Comfort Systems USA Inc (FIX) 2004 Q3 法說會逐字稿

Good morning and thank you for standing by. [Operator Instructions]. Now I would like to turn the meeting over to Mr. Gordie Beittenmiller. Sir, you may begin.

Thanks, Carrie. Good morning everyone and welcome to Comfort Systems USA's third quarter earnings call. At the out set, 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 U.S.A. Those plans and expectations involve risks and uncertainties that could cause actual future activities in 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, our 10-Q and our press release covering these earnings.

On the call this morning are Bill Murdy, Comfort's Chairman and CEO and Tom Tanner, our Chief Operating Officer. Bill is going to open our remarks.

Thank you, Gordie and welcome everyone on this day of getting and discussing results. We know that all of you woke up this morning with Comfort System's results on top of mind, so we want to fulfill that expectation here. It is, by the way, no -- we did not arrange for the call coordinator's name to be Carrie here.

As we noted in our release, our third quarter reflected continuing positive progress for Comfort Systems. But we didn't do as well on the earnings line as, frankly, we are capable. Net income of $0.09 a share was up over last year's break-even result, which included restructuring and discontinued operations charges. Excluding last year's discontinued operations income from -- excluding those discontinued operations, income from our continuing operations was up 34% and, further, excluding last year's restructuring charge, income was up 8%.

We believe we are capable of better results in light of several factors that affected the third quarter that we think are non-recurring. One, we recognize increased costs associated with operational consolidation at certain of our western operations. We also had an uncharacteristically down quarter from one of our operations in the Southeast, as it closed out some challenging projects, while working through a -- what we believe is a temporary backlog lull. But we believe this unit has regained its footing and is back on a normal track going forward. It is one of our better operations.

We also recorded reserves on a project in the Southeast, where we have greater cost than we originally expected in this quarter. This reserve is in the mid six-digits. Ongoing discussions with the parties to this project, leads us to believe we will substantially recover these increased costs. However, because those discussions have not yet reached a final documented conclusion, and observing the accounting conventions attended to them, we are carrying this project on a conservative, fully reserved basis.

Finally, as most everyone knows, the weather in the Southeast this last quarter fell far short of what Chambers of Commerce usually wish for and, better recall, the Southeast is home to about 40% of our overall revenues. Our operations certainly felt the impact of each of the four hurricanes to some degree, including four direct hits in certain of our Florida and Alabama units. We are thankful that our people are OK, although many of them are contending with damage to their own properties and communities.

The impact on our business was noticeable, but not substantial. We worked closely with customers both to prepare job sites for storms, prior to the storm, and to bring them back up when the weather cleared. So, the primary effect on our business was work interruption during the actual storms and, of course, reduced productivity just prior and just after the storms.

While we certainly don't wish for it, these hurricanes also resulted in increased repair and rebuilding business. It's really too early to tell how much effect that will have on our activity in coming periods. But suffice to say, we hope we don't see another four-hurricane quarter in a long, long time.

Together, we estimate the factors that I've mentioned here, reduced our earnings in Q3 by about $0.04 a share. However, even with these setbacks, our results, as noted initially, show an improvement over 2003. A testament to the broad, steady progress of our operations as industry activity continues to improve.

Our backlog demonstrated this progress very well, reaching another record during the quarter, when increased seasonal activity usually reduces what's in our backlog. At $516 million, we were up 6% from our previous record of June 30, up 17% from last year's third quarter, and up 28% from the beginning of year, this increase was driven by adding new business in this quarter. The substantial majority of which were projects under $1 million. Our solid bookings, by the way, continued into October.

As a last thing I'll mention before turning things over to Gordie, here we continued to the improvement of our balance sheet in this quarter was a very strong increase in year-over-year for cash flow. Our cash net of debt position has now grown to about $11 million at quarter-end and when we returned to the near upper end of our historical range of over billings in our construction contracts. Our balance sheet continues to provide us both strength and flexibility, of course. At this point, I'd like to turn it over to Gordie, for more detailed look at financial results and I'll come back after Gordie's comments and after comments from Tom Tanner, our President and Chief Operating Officer.

Thanks, Bill. Revenues for the quarter were up 2% and up 5% year-to-date as we kept pace with re-emerging industry growth. Looking into our book of business a little further, revenue remains well diversified. Multi-family picked up to 16% of our mix and office buildings took a noticeable step upward to 15%. Manufacturing, health care, and education were each 11%, government 10%, retail 9%. The rest of our work spread among smaller, miscellaneous sectors.

Our backlog and quotation pipeline indicates activity is returning to the office building market, at least in our geographical markets. Multi-families should remain a strong sector for us and it also looks like we'll be doing more in education with health care steady.

Looking at our book of business from a different angle, our average project size declined as of September 30th to $226,000, reflecting almost 4700 projects in progress. We had one project at $20.5 million, six projects between $10 and $15 million, 11 projects between $5 and $10 million, 161 projects between $1 and $5 million, and then 4,500-plus projects under $1 million. Almost 60% of our backlog value is in projects under $1 million. This distribution of activity demonstrates a stronger diversification in our book of business than many observers appreciate and it improves our ability to work through the ups and downs of the broad, non-residential building sector where we work.

Our gross profit percentage decreased in the third quarter, primarily as a result of the factors that Bill, discussed to lead off. Reduced profitability in one of our Southeast operations, additional costs of operational consolidations in certain of our Western operations, added project reserves in the mid-six-digits, or a project where we believe we will get significant recovery of those reserves, and finally the impact of the hurricanes this quarter in the Southeast.

These factors were off set to a lesser extent by improvement from sharply curtailing operations in Western Colorado this year, where we were unprofitable last year. While the cost of commodities used in our work -- steel, iron, copper remained unsettled, we were successful in managing that risk this quarter in and so no appreciable impact on our results, less than half a penny a share. Commodity inflation bears watching and remains a risk for us, though. Tom Tanner will talk a little bit more about that in a moment.

Gross profit indications in our backlog were down slightly, 40 basis points this quarter. Our overall gross profit and backlog has moved up and down over the last year or so, but is generally stayed within a reasonably narrow band and that is where it remains now. Price competition is still a very real factor out there in the marketplace, as industry activity levels recover slowly.

For us, though, an added consideration is that we've encouraged our units to lean on the conservative sides as they estimate projected gross profit as jobs come into our backlog. That may very well be as much a factor in our margin variation as anything else this quarter. We do not view current gross profit indications in backlog as signaling a change in any significant way in our consolidated gross profit trend.

Finally, an overall reminder about backlog. Approximately 40% of our revenues, including service work and quick turn projects, is not captured in any particular quarter-end backlog cutoff. So, backlog indications, while general directional indicators, do not guarantee future results. SG&A was down 4% year-over-year, primarily as a result of various operational consolidations. As we suggested last quarter, we did see an increase in SG&A sequentially, up about 4% from the second quarter.

As several quarters of revenue and backlog growth have shown, activity levels have begun to turn in our industry. With higher levels of activity and after several years of unstinting cost reduction, it is very difficult not to see some increase in costs and, in fact, we noted that prospect as we mentioned last quarter. This particular increase has been driven by some costs associated with certain operational consolidation, somewhat higher incentives compensation accruals and increased costs associated with meeting the requirements of the Sarbanes-Oxley Act.

Significantly, our non-field head count actually went down slightly in the third quarter from the second quarter. We will continue to keep our eyes on cost and overhead. Netting out gross profit in SG&A, we showed a 9% gain in reported operating income, which increased to a 22% gain in reported pretax income on the strength of much lower interest expense in '04. Then to an increase of 34% in income from continuing operations as we reflected a better tax rate this year than last.

Excluding last year's restructuring charges, and the results of entities we sold, but which are not reported in discontinued operations, pretax and net income were both up at ongoing operations and only operating income was down modestly. As Bill noted earlier, we reported respectable results despite several items pushing our numbers downwards this quarter, and are encouraged by an expectation that we won't see this set of challenges to the same degree and at the same time in the future. We're also encouraged by the noticeable move upwards in our backlog. We believe we've got good prospects for solid performance in the fourth quarter and as we move into 2005.

Finally, a note on an equity item. In connection with a previous credit facility we put in place in 2002, we issued a warrant to a former lender of ours in the fourth quarter of 2002 to purchase just over a 400,000 shares of our stock. While this previous credit facility was in effect, changes in the value of this warrant were reflected as mark-to-market adjustments in interest expense.

This warrant remained outstanding after the related credit facility was terminated in the fourth quarter of 2003. And while it remained outstanding in 2004, changes in the value of this warrant were reflected as mark-to-market adjustments in other expense in the income statement. This warrant was exercised in full, following the end of the quarter in October. As a result of this exercise, approximately 408,000 shares have been added to issued and outstanding shares in October.

Also in October, the balance sheet value of the warrant aggregating approximately $2.8 million has been added to stockholder's equity and mark-to-market adjustments to other expense associated with this warrant will now discontinue. I want to make sure that we're clear on this. These are transactions that occurred after the end of the quarter and are not reflected in September 30th balance sheet in information, but they are and will be reflected in our balance sheets when we subsequently report after year-end. That's it on financial. I'd like to now introduce Tom Tanner, our Chief Operating Officer.

Thanks Gordie , good morning. As we discussed last quarter, our 2004 forecast focus is on margin improvement, rather than revenue growth. However, we are encouraged to see that market activity is improving, which is resulted in a records same-store backlog as of September 30th. In addition, we have had strong new project bookings in October. Our strongest backlog gains continue to be in our Southeast, South and West regions. Interestingly, 83% of the backlog increased related to projects that were less than $1 million in value, which tends to reduce our overall risk.

Clearly, one of our highest priorities for 2004 has been the improvement in our under-performing companies. Our two most troublesome companies each represent the consolidation of three or more companies from the same geographic area. The weaker companies were consolidated into the strongest company and we then asked the management of the strongest company to assume the responsibility for solving the problems left by the former management of the consolidated companies.

These problems included downsizing of some portion of the operation, working through troubled projects, uncollectable accounts receivables, warranty problems, and inventory obsolesces and shrinkage. In addition, the respected company's best resources had to focus on reactively solving old problems rather than proactively focusing on their new opportunities. During this quarter, an intensified review of these two operations gave us better visibility of the remaining problems. This resulted in the recognition of substantial additional costs in these two companies.

We believe we have addressed all the problems and both of these companies are now positioned to become profitable in 2005. As we previously mentioned, a third company, a perennial performer, operated at a loss for this quarter. The majority of this loss resulted from a discounted settlement of a long-standing claim, which was coupled with cost overruns on certain challenging projects and an overall revenue shortfall because of a weak backlog. The company is forecasting a strong return to profitability in Q4.

One of the key operational fundamentals of our business is to strike a balance between accountability and fostering an environment where management is encouraged to openly discuss problems as soon as they are discovered so the problems can be effectively addressed. We recognize that our companies can make mistakes that will occasionally cause results to suffer. However, our goal for all of our companies is to have them learn from their mistakes, share those lessons with their sister companies, minimize mistakes in the future, while incorporating solid operational judgment in managing their individual companies.

At the corporate level, we could have done a better job of earlier recognition of some of the problems we faced this quarter. In the future, we will do a better job of early recognition. Most importantly, we believe we have fostered a solemn mix of accountability and engagement.

Again as we discussed last quarter, we continue to focus on the following -- proper job selection in a still-competitive market. We recently walked away from a very sizable project where we could not get the appropriate gross margins, given the risk involved. We continued to focus on labor productivity training and several of our operations. By year end, we will have 15 of our companies involved in productivity trading with most of our remaining companies scheduled to begin trading during 2005.

We're focused on improvement in the operating results of certain of our service divisions. We are increasing the revenue of our preventive maintenance agreements through a focused sales training. We're focused on the growth of our national accounts business and HVAC maintenance and facility automation controls, primarily in the retail sector.

There is a continuing focus on SG&A costs and we are continuing to look at preventive steps to minimize the effects of commodity price increases. Price increases have slowed, but certainly they have not stopped. We have taken such steps as escalation clauses in our contracts, pre-purchasing of sizable amounts of material, and putting them into inventory. We believe these focus efforts both in our construction and in our service divisions will lead to improved results in Q4 and in 2005.

As we look ahead, our individual companies are excited about the levels of their respective backlogs. Our company presidents and their management teams are committed to successfully performing the projects they have secured, while continuing to pursue opportunities with existing and new customers. With that I would like to hand it back to Bill for a wrap up and questions.

Thank you, Tom. You know, we're realistically optimistic about our industry as we talked about before and we're optimistic about the current economic environment. We have noted some recent positive trends in non-residential activity as well as in the past we talked about some forecasts from those who forecast this industry, notably dodge, which are positive, going forward here, especially in '05. We're mindful about some comments have been made about the slowness of the return to real growth. We certainly have experienced some of that, but remain positive about the environment going forward.

Nonetheless, it makes sense to proceed carefully and we have adopted that methodology for the future. However, we also have a good set of operators and operations and we've staked out some very, very solid positions in various markets, including some units in strength, where the economy shows continuing growth, and that is health care facilities and the multifamily residential sector, apartments, condominiums, etc. These strengths are being reflected in our growing and records backlog and we think it puts us in a very good position to do well in the fourth quarter and to move into 2005 with great prospects for continued growth, top line and bottom line. Those are our formal comments. I hope there are some questions. I'd like to turn it over to Carrie and have her bring the questions in. Carrie?

Thank you. [Operator Instructions] Mike Roesler (ph), you may ask your question.

Good morning. I think Gordie touched on it a little bit, but I want to focus on the backlog increase and you may tell us where that increase is coming from, whether is it all multifamily, is it in that office area?

There certainly is a substantial portion of it in the multifamily residential area and we're talking both apartments, garden and high-rise, and condominium. And our atlas subsidiary company, which is our largest single operations, operating not only here in the greater Houston area, but also in Northern Virginia and Denver and Southern California, is seeing tremendous interests. They've got a lot of business booked and are utilizing their very-well-developed system to pursue that work. Most of the growth we're seeing, frankly, is in the Southeast-Southwest, and we haven't seen a great deal of return in the multi-tenanted office sector. It is principally schools, hospitals, and multifamily sector. Mike.

So, if you were to look at the balance between your public sector and private sector work and your backlog, how is that changed, say, at this point comparative to the start of the year?

I don't know how you're quite defining "public sector". If you want to put schools in all that -- Mike, if you -- we've in the past talked about the institutional sector as including schools, government, and health care and, you know, occasionally you have some nonpublic entities in that sector. But if you split it that way, institutional versus commercial, industrial, and everything else, institutional has stayed pretty steady throughout the year, down just a little bit in the third quarter, but not really in any significant way. So, it's still comprised of about one third of our book-to-business.

OK.

Mike, as you know, we really don't have a whole lot of what you'd call government business, government buildings, administrative government buildings, etc. You know, when we talk about institutional/government, it's really schools and hospitals and hospitals, most of them are private.

Maybe we can look at it a different way. In terms of you mentioned that a big increase in the backlog is the smaller project work is there any significant difference in profitability on those projects versus the larger ones that you're working on?

Well, in most cases, the smaller the project the higher estimated gross margin. So, we're encouraged by the backlog increase in these million-dollar-less projects. We like the fact that they're normally shorter in duration, which allows us to focus better on performing the work and it inherently has a higher margin than we would see on a $10 or $15 million project.

Got it. And Gordie, a couple of questions on the Q. There was some mention I think about the financing and also availability of surety bonds as well. Could you just may be give us some more details on the language that was in the Q?

The language that was in the Q that talks about what surety bonds are and the nature of the surety market environment has not changed from earlier queues or the 10-K. So, it's the same disclosure and it is generally meant to tell people that surety bonds are a factor in our business and that the surety markets are tougher now than it used to be. Now having said all that, there's been nothing but, I think, a continuing improvement in our stance vis-a-vis the surety market are surety support is very pleased with our results and so there's no change other than I think a continued improvement in the support that we get from our sureties.

And I think there was some comment about the availability on your credit facility. It seems it was a little unclear in terms of what the indication from that was?

Well, I regret if it was unclear, but let us be clear that our availability on our credit facility is nothing but larger than it has been in previous quarters. We have ample capacity under our credit facility. It is not impinged in any new way by surety or any other factor. We actually reduced our LC's outstanding this quarter. That, together with having no drawings on the working capital revolver, puts us, I believe, up in the mid 20's to high 20's of capacity, which is greater than our typical annual free cash flow right now or our working capital swings. So, any conclusions or interpretations of our availability should be actually incrementally positive.

Great. Thanks.

OK.

David Yuschak, you may ask your question.

Yeah, David Yuschak, Sanders Morris Harris. Congratulations on the good quarter and what was obviously hurdles that you had to jump over to achieve what you did. But I'd like to talk a little bit about operations. I mean, taking a look at what you did in the South East, one operation that did lose, that's been a strong operator, versus your Western consolidation. You know, we have been hearing for some time about how you continue to rationalize, shrink, like you did with Colorado, to try to focus on improving the profitability.

As you look at the -- I think it was the South East area where it's been a strong operator -- could you just give us a little bit of clarity as to what happened there that was just kind of a short-term problem? Because, you know, good operations have a way of bouncing back, versus what you've done in the western part of the country where you have had to do some consolidation here.

Are these non-recurring things about consolidating, getting behind us as you look in aggregate then, that your operations -- are we getting to the end of these, these kind of issues that have been may be drag, particularly given the fact that it has been a slow-growth environment for you, I think that's been helpful. But when you see backlog beginning to ramp, I think investors want to get some Comfort level that as that backlog begins to grow more rapidly, you will have much better control over the gross margin and deliver that kind of potential and the backlog suggested is there. Kind of long-winded, but I hope you grasp the concepts.

First of all, let's talk about the company in the Southeast region. The majority of that loss related to a project that was completed last year. And we had a situation where the owner, where we had some additional costs that we felt very strongly with the help of legal counsel that we are going to collect going forward. In this quarter, we entered into settlement negotiations prior to beginning trial on the situation and we made a determination that we should accept a settlement that ended up being, you know, less than what we were carrying on our books for this project. What's simply a matter of you know, one, the cost of going to litigation?

Secondly, the time and every it took from our operating people to take their focus off what they're doing proactively with their businesses and we made a decision to settle this, collect the cash, which amounted to about $900,000 and move forward. Relative to the consolidation, we are done with consolidations, as we know them.

We've actually unraveled a couple of consolidations earlier in this year where we felt that the companies operated best as freestanding companies. They were companies that continually operated profitably; that we believe that had strong management. So, we are left with these two consolidations in the West region, which, you know, frankly, you know, were poor companies with poor management and it's just taken us longer than we ever would have hoped for to work through these issues.

These consolidations are complete. We have worked through these under-performing projects. We have, you know, taken the hit for receivable problems that related to poor performance on projects. We've taken the necessary adjustments for inventory shrinkage and obsolescence and moved forward - moving forward with two very clean operations.

And then looking a little bit on the backlog, because generally like you had indicated, Bill, you usually burn backlog in the last year, I think backlog was, in fact, down about 12 million or so from the second quarter. As you look at that backlog in your strong performing operations versus some of your lesser performing operations, and particularly like you have indicated on that Southeast operations, going back to focus on getting business back in there, is there any particular operations that are really putting that backlog together, particularly given that we should be seeing burn instead of build that they're doing a superb job and it is just a matter from these lesser operations like the western operations, begins to kick and even wrap up that backlog even more than what it is now?

Well, I don't know if there is enough there to make a pattern out of it. As I have mentioned the robust activities, current and backlog for our multifamily operations. We are booking some substantial projects here, a large prison project we just booked in our major South West activity, headquartered in Phoenix, combined with our San Diego operation and another big project in southern California. Both of these projects, by the way, are projects of a type and in areas where those companies, specifically, have worked before and been successful before on the same kinds of projects.

One thing to note here, David is that, you know, this -- we still have a huge portfolio of activity. We have got, you know, almost 4700 projects and they average less than quarter of a million dollars. So, we have this huge portfolio of projects and, you know stands you could talk about us managing that portfolio to profitability and that's when you sit outside of it and look at it. But give some Comfort that we have got that breadth of depth and it is not all concentrated in one area, one sector, and that's a concept which we put to work for us with good results in the past. Gordie , do you want to say anything more about backlog?

You always have, Dave, some companies that are a little bit behind on maintaining or building their backlogs. You know there is always ebbs and flows. But at this stage of where we are, recovery wise, the good majority of our operations are booking business and building backlog in a good way and obviously a couple of operations have very strong backlogs.

So, I wouldn't necessarily infer that there is a number or there are a number of units who are behind on backlog and now are set to catch up. One modification or comment, though, to that when we look at these units out West where we've gone through this tough consolidation, actually one of those units, now that it is on an even keel so to speak, is actually going to participate in a sharing of one of the large projects that Bill just mentioned and that will be a nice increase to their backlog and a nice tailwind to help their results turn. So, that's a benefit that's backlog absorption related to some of this stabilization and break with the past that we've done out west. So, that's what I'd add to Bill's comments.

OK. Just one last question. I will get back in queue. The number of projects you have is up about 500 compared to the second quarter. Is that uncommon to see that kind of a pop and would it suggest maybe business is, like you suggested, even in October bookings are remaining strong, that we are finally seeing some of those expectations dodge, I think I could have in 2005, as far as a broadening non-residential construction market?

Well, we believe that's the case, but we would have to more specifically compare our number of projects and stratification of them to last year at this time and don't have those statistics immediately handy. But the feeling from the operations is that is a phenomenon that's taken place.

Appreciate your comments. I will get back in queue. Thanks.

Thanks, Dave.

Rich Ozlovsky (ph) .You may ask your question.

Good morning, everybody.

Hi Richard.

What are you hearing from the big OEM suppliers, concerning the condition of the commercial HVAC market?

When you talk to them, when you listen to their comments, on their third quarter releases, for the overwhelming theme is commodity costs. They are absorbing a lot more commodity costs increases, than those of us on the installation and service side are. That's a theme and that's a theme that they are trying their darnedest to work into price, with only limited success.

In terms of the direction of the market, most of them observed that there was a bit more of an inventory build, into the end of the second quarter and the beginning of the first quarter, both in the residential and commercial side, then activity in the third quarter sort of sustained. Each of them, we referred in our remarks to others making cautionary comments, each of them -- each of the big three, has said that commercial activity continues to grow, but at a somewhat slower pace than everyone expected. So, they were each cautionary in their comments. None of them said that there seems to be a significant risk, to the recovery on the commercial side, running out of gas. It's just the pace of it is a little slower somewhat than they expected.

OK. Looking out towards the next year, to what degree are you guys going to be short, on project managers or field labor, you know like, as you book more and more work?

Well, you know, we are certainly focused on training for those various reasons. You know, we will institute in the first quarter of next year a project management training course, through our outside consulting firm, F.M.I., recognizing that, you know, there are true ability to improve gross margins starts at the project management level. You know we'll continue, the local operations, provide training for, craft training their peoples.

We provide them with opportunities and material and information to move forward and do that training. But it is done on a local company basis, primarily because of code issues and state licensing issues that we deal with in each location. But that is, you know, something that we're proactively working on, presently, because we do see, you know business continuing to improve as we go into 2005. And we -- you know, we certainly think there will be unfortunately or fortunately business driven from the hurricane activity that we've seen in Florida and Alabama.

OK. That sounds to me like you are improving the skills of your existing work force. What I'm trying to drive at is, how much business might you have to forego because you just don't have the body to do it?

One of the reasons for improving our existing work force, if we can do that, it allows us to do a greater capacity of work with the same amount of work force. You know, if -- rather than, you know -- we will certainly -- the potential is certainly there to forego some work. What that would normally mean to us is we would try to raise prices in our marketplace to take advantage of this abundance of work.

Excellent comments. That's very helpful. And finally, your cash balance has ballooned in the last couple of quarters, and if we continue to see the status quo, as far as both the growth in construction plotting along, and the relationship of your major balance sheet out, in which the sales, and that cash is going to continue to grow? Do you guys expect to have more cash you need and if so, what do you plan to do with it?

We're not sure what you exactly what "more cash than we need" means, but let's say we come to some tentative conclusion on that. We're having, right now, as we look out at '05 in the budget sense and start allocating resources, we're looking at what cash we want to devote to growth in all its forms, you know, organic growth to include, you know, some emphasis on sales and sales training, step out growth, I.E. up, establishing operations adjunct to others in near territories, some operations diversification, i.e. adding plumbing capability to our HVAC capability in certain locations.

We're finding that plumbing and HVAC are usually bids -- or in many areas are bid in the same package. And then lastly acquisitions. We are -- as we have state before, we are not going to become an acquisitions platform, but certainly we have a lot of strength, both the financial strength and management strength, and momentum here, so that prudent acquisitions might be on the plate. After all, that's the primary kind of thing we're looking at.

Certainly excess cash would potentially drive one to at least think about share repurchase, dividends, etc., and we -- we are at least in a general way in a planning way thinking, that way. But we -- we'd like to, you know, see a lot more of this cash that we have projected, actually materialize here. So, we're not making any commitments to that sort of thing. But be assured that we are discussing both allocation of cash and capital to growth and to the potential of dividends and-or share repurchase.

OK. Finally --

We're looking. Just looking.

OK. Just a quick one finally. The four functions that you guys have brought in the Q, the HVAC, plumbing, building automation, and the other, the last column there, was the one that seemed to be up significantly from the prior two quarters. What is that? What is that other comprise?

Fire protection is in there. I think that is the single largest item there. There is a little bit, I believe, of electrical in there. And why it moved upward, I can't precisely cite.

I was just trying to --

I would not look for that to be any significant trend that's developing at this stage of the game.

Thanks a lot, guys.

OK.

Thanks.

Evan Marwell (ph), you may ask your question.

Good morning, guys. A couple of things. First, I'm a little confused on the gross margins in the backlog. Could you say again what's happening with those?

Gross margin indications in the backlog are down 40 basis points from where they were at the end of the second quarter. And that is a little counterintuitive when; set beside the fact that most of our increase in backlog has come from projects under $1 million. Our observations about that juxtaposition is that pricing continues to be challenging out there, although you'd expect a little bit better margins from the smaller projects.

Our other observation is that we have been jawboning, if you will, our operations, encouraging our operations to, as they complete their estimates and complete their projected gross profit, calculations for the projects that they are adding into backlog to err more on the conservative side, to ensure that there are contingencies, allowances for contingencies in their estimates, allowances for commodity, growth, in cost, and so forth and we believe that that, is probably contributing to a somewhat more conservative gross margin picture in our backlog information.

So, I guess what I'm trying to understand is, you know Tom said, earlier in the call that, you know, the focus in 2004 is on margin growth, not revenue growth and yet here we've produced a quarter that's done exactly the opposite. So I'm wondering where the disconnect is between the goals you're setting for the operations and what the operations are actually delivering.

Let me speak to -- I'm not sure what you mean, Evan, by the results of it just the opposite. The important part of this, I think what Tom was referring to is the net here. And we're doing a much better job, and have done a lot of work on retaining the margins. In other words, the margin fade has not been great. We keep a lot of close tabs on that and our -- you know, we're bringing in projects a lot closer to their estimates and, in many cases, slightly better than their estimates with greater regularity than in the past.

On your aspect of your question, what are we holding operations to -- our whole incentive and motivational system, if you will, is based on net, both, by the way, net operating income and cash flow. So, I think we've got the proper emphasis in the proper place. We are -- and I think Tom mentioned an example where we've just -- we have rejected some low margins, jobs and some jobs where we felt that the risk of margin space was not worth the candle.

We also are working through some projects that were acquired in 2003 and in a couple of cases even earlier and we have had some job slippage on those jobs as they have completed. And when we have gone back and talked to the operations about what was the reason for this slippage, in many cases they said, you know, they were done before we implemented this new productivity improvement process that we have learned in 2004. And the indications are that if they had used those techniques, that most of this slippage could have been avoided.

So, you know, we are still dealing with some issues that related to 2003, especially when some companies had weak backlog and probably took some backlog at margins that we -- that were less than what we would like them to be and the projects didn't turn out as well as they had originally anticipated.

OK. And I guess what I was referring to is more of the backlog. You know, for emphasizing margins, not growth, and yet here we turned in you know a really phenomenal backlog growth quarter, but yet some margins in the backlog slipping. So, you know, I guess that's the disconnect that I was really more focused on.

I think it's fair to say that we could have increased our backlog even more than we have this year, given the growth that has returned to the markets in general and given the strength that some of our specific operations have in certain markets and certain sectors. We have been encouraging people to husband a little bit of capacity, to pay attention to looking for price and preserving margin as they book additional business. I think also we've made the comment that -- and that probably has had the effect of holding margins in backlog.

We could have a greater backlog, but at an even lower margin indication and that's not the direction we felt made sense for this stage of their recovery. I also want to come back to the comment that we made earlier and that is that we have encouraged our operations to be even a little more conservative at their margin projections as they put jobs into backlog.

Right.

That probably has had a little bit of influence on this number. When we actually perform this work, there is probably a somewhat better chance than there has been in the past, that it will come in at these margins, if not better, for two reasons. The first one I just mentioned, and that is some conservatism in how they are setting them up and, number two, the emphasis on improved execution, training and productivity, as Tom has described. It should enable us to actually execute these projects better. So, your question certainly makes sense, given the information we've released here as of where we stand at the end of the third quarter. We believe and expect that our emphasis on margins, versus top-line growth, will be borne out in subsequent quarters.

OK. And my last question -- what's your expectation for where we can get sustainable operating margins to at this point? And what's standing between where we are today and getting there?

Well, we have suggested in the past and it's still very much believed that we believe we can get operating margins back to 4% on a sustainable basis. We have not said precisely when we will achieve that, although that point in time should not be too far in the distant future. What stands between us and that is just continuing improvement in our execution and our operations, but also completing the process of addressing our underperforming operations. In the Q, we noted that we had 10 entities that actually lost money last year. This year, that number is down to four, which includes the three that we've commented on in this call. And the aggregate of the losses that we've incurred this year is significantly less than last year.

But we still have some distance to go in that, but we are much closer to turning that tide. So, the two biggest things are fully addressing our under performers, which we think we have made substantial strides in this quarter, and then continuing to improve the execution and performance of our ongoing operations as Tom discussed.

So, you would think that some time in '05, we should have those roadblocks out of the way and should have a shot at those kind of operating margins?

Well, without being specific as to the -- I'll capitalize on your words "Have a shot at". We certainly should be in good position for that in '05 and see if we can achieve it then.

OK. Great.

Thank you.

David Yuschak (ph), you may ask your question.

Yeah, let's go back to gross margin real quick as you mentioned about it in your backlog. On a normalized basis, shouldn't we be getting gross margins in reasonable conditions north of 17%? Is that correct? You set your reasonable target to your booking business and looking at what would be normalized at 17% and North would be fair level to look at?

Well, Dave, I'm not sure that we would want to be specifically down to 17%, other than, you know, I'll come at it indirectly. And that is at a 4% operating margin with SG&A in the 12% to 13% range, then more of our margin improvement in the future is going to come at the gross profit line than anywhere else. So, we would certainly be moving back in that direction.

So, that would be safe to say as you look at some of these projects, these are the kind of things you are putting in your matrices to determine what's a reasonable project as these guys book it?

That's fair to say.

OK. As far as your service contract, national initiatives, bringing in more service revenue, given that there's been a lot more activity on the new construction side of it, could you just give us maybe a snapshot as to how that's progressing as well?

You know, unfortunately, the booking of national business is a very, very long sales cycle. We have, you know, over the last year and a half; we have totally changed out our sales force. We believe that we have a very strong sales force. Moving forward in the quarter just ended, you know, we've added 550 new sites during the quarter and in October; we had an additional 1728 sites. So, you know, we are moving forward, booking business, even though it's a very difficult environment and there's certainly a lot of players out there looking at trying to grow the same type of business that we are.

OK. And then question here on just on the cash flow. First, impact of Sarbanes-Oxley in the quarter. Anything material there at all? Gordie .

Well, it cost us more money in SG&A, but with regard to our work on meeting the requirements of Sarbanes-Oxley, we are on track there.

OK. So wasn't anything like penny a share. Because we're seeing some companies where that has been a lot bigger cost than what maybe was initially anticipated. But you're saying, as you accrued -- the accrual rate is pretty much inconsistent with your expectations?

It is costing us more than we expected at the beginning of the year. For the full year, the full-year impact, Dave, will be a little bit over a penny a share. But, of course, in a single quarter, that is a little bit less.

OK, and then one question on the cash flow. You know, your billings in excess popped nicely in the second quarter. Again, would confirm the kind of bookings backlog you've been picking that you're certainly working hard on that cash flow component of the -- of your compensation. So, could you give us an -- I mean, that, again, is abnormal thing I would expect given a seasonal slowdown that you're seeing that kind of pickup. Does it suggest that it is more aggressive on getting projects paid up front as well as the underwriting strength in the bookings?

Well, the observation there is that the last two quarters, first quarter and the second quarter, were probably lower levels of net over-billings and at that time that was driven in no small part by putting additional costs, putting additional commodity costs into projects to try and lock in pricing ahead of inflation before we actually needed the material in those jobs. And so I wouldn't necessarily say that there's been a significant increment this quarter in our billing and collection cycle, although it did improve modestly as it has in most quarters. But what you're seeing in net over billings is more a return to the typical range and, thankfully at the upper end of the range of a net over-billing position.

You guys have to be congratulated, though. A few years ago you guys didn't have as much cash around today. You ended the quarter with $20.5 million. You know, I think you could probably end up with close to $27 million at the end of this year and well over $40 next year. So, I can't imagine that cash does suggest that, as you talked earlier, some options to pursue the use of that cash in the business. So, you ought to be congratulated on how well you turned the liquidity around in the company.

Thanks. It's been an interesting road to do that.

[Operator Instructions] Now this time sir, I show no questions.

Thank you, Carrie and thank you everyone for joining us on the call. We are optimistic, both for internal reasons and by virtue of the -- our look at the continuing recovery in the economy, especially as it relates to the commercial industrial sector. So, thank you for joining us on the call and we reported our results and maybe we can get some results now out of the national election. Thank you.