Good day and welcome to the Watsco Third Quarter 2024 Earnings Conference Call. Please note that today's event is being recorded and all participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Also, please be aware that today's call is being recorded. I would now like to turn the call over to Albert Nahmad, CEO of Watsco. Please go ahead, sir.

Good morning. Welcome to our third quarter earnings call. I am Albert Nahmad, Chairman and CEO. With me is A.J Nahmad, President; Paul Johnston, Barry Logan, and Rick Gomez. Before we start, our usual 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 these forward-looking statements. Watsco produced record sales and net income for the quarter. Our markets have shown signs of stability, and the fourth quarter is off to a good start with October sales up mid-single digits, driven by meaningful unit growth. Let me reiterate that: October sales are up mid-single digits, driven by meaningful unit growth. We also believe we have gained market share based on industry data and shipment trends. We have generated record cash flow this year, and our balance sheet remains in pristine condition, enabling investments in growth. As communicated in our press release, we are in recovery mode with one of our primary OEMs, a significant supplier of equipment to us. We are collaborating with them and co-investing to make the needed investments to regain business and add new customers. Moving on, we continue to make investments in the industry's most innovative technology platforms for HVAC contractors. Greater adoption and usage of our platforms by a growing number of contractors have helped produce 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 digital sales platform, continues to expand and generate growth for contractor customers. Thus far in 2024, OnCall Air contractors presented to approximately 258,000 households, which is a 17% increase and generated $1.2 billion of sales for our contractors, a 22% increase over last year. We are also leveraging our technology platforms to optimize the launch of the new federally mandated A2L systems beginning in 2025. Historically, regulatory change has been beneficial for our industry and our business. In 2023, energy efficiency mandates went into effect, 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 pump systems, which are sold at higher average unit prices than conventional alternative systems. The growing penetration of ductless HDA systems has also acted as a catalyst for growth, as they provide homeowners and businesses with a more energy-efficient alternative to conventional systems. Now, with the A2L transition upon us, we look forward to the opportunities it presents. Turning to our balance sheet, we have a strong cash position with no debt, supporting most of the investments we choose to make. Although we have produced record cash flow this year, we are still not satisfied with our inventory turns. We are working with our OEM community and continuously improving our methodology to enhance our inventory turns. We have also made progress improving operating efficiency across our network, as evidenced by the modest change in SG&A year-over-year, but there is more to do. In summary, we operate in a great industry and in attractive geographical markets. We have a proven entrepreneurial culture that empowers local leaders. We possess the industry's most innovative technology platforms for HVAC contractors. We have leading scale and product diversity, particularly in high growth markets. Finally, our balance sheet and access to capital enable future investments in our fragmented industry. As always, if you have an interest in learning more, please visit Miami and see us. We are transforming an industry and enjoy sharing our story with you. With that, let's now move to Q&A.

We will now begin the question-and-answer session. At this time, we will take our first question which will come from David Manthey with Baird. Please go ahead.

Morning, Dave.

Hey Al. Good morning everyone. First question I have to ask is about the hurricanes, particularly Helene, which hit us pretty hard here in Tampa. Could you talk about the negatives and potential unwinding positives you might see from Helene and/or Milton?

Well, let's see if we can get one of us to tell you at least what he thinks. Do you want to take that, Paul?

Sure, I can get it started and then someone else can pick up. But yeah, we had our branches shut down for a couple of days for Helene and then we also had them shut down for a couple of days with Milton. Most everything is back to normal now, and obviously we're seeing an initial rush, at least of repair components that are going out the door in October. Milton came through so quickly that it didn't impact us as severely as the other storm. However, when you get up into the North Carolina, Georgia area, a lot more severe damage was done. Yes, it slowed us down, but it didn't really impact our sales that dramatically, more or less.

Just to add to that, I've said for many years, growing up in Florida and being in Watsco for 32 years, that hurricanes typically disrupt local markets and may not have an impact on the whole market. The reverse is true; if there's business opportunity, it's good for those markets and not necessarily material for the national scale. I think the most obvious question and thought is when they talk about $10 billion, $20 billion, $30 billion of insurance investment that follows these events. A portion of that is always in our industry, whether it be equipment or non-equipment. The materiality of that needs to play out sometime this year or next year obviously, and that's how I've characterized it at least over time.

Okay. So, but even though Florida is clearly your biggest market and Helene, in particular, ripped up the whole coast, you're saying it's fairly immaterial and we shouldn't view the mid-single-digit growth in October as just a temporary snapback from storm activity?

Absolutely not. No, it's nothing that material relative to Helene and the disruption in the last week of the quarter or a benefit for the first part of October. When the insurance kicks in, it's going to be within the next 30 to 90 days. So we really don't see equipment sold, we see the motors sold, the compressors, that type of thing, to start with.

Got it. Okay, thanks. Great. Yeah, thanks for that. And then on the gross margin that came in a little bit light. I know you had a reason for that here that you discussed with one of your major OEMs, but just medium term you still feel good about 27%?

This is A.J. I'll jump in. The answer is yes in the short term and the ambition is much higher than that. I think we've talked about publicly; one day we'd like to achieve 30%. So our engines are revved up, and we very much have a focus on gross margins and we're investing there with high expectations.

I think in the analysis, Dave, the magic words are price and mix. Price overall was pretty consistent this quarter, so that's not really a discussion item. Mix is where the variations are so far this year and for this quarter. And the word mix is a broad term really. There's customer mix, geographic mix, product mix, end market mix, and brand mix, all of which contributed a little bit of weight to those factors. If I spent 20 minutes explaining to you what I just said, there was a little bit of weight on margin this quarter. But those are short-term conversations. If you consider the A2L transition, it's really an opportunity to re-price and go to market with what will essentially be 60% new products over the next 12 months. Our OEMs have paid attention to this call and this is a very critical stage where we're making tremendous investments. Inventory is going to completely cycle over the next 12 months. Pricing, marketing features, and benefits overall mix are going to be critical to drive margin. Year to date, unit volumes are positive in the quarter and are overall positive for our selling season.

Thank you. Our next question will come from Tommy Moll with Stephens. Please go ahead.

Good morning. Yes, sir, and thank you for taking my questions. I wanted to start on some of the co-investment you described in the press release this morning alongside one of your OEM partners. And it's a two-part question here. First part is where you did call it out this morning with substantial detail. Did something change since last quarter that prompted the enhanced discussion on this item? And then as you look forward, is there anything you can do to calibrate our expectations about how this ought to progress and ultimately fade?

Terrific question. Who wants to answer? Paul, Barry, A.J., or Rick?

Didn't mean to leave you out, Rick. Yeah, I think I'll go first and just add to it because it's an important point and in our collaborative spirit you'll get insight into how we look at these discussions internally. I wouldn't say anything critically changed in the third quarter as an isolated event. We felt it was needed to reconcile where we are year to date. A year ago we talked about disruptions and whatever the range of revenue was, $150 million to $200 million of revenue at the time, you have to go back and look at the disclosures. A year later, the idea of recovering that business, growing volume, growing market share—these are markets like Florida, Texas, California, and the Carolinas that are huge. There is collaboration and co-investment— that term was used intentionally in the press release where we work with our OEM partner, trying to sort this out. The scorecard year to date shows that business and unit growth has outpaced overall growth rates for that product group. When we talk about pricing, there’s more to it than just the price of the product. There’s a mix of those products, and I won’t give too much competitive detail here. Incentives that we chose to put out there were to not just get someone back buying more from us, but also to attract new customers simultaneously. In other words, play offense with this opportunity. This is a shared cost and experience with our OEM. We thought it was important to reconcile that scorecard for the year to date. As far as lingering impact—which is the second part of your question—there's some lingering impact, needless to say, in the fourth quarter, and that will dissipate more so next year when all the new A2L products come in. We are kind of truly working today on a complete set of economics for those new products with all of our OEMs, and it's a chance to recalibrate those economics looking forward.

Yeah, I'll just stress that our OEM partner here is truly a partner. They are a long-time relationship and we think it's a successful partnership now. It has been, and it will be. This is absolutely a collaboration with them, and it's nice to have such a wonderful partner.

Anyone else before we move on here? All right. I also wanted to ask about inventory and any pre-buy dynamics we may be seeing. Al, you talked about hoping to improve inventory turns, and I did note that inventory dollars were up versus the second quarter, which is atypical. But is some of that just the 410A pre-buy that we're seeing? What's your view there at this point?

Yeah, it is.

Yep, go ahead.

It is the inventory pre-buy on the 410 as each of the OEMs has come up with a program to at least fill in for the 410 that they have to be able to manufacture and complete by the end of the year. Some of them have asked if they could move the inventory quickly into our inventory so that we can be ready for at least the first quarter selling of the 410A that should taper down. At the same time, we will be bringing in the A2L inventory, so I don't see much fluctuation in the next quarter with our inventory.

Yeah, Tommy, I would just add to that, when most OEMs have had their last call, those products are starting to get received. So as you look forward to Paul's point, the seasonality around inventory probably looks different over the next quarter or two. As we go through this transition, it likely picks up its normal seasonal cadence by the middle of next year, once 410 diminishes as a percentage of shipments and sell-through.

Hey everyone. Good morning. Just wanted to ask, on October to start, you said meaningful unit growth improvement and then mid-single digit growth. Can you just clarify what pricing is? Because my assumption was pricing is still kind of running up maybe 3, 4. So how do we bridge the mid-single digits if volumes are popping back positive?

Yeah, I'll cover that. Let's be careful. I'll give it to you in a spoon-fed way because this is critical data. I'm not going to comment as much on specifics for October other than to say what we've said, which is meaningful unit growth. But let's analyze it and we can discuss the business side. So for the quarter overall, units were up 4%, which includes both ducted products that actually declined 1%, and ductless products that were up double digits. So it's a year-to-date trend—it's probably an 18-month trend where our investments in ductless are paying off very well. Brands like Mitsubishi, Gree, and Carrier's ductless products have been doing well, both domestically and internationally. So there's a bit of a story behind that number. That's our investment and our business units doing well with ductless products. As for the ducted product, volumes were down 1% and pricing was down 1% in ducted products. That has nothing to do with deflation or average selling prices. The price risk is tied to mix. That's what I'm alluding to earlier in the call. If I look at brand mix, customer mix, and market mix, there's a little bit of pressure on price this quarter. For the year, unit volumes are up 5% and unit pricing is also up 1%. Pricing in the ducted category is up 1%. That makes sense because the OEMs launched pricing earlier in the year. I think they've all kind of said about the same thing about it. This is a year where price has not contributed to the equation. I'm glad our gross margins look the way they do in the absence of any price, and we know that's going to change.

We know that's going to evolve from here, and I welcome anybody else's color. Okay, well, yeah, that's helpful. That explains it then. And then just back to gross margins. Can we bridge 3Q back to 27%? It sounds like parts and supplies were down, so there's a mix element occurring. You also didn't quantify for the quarter, but this co-investment. So can we get back to 27% or what are the pieces?

Go ahead, Rick.

Yeah, Ryan, I think you heard AJ say the answer is yes, and I think there's an upward bias to that over time. The most important layer of margin, which we haven't discussed, is our transactional margin, our invoice margin. This is the most basic form of margin that any distributor can have before you get to mix. To Barry's point earlier, that transactional margin is constant versus last year in a year where there's been relatively no contribution to price at all in our gross margin. That is a testament to some of the pricing technology that's been deployed and to the work our field leaders are doing on this subject. So then, what do we bridge if transactional margin is constant and consistent with last year? It's those four basic elements of mix we talked about. Firstly, there is a difference in growth rates between equipment and non-equipment that will weigh on your overall margin to some extent. Secondly, within equipment, it is a difference in growth rates between residential and commercial. Residential has been in that low single mid, single digit type environment, while commercial has been higher. We like this because we have profit dollars to account for that higher growth rate, but it still weighs on our overall mix. Thirdly, in the third quarter, during our seasonal period, you tend to have more residential new construction than add-on replacements. This is a time when the builder channel gets a lot of work done, which tends to weigh a little bit. It’s been true for the last year or two that the residential new construction end market outpaces add-on replacements. Finally, customer mix is the hardest to untangle. However, our data shows that larger, more progressive, more tech-enabled customers are growing faster compared to their smaller, less sophisticated counterparts. Not to complicate matters too much, but those are the elements that explain and help contextualize a year-to-date margin profile that looks different. I go back to where I started; the key point is that transactional margin, remaining the same customer and product, is very consistent with last year.

Thank you. Our next question will come from Jeffrey Hammond with Keybank Capital Markets. Please go ahead.

Hey, good morning everyone. Just on the A2L new product introductions, what kind of pricing are you seeing relative to around 10 to 15%? As you talk with your major OEM partners, can you address their readiness so there are no hiccups as the transition occurs?

Yeah, I can cover part of that. Among all of the OEMs we talk to, everybody is ready. As a matter of fact, one OEM has started their launch in the fourth quarter, and we have actually taken equipment in and started selling A2L. Regarding pricing, it has been consistently in the low double-digit range, around 8% to 10%, with some pricing a little bit higher. However, we will probably need to wait until the second quarter to see where that price settles. This is an unusual situation for each of the OEMs because it's a totally new product line being offered. The unusual aspect is that the consumer will have to buy a system now, as opposed to in the past when we sold the 410 product and could just install the outdoor unit. Now, it's necessary to replace both the indoor and outdoor units. This is not just about raising the price; it's also about selling more systems rather than single unit replacements— once A2L is firmly established.

Okay, and a quick follow-on. Can you remind us about the multiplier effect when comparing the matched versus the standard? Also, what do you see in the M&A environment? It seems like private equity has gotten more crowded in this space. What do you see in general?

I can tackle the M&A piece here. Jeff, there's always more M&A to consider; it's hard to predict or regarding the cadence of it. I would say that private equity was much more prevalent in the space the last two years. However, that has subdued a little lately. This is significantly a fragmented industry and another element of M&A that you might not see is that we're focused on partnering with the right entrepreneurs. That’s different from consolidating an industry; it’s very much a cultural discussion. We want the right entrepreneurs who will embrace our technology and growth spirit to help transform their businesses. I think that is key. The second point I want to note is that today, our technology platform and M&A discussions essentially go hand in hand. We've invested in this technology platform that is better understood in the market now and is leading to more discussions with long-term prospects. My goal is to lead some of that effort, and we desire more of it. But also, I want to highlight, as a $7.5 billion company, we have several internal levers at our disposal to grow, and we're not reliant on M&A to grow profitably in the future.

Rick, this is A.J. I think what you said about these being cultural discussions more than financial discussions is so true. It runs both ways; it needs to be a good fit. These are often multigenerational family businesses, and we invite them to join our multigenerational family business. They can keep their leadership team and branding while operating under our umbrella and utilizing our resources. Those resources include capital, equity to recruit and retain top talent, and technologies aimed at helping them grow and better serve their customers. That long-term sustainable growth is our priority, and those families and their leaders, who have joined our business over the last five to ten years want that as well; they are thriving in that setup.

Our next question will come from Patrick Baumann with JP Morgan. Please go ahead.

Good morning, Al. How are you? It's hot and humid here. It's actually warmer up here than usual for this time of year. I wanted to quickly return to something Barry said about units. I believe he stated year to date up; was that a total unit comment or was that solely ducted? I assume ducted is not up that much. Right? Could you clarify that?

Yeah, I should clarify that. So ducted is flat in units year to date and overall is up 5%. This would suggest ductless is up double digits.

That's helpful.

To be more specific, in the press release, when looking at the seasonal performance, we can join together the second and third quarters, so there's no push and pull aspect to this analysis. For the season, the combined ducted units are up 3% and overall up 5%. When we talk about stability, that’s the frame of mind.

Okay, helpful. Have you been... I think we discussed inventory earlier. You expect it to stabilize through the end of the year, correct? Is the channel restocking currently in terms of inventory?

Yeah, the channel right now is picking up 410 equipment, which they'll take in November, December, and January. So yes. It's not restocking, but it’s a pull forward, if you will, into first quarter sales, with fourth quarter shipments turning into first quarter, second quarter sales.

Right. The industry and we, are largely bringing into our stock what we will sell—410A products will sell through the first quarter. As stock is being sold through, we can't replace them with 410A units, so we will replenish them with A2L units.

Helpful. One more on margin, regarding gross margin. Typically, we expect a lift from seasonality in the fourth quarter due to mix, which I guess hurt you in the third quarter. Is that a reasonable assumption this year, or are there factors like OEM investment collaboration that hold that back at year-end?

I think we should see some lift with the mix. As we get into the colder season, we start seeing more furnaces and more heat pumps, which obviously have higher margins and volumes. Without knowing what the weather will be in the fourth quarter, I would say yes.

Our next question will come from Nigel Coe with Wolfe Research. Please go ahead.

Good morning, guys. Thanks for the time. This winter is expected to be quite cold, according to forecasts, which could help you guys. I don't want to retread ground we've already covered. On gross margin, it seems there was some lapping of pricing from earlier this year. You discussed mix and some OEM support. Is there more discounting going on, especially at the higher tier levels? Is that a factor in your gross margin compression?

If you listen to Rick's comments, the most important metric to look at is whether the transactional margin has undergone any material change. The answer is no. So I don't think there's any risk related to deflation at really any level of product group. It’s more subtle, and it’s related to the mix of it. Paul, do you have insight into this?

It happens every time there's a change in standards from the federal government, whereby there's a compression in which a greater percentage of the industry moves towards standard efficiency. The last energy efficiency change increased the efficiency to roughly 15 seers from 14 seer.

When that occurred, we definitely saw a compression of high-efficiency equipment, making its size in the marketplace less meaningful. Is that correct?

And Paul, maybe you have some perspective.

I think the consumer is probably not ready for this P2L transition. They may not understand what will come at them. It's going to be a system change and not just an outdoor change; that might cause some sticker shock for consumers once they see the pricing. On the other hand, contractors should transition easily. The only significant change inside the units is a detector to identify any refrigerant leaks. If any leaks are detected, the blower motor will deactivate to prevent contamination of indoor air.

So, it sounds like it's not going to be a massive issue?

Yes. It’s our responsibility to assist them in preparing—from a technology perspective, product perspective, and from a business and selling perspective. We support them in determining which products are necessary. We have the technology and scale that sets us apart.

I think that’s one of the primary reasons customers or contractors prefer to conduct business with a lot of companies.

And our next question will come from Steve Tusa with JP Morgan. Please go ahead.

Senor Tusa, how are you? Hey, good morning. Just to follow up on Pat's question; I got on the call a bit late. Do you have complete visibility into all the OEMs pricing for the A2L product at this stage? Is there anyone holding back on the information?

Yes, we have visibility into every manufacturer's pricing. There are only one or two that haven't fully released their pricing yet. I don't think they are attempting to be evasive; I believe their timing is off. However, we have most of the pricing.

Do you think customers view it similar to a list price increase? I sense most of the OEMs are framing it as cost push, which is inevitable. How are they generally perceiving it?

I think most OEMs are serious about this price. They are incurring additional costs due to the new components in the systems, which leads me to believe pricing will probably remain around that 8% to 10% range instead of the estimated 15%. So there may be a slight reduction.

So, the 8% to 10% is somewhat lower than what they previously anticipated?

I think it is a bit lower, but not that much. We'll have to wait and see.

I want to remind you that you may be asking that question from an OEM perspective. From our side, buying $25 million of one SKU from an OEM, we might resell that $25 million at 1,000 different prices depending on the customer, market, and end market. So there are various prices, and even more importantly, there are variations in our buy prices based on the intended customer or end market. This process requires artful management, more so than strict analysis. We have improved our capability in this regard significantly over the last few years. This transition provides yet another opportunity to achieve the same results. If we need to react to market conditions, our OEMs will respond to our cost changes, which is why this is unpredictable. Our recent successes over the last few years are an indicator.

Right, and your point is that taking 10% and plugging it into a model isn’t that straightforward.

It’s far more complex because you have different market segments and variations in pricing.

Got it. Last one: on the light commercial side, everyone has had a good 3Q. One of your peers noted it was a bit slower in the fourth quarter. Do you see any signs of weakening there based on fundamentals for next year?

As the availability of commercial products improved, we saw some reduction in pricing. However, demand has remained fairly strong, still up double digits.

Great. Thank you, guys. That concludes our Q&A session. I would like to turn the conference back over to Albert Nahmad for any closing remarks.

Once again, it's always good to communicate with all of you. We hope you'll be here for the next quarter's numbers and performance. Thank you for your interest in our company. As we said earlier, it's winter time. Why not come down to Miami and see us for yourself? Bye-bye.

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