Earnings Call Transcript - FIX Q2 2022

Operator, Operator

Good morning, and welcome to the Comfort Systems USA Second Quarter 2022 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Julie Shaeff, Chief Accounting Officer. Please go ahead.

Julie Shaeff, Chief Accounting Officer

Thanks, Kate. Good morning. Welcome to Comfort Systems USA's Second Quarter 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 regulations. 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, and thank you for joining us on the call today. Before we start, I want to sincerely thank our employees across the country for working through so many tough challenges, including record heat and achieving amazing results for our customers. We had a strong second quarter. Thanks to careful planning and superb execution, our teams continue to perform for our customers and our stakeholders. We earned $1.17 per share this quarter compared to $0.90 a year ago. Unprecedented market conditions resulted in same-store revenue growth of approximately 25%, driven by increased activity in strong markets, combined with the effects of cost increases in materials, equipment, and other inputs. New work is commencing across our footprint, and our backlog and pipeline remain strong. Cash flow was also excellent this quarter, especially since we are investing capital to support our growth. During the quarter, we also amended our credit facility to increase it to $850 million and improve flexibility and cost. We want to thank our banks for recognizing the strength of our balance sheet and providing us with this additional financial flexibility. I will discuss our business and outlook shortly. But first, I will turn this call over to Bill to review our financial performance. Bill?

William George, Chief Financial Officer

Thanks, Brian. It was quite a quarter for us, especially in terms of revenue. Revenue for the second quarter of 2022 was $1.02 billion, an increase of $304 million or 43% compared to last year. This is the first time we've exceeded $1 billion in revenue for a quarter. Our recent acquisitions contributed a total of $128 million of new quarterly revenue, and we had same-store revenue growth of $176 million. Our sharp increase in revenue was broad-based, with a lot of new work starting, and we experienced inflation in equipment, materials, and other inputs. As Brian mentioned, our same-store revenue increased by 25% in the second quarter, while our same-store employee headcount increased 10% in the same period. During the second quarter last year, our revenues were negatively impacted by the air pocket from COVID. Overall, for the remainder of the year, we currently expect double-digit same-store revenue growth, probably in the range of 10% to 15%, although there are certainly more variables than usual. Gross profit was $175 million for the second quarter of 2022, a $49 million increase compared to a year ago. Same-store gross profit measured in dollars increased by 23%, very close to our same-store revenue increase. Our gross profit percentage was 17.2% this quarter compared to 17.7% for the second quarter of 2021. Our gross profit percentage in our Mechanical segment for the second quarter declined from 18.4% in 2021 to 17.8% in 2022, while the margins in the Electrical segment increased from 13.8% to 15.1% over the same period. The changes in gross profit percentage resulted from the evolution of our business mix as we're doing more new construction, as we're early in many of our jobs, and materials and equipment are a higher proportion of our cost of goods sold. SG&A expense for the quarter was $119 million or 11.7% of revenue compared to $88 million or 12.3% of revenue for the second quarter in 2021. Most of the dollar increases came from new companies, and on a same-store basis, SG&A was up moderately considering our growth by $13 million. Our operating income percentage increased slightly from 5.5% to 5.6%. Our tax rate for the second quarter was 21.1%, and we continue to benefit as expected from the R&D tax credit that we finalized last quarter. After considering the above factors, net income for the second quarter of 2022 was $42 million, or $1.17 per share. That compares to net income for the second quarter of 2021 of $33 million or $0.90 per share. EBITDA increased from $55 million in the second quarter last year to $77 million this quarter, a remarkable 41% year-over-year EBITDA increase. Free cash flow for the first six months of 2022 was $90 million, including the $33 million refund from the IRS for the R&D tax credit that we got in the first quarter. This is good cash flow as we invest in growth. Our debt at the end of June was $406 million. As Brian mentioned, we increased our credit facility to $850 million. The new facility includes improved credit costs, greater capacity, and even more favorable covenants. The amendment also adds flexibility with respect to acquisitions, dividends, and stock buybacks. We are actively repurchasing our shares; in the first six months of 2022, we have repurchased 388,000 shares for approximately $33 million. And since we began our repurchase program in 2007, we have bought back 10.1 million shares at an average price of $24.12.

Brian Lane, President and CEO

All right. Thanks, Bill. I'm going to spend a few minutes discussing our backlog and markets, and I will comment on our outlook for the rest of 2022 and on inflation and supply chain considerations. Our backlog at the end of June was $2.81 billion. Year-over-year, our same-store backlog is up by $702 million or just over 38%, with increases across most of our operations, with notable strength in Texas and North Carolina. Sequentially, our same-store backlog increased $52 million. Our industrial revenue was 46% of total revenue in the first half of 2022. This sector, which includes technology, life sciences, and food processing, remains strong and is heavily represented in new backlog and in our pipeline. Institutional markets, including education, health care, and government, are solid and represent 32% of our revenue, consistent with last year. Finally, the commercial sector is doing well, but without changing mix, it is now a smaller part of our business at about 22% of revenue. Year-to-date, construction was 78% of our revenue, with 48% from construction projects for new buildings and 30% from construction projects in existing buildings. Service is 22% of our year-to-date revenue, with service projects providing 9% of our revenue and pure service, including hourly work, providing 13% of revenue. Year-to-date service revenue is up approximately 33%, including a same-store service revenue increase of 15%. Overall, service continues to be a consistent and growing source of profit and cash flow at Comfort Systems. In all our activities, including both service and construction, we are uniquely positioned to encourage and support our customers as they seek to improve the efficiency and sustainability of their buildings and operations. And we are raising our own standards in the areas of sustainability, diversity, and governance. Inflation is widespread. And in the coming months, we expect continued challenges in the cost and availability of the inputs that we use to serve our customers. Although conditions are hard to project in the near term, we are recognizing these challenges in our job planning and pricing. And we are working to order materials earlier than usual and seeking to collaborate with customers to share supply risks and mitigate these challenges. We have a good pipeline of opportunities, and so far, we have been able to maintain activity levels and productivity despite supply chain challenges. We are watchful of world events and Fed tightening. However, giving ongoing demand, our record backlog, and our focus in the industrial and institutional sectors, we anticipate continued strong earnings and cash flow in the coming quarters. This month marks 25 years since Comfort Systems USA was formed. As we look ahead, our priority is to preserve and grow the best workforce in our industry, so we can continue our legacy of constructing, installing, maintaining, repairing, and replacing our nation's buildings and in helping our communities achieve sustainable growth. We are optimistic about 2022 and beyond. With the highest backlog in the history of Comfort Systems USA, we will continue to invest in our workforce, technology, execution capabilities, and in our service businesses. Our skilled workforce is the heart and soul of Comfort Systems USA. We are grateful for their dedication, and we are committed to developing and rewarding our unmatched team members as they serve their communities. I want to end by thanking our 14,000 employees for their hard work and dedication. I'll now turn it back over to Kate for questions. Thank you.

Operator, Operator

The first question is from Julio Romero of Sidoti.

Julio Romero, Analyst

So I wanted to start on the top line. You mentioned for the remainder of the year, you expect same-store sales growth in the range of 10% to 15% for the remainder of the year. How much of that do you think is going to be increased activity versus cost pass-throughs?

William George, Chief Financial Officer

That's a really good question. One of the reasons I mentioned our same-store headcount increase in my prepared script was to help people dimensionalize that. So in the second quarter, our revenue was up 25% same-store. Our same-store headcount was up about 10%. And we have a big group of temp workers at any given time, that was up by a little more than 10%. So my best estimate is that in the second quarter, we don't know what would have happened without all of the craziness with the supply chain. But my best estimate is that about half of our same-store growth of 25% was just us doing more work, irrespective of inflation, and the other half was driven by inflation. For the rest of the year, I don't have a better estimate than that. There are a lot of moving variables right now.

Julio Romero, Analyst

No, that's fair. You mentioned the variables as well. So how do you think we should consider the gross profit percentage for the second half of the year?

Brian Lane, President and CEO

Yes. So Julio, it's Brian. I'll give it for us and then Bill can follow on. So I mean if you look at where we are right today, we're really happy with our gross profit and the execution that we're getting on projects, for sure. The good news for that is we're relatively still early in a lot of our jobs. So that was not really driven by any closeouts of pickups in particular. It's just good fundamental blocking and tackling that's driving that. So I think as we go through the rest of the year, I think service will maintain strength, particularly with the heat we're seeing throughout the country. We're really busy in service. And I would anticipate that I don't know how many closeouts we get this year, but we will maintain our gross profit in the range we're currently in, I think through the end of the year. Bill, anything?

William George, Chief Financial Officer

Yes. We were at 17.2%. A year ago, we were at 17.7%. We believe the 17% to 18% range is appropriate. It's been challenging to make predictions, as it has never been harder. Usually, our second-half gross profits exceed those of the first half. However, we typically have a higher proportion of jobs nearing closeout. Many of the significant job closeouts that are crucial for us are being pushed into next year. Therefore, the best guidance we can offer is that same range, 17% to 18%, and based on these revenues, that results in a solid outcome.

Julio Romero, Analyst

Yes. No, that's helpful. And I guess just maybe last one for me is on the new revolver. Maybe any comments on how the increased debt facility changes anything with regards to capital structure, uses of cash, etc.?

William George, Chief Financial Officer

It's great to have a significantly improved revolver. The flexibility we've gained is remarkable, especially for potential large acquisitions or buybacks. We now have unprecedented flexibility in that area. The pricing has improved considerably, as the pricing grid has clearly decreased, which was already quite low. We've switched to a net leverage ratio instead of a total leverage ratio, which is much more favorable. Our covenants were already quite friendly, and we have moved to an interest coverage ratio rather than a fixed charge ratio, both of which offer us excellent opportunities. We're really in a strong position to meet our covenants given our business operations. We're quite excited and feel that our timing was excellent. Many of our bankers have mentioned that their clients are preparing for renewals, and we feel fortunate to have made our move at just the right moment.

Operator, Operator

Next question is from Brent Thielman of D.A. Davidson.

Brent Thielman, Analyst

I guess, Brian or Bill, the first question is just you touched on it a little bit, and it sounds like you're getting booked sort of further and further out, and I'm trying to conceptualize kind of the burn rate on this backlog right now. And the other element, I guess, that's in there is sort of the inflationary component to the dollars of backlog you report. I mean any help in terms of how you expect to kind of burn through this backlog with these large jobs you've got?

Brian Lane, President and CEO

I believe our burn rate will remain quite standard. Our average project size continues to be around $777,000, so we expect to consume a significant portion of it in the next 6 to 9 months, likely about two-thirds to 70%. However, we are successfully securing work into 2023 with several larger projects. Overall, the rate at which we are using our resources seems favorable, and the balance between labor and the scale of our operating companies is effective. Currently, we are pleased with the projected burn rate.

William George, Chief Financial Officer

Right. And our backlog is going to be very big at a moment when we're on average early in jobs because that means there's more work left to do than usual for the number of jobs we have. So we keep saying that our WIP schedules are gone. That's one of the reasons why we're pretty comfortable that we have the manpower to do this work. It's a pretty eye-popping increase in same-store backlog. But there are things that are making that accentuating that backlog currently. The other big thing that accentuated the size of the backlog since it's measured in dollars is the inflation. So when our guys in the field are looking at backlog, what they're looking at is their workers, their manpower, essentially, their timing, and I think they think they've got it exactly right, and we'll see. They've got a pretty good track record.

Brent Thielman, Analyst

To follow up on that, you're booking over $1 billion a quarter, and it sounds like your markets are still really strong. How do you see the backlog evolving as we move through the rest of the year?

Brian Lane, President and CEO

Well, I think if you look at how much we're burning right now, I think the backlog will probably stay pretty steady, knowing how many opportunities are out there. I don't think we'll see an increase in it. We're burning, as you can tell, at an extremely high rate. I booked the burns over one for the quarter, and I think we'll hold that, Brent, at least for the next couple of quarters.

William George, Chief Financial Officer

We don't know when it will happen, but I believe there will eventually be a point where material costs start to stabilize. This will affect the dollar value of our backlog. However, we believe that the demand for our labor will remain very strong. Since backlog is measured in dollars, predicting it involves variables that may not significantly impact our earnings but are important for understanding our revenue. Our main focus is on gross profit per hour of work.

Brian Lane, President and CEO

And just to follow on that, Brent, the type of work we're winning is the type of work we're good at. So it's really in our wheelhouse. So obviously, the guys are doing a great job managing it and executing it.

Brent Thielman, Analyst

Yes, absolutely. Maybe just one more for me. The mechanical margins just quarter-over-quarter, I guess I would have typically thought they'd pick up from the first quarter to the second quarter. It looks like that did happen in Electrical. But I guess any other color around that in terms of the quarter-over-quarter decline?

William George, Chief Financial Officer

There weren't any significant job phases. Essentially, people are facing higher material costs, and they are being careful about how they recognize profits right now. They want to ensure they have enough funds for all the variables that are out there. I'm not sure if that's particularly helpful. The main question is whether the mechanical sector is healthy, and I would say it is very healthy. Additionally, the shift in job size and new work is larger in mechanical than in electrical because our electrical division already had a higher proportion of work that aligns with our company’s current direction. Therefore, there's less of a shift for them. Some of this is a matter of mix. I apologize if that's not very clear.

Brian Lane, President and CEO

And on the electrical front, Brent, we really had a good steady-state improvement. I mean the companies that have joined us are really strong, and the work they have is work they're good at. As Bill said, it tends to be bigger, and they're just doing a really good job of doing it right now.

William George, Chief Financial Officer

I would say there was a lot of new construction that started being worked on in Mechanical this quarter. That's where we look at our revenue, right? Revenue up 25% is not because we ran an extra service cost.

Operator, Operator

The next question is from Sean Eastman of KeyBanc.

Sean Eastman, Analyst

Great update here. I just wanted to round out the margin discussion. We got some good color on gross margin. But obviously, the SG&A leverage in the second quarter was quite notable. I just wondered how to think about that on the 10% to 15% organic growth in the second half. And maybe to try and push you guys a little harder. I mean is flat operating margin potentially in the range of expectations for the full year. Any thoughts around those last few pieces of the puzzle would be helpful.

William George, Chief Financial Officer

SG&A decreased from 12.3% of revenue to an all-time low of 11.7%. We experienced excellent cost absorption on these jobs, and I see no reason for that to change. However, I don't expect significant improvement due to tougher comparables; a year ago, we had higher revenue in the second and third quarters as we started to emerge from COVID, leading to better absorption. My honest assessment is that 11.7% is likely a solid figure. We will maintain our current absorption rate, and it's challenging to foresee much more improvement as comparables become slightly more difficult on the revenue front, not to mention the need to compensate our workforce.

Sean Eastman, Analyst

Okay. Great. Great. And just in terms of the updated message on the supply chain challenges, I mean, clearly persisting in terms of operating conditions. But just after experiencing some of the busier summer months, are you feeling better or worse about Comfort Systems' ability to manage through that sort of unscathed?

Brian Lane, President and CEO

I believe the team managing our supply chain is doing an excellent job. As we've discussed, it's a daily situation. Specifically regarding supplies and fittings, we are seeing stability in pricing and availability. The challenges arise mainly with items that contain electronic chips, such as vehicles or large equipment. However, this is a daily management issue and has not significantly hindered our operations. There’s no secret to it; it’s about staying connected with our vendors, being transparent with customers, and proactively addressing any issues.

Sean Eastman, Analyst

Got it. Okay. And then on the industrial segment, this has been a great growth story for a number of years now. How would you characterize just in your discussions with the customer base there, how sensitive those capital programs are going to be around the broader macro? And has that industrial growth story evolved at all? I mean, we've been talking about data centers for a while, pharma, food, but now we're hearing more about battery and semiconductors. I mean, is there sort of any evolution that you're seeing come through as we just think about the next couple of years around this story?

William George, Chief Financial Officer

So those types of customers don’t have concerns about financing. They have everything they need. The question is whether they have the confidence to invest in building. Generally, I believe there’s a strong reason to think that what they are creating will be necessary, particularly in areas like batteries and semiconductors. And even in data, there hasn’t been a shift away from it so far. As for food processing, especially pet food, it remains robust. If there are going to be any changes, they haven’t occurred yet.

Brian Lane, President and CEO

And there's no indications we're still seeing a lot of very early us participating in these opportunities, Sean. So as far as we know right now, there is no let-up.

William George, Chief Financial Officer

The pharma hasn't even really kicked in. The battery hasn't really even kicked in yet. There's upside in hospitals. So even if there's weakness in some other areas, you can really look and see where other things that get you feel pretty good about.

Brian Lane, President and CEO

And add on to that, we're seeing good strength in education. Our backlog is up in education. So we're still seeing very good opportunities at the university level as well in addition to the others you mentioned.

Sean Eastman, Analyst

And then, of course, service continues to chug along with healthy growth. So maybe there is a lot of optionality around the growth profile going forward?

William George, Chief Financial Officer

And modular is booking up pretty nicely too.

Operator, Operator

Next question is from Adam Thalhimer with Thompson, Davis.

Adam Thalhimer, Analyst

Great quarter. Bill, can I just keep going there on the modular? What percentage of revenue is modular now? And what's the growth outlook? What growth are you seeing there?

William George, Chief Financial Officer

It won't be far from 10%. I haven't seen that yet, but it's impressive considering how much the rest has increased. It's maintaining its growth. Right now at Comfort, your size in the company is determined by how quickly you can grow, as everything else in the business is expanding so rapidly that a 10% growth could still mean a reduced share of overall revenue. They're on track with this growth. Additionally, there are some significant orders coming in from technology and the biospace. We have increased our square footage in the modular sector, both in North Carolina and Tennessee, and we are actively adding more capacity as we speak. They are keeping up, which is quite remarkable.

Adam Thalhimer, Analyst

Okay. The 10% to 15% organic revenue growth in the back half of this year, what's your best guess on what that moderates to next year?

William George, Chief Financial Officer

You're going to have to provide insights on inflation, but if we assume it stabilizes, I think it will settle into the mid-single digits since we can only expand our workforce at a certain pace. If prices begin to decrease—not just dropping significantly—and if China reduces its purchases, there are reasons to believe the supply chain issues won’t persist indefinitely, especially for key cost items. You will notice a reduction in backlog and revenue. However, this will make us appear highly efficient in managing margins. Ultimately, our focus isn't on revenue; it’s about profitability, and we believe we have the potential to earn significantly.

Adam Thalhimer, Analyst

Great. Last one for me. I was trying to model electrical revenue? Because you had $241 million in Q2, which is a really strong number, had to be a record. I guess I had the acquisition there too. But that $241 million, where does that go to in the back half?

William George, Chief Financial Officer

If you figure that out, let me know. Here's what we have going on. We've owned a large, dynamic company in Texas for a few years, and initially, they shrank a bit. However, they have become more profitable and are now experiencing significant growth, accompanied by profitable gains. We also acquired more electrical assets, and typically, there is a period after an acquisition where performance can dip. Historically, among our seven biggest acquisitions over the past seven or eight years, five shrank somewhat in the first couple of years, but all of them have since grown substantially and have higher profit margins than when we acquired them. Currently, we have one major company performing well, creating a unique situation. The electrical sector is new for us, making it difficult to predict outcomes, but I'm optimistic about it.

Brian Lane, President and CEO

We're going to get growth.

William George, Chief Financial Officer

A company that's growing is going to win. And I'll take the over, but it's really hard to make out. There's a lot of things that could happen. But I'd tell you what will happen unless the new higher margins are good.

Brian Lane, President and CEO

And we're really focused on that and improving margin in the electrical business, Adam. So far, we've been steady as she goes, but hopefully, we'll keep doing that.

William George, Chief Financial Officer

I'd be more comfortable predicting good to somewhat improving electrical margins than I would predicting their revenue. It's hard to predict their revenue. Their margins are well positioned.

Brian Lane, President and CEO

Yes.

Adam Thalhimer, Analyst

You think you get to parity at some point?

William George, Chief Financial Officer

I believe the construction business is at parity. We're quite close. Considering the job sizes, for the electrical side to be on par with mechanical overall, electrical needs to perform better since mechanical has a greater service component. However, in terms of operating income, I think we’re at parity. Their selling, general and administrative expenses are significantly lower because the service aspect involves sales personnel, commissions, countless transactions, billing departments, and other factors.

Brian Lane, President and CEO

And our mechanical service will always be bigger than electrical service.

William George, Chief Financial Officer

Yes, moving parts do wear out, right? So I hope that's not the case because I hope electrical can reach the level that mechanical is at today, but mechanical has advanced further in terms of gross profit.

Adam Thalhimer, Analyst

How does the accounting work? Are you making less profit from your large mechanical jobs due to their early stage and supply chain concerns?

William George, Chief Financial Officer

I'm going to let Brian handle the accounting question. Initially, for any larger job, you bid at a specific gross margin and hold a handover meeting where the team taking over the project assumes responsibility for the costs. They set the margin based on what everyone considers reasonable but typically include a contingency because there are factors that cannot be predicted, such as weather conditions or the availability of subcontractors. Consequently, at the beginning of a job, we generally have higher contingencies, which leads to lower margins initially, although we usually see an improvement as the year progresses. Our history shows that we’ve never experienced a year without a net gain across our projects. Right now, there’s more caution than usual due to uncertainties in the supply chain and tight labor conditions. Therefore, we approach jobs more prudently at the start. A single misstep can jeopardize a business, and we have never acquired a construction company that didn't show net gains in their projects; otherwise, they would risk going out of business. So, yes, we recognize this situation.

Brian Lane, President and CEO

When do the large jobs you mentioned starting in Q2 reach the later stages?

William George, Chief Financial Officer

I think some will be in the fourth quarter this year, but mostly you'll see, I think, in the first early second quarter.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Brian Lane for closing remarks.

Brian Lane, President and CEO

Okay. Thanks and closing, I really want to thank all our diligent employees again. We really appreciate all the hard work you do. I want to thank everyone for joining the call this morning. As you can tell, we are very excited about our opportunities, and we are optimistic for both the second half of this year and beyond. I hope everybody enjoys the rest of their summer. Thank you.

William George, Chief Financial Officer

Yes. Thanks, everybody.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.