Comfort Systems USA, Inc. (FIX) Q2 2012 Earnings Report, Transcript and Summary

Welcome to the Q2 2012 Comfort Systems USA Earnings Conference Call. My name is Vanessa and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Julie Shaeff. You may begin.

Thanks, Vanessa. Good morning, everyone. Welcome to Comfort Systems USA's second quarter earnings call. Our comments this morning, as well as our press releases, contain forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. What we will say today is based on the current plans and expectations of Comfort Systems USA. Those plans and expectations involve risks and uncertainties that could cause actual future activities and results of our operations to be materially different from those set forth in our comments. You can read a more detailed listing and commentary concerning our specific risk factors in our Form 10-Q as well as in our press release covering these earnings. A slide presentation will accompany the prepared remarks, and has been posted on the Investor Relations section of the company's website found at comfortsystemsusa.com. Joining me on the call today is Brian Lane, our President and Chief Executive Officer; and Bill George, our Chief Financial Officer. Brian will open our remarks.

Thanks, Julie. Good morning, and welcome to our second quarter call. Before we start, I'd like to take a moment to thank the Comfort Systems employees who are listening for their continued hard work and dedication. On today's call, I will start with a quick overview of the quarter. Bill will then take a few minutes to walk through the financial results. And finally, I'll discuss backlog and the outlook for the rest of the year. We are happy to report a profitable second quarter at $0.12 per diluted share as compared to the $0.08 per diluted share we reported in the second quarter of last year. We had good performance across the board and most of our locations delivered solid results. Our Construction operations continued to focus on execution, and our Service operations achieved continued strong profitability and growth. We had good top line growth both from acquisitions and on a same-store basis. As we mentioned during our first quarter call, we have a very large, fast-paced data center project that has contributed to our same-store revenue increase for the first half of the year. Backlog is down slightly on a sequential basis as we burn through revenue at fast pace on that large data center job. The majority of our markets are stable but pricing remains very competitive. We continue to see large projects being delayed, and in some cases, being awarded in smaller phases. Our focus, as always, is on project selection, estimating and execution. We are keeping our eye on costs and we are focused on generating cash. We still feel good about the rest of the year. But before I get into that, let me turn this over to Bill for some financial comments.

Thank you, Brian. Despite weak overall demand, there are a number of indicators of incremental improvement and stability in our results this quarter. If you're online and you have access to our slides, you can refer to Slides 1 through 5, as I review our financial results. Total revenue this quarter was $355 million, an increase of $43 million or 13.6% compared to the second quarter of 2011. The EAS acquisition, which was completed during the fourth quarter of last year, contributed 7.6% of this increase. Revenue on a same-store basis increased 6%, or $19 million to $331 million. As Brian mentioned, most of the increase in same-store revenue arose from the fast-moving data center project in the mid-Atlantic area. Data centers are classified as manufacturing in our pie chart. That project contributed significant revenue for the first half of the year, but that increase will disappear in the third and fourth quarters as July was the last significant revenue month for that project. As a result, we expect same-store revenue for the rest of the year to be closer to the 2011 levels. Gross profit was similar to last year at 15.4% for the second quarter of 2012, compared to 15.2% in the second quarter of 2011. As Brian mentioned, we had solid performance for most of our operating companies. Despite the small relative improvement, we continue to experience gross profit in operating income results at lower levels due to continued challenging market conditions. SG&A expense was $47.1 million for the second quarter of 2012, which compares to $41.9 million for the second quarter of 2011. The largest reason for the dollar increase in SG&A was the acquisition of the EAS. We also saw an increase in bad debt expense as we made a decision in the quarter to reserve specific receivables at a couple of locations. Overall, SG&A as a percentage of revenue decreased during the quarter compared to last year, dropping from 13.4% to 13.3%. EAS added revenue of $23.8 million and its overall impact on the bottom line was approximately breakeven. As we have previously discussed, we have a 60% interest in EAS and thus we consolidate their results. From the field level, EAS reported a small operating loss in the quarter due to job write-downs on 2 jobs that are substantially complete. Within our purchase agreement, we have contractual mechanisms and formula that specifically adjust for changes in the gross margin on jobs ongoing as of closing. As a result of this purchase adjustment, much of the impact of the job write downs was not -- have not been borne by Comfort Systems. The former owners expect some recovery through negotiated change orders and when and if the recovery occurs, they will receive the benefit of such recovery. So as I said last quarter, the net effect on Comfort Systems is not large, but I wanted to describe the mechanics to help you understand numbers that you may have noticed on our income statement. And also, so that if these numbers turn around later in the year, it will be clear why the benefit is muted in our numbers. The tax rate for the quarter was 43.9%. We currently expect the full-year tax rate to be in the 38% to 48% range. We're happy to report that free cash flow was positive $2.6 million for the second quarter of 2012. This compares to negative free cash flow of $5.8 million for the second quarter of 2011. Although we expect overall headwinds in 2012, we have generated positive free cash flow for the past 13 calendar years and we feel good about our cash flow prospects in 2012. We repurchased 96,000 shares under our share repurchase program during the quarter. We continue to be price sensitive and opportunistic in share repurchases. Overall, this was a strong quarter in a tough environment. The recession continues but we are still investing, and we feel good about our prospects when markets improve. That's all I have on financials. Brian?

Thanks, Bill. I will now comment on backlog, performance and revenue mix, as well as our prospects for the rest of the year. Please turn to Slide 6, and start with backlog. Q2 backlog was $618 million, down $4 million or 0.7% sequentially. The decrease is due to the burn off of the large fast-paced data center project mentioned earlier. That project is slightly unusual for us as the majority of our very large projects typically take more than a year to work their way through our backlog. Absent the effect of the burn on that large project, our backlog would have been up slightly this quarter. If viewed either way, backlog is still flat in a tough market. As noted in Slide 7, institutional markets, which are government, health care and education, still represent a significant portion of our revenue. These markets are active and make up 55% of our backlog. The private commercial sectors remain challenging, but the proportion of work in our backlog, that is private, is increasing, and we feel an industry shift to its private work plays to our strengths. We continue to win our fair share of smaller and midsized projects. Overall, although margins remain tight, we remain cautiously optimistic that activity levels in most market sectors are stable. Geographically, the Northeast region, which for us also includes the companies in the upper Midwest, remain stable and is the most profitable region. The operations in Maine, Michigan, New York, Northern Maryland and Wisconsin continue to report good results. Building on their strong performance for the first half of the year, the majority of the operating companies in this region have strong backlog and are operating near capacity. As we told you during our first quarter call, the mid-Atlantic region experienced the downturn later in the cycle, and we expect this to continue in the near future. The Southeast region, including the mid-Atlantic, continues to experience a weak pricing environment. Elsewhere in the Southeast, our Central Florida operations has very strong results despite tough conditions. Most of the markets in the West have stabilized their conditions, and many of the Western markets are still among the slowest in the nation. Please turn to Slide 8 for a comparison of the revenue mix. Pure service, which is maintenance and repair, is 15% of revenue for the first half of 2012, compared to 17% in 2011. The large data center job led to a temporary increase in the relative proportion of revenue that came from construction. Revenue percentages will likely shift back to its service and retrofit, although that project continues to impact the year-to-date numbers. Our service maintenance base is steady. Finally, let me discuss the outlook for the rest of the year. The ongoing weakness in the nonresidential markets continues to impact our business. Pricing is still competitive, and the customers are often hesitant to commit and pursue construction and improvements, and some are taking a wait-and-see approach. That being said, the majority of our markets are stable and we have a good baseline of work. We are focusing on ways to be successful in this environment. Execution, cost controls and efficiency continue to be our main focus. Our strong financial position and the bonding capacity remain a competitive advantage. We are confident, we are more efficient than ever, and we are ready to take advantage when markets improve. Again, I'd like to thank all of our 7,000-plus team members for their efforts. I will now turn it back over to Vanessa for questions. Thank you.

[Operator Instructions] And our first question comes from Rich Wesolowski with Sidoti & Company.

These are the highest bookings you've reported in a long, long time, but your commentary is a little bit darker. Are you feeling any better about your bidding prospects than 3 months ago?

I mean -- Rich, this is Brian. The bidding's pretty much the same as it was. We're in a very large industry, there's always going to be stuff to bid. But I think it's pretty stable. We're seeing good opportunities, and I think we'll get our fair share.

Would you maybe elaborate a little bit on the data center project, specifically with regard to the influence it'll have on the comparisons of the second half versus the first half, and messing with the seasonality a bit. Are we to see less revenue but higher gross margin as a result of that?

Yes. So I think that we will definitely see less revenue and there's a -- there is a possibility of higher gross margin. That -- the data center -- the vast majority of those revenues have now come through. A little bit came through at the end of last year but then, something in the $15 million to $20 million range came through each of the first and second quarter. This could be a couple million in July and August of this year. But because of the -- because we were asked to accelerate that project, as we indicated on the first quarter call and the acceleration demands forced us to commit to an incurred cost before we had negotiated the appropriate change to the contract price relating to those changes, we did not meet -- we have not met our strict criteria for booking a claim or a change order. And so we've added the cost to that project but we have not put any -- we have not increased the contract price for any compensation we would get for those incremental costs. What that means is that project, for the first 6 months of the year, revenue coincidentally on a breakeven basis. And there is a prospect that as we get compensated for those additional costs, that would essentially improve our results later in the year. The timing of that is difficult because if it's a negotiated change, it could happen in the third or fourth quarter. But if it turns into a more protracted situation, of course, it could push into next year. But there should -- as far as we could tell at this point, there's only upside left on that project.

Great. And then lastly, EAS seems to be contributing more revenue than I would have expected or I think maybe it was being recognized in 2011. How is that subsidiary doing and have you had any early success in expanding their prefab capability to any of your other operating companies?

We've had a little bit of -- we've certainly had them -- they've worked very well with some of the operations that surround them, in particular ColonialWebb. They've shared labor. They've sold work for each other. They're off to a good start. It's not been -- there certainly hasn't yet been -- it hasn't yet been the case that they've expanded their capability to add that capability to another subsidiary, and I think if that would happen that would take a long time. As far as how they're doing, their net contribution to Comfort Systems has been approximately breakeven, slight negative if you take into account all of the amortization that we've had to put into. But a nice EBITDA contribution, but not as much as we would have liked. As we said, the recessions hit the mid-Atlantic, and it's hit them as well so they have not done quite as well as we would have hoped, but we still feel very good about that acquisition.

And our next question comes from Tahira Afzal with KeyBanc Capital.

It's Saagar on for Tahira. Well first off, congrats on a great quarter, great execution in a tough environment. Looking at your gross margin profile on -- thanks for the additional commentary, Bill, on the data center project's impact. But if I'm to take your commentary, which is pricing is not getting better on the non-res side, and I'm just looking at gross margins for the rest of this year and into next year, and taking the data center project out, maybe I can see it trending up to the 15 -- the high-15 range. But going into next year, can you really get to that the top of your 14% to 16% range without pricing coming back?

In 2013 -- it's a little early for us to really have clear expectations for 2013 because we haven't really seen bookings and pricing and backlog that we'll have seen in 3 or 4 months. It's getting kind of late in the game for there to -- for 2013 to be strongly helped by a recovery. Remember we're a late cycle player. So when things get noticeably better in our industry, that tends to hit us, sort of, in a rolling manner, 6 to 18 months later. So having said that, I think we feel pretty good at 13%. At least, we continue to benefit from the stabilization. Until -- no, last year, the year before this year, although markets are at very low levels, they've been at low levels for a while, and so capacities had more time to adjust to the lower levels. People who are coming in and maybe making a mistake on a bid or taking work at a loss or breakeven, they're not doing that anymore. They've generally -- it still happens but it's not rampant the way that it was a year ago. So I think we have prospects even if we stay stable at the bottom for a modest continued gross margin improvement in '13 over '12.

Saagar, it's Brian. The other part of the curve, is our workforce had done a terrific job over the last few years through this recession. Efficiencies, just getting better at what we're doing, and that continues. And I think a lot of the progress we made is here to stay.

Okay, perfect. And then one...

Saagar, let me add one other thing. If we were to see some demand come into the market, then I really like our prospects for improvement. I just want to add that. We talk as if it won't be there. But having said that, someday it'll be -- it's going to come, it's just a matter of when.

And so if that does comes earlier than expected, you could see initial benefits 6 months from when that demand comes up, right? So you could still see benefit potentially in 2013 or something?

Yes.

Yes. You can see benefit late in the year on the margin line. You'd start to see revenue sooner.

Your assessment is correct, Saagar.

And then one follow up on the institutional end market. All -- differently leading indicators, and I know everyone looks at different things. But a few of the matrix that I've been looking at -- or metrics, sorry, have been showing that institutional could be taking a little bit of a hit in the -- in 2012 time frame, early 2013. Are you guys seeing anything from your customers to suggest that, that trend is happening, or do you say institutional is going to just stay at this current level?

Yes. This is Brian. I think if you look at us from a year ago, 70% of our backlog was institutional, its 55% today. Manufacturing office buildings and multifamily have increased. The one good thing about our structure is our operating companies are close to our customers. And we are able to adapt pretty quickly. So the adjustment we're seeing is pretty smooth. But the institution has slowed down a little bit, the private work has picked up, and we're right there for it.

We have our next question from Adam Thalhimer from BB&T Capital Markets.

I know you don't like to give outright EPS guidance. But can you just give us a flavor for -- how the second half might shape up on a year-over-year basis?

I think what we have -- I think what we've said the last couple quarters continues. Absent any effect of that data center, I would expect the third and fourth quarter of 2012 to be very similar to the third and fourth quarter of 2011, with the exception of we'll get incremental revenue from EAS. And -- but having said that, as we announced at the time of acquisition, I don't think they will -- given their amortization early on, I don't think that they will add much to EPS. I think they may make a small contribution to EPS in the second half of the year but early on, they've got a lot of amortization to come. So I'd say more of the same.

Okay. And as it relates to the kind of economic softness we've seen since, I guess, you could say over the past 3 months or so, it looks to me like maybe that's pushed -- maybe that's caused the hope for a new construction recovery, maybe that pushed that out a little bit. But doesn't seem like that's really impacted your service and repair and remodel work, is that the right way to think about where we are today?

Yes. You're right on. And we've seen a lot, as I said in my script, a lot of small midsize work that's never makes it into backlog because we burn it in the quarter. We've seen a lot of that activity and it's -- luckily we're able to do that work and do the large construction work as well. So Adam, you're right on the money on that. We are seeing a lot of that small to midsized stuff around.

One interesting factor is there's a lot of delay. Things that will get really -- they'll have a date, they're supposed to start in February and they're supposed to start in May and they just keep not starting. And yet, in this -- compared to a year or 2 ago, the difference is in these cases, the owner owns the land, the owner has permits. They It just seems like people are not pulling the trigger.

They're letting it out in small bits and pieces, as opposed to letting it go on the whole thing at one time your that's happening recently as well.

And that's somewhat typical in prior coverage or are we kind of uncharted territory?

There's nothing typical about this recession.

And our next question comes from John Rogers with the D.A. Davidson.

A couple of things. I guess, first for Bill, the receivables charge that you had in the quarter, how much was that?

It was all a little over $1 million. It was a -- and it was a diverse group of specific things that we just -- we reached a point where we said we're going to go ahead and reserve them. They're all things that we continue to pursue. But it's just some distinct things. In any quarter, there's a certain amount of that, right? And this time, there just happens to be a little more than we put up than usual. And we run our bad debt expense through the SG&A line. So the reason I bring it up is you were solving for the dollar increase in SG&A, no, there wasn't much of one once you take out EAS in that and -- so I just wanted to point that out.

And just one more thing, John. We haven't lost our focus of collecting that money.

Good. Good. And secondly, the tax rate, 38% to 48% is a big range.

It is and -- so I'll give you some detail on our tax rate. I believe our tax rate by year-end will be a very, very low number with a 4 in front of it. But the problem we have is we such a small numerator of earnings right now in the second quarter that even if you had a little 3-year -- if you have a little $300,000 charge from a state matter, which is a very small number on a scale of Comfort Systems, but it's a kind of a big number on a scale of year-to-date, we only have $3 million or $4 million of earnings. So the problem is that/the small numerator. Having said that and we had about $400,000 or $500,000, earlier this year, of negative incremental development on some tax situations on some audits and stuff. That created a big loss of benefit in the first quarter, remember we were at a loss. It got us at a weird tax rate of like 43% now. But assuming nothing else unexpected happens with that we will slowly moderate towards a typical tax rate for us. A typical tax rate for us is going to be the federal rate of 35%, plus sort of the blended average state rate of 6% or 7%, minus the benefit, right? You get to deduct your state taxes so minus the benefit, I believe it's just about a 39% normalized rate. This year we're going to be 1% or 2% above that just because of the discrete items.

Okay. And then, I guess, in terms of the margin [ph] short term basis, are you seeing any impact from the weather because of the heat?

John, its Brian. Yes, the weather is -- has helped us serious results in the quarter. But basically, we had a warm summer last year, so the marginal improvement isn't there.

But in the third quarter it seems like it's appreciably hotter.

Right. As we move to...

We're only one month into it but...

Right. As we move into this quarter, we'll see how that pans out. But, obviously, the month of July was warm, as well. Last year, we also in the third quarter, had a lot of a flood, tornado damage in the middle of the country that kicked off a lot of work for us as well. So we'll see how the quarter plays itself up, but it is still warm, and it does help our service numbers, no question about it.

Okay. And lastly, I mean appreciate your guys' conservatism but on the other hand, and I know it's a tough recovery and it's slow and there's no snapback, but if you look at overall nonresidential construction spending, it's a better than we were a year ago, specifically in a lot of the building markets that I think you addressed. And are you -- and I know you're a later cycle business. But is there any hope that even though it's coming off of a small base that we should see some acceleration in growth at some point? I don't know whether it's couple of quarters from now, just based on what we we've already seen?

I presume by conservatism, you're not referring to our politics. No. No. I mean, we have a lot of help. We feel pretty good. But having said that, this recession taught us anything, its that you can't count on the fact that something is about to take off just around the quarter -- corner. What we -- our focus, Brian, might have heard him say it 100 times, has been we need to make money now and we need to run our business for now. We need to be ready for improvement. We're ready for improvement and just, we're a late cycle player, and I'm just not sure we're the guys who ought to be out there calling the, sort of, calling the upturn. But we feel good, Brian, do you?

Yes. I'll tell you, John. It's -- it is a little bit better than it was than 1 year ago. We just -- as we tend to call it, because it's been up and down before, we like to see some legs to it. And yes, we are conservative. But we are cautiously optimistic that this thing is going to turn at some point. It's got to turn.

Okay. And -- I'm sorry, and lastly, if I could. Acquisition pipeline, what does it look like now?

I think, for the foreseeable future, you will see us concentrate on tuck ins. We did a tuck in actually during the quarter. It was small enough that we really haven't brought it up. But one we like a lot and this -- it controls tuck in, in the Southeast. We continue to very actively look for tuck-ins. But probably we'll not see us do free-standing [ph] businesses this year, and if you saw it next year, it would be because we were actually convicted that there was some strength coming back into the market. We are very, very happy with the acquisitions we've been able to do during this downturn. We've deployed a vast majority of our available capital. We've bought the largest private company in our business. We bought -- or at least 60% of a super innovative company in the mid-Atlantic. We got into markets like Nashville and Raleigh that we've wanted to be in for a long time. But at this point, you're not going to see anything but tuck ins probably for at least 2 or 3 quarters

And we have a follow up question from Rich Wesolowski of Sidoti & Company.

I was hoping to just expand on that last discussion. Even at reduced earnings, by my model, at least your cash going is to start building back up. Would you mind discussing your priorities for that, historically? Of course, you paid the dividend? Is there potential for that to go up for the share repurchases, M&A, et cetera?

I would say nothing has changed on our priorities for cash. Our Board has given us very, very clear strategic guidance items for many years. Our #1 priority with our cash is good acquisitions that we feel good about. After that, it's obviously we pay our dividend and we'd like to begin to increase that. If cash were to get better we'd like to get back to at least incremental improvement there. In the end of the day though, when the stock price is low, we think our stock is a very, very good use of our cash. The #1 use is acquisitions, and we believe, we continue to believe, that the multiples the companies trade for in our industry, we ought to be buying an incremental $100 million or so of revenue. We ought to be averaging buying that every year. And we think we can absorb that. We can effectively grow Comfort and make it a better place and take advantage of synergies by doing that, and that's the plan for the foreseeable future. So hopefully cash starts to build in good times, we get a chance to buy some more great companies at a point in the future, and we become a much bigger, stronger and more effective force in our industry.

And that was our final question. I will now turn the call back to Brian Lane for final remarks.

Thanks, Vanessa. Everyone, we really appreciate you joining us in this call today. Thank you for your interest in the company. We really would like to thank, once again, the employees of Comfort Systems who are doing a terrific job. We're very happy with the second quarter. Hope you all enjoy the rest of your summer, and we look forward to seeing you down on the road here in the near future. Thank you and have a great day.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.