Comfort Systems USA Inc (FIX) 2006 Q2 法說會逐字稿

I'd like to thank everyone for holding for today's conference call. (Operator Instructions.) I would also like to inform everyone that the conference call is being recorded and if you have any objections, you may disconnect at this time. Now at this time, I'd like to turn the conference call over to your speaker, Mr. William George, Chief Financial Officer of Comfort Systems USA. Thank you, sir. You may begin.

Thank you, Barry. Good morning, everyone. Welcome to Comfort Systems USA's Second Quarter 2006 Earnings Call. To begin, we want to remind everyone that our comments this morning, as well as our press releases, contain forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. What we say is based on the current plans and expectations of Comfort Systems USA.

Those 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. You can read a more detailed listing and commentary concerning our specific risk factors in our Form 10-K that was filed last March, as well as in our press release covering these earnings.

On our call with me this morning are Bill Murdy, Comfort Systems USA CEO, and Tom Tanner, our Chief Operating Officer. Bill Murdy is going to open our remarks.

Thank you, Bill, and welcome everyone. And welcome to the Presidents and RVPs who are on the phone. To start--I'd like to start by congratulating them on the continuous improvement which is--that we show and is due in great part to their efforts.

We're very much pleased with our second quarter operating results, which reflect increased revenue, and importantly, the results of continuous improvement efforts in many of our operations. These factors add to our general optimism about the future.

In Q2, revenues of 264 million were up about 15% from the corresponding '05 quarter. Q2 income from operations at 12 million was up 26% from Q2 of '05. Six-month revenues were up 18% and six-month income from operations was up 58%. And again, for the six months, net was $0.30 a share versus $0.13 for the first six months of '05. Six-month '06 income from operations was at a net operating income margin of 3.8% of revenues versus 2.9% of '05, and that was--in the quarter that was 4.6% of revenues.

As we have released, our backlog at 6/30/06 was down slightly at 5% down from backlog at the end of the quarter, which ended 3/31. But it's still up from 6/30/05. This sequential quarterly decrease in backlog is more than accounted for by the decrease in multi-family backlog, that's multi-family rental and condo. And thus, backlog for our commercial, institutional, and industrial work actually increased during the quarter.

Our focus remains expanding and improving our current operations in their home locations. But we do continue to extend our operations to other favorable areas. For instance, we have recently started up modest size operations in Charlotte, Las Vegas, Memphis, and Cincinnati. And we are diligently pursuing further growth in other target areas, and some of that may be by acquisition.

We also continue our efforts to expand our commercial service activities. This is a diligent effort, both in existing operations and something we look to in these new operations, which I've talked to.

Bill and Tom will have more detail on the foregoing. I'd like to end my remarks by again congratulating our operators for their continuous improvement in productivity, which shows up on the bottom line here. With our strong balance sheet and our focused efforts, we are looking to a very busy and a very successful third and fourth quarter.

Bill?

Thanks, Bill. I would like to give a few details and some color on the strong results you just reviewed. First, I want to comment on our cash flow. Free cash flow was a positive 6.8 million for the second quarter. This reflected a nice turnaround from our seasonally low first quarter cash flows, but free cash flow is still tracking behind last year. We believe that difference is due to a much larger than usual investment in working capital that arises from our continuing sharp revenue increases.

Our cash flow and collection metrics are all tracking normally, at good levels, and we still feel very good about our ability to generate cash. Our cash balances were up again and we ended the quarter at a new high of $67 million.

As Bill mentioned, total backlog was down, although it remained at very high levels. Two years ago, in June of 2004, total backlog was $442 million. Last year at this time, it had rocketed to $619 million. We ended this quarter with $690 million of backlog, which although it's still extremely high, is down 36 million from three months ago. There were no noticeable cancellations in our backlog, so the decrease resulted from the extremely high work levels that we have been experiencing, as we work our way through a busy summer.

Backlog represents future profit. And those of you who know us well, know that we work hard to emphasis profit over revenues in every incentive, every program, every initiative and every communication. As we indicated, the shift in our backlog reflects a shift away from multi-family bookings to all other categories of commercial work. Although we continue to book multi-family work, we have become more selective. We believe that this is a good trend, since for the last few years, our multi-family work has experienced gross and net margins that are about one-third to one-half lower than those found in our remaining book of business.

At busy times like these, it's crucial that we concentrate our resources where we can get the best return. And the changes you are seeing are evidence of our efforts to do that. We believe that by sharply increasing our scrutiny of the multi-family work that we take, we can improve our mix of business and get better margins from the multi-family work that we do choose to do.

Finally, I want to talk for a minute about factors affecting our earnings. Earnings were up considerably in the second quarter and our EPS was impacted by three notable factors - a lower effective tax rate, good SG&A leverage, and a small decrease in gross margin. The tax rate was 39% for the quarter. The tax rate improvement stems from our increased earnings, which dilute the effect of our permanent differences, and from the fact that proportionately more of our earnings were in favorable state tax jurisdictions.

In light of the first six months results, we changed our full year effective tax rate guidance in our quarterly filing to a range of 38 to 41%. As we have noted in the past, the cash that we pay in taxes is considerably below the provisions that GAAP requires us to make. And this helps explain the reason that we have generally tended to cash flow amounts in excess of our earnings.

SG&A was up slightly in dollars, but reduced from 12.4 to 11.5% of our revenues. The relative decrease represents leverage that we can get on these expenditures during a busier time. The drop in gross profit for the quarter, which went from 16.7 to 16.1% in a quarter-over-quarter comparison, was mainly due to the mix of new construction and to the higher percentage of multi-family work that we have been experiencing this summer.

For a company like ours in a busy time, there are two competing factors that affect margins. Pricing has improved and is a factor that support higher margins. But the mix of work naturally weights to more new construction in a busy time and larger jobs, and that fights that trend. Both factors, however, can support higher absolute profits, and we've demonstrated those. As evidence of the competing factors, although down a bit in the three months, gross margins for the six months of this year were slightly higher than for six months--the first six months of last year.

In summary, as a [indiscernible], we are aware that busy times like these are good opportunities, but can also be dangerous if we are not disciplined. We feel that the mix of work and opportunities that we have in the underlying market conditions give us a good opportunity to improve as the year continues.

That's all I have for financials, so here's Tom Tanner, our Chief Operating Officer.

Thanks, Bill. Good morning, everyone. As I did last quarter, let me start by thanking and recognizing all of our team members for their dedicated efforts over the last several quarters. Their efforts resulted in this quarter being the best quarter we have had in several years. As a whole, we are certainly very pleased with our financial performance for the first half of the year, especially as compared to our performance for the first half of 2005.

Our recent financial achievements continue to underscore the value we are receiving from our continuing focus on project selection, pricing and execution, improvement in our service divisions, and increased key member education. We will continue this focus over the second half of the year by providing productivity improvement training at select operations, and by continuing our commitment to team member education in both our construction and service divisions.

Our service operations are gaining momentum as our new group of regional service vice presidents begin to get real traction within the service divisions in their respective regions. We are seeing increasing awards of preventive maintenance service agreements, as well as improving processes and procedures in certain of our service divisions.

As we have previously discussed, one of the reasons for our improved results in our most recent quarters is because there's been a marked improvement in certain previously underperforming companies. Our management changes, the improved quality of manpower resources, coupled with the right-sizing of certain operations, has led to a continuing improvement in these underperforming companies. We also believe that our continuing focus on these companies will result in additional improvements in subsequent quarters.

As Bill George discussed, and as we had suggested last quarter, cash flow for the quarter was positive, even given our large revenue increase, which certainly required us to employ additional working capital. This results from our very strong cash culture, which is based on the foundation of truly recognizing the importance of positive cash flow. Our incentive plans for all of our operating company presidents are tied directly to cash flow, which is the primary reason we believe cash flow will continue to be quite positive for the second half of the year.

As we look forward, we are very encouraged that our backlog has increased 12% year-over-year. Although our backlog is down sequentially, the decrease is attributable to our decision to reduce our backlog in the high-rise multi-family condominium market because we were at risk of outselling our existing resources. Plus, the backlog in our core commercial business is actually also up slightly on a sequential basis. In addition, our pipeline remains strong as we head into the second half of the year.

As Bill mentioned, we continue to be very encouraged by our growth in new markets. Just this quarter, we have opened a new operation in Charlotte, North Carolina, and one of our existing operations has opened a branch in Las Vegas, Nevada. We were very fortunate to have attracted experienced and dedicated individuals to develop and grow these new markets.

Other examples of new start-ups over the last few years include our locations in Baltimore, Maryland; Atlanta, Georgia; Memphis, Tennessee; Columbus, Cincinnati, and Dayton, Ohio; Los Angeles, California; and Panama City, Florida. We will continue to seek start-up opportunities in new geographic areas, especially in geographic areas that are contiguous to our existing operations.

As we look forward to the second half of the year, we continue to be upbeat and optimistic. The management of all of our operating companies remains focused on making the necessary operational changes and improvements in their companies that will result in improved operating results for all of 2006 as compared to 2005.

I will now turn it back to Bill for his wrap-up, and then, Q&A. Thank you.

Thank you, Tom and Bill. Other than re-expressing the optimism which we have about the third and fourth quarter here, I really don't have anything further to add here. We could throw it open to questions and answers. I hope there are some. We know we have some answers. I don't know if we have any questions.

(Operator Instructions.) And your first question comes from Rich Wesolowski.

Good morning.

Good morning, Rich.

Tom, you mentioned you would be at risk of outselling your resources, and that's one of the reasons why you're taking down the multi-family backlog. Is there a lid that we can see - a dollar lid - on revenue that you guys can generate in the next year to 18 months without having to go out there and hire a bunch of additional workers?

Probably at our current operating levels, we're operating within our existing resource structure. But we could have additional start-up operations. We could also do some acquisitions that would allow us to increase our revenue without doing--as you suggested, going out and having to hire a lot of additional people. But we--as we continue to be kind of the company of choice in several marketplaces, we have opportunities to increase our resources as we move forward, reflected on if we have increased backlog in certain operations.

We also have the ability to share resources within our Comfort companies where certain markets may have more work than their existing resources can handle. And we've had some very successful examples of that in the past couple of years.

Okay. My second question. We talk a lot with Comfort Systems about improving the execution over the last year to year and a half, and the project pricing improving. And yet, it looks like the earnings that you generate, the growth that you generate, is based on the top line growth and the operating leverage. Is that the trend that you expect to see going out through 2007?

I don't think so. I think we should see--our expectation is that we would see improvement in both areas. We have had some disappointing performance in sort of our general multi-family book of business that we certainly think we're taking the steps to improve on. I think there's opportunity to improve both. What do you think, Bill?

Yes, I absolutely agree. I mean, to cut through it, the revenue from multi-family, both for rent and for purchase activities, is 24% of our revenue. And it's operating at half our gross and half our net margins. We don't intend for that to continue, and the--actually the reduction in future business probably will help our ability--or the--help the operation's ability to improve the bottom line there in terms of productivity and utilizing properly the resources we have.

I think that the resource constraint that Tom was talking about really is in this multi-family high-rise area, principally. This is an intense business. It's always been competitive. We think we can do a lot better than we have in the past. And this is not to say that we're not profitable in that area, we're just not as profitable as the other parts of our operation, or as profitable as we think the future portends.

Okay. Just to make sure I understand your point, Bill. By taking down the multi-family backlog, you expect that to help your operations through the improvement in the mix of work or from improvement in the execution of the multi-family, or both?

Both.

Both.

Absolutely, both.

Okay. Thank you.

And I think we're seeing that happen, and there have been improvements in all. And our multi-company operation is--80% of it's in one organization and there has been tremendous, tremendous improvement over the last six to eight months.

Again, thank you, guys.

Yes.

Thank you. Your next question comes from David Yuschak of Sanders, Morris and Harris.

Thank you. Congratulations, gentlemen, on a great quarter. Just a little more on the multi-family. I think you said, Bill, it was about 24% of revenue. And so far this year on the construction data, multi-family has certainly held up better than residential single family, as far as total spending goes. I'm just wondering how did it end up getting such a large percentage of your business in the quarter. Was there a need to accelerate some of these programs and get them done in the face of maybe some potential excess capacity in multi-family? Or--I'm just kind of curious as to--because that has to be a pretty good high for you in the way of the mix in the quarter of business you did in that sector versus others.

I don't think it's necessarily an acceleration toward completing those jobs. I mean, we--that accounts for that. I think we had booked a tremendous amount of business. And remember, when we talk about multi-family here, we're talking about for rent and condos. And we burned off a lot of that business in the quarter as an actual consequence of the schedule in those jobs. I've been through three of these cycles like this. And it's very interesting what happens now, I think--and we're starting to see this--or hear about this where condo development perhaps will mitigate and that will move to high-rise apartments.

And some of them will actually convert to plans that they have for condos to apartments, some will go to multi--mixed use, some will simply delay condo projects in favor of rental. I mean, there's certainly demand for living space out there. And unless there's a drastic increase in the cost of financing here, I--we don't see this thing mitigating overall - the combination of high-rise apartment and high-rise condo. We don't see that mitigating to a great extent. The condo side will go down. The apartment side will go up.

As long as--in the quarter, too, could you give us a sense as to how old are some of those projects you've been working on? And by taking down--a disciplined effort to taking down that backlog, does that bring most of your new business in multi-family current compared to maybe a more aged backlog that might have been in there? Could you give us a sense as to that?

I do think it's a more current backlog. One of the things--to go back to your first question, is we're not seeing necessarily projects accelerating. But what we are seeing is work that we thought was going to happen in 2005 got pushed into 2006. And so, that's increased our revenue mix this year, more so than we would have thought it would have been had this work happened in '05.

So currently, we're much closer to projects being approved and permitted and moving forward, so there's not the lag between getting the business and actually starting the business that we've seen in previous years. So it is a more current backlog.

Okay. And as far as starting up these--your newer operations, could you give us a sense as to the kind of cost and resources you need to do that? How much of a drag potential it could be on the operating income line over the course of a 12 to 18-month period before it really begins to show expanded profitability versus the cost of an acquisition to get in that space.

That's a good question, Dave. And in my initial comment, and Tom can embroider on this, I said modest. And that's what I meant. We are not spending heavily in these markets. We are assembling people in most cases. Now each situation has a different story, if you will. But we're not spending heavily, and we are cognizant of the fact that we need to get to immediate--the contribution--a positive contribution in these activities.

So we're being very modest, very careful, and building up against work, especially construction work. And remember, we've focused a number of these operations on service, which has a faster turnaround in terms of cost to get them in place and profitability.

So then, you're saying that these newer areas are more focused on service, so that's where your higher business is. And therefore they may not need as much business to support themselves initially until you get to see how successful they can be.

That's right. I mean, we're not building Taj Mahal and hiring 50 people. That's not what we're doing.

One other thing I'd point out, Dave, is the cost of doing this--there were a couple this year. There have been a couple of nice ones this year in Las Vegas and Charlotte that we're really excited about. But we were doing this last year - the ones that Tom listed. There is an investment. It's modest. We do make an investment in this. We are investing more in a lot of areas, like training, and that does--we could report higher earnings if we weren't making those investments. But we just feel like that's the right thing to do.

Okay. And then, one other thing. As far as the rest of the year is concerned, given the kind of heat wave we've seen here across the country, does that suggest in the third quarter you're going to see a much stronger shift in service-related revenue? And is some of the strain that is being put on the infrastructure for HVAC because of this heat wave beginning to show the aged infrastructure out there that may help accelerate a replacement cycle at all?

Well, we've certainly seen very increased activity levels in our service groups throughout the country. They're pushed to the max at this point. It clearly causes things like compressor failures, which lead to replacements, and makes people look at replacement of existing--for example, roof top units that are probably old and need to be replaced anyway. So I think it does have a tendency to increase that cycle.

But by the same token, we see people out there very concerned about spending capital, more so than we think would really make sense from an energy basis and from a replacement basis. So--but we're optimistic that that's going to certainly improve our situation in the third quarter.

Okay. I'll get back in queue. Thanks.

Thanks, Dave.

(Operator Instructions.)

Dave, it looks like you are the queue.

Okay. Our next question comes from David Yuschak.

Thanks for sticking with us through that, Dave.

Okay. A question on the SG&A. Certainly, you've shown a lot of discipline there as far as what you recorded in the quarter. Just kind of curious. You made some comments here about some initiatives like the training and setting up some of these newer operations. So you're obviously spending in some good places to get the productivity where you need to be. But it obviously also suggests that you're taking care of business in places to keep the costs down.

I'm just wondering how much more leverage can we get out of that relative to sales? Because I think this number on the percentage of sales has to be one of your lowest ones in some time in a busy season I would think.

Well, I would put it this way. I think we can continue to get leverage out of the money that we spend on our SG&A. Where that ends up as a relative percentage of revenues is tough to predict because it's really tough to predict revenues. It's--so I don't--we don't--we know for a fact that as our revenues increase, not all categories of SG&A have to increase, and we keep a close eye on that. And so, that makes us optimistic. But as a percentage, this was--I think there were remarkable revenues in this quarter that certainly helped that percentage. I'd be happy if we can maintain it this year.

And then, as far as the--everything that you read today continues to suggest - and I still have to believe - that non-residential spending relative to residential spending is going to be exceptionally strong in the course of the next 18 months. That's just kind of our view here. But I just was wondering--you had said earlier, Bill and Tom, that the pipeline looks very strong. I wanted to get a sense from you as to where you did have bookings in the quarter. Can you give us a sense as to where you saw the biggest strength coming from? Were there some larger contracts in there? What's the potential for maybe larger contracts as this non-residential construction market stays pretty heavy?

Hospital work and healthcare still remain strong. In certain markets, we're seeing school projects that make sense to some of our operations. The hospitality industry, hotels, is strong in certain markets and there's a big percentage increase in that business around the country. In some of these mixed-use projects, which could be retail, apartments, condominiums, all in the same complex, we're seeing some opportunities for that around the country. And certainly, as Bill said, this movement from condos to apartments we're seeing in several markets.

So--and there's certainly select markets where the condo projects are still very strong and they're--we're seeing projects on the board. We're budgeting a lot of projects as we move forward. So we're optimistic broad-based in all of the areas that we're--that we have expertise in.

So at this point in time with that kind of potential outlook, you're not--the resource issue is still not a pressing matter, would you say?

I would not say that it's a pressing matter today. No. We are able to move workers when we need to. The training helps make our people more efficient and more effective, so we can do more work with the same number of people. So that training becomes critical to us. And there's opportunities for us to hire employees from other companies. We--as a strong national company, we have very strong benefit programs that are cost effective for us and for our employees. So we're seeing the ability to pick up employees from smaller organizations that can't offer the career path or the range of benefits that Comfort Systems offers to people today.

And one last question on labor cost issues. Is that beginning to surface at all at this point in time, or is that still under control?

We're not--I'm not seeing evidence of that being a major driver in our marketplaces. It just hasn't been. Again, we try to really treat our people as well as we possibly can. We have good incentive programs. We have good benefits, which makes many, many of our employees very loyal to their local organizations.

One thing, David, at the low end, both on the construction side and the service side, the mitigation in single family residential construction provides a pool of some people. It's hard to make the transition sometimes from residential to commercial. But at the low end, we--that's a pool of people out there that's to be drawn on. I know a lot of the other construction trades are seeing--that are involved in commercial, non-res, are seeing employees from that sector.

Well, just judging from the potential weakness you could see out there in the residential, I could see where that could be a good pool of potential hires. So it makes a lot of sense. Thanks.

Thank you. Your next question comes from [Joshua Pollard] of Goldman Sachs.

Hey. Great job, guys. Two quick questions. [Moving quickly], how far is management looking to scale back that multi-family? Have you guys spoken about that? I just wanted to get a sense of how far back you guys want to scale that back?

Multi-family has been a good area for Comfort Systems for years and years. If you looked back historically at the pie charts that we put in our Investor Presentation--and by the way, our Investor Presentation is posted on our website within a couple of days after our earnings release each quarter. You would have seen multi-family in the teens, often in the low teens, for many years. It spiked up into the 20s. I think it's going to be there for many years to come. And if I were guessing, and it's just a guess, I think it will be there at historical levels. I just think we're going to get a little more selective and try to do better.

So you're thinking--I mean, without giving a point estimate. What you guys are thinking--low 20s, high teens?

I'd say more like mid and low to mid-teens at some point is what we'll regress back to. But we're going to be busy with multi-family for the rest of this year. It's a good area next year. So maybe what you said is more like what you're going to see in the near term.

The long-term--by the way, if you looked at that chart generally by sector, things do move up and down in that chart quite a bit. So there are times when institutional has grown a lot or there are times when various sectors grow. So there's not a baseline level. But what I would emphasis is, I think multi-family--it's an important part of Comfort Systems. We value it. We don't accept that it has to be lower margin. We're going to--we plan to do it and do it at good margins. So it will be there.

Great. The second question is just on the tax rate. What do you guys--you guys said that you had done proportionately more work in some of your lower tax regions. Can you just mention just a few of those and what you guys are seeing for the rest of the year? I wasn't sure if I misheard you, but you said 38 to 41. And was that cash or was that GAAP?

That's GAAP. 38 to 41 is the number that will be applied in calculating EPS. It's the GAAP number. The low tax rate jurisdictions that we've been enjoying some success in include--they include Texas, they include Florida, they include a lot of the Southeast. We have a very good concentration of companies in the Southeast and Southeastern states tend to have nice tax rates. The higher tax rate states, some of them are in the upper Midwest. A lot of them are in the Northeast. We do well in a lot of those states, but obviously, they do--if work moves into--if our profits come from states that have higher tax rates, that affects our tax rate.

Understood. And as you move out of multi-family, which has a decent concentration in Florida, as I look at it, do you expect that to stealth back up in the coming years as you guys go back out of multi-family?

I don't think so because we have a Central Florida operation that's highly--does a really, really broad range of business that's perennially successful and it's a big revenue company. I'd say it's more--it's a more important factor in that future than the work that we do on the Gulf Coast. So my guess would be no. And frankly, because Florida is not unitary, actually, we're not making--as we mentioned earlier, we're not really terribly profitable in the multi-family we're doing in Florida. So that's not even--that's not really where that's coming from anyway. So I wouldn't expect that to be much of a factor looking forward.

All right, great. Thank you.

All right. Thanks.

And at this time I show there are no questions.

Thank you. And thank you all for being on the call. As we mentioned, we're very pleased with our second quarter results and looking forward to a robust activity period here in the next few months. Thank you very much.

Thanks.

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