Yahoo Finance

Question and Answer Session

Operator

(Operator Instructions) Stephen Volkmann, Jefferies.

Stephen Volkmann

Maybe I'll dive in on the residential side. I think you said plus 10%. Can you give us a sense of what you're seeing? How much of that was kind of R-454B versus 410A and how the pricing kind of layered into that?

Albert Nahmad

Paul?

Paul Johnston

Most of what we saw in the first quarter was 410A. We only had about 20%, 25% of it that came out as 454. So when you look at the residential, what we're talking about being up over 10% is the replacement market, not the new construction. And so the bulk of that in the first quarter was 410A.
Early in the second quarter, we're starting to see the transition over to the A2L product. And hopefully, that will continue as the summer goes on because we're going to be out of 410 probably by the end of the quarter.

Stephen Volkmann

Okay. Great. And then maybe just following up, we've seen a fair amount of that's come through from a variety of suppliers across the industry. And traditionally, that drives your gross margin a little bit higher, at least in the near term. Is there any reason to think we shouldn't that happening as the year progresses?

Paul Johnston

I think after April -- April is when we had the two big price increases from the OEMs. So that's really what's going to be. That could be an impact, obviously, in our gross margin. But in the first quarter, we were fairly clean as far as price increases.
Most of the improvement in the gross margin really was related to the segment mix that we had, moving more towards add-on replacement less towards commercial, less towards residential new construction.

Operator

David Manthey, Baird.

David Manthey

So as it relates to the top line, it seems international was weak but really not big enough to move the needle and what Paul just said about the mix. And that, along with other HVAC products being somewhat weak parts and supplies, I understand.
But should we read into this that residential new construction, even though it's less significant for you guys was substantially softer year-to-year? And are you holding share there, do you think?

Barry Logan

Let's give some insight to it. Well, first, we don't really do the algebra for you, but there is one less sales day in the quarter. So that has actually a bigger impact than the new construction does, by the way. In terms of algebra, but the new construction element of it is also a choice being made by the contractors that do work for builders in the quarter to use 410A or wait to use 454B upon availability.
So there is some disparity in how a market like that this time of year operates in terms of this transition. The other reality, Dave, as you know, is we're a 40% larger business in the second quarter. So new housing, which is relatively equal in sour quarters, has a bigger impact in this small quarter and should have less of an impact over time. And I think also, there's some backlog that's built that will consume 434B and as time goes on.

Paul Johnston

Yeah, I don't think we've lost any share in the new construction market. I think we're still -- where we do it, we do it well. And I think it had more of an impact on the supply side than it did on the equipment side.

David Manthey

Yeah, that's good to hear. So impressing on gross margin a little bit here, too, as you think about the transition of refrigerant and along with the kind of the mix driven by seasonality and so forth, and then you've got these, what I assume are apples-to-apples kind of tariff-driven and general price increases we're seeing, as you pointed out, in April, Paul.
As we think about the normal cadence of gross margin from first quarter through the year, should just directionally and bigger than a bread box detail, can you tell us, do you think it will be less of a degradation as we move forward because of those positive factors that are rolling in here?

Paul Johnston

Well, that's a lot of questions. I would -- I wish I could see that far out in the future, but --?

Albert Nahmad

Let me give you an aspirational goal that we've stated before. Watsco is working to achieve its goal of 30% gross profit margin. That's where we think we're headed. I don't know when we're going to get there that we're working to achieve that. And we have several different ideas on how to get there.
Now do we have short-term changes to that? Yes, but that's our goal, and we aspire to it.

Operator

Jeff Sprague, Vertical Research.

Jeff Sprague

Interesting times, no doubt, I hope everybody is doing well. Just wanted to kind of think about sort of the cadence of what the OEMs are doing on the price side. I think you said you're collaborating closely with them.
Just got off call with a key player. They said price has gone up twice here just in the last several weeks or so. Maybe just give some view on how this collaboration is working, how the lags of getting price through into the channel, and whether you are seeing any kind of negative demand response and given the magnitude of price that's coming through the pipeline.

Paul Johnston

No, I don't think we're seeing any real pushback yet from the customers. It's such a newsworthy subject to tariffs that I think most contractors and consumers are assuming that there's going to be higher prices.
How much of that price has been related to the consumer, we really don't have visibility to that. The OEMs have been very prudent as far as getting the price increases out. We have the technology to go ahead and implement the price increases instantaneously. So it really hasn't been that much of an issue to date. We'll have to wait and see what happens in Q2 and Q3. As far as how long these price increases stay and what the impact has on the consumer.

Jeff Sprague

Is there a mechanism in place? Or should we expect if the tariff pressure changes that this will feed back into the market as some relief on price? How much of the price is surcharge, which is visible and could go away versus what might be in the base and what you might be able to maintain even if there is some tariff relief?

Paul Johnston

Yeah. There's outside of one manufacturer, I think every pricing action by every manufacturer right now is a price increase. It's not a surcharge.

Operator

Tommy Moll, Stephens.

Tommy Moll

In the earnings release, and I think as Paul just mentioned, you talked about being able to leverage the technology to quickly, if not instantaneously implement some of these price increases? But I want to unpack what other levers you have with the technology because, as you've discussed before, it's not just one standard increase across your entire customer base, you have to be a lot more nimble.
So in this environment of OEM price increases, what additional capabilities do you have through the technology to really customize if not [profitize] some of that at the branch level?

Albert Nahmad

A.J., do you want to share that?

Aaron Nahmad

Yeah. I'll take that one. And my instinct to that answer is I don't mean this to be flipped, but it's infinite because the technology we put in place, what it does is provide visibility and tooling for world-class analysts to see opportunities across all of our business units and collectively as an enterprise.
So just for an example, and this is an environment where there are raising prices, which, by the way, there are and there will be from not just our major equipment manufacturers but from the thousand parts and suppliers, manufacturers that we buy products from.
And just to give you a sense of the scale, it's 1,000 parts -- excuse me, 1,000 manufacturers of products, we sell products to 100,000 contractors. And it's not too hyperbolic to say that we have a different price for every product, for every customer, almost.
And so the tooling enables that sort of intricacies and being dynamic and seeing where there are opportunities to raise prices to a market level that you see customers of a particular segment or size buying at, which perhaps it needs to be adjusted for others or the other way around. Perhaps we're out of market with the price, and we need to get in line and so that we can effectuate more sales.
Just -- I mean, again, as a small example, say we sell products A, B, C in one market, take Miami. We probably saw it in 20 locations here to several thousand customers at several thousand prices. And if you put that on a histogram, the spread is too big, right? So if we can put a floor and a ceiling and do some intricate analytics, we can affect margin impacts as well.

Tommy Moll

Thank you, A.J. As a follow-up, I wanted to ask for a little more detail on the early selling season trends. Al, you mentioned that there's been some improvement. And so while we're all here live, I wanted to just give the opportunity to give any quantification there or additional insight into what you were referencing there?

Albert Nahmad

Barry, do you want to deal with that?

Barry Logan

Sure. Again, I'll focus on domestic. We've said that international is still probably greater uncertainty. But if I address the domestic, 91% of our business, it's mid-single-digit growth, thus far in the quarter. And if I add a sentence to that, and margins are behaving well additionally.

Operator

Ryan Merkel, William Blair.

Ryan Merkel

I guess I'm going to follow up on that last question. I guess it sounds like we shouldn't extrapolate the weak first quarter to the rest of the year. Is that the right read here? You feel like the business has found better footing?

Albert Nahmad

Yes.

Ryan Merkel

Okay, that's a simple answer. And then can you just unpack, I think you mentioned the A2L transition was a negative in the quarter. What was the impact there? And what was that negative?

Albert Nahmad

Negative? No.

Ryan Merkel

Okay. So I misunderstood that.
Okay. So the one-third of the business that was weak, it was the international down 9? And then what else was in there that caused the weakness? Because again, the algebra is kind of difficult for some of us to figure out.

Barry Logan

Sure. I understand. Let's go through it. It's -- I think a lot of the numbers are there in the press release, Ryan, you have non-equipment going down for the quarter. It's about 30% of the business, right? Refrigeration as a small component. Nonetheless, it's part of what else is down, which is what your question is.
We have commercial products, which is down right around 10% for the quarter. That, too, has a heavy influence going on with the product transition and 410A versus 454B, and we think that levels out or at least has less disruption or less disparity going on as time goes on. The commercial product is a component of what else went down. International, we talked about.
And then there are other -- some other products that I would just -- or some other segments, I would categorize as large accounts, national accounts, where, again, the 410A versus 434B has some disruption in it. And that's short term, and we don't see that as a seasonal reality over time. And I mentioned the same day, one less selling day and this quarter is about almost 2% impact on sales?

Ryan Merkel

Okay. I got it. That's helpful. The commercial piece is, I thought that might be part of it.
Last question. The price/mix outlook, we've had some new price increases. Any chance you'd help us with what you're thinking there for the year?

Barry Logan

Well, I would say we tend to talk factual about what we see -- what we've experienced in the first quarter and not extrapolate that until we have more data and more time in the season, Ryan. But price was up about price and mix for what is our unitary business was up about 5% for the quarter.

Operator

Brett Linzey, Mizuho.

Brett Linzey

I wanted to come back to the A2L transition. One of your peers have noted some of the delays there, maybe a little bit more on the commercial side, but it was related to the learning curve. And I'm just curious, what's the industry readiness like on the transition from a technician standpoint? Are you seeing any bottlenecks? Is it driving some delays in residential? Any color would be great.

Paul Johnston

This is Paul. I don't see any real delays with the product. I mean, if you consider that 410A is -- basically 50% of 410A is 32. and the balance of it is a 125 combination, whereas when you get into the 454 and the 32 products that we sell, they just become 70% on the 454 becomes 32, and of course, 32 is 100%.
So we're really not seeing a bottleneck from the mechanics viewpoint. No. I just think it was a -- there is a price difference between an A2L product and a 410 product, and I think the contracts gravitated towards 410. That's just an opinion.

Barry Logan

I think, just editorialize that probably the right way is this is a quarter that, as we said seven times, thus far, the smallest time of year, but also had a lot going on with whether 410A was in the channel or not. If you own a lot of 410A and you leaned into it, you have some short-term benefit this quarter, you have long-term risk of obsolescence.
It should be obvious by our balance sheet at year-end. We did not lean in to 410A. We did not choose short-term consequences with longer-term risk. We wanted to move to the 454B. We have the pricing, the margins, the activity with replacement is a good indicator of that decision.
Maybe some of the large giant customers that wanted to chisel into 410A and get some short-term wins. That's a transient business that is short term.

Brett Linzey

And then just a follow-up on the second quarter, I guess, near term. So I think the industry is talking about some destocking on the R-410A but also we're seeing the industry raise prices really across the board on tariffs.
Would you expect some level of prebuy on price escalation here in the near term? Or how do we think about the netting of those two pieces as we get into the selling season here?

Aaron Nahmad

I don't see any prebuy coming on. On the A2L product, you can't really get 410 products from any of the OEMs. So they had to stop manufacturing that on 12/31. So anything that we would have in stock right now that's coming in is going to be an A2L product. The price increases are very rapid.
They happened on April 1 and then a second price increase occurred for most of the OEMs on the third. So unless there is a reversal of the tariff, I really don't see much of a prebuy opportunity for 454.

Operator

Patrick Baumann, JPMorgan.

Patrick Baumann

So I just had a question on the gross margin in the first quarter. And I was wondering if you were able to optimize price on the 410A inventory that was sold and whether that had a benefit there? I'm asking kind of in context of I think you said price mix was a 5% benefit in the quarter, and I don't think the OEMs raised price on the 410A since they're not really making it anymore. Just curious if you could give any color on that.

Barry Logan

Yeah, Pat, it's a good question. And the answer, I think most distributors were able to gain some price on 410A as we started the year. And also, it wasn't said in this call so far, but mix also improved, meaning energy efficiency mix that tends to help margin to an extent. And third, as Paul said, I think is we have a higher mix of replacement versus new construction that helps margins to an extent.
And the rest of the pricing discussion is -- I think Paul mentioned 25% of the business is 454B in the quarter. And obviously, the higher pricing contributed something to that equation.

Patrick Baumann

Yeah. That makes sense. The benefit on the price optimization maybe in the 410A stuff, is that like in the tens of basis points?

Barry Logan

Yeah. It's not material enough. It was not like something to exploit, Pat. It was something to add a bit of inflation as we started the year. It's in basis points.

Patrick Baumann

Helpful. And then we've been hearing about shortages of the 454B refrigerant due in part to container issues. Just wondering if you're -- if you've seen or heard anything on this front? And what your view is on whether this could have any impact on the selling season?

Paul Johnston

Yes, we have heard that. It's supposed to be over by June as far as the containers. But it's not just on 454, it's also on 32A. They both use almost the same container, so it's not -- there's no real difference.
So yeah, there's been a shortage. We've been on allocation. Everybody in the industry is on allocation right now. There apparently is still some 32 out in the marketplace. But the 454 has become increasingly difficult to obtain.
Is it going to impact us longer term? No, it's not. Our creative branches have gone up with other ideas to be able to satisfy the need of the contractor to be able to get the refrigerant they need to top off a new system.
You do know that all the equipment is pre-charged with 454. There's no shortage of 454. It's strictly the container that's missing right now.

Operator

Jeff Hammond, KeyBanc Capital Markets Inc.

Jeff Hammond

The consumer just can't get to break. They keep getting hit with these price increases and high rates. Just wondering if you're hearing or seeing anything on kind of repair versus replace or mix down as people maybe choose a defeatured product?

Albert Nahmad

Very good question.

Paul Johnston

In the first quarter, you really aren't going to see a lot of compressor sales. And compressor sales, when you look at parts and supplies, parts is what it takes to repair units, supplies is generally what it takes to install a unit.
And so when we look at it, we look at the motors when we look at the compressors. And I -- as I've said, I think on the last call and the call before, I'm hoping that we have a repair and replace market. Motor sales for the quarter were up 7%, which is good. And then we were up slightly with the compressors. It wouldn't really be indicative of a repair versus replace type mode yet.
So I think with the dichotomy that we have in the homeowners, I think we're going to see I think we're going to see a lot of replacement, and I also think we're going to see a lot of repair.

Jeff Hammond

And the trade down dynamic?

Paul Johnston

I'm not sure -- it isn't showing up.

Barry Logan

That's something we've seen. It's obviously two comments. First, energy efficiency mix actually improved this quarter. I want to ring the bell in October when we have our third quarter conference call if the trend continues.
But also what's competitive for us, every location in Watsco has multiple brands, multiple price points, many of our competitors, including OEM networks, have -- do not have that variety, do not have that functionality or flexibility at a store level. So we can make hay in a tricky environment if that's where the consumer is. And I'm glad we have that variety in our stores.

Jeff Hammond

Okay. And then, Barry, you mentioned people that leaned in on 410A, which was not your tech, maybe benefited 1Q and maybe they're a little bit behind. So I'm just wondering if you think 1Q was impacted at all because maybe you had less than your fair share of 410A and maybe you catch up some of that. And then it seems like your inventory position is really strong coming out of 1Q. Just kind of thoughts around play in the merchant and gross margin arbitrage around these kind of follow-on increases?

Barry Logan

Yeah. I mean, obviously, I don't have access to anyone else's financial statements to know what somebody else sold versus what we sold. But the anecdote in the market is there are some national accounts, multifamily channels, facilities maintenance channel that consume 410A.
And I think that provided that short-term opportunity. Those aren't channels that we necessarily are going to take product away from our other good higher-margin customers and serve that market. And instead, we're going to try to serve the good customers that will be there longer term.
So that's just an anecdote, Jeff, I don't -- but we -- that's volume where those customers in a more conventional environment, 60 days from now when 410A has gone or customers that as opposed to maybe being more opportunistic over the last quarter or so.

Aaron Nahmad

Yeah. I think that's perfectly framed. I mean you can't see even within our business, some of our business units who did have higher position of 410A products, they did have bumps this quarter and mass in total, Watsco, that was not our tax, as you said, but I think that was a Q1 dynamic.
And as A2L becomes the prevalent or the more prominent product that it's going to level out that playing field. And yes, we will be merchants and again, I think looking at Q1, our core performance in our core AOR business, it shows that we're healthy and strong and poised for a good year.

Jeff Hammond

Okay. Barry, we thought you were all knowing over 25 years I've known you, but I understand you can't see everything.

Operator

(Operator Instructions) Chris Snyder, Morgan Stanley.

Chris Snyder

I wanted to follow up on some of the prior commentary. And it seems like you guys didn't lean into 410A as hard as others and maybe there was some softness in Q1 as a result.
I guess my question is, do you have any sense of how much 410A your distributor competitors still have into Q2? Because it seems like maybe that share shift back to you or 454B will happen really ultimately when the 410A is just totally done being sold.

Albert Nahmad

Chris, we really have no idea. Yes. Go ahead, Rick.

Rick Gomez

I was going to say that that's awfully hard to have a line of sight into our best and it's purely anecdotal, but obviously, we talked to a lot of other distributors in our in our quest for more acquisitions. And as we do that, this is obviously a recurring topic and something that is on everyone's mind.
I don't get the sense in talking to those independent distributors that they have -- that they're planning on -- or that they have enough 410A inventory to get very much past the second quarter. And nor could the OEMs supply a whole lot of that to close out the year. So I think by the end of 2Q, 410A will largely be in the rearview mirror.

Chris Snyder

Thank you. I appreciate that. And then I think you guys said maybe 20% or 25% of your volumes in the quarter were 454, if I heard that right. So I imagine we're still, the field is still not installing a ton of 454B maybe in April, that's changing. But I guess, do you have any sense of the rate at which 454B is being installed and just trying to figure out like have we tested the demand or even maybe the price elasticity on 454B. Because it still seems pretty early in the process. Thank you.

Barry Logan

I was going to say I don't feel like it's that early. I feel like it's going on materially and importantly, and we do have a view into what's going on. I mean 25% of the first quarter is probably $250 million of product. I don't think that's a small number. That's larger than most distributors for a full year.
And so there is some insight into it. If I look at the last two weeks, it's probably over 60% of what we're selling is 454B products. So the ramp is happening pretty quickly. So when we talk about current trend and current margin visibility, we're satisfied the new product is being accepted well.

Operator

Steve Tusa, JPMorgan.

Steve Tusa

Sorry, just to follow-up to Pat's questions. Just philosophically, as a distributor and when you're looking at like these situations. What is the difference between a -- how do you look at the difference between like a surcharge and a price increase?
And like what is there to read into from OEMs that are picking surcharges versus price increases just broadly? What do you take away from that from an industry perspective?

Paul Johnston

I think a surcharge is temporary and because of some exterior condition and a price increase is longer term. Surcharge doesn't affect your inventory, a price increase does. To my knowledge, there's only been one OEM that's issued a surcharge.

Albert Nahmad

I would say, look, this is a new and dynamic environment we're in with these extreme tariffs or potential tariffs. So everybody is working their models and figuring out the best approach. And this is where we've referenced our great relationships with our OEMs and the collaboration. There's a lot of conversation about how to do this without creating much friction or as little friction as possible and make this a harmonious as possible.
And that's one of the dimensions that was discussed early. And this pros and cons of doing a surcharge versus a price increase. And like Paul said, I think one OEM went with surcharge. But I don't think there's too much to read into that other than just trying to do the best we can or anybody can to keep harmony in the market.

Steve Tusa

Are you guys doing any surcharges? Or are you mostly like price increases. Obviously, you guys can be pretty agile with the tech you have. But are you -- is it mostly of what you do surcharges or price increases or mix?

Albert Nahmad

It's mostly price increases.

Barry Logan

And Steve, to remind you of the texture of this because it's just important to know the two-sided equation we deal with. A.J., said earlier, if we have 1,000 customers in South Florida, we may sell the same product at 1,000 different prices. We also buy the product, purchase the product, the same product at different prices. Depending on the market segment we're addressing.
And so an OEM's price to us varies depending on those variables. So in that double-sided equation, there's a lot of, I think, artistic and good ways use technology to deal with these kind of environments where, again, I'm not sure our competitors have it.

Steve Tusa

One last one, Paul. Just from an industry perspective, how much of the like unitary product do you think is like sourced directly from China, like where you have a Chinese manufacturer who may be shipping it over here and sticking a label with the US guys sticking a label on it. My guess it's not huge, but like it's been growing in the last couple of years. How much do you think there is of the industry?

Paul Johnston

I think in the industry, it's less than 5% on the ducted side and then on the duct-free side, obviously, it's higher. I don't think we make a single unit in the US. There's a few units made in Mexico. But the ductless side would be heavier the ducted side would be very small. The only -- there's maybe one manufacturer left, I think that's using a product that's made in China.

Steve Tusa

Right. And then sorry, one last one. I know we got like 15 minutes left for the hour, so I might as well get one more in. I heard the kind of the tail end of Pat's question on 454B, like why is Honeywell putting this huge price increase out there if there's like such abundance and it's just -- it's a container issue? Trying to like figure that one out.

Paul Johnston

I would, too. I'd like to figure out why there's not more of a shortage on 32 because it's the same container. But I have no clue. But at the same time, there's only two manufacturers that make 454, and that's Honeywell and Chemours. And Chemours had a price increase, a fairly sizable price increase.
The primary reason why they had that price increase is because the majority, 80%-plus of the 32 that's brought into the US is from China.
There's been a lot of inventory of 32 in the US, but I think those two manufacturers with 70% of 454 represented by 32 felt like they had to have a price increase. So both of them went up, it wasn't just Honeywell.
On the other side, we're starting to see allocations forming around 32. Yesterday, we saw a material price increase on the 32 that we buy. The price spread between the two products now has narrowed to just a little over $3 a pound. So it's not as big of a difference or delta as it was when they were introduced.

Operator

Thank you. This concludes a question-and-answer session. I would like to turn the conference back over to the management for any closing remarks.

Albert Nahmad

Well, thanks for your interest in our company, and we look forward to catching you up at the end of the next quarter. Bye-bye now.

Operator

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