Julie S. Shaeff - Chief Accounting Officer and Senior Vice President Brian E. Lane - Chief Executive Officer, President and Director William George - Chief Financial Officer and Executive Vice President.

Sean Eastman Adam R. Thalhimer - BB&T Capital Markets, Research Division John B. Rogers - D.A. Davidson & Co., Research Division.

Good day, ladies and gentlemen, and welcome to the Q2 2014 Comfort Systems USA Earnings Call. My name is Karen, and 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 call over to Julie Shaeff, Chief Accounting Officer. Please proceed..

Thanks, Karen. Good morning, everyone. Welcome to Comfort Systems USA's second 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 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. Good morning, everyone, and thank you for joining us. I will start with an update on our results and comments about recent events. And then Bill will take us through the financials in more detail and finally, I will discuss backlog and the outlook for the rest of the year.

During the second quarter of 2014, we had revenue of $363 million and earnings of $0.12 per share. The results for the quarter are disappointing and reflect additional job breakdowns at our Southern California operation.

In addition, our SG&A increased this quarter due to our planned incremental investment in service and information technology that we have been discussing since 2013. Apart from these factors, our field operating income was approximately the same as last year. Bill will provide more details about these factors in our operating results in a few minutes.

On a positive note, our cash flow was very strong, and we have the largest backlog increase on a same store and year-over-year basis since the beginning of the recession.

Our backlog was $674 million as of June 30, 2014, and includes approximately $43 million from our recent acquisition of Dyna Ten, which expanded our footprint into the Dallas and Fort Worth markets.

We have owned Dyna Ten since the beginning of May, and I couldn't be more pleased with the resources, capabilities and teamwork that they bring to Comfort Systems. As you may recall, last June, we increased our credit facility from $125 million to $175 million.

Last week, we amended our credit facility to further increase the capacity from $175 million to $250 million and extended the maturity to 2019. This new arrangement will allow Comfort Systems to have the continued financial flexibility to prudently invest in our future.

Although this quarter had its challenges, we have seen encouraging signs in our backlog, and cash flow this quarter was terrific. We believe that over the next several quarters, demand for nonresidential construction is likely to gradually increase in a 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 financial performance..

first, additional disappointing results at our Southern California operation, where job losses reduced our EPS by $0.03 per share; and second, SG&A increases relating to our service growth initiative and the investments that we're making in information technology, with those SG&A increases accounting for a reduction of $0.03 in EPS compared to our expense levels of last year.

We also experienced a reduction in our EPS of $0.01 from a small goodwill impairment as we determined that it was appropriate to write off approximately $700,000 of goodwill relating to our Southern California operations. That was the entire remaining goodwill balance on our books relating to that operation.

I think it's important to note that if you set aside the job losses and goodwill impairment in Southern California this quarter, our aggregate field operating income was virtually the same in the second quarter of 2014 as it was 1 year ago.

In fact, our gross profit percentage this quarter, which is 17.1%, is identical to the 17.1% gross profit percentage that we reported 1 year ago. We had hoped that we could cover the increase in SG&A from improvements in operating results, and we did not expect the losses that we experienced in California.

On a broad basis, apart from California, our operating locations are earning profits at the same levels as 2013.

The final factor that accounts for the lower earnings per share this quarter compared to last year was a larger-than-usual subtraction of minority interest, which is a product of very strong results at our partially owned North Carolina subsidiary, Environmental Air Systems or EAS.

When the EAS does well, 40% of the income goes to the minority owners. Switching to SG&A details. Our total SG&A expense was $50.6 million for the second quarter of 2014, which represented an increase of $4.9 million as compared to the second quarter of 2013.

SG&A as a percentage of revenue increased from 13.0% during the second quarter of 2013 to 13.9% during the second quarter of 2014. On a same-store basis and excluding intangible amortization, SG&A expense increased $3.9 million for the comparable quarters.

This increase is primarily related to the incremental investments in service growth that we discussed throughout 2013 and higher IT expenditures as we implemented a couple of important initiatives to improve our basic IT infrastructure.

2014 is the year that our strategic investment in service is expected to peak, and we continue to expect that our combined investment in service growth will be lower by approximately $2 million in 2015, although that spending is subject to adjustment as we assess the traction we are getting in the overall initiative.

We had very strong cash flow of $18 million during the second quarter, which was a big increase from $3 million in 2013. Finally on financial details, I want to point out that our year-to-date tax rate for 2014 was 37.4%, which is down slightly.

The improvement in our tax rate is primarily due to strong performance of EAS as the 40% minority interest is treated as a partnership for tax purposes. Before I finish, I want to note a few details about our acquisition and the increase in extension of our credit agreement.

As I previously mentioned, we closed the Dyna Ten acquisition in early May, and 2 months of their results are included in the current quarter. Dyna Ten is also a good start having added $10 million of revenue and good gross margin and field level profitability.

As expected, amortization of intangible assets and other fair value adjustments related to the contractual terms of the transaction resulted in offsetting expenses that meant -- that as expected, the Dyna Ten effect on EPS was neutral.

Also as Brian mentioned in his opening remarks, last week we amended our senior credit facility to increase it substantially from $175 million to $250 million and to extend the maturity to more than 5 years from now, with the facility now set to expire in the fourth quarter of 2019.

The terms, covenants and conditions of this arrangement are substantially similar to or improved from the prior agreement with continuation of very good financial terms for borrowings and letters of credit, 2 very reasonable covenants, additional acquisition flexibility and improvements in our already very favorable terms regarding returning money to our shareholders with dividends and buybacks.

We currently have $50 million of borrowings outstanding under this agreement. And as of today, the interest rate we are paying on those borrowings is approximately 1.5%.

Despite a disappointing first half of 2014, we remain optimistic that the underlying trends for new construction and the majority of our markets are gradually improving, and we believe that our investment in service growth will turn out to be money well spent. That's all I have on financials, Brian..

Thanks, Bill. Let me start with backlog and activity in various sectors and markets. Please turn to Slide 7 and we'll start with backlog. Backlog at the end of the first quarter was $674 million and includes approximately $43 million of backlog from the recent acquisition of Dyna Ten.

On a same-store basis, backlog was $630 million as of June 30, 2014, which is an increase of $18 million since last quarter and an increase of $40 million from a year ago.

One thing that I find encouraging is that we are seeing modest increases in backlog in various geographies throughout the U.S., and this increase is not the result of a few large projects at a handful of locations. It truly is broad based.

Pricing, while relatively stable, is still competitive overall, even in markets where we are starting to see signs of increased demand. At this point, although underlying activity levels are solid, we do not see an increase in bookings that would support meaningful revenue increases in 2014. Please turn to Slide 8 for a look at our end-user sectors.

Our industrial and commercial sectors comprised 61% of our revenues for the first half of 2014 and 45% of our current backlog. The largest sector continues to be manufacturing, representing just over 1/4 of our 2014 revenue to date. It includes projects such as industrial plants, food production facilities, data centers and pharmaceutical projects.

We are seeing a slight increase this quarter related to the amount of institutional work in our backlog, and this is primarily due to the fact that Dyna Ten does a significant amount of work in the healthcare area. Overall, we are pleased with the existing distribution and trends for our work in the various sectors.

If you please turn to Slide 9, you can see our current revenue mix. Pure service, which is maintenance and repair, was strong at 18% of revenue for the first 6 months of 2014, and service, repair and retrofit together again exceeded 50% of revenue.

Our service business are producing good results, and our maintenance base has increased by approximately 6% since year end after a very strong 12% increase in 2013. Finally, I'd like to discuss our outlook from both a near-term as well as a longer-term market perspective.

We are disappointed in our results for the first half of 2014, and although we expect to be solidly profitable for 2014, our full year earnings per share will be lower than we reported for 2013.

On a longer-term basis, our backlog is showing signs of improvement, and we have invested in our future through our service investment in our training programs. And we expect to see the benefits from these efforts as market conditions improve.

We are optimistic that our investments and the signs of improvement in our backlog will provide life in 2015 and beyond. Finally, I'd like to thank all of our 7,300 team members for their efforts. I will now turn it back over to Karen, and we'll be happy to take questions. Thank you..

[Operator Instructions] First question comes from the line of Tahira Afzal of KeyBanc..

This Sean here on behalf of Tahira. So my first question is just with regards to the strong free cash flow in the quarter. I mean, obviously, this is good to see.

But we're just wondering how you're thinking about a sustainable run rate in free cash flow versus net income going forward?.

So I'll take that question. So this was a great second quarter. Honestly, I don't know that -- it's probably our best second quarter ever and really gratifying.

The cash flow in the first where it came from, the biggest factors in the increase in cash flow in the second quarter were good collections at EAS, which is always lumpy because they do a lot of off-site construction, where you get paid at one time when you deliver big items and ColonialWebb.

The other factor that's apparent in our cash flow right now is, historically, we would get more than half and sometimes a lot more than half of our cash flow for the year in the fourth quarter.

The last couple of years, that's -- we've trended away from that because we've been doing less large construction projects that tend to close out and get paid in the fourth quarter. A much higher proportion of our work now that the U.S. isn't building as many buildings is service work, which sort of pays ratably over the year.

So we feel great about cash flow for the full year, certainly, well exceeding last year. I don't think you'll see the same pattern where you have -- 18 probably is a special quarter this year. We'll still have a good fourth quarter, but it won't be proportionately as good as other years.

But I think we feel great about our cash flow trends for this year. And as far as your other question about how it'll relate to income, we should cash flow, actually a little better than our after-tax income over time, just because our cash tax rate is a little lower than our reported tax rate.

So if the backlog continues to go up, you might see next year that our cash flow is less than our income just because we would have a net investment and working capital as our revenue started to go up. That's historically been what's happened.

But other than that, we should, within a few months, plus or minus, we should be cash flowing our net income..

All right, that's very helpful. And just as a follow-up to that.

Based on the strong outlook for free cash flow going forward, what can we expect with regards to capital allocation between dividends and acquisitions? And do you expect the profile of your acquisitions to remain smaller niche like we've seen in the past? Or could we see a more transformative move in the future?.

Smaller niche is in the eye of the beholder, right? In our industry, the deal we did this quarter is a pretty big deal for us. But having said that, I think our goal would be to continue the buy the best companies in the attractive geographies that we're not in.

One of the reasons we went and significantly increased our borrowing capacity is to make sure that we can continue to do that. But we will be opportunistic. I think our board is currently still very interested in getting -- continuing to get cash to our shareholders.

Our buyback in the first quarter, where we didn't do any buyback, I think we bought 6,000 shares. That doesn't mean we won't do buyback opportunistically throughout this year.

One of the things we did was, we just -- this credit agreement has additional flexibility for buybacks, where the first -- if you looked at it, it's available online, because it's on the SEC website. The first $25 million we spend on buybacks doesn't count against our covenants. We have a basket to do that.

And then also, our new credit agreement gives us greater flexibility to increase our dividend. And then obviously, we got additional acquisition flexibility, like you heard. So I think we want to -- our goal is to grow but to be very prudent about it.

And I think we'll do whatever the market gives us and whatever we think will benefit our shareholders the most..

Next question comes from the line of Adam Thalhimer of BB&T Capital Markets..

Can you talk about margins in the back half of '14 a little bit? I mean, you're up against a tougher comp. You had some pretty good margins at the back half of last year, 18.6% gross margins.

Can you be flat there?.

I don't -- we are up against a good comp. Our tough comps were the second and third quarter of last year, where we beat earnings by as much as we missed them this quarter, unfortunately. Having said that, I think -- normally, the last 3 quarters of the year, we have higher gross margin. I think that's true this year.

Last year in the third quarter, we had some special events that happened, where we had $0.03 out-of-period income that ran through that line. So I think that would be a tough thing for us to do this year. I think we feel -- I don't think we feel like the first half of the year is a reason to be pessimistic about the second half of the year..

No, Adam, this is Brian. If we look at what the market is out there, they're about stable. They're up a little bit. Bill alluded to the couple one-off events. But our margin should be good for the rest of the year..

Okay. And then, Brian, in your prepared remarks, you mentioned that even the markets where demand is improving are not seeing much pricing momentum.

I just want to ask about that because part of the story was that, with so much capacity taken out, as bad as this nonres downturn was, that when demand comes back, maybe even a little bit, you would start to get some pricing. So I'm just curious why you're not seeing that..

Well, I'll start by saying we're anxious for pricing to improve, and we're ready for it, no question. We had some capacity go out, but until people have confidence that they can keep their workforces busy, as far as they can see out, margins are going to stay pretty competitive. But they will improve over time.

I just think that this is a very slow recovery and might as [ph] going to be the last to react to improvement.

Bill, you want to add anything to that?.

No, no. I think we see signs of improvement in selected markets. But it's gradual. Keep in mind we're late-cycle player, right? So there's been -- the first half there was a delay for everybody else, and we're late-cycle players so naturally, there's going to be a delay for us..

Next question comes from the line of John Rogers of D.A. Davidson..

The name of the company that you acquired in Fort Worth, was that dilutive or accretive in the quarter?.

It was neutral..

It was neutral.

And Bill, are you expecting it still to be neutral for this year, for the remainder of the year?.

I think the weighted likelihood is that it will be neutral for the year. I don't think it'll hurt us at all. I think if we have some help from it, it would be almost not -- it'd be difficult to measure. I'll give you a little more on that.

Their gross profit margins, their gross margins are similar to Comfort as a whole, which actually means they're doing very well because they have less proportionate service.

But they -- actually, the gross margins that they are contributing in this quarter into the next few quarters will appear lower because the amortization of intangibles related to backlog runs through cost of goods sold. It runs through a line that reduces the gross margin.

So the 2 effects you're going to see in the numbers just at the margin is that they do depress the way that gross margin gets reported, because you have an intangible running through that line. And the biggest intangible at first always is your backlog amortization.

And then most likely, based on 2 things, one, amortization of intangibles and very strong contracts that we enter into at the time we close deals, where they guarantee how the jobs that are ongoing will do, but we let them have the upside. It's just a sort of practice we have that we think is prudent.

So it keeps them from having upside surprises for the first couple of quarters. Or downside. By the way, it also ensures us against downside surprises..

Yes, okay. I mean I appreciate, Brian, your earlier comments just on allocating for acquisitions. But what does the pipeline look like? Are there deals out there to be done? I know you're always generally out talking.

But do you expect the activity to pick up?.

This is Bill. So I run the acquisitions. I would say that we probably don't have another Dyna Ten in this calendar year in us. We would be open to that, but we have long lead socialization and due diligence times when we do deals like this.

And I would say, I think, we will have a couple of small -- we have reasonable prospects of a couple of small acquisitions. We have a couple of good prospects we're working hard with.

But as far as something that would close and certainly something that would close in time to affect numbers you're putting in your model for this year, that's probably not something -- Dyna Ten is just 1 month or 2 old. It's our third biggest deal in the last 10 years. It's probably the biggest deal we'll do this year..

And Bill, if I look back over time, I think acquisitions have been 3% to 5% of your growth annually, and obviously, less in recent years.

But is that a good sort of long-term expectation?.

Our long-term plan, the plan that we've agreed with our board and that management gets measured on, is that we need to accrete $100 million of good acquisitions per year. And we've averaged that since 2010. But some years, we've had 0, and some years we've had double that. So I think that, that is the best guideline I have for you.

I think that's what we think we can do. That's we think we can effectively bring in, but it's going to be very lumpy in our industry.

For example, if markets pick up the way we think they might in '15 or '16, our 15-year history is that it's hardest to do acquisitions at the top of the market, because when you pay 5x, 5.5x EBITDA, and a guy's EBITDA is twice what the average is, you're going to keep it, you know what I mean? He's going to keep it for that good year. So it depends.

If markets stay weak, we'll get some deals done. If markets take off, it might be harder..

Okay.

But that would still imply that acquisitive additions of 6%, 7% for revenue?.

Yes, that's the plan..

But prudent, John, we're just not....

No, I'm trying to think -- look out more than just the next year or 2..

Yes..

I'd now like to turn the call back over to Brian Lane for closing remarks..

Okay, Karen, thank you. Everybody, thanks for listening to our call. We appreciate the interest in the company.

We really do feel good about the balance of the year, working hard to recover as much of our position as we possibly can, excited about the service investment and what we're seeing there in terms of the results we're getting so far, and optimistic about the backlog will continue to grow. Hope you all have a good day. We'll see you on the road soon.

Thank you..

Thanks..

Thank you, ladies and gentlemen. That concludes your conference for today. You may now disconnect. Have a good day..