Good day, and welcome to the Watsco Second Quarter 2024 Earnings Conference Call. I would now like to turn the conference over to Al Nahmad, Chairman and CEO. Please go ahead.

Good morning, everyone. Welcome to our second quarter earnings call. This is Al Nahmad, Chairman and CEO and with me is A.J. Nahmad, President; Paul Johnston, Barry Logan and Rick Gomez. In this call, I have asked these executives to join in anytime they wish with their thoughts so that all of you can get the views from multiple people in the company. Before we start, I will state our 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. Watsco delivered another strong quarter. We achieved record sales, reflecting strengths in both residential and commercial markets. Operating efficiency improved during the quarter as evidenced by lower SG&A as a percentage of sales. We generated strong cash flow and our balance sheet remains in pristine condition to enable most any size investment to grow our business. Simply put, Watsco's entrepreneurial culture, which empowers local leaders to make local decisions continues to perform well. Technology continues to have an impact and we are fortunate to have served such a large and growing number of contractors with the industry's most innovative technologies. Greater adoption and use of our platforms by a growing number of contractors has produced growth and market share gains. Annualized e-commerce sales now exceed $2.5 billion and our active users continue to grow faster than non-users. OnCall Air, Watsco's consumer-facing sales platform that helps contractors do business continues to grow and expand. Thus far in 2024, contractors presented quotes to approximately 160,000 households, an 18% increase and generated $743 million of sales for our contractors, a 27% increase over last year. We are actively updating our technology platforms to optimize the launch of new low GWP A2L systems. This presents another important federal regulatory change providing the opportunity for growth in the coming years. Other federal regulatory changes continue to influence growth. Energy efficiency mandates went into effect last year, providing contractors the ability to upgrade older systems with higher efficiency systems. The trend towards electrification of fossil fuel heating has driven increased sales of heat pumps contributing to growth. We are fortunate to be in such a great industry and believe our proven culture, customer-focused technologies, scale and access to capital provide unique advantages and opportunities. Finally, as always, if you have interest in earning more, please come to Miami and see us. We are transforming an industry, and we will enjoy telling you about it. With that, let's go on to Q&A.

The first question comes from Jeffrey Hammond from KeyBanc Capital Markets Inc. Please go ahead.

Hey, good morning, guys. What's going on?

Hi, Jeff. Well, it's bright and sunny and happy to hear your voice.

Okay, great. Can we just talk about the moving pieces in gross margin? I know you've kind of been level setting people around 27%, but it looks like it was down 100 basis points year-on-year and I know kind of the price timing with the price increases maybe was going to be supportive in the quarter? Thanks.

Paul or Barry or both, please answer.

Sure. Jeff, good morning. Again, we look at things a little by little in a quarter. I want to just zoom out a bit and look at the first half of the year; you look at the first half of the year at 27% plus, which has been our goal. We've been asked about this now consistently for 2.5 years and have kind of said the same thing, and the moving pieces are more obvious than just the timing or level of an OEM price increase. In fact, the only kind of real price increase that straddled the quarter that's material is the carrier price increase that came in March, helped the first quarter some and obviously came into the second quarter as well, but I just don't want to get too obsessive about short-term discussions when the long-term is working through. Having said that, in the quarter, you can see that our equipment business grew at, I think, a pretty terrific growth rate and our non-equipment business didn't and obviously, there's a big disparity in gross margin in those two families of products. Enough so to account for some of the year-over-year change in margin. Also, mix is a conversation when it comes to price and margin and we're far more complex in that regard than an OEM. Watsco has brand mix. We sell multiple OEMs with multiple brands and I won't discuss how much, but there is a variety of margins we make depending on what brands we sell and growth rates that pertain to those brands that can affect margin. There was some of that in the quarter in terms of mix year-over-year working against margin. It's again in basis points; it's not a big material thing, but it's a component, as I mentioned. We also see less inventory being owned this quarter. That means purchases have been down and replenishment has been down. There's a little bit of a consequential impact year-over-year on rebates and discounts, things like that, that are earned in the period, and I could give you like five more basis point conversations in that mix conversation, but if I again dial it back, look at the big picture year-to-date, where we said we would be, we're never satisfied where we are, by the way. We still have certainly more potential and as we've said, long term, much higher aspirations than this, and I'll let Paul talk or Rick as well. Rick, you have a lot of insight too.

Rick? There you are. Wait a minute. Rick? I don't know what happened to Rick. Anybody know?

I don't know.

Can you all hear me?

Now we can. I guess I was muted on the other end. Sorry about that. Yeah, Jeff, good morning, and just to I think Barry explained it very well. I'll just add two tidbits to it that I think are maybe helpful. First is, for that year-to-date period, we have also seen again just steady commercial strength and that family of products relative to residential also has some mix implication as it relates to gross margin. Second thought I'd share is just, again, if we look ahead a little bit and not backward, we've got a big product transition coming at the end of the year. Those periods of time are usually good opportunities to evaluate margin and act on opportunities and for us, I think what we're looking forward to is leaning in on some of the technology tools that are now maturing that can be helpful to margin long term as we go about that regulatory transition.

Okay, great.

Okay. He's satisfied. Let's go.

That's a good segue here because I wanted to jump in. It seems like a couple of OEMs have kind of put out last calls for 410A product. Just maybe your updated thoughts on how much 410A you want to exit with and any kind of implications around pre-buys? And then just as you talk to your OEM partners, how are you feeling about the readiness for the A2L transition in new products?

Yes, I think, Jeff, everybody is pretty much ready to go with their A2 products. In fact, we're seeing one manufacturer located in Texas that's already putting out their A2L product. So I'm not really concerned about a transition here. It's not much of a transition; it's putting in a different compressor into the unit, and it's also putting in a sensor that senses and smells if there is any leakage and then a switch that basically will turn on and off the system. So there is not a big change in the product. When you get to the 410, how much 410 are we going to carry forward? We put in our final orders now pretty much across the board. We think we're going to have enough product to go perhaps into the first quarter, but probably no further than that.

Okay. Thanks, guys.

The next question comes from Tommy Moll from Stephens Inc. Please go ahead.

Good morning, Al. Thank you for taking my questions. I wanted to talk about some of the trends for the residential business. You called out 6% growth in ducted units year-over-year. Can you walk us through how the selling season progressed through the second quarter and are you able to give us an update on how July paced?

All right. Well, Barry?

Good morning, Tommy. During the quarter, we experienced stronger growth rates. Interestingly, we had two more days in April and two fewer days in June, which impacted our figures since our business volume is greater in June. This resulted in a $20 million headwind for the quarter. Looking at average sales per day throughout the quarter, we saw that June had the strongest performance among the three months. The average sales per day were above our overall growth rate for the quarter, reaching high single digits on a same-store basis. In July, we faced some unusual circumstances, particularly in our largest market, the Texas coast, which was affected by hurricane activity leading to closed stores. However, aside from that, July has maintained a growth rate consistent with the quarter. It’s still early, and August is expected to be as significant as July, so I remain cautious about our outlook for July. We anticipate being fully operational throughout August as we move past the summer challenges we faced in part of July.

Thank you. As a follow-up, I wanted to ask about the OpEx leverage that you showed this quarter. It's been a theme that's come up for some time now and I think you grew same-store OpEx at about half the rate of sales, so showed up clearly leveraging that expense line this quarter. What are some of the drivers there that you can unpack for us and how are you feeling about the initiative that's been in place for some time now to continue to drive leverage there? Thank you.

I think, yeah, I think first, going back in time, some then I'll do what Rick does, which is go forward in time. I go back in time, in COVID, it was a circus act to get product to get everyone served and SG&A had to be built and incurred to serve businesses and to serve our customers in a difficult environment. So two years later, how do you evaluate that, look back and set expectations or communicate the data to our field to act on it? So I would say beginning last fall, it was a more aggressive campaign to act on SG&A. More actions occurred in the first quarter, and this is the first quarter where I think there's more evidence of everything I've just said with more opportunities and more actions and more results to come and I looked at SG&A right before the call actually. The only thing peculiar, for example, is health care is up $7 million year-to-date. That's the only outlier in the whole list of how we look at it and we improved our benefit plan, we improved our medical plan with intention and there is some bottom-line impact to that reality for our employees, which is a long-term perspective. That's the only thing that stands out amongst a long list of things and so I think the teams in the field have acted, have reacted and have more to do and I think you'll see the results of that and it's all database. None of this is emotion or reactionary. It's all in the numbers and looking at the data.

This is A.J. I was going to go to the same place, Barry, where it's intentional. This is a continuous improvement culture that we have at Watsco. When we talk about technology, it's really become a buzzword, but really what it also means is looking at processes and systems and opportunities to be more efficient with our time and our people and getting orders processed and filled, etc., etc. So, there's certainly been work to continually improve everything we do.

Thank you, both. I'll turn it back.

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

Hey, good morning, everyone. Thanks for taking the questions. Can we talk about the other HVAC products, parts and supplies? Why was it a little bit weaker than equipment? Is there anything that stands out?

No, there's nothing I can really think of that was odd or unusual about other. If it was down, it was down a bit, but there really isn't anything in there that was very strange.

And then I mean, just to be helpful with something we've talked about in the past and because Ryan, I think it's a good question, is, if we say it's 25% of our business, then in the quarter it was a $500 million business, right? And there's probably 60 different product groups, 300 or 400 different vendors. It's a hodgepodge of a variety of stuff, right? We have talked about commodities and we only have really three that we consider commodities; that's copper tubing, sheet metal products and refrigerant, and again, that component of our revenue is closer to $100 million in the quarter, $100 million, out of the $500 million, and there we have seen stability in price and cost and margin. That's one of those more volatile variables we were seeing a year ago. A year later, it's much more the bandwidth of volatility is much less, but the dollars are less because the pricing is less. So a little bit of headwind still in revenue, but not on margin and not in general business conditions from a materiality point of view.

Got it. Okay. That's helpful. And then as it relates to product mix, are you seeing the higher share stuff grow? Or are you seeing people trade down to base systems?

I think it's certainly trading, yes it's basically trending towards the basic product. We've got a minimum efficiency now, which is at a point where, the higher share product really doesn't have as much impact as it used to. So what we're seeing is the industry is tracking at, I would say, close to 90% at the standard efficiency level. So definitely, you're seeing a trend down.

Okay, great. Thank you.

One consistent and positive trend for our business and the industry is heat pumps. They are definitely growing more quickly than the demand for traditional furnaces, which reflects in our figures and impacts selling prices. Additionally, high-efficiency heat pumps have also experienced significant growth compared to traditional options. So, I want to emphasize that there are encouraging developments in the heat pump market.

Thanks, Barry.

And I think as Rick said, A2L is going to basic – the A2L products, if you think about it, it's going to replace basically probably 55% of what we sell company-wide and it's all new equipment, all new efficiencies, all new opportunities, all new discussions, all new training, all new inventory, but it's a nice chance to kind of refresh the opportunity that's in front and we kind of like those changes because it puts us in a position to do that.

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

Hey, guys. This is Peter Casa on for Brett Linzey. I just wanted to ask around inventory levels in 2Q. You guys took them down sequentially and historically I think it tends to increase. Is there anything to read into there or is that more of a function of the build in Q1? And then how would you characterize inventory levels just relative to what you're seeing in the market? Thanks.

I'll make a brief statement on that. First of all, we're very focused, as we've been saying quarter after quarter, on the inventory asset, which is our largest asset, and we've been applying a considerable amount of technology and science to it. So we're getting more efficient on inventory turns, and Barry, you can follow that up with whatever you want.

Yes. I think, again, it's A.J. mentioned the term continuous improvement and heaven knows after the COVID challenges, inventory remained high even post-COVID and inventory turns, if you look at today do the math today versus any historical period, we are looking to improve turns. We obviously must take care of customers in season, and we're doing that as evidenced in the growth rates, but I would say inventory is still a work in process also. It's still a matter of continuous improvement to really get the inventory turns back in the closer to five times instead of today; it's closer to four times. I think that process takes time because of A2L transition coming in front of us. There's another huge transition occurring, but if you talk to us two years from now or three years from now, I would expect inventory turns to be more historical at closer to five than today, closer to four. I wouldn't read into the—there's no science or message in the sequential change. If Inventory was built in the first quarter, that was in order to be in a good position for growth, which occurred and how to react to what's going on for the rest of the year. I wouldn't read into that and there's certainly no message behind it.

Thanks, and then could you just walk through what you're seeing more broadly from the consumer affordability side? Are you guys worried about any sort of pushback or erosion there?

Really when we look at what the prices have gone up over the last, gosh, it's been five years now, that we have seen prices continue to move up. We have expected the consumer to start pushing back on price. We have not seen that as of yet. As we indicated in the release, our residential sales were actually up in units for the quarter, which is a strong indication that the consumers out there and they're still buying the product at the price that we're offering it. Secondly, we are seeing some moderate increase in the repair side, where we've been seeing high single-digit increases in compressors, motors, the type of things that you would repair a unit with; those continue to remain strong. So it's kind of like we have the best of both worlds going right now where we have a consumer that is willing to purchase it at the price that we offer and at the same time, people are repairing.

And just to add to that, Paul, I think what we don't talk a lot about, the industry doesn't talk too much about, is the ductless side of it, the ductless side of the market. We represent multiple OEMs on the ductless side. Unit growth rates for ductless actually exceeded the ducted product this quarter and year-to-date. That's a solution that contractors are offering more often, they're comfortable offering and that will work in cold climates now where they're all high efficiency, they're all heat pumps and it's both international and domestic. So that is a product that fits somewhere in that conversation of affordability. When you look at the traditional ducted systems versus repair, ductless does fit somewhere in that discussion and we're certainly seeing growth rates in ductless, and have for some time now.

The next question comes from Patrick Baumann from J.P. Morgan. Please go ahead.

Thanks for taking my call. First question is on the Texas manufacturer that has made the decision to move to A2L, maybe quicker than others. Are you seeing any or do you expect to see any short-term share impacts for the other OEMs that have maintained supply, steady supply of their 410A product? And then if so, what kind of impact would that have in the business?

No, I really don't see a big impact in market share coming from that one manufacturer that's introducing their A2L product. I think it's more of an availability issue on their part to be able to provide product that's going to be available in 2025. They decided to come out early. They've got a unique design to it and hence they feel that they've got an opportunity to try to step in and at least lead the way on A2L, but I don't see it as a big change in the marketplace as far as share market for them.

I'll just add one other note regarding A.J.'s points. In response to an earlier question about pre-buys, I want to clarify that we are not making predictions about pre-buys or how the transition will unfold, nor are we making any special bets. Our goal is to ensure a functional, harmonious, and seamless transition to the new products. We will also have a year to sell through the existing inventory, so we anticipate that the process will be quite smooth.

And what type of initial pricing are you seeing for the new technology versus the current generation or the 410, I'm sorry?

We're seeing the 10% increases that were indicated by, I think, every OEM probably a dozen times here in the last year.

Yes. Okay. Just wanted to check that. And so we take basically so 55% times to 10% is the way to think about your mix impact for next year from selling this new product? Maybe that's a Barry question. I don't know.

Yeah, Patrick, the only reality, right, is it's not 100% new product, 0% old. There's a blend that's going to play out into next year too. So it's a blend into next year, if not all of next year. Plus, we have to wait for the Department of Energy still has not pronounced what represents a replacement unit. The current write-up that we've been provided by the government indicates that you can sell a unit, a 410 unit if it's repairing a system. It would be a component, and there's a lot of debate in the industry right now about whether or not that will really hold true going forward into 2025. So we really need to wait to find out what the DOV decides, which hopefully will happen soon.

Yes. No, we're waiting to hear that as well. Okay. And then maybe one quick one for Barry, if I could, on gross margin, normal seasonality or however you want to talk about it through the rest of the year. Is there anything unusual we should think about versus normal seasonality for gross margin for the rest of the year?

No, I think we should focus on the overall target for the year at the 27% level, and the third quarter will indicate our progress. I believe we are staying committed to the goal of 27% for the year. The seasonal trends during the third and fourth quarters will follow historical patterns, and you can draw your own conclusions from that.

Yeah, makes sense, will do. Thanks a lot.

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

Yes. Hi, good morning, everyone. First off, Barry, in the release, you mentioned that ducted residential units average selling price was up about 3%. I was hoping maybe you could zoom out and talk about the overall price mix impact on both equipment as well as other HVAC products in general?

Sure. Regarding other HVAC products, I don't keep track of exact sales figures like how much duct tape we've sold, and there are about 80 product lines in that category where I'm not fully aware of the specifics. On the commodity side, I mentioned that previously volatile pricing has stabilized, and from my perspective regarding HVAC non-equipment, there doesn’t seem to be anything particularly noteworthy in terms of pricing units. On the equipment side, when we refer to average selling price, that reflects a mix of actual prices, which can vary by geography, product types, brands, vendors, and customers. It's quite complex, and I can't break down all those elements. However, the OEM pricing actions this year have flowed through without much change in our equipment margins over the first six months, and so far, the pricing actions seem effective. There is a cautious sentiment within the market that we've noticed, but we continue to replace systems. It's crucial to recognize that every Watsco location offers various brands and price points. If one market is tighter than another, we still have options to maintain margins and serve the replacement market. Most competitors only sell one brand, including OEM networks, so having that product diversity is beneficial for our market share, margins, and competitive position, allowing us to respond effectively to local market conditions.

Okay. Thanks, Barry, and just to clarify your statement on the commodity product, when you say stable, are you referring to it is stable today relative to what it was a month or two ago? Or are you talking about a year-over-year we should be thinking that that's sort of a flatness today?

Yes, I would say, if I look at the first quarter of 2024 and the second quarter of 2024, price margin and really the quality of gross profit is sound this year, where last year, it was highly volatile. It would go up and down quarter to quarter and it's much more stable and I would say in a very narrow range and acceptable margins for those products this year.

Okay. All right and then one more on acquisitions. Is there any update on the Gateway acquisition? And then given the timing of that, I think it was September of 2023, the rollover effect from acquisitions in the third quarter, I'm coming up with about $40 million in revenues. Does that sound right to you?

Jeff, it's Rick. I can address that a bit. First, we are very pleased with how Gateway is performing. They have an excellent team and are in a great market. We will actually be meeting with them soon, and I can say they are exceeding our expectations based on the numbers compared to our investment and their performance last year when we made that investment. So, I'm very happy with how things are progressing. Your estimate regarding the contribution for the third quarter is on point, and I believe September 1st marks the anniversary of that, so we will start to see that reflected in the third quarter.

All right. Thanks, Rick. Thanks, everyone.

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

Thanks, Al. Thanks, everyone. I know the 454B isn't a major factor, but you mentioned there are a few distributors and customers accepting products. I'm curious about the customer acceptance and whether the price on 454B is holding. Are you seeing an uplift of around 10% to 15% on the mix? Thanks.

It's difficult to predict how customers are responding to the product. We recently completed our first delivery of 100 units to a specific customer, so we will soon learn about their feedback. We've invested a lot in training and will continue to enhance that support to ensure customers know how to use the tools and install them properly. Some variations may arise, but it's too early to accurately assess the price and acceptance of the product. However, I am confident that it will be well received.

Yeah, it's actually earlier than expected. So sorry for the question, I thought maybe it's a bit more on that. And then you mentioned share gains I'm just curious how you view the market in second quarter versus the 4% same-store sales. So just any color there, and then inventory I know you've built a fair amount of inventory in 1Q, you looked that down in 2Q. Normally you'd work up inventory in the second quarter and I suppose the question is really that it feels like this is a year when inventory is moving higher, not lower. So just curious your perspectives on inventory over the back half of the year.

Paul, let me deal with the first parts. I've earlier stated that we're very focused on using our tools to improve inventory turn, and we are succeeding that we have certainly enough inventory to meet demand, and hopefully, the turns will increase and will carry less inventory and still meet demand.

I would say, as we go through the year, I see our inventory actually trailing downwards and continuing to move down as it does because of one seasonality and two because of the transition to the new A2L refrigerants and then we'll probably see in the first quarter, we'll probably see an overlap of inventory where we can have 410 and we're going to have A2L, which perhaps will cause a bump in the inventory, which would be normal anyway just based on the season. So it's going to be an unusual ride, I think, as we go through this transition to the new product. A lot of the product information that we have right now indicates that it should go smoothly and knock on wood that it does.

So, what you're saying loud and clear here is no pre-buy or no material pre buy.

No material pre-buy, no.

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

As always, thank you for your interest in our company. We very much appreciate it and we're very sincere in asking you to come visit. You want to learn more about what we do, especially in the technology field. You're always welcome. All it takes is a phone call and to that end, we look forward to catching up with you in the next quarter. Thanks for your interest and for your support. Bye, bye now.

The conference has now concluded.