Good day and welcome to the Watsco Third Quarter 2023 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Al Nahmad, CEO. Please go ahead.

Good morning, everyone. Welcome to our third quarter earnings call. This is Al Nahmad, Chairman and CEO. With me is A.J. Nahmad, President and Paul Johnston, Barry Logan, and Rick Gomez. 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, on to the quarter. Watsco delivered a record quarter, which is all the more rewarding given a record performance achieved in the third quarter last year. Last year's third quarter was a barnburner. And so, I am so happy we are able to beat that. Sales grew 4%, driven by a 6% increase in HVAC equipment. Residential unit volumes steadily improved throughout the quarter, and price realization continues to be strong. Commercial end markets also remain very healthy. As a reminder, we have navigated through immense product transition in 2023 following the step-up minimum efficiency standards mandated across the United States by the U.S. federal government. Approximately 60% of the HVAC systems we are now selling represent new products. Let me repeat that: 60% of the systems we are selling are new products. Thousands of customers have been trained. Our digital product library has been updated, adding over 400,000 new SKUs since the start of the year. As mentioned in our second quarter call, one of our primary OEM partners was disproportionately impacted by the product transition affecting product availability during the summer selling season. That impact diminished during the third quarter, and I am happy to share that our locations are now fully stocked. Sales growth has returned to the effective stores, and our partner is aggressively investing and collaborating with us to drive growth. But the reality is that all our OEM partners were affected to some measure, and all have improved their supply chain to help us meet the needs of our customers. Here are some other highlights. Our commercial business continued to grow at a healthy double-digit rate 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 the continued trend of gas furnaces converting towards heat pumps, which sell at higher average selling prices. SG&A as a percentage of sales decreased by 80 basis points this quarter, a good start to what we feel is an important opportunity to improve productivity and overall efficiency. We are optimistic about driving more operating efficiencies across our network as supply chains improve and operating conditions return to normalcy. We have the tools, the technology, and most importantly, the entrepreneurial culture to achieve more, particularly related to our internal productivity. We are focused on internal productivity. And of course, our balance sheet remains strong with a small amount of debt offset by cash; in other words, no debt. As always, the financial position improves – the financial position provides us the flexibility to invest in virtually any opportunity as we continue to grow our scale in a very fragmented $50 billion plus North American market. M&A remains an important contributor to growth. This quarter, a great family business joined our family with the acquisition of Gateway Supply in South Carolina. I have spoken to the principals, and you couldn’t ask for higher quality people. Gateway is a legendary company in its Sunbelt markets and provides us with the ability to partner with great leadership to grow beyond their current $180 million sales run-rate. We continue to look for more entrepreneurs and businesses to partner with. Watsco is a great home for entrepreneurs in our space. We sustain culture, invest in people, and provide technology to secure and build under great legacies. Looking beyond the short-term, our press release provides critical details to support Watsco’s long-term growth strategy. We have an immense technology advantage and we are investing to grow that advantage. Our mobile platforms 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 brand is a competitive advantage that allows us to serve contractors in any environment. We have a leading market share in Sunbelt markets that provide stability and higher growth rates over time. We have also made important technology investments with our business that will support margins and productivity in the years to come. In addition, there are several important regulatory and industry catalysts that are in effect, which are listed in today’s press release. All of these catalysts will be good for the industry in the coming years, and we believe our scale, technology, and financial strength position us to especially benefit from these opportunities. With that, let’s go on to Q&A.

The first question today comes from Tommy Moll with Stephens. Please go ahead.

Good morning, Al. Appreciate you taking my questions.

Of course.

I want to start on the topic of gross margins. I don’t imagine you will get any more than a question or two on that today. But just to start the conversation, what can you tell us about the drivers, headwinds or tailwinds from your second quarter to your third quarter results? And then associated with those, if I look over the past few years, the margin rate tends to improve as you move into fourth quarter from third quarter. Is there any reason that should not be the case this year? Is there something else going on that you want to make sure we are aware of?

Well, I am going to turn that over to two persons, A.J., the President and Barry Logan, our Chief Financial Officer.

Good morning, Tommy. Yes, we had a bet going. Would it be the first question would be on margins or would it be every other question?

For the first 10.

Exactly. So I’ll let Rick and Barry get into the details, but I wanted to spend a second in here and abstract as a layer and talk about the big picture. And start with reminding everyone what Barry usually reminds us of is that there are many components to our gross margin. There is the transaction margins or what we make on an invoice-by-invoice basis, on a markup basis if you will. There are cost changes that come from the 1,000 or 2,000 manufacturers that we buy products from. There is volatility in commodity items that we sell. There are internal pricing actions with our optimization tools that we are getting more fluent in. There are product delivery costs. There are product mix changes between commercial and residential equipment, supplies, etc. So there is action in all of these categories all the time. But what I want to get across is a reminder that we are a long-term company. And quarter-to-quarter, there is going to be noise and actions in all those categories, but we are focused on the signal. And as we have said, the long-term aspirational goal of margins is 30%, and we see that within reach in time. And let me tell you why. And really, it starts with what we talk about a lot, which is our technology, but we should really call our continuous improvement culture. What the technology enables is our teams to be able to do analytics, to spot opportunities, enhance our capabilities, measure and track our successes in all parts of our business. Things like prospecting and winning new customers and changing and improving how customers engage with us with things like e-commerce and our apps, which eventually reduce our cost to serve those customers. We can increase with the tech or the continuous improvement. We are increasing our productivity levels in the warehouses. We spend a ton of money moving cost in and out and through our network and our fleet and transportation, which is now another frontier how we can use technology to improve what we are doing there. Optimizing our inventory, we have talked about a lot, and there will be meaningful gains there. Marketing and sales is a new system that goes on and on and on. But that continuous improvement culture or what we call technology, so it’s a tool set to win in the marketplace and increase our – what we do and margins will be part of that. Higher gross margins will be part of our – is part of our DNA and more importantly will continue to grow profits and generate a lot of cash. But quarter-to-quarter there will be noise and I know that, that’s very interesting to you all. Rick and Barry and Paul can much more eloquently answer questions about the noise, but I want to make sure that, that big picture was communicated and a reminder that we are a long-term company and long-term we expect to have not only strong gross margins but continuous growth. Yes. So Barry, I don’t know if you want to jump in and answer a specific question, but I wanted to just to have underlying the conversation here.

Okay. That was well done. And Rick, too, you both can jump in wherever you want.

First, I think there are two to – if I become the analyst for a second, there are two things to analyze, right. There is year-over-year margins, and we are talking about a 90-day period, and that’s okay, we have to address it. But I wouldn’t get in this box of thinking that every 90-day period is like a new conversation; that’s not. It’s a continuous process, as A.J. suggested. But if I go ahead and put myself in the box and talk about it, obviously, our equipment business grew nicely this quarter. Our non-equipment business did not, and that’s in the press release, 6% growth in HVAC equipment, 4% decline in other HVAC, and there is a margin difference between the two, and that mix is about 30 basis points year-over-year in terms of just pure big impact of margin. And so if the question beyond that is what happened to non-equipment, that’s where our commodities reside, 6% of Watsco is refrigerant, copper tubing, and sheet metal products. Deflation in those products in the quarter cost revenue. Pricing of those products has improved throughout the quarter and is more well-established today than it was 90 days ago. So that’s good news. But those are some break considerations there. Also, obviously, our commercial business, somebody will ask later in the call, grew double-digits. That would mean our residential business was single-digits. There are a few basis points of margin there; if you again stay in the box of year-over-year change in gross profit margin. Sequentially, which is your question, Tommy, if I finally get to your question. Sequentially, we talked about last quarter having OEM pricing actions that took effect in March benefited the margin in the second quarter. That’s a nice, again, algebraic benefit to that quarter’s performance. Sequentially, no such thing occurred. And that’s the noise that A.J. is referring to; you just can’t get trapped in 90-day periods and try to gain inferences over a long period of time. So if I kind of wrap it up and Rick, maybe you have more, but the concept of, let’s look at the last 12 months being 27% and change; that’s very consistent with what we’ve been saying. And to add to that in the future, where the aspiration is 30%, the other credibility in that is we have business units within our portfolio of business units that approach that number today. And we certainly have locations that are in excess of that today. So when we talk about continuous improvement or looking out to a horizon, that’s the perspective. Rick, I don’t know if there is anything – we are going to talk about this all day, Rick and I, but it will be boring, Rick?

I can’t expand on it. I would only – I would just add a data point, Tommy, that when you look at the year-to-date margin picture, right, let’s take a more medium-term perspective on it. It’s almost a rounding error as compared to last year. And I think that’s an achievement on our part, given the unit environment we have been in and given the relative lack of price that’s been in the market this year relative to last year to say that there is only a 20 basis point difference; I call that a good outcome.

Thank you, all. I’ll pivot to a forward-looking conversation here and I hope that we could advance the conversation around potential revenue impact next year and into 2025 from the coming refrigerant regulations. The OEMs have certainly been more vocal here. We have heard that the impact could be as much as 15% to 20% cumulative price over the next couple of years. And so my question for you is, does that sound like a reasonable range? And if you unpack the dynamics here, what do you expect to see in terms of impact from the pricing on the new equipment? And what are you seeing now or what do you think you might see on the existing equipment configured for R410, where there will be a big curtailment of supply as you head into next year?

So let me call on Paul Johnston for that.

Yes, easy question here. I think what two of the OEMs have announced that they think it’s going to be in the 10% to 15% range. We’ll just have to see what movement they have on that. There are going to be higher costs in the new products. And obviously, those are going to be reflected in higher prices. I think as we move into next year, we are going to find out more and more about what the regulations actually state and what the regulations allow going forward into 2025 as far as the curtailment of 410A equipment. And I think that’s really the open question that we have right now. Obviously, at some point, we are going to be 100% 454A or 32A refrigerant, which are going to have higher prices, because they are slightly inflammable. There have to be safety devices on the units. It is going to increase the price of the products. There is no doubt about it. I am not going to give you a forecast what I think it’s going to be, but it will be higher than what we are seeing right now. It’s the new higher efficiency products that we introduced this year.

And just on the existing equipment configured for R410, are you seeing anything or hearing anything or expecting anything as you move into next year where the refrigerant itself is likely more expensive and what that could mean for overall equipment pricing there?

I think there is going to be – there is going to be some increases. There have been increases here recently in the last couple of weeks on R410A. It’s a matter of what the refrigerant manufacturers are – how they are going to handle their new allocations. Their allocations for GWP products were reduced by 30% for next year. And so they are going to have to come up with their formulas internally that would determine how much R410A they can afford to make versus some of the other lower GWP products given their allocations. And then secondly, we get into the long-term issue; we’ve got another 30% reduction coming in 2029. And when that occurs, I think you are going to really see a crunch, if you will. But right now, we are just – we are trying to ferret out exactly what the regulations, how they impact the OEMs, how they impact the service level for the contractors that we work with, and what’s going to be the long tail or short tail of existing R410 equipment in the market.

Thank you, all. I appreciate the insight and will turn it back.

The next question comes from Brett Linzey from Mizuho. Please go ahead.

Hey, good morning. Yes. So just the first question regarding HVAC equipment growth, a nice snapback up 6% in the third quarter. Do you think there is a little bit of catch-up from some of the OE issues you had in the second quarter? And then any comments just on underlying replacement activity does continue to show some resilience here. But just curious if there is any cracks in terms of metrics or ticket size, etc.?

This is Paul again. I don’t think we saw any real change in dynamics as it relates to the replacement market. The replacement market remained healthy and strong, and a lot of conversation, a lot of debate going on. Are we moving to a repair versus a replace type of market? Our indications are slightly – we are seeing a slight uptick in parts, which shows up in our numbers as far as compressor sales, motor sales, those types of things that would be a repair item. But really too early in the game, and it’s – we are not really seeing any real trends yet. But I think the consumer is replacing the equipment with a higher efficiency product, and we are all happy for the consumer.

Yes. Great. And then maybe just one on price. So you’ve been talking about the price optimization software and some of the deployment across the organization. I’m just curious how you think about price capture above sort of normal course of business as you think about some of the surgical opportunities on price and various SKUs across the line curve there?

I mean I’ll handle some of that.

Yes, go ahead, Barry.

Yes. I mean, first, I just want to say this that when we say 60% of our equipment products or new products, that’s obviously a huge inventory conversion. It’s also a pricing and margin execution process. Everything is new. Everything has a new price. Everything had to be prosecuted in the market with our customers. And – so this year, for example, 8% is the price increase achieved on our residential products. This quarter and year-to-date is about the same. So it’s consistent through the year. By the way, units this quarter were down 4%. Obviously, last quarter was down double digits. And if I account for 1 less selling day this quarter and look at – start to look at things a little bit pro forma, the quarter’s units were near flat, if I look at it that way. So price and units are combining to help business. And that’s just the – that’s the equipment business. A.J., you’re going to talk about the broader picture now.

Yes. I just – we talked about the pricing optimization a lot, and it’s not one thing. It is hundreds of opportunities across every product we sell to every customer in every location. So just that one maybe small example would be, if you say, everybody sells the same, meaning all of our business units just in the Florida market or Miami market a Honeywell 1, 2, 3 APC thermostat. And maybe there are 3,000 customers that bought that thermostat in the last 6 months. Well, it probably is at 3 different – 3,000 different prices. And there is wide variation in that sale price. Well, now with this tool, for example, what we can do is understand all those sale prices of that same thermostat in the same market, and we can do some rationalization and some floor setting and making sure that the right customer, meaning larger customers are getting a more appropriate price, and smaller customers who haven’t earned a lower price being getting a price that’s right for them. And that’s – if you do that one at that micro level, but you multiply it times hundreds and hundreds of opportunities, that’s part of the effort that’s going on now, and it helps. It’s going to help drive margins and it’s going to help, in fact, sell more products because it’s not always about raising price. It’s about getting the price right so that customers find it attractive and want to purchase the product from us as well.

Got it. Appreciate the insight.

The next question comes from Dave Manthey with Baird. Please go ahead.

Good morning, Dave.

Thank you, good morning, Al. In the press release, you noted potential for additional productivity gains as operational complexities abate. And I’m just wondering if you can outline the key remaining complexities that would represent the biggest opportunity over the next 6 to 12 months?

That’s an interesting question. Who wants to deal with that?

Yes, sure. Hi, Dave. Good morning. Yes. I mean I don’t think I’m overstating it by saying it’s been the Wild West out in the field the last couple of years, and all of that supply chain imbalance weighs on that same-store productivity equation. And so what you’ve seen in the last few quarters is variable SG&A reacting to a different end market. But more importantly, what we’ve been working on the last year or so is a lot of energy into understanding our own internal productivity. And we’ve armed our leaders with real-time data that should help drive this in the field. They know this is a priority and they are responding. But that – this productivity journey that we’re on is going to take some time. It encompasses a huge number of things. It starts with how we order and receive product from 2,000 suppliers. And we talk about supply chains getting better, but they are not better everywhere just yet. Commercial is one example. And you asked where are the pain points still? That is still a pain point in the supply chain is commercial and high-efficiency product. But it starts with how we receive product from over 2,000 suppliers. It impacts the real estate footprint, how we fulfill orders in the warehouse, and finally, how we deliver product to customers. That’s really the what this productivity effort encompasses; it’s a lot of things really from the very beginning to the very end of our processes. And so we’re starting to see progress, but there is a lot more to do. And I think, big picture, two thoughts, I’ll leave you with two thoughts. One is that I think our growing scale naturally enables more efficiency, right? As a $7 billion company, we have more opportunity to be more efficient than we did as a company half our size four years ago. And secondly, we possess the technology and the tools to drive this productivity throughout our network. And you’ll note in the press release that we talked about what some of those internal investments have been in the pricing technology that A.J. just talked about, the warehouse management and order fulfillment technology. Some interesting work going on around logistics in our network. And so over time, that will bear some fruit in productivity and that will – we’re starting to see the benefits of that today and not just variable SG&A reacting, but fixed SG&A reacting as well.

Thank you.

I’ll double click on the last one, the logistics and transportation delivery. That is the third biggest expense for the company. About $200 million we spend moving products in and through and around our network and delivering products to customers. And I call it our next frontier of opportunity for continuous improvement. I think there are about 800 trucks in the fleet today. But there are now, with the data being exposed and smart people taking smart actions, we’re realizing that some of those trucks are sitting idle for 90% of the day. It doesn’t make sense to have that truck or maybe use a different means of transportation to get product from point A to point B? Or can our business unit share trucks? Or is there a more efficient route to deliver the product? So all those questions now about the millions of times that we’re moving products around our network in and out and through to customers are open season on that effort, and it’s a big bucket. So we’re going to move a needle on a big bucket.

Okay. Thank you for that detail. And second, could you give us your take on Governor DeSantis rejecting IRA funds?

We do not expect political risk. And we are not going to talk about that. Next questions.

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

Good morning, Nigel.

Thanks. Hi, guys. Thanks for the questions. So inventory. Can we talk about where we stand right now on inventory? I think you’ve said in previous calls, maybe $200 million of reduction for the full year. Are we still on that track?

Well, that’s a good question, and I’ll turn it over to the executive that’s taking care of that for me. Go ahead, Paul.

Alright. Yes, we can expect that. We’ve been delayering our inventory now since the season ended, and we’re seeing great progress. We’ve set goals for each one of our operating units. We track them daily with our ability to identify what we have on order and what our sales through is – sales output is. And we’re seeing definite reductions month over month, day over day.

Okay. So that implies fourth quarter should be a big source of funds from inventory. That’s the way to read that?

It better be. I would – okay. I would not want to pigeonhole into that. We’re not giving you that kind of...

Okay. I think just – with the question.

Yes, we’re very focused on it. Don’t forget that during the – all these delivery issues that we had to do things that we normally don’t do, the producers couldn’t ship partial the order and that sort of thing. And it takes a while to get that inventory we have to be what it should be in terms of complete systems and that sort of thing. But we’re working very focused. And yes, I do plan to take out that kind of number and improve our cash flow along with it.

Okay. That’s great. And my follow-up question is around the 410A phaseouts. I mean I think the EPA, the way that it was written right now, I think it’s an installation deadline as of January 1, 2025 as opposed to a production deadline. So how are you guys thinking about that in terms of managing 410A inventory levels? And how do you think the 454B availability will come through next year?

Are you asking about the new EPA?

Yes, I think...

Yes, it came out last Friday night. Yes, everybody is still working their way through it. Basically, what it provided was that the outdoor unit becomes a component and hence, can be replaced as a repair item or a system that you can’t install systems, indoor and outdoor units, but you can repair by putting in an outer unit. And that’s got a lot of ramifications, which I don’t know if really have been thought all the way through by the people who wrote it up. For instance, how can you make sure that the coil on the inside matches the outdoor unit, which is only going to be the higher efficiency product? So if you’re putting in a 15.3 outdoor unit with a 13 or 14 SEER indoor unit, you’re not going to get the efficiency that you’re paying for, for the outdoor. And then secondly, I think we’re looking at a difference from when we went through the transition between R22 and 410A. This one is different. It’s different in the regard that there is no replacement for 410A. There were other replacements that you could drop in that would replace the R22 that aren’t going to be available with the new product. Also, a lot of questions that I think we need to ask our OEMs, and OEMs will have to answer the question what’s going to happen to the price of the 410 units because, obviously, the production will be lower from the OEM, will that raise the price of the product? What’s going to happen to the availability of 410A to make the repair cost so the repair cost would be acceptable to the consumer? What happens to the 30% to 40% of the installed base, which is still operating on R22 where you can’t change out the outdoor unit with a 410A unit? So I’ve got a lot of questions. I guess I don’t have a lot of answers for you. That’s – but those are things that we’re thinking of, and we’re working with our OEMs and working with the refrigerant manufacturers to try to figure out how all this is going to play out and not only in ‘24, but also in ‘25 when we do the actual rollout.

Thanks. Look, you actually have more questions than I did. So – but it sounds like it’s a little bit too early to have a view, but I appreciate the context. Thanks a lot, guys.

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

Good morning, Ryan. Good morning.

Hey, morning. Good morning, everyone. Nice quarter. So I wanted to ask about demand trends through the quarter and maybe even through October, just given the fears out there about consumer spending starting to decline. Just update us on what you saw through the quarter and into October?

Barry?

Hi, Ryan, yes, I mean, very consistent, I would say, throughout the quarter and quarter ended. If I looked at September, for example, just to say it that way, it looks like the rest of the quarter, so pretty consistent throughout – October is only a few business days, and it’s our biggest month of the fourth quarter last year. So, not quite the same answer, but all of our field checks, talking to our people see a good fourth quarter.

Okay. That’s helpful. And then I had a high-level question, too, that’s probably hard to answer, but we all see the price increases coming 15% to 20%. And then obviously, there has been a lot of price increases on equipment the last few years. How do you guys think about sort of the impact to the consumer? Are they going to be able to afford these systems? Is financing going to need to be a bigger part of the HVAC industry? How much worry do you have that there will be more sort of repair versus replace?

That’s an interesting – we think about things like that. As you may or may not know, we now have a financing platform ourselves, and it’s probably – when we speak consider the most user-friendly platform that exists for a customer to find the loan that we want to finance it. So – anyone, do you want to take a shot at a more sophisticated answer?

Yes, there is a concern. Is there an elasticity issue here where we’re going to reach a point where a consumer can’t afford it? I don’t – I still feel like this is a necessity of life that people have to have heat, have to have cool. Also, we’re seeing a lot more interest; obviously, we really haven’t felt the impact of 25C as far as the tax credits coming into effect for the higher income people. The rebate programs that hopefully will start maybe in the second or third quarter of 2024 should start picking in now support at least with an $8,000 rebate to the medium and low-income consumer to be able to replace their unit and their system. But the consumer so far has been fairly resilient as far as taking care of what I would consider to be an absolute need for life, if you will. Also, we’re starting to see a lot more activity around what utilities are doing, what states are doing in the area of the weatherization programs and that type of thing. So maybe that’s a little bit of pollyanna, but I think going forward, the consumer is going to have to figure out which programs work out best for them so that they can be replacement. And with the financing is going to help also.

Yes. I think affordability has always been a question, and yet the industry has grown 3.5% compounded for 30 years, and things are obviously always more expensive over time given all the regulatory things. So I would just point to that as a long-term reality of it. But Ryan, if I give you an interesting answer, I just recently took out a system in my home, $6,200 was the bill. Contractor did it in a day. They expect it to be paid that day. And I was curious; I went back and looked at our cost to him, meaning our revenues, what did Watsco sell that guy in my $6,200 installation? And the answer was around $2,900. So the layer – my point is there is a layer in this called the contractor that’s also a very important layer of both profit and cost and consumer price and so on. if our cost of goods went up 10% because of regulatory matters, that’s $270. That’s something the contractor would have to decide how to pass that on or what to do about it. But there is this entrepreneurial thing, and it’s really doing a lot of the work called a contractor, not just Carrier or not just Watsco, but the contractor, and that’s where all these tools we’re talking about, how do we help the contractor sell products? How do we help them grow their business? How do we help them digitize our business? How do we help them improve their business processes? How do we cater to that clientele that’s growing at a much faster rate and build on it? So this whole idea of how we’re approaching the contractor gets beyond just the economics of a price increase. It really is a much bigger picture that we’re after.

Yes, makes sense. Alright. Thank you for the color. I will pass it on.

The next question comes from Jeff Hammond with KeyBanc. Please go ahead.

Good morning, Jeff.

Hey, guys. Good morning. Just want to come back to this regulatory issue. I know there is a lot of uncertainty. But like is your expectation that the split system kind of needing to be installed kind of sticks? And if that’s the case, just how do you think about transition timing? Are the OEMs going to be ready to kind of start getting a new product? This kind of brings in kind of inventory obsolescence. Just maybe talk a little bit more about that.

Yes. I think all of our OEMs are geared up to have the new product and hopefully, we can start introducing product in the second and third quarter of next year, the new product. So I really don’t have a lot of concern that they are not going to be ready. They will be ready. And then on the 410 transition, your guess is as good as mine. If they allow this to continue the way it’s unfolding right now or has been written up in the latest blurb we got from the EPA that means R410A units will be available indefinitely until we run out of the ability to supply them with R410A. But I think that’s not a good move for the consumer; and the consumer would be much better off with the longer warranty period as well as having a new machine that actually is operating to specs, and improve their overall efficiency in their home. So, it’s a guess as far as whether or not the EPA is going to continue on this path, where are they going to change their path or modify it in some way, we don’t know.

It seems like the R22 drive ship over again, but…

It is. As I indicated, that was different at that time because you had all these drop-ins available and the consumer could rely that they were going to have a unit that would be serviced for the 10-year or 12-year or 14-year lifespan of the product. We don’t have that certainty this time.

That’s another one of those questions added to the list of questions is what does warranty look like on our R410A products moving forward when 5 years, 10 years – 5 years to 10 years from now, they didn’t even be serviceable.

Yes. And then just on this 30% gross margin target, I mean I think you put it out there maybe a quarter or two quarters ago. Just level set us on – as you think about the path from 27% to 30%, what do you think the biggest buckets of opportunity to kind of get there over time? Thanks.

I will answer that. We have a lot of pockets of opportunity, and we will just have to take one at a time and see how we get there, but we have folk, we have ambition and knowledge and the financial capability to achieve. And at some point in time, our goal, that’s our confidence level. Yes.

I would say there is not a silver bullet or two silver bullets. It’s hundreds of small opportunities that add up to a lot. But now we have the tools and the teams and the drive and the focus, and we will get there.

Got it. Thanks.

The next question comes from Damian Karas with UBS. Please go ahead.

Good morning, Damian.

Good morning Al. So, maybe I will throw you guys a real curveball here and ask a more strategic question. With the Gateway deal, you are sort of stepping up into the plumbing space. So, maybe you could talk a little bit about the deal rationale and how you are thinking about that market opportunity? And just kind of comparing, say, the water here and the HVAC market, are there any notable differences in the distribution model and financial profile?

Well, we don’t want to provide publicly our thinking about things like that. Let’s say that we do believe that heat pump water heaters will have a substantial opportunity for us, and we are thinking about how to take advantage of that.

Okay. I appreciate that. Would you be able to give us a sense for kind of where Gateway’s gross margins are coming into the business?

I don’t have that. Do you have it, Barry or Rick? I don’t mind sharing it.

Yes. No, it wasn’t dilutive and it wasn’t accretive. So, that means it’s very comparable.

I think we have to take this opportunity to say how impressed we are with Chris Williams and his brothers and the team at Gateway. They have both a tremendous company over many years, and we are so proud and excited to have them as part of the family. It’s an honor that they are with us now and we can do great things together.

Yes. I would say it this way too that, everyone on this call, you are in a community. And you know the legendary players and wonderful track records and so on, you know that within your industry. And with our – within our industry, Gateway is one of those very special stories and companies. So, the fun part is what happens next though which is what can they do with kind of the keys to the kingdom in their hands; how can they grow, where can they expand, what new things can they accomplish, and what ambitions did they have that were parked because of capital, things like that. So, it’s a – there are more special companies like this, a very special company.

Great. Appreciate all the color guys, best of luck.

Thank you.

The next question comes from Steve Volkmann with Jefferies. Please go ahead.

Good morning, Steve.

Good morning guys. Thanks for fitting me in. I don’t think anybody has mentioned gross margins yet. So, I wanted to ask.

My goodness.

Since we are at the end of the call, Barry, I appreciate you jumping into the short-term box with us against your will, but you didn’t provide any thought about 4Q, anything to call out in the fourth quarter that we should be aware of?

Yes. I had – my brain goes back to last year. Is there anything peculiar or interesting about last year in comparative? And I don’t know the answer. My instinct is a measure of consistency as we play out the year with what you are seeing because I think – I don’t think there are any big pricing actions going on in the market at this point. Paul, do you have any insight beyond that?

No, not really. I have got a little bit on the commodity side. I think we are going to start seeing some upticks in some of the commodities, but whether they will kick in, in the fourth quarter, I can’t definitively say.

Okay. Great. And then – sorry, my real question is I wanted to ask about this refrigerant transition but from a different angle because it feels like – I think, Al, you mentioned at the outset here that 60% is now new products. My guess is 12 months to 18 months from now it could be even more new products just as we go through all these transitions. And I am curious sort of how you guys feel like you are going to be able to manage that from two perspectives. One, SG&A, because I imagine there is going to be a lot of training on the new products and how to replace old products and all that kind of stuff. And I’m curious how that impacts SG&A. And then also on the inventory side, my guess is that you may have to layer in a little extra inventory in ‘24 as this transition kind of goes through. So, just any early thoughts on how those two things might trend?

Whatever those opportunities are in the future, we will deal with them as we have in the prior changes that come to the industry. We are very good at it. We have never been better at it. And so far as specific goals, anybody from the Watsco team want to deal with them?

Yes, I think we have got some ideas on how we can handle it without having to really overlay inventory, different ways of handling our logistics, our order plans, and how we utilize some of our DC attributes to accommodate the replacement of the R410A units, early innings on that.

I will say this. I am glad that we have the scale and the strength that we have because we can do exactly what was just said; is deal with anything that comes with us in an efficient way and effective way. And we can use our resources as needed. It’s going to be presumably more difficult for smaller competitors of ours. They will have a tougher time with the challenges I would imagine.

Great. I appreciate the color. Thanks.

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

Hi guys. Good morning.

Hey. Good morning. Thank you.

Can you just clarify again what you said about October? You said it was like a different comment or something. I didn’t quite understand what the October comment was.

A bit lower growth rate. But again, if I look at a year ago, it was very strong this time of the year. So, I am not going to get too much of an inference out of it. If we look out the rest of the quarter, we are seeing – expected to drive growth.

Okay. Got it. And then I don’t quite understand the comments. I mean the refrigerant prices we have seen, which is kind of curious or down double digit year-over-year, which is kind of unusual going into a period where everybody has visibility on this wind down. I know everybody is very highly convicted that, that price is going up. But from what we have heard in the channel from the actual refrigerant suppliers themselves, they continue to say it’s actually going down sequentially, and it’s like now in the high-single digits per pound type of area. You said you saw an uptick this week or something like that or the last couple of weeks. What are you guys seeing?

We saw a definite uptick, and those are the guys that are selling it to us. So hopefully, they saw the same uptick. But yes, we have seen an increase in the price of R410A. We had – there was some dislocation where some people were taking inventory out earlier, and we were reducing price to be able to create some sort of sell-through, and when that ended, we started seeing the price come back the other way.

Got it. So and then just the last one, Barry, the $2,900 equipment number that you mentioned in your instance, that’s after like, obviously, like a 30%-plus increase over the last few years. That just seems low. Is that – I don’t know, is that for like a pool house or something like that, like maybe clarify what, because I mean you have done pretty well for yourself over the years. I mean that seems like a pretty low number. What is building on your estate?

That’s right. That’s right. It’s a 1.5-ton home office system that sits. So it’s a smaller tonnage system. It’s not a 5-ton system, but the more important…

Got it. Is that a ductless system?

No, it’s a ducted system.

Okay. Alright. That’s…

And it is an arms length of margin for the record when I purchased something from one of our subsidiaries.

Yes, something didn’t quite add up there. And then just one last one. Have you actually seen the – I mean these OEMs haven’t even really come out with their new products. I mean they have kind of perhaps giving you a bit of a sneak preview on some of them, but like have you actually seen the pricing yet for the 454 products?

No, we have not; did not establish a price yet for us.

So, if you guys are kind of saying that like it sounds like there is some uncertainty here. I mean I know the rule of the EPA just went through last week, that is finalized and in the Federal Register in a few weeks. But like how can they be so confident in kind of going out there and predicting what their – what kind of price they are going to actually capture over the next 2 years, like what’s the disconnect there?

You have to ask them.

Yes. Okay. We will do. Thanks guys.

The next question comes from Jeffrey Sprague with Vertical Research. Please go ahead.

Thank you. Good morning everyone.

Good morning, Jeff.

Hey. A lot of good ground covered here. So, let me just do two quick little cleanup ones. Barry, you gave us 8% price and down 4% on units, so consolidated revenues up 4%. Can you do the same on HVAC equipment? And give us a little bit of detail on within price, kind of what the price mix dynamic is there?

That is residential equipment at those data points. And then our double-digit growth in commercial brings the overall equipment growth rate up to 6%.

Got it. And then on the – and can you say anything about mix Barry? How much is kind of price versus mix?

Boy, again, it’s an infinite array of data in that answer. The 8% price is – it’s a number of answers inside that 8%. It’s more so, what it’s most of is the new products having a higher cost and a higher price in the market than that composite a year ago.

Yes. And just back to the 60% of products being new, I would assume that is just mostly SEER change units. But could you maybe address what percent of your volume is the new higher SEER product at this point? How much more do we have to go until we are 100% there? Maybe if there is a difference between that 60% on new product, new SEER product versus other new product?

It’s a solid question. Go ahead, Paul.

We can’t replenish the old product. So, it’s no longer in production. So, it’s going to be pretty much at 100% at some point once the remaining product is sold through.

Domestically, right, internationally?

Yes. Just a reminder what changed, and this was a change from prior times, is it’s not just a higher efficiency systems being mandated. The way efficiency was measured changed and kind of what we would be called SEER 2. And SEER 2 changed the way a 17 SEER system is rated a year ago versus now or a 16 SEER system is rated today versus a year ago. So, when we talk about – and then the matching air handlers that go with it and the matching components that go with it. That’s the complexity. That’s the nuance. And that’s why as a composite, it’s a higher price. But I guess your question is how mature is that within…?

I am trying to break out – how much more mix effect do you have to come through for us to get to that 100%?

The question is when does it annualize, so to speak, and it would be obviously some time probably early next year. Paul, does that make sense?

Yes. I would say early next year will be pretty much all new equipment.

Great. Thank you. I will leave it there guys. Much appreciated.

The next question comes from Joe Ahlersmeyer with Deutsche Bank. Please go ahead.

Good morning.

Hey everybody. How are you?

Well. You?

I am good. Just – I will just kind of clean up with one more about the model here. A lot of great questions so far. A lot of mine have been taken. If I think through a lot of the considerations for the fourth quarter, Barry, kind of asking you to get back in the year-over-year box again here, but volume comps getting easier into November and December. You are starting to actually get probably even more SEER mix benefit because of the geography of how it rolled out. There is probably some catch-up from the weather in the third quarter benefiting even into the fourth quarter, and then also the OEM logistics. So, is it possible that we could be looking at like high-single digit type revenue growth in the fourth quarter? And then just thinking about – you said at the beginning of the year, you were targeting earnings growth. It looks like you are likely to get there? Just kind of wondering how much you might be able to grow EPS this year with just one quarter left? Is it 2% to 3% or potentially something more?

We don’t have that in our history. We do not forecast because we are in a business that fluctuates considerably with weather. And that’s been our tradition. And I don’t know that we are going to change it. Barry, if you can help them without changing that.

No, I was going to say we will give you our thoughts and our educated close reaction to what’s going on, but we are not going to give guidance, and we are not going to give – certainly not fourth quarter guidance when again, we are getting a 90-day period and trying to crystallize something. So, we have given you the trends. I think again that – if you think about where we started this year, where unit volumes were down 10% or more and worry – and the question was, will that get worse or better, it’s gotten much better as the year has gone on in a short period of time. Inventory flowing into the channel and earnest at this point. Our one vendor issue that hurt the first half of the year is now converting into a growth opportunity for the rest of the year. So, just kind of leave it at that. And our focus has to also be looking into next year, and as we are the major partner for much of the OEMs that you can talk to, and growth and market share and expansion and more brands and more SKUs and new SKUs next year, we start to look ahead, and that’s pretty exciting. Fourth quarter, we will see. I wouldn’t say…

Alrignt. Barry…

Okay. I appreciate that. Maybe just one more then, kind of related to the prior question about this year proportion. I noticed in the release in the second quarter, you talked about 60% of year-to-date sales representing the new equipment. And then now in the release it’s the same number, but you are talking about the number of SKUs at your locations. Just wondering if that was an intentional change, and if that was intended to communicate anything there?

That’s a fair question, but I don’t – maybe somebody else can answer it, because I am not sure. Barry, go ahead.

Yes, it’s a clarification that the inventory we actually carry in our stores; that 60% is new, and that’s the clarification versus a digital catalog where it’s a much broader set of products that we actually carry in stores. And the point is, we emptied out 60% of what we sell a year ago into new products this year. It’s an immense change, and obviously, also an immense opportunity with what’s going on.

Alright. Thanks a lot guys.

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

Once again, thanks very much for your interest in Watsco. We hope to continue to build this wonderful company and appreciate very much your interest. Bye-bye now.

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