Good day, and welcome to the Watsco First Quarter 2020 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.

Good morning, everyone. Welcome to the first quarter earnings call. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Executive Vice President. Now before we start, our cautionary statement. This conference call has forward-looking statements as defined by the 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. Once again, good morning. I hope you and your families are healthy and getting through this period safely. Today's press release speaks to Watsco's strength and innovative spirit. These are attributes that we believe will bring comfort and confidence to our employees, our customers, OEM partners, and our shareholders. As we highlight in our press release, Watsco's financial strength is our most important attribute. Our philosophy of maintaining a strong balance sheet, low debt levels, and ongoing access to capital is a significant advantage for us as we work through the impact of the pandemic. We are well positioned to support our customers, employees, and OEM partners while actively looking to invest in expanded product offerings, new locations, and acquisitions to benefit our long term. Our ability to generate consistent cash flow also represents an important strength. Next week's scheduled dividends, which reflect an 11% increase, signal our confidence in our business. We also operate in a great industry as HVAC products are fundamental necessities in homes and businesses. Local authorities in our markets have deemed our industry as essential. Our branches are open, providing needed products and services to our contractor customers. Watsco's technology team has also accomplished a lot in recent weeks, and adoption of our tech platforms is rapidly expanding. In terms of day-to-day activities, our leaders took immediate actions in response to the pandemic. In many cases, in less than 48 hours. For example, branch locations were quickly transformed from retail walk-in showrooms to no-touch e-commerce curbside pickup centers. These changes have been well received, and our customers are asking us to sustain these services going forward. As to growth in investment, we remain in touch with great companies, knowing it's an opportune time for them to join the Watsco family. Our resources can help them grow and develop scale, and we can provide access to our great technology platforms. In terms of results for the first quarter, sales growth was driven by strength in U.S. markets for residential HVAC equipment, which grew 5%. Sales and earnings in international markets declined due to softer market conditions and strong comparable results. Results also reflect 35 new locations, mostly from acquisitions completed in 2019, including Peirce-Phelps, DASCO Supply, and N&S Supply. These companies come with great leaders who are now part of our culture and team and are responding to current events in their respective markets. Further analysis of our financial results are provided in our press release. I will not recite these details in my prepared remarks, but we will be happy to provide more color during the Q&A. With that, A.J., Barry, Paul, and I are happy to answer your questions.

The first question today comes from Josh Pokrzywinski of Morgan Stanley.

So appreciate that visibility is kind of tempered right now. But a couple of questions that I just want to make sure that, to the extent that you don't really have a ton of visibility, maybe you can still answer. I guess, first, have you seen any change in consumer behavior vis-a-vis trading down in efficiency or more repair versus replace? Anything that would give you an indication of, hey, people are still spending money, but under the surface, there's a couple of changes afoot. Has that shown up? Have you gotten that anecdotal feedback yet?

Well, our data expert, Paul Johnston.

In the first quarter, we really didn't see it. We had a pretty good balance between system sales as opposed to just an outdoor replacement. Perhaps anecdotally, we'll see a little bit more of a repair or just replace the outdoor unit in the second quarter perhaps. Really, we're not at the consumer level. But what we hear from our contractors is regular checkups and service calls that don't require repair are pretty much being pushed out right now. Consumers aren't looking for someone to be in their home.

Got it. Which would be more of a social distancing comment? Not a like, 'Hey, I ran out of money' comment?

Correct.

But we also have a very effective consumer finance program that would help at such a thing, if it should come to that.

Yes.

Got it. And then I guess, I'll leave some of the other kind of near-term or macro questions to some of the other folks. But maybe to turn away from COVID for a second. Obviously, one of your major equipment partners is now kind of liberated from their multi-industry owner. What have been kind of the early changes, observations, engagement actions that you guys have seen with Carrier now?

Well, first, it was good news that they separated. They can be focused on our industry, and they are. They're very well led. They're very responsive. I think it's all great news going forward. I couldn't be happier.

Anything, I guess, more specific on where they're saying, 'Hey, we did this before, but now we've rethought that initiative.' Anything, I guess, more tangible on an action?

The focus is clear; they don't need to be concerned about dividends going to United Technologies, allowing them to concentrate more on their own company and industry. This investment in their own sector is promising news. There is nothing negative about these developments, and we are very pleased with the leadership.

The next question today comes from Brett Linzey of Vertical Research Partners.

Hope you're well. Just a question on pricing. I guess, from your vantage point, are you seeing any signs of deflationary pressures across some of your markets as we've shifted in April here, be it on the equipment side or other products, which I think you typically do see at first in?

Paul?

No, we're not seeing any deflation. In fact, we've had some of our commodity pricing actually starting to move back up again. So no, no deflation.

Okay. And I guess I'll ask the April question. Maybe just an update on the trend so far. You did mention in the release it decelerated. But just any sense on the magnitude? And then if you could maybe just drill down into the regional or state-by-state view. Any particular regions that stand out strong or weak?

In April, we don't want to jump to conclusions because what's most important is that the first quarter has ended. The fourth and first quarters often don't provide much insight. However, April marks the beginning of the second quarter, coinciding with the time when many were asked to stay home. At the start of April, we noticed some softness as people were hesitant to allow strangers or unknown contractors into their homes. Nevertheless, since early April, we believe things have stabilized after that brief dip in the first couple of weeks. Now we feel confident that stability has returned.

The next question today comes from Stephen Volkmann of Jefferies.

A couple of sort of recession questions for you since we seem to be heading into one. I think you alluded earlier, maybe it was Paul, to the fact that you might see some mix shift toward parts and away from units. Is that something you've seen historically? And should we expect a little bit of margin improvement because of that?

Well, I can say this unequivocally that last time there was a downturn, the product mix went a little bit more towards parts than equipment because consumers wanted to repair more than they want to spend money for new equipment. What were the results to our company when that occurred? Well, first of all, our working capital came down. And second of all, our cash flow jumped, enormous cash flow gains. So everything has a benefit. If there is a slowdown or more of a conversion for new equipment to repairs and parts and that sort of thing, sure, it may slow sales. But from a perspective of cash flow, it will be very strong. Do we see any evidence of that now? I don't think so. It's too early. It's just beginning to get into an air conditioning season.

Okay. Great. You sort of predicted my follow-on, Al. Are you guys planning to reduce your inventories already? Or is it too early to make that decision?

Well, we're entering the season now. I wouldn't say we're planning to reduce, but we're certainly considering how we're managing future orders. We have excellent software that supports us with that. However, we operate as a decentralized organization. The leaders in our regions influence these decisions. If they feel the need to increase inventory using our tools, they can do that. Conversely, if they prefer to be more conservative, they will choose that route. We avoid determining inventory levels at the corporate level because we believe it's more effective to make those decisions in the local markets.

Okay. Fair.

Al, it's Barry. I want to add to your earlier question about the product mix. First, replacement parts make up less than 10% of our business, which helps put that question into context. In our press release, we emphasized the diversity of our products. Similar to other consumer products, we observe a mix within the brands we offer, the price points we provide, and across the full range of equipment we sell. Contractors who are using our selling platform, even those not yet at the kitchen table, are presenting a variety of price options. This diversity is a significant advantage for our business. In comparison, some of our competitors tend to focus on fewer brands rather than a broader selection, which is relevant to our discussion of diversity in the press release.

The next question comes from Ryan Merkel of William Blair & Company.

All right. So first off, just wanted to clarify the comment on April. So it sounded like you saw trends decelerate right at the beginning of April.

Decelerate.

Yes, decelerate. I think, Al, you said kind of stabilized here. Is that just in the last couple of days? Last week? And I know you never want to over-extrapolate a couple of days of sales, but what makes you confident that maybe we could be stabilizing?

Daily sales numbers. And I would say, over the last few days.

Okay, okay. I guess we'll see. And then the 5% resi equipment growth, that's what I would have expected, but then it was 2% to the total company. So it implies some big declines in some of the other areas. Can you just expand on that?

I'll let Barry add to this. However, we mentioned earlier that Canada, Mexico, and exports in Latin America have been much weaker compared to last year. The international business has been soft. Additionally, it's clear that the northeast United States is experiencing various issues, which is causing a temporary decline. Nevertheless, the rest of our network has remained stable during this period.

I wouldn't add much to that. In the international markets, revenues and profits were down. There was dilution in the quarter for the international business. Last year was particularly strong in those markets, so part of this is a comparison issue. These factors stand out more in the first quarter, which is the smallest part of our year, in terms of their impact on earnings per share. However, as Al mentioned, in areas where conditions are favorable, we are seeing stability in the business.

The next question comes from David Manthey of Baird.

So first question, what part of your business goes away under social distancing? I'm thinking if my AC stopped working down here in mid-80s Florida today, and I knew for a fact that my contractor had COVID, I'd probably still take my chances. I'm just trying to understand.

I hope you don't.

Conceptually. I mean, how do you miss sales if air conditioners are doing what they're doing? I mean, where is the gap in someone saying, 'I'm just going to wait' or 'I'm not going to have that service.'

That's a legitimate concern. I believe most people won't delay on repairs during extreme heat because they want to avoid discomfort. However, if the weather is mild, they might choose to postpone. The preference for not having a stranger in their home could play a role in this decision, although I don't have specific data to support it. As temperatures rise, the options for consumers may decrease. They will need to ensure their systems are operational, whether through upgrades or repairing existing issues.

Right. Okay. That makes sense.

It's a pretty necessary industry, as you know. In fact, as you've heard me say, we're considered an essential industry. And good reasons. You've got to have the cooling, and you've got to have the heating.

I definitely consider you essential. Looking back to 2008 and 2009, the recession was clearly driven by housing, so that might not serve as a good model. However, in 2001 and 2002, the housing market barely slowed down, and your revenues were down 5% to 7% during that period. Isn’t that a reasonable expectation? As you mentioned, if an air conditioner fails, people will either repair or replace it. There is a trade-down effect where customers may choose to repair rather than replace, resulting in lower ticket sizes and possibly opting for more affordable options instead of premium ones. Can you provide some insight into that as an initial outlook, perhaps suggesting mid-single digits? Is that what we should anticipate?

In terms of revenue growth, we prefer not to make any early guesses. We want to report something with more certainty. What I can say is that we are financially strong and have a competitive edge, including in our technology. We feel positive about our position, and I hope our M&A program will enable some distributors to join us. I always see opportunities in an industry that may slow down; while I'm not predicting a slowdown, if it happens, there will be opportunities.

The next question comes from Steve Tusa of JPMorgan.

So I guess you guys aren't going to comment really on your revenues, but like Lennox was out talking about a 15% decline in the industry. I mean, any broad color on kind of what you think the industry is going to do this year, not really talking about you guys?

See, I'm not that smart. Paul, do you want to give it a shot?

Boy, if you're not that smart, I'm certainly not that smart. Steve, we represent so many different products, we represent so many different OEMs and constantly polling them for what their outlooks are and that type of thing. And frankly, there's no consensus that I've been able to locate out there to guide us in our direction. So we're with the market. We think we can outpace the market and outgrow the markets. So whatever that market is, we think we're going to outperform it. That's about as close as I can come to, I guess, on what's going to happen.

On the margin side, how are you considering gross margins moving forward, assuming trends similar to the first quarter or a stable revenue dynamic? Where do we stand on gross margin expectations going forward?

I understand why you want to know that. But again, that's hard to predict. But nevertheless, let me tell Mr. Logan, he should try to answer that.

Sure. Well, again, with the concentration in equipment and the OEMs having a fairly close watch over their own pricing and margin, I don't think there's any disruption or any real strangeness or weirdness that we would expect to come from that. The price increases a couple of years ago, obviously, did disrupt what ended up being at margins, and we're kind of climbing through that and working with our OEMs through that as well still. But we don't expect anything dramatic or epic or disruptive or necessarily helpful either as we're in this kind of arena. So I think you see some progress in terms of this quarter versus the sequential change of last quarter and the prior one. Again, we'll get it this season, and we'll know more, but I don't expect any disruption to price.

I understand you previously indicated that gross margins were expected to improve last quarter. Did we perhaps interpret that too optimistically? Is that still a possibility, or did I misunderstand that statement?

Oh, gosh, whatever we did last quarter, we weren't anticipating any pandemic at the time.

That's a very, very, very fair comment. Just one last one. I know you guys don't touch commercial a ton. But what are you seeing there in the last several weeks on the commercial unitary front or VRF front?

Paul? Well, obviously, it's for sure.

Yes, it's very heavily skewed towards international markets and the Northeast for us regarding the VRF and commercial applied products. All those projects and jobs have basically been halted, so we might see a little backlog there. The unitary side has been weak, and it will likely take a bit longer for that to improve. However, when considering commercial as a whole, it remains a small percentage of our overall business.

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

So just on, I guess, maybe focusing on the 1Q margins, which were down. I know it's a shoulder quarter. Can you just give some better color? Because I think you gave on a same-store and ex the investments, margins were still down. I'm just trying to understand, was it mix? Was it some other added SG&A costs, etc.?

I'm not sure I understood. But Barry, you're the numbers guy, what do you got?

Sure. Well, on the gross margin, Jeff, again, we do operate with higher gross margins internationally and in the Northeast. So there's some algebra there that did impact the performance in the quarter. That accounts for some of the profitability dropping down to the EBIT line as well. On SG&A, there were investments made in the business to start the season as we get into the year. And that SG&A does stand out in a, I think, in a shoulder quarter like this. Some technology investments, as we highlighted, is in that number as well. And so it goes into the mix of how our leadership is managing their local markets. And SG&A will play out very differently and very sensitively to what's going on in local markets. But to start the year, just some of these numbers show up more materially in terms of their impact in the shoulder quarters.

I want to convey that our financial strength, characterized by very little debt, enables us to adapt to market changes. If the market softens, we leverage our strengths, including product diversity and technology that ensures faster service. We also have the capability to finance both distributors and homeowners. I am very pleased with our current position and our minimal debt. I believe that regardless of market fluctuations, we will emerge as a leading distributor.

This is A.J. I want to express my appreciation for the detailed questions regarding Q1 and April, which are challenging to anticipate. However, it's crucial to keep in mind the broader picture of Watsco. We are a long-term company with exceptional leadership at both local and regional levels. In light of the pandemic, we are in a position of strength—financially, in terms of leadership, and within the market. As we discussed earlier, we are focused on thriving rather than just surviving this pandemic, and we're determined to become a better company and capture market share. The initial results of our efforts and our future operational outlook compared to our competitors are promising, and they make me proud. For instance, the contactless pickup initiative was implemented within 48 hours manually, and soon it will be fully digitized in our apps for contractors and warehouse teams. This will fundamentally change our operations, and our customers appreciate it. This is just one example of the exciting energy surrounding our processes and how we are leveraging technology and data in previously unexplored ways. We are committed to thriving. It might seem awkward to say, but from a long-term perspective, this is an exciting time.

Okay, great. It seems like you're experiencing some stabilization in April. However, if we enter a phase of 5% to 10% declines this settling season due to significant economic challenges and high unemployment, do you plan to continue investing during that downturn? Are there any actions...

Absolutely. No, absolutely. We will. That's the nature of our thinking because our financial strength allows us to invest during downturns as well as steady markets. We are long-term-oriented, and we have the ability to invest, and we'll continue to invest. We're relatively a $5 billion revenue business in that side. It's a $40 billion market. We're very ambitious. And in order to get some growth, you've got to continue investing, and you've got to continue improving the customer experience, things that we're really getting good at. So we're not going to stop the investing.

And Jeff, we reminded everyone in the press release that in 2009, that is when we made our largest investments in our careers. And it wasn't just buying a company or doing the joint venture. It was adding capital and adding branches, adding people, adding an entire renaissance to a business in the middle of the recession last time. And dividends were increasing, and cash flow was increasing. So again, it's a script that we know and can play out.

I have one final question about the mobile app. I noticed that about 8% of your contractors use it, while 36% of sales come from e-commerce. Does that mean most of the e-commerce sales are still made through computer-based online ordering? I’d like to understand the difference in usage between the mobile app and overall e-commerce.

Well, I don't have the information regarding where you obtained the data, but we've provided that information in the press release. You can refer to that for details.

No, no. I have it. That's what I'm pulling out of the press release.

Yes, you're observing the weekly active users on the mobile app. If you consider the monthly or quarterly figures, they represent a much larger segment of our customer base, with those numbers doubling. For instance, in 2019, we had around 110,000 unique users of our mobile app, which is significantly higher than your reference point. The mobile app is particularly designed for technicians in the field. The purpose is to allow a technician, when arriving at your home, to quickly identify the system you have and all its components. They can determine which part you need, check inventory in our locations, access every document related to that part and equipment, check warranties, process warranty claims, or even have the product delivered. It serves as an essential tool for technicians and extends our e-commerce capabilities, going far beyond just online ordering.

The next question comes from Chris Dankert of Longbow Research.

So the Credit for Comfort numbers show that utilization has increased significantly. Watsco is in a strong liquidity position. How are your customers feeling right now? Is there any stress? I would like to hear your comments on credit.

That's a great question. Yes, they are experiencing challenges, but that's where we come in. We can assist them by providing financing programs to help them grow their businesses. We can support their customers in the same manner. It does get difficult for our contractors, but as we always emphasize, we excel when times are tough. We leverage our financial strength, which some of our competitors do not have. Barry, Paul, or A.J., would you like to add anything?

Yes, this is A.J. Let me respond, Barry. Over the past few weeks, we have around 2,000 Watsco associates reaching out to contractors daily, starting with the question, how can we assist you? Whether it's access to products, extended credit terms, or anything else, we're engaging with both our regular customers and those we don't frequently work with. There's a significant amount of follow-up and goodwill being generated, as well as greater exposure to contractors we don't regularly interact with, helping them see who we are, what we can offer, and our willingness to support their growth. Contractors remember these interactions, so even during challenging times in their markets, our assistance now can positively impact our future relationships. Go ahead, Barry.

Yes. And Chris, you mentioned about Credit for Comfort. And just to be very specific about what that is, this year, there'll be about 7 million replacement systems sold in the U.S. and only a very small fraction of them can a contractor sit with someone and offer credit to help that homeowner acquire that system and install that system. So consumer credit really has been a laggard in this industry for most of my career. Credit for Comfort is our digital platform that takes all of our product information, takes all of our capabilities as a distributor into the contractor and into the home to help provide consumer credit through different credit companies. We don't provide the actual financing. This is all third-party financing, but bringing in the actual technology into a digital platform that's easy to use that a contractor can use to grow its business. And that's the growth that we're seeing. Because inevitably, two things can happen. Innovation can help the entire equation, and the necessity helps the whole equation. And so part of that customer engagement over the last several weeks is engaging contractors and that potential of this financing platform. That's what Credit for Comfort is.

Got it. Got it. Thanks so much for the color there. Certainly, a market share opportunity to be had. I guess, just one other thing for me. Is there any way to quantify kind of any additional cost to operate some of the shorter-term costs, I assume, in terms of social distancing, additional PPE, that kind of thing? Or can't you really break that out from the SG&A at the moment?

No. Those categories, as you mentioned, don't apply to us. We're not installing anything where our customers are. I don't see any additional information there. Anybody else? Paul?

No. No, no. It really hasn't impacted us.

Yes. I just think in the disease, just trying to make sure everyone stays safe. But yes, obviously, that's a smaller impact then, not material. Well, thanks so much, guys. Good luck, and take care.

The next question comes from Cory Fulton of Gabelli Fund.

I have a quick question. I know you made several acquisitions last year, and typically, those acquisitions tend to have margins that are somewhat lower than the overall business. Can you provide an update on the current margins for those acquisitions and how COVID might affect the timeline for them to reach the overall Watsco margin level?

Well, generally speaking, we don't ask them to change their gross profit margin because that's not our business. They have to figure that out. I just had a phone interruption. Is that just me? Hello?

Yes, we can hear you. We can hear you.

It's very difficult for us to answer that question because those three companies operate independently, and we want them to remain independent and maintain their entrepreneurial spirit. If they need our assistance to enhance their margins, they will reach out to us. However, I cannot provide a response to that question.

I believe my second question relates to your decentralized business model that allows regional managers to make decisions at the market level. Are you seeing or expecting any cost-cutting measures? Specifically, is there anything affecting the business in terms of layoffs or furloughs that might indicate future changes throughout the year?

You're talking about these three companies that we acquired or in general?

No, no, just overall business level for this question.

Barry?

It is a decentralized model, and local knowledge and intimacy with the market will be important. SG&A will be part of the leader's daily responsibilities. As A.J. mentioned, growth is also a focus. We need to consider how to engage more customers, grow our business, incorporate more technology, and conduct more training. All of these elements are happening simultaneously, creating a dynamic situation. It’s a short-term framework for managing the business while also pursuing long-term strategies to increase market share and investment for growth. Both approaches are happening at the local market level, and there are no simple or uniform solutions. Everything is being analyzed and directed in these local markets.

Yes, I'll address this. It's A.J. As an example related to your first question, the three businesses we acquired last year are located in the Northeast, which is the epicenter of this pandemic. They are experiencing significant benefits, which I can attest to, through enhanced communication with one another. These business leaders have been successful in their ventures for a long time, but they are now connecting at least weekly to share ideas, learn from each other, and explore ways to assist one another or exchange resources. Being a fly on the wall during those discussions, I understand how valuable they are for those individuals and how beneficial it is to be part of a larger company like Watsco, providing such resources.

The next question comes from Blake Hirschman of Stephens.

First one for me. Could you give us any rough sense as to what kind of top line declines or just really what kind of combination of different factors would have to occur for the dividend to be at any risk of potentially being cut?

Oh, gosh. I haven't got a clue. Barry, go ahead. I mean we're in such financial strength that if this slows down, our cash flow increases. It doesn't decrease. So...

Yes. I can provide a standard response followed by details from our experience. Both can be framed as you prefer. Al is correct that in this business, when revenues decline, working capital adjusts within a few days. We place orders with OEMs daily and collect payments daily, meaning our working capital is essentially recalibrated every day. As a result, working capital is generated quickly, and cash is deposited in the bank for use, including paying off debt. For instance, our debt currently stands at under $100 million.

$85 million.

The concept of having a bit of an ATM in a more stable environment is reassuring and also addresses the need for cash to maintain dividends and keep everyone engaged with the business. Looking back to 2008, 2009, and 2010, we observed three significant trends: a drastic decline in new construction, considerable investment in the Carrier joint venture, and our cash flow along with dividends increasing by about 60% during those years. These are notable points to consider. As for the future, it remains to be seen, but this is our history, and it illustrates the underlying mechanics of operating under these conditions.

Got it. And then I know a lot's changed since last call, but I believe there was like some ongoing OEM price cost negotiations. Did everything that's happened, the pandemic and stuff, has that impacted those ongoing talks? Or is the margin outlook and stuff just more based on the uncertainty around what happens with the market?

Our OEMs are very cooperative and work collaboratively with us. It's in their best interest to maintain competition, and I believe they are committed to that. We have a strong relationship overall. I estimate we have around 1,000 vendors, and I think we are likely the largest customer for all of them.

Yes, since this call began, we've been actively monitoring pricing, competitiveness, and market dynamics. This process is ongoing. We believe we have more information, technology, insights, and supporting evidence across various markets to determine appropriate pricing and margins. It's a continuous effort throughout the day.

We work with our vendors daily to ensure a consistent supply of products and to avoid any disruptions. Changes in market conditions are responded to almost immediately. Our team at the operating units is actively managing relationships at both the OEM and vendor levels.

As there are no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

Yes. Thank you very much. I want to say again that I'm sure hoping that all of you are safe and stay healthy, and let's be together as Americans during this pandemic and come out stronger than when this started. I certainly hope so. Thank you again for your interest in our company. Bye now.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.