Comfort Systems USA, Inc. (FIX) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q3 2016 Comfort Systems USA Earnings Conference Call. My name is Matthew and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And now, I would like to turn the call over to Ms. Julie Shaeff, Chief Accounting Officer. Please proceed, ma’am.

Thanks, Matthew. 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 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 commentaries 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 as is 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. We are pleased to report a very profitable quarter. And today, we are reporting the highest quarterly earnings per share in our history. We earned $0.54 per share in the third quarter, a 17% increase compared to the strong third quarter we had last year. Through 9 months, we have earned $1.27 per share, which is $0.31 higher than last year at this time. Our operating income margins for the third quarter, was 7.5% and was 6.1% year-to-date. Once again, our operating teams at our field locations have delivered superb execution. We are also reporting record quarterly revenue of $429 million, which compares to $411 million of revenue last year. Backlog is $719 million and our backlog now is higher than last year at this time, both on an absolute and on a same-store basis. Overall, we continue to believe that our backlog and prospects are consistent with continuing strong results in the coming quarters. Before I turn this call over to Bill to review some details of our financial performance, I want to take a moment to thank the Comfort Systems’ employees for their continued hard work and dedication. Bill?

Thanks, Brian. Please refer to Slides 2 through 6 as I provide some additional information regarding our financial results. Third quarter revenue increased to $429 million as compared to $411 million last year. ShoffnerKalthoff, our newest company, contributed approximately $19 million of revenue during the quarter and was mildly accretive to EPS. On a same-store basis, our revenues were essentially flat with last year and you may recall that last year, we had a significant revenue contribution from some large projects in the mid-Atlantic area, so we were able to compensate for those expected declines. Gross profit was 21.6% for the third quarter of 2016, a continued improvement from the very strong 21.3% we achieved in the third quarter of 2015. The increase was broad-based reflecting solid project execution and improved service performance. SG&A expense was $61 million for the third quarter of 2016 compared to $58 million for the third quarter of 2015 and this increase was due to the ShoffnerKalthoff acquisition. Net income for the third quarter was $20.5 million or $0.54 per share compared to $17.7 million or $0.46 per share last year. This is the first time we have earned more than $0.50 in a single quarter and that results from strong performance across our operating locations. Our year-to-date tax rate was 36%, which is up from the prior year tax rate of 34.3%. With the acquisition of the remaining interest in EAS at the beginning of this year, our tax rate has increased. We would have expected our current year rate to increase to more normalized levels such as 37% or 38%. However, for 2016, a portion of the expected increase has been offset by a tax benefit from the adoption of a new accounting standard relating to equity awards as well as by benefits from some other small discreet items. We continue to have good free cash flow. We already have $33 million of positive free cash flow this year. And we have been able to step up share repurchases a bit and at the same time, retire a good portion of the modest debt that we incurred for the two strategic transactions that we closed in the first quarter of this year. During the third quarter of 2016, we purchased 214,000 of our shares at an average price of $28.29. So far this year, we have purchased 400,000 shares and since 2007, we have bought back well over 7 million shares. Overall, we are very pleased with our strong results for the quarter and we are optimistic that improved activity levels will continue in 2017. That’s all I have on financials, Brian.

Alright. Thanks, Bill. Let me start with backlog and activity in various sectors and markets. Please refer to Slides 7 to 9. Backlog as of September 30, 2016, was $719 million compared to $666 million 1 year ago. The February 2016 acquisition of ShoffnerKalthoff contributed to the year-over-year increase in backlog, but even without the acquired backlog, our backlog is up from last year by about $10 million. Sequential backlog is down by $5 million, which is in unexpectedly small decrease for a busy third quarter. In general, our operating companies have good and active pipelines and in many areas of the Northeast, in particular, we are operating near capacity. Pricing is stable in the majority of our markets and we continue to book good projects. Although large projects continue to be less common than one might expect given the economic recovery we have experienced over the past few years. Let’s turn to Slide 8 for a look at our end-user sectors. Institutional markets, which include government, healthcare and education, made up 42% of our revenue for 2016. The commercial sector with 35% of our revenues and industrial and distribution represented 23% of our year-to-date activity. We are generally pleased with trends in the various sectors and at this point, no individual sector stands out either as a primary driver or challenge. Please turn to Slide 9 for our current revenue mix. Those of you who have followed our company in the past will notice that we have made a change to this slide. Over the past few years, more and more of our construction work, including even many large projects, have been renovations and additions to existing buildings. In order to provide a little more clarity on this, we have broken our project work in existing buildings into two parts: construction projects and service projects. With our activities now divided into four buckets, you can see that through the first 9 months, 39% of our revenue was construction projects for new buildings, 31% of our revenue was construction projects in existing buildings, projects performed in connection with our service activities provided 11%, and pure service, which is composed of repair, maintenance agreements and other hourly work with 19% of revenue. Generally speaking, the 71% of our revenues that arise from the activities we jointly referred to as construction are the revenues that are primarily supported by our reported backlog. Our pure service as well as the substantial majority of the smaller projects we include in service are merely represented in our backlog as they are substantially contracted and performed within any given reporting period. Our service business had a particularly good third quarter. We continued to benefit from the investments that we made and we are continuing to invest in service. Our maintenance base is growing and we are seeing improvements in margins in many locations. This quarter, our fantastic operating company in Michigan achieved remarkable milestone of having $10 million in annualized revenue for maintenance agreements. And as that kind of individual effort multiplied across numerous locations that has helped us to gain share and improve our service results. And we expect continued overall improvement in this profitable business as we move forward. Overall, our investments and our people continued to lift our results. And we believe they will continue to benefit us in the coming quarters. Our balance sheet is strong and our long history of cash flow gives us confidence to continue to invest and return capital to our shareholders. We believe that our main markets are active and supportive, especially demand for work in existing buildings. We remain optimistic about our prospects for the rest of 2016 and for next year. In closing, I want to say thank you once again to our nearly 8,000 employees for their hard work and dedication. I will now turn it back over to Matthew for questions. Thank you.

Thank you, sir. [Operator Instructions] And your first question comes from the line of Tahira Afzal of KeyBanc. Please go ahead.

Hi folks and congratulations first of all, your record quarter.

Thanks Tahira.

Thanks.

So it looks like you are sort of hitting on all cylinders in certain areas Brian, as you mentioned, in the Northeast you are fully utilized, do you have expansion plans within that area as a consequence or are you a little more nervous of expanding in this macro environment?

Yes. Tahira, this is Brian. We will continue to gradually expand, continue to hire people, but the one thing we want to be really prudent about is taking good work with good margins, make sure we got the supervision and the labor to do it. So we will frankly expand prudent, but we don’t want to get over our skis and not remain profitable in doing good work. So yes, I think we will continue to hire people and continue to expand.

Got it, okay. And then this new breakup is really helpful, Brian and Bill, so thank you for putting this out there. When you talk about where you are gaining market share going forward and your initiatives to grow, I assume it’s within that – would you say it’s more within that 11% bucket or the 19% bucket?

It’s a combination. It’s the entire – so the 19% includes maintenance agreements and that’s definitely growing. And you will recall a few years ago, we were at $68 million, $70 million, now we are well past $100 million. That’s in the $90 million and that is really our number one metric. We look at internally to see if we are getting traction. But also, the reason that maintenance agreements are important is because they turn into those – they feed those service projects as well. So it’s the entire 29%, that’s the combination of those two. That’s how we – that is exactly how we measure the success of our service initiative.

And last question for me, now that you put these charts out there, any sort of qualitative commentary or help you can provide us in terms of the margin profiles of these four buckets?

There is a part of those construction projects that was south of $1 million, even in the construction part that has higher margins. But I believe that generally speaking, a really big, like an addition to a hospital which is a work on an existing building, has similar margin profile to what you would expect for new. I don’t think that there – there is a little – I would say there is a little more opportunity for margin. But I would say that there is not necessarily a big distinction in gross profit per man-hours. Sometimes when you do work in an existing building, there is less material that passes through, because there is already things inside the walls you could reuse and stuff. But at the end of the day, I don’t – I wouldn’t focus on that too much.

Yes. What you hear is you can look at the margins, but it really comes out in execution. Right now, if you look at those sectors, the operating companies and the folks in the field are really executing at a high level and that’s what’s really driving our margins.

Got it, Brian and congratulations to your team once again. I have two more questions but I will hop back in the queue.

Okay, thanks.

Thank you for your question. Your next question comes from the line of Bill Newby of D.A. Davidson. Please go ahead.

Good morning guys. Bill on for John today. Thanks for taking my call and congrats on the good quarter.

Thanks Bill. Good morning.

I guess first, I guess we will kind of just stay on the kind of growth outlook as you move through this year into ‘17, I am assuming that the majority of the prospects you guys are looking at continue to be in expanding that services segment of the business?

Yes. That’s correct. I mean we have had it for a while now. We have focused on growing all aspects of the service, both business, both maintenance base and projects. But also in construction Bill, we are seeing very, very good activity for the rest of this year and into 2017, particularly on our work in existing buildings. So I think in our commentary, we are probably more optimistic than usual, but I am feeling pretty good going into next year.

Okay, good to hear. And then in terms of regions, is there any one that’s sticking out as you look at the prospects into ‘17?

Yes. If you look across the country, what we call the Northeast is really the Northeast, sort of goes from Maine all the way to Wisconsin, but it was up from Boston, we expanded Northeast. So Washington – that region, I think in particular, is really strong at the moment, both in activity and how performing the work. But we are getting good balance across the country. I just think we are seeing probably out of norm exceptional performance up in that territory right now.

Okay. And then from a project size standpoint, I mean do you guys have those big data centers last year, this year you kind of have a smaller mix of work, is that kind of the outlook going into ‘17 has continued smaller projects or do you see any bigger projects coming into the pipeline?

Well. So let me actually give you some specific color about the first part of that you mentioned. The big projects that we had last year was at the subsidiary EAS in North Carolina, they had $10 million less of revenue, just that subsidiary this quarter, than they have the same quarter last year. And yet have the second highest revenue they have ever shown us. So it was just last year was an extraordinary year. Year-to-date, that subsidiary by itself is $40 million lower than a year ago. So we aren’t really a company that like to add things back or adjust for things. But one of the things that – if you really – if you were to take EAS out, it’s a really different picture of what’s happening across Comfort. They just have that big bounce last year. I think it’s important for people to sort of scratching their heads about our trends to be aware of that. And I know we warned it out, but we warned it out because it really is driving almost every comparable that you see. Having said that, as far as next year goes, I think we continue to think conditions are supportive. If you looked at our increases from 2011 to 2015, our average – I think our average EPS increase was something like 75% a year. We are not seeing those kind increases, but we think next year – we feel good about next year. We think we will stay at high levels and that should give us an opportunity to go make some money and improve. Brian, would you add?

No. I think you hit it all, Bill.

Okay. That’s all I got for now. Thanks guys.

Alright. Thanks Bill.

Thank you. Your next question is from the line of Joseph Mondillo of Sidoti. Please go ahead.

Hi guys. Good morning.

Good morning.

Good morning Joe.

So just to tag on to the last question, if you were to take EAS out, what kind of growth would you be seeing this year?

So if you just add back $40 million through nine months on a $1.2 billion you would be seeing what we said which was low single-digits, right. You will be seeing 3%-ish growth for the same-store across the business.

And Joe, that’s how we think going forward. We are no low to mid single-digit I think in our residential market, which is quite good really, keeps the labor risk manageable. I think we are pleased at that rate.

Okay, great. And so EAS, now that we have sort of anniversaried some of these are for the most part, anniversaried most of the projects that were in 2015, those large projects, that company was growing very strong over the last 2 years or 3 years up until this year, just because of the tough comp, do you expect above average growth to return to EAS, how has that business been trending?

If I were modeling it, I would model them over – really they have two businesses. They have construction and they have all-site construction. I think their construction would trend line with the rest of our business. Offsite construction they have maybe an opportunity to do a little better than that, but the reality is Joe as you model Comfort Systems, that’s not going to be mathematically important.

I just want to jump on real quick. We check a lot about EAS and the comp is down. This is a great company that’s having an outstanding year. So I don’t want – just in case if they are listening, we don’t want to act like we don’t appreciate it. They are doing a heck of good job…

Sure, understandable. So my next question, in terms of and this is sort of partially pointed out earlier, average project contract prices, the average price for your contracts are at the lowest, I think since 2013, but the number of projects that you are working on currently are the highest since 2012 and yet your gross margins are extremely high, so I am just wondering what your thoughts are on that and if that sort of changes your view going forward in terms of how you go about dealing with if and when larger projects come on board, if that – does this deter you at all and should you be focusing more on small projects, but many more number of projects, but lower contract price contracts?

I mean Joe the reality is that 31% that’s in existing buildings, it’s not that different. A lot of those projects aren’t that different than construction projects. What our guys are going to do is they are going to go try to get the best possible gross profit per hour of labor that they can sell. And so if the new construction gives us the right pricing, that’s what we will do. I mean our guys, they – there is not – when it comes to guys who are out welding and putting in pipe, there are considerations either way, but there is really no reason you would make a strategic decision to pursue one of the two kinds of work, what you have to do is maximize your gross profit for what used to be referred to as man-hours. And that’s what our guys will do.

As you know Joe, a real strength of our structure, were not here in the Shenandoah Valley or in Denver, Colorado, both places having terrific years. They adapt to what their market is. So you might have different micro markets around the country and the strength of this structure that we respond whether it’s a bigger job, a smaller job, we can react what’s ever n that marketplace which is a real strength of our folks.

Okay. And then just sort of I think you may have sort of answered this on this past question, but if you take that pie diagram data that you provide based on the new construction retrofit, now that you have broken it out a little differently, but going back over the last 1 year or 2 years, taking that data, it sort of translates into new construction declining by about, I don’t know it looks like about 10% or 12% this year, but retrofit is up – upwards of around 20% and services has been sort of constant at about 10% or 12% the last few years, but given the decline in the new construction, is that part of the market or is that part of the just going after the retrofit work because it is higher gross margin and just a factor of that, more so than markets sort of getting a little worse on the new construction side.

That’s a good question and let me take an opportunity to say one thing I would really want to say that your question maybe think of. When we changed this chart, the only thing we did was divided work in existing buildings. So pure service is still – it’s all…

Great. I understand that.

Perfectly comparable. Now, having said that, the reason you see that difference year-over-year is that same reason is that EAS comparable. Last year, their big jobs were new build. This year, year-to-date $33 million of their revenue and it was big projects came through the work in existing buildings lines. So I think that’s actually – I am not sure there is a trend in that. I think that’s actually one event. It’s the same thing. I keep saying a lot of these – the little nuances in these comparables frequently just come right back to that, that’s a perfect example.

And Joe from where we are sitting, we are going to construct a new building, you are going to construct an existing building, we are running it like a construction project. This chart, I thought was extremely helpful.

Right, okay. Even if I have the $40 million back of EAS work, it’s still down slightly. So do you – I guess, do you feel like new construction is getting a little tougher out there or again, is it just a matter of you have so much capacity and the better margin projects are going after the retrofit work or is it a combination of both?

I don’t think new construction gotten worse. Last time new construction got worse was 5 years ago. It’s just not gotten better by match, the big projects…

Maybe I meant sort of slowing then, I meant so...

I don’t think it’s slowing. I think it’s pretty consistent. I just think we are trying to take the best route we can on what the opportunities are there, Joe. I wouldn’t read too much into it.

But you are subtracting the 40, but it’s really more than that with EAS, because this year, two of their big projects are retrofits. So $33 million of the revenue they are still giving us has moved over to work in existing buildings. But it’s a good example of how this business is. We can go renovate a hospital or add a wing to it or we can go build a new data center or we can – you know what I mean, it’s just not that different. I mean it is different but it’s – what I don’t want this new slide to do is make people starting thinking those are two businesses. Actually the goal – what caused us to change this was used to be, new construction was such a big part of our construction business. It was just a good thing to look at. Now so much of construction is work in existing buildings, we thought we needed to make sure people saw this, because we saw people really misinterpreting, especially peoples who had very casual looks at our company. They were misinterpreting and thinking construction was just that little blue section. But I think the new…

Alright. Well, thanks a lot. I appreciate it.

Thank you, Joe.

Thank you for your question. [Operator Instructions] And we have another question now from the line of Tahira Afzal of KeyBanc. Please go ahead.

Hi, guys. Just one more question and that’s really, I don’t know if I missed it and you talked about it earlier, you guys are going to continue to churn in a lot of cash, all year round you talked about really getting more proactive with buybacks potentially in the mid-20s level, having your stocks a little lapped from that right now, but we would love to get an update from you on that?

Okay. So we bought back – year-to-date, we bought over 400,000 shares. That’s more than we need to offset dilution, right. So clearly that means that we think that our stock – we have had some opportunities to buy stock at what we would consider a good value accretion for our shareholders for the future. I guess that’s going to drive another question, which is we have some good acquisition opportunities in the next several months. We will be very disciplined about pricing, we may or may not do those. We consider both uses of capital to be valid, so I guess that’s a question. By itself, I think at the current pricing, we think buying shares is a good use of free cash of a very small portion of our free cash flow. Keep in mind we are only using a small portion of our free cash flow. We are not borrowing money for this. But at the end of the day, it all depends on the other two parts of that pie chart, right. So what we do with our dividend and what we do – what happens with that and what comes up with acquisitions.

Got it, okay. Well, thanks a lot.

Thank you.

Thanks.

Thank you. And we have a question from Joseph Mondillo of Sidoti in queue.

Hi guys. Just two quick follow-up questions, regarding your SG&A run rate, just wondering what your thoughts are on that, if that’s – looks like a normalized run rate or going into next year, do you expect that to – new investments or something to fall off, just wondering what your thoughts are?

Interestingly, as a percentage, it was identical to last year and this quarter. And the dollar difference was exactly accounted for by our acquisition purchase, so that seems like a pretty good run rate if the mix stays the same. And that is the big question, right. The mix – if big projects come back, you will see it as a percent come down. But if the mix stays the same, which I think right now it looks like it will, certainly going into next year it will be even if new projects come out, it takes a while for us to revenue from them. I think that’s certainly the rate I would use modeling for myself or my Board of Directors. I don’t have anything better.

Okay. And in your prepared remarks, you stated that a lot of your operations or locations are operating near full capacity, just wondering how that translates into what the rest of the industry is seeing and as a result, what you are seeing sort of on pricing, how that translates?

Joe, just to clear up that, mostly in the Northeast, we see near capacity, we are in pretty good shape in the rest of the country. Northeast is extremely active at the moment. So I think we are pretty good shape for our resources to next year.

So saying in the Northeast, are you able to increase price at all or is there still enough slack in the industry overall that you still can’t – you are not seeing the ability to being able to do that?

I think you are seeing pricing going up a little bit and they are executing extremely well. So the results coming out of the associates, the combination of both probably a little bit pricing and a little bit on execution.

I mean, if you look at why we have our highest EPS ever, it’s because they are getting really good pricing. And they are busier now than they were a year ago.

Okay. Thanks a lot. I appreciate it.

Alright. Joe, thank you.

Thank you for your question. And we have now a question from Bill Newby of D.A. Davidson. Please go ahead.

Hi guys. Just one quick follow-up on the tax rate, in the prepared remarks, you had said that on a go forward, this is probably going to push-up to about 37% to 38%, so you are going to have a couple of one-time benefits in the fourth quarter, is that right?

So we had a big one-time benefit in the second quarter. There is a new accounting pronouncement relating to how you have to book equity. That is a one-time benefit. All companies will have it at the end of the year. By the end of the year, everybody will adopt this principle. Those whose stock has gone up a lot in the last couple of years will benefit from it. Those whose stock has been flat or gone down, it might hurt their tax rate a little bit. And then we had – we have picked up some income out of Puerto Rico, a company we have shutdown, we collected a little bit of old money. So those are things that have already happened. So we will trend up a little for the rest of this year. And then it’s my best guess is next year we will be in that mid – somewhere 37%, 38% range – I got no – there is nothing that would pull me out of that sort of normalized 38% rate right now. But I will be more than happy to find some if we can, so.

Okay, perfect. Thank you.

Thank you for your question. Ladies and gentlemen, I would know like to turn the call over to Mr. Brian Lane for the closing remarks.

Alright. Thanks, Matthew and thanks everyone for joining us. As you probably can tell, we are very pleased with our results. We are looking forward to finishing off 2016 very strong and starting 2017 with some optimism. Hope you all have a great weekend and we look forward to seeing you down the road. Thanks folks.

Thank you, sir. And thank you for joining me in today’s conference. Ladies and gentlemen, this concludes the presentation. You may now disconnect. Have a good day.