Business Breakdowns
· 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.
· Matt Reustle
[00:00:00] S0: It certainly adds visibility when you have some sense of equipment, its useful life and replacement, let's transition to the management of cash flows and balance sheet inventory. I think of a distributor with a lot of inventory available to serve the entire market. How does that impact the financials of the business, whether it's conversion of free cash flow or capital being tied up in inventory, how do you think through that?
· Lucy Adams
[00:00:00] S2: This is a highly cash generative business with over 100% cash conversion in most periods. Their top priority is to invest in the business and improve their strength over the longer term. Whether it involves investing in working capital to ensure that inventory is in the right places and readily available, that is a top priority. It's also investing in the salesforce and these technology initiatives. But after these investments, the priority is returning cash to shareholders through a growing dividend stream. Over two-thirds of free cash flow goes into paying dividends, and those dividends have compounded at over 20% annually over the last 35 years. That's quite a remarkable achievement. The prioritization of dividends is not as common in the US; we often see cash being diverted more towards share buybacks at Watsco. It's an important source of income for key leaders who are restricted stock award holders because they're entitled to receive these dividends during the vesting period. It's important to mention here the special dividend distribution that they did back in 2012, because it shows their thoughtfulness around capital allocation and maximizing shareholder returns. This is when they paid the equivalent of two years of dividends ahead of an adverse change in tax rates on dividend income. The final point on capital allocation is the robust balance sheet that they run. Alan touched on this when he talked about the transactions that they've completed. They have this strong aversion to running too much debt. It is cultural and, as they'll say, they will not bet the ranch. This allows them to withstand difficult macro environments, but it also allows them to be in the best position to fund any growth opportunities at any point. The carrier transaction illustrates that perfectly. Because of their strong financial position and their long-term mindset, they were able to execute this deal during the GFC, a transaction that doubled the size of the company.
· Alan Murran, Matt Reustle
[00:00:00] S1: The inventory turns have always been a focus at Watsco, and they've been using technology to improve this. We haven't yet seen this turn up in the numbers, and that's because during the supply constraint periods post-COVID, it was more difficult to manage inventory. This technology allowed them to maintain their turns, rather than worsen them during that period. We expect to see this improve over the next year. [00:00:00] S0: You brought up technology adoption within that answer. It's been something you mentioned. Being a service that can improve productivity of contractors, you can understand why that might show up in the margins. I picture a contractor no longer needing to get on the phone and spend 35 minutes figuring out where a part is. They might have access to software or some type of digital database to look for that. Sometimes we hear about this investment in technology and hear the story, but it doesn't show up in the numbers. Can you touch on those two things? The use cases and how it would show up in a real-world example, and then whether you're seeing the follow-through into an improvement in financial performance.
· Alan Murran
[00:00:00] S1: In Watsco's case, it shows up in a number of places. Watsco started to digitize this entire business model about 15 years ago. The HVAC industry at this time operated in an analog way. Imagine all the product information was paper-based. There was no e-commerce. You can picture the contractors who turned up at the branches in their trucks. They would wait in line, they would check to see if the product was available, or they would be filling in reams of paper to determine if it was under warranty. It's really an industry ripe for digitalization, and this is going to be addressed through three different core pillars. One would be their internal tools, the second would be the solutions they've developed for the contractors. And then third would be this customer-facing innovation. This is to help the contractors sell to the homeowners. On the internal tool side, Watsco uses this to improve their own operating excellence across areas like demand forecasting, inventory management, and pricing. Matt, it involves using data and technology to help their employees. For example, by digitalizing order fulfillment in the warehouses. This makes life easier for the warehousing staff and makes them much more efficient. As an ancillary benefit, contractors will know when the orders are ready and they can arrange an express pickup. Another example is the pricing optimization tools. That is something we have seen contribute to gross margin. In fact, it has been one of the key contributors over the past couple of years. In addition, regarding the roll-forward improvements and the new targets for the tools for contractors, the goal is to make life easier for contractors, increase their productivity, and make them grow faster. And one key platform we have seen grow is e-commerce. This accelerated around 10 years ago, hitting about a quarter of sales in 2017 and is now closer to 35%. Some of the benefits evident in the numbers are that, in Watsco's traditional business, customer attrition is about 10%, but it is only half for e-commerce users. Additionally, Watsco tends to sell 20 to 25% more line items through the e-commerce platform. And on the last leg is this customer-facing innovation. As I mentioned, this is to help the contractors sell to the homeowners. This sits within a division of Watsco called Watsco Ventures.