Good day everyone, and welcome to the conference Q1 2019 Comfort Systems USA Earnings Conference Call hosted by Comfort Systems. My name is Sue, and I’m your event manager. [Operator Instructions] And now I would like to hand over to Julie Shaeff, Chief Accounting Officer..

‘ Thanks, Sue. Good morning. Welcome to Comfort Systems USA’s first 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 could 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 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..

Thanks, Julie. Good morning, everyone and welcome to our first quarter earnings call. Let me start by thanking all the Comfort Systems USA employees for their hard work and fantastic performance. I'll start with highlights of our quarterly results and some comments about two recent events and then Bill will cover the financial results in more detail.

We are pleased to report strong first quarter revenue and profits and a terrific start to 2019. Building on solid execution over the past several quarters, we had our strongest ever first quarter performance. Revenues are 16% higher than the first quarter of 2018 and 10% higher on a same store basis.

We had another quarter of solid execution by our operating companies. As a result, earnings improved substantially with earnings per share of $0.53 this quarter, compared to $0.44 per share a year ago. The real increase in operating performance is even larger than this, because last year, we had a $0.07 tax benefit.

Our backlog continues to build, with strong new construction activity in many of our markets. Backlog, as of March 31, 2019, is 1.14 billion and same store backlog is 4% higher, compared to the same time last year.

Our booking trends continued to be good, service continues to grow and we were also happy to be able to reward our shareholders with another dividend increase. Overall, I continue to be optimistic about our prospects this year.

As most of you probably know, in spite of our investments and precautions, over the last two weeks, we were struck by a ransomware attack that adversely affected crucial back office functions across our many locations. Despite the incident, our field work force has continued to work hard for our customers every day.

Although a recovery is ongoing, I am happy to report that our operations were able to meet their ongoing obligations and we have returned to a normal functioning in most ways.

Throughout this event our teams across the country worked together effectively and constructively to manage and ultimately overcome this challenge, and I am deeply grateful for that commitment. We believe that the effects of this incident are temporary. Comfort Systems USA is on track.

On a much more positive note, we are very happy to announce a significant new investment in electrical contracting.

As previously released on April 1, we closed our largest acquisition ever when we teamed up with Walker Engineering, a nationally prominent electrical company headquartered in Dallas and with offices and substantial operations in Dallas, Houston, San Antonio and Austin.

We could not be happier to welcome the Walker team and we feel confident they will make a fantastic contribution to Comfort Systems. 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 the details of our financial performance.

Bill?.

Thanks, Brian. Slides 2 through 4 may be helpful as I review our financial results. First quarter revenue was $538 million, an increase of $74 million or 16% compared to the first quarter of 2018. Same-store revenue increased by 10% or $45 million compared to last year.

Our same-store growth is primarily due to increased project activity in our businesses this quarter. Net income for the first quarter was $20 million or $0.53 per share, compared to $17 million or $0.44 per share for the first quarter of 2018.

Of the $0.44 of earnings per share we reported in the prior year, $0.07 resulted from a tax accounting method change. So, the improvement in our underlying performance is actually larger. One way to think about the underlying performance of the business without the tax credit last year is to look at the change in our pre-tax earnings.

In the first quarter of 2019, our operating income, which is before tax, was 45% higher than it was in the first quarter of 2018. That 45% improvement clearly demonstrates that our teams achieved a big increase even over the fantastic results that they had achieved in the prior year.

Gross profit was $107 million for the first quarter of 2019, an increase of $18 million or 20% compared to the first quarter of 2018. Gross profit, as a percentage of revenue, was 19.8% for the first quarter of 2019, compared to 19.2% in the first quarter of 2018.

SG&A expense was $79 million for the first quarter of 2019, compared to $70 million for the first quarter of 2018. SG&A, as a percentage of revenue was 14.7% in the current quarter compared to 15.1% in the first quarter of 2018. So we continue to benefit from SG&A leverage. Our 2019 tax rate was 25.9% compared to 11.1% for the first quarter in 2018.

The 2018 rate benefited from a tax accounting method change as I mentioned before and excluding that discrete benefit, our tax rate last year was also approximately 26%. Free cash flow was a negative $7.5 million, compared to negative free cash flow last year of $1.4 million in the same quarter.

We almost always have negative cash flow in the – early in the year and this small negative cash flow is actually encouraging when considered in light of the remarkable $75 million of free cash flow we achieved in the just preceding fourth quarter.

We feel very good about our cash prospects for the remainder of this year, although, the ransomware incident could conceivably result in some delays in cash collections in the second quarter. We return capital to our shareholders this quarter by repurchasing 67,000 shares and as Brian noted, we increased our dividend again this quarter.

Before I finish, I want to take just a minute to remind everyone about our expectations regarding the transaction that we closed on April 1. When we complete acquisitions, we have to value their backlog, trade name and customer list, with the help of a valuation firm.

The amounts that are attributed to those attributes are then put on the balance sheet as an asset. And then those assets are expensed each quarter in the following years on a schedule that is generally declining with a much shorter life for backlog than for the other assets.

That non-cash expense is why we disclosed in our press release that we do not expect much accretion for acquisitions at first. In the case of Walker, we said 18 months to two years. Our current expectation is that Walker will be a solid source of EBITDA earnings, cash flow.

However, the earnings will not have a big effect on net income, especially at first after amortization measures such as EPS for just a little while. Past acquisitions continue to create amortization expense as well.

For example, even though we had not yet closed Walker, in the first quarter that we just reported, our operating income was decreased by just under 5 million for non-cash amortization expense.

As a management team, our goal is to create the best company we can and we believe that the stream of future cash flows is what builds long-term value and gives us an opportunity to invest in our people and in growth.

And so we evaluate our estimates – our investments on that basis, knowing that the effects on operating income are temporary that in the long run the value of Comfort Systems will ultimately depend on our ability to generate cash flow and then to invest it wisely.

Overall, we're very pleased with our results and we're optimistic that the improved activity levels will continue in 2019. That's what I've got on financials, Brian..

Thank you, Bill. I'm going to spend a few minutes discussing our backlog and activity in various sectors and markets. These are covered in slides 5 through 7. I will then comment on our prospects for the rest of this year. Backlog trends and demand for our services continued to be supportive. Our sequential backlog declined modestly compared to year-end.

However, our backlog is up compared to the same time last year and we continue to feel great about both our strong backlog levels and our ongoing pipeline of opportunities. Backlog at the end of the first quarter of 2019 was $1.14 billion, an increase of $64 million or 6% compared to the first quarter of 2018.

On a same store basis, our backlog has increased by $46 million, which is a 4% increase compared to a year ago. In general, our end user sectors reflect good balance and positive ongoing prospects. Institutional markets, which include government, healthcare and education, made up 36% of our revenue for 2019.

The commercial sector was 33% of our revenue and industrial represented the remaining 31%. Please turn to Slide 7 for our current revenue mix. For 2019, construction is 75% of our total revenue with 41% from construction projects for new buildings and 34% from construction projects in existing buildings.

Our construction business is benefiting from good fundamentals and trends in the non-residential construction market. We continue to book good projects with some companies booking into next year. We have made and continue to make investments in our service business.

Service is 25% of our revenue, with service projects providing 10% of revenue and pure service including hourly work providing 15% of revenue. Our service business is doing well and exceeded the first quarter of 2018 in volume and profits. Finally, our outlook.

Pricing remains supportive and we believe that our prospects for revenue growth continue to be good. We expect mid to upper single-digit full company revenue growth in 2019. We believe we are positioned to execute on these opportunities and we intend to continue to invest and return capital to our shareholders.

With our backlog and the strength we perceived in most of our markets and with good opportunities to invest, we are optimistic about our future. Thank you once again to our now over 11,000 employees for your hard work and dedication. I'll now turn it back over to Sue for questions. Thank you..

Thank you. Your question-and-answer session will now begin. [Operator Instructions] Your first question comes from Tahira Afzal, KeyBanc. Please go ahead..

Hey, Brian, Bill. Thank you for taking my questions..

Thank you..

So, Brian, you just talked about mid to upper organic – sorry, mid to upper revenue growth. I assume that's organic.

That's not include Walker?.

That's correct. Yes, that's organic, Tahira..

Okay, great.

And you also talked about now starting to see work being booked into next year and I know next year is so far away, but the cycles being so different, could we conceivably see organic growth continue into next year?.

I absolutely think so, Tahira. This, as you know, is very early for this industry to be booking work a year in advance. We are actually seeing very good opportunities beginning of next year, into mid next year. So I think at the pace we're going, we should see organic growth in 2020 as well..

Okay, great. And I found that your commentary was maybe a little more positive on pricing. I know you guys are always careful on commenting on that. But even if I go through your Q, it seems execution continues to be good. Pricing is holding out. I know you have some margin dilution coming in just from Walker and higher place through.

But post that, could we see margins also being sustained in the cycle a little longer than you thought..

Well, I think I'll comment and I'm sure Bill will too. I think pricing is holding up, which is very good. But our execution in the field, Tahira, has been just exceptional. Producing results that we're bidding is key to our business. I think that will hold up, here we just say about Walker.

That is true, but I think the ongoing organic business that we have in here, we'll see that rolling into next year as well.

Bill, do you want to add on to that?.

Yes, so as you said, we do have – the mix is changing a little bit. Comfort is about to get much bigger on April 1 and we will be earning more money, but it will average our margins down a little. But our ability across our businesses to get fair and good gross profit per man hour worked is very good right now.

And as we're investing in productivity to even build on that and obviously, we're also investing to grow our workforce. So we feel, we do feel positive..

The other thing, Tahira, not to discount is the service business. I know the percentage is 25, but in real terms, in real money that you can spend, net revenue and profits are up and it's really helping our margins. That service business is doing terrific right now..

Got it. Okay. And one last question from me and it's a tricky one. There have been rumors of one of your peers potentially getting taken over.

Would love to get, I know you guys have been consolidating, but as you look at the industry as a whole, do you see some of your larger peers consolidating and does that change the competitive landscape for yourself?.

Well, just to comment on the one that's out there, we know the same thing everybody else knows that what was published, but we think that company is an exceptional company, we have a lot of respect for them.

Bill, do you want to comment on the bigger question on consolidation?.

We love our company the way it is. We think we have a fantastic ecosystem, a great opportunity to continue to invest. We think that the way that we run this business is what draws such fantastic people to us. So we're pretty happy with the way things are..

We're just going to get up every day and try to get better at it, Tahira..

You guys are doing a good job. Congratulations and thank you..

Thank you..

Thank you. Your next question comes from Brent Thielman, D.A. Davidson. Please go ahead..

Hey, thanks, good morning..

Good morning..

Brian or Bill, maybe to follow-up on to Tahira's question. I mean, the margin is obviously really good, seems like the market environment conducive to better terms to the contractor right now, your execution is solid.

Has your appetite for risk changed it all? Are you more comfortable today than a year or two ago in terms of taking on jobs you may not have three or four years ago?.

Oh, boy, I'm going to give that one a first shot. No. I think Brent, where I'm sitting, I think the execution is solid because in good markets, you can probably stick to work that you're good at, work that's more in your wheelhouse that each company is comfortable doing.

But in terms of our risk profile, we try to take every company in an individual basis, that's part of us about what they're good at, what size they can good at and sort of keep it between the fairway. So in terms of risk, I don't think that profile has changed..

And there's not one thing in our DNA that makes us want to have big revenue. What we want to have is the biggest and best workforce. And the growth, I think has obviously followed from that, but we – the day we – when a company becomes as part of Comfort Systems, the first message they get is, we do not have to be the biggest company in their market.

We just need to be the best..

Got it, Okay. I appreciate the color. And I guess my second question, you've built the bigger position in the Texas market now, certainly a larger piece of your revenue stream than it's been in terms of that state.

Can you talk about the opportunity and/or your interests and further consolidation in that market? Do you want to try and manage how large Texas gets for you and the overall piece of the pie?.

So we – so let me give a little color around that, right. So before we did this transaction, we had – our five biggest states were Florida, North Carolina, Virginia, Texas and New York, although in New York, we're in the upstate. So people are sometimes surprised by New York. With this acquisition, Texas is going to be about 25% of our revenue.

We love Texas, we think it's really, I'll just say, with a fantastic opportunity to get good business with good partners and also it's a state where a high quality product is rewarded. So we love Texas, but having said that, I wouldn't say that our future investments would be weighted toward Texas.

I think that we will go look for great companies wherever we can find them in the kind of markets that we like, and there's a lot of those markets.

And if I have – you made me sort of talk about the area of the United States that has most likely build – over a long period of time, the most opportunity for us for a long time, I would have said, it's the two-thirds of the population of the country that sort of goes from the upper Mid-Atlantic, all the way through, all of the South and into Texas.

That's a good area for us, but I'll tell you what, there's nowhere any good company. It's all we want, what do you think, Brian..

I totally agree, we look for good companies now, doesn't matter where they are..

Okay, all right, guys. Appreciate the color. Thank you..

Thank you..

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

Hey, good morning guys, great quarter..

Hey, Adam. Good morning. Thanks, buddy..

Hey, Brian, can you give us a sense for bidding activity and what your outlook is for backlog?.

Yes. Thank you. Bidding is very good. Just in April alone, we've had a very good month. I think prospects are still very healthy, Adam, pretty much across the country. We're seeing good opportunities, a lot of industrial work, education, healthcare has picked up. So I think you're going to see the backlog grow here in the second and third quarter.

So I'm feeling very good about the markets today and what we're seeing going into next year. Next year looks pretty good as a start here in April..

What are you looking for next year, by the way? Is it like huge data centers or what gives you the confidence?.

Pretty much a mixed bag. We're seeing some education going into next year and a fair bit of industrial..

Got it. Okay. And then now that you have Walker or maybe there's a digestion period.

What are your thoughts long term on electrical?.

So as you know, this wasn't – this is something we looked at for three or four years, chose what we think is a great partner to get us started in electrical, but we continue to keep doing what we've been doing. There aren’t – Walker is one of just a few truly nationally prominent players, right.

And so, buying a company in that scale is something that’s not going to happen very often, but there are a lot of just really, really good electrical companies, they’re old, they’ve grown on a rational timeframe. They have workforces that they’ve really invested in and they self-perform.

And I really – as I continue to like some of the opportunities that we have in mechanical, but I think electrical opens up a really good opportunity for us to do what we really do, which is just try to bring good people in, who have capabilities that people need.

So, yes, I agree that obviously we’re going to pay down a little debt probably for a few months, but we’re going to keep doing what we’ve been doing..

Yes, sir..

And then, Bill, can you help, what’s the quarterly D&A going forward with Walker?.

What does that mean the quarterly D&A?.

Depreciation and Amortization..

Oh, depreciation. We don’t know yet. It’s roughly what you – obviously, if you were to read our press release, I heard D&A, I was thinking that deoxyribonucleic..

Yes, boring D&A. It’s all great..

It was like, well they have a great D&A. So as far really is the amortization that matters, right. And depreciation will be really proportional to our depreciation. The amortization – I think their amortization will likely bigger than – be bigger than what we’re amortizing right now for all of our other acquisitions put together.

So you’re going to have to start paying more attention to it. And if you read our press release, I essentially tell you what I think they’re going to earn and I tell you that I think that the amortization is going to kind of zero that out at the bottom. So they should roughly equal, right.

And that’s by the way, what we’ve said, that’s what we’ve experienced with the last three, four, five deals. And that’s really what we predict will happen. And then so what then starts to happen is the amortization comes down and you start to unveil the earnings on the lower lines of the income statement.

But on the place that it matters the cash flow, a lot of cash goes out day one, but cash starts coming back in day two..

Right.

And at the earliest, the amortization starts to come down late 2020?.

Well, it starts to come down right away, but it’s – because backlog is usually given about a two-year life, so, and it’s a big, big chunk of the amortization. It’s just really big the first year. But the reality is in a year or two of an acquisition like BCH, we did start to get a little bit of accretion, right.

It’s not fully covered, because it does come down some. But it drops off precipitously after about 18 months to 24 months. Although, there is still a part of it after – even after that, constantly hiding a portion of what those assets are producing..

Got it. Okay, thanks so much..

Thanks..

Thanks, Adam..

Thank you. And your next question comes from Joe Mondillo from Sidoti. Please go ahead..

Hi, good morning, guys..

Good morning, Joe..

So I was just wondering if you could sort of give us your feeling on the trajectory or the trend in the market itself. It sounds like you’re still very positive. But I imagine in terms of bidding activity, if you look like 18 months, 24 months ago, those are ramping up tremendously.

And I would think maybe they’re sort of plateauing, not that they’re turning down. But they’re not accelerating as much as they were, if you could comment on that. And then also, I don’t know if you saw the Architectural Billings Index.

It was the weakest in maybe two years this last month, any comments on that as well?.

I’ll go first on that, just the last thing first, a single reading on that index doesn’t really bother me at all, and I would note, if you got inside the details of it. The South was above 53, is still very strong and as you know, we have a lot of our business in the South.

Sometimes, those numbers get really driven by what’s happening in New York City, in the Bay Area and we are just not in those areas. So it’s always – it’s what really matters to us is what Main Street’s doing. As far as demand, it’s certainly the case that bookings cannot go up at the percentage increase that they did a couple years ago.

Ironically, I think the demand is still there. I think that there’s capacity constraint. I think, one of the reasons why it’s hard for it to go up further is because there’s capacity constraint.

That’s why the pricing is good, but I do think the underlying demand, this is the United States, it’s a fantastic place to deploy capital right now compared to anywhere else you might deploy capital. We have a better tax rate, we have energy, we have offshoring has kind of ran its course.

So we, I don’t know, I think there are lot of secular trends that support the U.S., whether we have a downward blip for a year or two, at some point like we always do. I think the long-term opportunities and first time I can say this in the 20 years, I’ve been here until the last year or two, I think secularly, there is a lot to be said, right now..

I think production of capacity is the issue, Joe, not the market..

Okay. That leads me to my next question actually. So I assume and I assume the answer is because of capacity, but you continue to talk about how you’ve booked the most amount of work that you have ever for the following year at this point in time of the year.

That’s not because demand is so strong, that’s because you just don’t have capacity to do it this year, is that correct.

Whereas if you had the capacity, you could do the project this year, it’s really just due to capacity, correct?.

No. I just think – I think, it’s like good general contractors are making sure you had the resources that they know that they have worked on that. They just want to make sure they can book you to do it and I think it’s more driven by that.

We find a way to do things, I think it’s just that it’s getting spread out more and the good general contractors are awarding more earlier..

Okay..

There is another interesting thing happening, which is we still have this underlying trend toward industrial. The market is trending that way and our acquisitions have driven us further into that trend. And so that also has – that mix issue also has an impact on our backlog..

All right. And just sticking with sort of the capacity theme.

If you were to go around and sort of measure how much utilization, if you could measure every single one of your locations and how much capacity in terms of number of projects that they could handle at this point in time and you measure what they’re actually doing right now at this point in time.

So in other words, sort of a utilization rate measurement of where your locations are at right now, how much room to 100% do you have, how close are you to 100%?.

So I realize you said if, right, because you really can’t. There are times – you can take a project if you – if you can get the pricing that would allow you to do it with more labor that’s not your core labor, right. So it'd be less productive labor. But you can get it.

Also, there are investments you make in productivity, but having said that, I think I would admit and Brian would admit, most of our guys are busy, they are working their guys over time there, it's not sustainable to think you're going to push those guys harder. That's why we said earlier, our goal is not to be big, our goal is to just....

I mean, look at the revenue, we had in the first quarter, when you think that's usually our slowest, I mean it was pretty strong..

Think about it, it was 10% same store increase in revenue. After last year, when you know we were flying, so some of that's pricing, but most of that is our guys. And by the way, some of that's mix, we're doing more, you see a trend toward more new construction.

There is a little more pass-through of materials and subcontractors in the revenue on that part of the business, but ironically, we're still getting the same mix of overall margins for that. So there's a lot going on with mix, but your underlying thesis that can we go push our guys harder, the answer is, we play a long game on that..

Okay. Sure. And then last question, in terms of the mid to high single digit organic growth guide that you sort of talked about, how much of that is price and where was it two years ago? I'm just curious of how much price is contributing right now..

Price at the margin is not contributing all that much. If you look at our year-over-year change in gross margin, it was 19.8% this year and I think 19.4% last year.

So most definitionally, a half a percent of your growth came from that, so I don't think it's mostly price, I think it's mostly utilization, but price is important, but when you're growing 10%, it's not because you're raising your prices 10%..

I mean, Joe, I can't say that we are getting really good productivity from the workforce..

Okay. All right. Well, good luck guys. Thanks for taking my questions..

All right, Joe. Thanks..

Good questions..

Thank you. And our next question comes from Tahira Afzal from KeyBanc. Please go ahead..

Hey, so I just had a quick follow-up. Bill, I think it was you who mentioned secular trends and some interesting ones shaping up, has the change in tax structures, maybe created more resilience in some of your markets as you look at your geographical footprint.

We are seeing a lot of businesses move out of New York and unfortunately people as well, any comments on that?.

So first of all, my comment was, yes, I'll make a comment. First of all, I do want to say, what I was referring to is the U.S. taxes versus international taxes, where we now have sort of an average tax rate rather than a very high one. I think that's very important and I think also some of the changes they've made to territorial.

As far as tax rates in between states, I don't know that that's always been there. Right.

If you – it's interesting, if you have a business in the DC area, right and you ran a business as a private person, you would be acutely aware that the tax rate was extraordinarily higher in the districts, say than in one of the states around, some of the states to be – one said it will be 33% higher than some that plays a mile from it, that's been true for a long time.

So I'm not sure that's something different..

Got it. Okay, thanks a lot..

It does matter..

Thank you. I would like to turn the call back to Brian Lane for closing remarks..

Okay, thank you everyone for joining the call. I am very proud of this company and its resiliency and grit. We feel good about the year and we are very optimistic about our future. We look forward to seeing you all in the road. Have a great weekend and thank you..

Thanks..

Thank you, everyone. That concludes your conference call for today and you may now disconnect. Thank you for joining and have a very good afternoon..