Julie Shaeff - CAO and SVP Brian Lane - CEO, President and Director William George - CFO and EVP.

Sean Eastman - KeyBanc Capital Markets Adam Thalhimer - Thompson, Davis & Company, Inc. Joseph Mondillo - Sidoti & Company Sophie Karp - Guggenheim Securities William Newby - D.A. Davidson & Co..

Good day, ladies and gentlemen and welcome to the Second Quarter 2017 Comfort Systems USA Earnings Conference Call. My name is Dave. I will be your operator for today. [Operator Instructions]. As a reminder, the call is being recorded for replay purposes. I'd now like to turn the call over to Ms. Julie Shaeff, Chief Accounting Officer.

Please proceed, ma'am..

Thanks, Dave. Good morning. 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.

These slides are posted on the Investor Relations section of the company's website found at 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 thanks for joining our call this morning. Before we start, I'd like to thank our Comfort Systems employees for their continued hard work and dedication. Let me take you through a few key highlights of the quarter and then Bill will discuss the financial results in more detail.

We're pleased to report our highest-ever second quarter earnings per share as our operations continue to post historically strong results. We were at $0.48 per share this quarter, slightly higher than what we earned in the second quarter last year. Revenue for the quarter was $465 million, a 9% increase compared to the second quarter of 2016.

Our booking trends continue to indicate a strengthening of our construction prospects. Backlog at the end of June was $938 million, a remarkable increase from $724 million a year ago. These increases give us confidence that our backlog and prospects are consistent with continuing strong results.

Our most recent acquisition, BCH Mechanical, based in Tampa, Florida, had a great quarter.

Although we must amortize their intangible assets for the initial post-acquisition quarters which prevents us from reflecting their full earnings contribution in our reported earnings, we're encouraged by the superb second quarter earnings contributed by our new partners.

We continue to believe that we're well positioned for another year of strong earnings and cash flow. The underlying nonresidential construction markets are strong and I am optimistic about our prospects this year. I will discuss our backlog and outlook in more detail in a few minutes.

But before I get into that, let me turn this call over to Bill to review details of our financial performance.

Bill?.

Thanks, Brian. Please refer to Slides 2 through 6 as I provide some additional information regarding our financial results. Second quarter revenue increased to $465 million as compared to $428 million last year. The increase is related to the BCH acquisition which closed on April 1, as our same-store revenue was essentially flat compared to last year.

We own BCH for the entire quarter and they contributed approximately $39 million of revenue and were slightly accretive to earnings per share after amortization. Gross profit was 20.6% for the second quarter of 2017 compared to 20.9% in the second quarter of 2016.

With the BCH acquisition, our amortization expense is up significantly for the first several quarters. And if you exclude that additional amortization expense, gross profit was similar to last year. SG&A expense was $67 million for the second quarter of 2017 compared to $63 million in the first quarter and $61 million for the second quarter of 2016.

SG&A, not including BCH, is down slightly from the first quarter of 2017 and SG&A as a percent of revenue was 14.3%, both in the current quarter and for the second quarter of 2016. Net income for the first quarter was $18 million or $0.48 per share compared to the second quarter of last year when we earned $17.7 million or $0.47 per share.

Our tax rate for the second quarter was 35.1% and we continue to benefit from the change in treatment for equity grants. During the second quarter of 2017, we purchased 46,000 of our shares at an average price of $35.28. And since we began our stock repurchase program in 2007, we have now repurchased 7.4 million shares.

We had another quarter of positive free cash flow. For the quarter, our free cash flow was $5 million which compares to $16 million for the same period in 2016. We feel good about our cash prospects and we're not surprised that cash seems to be coming later in the year as that is consistent with an increase in construction mix.

We're pleased with our results for the quarter. We're optimistic about the remainder of the year and the opportunity presented by our increased backlog. We currently expect that our earnings as measured by our EPS will be similar in 2017 to the record levels that we achieved in 2016 and we believe that the underlying EBITDA in 2017 will exceed 2016.

As Brian mentioned, our strong bookings suggest a good opportunity for improvement in 2018. That's all I have on the financial, Brian..

All right. Thanks, Bill. Let me start with backlog and activity in various sectors and markets. Please go to Slide 7. Many of our markets are finally experiencing a decisive increase in construction activity after many years.

Our improving backlog trends continued this quarter and backlog at the end of the second quarter was $938 million which includes approximately $42 million of backlog from the BCH acquisition in April. On the same-store basis, backlog was $896 million as of June 30, 2017 which is an increase of $33 million or 4% since last quarter.

The sequential increase is significant for some quarter. Our year-over-year backlog comparison is even stronger. Compared to a year ago, on a same-store basis, our backlog has increased by $171 million which is a 24% increase. The increase gets distributed over the majority of our companies.

Pricing is stable and we continue to book good projects with some companies booking into 2018 already. Let's turn to Slide 8 for a look at our end user sectors. We continue to experience good balance in our portfolio of work. Institutional markets which include government, health care and education, made up 39% of our revenue for 2017.

The commercial sector was 39% of our revenues and industrial and distribution represented 22% of our 2017 activity. We continue to win projects and overall, we're happy with trends for our work in the various sectors.

Looking regionally, our companies in the Northeast and Upper Midwest continue to execute and produce strong results, especially our operation in Wisconsin this quarter. The majority of the operating companies in these areas have active pipelines and many are operating at capacity.

Our operations in the Southeast region, although lightly impacted by a few project delays, continue to strengthen and improve. Western markets are mixed. Our Denver operations had a standout quarter, but we continue to restructure and stabilize our Southern California operation.

In general, our operations are achieving great results and we see signs of improving demand. Please turn to Slide 9 for our current revenue mix. For the first half of the year, 39% of revenue was construction projects for new buildings and 31% of our revenue was construction projects in existing buildings.

Construction is 70% of our total revenue and our backlog is primarily construction revenue. Our construction business is benefiting from good fundamentals and trends in the nonresidential construction market. Projects performed in connection with our service activities provided 11% of revenue.

And pure service which is composed of repair, maintenance agreements and other hourly work, was 19% of revenue. Our pure service as well as the substantial majority of the smaller projects we include in service are substantially contracted and performed within any given reporting period. Our service business is solidly profitable.

And as we mentioned earlier, we continue to make investments to grow this business. As evidenced by our backlog, our markets have improved over the past few quarters. We believe that the majority of our markets are likely to remain active and supportive for the next several 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're positive about the remainder of this year and our prospects in 2018. Thank you, once again, to our 8,700 employees for your hard work and dedication. I will now turn it back over to Dave for questions.

Thank you..

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

This is Sean, on for Tahira today. I just wanted to start off on the bookings. Obviously, really strong momentum here in the first half of the year.

I'm just wondering if -- wondering if these kind of -- if these bookings trends you've seen have changed your outlook on the broader market? Or is this more of a timing of award type of situation? And if you're seeing better momentum in the broader market, has it changed, at all, the way you're thinking about you're allocating Comfort's capacity here?.

Sean, in general, the trends are good. We're pleased -- I think we're pleased not only with the bookings but the quality of work we're winning. And we're still really pleased with the prospects we're seeing come through. So I think momentum has picked up in the last 18 months and we're pretty optimistic this year into next year..

Okay. And I know it's been broad-based activity, but if you could maybe characterize sort of the size and duration of some of these new construction work you guys have been picking up this year. And when you think it's going to really ramp up, just as we look to see when organic revenues will move into positive territory..

It's interesting. Like the last time we had a big jump in backlog, it was 1 or 2 big projects. And in this case, it's really not that. It's broad-based. Every quarter, it's different companies because they're just booking the jobs. We're not seeing a lot of jobs over $15 million.

And frankly, our jobs are staying in that $5 million to $10 million range, the new construction work we're seeing. So I'd say that is definitely an encouraging aspect of what we're seeing.

As far as when that starts to translate into organic revenue growth, I think last quarter, I mentioned that we thought the earliest we'd see that is probably the fourth quarter and going into next year is our best guess. You won't see too much of it over the summer. This summer there's bookings. People are booking a little earlier.

I think there are some GCs and owners who started to scratch their head and realized that there might not be enough labor to the around here at some point in some locations by next summer, so some people are getting committed a little earlier..

And Sean, if you look at the, what I call, pace of the work, right now, the pace is looking good for the back end of this year into next year. So we feel pretty good about when these -- the timing of these projects are going to be executed..

Okay, that's great. And then, a lot of focus on new construction with this pickup in bookings. But Brian, maybe you could just talk about the trends in the maintenance space on the service side and just how the traction has been going on, some of the market share gains you've been targeting and that piece of the business..

You know what, thanks for asking the question. We're still, as you know, very committed to the service business. We continue to invest in service both from an acquisition of work and execution of work perspective. Our revenue in service is up this year, year-to-date and for the quarter.

The output maintenance space which is really the basis for growing the service business, has grown this year and in particular, in the second quarter. So we still see trends excellent in service and we still fulfilled our service.

And it's a good question because it's easy to say, are your getting distracted with all of those construction work? Service is fully entrenched in this organization right now and we're very -- we feel very good about the long term benefit we're going to get from the service business..

The next question is from the line of Adam Thalhimer at Thompson, Davis..

The work that you're booking for 2018, are you seeing any pricing movement from customers?.

I would say that we're getting very good pricing. Our guys are more likely to put some of that pricing into their labor lines, just in case labor costs go up, so gross margin and backlog. People are keeping that pretty reasonable, the way that they're presenting it to us. I think we're trying to be -- we're a pretty cautious company.

We realize you can go get this work, but you still have to do it. But frankly, we're optimistic. We think as resources get scarce, so you want to be paying for the ones that give people..

Okay.

And then, Bill, the amortization for BCH, when does that start to roll off?.

So amortization has three pieces. We have to put a value on the customer list, tradename and on the backlog. And they all hurt because they -- you hire some accounting firm and they try to figure out something the SEC would accept about throwing a value on this thing.

But then they make you -- you take it as an expense against earnings, even though the money was gone the day you did the deal. But the one that really hurts the most is backlog. Because each of these amounts of money that you assign to these intangible assets that you're required to assign to these intangible assets, it goes off over a period.

Well, a customer list or a tradename like [indiscernible] off over 10, or 15 or 20 years. With that backlog, they look how long the jobs are and if it goes off over the next 1.5 years. That just covers up a lot of the earnings, of that company's earnings. So we still get the cash flow.

We still get the EBITDA, right? But when you guys see our EPS, we've sort up taken what we paid for that company and use some of that money, sort of turn it into an ordinary expense based on the accounting rules..

And that really impacts your--.

You can probably tell that's my favorite thing. You can probably tell that's my favorite thing..

But I guess the question is when does that hit lessen? I mean, is it back half '18 or is it [indiscernible]?.

So the first 4 quarters, it's ugly. So it's come down a little in the fourth, fifth and sixth quarter. By the end of the sixth quarter, virtually all the backlog intangible is gone. You're starting to see a little -- it's a declining pool for the others.

So really, if you read our press -- every press release for every deal we've done since 2012 or something, we basically say don't expect much EPS accretion in the first 12 to 18 months and nothing has changed. That's about -- you start to get more of it after 12 or 18 months.

And other thing is, Comfort has done a fairly sizable deal, most of the winters for the last five years. And so one of the reasons our results have developed that as they do if you go back and look, is that once you do these deals, the amortization is out there and it's coming down all the time.

And so you sort of have this sort of delayed and spread over time, way in which the acquisitions start to help you. So we've got enterprising in our business; the same time we've started to get more and more of the actual earnings of our acquisitions falling through and being shown in the EPS line..

And I'll add [indiscernible], just to answer that one, I'm disappointed Bill jumped in. I'd like to get a little webinar on that [indiscernible].

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

So just related to that last question, is there any way you can quantify yet or ever the -- what the quarterly amortization related to the backlog is?.

So this, if you look at our amortization schedule, it is an enormous spread sheet with lots and lots of lines on it. And unfortunately, it's hard to -- can see -- you can pretty much see it if you look at our amortization line, right? But it's very hard to quantify because you use estimates in the first couple of quarters after an acquisition.

You have to hire them. They go like -- they go interview people at the company and they do math and then they argue with our accountants about the math. And so I just -- it's just all done on estimates at first and then it becomes solid numbers.

But really, if you just look at the amortization line, that's pretty much all that's in it and you'll just -- you'll see it come down. And if you look over the last 5 years, you'll see how other acquisitions, what they hit at and how they came down. That's the best way to look at it. I'll be honest with you, that's how I do it..

Okay. I wanted to ask about the gross margins. Obviously, they were sort of flattish year-over-year and I think it was a little weaker than maybe the Street anticipated.

Just wondering sort of what is your view on how the gross margins trend over the next four, five quarters or so, given what you know about the backlog, given the new construction aspect of it? I think the front end of new construction projects tend to carry a little lower gross margin, but then maybe on the out quarters or whatnot, maybe we see better gross margin.

And also, like you mentioned, the small projects which I think carry a little higher gross margin historically really is what's been coming through in the backlog as has been showing that 1 table in your 10-Q. So just give us some idea what your thoughts are on how the gross margins trend....

So I'm going to do that. It makes -- if you want to reread the forward-looking statements language that Julie read. But essentially, you will see -- so our gross -- we should have a very supportive trends for our gross margins for the next quarter, right? It's a summer quarter, service will be busy.

We already told you that we didn't think a lot of the new construction proportionately which start hitting until the fourth quarter. So we're going to continue that with service mix. That's going to give us the same -- should give us the same 20%-plus margins in the third quarter.

Now you may have heard in my script, even our slight down-ticking gross margin this year, more than 2/3 of that downtick was just part of that amortization that had to go through the line of cost of sales. Some it goes through SG&A. Part of our S&A is that amortization.

But then, I believe that as the new additional revenue start to kick in and we start to get a little bit of same-store growth, our mix will shade more towards new construction. I believe that will exert downward pressure on our gross margins that -- very slight because pricing is very good in that work.

And so you've got two things fighting each other. You've got the mix moving more towards work that has lower gross margins but lower SG&A. At the same time, pricing trends are pretty good. So I think, if I had to guess, I think that we'll have revenue up, gross margins down slightly, but the net effect should be beneficial overall. Man, that's a guess.

I mean....

And Joe, I just wanted to jump in. I've already said this before, but you're running green in 20% gross margin in this business because of our mix and the add-on service and you don't have it -- we have an absence of bad [indiscernible] jobs. So the field is executing extremely well. The other thing is our operating income is greater than 6% again.

And I think you're on the high 5s above that in a contracting business, you are getting excellent execution in the field..

Okay.

Regarding SG&A, the $67 million or so, is that a good quarterly run rate to think about going forward?.

Yes. For the rest of this year, though, my best guess is it would stay about the same way. That now has the BCH stuff in it. And most of our investments are at full run rates right now. So I -- my best guess would be that. I would say the biggest moving piece is going to be compensation accruals.

So if our results were a little better, a little worse, that's going to -- we'll pay a little more or less bonus to about 100 people....

But for your model, Joe, that's a good run rate for what....

Yes, that's exactly what I would use with my board..

Okay. Okay. And then the leverage of SG&A, so this backlog is suggesting that 2018 is going to be a pretty solid year.

Say, hypothetically, we see 10% revenue growth, how much should SG&A increase in that kind of revenue growth environment?.

We shouldn't have much increase in SG&A. It's going to be in the construction front, right, because you don't need to add that much. It will be compensation that Bill already alluded to that would be material. But we won't have to add on that much more overhead..

I want you to look back at points of inflection at Comfort and if we would tend to get -- if you look at sort of the historical points of inflections, we would get like 50% SG&A leverage on it that's -- when it was going up and we would get about a 50% relief going down.

As part of that -- part of that is -- the change is you pay people more -- people in the construction industry expect to make more money in good times because they understand you're going to pay them less in bad times, but we still get some leverage..

Now we won't go crazy adding overhead because we have more revenue..

Yes..

All right.

And then, Brian, you mentioned in one of your answers to one of the prior questions, the backlog, considering the quality of work, what do you mean by quality of work per se?.

Yes. Well, if you look at our backlog, about half of it is education and health care-related. There were good customers. It's just that the work we're getting is with a good base and the people that are doing the work are well-known established companies. So I'm just really happy with what I see on that list..

Okay. And then, just last one from me.

Regarding your working capital needs, is there any way you can sort of quantify or help me understand if we see a big tick-up in revenue with this new construction and everything, how much working capital needs you need? So say, if revenues up 10%, does your working capital have to increase by a certain percentage? Or how do -- how should I think about that?.

It's a simple way of looking at that, if we start to get real revenue increases which, as you know, we haven't yet, but we should, right, with the 24% increase in backlog, I would say that you might see us -- you would see us -- normally, over time, we will always cash flow our earnings, right? With a little difference in our cash tax rate, we will cash flow ROI.

But in a rising year, we might cash flow ROI minus $20 million or -- and a really hard rise, so $5 million to $8 million a quarter of capital deployment, more of that in the summer. And then if it it's over and markets slowdown, we usually cash flow more than ROI, right? We have to catch up as we do some best in working capital.

So rather than use a percentage which I don't know what it would to be a percentage of, I would just say something like $10 million to $20 million a year shortfall, net investment and working capital. And that is just a guess, right? There's a lot of moving pieces in that, but I think it's good way of looking at it..

The next question is from the line of Bill Newby at D.A. Davidson..

I was hoping just to push you guys a little bit more from -- on the backlog from, I guess, a capacity perspective. Are you guys starting to run into any constraints from a bidding perspective? I would imagine things are starting to get little tight from labor..

Yes. So labor is an issue and folks know it. And it's all about the timing of the backlog and when it's going to tick. So each of our operating locations have a manpower loading charts. And what's a little bit different for this time of the year is how much work we're looking at to 2018 that's already been committed to.

So if you look at the schedules we have right now, today, we're okay from a capacity standpoint and we're going to bid accordingly based on what each location needs us. So labor is an issue, no question. But the timing of the backlog, the way it looks, we're okay today..

Okay. And then, switching gears just from an M&A perspective, I understand what you've probably done for the year.

But when you guys -- I imagine, you have revisited in the winter, is there -- and from a broad perspective, what do you guys looking to -- I mean, what's the most attractive to you right now, from a service perspective?.

So this is the kind of question that the answer doesn't change for us very much over long periods of time. We get to know these companies over a long period of time when we're ready to -- when companies we really like are ready to sell, we're ready to buy them.

So we're -- there's certainly opportunities that -- for deals we might do over the winter, if we got the conviction about it. But I would say we just closed a big deal this quarter. So -- and we -- and you're right, we don't usually -- you will not usually see us do big deals over the summer.

It hasn't worked out well for us many years ago and so we decided this winter is a good time to do deals. It's too soon to know what's going to happen next winter..

The question is from the line of Sophie Karp at Guggenheim Securities..

I have a question on the balance sheet first.

So you, obviously, you drew the revolver to finance the acquisition, correct?.

Yes..

So how long do you think it's going to take you to pay down? How do you see it as a priority in our capital allocation process?.

So I think we will bill them. So we will go a long way towards paying down a lot of that debt by year end. I don't think we'll -- I think we'll pay down less than half of it, but I think we'll pay down a lot of it. That will be a little -- the moving pieces on that are we do have some small tuck-ins we might do.

That can make a little bit of difference because we're always doing these smaller tuck-ins. You can find -- sometimes we mention them in our footnotes. But the other thing is if our stock price became what something that we consider to be very cheap, we would buy some shares, but not -- those are just -- those are not important.

What's really important is flowing our cash which is new model, how much money we make, that's -- whatever amount of money we make, that's how much cash we're going to get, plus or minus a quarter or two. And then we use it to pay down our debt until the next deal that we have conviction about comes along.

We're going to keep our balance sheet very low levered, but we're not afraid to do some leverage as we finally proved this quarter after 12 years. If we have a company that we really, really have conviction about, we will never -- we'll never go borrow a ton of money because we have to get bonding.

So we're kind of -- in our industry, we're required to keep a strong balance sheet. But we have capacity -- we have capacity to do a bigger deal today if we wanted to. But by the winter, we'll have more capacity because we will pay down some of that debt..

Got you.

And then, just remind us, does -- sorry, the BCH, does -- do they have a different seasonality slightly than the rest of your business? Or is it [indiscernible]?.

Yes. They say -- all of our -- the farther south you go, the less of a dip there is in the winter. And I will say, for some reason, even in a market, we do have seasonality, a cry. If you look at all of our sunny companies, even they have seasonality. I'm not sure why. But it is much less.

There's a lot more seasonality in Syracuse, New York, right?.

Yes. And also, Sophie, if you look at what's happening in that Central Florida, in particular, in Tampa area, the amount of building going on today is above average and forecasted to continue. There's a lot of activity there right now. So the season shouldn't affect us for a while..

Although I do want to say, there are $39 million of revenue in the second quarter. That is not -- there is -- we mentioned before they would annualize something like $110 million to $120 million. We still believe that. As you know, our industry is lumpy and they have a lot of work they had to get done in the second quarter.

To their credit, they got it done. They earned a ton of money on it as you can sort of see in some of the lines on our income statement. Unfortunately, we -- some of that got amortized as I reported to you with earlier..

And we have another question from Joe Mondillo at Sidoti & Company..

Just one follow-up, guys, if you will. Just regarding the capacity issue. I just wanted to touch on that again.

If you're booking so much work right now and you're not fully constrained, is there a scenario if the market continues to remain sort of solid where the bookings that you booked in, say, the fourth quarter, first quarter of next year, that could potentially see really good pricing because the industry is somewhat constrained with labor and you've already had -- you already sort of booked up with this huge backlog? Is there sort of a scenario where gross margin of bookings going forward could get that much better because of pricing?.

Yes and that's my favorite scenario..

Yes. Yes..

If you go back to 2008 or '99, there were times when really, we made, on a same-store basis, if you go back, we hit things, we haven't seen anything like on a same-store basis. Sometimes that happens. Whether that -- a year or 2 ago, look like might never happen again in the United States.

I'm not putting it in any of my forecasts, but it certainly seemed like that could happen at some point in the next few years. But I will say, that's what your bonds pay you for, to figure that out..

And Joe, we'll -- folks who try to get as much pricing as we can in the market area..

Right. We've been talking about the labor constraints for a while now.

Is it getting much more constrained? Can you feel it more? Or anything changing from, say, 3 or 4 quarters ago when we were talking about it then? Are you feeling more or?.

No, I think, Joe -- Joe, I think the labor is going to be constrained for a while and I think you got to do what we do. We have a good company. We do good work. We offer good wage and benefit package. And we got to go out there recruiting people and sell the value to our company.

But you got to be very proactive and aggressive finding folks because the labor is constrained. But we just have to battle our way through it and get the folks..

There are no further questions, ladies and gentlemen, so I'd now like to turn the call back to Mr. Brian Lane for closing remarks..

Okay. Thank you, Dave and thank you to all of you for joining us today. We're pleased with the results for the quarter and I'm very optimistic for the remainder of the year. We hope you all have a safe summer and Bill and I look forward to seeing you on the road shortly. Have a great weekend. Thank you..

Thanks..

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day..