Watsco (WSO) Q2 2018 Earnings Conference Call Transcript

Watsco (WSO -2.28%)
Q2 2018 Earnings Conference Call
Jul. 25, 2018 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning, everyone, and welcome to the Watsco second-quarter 2018 earnings conference call. [Operator instructions] Please note, this event is being recorded. I would now like to turn the conference over to Albert Nahmad. Please go ahead.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Good morning, and welcome to the Watsco second-quarter earnings call. We are coming to you from sunny Miami, where it's very warm. This is Al Nahmad, chairman and CEO. And with me is A.J.

Nahmad, president; Paul Johnston, executive vice president; and Barry Logan, senior vice president. As we always do, before we start, the usual 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 statements.

Now on to the report. Watsco achieved record second-quarter results. Our performance includes record sales, profits, operating margins, net income and earnings per share. Sales growth was driven by increased unit demand, price, and mix for replacement systems.

In partly, Watsco's results were achieved while continuing to make significant investments in our industry-leading technology platforms as well as the addition of customer-facing employees to expand sales and service capabilities. As we mentioned in the release, we are challenging our employees to accelerate utilization of our innovation to build market share, develop more efficient processes, and reduce costs. A number of initiatives are under way, all with the goal of improving sales and profitability over the long term. During the quarter, we raised our annual dividend to $5.80 per share.

2018 marks the 44th consecutive year that we have paid dividends. Future dividend increases will be considered in light of investment opportunities, cash flow, our financial condition, and business conditions. Our balance sheet remains conservative with a debt-to-total cap of 8%. This positions us to make -- take advantage of almost any size investment opportunity that may come along.

As always, the second half of the year will be a strong cash flow period. We, again, target a cash flow to exceed net income this year. On our very important game-changing initiatives, we continue to grow adoption and use of our various technology platforms. For example, more customers are using our apps and e-commerce to gain speed and efficiency in their business.

More SKUs are being digitally mastered and added to our product information database, which is now over 650,000 SKUs. Given our progress to date, we believe our e-commerce sales could reach $1.2 billion this year and exit the year close to a 30% run rate. More of our locations have implemented order fulfillment technology to complete and ship orders faster and save customers time. More employees are using our data analytics to gain insight into operations and opportunities.

Technology spending so far this year has increased 9% with an annual run rate of $24 million. In summary, Watsco's transformation of our distribution channel continues. Now the second-quarter results. Revenue grew 5%, including a 6% in equipment sales.

Operating income increased 6%. Operating margins expanded 20 basis to a record 10.3%. EPS increased 16% to a record $2.40 on net income of $90 million, including the benefit of lower income taxes. Debt has been reduced by $238 million from a year ago.

Our gross margins reflect higher equipment-selling margins but are offset by non-reoccurring benefits last year related to refrigerant. Gross margins were also impacted by the timing of the vendor-related incentives. The overall pricing environment for equipment remains positive. The first round of our OEM price increases are reflected in our results.

Now the midyear price increases recently introduced are presenting us with a sales and profit opportunity during the second half of the year. Now results for the first half. Revenues grew 5%, driven by a 7% increase in residential HVAC equipment. Operating income increased 7% to a record $191 million.

Operating margins expanded 20 basis points to 8.5%, and EPS increased 19% to a record $3.32 on net income of $124 million. Now one last comment before we move on to Q&A. This past May, Baird and Watsco hosted a technology summit to provide institutional investors greater insight into our long-term thinking. It was a great event, which you are invited to listen to on our website.

As a follow-up, we are also happy to host institutions who wish to learn more about Watsco and learn firsthand how our technology platforms are redefining the industry. A visit to our Miami headquarters also provides a deeper understanding of our unique culture, which is critical to our long-term success. With that, A.J., Paul, Barry, and I are happy to answer your questions.

Questions and Answers:

Operator

Thank you, sir. We will now begin the question-and-answer session. [Operator instructions] The first question will come today from Ryan Merkel with William Blair. Please go ahead.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Good morning, Ryan.

Ryan Merkel -- William Blair & Company -- Analyst

Hey, good morning.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Is it warm there as it is here?

Ryan Merkel -- William Blair & Company -- Analyst

You know, it's been warm in Chicago this summer, so it's going to help the [Inaudible] I would think. So a couple of questions on gross margins, if I can. Firstly, can you quantify the year-over-year impact from the nonrecurring refrigerant boost? Just wondering how big that was.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Sure. Barry?

Barry S. Logan -- Senior Vice President

Ryan, again, it was a spike in price that was temporary and short-term last year. It has about a $4 million impact on last year's earning that did not recur this year.

Ryan Merkel -- William Blair & Company -- Analyst

Which is $0.09 per share, is it not?

Barry S. Logan -- Senior Vice President

That's correct.

Ryan Merkel -- William Blair & Company -- Analyst

Got it. OK. So it's sizable. And then secondly, the timing of vendor incentives.

What was the impact there in the quarter?

Barry S. Logan -- Senior Vice President

Again, it's driven by the timing of purchases. And it's probably a similar magnitude, Ryan. And again, that's a matter of timing of when we make purchases and when we pay vendors.

Ryan Merkel -- William Blair & Company -- Analyst

OK. So then the important question is, as we look to the second half, it sounds like given the pricing environment, maybe the timing of vendor incentives, should we expect that gross margins could improve year over year in second half, such that you might get that flat for the year?

Barry S. Logan -- Senior Vice President

Obviously, there are moving pieces. I mean, Paul, you may want to comment on refrigerant, but I can take a stab at it. And first, we do think that's a temporary thing from last year and is somewhat not in the cards going forward. The purchasing side of vendors and rebates and discounts, things like that that should flatten out over the course of the year, something I think we just needed to deal with this quarter in this conversation.

And pricing also has been introduced across most of our OEMs for the second half of the year. And there was -- obviously, there was momentum in pricing and margin for equipment in the first half. And it's an opportunity to do that incrementally in the second half. Where it plays out at the end of the year.

I can't say, but we like the general conversation of this.

Ryan Merkel -- William Blair & Company -- Analyst

OK. Just lastly, and I'll turn it over. How much did price contribute to the 5% total company sales growth this quarter?

Barry S. Logan -- Senior Vice President

Again, most of the energy we talk about is on equipment, equipment being about two-thirds of our business. And so if I dial in on the 6%, as Al's comments suggested, both unit volume, price and mix contributed to the 6%. And generally speaking, we'll leave it at that.

Ryan Merkel -- William Blair & Company -- Analyst

Very good. Thanks a lot.

Operator

The next question will come from Dave Manthey with Baird. Please go ahead.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Good morning, David.

David Manthey -- Robert W. Baird & Company -- Analyst

Hey, Al. Good morning, everyone. So first off on the -- on this refrigerant issue. I guess the $4 million is the difference between the current price for R-22 of $11 or $12 versus something like $20 last year? And Barry, based on what you said, are we to assume that that might be the case in the third quarter as well?

Barry S. Logan -- Senior Vice President

No. We are not suggesting that. There is an overhang to this for the rest of the year. No.

David Manthey -- Robert W. Baird & Company -- Analyst

OK. And this is all price. There was not some volume influx in the second quarter last year, it was just the price?

Barry S. Logan -- Senior Vice President

That's correct.

David Manthey -- Robert W. Baird & Company -- Analyst

OK. All right. And then on the price mix impact on equipment this quarter. You said it contributed to the 6%, but you're not saying how much.

But we should assume that you will pick up something in the third quarter based on the midyear price increases. Should we assume another 1% maybe, 2%? I'm just -- any idea as far as what the incremental might be from second to third quarter?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Paul, maybe you have some insight, I think. Again, we said -- go ahead.

Paul Johnston -- Executive Vice President

No. I mean, I can't calibrate exactly how much it is, only because the OEMs stay to their price increases across the board. So we had OEMs going up in June, July, May, August. And so it's going to be a difference for us of mix as well as when the timing of their price increase actually occurred.

Very unusual. I'd never seen a price increase in season before.

David Manthey -- Robert W. Baird & Company -- Analyst

Right. Do you know, Paul, the increase in the number of units you shipped this second quarter versus second quarter last year?

Paul Johnston -- Executive Vice President

Yes. We don't -- we do not disclose that.

David Manthey -- Robert W. Baird & Company -- Analyst

OK. All right. And just overall, I guess, you've -- over the past couple of years, you've not provided any guidance at this point in the year, but I think from, I don't know, going back to the 2010 or even before, you'd normally give some level of guidance. Is there anything you want to provide or qualitatively discuss about the year at this point, Al?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Well, we're not going to quantify anything. But we do want to tell you we're expecting record performance, obviously.

David Manthey -- Robert W. Baird & Company -- Analyst

Right. OK. Thank you.

Operator

The next question comes from Brett Linzey with Vertical Research Partners. Please go ahead.

Brett Linzey -- Vertical Research Partners -- Analyst

Thanks. Good morning. Yeah. Just wanted to come back to some of the technology strategy rollouts.

In terms of the business intelligence and the data analytics rollout, what percent of the footprint currently has those tools in as live? And what's the cadence of that penetration look like here over the next several quarters?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Good question. A.J.?

A.J. Nahmad -- President

The answer is 100% has the tools and the technology and data at their fingertips now. But the data and the insights and the dashboards and scorecards and reports and analytics will ever -- forever evolve. Right? There is more datasets being added to the mix. There is new math and new dashboards and new ways to torture that data to derive insights and eventually see trends and patterns and opportunities.

So while everybody has it, the usage and the value creation and realization of the usage should continue to increase.

Brett Linzey -- Vertical Research Partners -- Analyst

And then, I guess, just in terms of SG&A leverage, I mean, how should we think about as that rollout or a big portion of that rollout is now live, how does SG&A leverage or SG&A as a percent of sales look into 2019 and 2020? What are sort of the expectation and targets there?

Albert H. Nahmad -- Chairman and Chief Executive Officer

It is hard to quantify that because we are open-ended with respect to technology investment. We are so long-term orientated. We are not a quarter-to-quarter sort of investor. So I would not venture to say -- to answer the question directly, just that we just think we're going to continue to operate at record levels, while we continue to make for us, and we have very large investments in technology because of the long-term focus that we have.

Brett Linzey -- Vertical Research Partners -- Analyst

And then, I guess, just in terms of the higher customer-facing investments.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Yes, that's a lot of people

Brett Linzey -- Vertical Research Partners -- Analyst

Yes, another year-over-year headwind in the quarter...

Albert H. Nahmad -- Chairman and Chief Executive Officer

I don't -- well, that I can't answer. We've added, what is it, Barry, 300 people.

Barry S. Logan -- Senior Vice President

In the last two years, almost 300, about 140 during the...

Albert H. Nahmad -- Chairman and Chief Executive Officer

I think that's top off.

Brett Linzey -- Vertical Research Partners -- Analyst

And what was the drag from that in -- I mean, in the first half or in the quarter?

Albert H. Nahmad -- Chairman and Chief Executive Officer

I don't know. Did you quantify that Barry?

Barry S. Logan -- Senior Vice President

Yes, it's also about $3 million to $4 million of impact in the quarter.

Brett Linzey -- Vertical Research Partners -- Analyst

In the quarter. OK.

Operator

The next question comes from Chris Dankert with Longbow Research. Please go ahead.

Chris Dankert -- Longbow Research -- Analyst

Hey, good morning, Al. Thanks for taking my questions, guys. I guess, first off, just any kind of update on Sigler as far as the coordination with the other owners there? Or kind of how you've been working with the guys in the ground? Just any comment there would be helpful.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Yes, we can add. Barry, tell him of the small addition.

Barry S. Logan -- Senior Vice President

Well, first, we did close on a purchase to add 1.4% to our ownership, so we are at 3 point -- 36.4%. The concept and the process, the technology we designed with the family worked, and we've added a small piece to that. As far as the remaining ownership, again, it's up to the family of when and how and to what magnitude they want to sell. From the business perspective, Al, I don't know what you want to cover beyond that.

Albert H. Nahmad -- Chairman and Chief Executive Officer

They're doing very well. Their performance is very good. It's a great company.

Chris Dankert -- Longbow Research -- Analyst

And then just thinking about on the ground. I mean, obviously we see the price increases coming through from the vendors, but as far as the dealers you're working with and that kind of thing, how's acceptance been there? I mean, is the pushback been as severe in the years past? Or they're just going to pushing on to the customer at this point?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Paul?

Paul Johnston -- Executive Vice President

The acceptance obviously has a little bit of a snarl to it, but generally speaking, the customers are accepting the increase. There's such strong compelling evidence out there with the tariff change, with some of the freight issues that we're all running into to justify and rationalize an increase in price.

Chris Dankert -- Longbow Research -- Analyst

Got it. And just last one for me. Since we're kind of coming up on the hurricane comp from last year, I think it was $0.10, if I'm remembering correctly. You -- as expected, you've already recovered most of that repair damage over the past 12 months? Or is that something that's still going to be a meaningful benefit on a year-over-year basis here?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Well, the hurricane affected only parts of our market. I mean, obviously important parts, but that's a very hard question to quantify. I just think we're going to have a very good year. And it's hard to say how much of that comes from hurricane impact last year.

Brett Linzey -- Vertical Research Partners -- Analyst

Thanks again, guys.

Barry S. Logan -- Senior Vice President

I think there's two words in the hurricane discussion. There's the word disruption. And that is what happened last September and some of that business came back in the fourth quarter. Second word is destruction.

And there certainly was destruction in some limited markets in Florida and Houston. But we said many times now, in the big picture, that's not a material thing to all of Watsco.

Albert H. Nahmad -- Chairman and Chief Executive Officer

And that's a better explanation than mine.

Brett Linzey -- Vertical Research Partners

Thank you.

Operator

[Operator instructions] The next question will be from Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Hey, good morning. Carrier mentioned in their call some issues in June with trucking shortages. Can you just speak to what you're seeing there? And if that's impacting momentum of business?

Albert H. Nahmad -- Chairman and Chief Executive Officer

That might reflect itself in the amount of inventory we're carrying. But go ahead, Paul.

Paul Johnston -- Executive Vice President

Yes. There has been a lot of conversation in the press about truckers and lack of drivers. And to date, knock on wood, yes, there was a little bit of an issue that Carrier had. We compensated for it, obviously, by prebuying the inventory and bringing it into stock in anticipation of the trucking shortage.

So to date, Watsco really hasn't been impacted by a shortage of inventory because of truckers.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

OK. Great. And then just on margins. I mean, I understand the refrigerant dynamic, but we're certainly in a good environment.

You seem to be getting price and mix. And I'm just wondering what might be holding back more meaningful improvement in the margins?

Albert H. Nahmad -- Chairman and Chief Executive Officer

I'm not sure I understand the question.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Well, I mean, if you kind of pull out the Sigler, the incrementals were like 9% in the quarter. And I think you guys typically run 15%, and just seems like with price and mix, you would be able to hit that bogey?

Albert H. Nahmad -- Chairman and Chief Executive Officer

Barry, I don't get it. What -- do you have an answer to that?

Barry S. Logan -- Senior Vice President

Yes, I mean, I -- first of all, it's the first half of the selling season, and we needed to have a conference call to talk about our second quarter. I think the whole of our selling season when the third quarter offers that opportunity to have better and better margin expansion. I think we've called out a few items in the second quarter that did...

Albert H. Nahmad -- Chairman and Chief Executive Officer

Well, I mean, I -- it could be for the interruption. But even margin is at a record high. Were you aware of that, Jeff?

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

I mean, I have margins down year over year, and you had Sigler and other adding to that, which was...

Albert H. Nahmad -- Chairman and Chief Executive Officer

Watsco's EBIT margin is at a record high. It doesn't mean we don't have opportunity to get better, if that's your inference, yes.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

OK. Thanks.

Operator

[Operator instructions] This concludes our question-and-answer session. I'd like to return the conference back over to Albert Nahmad for any closing remarks.

Albert H. Nahmad -- Chairman and Chief Executive Officer

Thanks very much for your interest in our company. And we look forward to some of you visiting us in Miami to get a firsthand look at our technology platforms and our culture. We really wish you would come, and thank you for your interest in our company. Goodbye, now.

Operator

[Operator signoff]

Duration: 23 minutes

Call Participants:

Albert H. Nahmad -- Chairman and Chief Executive Officer

Ryan Merkel -- William Blair & Company -- Analyst

Barry S. Logan -- Senior Vice President

David Manthey -- Robert W. Baird & Company -- Analyst

Paul Johnston -- Executive Vice President

Brett Linzey -- Vertical Research Partners -- Analyst

A.J. Nahmad -- President

Chris Dankert -- Longbow Research -- Analyst

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

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