Business Breakdowns
· Matt Reustle
[00:00:00] S0: This is Matt Reustle and today we are breaking down Watsco. They are the market leader in HVAC distribution with a unique value proposition that they offer to the OEMs and suppliers in the space. My guests today are Lucy Adams, investment director at Caledonia Investments, and Alan Murran, co-head of public companies at Caledonia Investments. If you've ever had an air conditioning issue, you call your maintenance contractor and then you have them sit there on the phone as they locate a part. There's a decent chance it was a Watsco distributor on the other side of that phone call. Lucy and Alan will take us through the history of Watsco and some of the key steps like the initial pivot from manufacturer to distributor, how Watsco formed those key relationships with the major OEMs like Carrier, and then we dissect their reputation for a strong culture, one of those things that can be thrown out there as a term. But here you have an ownership mindset with what has to be one of the most unique employee compensation plans I have ever come across. Another long duration business that has been around for a while and evolved over the years that are always worth studying. Please enjoy this breakdown of Watsco. All right, Alan and Lucy, I am excited to be covering Watsco today. It is a highly regarded business in terms of how it has been run for a very long period of time. Just getting into it, I think the best place to start is with a simple introduction to Watsco, with an overview of what they do and just some general description around their business.
· Alan Murran, Matt Reustle
[00:00:00] S1: Thanks for having us on, Matt. It's great to be here. For anyone who lives in a hot climate, there's an important product in the home and that's air conditioning. We're here to talk about Watsco, North America's largest distributor of HVAC equipment. That's heating, ventilation, air conditioning and refrigeration. Watsco acts as the crucial link between manufacturers who make the equipment and the contractors who install and maintain it. Watsco was itself a manufacturer and moved into distribution in 1989. This was really a transformational moment for the company. Back then their revenue was around $64 million and it's now $7.5 billion, which means they're part of the Fortune 500. In 1989, the market cap was $22 million. Now it's around $20 billion. That's a 20% annualized shareholder return that's consistent over 5, 10, 20 and 30-year periods. It's really an amazing achievement and it makes Watsco one of those long-term quality-compounding businesses that we love to look for. [00:00:00] S0: We've covered some other HVAC names. Trane being a manufacturer, you mentioned they're a distributor. They act as this link. Can you get into a bit more detail about what it entails to be a distributor?
· Lucy Adams
[00:00:00] S2: They primarily sell HVAC equipment. Think air conditioning units, heat pumps, gas and electric furnaces. They also sell the parts and supplies that are needed to service these systems, and they sell exclusively to contractors who are licensed to install and maintain these systems in both residential and commercial buildings. As Alan said, they act as the middleman between those equipment manufacturers and the highly fragmented base of contractors. They operate through a network of distribution businesses and their local sales branches, catering to these contractors in a number of different ways. First it's about stocking that wide range of equipment and parts. Think multiple brands, multiple price points, and they are readily available across their large network of 700 or so sales branches. They also provide technical expertise to these contractors. The contractors rely on the Watsco sales team to help them with the right product selection, to help them check and process warranties, or even just to get quick access to product information. Finally they offer this suite of value-added services. By that I mean things like training programs. They're keeping this contractor base up to date with the latest product knowledge. They also have a range of digital tools, offering anything from access to a searchable product database, to the mobile ordering app, or their e-commerce platform, and even customer-facing tools that for contractors themselves – tools that help contractors grow their own businesses. If you bring all these things together, this is what makes Watsco a valuable partner to these contractors and not just the supplier.
· Matt Reustle
[00:00:00] S0: To paint the real world picture, I can remember distinctly having an issue with my heating system this past year; I called someone for maintenance. They checked it out. It's some very old system that needed a very specific part. They were calling around for it. I'm imagining that is where a Watsco distributor comes into play. Can you tell me if that is the correct example? And in general, would you say that the just-in-time, I need this at the moment is a big piece of their service? How much are they doing that versus well in advance project planning around HVAC equipment installations, maintenance, and more.
· Lucy Adams
[00:00:00] S2: I think that residential end market example is a great one, not only because we can all relate to it, but because that immediate need for repair and replacement products in the home is what generates the majority of Watsco's revenues. If your unit breaks, you want it fixed quickly. But it's not a DIY job. It requires a licensed professional. As you said, that first step is searching for and calling up your local contractor who visits your home, diagnoses the issue, and recommends a solution. It's at this point that the contractor would go to their local Watsco store to search for and buy that part that is needed to fix the problem. It's also at this point that the contractor might draw on the technical expertise of a Watsco salesperson. You use the example of helping to find a compatible part for an older system. Once they have both that knowledge and the part, they return to the home to complete that repair. What's interesting here is that the contractor makes a recommendation to the homeowner on what they should do. That's what puts the contractor at the center of this industry. It's why Watsco is laser focused on the contractor. They put them at the center of their universe and are focused on improving that contractor's experience, for example, by thinking about ways to make their life easier and helping them to be more efficient and more productive so that the contractors can grow their businesses. Fundamentally, the success of the contractors is what drives Watsco's growth.
· Matt Reustle, Lucy Adams
[00:00:00] S0: Can you give a sense just in terms of the market competition where Watsco ranks in terms of whether it's market share or any other numbers that you could just put around the business? [00:00:00] S2: This North American HVAC distribution market is valued at around $64 billion today. And that is primarily served by over 2,000 distributors. It's highly fragmented and primarily served by many local and regional players. Watsco is the largest national distributor. They have 11 to 12% market share and they're actually more than two times the size of its next largest competitor. After the top three or four players, the size of the competition drops away quite quickly to these smaller local players. A key differentiator between Watsco and its largest competitors is that Watsco is exclusively focused on the HVAC market, whereas the number two and number three players are actually more diversified across HVAC, plumbing, and other industrial end markets. They have that slight competitive edge in being able to focus on that narrower addressable market.