Watsco, Inc. (NYSE:WSO) Q1 2023 Earnings Call Transcript April 20, 2023
Watsco, Inc. beats earnings expectations. Reported EPS is $2.83, expectations were $2.36.
Operator Good day, and welcome to the Watsco First Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode for the duration of the call. [Operator Instructions] Please note this event is being recorded.I would now like to turn the conference over to the Chief Executive Officer, Albert Nahmad. Please go ahead, sir.Albert Nahmad Good morning, everyone. I hope you all got to see the space ship Starlink launch few minutes ago, biggest space ship in the history of country or probably in the history of the world. Disclaimer for my error or [inaudible]. In any event, welcome to our first quarter earnings call. This is Al Nahmad, Chairman and CEO; and with me is A.J. Nahmad, President; Paul Johnston, Barry Logan and Rick Gomez.Now before we start, the 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 statement.Now Watsco delivered an exceptional first quarter especially in light of last year’s impressive first quarter. Last year same store scale sales were up 25% and EPS was up 109%. Let me say that again. This quarter compares to last year and last year’s sales were up 25% and earnings per share was up 109%. This quarter sales grew 2% to record $1.55 billion, gross margins up 28.9% reflect our mindset around price and continued progress in our investments and pricing technology to help our leaders in the field optimize margins.
You will recall that last year’s first quarter gross margins also benefited from OEM pricing actions in response to unprecedented inflation. We are happy with the quarter’s result given the reduced level of OEM pricing actions during this first quarter of this year compared to last year.SG&A increased 1%, reflecting early progress with cost containment and gains in operating efficiency that builds on what we achieved, started to achieve last quarter. Operating income was $165 million, operating margins remain in double digits at 10.6% and earnings per sale was $2.83 for the quarter. As per cash flow, this is the time of the year when we build inventory for the upcoming selling season and we are seeing supply chains ease in certain product segments versus last year.
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I must say not all OEMs are over the supply chain problem yet, but they’re improving. Cash flow during the quarter improved $54 million year-over-year despite an unprecedented shift in inventory to new higher cost systems as a result of the change in efficiency standards that took place January 1. We expect further progress in terms of improved inventory terms and cash flow as the year goes on. All-in-all, our balance sheet remains strong with almost no debt. This provides us the flexibility to invest in virtually any opportunity As we continue to build scale in a very fragmented $50 billion plus North American market. We continue to look for acquisitions, as Watsco is a great home for family businesses. We sustain cultures, invest in people, and provide technology to secure and build on their great legacies.
That’s something we love doing building great legacies of companies that we acquire. Looking beyond the Short term, our press release today provides critical details that support Watsco’s long term growth trajectory. We have an immense technology advantage, and we are investing to grow that advantage. These technologies are increasing customer engagement, reducing attrition, creating market share gains, and supporting margin.Watsco’s broad array of products and brands is a competitive I should say, a competitive advantage that allows us to serve contractors in most environments. We also have a leading market share position in some bell markets to provide stability and higher growth rates. In addition, there are several important regulatory and industry catalysts for growth that will play out in the next few years.
2023 saw the introduction of federally mandated high efficiency standards for HVAC equipment, which will deliver price benefits in 2023 and beyond. 2025 will also mark the introduction of new refrigerant standards, which historically has made it harder to repair existing systems and favors more demand for replacements. We also see continued movement towards electrification and greater adoption of heat pumps which generally come at higher prices and higher margins. Sales of heat pumps grew 7% in our company during the first quarter, outpacing overall growth rates.Finally, we also expect new Inflation Reduction Act to provide enhanced tax credits and incentives for efficiency upgrades and electrification in the years ahead. All of these catalysts would benefit the industry in the coming years, and we certainly believe our scale, technology and financial strength position us to capture the new market share opportunities.With that let’s go on to questions and answers.
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Question-and-Answer Session Operator [Operator Instructions]
Our first question here will come from Ryan Merkel with William Blair.Ryan Merkel Hey, guys.
Good morning. Thanks for taking the question. I guess, first off, can you comment on trends so far in April? Just trying to figure out if things are continuing at this pretty healthy pace.Albert Nahmad Well, that’s just a few days start, but I’ll let Barry provide some — an answer to that.Barry Logan I think, really, the first four months of the year all pretty consistent in a very – is not volatility, there’s not a lot of change. It’s been pretty consistent all four months as we start the year. But I would very critically and importantly say that May and June and the rest of the third quarter is where the big seasonal increase is for the quarter. For example, May and June would probably be 80% of the earnings of the quarter. So an early read in April, I’ll give you some inference, but it’s not representative of what the rest of the season looks like yet.
But so far, so good. If I say it more simply.Ryan Merkel Okay, well, I’ll take that and appreciate that. Yes, we’re not in the season yet. And then turning to gross margin, was the quarter hurt by inventory profits rolling off year-over-year? And I guess, really my question is, are inventory profits out of your gross margin at this point?Albert Nahmad That’s a great accounting question, Mr. Logan.Barry Logan Yes, I mean, it’s funny for my 30 year career, it’s always been a first quarter question and never a question beyond the first quarter because that’s generally the timing of pricing. But I’ll take a shot at it, Ryan, because it’s been anything but normal the last couple of years. So a year ago, OEMs had near double digit price actions effective January 1.
This year they did not. This year, the pricing action is in on March 1 and it’s less than double digit. So there’s clearly a cost, as to use your term, which is really I wouldn’t call it a cost. I would say there’s clearly an impact in the short term margin this quarter could be 150 – 200 basis points in the quarter because of that algebra in the equation. And obviously our margins didn’t go down by that amount because there is everything we’ve been saying now for a year about the entrepreneurial culture, the team, the technology, the culture. Working with our OEMs, all the heavy lifting going into the margin and pricing development the last two years, you can see offset some of that short term cost and margin. So that’s the difference between short term and long term.
In the short term, yes, there’s an algebraic impact in the quarter. Long term, the benefits you can see, and you’ve been seeing it now for the last two or three quarters in a pretty significant way.Operator And our next question here will come from Dave Manthey with Baird.David Manthey Hey. Good morning, Al. I was wondering if you could talk about the OpEx a little bit here. Is it true to say that your increased investment and driving sales for key OEMs via selling and marketing expenses is being offset by tight cost control at the business operating unit level? Any color you can provide on those offsetting OpEx factors?Albert Nahmad Well, we certainly hope so, but let me have Barry explain that.Barry Logan Hey, Dave. Well, again, I like to look at things over a longer timeline just to tell the story conceptually more than just short term.
So the last two years, it’s pretty remarkable. I think that headcount is up about 15%. That’s 800 people, say $60 million -$70 million in cost added to our network to serve customers, to deal with the environment we’re in, to sell more products, to bring more technology, whatever it might be. And it’s a remarkable number. And that’s part of the investment that we talk about in growing the market, growing the business, the two way street of economics that we’ve been looking for to grow the business long term. And that’s in the numbers.And if I dial into the quarter and be again more surgical about it for example, we saw fixed costs increase this quarter high single digits. And that goes with the people and the investments that are made where variable cost, some of the variable selling costs went down double digits in a quarter.
So that’s a little bit of what we expected, right? We’re not going to shut off investments, we’re going to keep investing, some of the variable or transitory costs of what’s been going on the last two years if that eases and as those eases, we would expect cost reduction. So everything I’ve just said is playing out in 673 locations in very different ways. But culturally you can see over the last six months there’s a big impact going on in SG&A, not just the quarter.David Manthey Yes. Okay. And second, at a recent investor conference, Carrier said that they believe they’re underrepresented in their aftermarket. Do you have any idea what they mean by that?Albert Nahmad No, that’s news to me. I’ve never heard that.Paul Johnston I think this OEM is now has been looking for an increase in their aftermarket share and it’s something that all OEMs are after.