Good day, and welcome to the Watsco Fourth Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.

Good morning everyone. Hope everyone is healthy and safe. And welcome to Watsco’s fourth quarter earnings call. This is Al Nahmad, Chairman and CEO and with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, also Executive Vice President. Now as we normally do, before we start here’s 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. Now onto our financial report. Watsco produced another record year, with sales, net income and earnings per share reaching record levels. We generated record cash flow of $534 million during the year, well in excess of our goal of generating cash flow greater than net income. This further strengthened our balance sheet, which is now debt-free and provides us the capacity to make almost any size investment to grow our business. We also announced this morning a 10% increase in our annual dividend to $7.80 per share. That reflects our confidence in our business. 2020 results were driven by steady growth with market share gains in our U.S. residential HVAC equipment business, which grew 10% for the year and 17% during the fourth quarter. Homeowners continue to invest in their homes as replacement sales at higher efficiencies remain strong from early summer through today. Looking long term, we see opportunity to be a significant participant and contributor in efforts to address climate change. Sales of high-efficiency products have long been a component of our business and have grown steadily in our sales mix over the past decade. This is an interesting data point. there are over 110 million installed HVAC systems in the United States, many of which are operating…

Good morning, Stephen.

Good morning, guys. Thanks for taking my question. I guess maybe just to kick off, I mean, obviously, 2020 was an extraordinary year in lots of ways, in terms of the stay-at-home spending and your market share gains and improvements in e-commerce, etcetera. But of course, that sets us up for what is potentially a difficult comparison in 2021, especially, as the year progresses. So I'm wondering, Al, maybe you can give us your thoughts about how you think the market will kind of be unveiled in 2021 relative to the opportunities for continued growth?

Well, I'll start with an answer, and then I'll turn to Paul Johnston to talk about the industry. I'll talk about ourselves. I think that we will -- we are set up to continue to grow over a number of years. We've talked about technology adoption. We've talked about our financial strength, which allows us to continue our active M&A program. We have a lot of things we can do to continue our growth, regardless of what happens to the industry, and we feel very confident in that statement. Paul, you want to talk about the market, next...

Yes. Yes, the market in 2021, it's tough to make a comparison, obviously, to 2020 because we had so many ups and downs and ebbs and flows and inventory issues and such. However, I think it's fair to say that the industry will remain strong during the year. New construction remains strong. Replacement demand, we're still seeing that following through with where we ended last year or beginning this year on the right footing. I think there's another phenomenon out there that's helping and changing the replacement dynamics. And that is, we're seeing homeowners stay in their homes for longer periods, and I don't mean because of the pandemic. I mean they're not flipping houses as they were in the early 2000s. We're seeing them stay in their homes 13, 14 years, which is a good indicator that when something does happen to your air conditioning system, you're probably going to replace it as opposed to repair it. You'd have more of a tendency to repair if you are planning to sell your home. So I'm bullish on that. Secondly, I'm also bullish on the idea that we have markets where we have very good market share, and we have markets where our market share isn't as high as we think it should be. So we still have market share gains that we're striving for and going for. And we have great partners working with us on the OEM side to help make that happen.

Good, Paul.

Okay. And my house is -- we're going on year 20, actually. So I get your point. Quick follow-up, if I could. I was really surprised by the inventory levels. You guys just did a really good job of keeping that under wraps as we ended the year. And I'm curious whether that's just more the strong demand in the industry, and you might have even preferred to have them a little higher? Or is that actually kind of the new normal with all the information technology kind of benefits that you've added to your inventory management.

That's a great question. Let me turn to A.J. for the answer.

Sure. It's a combination of all of the above. There were supply chain constraints in the industry. There was strong demand. And our technology enabled us to fill customer orders and take market share and show sales growth in that environment as well as it gave us new insight and tools to attack what we call non-performing inventory. Inventory that's probably been in our shelves for too long. So with more detail and more talent focused on it, we were able to move some of that old product out of the network as well. So it's a mix and a confluence of all three factors. And certainly, those efforts are going to continue going into 2021 and beyond.

If I could add -- I have one more thing to that, and that is, A.J. did a great job of not only getting the technology that we needed with the system side of it. So we had a visibility all the way through to what the inventory should be. But also, we were able to, fortunately, for us, before the pandemic, add people from different walks of life in the purchasing in the inventory management systems. People from retail, from different commodities mixed in with our group of people that knew the HVAC industry. So I think it bode well once we got into the pandemic that our people had varied backgrounds and capabilities, and we're able to work hand in glove with our OEMs and our other suppliers to make sure that we had a proper cadence with inventory receives.

You're so right, Paul...

And I...

We -- sorry, Barry. You're so right, Paul. We use technology as really shorthand. It's really people, process and technology. Technology just enables great people to put in great processes and create change and increase profitability.

Yes. I'll just add a layer of numbers to it. The reduction year-over-year was around $120 million, which is pretty astounding number. And I think part of the question is, how much of that is temporary versus permanent, right?

Yes.

We had to kind of cut through the conversations on and more than -- well more than half, I would say, it's permanent reduction from the point of view of technology and recalibrating how our stores actually operate and stock products and new order products with finished products. So certainly more than half and is, I would call it, a permanent reduction.

That's perfect. Thank you, guys.

Sure.

The next question is from David Manthey of Baird. Please go ahead.

Hi, David.

Hey, good morning. Hi, guys.

I hope it's not too cold where you are.

No. In Tampa, Al

For the Super Bowl.

We're absolutely fine. Actually, a little warm yesterday in the 80. But as always, hoping you can disaggregate the organic equipment growth, units versus price/mix there? And then your outlook for 2021 as it relates to pricing?

Barry, do you want to take a shot?

Sure. Well, Dave, first, if you look at the full year, which I think is a responsible way to look at it, the potential business up 10%, almost all unit growth, very little price, if any, a slight benefit on mix, mostly unit growth this year. And for the quarter again, I would say, a very similar circumstance, almost all unit growth, almost no price and a slight amount of mix benefit.

Okay. And with copper and steel and everything being up, should we expect that 2021, we could actually see a positive impact there?

Barry?

Well, there are two groups in that discussion. There's what the OEMs make products and what their cost inputs are, right? So almost all the OEMs already announced pricing actions, price increases for 2021. And that will flow through the inventory cycle and into the season this year. So I don't think we're ready to call it. It's a crystal ball, but there has been pricing announced, and we'll see how that fits through the market this year. We do sell non-equipment products that consist of metals, right? And there is inflation going on in that, and those prices have been increasing and accounts for some of the fourth quarter's benefit that you see in the nonequipment growth, while you're more encyclopedic than me about that, but I think it's some helpful price increases heading into 2021.

Correct.

Got it. Okay. And just to stay on that theme of the other HVAC products, assuming there was some volume there, I know you had a major initiative that you're working on and I'm assuming that some of that growth was early returns from that program. Could you just talk about the trends that you're seeing and the early returns from the initiative relative to other HVAC products?

I guess we can take a shot at it, Paul -- with that picture.

Yes. I don't think a lot of it was from the early parts of our initiative. I just think a lot of it was a little bit of pent-up demand with some of the equipment spotting that we had, that equipment wasn't available. So people had to repair their product. Had to repair a furnace. That's been probably the tightest market for everybody right now. As far as price increases, a lot of the steel and copper prices that Barry mentioned, did occur in the fourth quarter. They had a benefit, but really not material in the overall scheme of Watsco's revenues for the quarter. I think more of that is going to bleed into perhaps in the first and second quarter of this year. We'll have a better idea for what's going to happen price-wise with those commodities.

Thank you, alright. Thanks for the update, guys.

Sure.

The next question is from Jeff Hammond of KeyBanc Capital Markets. Please go ahead.

Good morning, Jeff.

Just on the -- good color on the U.S. res HVAC. Can you just kind of update us on, whether it be the quarter or full year, what you saw from the businesses outside the U.S., which still seem to be a headwind? And then just commercial trends 4Q and into 2021?

Barry?

Jeff, well first, the U.S. market, we speak to that pretty directly in the press release. Our other international -- we have international businesses really split into two other markets, Canada, which actually looked a lot like the United States at the end of the day. A good market, commercial market, underperforming residential, but on whole, Canada grew its sales and profits in 2020. And certainly is Latin America, that's where in our Latin American business, which we do publish in our 10-K, you can look -- glean some data from it. That's mostly a commercial business, and that's the business that went down in sales and profits this year, probably to the tune of about $0.20 a share, if I look at the full year. So when we speak about our results, again, put a placeholder for Latin America, which we expect a recovery this year and after costing us about $0.20 this year. Again, largely a commercial market. And like you're seeing in everyone's discussion, commercial market is improving, but still lagging. And 2021 could be a year of recovery that can have some benefit. We'll wait and see it and talk about it as it happens, but that give you a sense of 2020.

Okay. That's helpful. And then just on the SG&A line, can you just talk about maybe puts and takes as you think about that into 2021? Certainly good incrementals, very good incrementals in the back half. But it seems like a lot of companies tamped down costs in 2Q and then demand kind of came back quickly. So just how are you thinking some of those tamp down costs or temp costs start to come back and impact SG&A?

Go ahead, Barry.

Yes. Again, three factors, I think, in the answer, Jeff to kind of unbundle it. So 2020, you're right, an early spring reaction to all the knives that were falling helping with cost reduction and provoking cost reduction for good reasons. Second was interesting, the need to deal with double-digit demand thereafter for the next eight months. So certainly, some costs needed to conduct clear equation as 2020 played out. And then third, technology. What did we do, can we do, can we continue to do relative to technology, which is kind of the whole, outcomes of technology is to improve cost. Especially we should see gain of all the technology that's intended in that. So that's nice in abstract answer. If I look at 2021, I would say this, half of our SG&A are people. And commission growth, growth in incentive pay, we want that to happen. We would expect that to happen next year. And so with the SG&A increases, for example, in that category. Rent, which is about 15% of SG&A is, I think, flat this year. That's an accomplishment. Our teams went to landlords and dealt with the realities of what was going on in the market and this year's rent is flat. Well, that was otherwise intended to are likely to increase. I think some of those savings will be kept and sustained into next year. So if I try to summarize it without another 10 minutes of explanation, we would see some SG&A growth next year, just in the realities of what happened in 2020. We are making investments in our distribution network in 2021 with people and locations. And we see the opportunity. We have really OEM partnership in many of those efforts, and we're going to go out and expand our network some next year, and there'll be some SG&A growth for that. Otherwise, technology will help pinch those increases. And again, I would expect not the same performance but a moderate increase next year.

Okay. Thanks for the call, guys

The next question is from Chris Dankert of Longbow Research. Please go ahead.

Good morning, Chris.

Hey, good morning, guys. Thanks for taking the question. I guess just kind of looking into 2021, I mean, great, great performance on the gross margin in the back half of 2020. Definitely got things stabilized. I guess, Latin America is a moving piece. I know there's some mix dynamics going on, but how do we think about gross margin into the new year? Just any puts and takes you'd call out anything to kind of bear in mind besides just the typical price/volume mix?

Well, it's something that we're focused on. And whatever improvements you saw this year or last year, I should say, we continue to believe this year will show improvement as well because of our focus and because of the ability to do something about it through our own internal systems and approach to the marketplace.

I do assume Latin America was a piece of kind of what the headwind was kind of late 2019, early 2020, though?

2019, 2020? Barry, if you understand that, go ahead and answer.

Yes. Go ahead. Ask your question again. So what's the -- what are you getting to?

Yes. Sorry. So I think gross margin is kind of on a year-over-year basis in the latter half of 2019, early half of 2020. We're facing some year-over-year headwinds. I'm just curious how much Latin America was playing a role in that gross margin decline earlier in 2020?

Oh no, not at all. The margins internationally look like the U.S. margins -- gross margin. So there's no algebra that affects the mix of -- in some sort. It's really the blocking and tackling of getting pricing in the market. It's technology. There's a big pricing initiative going on to improve how we price our products go to market. And we talked earlier about inflation. And there's a lack of inflation in 2020. The opportunity inflation might help. We'll see. We don't know, until we get into the season. But those are the larger moving pieces.

Got it. Got it. All right. And then I guess, something we haven't touched on lately. Just any update on Russell Sigler, either in terms of investments being made there, kind of what's required in terms of investments? The likelihood of kind of further consolidation of ownership? Just anything you can share there would be great.

Well, we can't share much. We're in a minority position, and we're very supportive of anything they want from us. And that's all I can say. We don't -- we have no idea what their intentions are in terms of divesting more ownership.

Yes. Even in terms of -- I mean, how are they pulling on some of the technology tools? Are they fully integrated in terms of how they can use OnCall Air, that type of thing?

What we can tell you is that we're very pleased with their performance. All Across

Understood.

Yes.

Thanks so much, guys.

The next question is from Jeff Sprague of Vertical Research. Please go ahead.

Good morning, Jeff.

Hey good morning everyone. Thanks for the questions. I guess maybe somewhat following up on that last point. I just wonder if you could speak a little bit to what you are seeing in potential M&A landscape. And I imagine there's a little bit of tug of war. Business is good. So perhaps people aren't eager to sell, but by the same token, it does seem like the technology changes maybe are kind of increasing the pressure on some of the smaller guys. So just the state of play there? Should we expect other M&A to happen in 2021? Maybe some color on the activity in your pipeline?

Well, I'll make a general statement and then Barry, who leads our M&A, can provide more information. Watsco is an acquirer. And as part of our overall strategy, we have a $5 billion revenue in the $40 billion industry. So our share has a lot of room to grow. And we use our balance sheet to support M&A. And we are active, and we do think there's no promise, but we do think we'll have M&A this year. And I do think that the reputation for our culture, we're a different kind of an acquirer. We're not disruptive, we're supportive. And all the other things that we add, the capital, the equity for the key people in the organization, our 401k, which is -- our donations are in Watsco shares. That sort of thing is culturally attractive, I believe. And as I said, lots of opportunities since we're only $5 billion out of the $40 billion. And now some of them are very small, but it doesn't matter to us. We just try to bring in people that want to continue working and continuing building what they have with our support. And Barry?

Yes, Jeff. Just first, Jeff, welcome back. Yes, two things I take to remind everyone of is, the focus of M&A is kind of the regional superpower businesses that are in this industry. We're not attempting to roll up a fragmented industry. We're focused on the largest of targets that will drive growth and share and then platforms to build on and invest in. The second, big picture fundamental is, we would rather invest in businesses when they're growing and reaching greater strength, we'll not turnaround experts, we're not looking for a dip in the market to buy. We're looking to invest in strengthening businesses. So I think this environment after everyone has been through a lot this year, net-net is stronger now than it was a year ago. So I would say that presents us opportunity and certainly gives us confidence in where the good businesses are. But having said that, for 2021 I'll never be able to predict a thing, other than to say some of the targets that were technology discussions were the reason for the discussion. Along with performance, I think that rekindling of that effort can happen now that we're through some of the weirdness and again, the foundations are stronger today than they were a year ago. So I would expect some great conversation. Whether there's great transactions or not, is still to be seen, but...

There's got to be a great transaction, Barry. Good answer. We're very optimistic about that. No guarantees, but we're very optimistic.

Very well. Thanks for that color and good to be back on the beep, Barry. Thanks.

The next question is from Steve Tusa of JPMorgan. Please go ahead.

Go on, Steve.

Hi, guys. How is it going?

Doing good. Come visit.

I'd love to. It's a little snowy up here. Question for you on Carrier said their backlog in residential was up three times year-over-year. Backlog is not typically the type of thing we talk about in residential, especially not in December. Did you guys get out in front of some of these price increases or availability concerns and order a bunch, that they'll deliver to you guys in the first half here?

What a question. Who wants to volunteer for that answer?

I will. It's -- no, we did not do huge pre-buys. We did several buys just to make sure that we were refilling the inventory that we lost though we still had a deficit in. Very selective. One thing that we did during the entire pandemic is, even when everybody else was canceling orders, we maintained the cadence of putting in orders and maintained our order board throughout the entire pandemic. And so we really didn't -- we had shortages, yes, but we didn't have these yoyo type inventory movements like a lot of people did. So we feel like, we finished the year in good shape on inventory. Yes, we have a concern going into 2021, that we'll be able to maintain that status. But we're working diligently with our OEMs on a daily and weekly basis to make sure that we're getting the fulfilment we need on what we have on order.

Yes. I guess that wouldn't be an inventory, right? If there was backlog for them, that's something they would kind of shift to you guys in the first half or whatever? So I mean, are they -- it's kind of unusual that you'd be allowed to just kind of like place a paper order and get terms and they would essentially be holding whatever what they have or finished goods they have. So none of that activity?

Like I said, we've got our orders -- we put our orders in the way we always have. We have a pre-buy, like we always do. We're not trying to be unusual here. Most of the manufacturers, I think, continued building product during the offseason, where they normally would have shutdowns. I think that was pretty much universal across the OEMs.

Did you -- speaking of the OEMS, I think it's pretty clear that Goodman lost some share, whether it was their fault or not. Are you seeing any kind of -- do you expect any kind of swings? I mean you pretty much serve them all. So it's not like it's a negative or a positive for you guys either way. Do you see any kind of swings back this year between the guys that kind of won and lost in 2020?

I guess that's an hundred dollar question that everybody has. Will the dealers go back to the brands that they first worked -- that they were loyal to, that they couldn't get availability or they lost and they went to other brands. And I guess that's what everybody's marketing plans are all about. It has been able to maintain share gains that they picked up in prior year.

And then one -- just one last one. I've noticed Goodman's acquiring a few distributors recently. I think it's been selective and mostly around their Daikin brand. And we also understand Ferguson is kind of looking to be a bit more aggressive here. They put out some pretty publicly aggressive targets. Anything you've noticed on kind of around the block, if you will, about a little bit of an increase in competition?

Competition is always strong. And the one you mentioned and others, it's a very fragmented industry that we think we have advantages that others don't have. And we've had that for a number of years as evidenced by the growth that we've had. I don't see any reason why that's not going to continue. I think we're actually getting stronger. I'm more optimistic about the future than anything we've done in the past. We're on a roll.

Right. Clearly, the digital stuff has worked out for you guys. So congrats on that.

Yes. It has. And it's just beginning.

This is A.J. Going back a question to the market share, which ties right into what the conversation was now is that, we saw huge new growth and new customers buying from the Watsco Company, which is exciting. And at the same time, we're seeing all-time low attrition rate of customers. So I think what that tells you is that customers are finding -- it's very good to buy product in the Watsco companies. We're good partners to these contractors as we try to make it easy for them to do business with us, we try to help them grow their businesses, and that's getting more and more valued and appreciated.

Right. It sounds like A.J. is up for a raise, Al. So

Well, I agree with that.

Thanks, guys, appreciate it.

Good to talk to you.

[Operator Instructions] The next question comes -- is a follow-up from Chris Dankert of Longbow Research. Please go ahead.

Hi, Chris. Just one more from me. I guess we talked about your inventory, OEM inventory, let's go down one level. I mean what are you seeing at the customer level? I mean are they still stocking a bit more than normal, still kind of skittish about being able to get product on time? Just what are you hearing back from customers and what their inventory position looks like?

Paul, why don't you take that?

Yes. It's -- most of the dealers and contractors we do business with, really don't maintain any inventory, just base inventory in parts and supplies. So that really isn't an issue. Some of the larger contractors do carry some inventory, but it's -- they really rely on the most part, the industry relies on the distributor's supply inventory. Do we think there are some contractors who may have been concerned about the shortages of last year and they're trying to put some inventory in place? Yes, I think there is some of that happening. To what extent? I really wouldn't have a read on that right now.

And it also remains true. The vast majority of our customers rely on us for their inventory.

Yes. That's right.

Yes. I mean an example, we have 100 business units that we call Baker is probably pushing $1 billion in terms of revenue as part of Watsco. I would say 99.9% of what they sell today was ordered within the last six hours. None of their customers are out, talking, drawing from inventory and replenishing with us. If I said de minimis, that's overstating it. Some of them...

That's 95% of the market. I mean dealers carry motors and ambassadors and some line set, some copper tubing, refrigerant, but generally not equipment.

Got it. Thanks so much.

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

Well, thanks for listening, and I'll talk to A.J. about his raise. We appreciate your interest. I just want to give you the confidence level that I have, that we're really on a roll here. I think we're very strong and going to get stronger. I think business is solid at the start of the year. And I hope that continues. And take us up on our offer; call us about learning more about the technology initiative. It's a game changer. And other than that, I wish you all to stay safe and stay healthy, and we'll talk at the next quarter. Bye-bye now.

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