Comfort Systems USA Inc (FIX) 2006 Q3 法說會逐字稿

Welcome to the Comfort Systems Third Quarter Earnings Conference Call. [OPERATOR INSTRUCTIONS] Today's conference call is being recorded, so if you have any objections, you may disconnect at this time. I will now turn the meeting over to Mr. Bill George, Chief Financial Officer. Sir, you may begin.

Thanks, Mark. Good morning, everyone! Welcome to Comfort Systems USA's Third Quarter 2006 Earnings Call. As always, we want to remind everyone that our comments this morning, as well as our press releases, contain forward-looking information and statements within the meanings 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. Bill?

Thank you, Bill.

We are very pleased to report the net income for the third quarter of just under $9 million or $0.22 a share vs. just over $6 million or $0.15 a share for the comparable quarter last year. That's a 46% increase. Our Q3 revenues were $288 million, a 22% increase from last year.

Free cash flow was $2.9 million compared to $6.6 million in Q3 of 2005, as we continue to invest funds in working capital and our growth.

Backlog as of September 30 remained high at $679 million, down slightly from the $690 million at June 30, as we continue to right-size our multifamily high-rise business. Backlog was up in the rest of our sectors and, in any case, was up $45 million from the backlog measured at September 30, 2005.

We believe that this shift in our backlog composition as well as the continuing productivity improvement we expect in our multifamily sector are very positive factors for future bottom-line performance.

For the nine months ending September 30, we report a net income from continuing operations of $21.2 million, about $0.52 a share vs. $11.4 million or $0.30 a share in 2005, a 73% increase on a nine months basis.

The revenues of $788 million for the nine months vs. $659 million in the first nine months of 2005 were up just under 20%.

With those brief introductory remarks, I'd like to turn the mic over to Bill George, our Executive Vice President and CFO, who will have some further comments to make on the financials and our cash flow and backlog. Bill?

Thanks, Bill.

I would like to point out and discuss a few items with respect to the strong results that we released and that you just detailed.

As the numbers that Bill reviewed demonstrate, our earnings have increased strongly. After three quarters of 2006, we have earned over 70% more than we had earned during the first three quarters of 2005; and we continue to experience good leverage on our SG&A expenditures. Meanwhile, revenues have increased steadily and strongly, albeit not as quickly as operating income.

During our first nine months this year, we generated approximately $130 million more in revenues than we had during the same period in 2005. One result of the surge in revenues has been that we have been investing substantial additional money in working capital and growth and because of these investments, free cash flow is still tracking behind last year. Receivables have increased by $50 million through the first nine months and our aging and collection metrics are all tracking very well. We still feel confident of our ability to generate cash. Our cash balance at quarter end was $69 million and we have no debt.

As Bill mentioned, total backlog was down, although it remains at very high levels. Two years ago, in June of 2004, total backlog was $447 million and had already increased sharply as we came out of a recession. Last year at this time, backlog had surged to $634 million and we ended this quarter with $679 million which, although still extremely high, is down $11 million from three months ago. There were no noticeable cancellations in our backlog; but as our revenues indicate, we have experienced extremely high summer work levels.

Backlog represents future profit, and we emphasize profit over revenues in every incentive program and all of our operational initiatives. The change in our backlog reflects a shift away from multifamily bookings to all other categories of commercial work and, thus, backlog in nonresidential building work is up. We believe that this is a good trend, since our multifamily work has experienced gross and net margins that are substantially lower than our remaining book of business. We feel this change will help us improve our mix of business and get better margins from the multifamily work that we will do in 2007.

We hope that our investors don't mistakenly conclude that the decline in backlog automatically indicates that a decline in revenues is inevitable sooner or later. That is not necessarily the case. Service and smaller project work does not appear in our backlog in any meaningful way, and these represent a big portion of our revenues. Larger projects stay in our backlog for many quarters and sometimes for years and are more likely to be awarded and, thus, added to backlog well before a project starts.

Multifamily work represents our largest projects with the greatest durations and so it is, by its nature, overrepresented in backlog compared to its revenues. Because of these factors, any transition away from multifamily work can reduce our backlog, even though revenues for the company might continue to rise very well.

Strong markets make for strong opportunities. However, unless we are disciplined in work selection and execution and then are equally diligent in collecting payment, busy times can also pose dangers in this industry.

We feel that the mix of work and opportunities that we have, the discipline that we are working hard to show, and the underlying market conditions give us a good opportunity to continue to produce strong results.

That's it on financial, so now I'll introduce Tom Tanner, our Chief Operating Officer. Tom?

Thanks, Bill. Good morning, everyone.

As Bill mentioned, we were certainly pleased with this quarter's results which I believe represent the best third quarter on a same-store basis that we have ever achieved. We would like to recognize and thank all of our almost 7,000 team members who do a great job everyday. Without the talents, dedication, and commitment of all of our team members, we would not have achieved the consistent financial improvement we have had in the last few quarters.

These results continue to underscore the benefit of our continuing emphasis on project selection, pricing, and execution; the improvement in our service divisions; and the increased team member education in both our construction and service divisions.

As we complete Q4 and move into 2007, we will continue our focus on incremental improvements in all of our operations.

As we have previously discussed, we continue to see growth in both the revenue and operating income of our service divisions. Our service vice presidents are focused on growing our existing base of preventative maintenance service agreements while improving operational processes and procedures in certain of our service locations.

To further accelerate the growth of our maintenance contract base, we are adding a very experienced Vice President of Service Sales to our existing service group resources. He will primarily be responsible for providing grassroots sales training for our current and future service sales team members.

In the current quarter, we continue to see a marked improvement in certain previously underperforming companies. These improvements result from our past management changes and our current focus on these operations. We also believe that our continuing emphasis on these operations will result in additional financial improvements in subsequent quarters.

In addition, we are also very focused on improving the margins of our multifamily housing projects. We are right-sizing certain operations to better match their revenue with their manpower resources. This should result in better project selection, which will lead to improved project pricing and much improved project execution. We believe we will start to see marginal improvement in this segment of our business during the first half of 2007.

We are pleased with the current level of our backlog. We believe our backlog is well-matched with our current and available resources, which makes us well positioned for future profitability. We are also encouraged that our pipeline remains strong as we move into the last quarter of the year. Thus, we continue to be upbeat and optimistic about our future.

Our management and our team members are committed to continuously making the incremental operational changes that will improve their profitability in Q4 and beyond.

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

Thanks, Tom. And I'd like to add a special thanks and congratulations to our employees, who have worked hard and well to produce the results that we are talking about here today.

For the future, both external and internal indicators remain very positive for the commercial construction sector, including multifamily. We believe our strategies of productivity improvement, increasing the service and retrofit component of our business, and our strategy of overall growth are working well and we remain optimistic about the fourth quarter, about 2007, and beyond.

At this point, I would like to turn it back over to Mark to conduct the Q&A section.

Very good. We'll now begin the question and answer session. [OPERATOR INSTRUCTIONS] Our first question comes from Dave Yuschak of Sanders Morris. Go ahead.

Good morning, gentlemen. Great quarter. Could you guys give me an idea about what your multifamily revenue was in the quarter as well as what percentage of the backlog that represented and how that compares with the second quarter?

This is Bill, Dave. We've never published numbers about the composition of our backlog. In part, that's because we don't -- many projects have multiple aspects to them, so I guess what we are comfortable doing is talking about the comparatives. As a percentage of backlog, multifamily is down a few percent over the last two quarters, but were quite a few percent if you go back to the beginning of the year.

As you know, multifamily has driven almost all of our drop in backlog. Multifamily as a percentage of our revenues and, as you know, this will come out in the pie chart that we will be publishing on our web site, as we always do here in the next day or two, it tracked approximately the same as last quarter. I think it was down 1%, from 24% to 23%, but virtually the same.

As we said in our second quarter call, very, very busy summer in multifamily and the third quarter is actually even a busier time period for us, a busier set of summer-type months. And quite honestly, multifamily is still very active for us over the next few months, as we close out projects on both coasts and in some other places. So those numbers -- I think in his comments Tom indicated that we were looking for the first half of next year to be when you would begin to see that multifamily completely change in a way that is very noticeable.

Now, sequentially, the operating margin is up almost 30 basis points from the second quarter, despite a pretty good level of multifamily in the mix. Could you give us a sense as to whether that was other things going on in the quarter that gave you that nice boost or was it multifamily's improvement was a leading factor?

Multifamily did not perform any better in the third quarter than it did in the second quarter, so that improvement was virtually all in our remaining bulk of business.

And what would be the primary drivers of seeing that kind of nice improvement on the rest of your business because with multifamily being that high a mix, it would kind of suggest things were cooking in other places?

Tom?

Going back to our focus over the last 18 months on project selection, on execution, on focusing, being in geographical areas where we can successfully complete work, choosing work that we have experience in, not reaching out to do work that we are not comfortable in doing, and a lot of this training that we have gone on for project management and field superintendents, we are really seeing the benefit of that. It was a very, very successful quarter across the board for the great majority of our operations.

Okay, let me just -- one more question -- I'll get back in queue. On the backlog, you guys indicated earlier that, don't put as much emphasis on it at this point in time because some of it was driven by the multifamily projects. For a while there, you were just blowing and going on backlog, so is it fair to say then that a lot of that strong backlog growth was the multifamily driving that back then and at this point in time, given what you've been doing with the rest of your project business and the execution you've seen in it that that's why you are arguing not to pay as much attention to it? Because -- the general nonresidential market still remains healthy, whether it's multifamily or other; it seems to be pretty broad across the board.

That's right Dave. I would not characterize our approach to multifamily as not paying as much attention to it. We are paying an awful lot of attention to it. I think what I would agree with is that we are being very selective. We are reducing the amount of multifamily work we are taking.

As Bill eluded, the percentage of multifamily in the backlog going forward is less than what it has been. It is tough. Some of these are multiuse projects, some portion multifamily, for instance. So it's hard to be absolutely accounting-like precise, but it's clearly down from where it's been; whereas, the backlog in the other sectors is actually up, hospitals, schools, etc. So, we feel pretty comfortable with that. We are certainly not backing off from multifamily.

We believe that, as Tom eluded, not eluded, said in his comments, we believe that moves we have made there to right-size and get that business inside of the managerial, superintending, foremanning capability of our multifamily companies are really going to show good results.

Are you willing to put a timeline on when that drag becomes less of a drag then?

Tom is the timeline man.

Well, I mean, it will be in late first quarter, second quarter of 2007.

Okay. I've got it down guys.

One other thing, Dave, you mentioned, you talked about how historically, when our backlog was going up very fast, and it went from low 300's to break 700 in a couple of years. Was a lot of that this composition issue? And I believe on every call through that period we talked about how things change. As the market gets busier, you get larger average project size, you book farther out. We were always at great pains to point out to people, look our backlog doubled; it doesn't mean our revenues automatically double. So this is just a reverse of that coin. It's just healthy project mix changes that you are seeing.

Okay, great. Thanks a lot and good quarter.

The next question comes from Rich Wesolowski of Sidoti & Co.

Thank you. Good morning.

How would you guys characterize the pricing power of the commercial space vs. say 9 to 12 months ago? Maybe even in relation to some wage pressure you may be seeing on the other end.

In general, we see the opportunity for price increases as the level of construction has risen and we have focused on-- we keep repeating this, but we have really focused on project selection. And, therefore, part of that is where we can get better pricing. And that's really -- we have seen a significant increase in that ability. As the markets fill up and our competitors are filled with work, it gives us opportunities to get better pricing. So it is definitely better than it was 9 to 12 months ago.

Is labor availability going to be a limiting factor to growth within the next year to 18 months?

In certain markets there are labor constraints, but one of the things that drives pricing changes is the fact that we recognize that some of our labor is going to cost more in certain markets. One of the things that we are really trying to do is make sure that we manage to our existing resources and grow the bottom line greater than what we will grow the top line. So we don't -- we have the ability to share resources, which we have gotten very good at. We currently have three or four companies sharing resources with other Comfort companies today to move forward on projects, so we think we have gotten good at that. So we don't see resources as being a big constraint on future growth.

Okay, it seems that when you want to transition, not away from but at least reduce the multifamily to its historical level, it depends on the strength of the commercial market. Have you seen any even initial hints of a slowdown there?

We really-- we haven't. And we haven't had any cancellations of projects. There is a huge amount of schools work, public and private, out there. There is vitality even in the manufacturing sector. We just haven't seen it, Rich. Now, I read a lot of the same things you do and a lot of people are talking about the potentials, but I think mitigation of some of the materials, prices have maybe encouraged developers to continue on. Labor continues in general and I agree with Tom that in certain markets it's a challenge, but in general we have been surprised that we haven't seen things getting out of hand.

If you look at outside resources, Rich, the guys at Dodge thought their newest forecast last week. I’m sure many people on this call saw it was the lead story on the Wall Street Journal the day it came out. Mostly because of what it said negative about single family and about residential generally. But, earlier this week on Monday I heard them present their new results and what they released last week shows that they don’t see a downturn coming in virtually any sector of residential institutional -- I’m sorry of commercial or institutional work. I’m sorry I didn’t mean residential.

Okay. Finally if you guys, if this all plays out and you succeed in reducing the multi-family business to what it had been in the past and the status quo of bidding activity prevails with commercial market, would you expect to generate significantly higher operating margin than what you’ll end up doing in 2006?

We continue to resist giving what you would classify as guidance. But I think in our current outlook is that we will do better in 2006 than in 2005 and do better in 2007 than in 2006.

It's not all. We’re going for, in one way, much higher ground than just keeping up with the construction cycle here. I think our productivity moves move toward service and retrofit that Tom outlined by talking about people that we are working with there and our selective growth pattern here. It’s going to stand us in good stead even in a cyclical downturn, which ultimately will happen. We understand that. But I think we are insulating ourselves a bit from that by these other initiatives and strategies we have implemented here.

Thanks a lot.

Yes.

The next question comes from Brad Evans of Heartland.

Good morning, everybody.

Hi, Brad.

I have a question for Bill Murdy, I guess. Bill, could you just talk about how much cash you think you need to have on the balance sheet to run the business from a day-to-day perspective? And what you think the best deployment of free cash flow and excess cash are as you move forward?

Well, as to the first part of that question, this is a seasonal and cyclical business. Right now we are growing our top line. As we’ve indicated we need to in effect invest in working capital. You feel comfortable with cash on the balance sheet. You could indicate that maybe we have too much. But we are looking at growth by modest acquisitions. We think that is a very good use of the stockholder’s money. But we’re being selective there. In times like these many construction sector entities decide not to grow by acquisition. And I guess we are one of those since we have not acquired anything recently. And wait for softer times, if you will. At the same time, and we’ve announced this, we continue to have discussions and look where things fit well and where there is a service component to it we are interested. So, that is a long way of answering your question. I think that some of those funds are properly used in growth via acquisition.

How does the pipeline look at this point? Just generically speaking.

Pipelines of acquisitions or work?

Acquisitions.

We’re having a lot of discussions. And we just don’t want to overpay. And we’re having a lot of discussions in the sun belt of the country.

We’re not located in a lot of places. We are located in a lot of places. But we are not located in some very attractive non-union markets. Where we’re not, and we are focused on those. So there is a -- it is somewhere between the reasonable and very good pipeline.

Excuse me, could you just refresh my memory as to how much of, in a typical quarter, how much of revenue comes out of backlog versus revenue that does not come out of backlog?

Well, the problem with that -- I’ll give you a simple answer which is a good third of our revenue never goes through backlog, virtually never goes though it. But because even a one month project, if it happens to be in the middle of the project on the last day of the quarter, half of that project value is going to be on the POC, so there is a lot of low level project work that just passes through the backlog ephemerally and that’s why I’m hedging this discussion. There is probably a third of our work that never goes through backlog. There is probably another third that barely goes through backlog compared to how the big work represents in backlog. Part of the point I was making earlier. Just the time sequence of the work.

Could you just give a sense as to when you expect to see some of this more favorably priced business move through the P&L as it comes through the backlog? How far away are we from starting to see the benefits of the improved pricing environment?

I think we saw some of it this quarter. And we certainly expect to see it going forward. The real effect of it will be seeing when we are completed right side on the multi-family operations and we get the type of margins from the multi-family business that we know are achievable. And that’s when you will see the full impact of some of these pricing increases that we have been able to get in our backlog.

Okay, great. And then my last question was just how big on an annualized basis is your national accounts business at this point? Can you just give us an update on your activity there?

Our national accounts business is growing moderately. We’re probably -- let me look up the number here for a second -- it's just under $30 million. We have steadily grown it over the last couple of years. It is not something -- we do not believe it will be the driver of business today that we might have though about two years ago. It is a profitable business, and nicely profitable, but we have got to be careful here, we do a lot of work locally for national names that we don’t count in the revenues of national accounts. So when we talk national accounts, we are talking about something that is peculiar to the way we look at our revenues. It's housed in an operation in Indianapolis with a major call center component, etc. But we certainly do work for other national names in regions and sub regions around the country but that revenue flows through our individual operations.

Okay, thanks. I lied, I’ve got one more question I guess. Could you just give us a long term margins forecast or long term margin goal for the business? Assuming normalized operating environment, where do you think you can get the business under favorable market conditions from an operating margin perspective? What’s a good goal?

We’ve talked about that in the past. And we believe there is a sustainable net operating income margin after everything in the 4.5% to 5% range. Sustainable is an important thing. We will be above that in very good parts of the cycle. But I think it is achievable and sustainable at 4.5% +.

Sir, that’s a net operating margin -- net margin -- net after tax?

No.

That’s a pre-tax --

That’s a pre-tax number. If that were after tax, that’s not this business.

Thanks for clarifying that. Okay, thank you.

Thank you, Brad.

Your next question comes from Susan McGarry of Granahan Investment.

Hi, I have two questions. I was wondering if you could first talk a little bit more about the gross margin. Was the decline in gross margin entirely a result of mix?

Well, it’s a combination of two factors. One, bigger average project size and, for a variety of reasons your gross margin is higher when you have bigger average project size, and then multi-family. The effect of multi-family, obviously, if you read our MDNA you’ll see that is the first item that’s mentioned. Of course, any time you’re talking about the downside of gross margin, whatever sector is doing the worst is going to be listed. That’s certainly the case here. Now, the reason you can have lower gross margins and higher net margins is because obviously there is less SG&A associated with the big project work. And that’s one of the reasons it gets bid. It can be taken as a weighted average of the whole. It can be bid at lower gross margins.

So, apart from the multi-family work, which it sounds like, on an apples-to-apples basis, was maybe about the same margin as it’s been, is that correct?

About right, yeah.

So outside of the multi-family work, are you seeing some expansion in your gross margins?

Well, you have two -- it's really hard to predict at a busy time like this for us. You have two factors, both pushing really hard in opposite directions. On one side you have pricing, which is a very potent factor to improve gross margins. But on the other side you have project size. And if you looked at, not just our company, every company in this industry, gross margins are endemically lower the bigger a project gets. And so for many quarters now one of the things we’ve said is we see scenarios, both of those are good trends. They go in opposite directions but you’re very happy about both. So we can see futures where gross margins trends a little higher or a little lower, but we don’t see a bad outcome from that. It's just better bottom line from that, either way it's on those factors.

So the project size is going up in general, apart from multi-family?

It’s been going up and I think ---

The multi-family has really driven the increase in project size in the last two quarters.

Right, so if we get relief, which I don’t know if relief is really the right word, but project size might be topping out now. We might still, we did go from $300 million in backlog to $600 million in backlog over the last two and half years. So there might still be some increase in average project size. But it ought to be pretty near steady state right now. I don’t have a clear answer to that but I have a sense.

On the revenue mix, it seems like less of the growth came from the office building projects this quarter. Was that a function of finishing up a big project? Or are you seeing any trends in the office sector?

Well, yes. Trend -- we’re not everywhere. I think it was down 1% from third quarter. That could be one -- I’ve been out on a project. It’s tough to --- We’re a micro part of the total market so to predict a trend off of us is kind of difficult. We are seeing our pipeline, which is not our backlog, but our pipeline beyond the backlog has a lot of office in it.

Okay.

In Dodge, office buildings lagged pretty much every other part of the commercial and institutional sectors. Dodge has said office buildings are coming back and I think we’ll see that.

We’re especially interested in, Susan, in the retrofit potential in office buildings. Especially as owners there of become concerned about energy efficiency and interior air quality. So massive install base out there. That is a real opportunity for us.

And then just on the cash flow front. Are you expecting positive cash flow from operations anytime in the near future?

We always have our strongest cash flow quarter of the year in the fourth quarter. Typically we get half or more of our cash in the fourth quarter of the year. So, we absolutely expect strong cash flow in the fourth quarter. On the other hand if I were to predict whether it would be proportional to prior years, there are two things. One thing pushing it towards that good or better, which is rate increase in receivables that are aging to that prime time. They will be prime time for collecting being 40 to 90 days out from a busy summer as you get into the fourth quarter. On the other side of that, we still have sharp increases in revenues and our forth quarter revenues, if the trend continues, our fourth quarter revenues for this year will be higher than our fourth quarter revenues for last year. So I think there will be additional net investment and working capital. But there should also be really, really good cash performance because of the investments and working capital early in the year. I want to emphasize our measures of DSOs, our measures of receivable accruals as a percentage of receivables. All of our measures for collection look fine. They look just absolutely fine. We’re building up a ton of stockholder’s equity. We’re very comfortable that the cash that we’re earning, we’re going to collect it, predicting where that’s in the next 3 months, 6 months, or 9 months is tough. Also with larger project sizes there is more retainage on bigger projects. 5% to 10% of the project is held back until absolute completion. So when we run these collection statistics, we run them with and without retainage because retainage has a different dynamic to it. We’re comfortable with both. But I will say retainage is up very strongly as well. So all of those factors, absolutely comfortable saying there will be good cash flow in the fourth quarter, the range of what it could be is very big and the factors that made it tough in the second and third quarter will still be there.

Alright, thanks.

Alright, sir. We are showing no further questions on the phone line. We’ll turn it back over to you for more comments.

Thank you, Mark. And thank you to those of you who have been on the call with us. We’re very happy to be reporting this quarter and look forward to -- did someone come back in the queue? No. Thank all of you for your questions and attention. We’ll see you three months from now.

This concludes today’s conference call. We thank you for your participation. You may disconnect at this time.