Watsco：空调，显而易见——[商业拆解，第209期]

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 over 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 a general description of 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. We’re here to talk about Watsco, North America’s largest distributor of HVAC equipment. That’s heating, ventilation, air conditioning, and refrigeration.

Watsco acts as the crucial link between manufacturers, who make the equipment, and the contractors who install and maintain it. Watsco was itself a manufacturer, and it moved into distribution in 1989. This was really a transformational moment for the company.

Back then, its revenue was around $64 million, and it’s now $7.5 billion, which means it’s part of the Fortune 500. In 1989, the market cap was $22 million. Now it’s around $20 billion. That’s a 20% annualized shareholder return, consistent over 5-, 10-, 20-, and 30-year periods.

It’s really an amazing achievement, and it makes Watsco one of those long-term, quality-compounding businesses that we love to look for.

We’ve covered some other HVAC names, with Trane being a manufacturer. You mentioned that Watsco is a distributor. Can you get into a bit more about what that entails?

They primarily sell HVAC equipment, so think air conditioning units, heat pumps, gas and electric furnaces. They also sell the parts and supplies that are needed to service these systems, and they sell exclusively to contractors—those who are licensed to install and maintain these systems in both residential and commercial buildings.

As Alan said, Watsco acts as that middleman between the equipment manufacturers and a highly fragmented base of contractors. It operates through a network of distribution businesses and local sales branches, catering to these contractors in a number of different ways.

First, it’s about stocking a wide range of equipment and parts across multiple brands and price points, making them readily available across its large network of around 700 sales branches. Watsco also provides technical expertise to these contractors. They rely on the Watsco sales team to help with product selection, check and process warranties, or simply get quick access to product information.

Finally, Watsco offers a suite of other value-added services. That includes training programs to keep this contractor base up to date with the latest product knowledge. It also has a range of digital tools, from access to a searchable product database, to a mobile ordering app and an e-commerce platform.

It even goes as far as customer-facing tools for the contractors themselves—tools that help contractors grow their own businesses. If you bring all these things together, that’s what makes Watsco a valuable partner to these contractors, and not just a supplier.

To paint the real-world picture, I can remember distinctly having an issue with my heating system this past year. I called somebody for maintenance, and they checked it out. It was some very old system that needed a very specific part. They were calling around for it, and I’m imagining that’s where a Watsco distributor comes into play.

First, can you tell me if that’s the correct example? Second, in general, would you say that the just-in-time, “I need this at the moment” aspect 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?

I think that residential end-market example is a great one. Not only because we can all relate to it, but because that immediate need for repair and replacement products in the home actually generates the majority of Watsco’s revenues.

If your unit breaks, you want it fixed quickly, but it’s not a DIY job. It requires a licensed professional. As you said, the first step is searching for and calling up your local contractor, who then visits your home, diagnoses the issue, and hopefully recommends a solution.

At this point, the contractor would go to their local Watsco store to search for and buy the part needed to fix the problem. It’s also at this point—the point of sale—that the contractor might draw on the technical expertise of a Watsco salesperson. You used the example of helping to find a compatible part for an older system.

Once they have both that knowledge and the part, they return to the home to complete the repair. What’s interesting here is that it’s the contractor making a recommendation to the homeowner about what they should do. That puts the contractor at the center of this industry, and it’s why Watsco is laser-focused on the contractor.

Watsco puts the contractor at the center of its universe. It focuses on improving the contractor’s experience—for example, thinking about ways to make their life easier and helping them to be more efficient and productive, so that they can grow their businesses. Fundamentally, the success of the contractors is what drives Watsco’s growth.

Can you give us a sense of the market competition? Where does Watsco rank in terms of market share or any other numbers that you could use to put the business in context?

The North American HVAC distribution market is valued at around $64 billion today, and it’s primarily served by more than 2,000 distributors. It’s highly fragmented, with many local and regional players.

Watsco is the largest national distributor, with an 11% to 12% market share. It’s more than two times the size of its next-largest competitor. After the top 3 or 4 players, the size of the competition drops away quite quickly to these smaller local players.

If I were to think of a key differentiator between Watsco and its largest competitors, it would be that Watsco is exclusively focused on the HVAC market. The number-two and number-three players are more diversified across HVAC, plumbing, and other industrial end markets. Watsco has a slight competitive edge in being able to focus on that narrower addressable market.

I love markets like this, where you do have a lot of fragmentation. You see some players emerge as having market shares that are significantly larger, as you just mentioned, but still a fraction of the overall market.

Maybe we can get into a bit of the history. Alan, you touched on it at the very beginning in terms of its late-’80s launch. What have been some of the evolutions of this business? How did it evolve into what it is today? Were there key players involved, or anything else along those lines?

It’s a 50-year journey of entrepreneurship and evolution that was driven by Watsco’s founder and CEO, Albert Nahmad, and is now being carried forward by his son, AJ.

Albert’s background is a true entrepreneurial story. He was born in Panama, then received a scholarship to study in the United States. After graduating, he got a job in consulting and then moved into mergers and acquisitions. It was there that he learned a lesson that continues to impact Watsco’s culture today: the power of decentralization.

The conglomerate where he worked had more of a command-and-control approach, which he felt stifled innovation and eroded value. He wanted to do it differently, so he left and went looking for a business to buy.

After about a year of looking, he found a company called Wagner Tool and Supply Corporation, whose initials form Watsco. It was a manufacturer in the HVAC industry.

So Al, with some financial help from some friends and family, bought his original stake back in 1972. Now, if we turn to his son and Watsco’s president, AJ, he’s really been immersed in the business his entire life and, as a consequence, he’s really learned about all aspects of Watsco. He interned during the summers before joining the company around 20 years ago.

Now, we’ve been invested in Watsco for about 8 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 in and understanding of the benefits of technology.

Now, I would think about Watsco’s history in a series of chapters, and I probably call out 2 of them. 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 move from manufacturing to distribution is quite an interesting story. The story goes that one day, Al received a prospectus from his bank, and this was giving him the opportunity to buy one of his customers, a company called Gemaire, which was a distributor for the manufacturer Rheem. Watsco entered an auction and bought the company. Interestingly, they’ve done over 70 deals since and have not entered another auction.

Al structured this original transaction as a joint venture. The reason was that he wanted to align the incentives between Watsco and the manufacturer and share the risk with them. This thoughtfulness on incentives is something that we continuously see across many areas of Watsco. In fact, they also used 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, Watsco looked to grow by buying more of Rheem’s distributors. As that became more difficult and slowed, they knew that they needed to go out and form relationships with key leaders at other manufacturers.

During the 1990s, we saw this shift from single-brand to multibrand distribution, and that was an important strategic move for Watsco because it decreased their reliance on this one manufacturer, Rheem, and it also acted as the next leg of growth for the business. There was a period of 3 years in the 1990s, I think from 1995 through 1997, where we saw them complete over 20 deals as they partnered with other manufacturers. This meant that they were able to broaden their footprint, broaden their product offering, and reduce their risk profile.

And it’s this buy-and-build strategy that’s helped it become the multibrand business that it is today. You can think of Watsco as this aggregator of 10 or so major operating companies, and then each one of these operating companies, or subsidiaries, has an exclusive relationship with one of the leading domestic manufacturers to sell their products in specific regions in the US.

There are interesting similarities to another name that we covered with Hajoca, 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. I can understand that in certain industries, exclusivity can be very powerful, but it depends which side is getting the better side of that agreement. Exclusivity 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 that 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.

If we go back to when I mentioned the service element that Watsco offers above and beyond distributing equipment and parts, these services not only help to grow Watsco’s business, but they’re also beneficial for the manufacturers, too, improving customer satisfaction and creating brand loyalty. These are things like customer support, after-sales support such as warranties and training programs, and even providing e-commerce and technology platforms, which ultimately help the manufacturers to capture online sales.

And what this does is that, while Watsco can focus on delivering those services that help to grow both sides of the manufacturer’s business and Watsco’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. For 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 we’ve just described between the manufacturer and the distributor, and in addition, both parts of the business primarily relate to servicing replacement demand. Two differences to call out in Watsco’s case would be that Watsco is less penetrated in the commercial space than 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 Watsco 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 Watsco, 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. That’s quite straightforward. They’re purchasing equipment from the major manufacturers, as well as those parts and supplies 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. 90% of its sales come from the US, with the remainder split equally between Canada and Latin America.

And then, if we move on to the products that it sells, it groups these into 3 categories. Equipment generates 70% of sales, parts and supplies around 25%, and then the remaining 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. Within that core residential market, around 80% is driven by repair and replacement, and then 20% from new housing.

It’s also worth adding in there that new housing was around 30% of Watsco’s total sales prior to the global financial crisis. But obviously, as the installed base of HVAC units has increased, and also Watsco’s growth in other areas like parts and supplies, this percentage is now smaller, and that obviously reduces a bit of the cyclicality risk in the business.

That 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 joint ventures, the Carrier deal. We touched on that a little bit, but it might be good to paint a bit more of a picture about that. How 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 deliberate are they about M&A, more just in terms of the top-line expansion of the business?

We would expect organic revenues to grow at around 5%. Let’s break that down between volume and then price. If we start with volume, we have industry unit volumes growing at around 3% to 4%. Therefore, we’d expect both equipment and parts to grow in line with that.

Now, Watsco actually tends to grow a little bit more, and that’s really a combination of market share gains and the fact that 60% of its network is actually in these faster-growing Sun Belt states. If we then turn to price and mix, we think that adds a further 2% to 3% of growth each year. That’s primarily driven by 2 things.

So first, we have the typical annual price increases by the manufacturers. So they typically realize a low single-digit growth rate each year. And then we have a regulatory-driven mix impact. This happens every 10 years or so, and so we smooth that out over time. 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 years, M&A being a key one, and that’s opportunistic. If we smooth that out again, we expect that to add another 2% to growth.

I know it can be hard to model any future M&A or make any forecast or take any view on that. How much does that play a role? Whether it’s new joint ventures or acquiring more distributors, is that a key piece of the DNA? Maybe it was in the beginning and it isn’t now, but how would you describe that in terms of playing a role?

It is an important driver to returns through the cycle. It’s probably worth understanding what types of companies Watsco does buy. These are family-run distributors, and they can be up to 3rd generation. As a consequence, deals can take years to come to fruition and often require some sort of catalyst within the family. But in the meantime, Watsco’s pitch to these companies is compelling.

They say, “Look, come and join our Watsco family.” That’s not just talk. It’s backed by a decentralized philosophy, with the companies retaining their brands and their teams; they benefit from Watsco’s expertise, capital, and technology. Broadly, there are 3 components to Watsco’s M&A philosophy. One would really be about cultural alignment. The second one is about the fact that 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 Watsco, and it’s probably the most important thing for Watsco. The second is around the fact that Watsco looks to buy performing businesses and not turnarounds. Then, finally, on financial discipline, they look to use minimal debt in their M&A. So, as the leadership of Watsco likes to say, they never bet the ranch.

This philosophy actually ties back to the family ownership that wants a company to endure and succeed over the long run. When you look at 15+ years of transcripts, you can see this philosophy consistently articulated by the entire management team.

What’s also interesting—you touched on it a little bit—is the growth potential for a company underneath the Watsco umbrella. What’s interesting here is that they did a deal with a distributor called Russell Sigler. They bought a 35% stake in the business back in 2017. If you look at the accounts today, you can see the value of the stake, as it’s based on a fixed multiple of operating profit. Therefore, you can calculate that operating profit has grown by over 400% since they did that deal.

That’s a really great example of the potential benefit of these acquisitions to investors. This is really due to both hard work at the subsidiary, but also Watsco’s expertise, relationships, capital, and technology. These technology improvements have been and continue to be an additional catalyst for deals. Since 2017, they’ve done over 9 deals, adding over $1.2 billion in revenue. They have the balance sheet in place and the appetite to do more deals.

As I say, it’s really about whether the opportunities arrive, which are driven by what’s happening with the families, but also by the technological improvements that Watsco is adding.

The 35% is notable. It 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 acquire the entirety of the business. In the case of Russell Sigler, it was one of the larger acquisitions, and what it was structured as was that the family did not want to sell the entirety at once. There’s an agreement in place that Watsco can purchase, at a fixed multiple, the additional equity that’s available, effectively.

It’s nice that you get to see the stake and track it over time. It helps the analysis.

Just to touch on the JVs, the Carrier-type deal, how much does that play a role in the growth engine, and how much flexibility do they have to do more of those in the future? It’s different from M&A in terms of just tucking in a distributor. It’s a little bit more strategic in terms of what they’re doing. How would you describe that, the potential for that to happen again in the future, and how key it is to the business?

It’s an interesting opportunity with Carrier. But in terms of the future opportunities with Carrier, out of those 9 deals, on a number of them, Carrier continued to partner with Watsco. When they looked to do the acquisition, they often folded it into the joint venture structure, where Watsco owns 80% of the acquired company and Carrier owns 20%.

They continue to partner on that, and Carrier continues to remain Watsco’s largest supplier, representing 65% of their purchases.

It might be good to get into the history of that transaction, as you mentioned it’s a very interesting deal. The history of Carrier itself is as well.

This history starts 120 years ago, and the story is that there was effectively this printing plant in Brooklyn. During the summer, humidity was ruining the paper in the plant, and the company asked a guy named Willis Carrier to effectively come up with a solution. He invented this system that used chilled coils to cool and dehumidify the air. That was the start of the modern air-conditioning industry.

Willis went on to found Carrier, which today, as you know, is one of the largest manufacturers in the HVAC space. Throughout the 1990s and 2000s, Watsco wanted to manage more of Carrier’s distribution. In 2009, they did this original joint venture with Carrier, which effectively nearly doubled Watsco’s revenue at the time, adding about $1 billion. It was a transformational deal.

Watsco financed this with equity, and this was similar to the deal with Gemaire 20 years ago. This was to align Carrier to the joint venture and to the ultimate success of Watsco. What’s interesting as well is that, if you study the disclosures at the time of the deal, you can see that Carrier’s margins were actually only around 2%. It was a third of Watsco’s at the time, and those have now grown sixfold. So, it was a true win-win for both parties.

The next step of this collaboration was that they agreed to do additional joint ventures for additional regions in 2011 and 2012. As I mentioned, they’ve done 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? It seems like there’s a very nice arrangement there. Could Watsco ever come up with a similar arrangement with another manufacturer?

It’s a 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 Lennox. Most of them have this outsourced distribution model, so it’d be quite difficult for Watsco to do it at scale through its acquisitions. Given the multibrand approach, they are able to acquire distributors that have different manufacturers, effectively.

You outlined the Carrier margin improvement over the course of their joint venture. For Watsco, 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.

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. Equipment sales, which represent the majority of Watsco’s revenues, are actually lower gross margin compared with parts and supplies. That’s because systems are higher-cost items and more competitively priced compared with parts and supplies, which are smaller-ticket items and less price-sensitive.

Parts and supplies have been a more recent focus for management over the last few years. That’s really driven by the fact that they’ve looked to capture a larger share of wallet from the contractors, but also as they’ve looked to drive improvements in gross margins through product mix. In terms of the end market served, Alan’s already highlighted that residential sales are slightly higher gross margin than commercial.

If we turn to margins for the business as a whole, gross margins are just under 27% today, and management has clear ambitions to reach 30%. Their confidence here comes from the fact that some of these businesses in certain markets are already operating at that level.

Gross-margin expansion has really been driven by 4 things over the last few years. Firstly, it’s greater purchasing power as they’ve scaled. Secondly, it’s securing better commercial terms with the manufacturers. Thirdly, it’s the product mix that I’ve just mentioned—parts versus equipment. Finally, and more recently, it’s been pricing optimization, as they’ve looked to incorporate technology into their operations and benefit from data-driven pricing.

On operating margins, these are just below 11%. Improvements here have really been driven by operating leverage as they’ve scaled. Then it’s a case of broad-based productivity gains right across the supply chain, logistics, and warehousing. More recently, we’ve started to see increased technology adoption by the contractors, which is starting to reduce Watsco’s cost to serve.

We think there’s further opportunity to grow operating margins across all of these areas. Perhaps I can give you a couple of examples. In logistics, they’ve talked about the opportunity to optimize their fleet of trucks—again, incorporating technology to better understand how they can move product around their network, across those 700 or so sales locations, more efficiently.

Another example would be the fact that we still think there’s a latent opportunity in the form of cost to serve for the 60,000 or so tech-enabled customers. We think that’s just getting started.

On the pricing impact on margin, you mentioned a little bit about where price increases come into play for the revenue side of things. But if we see manufacturers increasing the price of equipment, how does Watsco treat that in terms of a pure pass-through on a dollar-for-dollar basis? Is it a pure margin pass-through where they manage it to maintain the exact margin? Do they have a specific methodology or strategy around that?

I think there are 2 drivers of pricing in the industry. Number 1 is the normal annual price increases by the manufacturers. They’re typically raising list prices by mid-single digits in January every year. The realization of those list prices is dependent on things like manufacturing capacity, local demand, and the competitive dynamics across the distributors and, of course, in the different markets. But typically, Watsco’s markup remains pretty stable throughout the year.

The second driver of pricing in the industry is regulation-driven pricing.

That is really where the manufacturers need to redesign systems or certain elements of systems to meet changing regulations. To make these units more efficient and more sustainable, there is obviously a cost to the manufacturers, and they need to recoup those costs. Therefore, that results in high-single-digit to low-double-digit list price increases for these new systems. The realization of those list price increases in the market is really a factor of demand that plays out throughout the year, but Watsco’s margin remains fairly stable.

In terms of the visibility from year to year, every contractor or home appliance person that I now work with has sold me on some type of annual maintenance contract. Everyone loves that recurring revenue stream. Does Watsco capture anything along those lines, where there is some type of contractual nature to whatever they’re doing? I know you mentioned a bit about the maintenance and services, and so much of what they’re doing falls into the bucket of maintaining equipment, which can also be associated with those contracts. Do they capture anything that would fall into that category?

Those maintenance contracts that you highlight are typically between the contractor and the homeowner. Now, Watsco is one step removed from the homeowner, given the two-step distribution model that we’ve discussed. Watsco’s business model is really transactional. It’s not based on any long-term contractual agreements, and that’s because sales are primarily driven by that immediate need for repair and replacement products.

Watsco’s recurring revenues are really driven by a large and growing installed base of these HVAC systems. There are over 120 million units installed across the US today, and that base has never gone down. It has actually compounded at over 3% each year since 1980. Of course, all those units are going to break at some point.

If your system breaks and it’s hot and humid outside, you’re going to act. It’s a necessary product, and that necessity isn’t going to change over time. There’s not a lot of discretion in terms of demand in this industry. I guess the only real question, actually, is how you act. Do you choose to repair or replace your system? If it’s the latter, at what price point? But fundamentally, there’s no deferral of that purchase, and that’s what drives the steady repair and replacement business and, ultimately, those recurring revenues for Watsco.

That certainly adds visibility when you have some sense of equipment’s useful life and replacement on that side of things. Transitioning a little bit to the management of cash flows, the balance sheet, and inventory, when I think of a distributor, I think of a lot of inventory being held to serve the entire market. How does that impact the financials of the business, whether it’s conversion of free cash flow or capital being tied up in inventory? How do you think through that?

This is a highly cash-generative business, with over 100% cash conversion in most periods. The top priority is to invest in the business and improve its strength over the longer term. Whether that is investing in working capital to make sure that inventory is in the right places and readily available, investing in the sales force, or investing in these technology initiatives, that is a top priority.

After these investments, the priority is returning cash to shareholders through a growing dividend stream. Over two-thirds of free cash flow goes into paying dividends, and those dividends have actually compounded at over 20% annually over the last 35 years. I think that’s quite a remarkable achievement.

The prioritization of dividends is actually not as common in the US. We often see cash being diverted more toward share buybacks. At Watsco, it’s an important source of income for key leaders who are restricted stock award holders because they’re entitled to receive these dividends during the vesting period.

It’s important to mention the special dividend distribution that they made back in 2012 because I think it really shows their thoughtfulness around capital allocation and maximizing shareholder returns. This is when they paid the equivalent of 2 years of dividends ahead of an adverse change in tax rates on dividend income.

The final point on capital allocation is the robust balance sheet they run. Alan touched on this when he talked about the transactions that they’ve completed. They have a strong aversion to running too much debt. It really is cultural, and as they’ll say, they will not bet the ranch. This allows them to withstand difficult macro environments, but it also allows them to be in the best position to fund any growth opportunities at any point.

The Carrier transaction illustrates that perfectly. Because of their strong financial position and their long-term mindset, they were able to execute this deal during the GFC, a transaction that doubled the size of the company. Inventory turns have always been a focus at Watsco, and they’ve been using technology to improve this. We haven’t yet seen this turn up in the numbers, and that’s because during the supply-constraint periods post-COVID, it was a lot more difficult for Watsco to manage inventory.

This technology allowed them to maintain their turns rather than have them actually worsen during that period, and we expect to see this improve over the next year or so.

You brought up technology adoption within that answer. I didn’t want to gloss over that. It’s been something you mentioned in terms of being a service that can improve the productivity of contractors. You can understand why that might show up in the margins.

In my mind, I’m picturing a contractor no longer needing to get on the phone and spend 35 minutes figuring out where a part is. They might have access to software or some type of digital database to look for that. Sometimes we hear about this investment in technology and hear the story, but it doesn’t actually show up in the numbers. Can you touch on those two things: the use cases and how it would show up in a real-world example, and then whether you’re actually seeing the follow-through into an improvement in financial performance?

In Watsco’s case, it shows up in a number of places. Watsco started to digitalize this entire business model around 14 or 15 years ago. The HVAC industry at that time operated in a really analog way. Imagine: all the product information was paper-based, and there was no e-commerce.

You can picture the contractors turning up at the branches in their trucks. They would wait in line, check to see if the product was available, or fill in reams of paper to understand if it was under warranty. It was really an industry that was ripe for digitalization.

Watsco has addressed this in 3 different core pillars. One would be its internal tools. The second would be the things it has developed for contractors. The third would be this customer-facing innovation, which is to help contractors sell to homeowners.

On the internal tool side, Watsco used this to improve its own operating excellence across things like demand forecasting, inventory management, and pricing. So basically, Matt, it’s about using data and technology more to help its employees. For example, digitizing order fulfillment in the warehouses makes life easier for the warehousing staff and also makes them a lot more efficient.

As an ancillary benefit, contractors will know when the orders are ready, and they can arrange an express pickup. Another example would be pricing optimization tools, and that is something we’ve seen feed into gross margin. In fact, it’s been one of the key contributors over the past couple of years.

In addition, with the rollout, improvements, and new targets they’re thinking about for the tools for contractors, this is really to make life easier for the contractor, make them more productive, and help them grow faster. One important platform here that we’ve seen grow is e-commerce. This accelerated around 10 years ago, hitting about a quarter of sales in 2017, and it’s now closer to 35%.

Some of the benefits that you see here in the numbers are that, number 1, in Watsco’s traditional business, they have about 10% customer attrition, but it’s half that for users of e-commerce. Secondly, Watsco tends to sell 20% to 25% more line items through the e-commerce platform.

The last leg is this customer-facing innovation. As I mentioned, this is to help the contractors sell to the homeowners. This sits in part of what’s called Watsco Ventures. That part of the business invests in startups as well as develops its own in-house software.

One success story here is something called OnCall Air, which is a digital sales platform for contractors. Imagine the old process, where the contractor would come to your kitchen, scribble prices on a notepad, and flip through the brochure. Now it’s a much more interactive process on an iPad. There are images and multiple options, and it’s much more suited to what consumers would expect today.

As an ancillary benefit, Watsco Ventures is attracting great young talent into this established industry. You can picture it from an employee perspective, because if you join Watsco Ventures, you’re working in an industry that’s ripe for digitalization. You’ve got proper backing from the C-suite and significant financial resources. As a consequence, these hires cause a ripple effect in Watsco’s culture and keep it moving forward.

Is the Watsco Ventures strategy new? Is it something that’s been around for a while?

It was established probably around 10 years ago, I believe. When they were looking to digitalize and wanted to have this part of the business that was really helping contractors more, they created this area. If they have the right skills and the right internal attributes, they will develop the in-house software; otherwise, they’ll partner with or invest in startups. It’s quite an interesting, innovative way to try to improve things within this established industry.

It’s very fascinating to see the evolution of that strategically, and those who do it well versus those who spend a lot of capital towards things that don’t end up being much. But that certainly seems like the proper way to open-source good solutions for the customer base and potentially get some aligned incentives there. On that point of incentives, the cultural dynamics are very interesting at Watsco, and one of the most interesting things that I’ve ever come across is their incentive plan. Maybe you could just outline that and what makes it unique.

They take a unique approach to their restricted stock program. For most companies that grant restricted shares, they typically vest over a period of a few years—typically 3 to 5 years—but at Watsco, they cliff-vest at retirement. So they vest all at once at age 62 or older. If an employee leaves the company for any reason other than death or long-term disability, all of those awards that they’ve amassed over the years—100% of those—are forfeited.

But if they remain at the company up until retirement, that’s when they get to really benefit from this wealth creation that’s developed over time. And that’s in line with the development of shareholders’ wealth. The plan seems to be working. Since its inception over 25 years ago, only 8% of these shares that have been granted have been forfeited. There are over 160 of the company’s key leaders who get to participate in this plan.

What that means is that you’ve just got this large family all pulling in one direction and working to drive change at Watsco and even the industry itself. We’ve actually heard firsthand how motivational that is, and the energy in the room that it creates, and that alignment. I think it’s what really forces them to think long term and to ultimately decide long term. And you’ll hear management say that quarters are important, but quarter-centuries are mission-critical.

This really is a business that is setting itself up to hand down to the next generation. This plan really enforces that ownership culture, but it also creates stability in their leadership team. They’re getting to retain these key leaders for the duration of their careers, and they’re industry veterans. They have a wealth of industry knowledge. They’ve been through a number of cycles themselves.

They’ve seen it before, and then they get to share this knowledge and impart that knowledge with the next generation. I think that’s quite powerful. But it also acts to influence the type of new talent that Watsco can attract. It’s essentially a great recruitment tool because it appeals to those who can think long term. New joiners must really want to be part of this business because they’ve got to wait many years for these shares to vest.

As you’d expect, the family are significant shareholders of this restricted stock, and they typically receive Class B shares. They have enhanced voting rights versus the common stock. This dual-class structure allows the family to maintain decision-making power, and that ensures that the continuity of their long-term vision for this company remains. This plan just underpins that ownership culture. It provides stability, and it provides consistency in this business.

The sub-10% forfeiture of those RSUs is quite a startling number, and the stock performance maybe tells the story in terms of that being too much to give up or being very hard for a competitor to bid into. On the point of the Class B shares and that different structure, was that something that was always in place, or did that evolve over time?

It dates back to that period in the 1990s that we spoke about earlier, when the business was growing rapidly as it partnered with other manufacturers and issued additional shares to support that growth and acquisition strategy. The dual-class structure was introduced really to allow the family to maintain control while also allowing for broader investment through the common stock. It’s a move that is consistent with what other founder- and family-controlled businesses have done. It’s really about balancing external capital needs with internal control.

It’s nice when you have a track record and precedent as investors. I’ve come across some businesses before with similar setups and maybe didn’t have as much confidence. So, it’s one of those things that has a certain nonlinear impact on how I view a stock, depending on the success rate of that management team.

When you think about risks for this business, they have this long track record. They’ve executed on this playbook. What stands out as a risk for Watsco?

There are a couple of risks that we think about. One would be increased private equity involvement in the space. It’s more on the contractor side. That’s where we’ve been seeing private equity consolidating, but it still remains highly fragmented. Increased consolidation here does give the contractors greater buying power. That being said, larger contractors would probably want to deal with a larger distributor to benefit from the density of the stores or the breadth of the product offering.

In addition, PE consolidation on the distributor side is harder, given the family ownership dynamics and the requirement to have manufacturer consent. But success here could drive up prices or make it harder or more expensive for Watsco to execute its M&A strategy. In addition, you’d have the risk that there’s some product disruption to the HVAC industry. This would be where new technology replaces traditional air conditioning or changes the distribution model.

That being said, Watsco is pretty adaptable, and it’s quite hard, we think, to bypass licensed contractors in this space. The contractor roll-ups by PE are getting their benefits from the consumer base to start, selling them maintenance contracts for whatever it might be, and tying in that recurring revenue. So they’re easier targets or prey versus a business like Watsco. An interesting one to monitor.

Would you point to anything else structurally about the culture that really stands out outside of the incentive program, even if it’s qualitative in nature? Anything that you picked up on?

Watsco is the gold standard ownership culture, underpinned by the decentralized model. You can think of Watsco really as a company of entrepreneurs. Management and employees really do think and act like owners of this company, and they’re taking decisions for the longer term. We went out to their headquarters in Miami, and I felt like this really just brought it to life for us.

We sat around what I’m sure was a purposely round board table, and the door was open throughout our conversations, with key leaders popping in. It was clear that we were sitting amongst their chosen family. I noted the phrase “competition of ideas,” and they just had this passion to continually evolve, be better, be smarter, do things differently. Also, what’s really important is they’re looking to disrupt themselves as leaders.

At their headquarters, there are around about 120 people. There’s only a small team of 20 people at most that I would say are involved in the business operations, supporting the 700 or so sales locations, and it’s their job to be helpful to the local leaders. No one’s telling these managers what to do. Instead, it’s that small team’s job centrally to encourage the businesses to share best practices, to give them the resources that they need to grow their businesses, and then correctly incentivize them through various equity programs.

I think what’s really interesting is that across their 700 or so sales centers, not one of them has Watsco above the door. It’s this decentralized model that empowers these local leaders, and it gives them the autonomy to make decisions and ultimately that flexibility or agility to react to whether it’s changing market conditions or the changing needs of these contractors.

What that means is multiple people innovating in this business, trying different ways of doing things and obviously having different successes, but then learning from one another. Buffett has spoken about the power of decentralization. When it’s done correctly, the people that are working in these decentralized businesses find it almost identical to running their own show. I think that’s exactly what we have here at Watsco.

We always close these conversations out by capturing the lessons. I think Watsco is a business that is studied, and we’ve gotten into a lot of reasons why throughout this conversation, but what stands out the most to you in terms of lessons from Watsco that you could potentially apply elsewhere as an investor?

We hear a lot from companies about their digital ambitions. Watsco is a great case study, and that’s because they were early into it, into what was very much an analog industry at the time, and they’ve undertaken this fundamental transformation across all of their business that’s impacted both business processes and culture. One important factor of this success has really been A.J. Nahmad’s involvement—he’s Watsco’s president—as well as his passion and his direct ownership of it. So one lesson that we do take away is that when leadership is properly engaged and all over this digital transformation, then it’s much more likely to be a game changer.

The second lesson is the power of combining standalone indicators of a quality business. That is effectively moving beyond a simple checklist and really thinking about how these attributes interact to create sustained competitive advantage. That’s where traits such as family ownership or long-term thinking, which are often associated with successful businesses, matter.

But the question is: Does a family’s entrepreneurial spirit continue to permeate through an organization, keeping it nimble and innovative as it scales? Does it have the right culture to allow for this? Or is long-term thinking reflected in incentives for staff or the strength of the balance sheet? In Watsco’s case, the company and the industry’s unique characteristics work together, reinforce and strengthen each other, and form this powerful engine and moat for long-term compounding.

Watsco's differentiated approach not only generates long-term, impressive results for their business, but has also made our investment time well invested.

Excellent. Well, this has been a very fun conversation and a very fascinating business. It was great to go deep into this one with you both. Thank you, Lucy, and thank you, Alan, for joining us.

Thank you. Thanks for having us.