Comfort Systems USA, Inc. (FIX) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Comfort Systems USA Earnings Conference Call. My name is Kim, and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would now like to turn the call over to Ms. Julie Shaeff, Company Chief Accounting. Please proceed.

Good morning, everyone. Welcome to Comfort Systems USA's Fourth Quarter Earnings Call. Our comments this morning, as well as our press release, 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-K, 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 www.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, everyone, and welcome to our fourth quarter earnings call. We made good progress in 2012, and I'd like to start by thanking all of our employees for their hard work and dedication. I would like to extend a special thanks to all the finance and accounting folks for doing their usual terrific job, especially over the last few months. I will review some highlights, and then Bill will cover the financials in more detail. We had a strong finish to the year, and we are pleased to report another solidly profitable quarter. Full year 2012 revenue was $1.3 billion, compared to $1.2 billion in 2012, a 9% increase from last year. Cash flow was good, and we generated solid earnings in the fourth quarter. Despite tough market conditions, we had good operational execution at most of our 37 operating locations. Net income for the quarter was $4.4 million, or $0.12 per share. Execution and our disciplined cost structure were the keys to our solid progress in 2012. Thanks to $25 million of free cash flow in the fourth quarter, we achieved our 14th straight calendar year of generating positive free cash flow. When you consider the cyclical nature of our industry, some of the conditions we have faced in the last 14 years, our reliable cash flow is a great feature of Comfort Systems. Markets remain challenging, and 2013 is not signaling immediate improvement. Despite some challenges, we believe that the underlying markets are sufficiently stable that we can turn our focus to future growth. And after Bill had discussed the financial results, I will talk about that further. Bill?

Thanks, Brian. I'm going to take a few minutes and discuss both our quarterly results and our performance for the full year. If you are online and have access to our slides, you can refer to slides 2 through 6, as I review our financial results. Before I get into the numbers, I need to point out that during the fourth quarter, we reached the point where we met the GAAP requirements to reclassify to discontinued operations the historical results of a Delaware business that we exited in 2011. Since we were required to remove their results from continuing operations for all periods, the continuing operations numbers will not tie to prior filings. However, the information is still available to you in the discontinued operations caption on our financial statements. With that explanation, let's review our numbers. Revenue this quarter was $315.9 million compared to $313.9 million in the fourth quarter of 2011. Revenue on a same-store basis was $308.5 million. But for the quarter, revenue was up very slightly and same-store revenues were down slightly. But overall, revenues were flat. Full year total revenue increased to $1.3 billion, which represents an increase of $115 million or 9.4% compared to 2011. EAS, which we acquired in the beginning of November 2011, and thus owned for an additional 10 months this year compared to 2011, contributed 6% of this increase. Revenue for the full year increased on a same-store basis by $41 million or 3.4%. You'll note that the full year same-store increase was driven by a fast and large data center that drove increases in the first 2 quarters of the year. And with that job taken into consideration, I think it is fair to say that like the fourth quarter, same-store full year revenues were also flat. By the way, after the end of the year, we came to an understanding with the general contractor on that data center job to provide it for an increase in the contract price. And as we mentioned in the subsequent events footnote in our Form 10-K, we expect that once we have completely settled up with subcontractors, we will receive a benefit of about $1 million in the first quarter from that settlement. Gross profit was 17.4% for the fourth quarter of 2012, and that was a strong increase from 16.1% for the fourth quarter of 2011. Gross profit was 15.6% for full year 2012, an improvement over the 14.9% gross profit we reported in 2011. As Brian mentioned, we had solid performance from most of our operating companies. We also had improved profitability at our New York operations and improved results at our Virginia operations. Despite the relative improvement, we continue to experience gross profit in operating income margins that reflect the continued challenging market conditions. SG&A expense was $47 million for the fourth quarter of 2012 compared to $43.6 million for the fourth quarter of 2011. SG&A, as a percentage of revenue, increased from 13.9% during the fourth quarter of 2011 to 14.9% during the fourth quarter of 2012. SG&A, as a percentage of revenue, increased from 13.7% in 2011 to 14.0% in 2012. The quarter and year-over-year increases reflect higher compensation accruals due to approved profitability, higher medical claim costs and additional amortization from the EAS acquisition. Our tax rate for the quarter was 46.9% and 46.6% for the full year. Increased tax rate reflects the accrual that we discussed earlier in the year and the distribution of income between high and low tax jurisdictions. Our net income for the fourth quarter was $4.4 million compared to $1.7 million in the fourth quarter of 2011. Net income for full year was $13.5 million compared to a $36.8 million loss on a GAAP basis for 2011. You will recall that during 2011, we had a goodwill impairment. EPS for the fourth quarter of 2012 was $0.12 per diluted share compared to $0.05 per diluted share for the fourth quarter of 2011. For 2012, EPS for continuing operations was $0.10 per share. We had strong free cash flow during the quarter and the year. For the full year, free cash flow was $20 million compared to $22 million in 2011. We have generated positive free cash flow for the past 14 calendar years. We repurchased 142,000 shares in the fourth quarter and 286,000 shares for the year. We continue to be open to price-sensitive and opportunistic share repurchases. Overall, we remained financially sound and solidly profitable. Although our profit levels are not satisfactory to us and reflect continuing weak industry conditions. Despite tough market conditions, we continue to search for and implement strategies to prudently use our strength to compete, improve and grow. That's all I have on financials. Brian?

All right, Bill, thank you very much. Let me walk you through the backlog, what we're seeing in the various sectors and markets and our outlook for 2013. Let's turn to Slide 7 and start with backlog. Backlog at the end of the fourth quarter was $618 million compared to $623 million at the end of the third quarter. Year-over-year backlog decreased $12 million due to the burn off of the large fast-paced data center project mentioned earlier. Overall, we are heading into 2013 with similar backlog levels to a year ago. Please turn to Slide 8 and where we look at our sectors. The institutional markets, which are government, health care and education, make up 48% of the backlog. The private commercial sectors remain weak, but we continue to win our fair share of smaller and midsized projects. Larger projects are still few and far between. Although margins remain tight, we remain cautiously optimistic that activity levels in most market sectors 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. Northeast region, which includes our companies in the Upper Midwest, remain stable and in 2012, it was our 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 stable backlog going into next year by doing a superb job of making the most of a tough environment. The Southeast is experienced -- is experiencing improved demand in some markets but still has pockets of weakness, such as Florida and Atlanta. Our operations in the Mid-Atlantic experienced the downturn later in the cycle and continue to face a weak pricing environment. I was in a number of these operations over the past few weeks. Our folks there and in the West do a terrific job working in these tough market conditions. Let's now review our revenue mix. Please turn to Slide 9. Fuel service, which is maintenance and repair, was 16% of revenue in 2012 compared to 17% in 2011. Service, repair and retrofit, again, exceeded 50% of our 2012 revenue. These activities continue to provide us with the majority of our earnings and cash flow, as we prepare for a recovery in Construction. Our Service & Maintenance base is steady. We have consistently invested in our Service business for the past several years and we plan to continue these investments in 2013. Finally, let me describe our outlook for this year and our general approach to the overall market. The nonresidential construction markets remain tough. Demand remains mixed and pricing is still very competitive. We are entering 2013 with a very similar set of backlog, demand and pricing conditions, so we expect that weakness in the underlying environment for nonresidential activity to continue to affect our results and our industry in 2013, with overall activity remaining at subdued levels. Our focus for 2013 is execution, cost discipline and service performance. Based on our backlog and the weak economic conditions for our industry, we expect continued profitability during 2013, but we expect that lower levels of profitability, some which are those that we experienced in 2012, will continue in 2013. So what do we expect beyond 2013? Those of you who follow us closely, know that we have continued to invest in our business during this recession. We plan to increase these investments in 2013 because we believe it's time for a renewed emphasis on growth. We are hopeful that incremental demand will appear for 2014, but whether or not that is the case, we believe that after more than 3 years of unprecedented weakness, many or most of the markets we operated in have adapted to ambient levels of demand. We plan to begin to leverage our excellent workforce and business to achieve growth in the coming years. The benefit of our approach is not likely to appear in 2013, especially since we have tough revenue comparisons in the first and second quarters. However, our focus in the coming years will be profitable growth and we are optimistic about the future. Finally, and again, I would like to thank all of our 6,700-plus team members for their efforts. I will now turn it back over to Kim for questions. Thank you.

[Operator Instructions] And your first question comes from the line of Rich Wesolowski.

I understand the opportunity to foster growth in your Service business, but not so much in the retrofit. Isn't that work doled out on a competitive bid basis, much like new construction?

Hey, Rich, it's Brian. Yes, particularly on Service, Rich, you picked up as we've talked about in the past, the efforts we've made in Service and we're going to continue. We think we're really well-positioned there. We got an excellent workforce. And a lot of it is driven by growing our maintenance base. But a lot of that follow on retrofit work is a result of having a maintenance base with a company, Rich, so not all of it is bid. Some of it is you're in the building and know it, and you get to work as a result of it. So it's twofold for us. It's the maintenance and it's the project work, as well, at the service level.

EAS looks like they turned from a loss in the first 9 months to a profit in the fourth quarter. Would you discuss the progress there?

All right. Well, EAS had a -- they had a challenging year. Although for Comfort Systems, they were a net neutral to a very small benefit because of how the financials work. There were some jobs that faded after we closed the deal, but that was on the old owner's dime. So despite what you saw run through that line, we did okay up until this point of the year, they covered their amortization, which is what we were hoping for. Having said that, they went through this past year, an air pocket. They had a very large job that was supposed to have performed in 2012, that moved to 2013. As a result, their workforce decreased by a couple of hundred people. That job is back on. Their workforce is back up to its historical levels. And we expect normal profitability from them in 2013. That air pocket should be over.

Circling back -- excuse me, to the discussion on the growth. Absent improvement in the Construction market, if you aim to improve the service business, can you discuss what kind of investment that's going to result in SG&A?

Right. I mean, Rick, it's going to be a lot of what we've been doing. Training, hiring sales folks, improving our processes. We've been doing that, I think, as we've talked about here, at least since I've been up here for the last 3.5 years. I just think we're poised now. We've developed our systems and in place, so it will be more of the same.

But if -- I mean, I recognize that Comfort had a big data center job in the first half of last year, that will impede your comps. But if revenue grows low to mid single-digits in 2013, can SG&A be a higher percentage of sales in '13 than it was in '12?

I think that there's a -- that's a definite possibility, as we assess the investments that we make. The fact is, in our business, we -- our business is people. And when you decide that growth may be coming and you decide that you need to prepare for that, or when you decide to go and sell for growth and perform more growth, that involves hiring people. The only way that you can do that is to put -- run that through. That's all SG&A, right? By definition, sales, general and administration includes sales. So I think one of the reasons we're communicating that we're switching our focus to growth, which I think is a combination of net incremental -- additional incremental investment and service. But also, we are hopeful that there will be at least some additional demand in 2014, and we will not do well if we're not prepared for it. So I think across the board, we think it's the right time for Comfort Systems to be prepared to grow. That will involve things that will be detectable in our financial statements over the course of this year, and so that's one of the reasons we want to -- apart from wanting to be transparent about our beliefs and our intentions, that's another reason we want to communicate that right now.

Right. And then so, just wrapping it up, the -- we should interpret that investment as maybe a little bit more optimism from management that we are entering a new spending cycle or a service demand?

I think it's a combination of -- we believe stability, right? We believe there is less downside risk. We believe that '14 -- there are certainly things that suggest to us that demand may pick up, and we think we -- the prudent step is to be ready for that. We think that the gain from being ready for it is worth a small incremental cost that we'll bear, even if '13 looks like '12.

And Rich, in addition to that, is the quality of the folks we got in the service front right now. I'm very optimistic and confident in their performance going forward.

And your next question comes from the line of Adam Thalhimer.

So what are you seeing that would make you feel like now is the time to invest in the business? Is it the ABI? Is it the level of bidding activity out there?

Well, 2 things. If you -- I think what you're asking about is not just -- so there's 2 parts. And the first part is important, right? We feel very, very comfortable with our underlying business. We're coming out of 3 or 4 years of unprecedented weakness in our business. So we were in a very cautious mindset during a good part of that. We are, compared to a lot of other companies, we are uniquely dependent on the nonresidential construction market, and even compared to some of our comparables. And so we felt like we needed to really concentrate on running a good business, making some money, flowing cash and investing it wisely. Our belief now is the ABI is stronger. There's a pick-up in residential home demand, which is really the first time that's been really something you could confirm in the last 4 years. And we just believe that even -- we just believe that our markets have adjusted to the size of the market more now, and there's just greater opportunity. I mean, it's time for us to change our focus to pursuing that opportunity. We think we can and so we should.

And where would acquisitions possibly play into that?

Acquisitions? I think our mindset on acquisitions hasn't changed at all. We -- as you know, we're always open to acquisitions. There are many companies across the country that we hope -- the best companies in our business in -- are the markets that make sense for us. We want them to be a part of Comfort Systems at some point. And well, when they're ready to sell, we're always ready to buy at the right price. But having said that, significant incremental construction purchases, I would say we would be still in a bit of a wait-and-see mode on that. We'd want to have more conviction that the markets were -- construction markets were returning before you'd see us make those investments. We're very optimistically and happily investing in service and controls companies. And tuck-ins, we have had a very -- not -- a very good run of results from doing that. It's really helped many of our businesses.

And Adam, if I could just reiterate. We have not changed our philosophy in acquisitions. It's the same.

Okay. What's the outlook for the education sector?

I would say that on the government-owned education sector, it has -- you have to be concerned that it's taken another leg down. We still see some work in private colleges. They still seem interested in building, in particular, revenue-generating buildings. For them, a dormitory generates revenue and a lot of them need revenue. And one of the ways they can get that is by capturing money that would have gone to private apartment complexes around their campuses and stuff. But I would say that, that is probably a flat market for us.

Yes, Adam, it's definitely flat, but we don't see it decreasing. We still see a lot of opportunity as Bill said in the private sector, particularly on the housing for the student. They're still upgrading those facilities, and a lot of laboratory type of works, science labs, at these major universities, they're still out there.

So of the -- I'm looking at the revenue by sector slide. I mean, which one of these sectors have the most promise for growth in 2013?

It's definitely industrial.

Yes, industrial. Data centers and the like, Adam, that's what we're seeing today.

Industrial for us is data centers, food processing and manufacturing.

Manufacturing.

And year-end markets. But not -- the markets that we're in across the Southeast are well-positioned to attract incremental investments into manufacturing, for example.

Is it reasonable to expect maybe double-digit growth in that sector? Or is that not how you look at it?

That's certainly what we're working towards. It's really lumpy, right? These are big projects. So it's really hard to -- it can be better than that or worse than that. But we -- and really, we're counting on that sector to grow.

I don't know what the percentage is, Adam, but I know it's a lot of activity right now.

And your next question comes from the line of Saagar Parikh.

So first off, you guys have bought a lot of businesses over -- since '08. Since the downturn, I think, you've added $400 million or so in revenue. And now that you're more confident that the market is turning, can you just give us an overview of how you think the business is different now, this time around going into the upturn versus what it was back in the mid-2000s?

Well, at this moment, the big difference is that there isn't an upturn. There should be and yet, after I think a few years of buffeting a lot of the financial -- the decision-makers are having a hard time pulling the trigger on things. When things pick back up, I expect that you will see -- I'm hopeful that you will see a lot of very responsible bidding. There are a lot of people who have come through a hard time, people that had the mindset to chase everything, kind of if you've gotten hurt the most by the recession. So I suspect 2 things. I expect one, most likely any improvement will be very gradual after what we've been through. But I am hopeful that pricing will get more reasonable quickly, just because of distraction of capacity and because of what people have been through.

And I think, Saagar, from my perspective, a couple of things. We're a lot more efficient, a lot of the improvements in technology are now embedded in our -- whether it's prefabrication, modularization, BIM are well entrenched in our company. The other thing, we have a lot stronger service element to our business than we did in 2008.

Right. That won't go away just because of the recession.

Yes.

Okay. And then the headcount levels. The big theme, it seems, I guess, investing for growth. Did you guys add headcount in the fourth quarter? Or are you guys going to start adding headcount through 2013 now?

We did not add headcount in the fourth quarter. I don't think we'll have a big increase in headcount.

Right. Even if when an upward trend develops, if you're looking at a fourth quarter, the seasonal trend is always going to dominate that. This is not the heavy season for Construction. This is our slow season. So the question is what will happen to headcounts next summer? The answer is, there's no reason at this moment to think they're going to be any better than last summer because our backlog is the same, but once demand comes back in, headcount would start to move.

Okay. And then the last question on my part, and I know Adam touched on the education sector. Could you touch a little -- or asked about the education sector. Could you guys talk a little bit on the health care sector? I know it's an area that did well for you guys in 2011, and then there were some headwinds from health care going down in 2012. What are you guys seeing on that side in 2013 and beyond?

Yes, it's Brian. I'm still very optimistic about the health care sector. It did hit some headwinds. We still had a very robust health care part of our business, hospitals, ambulatory centers, et cetera. You look at all the demographics, aging population, et cetera, et cetera. I think that in the aggregate, over time, it will still continue to be a very strong sector for us, Saagar.

And your next question comes from the line of Clint Fendley.

My question is sort of along the same lines as the prior questions and it's sort of long term in nature, but I'm just wondering, your peak earnings were back in 2008. And I'm wondering what could the peak earnings look like in the next cycle, given some of the changes that we've seen in the company since that time? And obviously, you discussed on the efficiency in the prefab work, and just your expectations regarding the pricing?

That's a question we have to be very careful about because if you take what the companies we owned plus the companies we now own, what they did back in 2008, the numbers are very -- they're very, very robust. And they're numbers that, honestly, we'd be thrilled if we could ever get back -- if we ever got it back to 75% of that number, it would be amazing. So that's not answering your question. As far as what the peak, the peak could be -- I think, there's 2 parts to that. One, how much revenue demand is there and much to say, there's enough for our revenues to go up 15% or 20%, I do think we could get back to OI margins in our long -- in the range of our long-term, sort of averages before these 3 years, which would be 4, 5s -- 4%, 5%. That ought to be -- in any market with reasonable demand, that ought to be very, very doable. It's just been so long since we've seen yield demand, decent pricing, that we've kind of forgotten what it looks like.

And no further questions. I would now like to turn the call over to Brian Lane for closing remarks.

Okay. Thanks, Kim. Once again, I really like to thank all the folks at Comfort Systems for having a terrific 2012 and doing a great job. We really appreciate it. I'd like to thank you all for your interest in the company. As usual, Bill and I, will be seeing you all on the road shortly. Thank you, and I hope you enjoy your weekend.

Thanks, everybody.

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