Watsco, Inc.

Thanks, Michelle. Good morning, everyone, and welcome to Watsco's Fourth Quarter Conference Call.

This is Albert Nahmad, President and CEO. With me is Barry Logan, Senior Vice President; and Paul Johnston, Vice President.

First, let me give you the first -- the cautionary statement I always do. This conference call has forward-looking statements as defined by the SEC laws and regulations that are made pursuant to the Safe Harbor provisions of these various laws.

Ultimate results may differ materially from the forward-looking statements.

Now for the quarter, we delivered strong growth in earnings per share in the face of very difficult sales and earnings comparisons from last year. So I think it's been good execution by our team.

Fourth quarter cash flow was a record for any quarter in our company's history, selling margins improved and operating expenses were reduced to produce a 49% increase in operating income and 26% growth in earnings per share. Our balance sheet remains in pristine condition, with net debt near 0 at the year end.

For the year, Watsco delivered double-digit earnings per share growth against a very strong 2010 comp. Our team effectively navigated a shift in demand that affected sales mix and a weaker consumer environment.

Highlights of this include Watsco's leadership position in the industry, expanding in 2011. Sales were just shy of $3 billion and operating profit was a record $199 million.

Our network expanded by 37 locations in 2011, adding new markets in the Northeast U.S. and Mexico.

We also increased our portfolio of commercial products in 2011 and added new locations and other new products. Same-store sales of commercial HVAC equipment were up 18% in 2011 and we expect our expanded footprint to produce additional growth in 2012.

Operating margins expanded 90 basis points in 2011 and has increased 270 basis points over the last 2 years, representing substantial progress towards our 10% margin target. Watsco's wide variety of brands and products have brought relative stability to the otherwise volatile market for residential HVAC products.

We are well-positioned to compete in all segments, from the value-based models up to the high-tech, high-efficiency units.

Carrier Enterprise, our innovative joint venture with Carrier, ended its second full year with strong earnings growth, and we are very happy about the partnership. And we continue to be impressed by the Carrier Enterprise team on how well they have responded to our entrepreneurial culture.

Now for details on the fourth quarter. Revenues declined 12% on a same-store basis.

To remind everyone, organic sales on last year's fourth quarter, that is 2010, increased 17%, with HVAC equipment growth of 23%. Our team did a great job of growing earnings despite the difficult sales comparisons.

Same-store gross profit declined 6%, reflecting a 180 basis-point improvement in gross margin on softer sales. SG&A, excluding new locations, decreased 13% or $17 million.

Same-store operating income increased 31%, with operating margins also expanding 170 basis points, and diluted earnings per share increased 26% to $0.39.

Moving on to results for the year, same-store sales declined 1%, including a 3% decline in sales of HVAC equipment, a 1% decline in other HVAC products and a 3% increase in sales of commercial refrigeration products. Same-store gross profit improved 2%, with gross margin improving 90 basis points to 24.5%.

SG&A, excluding new locations, declined 3%. On a same-store basis, operating income increased 14% versus the 1% decline in sales and operating margins expanded 90 basis points to 6.7%.

Diluted earnings per share increased 10% to $2.74 per share for the year. Now, as to cash flow, Watsco generated a record $120 million of cash flow during the fourth quarter.

This performance again demonstrates the safety and cash efficiency of our business in the slower sales environment. Adjusting for one-time payments, cash flow for the year was $148 million or approximately $4.83 per share -- $4.83 per diluted share, well in excess of net income.

We have continued confidence in our ability to generate cash flow and raised our most recent dividend payments to some 9% to $0.62 per share. This marks the 11th consecutive year that we have raised our dividend.

Our balance sheet remains in pristine condition, with cash of $16 million and debt of $20 million. We continue to evaluate opportunities to expand our network and can consider almost any sized transaction given the strength of our balance sheet.

As for our outlook, the first quarter is showing softness. This is the slowest time of the year, seasonally, so we will wait until we have a better sense of the selling season to provide a more formal outlook for 2012.

As for our long-term outlook, our passion for our fundamentals remains. Our products are a significant component in the movement towards energy efficiency, energy conservation and greener solutions.

HVAC systems account for more than half of the energy used in U.S. homes, and 89 million systems are over 10 years old, operating at efficiency levels well below current federal mandates.

Replacement of these systems is inevitable and offers us terrific revenue opportunity and meaningful cost savings for consumers. We also continue to build the company.

We'll continue to grow our network by opening locations and by making acquisitions. Over the last 10 years, our focus on strategy has produced compounded annual growth rates of 10% for sales, 15% for operating income and 36% for dividends.

And our goals remain consistent with our 20-year track record, to provide the best local service, to be a great partner for our suppliers, to innovate with technology and to maintain our conservative, long-term focus on growing a much larger and more valuable company. And we are seeking great talent.

To paraphrase a quote from General Colin Powell, "Only by attracting the best people will we accomplish great things." And with that said, Barry, Paul and I will be happy to answer your questions.

I just -- you had mentioned that the quarter was off to a slow start and so you didn't want to give an outlook, but on the third quarter call, you had made some high-level comments about earnings growing at least 20% this year. And I was just wondering if you could update us on the thinking around that comment, please?

I don't remember what I said in the third quarter but the facts today are the most important things to look at and business is soft. I think the OEMs have reported that.

I don't mind soft markets because that gives us an opportunity to acquire businesses sometimes, and we're positioned stronger than anybody else with all our brand extensity and the variety of products that we offer. No one else does that.

Is there any area of particular softness or any kind of -- more granularity you might put around the comment?

Well, that's a good question there. The softness, there's growth in some areas and softness in other areas.

So it's a territorial thing, has been an unusually cool winter in parts of the country and that makes for soft furnace sales. But generally speaking, I'd rather be more conservative than -- at this point than optimistic, and so I like to say it's soft and we look forward to things improving as the year progresses.

Okay, and then, just maybe touching on the margin performance, which was very strong in the quarter. I was wondering if you could give some dimension around how much of the year-over-year growth in margin was related to mix versus improvements at the Carrier business versus lower commissions, cost controls, things like that?

Barry, you want to take that?

Robert, obviously, the biggest contributor to the margin expansion -- operating margin expansion is the gross profit increase year-over-year. And it's always worth reminding that transactionally, incentives, commission structures are pushed all the way down to a sales personnel level, to a branch level, then a regional level, then an operating business unit level.

And my point is that there are immense incentives to produce profitability, to produce margin and that's how people are primarily paid in generating those sales is based on margin dollars. So that's clearly a benefit that flowed this year.

I think as people feel sales pressure, they become merchants and that's how they make a living. So that's certainly part of the culture at that local level.

The other thing we saw this year, which is in 2011, were price increases. We've always spoken very well about our capability to pass along price increases, to push price increases through the market and the productivity of that shows up in the quality of gross profit margin as that occurs.

So we saw that in 2011. SG&A is really a combination of 2 or 3 years of effort continuing.

If you look back the last 2 years, prior to 2011, you saw SG&A improvement. That continued this year and in the fourth quarter, more specifically, they saw a full quarter press by everyone again to produce profitability, and some of those costs would come back in the form of incentives or in higher commissions again because of the sales results that you see in the fourth quarter.

But the most important point is all this happens at a very local level and was executed that way, and we can see the benefit of it.

I mean, how do you think we should be thinking about the margins tracking going forward from here?

Well, I think we're still 150 basis points -- 200 basis points away from even historical peaks of operating margin. So there's certainly more to do and more improvement, too, that should occur.

Carrier Enterprise network that was added to in 2011, also, is operating somewhat behind the rest of Watsco, so to speak. And so there's improvement there in 2012.

And any level of sales improvement becomes very productive to EBIT margin. So, the sales initiative that we have for 2012, not just relying on what the market is doing, but initiatives we're taking would provide margin lift as well.

The first question I've got is with regard to mix of R-22 versus R410a. How is that trending?

And how are you guys planning your purchases around that in 2012?

Paul, you want to take that?

Sure. The trend in the quarter updated a little bit, which we expected.

We saw R-22, as a percent of our total mix, go down several points. And that's mainly because the R-22 unit is an unplanned replacement-type product.

So the consumer who would buy that probably wasn't using air conditioning in the fourth quarter. How do we plan our inventory around that?

We're very cautious on inventory, on the dry charge units. We work very closely with our manufacturers and they've done a great job supplying us with product.

And it's created a situation for us, at least, where we have not been building inventory of R-22 product. We just work closely with our vendors on that.

Okay. As we look at replacements versus new construction for you guys, how do you feel like those 2 markets are trending, and do you have any feel for how much those 2 were up or down for you in the quarter?

Go ahead, Paul.

New construction, I don't think that shows up...

What's that?

Yes, on our screen right now, if -- there are new homes that are being started. We've been hearing a lot of good buzz that there's potentially more homes underway.

As you know, we would be in the later stage of a new home start. So we really haven't had -- haven't been impacted by that yet.

Replacement, replacement is still the guts and the core of our business. And that's what we do and that continues probably north of 90% now of our sales.

Paul, can you maybe give us a breakdown then of what happened with equipment sales versus parts and supplies in the 4Q? You gave it in the press release for the full year but not for the quarter.

For the quarter, our equipment sales were soft as the industry was soft. We were not quite as down as the OEM reflected, which we rarely are in the fourth quarter.

Our sales would indicate that we gained share in the fourth quarter against industry -- against OEM shipments. When you get into the actual parts and piece business, you've almost got to pull it apart, part by part, and the one area that we're starting to see some increase in our volume is on what we call authorized parts business, where we're starting to see more traction around selling more of the proprietary parts that go into the equipment, which would indicate that there's still a good deal of repair going on in the marketplace.

Really 2 questions. First, Barry, digging in on what you had talked to us about a second ago.

Specifically on the gross margin, if I'm running one of the units, what kind of leverage in a short period of time can I pull to be able to produce the kind of gross margin we saw, with a very difficult top line environment?

Well the primary lever, Keith, is transactionally, the units are sold across the counter one by one, 2 by 2, and the pricing discipline of that happened at that level. It is really a merchant process.

It is that simple.

That it is -- would that be the primary driver in this quarter?

Yes. It's what we call selling margin or raw margin, which is purely the markup that we push through to the marketplace and that's where we saw the benefit.

Okay, and then you gave us the segment sales for the full year, HVAC versus refrigeration. Can you give us that for the fourth quarter?

You mean, in terms of the product groups? Again, it has to be put in context of the volatility that was there a year ago, and that's part of probably why a year later, it almost becomes incomparable because of the volatility of what we -- of the mix in kind of a quarter-over-quarter basis.

Overall equipment...

I did -- refrigeration was down a fair amount. I understand what you're saying on HVAC and the weather.

What happened in the refrigeration in the quarter?

Yes, refrigeration was down single digits for the quarter, and that's again, now becomes a seasonal period for it. It was up for the year.

And was there any specific thing going on in refrigeration in the quarter? It had a tough comp, I know that.

Yes. We saw in some weakness...

Sorry, Paul. Go ahead.

We did see some weakness in just some of the refrigerant sales, and not on a pricing basis, just on a pound basis, that our refrigerant and copper tube sales were down in the refrigerant sector.

Maybe just a go at the R-22 a little bit differently. Can you give us a sense of what you think the mix was of R-22 in 2011, and just how from an industry perspective you see that changing or not changing?

We don't get any real good data out of the -- out of ashtray [ph] on that. I mean, I don't know if they're even tracking that.

So we look at that we're doing and what our mix is. Like I say, we probably got into 22 later than most of the industry but when we got into it, with got fully engaged with it with our OEMs.

The numbers we have, as far as looking at what the industry's doing, would be very similar to what you've heard, I'm sure, from the other OEMs, or from the OEMs that you've had on your conference call. I did indicate, though, that in the fourth quarter, we did see a reduction in the mix of the dry charge units and I don't think that was really a reflection of the softness in that sector as much as it was just the lack of the replacement that was going on in -- on the air conditioning side of our business.

And then Paul, you mentioned taking a cautious stance on R-22 inventory. Just-- I mean, would you expect your mix to be up in '12 and why the cautious approach?

I think in the first half of the year, I think we may have a slight increase because we were so light in it last year in the first half of the year. It really wasn't in existence.

It was slowly building. So the first half here, yes, we'll see a mix change where we're going to sell more dry charge units than we did last year.

Why are we cautious? A lot of things to be cautious about there.

As you know, there's several things going on at the Department of Energy right now, as far as how they're going to classify what is a 13 SEER dry charge unit. There's also the issue around availability of R-22, the gas itself to be able to charge the units.

And what's going to occur if there are any spot shortages of R-22 around the country. We don't expect to see a lot of shortages of the refrigerant itself, but like I said, we're going to be cautious about it.

No sense in having equipment if you don't have the gas, right?

Right, exactly. And then just shifting gears, you mentioned last quarter, Baker and the refrigeration business in general, and some issues with profitability around refrigerant gas and maybe that business lagging behind, can you just talk about any progress to kind of correct some of those issues?

Where do those guys stand relative to the other divisions? What are you doing structurally to drive improvement there?

Barry?

First question is on SG&A, if I could. How much of the $17 million in core SG&A is permanent cost takeout?

Barry?

The -- about 60% of what is there is, I would call, variable costs related to sales. The rest, permanent means fixed cost reductions that can sustain themselves into 2012.

Okay, and what were those permanent, more fixed cost takeout? What were the areas?

It's always -- that answer's always facility-driven, rent, the number of locations, the amount of square feet, the number of people that are -- or the base level of people that operate in the branches, the maintenance and service and repair that goes to operating a network of this size. That's purely facility-related.

Okay, and then second question, could you guys talk about sales by month? I think you said last quarter, same-store sales in October were down low single digits.

So clearly things got a bit more difficult.

I don't think we want to do that because it would be misleading. I think we'd just like to -- we'd like identify trends for you and the trend, I mean, I am being conservative.

We are seeing some growth of certain areas, but we're also seeing softness in other areas. I'd just assume where report all of it is conservative, saying that it's soft, and -- but we're way down.

This is the worst period of the year for our business, the first quarter. So we'll give you a better feel for it when we come in with the -- closer to the selling season.

Fair enough, Al, and maybe, could you just talk about how did weather impact December? Was it pretty meaningful given the mild weather we had?

Well, yes, because anytime that you have unusual weather, one way or the other in the winter, if you have mild winters, then you affect furnace sales, heating products. And then in the summer, if you have unusually mild weather, then you affect the cooling products that we have.

And there's no doubt that in major markets, we did have a mild winter. Our products now are sold throughout the Northeast, with Carrier and along the Atlantic seaboard.

And that reacts to local weather conditions.

Okay, and then maybe just lastly, could you comment on the M&A landscape right now? Is the pipeline full and active?

Any commentary there would be helpful.

Well, I mean, that's a great question because, you know us, we like to acquire, and we like to grow the company through acquisitions, and we are ready to bring more quality companies into our network. I can't tell you that we're going to announce anything in the near future because that's not something we do.

But we are there and for those that want to join us and we have a good reputation, what happens after the acquisition. And I'm hopeful that more will come our way.

I wanted to ask about housing, just -- you mentioned not -- maybe hearing indications that housing activity's picking up, but -- I mean, would you guys not necessarily see it until the order hits the -- hits a given branch or, I mean, obviously you've been in the worst decline in decades, so are we just -- we'll believe it when we see it, sort of approach?

I think it's the latter. We'll believe it when we see it.

But when you build a house, the last thing that -- one of the last things you do in the house is install the air conditioning and heating. So it's a period well beyond when the housing start begins.

So that's, that lag we were talking about. And -- I think we'd rather manage our company conservatively and not get too excited about anything until we actually see it.

Sure. If housing starts were to improve, would that not help mix for you guys and profit margin percent of your HVAC [ph]?

Sure, of course it would. We'll be selling more volume to the same structure, yes.

Absolutely.

And so the margin improvement in the fourth quarter in gross margin, which was substantial and you guys referenced it already, but was there any mix in that, favorable mix? Or...

Not related to housing.

No?

No.

How about anything else?

Well, Barry has already covered that. And some of it is price increases that went in.

Traditionally, this industry raises prices to offset commodity cost and we pass those on.

Just referring to mix, though, Al. Just...[indiscernible]

No, I would not say there has been any movement towards -- if you're asking, any great movement towards higher efficiency, I would not say that.

First question, if you could is, just if you could expand on your comments on the regulatory environment in regards to R-22 as we move into this year? And also, if you can maybe comment on your thoughts on the accelerated refrigerant phaseout, and whether you look at that as a backdoor strategy maybe to start metering down the dry ship R-22 sales?

Well, the expert on that is none other than Paul Johnston.

Well, I'm sure, if you've been following all the regulatory things that are going on right now, we've got 2 things going on. One is that everybody's trying to figure out what a 13 SEER product is, when it's dry charged and has to be measured without putting it together as a system.

And so what's happening there is the DOE is trying to come up with some logic behind that as far as what that measurement is and what the equipment has to look like. And when was it in production?

Was it prior -- was it rated prior to the expiration of the R-22 product sales? The second part of it has to do with the EPA and the EPA has reduced -- materially reduced the availability of R-22 for the marketplace for 2012.

And that for now, has maintained midpoint in January. And we had a range of what we thought the step-down was going to be based on the Montréal Protocol, and the EPA decided to greatly accelerate that.

And our feeling is that there's inventory in the field and there's product that's available through our OEMs. Our manufacturers of that product, we've met with all of them to make sure that we understand what's going on and we can adapt our product sales goals as well as our aftermarket goals around what the product is that we're going to be able to sell.

And Paul, specific to the price increases that we are seeing on the R-22 refrigerant...

Right?

Do you think that we're getting near a point where that has any impact on the cost differential from a fully installed basis of a consumer swapping out of...

Yes?

The R-22 dry ship or going to a 410a system? Or is that still pretty far away?

That's pretty far, far away. As far switching that off, it's probably increased by $80 to $100.

The cost increase on the R-22 probably increased the install price of changing out with the dry charge by $80 to $100 versus what it would cost to change out a complete system with the indoor unit and the indoor coil being replaced. So I don't think we've reached that threshold yet.

And then just one other question on the inventory side?

I wish I was wrong, but...

Just on the inventory side, if you can maybe talk about the drivers of the increase that we saw year-over-year versus sales being down a little bit. Is that something to maybe, to maybe stack for in the Northeast in suspicion of higher furnace sales, or is something else going on there?

On a same-store sales basis, our inventory was actually down about 5% to 6%.

[indiscernible]

Since, yes, if I look at just same-store sales of where we were last year versus the same stores that we had at the end of this year. Obviously, we added Carrier Northeast.

We added Carrier Mexico to our joint ventures this year, which had an increase in the amount of inventory that we carry. And in addition, we had one of our OEMs change his payment terms to us for the method in which we inventory the product which had no change as far as the number of dollars of inventory, just a change in the procedure there.

And we had a very minor increase in the amount of dry charge 22 inventory that we added. So on a net-net basis, when you look at it same-store, it really isn't that much.

Okay, and then just last, in terms of pricing, and we've heard maybe some rumblings of Asian currency-related cost pressures. Have you seen any increases announced from your OEMs yet?

For 2012?

No, we haven't.

First question on the margin performance in the quarter, first, just not that I strongly suspect this, but were there any accrual reversals or any kind of one-time issues in the quarter that we should be aware of?

Barry?

No, Josh. There was nothing unique in this quarter.

Okay, and then how much of this gross margin performance is, I guess, 1, sustainable or 2, due to seasonality, with having Carrier Northeast in there and maybe a different-shaped earnings curve for that business?

Barry?

Well, I think we want it to be sustainable but of course it's tested every single day and in the same context of it other being a competitive marketplace. The rate of improvement, I think is something that cannot be sustained because obviously, price increases again help us implement higher margins over time, and that's part of the story for this year.

But going forward with the Northeast and for Mexico, in particular, it's not so much a gross profit margin story as it is a growth story on revenues. Opportunities to add more products adds opportunities to really expand the market share that was already there is the primary driver of that.

It's not a -- we don't really have a big profitability gap in those markets. It's primarily a market share gap that is that opportunity.

Understood, and then just a final question, I understand kind of the momentum on the residential side through 4Q and into January. Any -- can you comment at all on how commercial played out over that time period for 4Q, and any signs of that being weaker into January or holding up better?

The commercial business sale in those comments for the year was up about 18% and the fourth quarter was up precisely 18%. So a very simple trend as the year closed out, Josh.

Very good. And has that persisted as we flipped the calendar?

Again, it's not something that -- we'll just speak generally about the first quarter, what we see so far. I won't make inferences off the data that we have thus far.

Jeff, I don't think we answered your last question.

Yes, I wasn't sure if you had heard it or not. So...

It was sort of cut off, so ask again, all you want.

Yes, so, last quarter, you mentioned some issues in the refrigeration business and that business kind of lagging behind on margins and some issues with the refrigerant pricing. And so I just wanted to get an update on progress there, what are you doing structurally to drive margin improvement?

Is that a big driver of some of the margin improvement into the fourth quarter? Just kind of what's the update there?

All right, Paul or Barry, who wants to take this one?

Well, the -- Jeff, one answer is that the refrigeration business had a better fourth quarter from a profitability point of view. From a pricing and kind of a business mix point of view, it had again, issues as Paul mentioned, on refrigerant in the fourth quarter.

That's more seasonal than structural from our perspective, and if we looked at the context of the year, they had a good year. I just think it was a better performance in the front half versus second half and some pricing volatility and otherwise, that irritated the performance.

I just had a few housekeeping items. I was wondering if you could tell us what the revenue in the quarter was from the acquired properties, CapEx and D&A?

And just also what kind of -- what the tax rate is we should use for modeling 2012?

Sure, first, Robert, on same-store sales for the fourth quarter, you can compute the contribution of new branches off the press release. As far as CapEx for the quarter -- that was your next question?

Yes, CapEx and D&A.

For the quarter or for the year? Looking forward?

Yes?

Going forward? [ph] Well, if you have an outlook on it, that would be helpful, too.

It's not large numbers as you know. Go on, Barry.

Yes, CapEx for the year was $13.9, million and depreciation and amortization, $7 -- $11.7 million.

Okay, and just what tax rate should we all use for modeling purposes going forward?

Robert, it's quite simple and yet, it's hard to glean that it's simple off of the press release. So I'll explain it.

Watsco's tax rate across all its business units is 38%, and one of the assumptions of your model has to be, the profitability split between the joint ventures and Watsco legacy businesses, which are obviously, the legacy business is 100%, on the joint venture, 60%, and you simply do the algebra and use 38% as the rate. And part a of the equation is 100% times 38%, and the second part of the equation is 60% times 38%.

But our tax rate is consistent year-over-year at 38%. It's the composite between the business unit that makes the difference in the tax rate.

This is -- excuse me, this is Todd Morgan for Ian. On Carrier Enterprise, can you update us on your thinking for increasing your ownership stake this year, and remind us what the terms are for that?

Yes, there's no secret that we will exercise as we should both options when they come due first month of this year, in July. And the price of those things are disclosed.

And Barry, have you stated publicly, or you just refer to the documents?

Yes, well, it can be calculated off the document, the first option at $51 million and change. You want the change, you can go to the document.

I'll help you compute it. It's in an algebraic formula for the first option.

The second one is not calculable until the time of the exercise.

But our intent is to exercise both.

Super. We'll look forward to talking to you again in another 3 months.

Thank you for joining us. Bye.