Albert H. Nahmad - Chairman, Chief Executive Officer, President and Chairman of Nominating & Strategy Committee Paul W. Johnston - Senior Vice President for Office of The Chairman Barry S. Logan - Senior Vice President, Secretary and Director.

Winifred Clark - UBS Investment Bank, Research Division Michael Sang - Morgan Stanley, Research Division Matt Duncan - Stephens Inc., Research Division Joshua Charles Pokrzywinski - The Buckingham Research Group Incorporated Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division Mark Douglass - Longbow Research LLC Keith B.

Hughes - SunTrust Robinson Humphrey, Inc., Research Division Luke L. Junk - Robert W. Baird & Co. Incorporated, Research Division David Mandell Charles Stephen Tusa - JP Morgan Chase & Co, Research Division.

Good morning, and welcome to the Watsco third quarter earnings conference call. [Operator Instructions] Please note this event is being recorded. I would now like to turn this conference over to Mr. Albert Nahmad, President, CEO. Please go ahead..

Good morning, everyone. Welcome to our third quarter conference call. This is Albert Nahmad, President and CEO. And with me is Barry Logan, Senior Vice President; and Paul Johnston, Office of the Chairman. As we always do, let me give you a cautionary statement.

This conference call has forward-looking statements as defined by SEC laws and regulations that are made pursuant to the safe harbor provisions of these various laws. Ultimate results may differ materially from the forward-looking statements. Now on to our report. Well, we delivered another quarter of solid performance.

We are continuing to operate at record levels, establishing new records for sales, operating income, net income and earnings per share. We continue to gain market share in our HVAC equipment business in the United States and Canada. Sales increased 5% to a record $1.13 billion during the quarter.

Residential HVAC equipment sales in the United States increased 8%, reflecting share gains and double-digit growth in sales of high-efficiency systems. Other HVAC products were flat and commercial refrigeration products increased 14%. Domestic revenues increased 5% and the international revenues increased 4%.

Gross margins improved 30 basis points and SG&A as a percentage of sales decreased 20 basis points during the quarter. Operating margins expanded 50 points to 9.3% in our third quarter. Net income increased 19% to a record $54 million and earnings per share increased 18% to a record $1.56. Now the 9 months.

Revenues increased 5% to a record $3.1 billion. Residential HVAC equipment sales in the United States increased 9%. Sales of other HVAC products increased 2% and commercial refrigeration products increased 7%. Gross profit margins increased 20 basis points and SG&A as a percentage of sales decreased 20 basis points during the 9 months.

Operating margins expanded 40 basis points to 8.3%, matching the all-time high established prior to the recession. Net income increased 15% to a record $127 million and earnings per share increased 14% to a record $3.64 per share for the first 9 months of 2014.

I do want to remind everyone that 2014 results include a significant investment made in our business. We have opened locations and added over 200 employees to increase sales capacity and improve local service. We added more products and launched new technologies that will provide innovative solutions to sell products and help customers.

Over the next several years, we expect these investments to generate growth, develop share for our vendor partners and further distance ourselves from the competition. Now the balance sheet remains conservative with a debt-to-EBITDA of only 1.1x at September 30, 2014.

Going into the fourth quarter, which is a strong seasonal period for cash flow, we expect a meaningful reduction in debt by the end of the year. Regarding dividends, the present annual dividend rate is $2.40 per share, an increase of 50% versus a year ago.

Our philosophy on dividends is to reward shareholders by sharing increasing amounts of cash flow through higher dividends. For the 9-months period, dividend payments increased 88% to $49 million.

We will consider further increases in the near future as we remain confident in our ability to generate strong cash flow while maintaining a conservative financial position and a low cost of capital to invest in our business. Now moving on to our outlook.

Our outlook for this year is for EPS, earnings per share, to remain in the range of $4.20 to $4.40, representing annual EPS growth rate of between 14% and 20%. That's for the year 2014. Now one final thing, a housekeeping item. On November 10 at 12 noon in New York City, we are hosting an Investor and Analyst Meeting.

We will present the Watsco story and answer questions until we're done. If you're an institutional investor or one of our analysts and have not signed up, let Barry know. And his email address is in the press release and you can contact him. Now with that said, Barry, Paul and I will be happy to answer your questions..

[Operator Instructions] Our first question is from Winnie Clark with UBS..

So with the summer season behind us, can you talk about how business trended over the peak period for this year? And did you see any improvement over the course of the quarter? Also I know you don't like to comment on weather, but conditions were fairly mild this season, so I'm assuming that could have been a modest headwind..

Gee, I don't know how to answer that. We don't like any excuses like weather. We've just done real good for the first 9 months and don't anticipate that's not going to continue in the fourth quarter.

But Paul, do you want to add any color to that?.

Yes. The quarter obviously had weather like it does every quarter. And the weather was different in each one of the months. And what we were seeing was we have a wide geographic expanse that Watsco carries with its branches. And so like Al said, we really don't like to lean on weather as a reason why sales are up or down.

I'm real proud of our guys that they continued to sell product and grew faster than the marketplace. That's the real story..

Yes. No, absolutely. And so to that point on share gains, can you talk a little bit about the level of share gains that you realized in the U.S.

and Canada, maybe specifically, some of the key drivers there and how actually you think the underlying market performed relative to what -- the strong results you posted?.

I think our share gain is just a reflection of sales force, adding salespeople, and like we said, adding locations in the field. We have great manufacturers that support us in those endeavors to grow share. I just think it's a combination of an awful lot of things that go into forcing share gains in a market that wasn't that exciting this year..

Great. And I guess, just one last one on refrigeration. You saw really strong pickup in the quarter. Can you comment on kind of the key drivers there? It looks like your business trended far better than some of the other companies have been experiencing this quarter..

Gee, that just means we're better, doesn't it? That was a joke..

Barry's got....

Well, it's also been one of those parts of our business where we're investing in people to drive the business and grow the business. There's over 80 product lines in the category of refrigeration. And as I look down the list, there is double-digit growth in many of them.

So I think it's just some raw energy going into that market and some territories that have been granted to extend our reach into new territories. And it's been a good business for us this year..

Our next question comes from Mike Sang with Morgan Stanley..

Paul, you -- I guess, Barry, you talked about in the past question just making lots of sales force investments this year. But G&A as a percent of revs is actually down year-over-year, which is pretty impressive. And I think CapEx is down year-over-year, too.

Could you maybe talk about the puts and takes there in terms of investments versus cost-out?.

Well, I'm looking at SG&A being up 4% year-over-year in the quarter, so I'm not sure what you're looking at. That's what I've seen in the financials, is a 4% growth in SG&A. So that trend is probably above the recent average over the last few years, and that's where the investments are showing themselves. CapEx is more a reflection on....

But as a percentage of sales, SG&A is dropping to record levels. That's because we're leveraging. As we scale our revenues, we're leveraging the infrastructure and as a percentage of sales, SG&A is dropping. It's a good thing..

Right. And on the tax rate during the quarter, I don't think it's been that high since 2010.

Is that a function of the Carrier transaction? Or could you talk about what's going on there?.

It is, yes. We picked up 10% greater investment in Carrier for this last quarter in Carrier Enterprise. That adds to our tax dollars and increases our tax rate. And that's just raw algebra on additional earnings coming from Carrier Enterprise..

Our next question comes from Matt Duncan with Stephens Inc..

Hey, Al, you guys are seeing your equipment growth obviously outpacing parts and supplies. I assume that, that's probably a function of more of the growth is coming from the replacement market as compared to construction.

Can you talk a little bit about what you're seeing from those 2 drivers for your equipment growth and also the parts and supplies?.

Sure. Go ahead, Paul..

Yes, it's -- I think we've been seeing this trend for the last several quarters, where our equipment growth is outstripping our parts growth. Obviously, when equipment gets stronger, there is pressure on our parts sales. And it's a trend that we like.

We've got a nice balance of business between our parts business and our equipment business, and it's a good healthy situation that we've got here..

And Paul, how much is the mix shift towards higher-efficiency systems helping that equipment growth rate?.

It's -- I can't give you an exact percentage on that, but it's growing at a much faster rate obviously than our overall equipment sales growth..

Okay. And then last thing for me. Last week, the EPA came out with its final ruling on R-22 manufacturing allowances for next year through 2019. And it looks like they're phasing that out a bit faster maybe than previously expected.

How do you think that's going to impact you guys?.

Great question, Matt. Go ahead, Paul..

Yes, that was a great move. We really applaud the EPA for being courageous to take that action. They reduced the allocation for 2015 by some 57% on R-22. Obviously, that's going to cause the price of R-22 as a material to go up.

We really don't know what the impact of that's going to be in the sell-through of higher-efficiency equipment because we got -- we know we've got the regional standards coming into play, at the same time there's a reduction in R-22 availability. All I can do is say right now that I hope it's very positive. I feel it's going to be very positive..

And Paul, what role are you guys going to have in the potential recycling of R-22? Are you going to get involved in that at all to help out, maybe keep some R-22 systems alive that maybe don't necessarily have to be replaced yet? Is there a way for Watsco to be involved in that?.

Absolutely. As a matter of fact, we've been involved for about the last 5 years. We got very aggressive when we thought there was going to be some spot shortages 5 years ago. Never panned out or materialized, but our people continue to have a pretty strong recycling program in each one of our companies.

It's probably going to accelerate obviously in 2015. It's good for the environment because the gas now has a value to it to recycle. That means its contractor wants to reclaim it..

Right. They're less likely to vent it off now, I would assume, so....

Correct, too valuable..

Our next question comes from Josh Pokrzywinski with Buckingham Research..

So I'm actually surprised we've gone this long on the call without really touching on the regional standards. I guess, a few things.

First, on the inventory transition or any kind of prebuild versus prebuy, it seems like the prevailing wisdom is that there's going to be a good amount of, I guess, either consigned inventory or inventory held by the OEMs.

Is that the way you guys are thinking about next year? And should we see any inventory build in your network in the fourth quarter, I guess, first question?.

Al?.

No, go ahead, Paul..

Okay. Yes, I think we're going to see -- yes, Josh, definitely there's going to be a prebuild by the OEMs, and I think that's something that they can address. Is there going to be a prebuy by the distribution network and how that's going to flow through is something that we're going to be managing.

And obviously, we're going to be managing it very closely. I really don't see an awful lot of activity in the fourth quarter for us. If it is, it's going to be a very small amount. So I can't speak to any of the other distribution in the marketplace..

That's fair. And then I guess, as we think about once this transition is completely moved out and there's no more 13 SEER in the Sunbelt, how much of your business today should go 13 to 14 SEER? I get the sense that the industry is about 25% of the market, 13 going to 14 with the transition.

Clearly, you guys would be higher, just given some more Sunbelt exposure. So I guess, first question, how should we think about that percentage? And then I think prevailing wisdom is a 15% price increase, 13 to 14, once price gets worked down.

Is that something you guys would still agree with?.

Those are the numbers we keep on hearing, and we hear the same number as you do from the same OEMs as far as what the price increase is going to be. I think we've stated this each quarter. We've seen material increases over the last several years in our high-efficiency products.

And being in the Sunbelt, I think people have a greater need for high-efficiency product. We're not in sync. We have not been in sync with the industry as far as percent of our equipment that is 13 SEER for quite a number of years.

Most of our contractors have been selling up using utility rebates, using some of the tax credits that we had in years past. So I'm hoping to see a change, but it's -- I don't think it's going to be quite as big as what it will be for some of the lower-efficiency distributors..

Even with the additional exposure in the Sunbelt versus some of the other guys, do you think it's going to be below kind of that herd average of 25%?.

I don't have any idea what the herd average is, you know..

Fair enough. And then just one last one. Al, I know you don't want to give specific numbers or kind of shy away from it for competitive reasons.

But you have signaled, I think the past few calls, higher investment spend, and I think in quotes, "in the millions of dollars." I guess, maybe leaving specific numbers out, how should we think about the trend line '14 to '15? Should '15 see another step-up? Or should that kind of hit the same run rate? Or are these one-time investments that should go away?.

That's a good question. That's an unequivocal yes. It will continue to increase..

Okay. So it will be higher next year than it is....

We're on a growth pattern, where we're going to -- we have the cash flow to invest and we're going to continue to make significant investments in people and technology..

Our next question comes from Jeff Hammond with KeyBanc Capital Markets..

So your guidance range kind of unchanged with a pretty wide range still with 1 quarter to go and seasonally weak. Can you give us kind of a bias within that range, kind of how you're thinking about....

Jeff, that's -- we thought about that. This is the best we're going to do, I mean, in terms of guidance..

Okay.

And then kind of outside of the regional standard noise, what are you hearing from your OEMs just in terms of general normal course of business price increases into next year?.

So Paul, do you have a feel for the price?.

Yes, I do have a feel for that. This is the time of year where we always see the price increases being announced, and we've had a couple of them come in. They're coming in as they normally do in a normal range, somewhere between 3% to 5%.

I think the price increases this year aren't going to be quite as relevant as they've been in the past because as we transition in the Sunbelt to a 14 SEER minimum, I think we're going to see price increases reflected in the mix change..

Okay, that's helpful. And then just back to this R-22 dynamic. If I recall, I think some of the volatility has been maybe a headwind.

I mean, if we do see this kind of spike in price, and is that a nice margin opportunity as we look into '15?.

We don't play the game with commodities, especially on R-22. So we don't maintain large inventories of it. So I think what you're going to see is it's not going to be -- maybe $1 margin increase will generate from the price going up. But there's no surprise earnings coming out of it, no..

Okay. And then just final question. Maybe you guys obviously took down the other portion of the Carrier JV, but you've been pretty quiet on M&A otherwise. Maybe just update us on what you're seeing in the pipeline, anything outside of the norm in terms of kind of new adjacencies or geographies..

Well, we want to make investments in M&A. We're always very interested. We like people to know that. And we can't tell you that we have anything in particular to discuss at this point, especially if the buyer's there and the ability is there..

Our next question comes from Mark Douglass with Longbow Research..

Some details, what were commercial HVAC equipments? What was the sales growth for commercial HVAC equipment in the quarter?.

I would call it the upper single digits..

So high single digits?.

Yes..

Okay. And then with the 8% in U.S.

residential, a very good number, what was the price? Do you happen to know what price component made up in that number?.

Mark, it's a measure of both price and mix. We saw unit growth and we saw mix change, which helped the overall sales growth rate. It's not something we break out into pieces for you..

Okay. And then -- well, let's see if -- what do you think the market unit growth was in third quarter for that U.S.

resi? Do you think you have a handle on that?.

For the industry?.

Yes, for the industry..

It's estimates we make internally based on the public trends that are out there and discussions with our OEMs, it's not something that we publish. It's something ARI will come out with..

Our next question comes from Keith Hughes with SunTrust..

My questions have been answered. Thank you..

Our next question comes from Luke Junk with Robert W. Baird..

Wondering if you could quantify or maybe just give some context to the percent increase in new salespeople relative to what it was maybe this time a year ago. I'm just wondering either for the specific roles that you mentioned in the press release or maybe just for the company overall..

The percentage increase in people, you said?.

Yes, or -- just trying to get an idea of, as you're making these investments in the business, kind of sizing the magnitude of the increase in selling energy that you have..

It's a double-digit increase..

Okay. And then to follow up on the commercial....

That will continue by the way, Keith. That will continue. Somebody asked me earlier whether that's it. No, it's not it. We're going to continue to make those kind of investments..

Okay, that's great.

And then to follow up on commercial trends, up high single digits, I think that was up 6% last quarter if I'm remembering, can you maybe just expand on that and touch on any areas of the business where you're seeing strength or maybe some traction in some of the newer product lines you've been investing in?.

Do we have that kind of information, Paul?.

No, we really -- most of what we do is in the replacement side of the business, so it's a lot of rooftop replacement jobs that we're getting into.

And I just think a lot of that is just a little bit of pent-up demand that people delayed their replacements with repairs over the last several years, and we're starting to just see some normal replacement business..

I mean, what I would say -- what I would add is that we've seen consistency. That's the best where we've seen in the commercial market. It's been a consistent growth rate pretty much all year. Pricing margin is up. And I think we've done a good job with commercial. And for refrigeration to tack onto that, adds to the confidence of it.

So my point of view, it's been a good consistent business this year..

Our next question comes from David Mandell with William Blair & Company..

Within the international side, can you discuss kind of the trends you're seeing in the different regions?.

Go ahead, Paul..

Yes, it's -- we've seen a real strong Latin America this year. It's been great for us. And Canada, of course, with the currency weakening, has been a tough market. The market is -- the industry is down up there. But like we said in our announcement, we've seen some moderate share gains, which have been good..

And then with the people you're adding, how long does it take them to kind of ramp up to full productivity?.

Gosh, we want performance right away. We try to hire veterans..

Our next question comes from Steve Tusa with JPMorgan..

So you talked about the 15% premium for 14 SEER.

How does that compare to where we currently stand on 14 SEER and just what's your outlook for how that price comes down, if it does, over the course of the next year, the premium?.

I wish we could predict that, Steve, as far as what the price is going to -- that would be great..

It's a great question, Steve..

Well, what kind of indications are you seeing from your suppliers? I mean, is there anybody that's coming out with something initially that's looking more opportunistic than the other guys?.

No. [indiscernible] I don't know..

Okay. And as far as the industry is concerned, I mean, Carrier came out with a pretty big inventory number.

What do you think is going to kind of be the magnitude of the prebuild?.

We would have no idea. I mean, that would be something you'd have to ask the OEMs, Steve. That's -- we're the buyer, not the builder..

Right, understood.

As far as you're looking to next year, is there anything at present that would -- whether it's trends in construction or consumer behavior that would lead you to believe that next year should be anything but kind of a trend line year in resi HVAC?.

The only thing [indiscernible]..

Well, we're in the aftermarket business [indiscernible] is that we're optimistic..

What's that?.

I mean, the reason we're optimistic is because we're an aftermarket business. And whether construction goes up or down, it doesn't have a big impact on us. It adds a little bit when it's up, but it doesn't take much away when it's down.

And there's, what, 85 million, 89 million homes that use central air conditioning in the United States, and they have a limited life. And there will be demand for replacements, and that's our sweet spot. And yes, [indiscernible]....

More sales win and more market share..

This is our market. This is the one that we focus on. We're not focused on anything else..

Right. And then one last question for you, just your replacement compressor sales through your distribution.

What did those do in the quarter?.

I don't have them. We can get that for you if we have that..

We have a follow-up question from Josh Pokrzywinski with Buckingham Research..

Paul, if I can tap into your memory bank a little bit here and just go back to the 10 to 13 SEER transition.

On any kind of prebuy, prebuild, what was the pricing dynamic on the outgoing equipment? So what did 10 SEER pricing do through the year? And how would you guys think kind of the status quo on 13 SEER equipment pricing should be in the next year? Is it kind of up, down, flat versus other slices of the equipment market?.

Well, what happened on the 10 SEER was we actually saw a little bit of an uptick, as you remember, on the 10 SEER pricing during the transition as we narrowed the gap between a 10 and a 13 because it was such a big spread between them.

And going back to what we've heard for a question already, what sort of compression is there going to be on 14 SEER and what impact is that going to have on our 13 SEER, I don't have a feel yet for how that's going to play out.

Is there a big enough spread going from 13 to 14 SEER that we would actually see a little lift on 13 SEER product? I don't know..

Got you. But the bias would be that as 13 SEER becomes more scarce that there's a little bit more of a pricing umbrella there. And maybe that could help offset a little bit of a compression in 14 SEER. Just big picture, not knowing numbers..

I don't know. I can't speculate on that..

Well, something I would add just to this discussion, so we're not forgetting about it, is the 16 SEER product and above is part of that category that has been growing double digits now for several quarters. It's not -- the whole world doesn't just revolve around 13 to 14 SEER.

There's 16 SEER and above product groups that have been growing very nicely. And there's no reason to think that good, better, best philosophy that's in place today continues to expand as well..

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

Well, as always, we thank those of you that are interested in our company. We appreciate it. And we look forward to reporting again in the next 3 months. Goodbye for now..

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