Good morning, and welcome to the Watsco First Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO and Chairman. Please go ahead.

Good morning, everyone. Welcome to our first quarter earnings call. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, who is the President, along with Paul Johnston, Barry Logan, and Rick Gomez. Before we start, I would like to give our usual cautionary statement: this conference call includes forward-looking statements as defined by SEC laws and regulations made pursuant to the Safe Harbor provisions. Ultimate results may differ materially. Now that that's out of the way, let me report that we had another exceptional quarter. New records were set on virtually every measurement of performance. Earnings per share jumped 109% to a record $2.90 per share. Sales grew 34% to a record $1.52 billion, and operating income increased 109% to a record $171 million. Gross margins expanded, and this, along with improved operating efficiencies, led to record operating profit as well as operating margins, which expanded 400 basis points to a record 11.2%. This is critical: the sales growth was strong and consistent across all markets and product groups. Additionally, the companies we acquired during the past year also performed at record levels. We believe this demonstrates that Watsco is a great home for family-owned businesses. We sustain their culture, invest in people, and provide technology to secure and build upon their very great legacies. It is important to note that the quarter’s results are even more impressive given the strong comparison from a year ago. The year-ago quarter was very strong, and this year is even stronger. While it’s early in the year, we are encouraged by this terrific start and by current demand trends. Let me reiterate: we are encouraged by a terrific start and current demand trends. We believe that 2022 should be another record year for Watsco. Looking beyond sales and profits, I would like to highlight some important catalysts happening both in the short-term and the long-term. The industry is still experiencing inflationary pressures, and OEMs have recently announced additional price increases. As you can see from our results, we are capturing price in the marketplace due to the reliance and necessity of HVAC products in homes and businesses. Looking forward, energy efficiency mandates enacted a few years ago are now in effect and will raise the minimum standard for base efficiency systems beginning in 2023. The government is heavily involved in raising efficiency ratings through these mandates. We are working closely with our OEM partners to transition inventory ahead of next year. Historically, energy efficiency mandates afford us the opportunity for a richer sales mix of high-efficiency systems. Our expectations are the same moving forward. Federal mandates are also in place to phase out current high GWP refrigerants used in millions of systems across the country. A 10% reduction in these refrigerants is now mandated by the government, with a 30% reduction scheduled for 2025 and another 30% reduction in 2030. OEMs are actively developing new products to incorporate lower GWP refrigerants, expected to be launched in the next couple of years. Consequently, today’s repair costs for older systems have risen sharply, as have the costs of maintaining those systems. Working with our contractor customers, we see the opportunity for homeowners and businesses to upgrade systems that will, over time, be more efficient and environmentally friendly. That's a significant trend coming to our industry. In our commercial markets, we believe there is potential for greater infrastructure upgrades and climate change capital spending, along with an increased focus on indoor air quality. Although it is likely that this trend will take years to materialize, Watsco’s organic sales growth for commercial products accelerated during the first quarter to 29%. That’s 29% growth in commercial products in the first quarter. Long-term, we see other catalysts, including the expansion of federal, state, or local programs to help fund the purchase of high-efficiency systems. The trend towards electrification and the adoption of heat pump systems to replace fossil-fuel-powered heating systems is also notable. The second phase-out of even lower GWP refrigerants is scheduled for 2029. This information underscores Watsco's significant role in the drive to lower CO2 emissions. According to the Department of Energy, heating and air conditioning account for roughly half of U.S. household energy consumption. Thus, replacing HVAC systems for higher efficiency is a valuable action homeowners can take to reduce their energy consumption and carbon footprint over time. We offer a broad variety of systems that exceed the minimum standards and can achieve ratings of over 20 SEER. First quarter sales of high-efficiency systems surpassed the minimum standard by 31%, outpacing the residential equipment growth rate of 26%. Based on estimates validated by independent sources, Watsco has averted 11.4 million metric tons of CO2e emissions since January 1, 2020, through the sale of high-efficiency HVAC systems. This kind of information and more is available on our website, including sources and assumptions used to support the estimates. To sum up, there’s a lot going on, and we are excited about our industry. We believe our entrepreneurial culture, customer-focused technologies, scale, access to capital, and leadership positions provide unique advantages. We are fortunate to serve a large and growing population of contractors and technicians with the industry's most innovative technology. Our annual run rate for e-commerce sales has now exceeded $2 billion, and we can see our active technology users continue to grow at a faster rate. Let me reiterate: e-commerce users of Watsco technology, particularly on our e-commerce platform, are growing at a faster pace than those that do not engage in e-commerce with us. OnCall Air, our digital sales platform used by contractors, and CreditForComfort, which extends credit to the end user, continues to expand. Contractors presented quotes to approximately 45,000 households during the quarter, a 40% increase, generating $160 million in sales for our customers, an increase of 59% over the previous year. The information presented today is just a portion of what is happening regarding technology initiatives. As we mentioned earlier, if you are interested in learning more, please let us know. We will schedule time with A.J. and his team. We believe we are transforming the industry and are always happy to share more about our progress. With that, let's move on to Q&A.

We will now begin the question-and-answer session. Please follow the operator's instructions. Our first question comes from Tommy Moll of Stephens. Please go ahead.

Good morning, Tom.

Good morning, Al, and thanks for taking my questions.

Of course.

So an 18% increase in residential average unit selling prices. You called out that it's a combination of pure price plus beneficial mix, and I think on both of those points, there's a nexus to some of the technology investments you've made. Can you help us understand that nexus?

That's a very good question. Barry, A.J.?

Good morning, Tom. First, the pricing actions are always built on the costs coming in the door. As we receive higher costs, we pass on higher prices. That’s basic economics that has gone on for the last 25 years: cause and effect. The technology discussion involves a pricing system that's been in place for a couple of years and is more mature today than two years ago. When pricing actions play out across all product lines, not just equipment, an increase of 18% is noticed just in equipment. This discussion covers about 150 product lines, 600 vendors, and the administration of pricing has changed significantly compared to two years ago.

And on the mix side, sorry, go ahead.

Is that you, Rick?

No, it's A.J. What Barry is saying can be stated differently: you need to consider the scale of what we're discussing. We’re looking at numerous price increases from over 1,000 manufacturers sold to 100,000 contractors across 671 locations. The changes can be overwhelming, and our technological tools allow us to administer those changes quickly and efficiently. This gives us the time to apply analytics to optimize pricing by customer, geography, product, etc., enabling us to make a real difference in the market.

Thank you. That's all helpful context. I guess to consider the other side here, demand destruction. I'm curious for any insight on that. In an environment where you have realized substantial price increases and your numbers indicate no significant demand destruction on the end-user side, but it's a concern. Can you offer any insights or opinions?

Barry?

Yes. This isn’t unprecedented. Several years ago, when products went from 10 SEER to 13 SEER, there were probably 15% to 20% price increases then, and we didn’t see demand destruction then. As you suggested, I don’t believe we are seeing it now. The fundamentals are simple: people won’t live without our products. There’s a health aspect, there’s comfort. If it’s a business, it has to stay in business. The necessity of our products has always been a strong fundamental for the industry. Furthermore, these are products with a lifetime of 10, 15, or 20 years. You don’t buy these things weekly, you buy them once every decade, and when you do, you’re upgrading the efficiency of your current unit. Contractor collaboration and skills have significantly improved, influencing recommendations and installations for high-efficiency systems. Obviously, we’re supporting that with some of our technology, but this life cycle has remained unchanged for a long time. If your real question is when consumer sensitivity matters regarding price, you’ll notice our press release mentioned we sell 29 different brands of equipment, which highlights our diversity. This is reassuring as it’s part of a broader equation: how well consumers spend on these products, and I’m glad we’re the most diverse player in the industry.

And there is a return on investment for consumers buying high-efficiency equipment that saves on electricity costs over 10 to 15 years if there’s a return on that investment.

Thanks a lot. I appreciate it, and I'll turn it back.

The next question comes from Jeff Sprague of Vertical Research Partners. Please go ahead.

Good morning, Jeff.

Thank you. Hey, good morning, everyone. In addition to the revenues, the margins stand out here. I wonder if we could dig into that more. Obviously, you receive leverage from the year-over-year growth. However, looking at the sequential numbers, Q1 revenue is similar to Q4, as it usually is. Prior to last year, gross margins in Q4 and Q1 were similar, but now we see a substantial step function change occurring. Perhaps you could unpack this for us. I suspect it’s price on price, but maybe you can provide some perspective on how to interpret the gross margins this quarter and what it may indicate for the year?

Paul?

Yes, it’s somewhat a result of price upon price increases. We experienced price increases at the end of the fourth quarter ranging from 8% to 12%. We’ve also had secondary price increase announcements for April and May. Thus, our prices continue to rise, and as prices rise, our gross margin increases as well.

Could we discuss inventories? There’s clearly a lot of price and mix at play in the inventories as reported. Is there any disconnect in inventories regarding what you foresee in Q2? There was also a comment about transitioning inventory with the OEMs; could you elaborate on that comment and how you see it playing out over the year?

Sure, for the first question, inventory dollars are up. We’re evaluating how many units we have and whether we’re prepared for the season. Currently, we’re in excellent shape with inventory to carry us through the second quarter and into the stronger third quarter. What we face is transitioning our entire SKU range regarding outdoor heating and cooling products, effective January 1, 2023, as indicated. However, we plan to begin moving the new products in late third quarter or early fourth quarter to ensure a smooth transition into 2023. When this transition occurs, we will see another price increase due to the higher efficiency ratings of the new products.

So you anticipate selling the newer equipment in the latter half of the year, not just stocking it for 2023, correct?

Yes, we look forward to selling it in the latter half of the year.

Great. Thank you.

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

Good morning, Jeff.

Hey, good morning. I wanted to revisit gross margins. You’ve had a substantial increase over the past several years, currently at around 24.5%. And now, you see another step up. I’m wondering if there are any anomalies in this first quarter. If inflation normalizes, where do you see your margins ultimately landing, considering your price-cost arbitrage and structural changes?

That’s a great question. I think both Barry and Paul should address that.

Thanks. Good morning, Jeff. There were indeed price increases effective in the first quarter, as Paul remarked. There’s a benefit as we turn inventory, which, in this quarter, is relatively small. If we review the sequential data from the fourth quarter, the margin was 27.3%, and this quarter it increased to over 29%. This shows a benefit in what is typically a smaller quarter; this margin increase doesn’t account for the entirety but is a significant portion. However, do not just take the algebra at face value—this reflects a significant structural change in how we manage pricing. Furthermore, we work with OEMs to invest in our business, which improves the economics between us and OEMs, evident in the SG&A expenses. Part of the counterbalance to higher gross profit is found within our SG&A expenses through investments we make for long-term growth. Our parts and supplies business, which we often overlook, represents a considerable level of gross profit improvement with the technology gains in pricing.

That’s very informative. Please continue.

As we mentioned, we have price increases being implemented this quarter and reasonably assured a further price increase with the introduction of new products in Q4. Additionally, some products we sell have long-term pricing advantages, particularly in parts and supplies due to government restrictions on GWP refrigerants, creating a supply issue that will extend for at least the next ten years. A multitude of factors is in play.

Furthermore, a direct result of gross profit margin development is product mix. As we shift to higher efficiency systems, this elevates our gross profit margin. The expansion of our parts and supplies business contributes positively too, in addition to what Paul and Barry have already outlined.

That’s quite informative. On a different note, non-equipment pricing—how does it compare to equipment pricing? And could you provide some insights into growth rates in the international and commercial segments?

On the non-equipment side, we’ve witnessed lower price increases for parts than for supplies. The refrigerant prices are rapidly rising. Nevertheless, demand remains strong across both equipment and parts, despite parts experiencing lower price actions.

To answer your overall question, we have mentioned for several quarters that the overall same-store growth rate is around 25%, whether domestic or international.

And what about commercial growth?

As mentioned previously, that’s at a rate of 29%.

The next question comes from Nigel Coe of Wolfe Research. Please go ahead.

Good morning, Nigel.

Thanks. Good morning. I hope you’re feeling better. Sounds like you’re suffering from a cold. I wanted to clarify the mix side, particularly the 18% on residential—was that purely price or a mix? In an environment where consumers face various inflationary pressures, typically, we see a shift toward value brands. Is any such behavior evident with you?

Not really, we aren’t seeing any real change in brand reactions. All brands and OEMs we represent are experiencing increased sales across the board. As Barry indicated earlier in the call, most consumers only make this purchase every 10 to 15 years, so they don’t really consider the list price differences among brands.

Okay. And what would you say is the mix component of that 18%?

We don’t break it down in that manner.

On the inventory side, the message seems to indicate a shift in stocking ahead of deadlines. Should we expect to continue building inventory through the mid-part of the year?

First, let me mention that OEMs are still supply constrained, hence we have more orders due to high demand. Barry or Paul, any comments on that?

We won't see inventory build-up. The transition is unlike previous changes when moving from 10 SEER to 12 SEER and then to 14 SEER. We would quickly reduce standard efficiency units and focus on environmentally friendly options like heat pumps. It will not be a situation where the industry builds inventory of lower efficiency products to compete with new products coming into the market.

Okay. Great. Thanks. I’ll leave it there.

The next question comes from Ryan Merkel of William Blair. Please go ahead.

Good morning, Ryan.

Good morning, guys. Great quarter. What’s the outlook for residential growth in 2022? I know the team at Hardy predicts flat growth, but given this quarter's performance, that feels conservative.

Paul?

We normally do not forecast market conditions, but the market is very strong right now, and we’re adapting to that. New construction, a small part of our business, remains strong and is not showing signs of decline. We feel confident regarding replacement demand, although several factors we cannot control, such as weather, influence predictions.

Yes. We're seeing quite strong demand.

Agreed.

If you analyze closely, we mentioned in the press release the discussion on ductless systems, both residential and commercial. This product group saw a 45% growth in the quarter. Examining this growth over three to four years reveals a compound growth rate well beyond the overall industry’s growth rate. It goes beyond simply examining market trends.

Understood. To follow up, many are asking about the impact of inflation and rising interest rates on replacement rates. Historically, how have replacement rates reacted to rising rates? Should we anticipate a forthcoming decline in replacement rates?

Yes. I believe Barry can elaborate.

Firstly, consumers won’t live without our products. The real question ties back to their spending on replacements. The relationship with contractors is pivotal in that scenario. We work to provide a variety of brands and products to meet various needs. Contractor relationships are essential. Financing opportunities are also crucial; we are investing in this area. Historically, during past recessions, if we observed a trade-off between purchasing a 20 SEER unit and a 16 SEER unit, price sensitivity was noted, but wasn’t significant overall. These purchases are not discretionary.

That’s all very helpful. I’ll share this insight further. Thank you.

The next question comes from David Manthey of Baird. Please go ahead.

Good morning, David.

Good morning, everyone. Can you discuss the price differential concerning SEER ratings? Historically, this has been fairly linear with efficiency. Where does the price differential stand between a 14 SEER and a 15 SEER unit today?

The 15 SEER is a product line but not a substantial seller currently. The primary market segments are 14 SEER and 16 SEER. There’s a double-digit price difference between these two.

That’s useful information. Regarding your success in selling other HVAC products, this segment historically lagged equipment; recently, however, it has seen similar or even better growth. Can you identify the drivers behind that improvement? Is it due to incentives, training, technology?

Paul?

I’m unsure I understand precisely which products you’re referring to.

I’m referring to non-equipment products that used to lag behind equipment purchases but have recently seen improved growth rates. I’m curious to learn about the underlying causes—are they market-driven, or is there something unique to your strategies?

It is a mix of both. We are actively driving this business. It has lagged in past years and is now showing growth due to better availability of products and improved inventory management. We have resources dedicated to this sector containing people with relevant backgrounds who can drive this business successfully. We're examining attachment rates regarding units sold alongside other products. We’re putting a great effort toward this and it's something we’re earnest about.

Moreover, getting the pricing right is key. Part of our pricing optimization is recognizing non-equipment sales. Previously, the focus was primarily on equipment sales. Now, we’re leveraging technology to optimize pricing profiles tailored to our customers, enhancing market presence through e-commerce and targeted communications.

Dave, this is Rick. I’d like to add a point: three years ago, our mobile apps and e-commerce platform had significantly fewer users. As we've stated before, order line items via these channels are increasing. This quarter, we saw a 34% growth in supplies. The more contractors we attract onto these platforms, the better our future looks.

That's an excellent point.

Thank you, everyone, for the detail.

The next question comes from Josh Pokrzywinski of Morgan Stanley. Please proceed.

Good morning.

Hi, good morning everyone. Regarding gross margins, I understand numerous factors are influential, but there seems to be considerable variance between the 24% then approaching 30%. To reframe, if you were to remain in the range of 26% to 27% long-term, would you consider it satisfactory or disappointing, based on the changes observed in Q1?

We aim to do better than that. We haven't publicly outlined a specific target, but we believe that with current investments, significant improvement beyond historical margins is attainable. Multiple factors contribute to this: the wave of higher efficiency, potential government incentives for high-efficiency systems, and our rising parts and supplies business.

As you know us, we never settle for satisfaction. This company’s mission is to improve everything we do, resulting in all our outcomes. There is no threshold where we're fully satisfied. We continuously strive for more.

Understood. Given Q1 is often influenced by multiple seasonal factors, can you characterize the activity levels contractors are experiencing? Is this indicative of an early season start or a catch-up on lost installations from prior years due to workforce or equipment shortages?

Paul?

It's challenging to predict, Josh. People don't usually replace systems ahead of time (e.g., in February) if they expect issues in April. Historical trends suggest consumer behavior favors emergency replacements. Thus, evaluating consumer activity during the shoulder season is insightful. It’s during this time that price, margin, and gross yield have shown improvement over the last six months, indicating positive consumer trends.

I agree. We lack a clear way to predict consumer behavior at this time. Historically, about 80% of replacements occur due to emergencies, while only about 20% result from planned purchases. I don’t perceive any drastic changes in this behavior.

Great insights. Thank you.

The next question comes from Steve Tusa of JP Morgan. Please go ahead.

Good morning, Steve.

Good morning. Could you clarify what you meant when you said heat pumps are grandfathered in?

The heat pumps can continue being sold throughout the following year.

And this compliance remains constant, or will there still be a step-up requirement for heat pumps?

There will be a step-up requirement for heat pumps, but any current inventory is grandfathered and can continue to sell throughout the next year.

Got it. Will this apply even in the south?

Yes, that applies in the south.

Correct. The government's mandate is to reduce gas furnace use due to emissions, and heat pumps help address that issue.

In the past, you mentioned targeting a 10% operating margin; however, it looks like you are currently exceeding that. Could you describe your trajectory—is low double-digit, perhaps 15%, a realistic target moving forward?

That remains our goal—to enhance EBIT margins.

Understood. Lastly, what was the total price capture for the entire quarter?

We report only on equipment; it was at 18%.

Our next question will come from Chris Dankert of Loop Capital. Please proceed.

Good morning.

Good morning, everyone. I’d like to revisit gross margin commentary—it seems compelling. Can we summarize it by saying that critical mass in the adoption of business intelligence and operational efficiency tools drives this improvement? Is it fair to conclude these efficiency tools significantly contribute to gross margin gains and are durable over time?

Who would like to answer that? Barry, Paul, A.J.?

Barry touched on this earlier—while price-on-price improvements exist, there is a structural element as well. Business intelligence, transitioning customers to online purchasing, analytics, and process improvements contribute positively to our margins. We are consistently working towards continuous improvements in these areas, which should yield higher gross margins over time. Yes, some improvements are being realized today, but we have much room to grow.

We still have plenty of runway in implementing these advancements throughout our operations, and that's where my excitement lies.

One way to approach this is to evaluate how we can assist any customer—large or small—across any region in our platform. We’re strategizing to access smaller customers to grow their business with us through technology, effectively turning them into larger customers.

I’d like to reiterate, given the labor shortages plaguing the HVAC industry, our technology enhances mechanics' efficiency in the field, increasing productivity, allowing them to perform more jobs over time.

That’s an excellent point. I wanted to ask where do you see your hiring moving forward? Are you finding decent availability of labor?

Hiring decisions are decentralized and based on local circumstances. We are continually opening new branches, requiring additional headcount. This is a continuous motion; while we cannot quantify whether we will gain 50 new employees, local leaders make the necessary adjustments. We offer competitive health insurance and retirement plans at our corporate level, but local leaders have discretion concerning hiring.

Your regional managers haven’t reported hiring shortages as impediments to growth? It seems you are finding the necessary talent?

Not to that extent. We encounter challenges in adequately staffing. However, our decentralized approach allows local leaders to navigate talent shortages effectively without major hindrances to performance.

That’s reassuring. Thank you for the detailed insights, and congratulations on a successful quarter.

Thank you. It’s worth considering, from a corporate viewpoint, how factory branches would approach the question of what to pay and how many employees to hire. Our decentralized model is beneficial in this respect.

That’s a thought-provoking perspective. Thanks again.

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

Thank you all for your interest in our company. We’ve demonstrated our capacity to perform well, and we strongly believe we will continue to excel. I look forward to our next conference call. Bye for now.

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