Comfort Systems USA, Inc. (FIX) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 Comfort Systems USA Earnings Conference Call. My name is Regina, and I'll be your conference operator for today. [Operator Instructions] As a reminder, today's event is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Ms. Julie Shaeff, Chief Accounting Officer. Please go ahead.

Thanks, Regina. 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 than those set forth in our comments. You can read a more detailed listing and commentary concerning our specific risk factors in our most recent 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.

Okay. Thanks, Julie. Good morning everyone, and welcome to our fourth quarter earnings call. I would like to start by thanking all of the Comfort Systems USA employees, who are on the call today, for their continued hard work and dedication. Also, I would like to extend a special thanks to all of the finance and accounting folks for doing their usual terrific job, especially over the last few months. 2013 was a year of good progress and improvement, and we were pleased with the strong finish to 2013 and the fourth quarter. Both our full year and fourth quarter revenues were up in 2013, with full year revenue coming in at $1.4 billion, a 2% increase compared to 2012. Our operating teams continued to deliver solid execution and good cash flow. We reported earnings for the quarter from our continuing operations of $0.15 per share as compared to $0.10 per share in the fourth quarter of 2012. As of yearend, our backlog had also strengthened noticeably for the first time in several quarters, and I will discuss this in more detail later in the call. We believe that nonresidential construction is showing signs of gradual recovery although overall, nonresidential building continues to track well below its long-term trend, following the weaknesses of the past few years. Most of our markets are stable, but pricing remains competitive. We continue to be focused by project selection and execution, and we are actively investing for future growth. Our investment in service will hit full stride during 2014, as we fully implement our plan to increase service. Although this investment will increase our SG&A in 2014, as Bill will detail in a few minutes, we feel this investment will drive long-term value for our stakeholders. I will describe our outlook in detail in a few minutes. But before I get into that, let me turn the call over to Bill, to review the details of our performance.

Thanks, Brian. If you are online and have access to our slides, please refer to Slides 2 through 6, while I review our financial results. Revenue this quarter was up 5% compared to 1 year ago, as we reported $330 million of revenue compared to $316 million in the fourth quarter of 2012. During the first and second quarters of this year, we reported flat to slightly down revenues, influenced by the fact that the first 2 quarters of 2012 included a fast and large data center project in Central Virginia. The second half of 2012 was the more normal comparable. And our increased revenues in the third and fourth quarters of 2013 were large enough to overcome the declines earlier in the year. And overall, our largest increases for the year resulted from projects in North Carolina and Arizona. Gross profit was 18.6% for the fourth quarter of 2013, and that was an improvement from the 17.4% for the fourth quarter of 2012. Gross profit was 17.7% for full year 2013, a strong increase from the 15.6% gross profit that we reported in 2012. We had meaningful margin improvement at the majority of our operating companies, with the companies located in the Northeast and Upper Midwest continuing to make strong contributions to our earnings. Our gross margin also benefits from the mix of business between service and construction, as low activity in project work and the ongoing relative strength of service work has led to a higher proportion of service work than usual. Because service has significantly higher gross margins, when service is a greater proportion of our revenues, that benefits overall margins. SG&A expense was $52.6 million for the fourth quarter of 2013 compared to $47.0 million for the fourth quarter of 2012. SG&A as a percentage of revenue increased from 14.9% during the fourth quarter of 2012 to 15.9% during the fourth quarter of 2013. SG&A as a percentage of revenues increased from 14.0% in 2012 to 14.3% in 2013. The increase in SG&A as a percentage of revenues is also influenced by the higher service mix, as service includes additional selling, billing and other management costs. In addition, as we mentioned in previous calls and as Brian said a few minutes ago, we are continuing to make net incremental investments in service growth. In 2013, we made an incremental investment in service growth through our SG&A line of approximately $1.0 million. During 2014, our strategic investment in service will peak, as we will invest an incremental $3.0 million in training alone, plus an additional $1 million to $1.5 million in people and systems. This $4 million to $4.5 million addition to SG&A for 2014 as compared to 2013, will subsequently decline in 2015 and thereafter to approximately $2 million above our 2013 SG&A run rate. This is a significant investment for our company, and we believe it will generate a strong return. Our tax rate for the year was 38.8%. Net income from continuing operations for the fourth quarter was $5.6 million or $0.15 per share compared to $3.8 million or $0.10 per share for the fourth quarter of 2012. On a full year basis, net income from continuing operations was $27.3 million or $0.73 per share compared to $13.1 million or $0.35 per share in 2012. As we mentioned in our press release, earnings per share for the current year includes $0.03 arising from income from prior reporting periods that was recorded in the third quarter of this year, and $0.04 overall from changes in the fair value of earnout liabilities. Free cash flow for the quarter was $10 million, which aggregates to $22 million for the full year as compared to $20 million in 2012. We have generated positive free cash flow for the past 15 calendar years, although the increase in service and our mix has smoothed our cash flow somewhat throughout the year. And as a result, we did not experience a large spike at year end as we often do. We purchased 126,000 of our shares in 2013 at an average price of $14.59. We remain open to opportunistic and price-sensitive stock repurchases. Since we began our program, we have purchased over 6 million of our shares at an average price of $11, returning $66 million to our shareholders. As our financial performance improves, we are seeing the per share benefit of those repurchases. With the shrinkage in our share base and with the numerous acquisitions we completed over the course of the recession, we believe that we are well positioned to benefit when markets improve. It has been a long recession, but we like our positioning. We are prudently investing to grow our existing business. We are open to adding new businesses, and we are committed to dividends and stock repurchases to return capital to our shareholders. As Brian mentioned, we are seeing signs of gradual improvement and activity levels in many of our markets, while other markets remain slow and price competitive. Based on our backlog and as the late cycle business and apart from acquisitions that we might make, we expect that any improvement in 2014 will be gradual. At this point, we expect the profitability will be comparable to the improved levels of 2013. That's all I have on financials, Brian.

Okay. Thanks, Bill. Let me start with backlog and activity in various sectors and markets. Please turn to Slide 7, and we'll start with backlog. Backlog at the end of the fourth quarter was $604 million, an increase of $33 million or 6% compared to the third quarter of 2013. This increase is largely due to our operation in North Carolina, where we own 60% of the company. Pricing, while relatively stable, is still competitive overall. We feel optimistic that some recovery in project activity is starting to develop. However, as most of you on this call are aware, given the timing of our activities in a building project, we tend to participate in increases on a somewhat delayed basis in construction recoveries. At this point, although underlying activity levels are solid, we do not see an increase in bookings that would support meaningful revenue increases over the next few quarters. Please turn to Slide 8 for a look at our end-user sectors. The institutional markets, which are government, health care and education, made up 45% of our revenue for 2013. Our industrial and commercial sectors comprise 55% of our backlog as of the end of the year compared to 30% to 40% levels back in the 2010, 2011 periods. Overall, we continue to win our fair share of small to midsized projects. However, larger projects continued to be less prevalent than they are in normal conditions. Let's look at what we're seeing across the country. Overall, we have seen stability in most of our markets. Our operations in the West were the first to be impacted by the recession, and they are relatively stable at this point. The Northeast region, which includes our companies in the Upper Midwest, remains relatively strong and continues to be our most profitable region. We've seen some improvement in the South to Southeast and in the Mid-Atlantic but at generally modest levels. If you turn to Slide 9, you can see our current revenue mix. Pure service, which is maintenance and repair, was strong at 17% of revenue for 2013. And service, repair and retrofit again well exceeded 50% of revenue. Overall, we had the best maintenance base new booking performance than we have had in many years as our maintenance base has increased approximately 12% during 2013. For the quarter and for the year, our service businesses provided solid returns. We have invested in our business throughout the recession. And as Bill detailed, in 2014, we will be making an unprecedented investment in our service business through training, investment -- investing in systems and growing our service workforce and leadership. These investments are significant for Comfort Systems, and we believe that they will benefit us for many years to come. However, they will result in higher SG&A in 2014. As I mentioned on last quarter's call, James Mylett, a seasoned service leader at our industry, joined Comfort Systems as Senior Vice President of Service in November. In the first couple of months since his arrival, I am already excited about the progress he has made. We expect to continue incremental investments for the next several years, but we believe they will be providing a net return on investment by the end of 2015. And we believe these investments will provide valuable benefits to Comfort Systems for many years to come. Overall, I am very pleased with our performance in 2013. We are financially sound and solidly profitable. Our outlook for 2014 is positive but realistic. Although we are hopeful that new construction activity levels will improve, we expect that even as markets improve, 2014 will be a transitional and investment year. And we currently expect that near-term improvement will be gradual. And Comfort Systems 2014 revenues and earnings will be similar to our improved results in 2013. Although underlying pricing for our services is more reliable than it was in the depths of the recession, we do not yet see significant incremental demand in most of our markets. To achieve our goals, we will need to continue to improve our execution and invest in growing our existing businesses and through acquisition. 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 Regina for questions. Thank you.

[Operator Instructions] And your first question today is from the line of Charles Redding with BB&T Capital Markets. Charles E. Redding - BB&T Capital Markets, Research Division: What are the margins on your service business right now?

So at the field level, we expect our service business to make at least 15%. That's without giving effect to corporate overhead, and the vast majority now of our businesses are achieving that. So having said that, we also -- in addition to growing our Service business, we have a very, very strong initiative to try to improve margins. So we hope to see that improve over time. Charles E. Redding - BB&T Capital Markets, Research Division: If you think about where the percentage of revenue could be for the service business after the completion of the buildout, what are your thoughts there? Do you have kind of -- do you have a ballpark there that maybe we could kind of think about going forward?

Okay. So -- well, you have to look at how we define service. And for the purposes of the service initiative, it would not be the larger definition of service that includes all retrofit. It would really be the pure service that you see in that pie chart that we publish, plus small projects. So the small projects that are sold really by service technicians in main -- and performed in the main by service technicians. An important characteristic of those is they're owner-direct, right? So a retrofit will often involve a general contractor. And that's probably -- today, that's something like 25% of our revenues, if you put the pure service with the very small projects that is the focus of this. And I think that what we'd like to see is our companies achieve 5% to 8% growth. Having said that, when you ask the question, what percentage of revenues it will be? That's extremely sensitive to what's going on in new construction. In the United States today, we're building half as many buildings, nonresidential buildings, as we were building in 2008. Even though that's not changing quickly, that's starting to change. And there should be a time when we regress back towards the mean. So one scenario you might see, one scenario I'd love to see is new construction starts to take off but service doesn't decline as a percentage because we're selling a bunch more service. And that would be a very, very, very virtuous cycle for Comfort and its shareholders.

Charles, this is Brian. I just want to add-on. We talked a lot about service on this call. But construction is still a very, very important part of this business. We're still working on it, and we still intend to grow it. So the percentages might change, but we expect construction to grow as well. Charles E. Redding - BB&T Capital Markets, Research Division: Sure. And then one more if I could. In terms of weather, I mean, do you guys feel that -- view this more as a potential drag or a potential catalyst?

It's Brian again, Charles. The weather has been pretty interesting, particularly if you live in the northern part of this country this winter. In general, if you get extreme of cold and heat, that's going to help your service business for obvious reasons. It can be a negative drag in construction, and we've seen some of that in the first quarter. You got heavy snow, it's difficult to get the job site, so when the temperatures fall to what they've fallen, your productivity levels almost remain too poor to work in. So it's been due to the excessive temperature that we've seen, been a slight drag on construction, particularly in the north.

[Operator Instructions] Your next question comes from the line of Saagar Parikh with KeyBanc.

First off, your bookings in the fourth quarter were up around 6% quarter-over-quarter. But then your initial commentary -- prepared commentary suggested that you don't expect bookings to continue at a level where you'll see material top line growth. Could you kind of just tie the knot for us and explain maybe if you're still going to be able to see nice bookings and backlog growth through the year, but just not maybe 10%, 15%? Or what you're thinking on those comments?

So one thing I'd point out, Saagar, is even though we're up sequentially, our backlog's up sequentially against a year ago, it's actually very similar. I think that we think that there is a more supportive booking environment today. But I would say at this point, I think we would expect -- everything we're seeing today would suggest that our backlog growth would be gradual. And you might have a quarter when it's down, a quarter when it's up. I think the trend will be in an upward direction. That could change quickly, it has in the past. But when we say that it's not going up fast, you have to remember when we came out of last couple of recessions, our backlog doubled in a several quarter period. So this is -- it's nice to see an increase, but this is a relatively measured increase. Still is a lot better than the flat step we've been experiencing forever now, but it's still -- it's not a pop.

Sounds good. And then looking at the last cycle and looking at this cycle and the fact that you guys have added $450 million or $500 million or so in acquisition-related revenue, where do you guys think the top line could go this time around? And I'll go a step further, where do you think the top line can go in this cycle, and where do you think peak margins could go? Again, in 2016, 2017, not now.

So if you want to put an assumption in that question that we get back to 90% of the demand we had in 2008 or let's say 80% or 85% of the demand in 2008, you take all of our existing buildings if they could get back to -- all of our existing companies if they could get back to that level, and we still hope to do some acquisitions. We're still actively looking at acquisitions. I think we would hope to get to the $2 billion -- the $2 billion range. Margins are harder to discuss, but we think that everything we're doing suggest that margin should be improving for us over time. And obviously, the most potent thing that could happen is pricing can come off of just very, very, very bad levels.

And if we got to around -- this is Brian, Saagar. If we got to around 75%, 80% of those margins, I think we'd be pretty happy.

Yes. But in the last cycle, excluding Atlas-related issues, you guys did close to 7% operating margins. So maybe something like 6% is achievable in the peak this time around?

We'll see where it goes. In my opinion, we'll do everything we need do in this company to achieve that level.

Your next question is from the line of John Rogers with D.A. Davidson. John B. Rogers - D.A. Davidson & Co., Research Division: A couple of things. First of all, Brian or Bill, in terms of the cycle the way it's developing here, I know it's been a lot slower than probably all have expected since the recession. But as you think about the market over the next couple of years from mechanical services, do you see a dramatic change in who your target customers are, especially versus what we saw in 2008, 2009? I know you're out of the multifamily, but is there other shifts, I mean, towards industrial or necessarily noncommercial projects?

So I think we'll both answer this question. Mathematically, there is definitely a shift towards industrial. We -- historically if you look back over 10 or 15 years, we were always 11% to 15%. And now we're at 25%. That comes from 3 factors I would say. One is we bought some companies that do more industrial than our historical mix. Two, industrial is doing very well in the United States and has very good underlying fundamentals. And three, our footprint is across the Southeast. And a lot of the new industrial work, some of the pharma, the -- whether -- foodservice, auto plants, a lot of that's going towards the geographies that we are strong in. And really, we go to market -- we go to market -- you mentioned the market for mechanical services. And the way that we acquire customers for mechanical services is through our service route and through our sales of construction. But really it's not 2 businesses. It's a continuum, and that's -- we think that the investment that we're making in service will benefit us up and down the continuum of sort of the single business that we serve, which is the mechanical services thing you mentioned. John B. Rogers - D.A. Davidson & Co., Research Division: And sorry, Bill, the margins on that work, I assume it's a little more sophisticated work. Are they notably different?

I think that it's, a, it is better -- it's got a bunch of really good things about it. One is, you work in facilities where you have access to do the work like -- so a large project is constructed over a shorter period of time typically, and that gives you a much better chance of hitting your budget. One of the hard things in a construction project is managing all the factors that -- like when you're building a hospital, there are a lot of people coming through every room you want to come through. And you have less of that. Typically, the industrial customer is more interested in getting their work done, getting it done well. And so that plays to our strengths. If you think about it, their costs as a percentage of their cost of goods sold, their costs for the building is much lower. If you're putting in a pharmaceutical line, speed is much more important to you than saving a few bucks here and there, as compared to somebody who has a big building program. So I think there a lot of things. I don't know, Brian, what do you...

John, that's a good question. And I think the margins will be a little bit better. But at the end of the day, as you and I both know, this comes out to execution in the field and how good you are with the teams you've got out doing the work and serving your customer. And I'm really optimistic about this sector because we've got a terrific workforce, world-class and as good as it gets. So I think based on what Bill said, maybe a little bit more speed to it, this fits right into what we're good at. John B. Rogers - D.A. Davidson & Co., Research Division: Okay. And just to follow up, I guess on, Bill, your comments relative to SG&A spend in 2014. I appreciate the comments on investment in service. But your SG&A tends to move with your revenue regardless. Though, I mean, I assume you're not implying that your absolute SG&A only changes by $4 million this year.

No, in fact -- no. So if we start-- if construction picks up, and we start making more money, we'll start paying more bonuses to project managers and things like that. So this is incremental. That is -- it is a sterile year-over-year look at an amount of money we spend on training and an amount of money to add some people that we're adding, add some systems, like CRM that we're adding. But the number's big enough, and it will probably make our SG&A as a percentage of revenues, it will affect them unless we get some good revenue -- unless demand really does start to come in and the revenue starts to move more. It will affect that in a way that we really feel like our shareholders deserve to be apprised of, even though we've been talking about it for 1.5 years to 2 years. Given that we're peaking this year, we thought we owed it to everyone to be very specific. And really we want to be accountable for the investment. We need to be accountable for the fact that next year and the year after, something comes of it. John B. Rogers - D.A. Davidson & Co., Research Division: And then, just lastly if I could, the acquisition activity has been fairly quiet of late. Are there just not opportunities out there? Or nothing that fits? Or price is too high?

I want to go first, then Bill can give you some details. But we were quiet last year, but I think the acquisition template out there is actually pretty active. We're looking at a lot of opportunities right now, John. As you know, we're very selective. We're very prudent. It takes us a long time to get comfortable and some companies to get comfortable with us. And we try to be very diligent with that, and we're doing that right now. Bill, do you want to add on to that?

I think the people that I report to expect me to get some acquisitions done this year.

That's why I went first, John.

Ladies and gentlemen, this concludes the question-and-answer portion of today's event. I'd like to turn the call back over to Brian Lane for any closing remarks you'd like to make.

Okay, Regina. Everyone, thank you very much for listening to the call and your interest in Comfort. We appreciate it. This was a very good quarter and a very good year for Comfort. And I am very proud of the work done by all the employees of this company. We are poised for growth, we're investing in our service, and we're ready for construction growth to finally improve. With that, we hope you all have a very safe and happy weekend. And we'll see you on the road soon. Thank you.

Thanks.

Ladies and gentlemen, thank you so much for your participation. You may now disconnect. Have a great day.