Comfort Systems USA Inc (FIX) 2003 Q2 法說會逐字稿

Good morning and thank you for standing by. Welcome to the Comfort Systems second quarter results conference call. All participants will be able to listen only until the Q&A session of the call is being recorded. If you have any objections, you may disconnect at this time. I'd like to introduce Mr. Gordie Beittenmiller, Chief Financial Officer. Sir, you may begin.

Thank you Pat. Good morning everyone and thanks for joining us on Comfort Systems USA second quarter earnings conference call. At the start here we want to remind everyone that our comments this morning, as well as what we issued in our press release, contain forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. What we say is based on the current plans and expectations of Comfort Systems USA. These 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. A more extended list of specific risks is detailed in our 10-K and our second quarter 10-Q that we filed yesterday with our release, and in our press release itself.

On the call this morning are Bill Murdy, Comfort's Chairman and CEO, and Norm Chambers, our President and COO. Bill is going to open our remarks.

Thank you Gordie. Welcome to the call, everyone. I'm going to turn this back over to Gordie and to Norm here to make some detailed comments. I think I ought to say that the external economic environment here especially as it relates to the commercial industrial construction sector remains challenging as we have mentioned and people are generally becoming aware. 2002 was down 15%-20% in this sector. 2003, according to all the predictors was supposed to be a recovery. It is now projected that that recovery happens late in the year, and really is a 2004 event. F.W. Dodge [ph] the respected expert economic prognosticator even used by the Commerce Department has modified its own view to that. That the recovery, the general economic recovery and the construction recovery happens in the second half of this year and into '04. Simply stated, the economic activity levels have not improved as we and many other participants expected them to. There are some very positive aspects to that in that we believe, and it's generally accepted, there is a tremendous amount of deferred maintenance and replacement out there to be done. And that that will take place as I will continually, always say--our business is the installation, servicing, repair, retrofit of mechanical equipment which does need service, maintenance and ultimate retrofit. And deferred maintenance is something that we track and are very interested in.

Despite this tough environment we showed a profit improvement, certainly from our first quarter, and we have a very steady backlog. And we're very proud of our cash flow. We produced very positive cash flow for 11 of the last 13 quarters and that continues. We've combined our work on getting work with cost reductions-- with the decreased general activity. All of these factors cause us to be pleased with our improvement and interested in the continuing improvement. And we believe it is continuing improvement, quarter-to-quarter here, coming. Based some on the general economic recovery, some on our own internal productivity increase, and some on our cost reductions.

And we believe that that continues and really happens over the next 6 months and into '04. We had previously thought that our results for all of '03 would be increased from '02. Our current expectation is that it will be comparable with '02, '03 being comparable with '02. And that more importantly, the real and significant improvement come in '04. At this point I'd like to turn things over to Gordie who will have some detailed comments.

Thanks Bill. As Bill noted, our second quarter was marked by a continuing headwind in our industry and activity levels remained sluggish longer than most industry participants. As a result, price competition has also remained fierce. As we'll discuss a little bit more later, there are signs of improvement on the horizon. Bill went through those initially both for industry activity levels and for price.

Same store revenues at continuing operations were down 3.4% against last year's second quarter. This decline was less than the overall decrease in industry activity during the period, as reflected by Federal Government construction put in place statistics for the sectors in which we participate. We worked against this market weakness at most of our operations. We did see some larger, but what we believe are temporary declines in two of our markets where we are consolidating operations, and these were offset at the other end by some notable activity increases in our Phoenix and Washington DC operations. Again, more broadly, we work against the headwind for activity in pricing in the market.

This ongoing weakness in the non-residential sector can be seen in several measures. The government put in place statistics showed a year-over-year decline of 5% in the sectors in which we participate. Those are private, non-residential, public [other than] roads and residential multi-family. Bill mentioned F.W. Dodge and their statistics also show an overall decline in spending for the year. The shipments information from the original equipment manufacturers, the OEMs, of commercial HVAC equipment, were down 3%. And all of the OEMs noted continuing non-residential sluggishness in their second quarter comments. Other public specialty entities have made similar observations.

However, we would also note that most industry participants continue to expect improving activity levels over the next year stemming from two factors. Bill mentioned both of these, again, deferred maintenance and replacement. Most facility owners have deferred this activity over the slow economy of the last two years, and that cannot go on indefinitely due to the fundamental operating needs of the equipment.

The OEMs and certain industry analysts have also noted this trend. Second, there continues to be indications of an improving general economic outlook. As our business generally lags the overall economy by 6-18 months, we believe that improving outlooks bode well for general industry activity levels over the next year. The major construction activity forecasters agree with this. These factors underlie our expectations of improved '04 results that Bill noted. We should note that while weather does affect our operations, it does not do so to nearly the extent that it does the residential side of the business as more of our work is done on a planned and project basis. Therefore weather would affect us noticeably if we were to experience sustained bad weather over a region of the country where we have a significant portion of operating activity. We have typically not experienced a broad weather impact in the past and fortunately did not see it this quarter either.

Further to general revenue direction, our backlog held essentially steady from first quarter levels at $457m as of June 30. Excluding the effect of a $16m project that we removed from backlog in the 4th quarter last year, our current backlog shows an increase of 2.4% over last year's June 30 level. New bookings in the biotech and institutional sectors, along with upticks in a couple of sunbelt markets offset our typical Q2 seasonal burn-off. The schedule of our backlog moved forward somewhat with 92% of it scheduled to perform in the next 12 months. This is a historical high for a measure that normally reflects a 12-month figure in the mid to low 80% range. Looking at sectors, our book of business remains very diversified. One/third of our revenues this quarter were in the institutional sectors of healthcare, government and education. 15% of our business was in manufacturing, 12% in office buildings, 11% in multi-family, 10% in retail, with the balance spread amongst small and miscellaneous sectors.

Our backlog and quotation pipeline indicate easing in the education sector which has been a steady grower through the recent down economy. While government looks to remain active, manufacturing is picking up and healthcare remains active. Our gross margin declined 100 basis points as compared to last year's second quarter. This primarily resulted from the ongoing volume and pricing weakness we experienced in most of our markets. Consistent with our expectations of improving activity levels, we do see some signs that pricing may be bottoming out. Our quotation pipeline and [sentiment] indicators show an improving pricing environment. And gross margins in backlog scheduled to perform over the next six months are 50 basis points higher than the same measure at March 31.

Turning to SG&A, we posted declines of 5% sequentially and 6% year-over-year excluding the effect of a credit to SG&A we took last year when we settled receivables with Kmart. These decreases came from downsizing our energy efficiency initiative, consolidations of certain field operations, reductions in the corporate office and in reduced bonus expense. We reported restructuring charges of $1.1m this quarter, based primarily on continuing steps to revitalize a multi-location service and national account initiative. We expect to complete this work in our energy efficiency downsizing this quarter. Additionally, we are continuing our broad cost reduction initiatives begun in the 2nd quarter. These factors will result in some additional, but smaller, restructuring charges in the 3rd quarter. Based on our first quarter results, our first quarter tax provision reflected a tax benefit. Being conservative in a benefit situation early in the year, we used a lower effective tax rate of 33%. Based on our second quarter results, we believe we will be in a taxable position for the year as a whole, and as a result we adjusted our year-to-date effective rate 47% which is the rate we expect to be applicable to our results for the year as a whole. This year-to-date adjustment yielded a relatively low effective rate of 22% for the provision for the current quarter. During normal profitable quarters, it is more typical for our effective rate to be similar to our current year-to-date effective rate.

We posted stronger than expected free cash flow in the quarter at $13m by again improving our working capital efficiency. Notable here was our second largest historical increase in net over-billings, combined with a reduction in 3 days in receivables, rather than an increase that can often accompany faster billings. We've now generated positive free cash flow in 11 of our last 13 quarters, with one of those two down quarters being only marginally negative. Our trailing 12 months free cash flow at June 30 was $31m, up from $29m at March 31. Our debt levels remain historically low at $14m, or just under one times our trailing 12 months EBITDA.

Now, I'll turn it over to Norm Chambers, our president and Chief Operating Officer who will comment on our operations in more depth.

Thank you very much, Gordie. What I'd like to do is to walk through a little overview, and then speak briefly on each of our regions. Sequentially on a same store basis, field level results for the quarter improved. Revenue increased by nearly 11%, the [operating income] OI improved by consolidated $8.5m over the previous quarter. Even with the improvement our first quarter- over our first quarter, our results were below our expectations. On a positive note, a number of our companies significantly improved their cash and enabling us to reduce our revolving debt to zero by quarter-end. The operating problems and losses that I explained in our first quarter call, at Casey Electric and Atlas, should be fully contained in 2Q. We do not expect them to reoccur in 3Q. Our confidence is growing that Ken Kilgore [ph] and his team at Atlas are on the road to sustainable profitability. Albeit one month at a time. However, due to the size and complexity of the Atlas operation, they will remain on our watch list for some time to come.

Casey is operating now as a division of S.M. Lawrence under the watchful eyes of one of our top performing presidents, Bill Lawrence. When we compare our 2Q same store results with the same period last year, we can see, as Gordie has mentioned, a continued contraction of the industry. Revenues are off by nearly 4%, but we've been able to reduce our headcount by 6%. The rate of field personnel to total personnel is the highest it's been in the last 2 years. That's a good trend. As I mentioned above, our company president did a first class job in not only collecting receivables, but also reducing inventory by $1.6m. And increasing our over-billing by $5.5m, while keeping their capital expenditure below 1% of revenue.

Finally, our safety record continues to improve and lead the industry in [ocea] incidents rates of less than 4, compared to the industry average of 9.7. We are very proud of the leadership of Andy Estrada and his safety team. The same emphasis that has led to the improvement in our safety performance is being applied to job [loop] training. As you may remember from the call last quarter, job [loop] training is the process by which we improve the efficiency and effectiveness of our work acquisition and execution. Job [loop] training has been kicked off with a full schedule for 3Q and 4Q. In addition our presidents and regional vice presidents are working all out to begin to raise margins as the rate of decline seems to be slowing.

Now a word on cost reduction. The full impact of our cost reduction efforts began to show up in our June results. For the month of June, field SG&A and indirect costs declined by 10% over June of 2002. Net reductions of over 204 people were made in terms of field personnel for the four months that ended June 30th, in 34 of our locations where we focused on cost reduction. Backlog--year-on-year backlog on a same store basis is, as Gordie said, basically flat. One of the things that we look at from the operational perspective is if we were able to, again, improve our job performance and execute at the levels of just say, June of last year, we would contribute another $6m odd dollars to our bottom line. Which, at the field level, which would be a great target for us to improve to. Sequentially the rate of decline in gross profit appears to have slowed. This seems to be supported as myself and my colleagues travel around and visit in our companies, who demonstrate current pricing at higher margins.

And about half of our backlog is institutional, schools, government, hospitals and healthcare. And the other half is commercial and industrial manufacturing, office building, retail and hotels. We continue to maintain a diverse revenue mix while our capabilities in the healthcare sector have been paying off. Our revenues form the healthcare sector increased to 14% of revenues for the first half of the year, compared to under 10% in the same period of the prior year. And it continues to be a strong part of our backlog for the second half of this year. In addition to the two large projects we have in the DC market, we are performing healthcare related projects in Orlando, the Florida panhandle, Phoenix and Arkansas, and in Texas.

Now I'll just touch a bit on each of our regions to give you a flavor of how they're performing. The East continues to perform very, very well. On a sequential basis, revenue grew by 21% and operating income by 51%. We had a solid performance in a number of our companies, but most noteworthy are Bob McKinty [ph] of Syracuse, Jimmy Harden [ph] at Seasonair, Cathy Title [ph] at Hess [ph] and Rich Parament [ph] at Portland. All made outstanding contributions. Southeast-the region turned around in 2Q. Sequentially revenue increased by 5.7% while the operating income went from a first quarter loss to a profit. We had very good performances by Bob Coin [ph] at Capital Refrigeration and Clive Jester [ph] also turned in a solid performance to help the region. The Midwest-the region experienced a stronger 2Q-sequential revenue is actually down 3.7%, but our operating income was up. That's a good thing. However, year-to-year the region has been hit very hard by the downturn in the industry, and this has been supported by other companies who have reported the same phenomenon. Revenue is down by nearly 22%. But we have taken necessary steps, we've got the SG&A down, and our backlog is up 6.6%, and we feel that we're well poised for recovery.

The South - the south region experienced a significant turnaround. Sequentially revenue climbed by 16% and again, OI operating income went from a loss to a profit. We are expecting the South to continue to improve. We had some outstanding performances. People like Curtis and Mason [ph], Thomas Sierra [ph] in Puerto Rico and Mike Wade [ph] in Neil [ph] all turned in very good performances, indeed.

Probably our most troubled area was the West. Our region performed poorly on substantially increased revenue. Our revenue sequentially was up by 21%, but our operating income as a percentage of revenue was well below our expectations. We have spent much of the quarter shutting down under-performing operations, restructuring others and merging yet a few more. We think that we have things fairly well tidied up and expect a much improved second half of the year. The team is working very hard to make sure that that is delivered.

Facilities automation, while being a fairly small part of our business, we are still the largest independent controls company in the nation. And we have improved sequentially. Our revenue is up by 7.4%. We had a little slip in our OI, but again, continue to expect a very solid performance in Q3 and Q4. National accounts which is one of our major initiatives in growth continues to gain traction in a tough business environment. We currently have 45 customers with approximately 4,750 sites at which we are contracted to provide preventative maintenance. The sales team under Dave Irwin have added 12 new customers with 850 sites since the last call, Q1. And these new customers represent a potential of 8,000 additional sites.

We are in beta test in a number of these sites, and are looking to perform and have that performance lead to gaining more sites. We have moved our old national accounts from Cincinnati to Indianapolis, with upgraded IT infrastructure and operational team under Bob Nulman [ph]. We expect to see continued growth and development over the next few quarters. Just to wrap up conclusion-we are pleased that our top line decline appears to be better than the industry norms, however, we feel that our operating profitability is unacceptable. We will improve the job [inaudible] process and project management skills to increase the profitability. Thank you. Over to Bill.

Thanks, Norm, for that tour through our operations, a lot of positive actions and activities going on, and the emphasis on our people, which make Comfort Systems work, is certainly warranted. Just in summary, '03 comparable to '02 is our expectation. '04 significantly better than '03 based on general economic improvement which is inevitable at this point based on deferred maintenance and based on our continuing commitment to cost containment.

We, as Norm has alluded, execution is a priority for us in terms of project management, cash management and we are making very good strides in improving that from an already reasonable level across the company. The improvement in the national accounts area, the newly improving general margins in some of our work is very heartening indeed. We believe we are well positioned to capitalize on this inevitable improvement in the economy, especially given, as Norm has alluded, our diverse base of customers, both functionally and geographically, as well as the other factors such as deferred maintenance that we've mentioned.

At this point, I would throw this open to questions and I hope we have some from the participants out there.

Thank you very much. At this time we are ready to begin the Q and A session. If you would like to ask a question please press (star) (1) on your touchtone phone. You will be announced prior to asking your question. To withdraw that question you may press (star) (2). Once again, to ask a question, please press (star) (1). One moment. The first question comes from Mr. David Yuschak] with Sanders, Morris, Harris you may ask your question.

The restructuring charges and stuff you took in this quarter, what would be the biggest impact as far as the income statement is concerned, and do you have any idea how much that may result in lowering your costs on an annual basis?

Dave, first of all, the restructuring charges that we took in the first quarter, probably weighed a little more in the direction of our energy efficiency initiative. And we are already seeing the benefit of that in reduced SG&A. That's been a notable part of our SG&A reductions. This quarter the restructuring charge is focused more on revitalizing multi-location and national account work, and that is not so much cost reduction as it is establishing a platform for even greater growth.

Our broader cost reduction initiatives, all smaller portions of the charges, in both periods, and those are contributing benefit in the second quarter and should contribute more benefit in the third quarter both in SG&A and even more so in indirect costs in overhead, or part of cost [revenue]. So that's basically where you should see it over time.

As far as the weakness in the West, how much of a variance in the quarter was it versus your expectations?

I think Gordie is going to comment.

Operating income was certainly off by probably 4%, meaning that we had expected the performance of our companies in the West to be quite literally 4% points higher than it actually was.

For the operating margin?

That's correct.

Okay. And then, on the--you guys paid down about $10m or so in debt, I think it the quarter.

Yes.

Is that doing anything for your debt covenants as far as restrictions on share buybacks at all? Where might debt fall into place to reduce those restrictions.

Well, I think it certainly helps. We have built a long track record here of solid cash flow, and even though our revenue and profit performance due to this tough economy has reflected declining industry activity, we have done better than the industry as a whole. We've remained profitable throughout this period of time. But we've also demonstrated that we can scale our capital base with the size of our business. And that has been importantly reflected in our strong cash flow performance through this period of time. Now, it continues to be a tough and restrictive credit market out there. And I think the credit markets are going to look for us to post a couple of more quarters of this kind of improving performance and consistent cash flow before they will be willing to support share buybacks. So, I wouldn't look for that in the next quarter or two, Dave, but certainly the record we're building supports it.

Okay, and then one last question. With backlog holding up pretty well in here, can you maybe just describe, kind of your walk up business, is that primarily where maybe, from a forecast point of view you're seeing the weakness? Is backlog kind of shaping up where you thought it could be at this point, or is it a combination of both, and where would maybe the biggest disappointment be from the ordinary business versus backlog?

Well, here's what I would say about that--roughly 60% give or take, of our business, turns through backlog. Which means that the other portion, 40%, generally does not turn through in our quarter end backlog measurements. These are shorter term projects that will happen within a quarter. This is service business, or on-demand, or on-call service business. Now, you will see a little bit of weather impact on that, but that is also driven to a great degree by general activity levels. And while backlog work and the margins in it came in for the most part where we expected it would, I think the premise of your question is right, that more of the forecast fall off came in the non-backlog work. That's why we indicate that backlog is a general directional indicator and is meaningful, but it is not determinative of next quarter's results. But it does give us a general direction and it does give us a general correlation.

One of the other things we're looking at, anecdotally, and in some statistics as well, is kind of the portion that some of our leading companies had in [plan of spec] versus design-build. And we certainly had a period ending 2002 where the amount of negotiated design-build activities was much lower, much fewer opportunities in the pipeline that we are now seeing. So, that gives me some anecdotal confidence that we're seeing some improvement too, or will see some improvement in margins.

The walk up business would generally be more profitable too, is that fair to say too?

Yes.

So, that could be one of the reasons for the impact on the GM, gross margin.

Right.

David Yuschak. That's all I've got, thanks.

Thanks, Dave.

Thank you . Our next question comes from Mr. Ben Hasten [ph] with Stifel Nicholas [ph], your line is open.

I had my question answered. Thanks.

Thank you. Our next question comes from Mr. Steve Workman [ph] with Winfield Capital you may ask your question.

Good afternoon. Given the gross margin, or with the improvement in price that you're seeing, and the costs you've taken out over the last 12-18 months. Just trying to get a handle on the operating leverage you have in the model. Say, you know, revenue is up say, 5% next year, in '04, can you give us a range on what you think you can drive the bottom line.

Before Gordie answers that, what we are seeing is a loosening, if you want to call it that, in pricing. We're seeing pricing come back. We've come out of a period where with depressed levels of available work, lots of competition, we saw pricing go down, gross margins go down. And we're starting to see that loosen up, is what I intended to say. Gordie?

Let me answer your question two ways. You know, you premised a down environment, and I'll comment on that. And then I'll comment on an up environment. In a down environment, if '04 were to be a little worse than '03, which is not what we and most people expect, we would continue to sustain cost reductions, a broad cost reduction initiative and campaign. Through the last 2 years as the economy has been challenged, but as everyone has looked for the silver linings around the corner, what you encounter operationally is the inevitable discussion of--well, I'd like to reduce my costs, but I'm afraid that I'll be caught shorthanded in the turnaround that I believe is right around the corner.

Those dialogues go on, but at some point, in a slow economy, you have got to be more demanding in sizing your cost base and your workforce to the business at hand. And over the last couple of quarters, we have tightened down those metrics quite considerably. And if we were to see continued volume contraction in '04, we're going to stick with sizing our cost base and our workforce to the available work that is out there. So we would continue both to do that, as well as to probably look at some more significant operational structure considerations in terms of combining even more back office activity out there.

Now, the other comment is what happens in an up environment. We have said in previous calls, and it continues to be the case, that the cost base we have now, we believe could support a significant amount more business. And to the extent that we do see increasing activity levels, and increasing gross margins out there in a better environment, as we expect next year, we should not see our overheads, our indirects and our SG&As climb at the same pace. So we do believe we have some operating leverage in a good environment, and that contributes to our comments about '04 being significantly better than '03 in our expectations. Did I answer your question?

Yes, thank you very much.

Thank you. Our next question comes from Mr. Jeff Beach [ph] with Stifel Nicholas [ph] your line is open.

Yes, good morning.

Hi Jeff.

Are you saying, you've talked about all the forecasters and what they're looking for, they've been disappointed. Are you seeing any tangible signs that business is going to recover? One other contractor in, generally in your business, yesterday commented that they're seeing more projects at the architect level, more projects coming up in the budgets that have not reached the bid stage. Are you close enough to your customers to see that?

Yes, absolutely, that is the same thing we're seeing. I would say that the only reservation I have is the Midwest still seems to be lagging a bit behind other parts of the country for us. But we are seeing clear evidence, as I said earlier, in terms of the design-build aspects of our business that are definitely flowing through the pipeline at a much greater rate than they were the second half of 2002. And that's a good sign. You know, we're in good conversations. I was on a sales call yesterday with some folks and it's clear that even on the national account level and construction activity, there is just a good deal more conversation, real conversation about projects that are now being viewed and seen.

That coupled with our strong emphasis on healthcare, we continue to do very well in that sector. It provides us with opportunities to join a number of our companies together to tackle larger projects. So we're very pleased in that regard as well.

Jeff, this is Bill Murdy. I think this deferred maintenance thing I mentioned is very, very important in our industry, and if you look at what the Lennoxs and Yorks are saying, among others, that they're looking for equipment sales to go up. That's based on the fact that-you get into this maintenance, which leads to repair, which leads to retrofit, it is a pretty important driver out there. We see some other drivers. People wanting to modernize their automated building control systems, get them web enabled, get them so that they can control the entire building, or a number of buildings simultaneously. We see drivers from interior air quality mandates in certain areas, and concern about that. And very positively, we've seen some things come out of energy efficiency. People looking at, and this is a phenomenon of the East Coast and West Coast principally, where energy costs, people are realizing energy costs are not going to mitigate. They're only going to go up. And they ought to get efficient about their HVAC and mechanical systems which use more than half of the electrical load. So there are some real important drivers under here that we're seeing, and getting a lot of inquiries on that. And as you can see from the backlog, that's turning into work.

As a follow-up, on the 40% of your business that's not backlog business, what would you look at as the key to turn that business up, and would you see some visibility ahead of that occurring? Like, you're hoping to see right now on the backlog side of the business-seeing signs of that. Is there any visibility?

Well, some of the things that drive it are things I just mentioned. In addition to things getting better, people just don't service things as readily in a down economy. They sacrifice that, they take a chance with that. It's hard to measure it. It's not quite walk up business, or casual business, but it is difficult to measure how rapidly that comes back.

If your air conditioner is broken, and people are sweating, you're going to call somebody. However, if your air conditioner is making funny noises, but still working, that kind of service call, and the smaller projects that make up that 40% are the kinds of things that people don't spend money on in a constrained economy. So the biggest driver is a sense of confidence in business spending that might turn. That would be the driver of that. And there are clear indications of that out there. And so that underlies a little bit of our confidence looking forward. Another thing I'd add is that we do some analysis for quotation pipeline and some [sentiment] survey work, and there are clearer indications in that analysis than in previous quarters, of improved expectations out there on pipeline activity. And one place that we feel, in particular and ask about, is the, as you mentioned, the plans that are on the table of architects and engineers. We saw a clear uptick in that this quarter.

Then, just one final note on that as a kind of--something more than anecdotal, but the part of our business that is relationship based should be above 40%. And it's in those conversations that we often times get a clearer picture and a more immediate picture in terms of our visibility of activities. And to be sure, all of our presidents are highly engaged. And I think, broadly speaking, all are seeing improvement in that which had been the case over the last 6-9 months.

Okay, thanks.

Thank you. Once again to ask a question please press (star) (1) on your touchtone phone. One moment. I'm showing no further questions as this time, sir.

Thank you everyone for being on the call, we look forward to reporting the 3rd quarter.