Business Breakdowns
· Matt Reustle, Alan Murran
[00:00:00] S0: Might be good to get into the history of that transaction as you mentioned. [00:00:00] S1: It is a very interesting deal. The history of Carrier itself is interesting as well. This history starts 120 years ago. The story is that there was a printing plant in Brooklyn where, during the summer, humidity was ruining the paper. The company asked a man named Willis Carrier to come up with a solution. He invented a system that used chilled coils to cool and dehumidify the air. That was the start of the modern air conditioning industry. Willis went on to found Carrier, which today is one of the largest manufacturers in the HVAC space. Then, throughout the 1990s and 2000s, Watsco wanted to manage more of Carrier's distribution. In 2009, they executed an original joint venture with Carrier that nearly doubled Watsco's revenue at the time, adding about a billion dollars. It was a transformational deal. Watsco financed this with equity. This was similar to the deal with Gemaire 20 years ago. This was designed to align Carrier with this joint venture and to the ultimate success of Watsco. What's interesting is that if you study the disclosures at the time of the deal, you can see that Carrier's margins were only around 2%. That was roughly a third of Watsco's margins at the time. Those margins have now grown sixfold. Win-win for both parties. The next step of this collaboration was that they agreed to pursue additional joint ventures for additional regions in 2011 and 2012. They have done more deals more recently.
· Matt Reustle, Alan Murran
[00:00:00] S0: I like the history. Willis Carrier, that's a name I'll have in my back pocket now for trivia nights. Does the relationship with Carrier limit the potential to do that with other manufacturers in the future? It seems like there's a very nice arrangement there. Could Watsco ever come up with a similar arrangement with another manufacturer? [00:00:00] S1: It's a very concentrated industry of manufacturers in the States at the moment. A lot of them outsource their distribution. Most of them have independent distributors other than Lennox. Most of them have an outsourced distribution model. It is quite difficult for Watsco to do it at scale on their acquisitions. Given the multi-brand approach, they are able to acquire distributors that represent different manufacturers effectively. [00:00:00] S0: You outlined the Carrier margin improvement over the course of their joint venture for Watsco. What does the margin profile of this business look like? And you can break that down however you like, whether it's unit economics or on a consolidated basis.
· Lucy Adams
[00:00:00] S2: I'd start by highlighting the different margin profiles for the different product categories, and then we can get into the margins for the business as a whole. Equipment sales, which comprise the majority of Watsco's revenues, have a lower gross margin compared to parts and supplies. That's because systems are higher-cost items and are more competitively priced compared to parts and supplies, which are smaller-ticket items and less price sensitive. Parts and supplies have also been a more recent focus for management over the last few years. This focus is driven by their efforts to capture a larger share of the wallet from contractors. They have also aimed to drive improvements in gross margins through product mix. In terms of end markets, Alan has already highlighted that residential sales have a slightly higher gross margin than commercial sales. If we turn to margins for the business as a whole, gross margins are just under 27% today, and management has clear ambitions to reach 30%. Their confidence comes from the fact that some businesses in certain markets are already operating at that level. Gross margin expansion has been driven by four key factors over the last few years. Firstly, greater purchasing power as they've scaled; secondly, securing better commercial terms with manufacturers; thirdly, the product mix—parts versus equipment. Finally, more recently, pricing optimization. They have incorporated technology into their operations and benefited from data-driven pricing. Operating margins are just below 11%, and improvements here have been driven by operating leverage as they've scaled. It's also a case of broad-based productivity gains across the supply chain, logistics, and warehousing. More recently, we've seen increased technology adoption by contractors, which is starting to reduce Watsco's cost to serve. We believe there's further opportunity to grow operating margins across all of these areas. Perhaps I can give you a couple of examples. In logistics, they discussed the opportunity to optimize their fleet of trucks. Incorporating technology to better understand how they can move products around their network, specifically across those 700 sales locations, more efficiently. Another example is that we still think there's a latent opportunity to reduce the cost to serve for the 60,000 tech-enabled customers.
· Lucy Adams, Matt Reustle
We think that's getting started. [00:00:00] S0: On the pricing impact on margin you mentioned in terms of where price increases come into play for the revenue side of things. But if we see manufacturers increasing the price of equipment, how does Watsco treat that in terms of a pure pass-through on a dollar for dollar basis? If it's a pure margin pass-through, where they manage it to maintain the exact margin, do they have a specific methodology or strategy around that? [00:00:00] S2: I think there are two drivers of pricing in the industry. Number one is these normal annual price increases by the manufacturers. They're typically raising list prices in the mid-single digits in January every year. The realization of those list prices is dependent on factors such as manufacturing capacity, local demand, and competitive dynamics among distributors and across different markets. But typically, Watsco's markup remains pretty stable throughout the year. The second driver of pricing in the industry is regulation-driven pricing. That is where manufacturers need to redesign systems or certain elements of systems to meet changing regulations and make these units more efficient and more sustainable. There's a cost to the manufacturers for doing that, and they need to recoup those costs. That results in high-single-digit to low-double-digit list price increases for these new systems. The realization of those list price increases in the market is a factor of demand that plays out throughout the year. But Watsco's margin remains fairly stable.
· Matt Reustle
[00:00:00] S0: In terms of visibility from year to year, every contractor or home appliance person that I work with has sold me on some type of annual maintenance contract. Everyone loves that recurring revenue stream. Does Watsco capture anything along those lines where there is some contractual nature to what they're doing? I know you mentioned about the maintenance and the services, and much of what they're doing falls into the bucket of maintaining equipment, which can also be associated with those contracts. Do they capture anything that would fall into that category?
· Lucy Adams
[00:00:00] S2: Those maintenance contracts that you highlight are typically between the contractor and the homeowner. Watsco is one step removed from the homeowner, given the two-step distribution model that we've discussed. Watsco's business model is transactional. It's not based on any long-term contractual agreements. That's because sales are primarily driven by that immediate need for repair and replacement products. Watsco's recurring revenues are driven by a large and growing installed base of these HVAC systems. There are over 120 million units installed across the US today. That base has never gone down. It has compounded at over 3% each year since 1980. All those units are going to break at some point. If your system breaks and it's hot and humid outside, you're going to act. It's a necessary product. That necessity isn't going to change over time. There's not a lot of discretion in terms of demand in this industry. The only real question is how do you act? Do you choose to repair or replace your system? If it's the latter, at what price point? But fundamentally, there's no deferral of that purchase and that's what drives the steady repair and replacement business. Those recurring revenues for Watsco.