Business Breakdowns
· 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.
· Alan Murran, Matt Reustle
This part of the business invests in startups as well as develops its own in-house software. And one success story here is something called Encore, which is a digital sales platform for the contractor. Imagine the old process where the contractor would come to your kitchen, scribble prices on a notepad, and flip through a brochure. Now it's a much more interactive process on an iPad, featuring images and multiple options, and it's much more in line with what consumers expect today. As an ancillary benefit, Watsco Ventures is attracting great young talent into this established industry. And from an employee perspective, if you join Watsco Ventures, you're working in an industry ripe for digitalization, backed by a strong C-suite and significant financial resources. And as a consequence, these hires create a ripple effect within Watsco's culture and keep it moving forward. [00:00:00] S0: Is the Watsco Ventures strategy new? Is it something that's been around for a while? [00:00:00] S1: It was established probably around 10 years ago, I believe. And it's something that, when they were looking to digitalize and wanted a part of the business dedicated to helping contractors, they created this area and, if they have the right skills and internal attributes, they will develop in-house software. Otherwise, they'll partner or invest in startups. And it's quite an innovative way to try to improve things within this established industry.
· Alan Murran, Matt Reustle
[00:00:00] S1: It was established probably around 10 years ago, I believe. And it's something that, when they were looking to digitalize and wanted a part of the business dedicated to helping contractors, they created this area and, if they have the right skills and internal attributes, they will develop in-house software. Otherwise, they'll partner or invest in startups. And it's quite an innovative way to try to improve things within this established industry. [00:00:00] S0: It's very fascinating to see the evolution of that strategy and the contrast between those who do it well versus those who spend a lot of capital on initiatives that don't deliver much. But that certainly seems like the proper way to open source good solutions for the customer base and potentially get some aligned incentives there. On that point of incentives, the cultural dynamics are very interesting at Watsco, and one of the most interesting things I've ever come across is their incentive plan. Maybe you could just outline that and what makes it unique.