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 Brent Thielman - D.A. Davidson & Co..

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2017 Comfort Systems USA Earnings Conference Call. My name is Dave, I'll 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 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 commentaries 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 our remarks. The slides are posted on the Investor Relations section of the company's website found at comfortsystemsusa.com.

Joining me on the call today are Brian Lane, President and Chief Executive Officer; and Bill George, Chief Financial Officer. Brian will open our remarks..

Okay. Thank you, Julie. Good morning, everyone, and thank you for joining us in the call today. 2017 was another strong year for Comfort Systems, and our fourth quarter results provided a strong finish with encouraging signs for 2018. Fourth quarter revenue was $461 million and represented an 11% same-store increase from last year.

We had strong earnings for both the quarter and the full year. We reported $0.20 of earnings per share during the fourth quarter, including a large tax expense that resulted from the recent tax legislation.

The tax hit was $0.25 per share, and coincidentally, if you add that back, we earned $0.45 per share this quarter, which is identical to last year. Bill will discuss the tax considerations in more detail. Full year cash flow was $80 million, our best ever. Our backlog continues to strengthen.

Backlog at the end of the fourth quarter of 2017 was $948 million, which is up 5% sequentially. We are entering 2018 with $185 million more backlog than we had at the start of 2017. And most of that increase, $155 million, represents same-store backlog growth. Year-over-year, our same-store backlog gives up more than 20%.

2017 has been another year of excellent execution from our operating teams and we are grateful to our dedicated employees. Many of our operating companies, particularly in the Northeast and upper Midwest, had record years. Overall, a strong finish to a good year. I will discuss our outlook in more detail in a few minutes.

But before that, let me turn this over to Bill for the financials.

Bill?.

Thanks, Brian. Please refer to Slide 2 through 6 as I review our financial results with a little more detail. Fourth quarter revenue increased to $461 million, an increase of $69 million or 18% compared to the fourth quarter of 2016.

An upward trend in construction progress - projects combined with service revenue growth to produce year-over-year same-store part quarterly revenue growth of 10.9%. Revenue for all of 2017 was $1.79 billion, which represents an increase of $154 million over last year. On a same-store basis, full year 2017 revenue increased 3% compared to 2016.

Gross profit was 20.3% for the fourth quarter of 2017 compared to 22.5% in the fourth quarter of 2016. For the full year, gross profit was 20.5% in 2017 compared to 21% in 2016. Amortization expense increased in 2017 due to the BCH acquisition. Excluding that additional amortization expense, our annual gross profit was similar to last year.

SG&A expense was $70 million for the fourth quarter of 2017 compared to $63 million for the fourth quarter of 2016. Most of the dollar increase is due to the addition of BCH. SG&A as a percentage of revenue was 15.2% in the current quarter compared to 16.1% in the fourth quarter of 2016.

For the full year, SG&A as a percentage of revenue was identical in 2016 and 2017 at 14.9%. Our 2017 tax rate was a 45.2%. That rate includes a large noncash expense in the fourth quarter that resulted from recent tax legislation, and I want to take some time to review what happened and what it means for our future tax expense.

Comfort Systems has significant net deferred tax asset and a great majority of our deferred tax assets arise from the book accrual of liabilities for insurance plus some other items like warranty and certain intangibles.

These are items that we have already expensed for book purposes, but for which we will only get a tax deduction at some future time because they are not immediately deductible under tax law.

But in other way, we have a store of future tax deductions that we know about now and under accrual accounting, where we're required to calculate of those future benefits and record them on our balance sheet as assets, deferred tax assets.

The value that we record for these assets is a function of the tax rate that we expect will be in effect when we finally take the deductions. And tax rates or lower tax deduction save us less money in the future, and thus, deferred tax assets are worth less today.

So the fact that we will now have a lower tax rate means the value of our deferred tax assets is smaller and we must write down the value on our balance sheet to a new estimate of future benefit in light of the lower rate.

During the fourth quarter, we wrote our net deferred tax assets down by $9.5 million because we expect to save roughly at $9.5 million less in taxes over the coming years from these deferred tax deductions. We expensed that difference this quarter.

After taking that $9.5 million noncash expense for the remeasurement of our net deferred tax assets, we earned $0.20 per share in the fourth quarter. Excluding net charge, we would have earned $0.45 per share, and coincidentally we also earned $0.45 per share in the fourth quarter of 2016.

That net income was $55.3 million or $1.47 per share for all of 2017. The impact of the deferred tax remeasurement and the small goodwill impairment charge recorded during the first quarter was $10.2 million or $0.27 per share.

And excluding those charges, full year adjusted 2017 net income was $65.5 million or $1.74 per share compared to $64.9 million or $1.72 per share in 2016. We had strong free cash flow during the quarter and a fantastic year. Fourth quarter 2017 free cash flow was $30.3 million compared to $35.7 million in 2016.

For the full year, our free cash flow was a remarkable $80 million, our best cash flow ever. Notably, we made the biggest capital expenditure in our history during 2017 when we purchased a new building to accommodate our growth in North Carolina. Without that extraordinary discretionary capital expense, our free cash flow would have been $90 million.

We continue to deploy our discretionary cash in ways that add value to our shareholders. Acquisitions, dividends and share repurchases are important components of our strategy. The recent acquisition of BCH, along with the acquisitions we have made since the recession, have been major contributors to our performance in 2017.

During 2017, we purchased 263,000 of our shares at an average price of $34.23. Since we began our stock repurchase program in 2007, we had bought back 7.6 million shares and we returned over $100 million to our shareholders. Overall, industry conditions and the trends remain supportive.

Based on our backlog and considering economic conditions, we expect improvement in revenue and net earnings in 2018. That's what I've got on financials, Brian..

Okay. Thanks, Bill. Let me start with backlog and activity in various sectors and markets. Please refer to Slides 7 to 9. 2017 was a great year for Comfort Systems. We experienced strong results in many of our markets with standout performances in Michigan, Colorado, New York and Wisconsin. Backlog continues to strengthen.

Backlog increased by $185 million from one year ago from $763 million to $948 million, and backlog increased by $47 million from September. The year-over-year increase includes $30 million from BCH. So we are reporting a same-store year-over-year increase of $155 million, as I mentioned earlier, that is just over 20% growth.

Our backlog strength is broad based and we are optimistic about 2018 given the increase in bookings. As you know, the first quarter is our seasonally lowest quarter. And much of our work is early in the projects, so improvement is likely to be gradual. We have a good balance in our various end-user sectors.

Institutional markets, which include government, health care and education, made up 41% of our revenue for 2017. The commercial sector was 37% of our revenues and industrial and distribution represented 22% of our 2017 activity. Please turn to Slide 9 for our current revenue mix.

For 2017, 38% of revenue was construction projects for new buildings and 32% 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.

We continue to win projects and most of our locations are reporting strong ongoing prospects. We have made and continue to make investments in our service business.

Service is 30% of our revenue with service projects providing 11% of revenue and pure service, which is composed of repair, maintenance agreements and other hourly work, providing 19% of revenue. Our service business is a great source of profits and our maintenance space continues to grow. Finally, our outlook.

Our backlog and the pricing environment is strong and our ongoing prospects are good. We believe that our prospects for revenue growth have improved, and we currently expect a mid- to upper single-digit full company revenue growth for the full year.

We feel well positioned to execute on those opportunities and we intend to continue to invest and return capital to our shareholders. For several years, we've been acting on our belief that the two best routes to increasing the value of Comfort Systems are growing our service business and expanding our construction capabilities and execution.

With our backlog at an all-time high, with strength in most of our markets and as we continue to benefit from our ongoing investments, we are optimistic about our future. In closing, I want to say thank you once again to our 8700 employees for their hard work and dedication. I'll now turn it back over to Dave for questions. Thank you..

[Operator Instructions]. For your question, which comes from the line of Tahira Afzal of KeyBanc Capital Markets..

This is Sean on for Tahira today. I just wanted to start on the backlog. So obviously, really strong bookings in the fourth quarter and for the full year.

I just wondered, is there any kind of pull forward you saw in the fourth quarter? Or what are you guys seeing out there in terms of near-term opportunities that would drive the backlog sequentially up again into the first quarter?.

Yes. Sean, it's Brian. I think we're pretty optimistic about what we're seeing for bookings here early in the year. It's broad based and it's pretty much nationwide. Some bigger projects, a lot of retrofit work still. So I think we see good prospects for the remainder of the year on backlog.

Bill, do you have anything to add there?.

Yes. I don't think there was any pull forward. If anything, there were some projects that didn't get booked by year-end..

Yes. They didn't get booked down..

That's awesome. Okay, great. And I guess, we've been hearing from you guys about this broad-based strength across the geographies, across the end markets for some time now.

I just wondered, is there any particular areas you're starting to see getting a little long in the tooth maybe? And I just wondered, to the extent you see some shifts, how nimble can you guys be around moving resources to where there's the best growth? Any thoughts on that?.

Sean, I don't think we're seeing it yet in terms of if somebody is showing weaknesses. I think the prospects are still good. So I'm not concerned at that right now. And in terms of us being nimble, we've talked about this. We do move people around if it's appropriate. But right now, pretty much all our operating companies need all the labor they have.

So we can do it, but right now, everybody is very busy so don't have a need to..

Excellent. And just moving to the margins, maybe one for Bill here. Just looking at the 4Q performance, you called out the amortization as being a factor.

But if you can just walk us through maybe the delta between the quarterly performance at the gross margin line this year versus this time last year in terms of mix impact and just getting some context there as we try to forecast gross margins into '18..

Right. So there were - in a way, there were three factors. One was we did have more amortization this year and about 2/3 of the amortization that we get from acquisitions impacts that, but we have lower gross margins for sure in the fourth quarter of 2017 than we have in the fourth quarter of 2016.

Some of that was revenue, right? Our revenue is lumpy and we had a particularly low fourth quarter last year in revenue and a particularly really strong fourth quarter in revenue this year. And that means percentages get affected by the bigger denominator or the smaller denominator.

So last year, we had an eye-poppingly high, for example, SG&A number and our SG&A as a percent looks very small this year. But [indiscernible] that made that happen made that gross margin number in the fourth quarter of last year huge. So some of that's normalization in revenue.

And then the last thing is the real effect that we are starting to get in this project, so they're young projects. So that means we're not very far along. And then, if we don't pool a lot of profit out of projects at the beginning of them, we don't know much it's going to rain, right, or whatever while we're building it.

So as we've said for years, whenever the backlog picked up and whenever the project mix increased, you'd see some pressure on gross margin. You should also over time start to see leverage on SG&A.

And then, of course, as you get later in the projects, you'll start to see pickups on those projects because they have good pricing in them, and frankly, our guys are executing well..

Great. And one last one for me. Just obviously, really outsized cash flow in 2017, assume it's going to be strong again in 2018. What do you guys do with the extra cash here? And if you could maybe compare how you're thinking about capital allocation this year relative to 2017, that would be helpful..

So Sean, once a year - at least once a year, when we put out our Investor Relations packet, which we'll do later today, when we file that, we put a slide in that shows our 12-year history of capital allocation or our history of capital allocation since 2005 when we adopted our capital allocation plan.

That plan is that we spend about 2/3 of our cash flow on acquisitions. We split the rest between dividends and buybacks, and I don't see that changing. This may give us flexibility to invest a little more in our workforce for sure.

We are interested in improving our benefits because our guys have earned it, and honestly, because being an employer of choice is pretty good thing to be right now. But in general, it's that same as steady as she goes, right? We think what we've been doing has worked well and we just plan to continue doing it.

We'll just have a little more money to do it with..

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

Can I press you a little bit more just on the gross margins, your thoughts about gross margins in 2018?.

Yes. So I think that we will - I think we've never been as positive in our published sort of outlook as we are. So I think, clearly, we expect higher gross margins this coming year than we had last year. I think that, that will be more evident later in the year for the reasons I've mentioned a minute ago about how we are early in projects right now.

And we're early in projects to the winter months. We're just not going to be pulling a lot of profit out of those projects..

Adam, I talked about probably too many times in this call that that's a reflection of how well we execute in the field. I know it's what you're looking at. But at the end of the day, in this business, it's how well you perform in the field.

And right now, I could not be happy or more proud of the work and the quality of product, the safety with doing that as I am today with our folks in the field. So I'm very optimistic that the gross margins in a full year basis will be where we need them to be..

Okay, great. And I want to make sure that I understand the Q1 seasonality because we had the polar vortex during the month of January that affected at least 2/3 of the country. So we're going to have margin declines, I think, in Q1, I just don't know how much..

Yes..

You mean, Q1 versus last year's Q1 or sequentially? We will....

I think in Q1 versus last year's Q1 because we had this issue with Q4, where I think we all knew that gross margin was going to be down in Q4 year-over-year because you have a tough comp, but then it was just down more than we thought..

I think we're within the margin of error..

Yes. And I think, Adam, thanks for asking me the weather question in a different way, but our service businesses were pretty robust here over the winter because of the temperatures, particularly up north.

And we have had more - we've done more construction work this year than we typically do, I don't know why, in a winter considering the weather was pretty abysmal in a lot of places. But we've been able to perform actually quite well over here the winter in construction as well as in service.

But we'll have margins slow down because this is the first quarter, but I think the workload is still pretty good from a typical winter..

There's a lot of moving parts..

Yes..

Yes, I get that.

And then just lastly, Bill, I'm trying to - on the SG&A line, what kind of absolute growth do you expect this year?.

I hope there's a good bit because we pay a lot more bonuses to the guys in the field and a lot more project managers are in productivity and margin bonuses. But I would say that we'll get - what we normally say is in a rising market, historically, in a lumpy - rolling out in a lumpy fashion, we get about 50% SG&A leverage.

In this kind of a market, and we haven't seen this since 2008, '09 kind of time frame, typically, our SG&A goes up about half as fast as our revenues. And so we have more service now but I don't think that's going to change that.

We have more service than we had to last time this happened as a portion of our, you know what I mean, as a proportion of our work, but it's not enough to change, I think, that. That's our best guess..

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

So I just wanted to sort of touch on the gross margin again as well. Just going into little more nuance of how your business works. At the beginning of a project, when you receive it, your contractors estimate how much the job is going to cost.

I'm just wondering in new construction projects, are these fair estimates in terms of the cost that the revenue recognition is right now being recognized against? Or do they to be sort of conservative and at the end of the projects, when you look at where a bulk of your new construction revenue was coming through at the locations that you have, those - when you look at those specific locations, do they tend to over-execute historically based on sort of estimation of cost? I know every job is different and it's hard to say, but just generally speaking..

Joe, that's a really good question and I'm going to - and I appreciate the opportunity to address it. So the way that we take a project work, really of all sizes, is we - there's an estimate. And it's a very complicated estimate.

It might have 10,000 variables in it, believe it or not, literally in the software because of all these - you think about all the things that go into the mechanical systems of a building.

And at the end of that, we estimate how much it will cost us to do something, and then we make a pricing decision about how much we're going to charge for it based on what the market will bear and how busy we are and what the timing of the work is and how we need it. In that estimate, originally, there's contingency.

There's also assumptions about what will buy the sort of the materials that go into it for. Then typically, in good times when we're getting good pricing, as we prepare to load the job and begin to perform it, we take a hard look again at all of those lines.

More often than not, once we've secured the job, we will put some more contingency into the job because conservative - well, aggressive construction companies had a habit of going out of business, right? You're predicting the future. You're literally predicting how fast the drywall guy will go. You're predicting how much it's going to rain.

You're predicting 1 million things about vertical transportation and how their elevators work if it's more than a couple of stories. So we put conservatism in. And if you look across Comfort Systems, statistically, we've never had a year where we haven't had any - our worst years ever met pickup on our jobs. We do statistical analysis on our jobs.

We do regression analysis at times and we'd look at - and we know which of our guys are more aggressive, which of our guys are more conservative. But they're all careful people who realize that it's a tough thing to make a hospital here out of an empty piece of land.

And so what you will always see, we have always seen for project work is that the margins across the portfolio of our projects go up over the course of a project. And that's what we're talking about when we say, look, we're early in a lot of work. This is just you're just not going to see the big quarter from that.

But having said that, it's great news. So as you know, for years I've said when people said, what's your biggest risk to gross margin? I've said it's backlog shooting up. It's mix. And I'd said it's going - if you're going to have lower gross margins, you're going to make more net income and it's going to be nothing but good news.

But at first, people are going to scratch their heads a little bit and I think that's exactly what's happening. So thank you for getting me - letting me get on that, say that..

No, that's great color. I really appreciate that.

And so also, looking at the backlog, what is - how would you describe sort of the technical complication of these type of job relative to, say, the backlog a year ago? Are they more complex type of jobs where you're maybe - if you execute, can generate a higher profitability? Or how would you describe the backlog in terms of that?.

Yes. In terms of - so Joe, this is Brian. In terms of the backlog mix, it's been pretty consistent. I'm looking at the breakdown right now over the last three years. So in terms of complication, there's nothing out there that I would - that I'm worried about that we can execute.

We have - don't forget, we have a world-class workforce out there that can build anything that we can come up with. The challenge today is, as you know, skilled labor availability and Bill talked earlier about being an employer of choice, provide good benefits, et cetera, for folks.

But the key for us, and you've heard me talk about this before as well, is going forward is utilization of stuff like building information modeling, prefabrication is where we can get margin improvement.

The more we can build on a shop and less at a job site is really where you can get margin pickup for us in this business and that's a challenge, how we can keep getting better at that. But in terms of the mix-techni of the work, it's pretty straightforward for us..

Okay. And then I noticed when you sort of look at your end market breakout, 2017 compared to 2016, it sort of implies that one of your strongest end markets was health care. So I'm just wondering if hospitals or anything like that in nature is starting to come back.

Because I know in the past, I guess, in the last cycle, those certainly carry higher margins.

Are you seeing any pickup in hospital bills? Or what is that health care piece?.

Yes. I'll go first, then Bill can comment on it. One of the things that BCH, their recent acquisition in Tampa, brought to us was much more hospital work than we had had recently. So if you look at our backlog right now in health care, it's as high as it's been since probably 2008.

But a lot of health care, we're seeing some new hospitals but it's a lot of end-of-life care, addition to existing facilities. In small surgical centers, we're seeing a fair amount of that. But in addition to that, BCH did bring us some new hospital work when they joined us.

Bill, do you want to add anything to it?.

Yes. I mean, even if you set aside BCH, health care is up a little. So I guess, it's strengthening but only on a comparative basis. It's still historically very, very weak.

And you got to think sooner or later that, that work is coming back because the baby boomers are still getting older, right? But as of right now, I think there's a lot of uncertainty still for people in that business and their business models and making 40-year investments is something they're a little slow to do..

But Joe, as we're talking about before, new-build hospitals are complicated and they're right in that wheelhouse. So we're looking forward to that day when they come back..

Okay, great. And then last question for me, just on a sort of a net pricing basis for your business or more so the industry.

Just wondering what you're hearing as capacity gets absorbed within your business and within in the industry? Do you feel like pricing is rising for the positive for your overall business?.

I mean, if you look at our last three years, right, I mean, it's clear. It's clear that pricing has gotten better. Our sense is it's still trending in the right direction because of essentially supply and demand..

Yes. It's trending up, but you don't see a big leap in the pricing but it has continuously improved a little..

People always have asked them to not build a building, and at first, they think, oh well, I'm not going to do that. I'm going to wait a little. But that's okay, that's - that just stores up work for the future if they do that. Not everybody - so there are times when everybody who thinks they might build a building doesn't get a building.

We may be headed towards that in the next summer..

Do you feel like there's still a good amount of capacity within your industry and the regions that you compete in for these jobs? Are there a lot of - are there still a good amount of bidders? Or is that sort of tightening up at all?.

I mean, I think the bidding environment has been normalized for the last 3 or 4 years. It's been about the same amount I haven't seen. You might see one job here or there, Joe. But if you're looking at a trend, it's been pretty normalized..

It varies by region and one of the interesting things that still happens is you'll still have some people who - or let's say, general contractors and owners who they've just gotten really a lot - there a lot of young guys in those businesses that have never seen a tight market.

They've gotten used to there being a lot of capacity and we're seeing time - at times it's kind of interesting where an owner will come back and try to squeeze the price and be surprised when the contractor says, that's okay. Since we started, I've got a lot of other stuff, irons in the fire, so thank you.

We've got - we've had situations where they'll say we want you to rebid and we'll say, no, thank you. But now they're scratching their heads and sometimes they come back. So it's an interesting environment because a lot has changed. There's been a lot of turnover and change in our industry since the last time. Times are good.

So there's a lot of variability across the country..

And the next question is from the line of Brent Thielman at D.A. Davidson..

Brian, this is taking a little bit further out, but the backlog, which has a lot of these new construction projects in it, are you approaching these or able to be selective to a point, with those jobs, that what you're taking on should have a better opportunity to eventually convert to that service and maintenance opportunity over time? Maybe in other words, are the new jobs you're taking on in a sweet spot of that service and maintenance business?.

Yes. I think there's a couple of layers in that, one of them is I think we are more selective and more disciplined in the work we're taking.

I think the opportunity to have an extended relationship is really on a project-by-project basis, but we are much better today at engaging the customer earlier in the construction project about the service and maintenance opportunity long term.

I think that's why we've been - a big improvement we've made with the service initiative over the last five years.

Bill, do you have anything to add to that?.

No, I don't. I think it's....

Yes, that's a good question, Brent. And there's some we're really working on is engaging the end use customer while we're in the construction phase..

Okay, okay. And then the only one - other one I had, Bill, I guess, back to the SG&A question earlier. I think I was a little confused in the response. I guess, in essence, you guys should still be holding that sort of range of 14% to 15% of revenue as we think about into '18..

Yes. With a downward, slightly downward bias, as we just get more revenue. Keep in mind, that's a percentage of a number. And as the big number gets bigger, sometimes you get a little leverage on that. So I'd say, you made me - if I were predicting, I'd say it's in the same range as recently.

But there - I think there's a downward bias in our percent of - our SG&A as a percent of revenue. Keeping in mind our first quarter is a light revenue quarter, not it has a higher percentage. But in general, the next 24 months, SG&A as an absolute dollar amount will go up. SG&A as a percent of revenue has good prospects for getting a little lower..

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..

All right. Thank you, Dave, and everyone for joining the call. 2017 was a phenomenal year for our company and I am very proud of this organization and our terrific people. I'm very optimistic that 2018 will deliver extraordinary results as well. We'll see you on the road shortly, and I hope you all have a great weekend. Thank you..

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