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.

Tahira Afzal - KeyBanc Capital Markets Inc., Research Division John B. Rogers - D.A. Davidson & Co., Research Division Adam R. Thalhimer - BB&T Capital Markets, Research Division Joseph Mondillo - Sidoti & Company, Inc..

Good day, ladies and gentlemen, and welcome to the Q4 2014 Comfort Systems USA Earnings Conference Call. My name is Mark, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Julie Shaeff, Chief Accounting Officer.

Please proceed..

Thanks, Mark. Good morning. Welcome to Comfort Systems USA's Fourth 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, 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 would like to start by thanking all of the Comfort Systems USA employees for their continued hard work and dedication. I am happy to report that we closed out 2014 with a strong fourth quarter performance. Both our full year and fourth quarter revenues were up in 2014.

For the full year, our revenues exceeded $1.4 billion. We reported earnings for the quarter of $0.29 per share as compared to $0.15 per share in the fourth quarter of 2013. The current quarter benefited from favorable developments at our tax rate. But even without these items, we earned $0.21 per share.

Our bookings during this quarter were the strongest that we have experienced in many years. Total backlog increased by $150 million from last year, with same-store backlog up both sequentially and year-over-year by more than $100 million. Backlog strength was broad-based.

Full year free cash flow was $25 million, which represents a $3 million increase compared to 2013. We have now had positive free cash flow in each of the last 16 consecutive years. I will describe industry conditions and 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 financials of our -- to review the details of our financial performance..

Thanks, Brian. So if you have access to our slides, you can -- slides 2 through 6 of the slide deck have the information that you can refer to as I go through the additional detail regarding our fourth quarter and 2014 results. Fourth quarter revenue increased by $26 million compared to the fourth of 2013.

Of that $26 million increase, $17 million resulted from our May 1 acquisition of Dyna Ten in Dallas, with the balance reflecting a same-store increase of just under 3%. Net income for the fourth quarter was $10.7 million or $0.29 per share, a significant increase from the prior year when we earned $5.6 million or $0.15 per share.

Our current quarter benefited from a lower effective tax rate, due to a reduction in our valuation allowance related to certain state net operating loss carryforwards sometimes referred to as NOLs. On an annual basis, we're required to update our assessment of the likely recovery of accrued state NOLs.

And based upon our review this year, we reduced our valuation allowance by an amount that was equivalent to approximately $0.08 per share. Excluding the tax benefit, we earned $0.21 per share for the quarter, a strong improvement even at that from this time last year.

We had improved results at a large number of our operating companies and we continue to see strong results from our partially-owned North Carolina subsidiary, Environmental Air Systems or EAS. We also didn't experience any further write-downs this quarter on the project that we previously discussed at our Southern California operation.

This project is expected to be completed in early 2016. Our total SG&A expense was $54.5 million for the fourth quarter of 2014, which represented an increase of $1.9 million as compared to the fourth quarter of 2013, some of which is attributable to our acquisition.

SG&A as a percentage of revenue was 15.3% in the current quarter, which compares to 15.9% in the fourth quarter of 2013. On a same-store basis and excluding intangible amortization, SG&A expense increased $0.5 million for the comparable quarters.

In the year-over-year SG&A comparison, our IT expenditures and investments in service growth had less of an impact on our fourth quarter comparison because our higher expenditures on these initiatives had already begun by the fourth quarter of 2013.

The sequential increase in SG&A is mainly a result of incentive compensation accruals that occurred as we ended the year with improving results. Our full year tax rate for 2014 was 28.9%, which is lower than expected and lower than last year. As previously discussed, this lower rate is in large part due to the reduction in our valuation allowance.

The continued strong performance of EAS is also an important factor in our lower tax rate, as the 40% minority interest is treated as a partnership for tax purposes. We had good free cash flow in 2014 of $25 million this year compared to $22 million in the prior year.

With proportionately more service in small project business, we are realizing our cash flow proportionately earlier in the year. Before I finish I want to update you on our stock buyback program. We've been opportunistically repurchasing our shares since the middle of 2007. During the fourth quarter of 2014, we purchased 122,000 shares.

For the full year of 2014 we purchased 550,000 shares. And on a cumulative basis since our program began, we've repurchased 6.6 million shares, and that 6.6 million was at an average share price of $11.30 a share. Overall, we finished 2014 on a strong note.

We're optimistic that the underlying trends for new construction in a majority of our markets are seeing improvement. And we believe that our investment and service growth will benefit us over the next few years. That's all I've got on the financials, Brian..

Thanks, Bill. First I will comment on our results and then I will review our backlog and activity in various sectors of the markets. We experienced strong results in many of our markets, with standout performances in Wisconsin and North Carolina. Most of our remaining markets are achieving solid profits.

And as we indicated earlier, in many markets, we see signs of improving demand. We believe that we are on track in Southern California. We made money in Southern California this quarter. And our troubled projects met all meaningful benchmarks within the expected cost.

Although there is substantial work to be completed on one of the projects, we feel that we have taken prudent steps to ensure that we have provided for the money we need to continue delivery of a high-quality work product at that site.

As you can see on Slide 7, backlog at the end of the fourth quarter was $758 million, which is $100 million increase from September 30 of this year. We are seeing our largest sequential increases in our operations in North Carolina and our Virginia companies, as well as our most recent acquisition in Dallas.

On a same-store basis, backlog was $707 million, which was $103 million increase from 1 year ago. At this point, underlying activity levels are solid. And based on the increase in bookings, we expect some revenue accretions as 2015 progresses.

Having said that, the first quarter of each year is our seasonally lowest quarter and that will be true this year as well. Next, let's turn to Slide 8 for a look at our end-user sectors. Our industrial and commercial sectors comprised 60% of our revenues for 2014.

Manufacturing represents 1/4 of our 2014 activity and includes projects at industrial plants, food production facilities, data centers and pharmaceutical projects. The incremental increase in backlog came from the industrial and commercial sector. Manufacturing is seeing the largest portion of that growth.

Within the institutional sector, which includes education, government and healthcare, the largest decline was in education, with healthcare improving over the past couple of quarters. Overall, we are pleased with trends for our work in the various sectors. If you 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 2014. And together, service, repair and retrofit again exceeded 50% of revenue. Our service businesses are producing good results. And our maintenance base increased approximately 7% in 2014.

Our hope and expectation is that good trends will continue in our service business, as construction and retrofit becomes a source of improvement. Finally, our outlook. There are positive trends in many of our markets. And because of that, in our recent investments, we are optimistic about our prospects in the coming quarters.

For many years, the people who build and invest in nonresidential buildings have hesitated to commit to long-term capital projects. Comfort Systems is based 100% United States, and we have never done significant work in the energy industry. And those 2 considerations have weighed on our relative performance over the last several years.

Although there are risks, we believe that industry activity levels in many of our core markets are likely to strengthen in the coming months. Our emphasis for 2014 will be on project execution, service delivery and labor force development.

Overall, we believe that our investments and industry positioning are likely to provide improved earnings and growth in 2015 and beyond. Before I turn to questions, I want to thank all of our 7,100 team members for their efforts. I will now turn it back over to Mark for questions. Thank you..

[Operator Instructions] Your first question comes from Tahira Afzal from KeyBanc..

I guess first question, given your backlog strength, up 26% year-on-year, can you sort of help us frame how that is changing in profile so we don't over model how much of that translates into backlog at least for the coming 12 months?.

So Tahira, I just -- we were just looking at that actually. The strength continues to be in industrial and we mentioned that we've ticked up a little in healthcare. I don't expect that to become that important. I think that if healthcare and -- when healthcare improves, it's going to be gradual.

And we do have, believe it or not, a few subsidiaries who are attending -- who are sort of not taking opportunities in the healthcare area because they like the opportunities in the industrial areas better right now. So I'd say, education there's not a lot of that going on.

Any other sectors you're curious about?.

I guess what I'm asking is I assume we are not going to see 26% year-on-year revenue growth in 2015, so, but can we see sort of mid-teens?.

Yes. That's for sure. We -- when things start to get better, our backlog goes up much faster than our revenues because the average drop size gets larger. People commit earlier, and so if you look back historically, when we've had improvement, our backlog will end -- the dollar amount of our backlog will improve much faster than our revenue..

Got it. Okay. And along those lines, you folks do also have a lot of operating leverage in a sense even though you are more variable cost oriented as a company than, let's say, a manufacturing company.

So could you put into perspective, as your revenues go up, let's say hypothetically, let's say 10%, plus how that translates in terms of operating leverage, so we can kind of, again, just be modeling stuff a little more accurately..

Right, Tahira, this is Brian. I think as we grow and as we've talked about the variable cost component will go up, we'll be hiring more people. In terms of a fixed cost that we had add on, it's going to be significantly less than we need to increase in our variable costs..

Or in the past -- one of the things that will go up as we start to earn more money in our industry competition for people goes up, and that reflects in wages. But you plan for that in your job cost.

It also reflects in incentive compensation, project managers, and people at all levels, foreman, even but certainly, project managers and superintendents and the people who run construction departments in our subsidiaries will make more money when we're making more money. And that's just an expectation in our industry.

That's how you keep people they're patient with you in bad times but you pay them better in good times. Having said that, historically our SG&A has gone up about maybe 1/2 the rate that our revenues go up from those factors.

Now then we also sometimes make decisions, we make decisions as you saw the last 2 years, to push hard on something like service, that can change it. But we, as you know, we tend to tell you guys about that..

Your next question comes from John Rogers from D.A. Davidson..

A couple of things. First of all, I know your comments relative to the backlog growth you mentioned it was broad-based. But it was also, I mean it looks like concentrated or more concentrated maybe in a couple of market areas.

Were there -- were these significantly large projects or the typical lots of small projects to grow that growth?.

You know John, I think it's a combination of both. We have 1 more large project recently than we've won in the last 5 years. So I think it's more of a typical mix for us with large projects and smaller projects..

Okay. And on the industrial and manufacturing side, as you said..

A lot of the biggest ones, yes, especially in the sort of mid-Atlantic geography..

And how's the bidding pipeline look? I mean is it -- I know it's -- when you're bidding large projects gets lumpy but should we see -- I mean are there opportunities to continue to grow that backlog?.

I think there is, John. Right now our bidding activity is robust, to be honest. We have just a lot of opportunities we're looking at, probably we're being a bit more selective today than we've been in a long time..

And in terms of your efforts to expand the service side of the business, Brian, I mean, has that gone for 2014 as planned? And what are the -- how do we measure your progress on that in 2015?.

Right. So in terms of the service investment, John, I quite frankly couldn't be happier with the progress they're making. They've exceeded all the expectations that we set in 2014 for the investment and what the results we're trying to drive. And I would see nothing stopping us from meeting them in 2015 as well.

We're getting good leadership and commitment throughout the country to achieve those results. So I couldn't be happier..

Okay. And then lastly, just in terms of your gross margin in the quarter, they were relatively high, over 19% and you've been up there before.

But I guess, maybe Bill, was there anything unusual, project close outs or anything in there, or was that just hitting projects as being an elimination of loss?.

So the biggest, the biggest change sequentially is not having negatives in Southern California, in particular. There were a couple of markets where we had good close-outs to the year. Although I will say in those 2 markets, they were good all year.

But any time -- when you close your books for the year, you do a heavy, you do a heavy look and heavy billing. So I would say there were closeouts but I would say nothing, like, drives us in a good year, right? We're talking 2 markets out of 30-plus. Nothing -- I would say that hopefully there's more of that coming in the future.

That's a ways off for us because new work, it starts -- it's got to start and it's got to be performed and then it can finish, so that might not help us in 2015 but there are signs of better pricing in projects and more projects. It's mixed in different cities but it's better virtually everywhere, and it's pretty strong in some markets..

And John, with service growing, the gross margins are going to increase. They have higher margins in construction..

All right. Thank you. Sorry, 1 more if I could.

The acquisition pipeline?.

We're doing a lot of work on acquisitions right now, as much as we've ever done. I don't necessarily know whether we'll do anything meaningful this year.

One of the things is the smaller companies that we -- and by smaller I mean standalone, not tiny companies, but the smaller companies -- normal companies we've historically bought, they know what's happening in our markets, too. Historically it hasn't always been easy to get people to sell their companies at this point.

And we are always looking for larger transactions, I think, we're probably as open or more open to that than we've been in a while but those are very hard to predict..

Your next question comes from Adam Thalhimer from BB&T Capital Markets..

Bill, I wanted to follow up on your pricing commentary. You said in the past pricing could ramp quickly in a recovery just because of the magnitude of the downturn.

And maybe you had some competitors go away, I'm not sure if that really happened or not this downturn but what -- do you still think it could ramp quickly?.

So I think this is going to be -- as demand comes back in those markets, this is going to be different than other expansions that there are a lot of factors. There's been the destruction of capacity and there is more labor. We will probably get to labor shortages sooner.

It's the reason over the course of this recession, we've worked so hard to sort of keep our arms around and develop the labor that we had. So I guess I would say if demand, I think that we would frankly, there are markets already where we will get to where we're turning down work much sooner than we would have coming out of another recession.

And if that doesn't reflect in price, shame on us..

And then also to follow up on another one of John's questions on the gross margin.

You talked about gross margin in the quarter but looking towards next year, it may be too early to see some improvement on that line?.

So I don't know about improvement over the fourth quarter. I certainly -- we certainly think we can get improvement over the full year average of our gross margins, right. That's what it takes. We think we could get both, some rate and some volume this year. We will still be doing work that we'll be early in job.

We won't be -- John brought up closeouts, right. We will not probably get to closeouts on big new profitable work. But we ought to at least be rolling revenues through at somewhat higher gross margins on the construction side. And we like our trends in service. We're doing more service than we have.

And so really I can't think of a factor that -- because I don't know very well..

Adam, we stay away from a significant job loss and our margin is going to be all right because we're really impacted by that in 2014. We just stay away from that, we'll be all right..

Okay. And then I mean Brian, you talked about Q1 and kind of gave us a warning don't get ahead of your skis. And last year in Q1, you had $0.03 to $0.05 of weather impact. And we've had some tough weather in February.

What are your thoughts about the weather impact? And you don't give quarterly guidance I know but I mean is breakeven too conservative of an assumption?.

Yes. I mean the weather, right, the weather was bad last year. We've had spots, it was bad this year, some places are good. In general, the cold weather helps on the service front and it hurts us on construction. As you know, Adam, productivity -- you got to send guys home, with some of the temperatures we've had.

But I think the weather is going to be a push for us. I don't think it's going to be a huge negative at all..

Okay.

And then lastly, I just wanted to ask about the free cash flow and not that you're going to interrupt your string of 16 straight years of positive free cash flow, but as the cycle ramps, I mean is there -- how much of a working capital drain is there? And could that impact cash flow at all?.

So I've been thinking about that a lot. It really depends how demand, whether the jobs get -- there's new work out there, we know in a few places they're -- have lots of guys on jobs, right. We've got some places that are -- we got a couple of places that are at peak historical employment. But it really depends how fast these jobs get started.

It's a really hard question to answer. There have been times in the past, I don't think this is going to happen this time, but in a worst case, we've had years where we've cash-flowed 1/2 of our pretax earnings because we had such a pickup in hiring. Over a long period of time, companies like ours, we should be cash-flowing our after-tax earnings.

If we're not, you're going to find something out at some point. But in a year where if, if, if revenue started to build pretty fast, we started to mobilize guys on jobs, we could cash-flow significantly than we are in. At this point, I think the climb out is more gradual than that.

It would take a lot more market getting hot for that to -- for that to start -- after-tax earnings to start to separate too far from cash flow..

Your next question comes from Joe Mondillo..

In terms of your gross margin, I was wondering if you can comment how your book-to-bill execution has been up until now? Or how is that benefiting your gross margin? Or how much improvement could you see regarding execution with projects?.

So I'm going to sort of split what you said, and let Brian do the second half. Now book-to-bill was up in the 1.3, 1.4 level for us which is really we haven't seen anything like that since it feels like I was a lot younger man.

As far as -- I don't know that we execute our book-to-bill, we take what the market gives us and try to be -- we really almost more try to discipline ourselves in that area. The question is how will we execute on the jobs and that's Brian Lane's problem. So I'll let Brian Lane talk about it..

Thanks, Bill..

It's my problem too, by the way. It's all of our problems..

On the execution front, Joe, as you can tell whether gross margin in the fourth quarter we executed extremely well. When you're in the 19 to the gross margin level, and you've got a significant amount of construction, the folks in the field are doing one heck of a good job. And I don't see any reason why that won't continue.

You followed us through the recession, we never stopped training at all levels of this organization. I think it's really going to pay off for us both in the field all the way up through leadership.

We were also -- as I talked about in the worst times, on prefabrication, we do more work inside the shop than outside, that's in our culture on every job we plan.

And I hope -- I think those things now have been totally adopted by Comfort Systems and so I'm pretty confident that our performance in construction and well, you're always going to have issues, I know, we'll continue to be -- we'll continue to execute well..

Okay.

So you guys had a little bit of an issue in terms of execution in the Southwest that seems to be behind us, always a risk but it looks like 2015 should be much better in terms of overall execution?.

I'm knocking on wood, but yes..

Okay.

Also I was wondering if you can comment on sort of the competition out there in terms of pricing and just competitive pressures that you're seeing?.

Well, in terms of the competition that's out there, we did see some reduction in capacity over the recession, probably not as much as we all thought it would be. The other good thing we have going on is that we're good mechanical contractors.

And as particularly some of this work gets a little larger, a little bit more complicated, they want Comfort Systems on that work. So I'm really pleased to see more healthcare, more of this manufacturing. So even if the productive capacity didn't decline as much as we thought, some of the work that's coming is really in our wheelhouse.

So I'm pretty optimistic going forward that pricing will also recover, Joe..

Okay. And then in terms of larger projects, if -- the table that you put in the K regarding the price of projects, it looks like projects over $15 million are up pretty considerably from 1 year ago.

Have you been seeing more bidding activity regarding larger projects?.

Yes. Absolutely. Although significant projects come through this office where Bill and myself take a look at them. We're just taking a look at considerably more opportunities in that size than we have over the last 5 years, Joe..

Okay.

And is that the biggest driver to gross margin expansion, just more profitable -- bigger, profitable projects?.

I think it's just more profitable at all levels and an increase in the service business. So we'll do it for us, and staying away from a bad one..

Okay.

And then just lastly, new construction versus retrofit, what is the margin profile compare?.

So that's a harder question than it sounds like. Retrofit typically will have higher gross margin. Like service, it does have some more SG&A. There's more interface with the customer. And the average project size is smaller, which creates more SG&A.

New construction, the one thing that makes you say new construction revenues, new construction revenues are lower in a normalized market but when times get good and work gets scarce, we, certainly, in our best years historically our new construction revenues were just as high or higher -- margins were just as high or higher than retrofit margins.

So that's so sensitive to where you are in the business cycle, it's hard to answer..

I would now like to turn it over to Brian Lane for closing remarks..

Okay. Thanks, Mark. And thanks, everyone, on the call for participating. We really appreciate it. I think as you take away from this call is that we are poised for growth by continued investment in our service business and we are ready for construction markets to continue to improve.

Bill and I will see you all on the road shortly, and have a great weekend. Thank you..

Thanks..

Thank you very much. This concludes today's conference. Thank you for your participation. You may now disconnect and have a great day..