Good morning, and welcome to the Watsco Third Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. Operator instructions: After today’s presentation there will be an opportunity to ask questions. Operator instructions: Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.

Well, good morning, everyone. Welcome to our third quarter earnings call. First, I hope everyone is safe and healthy given the virus is going on. But this is Al Nahmad, Chairman and CEO. And with me is A.J. Nahmad, President; our two Executive Vice Presidents, Paul Johnston and Barry Logan; and Rick Gomez, Vice President. Before we start our normal 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. Now I am pleased to share that Watsco delivered another record quarter. New records were achieved in virtually every performance metric. Earnings per share jumped 31% to a record $3.62 per share and a 32% increase in net income. Sales grew 16% or nearly $250 million during the quarter, to a record $1.78 billion. Gross profit increased 29% with gross margins expanding 280 basis points. Operating income increased $50 million, or 32%, to a record $207 million. Operating margins expanded 100 basis points to a record 11.6%. And cash flow for the quarter was a record $238 million. Today's results are all the more positive when considered against last year's record results and in light of the industry-wide supply challenges that are still going on. Our teams throughout all of Watsco are doing an extraordinary job taking care of customers, and that has made a big difference. I want to say thanks to all of you. We also ended the quarter with a strong balance sheet with virtually no debt and cash of $137 million. This financial strength provides us the flexibility to invest in most any size opportunity. Our press release summarizes important fundamentals that are critical to understand as we continue to invest and build further scale in what is a very fragmented $50 billion North American market. An important fundamental is Watsco's geographic coverage and our large number of locations across many markets. The diversity of markets we serve reduces volatility and provides stability during a difficult operating environment, such as the one we are witnessing. Also, our large and growing customer base is increasingly equipped with our state-of-the-art technology that helps our customers grow their business and purchase more from us. Another advantage now and in the future is our offering of the broadest variety of products and brands in the industry. The depth and diversity of our product offerings should continue to serve us well. We're optimistic about current market conditions. Let me say that again, optimistic about current market conditions and recent trends. End market demand remains strong, and we see signs of improvement in our OEMs' ability to help us fulfill that demand. Looking ahead, the industry will experience more change in the years to come as minimum SEER standards rise — that normally will be done by the federal government, by the way — and refrigerant changes that take shape in the coming years. And with changes come opportunities; we believe that our long-term focus, our scale, speed to market, relationships with OEMs, and technology offerings position us better than anyone to capitalize on these upcoming changes. We are living in unusual times, but could not be more positive and excited about the future of the industry and our role in it. Now let's go on to our Q&A.

Operator instructions: Our first question comes from Nigel Coe with Wolfe Research. Okay, moving on. Our next question is coming from Tommy Moll with Stephens. Please go ahead.

You referenced increasing engagement with some of your OEM partners and an increased ability to help you meet the robust underlying demand. At this point in the year, I wonder if you've started to talk to some of the initiatives for 2022 planning? And if so, what, if any, insight can you give us on those?

I like that question because all of us in the industry are finding it difficult just to get enough product to continue to meet the demand. But for 2022, I think Paul Johnston is best positioned to answer that.

Yes. First of all, I'd like to say that we're not increasing our conversations with the OEMs; we have been continually communicating with our OEMs and they with us. So the relationship there, barring the pandemic and even before the pandemic, we have been working with them on product planning and delivery planning and all that. Right now, what we're looking at in 2022 is we're trying to straighten the inventories out a bit. What we ended up with was some of our inventories ended up being a little bit lopsided on indoor versus outdoor-type units. So we're working with them trying to balance that out so we can sell complete systems. We've been working with them on what the transition plans obviously are going to be given that next year is a big year when we're going to be transitioning to higher SEER levels in 2022 and 2023. So it's been a full agenda that we have with our OEM partners as far as communicating and planning with most of them. As you recognize, we're one of the largest customers, if not their largest customer. And so we're important to each other.

If I could, I wanted to pivot to the customer side of the business for you. How receptive have they been of late to price increases? And I ask that because clearly there's input inflation on the OEM side, and presumably in this environment your customers are going to be pretty receptive to your passing that through. It would occur to me that if you've got product available, there's less concern around pricing, which is going to be pretty well passed through to the end user anyway. But any context you can give us on that dynamic?

Well, I think your thought process is a good one, but let's see if Paul can fill in that hole there.

Yes. We always talk about the equipment. Yes, those are the most recognized price increases that we have. And the dealer contractors have been accepting of them, especially those who are in the replacement business. Perhaps, a little more resistance from people who are on the new construction side. But they're also experiencing upticks in commodity pricing, with copper going up above $4.70 recently per pound. We're seeing flex stock go up double digits pretty much every three to six months. So a lot of the other products that go into actually installing units are going up at the same time. So I think we're all a little bit numb to it, including our contractors, and accepting it, and trying to pass it on as best we can, given the timing of how many price increases we've had here in the last, call it, 18 months.

But it doesn't seem to be slowing demand. Our demand is strong.

Yes.

Your next question is from Steve Volkmann with Jefferies. Please go ahead.

Just following up on that last one, Al. Are you guys seeing any change in your mix relative to the type of equipment customers are willing to pay for at this point?

Well, that's a very insightful question because there is a chip shortage. So we see high-efficiency demand there, but we're unable to fulfill it given the supply of that product. Paul, do you want to fill in?

Yes, that's very true. It takes more hours for an OEM to make a high-efficiency 18 or 20 SEER product. So the focus has been pretty much on 16 SEER, 15 SEER, 14 SEER, 13 SEER product. So there's been a little bit of a shift where we're seeing a bump in 16 SEER sales and, obviously, 14 and 13 SEER sales and a small decline in 18 and 20 SEER. Having said that, the 18 and 20 SEER has never been a major portion of the market. And obviously, it's something we would like to have as a larger portion of the market. Hopefully, with the new energy standards, we'll be able to expand the very high-efficiency products as a greater percentage of our sales.

Yes, just to add a thought to that. Just so it's clear on the data, what the data says is the high-efficiency mix increased again this quarter. It's almost 11 straight years of quarters where it increased. But that ultra-high efficiency is where the missing link is and did not contribute; but overall, high efficiency grew at a faster rate than base efficiency.

So it almost sounds like, if the supply chain issues ultimately normalize and we have these SEER changes happening in '23, we may actually see a better mix shift going forward?

I would agree with that. Absolutely.

But we're definitely going to see a better mix change because efficiency will be going up to 14 SEER in the north and 15 SEER in the south.

Which is mandated by the federal government.

Yes. So we're going to see that regardless. Our focus is we really want to make sure that that ultra-high efficiency that Barry refers to grows at a faster rate and becomes a more material piece of the market.

Understood. Okay. And then a quick follow-up. I think you mentioned in your prepared release that SG&A spending was a little bit elevated, and you expected that to normalize as we go forward. Obviously, gross margin was also very good. Do you also expect gross margin to normalize going forward, or do you think you can kind of hold the rate that we have?

Well, that's a very perceptive question looking into the future. Who wants to take that? Barry or Paul?

Barry, that sounds like your question.

Alright. Let's get to SG&A first because that's easier to think about. Obviously, everything we've said — and I just want to put this on the table for the rest of the call — sales volume in the second quarter was up 29% on a same-store basis, something like that. So this has been an extraordinary summer if you look at things as a combined last six months. Let's not just talk in quarters, let's look at our seasonal realities of what we dealt with. Extraordinary demand, SG&A that needed to deal with a lot of stuff going on in terms of supply chain to make it work. A lot of austerity that came off last year's comparison that is now in this year's numbers. And again, as I said, drinking through a firehose over the last six months. So SG&A: we wanted to highlight some things very specific to SG&A that are big buckets. And the word 'normalized' usually means it goes down or declines. Let's put it this way: there's a lot of variable costs that increased; those costs remain variable and will adjust themselves to whatever the sales volume is over the next 12 months. As Al suggested in the remarks, we're not necessarily seeing a slack in demand as we get out of season right now. In fact, we're seeing increased demand as we're going out of season from recent days. And so SG&A will normalize. But again, time will tell and the variable costs should adjust over time. Gross profit is a more interesting question. Obviously, I've said this for a career, and we've said this in our comments over many years: inflation is something that we pass through and pass on. It adds to a gross profit equation and makes more money for us. There's no question of that. We're also doing immense work with technology to improve pricing and margin and to optimize pricing. That doesn't necessarily mean just getting higher margins; that means improving our pricing profile across customers, competitors, and products. There's a benefit this year in that equation, which is only just the beginning of a pricing discussion. I think mix also obviously has a benefit. You heard Paul's comments earlier about mix looking forward. But that's a big crystal ball to look into, to be honest. And for some of the undercurrents of inflation and mix and technology and incentives and the way we pay salespeople and commission our sales force, all those things are pulling in that direction. So next year I'll tell you more when we know more, but that's what I would tell you today.

The next question is from Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

So just a follow-on on the gross margin. It looks like if I do the math right, the gross margins on the acquisitions are higher than your blended average and the SG&A seems higher on a blended basis. Is there anything — I know TEC is the biggest acquisition contributor — but maybe just speak to those dynamics, those impacts?

Well, I have to say, Barry will answer that, but this is a $6 billion a year business. What you're talking about is small relative to the overall revenue. I can't imagine that's driving the overall numbers that you perceive. But Barry, go ahead.

Yes, Jeff. As related to what we've acquired lately: yes, the margin and yes, the cost of doing business is higher. That's unique and eccentric to TEC, and it's part of their legacy and profile of how they go to market. They've had an exceptional last six months as part of Watsco. They've had an exceptional year coming into this year. We're very proud and happy that they're part of Watsco.

Okay. Great. Thanks for all the color on the '21 performance. That was really helpful. Just sticking to the price dynamic, I think you called out a 6% increase in average selling price for the year-to-date. I'm just wondering if that number overall is higher within the context of 3Q? And then if there's any noticeable difference in that 6% between equipment versus non-equipment?

I'll take a first stab, but Barry, do you want to take the second half? Is there a difference between equipment and non-equipment? Yes. Anything that's commodity-based has an external profile where the pricing fluctuates on a daily, weekly basis. As I mentioned earlier, things like copper, refrigerant, and steel have definitely been on the incline and have gone up faster over the last 18 months than equipment. Equipment has a slower cadence to increases because there has to be an announced period of time before we have a recognized price increase. Normally, we get anywhere from 60 to 90 days lead time on the announcement before it's implemented. So it gives us an opportunity to adjust ourselves. So timing is not unique to the third quarter or to 2021 so far.

The next question is from David Manthey with Baird. Please go ahead.

So just definitionally, when you're talking about the 6% year-to-date price increase on residential HVAC, is that the typical price/mix definition that you've given us historically?

Yes, it is, Dave.

Okay. And then as far as the increased investment that you outlined, and thanks for doing that for clarity, is some of that incumbent on the gross margin being elevated here? You noted that some of the variable expenses will naturally flex down if things moderate a bit next year. But if gross margin moderates and sales moderate, is this a fluid plan? Do you modify that investment plan if things moderate a bit next year?

Yes. The answer is, of course. This is 673 location managers managing P&Ls. It's 30, 35 super regional presidents running markets. It's a data platform suggesting, telling, reminding, and monitoring margins and cost and profitability every single minute of the day. It's incentive systems geared toward EBIT growth and cash flow production. So yes, culturally the intent and the obvious culture is profitability growth in responsible ways is the mission. It may be different in Texas than in Massachusetts next year. It may be different in California than in Chicago. So this decentralization and data flow that goes on in markets is how we operate. When I say, of course, it's because all those dynamics get measured and carried out in different ways in different markets. Clearly, all these moving pieces that are going on are different everywhere. So culturally, every Friday morning we spend a few hours together, go through it all together and act and react accordingly. So the answer is, of course, there will be actions and reactions going on as things change.

Got it. Okay. And just quickly as it relates to technology investments or other corporate-level decisions — I know there aren't that many of those, but what about those? Those are obviously not controlled by the markets individually. Are those subject to change, or are those set in stone at this point?

Yes, let me deal with that. I agree that's not controlled the way you stated. A.J., respond to that.

Yes. As you saw in our release, our investments in technology continue to grow. That's because we are maturing things that are already in flight, and we're taking on new projects and programs, all with the intent of continually improving and modernizing everything we do, all focused around helping our customers do business more efficiently and helping them grow their businesses. So as we see more and more opportunity, we're going to continue to invest.

In other words, we are dedicated to the long-term, and A.J. said it: we don't see any reason not to continue to invest regardless of what's going on in fluctuations from season to season.

The next question is from Jeff Sprague with Vertical Research. Please go ahead.

I was wondering if you could give us your early thoughts on behavior around the potential for prebuy next year. I ask in the spirit that folks are programmed for prices to move up. Is there much logic or much to be gained from distributors wanting to prebuy into that efficiency change?

Right now, the reality is that prebuy doesn't help anything. We can't get what we want now, and we don't see an end of that yet. So we don't even face those prebuy decisions. What we need now is enough product to meet the demand that we seem to be having at record levels going into the fourth quarter. It will be adjusted, and prebuys, of course, we would consider. We have a lot of data and a lot of software that tells us how to manage our investment in inventory. Right now, it's a scramble.

So you would be interested in prebuying along historical patterns if the product was available to do so?

No. I don't think that would be the case. We just want what we have on order. We want to bring it in exactly as ordered. We don't see a prebuy coming at us. We want to make sure we get the inventory that we need to meet current demand and early part demand. I don't think anybody is looking at carrying a huge amount of inventory into 2022 because there are going to be different government regulations with different requirements for where and how you can sell product. So I don't think it's going to be an issue this year.

I was sort of meaning prebuying in '22, not right now. But it sounds like the answer is probably the same, regardless?

Yes.

And sort of related to that, what percent of your sales now is above the minimum efficiency standards across the platform?

They all have to be at or above the new minimums once the standards change.

As to what's above the minimum today, it's quite a bit higher than you might think. It's higher than 50% is actually above the minimum.

Interesting. That is higher than I would have guessed.

You've got a lot of other rules that apply to it, such as EPA and new home construction; in order to get your sticker from the EPA, you have to have a higher-efficiency product. There's an awful lot of the 14 SEER product that actually goes to 15.

The next question is from Chris Dankert with Loop Capital. Please go ahead.

Maybe one more targeted to A.J.. You did highlight some new projects. Anything specifically you're willing to discuss over at the skunkworks at Watsco yet? Anything new to talk about?

These are long-term initiatives, and we're a long-term company, so we don't need to highlight things just in early-stage development. I will say some of the earlier projects that are getting more mature: our OnCall Air, which helps contractors sell to customers, and CreditForComfort, which helps sell financing. Both are continuing to grow and are very exciting. Customers using those tools and our technology in general continue to be better customers for us — they are stickier, their attrition rates are much lower, and their growth rates with us are much higher. All the data shows these technology investments are paying off and having a nice return.

Got it. And you've given us some of the numbers in the past. Are you guys willing to comment on what e-commerce growth was in the third quarter here?

E-commerce grew about 15% to 16% for the quarter.

The next question is from Ryan Merkel with William Blair. Please go ahead.

I think it was Al who mentioned that the supply chain might get better in the fourth quarter. Is that across all of your equipment OEMs? Or are certain OEMs doing better than others?

Let me say it's not gotten better yet. When I say that, I'm talking about all of them. We're hoping it will get better in the fourth quarter. But demand is so high now that it's not easy for them to catch up. It's all of them; it's not that one is notably better than the other. We're probably the biggest customer for many of these brands. They are still catching up and have not caught up. Will we see some improvement as the quarter proceeds? I think so, but I don't see solutions to the supply chain yet that make me optimistic.

Okay. And I don't know if you mentioned this, but did you leave revenue on the table this quarter because you just didn't have product? Is that material?

Did we take a shot at that, Paul? I don't remember. Let's not speculate; I'd rather not speculate.

It's pure speculation. If you listen to the sales force, it's a lot higher than when you listen to the data. It's a way of thinking about it.

The OEMs are running flat out and doing the best they can. I'm talking about all of them that we buy from, and I think we have, besides the three major equipment OEMs, numerous other OEMs doing their best. Have they caught up? Not even close. Will we see some improvement as the quarter proceeds? I think so.

Okay, that's helpful. I'm noticing more private equity interest in HVAC distribution lately. Are you seeing multiples rise in the space and more competition for deals?

With private equity involvement, there is more competition. Is it affecting how we think about our strategy? We will not chase pricing because we're in it for the long term. I don't know how long private equity will be in terms of valuations for businesses. There are a large number of distributors — roughly 1,300 independent distributors — so there's room for a lot of activity.

In terms of acquisition, we've done about 65 acquisitions.

The next question is from Steve Tusa with JPMorgan. Please go ahead.

On price, you guys booked 12% ASP in the second quarter and 2% in the first quarter. I think you're saying it's up 6% year-to-date. Can you give us what the third quarter ASP for U.S. residential was year-over-year?

Very consistent, Steve, with the overall 6%.

So why did that decelerate? Most think things continue to accelerate with these price increases. Any particular reason why that decelerated quarter-to-quarter?

Seasonally things don't change much in terms of price within a season. There were some late-quarter price increases that flowed in, I think, in September that will flow into the fourth quarter. But in-season there's not much variation, and with the volatility over the last 90 days, I'm not going to surmise much.

We do sense that there will be more price increases in the near future.

So that would suggest U.S. residential volume was down a little in the quarter, right?

No, it was up slightly.

Do you think you guys took market share in the quarter? If you did, that would imply the industry was down in the quarter, right?

You really don't know for the quarter until all the data comes out. The shipment data versus movement data has been so out of sorts for about the last 12 months. It has thrown all of our models off. Would I like to say we gained market share? Given some shipment data showing declines in July and August, and given we were not down, it's possible we gained market share, but I don't want to make that a bold claim until we see more data.

And for these price increases that are coming through, should we expect price to accelerate in the fourth quarter? Can you get back to higher single-digit or double-digit levels for the fourth quarter?

No idea. We see essential demand in the fourth quarter, but we don't know what that's going to be.

One last one on inventories. They were flat quarter-to-quarter. I'm trying to reconcile that with the supply constraints. You look like you're pretty good on inventory. How do you feel your inventory situation is?

Barry gave you a clue on that in terms of having equipment inventory where we only have part of a system, not all of the system. So we are carrying unusually high numbers of items where we don't have the matching part yet of the unit.

Do some math: our version of inventory turns, which we can calculate as monthly averages, is hard for you all to do externally. The monthly average inventory turn as of September 30 was identical to the prior 12 months. So all the investment level is the same. The mix of that investment is what we are talking about and needs to improve. There's some inflation, there's some shortages, and there's a lot of product being moved around in our logistics to handle customer needs. That should help the inventory position as we go into next year. Still dependent on normalcy — normal lead times and normal order flow — and we're not there yet.

Right. Well, congrats on executing continually here in a challenging environment.

The next question is from Josh Pokrzywinski with Morgan Stanley. Please go ahead.

Even though it's not a critical market to Watsco, we're transitioning into furnace season. Does availability look any different than the AC market? Any improvement by virtue of turning on furnaces this year?

Furnaces are an important part of Watsco, especially with acquisitions we've made in recent years including TEC and others. Right now, what we're seeing is kind of an inversion relative to air-conditioning. We need more standard furnaces, and there seems to be some shortage of standard furnaces while getting some high-end furnaces. We continue to work with manufacturers to supplement supply; some units may be later than normal. Normally, we're able to do a preseason with contractors to presell furnaces; this year that preseason program may be a little delayed.

And on the refrigerant transition — the R-22 phaseout — some OEMs have described it as a de facto $1,000 off the system because it's cost avoidance on having to recharge a system. What is the pricing on R-22 today? How does that affect homeowner demand? Years ago recycling refrigerant was more topical; does that help now? How much of these upgrades or replacements is driven by the refrigerant piece?

The number of R-22 units is decreasing every year. My best estimate is it's probably 20% to 25% of what it was when we did the initial transition. So there are fewer units that need service. There were drop-in replacements from DuPont/Chemours and others that helped work around any shortages in R-22. We continue to see 22 sales decline on the residential side. The homeowner economics haven't changed that much because of these drop-ins. As we move into future phase-downs of refrigerants used now, like 410A, there'll likely be a slight acceleration of remaining older units being replaced, but that's a projection.

The next question is from Nigel Coe with Wolfe Research. Please go ahead.

Of course, all my questions have been answered. Just to clarify the point on pricing: you mentioned you got 69 days notice from OEMs on price increases. Does that allow you a chance to maybe get ahead of that and therefore create a mismatch between prices utilized for your customers versus what you pay?

It's a 60- to 90-day lead time, not specifically 69 days. And yes, of course, we can move ahead of that when appropriate.

Okay, thanks. Air-conditioning and refrigeration was up 27% for you. What drove that strength?

Paul?

Generally, a lot of it was driven by restaurant supplies, ice machines, reach-in coolers — that type of commercial refrigeration equipment — driven by the rebound in open business activity.

And then on the other HVAC products that outgrew equipment: was that because of availability issues and a shift toward repair versus replace in the quarter because you couldn't get product out?

First, that 'other' category includes over 100 product lines and about 600 vendors. Anything from duct tape to sunglasses to refrigerant to copper tubing and so on. Replacement parts is a component, but replacement parts does not account for the increase because it's a single-digit increase in parts during the quarter. So it's everything else across those many product lines. There's some inflation in building-material-type items such as flex duct, copper tubing, and other products. It's also been a focus of our business units to grow that part of the business. It is a much higher-margin category, and that's part of why overall margin was higher across Watsco this quarter. So there's not one single story, and it's not simply repair versus replace.

Okay. I didn't know you sold sunglasses. That's something I learned today.

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

Well, thanks again for your interest in our company. We hope that you'll join us for more of these calls and follow us as we progress scaling the company. Thanks again.

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