Comfort Systems USA, Inc. (FIX) Q1 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter Comfort Systems USA Earnings Conference Call. My name is Dave, I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I'd now like to turn the conference over to Ms. Julie Shaeff, the company's Chief Accounting Officer. Please proceed, ma'am.

Thanks, Dave. Good morning, everyone. Welcome to Comfort Systems USA's first 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 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 and 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 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 thank you for joining us. 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. I will start with an update on our results and comments about the acquisition we just closed. Bill George will then take us through the results in more detail. And finally, I will discuss backlog and the outlook for the rest of the year. During the first quarter of 2014, we had revenue of $321 million and earnings of $0.01 per share. The first quarter is always our weakest quarter of the year. This year we had a particularly bad winter at many of our locations, and that wintry weather led to delays and profitability losses that affected our revenue, as well as our profitability for the quarter. The extreme cold, as well as icy and snowy conditions impacted our ability to travel to and work on our construction sites in the Northeast, mid-Atlantic and Southeast for a number of days during the first quarter. The effect of weather on our service business was mixed. And in some cases, conditions led to days where our texts were delayed or could not work. In addition, our SG&A increased this quarter due to our incremental investment in service and information technology. We experienced some encouraging improvement in gross profit margins this quarter. However, the additional SG&A cost more than offset that improvement. Bill will provide more details about these factors and our operating results in a few minutes. Our backlog increased to $612 million, which represents our second sequential quarterly increase. I am very happy to announce that the acquisition of Dyna Ten was finalized yesterday. Dyna Ten has a long history of providing excellent installation and service capabilities for its customers in medical, industrial and commercial markets in the Dallas and Fort Worth area. We have viewed Dyna Ten as an excellent potential partner for many, many years. We began discussing a transaction with their team in 2005 and have maintained a correspondence with them since that time. We believe that Dyna Ten is the premier company in the Dallas market, and we are excited to have them on board. We view Dallas/Fort Worth as a key market for our future. Dyna Ten brings excellent resources and leadership at every level and, in addition to their direct contribution, we expect that they will help us to strengthen and improve our existing operations in Texas and across all of Comfort Systems. This quarter had its challenges, but it has also had encouraging signs. And we continue to believe that our overall profitability this year will maintain the strong improvement that we experienced in 2013. We believe that over the next several quarters, demand for nonresidential construction is likely to gradually increase in the majority of our markets. And as a result, we are optimistic about 2015 and beyond. I will describe our outlook in more detail in a few minutes. But before I get into that, let me turn this call over to Bill to review the details of our performance.

Thanks, Brian. If you're online and have access to our slides, you're welcome to refer to Slides 2 through 4 as I review our financial results. Revenue this quarter was down 1% compared to a year ago as we reported $321 million of revenue compared to $326 million in the first quarter of 2013. As Brian explained, in many of our geographies, severe weather suppressed revenue and operating results for this quarter. I believe that the adverse weather cost us approximately $0.03 to $0.05 in our first quarter results. Gross profit was 16.2% for the first quarter of 2014 and that was an improvement from the 15.8% for the first quarter of 2013. Weather affected our gross profit, but during the quarter, we also wrote down a large project in our Southern California operation that cost us approximately $0.02 this quarter. Despite these challenges, we were pleased to see improvement in our gross profit percentage as compared to the prior year. We had margin improvement at a significant number of our operating companies and we were also helped by improved development and risk management claims this current quarter. SG&A expense was $50.4 million for the first quarter of 2014 compared to $46.5 million for the first quarter of 2013. SG&A as a percentage of revenue increased from 14.3% during the first quarter of 2013 to 15.7% during first quarter of 2014. As we discussed throughout 2013, we are continuing to make net incremental investments in service growth. During 2014, our strategic investment in service will peak as we will invest an incremental $3 million in training plus an additional $1 million to $1.5 million in people and systems. At the same time, we have higher IT spending this year. The 2014 investments are weighted slightly heavier in the first half of 2014 as we prepare for our peak service season in the summer months. Overall, this is a significant investment for our company that will continue in future years although at lower levels and we believe it will generate a strong return. Our tax rate for the quarter was 39.1%. Net income for the first quarter was $0.4 million or $0.01 per share compared to $2.5 million or $0.07 per share for the first quarter of 2013. The first quarter is always a seasonally lower quarter for us, and the adverse impact of weather as well as our California project results in a near-breakeven quarter for us. As we always expect, first cash -- first quarter cash flow was negative. Free cash flow for the quarter was a negative $12 million as compared to negative $13 million in 2013. But overall, we feel good about our operating cash flow for the balance of 2014. As Brian mentioned in his opening remarks, we're very excited about our announcement this morning that we have closed the Dyna Ten acquisition. This company has a broad range of mechanical contracting projects, HVAC service and controls and expands our geographic footprint in Texas to include the Dallas and Fort Worth areas. Dyna Ten is expected to contribute annualized revenues of approximately $70 million to $80 million at profitability levels that are generally equal to or above those experienced by other conference systems operations. In light of the required amortization expense related to intangibles and other costs associated with the transaction, the acquisition is expected to make a neutral to slightly accretive contribution to earnings per share during the first 12 to 18 months after the acquisition. But it will contribute notable revenues and EBITDA starting in the second quarter of this year. We used funds from our existing line of credit to fund this acquisition and, as a result, we expect to have borrowings outstanding and an increase in interest expense for the next several quarters. We continue to have good cash balances, ample capacity on our line and significant cushion in our financial covenants. For 2014, we expect activity levels in our industry to remain at levels similar to recent years, but we're optimistic that trends are improving. Our backlog is steady, remaining at solid levels in light of ongoing industry conditions. Based on our backlog and as a late cycle business, we expect that improvement in 2014 will be gradual and at this point, we expect the 2014 profitability will be comparable to the improved levels of 2013. That's all I have on financials, Brian.

Okay, thanks, Bill, and congratulations on bringing Dyna Ten into the fold. Let me start with backlog and activity in various sectors and markets. Please turn to Slide 5, and start with backlog. Backlog at the end of the first quarter was $612 million, an increase of $9 million compared to the fourth quarter of 2013. This increase is largely due to our existing operations in Central Texas. This backlog number does not include our new acquisition. Pricing, while relatively stable, is still challenging overall. At this point, although underlying activity levels are solid, we do not see an increase in bookings that would support meaningful revenue increase this year. Please turn to Slide 6 for a look at our end-user sectors. Our industrial and commercial sectors comprised 62% of our revenues for the first quarter of 2014 and 50% of our current backlog. The largest sector is manufacturing, representing just over 1/4 of our first quarter revenue and includes projects such as industrial plants, food production facilities, and data centers. Overall, we continue to win our fair share of small to midsized projects. However, we are still not seeing the larger projects in our backlog. If you turn to Slide 7, you can see our current revenue mix. Pure service, which is maintenance and repair, was strong at 18% of revenue for the first quarter of 2014 and service, repair and retrofit again exceeded 50% of revenue. For the quarter, our service businesses provided solid returns and our maintenance base has increased by approximately 3% since year-end after a very strong 12% increase in 2013. Overall, we are experiencing stability and we expect to see gradually improving conditions in most of our markets. We have invested in our business throughout the recession, including our recent and unprecedented investment in our service business through training, 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 have led to higher SG&A in 2014. Although our first quarter 2014 earnings and revenues were below the same quarter of last year, we do not believe that these results indicate a trend. We continue to believe that the overall profitability for 2014 will be similar to 2013. We are beginning to experience gradually improving business conditions in many of our markets, and we are optimistic that these trends will lead to improved results in 2015 and beyond. We are very excited to welcome our new Dallas team members to Comfort Systems USA, and we are confident that this and our many investments over the last few years in people, processes and acquisitions have positioned us for success in 2015 and beyond. Finally, I would like to welcome our approximately 450 new team members in Dallas and Amarillo. And I thank all of our 6700 ongoing team members for their efforts. I will now turn it back over to Dave for questions. Thank you.

[Operator Instructions] Your first question comes from the line of Tahira Afzal at KeyBanc Capital Markets.

This is Saagar on behalf of Tahira. So my question is mainly pertaining to competition. Can you please comment on the competitive dynamics you're seeing on the institutional side of your business?

So institutional for us is health, education and government. Healthcare is not strong right now. We have far fewer jobs that are ongoing right now in healthcare sectors than we typically would have. When it comes to education, our education breaks down into 2 pieces: private, usually post-secondary education; and K-12. I think we only have a few companies who do much K-12. I think they remain active in that market. And we do have actually -- we booked a little bit of new work in private post-secondary, so I would not consider that a robust market but I know of at least one interesting job that we have, so. Meanwhile government, I think, overall government which is not as typically as big for us, is mostly, except for military bases, I think that, that's flat for us. We have some military work going on probably less than usual. I would not -- I would say that's definitely not a source of strength.

Okay, got it. Further, I have one more question. Can you talk about the further M&A activity for yourself? And where do you see the regional end-market opportunities?

Okay, so we still have active correspondence with acquisition -- potential partners for acquisitions. We've had a very good run for many, many years. We've done a lot of what we call tuck-ins. It's folding new capabilities typically or adjacent geographies into existing operations. And we haven't -- we've, knock on wood, we haven't had a bad -- had to report a bad tuck-in to our board in 5 or 6 years. So we're -- although we're very -- the reason we haven't is because we're very careful with those. But we still are pretty -- we're still very -- we're avid to continue to do the tuck-ins. As far as larger deals like Dyna Ten, those deals have a long gestation. I think we're open but I think we'll be very, very picky at this point in the cycle.

And where do you see regional end-market opportunities coming from? And are you seeing more competition there?

Are you talking in general or just for acquisitions?

This is in general.

In general, okay. Just to summarize how we're looking at it geographically, up in the Northeast, it's stable, we have probably slight improvement going on at the moment. The mid-Atlantic has improved since this time last year, significantly more opportunities we're seeing. And the Southeast as well has improved from this time last year. Texas is probably the strongest state at this point, very robust right now. The Upper Midwest has been stable for us and we've seen a lot of good opportunities. The West is probably more of a mixed bag. Some cities have improved such as Denver. Others may have slowed down a bit like we've seen in Phoenix, Arizona. But in general, I think across the country, we're seeing gradually slightly improving conditions in all markets.

And talking about Texas, are you seeing more competition coming into your Texas unit, given their strength?

No. I think the players that we see here have been the same we've seen for a number of years. Have not seen an increase, production capacity is about the same.

All right. And what about other regions? How is the competition there?

I think in general after 5 or 6 years of this recession, we had anticipated that there would be a reduction in production capacity. And though there has been some, it has not been material. A lot of companies have maintained and survived through this recession. So the good news is for us now though, with residential picking up, we do see a normal numbers of bidders that we saw in the mid-2000s today, so we're going to a normal bidding environment, in my opinion.

The next question comes from the line of Adam Thalhimer at BB&T Capital Markets.

I want to follow-up on that last question really quick on the, I guess, with regards to pricing. I mean, Brian, you talked about a gradual improvement in demand here. Is that enough to drive some pricing improvement do you think?

Well, we've seen a slight, Adam, nothing significant. Where we're seeing improvement in gross margins is mostly done on the execution front. In all the work, the training, prefab, the service mix that we've added. We've seen it more on that front than really a material improvement in pricing yet. Bill, do you have anything else?

We've got our fingers crossed.

Yes, we're ready for it.

That's what will really matter. And people are booking up so when they start to book up, they start to raise prices.

Okay. And we might have talked about this before but where was the maintenance initiatives, where -- how much maintenance revenue can that add and where are maintenance margins generally?

So one of the most gratifying things we've seen this year and for the first quarter -- that last year for the full year and this year for the first quarter this year, is increases in our maintenance base that are -- frankly they're unprecedented. Same store increased last year 12%, in the first quarter 3% and maintenance base -- our maintenance base is up to $87 million. Maintenance base in and out of itself is good, steady. We only take that business if it's profitable, we're not willing to lose it as a loss leader but it's a very, very important source of future incremental, small projects and change outs. And so that's why it's an important leading indicator and it's really -- it's a huge part of our service focus right now. So even though it's not something that has instant impact -- it's just probably the single most important element for getting the flywheel turning if you're trying to improve your service offering.

And you know, Adam, as far as the improvement, I know Bill and myself are really excited about the improvement we're seeing in the service business already.

Okay. And then I just want to ask one more about, it's a modeling question on SG&A. There's a couple of moving parts here now with the service and with the acquisition. I'm just curious if this $50 million per quarter is the good kind of run rate for the year? And then would it come down from that in 2015?

So the new acquisition will bring in -- it is proportionate SG&A. Their SG&A profile is similar to ours. So you'll see that change and we'll highlight that for you in coming quarters. I'm not ready to quantify that. If you were to take same-store, unless we start to do a lot better which would push bonus accruals, that would be good news. I think I am hopeful that we're really annualizing at the highest rate we will annualize for the year this quarter. We still have a lot of training on the service side in the second quarter. There will be less of that direct cost of training, in the second half of the year. We slow it down a lot during the hottest months of the summer. We have less of it at the end of this year. What we've said is that we have about $4 million in incremental service related SG&A increase in 2014. That's over already elevated levels of service investment last year. That would go down to $2 million next year. Our IT spend which is a little bit high, we've migrated the enterprise onto the cloud for a lot of our basic functions over the last few months. We're in the middle of that. It's a project -- internal project called Project Enterprise Spread. We've also obviously like a lot of companies, had to eliminate all of our XP machines. We're taking advantage of that to try to really bring ourselves into a higher level of IT sort of competency which we think will benefit us. So once again, that's heightened for this year. It's more heightened in the first half of the year than it will be in the second half of the year but much less -- obviously not near the magnitude of service but yet another element that's contributing to that.

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

I guess just getting back to your comments, Brian, on the optimism or slightly more optimistic about the market outlook. If we're not seeing it in backlog yet, can you just maybe give us a little more color on what you're seeing or thinking out there? I mean, are there project proposals specifically that you're looking at or...

Yes, John, as we've talked about in the past, we're looking at the prospects to me are pretty exciting at the moment, pretty robust to be honest. The bidding activity is good. Probably one recently would have been a higher profile job, size-wise than I've seen the last 5 years. So that's probably the source of my gradual optimism, if I could put it to you that way. But we are seeing prospects improve.

If you don't mind, I'll comment on that, too. We have been rotating out of institutional and hospital work into industrial work which has smaller average project size. So with that -- and the jobs stay in backlogs for a shorter period of time for the revenues that they represent. Industrial work moves much more quickly. We typically control the job. It's often in an open ceiling. So the same amount of backlog can actually represent more work in that particular -- that shift. If you look at the pie chart for our end users, there's just been massive movement into the industrial sector for us. And that's just really good work for us. There's signs of life in Pharma. We're seeing some things haven't seen in a while. So there is really good omens out there and...

You know, John, if you look at the manufacturing, it's about 30% of our business right now. And that's work that we have a long history of being very good at. And that's in the construction front. But in service we talk about the maintenance base, but the replacement business, I'm very optimistic about as well. A lot of this equipment is getting old. It's going to have to be changed out.

And I know you're, I mean, late cycle within even within construction environment, so when would you expect that we would start to see this improvement showing up in orders and backlog? Is that something we could see this year? Or is that more of 2015 as well?

John, the way it looks right now, I'd say that the back end of 2015 we should see it in our numbers.

Back end of 2015?

Well, yes, so it would age into our numbers.

In the backlog?

It should start to show up in backlog much sooner, should benefit us in 2015. We're getting to true robust underlying markets, it takes quarters to do that. And you of all people have seen it, right? You've seen, there's a reason why we continue to do great for a year or 2 after recessions start is the way, it's just the way money ages through.

Okay, I was just saying to -- some of the signposts to be looking for, and quantitative evidence?

Well, basically backlogs should start -- there should be a backlog as the year goes on. There is the compositional element of backlog as well but that's starting to get fully baked in right now.

Okay. And then, Bill, just to follow up, I appreciate the comments on the estimate for the weather impact in the first quarter. Do you have any guestimate on what the revenue impact was?

Yes, that's even harder. I would say -- yes, I hesitate to even say. It's somewhere in the order of probably $7 million to $15 million or little higher million. It's really hard -- that's a really hard thing to guess.

But as you know, John, we're not big fans of using the weather as any kind of excuse, but this was significant this quarter.

I mean, we had places where we didn't have electricity in our shops for days. We had places where kids were off school for 30 days. That affects their parents. There's a lot more of their vacation time that gets used, so you're still paying them. You had places that shut down, jobs that shut down, places where the governor said to stay off the road for a couple of days, so we could only send out emergency trucks. We had places where we had to -- we maintain call centers that keep important businesses like nationwide retailers open, and we -- sometimes we had to put people up in hotels next to the call center because we can't fail to meet that need just because Indianapolis has a snowstorm. So there's just a lot of ways in which -- and we are very heavily located in the Southeast and the mid-Atlantic. And those were areas that got weather they don't usually get. They don't have the resources to deal with in the same way. They shut down a lot more quickly. I mean, you saw what happened in Atlanta, right? So we just had a lot of places where we were canceling visiting places because they weren't going to be there that day, if you know what I mean. So it was -- we haven't talked about weather in a call or in a press release since the first quarter of 2005. It's not something we bring up unless we just feel like it's an element that has to be discussed.

Okay. And sorry, last thing if I could, acquisition pipeline. I know these things take time, but is there a lot of discussion activity going on?

This company is the proof of these things take time since we were -- we started with these guys in 2005 and, frankly, waited for them to some extent. They are, we believe, the best company in Dallas. We felt like we had to just be a premier. Dallas was a market we needed to be premier in, so we had other companies that we could have done something with that would have ultimately precluded what we were able to do at this great acquisition. It is a long and careful thing when we buy a bigger company. Having said that, we are in good conversations in some geographies where we think we could get some synergies. I don't see standalones in the next quarter or 2 that are close enough to come into fruition, but we are still very active, if anything, putting more resources at least into making sure we have our arms around what's out there. Sorry about the long answer.

The next question is from Joe Mondillo at Sidoti & Company.

Apologize if I ask anything that you've already covered, I jumped on a little late. But first question, you stated that your new construction revenue was actually up year-over-year. Was just wondering was that more southern geographies of your new construction projects hitting in the first quarter? Or considering the weather, how do you think -- what do you think about that?

If you're talking about the sort of the shift in those pie charts, what you're seeing -- we had a big retrofit project that was a big part of last year on the West Coast that kind of finished. And that's just -- and in the first quarter a couple of percent change in that pie chart on the low revenues we have. I don't think -- I think we're really right on where we were last year. Until bigger jobs start -- get started, I think you're -- I don't see a lot of change there.

And really, Joe, it can move with bringing some equipment into the quarter, really it's that close.

Okay. Even if it was flattish though, given the weather in January in particular, is this quarter masked by the weather, it should've been -- obviously, it should've been better if the weather was better. But the number -- I guess, what I'm saying is, the numbers look pretty good even with the challenges of the weather. What are your feelings going forward? How does April look? We can expect sort of mid-single digits second, third quarter and start to accelerate from there? How are you thinking about the future?

Well, I don't know how April's looking yet. But I think if you're looking at the 3% to 5% increase at McGraw-Hill. And I think that's we're seeing out there, Joe, at the moment. I think we'll see some improvement in the construction business throughout the country.

Okay. The second question I have is on gross margins. Can you remind us how sort of the profitability of sort of new construction versus retrofits versus servicing sort of plays out?

Well, service has the highest margins particularly over the course of the business cycle. There are times when things are -- when there's high demand that construction can have really remarkably high margins. For example in 2008, I think our construction margins exceeded some pretty good service margins. But as a typical matter, service will average much higher margins and it really carries you in tough times. Retrofit tends to have slightly higher margins than new construction. If you're in sort of -- if you're in a stable or a sedate market. The #1 reason for that really is that we're going direct to the owner. And having said that, retrofit can also have a lot of coordination. You're often working in a building that's being used. So if you're in school, you have to pack things into the summer. If you're in a hospital, you have to do weekend shutdowns, that gives you an opportunity to demand more. It also heightens execution risk. But generally speaking, our highest margins will be in pure service. Our second highest margins will be in small projects. Then will come retrofit and then will come new construction. And SG&A will be just the opposite of what I said. Lowest SG&A related to new construction going up from there.

Okay. So I guess, what I was trying to get at is that, are we going to expect once sort of new construction starts to pick up, maybe a little bit of a plateauing or at least just sort of a slowdown in the expansion of gross margins?

I'll tell you what's happened in the past. What's happened in the past when markets first get going and this is -- this I just have -- twice we -- I've been through this. When markets first gets going and revenue starts to roll through on the new larger jobs, you will have -- that will create downward pressure on margins. And hopefully, we'll be offsetting that with improvement in service but just that by itself will create downward pressure on margins. Large jobs, you tend to carry them at measured margins through the first part of the job. So because you don't know what's going to happen. There's a great deal of variability of what could happen. And so you will start the job at -- if you started at -- if you bid it at 10, you might carry it at 7. And then as you see critically once you're more than halfway done with the job and especially as you get much deeper into the job, as you see that's when you started the equipment it's running, as you see that the other trades are allowing you to do your work in an efficient and effective way, you start to release some of that margin. And so then you have the benefit of -- it's late in the job, where that -- you have the potential for much higher margins.

Okay. Lastly, I was just wondering -- I'm not sure if you touched on it yet, but acquisitions for the rest of the year, sort of what your expectations are?

I think we're concentrating on tuck-ins, although we're still working hard in particular on a few geographies, that we think we could -- we would have synergies in. But I think the price here at least a couple of tuck-ins, I would not at this point be willing to go out on a limb and predict that we do another standalone.

Okay. And that would mean sort of smaller type deals more so in the back half of the year?

You know, tuck-ins range from $1 million or $2 million of revenue for us, all the way up to low double digits: $10 million, $12 million, $14 million. And in revenue, we could pay anywhere from less than half of revenue to, if we buy just a premier like controlled company with a really -- with hundreds of installed -- hundreds of buildings in their installed base that they kind of have control, we might pay nearly as much as revenue, although the multiples in either case would be similar because the mature controls companies are going to have much higher margins. So that's the size range we're talking about. It doesn't really move the balance sheet much. It doesn't -- it moves revenue some, but what it does, it improves existing operations over time.

Gentlemen, there are no further questions. So I would now like to turn the call back to Mr. Brian Lane for closing remarks.

All right. Thanks, Dave. And, everyone, thanks for listening to our call and your interest in our company. We really do feel good about the balance of this year. We're optimistic and we're poised for growth in both our service and we're ready for construction to improve. And once again, we're very excited, and we welcome the folks in Dyna Ten into the Comfort family. Hope you all have a great day, and we'll see you soon.

Ladies and gentlemen, that concludes your conference call today. Thank you for your participation. You may now disconnect. Have a good day.