. What our kind of bias is for that to be in the Sunbelt. So about 80% of what we do is in the Sunbelt. Almost 25% of what we do is in Florida. And so there we love the data; permits and starts are up 30%, 40%. The data we don’t like is that completions are up 6% year-to-date.

So, we do like the crystal ball of the permits and starts turning into sales and completion, but that’s probably again more of a 2013 event in terms of that. We don’t just sell equipment. As we suggest, we sell supplies which is the duct work, insulation, everything else that goes into the house other than just the systems themselves. It’s a bigger ticket and it’s a higher margin, all of the other products. So it’s nice to think about and wonder about; we haven’t seen it yet in our Sunbelt market, but certainly, it’s laden potential and it’s an opportunity for us if not next year, in the next two years.

But in the context of it, at its height, it was 30% of our market. Today it’s 10% of the market. But replacement is still what matters more, so that can be a good catalyst for earnings in the next couple of years.

Adam Samuelson

And so, in that replacement market then, obviously, mix has been a big swing factor over the last couple of years given a whole slew of tax changes and regulatory changes in terms of this R-22 dynamic. Maybe talk about where we are with mix today and why that might be the kind of the extreme in terms of that mix down?

Barry Logan

Sure. Well, again, five years ago, the energy efficiency mix was less than 50% of the base level, more than 50% at the higher-tier. Today it’s more like 75% at the base level and 25% at the higher tier. And in that is simply a consumer spending money that either has less or less confidence today than they have five years ago. So the price different of good, better, best can be between 15% and 30%, depending on which level you end up at.

So, for us, again, it goes back to educating the contractor, incentivizing the consumer, maybe bringing some financing to the market that’s not there today which we’re working on with one of our banks. Maybe turning some of our advertising spend into something more direct to the consumer or direct to the contractor which we’re evaluating for next year. And then part of it is getting the OEM’s energy put into it because they benefit in the same way that we would by higher prices. But ultimately it’s the consumer that has to write the check, okay. So it’s probably more reflective ultimately of employment and confidence and we can influence it but at the end of the day it’s the consumer spending money.

Adam Samuelson

How much of that do you think is also the fact that the price of that good entry level product has gone up significantly with these changes in regulatory standards?

Barry Logan

It went up a lot in 2000 [ph] so it would be the last time there was a dramatic price difference or dramatic upgrade in -- I would say that’s work its way through the psyche of everyone. In terms of history, you only buy one of these things every 10 or 15 years. You don’t buy one like an automobile every four years. So I’m not sure anyone really knows what they cost until they have to buy one. It’s the sticker price of it of getting someone to spending $4,000 today instead of $3,000. And again, that’s where the consumer confidence matters is and that’s been today that will last for 15 years. But where we find ourselves today is a leaner mix, I think, again, because of the economy.

Adam Samuelson

Do you think that that’s also elongated the replacement cycle for these products for people who might be incented to do some repairs earlier in the unit’s life cycle than they were historically?

Barry Logan

Yes, I think that’s reality that just like on an automobile, you may fix it to keep it running a year longer and try to get by with it. And so, we saw that especially in 2010 and ’11. We saw replacement parts increase meaningfully. It’s the first time that had happened in a very long time. We’re beginning to see the parts volume decrease and the rate of replacement increase, but again, at a lower price level. So that’s a good transition. The next transition needs to be the mix. And as I said, in two years, a government regulation will manifest that.

Between now and then, it’s our job to try to just simply educate, train, and incentivize the contractor and (inaudible) upgrade.

Adam Samuelson

Okay. I want to open up to the audience if there’s any question, wait for the mike. Your microphone? Sorry.

Unidentified Analyst

You mentioned that 25% of your business is in Florida, what is the home, new permit statistics for that state specifically rather than from a national basis? I mean, is that a little bit different in as far as the overall completion rate of new homes in that state compared to the national average that you mentioned earlier?

Barry Logan

Well, permits and starts have been around 30% trends in the last few months in terms of year-over-year change.

Unidentified Analyst

Specifically in Florida?

Barry Logan

Yes, that’s right. But completions were in the single-digit range in Florida. Now, I don’t know the difference if I carve out multi-family versus single-family. I think multi-family is recovering at a better rate than single-family. But nonetheless, it’s still a big improvement from the run rates of last year.

Unidentified Analyst

And then also, I believe you have a new product, the HVAC, the 410A, how is that new product?

Barry Logan

Well, 410A was introduced in 2009 in mass [ph]. It’s been around for several years as the environmentally friendly product.

Unidentified Analyst

Right.

Barry Logan

2009, the government mandated of every new system needs to have that refrigerant in it. Industry kind of fully transitioned this year and they’re in a -- where 90% plus of new systems have 410A. But I wouldn’t call it a new product. I would say it’s finally here. The good thing we like and that’s the reality of it is your old system will not work with components of the new system. So if you truly have a kind of a fatal flaw in your existing system, you need to upgrade the whole thing. And as replacement parts start to become more scarce, as R-22 refrigerant more scarce, repairing your system will become harder to do. And then the idea of selling full systems to upgrade your house become more of a trend. It’s starting to happen.

This season in particular, we saw our indoor and outdoor systems start to run in tandem in terms of growth rate. And as we get closer to 2015, two things are happening. The energy standard is coming that will upgrade the price mix on energy. And then they’re also phasing out the old refrigerant down another notch to a point where it’s going to be very expensive but where the expense is looking more expensive, and the contractor really won’t see a reason to recommend fixing an old system.

Unidentified Analyst

What is the normal time frame, the HAVC was in 2009, obviously, the market downturn probably changed the replacement cycle of that installed base, what is the normal, the 2015, the new standard to take place? How many years do you get into the replacement cycle penetration on a year-to-year basis after it’s launched?

Barry Logan

We don’t know that data on how many units are repaired each year. We would love to know that data. I think they’re still replacing systems more often. It’s a 15-year life, useful life of these machines [ph] which is about right, that would mean about 6% of them should be replaced every year. And it should be about 6 million systems. Our industry this year will sell about 4.5 million replacement systems. So that’s some of the potential that’s there as we get either toward the new energy standard or toward the new environmental standard, that gap closes with replacement systems.

There’s nothing else that influences really the useful life, nothing else that has influenced the useful life. A compressor is the same compressor for the last 20 years, the motors, the controls, not a lot of technology in these systems that changes its useful life; really, what does the consumer do when they break, and the options will be less in terms of repairing those systems as we get closer to 2015.

Unidentified Analyst

You just said that the useful life really doesn’t change but as 2015 approaches and you have the higher priced units, more efficient units, I’m assuming there’s more technology in those, so the probability of them breaking down, you’re saying is no less or no greater than units today? Just trying to understand that dynamic.

Barry Logan

Sure. Again, I’ll let the OEMs defend whether they think there’s more technology in them. As the guy that sells the stuff, the 14 SEER system is simply larger, more surface area as far as heat displacement, kind of like the radiator in your car; if it were larger, it would displace heat better than a smaller one does. There is technology in this industry though that’s at the higher end, that’s even kind of the 3rd- tier [ph] or product with variable speed technology, better thermostats, better controls, better environmental treatment in your or the area that you are breathing in terms of filtration and other things.

So there is a -- 20% of our market is at that level of humidity control as well as temperature, air quality as well as air temperature. That’s the luxury side of our industry that is there that also can benefit from a consumer being stronger. But at the base level the 14 SEER system is more expensive than a 13 SEER system because it has more copper, aluminum, and steel in it and it would last longer.

Unidentified Analyst

I think you mentioned about financing with contractors, I guess, if you can explain a little bit more about that. And then also, I’m assuming a lot of contractors maybe went out of business in the Florida region, South East region over the last few years potentially, if not, please tell me has the distribution from that end changed at all? Is that how you’re running your business?

Barry Logan

Okay. Well, let’s go to the [ph] financing in your question. First is the consumer that needs $3,000 or $4,000 to buy one of these things. And typically, it’s been done through credit cards or cash savings, the home equity lines have kind of diminished. So if you want to buy a house full of furniture, you can go to the furniture retailer and probably pay nothing down and no payments for two years. That doesn’t exist in our $3,000 home purchase, and that’s our fault. That’s the industry’s fault for bringing that technology, that simple technology to a home. But we’re working with one of our banks to do just that. We dabble in it now. We’re trying to do a more broad-based and important effort with it next year and beyond. And that’s essentially bringing the same home financed backbone that Home Depot or other retailers use to close a large ticket sale.

But the primary financing that we do is 50,000 contractors owe us $400 million which is $8,000 a piece. We are the bank [ph] for that guy in the pickup truck that runs into your house and sells you one of these things. It’s the healthiest portfolio out of credit risk we have seen in our history today; because it’s 90% replacement contractors that shop at our place five and 10 times a day. They need us every day. They need our products, our expertise, and our right officer [ph] at the 10, 15 basis point range in terms of credit risks. It’s below Visa [ph].

So the cleansing that you’re suggesting of contractors came about four or five years ago, a new construction went through its cycle, and the contractors that were attached to those builders that were attached to those projects are gone. And so it’s actually a very healthy portfolio today. And when new construction reoccurs, we have a much different credit profile to perpetrate because we can now legally tie up houses, tie up closing statements, tie up through liens and so on for that credit protection for someone like us existed that wasn’t very used in the heyday. Well, that’s changed. So creditors [ph] is our cleanest asset and it’s really because the dependence the contractors have on us every day to finance their business and keep them going today.

Unidentified Analyst

Maybe switching gears a little bit then, Barry, talk about on the cost side, with the Carrier enterprise investments you’ve made, SG&A being the big focus of the company, it’s actually been down this year, is on an organic basis despite up slope, up organic sales, maybe talk about some of the expense leverage that you’re seeing, some of the drivers and how sustainable it is?

Barry Logan

Sure. Well, at its core we have, again, almost 600 stores selling things. It’s about 15 million square feet with 4,000 people in it; and serving our local contractor. And so our calibration of cost is really based on our business volume and revenues. The fact is our revenues today are 20% less than where they were five years ago organically. So we’ve been working really for the last four, five years getting leases renewed, space renegotiated, space reductions to deal with it, for a lack of a better term.

And so facilities and fixed cost and delivery and trucks and autos and a store-based has been reducing -- we’ve been reducing cost, and at the same time increasing productivity of inventory and (inaudible) and customer service, which we learned a lot when we bought Carrier. United Technologies did a very good job of playing those disciplines into the business. They spend too much money on certain things but from a productivity point of view were ahead of us. So SG&A as a percent of sales last quarter was the lowest we’ve ever had.

If I look at individual business units, we can do better by a couple of hundred basis points. And so we’re not mature yet in terms of that cost structure coming down in cost and size. So it should be a couple more years of that.

Unidentified Analyst

Maybe in that discussion, talk about the role of technology in your business, I mean, there’s been some big advances and then some industrial distributors, Grainger for example who use e-commerce and SAP planning to really optimize their business. Just talk about where you are in some those areas and how much SG&A leverage you can get out of that.

Barry Logan

Sure. Well, it’s a good question. And we’re in the midst of a lot of investments that we’ve quiet about and intentionally because we want them to have a very dramatic impact when we decide to talk about them completely. What I’ll talk about now because it’s somewhat implemented in public so to speak but [ph] I’m not telling you about putting an SAP; that’s not what we’re talking. This is the fact that we have 50,000 contractors that go to a backyard of the house or a kitchen table and needs to solve issues. They couldn’t carry a desktop to the job site so e-commerce, probably, 10 years ago was not available to us in that they don’t carry laptops in their truck to accomplish the same thing but they all carry mobile devices; they all carry a smart phone. They’ll sit in line at our counter and sit there and look for stuff while they wait in line to order stuff from is the way they have for 20 years.

So, for example, we launch an app that lets all of our products that we sell known to the contractor online, do you have it, which store. We sell technology with our OEMs. We roll, we show what component parts are in the systems. So if you want to buy a part, buy a compressor, you can find the part of the compressor with only knowing the model number. You don’t have to know the part number. You don’t have to know the part. All you have to know is the model number of the system you’re working on. And so the app technology has really let us bring our inventory database to a smart phone, in the backyard, at the kitchen table and no one else has it.

We weren’t sure who would sign up. We weren’t even sure how many would sign up. Well, 12,000 people signed up; 12,000 contractors have signed on in about 120 days. And we know that the productivity, the information, the capability is different having that technology. I don’t think anyone else has it. That will evolve into further applications and e-commerce as we get down the line, and by this time next year I think we’ll have a more, again, a mature story of what it is and what impact it has. But right now, no one else is really doing it.

We also are investing a little bit in the fact that we have a lot of data that we -- is what we use the same way for 30 years with our site that we have. We sell 20,000 SKUs, 600 branches, 15 different brands. From a credit perspective, we have a lot of insight into our customer. We’ve never really used that data other than keeping track. So business intelligence has become an interesting thing for us to invest in and we are -- and in terms of applications and impact, we’ll talk more about it after it gets implemented, and in fact, we narrow what the results are but we’re making some investments in the same way that I think some industrial distributors are doing so. And what we like, at least our imagination likes, is our next peer is about a third our size. And so we don’t think we’re catching up with anyone. We’re trying to kind of set the standard for what can be done.

Unidentified Analyst

And how, given that you do operate showing a decentralized business model, different operating businesses, different brands, and other competing in the same regions with one another, how is that technology being kind of where -- is it the business unit level or is it the corporate level and being given to all the different business?

Barry Logan

As far as, my extreme, crazy example is if your target, you’d like to know everything you know about the Target customer, the Target stores that you operate, if you could be the parent company of Target and Wal-Mart, you would want each of your business units to have the greatest of technology but then how do you get more insight in the fact that you’re the parent company of Target and Wal-Mart, so we’re doing both.

The technology would exist at the business unit level, so they’re smarter and more insightful. And the Watsco level given our scale and insight is how do we use data at that level as well. So if we’re dealing with Honeywell across our business unit; selling Honeywell products across our markets, we want the data at both levels -- both the business unit level and at the Watsco level to improve the margin, improve the price, improve the performance, improve the market share or whatever it might be. So, again, abstract [ph] today [ph], a lot of investments and strategy going in to that conversation.

Unidentified Analyst

Okay. Maybe switching gears to capital allocation, recently special dividend and maybe a change in your dividend policy relative to the passing, maybe walk through that and the approach to capital allocation going forward even given some uncertainty in the tax code.

Barry Logan

Sure. Well, there have been, really, the dividend policy has been simple to articulate paid dividends; so that doesn’t change. The second part of the dividend policy, really began about 15 years ago was to pay an increase in dividends. And we did so over the last 12, 13, 14 years. With the tax change, we decided to be aggressive with the special dividend; we paid basically two years worth of dividend to October 31st, $5 a share. And then decide what it is we want to do next with that money in everyone’s pocket. So we haven’t decided. We’re going to decide sometime when it’s clarity [ph] in the tax rates. We reserve the right to change our minds again, because I think that whole discussion of tax rates is going to be fluid or be fluid with it. And, again, we’ve been carefully to say that if things stay the same, we’ll pay a lower dividend. And then, again, decide and change our mind if things those evolve. But in the meantime people that own the shares have $5 in their pocket and it’s a very tax efficient payment so to speak.

But we have a great balance sheet, a lot of capital to deploy, a lot of cash flow that’s generated, so dividend ultimately will be the method of shareholder retrieving that cash. Share repurchase, we’re not big fans of. We’ve got in the past where there’s a big (inaudible) in the shares; but dividends ultimately is the most proportionate long-term way and it would stay that way. At what level of recalibration, we’ll see.

Adam Samuelson

Okay. Unless there’s any other questions in the audience.

Unidentified Analyst

I just wanted to make sure I understood you earlier. You said your SG&A this quarter was the lowest that’s been percentage of revenue wise or absolutely dollar wise; I just don’t have a model in front of me.

Barry Logan

Well, in the third quarter, the SG&A as a percentage of sales was the lowest that’s ever been.

Unidentified Analyst

Right. And then did you say after that that you think over time you potentially could take out between 100 and 200 basis point on that over time given the efficiencies you hope to gain?

Barry Logan

Yes, what I said is that we have certain business units. If we look at our best performing business units, they’re operating at another 200 basis points lower than where our composite is today. So that just gives us the knowledge that we can do better and that would be the type of performance we would have to give of our leadership.

Unidentified Analyst

Okay.

Adam Samuelson

Okay, great. And maybe, with that, we’ll stop there.

Barry Logan

Okay. Thank you.

Adam Samuelson

Thank you. Thank you very much.

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