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Edited Transcript of WSO earnings conference call or presentation 17-Oct-19 2:00pm GMT

Q3 2019 Watsco Inc Earnings Call

COCONUT GROVE Oct 19, 2019 (Thomson StreetEvents) -- Edited Transcript of Watsco Inc earnings conference call or presentation Thursday, October 17, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Aaron J. Nahmad

Watsco, Inc. - President & Director

* Albert H. Nahmad

Watsco, Inc. - Chairman & CEO

* Barry S. Logan

Watsco, Inc. - Executive VP of Planning & Strategy and Secretary

* Paul W. Johnston

Watsco, Inc. - EVP

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Conference Call Participants

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* Blake Anthony Hirschman

Stephens Inc., Research Division - Research Analyst

* Breindy Elizabeth Goldring

Morgan Stanley, Research Division - Equity Analyst

* David John Manthey

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Jeffrey David Hammond

KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

* Robert Douglas Barry

The Buckingham Research Group Incorporated - Research Analyst

* Ryan James Merkel

William Blair & Company L.L.C., Research Division - Research Analyst

* Stephen Edward Volkmann

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good day and welcome to the Watsco Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Albert Nahmad, CEO. Please go ahead.

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [2]

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Good morning, and welcome to Watsco's third quarter earnings call. This is Al Nahmad, Chairman and CEO and with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Executive Vice President.

Before we start our call, our cautionary statement. This conference call has forward-looking statements as defined by SEC laws and regulations that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements.

Watsco produced another record quarter with sales, net income and earnings per share all reaching record levels. In addition, cash flow for the 9 months was also a record and we expect cash flow to exceed net income for the full year. Our 2019 acquisitions, DASCO Supply and Peirce-Phelps, both contributed to the quarter and produced sales and profit growth over last year. We remain very active in the industry, seeking great companies. We believe in investing in great companies and providing their leaders with resources to grow their business. These resources include capital, technology, equity incentive and most important, encouraging the preservation of their own entrepreneurship culture. With the advent of modern technology, we believe it is an opportune time for independent distributors to join the Watsco family since our resources can help them develop scale faster.

In terms of results for the quarter, sales growth was driven by strength in residential HVAC equipment with more consistent demand trends across the Sunbelt markets. 2018's third quarter gross margin comparison proved difficult as last year's OEMs pricing actions did not reoccur in 2019. However, SG&A efficiencies were achieved during the quarter and that offset a good portion of the gross margin impact.

We continue to drive adoption of a variety of customer-focused technologies to better serve our contractor customers. That adoption has led to higher growth rates and lower attrition rates with customers who regularly use our technology. Over the long run, we are confident Watsco's innovations will transform the way business is done in our industry and will also influence and convince great companies to become a part of the Watsco family.

Moving onto our balance sheet. Our financial position remains conservative and strong with a 9% debt-to-total capitalization ratio. This financial strength allows us to take advantage of almost any sized investment opportunity. Our press release provides important details about our performance. I will not recite these details in my prepared remarks, but will be happy to provide more color during Q&A.

Finally, we renew our standing invitation to visit us in Miami and learn more about our technology journey. You will gain insight into our culture and many innovations that are underway. We hope you will come, visit us and learn more.

With that, A.J., Paul, Barry and I are happy to answer your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Jeff Hammond of KeyBanc Capital Markets.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [2]

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So yes, 6% residential, it was pretty impressive and I know that some other folks were kind of complaining about the weather. Can you maybe just talk about where you saw particular strength and where there still may be pockets of weakness regionally?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [3]

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I don't know that we get into that sort of competitive detail, but I'll let Barry deal with the question.

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [4]

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Yes, Jeff, without giving data by state or data by market, I could say this way, that really across our Sunbelt markets in particular, very consistent narrow bandwidth of growth consistent with what you see overall. So in our minds, it was nice to see that consistency. Up north there, we have some strength in the residential markets and Latin America also grew during the quarter. So nice and plain and simple in terms of overall growth.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [5]

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Okay. Great. And then it looks like the Carrier minority interest line was a little light versus my expectations. I know like Peirce and Homans were coming into the mix. Just maybe speak to the gross margin pressure and how that might have gone through the Carrier side. And maybe on this gross margin dynamic, you talked about just do you expect that to carry into 4Q?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [6]

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Go ahead, Barry.

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [7]

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Well, Jeff, I think most of the change in the quarter for the minority interest line is Homans. We purchased 20% of Homans at the end of last quarter and that's where the benefit of that 20% purchase flows as a reduction in minority interest expense year-over-year. As far as gross profit, looking in the fourth quarter, there is -- there were some price actions as well in the fourth quarter a year ago, there will be a measure of irritation and then that should play out in the fourth quarter.

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Operator [8]

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Our next question comes from Ryan Merkel of William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [9]

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So first off, back to the 4% equipment growth number, which is pretty solid. Do you think you're taking market share? And then is the tech spending the big driver?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [10]

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Well, who wants that one? Paul, A. J., Barry.

Go ahead, Paul.

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Paul W. Johnston, Watsco, Inc. - EVP [11]

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I can take the first question. I can take the first half of it, as far as the numbers aren't out in the third quarter yet from AHRI. So looking at the first 2 months of what came in, in the quarter, which would be the larger months, I think we definitely did grow some market share during the quarter on the residential side. We were up, I think the market's going to be flat to down slightly when all the numbers are tabulated. (inaudible) yes.

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Aaron J. Nahmad, Watsco, Inc. - President & Director [12]

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And this is A.J. Yes, this is A.J. As for technology, we -- it's hard to measure causation, but as far as correlation, what I can tell you is that the customers that are using technology and using it more regularly are growing out at a faster pace with us than the customers that are not and their attrition is much lower than customers that are not using the technology. So generally speaking, the customers that use it more often are stronger customers with us.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [13]

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Got it. Okay. And then on operating margins, just stepping back, it's been flat for a few years now. I'm just wondering, is expanding operating margins a priority to the company? And what is it that you need to achieve that, is it just better sales growth?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [14]

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Well, don't forget we're very long-term focused and we believe that for the long term, we have to invest significantly in our technology. And even though it may hurt short-term results because we spending more on technology, it's good for the long term. We have big lead on technology. We want to increase it, and I think that's a part of the SG&A. Although, overall, we sustained the same percentage levels as we did last year. So I'm pleased about that, but don't be surprised if we find opportunities in terms of technology and take advantage of it because we're not really focused on the short term.

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Paul W. Johnston, Watsco, Inc. - EVP [15]

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Yes, I'll say this too, I mean the technology spending has been a big part of our business for the last 3 or 4 years, but this is not a short-term exercise, right. This is a journey. I mean we're a big company, a big industry with a mature market and the investments we're making today will play out over a 10- to 20-year period probably. But we're -- that's why we can do that is because we're doing it from a position of strength, which is a nice place to invest from. (inaudible)

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [16]

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Yes. I would just add that part of that, Ryan, in terms of the long term is, what will OEMs think about dealing with distribution over periods of time as things are evolving this way? And we're already an immense partner to many or most of them and we think that will only improve and deepen over time. And then there are 1,300 independent distributors that also are going to face some sort of music about technology, and part of this investment, we're already seen some benefits in, in attracting some age-old businesses that had never sold their business to anybody and in terms of completing transactions and conversations going on, it's a very deep part of what we're doing. So that's a good feeling, and I think there'll be more to come.

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Operator [17]

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Our next question comes from Stephen Volkmann of Jefferies.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [18]

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Maybe I'll just follow-up on that, if I may, because your revenue line was little stronger than we were looking for, but so was your SG&A spending, I think. And I'm wondering relative to your plan, obviously we didn't know that, but did you find some additional things that you decided would be good investments during the quarter and sort of spent a little more than you thought? Or was this in line with kind of your longer-term plan?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [19]

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You mean in terms of technology spending?

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [20]

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Yes.

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [21]

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Well, let's have the President answer that.

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Aaron J. Nahmad, Watsco, Inc. - President & Director [22]

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Yes, there's nothing that stands out as a big spike in technology spending in this quarter, no.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [23]

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Okay. Yes, I'm just trying to think about how you sort of planned that out?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [24]

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I think year-to-date, we have a number of over last year. And Barry, do you have that number?

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [25]

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Yes. For technology, year-over-year it's up $4 million, about $0.10 a share and most of that, a good portion of that at least is the acquisition of Alert Labs, which is an IoT company that we acquired to help with our IoT strategy, also a long-term investment and that anniversaries this quarter, so that influence will not be great going forward. So there -- that's not a spike, that's an explanation for why it went up this quarter. And longer-term, again, it's opportunistic. It's not a -- the plan is to keep driving adoption of what we've invested in for the last 4 or 5 years. How do we get more customers every day making our technology their way of life? And obviously, there is spending going on to develop more and more customers and more and more usage across our network. But big spending, big tickets is not something that comes along and if it does, we evaluate it and make sense of it and decide if we want to do it or not.

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [26]

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But the specific transaction you just mentioned, Barry, it's a development company. We knew going in that it would be losing money and it will continue to lose money, but we think that the outcome of that technology improvement in the long term will have a major impact.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [27]

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Okay. Great. And then if I can just pivot a little bit. We've heard through some channel checks at Carrier, I don't know that they would want to say it this way, but maybe is a little bit focused on their end markets and little more willing to get involved in marketing and so forth. Are you seeing any kind of changes from them in terms of their partnership with you?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [28]

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Well, first, let me say I hope what you've heard is true. We're all for that. No, we met their senior leadership and they couldn't be more positive about their future in terms of being independently publicly traded. And of course, the word that applies to them now as it does to us is growth. And to get growth, you have to do the things you're talking about, invest in products and invest in distribution. All the signs are positive that this is a good thing for Carrier and therefore, a good thing for Watsco.

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Operator [29]

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Our next question comes from Robert Barry of Buckingham Research.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [30]

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Just wanted to follow-up on a few things. When you report the SG&A same-store as flat, does that include that $4 million of IT spend?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [31]

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Of course it does. IT -- technology spending is in our SG&A. And also the losses are included in the P&L too. I mean it's not a profitable business and we know that going in, but yes, that's all part of the main financial statement.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [32]

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Right. I mean, I guess just don't mean to beat a dead horse, but it seemed to like the tone at the beginning of the year was, listen, we haven't delivered much margin expansion in recent years, it's going to be more of a focus this year. There were some cost actions at the end of last year to kind of get you there and SG&A has been flat same-store, yet it seems like the responses to the earlier questions on op margins suggest that maybe the goal of op margin expansion is less of a priority now. I just -- (inaudible) characterize it, yes.

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [33]

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Well, we kind of -- yes, this is opportunistic. We don't look at things the way you outlined it. We look at what is the opportunity long term to keep growing the company and increase our competitive advantage. We're not numbers driven, why don't we do this because it's a budget or this and that, the other. So this year, it was the one we just mentioned, Alert Labs that's quartered (sic) [headquartered] in Canada, great products, not in the market yet, or they're coming to the market and we believe strongly in them. Now we're supporting them and we will continue to do things like that. Whether SG&A goes up or goes down, that's a consequence of what we do, but we're not so focused on numbers as we are the opportunities that we see.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [34]

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Got it. Got it. I did also want to just get a little more color on what drove the gross margin down. I mean you mentioned the tough comp with the pricing. How about (inaudible) the deals or...

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [35]

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Yes. Let's do that. Paul?

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Paul W. Johnston, Watsco, Inc. - EVP [36]

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Yes, we had -- as you know, last year was unprecedented as far as the number of price increases we had. And obviously that drove up our gross profit percentage and that was a big part of it. You mentioned that gross profit drive is always in front of us as far as what we're trying to drive to increase the gross profit on our products. There is a market out there, though and we are competitive in that market and we maintain our competitive nature in that market. And sales, we try to balance sales growth and gross profit at the same time. We want both to grow.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [37]

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Got it. Just lastly, just follow-up on the comments. It sounds like most of the markets were tracking in that 3% same-store growth rate. Does that include Florida and just any update on what's happening there and what the outlook is for Florida?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [38]

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No. We're not going to answer geographic questions. We don't want to assist our competitors. As you've heard earlier today, it's a mature market, very competitive and we don't want to give anybody an idea where they can do better against us.

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Operator [39]

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Our next question comes from Joshua Pokrzywinski of Morgan Stanley.

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Breindy Elizabeth Goldring, Morgan Stanley, Research Division - Equity Analyst [40]

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This is Breindy on for Josh. So just wanted to look at inventories. It looks like inventory is elevated relative to the amount of sales that were added from the deals or just general growth. Can you talk about core Watsco inventory and if it's running higher than usual this season? And any observations you have in the industry?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [41]

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That's a great question. I think any of these could answer that, but I think, Paul, do you want to take a shot at that, since you do all the buying? Just kidding.

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Paul W. Johnston, Watsco, Inc. - EVP [42]

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Yes, this is all my fault. Yes, inventory is up month-over-month from September -- of from August through September and what we've seen is inventory has been increasing. One, we had price increases compared to prior year comparisons in the equipment that we do carry and in the parts and supplies that we carry. Secondly, there was a small buildup that probably you'll see reflected across the industry with gas furnaces, where we had a cutoff in July for furnace energy ratings changes, and so we built a little bit of inventory for that, but nothing that exciting that won't be sold out in the second half of the year.

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Breindy Elizabeth Goldring, Morgan Stanley, Research Division - Equity Analyst [43]

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Okay. That's helpful. And then just wanted to follow up on the deals. Is there any -- do you see any potential for synergies that can be extracted on SG&A level?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [44]

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Yes. We have a ready answer for that because we give this a lot of thought. The reason we buy these great independent distributors is because they're very successful and we don't want to take risk and we will avoid taking a risk trying to do anything to change their culture and their record of success. We don't look for synergies. That's up to them, these businesses that have done so well. But we think we can grow them faster by what we said in press release, we can capitalize them better, we can ask them to take more risk if they wish to. But basically, our culture in acquisitions is support the entrepreneurship that was there before we got there. And we're not going to mess around with trying to take some cost out because that's not what we do. We're in for growth. What we want to do is just continue to build the network and we don't want the risk of trying to tell them how to operate as an independent business. So they're independent in terms of what they do, but they're part of Watsco, utilizing the resources of Watsco. That's a heck of a good combination which has helped us become the largest in the world in what we do. And so synergy is not a word we use. Growth is the word we use.

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Operator [45]

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Our next question comes from David Manthey of Baird.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [46]

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First off, if you could talk about the breakdown of price mix versus volume in both equipment and the resi equipment numbers you gave us, that 4% and 6%?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [47]

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Barry?

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [48]

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Dave, in the residential market, more unit growth in price, in terms if I dissect the 6%, and for the commercial business, which makes up the rest to get to the 4% overall, it's not really a price cost conversation to have. Just slightly less growth in the U.S. on the commercial side and I don't think price mix really had any consequence. So on the residential side though, it was probably better than expected unit growth.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [49]

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Okay. So couple points there. And Paul implied that there was also some price benefits in parts and supplies, I would guess that's fairly nominal?

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Paul W. Johnston, Watsco, Inc. - EVP [50]

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If I did, I did not mean to do that. That -- I did not say that, no.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [51]

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Okay. Maybe I misunderstood that, okay. Then on overall organic equipment unit volumes, if you take price out of the equation, you just sort of think about the selling season in the second and third quarter. It looks somewhat flat this year with the second quarter down and the third quarter up. And I know you talked about the cycle and you didn't really want to talk about it. Have you given any thought to just broadly nationally the HVAC cycle and any impact it might be having on the overall industry?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [52]

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Paul?

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Paul W. Johnston, Watsco, Inc. - EVP [53]

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Yes. Yes, we've been looking at this, yes. We've got a couple things that play into it. Obviously, we still have the $80 million to $90 million installed base on the residential side, which is going to be replaced over time. That hasn't changed. It's been increased by probably an extra 1 million, 1.5 million units this year. Secondly, as far as looking at it in total, it's kind of hard to come up with an exact number, but you're talking roughly 45% to 50% of those units that are out there are still R-22 and obviously, will have a replacement coming up sooner than later. So the general replacement cycle nationwide is still a good market to be in and a good place to be positioned for Watsco.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [54]

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Right. Okay. And one more if I could on when you mentioned industry unit shipments, you thought they'd be down for the full quarter. I'm just wondering why you think that given the quarter-to-date shipment data that we've seen that implies it's up sort of 3-plus-percent right now.

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Paul W. Johnston, Watsco, Inc. - EVP [55]

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I think I said flat to down slightly. And I just don't see where there is going to be a robust cycle of shipments in the month of September, that's all. And it's an estimate.

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Operator [56]

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(Operator Instructions) Our next question comes from Blake Hirschman of Stephens Inc.

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Blake Anthony Hirschman, Stephens Inc., Research Division - Research Analyst [57]

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First off, did the hurricanes during the quarter, did they impact activity in the near term at all and/or create any incremental repair work on the back end looking forward?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [58]

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Paul?

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Paul W. Johnston, Watsco, Inc. - EVP [59]

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Yes, I don't think it had a material impact on the quarter for us, no.

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Blake Anthony Hirschman, Stephens Inc., Research Division - Research Analyst [60]

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All right. And then back to the gross margins. Did the acquisitions that you guys have done year-to-date, did they create a drag at all or was it really just due to the tough comp and price increases from last year?

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [61]

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Again, Paul.

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Paul W. Johnston, Watsco, Inc. - EVP [62]

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Barry?

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Barry S. Logan, Watsco, Inc. - Executive VP of Planning & Strategy and Secretary [63]

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No, the acquisition gross margin is at par with Watsco, so there is no influence on gross profit from that perspective. EBIT margin is where there's opportunity to improve, but -- long term. The change in gross profit, if you look at it a year ago was up 50 basis points. Last year's third quarter gross profit margin was up 50 basis points, strictly due to passing on relatively material OEM price increases midyear, which almost never occurs. And so a year later that's the comp we're talking about. And again as things play through and we work through it, it becomes a more normal and stable circumstance going forward. So this is really just a quarter for that type of occurrence last year in terms of standing out.

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Operator [64]

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

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Albert H. Nahmad, Watsco, Inc. - Chairman & CEO [65]

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Well, once again, thanks for your interest in our company. I'm glad you're involved. I really wish you would come down here and get a better handle on what we're doing with our major technology effort. Think about the winter, that's a good time to come down to Miami. So thanks, again, and we'll speak to you at the end of the current quarter. Bye-bye now.

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Operator [66]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.