Julie Shaeff - CAO Brian Lane - President and CEO Bill George - CFO.

Bill Newby - D.A. Davidson Adam Thalhimer - Thompson Davis Tahira Afzal - KeyBank Joe Mondello - Sidoti & Company Sophie Karp - Guggenheim Securities.

Good day and welcome everyone to the Quarter Three 2018 Comfort Systems USA Earnings Conference Call hosted by Julie Shaeff, Chief Accounting Officer. My name Sheila and I am the operator for today. During the presentation, your lines will remain on listen-only. [Operator Instructions] And I will now handover to Julie. Please go ahead..

Thanks, Sheila. Good morning. Welcome to Comfort Systems USA Third Quarter Earnings Call. Our comments this morning as well as our press releases contain forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. What we will say today is based on the current plans and expectations of Comfort Systems USA.

Those plans and expectations include risks and uncertainties that might 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 filed Form 10-K and Form 10-Q 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. Thanks, Julie. Good morning and welcome to our third quarter earnings call. I want to start by thanking all our Comfort Systems USA employees for their hard work and dedication. I'll cover the highlights of the quarter and Bill will discuss the financial results in more details.

Thanks to superb execution by our field teams, we are happy to report our best ever quarterly results. We earned $1.02 per share this quarter which is the first time in our history, we've exceeded $1 per share in the quarter. Revenue for the quarter was $595 million, another quarterly record and a 24% increase compared to the third quarter of 2017.

Profits improved substantially and our operating income for the first nine months of 2018 has already exceeded last year's record full-year operating income. Free cash flow for the quarter was also a strong. And our cash performance this quarter and year-to-date goes well for the health of the underlying work.

We are on track for very good cash flow performance in the fourth quarter and next year. We have had positive free cash flow for 20 years in a row. In light of our strong results in cash flow, our Board of Directors raised dividend again this quarter, increasing it to $0.09 per share.

We remain committed to using our cash flow to invest in our existing business, add great companies and returning capital to our shareholders. Robust construction activity continues in the majority of our markets and our backlog has increased by a remarkable $300 million, since this time last year.

Overall, I am very optimistic about our prospects going into next year. I'll discuss our backlog and outlook in more in detail in a few minutes. But first let me turn this call over to Bill to review the details of our financial performance.

Bill?.

Thanks, Brian. Please refer to slide two, three, six as that provides some explanation and details of our results. Revenue growth accelerated this quarter, as we reported $595 million in revenue for the third quarter of 2018 which is an increase of $114 million or 23.6% compared to the third quarter of 2017.

Our same store revenue increased by $87 million, so same store revenue increase by approximately 18% driven by strong increases in construction projects activity. Gross profit was $128 million for the third quarter of 2018 an increase of $27 million or 26.8% compared to the third quarter of 2017.

Gross profit as a percentage of revenue increased by 50 basis points from 21% in the third quarter of 2017 to 21.5% for the third quarter of 2018 and that increase is a remarkable accomplishment in light of the revenue growth. SG&A expense was $75 million for the third quarter of 2018 compared to $67 million for the third quarter of 2017.

The modest dollar increase reflects our recent acquisitions and an increase in bonus accruals. SG&A leverage benefited this quarter's result as our SG&A as a percentage of revenue decreased from 13.9 % in the third quarter of 2017 to 12.7% for the third quarter of 2018.

Pre-tax income was $52.1 million for the third quarter of 2018, an increase of $16.3 million or 45% compared to the third quarter of 2017. In light of the change in tax rate, I believe that the 45% increase in pre-tax income is a good indicator of the underlying performance improvement achieved by our operations.

Income tax expense was $13.6 million with an effective tax rate of 26.1% as compared to income tax expense of $13.6 million exactly the same last year with an effective tax rate of 37.9% for the same period in 2017.

Net income for the third quarter was $38.5 million or $1.02 per share compared to $22.3 million or $0.59 cents per share for the third quarter of 2017. So to illustrate the effect of the new tax rates, our profits increased by 45% before tax, but with the help of tax reform they increased by 73% after tax.

Free cash flow was $23 million for the third quarter of 2018 and that compares to $39.5 million a year ago. Our nine month free cash flow is $47 million which compares to $49.6 million for the first nine months of 2017.

During the third quarter, we repurchased 85,000 shares and so far in 2018 including purchases we have continued to make since the quarter ended. We have retired over 3,50,000 shares and we have returned more than $16 million to our shareholders via stock repurchases.

In summary, the third quarter of 2018 was marked by revenue growth, margin expansion and SG&A cost discipline leading to exceptional overall performance. That’s what I have on financials, Brian..

All right. Thanks, Bill. I am going to spend a few minutes discussing our backlog and activity in various sectors and markets. These are covered in slides seven to nine. I will then comment on our prospects for the rest of this year. Backlog is a very strong. Backlog at the end of the third quarter of 2018 was $1.25 billion.

On a same store basis, our year will be a backlog increased by $319 million or 35% growing from $900 million to $1.2 billion. These increases are broad based and are distributed over most of our companies. Sequentially, same store backlog is barely down, but that is a positive trend for a third quarter when we typically experience a heavy burden.

Virtually all of our end user segments remained solid. Institutional markets which include government, healthcare and education made up 40% of our revenue for 2018. The commercial sector with 35% of our revenue and industrial continues to be strong and has now increased to 25% of our business. Please turn to Slide nine, from current revenue mix.

For 2018, construction is 73% of our total revenue with 38% from construction projects, the new buildings and 35% of construction projects in existing buildings. Our construction business is benefiting from good fundamentals and trends non-residential construction market. We are booking and good projects including many for next year.

Geographically, we experienced strong results in most of our markets with particular strengths in the mid-Atlantic, the upper Midwest and the northeast. We continue to reap benefits from the investments we have made in our service business. Service business exceeded the third quarter of 2017 in volume and profits.

Services 27% of our revenue with service projects providing 9% of total revenue and pure service including hourly work providing 18% of revenue. Overall, our backlog and pricing environment remain supportive, and we are optimistic about the fourth quarter and our 2019 prospects.

Thank you once again to our -- 9,800 employees for their hard work and dedication. I will now turn it back over to Sheila for questions. Thank you..

[Operator Instructions] And the first question comes from the line of Bill Newby of D.A. Davidson. Please go ahead..

Good morning, guys, and congrats on another great quarter..

Thanks, Bill..

I guess just to kick it off I mean Brian with backlog up where it is. I mean that doesn’t – you guys have grown that through this summer which is pretty unusual for you guys. I mean if you’re looking to 2019 are you thinking – I don’t know mid to high single digit growth on the revenue line should be pretty achievable.

How are you thinking about it into 2019?.

Yeah, Bill. That’s what exactly what we’re thinking with the backlog we’ve already have committed for next year. Bill and I both agree mid to high single digit growth going into 2019 is what we’re expecting..

And you know for the last quarter or two we’ve done significantly better than that. But we did have – we do have one factor affecting that which is we have a subsidiary in North Carolina that had extraordinary growth.

They’ve accounted for more than a third of that growth by themselves because there was a slow year last year in the markets of North Carolina and then they’re hitting a record year this year. So they doubled up that factor can’t continue. So that’s why we’re saying you know mid to high single digits is the most reasonable outlook..

Yeah, we’d be pleased if we got mid-to-high single digit growth..

Yeah..

And then I guess on the margin line I mean a little surprised to see the strength this quarter just given how much construction is coming into the mix versus service. I mean any color on what’s driving that.

Obviously execution and mix is helping me out but how sustainable is this margin going forward?.

Bill, I look at that that gross profit number for every day for a month now. And it’s fantastic no matter how you look at it and it’s a real tribute to the folks out in the field that are doing the work. It is performing exceptionally and well trained and safely and serving our customers which helps drive the results.

So we’re just really pleased to hover around that number for a while. But it’s just fantastic performance and also we’ve had an absence of bad news that we’ve had report. Combination of good pricing, good execution and lack of bad news, you know, get you good product gross profit.

Bill, do you want anything to add?.

No..

And just a little bit more on that. Guys, I mean part of that has to be this I guess pick up in industrial and healthcare, I guess to end markets that you guys pointed out in the past has been kind of higher margin work for you guys.

Do you see the strength there continuing, any thoughts there?.

So I would say that you’re absolutely right. That’s a big part of it. Medical’s come back some. It’s still far off of what it really was for most of the time I’ve been at conference systems as – as an opportunity and as a proportion of our revenue.

But industrial, if you were to look – if you look at over time how much more industrial we’ve been doing it’s a combination of really it’s the acquisitions that we’ve done overtime have just had more industrial in them and especially the one that we just did in Indiana this year.

They’re just fantastic in that segment of the market virtually 100% industrial at the moment.

And then one of the reasons it was such a big leap year-over-year is that company that I mentioned in North Carolina that had a lower revenue year last year and is hitting a record this year they have proportionately more industrial than our average mix across the company. So you’ll see – you’ll see the numbers.

They’ve really popped up but I think the new levels that they’re at are more what you’re going to see in the future because it’s compositional I think comfort is changing and we’re becoming more industrial you know. We’re having a bigger segment of our company that’s industrial..

And Bill also service has actually grown and you know real dollars both in volume and profit, so that’s helped too..

I got some more broads, back in queue and you guys take a shot. Thanks guys..

Alright. Thanks Bill..

Thank you. And the next question comes from the line of Adam Thalhimer of Thompson Davis. Please go ahead..

Hey, good morning guys. Congrats on a great quarter..

Thanks, Adam..

I’m on the same lines on the gross margin side. Can you give us any sense for the composition of your portfolio of large projects? And when you look at it as a whole do you feel like we’re early in the large projects still or are starting to mature and contributing on the gross margin line..

If you were to look at the percent complete across our PLCs, it’s sort of a low or neutral but it’s – we’re earlier in the projects than – because a lot of them have started, right. We haven’t been doing them for that long.

So we will for example we won’t have as many closing out at the end of this year as you would expect next year like in a robust market that’s been around for longer. As far as the composition, I would say there is more that the industrial work that there’s more of it turns a little quicker. It’s a higher percentage of the total job is with the owner.

That’s one of the reasons it can be more profitable. So that is in some ways it’s easier to understand manage and forecast under this business is almost impossible to forecast. I don’t know if that helps but I would not say that we are any.

If you look back at times in our history when we had a lot of big work going on we’re nowhere near where it was at times in our past as far as the percent of our work. That’s a big project. By the way I’m not predicting we’re going to get back to those levels but that’s our business. You know we’ve more than doubled our service business.

We’ve strengthened our small projects business. The industrial mix that we’ve brought in has a lot more like small and in plant at work like a 1 million or 2 million. We have more controls our control business has grown. We have you know we have some electrical embedded in some of our companies.

So we’re just we’re just a more mixed company which I think is very healthy..

So best guess maybe middle of next year when you would start to say that you’re – percent complete and your PLCs is where you would be above average?.

I’d say be closer to the three to fourth quarter, Adam..

Okay. And then your North Carolina subsidiary how does their backlog look and what would be the expectation for revenue from them next year. Kind of flattish year-over-year..

I think they’ll have another year like this year. Their backlog is fantastic.

By the way, you know our backlog sequentially was down 7 million there more than all of that by the way a number of our companies could be more than all of that but there – if you were to just back them out across the rest of our company we’re up and we’re up noticeably 20 or 30 million.

And they – their backlog still the second highest it’s ever been they have a hundred and fifty million dollar backlog and double their average in the last five years. So it’s not as if it’s healthy for their backlog to moderate a little that has to happen sometimes when you get this busy.

So I would say one of the reasons we’re pretty positive about 2019 and we’re willing to talk about 2019 a little earlier and just say like we think it should be another really good year because our backlog is really, really good..

Okay. And then lastly Brian I was just going to kind of try to push you on the regions. I mean the only if you look at the September ABI report the only region that shows any weakness is the northeast but you said your bookings were good there. I mean ABI looks fantastic in the Midwest and the South.

I mean what you’re seeing by region?.

I think we’re seeing a broad based pretty strong has been pretty interesting for us. The northeast has always been our strongest region historically. You’ve got great companies up there. They got a fair share of the work. So I know the ABI is down. But I work a lot of years still very strong..

We got really good companies up there, Adam. This is exceptionally different companies..

Okay. I’ll turn it over. And thanks..

All right. Thanks..

Thank you. And the next question comes from the line of Tahira Afzal of KeyBank. Please go ahead..

Hi, folks..

Good morning, Tahira..

So folks, obviously your free cash flow remains very strong and you know the overall macro environment for yourself is strong. Obviously the stock market in general is saying something else.

And you know you guys impact that trend now for two days, but is there a chance you could get more proactive in terms of buybacks, you know, given the disconnect between the two?.

We have gotten more proactive in buybacks over the – 250,000 shares at this point in the year is, you know that’s way more than – probably more than covers are dilution. I think that we should see very good cash flow in the next six months. We’ll be together with our board here in the next week or two.

But you know I think between you know acquisitions and buybacks there’s no point as earning this cash and not finding ways to benefit our shareholders. So what we won’t do is go borrow bunch of money to do buybacks but we don’t need to..

Right. And you know – just talking about that. I mean obviously the optics of operating performance for next year seems to be shaping up well. You know you have a tax comp into next year between buybacks and between ready organic and acquisitive strategy.

Do you think you can offset that on the EPS sign?.

It’s very early for us to get to a point where we’re talking about getting very specific about next year. I think our senses next year ought to be another great year. There’s a range of what that could mean. But I will say we do have some things going for us.

We even – we have acquisitions if we do them right they’re not that creative but we have the acquisitions we’ve done in the past. The amortization of those acquisitions continues to come down a little bit..

Right..

The shares we’ve bought back already have not fully baked into our fully diluted although you know those are those are all small things but they don’t help. So there are things that that will help us – with another good year. That should be helpful as we go into next year.

It’s really too early for us to give directional guidance is actually for us to be this positive this early out of the ordinary for us..

What we’re really basis – we have a really good backlog going into next year to hear, so I feel good..

Got it. Okay. Bill and Brian, if you look at – what should we be watching that we should view as red flags, it’s always tough to call these turned both for the positive and negative but are there things that would get you a little more defensive in your strategy going forward..

So I was – as far as what to look for – you know that the gyrations in the residential market I don’t think are very good indicators for us they haven’t been the time I’ve been CFO since 2005. The broader market like businesses willingness to make capital investment is really what going to drive us at the margin.

And as far as you know what to look for, going forward – we becoming defensive, we’re kind of always defensive. And I will say acquisitions. It’s a moment in time where you’ve had a few good years where you have to be very careful to maintain your discipline with acquisitions.

So we like our chances but I will say we’re only going to do a deal if we have conviction about it. That’s the area where we would be defensive and all other areas, we just go take what the market gives us and right now it looks like it’s going to give us a chance to make some money for a little while..

Our structure, Tahira, we’re in many parts of this country so that gives us some protection about the whole country would have trouble at the same time..

That’s a good point..

We have industrial we’ve doubled our service business..

So we’ve got some – some protections going forward if things this gets..

Got it. Okay. That actually makes sense. Folks, thank you very much and congratulations to yourself and your team..

Thank you very much..

And the next question comes from the line of Joe Mondello of Sidoti & Company. Please go ahead..

Hi guys. Good morning..

Good morning..

Most of my questions were answered but I wanted to ask you on pricing. You know as we’ve progressed throughout this year it seems like you know labor shortages and wages inflationary environment – the environment overall in terms of construction demand all of it seems like it's escalated.

So and over the last two, three years you guys are consistently sort of said yes we're starting to get a little pricing starting to get.

Have we gotten to a point where things are starting to go exponentially at all or starting to really start to escalate on pricing and are you seeing the net benefit of that or how it is that pricing environment then progressing?.

Yes, I mean the pricing environment has been good, it's been going across the country. You're right, there is going to be wage increases this year no question about it.

We are able to pass in a [law] there is lot of what's going on as well pricing is the improvement in productivity and the application of technology that we use and whether it's been trembled etcetera, etcetera and lot of training we do. So it's will offset some of these costs in the future for sure as one way to help with that.

Bill, do you want to add on that..

Yeah, the one thing I'd say about pricing is it's a busy market and our guys are pretty full. So for them to take new work they have to be happy with the pricing and they get it. They work and their people pretty hard, they care about their people. So I say our opportunities very good on pricing..

And one thing you get, Jose when there's a lot of work out there you can be a little more selective and do the work you are good at and our guys are good at lot of the work so they are able – what their strength is..

Is this the ideal sort of environment right now where you can get a widening spread between the price that you bid a job on versus the cost that requires you to complete that job or so….

That has been -- that is describing what's happened over the last 18 months where gross margins, frankly we didn't necessarily everything we see that is exactly why as far as how far that can run that I don't know. I mean we like I said there are a lot of things, there are a lot of secular things like energy in the U.S.

and offshoring having run its course and lower and more competitive tax rate and more competitive sort of receptivity for capital and sort of worldwide capital allocation decisions that make me feel -- make me wonder if it's if anybody ought to be getting too negative right about now at least about further the verticals the main street non-financial center verticals we are in, but that's predicting the future.

.

Right now there's a lot of work out there to do, Joe..

Okay. And sort of I guess to touch on maybe the negative component to everything, Tahira might have asked this question but I think I might have missed it or maybe you didn't go into that much detail.

Just in terms of the environment right now, I mean I went back historically I don't know if I could find a period of time where you're seeing backlog up 35% year-over-year. We're starting to see higher interest rates, the cost to build in terms of labor, materials obviously the cost to build a building is escalating.

I'm just wondering you guys have gone through these cycles many a time, does this give you any sort of pause or caution at all seeing such an escalation sort of 35% is pretty big and considering interest rates and costs to build.

I'm just wondering what your overall thoughts are on sort of a cycle and where we're at right now?.

I will go first on that and then Brian can give his high level thoughts. As far as Comfort goes, we’ve never seen a period-over-period increases like this in the backlog.

Some of that because I get to see the individual numbers like for example the mid-Atlantic situation where there was a slowdown in North Carolina and it's come back, some of that is a little bit of bunching, but in general it's very strong. If you will pull out sort of Mcgraw-hill numbers are the census numbers that are derived from them.

These levels are not crazy. The year-over-year percentage increases we've seen bigger wins in the United States many times than this, so I think some it is just we're in looking out and we’ve made some good investments and we bought some good companies and we're in some good markets. .

You're saying the macro?.

The macro, I don't think the macro is like off the charts at all. I don't think it's -- I think it's really good, but it was off -- it's been off the charts like and a couple times since I've been CFO in this company. It's not off the charts right now. I'm not saying it will be by or I am not sure it could be given the capacity that's out there.

Brian, what do you think?.

Well, I mean I think, you can help, everything is said Joe is correct. I mean if it's going to affect business it'll happen and we’ll respond like we always do..

Okay. Yes, now everything is going well so congratulations.

I'm just always looking out for the unpredictable or cyclical business, so I'm just wondering?.

All right. Thank you, Joe..

Thanks you. [Operator Instructions] And your next question comes from the line of Sophie Karp of Guggenheim Securities. Please go ahead, Sophie..

Hi, good morning, guys. Thank you for taking my questions. Congrats on the solid quarter. .

Thank you..

I wanted to push you a little bit on the M&A and go. I guess historically, you've done deals in the end of the year in the winter timeframe maybe, given how great the business is going right now and what you see in the macro.

Is this environment conducive for M&A or is it just getting to a point where it's too pricey and people are not willing to sell? Thank you..

I'll be honest. For us, M&A is not really an environment issue, we're not sort of speeding a process we're looking for individual companies that we really, really like. I think that the availability of good targets to talk to her is as good as I've ever seen it sort of their interest in being a part of us is very good.

The reason that I think it could go either way as far as whether we close a big deal in the next six months is whether we can get the pricing right. You're a person selling their company is staring at very, very good recent results. They're typically staring at a very good forward result.

They're being told by bankers still you know that they especially if they have more than a certain amount of EBITDA they can go sell the private equity. And you know we tell them yeah to be bankrupt within five to seven years or you'll be the first. That it wasn’t.

So we have a – there's a lot of things going on there and I think at the end of the day we have some good opportunities whether we get somebody who's willing to sell it or at a price that we can get a rate of return on it and be confident we can take care of their people on that basis. I don't know. I think, we -- most years we get a deal.

But we'll only do it if we have conviction. And also how does this -- how do equities trade right. I mean what are our stock could also be an attractive place to deploy extra capital.

I do think when you if you look back in 5 or 10 years you'll see that we in the next 5 or 10 years we did exactly what we did in the last 10 years which is you know spend about two thirds of 70% of our cash on acquisitions and split the rest between dividends and buybacks.

But if you look forward or backward any given year that can be way off of those -- way off of those you know those percentages..

Right. So you know on that topic so you obviously have a lot of free cash flow that's going to be coming your way just looking at the backlog and the organic growth opportunities. So you have some balance sheet capacity which you've discussed in the past. So it's quite a bit of a war chest.

If the acquisition [indiscernible] become more scarce, is there an option to increase the dividend yield little bit in your mind?.

Well, we have methodically increased the dividend increased it again this quarter and Board looks at it in every Board meeting. We both look at that and we both look at our buyback strategies, so as we go forward and we'll continue to do that..

I think we've increased the dividend three quarters in a row. So I think the board – what happens for years we were increasing our dividend at half a penny a quarter..

Yeah..

That wasn't enough to have a penny – each year half a penny per quarter. That wasn't enough to keep up with the growth the company was having. So I think the boarded recognition of that has increased the dividend a little more frequently lately. I think they'll continue to consider that.

And then when they get to a point, where they feel you know they want to pause to pause but three times in a row that never happened for us..

Okay..

So clearly there's a little bit of recognition of what you're saying..

Thank you for the color. Appreciate the answers..

Thank you..

Thank you, Sophie. Take care..

Thank you. We have no more questions. I’d like to hand back to Brian Lane for closing remarks..

Okay. Thanks, Sheila. And thank you everyone for joining the call today. We had an outstanding quarter and I am confident of a strong finish to 2018. I hope you all have a great weekend. And let's go [Red Sox]. Thank you..

Thank you. That might conclude your conference call for today and you may now disconnect. Thank you for joining and have a great weekend..