Comfort Systems USA, Inc. (FIX) Q3 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Third Quarter 2015 Comfort Systems USA Earnings Conference Call. My name is Derrick, and I’ll be your operator for today. At this time, all participants are in a listen-only mode. We shall facilitate a question-and-answer session at the end of the conference. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Ms. Julie Shaeff, Chief Accounting Officer. You may proceed.

Thanks, Derrick. Good morning. 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 up 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 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.

Okay, thanks Julie, and good morning everyone. Welcome to our third quarter earnings call. I'd like to start by thanking all of the Comfort Systems’ employees who are on the call today. Their hard work and dedication makes it possible for us to continue to deliver solidly profitable results. For the third quarter of 2015, we are extremely pleased to report year-over-year improvements. Revenue for the quarter was $411 million and 11% increase compared to the third quarter of 2014. Earnings for the quarter was the best ever, $0.26 per diluted share as compared to $0.20 per diluted share in the third quarter of 2014. Cash flow continues to be very positive and we are on track to generate positive free cash flow for the 17th year in a row. Overall, I'm extremely happy with the terrific execution at the majority of our operating companies both on the construction and service sides of the business. Over the past few years, we’ve made investments to improve our processes around which we call our job loop, which is a process map that helps us focus on continually improving project selection, estimating and execution. The investments that we have made in improving our construction operations and in growing our service business have really started to pay off. In addition, the underlying fundamentals in non-residential construction are solid. Although our backlog declined sequentially in the midst of our seasonally busy project months, our backlog is still up year-over-year. I’ll discuss backlog in more detail later on the call but first, let me turn this over to Bill for the financials.

Thanks Brian. You can refer to slide 2 through 6 as I review our results. And then I have one another slide, I just want to mention. Revenue this quarter was $411 million, as Brian said that's an increase of $40 million of 11% compared to the third quarter of 2014. Approximately 42% of this increase resulted from a high-level of profitable project activity at Environmental Air System or EAS which is our majority-owned subsidiary in North Carolina. Totals revenue for the first nine months of 2015 was approximately $1.2 billion which represents an increase of $142 million over last year. On a same-store basis, year to date revenues increased 12% compared to the first nine months of 2014. Gross profit was 21.3% for the third quarter of 2015 and this was an improvement from the 18% in the third quarter of 2014. The increase was driven by a combination of broad-based improvement at a majority of locations combined with improved results from our Southern California operation, which negatively impacted our results in the third quarter of last year. For the nine month period gross profit increased from 17.1% in 2014 to 19.6% in 2015. SG&A expense was $57.9 million for the third quarter of 2015 compared to $52.2 million for the third quarter of 2014. SG&A as a percentage of revenue was flat at 14.1% for both quarters. The dollar increase is due to increased compensation accruals as a result of improved results and also reflects expanded service activities in certain locations. For the nine-month period, SG&A as a percentage of revenue has decreased from 14.5% in 2014 to 14.1% in 2015. Our year-to-date tax rate was 34.3% with continued benefit from strong performance at EAS as 40% minority interest is treated as a partnership for tax purposes. Net income for the third quarter was $17.7 million or $0.46 per share compared to $7.6 million or $0.20 last year. As mentioned, we had strong performance at a majority of our operating locations and the acquisitions that we made during the recession were really strong contributors to our performance again this quarter. For the nine-month period, earnings per share increased from $0.33 per share in 2014 to so far this year of $0.96 per share in 2015. I also wanted to mention that something you might have noticed in our 10-Q disclosure. Earlier this month, we received approval of change orders on multiple jobs that have minimal cost remaining to be incurred. We expect this to result in project gains of approximately $3 million to $3.5 million in the fourth quarter. Although some of this income would have been earned over the fourth quarter and future periods, the approval accelerated the recognition. Also, the largest portion of these gains relates to EAS, so the earnings per share line only 60% of that income will be included. Then, strong free cash flow during the quarter. For the quarter, our free cash flow was $18.4 million as compared to $17.5 million a year ago our nine months free cash is an unprecedented $60.3 million which compares to $23.3 million for the first nine months of 2014. This improvement is largely due to improved operating results as well as higher income tax and compensation approvals. Our taxes are paid later in the year in some cases, early in the subsequent year as some of our bonuses. As a result of our very strong cash flow, our net cash flow increased to over $33 million and we retired most of the debt that we carried at the end of last year. Although we expect positive cash flow in the fourth quarter, it may not be as strong as our prior fourth quarters because we are - our fourth quarters in prior years because we're starting the fourth quarter with some significant known amounts that will be paid in the fourth quarter that truly relate to the first nine months of the year. These include incentive compensation at all levels of our enterprise that have been accrued but they are not yet paid and more significantly will make a very large cash tax payment this quarter of at least $10 million to $20 million and it could be more depending on results. For the first nine months of 2015 we purchased 200,000 shares at an average price of $25.17. Since we began our stock repurchase program in 2007, we brought back 6.8 million shares. As we hope and expect, these share repurchases have made a big contribution to per share results as our earnings have strengthened. You may see share increases in our shares outstanding for diluted earnings and that results from our increased stock price and the treasury method imputes more share into that, obviously we've been able to overcome that in our earnings. I also added slide 7 to this quarter to show you how we deployed our discretionary spending over the last nine years that's a period that includes the entire life of our share repurchase program that includes both good and bad years. Pursuant to a capital allocation philosophy that we adopted at that time meaning nine years ago and which continues today, approximately 60% of the money has been invested in acquisitions including companies such as Environmental Air System, ColonialWebb and Dyna Ten. We've also returned approximately 40% of our discretionary money to shareholders and that was about evenly split as you can see between share repurchase and dividends. We believe that this approach has allowed us to reward our stockholders and at the same time invest in our future. Our current improved results are greatly impacted by the investments that we've made over the course of many years and we believe that this capital allocation strategy will continue to serve our shareholders well in coming years. Overall, our operating cash flow performance for 2015 has been remarkable. Having been at Comfort Systems for 18 years, I know firsthand that when markets turn up, our results tend to manifest that improvement really in jagging charts, rather than on a linear upward progression, but still we're optimistic that the underlying trends for construction really are improving in a majority of the specific vertical and geographic markets that we serve. So that’s all I have on financials. Brian?

Okay. Thanks, Bill. I'm going to spend a few minutes discussing our backlog and activity in various sectors and markets. Those are covered in slides 8 through 10. I'll then discuss our outlook for the rest of this year. Backlog as of September 2015 was $666 million compared to $657 million in September 2014. Sequentially, backlog is down approximately $46 million or 6% from the second quarter of this year. This fluctuation in backlog levels is not surprising to us as we generally have our highest activity levels in the summer months. We experienced marked increase in backlog at the end of last year. The backlog increasing in the fourth quarter by approximately $100 million on both the sequential and year-over-year basis. After our heavy winter booking season last year, backlog has appeared to be less robust sequentially than you might expect in light of our revenue trends. We believe that bookings will be good over the next two quarters, but it is too early for us to know how bookings this year will compare to last year. On the primary drivers of our recent sequential trend and a good example of what I am describing arises from events that EAS, starting with a significant increase in backlog at the end of last year. In the fourth quarter of last year, EAS had a single quarter backlog increase from large project bookings of $37 million. Since that time, EAS has been working through this backlog and their backlog is currently flat from a year ago. EAS has also contributed disproportionately to our spike in revenues during the last nine months, as they had two very large projects that peaked at approximately the same time. If you set aside the two revenue and backlog trends at EAS, the fourth quarter 2014 spike in backlog and a subsequent heavy EAS revenue contribution over the last nine months, our backlog and revenues match up much more logically. We believe that EAS is well-positioned to have a good 2016, however, given the truly phenomenal year they had, it will be difficult for them to repeat the same results. At the same time, other parts of the country appear to be strengthening and we believe that the underlying demand for our services has strengthened overall. Many of our markets are getting closer to full capacity and although our recent results set a high standard for next year, we are optimistic about our prospects. Let's turn to slide 9 for a look at our end user sectors. The institutional sector which include education, government and healthcare, comprised 37% of our revenues. The proportion of our work in the institutional sector has declined in recent years, but we've seen an increase in industrial revenues at 31% for the first nine months of 2015. Industrial for us includes projects and industrial plants, food production facilities, data centers and pharmaceutical projects. Overall, we are pleased with trends for our work in the various sectors. Please turn to slide 10 for our current revenue mix. We feel good about our current mix of new construction at 46% of revenue and service, repair and retrofit at 54% of revenue. Our service business achieved continued strong profitability and growth and our service maintenance base has already increased approximately 10% this year. The investments we’ve made in growing our sales force and building service capabilities over the last few years are a major contributor to improved earnings and growth in 2015. In addition to the investments we’ve made in service, we’ve also redoubled our commitment and increased our investments in safety. Our OSHA recordable rate has improved 11% compared to last year and is 37% below the industry average. While we’re seeing the positive financial impact of the improved safety results, the important thing is to get our people home safely at the end of each day. Finally, let's discuss the outlook. In recent years, we have been making significant investments in growth initiatives and in our workforce. Although the construction industry has challenges with the labor supply, we believe that the investments we’ve made in our workforce, most notably in our national training programs, will continue to help attract and develop the best workforce in this industry. A year ago, we had one of our regional Vice Presidents, Bill Fourt who was a former construction project manager with decades of experience to lead a concentrated effort to improve our construction operations and to take our already world-class trading to a new level. He has continued to augment these efforts and we believe that similar to our service initiative, we will benefit from heightened focus on construction excellence and workforce development. These investments have positioned us to take advantage of strengthening demand in a majority of our geographic markets and we feel that our results reflect the effect of our growth and improvement initiatives. We have seen industry conditions improve during the first nine months of 2015 and we expect these positive trends to continue in the near-term. As our markets get busier, our challenges shift towards pricing, execution and staffing. We believe that the investments we’ve made over the last few years have portioned us for continued success. We will use our strong cash flows to continue investing in our business, to acquire new businesses and to reward our shareholders. Before I turn to questions, I want to thank all of our 7300 team members for their efforts. I'll now turn it back over to Derek for questions.

[Operator Instructions] And our first question will come from the line of Tahira Afzal, KeyBanc Capital Markets.

Good morning, gentlemen.

Hey. Good morning, Tahira. How are you?

I'm fine, I’m just floored by your results. Congratulations.

Thank you.

You guys must be very proud of the job your employees have done. So, outstanding. Yeah, I mean this is - execution wise, you're clearly - if I look at the last cycle versus this cycle, I'm sure, Brian, you remember, in your memory still, I mean, this is obviously execution. So you’re obviously delivering very well. So I have to commend you on that. I guess what I’ve heard in your call so far is there continues to remain a point of focus, so as you look into 2016 and I know it’s never a clear picture, especially given the macro environment is still sort of not familiar, do you still feel you can, let’s say, if you're doing mid to high single digit revenue growth, that you can maintain margins like the ones we’ve seen over the last two quarters?

So, those are really two questions there, right, revenue growth and margins. I would say, we will have a very good year next year. We’re setting a high standard this year, a lot of things bode well for us. In this quarter, although we had some standout performance as we always do, this really, these results were driven by broad-based strength, but there was about $0.02 a share from our medical costs coming in lower, they are up, but they did not come in - they came in, the increase came in less than we had planned, but if you set that aside, it’s all really execution in the field. As far as trends, it’s very hard for us to say to set a mark like this and then just say it ought to be fine for next year too. But I think overall our net results for next year should be very good. You may have heard in my script I said we go up sort of - even when we know we're going up, it’s still a jagged line, so I don’t know. I wouldn’t bet against our guidance, but it will be a jagged line.

We've got a good balance mix right now between service and construction. Service has been growing steadily over the last couple of years, so you combine that with good construction execution and our margins are solid.

Got it. And a follow up to that, I know you are appropriately telling us about some of the tougher comps into next year, but when I talk to our data center analysts and our tech analysts at KeyBanc, it still seems to be very heavy growth market going forward. So barring the tough comp metrics, and as you look out into next year, and given you guys have talked about this market not really peaking at the earliest till at least 2017, I assume backlog as of right now looks like it should grow next year.

Yes, I mean, I think I really do believe, Tahira, and you know we are pretty conservative on this, but there is underlying strength in this market. It’s pretty broad based across the country. We feel good about 2016, no question.

The trend is solid. Now, then there is the specifics. And specifically last year in the fourth quarter we had $100 million positive backlog. We are back into seasonality now, because we are mostly busy or more and more busy. And what that means is you burn a lot in good months and you book over the winter, but it will be very hard to even come close to repeating $100 million single quarter positive. Normally we get our backlog over both the fourth and the first quarter. And I think we will see, we expect to see good bookings, good broad based booking, but it’s almost to note more of our revenue now is not going through and living in backlog, that’s obviously service which is bigger, but that’s also true. Our average, the large projects other than a couple of our subsidiaries they are not back. Their average project size is smaller and the industrial work, they were doing, we are like a third industrial and that work turns very fast. They make a decision, they do it. We are a much larger percentage of the overall project. These guys, if they are putting in new - good process, they are just putting in a new line to make something, you get in there and you just do it, right. You don’t have to wait for a driver or a guy to come by in a piece of let me put a pretty piece of wood somewhere to roll in and put a piece of wood in. So there’s a lot of things going on that make backlog harder than usual to try to do math with.

Got it, okay. Well, a phenomenal quarter again guys. Congrats.

Thanks, Tahira.

Your next question will be from the line of John Rogers, D.A. Davidson.

Hi, good morning.

Hey, John.

How are doing?

Good and congratulations as well.

Thank you.

Couple of things. Bill, your math and probably figured this out quicker that I admit, if I look at the percentage of business that was derived from construction activity versus service and maintenance or retrofit work, it looks like your construction work is growing close to 20%. Is that accurate and I guess and what are the - I just thought that some of that business was sometimes lower margin business.

John, are you looking at for one quarter or for the nine months?

I was trying to do the math quickly for the quarter, but thinking of that nine month data that you gave.

All right, I am going to be honest with you. I haven’t dug into that much, I will say we have a bulge of construction this quarter and especially in the nine months we had a couple of data centers peak out at the same time, with like hundreds of people working on them. But I will say, you would expect construction to be growing a little faster. I haven't looked at the actual numbers.

And John, you mentioned about the margins here, it actually has little margins, but all credit to the folks working on the field, they just executed terrifically in the margins.

And when we describe that - when you see as construction pop up on us, you will see lower gross margin. We’ve always assumed that would be being driven by larger projects right and at this moment an awful lot of that’s not being driven by larger projects. Our project size isn't going down, isn’t going up materially yet. So I still expect that trend would happen, but these smaller projects, a larger portion of their G&A live outside sort of the direct costs, because you don’t park people in trailers on the jobs as much and they just part of it’s just the mix that’s coming. I do expect if larger project work picks up, there are signs that it might, you will I think see lower gross profit. Because of that we should make more net income nevertheless if we are doing it right [indiscernible] increase demand.

And, John, I would say even if they get bigger, I think we’ve done a lot of work a lot of discipline in what we've taken up. I still feel good about it.

Okay. And you talked about the big job last year in the fourth quarter that you won, are there - I would assume you’d be aware if there is any major bid opportunities out there now that could be in that $100 million.

There are, but no $100 million. We never had any bid jobs, but I don’t believe the development on some of that work that I know about at least as big drivers would support $100 million increase in the fourth quarter. Part of that is because for some of the same customers we have next phases of similar projects and they have done redesigns where we're just getting new drawings and to get something into our backlog, it’s highly sensitive to win a piece of paper and get signed. I don’t think we're well-positioned to sign a paper for some of the projects I know by the end of the fourth quarter and we just happen to be last year. That's why I emphasized you got to look in our winter booking season as the fourth and first quarter.

John, just in terms of trends that we are seeing, if drugs are above a certain size they have to roll through here and Bill and myself and we take a look at them and I will say the month of October I looked at more of lighter jobs, I looked at it a while.

Okay, good.

We are not going to win them all, but just in terms of by trend.

Yeah, so they are out there. That’s I guess what I wanted to get your sense on.

It’s probably a little bit more increase than we’ve seen finally.

And I guess final, Bill, are you getting a sense that pricing is getting - bid pricing is get any better?

No, I will take the first short at that and Bill can comment after. I think we are seeing gradual increase in pricing, not a spike, John, but improving slowly and rising a little bit which is better than what it was.

Okay, I agree with that. We got some really good pricing on a couple of those projects in the fourth quarter last year, so we do have tough comparables, but the trend it would have to change. There is definitely a trend. It is what it is.

Okay. And then what about on the acquisition front. I mean, it’s been a little while since you’ve added anybody. Are there opportunities out there and as the market gets better, some of these private companies maybe wouldn’t want to put up all the cash or working capital that’s required. Is that prompting any action or they just want to ride the cycle?

Hey, John, I just want to - Bill is going to answer that, but we’ve brought a couple of terrific companies here over the last five years and they started off maybe a little slower than one or two, but Bill George has done a heck of a job finding some really good members of Comfort Systems and pretty comfortable buying some more. And so Bill can answer the details.

John, as far as - thank you, Brian. As far as looking forward, those are really interesting time for us, scratching our head about acquisitions because there are some really good companies that we’re talking to and at the same time, we are just really committed to being disciplined. So over the course of this winter, I think that it wouldn’t surprise me, if we didn’t do much and it wouldn’t surprise me, if we had some acquisition. I know that’s frustrating, could be frustrating as an answer, but I guess I would say, we definitely have some good possibilities. But we really have to have a conviction that it will be good for us and good for them. Some of these are companies I think will be part of Comfort Systems sooner or later, but the question is can we achieve a conviction for us and then and for them that we can make it go. So yeah, I think we might do some deals, but I don’t know.

But you know, John, we tend to be prudent and patient and make sure it’s a good fit.

Okay. Yeah, I mean obviously they have worked out really well, but we always want more. And one other just quick thing, I guess, Bill what are you assuming for tax rate?

Right now, fourth quarter, I would assume almost exactly what you’re seeing would be my best guess, because I think the proportion of - it’s all driven by EAS right now. EAS, we get a 100% of their revenues in the denominator when we calculate that percentage and we only get 60% of their profits. And their profit for them will always pull us down if they are making money, but because their profits have been disproportional even to our good other profits, they pull us down more and I would say the fourth quarter, it’s just too late for that to change much for the full year and they look like they are defined in the fourth quarter. Next year, I would expect it to take up a couple of percent, because I think that other companies will do a little better and they repeating what they did this year is an unrealistic expectation. Every now and then, people not going out of a ballpark and into ocean and you can’t expect that every time. So I would say up a couple of 100 basis points or more depending on mix. But below the 39 range that you would expect if we own 100% of them. Our taxes are very, very predictable except for two things, what proportion comes from our partially-owned subsidiary and state tax accruals. State tax accruals drove our - made our tax rate hop around a bit a couple of years ago, when we were making a lot less money. They become an important when your net income is as big as ours, because $0.5 million here that just doesn’t moving as much. So that leads us with the contribution for minority interest, being the main drivers.

Okay. Thank you very much.

All right, John, thanks.

Anybody listening to this, I just want to say this. If you - when you’re modeling us, if you take out the 40% of minority interest don’t then go lower than tax rate. You got to make sure you don’t double count the benefit, right. It’s built into the fact that you take the earnings, the 40% of the earnings out of our model, if you happen to be modeling, it’s a very easy mistake to make, because people tend to apply the tax rate at the end. So down little thing, but I used to - I have made mistakes like that, so don’t double count the benefit. Thanks.

[Operator Instructions] Your next question will be from the line of Adam Thalhimer, BB&T Capital Markets.

Hey, good morning, guys. Congrats.

Good morning, Adam. Thanks.

So most of my questions have been asked and answered, but Brian can you walk us around the country a little bit in terms of what you’re seeing bidding wise?

Okay, got. Good question and thanks for asking it. If you look up in the Northeast, which for us goes from sort of Maine, over to Wisconsin, down to Washington, it’s been a probably a most successful region since the company started. Solid results and very good bidding activity. So the Northeast for us, still good. The Mid-Atlantic around that Washington D.C., Virginia area has really picked up, late coming out of recession, lot of good opportunities, got a company in Shenandoah Valley that probably has all of the work they need for next year already. So we’re seeing good activities here. Probably the Southeast is the biggest mixed bag, Adam. We have got some good spots, North, South Carolina, Florida probably still little slow, Arkansas very good. In general, I would say up a little bit. The Midwest, where we have some really strong companies, particularly in the upper Midwest, their bidding activity is good and the results are fantastic, but they have been like that for us since Day 1. The West for us one in the recession last one out. We’re seeing activity finally pick up there and across the board. Results improved significantly so far year-to-date and opportunities in bidding changed a lot of the management out there. Much more confident in what we see going forward on the west. And of course Texas, as you know, Adam, we don’t have any really oil and gas dependent, so it’s really not affecting us directly and our operations in Houston, Dallas and Austin are still doing very well. So in general, looking across the country, we are pretty optimistic across the board.

Okay. And then are you seeing any green shoots in the healthcare space?

No, hospital construction, no. I know of one or two projects and we are not even going out from.

That’s what’s up in healthcare actually, but nothing big. Still a lot of what I call end of light here, living or nursing home being a lot of urgent [ph] tier type activity. But the big hospitals not yet Adam.

That’s a really good question, as the last expansion was driven by hospital construction and it’s the lowest type being outgrowth [ph] in 18 years, the 18 years has been around that.

And then lastly, have you see any in your service business, I know, you picked up some nice work kind of middle of the year. I mean, are you still picking up some nice chunks of customers on the service side?

Absolutely. Our maintenance base is now over 100 million. That’s just been great leadership out of that, initiatives and the folks of the field, deal, et cetera, so a lot of improvement including execution and we are growing - we are just growing steadily. I couldn’t be more happy with what’s going on in service, Adam.

Great. Thanks guys.

All right, Adam. Thank you.

At this time, we’re showing no further questions in queue. I would like to turn the call back over to Mr. Brian Lane for any closing remarks.

All right, Derek. Thanks a lot. I appreciate everybody interested in Comfort Systems today. We had a really good quarter. I want to thank everybody out in the field and everybody in the company for doing a terrific job. Bill and I will be out on the road here shortly, look forward to seeing you all and I hope everybody has a safe and happy Halloween tomorrow. Have a nice weekend. Thank you.

Thank you.

Ladies and gentlemen, that concludes today’s conference. We thank you for your participation. You may now disconnect. Have a great weekend.