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Watsco, Inc. (NYSE:WSO)

Q1 2014 Earnings Conference Call

April 17, 2014 10:00 ET

Executives

Albert Nahmad - President and Chief Executive Officer

Barry Logan - Senior Vice President and Secretary

Paul Johnston - Vice President

Analysts

Josh Pokrzywinski - MKM Partners

Ryan Merkel - William Blair & Company

Matt Duncan - Stephens Inc

Keith Hughes - SunTrust

Winnie Clark - UBS

David Manthey - Robert W. Baird

Walter Liptak - Global Hunter Securities

Samuel Eisner - Goldman Sachs

Operator

Good morning, and welcome to the Watsco First Quarter Earnings Conference Call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Mr. Albert Nahmad. Please go ahead.

Albert Nahmad - President and Chief Executive Officer

Good morning, everyone and welcome to our first quarter conference call, where today will be all good news. This is Albert Nahmad, President and CEO. With me is Barry Logan and Paul Johnston.

As we always do, here is the 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.

Watsco continued to perform very well during the first quarter. The momentum from 2013 is continuing. Sales, operating income, net income, earnings per share and cash flow reach all-time highs. We enjoyed another quarter of growing replacement demand and a continued movement towards higher efficiency systems. The combination of sales growth, higher selling margins and improved operating efficiencies produced a 23% increase in earnings per share. Also, we have confidence in 2014 will be a very strong year of both earnings growth and cash flow. And we are pleased to announce our dividends will increase by 50% to an annual rate of $2.40 effective with our payment in July.

Now, for the details. Revenues grew 7% to a record $763 million. Domestic sales of residential HVAC equipment increased 13%. Non-equipment products increased 6% and commercial refrigeration products increased 2%. Gross profits rose 7% and gross margins improved 10 basis points. SG&A as a percentage of sales improved 30 basis points. Operating profit increased 16% and operating margins expanded 40 basis points. $25 million of operating cash flow was generated in the quarter compared to a cash use of $17 million last year, a $42 million positive swing. Our net to EBITDA ratio remains under one times and our debt to total cap ratio is 17%. We will provide an outlook for 2014 during the second quarter conference call when we have a look at trends in the selling season.

Now, with that said, Barry, Paul and I will be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Josh Pokrzywinski of MKM Partners. Please go ahead.

Josh Pokrzywinski - MKM Partners

Hi, good morning guys.

Albert Nahmad

Good morning, Josh.

Josh Pokrzywinski - MKM Partners

Al, could you just talk a little bit about the progression through the quarter? Any interruptions related to weather and then exit rates as we get closer to the selling season here for first question?

Albert Nahmad

Good question, Josh. Yes, the weather impacted regions of our country, particularly the Northeast, we think that’s temporary, but it did impact us. And I am glad to say I think we’ll recover from that as the year progresses.

Josh Pokrzywinski - MKM Partners

So, if I look at the overall U.S. equipment business, resi equipment business up 13%, should I think of that as being something on the lower end to start the quarter and then progressing higher as we get into March or is that putting too fine a point on it?

Albert Nahmad

Paul, you have a comment on that?

Paul Johnston

Yes, I think that’s too fine a point, Josh, because the volumes we are talking about in the first quarter as you know they accelerate during March. March is half of our sales. So naturally it did increase as the quarter went on.

Albert Nahmad

Don’t forget, Josh, this is a continuation of what we find last year. So it’s just continuously getting better.

Josh Pokrzywinski - MKM Partners

And then can you comment at all about how pricing has been on the resi side, are you seeing OEMs coming with price increases how is that sticking. And I guess on a related point I noticed you guys took in some more inventory was that in anticipation of more increases to come or just timing and build for seasonal demand?

Albert Nahmad

Go ahead Paul.

Paul Johnston

The price increase is pretty much across the board had been announced in the fourth quarter. Once again for the first quarter you saw some of its stick, some of it obviously you have a harder time pushing it through, you have some longer term commitments to those contractors. As far as the inventory is concerned, our inventory pretty much is in line with our sales, it’s up roughly 10% from the first quarter last year and it’s the inventory turns remained pretty much in line. So we have double digit growth in equipment you are going to have a growth in inventory also.

Josh Pokrzywinski - MKM Partners

Understood. And then just one last one for me I know it’s still a small part of your business and there is plenty of room to outgrow. Any comment on how the commercial business did and the sense of what you are seeing out there in the market maybe more broadly?

Paul Johnston

Yes, commercial wasn’t widely exciting, it was basically I mean when you look at it in total it was flat, when we look at the individual companies we had we probably had a little bit of shifting around due to some of the weather conditions that we had in the Northeast and the Mid-Atlantic on some jobs that maybe we had a little bit of a delayed delivery there, that’s all.

Albert Nahmad

I would agree with I think the commercial was half – more impacted in the first quarter certainly in the residential.

Josh Pokrzywinski - MKM Partners

Impacted by the weather, you said?

Albert Nahmad

Yes, because of the markets we are in the Northeast.

Josh Pokrzywinski - MKM Partners

Got it. And there are signs now much like residential but that is they are starting to improve as the weather turns?

Albert Nahmad

Yes.

Josh Pokrzywinski - MKM Partners

Excellent. Alright, thanks guys.

Operator

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

Albert Nahmad

Good morning Ryan.

Ryan Merkel - William Blair & Company

Thanks. Good morning everyone, nice quarter.

Albert Nahmad

Thanks.

Ryan Merkel - William Blair & Company

So want to start off with a couple of questions on sales, could you just give us the growth rate for the international markets in the quarter obviously the U.S. was pretty darn good?

Albert Nahmad

Pretty flat.

Ryan Merkel - William Blair & Company

Pretty flat, okay. And do you have the Canada number handy, I am just curious?

Albert Nahmad

We wouldn’t break that out.

Ryan Merkel - William Blair & Company

You wouldn’t break it out, okay. Alright and then do you have the volume and price mix breakdown for that strong growth on the equipment side?

Albert Nahmad

Go ahead, I didn’t know whether we should talk about those things, but go ahead, you start.

Paul Johnston

I don’t want to give any detail on that but we are – as we indicated in the release we are seeing a stronger presence with above 13-SEER equipment sales, a higher efficiency product. And as a matter of fact with some of business units we would have go back to 2010 to see those sort of levels of higher efficiency products when we have the tax incentive.

Albert Nahmad

Yes, that market is showing some good things.

Paul Johnston

Yes, I mean just to answer it a little more directly we did see double digit unit increases in the quarter again which as I have said is really a continuation of what we have been saying for last few quarters now.

Ryan Merkel - William Blair & Company

Alright, okay, great. And then last one for me, gross margins I am pretty impressed you are able to continue to inch that up especially given that equipment which is lower margin is growing faster, so what is it you are doing on the selling margins side to have those gross margins or…?

Albert Nahmad

I think it’s moving towards higher efficiency, most of it, yes.

Ryan Merkel - William Blair & Company

It’s that and did the price increases in the OEs helped you on the gross margin as well?

Albert Nahmad

Always helps.

Ryan Merkel - William Blair & Company

It always helped. Great. Well, thanks guys. I will jump back in queue.

Operator

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

Albert Nahmad

Good morning Matt.

Matt Duncan - Stephens Inc

Good morning Al. Good quarter.

Albert Nahmad

Thanks.

Matt Duncan - Stephens Inc

First thing I am curious about is on the equipment side is that still at this point mostly being replacement driven or do you feel like…?

Albert Nahmad

Yes, by far I mean we are replacement house. On an annual basis the new construction would be at most 10% to 15% so what you are seeing is the unraveling of the demand for replacement.

Matt Duncan - Stephens Inc

Okay so it’s just this pent up demand that we have all been expecting for some time it’s just coming through, yes?

Albert Nahmad

The good news of that is new construction is cyclical, it goes up and it goes down. We don’t like that. I mean we will participate in it that we really focus on the replacement business, that’s our core business.

Matt Duncan - Stephens Inc

Sure. Looking maybe this is for Paul at the recent I guess settlement with the DOE on the regional energy efficiency standards. It looks like instead of January 1, 2015 there is now going to be a little bit of a grace period for the install of 13-SEER units in the Sun Belt. Is that going to cause any noise in the market or is the market pretty much already shifted over the 14-SEER at this point anyway?

Albert Nahmad

It’s hard for me to talk for the market, I can talk for Watsco. But our people have been moving without the regional standard, so a lot of the movement has been going to the higher efficiency product just for energy rebates that you get or utility rebates that you get or from energy star credits that the builders get in the Southeast. So we’ve been seeing a movement to that. The real change is you’ve got 18 months now and an extra 18 months to adjust your inventories to make sure you don’t have any standard inventory which.

Paul Johnston

(indiscernible), it doesn’t matter because we can move our goods throughout the nation.

Matt Duncan - Stephens Inc

Yes, I guess that is the thought is you guys have the ability to move product around, but it maybe helped some of the regional guys a little bit?

Albert Nahmad

Yes.

Matt Duncan - Stephens Inc

And then last thing I know we’re early in the selling season if we even want to say we’re there yet since it’s still been pretty cool in a lot of the South. But as you look at equipment growth so far is it – your inventory was up, Paul I think you said 10% in the first quarter. You’re seeing a good sell-through so far in the selling season?

Paul Johnston

I’ll respond to that, April showing mid single digit growth rates in revenues and double-digit unit growth rates.

Matt Duncan - Stephens Inc

Okay. Thank you all.

Albert Nahmad

That was early in the April if through the first half of it.

Matt Duncan - Stephens Inc

Sure. It’s a continuation of what we saw in the first quarter.

Operator

The next question comes from Keith Hughes of SunTrust. Please go ahead.

Albert Nahmad

Good morning, Keith.

Keith Hughes - SunTrust

Hi, Albert. Our question is on the other age fact accessory sales, it seems a little growth last couple of quarters and we’ve seen in sometime there. You talked about what’s going on, how much that market and how much potentially cured?

Albert Nahmad

I’ll give you a general comment. You’ll see that growth whenever we start participating in new construction that’s because of the offering that we have that serves in the infrastructure in the non-equipment. Paul, do you want to embellish there?

Paul Johnston

Yes, the non-equipment part sales obviously are tied to – the non-equipment, non-part sales are the supply side of our business and that’s growing because of new construction. The other equipment that we saw increasing the parts that we saw increasing they’re pretty much related to some repair activity where particularly in the Mid-Atlantic all the way through the Northeast.

Keith Hughes - SunTrust

And finally on refrigeration any comments there lower growth small segment for you this, comments thereof what you see in the market in terms of trends for the year?

Albert Nahmad

Well there are some commodity pricing shifts that occurred with refrigerant. I wouldn’t say that a normalized performance for us particularly you have to wait until refrigeration, refrigerant pricings which is begun to stabilize I think then we’ll get a real feel for what growth rates all for in the future.

Keith Hughes - SunTrust

Okay. Thank you.

Operator

The next question comes from Winnie Clark of UBS. Please go ahead.

Albert Nahmad

Good morning, Winnie.

Winnie Clark - UBS

Good morning. Could you talk about you highlighted balancing the return of cash to shareholders with free investment in the business. Could you talk about the current M&A pipeline I know that you have the option to purchase the additional 10% in carrier in July and you've indicated you are likely to do that. But anything you’re seeing with independent distributors as well?

Albert Nahmad

We get that question every quarter and the answer as always we do have a pipeline, we are in conversations constantly and so that’s the best I can do regarding that. And on the question of the auction I want to once again state that we will exercise that option in July, the additional 10% of the joint – the original joint venture.

Winnie Clark - UBS

In terms of the dividend increase so and coming a bit earlier than we actually thought, we shouldn’t read that as there’s you’re not seeing as much in the pipeline so you're moving more in the direction?

Albert Nahmad

Not at all, I wouldn’t read that into at all.

Winnie Clark - UBS

Okay, great.

Albert Nahmad

I am never been more optimistic about that’s out of the business because we’ve reached a certain size where we have to do transactions that mean something to us and I’m optimistic we’re going to get those done.

Winnie Clark - UBS

Okay, great. And then you talked about the ductless opportunity, any update there in terms of the trends that you’ve been seeing?

Albert Nahmad

More of the same. It’s a high growth area but still followed in the overall scheme of things and we intend to be a major player.

Winnie Clark - UBS

Have you ever provided – do you provide the breakdown you’re taking about the higher efficiency and higher sales in the greater than 13-SEER product lines. Can you tell us how that’s increased in terms of a percentage of the overall mix?

Albert Nahmad

I am not sure I understand the question.

Winnie Clark - UBS

Just what is the percentage of your mix that’s in the higher SEER…

Albert Nahmad

No, well that’s not something we would provide to the competition.

Winnie Clark - UBS

Okay, perfect. Thank you very much.

Albert Nahmad

Sure.

Operator

(Operator Instructions) The next question comes from David Manthey, Robert W. Baird. Please go ahead.

Albert Nahmad

Good morning, David.

David Manthey - Robert W. Baird

Hi, Al. Good morning. First off, I think April is when your mobile app was going to go live and that the customers of Baker were going to be able to purchase from that app. Is there anything you can share with us on early returns on that effort?

Albert Nahmad

See, I think not. And I am not sure that we gave that information correct, I don’t know that we went live on ecommerce on Baker, I think we went – we are still in development across the board on all of our subsidiaries in terms of ecommerce or the latest version I should say, but there is nothing significant to report in ecommerce at all, David.

David Manthey - Robert W. Baird

Okay.

Albert Nahmad

Then we are investing heavily to be the best and the strongest in the industry in ecommerce and any other related technology.

David Manthey - Robert W. Baird

Okay. And then on related technologies, what about the business intelligence software, any update on….

Albert Nahmad

Yes, it’s a good question and we feel very strongly about it. And we are investing in it. And it’s going to take years to get the kind of benefits we want, but we are getting incremental benefits as we develop it. And we want to lead the industry in it. I think we are committed to that.

David Manthey - Robert W. Baird

Okay. And then in terms of this – the price mix question that has been asked a number of ways and times here. Looking past equipment, which it sounds like you did get some benefit, what about parking supplies and commercial refrigeration, is there any pricing component of those two segments of the business?

Albert Nahmad

Paul, you want to deal with that?

Paul Johnston

Yes, there is some pricing considering they are obviously the margins are higher when you sell replacement parks, but the opposite would hold true if you are selling more supplies, generally don’t have a very, very, very high margin through them. So they kind of balance each other out.

David Manthey - Robert W. Baird

Okay. And then last question if I can here. Could you share with us what percentage of carrier enterprise today is parts and supplies, I think when you bought it was less than 10% or when you went into….

Albert Nahmad

That’s not something we are going to report on either.

David Manthey - Robert W. Baird

No. Are you still making progress though and there is still opportunity there?

Albert Nahmad

Yes, I can answer that as primitively, yes.

David Manthey - Robert W. Baird

Alright. And then would you share with us what percentage of your sales today is R-22 gas?

Albert Nahmad

Well, we are going to do well over $4 billion this year. I don’t think it’s a material number.

David Manthey - Robert W. Baird

So low single-digit percentage?

Albert Nahmad

Paul?

Paul Johnston

Yes, it’s low single-digits.

Albert Nahmad

Yes, very low.

David Manthey - Robert W. Baird

Fair enough, fair enough.

Albert Nahmad

I mean, I understand the question because it ties into the earlier question, refrigeration. It did affect the refrigeration profitability and the revenue stream, but we see that as a temporary thing, because prices have stabilized.

David Manthey - Robert W. Baird

Alright, guys. Thanks very much.

Operator

The next question comes from Walter Liptak of Global Hunter Securities. Please go ahead.

Albert Nahmad

Good morning, Walter.

Walter Liptak - Global Hunter Securities

Hi, thanks. Good morning and great quarter especially on the leverage.

Albert Nahmad

Thanks.

Walter Liptak - Global Hunter Securities

And I apologize if I read this wrong, but my understanding was that there would be a little bit more guidance for the full year. And I understand that you have some data points here….

Albert Nahmad

That’s a good issue. We struggle with that, but I don’t want to let this great optimism that I seem to be enjoying right now get me carried away into too early an outlook putting together an outlook for the year. So it was a struggle in my mind, in our minds that we decided not to provide it now. So we will do it when we see something more concrete in the second quarter.

Walter Liptak - Global Hunter Securities

In your comments today, you did give us some clues about what you are thinking….

Albert Nahmad

Yes, the first few weeks of April.

Walter Liptak - Global Hunter Securities

Over $4 billion – well over $4 billion in sales, is that what we should be thinking about?

Albert Nahmad

I think well I can say that. I mean, we feel confident about that belief. I didn’t realize that was in the disclosure, but okay.

Walter Liptak - Global Hunter Securities

And then double-digit EBIT growth…

Albert Nahmad

I mean, that’s how we are experiencing now.

Walter Liptak - Global Hunter Securities

Okay. Should we think that, that’s something that could continue throughout the year?

Albert Nahmad

I’d like to hope so.

Walter Liptak - Global Hunter Securities

Can you give us double-digit can be a pretty big range, are you thinking 12%, 15%?

Albert Nahmad

I think we were fine to comment, I couldn’t do better when I have already done. We just feel good about it. I mean, this is not news here. It’s really continuation of what we saw last year.

Walter Liptak - Global Hunter Securities

Okay, good.

Albert Nahmad

And we feel that we have got the network to take advantage of the new market developments. And then we also feel although we don’t have data enough to substantiate what I am about to say that we are gaining share.

Walter Liptak - Global Hunter Securities

Okay. Okay, good. Well, we think so too. So thank you and we will talk to you by then.

Albert Nahmad

Thanks for your interest.

Operator

The next question comes from Samuel Eisner of Goldman Sachs. Please go ahead.

Samuel Eisner - Goldman Sachs

Thanks. Good morning everyone.

Albert Nahmad

Good morning. I haven’t seen you at a restaurant in New York in a long time.

Samuel Eisner - Goldman Sachs

Sounds good. So, in terms of just a couple of clean up questions here, just on the working capital this quarter, it seems as though you are just not investing as much, it was only about a usage of about $10 million or so. So just curious what the delta is year-on-year? Why was it so much of a build last year and why is I guess there is so I guess little this year?

Albert Nahmad

Barry, you’re going to answer that?

Barry Logan

Yes, again we pick our timing and we make our pre-season program as we see it and this year is a little more. Lots of the build coming into this year and part of that stem is the pricing, last year’s price increases a little stronger than this year. So again it’s just being a merchant and being effective when we make the decisions.

Samuel Eisner - Goldman Sachs

Understood. I appreciate that. And then just secondly I guess on the guidance question that was just asked, just to follow up on that. I mean in your mind, Al, you said that you struggled with giving guidance; you didn’t want to get too carried away. What about your business as it stands today, is it different than this point last year that doesn't allow you to give guidance?

Albert Nahmad

Well, we have done guidance before most of the timing, the second quarter sometimes we do it in the first quarter. I guess don’t want to carried away with my optimism. It’s all good, it’s something in what I am saying.

Samuel Eisner - Goldman Sachs

Alright. Thanks so much.

Operator

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

Albert Nahmad - President and Chief Executive Officer

Well once again I just want to thank everyone for their interest in our company and I look forward to another positive hopefully positive next quarterly review. Thanks again.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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