Investor Dialogue: Watsco

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Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

I’ve looked at Watsco for a while and one of the questions – probably the biggest question I have – is just the Carrier relationship. My understanding of a B2B distributor, a huge part of the value is, basically, having a wide breadth of offering; saving the customer time in either sourcing product from many different OEMs, offering them scale advantages, in terms of price and time, and holding that inventory so they don’t have to hold it on their balance sheet. They are the principles.

A wide breadth of offering, good price and selection, obviously, requires loads of different OEMs. From my understanding, I think 60% to 70% of Watsco’s revenue is from the Carrier relationship and it goes back to 2008, 2009 JV. From my work, most of the HVAC distributors, in the US, from OEMs’ demand, only hold one or two brands. For me, it’s odd to see a distributor being in the middle of the value chain and only offer their customers one or two brands. I couldn’t get my head around how much power does Carrier have? What are the risks with that? Why is that structured that way? I don’t know if anyone here has thought about that at all or has any opinions on that kind of structure, versus other industries?

Analyst 1: I think, in terms of the micro-economics of the situation, each distributor, or each HVAC operator, in the US, tends to be one brand. I think a lot of it has to do with the fact that there is some sort of rewards system for using the same brand and being an outlet for the OEM to generate a lot of volume. I’m sure there is also service support, service training and other factors that contribute to that.

We used to own A.O. Smith, which was in the water heater business. It was a very similar structure, where most plumbers that you would talk to only use one brand. That was because they were well-integrated with their systems, they would get rewards for installing however many water heaters in a year. There is a reason they have those relationships. There is nothing to me that was particularly surprising about that sort of close-knit relationship between Watsco, Carrier and some of its customers.

Analyst 2: It’s funny you mention A.O. Smith because we own them as well. They also have two family-owned companies, have been around for a long time and have a very stable industry structure. The competitive positions are pretty good that way. One of the things l like about it is, these little HVAC distributors are like little local oligopolies, almost. You have a distribution center in Florida and it’s not going to service the one in California.

I don’t know this for sure, but maybe it evolved that way because it used to be that the manufacturers all distributed their own stuff, like Carrier used to. Some of the big ones still do; Trane does. I’m surprised that more don’t because, it seems to me, from what I’ve done, that it’s been a boom for Carrier. Why not the other ones? Maybe that is a potential catalyst down the road that.

I believe they’ve got a JV together. I think Carrier were struggling and now they’ve got a joint venture together, where Carrier own 20% of the JV and most of it is owned by Watsco, from my understanding, and they shared some locations. That was one question I had; why don’t Carrier just do it themselves?

Analyst 2: I think they do better if they don’t distribute their own; that’s my understanding. The economics work out better to be a distributor. This is one of the questions I have; I’m not really sure why some of the larger ones continue to distribute their own products when it seems as if the economics favor getting a distributor.

Analyst 3: I think, also, when Carrier had their own distribution, when Watsco basically took over control, the business really boomed. For some reason, they do it much better and maybe it’s just that they want to focus on manufacturing and not on the distribution as well. It’s a different sport and it’s just not their expertise and, I guess, that’s why they use Watsco.

From the end customer’s point of view – the residential owner that needs the HVAC system – do they choose the brand or is the contractor that pushes the brand?

Analyst 2: We just got a new system, actually, and we just picked one of the local contractors and got different ones out to give us bids. They both had different brands; one was Daikin and one was Bryant. I was totally indifferent to the brands. We were more interested in whether they had variable speed, the efficiency and those kind of things. We didn’t care if it was a Bryant or something else. It was really the contractor; they tell you what they have, they try to meet it to your specs and then you go with what you like. You don’t pick the brand at all.

Analyst 4: It was the same story for us. It came more down to our relationship with the HVAC company, the installer, than anything else. They are down the street from us and we know that, if something breaks, they will be here in 10 minutes to fix it. That was a pretty primary reason why we chose the brand that we did. We didn’t look through brands and get multiple offers. This is a company we’ve worked with for a long time and there wasn’t enough differentiation between the brands to justify going with an unknown entity, in terms of service and installation.

Analyst 1: Just a couple more thoughts on the Carrier relationship. I do think, at least from my reading of it, it does seem as if, when Carrier turned distribution over to Watsco, Watsco has done it a lot better. I think it’s a symbiotic relationship. I think Carrier needs Watsco just as much as Watsco needs Carrier. I don’t necessarily view a break up as that big of a risk.

I’m happy they picked Carrier; Carrier is the leader so I’m glad their partnership is with them. To the comment on local oligopolies, we have Baker Distribution just north of us which, of course, is Watsco and JEM Air just south of us, which is Watsco. If you are a homeowner and you have a Carrier unit and something breaks down, then the HVAC contractor – at least here locally – he’s got to go to Baker to get the parts for your Carrier unit.

Unlike plumbing, where these dynamics don’t exist, the neat thing here is, Watsco sort of has a monopoly in Carrier aftermarket parts. It’s pretty amazing, when you look at gross margin, to have 24%, 27% gross margins, as a distributor. There are some other great distributors who are up there, as well. There is a lot that I like about the Carrier relationship. They picked the right kind of partner. You look at POOL and, of course, they are a fabulous business and has done phenomenally, but one of the things that worries me about them is that a lot of the products are commodity products. I like the fact that there is this kind of aftermarket monopoly in certain geographies, in HVAC.

With POOLCORP, for example, putting aside the end market and the volume growth, they manufacture their own chemicals, as well, which is a huge part of the margin. They can go and do that whereas, obviously, Watsco are purely doing the aftermarket and, pretty much, have to do whatever Carrier says. I was looking through an old earnings call, from five or six years ago, and there was a problem they were having with the warranties. Apparently, all the residential owners of HVAC trade in their HVAC just before the warranty ends and there is nothing actually wrong with it. Watsco have to process all of those, for no margin, because they run aftermarket for Carrier.

It just seems to me that Carrier have so much power in the value chain and Watsco is, effectively, a Carrier subsidiary. I don’t how that evolves over the next 10 or 20 years. Although it’s worked out pretty well for the last 20.

Analyst 1: That’s one of our concerns too; how the linchpin nature of Watsco operates, compared with Fastenal which we own and POOL which is another company that we’ve looked into. There are thousands of customers and thousands of suppliers and they are the linchpin but Watsco is highly dependent on one OEM and there aren’t many OEMs to begin with. One of our concerns is the bargaining power that they have and the opportunity they have that is unique and differentiated.

What stops Carrier turning around and taking 5% more margin from the aftermarket sales? I don’t know what the contract of the JV says.

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