Good morning, and welcome to the Watsco Second Quarter 2023 Earnings Call. This event is being recorded. I would now like to turn the conference over to Albert Nahmad, Chairman and CEO. Please go ahead.

Good morning, everyone. Welcome to our second quarter earnings call. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, President; Paul Johnston, Barry Logan, and Rick Gomes. Now before we start, a cautionary statement. This conference call contains forward-looking statements as defined by SEC laws and regulations that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Watsco delivered a solid quarter against a challenging backdrop. It was the second strongest quarterly performance in our history, which spans about 50 years, only surpassed by last year's record-breaking second quarter when sales were up 15% and earnings per share were up 33% last year. Our teams executed very well to generate this quarter's results, which came with considerable challenges, including product availability, as mentioned in our press release. The product shortages are a consequence of an immense product transition that is taking place this year following the step-up of minimum efficiency standards mandated across the United States. Approximately 60% of the equipment we are selling today represents new or revamped products. Pricing capture and margins consistency have performed well, as evidenced by our gross margin performance for the quarter and year-to-date. We are converting inventory and balancing our product offerings across our footprint. We have trained thousands of customers on the new products. We have updated our digital library to include all of the new products, adding over 400,000 new SKUs since the start of the year. The transition, however, has been uneven. One of our primary OEM partners was disproportionately impacted, affecting product availability of higher efficiency systems and, therefore, affecting our sales. We estimated a second sales impact of $75 million to $80 million, and as much as $125 million for the 6-month period ended June 30. The reality is that all of our OEM partners have been affected to some measure, and all are working to improve supply chain and help us meet the needs of our customers. Beyond the tough comparisons and supply chain issues, the arrival of hot summer weather was delayed this year, as evidenced by the decline in cooling degree days. Cooling degree days are measured by the U.S. government, so we have a lot of information regarding the demand for cooling systems during the year. Summer has now arrived, and current business conditions are encouraging. Apart from the product transition, which largely affected our residential business, other facets of the business are performing very well. Our commercial business continues to grow strong, with double digits this quarter, and our backlog of projects extends into next year. Sales of ductless systems, an increasingly important component of our business, also grew double digits during the quarter. We saw a continued trend of gas furnaces converting towards heat pumps, which we sell at higher average selling prices. Gross margins held firm this quarter at 28.1%, reflecting our disciplined mindset around price and continued progress on our investment in our pricing technology. We also exhibited good SG&A discipline this quarter, and we are optimistic about driving more operating efficiencies across our network as we move through the year. Of course, our balance sheet remains strong with little net debt at the peak of our seasonality. As always, our financial position provides us flexibility to invest in virtually any opportunity as we continue to grow and scale in a very fragmented $50 billion-plus North American market. We continue to look for acquisitions. Watsco is a great home for entrepreneurs in our space. We sustain cultures, invest in people, and provide technology to secure and build under great legacies. Looking beyond the short term, our press release provides critical details that support Watsco's long-term growth trajectory. We have an immense technology advantage, and we are investing to grow with that advantage. Our mobile preference and e-commerce channels have increased customer engagement, reduced attrition, created market share gains, and supported our margin expansion in recent years. Watsco's broad array of products and brands is a competitive advantage that allows us to serve contractors in any environment. We have a leading market share position in Sunbelt markets that provides stability and high growth rates over time. In addition, several important regulatory and industry catalysts are developing. For example, the introduction of higher efficiency standards for HVAC equipment has been fully realized this year, providing price and sales mix benefits. New refrigerant standards have historically made it harder to repair existing systems and benefit our sales of replacement systems. When the refrigeration mandate changes, it generally makes it very difficult to repair existing systems, prompting customers to purchase replacement systems instead. The phaseout of current refrigerants began last year, and the launch of new equipment that conforms to the new refrigerant standards is scheduled for 2025. We also see continued progress towards electrification and greater adoption of heat pumps with higher average selling prices. Finally, we expect the Inflation Reduction Act, enhanced tax credits, and consumer incentives to help upgrade HVAC systems in the years ahead. All of these catalysts will benefit the industry in the coming years, and we certainly believe our scale, technology, and financial strength position us to capture these market opportunities. With that, let's move on to questions and answers.

The first question comes from Ryan Merkel with William Blair.

I had a question on sales and then a question on group margins. So first on sales, you mentioned the weather, Al. Any chance you can share the July growth rate or just give us a sense of the magnitude change in sales from May and June to July?

For July, we're seeing growth, low single digits, but it's expanding, and I think it will end up with growth rates in the third quarter. What was the second part of your question?

Yes. And just in terms of the magnitude of the improvement in July relative to what you saw in May and June?

Over May and June or over the same period last year? I gave you the same period last year, we're up low single digits. Paul, if you have that answer?

Yes. I mean we're seeing definite growth rates pretty much across the board, seeing an uptick because the weather was so weak in the first half of the year. We're seeing an uptick in repair parts, which is always good for us on a gross profit basis. But really, there's not a big trend towards replacing versus repairing, whichever way you look at it. Both are starting to see some upticks.

Okay. Got it.

And Ryan, it's Barry. The question was how was June versus July; we can't be granular in that way. Obviously, June is a huge month within the quarter. So June looked a lot like our second quarter performance. July is obviously better, and that's a good thing.

Yes. That was what I was getting at. On the gross margins, everyone's favorite topic. The long-term goal is 27%. You just did 28.1%. So just unpack for us why you're 100 basis points above your target. And then should we think about the long-term target of 27% to 28%? Are you willing to make that change here today?

Well, I'm going to raise your expectations. We're shooting for 30%. Now I'm not going to give you a timetable on it, but we believe we can get there and eventually beyond that. Who wants to take a shot at his questions?

I'd be happy to. There are 5 or 6 important variables in the current performance that have improved versus 3 years ago, whenever that question was asked. I think all 5 or 6 variables have been influenced by technology, number one. We've talked about our pricing platform and how everything we sell to everyone has been influenced in some way through a pricing platform and so on. Also, we've talked about selling a lot of new products this year. We had the opportunity this year to go out and get price margin and support our OEM community with all of their new products and sustained profitability. So far, so good. Obviously, too, you have a growth in the replacement market relative to new construction, which helps margins. The overall mix of everything we're selling in terms of efficiencies and higher growth rates of heat pumps also helps margin. While I still haven't answered your question, I don't think there's anything pressing that is going to weigh on or add to gross profit where we are today. What I suggest longer term is we feel far from satisfied that we're doing all the things necessary to grow margin and get the full benefit of the technology that we put in place only a couple of years ago. The whole pricing discussion we've been having is relatively new and very far from being fully mature with benefits.

That was a long-winded answer. Was that a good one? I liked that, Barry.

The next question comes from Tommy Moll with Stephens Inc.

I wanted to start with a continuation of the pricing theme. We are potentially late in this pricing cycle, and I just wonder if you could provide any qualitative commentary on where it feels like we sit today. Additionally, if you could provide anything quantitative regarding the contribution in the second quarter, that would be helpful as well.

All right. Who is best to handle that?

Barry, do you want to take a run at that?

Sure, sure. Tommy, again, it's the same variables that we have to execute and layer costs through the market given the changes that have occurred. For the quarter, we saw about a 9% to 10% benefit to overall average selling price in our residential business or residential equipment. The 9% to 10% has very little OEM kind of inflation capture. There was some, but it was very moderate this quarter. Most of it comes from mix or from all the new products being layered in, and heat pumps, which obviously have higher average selling prices. So for the quarter and year-to-date, I think 9% is the overall average selling price increase.

That's helpful. I also wanted to ask about the disruption you called out with one of your key OEM partners. Any additional context you can share there would be good to know, in particular, can you provide the status today? Should we expect this to continue to pressure revenue in the third quarter and December?

That's a very good question. They're a great company, and they're working very hard at it and they're improving. My guess is that either through the end of this quarter or certainly by the end of the fourth quarter, they will be all caught up.

The next question comes from Dave Manthey from Baird.

Since you put it out there, I'll ask a question on your 30% gross margin target. Could you give us broad strokes, but I won't ask you for timelines, what mechanisms do you see that could move you in that direction?

There are lots of opportunities in the non-equipment side. A considerable amount of our revenues comes from non-equipment that people seem to forget. Secondly, the movement towards heat pumps creates a higher margin, and that's where the demand is going to expand significantly, motivated by federal government mandates and other factors. We have various technology enabling us to compete more effectively. So both internal and external forces can move us toward the 30% margin and eventually beyond. With this kind of scale we possess, we should be able to accomplish those goals.

This is Paul Johnston. You also see significant changes occurring with regulations over the next 5 to 6 years. We've got the refrigeration change that Al mentioned in his opening remarks, which will take effect next year, further reducing the availability of gas by another 30%. We saw a 10% reduction two years ago, followed by another 30% in 2028. We're going to experience definite squeezes on that as a commodity and an ability to sell more replacement products even from the products sold in 2024 and 2025. Additionally, we expect other significant changes, such as increasing minimum efficiency for gas furnaces to a minimum of 95%. We feel confident that will occur. There’s potential for an additional refrigerant change, where the government could reduce the global warming potential from 750 to 500. Whenever there are changing market dynamics, I think there's an opportunity for upside in gross profit for Watsco.

Yes, please don't take me literally regarding expecting a timetable for 30%. That's an aspiration, but we feel confident we'll get there.

No, that's great color. I expected to be shut down on that question, but I appreciate all of the details.

Well, I went to the resource, I knew we talked them also. You're good. You're good.

Absolutely. One second question relates to tech spending. If you maintain a run rate of $55 million now, that's about twice what it was when you began developing tools and populating your databases. I wonder if you could help us understand the key tech spending priorities and the categories you're focusing on today?

Are you asking who the big spender is?

Yes, yes. We've consistently stated our tech spending is going to pursue a limitless array of opportunities to apply technology, innovation, process improvement, and smart thinking throughout our operations. We've been at it now for 10 to 12 years, and I believe it's significantly impacted our business. With the advent of generative AI, there's a brand new world of possibilities. We are deeply involved in that opportunity as well; it’s changing very rapidly. So a somewhat ambiguous answer, but we're going to continue investing because we know it's right for the long-term health of the business.

And we might invest more. I think we will. We've been investing more every year. This company is very focused on the long term. I know an analyst asked us last year when we plan to stop investing, and I responded that we're never going to stop. This is our advantage, and we will continue to increase it.

I think – yes, just to add some perspective for your sake, David, roughly 300 people in technology are included in that $55 million figure. What isn't well understood is that probably two-thirds of that headcount is actually in the field with customers. They're not sitting in a corporate ivory tower developing new technology; we have that too. But a lot of the new investment is devoted to helping customers and growing both existing and new customers in the field level. It's a ground game that's evolving in local markets.

It's worth reiterating that our customers who utilize our technology are better customers. Their growth rates with us are higher, their attrition rates are lower, and our cost to serve them is lower. As we increase the number of customers using the technology more frequently, it benefits both the company and the customers.

The next question comes from Josh Pokrzywinski with Morgan Stanley.

Josh, are you liking us better recently?

You guys have done all right, Al. I'll give you that.

Thank you. Thank you.

A couple of questions here. Maybe one just kind of sticking to the quarter itself. Barry, I know you provided some good insights last quarter regarding some of the moving components in gross margin, essentially between selling initiatives and inventory or inflation margin phenomena. There was an extra wrinkle in the second quarter with the timing of price increases; could you give us some bridge items to unpack that?

Sure. In general, the selling margin, which reflects price versus cost, did increase in the quarter. This is a high-quality, important component of gross profit because it constitutes the largest component of our performance. Without considering the pricing actions taken in the quarter, pure quarter-over-quarter, year-over-year quality of margin improved. Below-the-line items remain fairly flat. Freight costs, where we pay our vendors to deliver items to us, still lack some of the savings we would like, as we're undergoing a significant inventory transition. However, nothing too remarkable has occurred either way. The key takeaway is the selling margin, reflecting the dynamics of price and cost in the market, was positively impacted with no influence from pricing actions.

Got it. That's helpful. And then perhaps philosophically on heat pumps. With all the stimulus available, especially the IRA, I understand these have a higher price point. However, do you sense that OEMs or the industry at large are raising the price of pumps disproportionately to capture some of that versus letting it all flow to consumers? I'm curious how you see the pricing strategy evolving as the IRA gains importance.

We finally received clarity around the IRA that the tax credits are now published by the IRS, detailing which equipment by model and SKU qualifies for the tax credit. We learned of this just this week. Because of our technology, we were able to quickly communicate this information to a couple of hundred thousand people through our dealer apps. We haven't really felt the benefits of this yet. Historically, there's been a disparity between heat pumps and straight cool systems due to the different components and electronics involved. Currently, I don't expect any real increase in heat pump margins because of the IRA. The two don't seem related, as we haven't seen any impacts on sales from higher rates. We finally have recommendations for states from the DOE on managing rebate programs for mid- and low-income citizens. We likely won't see any results until the end of the first quarter or the beginning of the second quarter next year.

The next question comes from Mitch Moore on behalf of Jeff.

How much inventory do you want or need to take out in the second half? I think you said you'd address inventory levels once you had a better handle on the selling season.

I sense we are capable of removing another $200 million when things settle down, and that will be helpful in terms of inventory turns and cash flow.

I would agree. That's a fair assessment.

Great. And then just one more. On the SG&A line, what can you do to temper decrementals if we continue to see volume declines in the second half?

I can answer if you'd like, Al. First, to be conservative, if you're asking to be cautious about the top line, SG&A is indeed a focus item. SG&A decreased this quarter, which is good. Inside that number, variable costs have decreased in the teens, between 15% and 20%. We expect that to reflect changes in the top line. Fixed costs increased by 4% in the quarter, which still indicates inflation and does not fully reflect productivity improvements our teams have emphasized. I can't predict the exact destination for SG&A, but it's clear that this second quarter was better than the first in terms of trends. There's significant effort underway to analyze SG&A for the remainder of the year to see how we can further reduce it. This would aid the decremental equation, and any growth would certainly enhance earnings growth rates.

The next question comes from Brett Linzey with Mizuho.

I wanted to revisit the refrigerant changeover starting in '25. Clearly, the regional SEER transition created some obstacles for Watsco concerning the OE issue. How do you view this change impacting your strategy on prebuying next year to secure more inventory?

That's a good question for Paul. He follows it.

We have discussed this with all of our OEMs. Currently, we're not considering a prebuy. I don't think anyone is looking at prebuying 410A given the anticipated 30% reduction in GWP allocations for next year, which will reduce allocations to 60% of what was set in 2011. We're expecting a further reduction in 2028. Offering a unit and performing a prebuy where the refrigerant will be in short supply or very expensive is not a prudent business opportunity for anyone.

Understood. I also want to ask about the consumer backdrop, particularly mix. Are you observing any indications from credit metrics across the organization or specifically regarding the composition of parts growth versus equipment that could suggest a shift towards repair versus replacement?

We primarily analyze two components when assessing repair quality versus replacements: motors and compressors. We are seeing an uptick in both as of July, which we did not observe in the first half of the year. An increase in repair business indicates more repair activity. We also monitor warranty claims back to the OEMs to ensure they align with the marketplace and gauge whether units require repairs under warranty. So far, as I mentioned earlier, we see an increase in repair business in July, but I wouldn't categorize it as a major trend yet. It’s only been three weeks of data, but it’s positive and I’m encouraged.

The next question comes from Steve Tusa with JPMorgan.

My first question is, who had the sweet pipes at the beginning of the call there? That was nice singing. Good job there. I know Barry doesn't sing, so maybe it was Paul; I'm not sure. Anyway, there are reasons to celebrate with those gross margins, so congrats on the continued execution there. I wanted to clarify your commentary regarding July. You said you were up low single digits, and I assume you see a bit more growth from a like-components and repair-related product perspective. What was the equipment unit volume looking like? Would that be down in high single digits in July?

Paul? Barry?

Yes, I would say it is. Barry, do you want to take that?

When we discuss growth, we’re referring to the entire business, Steve. Our parts sales aren't significant enough to matter in that equation. They are up, but they don't notably influence overall growth. We see the continuation of price that results in higher average selling prices. There’s probably a single-digit decline in equipment unit volumes, if I use common sense, that’s about it. Keep in mind, we’re still up against last year’s tremendous growth rates of 15%. So for July to show some growth is a good sign.

I find it difficult to reconcile something. You had a tough time with supply, yet your inventories are substantially up. Can you clarify how those two dynamics align?

Barry is the accounting expert.

Steve, the irony of your question is that if you took our data and looked through it, you would find that the overall units—including indoor and outdoor units, ducted, coils, furnaces—are down in June compared to a year ago by a single digit. So your question concerns why inventory is higher, right? First, the cost is up. The mix is richer. Part of the reality is we own inventory this year that entails new products. Every business that has emptied out 60% of its offerings in the last 6 months carries new products priced roughly 10% to 12% higher. Every customer price list and technology has been updated over the last 6 months, which has complicated our measurements. Simply put, while units are down, inventory is up due to cost increases and richer mix.

Got it. One last question regarding the product transition dynamic. As your supply partners come back on line, will you start shipping back to them as they become capable? My assumption is you accepted more inventory from others to compensate for the recent quarter?

Yes, our approach here is about balance. This means ensuring that each store has matching systems that fulfill customer needs, whether through calls, emails, or e-commerce. The balancing act involves having the right inventory mix to meet local demands. This has been challenging as OEMs need to manufacture matching systems while transitioning to a mix of new products desired by customers. Overall, balancing inventory isn't complete yet due to this transition. We fully intend to support our OEM partners and make up for any sales or market share losses experienced.

Got it. Lastly, you mentioned that inventories are down, and your sell-through unit numbers are also down, likely more than expected. If someone were to assert that industry residential HVAC unit inventories are balanced, or that destocking is complete, it seems that isn't the case for you, as you still wish to reduce inventory by another $200 million. It sounds like there's still room for improvement.

Yes, some destocking remains. To achieve the proper inventory mix, we need the appropriate indoor and outdoor units within our inventory. The backlog for commercial units still shows robust demand, and there’s a solid pipeline for jobs to be completed. We may need to take steps to reduce inventory by $200 million while balancing our product offerings.

The next question comes from Joe Ahlersmeyer with Deutsche Bank.

I want to follow up on the previous comments made regarding commercial. You mentioned the double-digit growth in backlogs extending into next year. Could you provide insight into whether those backlogs are decreasing at this time? Are your current sales outpacing the volume added to those backlogs?

Good question. Paul, you have the data.

It varies depending on the type. Commercial applied is generally related to made-to-order jobs and continues to show backlog increases. Regarding commercial rooftop units, supply now equals demand, resulting in stable backlogs. In summary, it’s a mixed overview when examining all commercial components.

Got it. One more question. What percentage of your commercial business would you attribute to repair and upgrade versus new construction? Previously, you mentioned less interest in new construction due to price and margin dynamics. Regarding the residential side, do you have an estimate of how much heat pumps could comprise your overall equipment business today?

Again, there's a mixed aspect when discussing commercial. For applied businesses, new construction is typical because these are made to order for specific buildings. For rooftop units, our focus has historically favored replacements. Regarding heat pumps as a percentage of our total business, I think you can find that information on the HRI website. Heat pump sales surpassed gas furnaces in 2022, now accounting for approximately 40% of the market. Watsco likely has a greater emphasis on heat pumps than most businesses, primarily because of our strong presence in warmer regions. However, as technology evolves, we expect an increased push for heat pumps in the northern climates as well.

The next question comes from Damian Karas from UBS.

I appreciate the details shared about pricing and mixed benefits. Are you observing any signs that competitors are becoming more aggressive on price as inventories are being worked down, or do you feel the pricing mix uplift remains consistent across the market?

I would say it's been fairly consistent. We haven’t really seen any breaks. Sure, if you ask the salespeople, they might say pricing is going down, but inspecting the reality of it, the marketplace remains generally disciplined, and we have not observed a decline in equipment pricing.

Understood. I appreciate that. A follow-up question on the refrigerant change. You will effectively have multiple refrigerants competing, which is a shift from previous cycles. I believe you work with OEMs on both sides of this spectrum. I’m curious how you see this dual refrigerant dynamic affecting Watsco.

One of our companies is adopting 32A, while the rest of our companies will go with 454B and 410A. It’s quite divided among our companies. We have one entity that will manage both 410 for repairs and 32A for new equipment. I don’t view this as a significant issue.

I would like to turn the conference back over to Albert Nahmad for any closing remarks.

Thank you again for your interest in our company. We appreciate it and look forward to speaking with you next quarter. If any of you would like to visit us to learn more about our technology and innovations, feel free. We are happy to provide you with valuable information. Thank you for listening, and see you next time.

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