Watsco: Air Apparent - [Business Breakdowns, EP.209]

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0:45This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. This is Matt Russell and today we are breaking down WattScope. They are the market leader in HVAC distribution with a unique value proposition that they offer to the OEMs and suppliers in the space. And my guest today are Lucy Adams, investment director at Caledonia Investments and Alan Moran co -head of public companies at Caledonia Investments. If you've ever had an air conditioning issue, you call your maintenance contractor, and then you have them sit there on the phone as they located apart.

1:24There's a decent chance it was a Watsco distributor on the other side of that phone call. So Lucian Allen helped track the history of Watsco and some of the key steps like the initial pivot from manufacturer to distributor, how Watsco formed those key relationships with the major OEMs like Carrier, and then we dissect their reputation for a strong culture, one of those things that can be thrown out there as a term. But here you have an ownership mindset with what has to be one of the most unique employee compensation plans I have ever come across. So it's an incredibly fun conversation, another long duration business that has been around for a while and evolved over the years that are always worth studying.

2:08So please enjoy this breakdown of Watsco. All right, Alan and Lucy, I am excited to be covering Watsco today. It is a highly regarded business in terms of how it has been run for a very long period of time. Just getting into it, I think the best place to start is with a simple introduction to Watsco with an overview of what they do and just some general description around their business. Thanks for having us on, Matt. It's great to be here. For anyone who lives in a hot climate, there's an important product in the home and that's air conditioning. And so we're here to talk about what's going North America's largest distributor of HVAC equipment.

2:53So that's heating, ventilation, air conditioning and refrigeration. What's going to act as the crucial link between manufacturers who make the equipment and the contractors who install and maintain it? What's in 1989 and this is really a transformational moment for the company. So back then, the revenue was around $64 million and it's now $7 .5 billion, which means they're part of the Fortune 500. And in 1989, the market cap was $22 million, now it's around $20 billion. So that's a 20 % annualized shareholder return that's consistent over 5, 10, 20, and 30 periods. It's just really an amazing achievement and it makes what's go one of those long term quality compounding business.

3:37that we love to look for. We've covered some other HVAC names, train being a manufacturer. You mentioned they're a distributor, they act as this link. Can you get into a bit more about what that entails to be a distributor? So they primarily sell HVAC equipment. So I think air conditioning units, keep pumps, gas and electric furnaces, and they also sell the parts and supplies that are needed to service these systems. And they sell exclusively to contractors. So those who are licensed to install and maintain these systems in both residential and commercial buildings. So as Alan said, acting as that middle man between those equipment manufacturers, and then selling to this highly fragmented base of contractors, and they operate through a network of distribution businesses and their local sales branches, and they cater to these contractors in a number of different ways.

4:42So first, it's about stocking that wide range of equipment and parts. I think multiple brands, multiple price points, and they are readily available across their large network of 700 or so sales branches. But they also provide technical expertise to these contractors. They rely on the WOTSCO sales team to help them with the right product selection or to help and check and process warranties or even just to get quick access to product information. And then finally, they offer this suite of other value added services and by that I mean things like training programs. So they're keeping this contractor base up to date with the latest product knowledge.

5:25and they also have a range of digital tools and that's anything from access to a searchable product database or it's the mobile ordering app or their e -commerce platform. It even goes as far as customer -facing tools for the contractors themselves, so tools that help contractors grow their own businesses. So if you bring all these things together, this This is what made WOTSK a valuable partner to these contractors and not just the supplier. To paint the real world picture, I can remember distinctly having an issue with my heating system this past year, called somebody for maintenance, they checked it out, it's some very old system that needed a very specific part, they were calling around for it.

6:11And I'm imagining that is where a WOTSK distributor comes into play. But one, can you tell me if that is the correct example? And then two, just in general, would you say that the just in time I need this at the moment is a big piece of their service? How much are they doing that versus well in advance project planning around HVAC equipment, installations, and maintenance and more? I think that residential and market example is a great one, not only because we can all relate to it. But actually that immediate need for repair and replacement products in the home is actually what generates the majority of what's goes revenues.

6:55So if your unit breaks, you want it fixed quickly, but it's not a DIY job, it requires a license professional. So as you said, that first step is searching for and calling up your local contractor who then visits your home, diagnoses the issue, and then hopefully recommends a solution. And so it's at this point that the contractor would then go to their local WOTSCo store to search for and buy that part that is needed to fix the problem. But it's also at this point, the point of sale that the contractor might draw on the technical expertise of a WOTSCo sales person. So you use the example helping to find a compatible part for an older system.

7:43So once they have both that knowledge and the part, they then return to the home to complete that repair. And I think what's interesting here is that it's that contractor making a recommendation to the homeowner on what they should do. And that's what puts the contractor at the centre of this industry. And it's why WOTSCO are laser -focused on the contractor. They put them at the centre of their universe. And so they are focused on improving that contractor's experience. So, for example, thinking about ways that they can make their life easier, helping them to be more efficient, more productive, so that the contractors can grow their businesses, because fundamentally the success that the contractor is what drives what's good is great.

8:35Can you give a sense just in terms of the market competition where rots go ranks in terms of whether it's market share or any other numbers that you could just put around the business? This North American H -Fact distribution market is valued around $64 billion today. And that is primarily served by over 2000 distributors, so it's highly fragmented, and primarily served by many local and regional players. What's go? They are the largest national distributor. They have 11 to 12 % market share, and they're actually more than two times the size of its next largest competitor. After the top three or four players, the size of the competition drops away quite quickly to the smaller local players.

9:28But if I was to think of a key differentiator between what's going to its largest competitors, is that what's going to are exclusively focused on the HVAC market. Whereas the number two number three players, they're actually more diversified across HVAC, plumbing, another industrial end market. So they have that slight competitive edge in being able to focus on that narrower adjustable market. I love markets like this where you do have a lot of fragmentation. You do see some players emerge as having market shares that are significantly larger as you just mentioned, but still a fraction of the overall market.

10:09Maybe we can get into a bit of the history, Alan, you tapped into it at the very beginning terms of late 80s launch year. What have been some of the evolutions of this business? How did it evolve into what it is today and whether there were key players involved or anything else along those lines? That's a 50 year journey of entrepreneurship and evolution that was driven by what's goes founder and CEO Albert Nammad and now carried forward by his son AJ. Al's background is a true entrepreneurial story. So he was born in Panama and then he got a scholarship to go study in the States. And after graduating, he got a job in consulting and then moved into mergers and acquisitions.

10:49And it was here that he really learned this lesson that continues to impact what's goes culture today. And that's the power of decentralization. So the conglomerate where I worked at this more of a command and control approach that he felt stifled innovation and eroded value. And so he wanted to do it differently. So he left and went to look for a business to buy. And after about a year of looking, he found this company called Wagner Tools and Supply Corporation, whose initials form WOTSCO, and they were a manufacturer in the HVAC industry. So our financial help for some friends and family brought his original state back in 1972.

11:26Now, if we turn to his son and WOTSCO's president, AJ, he's really been immersed in the businesses' entire life. And as a consequence, he's really learned about all aspects of WOTSCO. In turn during the summers before joining the company around 20 years ago. Now, we've been invested in what's go for about eight years now. So we've been out there and met with AJ a number of times and what's always come across is his passion and his energy for the business, as well as his deep interest and understanding of the benefits of technology. Now, I would think about what's goes history in a series of chapters and I probably call out two of them.

12:00So one would be their initial move from manufacturing to distribution and then the second one would be the transformational deal that they did with carrier. So this moved from manufacturing to distributions quite an interesting story. So it goes that one day effectively hour received a prospectus from his bank. And this was giving him the opportunity to buy one of his customers, a company called Gem Air, who were a distributor for the manufacturer Reem. What's go into the auction and bought the company? Interestingly, actually, they've done over 70 deals since and have not entered another auction.

12:36And I'll structure this original transaction as a joint venture and the reason was he wanted to align the incentives between what's go and the manufacturer and share the risk with them. And this thoughtfulness on incentives is something that we continuously see across many areas of what's going to affect. They also use this same joint venture structure when they did the carrier deal 20 years later. I can just build on that. After this initial move from manufacturing into distribution, what scope looked to grow by buying more of Reem's distributors? And as that became more difficult and that slowed, they knew that they needed to go out and form relationships with key leaders at other manufacturers.

13:23During the 1990s, we saw this shift from single brand to multi -brand distribution. And that was an important strategic move for WOTSCO because it decreased their reliance on this one manufacturer, Rene. And it also acted as the next leg of grace for the business. There was a period of three years in the 1990s, I think 1995 through to 1997, where we saw them complete, I think, over 20 deals as they partnered with other manufacturers. This meant that they were able to broaden a footprint, broaden their product offering and reduce their risk profile. And it's this buy and build strategy that helps it to become the multi brand business that it is today.

14:09You can think of what's go as this aggregator of 10 or so major operating companies. companies, and then each one of these operating companies will subsidiaries, they have an exclusive relationship with one of the leading domestic manufacturers to sell their products in specific regions in the US. There's interesting similarities to another name that we covered with HICO in terms of having a business and then finding a related business that seemed much more fruitful and more advantageous and then really leaning into that. Lucy, you tapped into the exclusivity dynamics. And this is something that's very interesting to me here, where I can understand in certain industries, exclusivity can be very powerful, but it depends which side is getting the better side of that agreement.

15:02Exclusivity can be limiting in many ways. It can open up opportunities in many ways. Can you just walk through the exclusivity dynamics and how much that plays a role for Watsco? The first point to note is these exclusivity agreements are commonplace in the HVAC industry, and importantly the deals are mutually exclusive. These are long -term strategic relationships. Both parties are working together to drive growth. So if we go back to when I mentioned the service element that WOTSCO offers above distributing equipment and parts, these services not only help to grow what's Co's business, but they're also beneficial for the manufacturers too.

15:45Improving customer satisfaction and creating brand loyalty. That's things like customer support, the aftermarket sales support, such as the warranties and training programs, even providing that e -commerce and technology platforms, which ultimately help the manufacturers to capture online sales. And what this does is that while what's Co can focus on delivering those services that help to grow both sides of the manufacturers business and what's co's own sales. It in turn allows the manufacturers to focus solely on product innovation. The other important thing to understand about this industry dynamic is that it creates significant barriers to entry for new entrants.

16:29For example, it prevents others entering either organically or through M &A because it requires the specific approval of a manufacturer. I have been picturing this through the residential lens throughout this conversation, but it is fair to bring up commercial, which you've mentioned several times. How much difference is there between commercial operations versus residential operations, whether it's in the business model itself and the strategy around it or more so in the numbers? commercial and residential are quite similar. For example, they both have exclusivity agreements that Lucy's just described, so I between the manufacturer and the distributor and in addition, both parts of the business primarily relate to servicing replacement demand.

17:13Two differences to call out in what's goes case would be what's goes less penetrated in the commercial space and in residential and also there's a slightly lower gross margin in the commercial space versus residential. I think I understand how transactions occur within the industry and where Wattsco is acting within some of those transactions. How does that show up in the numbers in terms of how pricing is getting determined, how a margin is being considered in terms of Wattsco and anything else that would go into how they're actually making money. So let's start off with how it is actually making money.

17:50That's quite straightforward. They're purchasing equipment from the major manufacturers, as well as those parts and suppliers from this long tail of other suppliers, and then they're selling those products to the contractors and adding a percentage markup. They're then investing part of this markup to provide these additional services that we've talked about to the contractors. So that's how it earns revenues. In terms of the size of the business today, it's generating over $7 .5 billion in sales, and that's primarily in the US and 90 % of its sales come from the US with a remainder split equally between Canada and Latin America.

18:29And then if we move on to the products that it sells, so it groups these into three categories, equipment generates 70 % of sales, parts and supplies around 25 % and then the balancing 5 % is commercial refrigeration products. And then just to complete that picture in terms of the end markets that it serves, that's 80 % residential and 20 % commercial. And within that core residential markets, around 80 % is driven by repair and replacement, and then 20 % from new housing. That's also worth adding in there that new housing was around 30 % of what goes total sales prior to the global financial crisis.

19:13But obviously as the installed base of HVAC units has increased, and then also what goes growth in other areas, like parts and supplies, as percentage is now smaller, and not obviously reduces a bit of the sickle -cality risk in the business. That's 70 % of revenue being equipment. A large majority of that is coming from replacement equipment and not necessarily new housing. That's right. Thinking about the trajectory of that revenue growth, you mentioned the acquisitions over the years, and join ventures, the carrier deal we touched on a little bit, but might be good to paint a bit more of a picture about that.

19:53How have they approached growth, whether it's just an organic pricing plus volume model that's playing out and then tapping into M &A periodically or how delivered are they about M &A more just in terms of the top line and expansion of the business? We would expect organic revenues to grow at around 5%. And let's break that down between volume and then price. So if we start with volume, we have industry unit volumes growing at around 3 to 4%. And therefore, we'd expect both equipment and parts to grow in line with that. Now, what's going to actually tend to grow a little bit more and that's really a combination of market share gains and the fact that 60 % of their network are actually in these faster growing sunbelt states.

20:45If we then turn to price and mix, we think that adds sort of a further 2 to 3 % of great each year. And that's primarily driven by two things. So first we have the typical annual price increases by the manufacturers. So So they typically realize below single digits, growth rate each year. And then we have a regulatory driven mix impact. So every 10 years or so. And so we smooth that out over time. So if I add volume and price together, that gets us to that 5 % organic growth rate. There are other growth drivers that we've seen over the M &A being a key one. And that's opportunistic. If we smooth that out again, we expect that to add another 2 % to great.

21:31I know it could be hard to model any future M &A or take any forecasting or view on that. How much does that play a role? Whether it's new joint ventures, acquiring more distributors, is that a key piece of the DNA? And maybe it was in the beginning and it is it now, but how would you describe that in terms of playing a role? It is an important driver to return through the cycle. or it's probably worth understanding what types of companies that WOTSCO does buy. These are family -run distributors and they can be up to third generation. As a consequence, deals can take years to come to fruition and often require some sort of catalyst within the family.

22:11But in the meantime, WOTSCO's pitch to these companies is compelling. They say, look, come and join our WOTSCO family and that's not just talk. It's backed by decentralized philosophy with the companies retaining their brands and their teams And then they benefit from what's goes expertise their capital and their technology Broadly there's three components to what's goes M &A philosophy One would really be about cultural alignment The second one is about the fact they look to get quality businesses and then the third is really around financial discipline So if you think about culture, this is all about the alignment between the selling family and what's going It's probably the most important thing for what's go the second is around the fact that what's good looks to buy Performing businesses and not turn around and then finally on financial discipline They look to use minimal debt and their M &A so as the leadership of what's good likes to say they never bet the ranch and this philosophy actually ties back to the family ownership that wants a company to endure and succeed over the long run.

23:15And when you look at 15 plus years of transcripts, you can see this philosophy consistently articulated by the entire management team. Now what's also interesting, you touch on a little bit is what is the growth potential for a company underneath the Wattsco umbrella. And what's interesting here is they did a deal with a distributor called Russell Siggler. Here they bought a 35 % stake in the business back in 2017. And if you look at the accounts today, you can see this value of the stake as it's based on a fixed multiple of operating profit. Therefore, you can calculate that the operating profit has grown over 400 % since they did that deal.

23:54That's a really great example of the potential benefit of these acquisitions to investors. And this is really due to both hard work at the subsidiary, but also what goes expertise, their relationships, capital and technology. And these technology improvements have been and continue to be an additional catalyst for deals. Since 2017, they've done over nine deals adding over $1 .2 billion of revenue. They have the balance sheet in place and the appetite to do more deals. And as I say, it's really about whether the opportunities arrived, which are driven by what's happening with the families, but it also what the technological improvements that what's go wrong.

24:36The 35 % is notable, catches my ear. Is that common for them to acquire minority stakes in businesses or sub 50 % ownership in businesses? Or was that more of a one off? Normally they acquired the entire of the business. in the case of Russell Siglia was one of the larger acquisitions and what it was structured as is the family did not want to sell the entirety day one. There's an agreement in place that what's good can purchase at a fixed multiple the additional equity that's available effectively. Nice that you get to see the stake and you can track it over time that helps the analysis. Just to touch on the JVs, the carrier type deal, how much does that play a role in the growth and how much flexibility do they have to do more of those in the future?

25:25It's different than M &A in terms of just talking in a distributor. It's a little bit more strategic in terms of what they're doing. How would you describe that and the potential for that to happen again in the future and how key it is to the business? So it's an interesting opportunity with Carrier. But in terms of the future opportunities with Carrier, out of those nine deals on a number of them, Carrier continue to partner with Wattsco. When they look to do the acquisition, them, they often folded into the joint venture structure, where Wattsco owns 80 % of the acquired company and carry on 20%.

25:57So they continue to partner on that. And carry continued to remain Wattsco's largest supplier, representing 65 % of their purchases. Might be good to just get into the history of that transaction, as you mentioned. It is a very interesting deal. The history of carry in itself is as well. So this history starts 120 years ago. And the story is that there was effectively this printing plant in Brooklyn, and during the summer humidity was ruining the paper and the plant, and the company asked a guy named Willis Carrier to effectively come up with a solution. And he invented this system that used chilled coils to cool and dehumidify the air.

26:38That was the start of the modern air conditioning industry. And so Willis went on to found Carrier, which today, as you know, is one of the largest manufacturers in the HVAC space. And then throughout the 1990s and 2000s, WattSco wanted to manage more of carrier's distribution. In 2009, they did this original joint venture with carrier that effectively nearly doubled WattSco's revenue at the time, so adding about a billion dollars, so really a transformation will deal. And WattSco financed this with equity. And this was similar to the deal with Jemera 20 years ago. This is to align carrier to this joint venture and to the ultimate success of what's go to.

27:15Now what's interesting as well is that if you study the disclosures at the time of the deal, you can see that carriers margins were actually only around about 2%, so third of what's goes at the time, and those have now grown sixfold, so true win -win for both parties. And so the next step of this collaboration, they did agree to do additional joint ventures for additional regions in 2011 and 2012. And then as I mentioned, they now do more deals, more recently. I like the history, Willis Carrier, that's a name I'll have in my back pocket now for trivia nights. Does the relationship with Carrier limit the potential to do that with other manufacturers in the future?

27:57It seems like there's a very nice arrangement there. Could Watsco ever come up with a similar arrangement with another manufacturer? So very concentrated industry of manufacturers in the States at the minute, a lot of them do outsource their distribution. Most of them have independent distributors, other than Linux. Most of them have this outsource distribution model. So be quite difficult for what's going to do it at scale on their acquisitions, given the multi brand approach. They are able to acquire distributors that have different manufacturers effectively. You outlined the carry margin improvement over the course of their joint venture.

28:36For WOTSCO, what does the margin profile of this business look like? You can break that down. However you like, whether it's unit economics or on a consolidated basis. So I'd start by highlighting the different margin profiles for the different product categories, and then we can get into the margins for the business as a whole. So, equipment sales, so the majority of what's to his revenues, they are actually lower gross margin compared to parts and supplies. And that's because systems are higher cost items and more competitively priced compared to parts and supplies which are smaller ticket items and less price sensitive.