Earnings Call Transcript - FIX Q1 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Q1 2023 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, Rica. Good morning. Welcome to Comfort Systems USA's first quarter 2023 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 and Form 10-Q, 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 have had a great beginning to 2023 with increased revenue and pre-tax earnings, unusually strong cash flow, and another increase in backlog. Our teams delivered amazing execution, and we are very grateful for their hard work. Excluding the private tax gain that Bill will discuss in a few minutes, we earned $1.51 per share, and that included $0.15 related to the favorable resolution of certain claims related disputes. Current year revenue was $1.2 billion and unprecedented same-store revenue growth of 30%. Our backlog is now over $4.4 billion, which is a same-store increase of $1.6 billion or 58% from a year ago. Our backlog growth is tangible evidence of the ongoing demand in traditional and modular construction. Cash flow this quarter was exceptional. This morning, we also increased our dividend by $0.025 per share to $0.20 per share. This increase reflects our continuing strong cash flow and our commitment 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

Thank you, Brian. Revenue for the first quarter of 2023 was $1.2 billion, representing an increase of $289 million or 33% compared to last year. Our mechanical services segment saw revenue growth of $236 million or 35%, while our electrical services segment grew by 26% to $200 million. The overall revenue increase of $265 million was complemented by an additional $24 million from acquisitions. This growth stemmed from heightened activity levels along with the pass-through effects of inflation, such as rising costs for equipment and materials. The same-store revenue percentage increase is influenced by the lower revenue figures from the first quarter of the previous year. We anticipate more significant revenue comparables in the upcoming quarters, making it unlikely that we will sustain our current growth levels. Revenue trends involve various factors, and we now project a full-year same-store revenue growth percentage for 2023 to settle in the mid-teens. Our gross profit for the first quarter was $205 million, a $52 million improvement from a year ago, with a gross profit percentage of 17.5% compared to 17.3% for the same quarter in 2022, benefiting from strong claims successes as mentioned by Brian. The gross profit percentage in our mechanical segment dipped from 18.6% in 2022 to 17.9% in 2023, largely due to the rising contribution of modular construction, which typically has lower margins. Conversely, margins in the electrical segment improved to 16.1% this year from 13.0% in 2022. It remains challenging to forecast margin developments for the rest of 2023. Key factors that will affect our margins include the growth in materials-intensive modular and new construction, ongoing cost inflation, and the early stages of numerous projects resulting from increased bookings. Modular construction is becoming a larger share of our revenue, and we are carefully managing the ramp-up of our new modular capacity. Despite structural trends that may pressure margins, we anticipate continued profitability, and we are hopeful that our 2023 margins will be close to the strong levels seen in 2022, backed by higher revenues. SG&A expenses for the quarter totaled $135 million or 11.5% of revenue, compared to $118 million or 13.3% of revenue in the first quarter of 2022. On a same-store basis, SG&A was around $1.4 million due to inflation and ongoing investments to support higher activity levels. Our operating income nearly doubled, rising by 99% in the first quarter of 2023 to $71 million compared to the same quarter last year. We expect interest expenses in 2023 to rise compared to 2022. However, this quarter, a temporary offset occurred due to increased interest income resulting from a favorable legal resolution. Our tax rate for the quarter was 13.1%, which included a $5 million or $0.12 incremental benefit from a conforming adjustment for the R&D tax credit, with $0.08 attributable to 2022. Should Congress approve immediate deductibility for research expenditures and revoke this conforming adjustment, we would need to negate the $0.12 income statement gain during that period. Although multiple items have influenced our tax rate recently, we continue to estimate a normalized tax rate of around 21% to 23%. Considering all factors, net income for the first quarter of 2023 was $57 million or $1.59 per share. It is crucial to remember that in the first quarter of last year, we recorded a substantial incremental $1.49 per share tax gain related to prior years. Without those gains, our first-quarter 2023 earnings per share stood at $1.51 compared to $0.91 the previous year, marking a 66% increase, with about a fourth of this growth stemming from favorable claim outcomes. Another perspective to evaluate the year-over-year profitability without tax complexity is through our EBITDA, which rose by 49% from last year to $90 million. Free cash flow for the first quarter of 2023 was $111 million, primarily driven by advanced billings and deferred revenue, benefiting from favorable upfront payment terms upon receiving large orders. The advantages from these advanced payments will be reversed as project costs materialize, except to the extent that new advanced payments are made. Therefore, we are facing a significant cash flow challenge in the upcoming quarters due to Congress's ongoing inability to extend the current deductibility for research expenditures. If current expensing is not reinstated, we will incur additional tax payments of approximately $120 million to $140 million in the last nine months of 2023, as the deductibility of a substantial portion of our business costs will be spread over the next five years. Furthermore, capital expenditures will be above usual this year as we expand our modular capacity by over 1 million square feet and purchase vehicles at a higher rate due to prior deferrals and limited availability during COVID. This quarter, our capital expenditures reached $17 million, an 80% increase from the previous year. In total, we estimate our CapEx spending for 2023 to be around $60 million to $70 million. At the end of the quarter, our debt was reduced as our substantial free cash flow enabled us to cut debt by $47 million and fund the purchase of Eldeco with cash received during the quarter. We also continued to repurchase our shares, acquiring 29,000 shares at an average price of $121.36 in the first quarter, adding to over 10 million shares bought back since 2007 at an average price of $24.80. Additionally, as Brian noted, we implemented another significant dividend increase this quarter. That sums up my financial overview, Brian.

Brian Lane, President and CEO

Okay. Thank you, Bill. I'm going to spend a few minutes discussing our backlog and markets. And I will also comment on our outlook for the rest of 2023. Our backlog at the end of the first quarter was a record $4.4 billion. Since last year this time, our same-store backlog has increased by $1.6 billion or 58% with increases in our traditional mechanical and electrical business and substantial new bookings in our off-site construction operations, where we are continuing to invest in new capacity. During the first three months of 2023, our same-store backlog increased $300 million despite heavy backlog burn in the first quarter. With a number of advanced bookings, our backlog will burn over a longer period and include audits that will be produced in 2024. Industrial customers were 51% of total revenue in the first quarter. This is the first time that industrial customers were the source of more than 50% of Comfort volume. This sector, which includes technology, life sciences, and food processing, remains strong for us as industrial is a major driver of new backlog. Starting this year, we are breaking out technology in our industrial revenue, and technology with 19% of our revenue in the first quarter is a substantial increase from 11% in the prior year. Institutional markets, which include education, healthcare, and government are also strong and represent 28% of our revenue. The commercial sector is active, but without changing mix, it is now a small part of our business at about 21% of revenue, much of that concentrated in our service revenue. Construction accounted for 80% of our revenue this quarter, with construction projects for new buildings at 54%, while construction projects in existing buildings accounted for 26%. Service grew rapidly this quarter as revenue increased by 21% compared to last year, and virtually all of this increase was same-store. Service was 20% of our total revenues, with service projects providing 9% of revenue and pure service including hourly work, providing 11% of revenue. We just published our annual sustainability report, and in addition to the actions that we are taking in our business, we continue to encourage and support our customers as they focus on the efficiency and sustainability of their buildings and operations. Before I close, I want to briefly point out a few things about certain trends in our business. As noted earlier, construction this quarter is now 80% of our revenue, which means that over the last several years service has declined on a percentage basis as a proportion of our overall business. This is not because service is underperforming. On the contrary, service was up over 20% just this quarter. In fact, our overall service business today is twice as large as it was in 2016. Construction has just increased even more. Also, when looking at the increasing share of our business represented by industrial and technology, you might ask yourself if other sectors are declining. In fact, when you look at absolute volumes as opposed to percentages, this quarter, every one of our sectors actually increased. Comfort Systems is thriving in nearly every possible way, and that is because of our teams across the country continuing their superb execution. Thanks to that excellence, and the strong ongoing demand that we are experiencing, we remain optimistic about our prospects for continued growth and strong profitability in 2023. Our number one priority remains to preserve and grow the best workforce in our industry, so we can continue our legacy of investing to meet the needs of our customers and our communities. We are grateful for their and your trust. I want to end by thanking our over 14,000 employees for their hard work and dedication. I'll turn it back over to Rica for questions. Thank you.

Operator, Operator

Thank you. At this time, we will conduct the question and answer session. Our first question comes from the line of Julio Romero of Sidoti & Company. Your line is now open.

Julio Romero, Analyst

Thanks. Hey, good morning. Maybe starting on the backlog, if you could speak to the organic sales growth you saw on the backlog quarter-over-quarter. And what type of customers or activity type were the drivers? Was it all just modular? Or were there other drivers there?

Brian Lane, President and CEO

Yes. I'll go first. And then Bill can follow up. But anyway, good morning, Julio. It's a broad-based increase in backlog, quite frankly, coast-to-coast. Obviously, we had strong performance out of technology. But we're getting it in multiple sectors. It's not just one area or one part of the country. So it's still very active out there. And we don't see it stopping in the short term for sure.

Bill George, Chief Financial Officer

Yes, Julio, we got a nice order from a new customer in modular this quarter. But the majority of our backlog increase within the sequential backlog increase was broad-based. And it really is where you'd want it to be in a lot of our most successful companies.

Julio Romero, Analyst

Got it that's helpful. And then maybe turning to the cash flow, second straight quarter of very strong cash flow, but you talk about the uncertainty you have there for the next nine months or so. How are you managing through that uncertainty? And does that affect anything regarding to CapEx, your M&A pipeline or cash usage?

Bill George, Chief Financial Officer

That's one of the great things about having a fantastically strong balance sheet. We realized $111 million of cash this quarter. So, it's very unfortunate that the federal government needs to borrow some money from us over the course of the rest of the year. But it's not a problem. It won't really impact anything else that we need to do.

Julio Romero, Analyst

Got it. That makes sense. And then conversely, I guess, could that change in deductibility of the R&D expenditures create some M&A opportunities from smaller companies who may not be as able to handle that change to their balance sheets?

Bill George, Chief Financial Officer

Maybe when some of them realize it. I think it's going to be devastating for certain companies on the West Coast, where research is really what they do as a company. I don't know how they'll be able to cope with this. But in our industry, I don't think it will have that big of an effect on the smaller companies. Most of them are unaware of it. And we might clear up by the time they figure it out. But it's black letter law. If you're a big company like ours, you have to just follow the law.

Julio Romero, Analyst

Got it. I'll pass it on. Thanks so much.

Brian Lane, President and CEO

Thanks, Julio.

Operator, Operator

Thank you very much. Please standby for our next caller. Our next question comes from the line of Sean Eastman at KeyBanc Capital Markets. Your line is now open.

Sean Eastman, Analyst

Hi team. Great start to the year. Thanks for taking my questions.

Brian Lane, President and CEO

Thanks, Sean.

Sean Eastman, Analyst

So, I mean, clearly a message that the demand environment remains strong and the strength is broad-based. And we're still seeing it in the bookings. But we also have this kind of unique dynamic where customers have changed their behavior. They are kind of booking you guys up early. There is more duration in the backlog. So, how would you kind of set expectations around the trajectory of the backlog around those two dynamics?

Bill George, Chief Financial Officer

I was surprised to see our backlog increase further this quarter. Many of our projects are now scheduled into 2025 in several locations. This might indicate a new trend in our industry due to the significant scarcity of productive capacity. However, I believe that for healthy reasons, our backlog will likely decrease at some point later this year. Two factors will trigger this decline: reduced advanced commitments and a return of customer commitments to a normal level. Additionally, I expect to see the backlog shrink as inflation slows and lead times shorten. That said, the underlying demand remains very strong and genuine.

Brian Lane, President and CEO

Sean, if you look at the bigger picture as well, backlog and demand are strong, and we're just seeing the beginning of all the money the government passed in terms of these various acts sort of coming out of engineering and state going. So, we're in the early days of that as well. So I think the demand environment is going to be strong for a while.

Bill George, Chief Financial Officer

For years, I've said that if you are following our stock, it's very important to listen to what we say about backlog, right, because we're very transparent about sort of factors that are outside of demand that are affecting our backlog and will be that for the rest of this year. We'll be very clear about if we see backlog start to come down, I think we'll be very clear about whether that's demand-based or whether that's just a normalization. But as of right now, there is no sign of demand weakness.

Sean Eastman, Analyst

Yes, that's helpful. For clarity, Bill, you mentioned that modular margins are dilutive at the gross margin level. However, I assume when you consider operating margin, they are actually accretive, correct?

Bill George, Chief Financial Officer

Well, so they're absolutely accretive to cash flow and earnings, so we wouldn't be doing it. We don't take risks if we can help it, and we'd rather be smaller than take work for which we're not paid for the risk, because there's a lot of risk in what we do. There's probably lower overhead in that business. But yes, and keep in mind that that business can be done with less skilled labor. So, one of the reasons that it's dilutive at the gross margin level is because if you need a lot of licensed electricians on something, you're going to pay a higher margin for that than if you need skilled plant workers, even though they are really at a premium. They're not nearly as high a premium as a pipe fitter that's licensed in a state and is the only person who can touch certified.

Sean Eastman, Analyst

So you're suggesting a lower operating margin with a higher return?

Bill George, Chief Financial Officer

No, not at all. I would say there is greater scalability and an enhanced capacity to expand. You can hire someone to work in a plant, and they can start generating revenue within a week after a couple of days of safety training. They will begin with one task and then learn the remaining tasks. When you hire a construction worker, it may take years for them to become profitable as you train them, but once they are up to speed, they become incredibly valuable. It's simply a different scenario. We are prepared to meet the demand for our rarest resources, and we charge more for those compared to less scarce resources.

Sean Eastman, Analyst

Yes, that's helpful. And how is the service business continuing to grow so fast? We kind of get into the drivers in a lot of detail on the new construction side, but maybe a refresh on the revenue build there would be interesting?

Brian Lane, President and CEO

Yes. Thanks, Sean for pointing it out. We've been talking about 10 years ago that we made an organizational-wide commitment to grow our service business, and all aspects have made significant commitments to training, sales side, leadership side, and the tech side. We've been able to use a number of innovative tools that Trent McKenna heads up for us that we're bringing over into the service tech. So, we are still very active in hiring salespeople, hiring technicians, expanding our base, both from some of the companies we bought, but most of it same-store. So that commitment is still 100%. And we will still fully embrace growth because the profitability has been terrific for us in the service business. I expect that to continue for many, many more years.

Sean Eastman, Analyst

And so, is that a market share story, just to be clear, is that a market share story there? Or is it there's some kind of juicy market growth story happening under the hood there?

Brian Lane, President and CEO

Yes. I think some of its market share; I just think there's a lot more opportunity. We have a lot of very skilled technicians. You might look at energy efficiency in a building or just upgrading the system. I think it's a combination of both. I think we're able to expand our services, higher capability of check now we have within the organization. All our companies are doing service. So, one thing is probably 10 things.

Sean Eastman, Analyst

Great. I'll turn it over there. Thanks for the insights, guys.

Brian Lane, President and CEO

Yes. Thanks, Sean.

Operator, Operator

Thank you. Please standby for our next question. Our next question comes from the line of Adam Thalhimer with Thompson Davis. Your line is now open.

Adam Thalhimer, Analyst

Hey, good morning, guys. Great quarter.

Bill George, Chief Financial Officer

Thanks, Adam.

Adam Thalhimer, Analyst

Hey, on the tax. So if Congress doesn't fix that, Bill, one question I've had is if there's a free cash flow impact next year?

Bill George, Chief Financial Officer

Interestingly, they are stating that the expense for your business must be deducted over five years. Consequently, next year, the headwind will be reduced because we will be in the second year, allowing 60% of it to be deferred instead of 80% this year. The following year, the headwind will lessen further, and by the fifth year, it should normalize. This would create a headwind for five years for anyone who takes the credit, irrespective of any owed amount. Additionally, the definition of expenses is much wider than what is typically found in the R&D tax credit. This is a five-year consideration, and I believe it will place many research-oriented businesses in a challenging position if it isn't addressed soon. They need to at least moderate the situation, but we will wait and see.

Adam Thalhimer, Analyst

Okay, helpful. And then, on modular, how are the capacity additions coming? Are you still thinking that comes online this summer? And then what would you do if you had another order similar to the one that you had in December?

Bill George, Chief Financial Officer

We have the ability to decide whether we can take on new orders. It's important to remember that the deal made in December was long-term. They also made additional commitments over a longer timeframe that allow us to invest without increasing our prices. With these new additions, we can handle more work, and some of the new space is taller, enabling us to operate on two levels. If we get another opportunity to expand further, we will evaluate the risks and rewards and make a decision then. For now, we are focused on the tasks at hand.

Brian Lane, President and CEO

We are on schedule in terms of getting him up and running.

Adam Thalhimer, Analyst

Okay. And then just lastly, maybe you can opine on the M&A outlook?

Bill George, Chief Financial Officer

We made some progress in mergers and acquisitions in 2021, particularly due to concerns about increasing capital gains. We're approaching our acquisitions with a patient mindset, only pursuing companies where we have strong conviction or where we've had long discussions. This approach will continue into this year. I was surprised we completed the Eldeco deal this year, but it's a company we've been in talks with since 2016, and we had great respect for them. When they decided to sell, we were ready to buy. As we approach the midpoint of the year, I’m uncertain if there will be one or zero additional deals this year. Currently, we are observing changes in the market; the cost of capital is shifting, and our competitors are facing very different circumstances than before. We've always prioritized patience in these matters, and we maintain a patient and high conviction approach. However, we are consistently working on development. In fact, I will likely conduct more development visits this year than I have in the past three years, considering the impact of COVID. We are committed to ensuring that we are actively engaged in development for the future.

Adam Thalhimer, Analyst

Got it. Thanks, guys.

Operator, Operator

Thank you. Please stand by for our next question. Our next question comes from the line of Brent Thielman of D.A. Davidson. Your line is now open.

Brent Thielman, Analyst

Hey, thanks. Good morning.

Bill George, Chief Financial Officer

Hey, good morning, Brent.

Brent Thielman, Analyst

Hey, Brian. Hey, Bill, just on that R&D tax issue, you made a comment could put a lot of people out of business. Are you referring to folks within your own industry?

Bill George, Chief Financial Officer

No, I'm really referring to technological companies, pharmaceutical companies, like startup pharmaceuticals, or they'll have to go sell very quickly to somebody. I mean, what you do as a primary part of your business is research, and you are only allowed to treat 20% of every dollar you spend on research as an expense for that year; you can take a company that's losing money in the real world and tax it as if it's got 70% margins. Many of those companies do not have the balance sheets to stand up to that. So, I think that's the kind of thing I'm talking about.

Brent Thielman, Analyst

Okay. And in the context of your own sort of capital deployment, I guess strategy over the next coming quarters is that top of mind for you before you decide to look at buybacks and deals and things like that?

Bill George, Chief Financial Officer

If we're being honest, our cash flow has trended better than we would have expected a year ago or two years ago by more than this headwind. So it doesn't feel like a terrible constraint. It feels like, I think we have cash that our guys are really executing; people value plumbers and pipe fitters. So, I don't see how this is a big issue other than we'll pay interest. We have less cash flow, we'll either earn less interest or pay less interest, depending on whether we're cash positive or in debt a little bit.

Brent Thielman, Analyst

Right. Okay. Okay. And then, the hyperscale data center activities have been a huge driver of modular business, I guess, for the company overall. It still kind of have some varying views out there about future prospects. Could you talk about the levels of inquiries, maybe reviews that you guys are seeing? And how does that market compare to the last couple of years? What's been pretty robust activity you've already seen?

Brian Lane, President and CEO

I'll go first. Yes, the activity is still very strong, both in modular and traditional construction. Quite frankly, we're not concerned about the datacenter market. We've got plenty of work.

Bill George, Chief Financial Officer

I would say some of the hyperscale guys, their level of inquiry is as high or higher than it's ever been. They are putting cost into the conversation earlier and more prominently than they have in the past. The thing about us is that when we do this kind of work for people, we partner with them. We work hard with them to get them a really good value. And they typically understand that we take a ton of risk and have to make investments to really give them the quality they expect. So I'm optimistic that the demand is high, and I'm optimistic that actually we're the best way to meet that demand right now for them.

Brent Thielman, Analyst

And then, on the modular side, at least, I think it's been mostly focused in that specific market with one sort of single large customer, correct me if I'm wrong. Is that expanding to new potential customers now in that market?

Bill George, Chief Financial Officer

So, it would be premature to say it's expanding. Well, so first of all, that one big order was from one customer. They were keen to make sure they got some things they needed, frankly, for their business, as far as we can tell. We did get a trial order from somebody else like them. And we'll see how that goes. But there is definitely interest. Really, the reality is that these guys who need to build hyperscale data centers, they're like us; we need to hire people. When people say, oh, what are you doing to hire people? We say everything that can be done is what we're doing to hire people. I think these hyperscale data center guys, when you ask them, what are they doing to build hyperscale data centers, I think every path towards getting these things into high-quality production is what they're taking. And so, the overwhelming majority of the data centers are not built modularly where the math couldn't possibly support that. But we think there's a nice opportunity here for us to grow and provide for our customers a really good, more scalable than most path to getting what they need.

Brent Thielman, Analyst

Got it. And I guess just lastly, I think you've said the past few quarters sort of ambitions and getting the electrical margins to match the mechanical margins over time presumably with the work you're seeing inbound. I guess any views on that turns into bid margins things attached with a new project that gives us more confidence around that?

Brian Lane, President and CEO

Yes. Brent, for sure, we've had a steady state increase in the margins in the electrical business over the last few years. I think that's going to continue. There is plenty of electrical work out there that we're good at, that we like to do. And the work coming forward is sufficiently challenging for us that we can raise our prices a little bit. So I'm really optimistic that we will see continued margin strength in the electrical business.

Brent Thielman, Analyst

Okay, all right. Thanks, guys. Congrats on a great quarter.

Brian Lane, President and CEO

Okay. Thank you, everyone, for your continued interest in Comfort Systems. And once again, thank you to all our diligent employees for just doing an outstanding job. I mean, these results just show what happens when commitment is being made. We are looking forward to the summer and we are very optimistic for the remainder of 2023. Hope everyone has a great day and we hope to see you on the road soon. Thank you.

Operator, Operator

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.