EarningsCall · WSO Q4 2023

spk31: Good morning and welcome to the WatsGo fourth quarter 2023 earnings call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing star then zero on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Albert Namid, Chairman and CEO. Please go ahead.

spk27: Thank you, and good morning, everyone. Welcome to our fourth quarter earnings call. This is Al Namid, Chairman and CEO. With me is A.J. Namid, Watts Coast President, and Paul Johnston, Barry Logan, and Rick Gomez. Now, before we start, our cautionary statement is always, This conference call has forward-looking statements as defined by the SEC laws and regulations that are made pursuant to safe harbor provisions of these various laws. Ultimate results may differ materially from forward-looking statements. Now, Wattswood delivered strong results in 2023 despite some market conditions which were somewhat inedible after two extraordinary years in 2020. 2021, and 2022. Reflecting in the year's results, I am proud of the accomplishments we delivered. We achieved market share gain in markets we serve. We further scaled Wasco's industry-leading technology platforms. We had a successful start driving down long-term productivity gains. I should say we had a successful start driving long-term productivity gains. We expanded our network and product offerings by acquiring great businesses to grow our scale, and we fortified our balance sheet through inventory reduction and generated record fourth quarter cash flow. And once again, shareholders will receive a meaningful dividend increase in 2024. which was in April 2024. This is Watsco's 50th consecutive year of paying dividends. 2023 was also a year of immense change, and virtually all equipment products transitioned to new high-efficiency systems. In collaboration with our OEM partners, Watsco introduced new products and SKUs for over 25 brands of HVAC systems. Our teams executed well, and thanks to our scale and speed to market, we are confident that we gained share. We also trained thousands of customers on new products, and our digital product library was updated with approximately 500,000 new SKUs. And this spring, we will begin the next regulatory transition to new 828. L products with lower GWP refrigerants. These regulatory transitions are positive for our industry and are good for WatchWiz business. They offer meaningful value to homeowners and businesses to upgrade systems that are more efficient and better for the environment. WatchWiz has an extra unit values, although still down, stabilized during the second half of 2023. Commercial end markets remain strong across all markets. Our commercial business continues to grow at a healthy rate and our backlog of products extends well into next year. Sales of ductless systems, an increasingly important component of our business, grew double digits in a year and offset declines in conventional residential business. SG&A has a percentage of sales on a same story basis decrease for the year, indicating progress in driving more productivity across the company. We believe we are in early innings of a long-term opportunity to meaningful improve productivity and overall efficiency. We have challenged our leaders and provided them with tools and data to implement change, and most importantly, We possess an entrepreneurial culture to execute change in a responsible way. Over the past year, we expanded our network through acquisitions with three terrific business joining the Wapsle family. Collectively, their annual sales are around $200 million. These businesses will retain their culture, leadership teams, and uniqueness in the market, consistent with a long-term practice of honoring and sustaining great businesses. Our industry remains highly fragmented, and we will continue to pursue other great companies to grow scale in our $60 billion North American market. We believe Wattsco's technology advantage, market-leading scale, and the strength of our balance sheet are all great reasons to join the Wattsville family. Now, before getting to Q&A, as always, I want to emphasize that our core focus remains on the long term. We believe our scale, the quality of our balance sheet, and unique culture will continue to drive long-term growth and performance. We have an immense technology advantage, and we are investing to grow that advantage. Wattsco's broad array of products and brands is also a competitive advantage that allows us to serve contractors in any environment. And finally, our industry is fortunate to benefit from an important regulatory and industry catalyst that should positively influence Wattsco's performance in the years ahead. With that, let's go on to Q&A.

spk31: Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question comes from Tommy Mull with Stevens Inc. Please go ahead.

spk10: Morning, Tommy. Morning, Al. Thank you for taking my questions. You bet. I wanted to start on gross margins. No big surprise there. Your fourth quarter gross margin percentage was a little bit below the long-term aspirations that have been discussed recently. It's a two-part question, really. One is just if you could unpack any of the factors there for us in the fourth quarter. And then if we think about the art of the possible going forward to start this year, is there a pathway near-term, you can define that how you want, near-term to recovering and moving back toward those longer-term aspirations in the high 20s or maybe 30s?

spk27: Very good question. As you know, I've stated earlier that eventually our aspiration is 30%, and we have a ways to go. So I'm going to ask Barry, Logan, and Paul Johnston to deal with current events.

spk25: Yeah, thanks, Al. Good morning, Tommy. Well, we've said all year long with some of the moving pieces with gross profit and also said two years ago or so now the short-term aspiration was 27%. And so if I just focus on the year for a second, Tommy, just some important things to be grounded in looking at the year's performance, and then I'll address the quarter and the shorter-term perspective. But for the year, you know, the 27.4 is what was achieved. And, you know, obviously it's better than it was two years ago, three years ago historically. And a lot of the moving pieces that we've talked about to drive and sustain that higher margin, you know, obviously are in place if we look at the year's perspective. If we look at a 60 business day perspective, which is the fourth quarter year, in the off season, you know, some of the variables have a greater impact in the short term. So that would be, you know, my first bias I would try to talk about is we're talking about 60 business days in the off season in the fourth quarter. And some of the moving pieces are more acute because of benefits of a year ago, not so much what's happening short term. So if I unpack that a bit and not be quite as abstract about it, we have about $16 million of benefit in the prior year from pricing gains, from weighted average cost gains, from inflationary gains, however you want to define it, which is roughly 100 basis points in the year-ago quarter. Some of that is equipment. A greater proportion is non-equipment. because there was a lot of inflation going on in some of our non-equipment products a year ago, like refrigerant, like copper tubing, like steel products, and probably 40 other product lines, where a year later those benefits are not there. So that's 100 basis points. That's $16 million of consequence. And if I look forward 12 months, instead of back 12 months, if I look forward 12 months, I don't expect there to be that kind of headwinds and those products, you know, let's say a year from now. And it's just one of those things that as the numbers are larger in a fourth quarter, their cuteness is higher. $16 million would not be as material to a second or third quarter. It's more material to a fourth quarter. So that's probably the biggest impact in the quarter if you look at things on a year-over-year basis. There are some other moving pieces which we've talked about. One is that equipment products in fact, have a lower gross margin than non-equipment products. So in the quarter, you see a mixed difference between the growth rate of equipment, which was pretty flat, non-equipment, which was down. So that's algebra that affects the margins in the quarter by 20, 30 basis points, I would say. And there are some other smaller things that aren't worth kind of going through. The bigger picture is this idea of of inflationary gains that occurred a year ago. With less inflation, there's less inventory gains to come by. And if we look in the next 12 months, I would expect a much smoother water, much more, you know, less volatility in terms of this dynamic. I think we need to get beyond the first quarter to clearly see that if I look forward the next 12 months. but I would say a greater feeling of stability versus the volatility that you've been seeing this year. Paul, anything you would add to that?

spk17: Boy, Barry, you've really covered a lot of ground there, yeah. Obviously, there's going to be some price changes that we're going to see in some of the commodities, especially refrigerant. We should start seeing some uptick in refrigerant pricing as we as we've got the 30% reduction in allocations coming into effect January 1. Too early in the season to have really seen those yet in the first quarter, but obviously those are expected. Secondly, we're also seeing some recovery in steel. We're seeing some recovery in some of the other products that we sell. Price increases are still occurring in the non-equipment side of the business, and we expect those to stabilize and perhaps grow as the demand picks up during the year.

spk10: Thank you both for those helpful answers. As a follow-up, I wanted to pivot to a volume conversation. And knowing that you won't give guidance, I'll try to frame it in a way that provides for a constructive discussion. If we look at the trends for unitary HVAC systems in the year you just concluded, down, I think it was 8% in your materials this morning that you provided, I think we would agree that's an abnormal-type trend. And so I'm just curious, if you look to 2024, is there anything abnormal that you see, anything worth calling out now, Or does it feel more like a normal kind of environment off that lower base from last year?

spk27: That is a great question. By the way, some of the OEM, particularly Larsen, announced 30% unit volume drop in the fourth quarter. And we're pleased that we're doing a hell of a lot better than that. Paul, you want to take a shot?

spk17: Yeah, the obvious elephant in the room is going to be how fast the transition goes to the A2L product, which is being discussed among the OEMs as perhaps a 10% to 15% increase or lift in price. And each one of the OEMs obviously has a different implementation schedule, so It's not going to be a full year implementation that we're going to see on that. We're going to see some start coming in in the second quarter and beyond. So I think that's going to be one of the things that's going to drive an increase. Secondly, obviously, a reduction in mortgage rates always helps. People buying existing homes, although they don't intend to replace the air conditioning system, that's really when they're at the prime period where they would do a replacement. is within the first 90 to 180 days after acquiring an existing home. So I think there's some good news out there. I can't forecast out exactly how that's going to overlay into the entire year, but I think there's some positive things that we're going to be seeing as the year goes on. Let me just say generally that I've always seen...

spk27: industry weakness is an opportunity for us. There are highly leveraged distributors in the business, and there are distributors that don't have perhaps the balance sheet to deal with tougher times. We see that as an opportunity to have them join us. With our culture, we provide capital We insist that they keep their culture and their organization, and we provide tools that no one else has. So I'm sort of, while I would not be very excited to have market industry data decline, if it happens, I'm also looking at opportunity to bring more wonderful companies into the partnership with us. Go ahead, Paul.

spk25: No, I was going to add about the unit data. I listened to the question, and I asked myself the question about units. Do we feel better or worse? That would be my simple way of asking that question. And so the first half of 2023, units were down, I think, in the teens. And second half of the year, I think units are down 2% or 3%. So I think we feel better about units than worse. Of course, the crystal ball needs to play out next selling season in April to September when our business multiplies in size. But I think generally speaking, things, again, seem more stable as opposed to being volatile.

spk10: Thank you all. I appreciate the insight, and I'll turn it back.

spk31: The next question comes from Ryan Merkle with William Blair. Please go ahead.

spk39: Hi, Ryan. Hey, everyone. Good morning. My first question was on price in the outlook for 24. What do you think in price will contribute, given what you've seen from the OEMs?

spk27: We have that information. Barry, Paul?

spk17: Yeah, we've seen price increases announced already in the year on the existing equipment. They range basically from 4% to 6%. So the equipment prices have already been announced. They're going to be further supplemented again by the introduction, as I indicated in the last question, with the A2L introduction. And so we're going to probably see some additional lift there. A lot of speculation around how big of a lift that's going to be. So nobody has really disclosed anything on their anticipated price outside of that wide range that I think you all have heard, 10% to 15%. On the other products that we sell, we're also seeing, as I indicated, increased prices on pretty much all of the copper products and all of the metal products that we sell. And we experienced some softness on some of the insulation products last year. Those appear to be stabilized now, and we should start seeing those products not have any sort of price degradation in 2024. How much all that's going to add up to, I think it's still a little bit of a question mark as far as being able to put a percentage against that, against total sales. I think it'll be clear in the second quarter as we start seeing what the rollout prices are going to look like for the A2L.

spk39: Okay, got it. And then I wanted to ask on SG&A, you've taken some actions there. Anything you can quantify for us in terms of how much is coming out in 24 or what your kind of aspiration is for SG&A growth in 24, either way? Mr. Logan?

spk22: Good morning, Ryan.

spk25: Yeah, well, first, again, there's two sides to that equation. And it's all being driven, again, through the field, through our stores, through our region, through our business unit leaders, in terms of in their 2024 plans, reducing SG&A. And when I say reduce SG&A, it's not just cutting SG&A, it's finding out the opportunities for productivity after what had been also two years of wildness in terms of SG&A growth. Talk about the business performance of 21 and 22. It was also a very unproductive period of adding SG&A to serve what was going on. So that's what we're looking to improve and to some extent simply, you know, get back to a little bit more normalized conditions in terms of how the branches operate and so on. So this kind of single digit declines that you're seeing, Ryan, is a composite of two things. In recent quarters, it's Variable expenses coming down 10%, 15%. Fixed cost inflation moderating, but still there's inflation in fixed costs, like rent, for example. So it's probably a slow grind of better improvement from what you've been seeing the last few quarters. This is, again, not restructuring the corporation. This is improving the daily expenses, the daily productivity. But in that, you know, that kind of Better progress from what we've been seeing in the last few quarters is our expectation. I'll have to leave it at that. Okay.

spk31: Fair enough. Thank you. The next question comes from David Manthe with Baird. Please go ahead.

spk30: Arnie, David. Mr. Manthe, your line is open.

spk31: Please go ahead with your question. Is it muted accidentally?

spk29: Got it. Yeah. Hey, good morning, Al. Good morning, everyone. Can you hear me now?

spk30: Yeah. Yes, please go ahead, sir.

spk26: Thank you. So I'm going to stay on the gross margin topic if I can here. Were there adjustments in the fourth quarter that hit gross margin disproportionately hard? Barry, you were kind of saying the year-over-year comparison looking back and then looking forward. Are you implying that the gross margin a year from now, give or take, will be in the range that it was this year? Or was there something unusual in this fourth quarter that might affect that comparison?

spk25: Yeah, good question. Well, a year from now, again, we'll have a completely different blend of new products a year from now. I would expect that to be a margin opportunity a year from now. There are no adjustments or funk that hit this quarter that I would call out as being material or even important to talk about or even immaterial to talk about. Really nothing that stands out. So, yeah, I think, you know, going back to the algebra of price and inflation and the seasonality and so on, again, I would expect as we get into season, we have pricing actions in our pocket. We have new products being introduced. And, you know, I would say a continuance of the technology that we've been using to improve margin. And as far as a year from now and next fourth quarter, you know, again, I think there's an opportunity to improve margin, but nothing that penalized this quarter in a particular way that would be important.

spk26: Okay, and, yeah, I appreciate you indulging us in all this quarterly conversation, which I don't think historically we would have done here. But, Barry, you also said we need to get through the first quarter, and you were kind of talking again about that year-to-year comparison. If you're down a couple hundred basis points in the fourth quarter year-to-year because of all the items you mentioned, and then we look to the first quarter, that would put us in a range in the, what, the 26.5, 27 range. Just trying to understand the cadence, again, knowing there's a lot of moving parts there. Is there anything in the first quarter unusual that we should think about there relative to your comments, Barry?

spk25: Yeah, I think the pricing actions of the OEMs are pushed out a little bit into the late first quarter, early second quarter, if I look at things comparatively to last year. So you can read into that comment and in terms of modeling, you know, you can... consider the comment. So sequentially, I think, again, there can be a certainly better margin in the first quarter versus a year ago. You have to consider my comment about the timing of some of the pricing actions that we're describing.

spk17: That's a good point, Barry, because instead of a January 1 price increase, most everybody went February 1st, March 1st.

spk25: So it's a little bit of a lag to Barry's point. Yeah, and a top 10 vendor that went April 1st instead of January 1st. So some of this, the benefit will push a little bit later into 2024 than simply January 1.

spk26: Great. Thanks very much, guys.

spk31: The next question comes from Brett Lindsey with Mizuho. Please go ahead.

spk33: Hey, good morning, all. Hey. Hey. I just want to come back to the inventory. So you took another $208 million out of the system. I believe that was a little bit ahead of your initial plan, but maybe you could just speak to your assessment of inventory levels as we begin to move into the selling season. Are there more actions that need to be taken, largely complete? How are you thinking about that?

spk27: Well, I'll give you a big picture of it, is that we do want and will work on higher inventory returns. So I do expect to have our inventory produce more cash flow as it turns. And the science that we use to do that is being implemented. It's a very long process, longer than I expected. But eventually what you'll see is lower investment in inventory and higher returns when compared to sales.

spk17: Yeah, absolutely. As Paul, you know, historically, you know, it's been a four plus turn industry. And obviously, during the pandemic and the supply chain disruption, everybody got lost in the mid to low threes. And so now as we strive to get back to the four turns, obviously, we're going to have a reduction in inventory. Right now, we're seeing better better cooperation and better lead times coming out of our OEMs pretty much across the board. And as those lead times improve, obviously that gets us a better position to not have to stock as much inventory. So that's one thing that's happening. Secondly, Wattsco's got an unusual position on inventory in that each one of our operating units manages inventory. So there's not one big central, you know, headquarter directive that gets into the inventory. We manage it in much smaller blocks with each one of the operating units actually functioning against their vendors, what they need to have in stock and in inventory. Plus, Wattsco invested during, before the pandemic, we invested heavily in the technology it takes to manage inventory, putting in new inventory management systems. It gives us daily management reviews so that we can identify what we have on hand, what we have on order, by region, by district, by branch. So a lot more visibility than you'd find in a normal distribution company.

spk33: Yeah, that's great. And then just shifting to the non-equipment versus equipment trends, as well as the second half being a little better than first half. I guess it doesn't suggest there's a meaningful retrenchment in the consumer on the replacement side. Is there anything in terms of high efficiency mix or credit metrics or things that you're watching internally that would suggest there's a step down here in 24 early in the year?

spk17: Take a stab on the equipment side. As we indicated a year ago, when we went to the higher efficiency minimums that were regulated by the government, we expected there to be a compression around the entry-level product. And we went from around 65% of the minimum efficiency products up to around 85%. So we've definitely seen more product coming out. It's higher efficient product than what we had before, but it has distorted the industry a little bit towards the minimum efficiency as opposed to high efficiency.

spk25: And it's a good question on credit. It's not asked often enough, frankly. Obviously, our accounts receivable represents contractor credit, giving the average contractor about $10,000 a month and a credit line, essentially. And so if you look at our cash flow statement, which is published in the press release, you'll see bad debt is actually down about 20% this year. So there's no obvious indication of change in the quality of the portfolio. It's roughly 10, 11 basis points of bad debt. And again, compare that against any peer or any kind of other distribution model you can find. It's in very favorable position. So credit is not something we're seeing as a risk. It's how we serve customers. And again, so far, so good from an economic point of view.

spk32: All right. Appreciate the color. I'll pass it along.

spk31: The next question comes from Jeffrey Sprague with Vertical Research. Please go ahead.

spk08: Good morning, Jeffrey.

spk18: Hey, good morning, Al. Good morning, everyone. Thanks for the time. Hey, just kind of back on price, just wonder if anything you make of the OEMs kind of going later and kind of not at the same time, is there sort of a message here of kind of price fatigue in the market, do you think? Is there Some game theory or something we should be thinking about?

spk17: I don't think it's that diabolical. I think it's just a natural progression of how they intend to roll out their new product introduction on the A2L. And if you listen to each one of the OEMs on their public broadcasts, you'd find that they each are putting out a different variety of products at different times during the year. And I think it has more to do with their engineering and their manufacturing plants and all that that goes into rolling out the product.

spk18: Yeah, interesting. Makes sense. And then just kind of back to the replacement question, it was asked, you know, kind of at least obliquely a couple different ways. You know, Al, in your opening, you know, you kind of talked about the inevitability of after year like 2023 here. You know, if we do go back to just that kind of, you know, old school demographic replacement type of analysis, get into the whole 15-year life and all that argument, you know, we're echoing against 2009 right now, right? So, you know, that math could argue for, you know, another soft replacement year. I just wonder, you know, your thoughts on that and kind of what you're seeing in repair versus replacement. Well, our guru in that is Paul Johnson.

spk17: Oh, my God. Start with the repair versus replace. You know, it's fourth quarter, first quarter, which is not the time when you're going to see a lot of repair going on out there. You don't have your air conditioners working. You have your heat pumps and your gas furnaces, which your gas furnaces are generally a lower repair item. So to date, We're not declaring that there's any trends that we've been able to identify in repair versus replace. Will it occur when the temperatures goes up? We'll wait and see and find out. The other part of your question was what?

spk18: Just the underlying health of replacement demand based on kind of where the installed base is and sort of the age of the installed base.

spk17: Now the age of the install base is newer than it's probably ever been since I've been around, which is a long time. But obviously the mix of the install base is changing. Gas furnaces generally have a lifetime. You can make a gas furnace last 25, 30 years. Whereas a straight cool unit, I think the industry has said it's around 15, 16 years. Heat pumps are something that are growing as a percentage of the total business, and those generally don't have as long a lifetime. Remember, they're not just operating in the wintertime. They're operating in the summertime also. So you've got more hours being packed onto that piece of equipment. What that's going to do to the overall mix of installed base out there right now I think that's going to be one of the questions that we'll be able to look at probably in the next year or so. But replacement pull-up, I figure that we probably had 2.5 to 3 million units that were pulled up during the pandemic. They were installed perhaps prematurely, perhaps not. Trying to get some data around that to see what the geography was of those replacements. Was it north or was it south, you know, where people were actually replacing equipment? So a lot of data coming in, a lot of data that needs to be analyzed there to answer that question properly.

spk38: Paul, I think you said something important there. This is AJ. In your 40 years in this industry, this is probably as dynamic a period for the space as there's ever been between, I mean, all these questions are pointing to all the different ins and outs and change in paradigms between the supply chain changing again, the OEMs going with different pricing at different times, the change of rate of pricing going on in inflation, the inventory and the change to the A2L products coming out. There's just so many different things going on in the industry today which creates a lot of noise. But I have to say that I think Wasco is very well positioned. Our inventory has come down. The quality of our inventory has gone up as far as lower excess and flow and damaged inventory. Pricing, Barry, you covered a lot of it. What I think you left out was a key fundamental block there is that our transaction margin or As I think it's been written, structural margin is going in the right direction for the 2023. I think there's more momentum around that in 2024. I think we're doing a good job. Our leaders and our teams in the field are doing a good job managing expenses, given all the craziness in the space. And the balance sheet, you know, the balance sheet being without any debt, well positioned for any opportunity that comes our way. So, and I guess my point is that in a crazy industry and a crazy time, I like where we sit, and I like our performance, and I remain very optimistic about the year and the future.

spk32: Thank you for the perspective.

spk27: And I think that's well said.

spk24: I agree.

spk31: The next question comes from Joe Ehlersmeyer with Deutsche Bank. Please go ahead. Morning, Joe.

spk16: Hey, everybody. Thank you for taking my questions. I think right after your last call, there was a rule by the EPA interpreting the AIM Act. I'm just wondering if you have any thoughts on the impact of that rule as it relates to the dates around the transition.

spk17: Yeah, it doesn't change the dates of the transition. All it really did was change the sell-through process. Originally, the AIM Act came out and indicated that you had to cease selling anything 410A product at the end of the year. EPA came out with that, with what you're talking about, and has a one-year sell-through now. The units have to be manufactured and produced in 2024. The dead date for building any more is December 31st of this year, and then there's a 12-month sell-through.

spk16: Understood. And I think there was also some consternation around what constituted manufacturing and if that could actually apply to things that were charged in the field. Wondered if you had any thoughts on that. And then over, like, bigger picture, though, does this actually change the time frame over which the OEMs are taking the actions that they're taking? Just any thoughts there?

spk17: No, it doesn't really change. The manufacturers, you know... have had to plan for this transition for the last several years. So it did not change the way that they're gonna flow this through. They had to get their manufacturing processes in order. They had to change their plan, get their vendors lined up. There was no real change in direction based upon that ruling. They still have to stop manufacturing all 410 units at the end of the year. I think what you were referring to had more to do with what was a component Was the outdoor unit a component and hence it could be replaced? That question is still a little bit up in the air. There's still some fuzziness around that. So that subsequent to the sell-through period, can you still install a 410 outdoor unit or indoor unit as a repair component? That has not been clarified yet.

spk16: Okay, understood. And if I may, I don't think I heard earlier what your commercial HVAC sales were year over year relative to residential, and if you have any thoughts on where commercial can go in the year ahead.

spk27: Well, I did comment that commercial is very strong, and that we have backlog for at least a year. Can you add anything more to that barrier, Paul?

spk25: I mean, for the year, you know, commercial is up in the teens. I think that's been the trend all year long. The fourth quarter was near double digits. We'll leave it at that. Residential down a little bit.

spk45: And looking forward?

spk25: I was going to say, and for the quarter, for the sake of the algebra, we had one less selling day in the quarter. So you can adjust for that if you choose to. I'm sorry, what was your question?

spk15: Just the outlook for commercial.

spk25: Again, we don't measure backlog in the same proportions as the OEMs who make large quantities of large commercial. But like we said, I think in the release or in the commentary, the backlog is still strong. We haven't seen much variation in trend. And so not a reason to think that there will be.

spk37: Yeah, and most of our...

spk17: Most of our commercial unitary products go at once. It's a replacement demand, so there is no backlog.

spk30: Always remember to put it in perspective. Commercial for us is about 15% of what we do.

spk25: Between 15% and 20% of what we do.

spk31: The next question comes from Jeff Hammond with KeyBank Capital Markets, Inc. Please go ahead.

spk36: Hey, good morning, guys.

spk31: Hey, Jeff.

spk36: So I heard a bunch of different things on gross margin. I wanted to come back to that. It sounds like transaction margin moving in the right direction. You've got these kind of headwinds that carry over maybe 1Q, 2Q. Maybe level set us on how you think about gross margins for 2024. Is that kind of 27% margin? You know, doable, or do we kind of run a little bit below that, given some of the moving pieces?

spk27: Mary and Paul, do you want to deal with that?

spk25: Yeah, I'll handle it. Well, first, I want to go back to the transaction margin. UJ mentioned that, and it's important to emphasize it, I think. So for the year, which I really want to speak about the year... In a year, in the headwind in terms of all this noise about weighted average cost gain, inflation, and so on, that headwind in 2023 was about 120 basis points. And that's what we expect that to diminish greatly, importantly, as we get into 2024. The margin gain, the selling margin gain in the year was 70 basis points. So that transactional margin that we make by improving pricing, improving everything we do relative to price and margin, you know, did improve in 2023. So the question for 2024 is, can that continue? Can that trend continue? And then some of these other, you know, some of these other noise diminishes, I would say has largely diminished. So to answer your question, we're going to stick with, you know, 27% as the goal for 2024. And there's some good momentum in the selling margin. And some of these other pricing action discussions we're having will have to play out, as we think, in the second, third quarter, especially, for that to play out. But I think it's where we stand today.

spk38: Including the transition to the A2L products. That'll be... We'll have to see how that plays out in the market as well. Right. Right.

spk36: And just to clarify that the non-equipment down six, did you have negative price in there where there was some actually real disinflation around whether it be refrigerant or copper steel?

spk24: Go ahead, Terry. No, go ahead, Paul. You've got it.

spk17: No, I don't think there was much of the way of a deflation that was really occurring there. Yeah, we had a couple of product areas where We did see some price degradation, but it stabilized and came back. But I just think it was overall demand. We just saw a slowdown in demand on those products.

spk36: Okay, and then just last one. You know, Barry, you talk about kind of being a merchant, and you've got pricing kind of a little bit later, but you're also kind of managing, you know, drawing down inventory. So, How should we think about buying ahead of price increases to be a merchant versus managing inventories lower as you go into the selling season?

spk25: Is it a more direct question whether we're buying forward in some way and beating the price increase and so on? I'm not going to publicly say what we do in terms of competing for, uh, but it's not, it's not a practice that, that we, you know, we entertain on scale. I think we look at it here and there. We look at it market by market. At no time do we look at Watskill as a skilled company and say, let's buy Ford. And it's not something that really is a responsible thing to do in that sense. So I think in markets we consider it and certain brands we consider it, but nothing on scale that would be, uh, Remarkable, Jeff.

spk38: Yeah, I would say we are emerging, but we don't bet the ranch. And we take a risk-adjusted approach to where we invest.

spk17: Right. And plus, Jeff, I think you've got the phase-in, phase-out of... We're going to be phasing out of 410, phasing into the A2L product. So I think right now, you know, we'll buy... We'll buy a product that we need when we need it.

spk31: Was there a follow-up, Mr. Hammond?

spk35: No, I'm all set. Thank you.

spk31: Thank you. Again, if you have a question, please press star, then 1. The next question comes from Steve Tusa with J.P. Morgan. Please go ahead. Hi, Steve.

spk05: Good morning. How are you? So just to, you know, get the math down on the kind of resi unit sell through, it looks like if we kind of parse that between light commercial and resi, that was down roughly 10 for the year, the resi stuff on units? Let's see.

spk30: It was down eight, including up commercial? Let's see.

spk25: I mean, we don't include commercial in our unit volume discussion, Steve. Okay, so that was just resi. That was just resi.

spk05: Okay, that's great. And I guess just thinking about the gross margin, I mean, there's just such a wide gulf between what you did this quarter and what you did last first quarter. Can you just give us – and you mentioned the price increases are coming a little bit later – Can you just give us any flavor for where that one cue might land in this whole construct on gross margin?

spk25: I would say without constituting official guidance, I think I tried to say it earlier, which is something sequentially better than the fourth quarter. Start looking at things more sequentially than year over year. It takes some of the year-ago volatility out. So it's an improvement sequentially from what you saw in this quarter into the first quarter.

spk05: Right. So not up year over year, but something better than the fourth quarter.

spk42: That's correct.

spk05: Yeah. Okay. That's helpful. And I guess this whole discussion on pricing, are you assuming that the non-A2L products are that you get price on those? I mean, you're making it sound like the degree of price you get will depend on what kind of A2L product you sell. Are you assuming some lift on the non-A2L equipment? And then secondarily, if there is some pushback in the channel, are you kind of prepared to ask your OEMs to kind of help you guys maintain or gain share in this market? With price?

spk17: Well, you know, those are all great questions of what if. You know, obviously, you know, we keep in constant contact with our OEMs and we'll be ready to make any sort of adjustment that is required to be competitive in the marketplace. We're not going to lose our competitiveness. And our OEMs certainly are not of that vein either. So, yeah, we'll be working with them on that. One thing that makes the A2L introduction unusual, if you remember when we went from the 410A to the R22, 410A was introduced five or six years before we transitioned out of the R22. So you had a price basis that gradually was inserted over that six-year period before we actually implemented the transition. This time we're not going to have that, so I think there's a a lot of question marks around exactly how this price can be set and will the price go up, will it be set too low, or will it be set too high? And so that's a what if that I guess I'm not smart enough to answer.

spk38: Yeah, I think it's more of a when, not if, because I think different customer segments will adopt their new products sooner than others and the prices will shake out as all this transpires and It's not going to happen in Q1. We know that. And so, really, it's this summer that we'll see how it works out in the market.

spk05: But are you assuming capture on the older – are you assuming price capture on the non-A2L? Or is most of the price lift from the A2Ls?

spk17: We have not assumed the price that there's going to be capture on the 410. There's going to be some sort of a spread that we're going to keep. Yeah. Yeah. We've got the price increase so far for the 410. It's not anticipated that we're going to be able to price that up against the A2L. I don't think anybody's assuming that.

spk05: Oh, against the A2L. I'm just saying relative to where the price was in 23 for the non-A2L. Do you assume you over your capture, if A2L wasn't happening, would you assume you over your capture on the 410A type products?

spk17: Oh, certainly, yeah. With the price increases that we have?

spk38: Yes, of course. Yeah, okay.

spk25: I want to be really clear about that. So Paul mentioned earlier, if we range it out across really six OEMs, we sell six OEMs products on the ducted side, probably another six on the ductless side. and the range of price consistently across the group is between 4% and 6%, as we said earlier. Your question is, do you expect to yield any of that in 2024? The answer is yes. To what extent, time will tell, but we certainly do not see outliers, and if there's a competitive need in the market or a customer type or an application, OEMs will always be asked to participate. and react to what's going on in the market. But on whole, on scale, we do expect a price capture of 410A.

spk05: And then, sorry, I just got one more. The call usually ends early, so hopefully I'm not taking up anybody's time here. But the 2.5 to 3 million units you mentioned, what's kind of the math on that? And can you just explain that, what you meant by that, the 2.5 to 3 units that you're calculating as being installed at the peak?

spk17: Well, you know, if you look at 2019 as your baseline at roughly 8.5 million units, and then we zoomed up to 9.3, 10.2, you know, we stayed above 10 million. And then in 2023, the industry shipments fell back down to 2019, a little bit ahead. So if you take a normal, let's say, 2% or 3% growth rate that the industry historically has had, put that against where we were in 2019 and take the delta.

spk05: Got it. Okay, great. So that's pull forward, you're saying, like kind of opposite.

spk17: Yeah, that looked like a pull forward to me, you know. Like I indicated to you, you know, one, we've got to look at it geographically because you have longer lifespans, obviously, in Michigan than you do in Miami, Florida.

spk04: Right, right. Okay, great. Thank you so much.

spk31: The next question comes from Damian Karras with UBS. Please go ahead. Hey, good morning.

spk07: Hey, good morning, everyone. I have a follow-up question on inventory. I know you talked about, you know, normalizing back to kind of four to five turns over time. Just curious if you're anticipating, though, later this year maybe having to go in a restocking mode, you know, as the 454B equipment becomes available and then basically you kind of get your last call on getting that 410A? And related to that, you know, I'm just curious if there's any incremental costs that you might expect just as you're kind of managing, you know, the legacy versus the A2L inventory buckets, or can you do that pretty efficiently?

spk17: You know, I think each one of our operating units is developing plans for what we call phasing in the A2L products and phasing out the 410 products. You know, we have a And obviously, we have a safeguard that we mentioned earlier with the AMAC where we can sell the 410A all the way through next year. But each one of our operating units is working on that plan so that we want to be able to hit our inventory targets. We want to be able to hit the demands of the marketplace and our contractors. And we want to be able to do it in a very – logical format so that it's not disruptive to the business and it's not creating additional overhead for it.

spk41: Okay, got it. Thanks.

spk07: And then kind of a follow-up question to a comment you made, Barry, about, you know, you sell six OEM products on the ducted side, six on the ductless side. I mean, it does appear to us there's a lot of kind of – newer players trying to make moves in the U.S. market, particularly in heat pumps and some of these alternative, you know, electric high-efficiency solutions. Would you guys foresee, you know, working with more equipment vendors over time, or are you pretty, you know, kind of satisfied and set in your existing relationships and product breadth?

spk19: Yeah, boy, it's a very new – sorry? Yeah.

spk25: Are you satisfied? I want to give like a half-hour answer to that, honestly. I mean, I don't think we look at our portfolio of brands and say, do we have enough or too much? I don't think we even consider that kind of notion. We look at the markets themselves. So where we've acquired great businesses, we've acquired a great carrier distributor in Chicago three years ago. We acquired a great ream distributor in Louisiana a few years ago. The acquisition campaign is somewhat indifferent to brand. It's focused on who are the dominant players in markets and over time building incredible franchises on top of the incredible franchise that owners had built. So I would say that from that growth perspective, and if you ask me, can Watts go double in size, the answer is yes, and we would do it that way. And oddly enough, ironically enough, the brands are relatively indifferent to that strategy because we're trying to grow share and markets and legacies and And that's what we've done, right? I mean, we were a billion-dollar company 20 years ago. We're a $7 billion company now. And we know we can double the size of Watsco in that same kind of way of growing over the long term. Now, if your question is very short-term and kind of the puzzle pieces that we operate today, we're not going to be satisfied unless market share is well above average in markets. And we're going to find, either build on relationships we have and add brands with Carrier. I don't think people really appreciate it, but we sell seven, eight different brands that Carrier makes.

spk21: And we don't have all of Carrier brands in all of our Carrier locations.

spk25: And that's an opportunity that we talk about in terms of how to bring more density to those brands and those stores. And, you know, we've added, there are niche products and manufacturers that operate in niches that we've added to our network. There's ductless that we've added to our network. We have a private label that's grown over time. So, you know, very interesting question with a very long answer. But, you know.

spk38: I'll say this. We're never satisfied. That's part of our culture. We're very ambitious. We always want to grow, always want to move up and to the right. It's an exciting time in the industry as key pumps have gained traction and regulation, frankly, and the changing markets are creating product innovation for the first time, I think, in a long time, and it's exciting. And that innovation is not only coming from new entrants, but it's also coming from our OEM partners with products that they've brought to market or that they will bring to market. It's fun and exciting to see the improvement and enhancements in the technology that's coming into the product, and it'll be fun to take into market as well.

spk07: Really appreciate the color. Best of luck, guys. And Barry, I'll make sure I follow up so you can give me the full 30-minute response. Take care.

spk31: This concludes our question and answer session. I would like to turn the conference back over to Albert Namid for any closing remarks.

spk27: Thanks for your interest in our company. We much appreciate it. And we believe that we have a enormous future ahead of us and we hope you'll be with us along the way. Bye-bye.

spk31: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. Thank you. Thank you. Music playing. Thank you. you So, Good morning and welcome to the Watsco fourth quarter 2023 earnings call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing star then zero on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Albert Namid, Chairman and CEO. Please go ahead.

spk27: Thank you, and good morning, everyone. Welcome to our fourth quarter earnings call. This is Al Namid, Chairman and CEO. With me is A.J. Namid, Watts Coast President, and Paul Johnston, Barry Logan, and Rick Gomez. Now, before we start, our cautionary statement is always, This conference call has forward-looking statements as defined by the SEC laws and regulations that are made pursuant to safe harbor provisions of these various laws. Ultimate results may differ materially from forward-looking statements. Now, Wattswood delivered strong results in 2023 despite some market conditions which were somewhat inedible after two extraordinary years in 2015. 2021, and 2022. Reflecting in the year's results, I am proud of the accomplishments we delivered. We achieved market share gain in markets we serve. We further scale Wasco's industry-leading technology platforms. We had a successful start driving down long-term productivity gains. I should say we had a successful start driving long-term productivity gains. We expanded our network and product offerings by acquiring great businesses to grow our scale, and we fortified our balance sheet through inventory reduction and generated record fourth quarter cash flow. And once again, shareholders will receive a meaningful dividend increase in 2024. which is in April 2024. This is Watsco's 50th consecutive year of paying dividends. 2023 was also a year of immense change as virtually all equipment products transitioned to new higher efficiency systems. In collaboration with our OEM partners, Watsco introduced new products and SKUs for over 25 brands of HVAC systems. Our teams executed well, and thanks to our scale and speed to market, we are confident that we gained share. We also trained thousands of customers on new products, and our digital product library was updated with approximately 500,000 new SKUs. And this spring, we will begin the next regulatory transition to new 8285. L products with lower GWP refrigerants. These regulatory transitions are positive for our industry and are good for WatchWiz business. They offer meaningful value to homeowners and businesses to upgrade systems that are more efficient and better for the environment. WatchWiz has its actual unit values, although still down, stabilized during the second half of 2023. Commercial end markets remain strong across all markets. Our commercial business continues to grow at a healthy rate and our backlog of products extends well into next year. Sales of ductless systems, an increasingly important component of our business, grew double digits in a year and offset declines in conventional residential business. SG&A, as a percentage of sales on a same-store basis, decreased for the year, indicating progress in driving more productivity across the company. We believe we are in early innings of a long-term opportunity to meaningfully improve productivity and overall efficiency. We have challenged our leaders and provided them with tools and data to implement change, and most importantly, We possess an entrepreneurial culture to execute change in a responsible way. Over the past year, we expanded our network through acquisitions with three terrific business joining the Watsville family. Collectively, their annual sales are around $200 million. These businesses will retain their culture, leadership teams, and uniqueness in the market, consistent with a long-term practice of honoring and sustaining great businesses. Our industry remains highly fragmented, and we will continue to pursue other great companies to grow scale in our $60 billion North American market. We believe Wattsco's technology advantage, market-leading scale, and the strength of our balance sheet are all great reasons to join the Wattsville family. Now, before getting to Q&A, as always, I want to emphasize that our core focus remains on the long-term. We believe our scale, the quality of our balance sheet, and unique culture will continue to drive long-term growth and performance. We have an immense technology advantage, and we are investing to grow that advantage. Wattsco's broad array of products and brands is also a competitive advantage that allows us to serve contractors in any environment. And finally, our industry is fortunate to benefit from important regulatory and industry catalysts that should positively influence Wattsco's performance in the years ahead. With that, let's go on to Q&A.

spk31: Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question comes from Tommy Mull with Stevens Inc. Please go ahead.

spk10: Morning, Tommy. Morning, Al. Thank you for taking my questions. You bet. I wanted to start on gross margins. No big surprise there. Your fourth quarter... Your fourth quarter gross margin percentage was a little bit below the long-term aspirations that have been discussed recently, so... It's a two-part question, really. One is just if you could unpack any of the factors there for us in the fourth quarter. And then if we think about the art of the possible going forward to start this year, is there a pathway near-term, you can define that how you want, near-term to recovering and moving back toward those longer-term aspirations in the high 20s or maybe 30s? Very good question.

spk27: As you know, I've stated earlier that eventually our aspiration is 30%, and we have a ways to go. So I'm going to ask Barry Logan and Paul Johnston to deal with current events.

spk25: Yeah, thanks, Al. Good morning, Tommy. We've said all year long with some of the moving pieces with gross profit and also said two years ago or so now, the short-term aspiration was 27%. If I just focus on the year for a second, Tommy, just some important things to be grounded in looking at the year's performance, and then I'll address the quarter and the shorter-term perspective. But for the year, you know, the 27.4 is what was achieved. And, you know, obviously it's better than it was two years ago, three years ago historically. And a lot of the moving pieces that we've talked about to drive and sustain that higher margin, you know, obviously are in place if we look at the year's perspective. If we look at a 60 business day perspective, which is the fourth quarter year, In the off season, some of the variables have a greater impact in the short term. So that would be my first bias I would try to talk about is we're talking about 60 business days in the off season in the fourth quarter. And some of the moving pieces are more acute because of benefits of a year ago, not so much what's happening short term. So if I unpack that a bit and not be quite as abstract about it, we have about $16 million of benefit in the prior year from pricing gains, from weighted average cost gains, from inflationary gains, however you want to define it, which is roughly 100 basis points in the year-ago quarter. Some of that is equipment. A greater proportion is non-equipment. because there was a lot of inflation going on in some of our non-equipment products a year ago, like refrigerant, like copper tubing, like steel products, and probably 40 other product lines, where a year later those benefits are not there. So that's 100 basis points. That's $16 million of consequence. And if I look forward 12 months, instead of back 12 months, if I look forward 12 months, I don't expect there to be that kind of headwinds and those products, you know, let's say a year from now. And it's just one of those things that as the numbers are larger in a fourth quarter, their acuteness is higher. $16 million would not be as material to a second or third quarter. It's more material to a fourth quarter. So that's probably the biggest impact in the quarter if you look at things on a year-over-year basis. There are some other moving pieces which we've talked about. One is that equipment products in fact, have a lower gross margin than non-equipment products. So in the quarter, you see a mixed difference between the growth rate of equipment, which was pretty flat, non-equipment, which was down. So that's algebra that affects the margins in the quarter by 20, 30 basis points, I would say. And there are some other smaller things that aren't worth kind of going through. The bigger picture is this idea of of inflationary gains that occurred a year ago. With less inflation, there's less inventory gains to come by. And if we look in the next 12 months, I would expect a much smoother water, much more, you know, less volatility in terms of this dynamic. I think we need to get beyond the first quarter to clearly see that if I look forward the next 12 months. but I would say a greater feeling of stability versus the volatility that you've been seeing this year. Paul, anything you would add to that?

spk17: Boy, Barry, you've really covered a lot of ground there, yeah. Obviously, there's going to be some price changes that we're going to see in some of the commodities, especially refrigerant. We should start seeing some uptick in refrigerant pricing as we as we've got the 30% reduction in allocations coming into effect January 1. Too early in the season to have really seen those yet in the first quarter, but obviously those are expected. Secondly, we're also seeing some recovery in steel. We're seeing some recovery in some of the other products that we sell. Price increases are still occurring in the non-equipment side of the business, and we expect those to stabilize and perhaps grow as the demand picks up during the year.

spk10: Thank you both for those helpful answers. As a follow-up, I wanted to pivot to a volume conversation. And knowing that you won't give guidance, I'll try to frame it in a way that provides for a constructive discussion. If we look at the trends for unitary HVAC systems in the year you just concluded, down, I think it was 8% in your materials this morning that you provided, I think we would agree that's an abnormal-type trend. And so I'm just curious, if you look to 2024, is there anything abnormal that you see, anything worth calling out now, Or does it feel more like a normal kind of environment off that lower base from last year?

spk27: That is a great question. By the way, some of the OEM, particularly Larsen, announced 30% unit volume drop in the fourth quarter. And we're pleased that we're doing a hell of a lot better than that. Paul, you want to take a shot?

spk17: Yeah, the obvious elephant in the room is going to be how fast the transition goes to the A2L product, which is being discussed among the OEMs as perhaps a 10% to 15% increase or lift in price. And each one of the OEMs obviously has a different implementation schedule, so It's not going to be a full year implementation that we're going to see on that. We're going to see some start coming in in the second quarter and beyond. So I think that's going to be one of the things that's going to drive an increase. Secondly, obviously a reduction in mortgage rates always helps. People buying existing homes, although they don't intend to replace the air conditioning system, that's really when they're at the prime period where they would do a replacement. is within the first 90 to 180 days after acquiring an existing home. So I think there's some good news out there. I can't forecast out exactly how that's going to overlay into the entire year, but I think there's some positive things that we're going to be seeing as the year goes on.

spk27: Let me just say generally that I've always seen – Industry weakness is an opportunity for us. There are highly leveraged distributors in the business and there are distributors that don't have perhaps the balance sheet to deal with tougher times. We see that as an opportunity to have them join us. With our culture, we provide capital We insist that they keep their culture and their organization, and we provide tools that no one else has. So I'm sort of, while I would not be very excited to have market industry data decline, if it happens, I'm also looking at opportunity to bring more wonderful companies into the partnership with us. Go ahead, Paul.

spk25: No, I was going to add about the unit data. I listened to the question and I asked myself the question about units. Do we feel better or worse? That would be my simple way of asking that question. And so the first half of 2023, units were down, I think, in the team's And second half of the year, I think units are down 2% or 3%. So I think we feel better about units than worse. Of course, the crystal ball needs to play out next selling season in April to September when our business multiplies in size. But I think generally speaking, things, again, seem more stable as opposed to being volatile.

spk10: Thank you all. I appreciate the insight, and I'll turn it back.

spk31: The next question comes from Ryan Merkle with William Blair. Please go ahead.

spk39: Hi, Ryan. Hey, everyone. Good morning. My first question was on price in the outlook for 24. What do you think in price will contribute, given what you've seen from the OEMs?

spk27: We have that information. Barry, Paul?

spk17: Yeah, we've seen price increases announced already in the year on the existing equipment. They range basically from 4% to 6%. So the equipment prices have already been announced. They're going to be further supplemented again by the introduction, as I indicated in the last question, with the A2L introduction. And so we're going to probably see some additional lift there. A lot of speculation around how big of a lift that's going to be. So nobody has really disclosed anything on their anticipated price outside of that wide range that I think you all have heard, 10% to 15%. On the other products that we sell, we're also seeing, as I indicated, increased prices on pretty much all of the copper products and all of the metal products that we sell. And we experienced some softness on some of the insulation products last year. Those appear to be stabilized now, and we should start seeing those products not have any sort of price degradation in 2024. How much all that's going to add up to, I think it's still a little bit of a question mark as far as being able to put a percentage against that, against total sales. I think it'll be clear in the second quarter as we start seeing what the rollout prices are going to look like for the A2O.

spk39: Okay, got it. And then I wanted to ask on SG&A, you've taken some actions there. Anything you can quantify for us in terms of how much is coming out in 24 or what your kind of aspiration is for SG&A growth in 24, either way? Mr. Logan?

spk22: Good morning, Ryan.

spk25: Yeah, well, first, again, there's two sides to that equation. And it's all being driven, again, through the field, through our stores, through our region, through our business unit leaders, in terms of in their 2024 plans, reducing SG&A. And when I say reduce SG&A, it's not just cutting SG&A, it's finding out the opportunities for productivity after what had been also two years of wildness in terms of SG&A growth. Talk about the business performance of 21 and 22. It was also a very unproductive period of adding SG&A to serve what was going on. So that's what we're looking to improve and to some extent simply get back to a little bit more normalized conditions in terms of how the branches operate and so on. So this kind of single-digit declines that you're seeing, Ryan, is a composite of two things. In recent quarters, it's Variable expenses coming down 10%, 15%. Fixed cost inflation moderating, but still there's inflation in fixed costs, like rent, for example. So it's probably a slow grind of better improvement from what you've been seeing the last few quarters. This is, again, not restructuring the corporation. This is improving the daily expenses, the daily productivity. But in that, you know, that kind of Better progress from what we've been seeing in the last few quarters is our expectation. I'll have to leave it at that. Okay. Fair enough.

spk31: Thank you. The next question comes from David Manthe with Baird. Please go ahead.

spk30: Arnie, David. Mr. Manthe, your line is open.

spk31: Please go ahead with your question. Is it muted accidentally?

spk29: Got it. Yeah. Hey, good morning, Al. Good morning, everyone. Can you hear me now?

spk30: Yeah. Yes, please go ahead, sir.

spk26: Thank you. So I'm going to stay on the gross margin topic if I can here. Were there adjustments in the fourth quarter that hit gross margin disproportionately hard? Barry, you were kind of saying the year-over-year comparison looking back and then looking forward. Are you implying that the gross margin a year from now, give or take, will be in the range? that it was this year, or was there something unusual in this fourth quarter that might affect that comparison?

spk25: Yeah, good question. Well, a year from now, again, we'll have a completely different blend of new products a year from now. I would expect that to be a margin opportunity a year from now. There are no adjustments or funk that hit this quarter that I would call out as being material or even important to talk about or even immaterial to talk about really nothing that, that stands out. Uh, so yeah, I think, you know, going back to the, the algebra of price and inflation and, and the seasonality and so on. Again, I would expect as we get into season, we have pricing, pricing, you know, actions in our pocket. We have new products being introduced and, you know, I would say, uh, a continuance of the technology that we've been using to improve margin. And as far as a year from now and next fourth quarter, you know, again, I think there's an opportunity to improve margin, but nothing that penalized this quarter in a particular way that would be important.

spk26: Okay. And yeah, I appreciate you indulging us in all this quarterly conversation, which I don't think historically we would have done here, but Barry, you also said we need to get through the first quarter, and you were kind of talking again about that year-to-year comparison. If you're down a couple hundred basis points in the fourth quarter year-to-year because of all the items you mentioned, and then we look to the first quarter, that would put us in a range in the 26.5, 27 range. Just trying to understand the cadence, again, knowing there's a lot of moving parts there. Is there anything in the first quarter unusual that we should think about there relative to your comments, Barry?

spk25: Yeah, I think the pricing actions of the OEMs are pushed out a little bit into the late first quarter, early second quarter if I look at things comparatively to last year. So you can read into that comment and in terms of modeling, you can consider the comment. So sequentially, I think Again, there can be a certainly better margin in the first quarter versus a year ago. You have to consider my comment about the timing of some of the pricing actions that we're describing.

spk17: That's a good point, Barry, because instead of a January 1 price increase, most everybody went February 1st, March 1st.

spk25: So it's a little bit of a lag to Barry's point. And a top 10 vendor that went April 1st instead of January 1st. So... Some of this, the benefit will push a little bit later into 2024 than simply January 1.

spk26: Great. Thanks very much, guys.

spk31: The next question comes from Brett Lindsey with Mizuho. Please go ahead.

spk33: Hey, good morning, all. Hey. I just want to come back to the inventory. So you took another $208 million out of the system. I believe that was a little bit ahead of your initial plan, but maybe you could just speak to, you know, your assessment of inventory levels as we begin to move into the selling season. Are there, you know, more actions that need to be taken, largely complete? How are you thinking about that?

spk27: Well, I'll give you a bigger, a big picture of it is that we do want and we'll work on higher inventory returns. So I do expect to have our inventory, you know, produce more cash flow as it turns. And the science that we use to do that is being implemented. It's a very long process, longer than I expected. But eventually, what you'll see is lower investment in inventory and higher returns when compared to sales.

spk17: Yeah, absolutely. As Paul, you know, Historically, you know, it's been a four-plus turn industry, and obviously during the pandemic and the supply chain disruption, everybody got lost in the mid to low threes. And so now as we strive to get back to the four turns, obviously we're going to have a reduction in inventory. Right now we're seeing better cooperation and better lead times coming out of our OEMs. pretty much across the board. And as those lead times improve, obviously that gets us a better position to not have to stock as much inventory. So that's one thing that's happening. Secondly, Wattsco has got an unusual position on inventory in that each one of our operating units manages inventory. So there's not one big central, you know, headquarter directive that gets into the inventory. We manage it in much smaller blocks with each one of the operating units actually functioning against their vendors, what they need to have in stock and in inventory. Plus, Wattsco invested during, before the pandemic, we invested heavily in the technology it takes to manage inventory, putting in new inventory management systems. It gives us daily management reviews so that we can identify what we have on hand, what we have on order, by region, by district, by branch. So a lot more visibility than you'd find in a normal distribution company.

spk33: Yeah, that's great. And then just shifting to the non-equipment versus equipment trends, as well as the second half being a little better than first half. I guess it doesn't suggest there's a meaningful retrenchment in the consumer on the replacement side. Is there anything in terms of high efficiency mix or credit metrics or things that you're watching internally that would suggest there's a step down here in 24 early in the year?

spk17: Take a stab on the equipment side. As we indicated a year ago, when we went to the higher efficiency minimums that were regulated by the government, we expected there to be a compression around the entry-level product. And we went from around 65% of the minimum efficiency products up to around 85%. So we've definitely seen more product coming out. It's higher efficient product than what we had before, but it has distorted the industry a little bit towards the minimum efficiency as opposed to high efficiency.

spk25: And it's a good question on credit. It's not asked often enough, frankly. Obviously, our accounts receivable represents contractor credit, giving the average contractor about $10,000 a month and a credit line, essentially. And so if you look at our cash flow statement, which is published in the press release, you'll see bad debt is actually down about 20% this year. So there's no obvious indication of change in the quality of the portfolio. It's roughly 10, 11 basis points of bad debt. And again, compare that against any peer or any kind of other distribution model you can find. It's in very favorable position. So credit is not something we're seeing as a risk. It's how we serve customers. And again, so far, so good from an economic point of view.

spk32: All right. Appreciate the color. Pass it along.

spk31: The next question comes from Jeffrey Sprague with Vertical Research. Please go ahead.

spk08: Good morning, Jeffrey.

spk18: Hey, good morning, Al. Good morning, everyone. Thanks for the time. Hey, just kind of back on price, just wonder if anything you make of the OEMs kind of going later and kind of not at the same time, is there sort of a message here of kind of price fatigue in the market, do you think? Is there Some game theory or something we should be thinking about?

spk17: I don't think it's that diabolical. I think it's just a natural progression of how they intend to roll out their new product introduction on the A2L. And if you listen to each one of the OEMs on their public broadcasts, you'd find that they each are putting out a different variety of products at different times during the year. And I think it has more to do with their engineering and their manufacturing plants and all that that goes into rolling out the product.

spk18: Yeah, interesting. Makes sense. And then just kind of back to the replacement question, it was asked, you know, kind of at least obliquely a couple different ways. You know, Al, in your opening, you know, you kind of talked about the inevitability of after a year like 2023 here. You know, if we do go back to just that kind of, you know, old school demographic replacement and type of analysis, get into the whole 15-year life and all that argument, you know, we're echoing against 2009 right now, right? So, you know, that math could argue for, you know, another soft replacement year. I just wonder, you know, your thoughts on that and kind of what you're seeing in repair versus replacement. Well, our guru in that is Paul Johnson.

spk17: Oh, my God. Start with the repair versus replace. You know, it's fourth quarter, first quarter, which is not the time when you're going to see a lot of repair going on out there. You don't have your air conditioners working. You have your heat pumps and your gas furnaces, which your gas furnaces are generally a lower repair item. So to date, We're not declaring that there's any trends that we've been able to identify in repair versus replace. Will it occur when the temperatures goes up? We'll wait and see and find out. The other part of your question was what?

spk18: Just the underlying health of replacement demand based on kind of where the installed base is and sort of the age of the installed base.

spk17: The age of the install base is newer than it's probably ever been since I've been around, which is a long time. But obviously the mix of the install base is changing. Gas furnaces generally have a lifetime. You can make a gas furnace last 25, 30 years. Whereas a straight cool unit, I think the industry has said it's around 15, 16 years. Heat pumps are something that are growing as a percentage of the total business, and those generally don't have as long a lifetime. Remember, they're not just operating in the wintertime. They're operating in the summertime also. So you've got more hours being packed onto that piece of equipment. What that's going to do to the overall mix of installed base out there right now I think that's going to be one of the questions that we'll be able to look at probably in the next year or so. But replacement pull-up, I figure that we probably had 2.5 to 3 million units that were pulled up during the pandemic. They were installed perhaps prematurely, perhaps not. Trying to get some data around that to see what the geography was of those replacements. Was it north or was it south, you know, where people were actually replacing equipment? So a lot of data coming in, a lot of data that needs to be analyzed there to answer that question properly.