Watsco Inc Q3 FY2025 Earnings Call

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

Good morning, everyone. Welcome to our third quarter earnings call. This is Al Nahmad, Chairman and CEO; and with me is A.J. President of Watsco; Paul Johnston; Barry Logan; and Rick Gomez. Before we start our normal cautionary statement, this conference call contains forward-looking statements as defined by SEC laws and regulations and is made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. I'm pleased to report that Watsco generated healthy earnings and record cash flow despite a very challenging market environment. As you all know, 2025, a year of significant transition to next-generation equipment continues A2L refrigerants. The transition affected roughly 55% of products sold and influenced nearly every aspect of our business. Regulatory changes have historically been beneficial for our business and for our customers. In the long term, we expect this transition to be no different. The transition is substantially complete, and we look forward to operating a much simpler business in 2026. Throughout all of the volatility, we are satisfied that our earnings are largely intact. Our balance sheet remains strong, and our technological advantages remain immense. We certainly expect the current volatility to be temporary and will ease as the transition concludes. We operate in a great industry with strong long-term fundamentals and have the most accomplished leadership team, all with a long-term focus to keep building on our success. Turning now to our third quarter results, sales declined 4% in total and 3% in the U.S. While unit volumes remain subdued, we achieved double-digit pricing gains on new products with growth in sales for both non-equipment and commercial refrigeration products. We again improved gross margins, which expanded 130 basis points to 27.5%. As we have expressed before, we have several ongoing initiatives to enhance gross margins with long-term goals of exceeding 30%. Operating expenses increased 5%, reflecting some ongoing inefficiency tied to the product transition, as well as new and acquired locations. With the product transition largely behind us, we expect SG&A performance to improve from here. We continue to fortify our balance sheet by reducing inventories and overall working capital. We generated record third-quarter cash flow of $355 million, providing incremental opportunity in the fourth quarter as we close out the year. We remain fundamentally positive and optimistic about our position in the industry and our ability to generate growth. Our balance sheet has a healthy cash position and no debt, allowing us to invest in growth opportunities of any size. This includes the capacity to co-invest with our OEM partners as we head into 2026. We also continue to invest in innovation and technology that separates us from our competitors. We have made long-term progress in driving adoption. For example, e-commerce penetration continues to grow and accounts for 34% of our sales, and up to 60% to 70% in certain U.S. markets. Let me reiterate, e-commerce penetration continues to grow and accounts for 34% of our sales, and up to 60% to 70% in certain U.S. markets. The number of contractors and technicians engaged with our mobile app now stands at 72,000 users and grew an impressive 18%. That means 72,000 of our customers are using our technology. The annual run rate of sales to OnCallAir, our digital selling platform for contractors, saw a 19% increase in the gross merchandise value, reaching $1.7 billion over the last 12 months. We are also making next-generation investments to enhance our competitive position. For example, we are developing new technology aimed at capturing more sales from institutional customers. We are accelerating the use of pricing optimization tools to make progress toward our 30% plus gross margin target. We have launched a new initiative to peak and grow sales in the highly fragmented non-equipment market, which today is roughly 30% of our sales. We have begun to harness artificial intelligence, both internally and externally, offering the potential to further transform our customer experience, improve operating efficiency, and create new data-driven growth strategies. Our technology investments are making a significant difference, and we believe the impact will only grow with time. We look forward to sharing more during our upcoming investor meeting in Miami in December. I can't wait to see and meet you all this December. These investments, along with our scale, entrepreneurial culture, and capacity to invest, are unmatched in our industry. With that, let's turn to Q&A.

The first question comes from Tommy Moll of Stephens.

I want to start with a question on the repair versus replace dynamic. It's been a couple of quarters in a row now where your non-equipment business trends have been well ahead of the equipment trends. You've obviously been very disciplined on pricing for the new equipment. I'm curious if the simplest explanation here is just that we're seeing some price elasticity among homeowners? Or is there something else you might call out?

I'm going to let Paul Johnston respond to that.

Yes. It's not a repair versus replace. It's a repair and replace. I think we said that on the last call. What we've seen is the larger dealers that have salespeople generally don't sell compressors and motors; they generally sell the equipment side. And what we see with the people that don't have an in-home salesperson is that they will repair the unit. So we see a dichotomy there among our customers. Also, there's a geographic spread where if you're in Pennsylvania and you've got an 11-year-old unit in your house, you're generally going to repair it and not replace it. It's got a 20-year life. In Florida and Texas, where you've got a shorter life, you're generally going to replace it with a new piece of equipment. It's really difficult to pinpoint exactly where and who is creating a repair versus replace market.

And just some data behind that. When we say non-equipment, there are really two things that are not equipment parts and supplies. That may be a more direct way of calling that category something parts and supplies. So parts essentially make up 8% of Watsco's revenues, while supplies make up over 20% of Watsco's revenues. So just in the scope of that discussion, parts will never substitute what's happening in the replacement market. The data just doesn't support that. So at the end of the day, it's the consumer that's spending $8,000 to $12,000 on a pair of new machines for their home. As Paul suggested, in the Sunbelt, that's a more frequent and necessary purchase compared to the northern regions. So we like that Watsco's 75% of the Sunbelt in that respect. But the crux of the answer is built on what consumers are spending on their homes right now. And that's probably a bigger orientation than whether we're selling more compressors or not versus the replacement market.

As a follow-up, maybe we'll address the elephant in the room here, maybe just take it on directly. Yesterday, Carrier mentioned that their October distributor movement was down 30% and they expect something like down mid-20s for November and December? Does all that sound reasonable in terms of what you have seen or expect to see for your equipment business this quarter? And should we think of that in terms of volumes or sales?

Well, that's a very good question. I don't think we're out of the woods yet, so there's some merit to that. Who wants to add more to that? Is it you, Paul, A.J.?

I think it's pretty much in line. You've got to remember that the shipment data you are seeing was up last year as a lot of the OEMs were shipping a lot of 410. So the shipment data coming out of AHRI isn't indicative of what's going on in the market. When you look at the actual unit sales without the price increase, I think they are pretty much in line with what the market is showing. Now that's going to vary from region to region. We're seeing some real strength in certain parts of the country, and definite weaknesses in others, so it's not across the board.

But in aggregate, we are not seeing an increase in demand in the fourth quarter. In aggregate, it's still below this time last year. This time last year was an extraordinary quarter. Nevertheless, we're observing that, and we're becoming more productive and efficient given the lower volumes, temporary as they may be. We are adjusting to the circumstances.

And Tommy, just to clarify one aspect of that is that the 20% to 30% is unit volumes, not sales dollars. I want to be clear about that.

You read my mind.

Let me just provide a little context here. A year ago, fourth-quarter unit volumes for Watsco were up almost 20%. And a year later, the variance will be exposed to that comparable. After the fourth quarter is when things began to stabilize. So I think the fourth quarter last year occurred when the transition started. The 410A availability peaked, and contractors and builders were drawing on distribution. It's the last of the cyclical components in this discussion. The fourth quarter is also the smallest quarter of the year, so there is noise this year, but it does not necessarily bear resemblance as we move forward into next year. It's more about the comparison to last year than any significant market change over the last 20 days.

Sure. I think that last one summarizes the barrier. Our pacing and the industry pacing is roughly the same, with the comp changes in Q4.

Rick, is there something you want to add with the work you've done?

Yes. It's obviously been a fluid market and one of the noisiest years in our industry in some time. With all that noise, our earnings are largely intact, which speaks volumes about the resiliency of our business model and distribution in general. To examine the big macro factors, we don't have influence over interest rates, consumer sentiment, or new housing completions, or existing home sales. These all impact unit movement numbers. However, we have control over many other aspects including how many customers we serve, which has grown steadily. We have influence over our margins, which have steadily improved with more upside to go. We manage our expenses and are taking steps to improve efficiencies. We control our inventory, and as you can see, we've made great strides in improving working capital and cash flow this quarter. We have influence on how we partner with OEMs, and we are developing aggressive growth strategies with key partners for next year. Our balance sheet is stronger than ever. We control our technology, which is our most important competitive advantage, and we are innovating in real-time to support future growth. Even as we navigate this admittedly fluid industry dynamic, we've done a great job acting on the things within our control, and we will continue to do so.

The next question comes from Ryan Merkel of William Blair.

I want to follow up on the fourth quarter. Could you just comment on what you've seen quarter-to-date in terms of total sales?

It's soft.

Okay. Got you. So yes, it sounds like your biggest supplier is talking about units down 30%, and we don't totally disagree with that?

No, we're not in that arena of softness, not even close. It's a single-digit decline, probably mid-single digit so far in revenue.

Okay. That's helpful. So mid-single-digit decline. And then I'm curious, if you talk about the third quarter, the shape of the quarter, it seemed like July started off flat year-over-year. And then from what I heard, August was rough, and September was also tough. So it's a two-part question. Did you observe the same? And what do you think is the reason that unit volume fell off so much in August and September?

Barry, Paul, do you want to deal with that?

I don't know. Barry, do you want to grab that one?

Because contractors installed fewer systems.

Yes. To consider the number of units that declined, we can count the number of units we sell into new construction, and it was down as a percentage in that overall discussion. New construction is the largest component of that discussion. Interest rates, homebuilding activities, and existing home sales all contribute to unit movement numbers. There's a measure of consumer discretion always when a contractor walks in and says that this will cost you $10,000 to $12,000. The consumer's state of mind impacts where this goes. Did it get worse in August and September? It appears so. Is it permanent or temporary? Is it long-term or short-term? We will see. Historically, it's usually short-term. But anyway, those are the big picture thoughts.

Okay. I appreciate that. I know that's kind of a hard question to answer, so I appreciate you entertaining it. I'll pass it on.

The next question comes from David Manthey of Baird.

This is the closest I've come to hearing guidance in my 25 years covering Watsco. But as long as we're talking about it, the minus 5% to 10% revenue declines in the fourth quarter, we're talking about equipment only, correct?

No, we did not give guidance. We did not give guidance. We provided a percentage of what we see thus far in the quarter in October.

But in equipment, Barry, right?

No, that's overall.

Okay. Fair. Okay. All right. If you believe in this normalization theme, you have a lot of cash, no debt, and a healthy dividend. The stock seems to be on sale here. Is there a thought about allocating some of your cash forward to more aggressive share repurchase at these levels?

That's an excellent question, and I thought about it. We considered it. But on the other hand, the softness in the industry creates opportunities for us to engage in acquisitions. When we compare our financial strength to others, we're at the top of the heap. Some distributors may finally want to venture with us, either through a joint venture or a full sale. We have to remain open to the possibility of stepping up our acquisition activity. I don't know if it will happen, but we need to be ready.

The next question comes from Jeffrey Sprague of Vertical Research Partners.

I want to come back to inventories. It was nice to see that sequential step down in Q3. Just want to think about where we end the year. Obviously, a lot of that depends on things you've said you can't control like end demand, but what is your view at this point in time of sort of how you end the year? How close to normal inventories you might be as you obviously then start to pivot the focus into 2026?

Well, I'd say that generally we want to increase inventory turns, and that effort will continue into the fourth quarter and beyond. We're going to improve inventory turns. That is our goal. So I believe I've answered your question; that is a focus, and we have the capability with our technology to do something about it. As you can see, inventory is coming down, and it will continue to do so in Q4, with turns slightly increasing. Turns create more cash for us, and we like that.

And like more cash too.

There are really two angles to this question. One is will our distribution channel at Watsco be in a more conventional position. That's really almost an OEM orientation that examines whether the inventory has been reset in line with conventional inventory levels. So, yes, there's considerable progress in Q3 and more in Q4. You can look at where we are today versus history and answer it analytically, and I can help with that. But what Al was stating is how does inventory affect us moving forward. What if we had five inventory turns instead of four? What would that do to our return on invested capital, our real estate, and cash flow? What would it do to the overall handling and load we carry in our stores with lower inventory and more optimal turns? These are our focus points while trying to reduce inventory by year-end. Last quarter, we targeted $500 million in reductions by year-end; the third quarter accounted for $350 million of that. I think we can improve on that target. It's a slower time of year to say, but by the end of the year, I believe inventories will return to near historical levels relative to our company's size.

Let me reiterate, we currently stand at about 3.6, 3.7 turns. We want to be significantly better than that. Barry was just throwing some numbers out there. I'm giving you more precise figures. We have an opportunity to significantly improve inventory turns, which will also substantially increase our cash flow, making our business more productive with higher inventory turns. We can get our manufacturers to participate in this improvement because generally, we are their largest customer, and we have the largest impact on the unmet market. That's what we're doing with them and our technology to achieve these higher returns. And I like that; I like higher returns and cash flow. We're at $600 million in cash flow right now. I'd like to see that number get larger so we can have the capacity to engage in any transaction that comes our way without going into debt.

Our next question comes from Chris Snyder of Morgan Stanley.

I wanted to follow up on some of that inventory conversation. It seems like you believe you'll be at roughly normalized levels by year-end. Should we expect the typical ramp in inventories from year-end into Q2 that you've historically seen, or could that be more muted given the inventory backdrop?

Well, that's an interesting question. I can only say that we're trying to improve our inventory management. History does not dictate what we'll do moving forward this year. I believe whatever we've done in the past, we'll do better.

Yes. Think about the last five to six years in our industry. We've had changes in industry standards on efficiency, then the refrigerant changes hit us, and we had the pandemic. It hasn't been normal regarding lead times with our OEMs for the last several years. For us to return to normal means that we order something and receive it within four to six weeks, without lengthy lead times. That's how you adapt your inventory to achieve a five-turn rate.

We're trying to get manufacturers to expedite deliveries. Whatever they have to do to reduce lead times is part of the effort. Given our size, they listen to us. I'm hopeful, but I believe we will see improvements.

I appreciate that. As a follow-up on price, the OEMs that have reported so far discussed expectations for incremental pricing in 2026. This is somewhat surprising given the affordability challenges and overall headwinds facing consumers. What are your thoughts on that? Given your balance sheet, do you feel like it gives you a better ability to negotiate than in years past?

I find it challenging to provide a complete answer.

That's a tough question.

We're a good customer of our manufacturers, and we will always aim to maintain those relationships.

Bottom line, when you look at the average transaction out there, our value content to the contractor is about 30% to 40%. If it's a $12,000 installation, the amount of product we're selling is in the $3,000 to $4,000 range. So a price increase at that point is not going to significantly halt transactions with the consumer. We don't know what we're facing from the OEMs yet, and until we do, we can't react to it.

The next question comes from Mitch Moore of KeyBanc Capital Markets.

I know most of the industry is already in those entry-level baseline SEER products. However, can you discuss the mix in the quarter? Could you elaborate on whether you're seeing consumers trade down to lower-tier products?

Yes, that's been occurring all year long. Whenever there's a change in product, everything tends to migrate to base models. The base model today is 15.3 SEER in the South, which is a very efficient piece of equipment that I wouldn't call base anymore; I would call it almost high efficiency. So it's been relatively steady. The data we have only covers the first two quarters of the industry, where it has remained flat as far as the SEER ratings. It's typically higher on heat pumps than it is on straight cool.

The exception and an exciting thing happening in our business is that we can assist our customers in upselling, particularly through OnCallAir. I can confirm we are approaching $2 billion in customer sales through that tool, and an impressive statistic is that over 70% of the sales that occur are above the minimum efficiency standard. Unlike the rest of the industry selling at 80% or 85% minimum standards, OnCallAir shows over 70% above the minimum standard. The more we can achieve this, the better it is for everyone in the channel.

Well said, A.J. Can you explain OnCallAir? There may be some new people on this call.

Sure. OnCallAir is a technology initiative. It is actually a business we created in our Watsco venture subsidiary and has developed software that's truly a sales engine for our contractors or our customers. A customer, like A.J.'s heating and cooling, would be an OnCallAir customer and use our software to sell in the neighboring houses. It's equipped with all of our data about products we sell, pricing, inventory—everything needed to create top-tier, professional proposals for homeowners or building owners from contractors. Our customers using it are winning more jobs, securing higher-ticket jobs, and there are more margin-rich jobs. As I mentioned, they're often selling higher efficiency systems than the base tier. So this initiative is growing rapidly and is a win-win-win for everyone in the channel.

That's super helpful. Also, record gross margins here in the third quarter. Could you unpack the moving pieces within that? How much of it comes from mix benefits from other HVAC products versus some carryover OEM pricing?

This is Rick. I can help with that. There are two or three contributors that support this positive trend and feel good and sustainable. First, we had growth in non-equipment, and as a category, that non-equipment business has higher gross margins. That contributes to our gross margin. There was some carryover benefit from OEM pricing actions made in the spring. Lastly, the pricing optimization tools we’re using are maturing and improving in the field. AI is improving these tools even more, and transactional margins have been very resilient in a down market and are actually slightly up. We take comfort in this and feel it will be somewhat sustainable, perhaps even permanent, and those are the key contributors to the margin expansion.

Just to clarify...

Let me just caution that we do not want to provide information to our competitors that they can use against us, so let's be careful how much detail we share.

I was just going to reiterate what you stated, Rick, about controlling what we can control. It's important to remember we're a long-term company. Although this is the third-quarter call, our responsibility is to invest and steer the business for long-term health and continuous improvement. We've talked about our inventory. We're discussing the current quarter and next quarter, but ultimately, we're focused on achieving five turns. This pertains to pricing, noise, OEM changes, etc., but we're also committed to enhancing our operational framework to structurally increase our margins over the long term. This is true of our technology initiatives—that help customers digitize their businesses for increased efficiency as well as ourselves. All of us are striving to enhance that efficiency.

Our next question comes from Steve Tusa of JPMorgan.

On that point about this year being unusual, as you stand today, do you view this as abnormally low? Should we expect a rebound in sell-through next year? Or is there not enough visibility to make that call?

We do think this year has been unusual; the demand has been unique. I would like to think we will return to normal next year, but no one can predict exactly how the weather and other factors affecting demand will behave. That's uncertain. However, are we stronger now? Will we be stronger next year? Yes. All I can control is what we do. We will improve our capabilities regardless of demand conditions because that's who we are. We are committed to enhancing our capabilities to do things our competitors cannot, innovating in technology and bolstering our cash position for potential M&A. Whenever the opportunity arises, we will be ready.

Yes, control what you can control.

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

It was a pleasure today. I enjoyed it. We have a great team here at Watsco in Miami, and I sincerely hope as many of you can come to Miami in December. We'll welcome you with open arms. Thank you for your interest in Watsco. Goodbye.

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