Comfort Systems USA Inc (FIX) 2023 Q1 法說會逐字稿

Good day, and thank you for standing by. Welcome to the Q1 2023 Comfort Systems USA Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded.

I would now like to hand the conference over to your speaker today, Julie Shaeff, Chief Accounting Officer. Please go ahead.

Thanks, Rifka. Good morning. Welcome to Comfort Systems USA's First Quarter 2023 Earnings Call. Our comments today as well as our press releases contain forward-looking statements within the meaning of applicable security laws and regulation. What we will say today is based upon 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 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 has been provided as a companion to our remarks. The presentation is 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; Trent McKenna, Chief Operating Officer; and Bill George, Chief Financial Officer.

Brian will open our remarks.

Thanks, Julie. Good morning, everyone, and thank you for joining us on the call today. We have had a great beginning to 2023, with increased revenue and pretax earnings, unusually strong cash flow and another increase in backlog. Our teams delivered amazing execution, and we are very grateful for their hard work.

Excluding the prior year tax gain that Bill will discuss in a few minutes, we earned $1.51 per share, and that included $0.15 related to the favorable resolution of certain claims-related disputes. Current year revenue was $1.2 billion, an unprecedented same-store revenue growth of 30%.

Our backlog is now over $4.4 billion, which is a same-store increase of $1.6 billion or 58% from a year ago. Our backlog growth is tangible evidence of the ongoing demand in traditional and modular construction. Cash flow this quarter was exceptional.

This morning, we also increased our dividend by $0.025 per share to $0.20 per share. This increase reflects our continuing strong cash flow and our commitment to reward our shareholders.

I will discuss our business and outlook in a few minutes. But first, I will turn this call over to Bill to review our financial performance. Bill?

Thanks, Brian. The revenue for the first quarter of 2023 was $1.2 billion, an increase of $289 million or 33% compared to last year. Our mechanical services segment revenue increased $236 million or 35%, and our electrical services segment increased by 26% to -- or $256 million.

Same-store revenue increased by 30% or $265 million, with the remaining $24 million increase resulting from acquisitions. Our revenue growth resulted from increased activity, combined with the pass-through effects of inflation, including higher costs for equipment and materials.

The same-store percentage increase is influenced by the fact that first quarter revenue last year was lower than the rest of the year, and we will confront much higher prior year revenue comparables over the next few quarters. So our percentage growth is unlikely to remain at these levels. Revenue trends have a lot of moving pieces. But overall, we now expect full year same-store revenue growth percentage for 2023 to finish the year in the mid-teens.

Gross profit was $205 million for the first quarter, a $52 million improvement compared to a year ago. Our gross profit percentage was 17.5% this quarter compared to 17.3% for the first quarter of 2022, including the benefit from strong wins on claims that Brian mentioned. Quarterly gross profit percentage in our mechanical segment declined from 18.6% in 2022 to 17.9% in 2023. That revenue -- that decline is largely driven by the relative growth in modular construction as a portion of our revenue. Modular construction has lower gross profit margins than field construction and than our service businesses.

Margins in the electrical segment rose to 16.1% this year from 13.0% in 2022. It is currently challenging to predict how our margins will unfold for the remainder of 2023. Important factors that will influence our margins include increases in materials-intensive modular and new construction, ongoing cost inflation and the fact that with the surge in bookings, we continue to be early in many projects.

Modular is also growing as a proportion of our revenue, and we are managing ramp-up considerations as we bring that new modular capacity online. Despite these structural trends that might put some pressure on margins, we expect good continued profitability. And we are optimistic that, overall, our margins in 2023 will be at or near the strong levels that we achieved in 2022 on higher revenue.

SG&A expense for the quarter was $135 million or 11.5% of revenue compared to $118 million or 13.3% of revenue for the first quarter in 2022. On a same-store basis, SG&A was up approximately $1.4 million due to inflation and ongoing investments to support our much higher activity levels.

Our operating income roughly doubled, increasing by 99% in the first quarter of 2023 to $71 million compared to the quarter last year. We still expect interest expense in 2023 to increase from 2022. However, this quarter, the higher interest expense was partially and temporarily offset by an increase in interest income related to a favorable legal outcome.

Our tax rate for the quarter was 13.1%. This included an incremental benefit of $5 million or $0.12 from a conforming adjustment for the R&D tax credit, of which $0.08 related to 2022. If Congress restores immediate deductibility of research expenditures and present this conforming adjustment, we will have to reverse that $0.12 income statement gain in the period that this occurs. Although many individual items have affected our tax rate lately, we continue to estimate that a normalized tax rate for this is approximately 21% to 23%.

After considering all the factors above, net income for the first quarter of 2023 was $57 million or $1.59 per share. When comparing EPS to last year, it is important to recall that in the first quarter of last year we booked a massive incremental $1.49 per share tax gain that was related to prior years. With those gains removed from both years, our first quarter 2023 earnings per share was $1.51 as compared to $0.91 in the prior year. And on that basis, our quarterly EPS increased 56%, with about 1/4 of that increase coming from our positive claim outcomes. Another way of looking at the year-over-year profitability comparison without tax complications is to simply compare our EBITDA, which increased 49% from last year to $90 million.

Free cash flow for the first quarter of 2023 was $111 million. The main driver of this outperformance was advanced billings and deferred revenue as we benefited from favorable upfront payment terms upon receipt of large orders. The benefit from these advanced payments will reverse as project costs are incurred, except to the extent that additional advanced payments are received.

So please note the following. We're facing a large cash flow headwind in the coming quarters as a result of Congress' ongoing failure to extend the current deductibility of research expenditures. Unless current expensing is restored, we will make additional tax payments during the last 9 months of 2023 of approximately $120 million to $140 million because the deductibility of a large portion of our business costs will be spread over the next 5 years.

Also, capital expenditures will be higher than usual this year as we add over 1 million square feet to our modular capacity and as we purchase vehicles at a higher-than-usual rate, resulting from deferrals in vehicle availability during COVID. This quarter, we had $17 million of capital expenditures, which is an 80% increase compared to the prior year. Overall, we estimate that our CapEx spend in 2023 will be roughly $60 million to $70 million.

Our debt was lower at quarter end as our substantial free cash flow allowed us to reduce debt by $47 million and even fund the purchase of Eldeco from cash received during the quarter. We also continue to purchase our shares, acquiring 29,000 shares at an average price of $121.36 in the first quarter and adding to the over 10 million shares we have repurchased since 2007 at an average price of $24.80. As Brian noted, we implemented another meaningful dividend increase this quarter as well.

That's all I've got on financials, Brian.

Okay. Thank you, Bill. I'm going to spend a few minutes discussing our backlog and markets. And I will also comment on our outlook for the rest of 2023.

Our backlog at the end of the first quarter was a record $4.4 billion. Since last year at this time, our same-store backlog has increased by $1.6 billion or 58%, with increases in our traditional mechanical and electrical business and substantial new bookings in our offsite construction operations where we are continuing to invest in new capacity.

During the first 3 months of 2023, our same-store backlog increased $300 million, despite heavy backlog burn in the first quarter. With a number of advanced bookings, our backlog will burn over a longer period and include audits that will be produced in 2024.

Industrial customers were 51% of total revenue in the first quarter. This is the first time that industrial customers were the source of more than 50% of Comfort's volume. This sector, which includes technology, life sciences and food processing, remains strong for us as industrial is a major driver of new backlog. Starting this year, we are breaking out technology in our industrial revenue, and technology was 19% of our revenue in the first quarter, a substantial increase from 11% in the prior year.

Institutional markets, which include education, health care and government, are also strong and represent 28% of our revenue. The commercial sector is active. But with our changing mix, it's now a small part of our business at about 21% of revenue, much of that concentrated in our service revenue.

Construction was 80% of our revenue this quarter, with construction projects for new buildings at 54%, while construction projects in existing buildings was 26%. Service grew rapidly this quarter as revenue increased by 21% compared to last year, and virtually all of this increase was same-store. Service was 20% of our total revenues, with service projects providing 9% of revenue and pure service, including hourly work, providing 11% of revenue.

We just published our annual sustainability report, and in addition to the actions that we are taking in our business, we continue to encourage and support our customers as they focus on efficiency and sustainability of their buildings and operations.

Before I close, I want to briefly point out a few things about certain trends in our business. As noted earlier, construction this quarter is now 80% of our revenue, which means that over the last several years, services declined on a percentage basis as a proportion of our overall business. This is not because service is underperforming. To the absolute contrary, service was up over 20% just this quarter. In fact, our overall Service business today is twice as large as it was in 2016.

Construction has just increased even more. Also, when looking at the increasing share of our business that industrial and technology represents, you might ask yourself if other sectors are declining. In fact, when you look at absolute volumes as opposed to percentages, this quarter, every one of our sectors actually increased.

Comfort Systems is thriving in nearly every possible way, and that is because of our teams across the country continue their superb execution. Thanks to that excellence, and in light of the strong ongoing demand that we are experiencing, we remain optimistic about our prospects for continued growth and strong profitability in 2023. Our #1 priority remains to preserve and grow the best workforce in our industry so we can continue our legacy of investing to meet the needs of our customers and our communities. We are grateful for their and your trust. I want to end by thanking our over 14,000 employees for their hard work and their dedication.

I'll now turn it back over to Rifka for questions. Thank you.

(Operator Instructions) Our first question comes from the line of Julio Romero of Sidoti & Company.

Maybe starting on the backlog, if you could speak to the organic sales growth you saw in the backlog quarter-over-quarter, and what type of customers or activity type were the drivers? Was it all just modular? Or were there other drivers there?

Yes. I'll go first, and then Bill can follow up. But anyway, it's broad-based increase in backlog, quite frankly, coast-to-coast. Obviously had strong performance out of technology, but we're getting it in multisectors. Just not one or one part of the country. So it's still very active out there, and we don't see it stopping in the short term for sure.

Yes. We got -- Julio, we got a nice order from a new customer in modular this quarter, but the majority of our backlog increase within the sequential backlog increase was broad-based, and it's really just where you'd want it to be in a lot of our most successful companies.

Got it. That's helpful. And then maybe turning to cash flow. Second straight quarter of very strong cash flow, but you talked about the uncertainty you have there for the next 9 months or so. How are you managing through that uncertainty? And does that affect anything regarding to CapEx, your M&A pipeline or cash usage?

That's one of the great things about having a fantastically strong balance sheet. We flowed $111 million of cash this quarter. So it's very unfortunate that the federal government need to borrow some money from us over the course of the rest of the year. But it's not a problem. It won't really impact anything else that we need to do.

Got it. That makes sense. And then conversely, I guess could that change in deductibility to the R&D expenditures, maybe create some M&A opportunities from smaller companies who may not be as able to handle that change to their balance sheets?

So maybe when some of them realize it, I think it's going to be devastating for companies -- certain companies on the West Coast, certain places where research is really what they do as a company, I don't know how they'll be able to cope with this. But in our industry, I don't think it'll have that big of effect on the smaller companies. Most of them are unaware of it, and it might clear up by the time they figure it out. But it's black letter law. If you're a big company like ours, you have to just follow the law.

Our next question comes from the line of Sean Eastman at KeyBanc Capital Markets.

Great start to the year. So I mean, clearly, a message that the demand environment remains strong, and the strength is broad-based, and we're still seeing it in the bookings. But we also have this kind of unique dynamic where customers have changed their behavior. They're kind of booking you guys up early. There's more duration in the backlog. So how would you kind of set expectations around the trajectory of the backlog around those kind of 2 dynamics?

So if I'm being honest, I was surprised our backlog went up further this quarter. I think some of our -- were now booked into 2025 in a lot of places. It is really -- it is possible that this is a new trend in our industry just based on the extraordinary really scarcity of productive capacity. But I suspect that for healthy reasons, our backlog at some point will come down at later -- probably late this year.

It'll -- there are 2 things that will trigger that. One is less advanced commitment. And certainly, the advanced commitments that were made to induce us to enter into some leases will roll out of our backlog, and the commitments that are being made by that customer will go back to a normal basis. But also, I think most likely, you'll see backlog decline when -- both when inflation moderates and as lead times get shorter. Having said that, the demand is -- the underlying demand is really, really strong. It's just the backlog is lumpy, and this is probably a very lumpy moment for us.

And Sean, if you look at the bigger picture as well, backlog is strong, demand is strong, and we're just seeing the beginning of all the money the government passed in terms of these various acts sort of coming out of engineering and start going. So we're early days of that as well. So I think the demand environment is going to be strong for a while.

Sean, for years, I've said that if you are following our stock, it's very important to listen to what we say about backlog, right, because we're very transparent about sort of factors that are outside of demand that are affecting our backlog. And we'll do that for the rest of this year, right? We'll be very clear about -- if we see backlog start to come down, we'll -- I think we'll be very clear about whether that's demand-based or whether that's just a normalization. But as of right now, there's no sign of demand weakness.

Yes. Okay. Very helpful. And then just for clarity, Bill, you highlighted the modular margins are dilutive at the gross margin level. But I would imagine when you look -- when you drop that down to operating margin, they're accretive. Is that right?

Well -- so they're absolutely accretive to cash flow and earnings or we wouldn't be doing it, right? We don't take risk if we can't be paid. And we'd rather be smaller than take work for which we're not paid for the risk because there's a lot of risk in what we do. There is probably lower overhead in that business. But yes -- no. And keep in mind that, that business can be done with less skilled labor. So one of the reasons that it's -- if you need a lot of licensed electricians on something, you're going to pay a higher margin for that than if you need skilled plant workers, even though they are really, really at a premium, they're not nearly at the same premium as a pipefitter that's licensed in the state and is the only person who can touch certain pipe.

So are you trying to say it's low -- perhaps lower operating margin, but higher return or -- I just want to be really clear.

No, not at all. I would say higher scalability and higher capability to expand because you can hire somebody to work in a plant, and they can be making you money within a week, right? There's a couple of days of safety training and other stuff. Then they will start doing one task. They will then train on the tasks to their left and their right. When you hire a construction worker, you might lose money on that worker for years as you train them and bring them up to speed, and then they're incredibly valuable forever. So it's just a different -- it's a different -- we're willing to take -- if you want to demand our most scarce resources, we charge you more for it than if you want to -- if your demand is for less scarce resources.

Yes. That's helpful. And how is the Service business continuing to grow so fast? We kind of get into the drivers and a lot of detail on the new construction side, but maybe a refresh on the revenue build there would be interesting.

Yes. Thanks, Sean, for pointing it out. As we've been talking about 10 years ago, we made an organization-wide commitment to go out of Service business. In all aspects of it, a significant commitment to training, sales side, leadership side and the tech side. We've been able to use a number of innovative tools that Trent McKenna heads up for us that we're bringing to the service tech. So we are still very active in hiring salespeople, hiring technicians, expanding our base, both from some of the companies we've bought, but most of it is same-store. So that commitment is still 100%, and we will still fully embrace growth because the profitability has been terrific for us in the Service business, and I expect that to continue for many, many more years, Sean.

And so is that a market share story? Just to be clear, is that a market share story there? Or is it -- is there some kind of juicy market growth story happening under the hood there?

I think some of it is market share. I just think there's a lot more opportunity, right? We have a lot of very skilled technicians. You might look at energy efficiency in a building or just upgrading the system. So I think it's a combination of both. I think we're able to expand our services, our higher capability of check now we have within the organization. All our companies are doing service. So it's not one thing. It's probably 10 things.

Our next question comes from the line of Adam Thalhimer with Thompson, Davis.

On the tax -- so if Congress doesn't fix that -- Bill, one question I've had is if there's a free cash flow impact next year?

Yes. So interestingly enough, what they're doing is they're saying this expense of your business has to be -- you have to take the deduction for the expense over 5 years. And so next year, there will be a smaller headwind because we would be in year 2, 60% of it would be deferred rather than 80% this year. The following year, there would be a smaller headwind. Then you would normalize in the fifth year. So this would be -- this is a headwind for 5 years. If they don't -- for everybody that takes the credit or that actually does, frankly taking the credit is irrelevant whether you owe this money. But the -- and it's a much broader definition of expenses than you find in the R&D tax credits. But yes -- no, it's a sinking thing over 5 years.

But Sean -- I mean, Adam, I think it'll put people at -- many people, especially sort of research-based businesses out of business if they don't fix it. At some point, I think they have to at least moderate it. But we'll see.

Okay. Helpful. And then on modular, how are the capacity additions coming? Are you still thinking that comes online this summer? And then what would you do if you had another order similar to the one that you had in December?

Well -- so we get to decide whether we can take orders, right? But keep in mind that the one in December was for a couple of years, and it was -- they also made some other commitments over a longer period to permit us to make those -- really to permit -- really, it was to permit us to make those investments without raising our prices.

And so we have -- with these additions, we have capacity to take some more work. Some of the space we're adding is also taller, which gives you an opportunity to work at 2 levels. But if we -- at some point, if we get an opportunity to expand further, we'll take a look at the risk and reward of that opportunity and how are -- this expansion win, we'll make a decision at that point. Right now, we're working on what's right in front of us.

Yes. And the -- we're on schedule in terms of getting them up and running.

Okay. And then just lastly, maybe you can opine on the M&A outlook.

So we advanced a certain amount of M&A into '21 with the concern people had about an increase in the capital gains rate. So we are in a very patient mindset, and we are only buying companies where we have very high conviction or have had a very long gestation. I think that would certainly continue this year.

I was surprised we did Eldeco this year. But this is a company we've talked to since 2016. We had a great deal of admiration for that company. When they were ready to sell, we were ready to buy. I would say in the middle of the -- we're coming up on the middle of the year, I don't know if most -- if there could be 0 or 1 more deal this year, but we're not -- right now, we're in a -- we're also watching the market change, right? The cost of capital is changing. The people who compete with us for those companies are facing very, very different circumstances than they have in the past. And we've always been patient about these things. And I would say we definitely have a patient, high-conviction mindset.

But we're doing development all the time. In fact, I probably will do more development visits this year than I've done. I'm on track to do far more than I've done in the last 3 years, keeping in mind COVID. So we're really trying to make sure we're working hard on development for the future.

Our next question comes from the line of Brent Thielman of D.A. Davidson.

Bill, just on the R&D tax issue, you made a comment, could put a lot of people out of business. Are you referring to folks within your own industry?

No. I'm really referring to technological companies, pharmaceutical company -- like start-up pharmaceuticals or they'll have to go sell very quickly to somebody. I mean, if you -- if what you do as a primary part of your business is research, and you are only allowed to treat 20% of every dollar you spend on research as an expense for that year, you can take a company that's losing money in the real world and tax it as if it's got 70% margins, many of those companies do not have the balance sheet to stand up to that. So I think that's the kind of thing I'm talking about.

Okay. In the context of your own sort of capital deployment, I guess, strategy over the next coming quarters, is that top of mind for you before you decide to look at buybacks and deals and things like that?

If we're being honest, our cash flow has trended better than we would have expected a year ago or 2 years ago by more than this headwind. So it doesn't feel like a terrible constraint. It feels like -- I think we have cash. Look, our guys are really executing, people, value, plumbers and pipe fitters and winning big. So we're -- I don't see how this is a big issue other than we'll pay interest, right? If we have less cash flow, we'll either earn less interest or pay less interest, depending on whether we're cash positive or in debt a little bit.

Right. Okay. Okay. And then the hyperscale data center activity has been a huge driver, modular business, I guess, for the company overall. There's still kind of some varying views out there about future prospects. Could you talk about the levels of inquiries, maybe reviews of bids you guys are seeing, how does that market compare to the last couple of years of what's been pretty robust activity you've already seen?

I'll go first. Yes. Brent, the activity is very -- is still very strong, both in modular and traditional construction. Quite frankly, we're not concerned about the data center market. We've got plenty of work.

I would say some of the hyperscale guys, they're all -- the level of inquiry is higher, higher than it's ever been. They are more -- they're putting cost into the conversation earlier and more prominently than they have in the past. The thing about us is that we really, when we do this kind of work for people, we partner with people. We work hard with them to get them a really, really good value, and they typically understand that we take a ton of risk and have to make investments to really give them the quality they expect. So I'm optimistic that the demand is high, and I'm optimistic that actually, we're the best way to meet that demand right now for them.

And on the modular side, at least I think it's been mostly focused in that specific market with one sort of single large customer, correct me if I'm wrong. Is that expanding into some new potential customers now in that market?

So it would be premature to say it's expanding. Well, so first of all, that one big order was from one customer, right? They were keen to make sure they got some things they needed, frankly, for their business as far as we can tell. We did get a trial order from somebody else like them, and we'll see how that goes. But there is definitely interest.

Really, the reality is these guys do need to build hyperscale data centers. They're like us, we need to hire people. When people say, "Oh, what are you doing to hire people?" We say, "Everything that can be done is what we're doing to hire people." I think these hyperscale data center guys, when you ask them what are they doing to build hyperscale data centers, I think every path towards getting these things into high-quality production is what they're taking.

And so the overwhelming majority of data centers are not built modular, right, where the math couldn't possibly support that. But we think there's a nice opportunity here for us to grow and provide for our customers a really good, more scalable than most path to getting what they need.

Got it. And I guess just lastly, I think you said past few quarters sort of ambitions of getting the electrical margins to match the mechanical margins over time, presumably with the work you're seeing inbound. Any -- I guess any views on that, turns into bid margins, things attached to those new projects that gives us some more confidence around that?

Yes. Brent, for sure, we've had a really steady-state increase in the margins in the electrical business over the last few years. I think that's going to continue. There's plenty of electrical, out there, works that we're good at, that we like to do. And the work coming forward is sufficiently challenging for us that we can raise our prices a little bit. So I'm really optimistic that we will see continued margin strength in the electrical business.

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

Okay. Thank you, everyone, for your continued interest in Comfort Systems. And once again, thank you to all our diligent employees for just doing, really, an outstanding job. I mean these results just show what effort and commitment is being made. We are looking forward to the summer, and we are very optimistic for the remainder of 2023. Hope everyone has a great day, and we hope to see you on the road soon. Thank you.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.