I very frequently get the question: 'What's going to change in the next 10 years?' ...I almost never get the question: 'What's not going to change in the next 10 years?' And I submit to you that that second question is actually the more important of the two because you can build a business strategy around the things that are stable in time. - Jeff Bezos
This is one of our favourite Bezos quotes. Although we enjoy studying fast-moving industries and disruptive business models, there is something special about studying ‘boring’ businesses that have stood the test of time. Selling HVAC equipment is one of those businesses. And it just so happens that the largest player, Watsco, is part of a small group of 30 US companies that has grown 18% annually for the last 30 years. We interviewed an executive with over 30 years HVAC wholesale experience to learn more about HVAC distribution.
In the US, there are ~120m installed HVAC units and shipments have grown steadily at 4% per year since 1980. This steady growth is mainly due to replacement demand which makes up 85% of installed units. Consumers replace their HVAC system every 10-15 years which creates a steady flow of demand to replace existing units.
The impacts of COVID could drive higher replacement demand in the next few years. We’ve been stuck in our homes for 10 hours per day for most of last year with HVAC units running 2-3x as long as usual. Also, in March, sales of new US-single family homes jumped 20% annually to the highest reading since August 2006 and home sales in the South, where there is greatest demand for HVAC units, increased 40%. This could potentially drive higher replacement demand because OEM warranties do not transfer across homeowners. Homebuyers will typically be faced with the decision to immediately replace the HVAC unit to get a warranty. So the more people move home, the quicker the warranty expires. This drives greater replacement demand.
There are also some peculiar aspects to HVAC distribution which are very different from other industrial or B2B distribution businesses. Distributors sit between manufacturers and smaller business customers that typically install or deploy the OEM’s product. So the distributor’s role is to help the contractor save time so they can complete the job and get paid quicker. This means the distributor usually needs a very wide selection of products that are always in stock, a network of branches close to contractors so they can easily drive to pick up products, and a technical understanding of the products to help contractors deploy products efficiently. This is the case for companies such as Grainger in MRO distribution, the IT services resellers, POOL Corp, and many more we’ve studied.
However, this is not the case in HVAC. Distributors only carry one brand per product line. OEM’s like Carrier and Lennox demand that each wholesale distributor may only carry their specific brand in that product category. So each distributor only carries one duct and one ductless brand. In a traditional sense, this almost defeats the objective of a distributor as contractors now need relationships with multiple wholesalers for different brands.
The OEM seems to own the mindshare of the end user. For example, compare the differences in the customer buying journey for plumbing and HVAC products:
Here's the unique perspective that I've had, having worked for strictly HVAC wholesalers and a primarily plumbing and heating wholesaler. Plumbing and heating guys are very loyal to their distributors. They find maybe one or two distributors that they do the bulk of their business with, and they stick with them. If I tell them I'm selling one particular boiler brand, that's the boiler brand they’ll use; the same applies to the heat unit I'm selling. They stick with it because they have that relationship. HVAC around here is a bit different. This goes back to something I said earlier about how it takes effort to build a business and to market it. Around here, if you're the homeowner, and you say, I want Carrier, the contractor will go to a Carrier distributor. I want Trane, and he’ll go to a Trane distributor. I want American Standard. I want LG. They let the customer dictate what brand they want instead of saying, these are the brands that I sell. They’re not going in there and selling themselves, selling their customer, and selling their company. That is a big difference between plumbing and heating with boilers and with HVAC. HVAC distribution is limited in market areas, and there's only one place you can get that particular brand.
Carrier and HVAC OEM’s spend fortunes to market directly to end customers. What are end users really supposed to know about ductless or ducted machines and what are best for their property? Because the OEM’s own the end customer, this seems to reduce the power of the contractor, which is the distributor's customer. So the contractor will merely take orders from the end user and then find the wholesaler that carries the brand the customer wants. Arguably, product selection and availability are far less important than specifically what HVAC brands you carry as a distributor.
Distributors still need to have a dense network of branches and provide the technical expertise to their contractor customers, but this is all irrelevant if they don’t carry the right brands. And the branded products seemed to be demanded by the final user, not the contractor. So the distributors with the biggest brands have a significant scale advantage over those that carry smaller brands that haven’t got the mindshare of a Carrier.
In 2009, Watsco and Carrier entered a JV, Carrier Enterprise, which gives Watsco the exclusive license to sell Carrier products in certain markets. Since 1989, Watsco has acquired 60 mainly family-owned wholesalers which carry all kinds of brands but Carrier still accounts for over 60% of sourcing costs. Watsco is effectively a captive Carrier distributor.
Given Carrier is the largest OEM with the best reputation, Watsco is entrenched with the market leader. This is a structural advantage. But this is only an advantage as long as Carrier owns the end customer and maintains brand equity. Given the R&D and advertising budget of Carrier, it’s hard to see what could dislodge them. But let’s assume new, more efficient products take share from Carrier. How would this impact Watsco? Could they easily switch out of Carrier? Would the new OEM’s taking share always want to work with Watsco given they are the largest player? This is a unique aspect of a value-added distributor that we will continue to explore.
Warhammer is a fantasy world where Orks, dwarves, monsters, and elves group together into armies for gamers to fight on tabletop games. Games Workshop, creator and owner of the Warhammer IP, sells miniature figurines that gamers purchase, paint, and collect. The company has created an ecosystem around Warhammer that has compounded FCF ~18% for 23 years.
From the 1980’s to 2004, Games Workshop (GAW) consistently grew revenues by opening new stores and growing the Warhammer player base. In the early 2000’s, the company signed their first license to produce miniatures and games for the Lord of the Rings franchise ahead of the movie launch. Lord of the Rings (LotR) was a huge success and Games Workshop saw revenue increase as new gamers purchased LotR miniatures and games. However, this growth was short lived. Sales peaked in 2005 at £158m and slumped to £110m in 2008. It was only until 2017 that sales reached £150m again. Games Workshop literally lost 13 years in growth.
Growth is a function of the capital reinvested and the incremental return on the capital invested. GAW had spent the early 00’s investing into the Lord of the Rings and not their core Warhammer owned-IP. This grew sales and brought in many new customers but these were not true Warhammer fans. They didn’t have the ‘Hobby Gene’ that defines a Warhammer fan. GAW had underinvested in their core asset that caused growth to stagnate after Lord of the Rings movies was released.
In the mid 2000’s, GAW went through a management change and focused on cutting costs to regain profitability. GAW came to realise a focus on costs rarely grows the topline. Assets need to be replenished to maintain a steady level of growth. Just as physical assets require regular maintenance, intangible assets need to be regularly replenished. This quote really stuck out from our recent interview:
The best way to think about it is comparing it with newspapers or comics. How often do you buy yesterday's or last week's newspaper? If you have every Batman comic, which is the most exciting one? It is the next one. I want to see this story develop and I want to find out what happens next. One of the absolute charms of building your own IP, such as Warhammer, is that it is constantly evolving and you can introduce new things. Models which were sculpted 10 years ago start to look a bit dated so you re-sculpt them and release those, and people add them to their army. People who were not playing 10 years ago see them and think they look fantastic.
Intangible assets need regular ‘maintenance’. For consumer or luxury brands, marketing spend could be seen as maintenance spend. If consumer brands don’t market their brands effectively, it diminishes the asset value. If Nike doesn’t have the best athletes representing them, they will sell less shoes. Gaming IP is no different. It needs regular ‘maintenance’ and deep, attentive care. The reason intangible assets are attractive is because the incremental rate of return on the ‘replenishment’ spend is typically higher than that for tangible assets. But if you miss a replenishment cycle, it can cause a huge decline in revenue and make it very difficult to revive the core asset. This seems to be the trap GAW fell into. During and after the LotR launch, they didn’t create enough exciting new games or market effectively online to recruit new users. This cost the company 13 years of growth.
There seemed to have been an inflexion point in 2015 when Rountree was named CEO. The company launched Age of Sigmar, a new world which brought churned users back into the ecosystem, and Warhammer has a thriving online community to recruit 13-15 year old gamers. Sales per store has increased from £300k in 2006 to over £500k today with 2021 EBITDA nearly equal to 2007 revenue.
But this begs the question: is gaming IP still ‘hit driven’? As gaming companies move online and sell more in-play recurring digital products and fewer hard discs, there is a view that gaming cash flows are more sustainable and should be worth more to investors. This is probably true. But this doesn’t mean the market is not still hit driven. If the business misses a IP-replenishment cycle, you can lose 3-5 years in FCF growth. Do we really know if sales per store couldn’t reach £300k for GAW again? If they didn’t refresh enough armies or create a new world like Age of Sigmar, maybe it is possible. Replenishing intangible assets is far more difficult than a physical asset, but when you do get it right, you can generate >80% ROIC like GAW.
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