Albert Nahmad - Chairman and CEO Aaron Nahmad - President Paul Johnston - Executive Vice President Barry Logan - Senior Vice President.

Will Steinwart - Stephens Inc Jeff Hammond - KeyBanc Ryan Merkel - William Blair David Manthey - Baird Chris Dankert - Longbow Research Robert McCarthy - Stifel Robert Barry - Susquehanna.

Good morning and welcome to the Watsco Second Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Albert Nahmad, Chairman and CEO. Please go ahead..

Good morning from hot and steamy Miami and welcome to our second quarter conference call. This is Al Nahmad, Chairman and CEO, and with me is A.J. Nahmad, President; Paul Johnston, Executive Vice President; and Barry Logan, Senior Vice President.

As I always do let me start with the 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. Watsco achieved record second quarter results.

This includes record sales, profits, earnings per share and expanded operating margins. Importantly, these results were achieved while we continue to make significant investments in our business. Sales growth was driven by strong demand for residential replacement equipment with comparable strength of commercial markets.

Operating efficiency was achieved even though we added over 150 new customer-facing employees over the last year. The additions were made to increase sales and service capacity in certain markets and they contributed to second quarter results.

We're also very pleased with the recent purchase of 35% of Russell Sigler that was completed in June of this year. Sigler is the market leader in the Western US with annual sales of approximately $650 million. It is a wonderful family business with an incredible history and run by a great team of leaders and employees.

Watsco will include its share of the Sigler earnings beginning in the third quarter. In addition, we have the exclusive rights to purchase shares if and when any current Sigler owner wishes to sell shares in the future. Adoption of our technology continues. More customers are using our apps and e-commerce to gain speed and efficiency.

More SKUs have been digitally mastered and added to our product information database, which is now over 600,000 SKUs - that's 600,000 SKUs. Given our progress to-date, we believe our e-commerce sales could reach a $1 billion this year. Inventory churns have improved due to supply chain initiatives with more progress expected to come.

More of our locations have implemented our order fulfillment technology to complete and ship orders quicker and save customers' time. More employees are using our data analytics to gain insight into our operations. All said and done, our cultural chain continues. Our technology has been continues [ph] at approximately $23 million.

As we execute our long-term strategy to help our customers and make our network more efficient. Now on to our results, for the quarter, sales increased 5% to record $1.28 billion. HVAC equipment sales increased 7%, including an 8% growth in United States. Other HVAC products increased by 2% and commercial refrigeration products increased 3%.

During the quarter, earnings per share increased 14% to a record $2.07. Operating income grew 10% to a record $129 million. Operating margins expanded 40 basis points to 10.1%. Gross margins improved 30 basis points. And SG&A as a percentage of sales increased - I'm sorry decreased 10%. Let me say that again.

SG&A as a percentage of sales decreased 10 basis points. Now for the first half, sales increased 4% to a record $2.15 billion. HVAC equipment increased 5%. Other HVAC products grew 1% and commercial refrigeration products increased 4%.

For the first half, EPS or earnings per share increased over - increased 10% to a record $2.80 and operating income increased 6% to a record $178 million. Operating margins expanded 20 basis points to 8.3%. Gross margins improved 20 basis points and SG&A as a percentage of sales was flat.

Moving on recently we raised our annual dividend by 19% to $5 per share. Our balance sheet remains conservative with a debt-to-EBITDA ration of just over 1x. As always the second half of the year will be a strong period for cash flow and we believe operating cash flow will exceed net income for 2017.

With that A.J., Paul, Barry and I will be happy to answer questions..

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Matt Duncan of Stephens Inc. Please go ahead..

Good morning, Matt..

Hey, good morning, guys. This is actually Will on the call for Matt. Al, I wanted to start with - with the monthly sales growth progression through the quarter. You noted 1Q that April was trending up in the double digit, but like you said it's relatively small contributor to the 2Q.

So trying to get a better idea of what might have driven the late quarter slowdown?.

I hear a late quarter slowdown..

Well, you had mentioned that April was up in the double digits and [Indiscernible] and you had mentioned -.

No. It's been a very strong quarter for us, best we've ever had. So, I wouldn't call anything a slowdown..

There were no differences in trends from - from May or June, just maybe a different than comparison from the prior year?.

We don't get into that sort of thing. We just had a great quarter..

Right..

And it's a best ever, made more money than ever before in 40-some years that I had been here. Great quarter..

Okay, Al, can you talk a little bit more about the Russell Sigler business?.

Gee, yes, that's I'm so happy about that. It's such a great company. And they have such great culture. And we think that over time we're supporting the technology when they ask for it and that we just can add capital if they need it. And just - just so positive about it. It's a big deal.

And I said earlier in the last conference call that we're looking to invest money and this is just by far the most exciting one we've done to suffice [ph] those comments..

Great. Thanks guys..

The next question comes from Jeff Hammond of KeyBanc Capital Markets..

Hello, Jeff..

Hey, good morning. Hey, so, Al certainly very good 2Q.

How are you thinking about guidance, is that kind of the third quarter event or is that something you want to kind of layout at this point?.

As you said, it will be a third quarter event, but we do think Jeff that it will be a record year in every respect..

Okay and then just - just on a relative basis, it looks like your equip more is up 7, I think you know -.

8 domestically, yeah..

Okay, 8 domestically and then Carrier is kind of saying a 11% for the quarter. Lennox was 14%. I think the orders from Carrier were in the mid-teens.

Can you just talk about maybe what the discrepancy might be on your equipment business versus some of these other guys?.

Sure, let's turn to Paul, Jeff..

Yeah.

Hey, Jeff, how are you this morning?.

Great, thanks..

Yeah, you know obviously there is always a difference between what OEMs report and what we report. Ours is purely movement, not shipment or backlog. So that's - that's one issue that is unusual about it. As it pertains to Lennox, you know we've got a different geographical footprint than they do. We tend to be much stronger in the Sun Belt.

They have other regions like the Northeast and the Midwest where they have strength. They also have a different mix than a lot of the other manufacturers.

We tend to be pretty strong on the replacement market and somewhat later, much later on the residential new construction, so kind of an apples and oranges type look if you are trying to compare us to them..

Okay. And then final question I guess while the discussion about Amazon and their impact on distribution and - can you just talk about where you see Amazon showing up in non-equipment where you think there is risk or not risk on their equipment side maybe just a thought on how you think about the Amazon perhaps thanks..

Well, I'm going to ask Paul and others to comment. But I can tell you that we do think that they are forced. It can't be a very same thing you like it. However we also think we are forced in the size of our intensity of our branch network and our technology that's supporting the contractor which I think is unparalleled, there is no one else.

It has anything near that. So, we keep our eyes on Amazon and we also have our own e-commerce business, which as I say is going to reach we think $1 billion and it's going to go well beyond that. But I respect them and we think that we constantly keep our eye on whatever threats come and also whatever opportunities come.

But right now we're not too concerned because of our enormous database, 600,000 SKUs it takes years to prepare which is important because our contractors when they go to our apps can find out many things that they need to know to die no equipment that has been that needs maintenance or needs to be replaced.

So we have a lot of edge in terms of technology and a lot of edge because of our density in branches and convenience in the replacement market that's a big thing, probably the most important thing.

Paul, you want to add to that or AJ, you want to add to that?.

Yeah..

Yeah, sure, I mean I think you spoke to what we are doing and what we are creating in terms of technology modes that provides [Indiscernible] against Amazon or any others threat really and then the industry has some natural modes as well. I mean this is not a DIY product, it's a technical sale that requires technical support.

Our customers rely on our staff in the field to answer a lot of questions. We process hundreds of thousands of warranties every year. It's a giant product in terms of - it's just a sheer size of the unit so. There are some natural modes that are some defense mechanisms.

And then like you mentioned we are - we are doing a lot on the technology side to increase convenience in not only the 600 or so stores we have but then help customers find the product they need and get that product ordered, get in and out of our stores quickly and get back to the customer who –.

And lastly the contractor doesn't necessarily know what he needs to buy until he shows up at your house that morning. So to have the density of our footprint and to have the tools to get that product quickly that's a major asset..

We have brands, global brands that mean Carrier is the inventor of air conditioning, that's our brand forever wherever we operate. Then we have Rheem that's our brand. We have Goodman. So this is a brand conscious industry and those are ours..

I think - this is Paul. I think AJ - I think AJ really put it well at the end there when he talked about you don't know what it takes to replace or repair a unit until you actually see the unit in the field.

And that's a pretty unusual application for someone just to assume that they can do it all on e-com and have the unit delivered there so big point..

Was there a follow-up Mr.

Hammond?.

All set. Thanks guys..

Thank you. The next question comes from Paul Dircks of William Blair. Please go ahead..

Good morning, Paul..

Hey, this is actually Ryan Merkel on. Hey guys..

Ryan, good morning..

Good morning.

So first question for me, it was nice to see the gross margin be, you mentioned improved selling margins, but was this really driven by price and equipment mix to higher steer?.

Barry, you want to take that?.

Sure, good morning, Ryan. Well, first, on mix, there is very little difference in our margins relative to mix that would be something that will be more volatile for the OEMs, but as a distributor we tend to make the same mark-ups across our portfolio. So that's not the answer.

The answer is some inflation that always help our margin and some out of it is execution in the field to get - we have more profit dollars as we are selling more..

And then what about the mix shift to e-com minus doing what that was a little bit higher gross margin, is that happening?.

Those aren't something we would disclose..

Okay.

Maybe I will just ask about to lie just given a tough [ph] comparison now maybe if you can just comment on how things are trending so far?.

Why don't we just tell you about the quarter, Barry?.

Ryan, I mean our outlook for the quarter is again very satisfying. We see growth and see some consistency. It is early in the quarter to make a complete read, but so far so good..

Record year is what we expect..

Fair enough, okay. I tried. It's been that you are offering your technology M&A candidate as a motivator to get them to sell their business or perhaps partner with you in a JV.

So, first, am I reading this correctly? And then secondly, how is it going?.

Yes, I think so Ryan, how is it going, well. I can't tell you all the reasons why the owners of Russell Sigler joined us, but I'm sure that this is one of them and we are in a marketplace searching for more partners to share our technology with either as an investor or as a merger. And I'm optimistic as hell about it..

Okay. Very good. Well, thank you so much..

You bet..

Your next question comes from David Manthey of Baird..

Good morning, David..

Yeah, hi, good morning, Al. To first start as it relates to Russell Sigler, when you look at the third quarter, you own 80% of the 35% or about 28% of it.

And I'm just wondering if you can give us an idea of the magnitude of contribution in the third quarter based on seasonality and that percentage and so forth? The second part of this question I guess is maybe if Ana or Barry, where in the P&L will that unconsolidated minority earnings reside?.

Yeah, I'll take the second part. It's a lot easier to answer the first part because we're new to this. But go ahead Barry or Ana either one. Ana is not on, so it would be Barry..

Well, first, Dave, the second part; yeah, there will be a line item that will be below EBIT, above interest expense that will show the income in Sigler. That's something we've worked with our accountants and - but that's the early read. It's a separate line item. It'll be as you said, 35% of their net income will be in that line item.

Down below there'll be a 20% allocation of those earnings to care as minority interest. And in terms of magnitude and the actual calculation and the family has asked us not to disclose profitability for their competitive reason. You can probably pick an average margin that's in your mind based on what you know about what's good for 25 years.

And impede something against the $650 million and seasonalize it very similar to what we have and come up with something..

Great. Okay. And then I know that Watsco is very decentralized, but are there any, what you call synergies relative to that acquisition or is it just a matter of making investments and trying to make that business more profitable. Just trying to understand how -.

Yeah that's a great question. We have always taken the attitude that if we're going to be a partner with someone, especially a minority partner, we're going to do what they ask us for. We're going to provide whatever assistance they ask us for. And we'll wait and see what they want.

Certainly can provide capital, certainly can provide technology, certainly can provide eventually equity and parent [ph] to motivate further leaders. So ours is a wait and see attitude. We're a minority partner, ready to help and we'll do that with anybody that we do similar transactions with.

We respect these great companies so much that it's not for us to tell them anything, it's for them to ask and evaluate what we have and then take what they want. It's the other way around..

I would add something to that that part of the success of Carrier Enterprise was sitting down with our partner every quarter and going through a strategic discussion about what's going on, how to help our partner, how to help our business and a very similar culture will - is going to be created whatsoever.

Let's sit down every 90 days, will have a board meeting, we'll go through the story, go through the performance and again use that forum to really orchestrate what opportunities there are and what opportunities they see that they need help with..

Great, thank you..

The next question comes from Chris Dankert of Longbow Research. Please go ahead..

Good morning..

Good morning guys. Thanks for taking my question.

I guess the first one, any commentary on pricing on the quarter? And have you seen those 3% to 6% increase that came through in the beginning of the year hold up?.

Barry or Paul?.

Yeah, pricing has held up throughout the year as I think we indicated in the first quarter call. And during the second quarter, we saw no deterioration at all from those prices. Price increases have held so far this year..

Good to hear. And then I guess maybe a second one quick more for A.J. Any update on the adoption of BI across the built force.

Can we expect that everyone on board to the system within the next 12 months or so?.

Yeah, I give them a big modest figuring is that..

Yeah, BI adoption in our business is pretty mature. It's the first major technology program that we started with five, six years ago. The tool is robust. Training and adoption is ongoing. The trick of the eye is that it's infinite opportunities to leverage this data and we keep adding data sets. The opportunity to lever these data, the data is infinite.

It can touch every part of the business. There is always new trends and patterns and anomalies that can be spotted, which create insights for not only sales people, but marketers and warehouse folks and you name it. So, it's an ever-evolving, ever rich opportunity to be a better company. So, it's going well..

Good. I guess because there is still that same kind of spread between salesman who are using it frequently and those who are forward to pick it up..

There is - I mean there is a noticeable performance improvement for those that use the technology, including BI. Our best performers are the ones that use them most frequently..

Yeah. And then I guess one last in here. I mean you mentioned the goal is a billion dollars to e-commerce platform exiting the tier I guess.

Any color on how much go to the app versus the other digital channels you guys offer?.

First, it's not the goal. A billion dollars is not the goal. That's the trend that we see right now. And the goal is well beyond that in the short, medium, and long-term. And as far as app versus online, that's not something that we have breakout..

Fair enough. Well, thanks again and congrats guys..

Thank you..

The next question comes from Robert McCarthy of Stifel. Please go ahead..

Good morning, Robert..

Good morning. Congratulations on a great quarter and best wishes for a record year..

Thanks again..

All right. Now that we've got that out of the way, I guess, the context around the billion dollars of sale in e-commerce, is there anything you can give us in terms of maybe staging what was the e-commerce business two or three years ago and how do we think about growth, just some context historically around it..

Go ahead, A.J..

I would say as far as the trend, there is roughly - it's not an exact number, but close to a 80% to 100% growth year-over-year for the last three years..

Got it. Okay..

And just about every metric regarding e-commerce..

Interesting. And then I guess obviously you've highlighted the spend you've been doing last 12 months has been pretty consistent. I mean given the strength we've seen and we're going to get to leverage in a second, but obviously you're getting leverage because you're adding salespeople and then you are getting growth on that.

Could we be seeing an opportunity for a step function higher in investment given the fact that you've had a pretty good return so far in terms of what you've been doing or are you comfortable with this level of spend as we go into '18, how do we think about it?.

A.J.?.

Yeah, I would say both. I mean we're comfortable with that level of spend. And then as there are more opportunities and we get comfortable with due diligence on different potential programs and projects to invest and we'll invest. We do see a return on these investments.

We turn off programs that are not showing a return or not getting the traction that we want or hope for. So, the answer is both. We're comfortable with the level of spend and we will invest more if and when we see great opportunities to do so, which there are a handful - there are a lot of things that we're not doing, right.

I mean we've only been at this for, like I said, five, six years and we talk about playing defense against doing too much. So, the universe of opportunities and technology is a very broad umbrella term. It's depot process and technologies being a better company using the latest and greatest and depot process and technologies. There's a lot yet to come.

And as far as what that means for our spend, that's PBB [ph]..

Then finally on the incremental margin, obviously a nice return to kind of the high-teens level, close to 20% and leverage on the SG&A line and obviously gross margin, how do we think about kind of refining that target over the next couple of years? Could we see consistently kind of a mid-teens incremental margin after this period of kind of spend and investment getting the return? And anything we should - Barry, anything we should be thinking about targeting there for incremetal margins going forward?.

Well, I think if we look at 28 years, Rob, I think 25.5 years has been in that 15% to 20% range like this quarter. So, the period of time where we are investing in technology interrupted that period of time for a good reason.

So, long-term going forward I think the variables that drive pretty consistent incremental margin in that 15%, 20% range should be in place and continue..

Thanks for your time..

The next question comes from Robert Barry of Susquehanna. Please go ahead..

Good morning, Robert..

Hey, guys. Good morning and my congrats to your - for the record quarter..

Thank you very much..

So, I think A.J. just mentioned you've been at the IT efforts for a few years now, five or six years. Investors are curious when you think you might be able to quantify a margin benefit to the corporation as IT gets deployed across the store base? You must already be seeing some impacts in a subset of stores where the efforts are more advanced..

A.J., you want to take that?.

Yeah. I mean so we have a number of programs going on, right. We talked about e-commerce and the apps. We talked about various supply chain technologies. We talked about BI. And because of our decentralized model some of these programs are more mature in one or several of subsidiaries than others.

And, for example, where we have - where we invested in supply chain technologies that help demand planning inventory optimization in one subsidiary first, that subsidiary is out in front and their inventory terms, which is a key metric in that program are improving at a faster rate and have improved more so than everybody else.

So, that's one example. In short I don't want to put an expiration date or a timing on these things. These are long-term initiatives. It's all about being bigger, better, faster and more profitable over the long-term and that's what these programs are intended to.

These are platforms for our business leaders to have bigger, better, more profitable businesses and that will play out over time..

Got you.

In the quarter, did weather help or hurt?.

All right, Barry or Paul, either one?.

Well, help or hurt, the answer is like probably..

So, Robert -.

No, it looks like it was cooler if you just look at the metrics..

Certainly, global warming will help our business..

Rob, I think we've answered this way for a long time. I mean 70%, 80% or more of our business is sun dealt. The sun comes out. It shines. The humidity and the volatility of the weather should not be really ever an excuse or ever a risk. It's something that can impact a week or a month, but shouldn't affect a year.

And I don't think anything peculiar this quarter..

Got you.

And then just a follow-up on some of the M&A commentary, I mean bottom line versus a year ago, six months ago, are you more or less or kind of neutral in terms of optimism around getting more M&A done?.

I'll answer that. This is Al Nahmad, more optimistic. We are out there. We think we have a lot to offer wonderful companies and we're up there and I'm optimistic. But I have to say that I'm going to keep the balance sheet conservative. I don't like leverage like some of our competitors are doing, because leverage can eventually bite you.

And our long-term strategy has always been a very strong balance sheet and we'll continue that policy, but we're still going to make as big an acquisition as we can find..

Got you. I mean how would you define that, like what's the threshold for where we had started to get concerned about the leverage..

I haven't put any math to it. I just don't like much debt..

Maybe, just lastly a more strategic question, as you look at the competitive landscape for the other equipment, parts and supplies type business in the portfolio, it seems like there's been stepped up competition there. Home Depot and Lowe is getting more into pursuing pro-growth.

Wolseley has been investing specifically in HVAC, just curious what your impression is of how the competitive landscape has been evolving in that part of your business..

Paul, Barry?.

Yeah. I really - I don't think from a retail perspective. It's really been nipping at our heels as far as the aftermarket is concerned. The entire after aftermarket business for parts is one that probably has a bigger impact on whether consumer attitudes as well as the consumer's ability to afford a replacement versus a repair.

So I think it's way too early to make any predictions as far as what some of the so called new competitors are going to do our aftermarket. To this date it really hasn't been bad..

Yeah, so kind of steady as it goes. Okay..

We obviously would react to anything..

Sorry, this is A.J., I'll add to that is that, my opinion is don't do a good enough job on parts and supplies and that's a big opportunity for us. Our leaders know that and they're more focused on - they're never on changing that paradigm and which will be a good thing for the company..

I think to emphasis right size of the business with the operating companies and given specific growth targets and modern treatment..

Alright, thank you..

[Operator Instructions] The next question comes from Steve Tusa of JP Morgan. Please go ahead..

Hello, Steve..

Hey, good morning guys. This is actually Pat [indiscernible] for Steve Tusa. Lot's already been covered here, just had a quick question on the sales growth, the 7% growth in track equipment in the quarter. Just curious to ask you, what you saw as it relates to growth by OEM and/or kind of regionally.

Carrier reported this morning 11% growth in their track and I know they make up a large portion of your sales.

I was just trying to understand what is the truth there? While acknowledging, obviously the 7% is good number, just kind of trying to hear?.

No, I understand that, but don't forget the Carrier is shipping to the distributors, whereas we're shipping to the contract which ends up somebody's home or business. And so there is a time lag there.

Barry, perhaps you can give him a more complete answer?.

Yeah, we're not going to give specific OEM data to you in terms of growth rates and as far as regional data, like I said earlier. We're much more proportionately large and significant in the Sun Belt of the US. The wall story [ph] of whether it can cause north of the Sun Belt can cause some of these swings. I don't know what their numbers are.

I know what ours are and we're seeing pretty good growth, pretty consistent growth across all of our Sun Belt market and as importantly within our residential and our commercial business where growth rates were very similar. So we've liked the consistency of that..

That makes sense. Thanks a lot. Nice quarter..

Thank you..

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

Thanks for listening and thanks for following our company. We appreciate it and look forward to talking to you in the next quarter. Bye..

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