Comfort Systems USA, Inc. (FIX) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Comfort Systems third quarter earnings call. My name is Matthew, and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would like to turn the conference to Julie Shaeff, Chief Accounting Officer. Please proceed, ma'am.

Thanks, Matthew. Good morning, everyone. Welcome to Comfort Systems USA's third 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 we'll open our remarks.

Thanks, Julie. Good morning, and welcome to our third 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. Let me take you through a few key highlights of the quarter, and then Bill will discuss the financial results in more detail. We are happy to report another solidly profitable quarter. Earnings for the quarter was $0.15 per share, compared to the third quarter earnings last year of $0.14, not including the goodwill and noncash charges that affected that quarter on a GAAP basis. Revenue for the third quarter was also up due to acquisitions. Although it was down slightly on a same-store basis. Backlog is steady at $623 million, up slightly on a sequential basis. We had solid operational execution across-the-board, including significant improvement in margins. Thanks to the solid execution by the majority of our operations, we achieved significant year-over-year improvement. It has also been a good quarter from a cash standpoint. And our free cash flow was strong in the quarter and is well ahead of last year. I'm going to ask Bill George to discuss some financial details and then I will comment a bit further on our future prospects. Bill?

Thanks, Brian. If you're online and have access to our slides, you can refer to Slides 1 through 5, as I walk you through our financial results. I will discuss both our quarterly results and our performance for the first 9 months of the year. Revenue this quarter was $335.5 million, an increase of $7.4 million or 2.3% compared to the third quarter 2011. The revenue increase is a result of our EAS acquisition, which was completed during the fourth quarter of last year. Revenue on a same-store basis actually declined by $12.5 million or 3.8% to $316 million. This small decline in revenue appears to be normal quarterly variation in an essentially flat market. Total revenue for the first 9 months of 2012 was almost exactly $1 billion, which represents an increase of $97 million or 10.6% compared to the first 9 months of 2011. We experienced both same-store and total increases for the 9 month period and the EAS acquisition contributed 7.2% of this increase. Revenue for the 9 months on a same-store basis increased by $31.6 million or 3.4% to $954 million. As we've discussed during our calls earlier this year, much of the increase in same-store revenue during the first 6 months arose from the fast-moving data center project in the mid-Atlantic area. As a reminder, data centers are classified as manufacturing in our business segment pie chart. That project, which was completed this past July, contributed significant revenue for the first half of the year. We expect same-store revenue for the rest of the year to be similar to 2011 levels. Another important effect of that big data center job was on backlog. This quarter, we reported a significant drop in backlog year-over-year as compared to a sequential same-store increase in backlog even in a seasonally busy quarter. A major driver of the year-over-year decline was the fact that last year at this time was the first time we reported backlog that included that data center job. If you eliminate that effect, even year-over-year backlog trends appears steady, especially when considered in light with our current job sizes when you eliminate the data center. Gross profit was 16.6% for the third quarter of 2012, a strong increase from 15.0% for the third quarter of 2011. Gross profit was 15.0% for the first 9 months of 2012, an improvement over the 14.2% gross profit we reported the first 9 months of 2011. As Brian mentioned, we had solid performance for most of our operating companies. A good portion of the increase resulted from the absence of job under performance at our Southern Alabama operations that we experienced last year. That company appears to be on track. We also had improved results in our Maryland and Virginia operations. Despite the relative improvement, we continue to experience gross profit and operating income margins that reflect the continued challenging market conditions. We did experience a small pickup on the large data center during the quarter as we received confirmation of payment for some changes. We continue to pursue additional compensation on that job. SG&A expense was $46 million for the third quarter of 2012, which include that SG&A from the acquisition of EAS and compares to $41.5 million for the third quarter of 2011. SG&A as a percentage of revenue increased from 12.6% during the third quarter of 2011 and 13.7% during the third quarter of 2012. This increase is mainly due to events in the quarter, including higher medical claim costs, settlement of a legacy lease, and additional amortization from the EAS acquisition, as well as higher compensation accruals based on slightly on the somewhat improved results. For the first 9 months of 2012, SG&A as is percentage of revenue is flat at 13.7% compared to the same time as last year. EAS added revenue of $20 million for the third quarter and $66 million for the first 9 months of 2012. Its overall impact on the bottom line was approximately breakeven this quarter. Our tax rate for the quarter was 42.9% and 47.5% for the first 9 months of 2012. The increased tax rate reflects accruals that we discussed earlier this year and the distribution of income with some of our better earnings coincidentally coming from high tax jurisdictions. We currently expect the full year tax rate to be in the 43% to 48% range. Our net income for the third quarter was $5.7 million compared to $36.6 million loss on a GAAP basis the third quarter of 2011. You will recall that the third quarter of 2011 included a goodwill impairment and some other non-cash items. Excluding those items, non-GAAP net income as adjusted was $5.3 million for the third quarter of 2011, similar to the $5.7 million this year. Net income for the first 9 months of this year was $9.1 million, compared to an adjusted non-GAAP net income of $3 million for the same period last year. EPS for the third quarter of 2012 was $0.15 per diluted share, which compares to the GAAP loss last year of $0.98 per diluted share, but excluding the goodwill impairment in the other non-cash items, adjusted non-GAAP, GAAP earnings per diluted share reflected our strongest quarter last year at 14%. So we improved year-over-year by $0.01. We had very strong cash flow during the quarter. Free cash flow was positive $13.8 million for the third quarter of 2012. This compares to negative free cash flow of $0.8 million for the third quarter of 2011. In the first 9 months of 2012, we have negative free cash flow of $5 million, as compared to negative free cash flow of $27.8 million at the same time last year. As you know, we've generated positive free cash flow for the past 13 calendar years. And with a strong improvement over last year, we continue to feel good about our cash flow prospects in 2012. We repurchased 49,000 shares under our share repurchase program during the quarter for a total of 145,000 year-to-date. We continue to be price sensitive and opportunistic in share repurchase. So overall, the recession continues but we are still investing in the business. That's all I have on financials. Brian?

Thanks, Bill. Let me walk you through backlog. What we're seeing in the various sectors and markets and our prospects for the rest of this year. Please turn to Slide 6 and start with backlog. Backlog at the end of the third quarter was $623 million, up $5 million or 1% sequentially. Backlog on a same-store basis was $570 million, compared to $636 million as of the third quarter of 2011. Year-over-year decrease is due to the burn off of a large fast-paced data center project that Bill mentioned earlier. Please turn to Slide 7 for a look at our sectors. The institutional markets, which are government, health care and education, still represent a significant portion of our revenue. These markets are active and makeup 56% of our backlog. The private sector remains weak, but we continue to win our fair share of smaller and midsized projects. Larger projects are still few and far between. Overall, although margins remain tight, we remain cautiously optimistic that activity levels in most markets are stable. Let me discuss what we're seeing across the country starting with the West. The operations in the West were the first to be impacted by the recession. Markets for operations in Southern California, Colorado and Arizona have stabilized. While we are encouraged by this, the conditions in many of the Western markets are still among the slowest in the nation. I was in Colorado, Arizona, Montana and California for the past 2 weeks. Our folks there have done a terrific job working in these tough market conditions. The Northeast region, which includes our companies in the upper Midwest, remains stable and is the most profitable region. We had strong execution and solid results from the operations in Maine, Massachusetts, Michigan, New York, Ohio and Northern Maryland. The vast majority of the operating companies in this region have strong backlog going into next year. Our operations in the mid-Atlantic experienced the downturn later in the cycle and continue to face a weak pricing environment. Despite the tough climate, we had strong results from our Alabama, Arkansas, Central Florida, Florida Panhandle and central Virginia operations. Let's now review our revenue mix. Please turn to Slide 8. Pure service, which is maintenance and repair, was 16% of revenue for the first 9 months of 2012, up from 15% for the first half of 2012. This compares to 18% in 2011. The large data center job led to a temporary increase and a relative proportion of revenue that came from new construction. Revenue percentages have started to shift back towards 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. Nonresidential construction markets remain tough, demand remains mixed and pricing is still very competitive. We continue to see large projects being delayed and in some cases, being awarded in smaller phases. Execution, cost controls and efficiency continue to be our main focus. Our strong financial position in bonding capacity remain a competitive advantage. Despite overall industry challenges, we expect continued profitability and positive free cash flow for 2012. Although we continue to hope for improvement in 2013, as yet, we are not experiencing any change in demand. And so it appears that at least the first half of next year will be a continuation of the stable but tough times we have experienced for several quarters. Again, I would like to thank all of our 7,000-plus team members for their efforts. I will now turn it back over to Matthew for questions. Thank you.

[Operator Instructions] The first question comes from the line of Rich Wesolowski from Sidoti & Company.

Brian, you had mentioned the data center job affecting the mix between Construction and Service, but it does look like the Service revenue dollars were flat maybe down a little bit versus the first 9 months of 2011. I was wondering if you'd discuss the progress and the hurdles in front of you in building the Service business while Construction is still flatlining.

Rich, on the numbers, I will say flat is a good description of them. Service is affected by the ambient conditions out there. We continue to make a big investment in service. We believe we're taking share, and we're focusing on specific markets. Anything you'd add to that, Brian?

Hey Rich, I'd just like to say, as Bill said we are continuing to invest training and hiring folks, it'll be a -- it's a long, slow climb in Service but we will continue that effort.

The other thing that we've had for many quarters now continued improvement and strong results in the margins and our service business. And so some of the flatness in revenue also reflects a little bit of a concentration on margin and certain of these markets. Money we're making on Services, really, very important to the overall results right now given the market for Construction. So we will say, we have seen margin increase that we're pretty happy with. So but we're disappointed in growth and we want more of it.

Are there many nonunion service heavy or even service only companies out there to buy?

The answer to that is, not in a way that's meaningful to our numbers. Many of our -- certain of our companies will occasionally buy very small operations, sometimes it's as small as -- they buy the assets of the company and hire somebody. A few of our service operations tend to be very small and so we're going to have to continue to grow this internally to really position ourselves for when demand comes back some. We've done a pretty good job of maintaining a maintenance base in the face of people, people really driving -- first of all, much higher cancellations than we've historically seen over the last couple of years as people forego or get very price-sensitive on those. Or they change from a full-service contract to some -- we have several levels of coverage to some lesser level of coverage which immediately hits the revenues, although it should come back as we make more money when we repair things. So it's an example of another tough market. The nice thing is it's a place where you can continue to make money. And we are making really good money in service.

Lastly, should we expect FIX to continue buying companies during the downturn, perhaps sizeable companies, which makes a lot of sense. Even if it takes the company to a net debt position of -- I don't know, pick a number, $50 million? Or do you view yourselves as approaching a self-imposed limit on how much you'll spent?

I think the way I would answer that, and Brian can correct me if I'm wrong and obviously the board -- it's not just the people on the phone, our board is very active in this strategy, is that we would not rule out additional large acquisitions, but I think you will see us being very slow to buy additional Construction revenue until we become really -- we attain a conviction that strength is coming back into the market. We bought, as you know, the largest private nonunion. We bought another large company in North Carolina. We've gotten into some markets we really are glad to be in like Raleigh and Nashville during this recession. So I think that we're open to acquisitions. I think we will become especially open if we reach a point where it's clear that construction markets are coming back somewhat. And I believe, and this is some -- I believe, actually, we may have opportunity at that point. Because a lot of these companies' balance sheet have gotten pretty stretched during the course of this recession. If you talked to bonding companies they'll tell you that most business failures in our business are right after the end of a recession when people are trying to fund growth. And so I think there may be some opportunities for us when things look better. But I think we're going to be very slow, make incremental investments, until we see signs we believe in that the construction markets are coming back. That was a really long answer, Brian...

And I think, Rich, you won't see anything in the near term, Rich.

Your next question comes from the line of Adam Thalhimer from BB&T Capital.

I wanted to ask about seasonality of margins. I mean, typically, you guys could see a sequential increase in margins in Q4. Is that the right way to look at the results historically?

Well, historically, if you're just saying the last couple of years, we have experienced that in the last couple of years. As far as whether you would see that this year, I actually would not personally view that as typical for us if you look over a longer period of time. When you're not really busy, when the colder weather starts, sometimes you have some drop off. I guess it's hard to predict, but I wouldn't count on an increase in margins in the fourth quarter, I'm certainly not counting on it. Having said that, fourth quarter is typically one of our 2 best margin quarters of the year. So I don't know. That's crystal ball stuff, but that's my thinking on it.

Okay. And then Bill what was the tax rate guidance you gave again for Q4?

43% -- well, for the full year, 43% to 48%, which means if we're far-off with the 9-month number, you have to solve for the difference for the effect on the actual quarter. So I would say -- so if I have to guess a rate for the fourth quarter, I would say something between like 40% -- for the actual quarter itself, I would say something like 42% to 43% because my best indication is what I did in the third quarter. But I'd love to see it a little lower and there are -- if we got the right mix of earnings, we would -- it would come down a little. We also have a natural but very, very small tendency towards a slightly lower rate because you'll be amortizing the negatives from earlier in the year over 12 months rather than 9.

Got it. Okay. And then, I mean, lastly, I just wanted to ask as it relates to the tone and outlook, I mean -- trying to think back, I mean was there a time earlier this year when you were more hopeful that we are on the verge of recovery and that's just didn't happen or would you say that your kind of outlook or optimism for the business has been more or less stable throughout 2012?

Adam, this is Brian. I think, for the most part, we've been pretty stable. I think in the spring, no. I think, we're probably a little bit more optimistic that maybe the curve was turning privately. But over the summer time, I think, we've slowed down a little bit and our outlook is probably going to be steady and stable going into next year.

Bill, you would kind of echo those comments?

Absolutely. I would absolutely connect with those comments. It's been really a few years, right, that you'll see signs of life and then they don't materialize. They will one of these times. But right now, it certainly looks like there's a few more quarters of just making money and flow in some cash and preparing and investing for -- to really hit it, to really hit it when demand is ready to help.

Your next question comes from the line of John Rogers from D.A. Davidson.

A couple of things. More as it relates to the market and looking out into 2013. As you talk to your guys in the field and some of the planning for projects, we've seen an uptick in the ABI index and some other very forward indicators. And I know you're a late cycle portion of the construction business, but -- I'm sorry for the long preamble, but in terms of opportunities, as we think about maybe second half '13, '14, is it going to be on the industrial, commercial or nonresidential markets, any thoughts -- is it more data centers? Where are you guys saying there's -- there is planning activity or where there's nothing?

Yes. Okay. John, this is Brian. And I've just been out running around here for the last little bit. What we're seeing is still good opportunities in education. Medical, slowed down a little bit. But I think on a long-term basis, John, medical health care is going to be there just based on the age of the population and the demand that's going to present itself. We're seeing a clear uptick in multifamily not so much in the condo side, but on the rental aspects of multifamily. Significant amount of opportunities there. And the other one, I think, you've hit on is the manufacturing/industrial data centers I think could be a good opportunity for a while. We're also seeing industrial opportunities on the food side that we do, particularly at ColonialWebb and across the country. So those would be the sectors I see as most active. I think office buildings'll be flat for a little while. But the bids and the stuff we're looking at here that we approve, those would be the sectors that we see some strength in.

Okay. And in terms of the margin opportunities over the next couple of years, I mean, in the past you've talked about some shop work and prefabricating equipment or doing things a little bit differently, I don't know, whether it's service or more plumbing versus air conditioning. Is there anything else that we should be thinking about? As, hopefully, we do eventually see some sort of an upturn? Is there a way to leverage the business, I guess, more?

I'll answer that. I'll let Bill have a go at it. I think all the things you talked about, we're doing. The number that's reflected in, I think, the gross profit you're seeing. The more amount in -- I walked a couple of jobs this week, 1 in San Diego in an airport job. You see guys just doing fantastic work with less than they had before, John, heavily driven by prefabrication. I think that's been the biggest driver of efficiency we've seen, probably in a large number of years. I think on a go-forward basis, you're going to see some technology that get applied either mobile technology, et cetera, that's going to make us more efficient. But the overwhelming theme I hear is that we're functioning at these levels and these efficiencies that we're not going to go back to what we were 4 years ago. But the changes that we've made, the recession is going on for so long and now are embedded in our culture. And no one's even thinking about the way it was. In fact, we're moving forward and just prefabbing more than we ever did before. And I think that's going to continue, John.

So I would say, I couldn't possibly agree with Brian more. In all seriousness, when I go and visit companies right now, it's really amazing to me at what they're accomplishing with the resources that they have. I've said before it's been a while. If you had taken me back 3 or 4 years and told me what was going to happen, I wouldn't have believed that the organizations that are part of Comfort Systems would accomplish the things they've accomplished in the markets they're in. We are in -- we have been, over the last few years, in some pretty, pretty -- I believe, significantly disfavored markets even within nonresidential construction industry. The places where we have our strengths were some of the places that were the most hard it. And I just think we are very well positioned for when things get better. From a point of view of everything from SG&A leverage to productivity to new processes. And I think the only challenge for us is going to be to make sure we ration the capacity we have on price.

Okay. And is there -- I guess, as a follow-on to that, are there -- is there any aspect of your business where you need to make investments to position yourself to either take advantage of a sector or as a way to grow your existing operations within essentially a flat market environment?

I'd say the #1 thing, and this is not a short-term view, but the #1 thing we have to be ahead of the market on, as we view what will happen to the construction market over the next 5 and 25 years, is modularization and prefabrication. And that's why we made the investment that we made and we're willing to consider a structure we've never considered before in North Carolina, to just buy a premier modularization company that will help, we hope, over time, our businesses and really be ahead of that curve.

Yes. I think, Joe, one of the things that exceeded my expectation is EAS, the company that does the modular work, how quickly they have adopted into our culture and have helped other companies around. I think that's going to really grow. It's been much quicker than I ever imagined.

Okay. And then -- I'm sorry, one other. A couple of some of the larger E&C companies that have reported so far have mentioned that there's some concerns about labor shortages developing especially in the south, possibly, I guess more out into 2014 with some of the big projects that are planned out there. Is that something that you're concerned about? I mean, is that a factor to think about with Comfort Systems or...

Well, John, I think, the labor issues one for the industry kind of the trades, in general, for construction all around the world, actually. It's been going -- it's been coming a long time. The number of youths that are coming into the industry is, probably not the #1 choice. But having said that, we're doing a lot here training people, bring them in. I was really optimistic at this San Diego job. The age of the people on that job and even in management, very young, doing a great job. So we are aggressively bringing folks in, training them up. We hope to work in the field and to manage the field. But I think it's a looming issue for the industry but luckily, Comforts size we're able to bring some people in and get us ready for that. There is no question as an industry, it's a looming issue.

Your next question comes from the line of Saagar Parikh from KeyBanc.

Quick question. And I apologize I dropped off the call by accident, I missed the beginning of the Q&A portion. So if any of these questions have already been asked, I apologize. But can you just talk about the sequential increase in gross margin that you had from 2Q to 3Q? I know you mentioned, in the beginning portion of your comments, that there was a slight positive impact from the large data center project in terms of a change order. Could you just talk about that? How much of an impact there potentially was and what's remaining for the next few quarters?

Sure. The impact was about $0.01. And it was, obviously, that was some of the money we hope to get. We're still going to pursue more but obviously, there's less of an impact, less get to get. A lot of factors contributed to the gross margin difference. Obviously, the number one is always going to be the companies making money. But as far as on a comparative basis, you quit having the Bank of America data center revenues run through it at 0 margin, right, which changes how things average out. We had, on a year-over-year basis, we had some negatives last year that weren't apparent in this quarter. And the other thing is we had this same-store revenue decline. And by the way, revenue has -- revenue in just a single quarter basis has a pretty high degree of variability for us. If there are no big equipment deliveries in the quarter, there are things that can happen that are pretty benign that can cost revenue swings. But when you have lower revenue and you still have the profit, obviously, that affect the percentage as well. So I think it was just a confluence of those factors. Some of which will continue so they should help, certainly, should help margins in the fourth quarter. But apart from that, it's really broad-based, it's not one job or one individual item.

I just want to jump in because I know some people listen on this call. We had a lot of folks out there just doing a great job running a mechanical contracting company. In all aspects and cost control, it's all on the work and executing it. It's just becoming more efficient and productive, so we really want to make sure that they know that we thank them for that.

Well, that's great. And you guys have done a great job in the downturn. Looking at the top line, and again I apologize if questions have already been asked in a certain way, but top line missed consensus. And I know, us here at Key and others on the Street, we're baking in that the large data center project would be rolling off. But I think the drop or the missed versus consensus was much more than anyone would've even thought about? And I know in the queue, you guys mentioned the health care project. Could you just give us more color on that. Was the health care project or the health care -- you mentioned that healthcare declined, was there a push -- Bill just mentioned, was there a push out there or was the top line really what you guys expected internally?

Not sure I understood your question. I will say health care was, if you just look at half of it, some of our health care jobs had fully closed out or had slowed down over the summer. We also had, in a few important companies, what we call air pockets. You have a workforce that's committed to one job and then it has to be mobilized to another job, and sometimes there are layoffs and delays in between those. We had a few of those hit at some specific places where business did a good job of writing their costs and not turning in bad results as a result of that. But they still, if the revenue's not there, there's nothing you can do with it. So I don't know it's really broad-based. Brian?

What I was really trying to go with that question is was the top line what you guys expected or was there anything that surprised you? That's pretty much what the question was.

I think from my perspective, we probably, to be honest, a bit more robust. But we did have some project delays on some pretty large work that when you factor it in, the math isn't going to work for you.

Perfect. And then last question on hiring trends. It seems like you guys have your outlooks been -- become a little bit more measured versus what it was 3 months ago or 6 months ago on when the uptick was going to happen. Has that followed through on the hiring trends also? Are you guys still hiring? Are you still hiring or are you looking at direct or permanent hires, temporary hires versus that? What's the trend with that right now?

In general, we're not hiring. We're down probably a couple of hundred people in the quarter. We used a lot of temporary workforce over the summer months, which does help your costs, particular when that project is concluded and you have to send the folks back home. But in general, I'd say we're not hiring.

The next question comes from Rich Wesolowski from Sidoti and Company.

Just a quick follow-up. I was wondering if you would comment on the progress of settling the matter with Ferguson that's been outlined in your last couple of filings.

I would say there were no major developments in the quarter other than I would say that we're becoming more and more comfortable with the constructive approach that Ferguson is taking. But there aren't any actual factual developments in the quarter.

Is there any way that you can qualitatively bracket the potential liability of the company, if any?

I don't think so. But I think it's getting better, I guess, would be our sense of what the risks that are there are. It's getting better. Obviously, we've had a quarter or 2 to see how customers react. We've had, really, no examples of customers overreacting to this. We got a couple quarters of seeing how Ferguson acts when we needed to at least take steps, reassure customers, in some cases, to take small actions to satisfy them. Ferguson has so far been, the kind of partner we hoped they would be. So I guess that's about all I have on that.

I would now like to turn the call over to Brian Lane for closing remarks.

Okay. Thank you, Matthew. And everyone on the call, thank you very much. We appreciate your interest in Comfort. Like I say, we're, in general, very, very pleased with the quarter and appreciative of the efforts of all the folks out there working for Comfort Systems. We look forward to seeing you all out there in the road here in the near future. Have a great day and a good weekend. Thank you.

Thanks everybody.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.