Earnings Call Transcript - FIX Q4 2022

Operator, Operator

Good day, and thank you for standing by, and welcome to the Q4 2022 Comfort Systems USA Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Julie Shaeff, Chief Accounting Officer. Please go ahead.

Julie Shaeff, Chief Accounting Officer

Thanks, Justin. Good morning. Welcome to Comfort Systems USA's fourth quarter and full year 2022 earnings call. Our comments today as well as our press releases contain forward-looking statements within the meaning of the applicable securities laws and regulation. What we will say today is based upon the current plans and expectations of Comfort Systems USA. Those plans and expectations include risks and uncertainties that might cause actual future activities and results of our operations to be materially different from those set forth in our comments. You can read a detailed listing and commentary concerning our specific risk factors in our most recent Form 10-K as well as in our press release covering these earnings. A slide presentation has been provided as a companion to our remarks. The presentation is posted on the Investor Relations section of the company's website found at comfortsystemsusa.com. Joining me on the call today are Brian Lane, President and Chief Executive Officer; Trent McKenna, Chief Operating Officer; and Bill George, Chief Financial Officer. Brian will open our remarks.

Brian Lane, President and CEO

All right. Thanks, Julie. Good morning, everyone, and thank you for joining us on the call today. We are pleased to report a great finish to 2022 with increased revenue, record earnings, fantastic cash flow, and a surge of backlog. Our teams delivered amazing execution, and we are grateful for their hard work. For the fourth quarter, we earned $1.54 per share on revenue of $1.1 billion. Full year revenue surpassed $4 billion and included same-store revenue growth of 22%. Backlog received an especially strong lift this quarter from our modular off-site construction operations as large customer purchases were committed in advance to support our ability to invest in modular construction capacity. Our backlog is now over $4 billion, a same-store increase of 75% from a year ago. Cash flow was also extraordinary in the fourth quarter. For the full year, our cash flow exceeded our impressive earnings by a substantial amount. We are excited to announce that on February 1, we acquired Eldeco, a premier industrial electrical company based in South Carolina. Eldeco will further strengthen our Electrical segment. Thanks to its capabilities and relationships in a strategically located market for us, we believe that this combination will allow us to achieve important synergies over the coming years. We also declared a larger-than-normal increase in our dividend of $0.025 per share, which increases our quarterly payout to $0.175 per share. This increase reflects our continuing strong cash flow and our desire to reward our shareholders. I will discuss our business and outlook in a few minutes, but first, I will turn this call over to Bill to review our financial performance. Bill?

Bill George, Chief Financial Officer

Thanks, Brian. So revenue for the fourth quarter of 2022 was $1.1 billion, an increase of $261 million or 30% compared to last year. Same-store revenue increased by $200 million or 23%, with the remaining $61 million increase resulting from our acquisitions. Revenue for the full year 2022 increased by more than 35% compared to 2021 to $4.1 billion. Our full year Mechanical Services segment revenue increased $636 million or 25%, and our Electrical Services segment increased by 81% to $431 million. Same-store revenue increased by 22% or $669 million in 2022, a broad-based increase driven by strong ongoing market conditions. Inflation of equipment and materials also contributed to revenue growth. With respect to revenue prospects for 2023, our growth is hard to predict because of unknown inflation developments and potential variability in the timing and revenue contribution of new bookings. However, we currently estimate 2023 same-store revenue growth to be in the low to mid-teens for the full year, with larger percentage increases likely to occur earlier in the year considering prior comparables. Gross profit was $211 million for the fourth quarter of 2022, a $57 million improvement compared to a year ago. Our gross profit percentage was 18.9% this quarter compared to 18.0% for the fourth quarter of 2021. Quarterly gross profit percentage in our Mechanical segment increased to 19.1%, while margins in the Electrical segment rose significantly to 18.2% this year from 14.8% in 2021. For the full year 2022, gross profit increased by $178 million, and our gross profit margin was 17.9% in 2022, as compared to 18.3% in 2021. Our full year gross profit margin held up remarkably well considering the spike in revenue, the relative increase in construction, and the changes in our cost mix, as higher prices meant that materials increased as a proportion of our costs and revenues. It is currently challenging to predict how our margins will unfold in 2023. Important factors that will influence our margins include ongoing cost inflation and the fact that with the surge in bookings, we will be early in many projects, and new construction should also expand as a proportion of our revenue. These factors are especially prevalent in our modular work, where we will also have ramp-up considerations as we implement increased capacity. Despite these structural trends that might put some pressure on margins, we expect good continued profitability, and we are optimistic that gross margins in 2023 will be at or near the strong levels that we achieved in 2022. SG&A expense for the quarter was $132 million or 11.8% of revenue, compared to $105 million or 12.3% of revenue for the fourth quarter in 2021. On a same-store basis, SG&A was up approximately $17 million. For the full year, SG&A expense as a percentage of revenue was 11.8% in 2022, down from 12.2% for 2021. On a same-store basis for the full year, SG&A increased $56 million, largely due to increased headcount to support our higher activity levels. Our operating income increased by 62% in the fourth quarter of 2022 to $80.1 million when compared to this quarter last year. Interest expense in 2022 was higher than a year ago due to the increased interest rates on our revolving credit facility. Our average interest rate on our credit facility was 5.7% as of December 31, 2022, and we expect that with higher rates, our interest expense will increase in 2023 compared to 2022, especially early this coming year when comparable periods a year ago had much lower rates. Our tax rate for the quarter was 21%, while our full year tax rate was a negative 4% due to R&D tax benefits related to prior years. We continue to view our normalized tax rate to be approximately 22% to 23%. After considering all of the factors above, net income for the fourth quarter of 2022 increased by over 40% to $55 million or $1.54 per share. This compares to net income for the fourth quarter of 2021 of $38 million or $1.04. Our full year earnings per share for 2022 was $6.82. Excluding the R&D tax benefits related to prior years, our 2022 earnings per share was $5.29, and that $5.29 earnings compares to $3.93 per share in the prior year after those adjustments. For our fourth quarter, EBITDA increased by 47% to $100 million. Our full year 2022 EBITDA has increased by 32% compared to the prior year, and it was $338 million. Full year 2022 cash flow was $256 million compared to $161 million in 2021. Our cash flow benefited from advanced payments that we negotiated as part of our modular backlog commitments that were mainly received in December. This work has not started, so receipt of this cash is reflected in a $73 million increase in our deferred revenue liabilities at the end of 2022. Our free cash flow also benefited from the $33 million refund from the IRS for the R&D tax credit that we got in the first quarter but was partially offset by roughly $50 million of net tax payment that we made in the fourth quarter that arose from Congress's failure so far to extend the immediate expensing of research and experimental expenditures. We expect a meaningful increase in capital expenditures in 2023 compared to 2022. This increase will be driven by investments to build out large additional production facilities that we have leased in Texas and North Carolina to support our increased modular backlog. We began the year with just over 1 million feet of modular production space. When our new facilities come online by midyear, that capacity will have increased to over 2 million square feet. We also expect that during 2023, we will have higher-than-normal fleet investments as we recover from deferrals and vehicle availability during the pandemic. Overall, we expect CapEx spend for 2023 of roughly $55 million to $70 million. Brian mentioned our acquisition of Eldeco earlier this month. Eldeco is headquartered in South Carolina and performs electrical design and construction in the Southeastern region of the United States. We expect this acquisition to contribute annualized revenue of approximately $130 million to $140 million with EBITDA of $8 million to $9 million. Because of the amortization expense related to intangibles and other acquisition costs, this acquisition is expected to make a neutral to slightly accretive contribution to earnings per share in 2023 and 2024. Our debt at the end of the year was $256 million, and we were able to achieve our goal of reducing our leverage below 1 times EBITDA by year-end. Our current debt-to-EBITDA leverage stands at 0.76. We are continuing to opportunistically repurchase our shares. In 2022, we repurchased 442,000 shares at an average price of $86.45. Since we began our repurchase program in 2007, we have bought back 10.1 million shares at an average price of $24.52. And with that, that's all I have of financial, Brian.

Brian Lane, President and CEO

Okay. Thanks, Bill. I am going to spend a few minutes discussing our backlog and markets. I will also comment on our outlook for 2023 and on inflation and supply chain considerations. Our backlog at the end of 2022 was a record $4.1 billion. Year-over-year, our same-store backlog increased by $1.7 billion or 75%, a broadly based increase with strong bookings in both our electrical and mechanical construction businesses. During the final three months of 2022, we augmented the increases in our traditional business with substantial new bookings in our oxide construction business. Sequentially, our same-store backlog increased $813 million despite heavy backlog burn in the fourth quarter. These early bookings will burn over a longer period and include orders that will be produced in 2024. The new bookings in our modular oxide construction operations reflected a decision by a key customer to reserve plant capacity further in advance, facilitating our ability to invest to increase our capacity. As mentioned, we are doubling our capacity, further accelerating the rapid growth in modular construction that we achieved over the last few years. We believe that we have unmatched capability in complex mechanical electrical modular, including scores of professionals with unique design and engineering capability, and we are investing heavily to maintain and increase that advantage. Industrial customers were 48% of total revenue in 2022. This sector, which includes technology, life sciences, and food processing, will remain strong for us as industrial is heavily represented in new backlog. Institutional markets, which include education, healthcare, and government, are also strong and represented 31% of our revenue. The commercial sector is remaining active, but with our changing mix, it is now a smaller part of our business at about 21% of revenue. A significant portion of our service revenue is performed for commercial customers, so the proportion of our overall construction revenue that is commercial is low by historical standards. Construction was 78% of our full year 2022 revenue, with 49% from construction projects for new buildings and 29% from construction projects in existing buildings. Service was strong this year with 2022 service revenue of over $900 million. Service was 22% of our total revenues, with service projects providing 9% of revenue and pure service, including hourly work, providing 13% of revenue. 2022 service revenue is up by 33%. With our continuing strong margins, service is a great source of profit and cash flow for us. In all our activities, including both service and construction, we are encouraging and supporting our customers as they seek to improve the efficiency and sustainability of their buildings and operations, and we are raising our standards in the areas of sustainability, diversity, and governance. Ongoing demand is holding up, and our record backlog combined with strength in the industrial and institutional sectors leads us to expect continued growth and strong ongoing profitability in 2023. As we look ahead, our priority remains to preserve and grow the best workforce in our industry, so we can continue our legacy of safely constructing, installing, maintaining, repairing, and replacing our nation's buildings while helping our communities achieve sustainable growth. We are investing to meet the needs of our customers, and we are grateful for their trust. We will continue to invest in our workforce, technology, and execution capabilities. Our skilled workforce is the heart and soul of Comfort Systems USA, and we will continue to develop and reward our unmatched team members as they strive each day to work safely, improve their communities, and serve our many markets. I want to end by thanking our over 14,000 employees for their hard work and dedication. I will now turn it back over to Justin for questions. Thank you.

Operator, Operator

Please proceed with your questions.

Julio Romero, Analyst

I guess to start on the modular side. You guys mentioned new construction is expected to grow as a proportion of revenue, and I believe you include modular in that. Just if you could talk about what percentage of sales modular makes up today? And what does that look like in 5 years' time?

Brian Lane, President and CEO

Go ahead, Bill.

Bill George, Chief Financial Officer

Modular currently accounts for 10% of our revenue, a figure that has remained consistent for the past couple of years. It's worth noting that we made several acquisitions in 2021 and 2022, with five of those occurring in 2021, none of which included modular. For modular to maintain its 10% share, it needed to grow rapidly, and it has done so until now. With the new backlog, we anticipate that modular will continue to grow and likely increase as a portion of our revenue. We expect this growth to happen gradually as our new capacity becomes operational, which will involve constructing 1 million square feet and bringing it online over several quarters. As this new capacity comes into play, we foresee modular reaching approximately 15% of our revenue while the rest of the company also expands.

Julio Romero, Analyst

I guess on the backlog, how much of the backlog boost that you saw in the quarter do you attribute to the modular portion?

Bill George, Chief Financial Officer

Well, so in the fourth quarter, virtually all of the huge sequential jump was modular. There was specific bookings that we received in December from a customer who made the decision to commit to us and give us commitments in advance to support our ability to make some investments that we needed to make if we were going to meet the capacity needs that they had. Having said that, we had very, very heavy backlog burn in the fourth quarter. With the huge increase in backlog in the first 9 months of this year in our other space, it's impressive that the rest of our business kept.

Brian Lane, President and CEO

Yes, yes. We're very fortunate the fourth quarter continues, and opportunities are still very robust. So we'll look into that for pretty consistent bookings this year.

Julio Romero, Analyst

I guess just last one for me would be just that $4 billion in backlog. Just how far out are you guys booked? And are you coming close to maybe slowing? Or are you coming close to not taking orders for '24 at this point, I guess?

Brian Lane, President and CEO

No. I think for 2023, we're in pretty good shape. There will always be some small work to come in, good customers, etc. But we're off to a really good start for 2024. We definitely have a lot of capacity to take in 2024. That would start in the book today.

Operator, Operator

And our next question comes from Brent Thielman from D.A. Davidson. Your line is now open.

Brent Thielman, Analyst

Brian, when you look at sort of 23% same-store growth this quarter, margins expanding, it seems like your group is just doing a terrific job in terms of productivity in the field, sort of a 2-part question. What are the things you and your teams are doing so well, I guess, to manage this extraordinary growth with what looks like no apparent stumbles? And then maybe how that informs you and gives you the confidence around taking on an even larger backlog here?

Brian Lane, President and CEO

Yes. Brent, thanks for the question. I really appreciate it. To get these results, obviously, we are getting exceptional performance from the field. If you look over the last 10 years at the gross profit level, we've been performing at a really consistent level, which makes you very proud. It's a combination of many factors, including the companies that we've brought in and the leadership we provide. We offer a lot of training, utilize prefabrication and BIM modeling throughout the organization. We're achieving a lot of collaboration among companies, which I think is outstanding. It used to be one or two instances 10 years ago, and now it seems like everybody is working together. It's fantastic. The modular, as we've talked about, speaks for itself. But we want to ensure everyone performs that safely and productively while delivering a quality product for our customers, which our folks are accomplishing. We're fortunate to have the workforce and leadership we possess.

Julio Romero, Analyst

I know you can't talk specifics about the key customer, but I'm more interested just in the insights regarding their commitment to this capacity. Is it simply just a sign of capacity absorption out there? Are your competitors committed further out? Any signs from some of your other customers looking to secure your services further and further out, or is this kind of a unique situation?

Bill George, Chief Financial Officer

I'm going to start with the first part of that. I think this is really a testament to that particular customer's deep understanding of the current market dynamics in the United States, right? With reshoring, new commitments to ship manufacture, the need for batteries in virtually every vehicle, and the data center buildup continuing with AI becoming denser and requiring more sophisticated mechanical and electrical setups. Additionally, there are plenty of drivers like food processing, especially in pet food, and pharmaceuticals. The reshoring trend is still in its infancy. There is a high demand currently. This customer recognized that not everyone who wants to build in the next few years will have their expected building projects realized. Therefore, they are making sure they secure their needs for a successful business. I believe that realization will soon become apparent to more companies.

Brian Lane, President and CEO

I think you addressed what he asked me to. Brent, did that answer your total question?

Julio Romero, Analyst

Yes. Yes. I suppose an annoying question around the growth outlook here. I mean, you've got 75% backlog growth coming into the new year. Totally recognize some of that spaced out. I guess what would you need to see to sustain this low to mid-teens same-store growth outlook? Are you concerned? Do we need to work through the year and see how your book and burn business is coming in? Just kind of wondering what the outlooks are there.

Brian Lane, President and CEO

Yes. I think that's a really good question. It's one we spend a lot of time on throughout the organization. You're spot on. The actual number is nice, but it's mainly about when it happens, the labor availability and the spacing of it at various times of the year, and who has resources. Currently, we're very comfortable with the labor plans we have and the resources available to us. However, that's a daily situation you monitor, Brent. But we're in good shape with the workload, allocation of work, and skill sets we have.

Operator, Operator

And our next question comes from Adam Thalhimer from Thompson Davis. Your line is now open.

Adam Thalhimer, Analyst

Great quarter. I guess as I'm trying to figure out the long-term modular opportunity, what would prevent you from going from 2 million square feet to 4 million square feet down the road if you needed to?

Bill George, Chief Financial Officer

So there's no law against it. The question is, could we manage that kind of growth? I think the answer is that's one of the great things about being Comfort Systems, right? We have 90% of our business focused on this fantastic, seasoned, and incredibly valuable production capability that gives us great cash flow and insights, as well as the engineering we need to take advantage of what we believe is a very important long-term trend in this industry. We think off-site or modular construction, currently only a tiny part of 1% of how buildings are constructed in the U.S., is bound to grow. The complex part of modular is where we see the most significant opportunity. There were big investments by companies like SoftBank to solve modular challenges, yet many have focused on less sophisticated builds. However, we believe that the important areas for technology and improvement are in the complex part of modular construction. These modular electrical mechanical plants are ideal for it. We've believed this for years and have consistently invested and grown in this area. The acquisition we did at PAS was due to our admiration for what they have accomplished, and we felt we could enhance their capabilities. This is a critical feature of our strategy moving forward.

Adam Thalhimer, Analyst

Switching gears. I mean, you're going to have a lot of revenue this year. Just curious about what you're seeing in the bidding environment and if you think you can continue to grow backlog.

Brian Lane, President and CEO

Bidding opportunities and general opportunities are very strong. There's no real letup at all. So I believe you'll see us at least hold water, maybe grow a little bit as we progress through the year. There's a lot of work available with various government-funded programs, etc. We just need to build a lot of industrial capability, which is really our expertise. What excites me is that much of this work is coming from good customers and in areas where we excel, which is a huge advantage in a busy market. Additionally, our service business has tripled over the last 10 years. We're close to $1 billion in service revenue, which has provided us fantastic margins and cash flow as we discussed earlier. So while we're discussing construction, our service business is a solid foundation for us as well. In terms of the construction bidding market, it's very favorable.

Adam Thalhimer, Analyst

Last one for me. Just a couple of numbers. Bill, can you just make it easy on us for the interest expense? Like what is it like $5 million to $4.5 million and $4 million and then in the back half?

Bill George, Chief Financial Officer

If you take the second half of this year and annualize that, that's about what our interest expense will be. I have no reason to think it's going to change much. There is one wildcard, though; it's how fast we pay down debt. So that could lead to some upside. But that's what I would estimate.

Adam Thalhimer, Analyst

And then, did you give gross margin guidance, or did I just miss that or expectations?

Bill George, Chief Financial Officer

Yes. What we said was that we expect the full-year gross profit margins for Comfort will be very similar to the full year 2022. So at or near, I think, is what we stated. There are factors that will push against margins just like this year. The increase in new construction means we'll be early in a lot of work, and we should be receiving closeouts from the significant surge of work we started a year ago. We've got an even larger surge with this backlog. So we'll be starting many new projects. Moreover, material costs remain high as a percentage of total costs; we don't earn as much margin on materials as we do on labor, and labor is a more predictable area for us. That's why we're confident that we will have a good year and achieve solid profits despite the unpredictability of revenue changes. Our best estimate of revenue is low to mid-teens as we ramp into this new work and capacity, but we can’t predict it with certainty.

Operator, Operator

And our next question comes from Alex Dwyer from KeyBanc Capital Markets. Your line is now open.

Alex Dwyer, Analyst

Congrats on the quarter. So to stay on the margins, can we talk about gross margins by segment in 2023 and 2024? I mean, obviously, electrical had quite a run here.

Bill George, Chief Financial Officer

So electrical has now achieved the same margins as mechanical in the project world. Currently, if you take mechanical, keep in mind, has more smaller projects with higher margins but more SG&A. Our average project size is larger than electrical. However, if you look at like-for-like, fully blended across our nearly $1 billion of electrical and $3 billion of mechanical, we're seeing the same margins. We believe that this is sustainable on average. Any given quarter, there can be some variation, but we think it is sustainable in both mechanical and electrical.

Brian Lane, President and CEO

Also on the electrical front, which service essentially went to zero during COVID. In 2022, we did experience a significant pickup in service. This should reinforce our belief that margins will likely remain close to each other.

Alex Dwyer, Analyst

Can you talk a little bit about the Eldeco acquisition you guys announced last night? What drew you to this one? And more broadly on the M&A pipeline, what are you seeing in the market? Should we expect more M&A in the near term in 2023?

Bill George, Chief Financial Officer

I'd like to answer that, if you don't mind. We started discussing this acquisition with Allen, the gentleman who sold us that company. He and his team are perfect fits for Comfort. They focus nearly 100% on industrial work and are situated in many of our strong geographies. They have established respect and relationships for organizations we already work with. Their capabilities are excellent, and the company has a long history. Everything we value aligns perfectly with this transaction. I'm very optimistic about it.

Brian Lane, President and CEO

It's truly a pleasure working with them, and I anticipate they will enjoy being part of Comfort Systems as well. Regarding the M&A pipeline, we're mindful of our significant backlog that requires our attention. Many of our past acquisitions have integrated into existing operations, requiring collaboration. We will remain cautious about pursuing new acquisitions, favoring opportunities that align with our strengths. If the right people and opportunities present themselves, we're open to them. But for now, we plan to take a measured approach as we focus on absorbing our previous five significant deals from 2021.

Operator, Operator

And we have a follow-up question from Brent Thielman from D.A. Davidson. Your line is now open.

Julio Romero, Analyst

Maybe just one more on the acquisition. Brian, Bill, I seem to remember a year ago or less than a year ago, maybe you wanted to take your foot off the accelerator just from the standpoint of monitoring what's going on in this economy. To see a deal seems encouraging in terms of your outlook moving forward. Is the idea that you'll take this in a measured pace just because the business is growing so fast? Or do you feel more confident in your end markets sitting here 9 to 12 months later?

Bill George, Chief Financial Officer

For a company based in South Carolina, which has favorable geography for reshoring, the ability to execute this acquisition was straightforward given their capabilities align with the work needed across reshoring verticals. If we were looking at a firm in a remote area that handles various projects, while it's a nice business, we would be more cautious. We believe there's a particularly advantageous moment for industrial capability right now.

Julio Romero, Analyst

And then I guess with all the different factors that can influence the margin, would deflation be a bit of a tailwind here this year? Or has it not been enough to matter?

Bill George, Chief Financial Officer

If deflation materializes, which has not yet happened, it would likely be selective deflation on items where we temporarily secured a premium due to shortages. A quarter reflecting this could slightly benefit our earnings, but it wouldn’t result in a permanent change in our profitability. Our customers have supported us remarkably during these unexpected cost increases. We'll be cautious about taking advantage of potentially lower costs. At Comfort, we play a long game across 40 businesses, ensuring close relationships with the same clients over decades. We don't aim to extract every cent at every opportunity. This philosophy has served us well.

Operator, Operator

I am showing no further questions. I would now like to turn the call back over to Brian Lane for closing remarks.

Brian Lane, President and CEO

Okay, Justin. In closing, I really want to thank everyone for joining the call and for your interest in Comfort Systems. Once again, I want to thank our diligent employees. We are very proud of 2022 and very excited about 2023, and we are ready to get started. So be safe, and we'll see you all soon. Take care. Thank you.

Bill George, Chief Financial Officer

Thanks, everyone.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.