Good day, and welcome to the Watsco Incorporated Second Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Albert Nahmad. Please go ahead, sir.

Good morning, everyone. Welcome to Watsco’s second quarter earnings call. This is Al Nahmad, Chairman and CEO; and with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Executive Vice President. Before we start, our cautionary statement. This conference call has forward-looking statements as defined by the SEC laws and regulations and are made pursuant to the Safe Harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. First and foremost, I hope all of you and your families are healthy, safe and managing well. I’m pleased to say Watsco is experiencing a very busy summer selling season. There are many heroic people in our company making an exceptional effort to serve and protect customers while protecting themselves. Our most sincere thanks to them. We also want to express our appreciation to our OEM and vendor partners who have done extraordinary things to react to the accelerated ramp up in demand. Since our last call in April, a steady recovery began in May, an acceleration to double-digit growth occurred in June and it continues into July. The growth occurred across our footprint and was driven by our U.S. residential HVAC equipment business which experienced over 20% growth rates in June with similar trends in July. Homeowners are clearly investing in their homes as sales of replacement systems at higher efficiencies are accelerating. Sales of commercial HVAC refrigeration products which were soft early on in the quarter are now recovering. I’m also glad to report that our industry-leading technologies are contributing to our results in driving market share gains. Adoption and use of our mobile apps and e-commerce platforms have increased significantly as more customers use our technology. Our best measurement of impact is that customers that use our technology are generally growing faster than non-users of our technology. Examples of our progress include mobile app weekly average users growing 34% over the last year to more than 22,000 with 100,000 total downloads. New processes were introduced to provide rapid onboarding of e-commerce sales. So far this year, the number of e-commerce users has grown 14% and the number of transactions is up by 12%. Our e-commerce sales run rate in June was 33% versus 29% in December 2019, and in certain markets our e-commerce run rate is now over 50%, which shows the potential of this e-commerce platform. We also justified the promotion of two other innovative platforms. They are called OnCall Air and CreditForComfort. These two platforms provide digital support for contractors and homeowners and connect proposals for buying products and for financing replacement systems. Our contractors’ fulfillment activities, which we refer to as curbside or dockside pickup expanded to more locations and will soon include contactless payment functionality. It is early, and the adoption and growth have been terrific to this point. As always, feel free to schedule a Zoom call with us and we can further explain our technology progress. We believe these capabilities provide a differentiated customer experience by engaging with us digitally in every way. We also believe a new standard for contractor service has been established, which will serve us well in the long term. Also during the quarter, we improved operating efficiency by reducing costs. Same-store SG&A declined 7% with few store closings and loss of business across our network. Our financial position is evidenced by our balance sheet strengthened during the quarter. We generated operating cash flow of $216 million, the highest of any quarter in our history. Over the last 12 months, we've generated $529 million in cash flow versus net income of $285 million. Dividends have been increased, and we have no debt at this time. Further financial analysis of our second quarter is provided in our press release. And now with that, A.J., Paul, Barry, and I are happy to answer your questions.

Thank you. We will now begin the question and answer session. Our first question will come from Josh Pokrzywinski with Morgan Stanley. Please go ahead.

So, I guess clearly some stimulus payments there helped put up a very good quarter relative to maybe the broader macro. But any regional commentary from Paul that you can share either at the Watsco level or maybe industry observations that can help square up that performance?

But we don't like to share regional data for competitive reasons. But Paul, the second part of the question?

Have we seen any other trends in the industry? Well, obviously demand is high and we're constantly focused on trying to make sure that we can maintain the inventory to satisfy our customer needs. That's been a battle for the last 60 days, obviously. Demand has been strong on the replacement side and is picking up again on the supply side right now, and we hope it continues through the quarter.

And then just on the technology initiatives, Al or A.J. I think most contractors, at least the bigger, more stable ones tend to use a couple of different brands, but are fairly sticky in that and not rotating around a lot. I guess, does that mean with the share gains or outgrowth or however you want to track the technology, is it just doing more business with customers that are already doing something with Watsco and just can do more, or is it really causing folks to bring on a new distributor relationship?

A.J., you want to answer that?

Yes, sure. It's both. I mean, we touch a lot of contractors in North America. Some of them buy lots of products from us every day, while others buy just a little bit of products from us every once in a while, but those are all targets to get visibility and see the technology in action and what it can mean for their businesses. That outreach to customers, whether they're small customers of ours or are new clients, is helping them understand how different it is to do business with our companies versus our competition, and it's moving the needle. To put it more succinctly, there are small customers of ours doing more business with us, and there are customers coming on board for the first time, and the technology is driving many of those conversations.

Another way to look at it might be, Paul, can you discuss here?

Yes. I mean for the second quarter we definitely had market share increases. As you guys recognize the industry shipments were probably down in the 10% range for the second quarter and our residential sales were flat. So that's a pretty monumental move towards an increase in market share. In the front half of the year, the same numbers apply, the market was down mid-single digits and Watsco was basically slightly up given what we did in the first quarter. So we are gaining share there. I'm proud to say we're gaining share in Canada. Those numbers come out faster than the U.S. numbers. So we're becoming a force in Canada again. So I'm very happy to see everything that's happening from a share perspective.

Our next question will come from Stephen Volkmann with Jefferies. Please go ahead.

Hey guys. Thanks for taking the question. I'm curious if you could comment a little bit around gross margin. I think that was a little better than some of us were expecting, especially given I think your mix is shifting a little bit more towards equipment, which I would have thought would be a margin headwind. So, just what's going on in gross margin? How should we think about that sort of going forward as business remains strong?

Barry or Paul, somebody jump in with that one.

Yes. Stephen, good morning. You're right. As equipment grows at a much faster rate, algebraically our gross profit margin is impacted by that in terms of what you see optically on the income statement. Also, as we get through a selling season and a busy time and make the efforts to sell products, price, margin, and cost within every day market-by-market, local competitive landscape, there's not one answer, there's 50 answers. There are 50 variables that are playing out every day. So this year is showing some improvement over the last year in terms of trend, but still there's a lot of work to do on margin; a lot of work to do as we get through the selling season and looking into next year and beyond.

Okay, thanks, Barry. Is there any reason to think the second quarter was unusually a little bit better than it would be or how do we think about the trajectory going forward?

There's nothing remarkable or unremarkable about the second quarter, Stephen, that would be a lead commentary.

Our next question will come from David Manthey with Baird. Please go ahead.

Al, I believe you mentioned that June and July so far have shown a 20% increase year-on-year compared to June and July. First, did I hear that correctly? And second, could you provide some context regarding same-store daily sales?

That was good. I enjoyed that. Barry?

Sure. Well, Dave. Yes, you heard right. And we did comment on trends. We are adjusting for sales days. Those are average selling day trends that you're hearing in the remarks.

And that was based on residential air conditioning sales. That wasn’t based on total, no?

Yes, in the press release, you read double-digit growth in June. And Al’s remarks you hear, residential up 20%, that's what you're hearing.

Got it. And that's same-store daily sales. Okay. Second, looking at the operating expenses from the first to the second quarter, the reduction was impressive. Probably the most impressive we've seen in Watsco’s history sequentially like that. You basically did $350 million more in revenues on $9 million lower OpEx sequentially. I know the company is very decentralized. But are there any major cost buckets you can talk about that drove that decline? And that's really unusual and a big drop?

Barry?

Hey, David. Well, again, I can't invite you to our Friday Zoom call with 35 core managers across Watsco. If I could, what you hear is what you said, decentralized challenges to constantly react to what's going on in the market. So, it was a Watsco pen and paper session, with 35 managers going out and prosecuting what they believe is important to take care of customers and employees in markets where revenues were untouched that needed to deal with a cost structure. We had other markets that were more heavily impacted. They cut costs and adjusted costs very aggressively in the short-term. The good news is this is all local-led and reaction to what's going on in the marketplace that drove the cost. As a parent company, we certainly have the conversation, but it's all driven in the field.

This is A.J. I just have to add, those 35 leaders or so have just been tremendously impressive during this whole period and the 5,000, 6,000 people that work for them, it's just unbelievable effort and spirit, and they deserve all the credit.

Yes, it's really impressive, guys. Thank you.

And this is Al. I mean the corporate cost of Watsco, corporate expenses is under 5% of SG&A. So for any level of reductions in the field, any reductions that you're seeing optically in terms of performance is all driven by them. So once again, the credit belongs there.

And our next question will come from Jeff Hammond with Keybanc Capital Markets Incorporated. Please go ahead.

Paul mentioned that inventory is a challenge. We observed that some of the OEMs are having difficulty getting products out the door. It seems there was an expectation that demand would be weaker than it actually is. Can you discuss your capacity to deliver products, how quickly things may return to normal, and your ability to keep pace with the strong demand trends?

Well, we can't speak for the OEMs, but I can tell you they're doing their best. It's complicated to get their supply lines to accelerate. But they've done it and they're doing a pretty good job. And I don't think they're going to lay off; they're going to continue to support the demand and God bless them. They're just great suppliers and not just the OEMs, but also the regular vendors. We've kept up our continuous cadence of orders, even in the down times of April and May. We continued replenishing the inventory. We didn't cancel any orders. We followed through with it. We have daily discussions with our primary OEMs. We have weekly discussions with our vendors. We're talking to them constantly about what their problems are and giving them lead time and a look at what we're doing and what our needs are going to be. Also, Barry and A.J. are mentioning a more cohesive opportunity that we've had with senior managers talking every Friday and going through what their issues are. We're seeing more and more intra-company movement of inventory as one part of the country gets hot and the other one cools down on sales; we're able to move inventory intra-company, but also a new feature that we've been able to do with our new technology on inventory is intra-Watsco inventory where we're actually moving orders or inventory amongst the Watsco companies. So it's tough. It's still tough. We've had to do some substituting the product from time-to-time. But once again, I'm very, very proud of what our OEMs and our vendors have been able to provide us to-date. And we just hope they can continue all the way through the season.

Every one of our OEMs has come to the party. They're functioning as best they can. And we're very grateful to them.

Hopefully those aren’t pool parties in Florida that they're attending. You mentioned the trends in the residential market. Can you elaborate on the commercial aspect of the business and whether you've noticed any signs of stabilization as the markets begin to open up?

Well, I commented on that but I’ll let Paul go ahead.

Yes. The second quarter obviously was brutal on the commercial side. However, as states began to open up, we started to see some upticks, but we're not back to zero yet, obviously, on the commercial rooftop side of our business. Applied has remained strong. And even commercial refrigeration we've seen good life in that in the month of July....

Okay, and then just last one. Can you give us the tech spend in the quarter either in total or year-on-year, how much you expect that to be up for the year?

It is running the same, and it will change from time to time as we see opportunities. So, don't think that's the end of it. I know that's a persistent question of yours. We're going to add as much as needed. Anything that we see we're going to invest; some of it will work and some of it will not, but that's the business we're in – innovation. That's what Watsco is, an innovative business and we're going to have the financial means to invest in it. However, there hasn't been any dramatic change from recent spending.

And our next question will come from Brett Linzey with Vertical Research Partners. Please go ahead.

Could you just update us on the efficiency mix trends in the quarter, any noticeable change whether it be mixed up or mixed down by homeowners, just a little bit of color there would be great?

By homeowners. Paul, have you seen any data on that?

Yes, we've seen some data on that. We've seen a mix up, where we've seen a bit more on the 16 SEER, 18 SEER front. It's not a remarkable change. The thing that’s been the most amazing to me this second quarter was I didn't see any material change in system change-outs; people were replacing entire systems, not just the outdoor unit. So, the consumer would never have guessed it was acting fairly normal as far as what we've seen historically.

Just an interesting data point on our technology; we mentioned OnCall Air in the prepared remarks. That tool is about helping contractors sell into homes and into building owners. It provides a very modern, feature-rich platform to provide a modern experience in the sales process. Without going into too specific, it is early days with a tool. High-efficiency sales are much higher on that tool. Without the tool, it’s helping sell bigger tickets, higher margin products, and higher efficiency systems.

And then maybe just shifting to price, what are you seeing from a pricing standpoint? Any intra, inter-quarter July price increases given the strength of the market here?

Paul, have you seen any?

No, I really haven't seen any price increases on the equipment side. There have been some commodity moves, which are normal this time of the season, but nothing on the equipment side and nothing on the finished goods, supply, and part side.

And our next question will come from Chris Dankert with Longbow Research. Please go ahead.

Kind of circling back to SG&A for just a moment. Again, really impressive, as David pointed out. I guess just out of curiosity, how quickly does some of that spending have to turn back on? I know the mantra is, we're investing for the next 10 years. So again, I was also very surprised to see SG&A come down to the magnitude it did. Just any comments on hiring, on what it takes to maintain this level of growth you've seen in June and July here?

Well, so Barry, you’re the futurist, given what you see is best.

Well, I mean the big picture obviously is that we're a labor-driven company. If you visited our stores, you'd find five to 20 people helping customers. To the extent that business is roaring, we will have more resources and more costs handling that issue. That's a good problem to have, where much of our labor can be variable or discretionary in a way that can be tied to the sales trends. So that will occur and we will see SG&A spend creeping up as business volume drives it. That's part of being a distribution company and inherent in the distribution model. We've also challenged the 35 leaders to look at under every rock over the last two to three months and determine what they can really change in terms of mindset or sacredness or how do they react to the technology flow that's going on, really challenging their status quo. That is going on as well. I would expect efficiencies that we can sustain well beyond just this temporary state that we're in. How much and how material? We'll find out as we get through this year. And that's sort of being a futurist. I know that we're a better company today, 60, 90 days into this, and the cost structure is a portion of that improvement that we've made.

And then again both your labor force and your customer labor force is a little more specialized, skilled. But again, we have seen some issues with guys not being able to show up or being kind of enticed away from certain jobs. Is there any difficulty in labor availability either for you or your customers that's having any meaningful impact?

We don't know what our customers are having issues in that way or not. But I can tell you that our workforce has been just terrific. We're keeping up with demand and we're very appreciative, and we expect that to continue.

Our next question will come from Steve Tusa with JP Morgan Securities. Please go ahead.

Hey guys. Good morning. Congrats on the execution and kind of a volatile quarter here. I'm just trying to put the pieces together. Did you have any significant difference in the performance of your suppliers on the equipment side in residential?

No, they're all just doing the best they can. And they know the fit, know what's going on. They're very supportive. We're not their only customer; they're supporting the entire customer base. And they're just doing a great job. I couldn't be happier with it.

And you guys don't sell a ton of Lennox, right?

I don't know that we sell any. If you have any ideas, we will continue to.

I don't have any ideas at the moment; it seems a bit confusing. If your major brands are gaining market share, is there a company in the industry that's really struggling to deliver products that you don't sell? Lennox has already reported gains in market share, while your company is flat, and they were down by 6. I'm just trying to understand if everyone is in the same position or if some companies are struggling more than others.

Well, I would say that all major equipment brands that we have are doing well. I mean the issue is, how quickly can they produce and get the product to us, but they're all doing well and they're all very supportive. I couldn't be happier with it.

Right. How do you guys look at the inventory situation; where does the inventory stand today and then how do you play that out in the back half of the year?

That's a very good question because the inventory has come down. Part of that is the tools that our technology group has come up with, very good technology. I don't know how much detail you want to get into that, but we're happy to.

Sure, a lot of the inventory reduction is due to supply chain constraint and the non-excessive but extreme demand. But also to the broader point, we are doing better managing inventory. We have new tools and technologies, better teams, better systems, and better focus on what we call non-performing inventory, and moving low performers, SKUs that don't sell in one place, moving them around. I would say a significant portion of the inventory reduction we've seen is about getting our inventory position healthier. And that should be sustained and continued.

Right, so you're kind of using these tools to maintain a lean inventory position while you're delivering. When you get to the back half of the year, do you feel comfortable with what you have?

Yes, I wouldn't say lean; I would say healthy, right? To put products in the right place at the right time is the key.

We refer to it as inventory effectiveness rather than inventory turns; it's about how effective our inventory is. Before we had these tools, it was challenging to manage hundreds of thousands of SKUs and determine their placement across 600 branches. The calculations you heard illustrate that point. With our new tools, we hold daily meetings with the senior inventory management teams from all Watsco companies, and sharing information and data among these teams has proven to be extremely valuable. From my perspective, the advancements we've made in technology have resulted in outstanding inventory systems.

And they're going to get better because we haven't implemented the tools throughout the company yet; we’ve just partially gone through it.

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

Well, let me just close with what’s on everybody’s mind, the pandemic. We truly wish all of you to stay healthy and stay safe. We are staying at home here as much as we can and just want everybody to have the best possible outcome from this terrible virus. Bye now. Thank you for attending.

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