Watsco: Air Apparent - [Business Breakdowns, EP.209]
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This is Matt Russell, and today we are breaking down Watsco. They are the market leader in HVAC distribution with a unique value proposition that they offer to the OEMs and suppliers in the space. And my guests today are Lucy Adams, Investment Director at Caledonia Investments, and Alan Moran, Co-Head of Public Companies at Caledonia Investments.

If you've ever had an air conditioning issue, you call your maintenance contractor, and then you have them sit there on the phone as they locate it apart. There's a decent chance it was a Watsco distributor on the other side of that phone call. So Lucy and Alan helped track the history of Watsco and some of the key steps, like the initial pivot from manufacturer to distributor, how Watsco formed those key relationships with the major OEMs like Carrier,

And then we dissect their reputation for a strong culture, one of those things that can be thrown out there as a term. But here you have an ownership mindset with what has to be one of the most unique employee compensation plans I have ever come across. So it's an incredibly fun conversation, another long duration business that has been around for a while and evolved over the years that are always worth studying. So please enjoy this breakdown of Watsco.

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 for 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 just some general description around 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. And so we're here to talk about Wattsco, North America's largest distributor of HVAC equipment. So that's heating, ventilation, air conditioning, and refrigeration. Wattsco acts as the crucial link between manufacturers who make the equipment and the contractors who install and maintain it.

Watsco were themselves manufacturers and they moved into distribution in 1989. And this was really a transformational moment for the company.

So back then their revenue was around $64 million and it's now $7.5 billion, which means they're part of the Fortune 500. And in 1989, the market cap was $22 million. Now it's around $20 billion. So that's a 20% annualized shareholder return that's consistent over 5, 10, 20, and 30 year periods. So it's really an amazing achievement and it makes Wattsco one of those long-term quality compounding businesses that we love to look for.

We've covered some other HVAC names, Trane being a manufacturer. You mentioned they're a distributor. They act as this link. Can you get into a bit more about what that entails to be a distributor? So they primarily sell HVAC equipment. So think air conditioning units, heat pumps, gas and electric furnaces. And they also sell the parts and supplies that are needed to service these systems and

And they sell exclusively to contractors. So those who are licensed to install and maintain these systems in both residential and commercial buildings. So as Alan said, acting as that middleman between those equipment manufacturers and then selling to this highly fragmented base of contractors.

And they operate through a network of distribution businesses and their local sales branches. And they cater to these contractors in a number of different ways. So first, it's about stocking that wide range of equipment and parts. I think multiple brands, multiple price points, and they are readily available across their large network of 700 or so sales branches.

But they also provide technical expertise to these contractors. They rely on the Wattsco sales team to help them with the right product selection or to help them check and process warranties or even just to get quick access to product information. And then finally, they offer this suite of

this suite of other value-added services. And by that, I mean things like training programs. So they're keeping this contractor base up to date with the latest product knowledge. And they also have a range of digital tools. And that's anything from access to a searchable product database, or it's the mobile ordering app or their e-commerce platform. It even goes as far as customer-facing tools for the contractors themselves. So

tools that help contractors grow their own businesses. So if you bring all these things together, this is what makes Watsco a valuable partner to these contractors and not just the supplier. To paint the real world picture,

I can remember distinctly having an issue with my heating system this past year, called somebody for maintenance. They checked it out. It's some very old system that needed a very specific part. They were calling around for it. And I'm imagining that is where a Wattsco distributor comes into play. But one, can you tell me if that is the correct example? And then two, just in general, would you say that

The just in time, I need this at the moment 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 and more?

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

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

And so it's at this point that the contractor would then go to their local Wattsco store to search for and buy that part that is needed to fix the problem. But it's also at this point, the point of sale, that the contractor might draw on the technical expertise of a Wattsco salesperson.

So you use the example helping to find a compatible part for an older system. So once they have both that knowledge and the part, they then return to the home to complete that repair.

And I think what's interesting here is that it's that contractor making a recommendation to the homeowner on what they should do. And that's what puts the contractor at the center of this industry. And it's why Watsco are laser focused on the contractor. They put them at the center of their universe. And so they are focused.

focused on improving that contractor's experience. So, for example, thinking about ways that they can make their life easier, helping them to be more efficient, more productive, so that the contractors can grow their businesses. Because fundamentally, the success of the contractors is what drives what's goes great.

Can you give a sense just in terms of the market competition, where Rotsco ranks in terms of whether it's market share or any other numbers that you could just put around the business? This North American HVAC distribution market is valued at around $64 billion today.

And that is primarily served by over 2,000 distributors. So it's highly fragmented and primarily served by many local and regional players. Watsco, they are the largest national distributor. They have 11% to 12% market share. And they're actually more than two times the size of its next largest competitor.

After the top three or four players, the size of the competition drops away quite quickly to these smaller local players. But if I was to think of a key differentiator between Watsco and its largest competitors, it's that Watsco are exclusively focused on the HVAC market, whereas the number two, number three players, they're actually more diversified across HVAC, plumbing, and

and other industrial end markets. So they have that slight competitive edge in being able to focus on that narrower adjustable market. I love markets like this where you do have a lot of fragmentation. You do 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 tapped into it at the very beginning in terms of...

late 80s launch year. What have been some of the evolutions of this business? How did it evolve into what it is today and whether there were key players involved or anything else along those lines? It's a 50-year journey of entrepreneurship and evolution that was driven by Whatscos founder and CEO Albert Namad and now carried forward by his son, AJ.

Al's background is a true entrepreneurial story. So he was born in Panama and then he got a scholarship to go study in the States. And after graduating, he got a job in consulting and then moved into mergers and acquisitions. And it was here that he really learned this lesson that continues to impact what's ghost culture today. And that's the power of decentralization.

So the conglomerate where Al worked, it is more of a command and control approach that he felt stifled innovation and eroded value. And so he wanted to do it differently. So he left and went to look for a business to buy. And after about a year of looking, he found this company called Wagner Tools and Supply Corporation, whose initials form Watsco. And they were a manufacturer in the HVAC industry. So Al, with some financial help from 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 What's Go for about eight 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 and understanding of the benefits of technology. Now, I would think about What's Go's history in a series of chapters, and I probably call out two of them.

So 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. So it goes that one day, effectively, Al received a prospectus from his bank and

And this was giving him the opportunity to buy one of his customers, a company called Gemair, who were a distributor for the manufacturer Rheem. What's Go entered an auction and bought the company. Interestingly, actually, they've done over 70 deals since and have not entered another auction. And Al structured this original transaction as a joint venture.

And the reason was he wanted to align the incentives between Watsco and the manufacturer and share the risk with them. And this thoughtfulness on incentives is something that we continuously see across many areas of Watsco, in fact. They also use 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 Reem's distributors. And as that became more difficult and that slowed, they knew that they needed to go out and form relationships with key leaders at other manufacturers. During the 1990s, we saw the shift from single brand to multi-brand distribution.

And that was an important strategic move for Watts Co. 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 three years in the 1990s, I think 1995 through to 1997, where we saw them complete, I think, over 20 deals as they partnered with other manufacturers.

This meant that they were able to broaden a footprint, broaden their product offering and reduce their risk profile. And it's this buy and build strategy that's helped it to become the multi-brand business that it is today. You can think of Watsco as this aggregator of 10 or so major operating companies that

And then each one of these operating companies or subsidiaries, they have an exclusive relationship with one of the leading domestic manufacturers to sell their products in specific regions in the U.S.,

There's interesting similarities to another name that we covered with Heiko 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 where I can understand how

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 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. So if we go back to when I mentioned the service element that Wattsco offers above distributing equipment and parts,

These services not only help to grow Wattsco's business, but they're also beneficial for the manufacturers to improving customer satisfaction and creating brand loyalty. That's things like customer support, the aftermarket sales support, such as the warranties and training programs.

even providing that 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 Lucy's just described, so 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 Watsco's 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 U.S. And 90% of its sales come from the U.S., with the remainder split equally between Canada and Latin America.

And then if we move on to the products that it sells, so it groups these into three categories. Equipment generates 70% of sales, parts and supplies around 25%. And then the balancing 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. And within that core residential markets, 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 What's Go's total sales prior to the global financial crisis. But obviously, as the installed base of HVAC units has increased, and then also What's Go'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's 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 a little bit, but 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 and expansion of the business?

we would expect organic revenues to grow at around 5%. And let's break that down between volume and then price. So if we start with volume, we have industry unit volumes growing at around 3% to 4%. And therefore, we'd expect both equipment and parts to grow in line with that. Now, Watsco actually tend to grow a little bit more. And that's really a combination of market share gains and the fact that

that 60% of their network are actually in these faster growing Sunbelt states. If we then turn to price and mix, we think that adds sort of a further 2% to 3% of growth each year. And that's primarily driven by two things. So first, we have the typical annual price increases by the manufacturers. So they typically realize below single digit growth rate each year.

And then we have a regulatory driven mix impact. So every 10 years or so. And so we smooth that out over time. So 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 year, M&A being a key one. And that's opportunistic. If

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 take any forecasting or view on that. How much does that play a role, whether it's new joint ventures, acquiring more distributors? Is that a key piece of the DNA? And 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 that Watsco does buy. These are family-run distributors, and they can be up to third 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. And that's not just talk. It's backed by decentralized philosophy with the companies retaining their brands and their teams. And then they benefit from Watsco's expertise, their capital and their technology. Broadly, there's three components to Watsco's M&A philosophy.

One would really be about cultural alignment. The second one is about the fact 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.

And 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.

And this philosophy actually ties back to the family ownership that wants a company to endure and succeed over the long run. And when you look at 15 plus years of transcripts, you can see this philosophy consistently articulated by the entire management team. And what's also interesting, you touched on a little bit is what is the growth potential for a company underneath the What's Go umbrella? And what's interesting here is they did a deal with a distributor called Russell Sigler.

Here they bought a 35% stake in the business back in 2017.

And if you look at the accounts today, you can see this value of the stake as it's based on a fixed multiple of operating profit. Therefore, you can calculate that the operating profit has grown over 400% since they did that deal. That's a really great example of the potential benefit of these acquisitions to investors. And this is really due to both hard work at the subsidiary, but also Whatscore's expertise, their relationships, capital and technology.

And these technology improvements have been and continue to be an additional catalyst for deals. Since 2017, they've done over nine deals, adding over $1.2 billion of revenue. They have the balance sheet in place and the appetite to do more deals. And as I say, it's really about whether the opportunities arrive, which are driven by what's happening with the families, but also what the technological improvements at Wattsco are adding.

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

Nice that you get to see the stake and you can 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 than 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 and the potential for that to happen again in the future and how key it is to the business?

So it's an interesting opportunity with Carrier. But in terms of the future opportunities with Carrier, out of those nine deals, on a number of them, Carrier continued to partner with Watsco. When they looked to do the acquisition, they often folded into the joint venture structure where Watsco owns 80% of the acquired company and Carrier own 20%. So they continue to partner on that. And Carrier continued to remain Watsco's largest supplier, representing 65% of their purchases.

Might be good to just get into the history of that transaction, as you mentioned. It is a very interesting deal. The history of Carrier in itself is as well. So this history starts 120 years ago. And the story is that there was effectively this printing plant in Brooklyn. And 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.

And he invented this system that used chilled coils to cool and dehumidify the air. That was the start of the modern air conditioning industry. And so Willis went on to found Carrier, which today, as you know, is one of the largest manufacturers in the HVAC space. And then throughout the 1990s and 2000s, what

Watsco wanted to manage more of Carrier's distribution. In 2009, they did this original joint venture with Carrier that effectively nearly doubled Watsco's revenue at the time, so adding about a billion dollars. So really a transformational deal.

And Watsco financed this with equity. And this was similar to the deal with Gemair 20 years ago. This was to align Carrier to this joint venture and to the ultimate success of Watsco too. And 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 about 2%, so a third of Watsco's at the time. And those have now grown sixfold. So true win-win for both parties.

And so the next step of this collaboration, they did agree to do additional joint ventures for additional regions in 2011 and 2012. And as I mentioned, they now do 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. On their acquisitions, given the multi-brand approach, they are able to acquire distributors that have different manufacturers effectively.

You outlined the carry margin improvement over the course of their joint venture. For Watsco, what does the margin profile of this business look like? And you can break that down however you like, whether it's unit economics or on a consolidated basis. So 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.

So equipment sales, so the majority of What's Co's revenues, they are actually lower gross margin compared to parts and supplies. And that's because systems are higher cost items and more competitively priced compared to parts and supplies, which are smaller ticket items and less price sensitive.

And actually, parts and suppliers have been a more recent focus for management over the last few years. And 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. And then in terms of the end markets served, Alan's already highlighted that residential sales are slightly higher gross margin than commercial.

So then if we turn to margins for the business as a whole, so gross margins are just under 27% today and management have clear ambitions to reach 30%. And really their confidence here is the fact that some of these businesses in certain markets are already operating at that level.

Now, gross margin expansion has really been driven by four things over the last few years. So firstly, it is greater purchasing power as they've scaled. Secondly, securing better commercial terms with the manufacturers. Thirdly, is that product mix that I've just mentioned. So parts versus equipment. And then finally, and more recently,

It's been pricing optimization. So as they've looked to incorporate technology into their operations and benefiting from data-driven pricing. And then on operating margins, these are just below 11%. And improvements here have really been driven by operating leverage as they've scaled. And then it's a case of broad-based productivity gains right across the supply chain,

logistics, warehousing. And then more recently, we've started to see that increased technology adoption by the contractors, which is starting to reduce what goes cost to serve. And we think there's further opportunity to grow operating margins across all of these areas. And perhaps I can give you a couple of examples. So in logistics,

They talked about the opportunity to optimize their fleet of trucks. So again, incorporating technology to better understand how they can move products around their network, around those 700 or so sales locations more efficiently.

Another example would be the fact 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 just in terms of where price increases come into play for the revenue side of things. But if we see manufacturers increasing the price of equipment

How does Wattsco treat that in terms of just a pure pass-through on a dollar-for-dollar basis? If it's a pure margin pass-through where they manage it to maintain the exact margin, do they have a specific methodology or strategy around that? So I think there are two drivers of pricing in the industry –

Number one is these normal annual price increases by the manufacturers. So they're typically raising list prices mid-single digits in January every year. The realization of those list prices is dependent on things like the manufacturing capacity, local demand, and then the competitive dynamics across the distributors and, of course, in the different markets.

But typically, Wattsco'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. So to make these units more efficient, more sustainable, they

And there's obviously a cost to the manufacturers of doing that. And they need to recoup those costs. And therefore, that results in high single digit, low double digit list price increases for these new systems. The realization of those list price increases in the market, that 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 reoccurring revenue stream. Does Watsco capture anything along those lines where there is some type of contractual nature to whatever they're doing? And 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? So 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.

So, 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. And so, Watsco's recurring revenues are really driven by a large and growing installed base of these HVAC systems. So, there are over 120 million units installed across the U.S. today.

And that base has never gone down. And actually, it's compounded at over 3% each year since 1980. And of course, all those units are going to break at some point. And if your system breaks and it's hot and it's humid outside, you're going to act. So it's a necessary product. And that necessity isn't going to change over time. And so there's not a lot of discretion in terms of demand in this industry.

So I guess the only real question actually is, how do you act? So do you choose to repair or replace your system? And 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 What's Go. Certainly adds visibility when you have some sense of equipment, it's useful life, and

and replacement on that side of things. Transitioning a little bit to the management of cash flows, balance sheet, inventory, I think of distributor, I think of a lot of inventory being able to serve the entire market. How does that impact the financials of the business, whether it's conversion of free cash flow, 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. Their top priority is to invest in the business and improve their strength over the longer term.

So whether that is looking to invest in working capital to make sure that that inventory is in the right places, it's readily available, that is a top priority. It's also investing in the sales force and, of course, these technology initiatives. But after these investments, the priority is returning cash to shareholders first.

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. And I think that's quite a remarkable achievement. The prioritization of dividends is actually not as common in the U.S.,

We often see cash being diverted more towards share buybacks. At Wattsco, 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 here just the special dividend distribution that they did back in 2012.

Because I think it really shows their thoughtfulness around capital allocation and maximizing shareholder returns. So this is when they paid the equivalent of two years of dividends ahead of an adverse change in tax rates on dividend income. The final point on capital allocation is leverage.

the robust balance sheet that they run. And Alan touched on this when he talked about the transactions that they've completed. So they really have this strong aversion to running too much debt. It really is cultural.

And as they'll say, they will not bet the ranch. And 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 and a transaction that doubled the size of the company. The inventory turns has always been a focus on what's going to be 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 to manage inventory. This technology allowed them to maintain their turns rather than that actually worsening 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 productivity of contractors. You can understand why that might show up in the margins. In my mind, I'm picturing a contractor no longer needs to get on the phone and spend 35 minutes figuring out where a part is. They might have access to a 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 this time operated really in an analog way. Imagine all the product information was paper-based. There was no e-commerce. So you can picture the contractors who turned up at the branches in their trucks. They would wait in line. They would check to see if the product was available or they'd be filling in reams of paper to understand if it was under warranties.

So it was really this industry that was ripe to digitalize. And Whatscore have addressed this in three different core pillars. One would be their internal tools. The second would be the stuff they've developed for the contractors. And then third would be this customer-facing innovation. So this is to help the contractors sell to the homeowners.

So on the internal tool side, what's going to use this to improve their own operating excellence across things like demand forecasting, inventory management, and pricing? So basically, Matt, it's to use data and technology more to help their employees.

For example, digitalizing the order fulfillment in the warehouses. So this makes life easier for the warehousing staff and also makes them a lot more efficient. And then as an ancillary benefit, contractors will know when the orders are ready and they can arrange like an express pickup. And then another example would be this pricing optimization tools. And that is something that we've seen feed into gross margin. In fact, it's been one of the key contributors over the past couple of years. And in addition on the roll forward and improvements and the new target that they're thinking about.

On the tools for contractors, this is really to make life easier for the contractor, make them more productive and grow faster. And one important key platform here that we've seen grow is e-commerce. So this accelerated around 10 years ago, hitting about a quarter of sales in 2017, and is now closer to 35%. Some of the benefits that you see here in the numbers is that number one, in What's Go's traditional business, they have about a 10% customer attrition.

but it's half for users of e-commerce. And then secondly, Watsco tend to sell 20 to 25% more line items through the e-commerce platform. And on the last leg is this customer facing innovation. So as I mentioned, this is to help the contractors sell to the homeowners. This sits in part of Watsco called Watsco Ventures.

And this part of the business invests in startups as well as develops their own in-house software. And one success story here is something called On Call Air, which is a digital sales platform for the contractor. So imagine the old process where the contractor would come to your kitchen, would be scribbling on the notepad prices and flipping through the brochure.

And now it's a much more interactive process with it on an iPad. There's images, multiple options, and it's much more suited to what consumers would expect today. And then as an ancillary benefit, What's Go Ventures is attracting great young talent into this established industry. And you can picture it from an employee perspective, because if you join What's Go Ventures, you're working in this industry that's ripe to digitalize. You've got proper backing from the C-suite.

and significant financial resources. And as a consequence, these hires cause this ripple effect into 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's established probably around 10 years ago, I believe. And it's something that when they were looking to digitalize and they wanted to have this part of the business that was really helping more of the contractors, they created this area. And if they have the right skills and the right internal attributes, they will develop the in-house software. Otherwise, they'll partner or invest in startups. And it's quite an interesting, innovative way to try and 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, so typically three to five years. But at Wattsco, they cliff vest at retirement. So they vest all at once at age 62 or older.

So 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. Now, there are over 160 of the company's key leaders that get to participate in this plan. And 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.

And we've actually heard firsthand how motivational that is and the energy in the room that it creates and that alignment.

And 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 are setting themselves 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 Wattsco 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, 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 on the Class B shares in that different structure, was that something that was always in place or did that evolve over time? So it dates back to that period in the 1990s that we spoke about earlier.

So when the business was growing rapidly as it partnered with other manufacturers, did

and issuing additional shares to support that growth and acquisition strategy. And so the dual class structure was introduced really to allow the family to maintain control, whilst also allowing for broader investment through the common stock. And it's a move that is consistent with what other founder-led and family-controlled businesses have done. And it's really about balancing external capital needs with internal control.

It's nice when you have a nice 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 one of those things that has 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 Wattsco?

There's a couple of risks that we think about. So one would be increased private equity involvement in the space. It's more on the contractor side. It's there that 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 make more expensive for what's good to execute their M&A strategy.

In addition, you'd have the risk that there's some product disruption to the HVAC industry. So this would be where new technology replaces traditional air conditioning or changes the distribution model. That being said, Watts Square is pretty adaptable and it's quite hard, we think, to bypass licensed contractors in this space.

The contractor roll-ups by PE, they're getting their benefits from the consumer base to start and slinging me maintenance contracts for whatever it might be and tying in that recurring revenue. So we're easier targets or prey versus a business like Wattsco. So 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've picked up on? Watsco is the gold standard ownership culture and 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. So 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. And 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. And at their headquarters, they're 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. So supporting the 700 or so sales locations.

And it's their job to be helpful to the local leaders. And 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

and then correctly incentivize them through various equity programs. And I think what's really interesting is that across their 700 or so sales centers, not one of them has What's Go above the door.

And so 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 whether it's 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. And Buffett has spoken about the power of decentralization. And when it's done correctly, the people that are working in these decentralized businesses, they find it almost identical to running their own show. And I think that's exactly what we have here at Watsco.

We always close these conversations out capturing the lessons. I think Wattsco is a business that is studied and we've got into a lot of reasons why throughout this conversation. But what stands out the most to you in terms of lessons from Wattsco 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 AJ as Watsco's president's involvement

his passion and his direct ownership of it. So one lesson that we do take away is that when leadership is properly engaged in all over this digital transformation, then it's much more likely to be a game changer. Now, the second lesson is the power of combining standalone indicators of a quality business.

And that is effectively moving beyond a simple checklist and really thinking how these attributes interact to create sustained competitive advantage. So that's where traits such as family ownership or long-term thinking, which are often associated with successful businesses. 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

Or is long-term thinking reflected in incentives for staff or the strength of the balance sheet? And so in Watsco's case, they and the industry's unique characteristics work together and 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, a very fascinating business. 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. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joincolossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S dot com.