Earnings Call Transcript - FIX Q3 2022

Julie Shaeff, Chief Accounting Officer

Thanks, Anthony. Good morning. Welcome to Comfort Systems USA's Third 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; and Bill George, Chief Financial Officer. Brian will open our remarks.

Brian Lane, President and CEO

All right. Thanks, Julie. Good morning, everyone. We had another great quarter with continued increases in revenue, earnings and backlog, and we are really grateful for the success created by our employees amid unique challenges. We earned $1.71 per share this quarter compared to $1.27 a year ago. Our results this quarter included a net gain of $0.10 per share related to legal matters and $0.04 related to tax benefits from prior years. This quarter marks the first time that we have achieved $100 million in EBITDA in a single quarter. Strong activity levels and ongoing cost increases in equipment and other inputs have again produced same-store revenue growth of over 20%. Bookings increased this quarter and we continue to experience solid bidding and planning activity. Our strong cash flow also continues and is especially satisfying since we are investing working capital to support our growth. We have also announced an increase in our dividend to $0.15 this quarter. I will discuss our business and outlook shortly. But first, I'll turn this call over to Bill to review our financial performance. Bill?

William George, Chief Financial Officer

Thanks, Brian, and good morning. Revenue for the third quarter of 2022 was $1.12 billion, an increase of $286 million or 34% compared to last year. Our recent acquisitions contributed a total of $97 million of new quarterly revenue. And so we had same-store revenue growth of $198 million or about 23%. That sharp increase in revenue was broad-based and was driven by strong market conditions. Inflation of equipment and materials also contributed to revenue growth. Our same-store revenue increased by 23% in the third quarter and same-store employee headcount increased by 8% in the same time frame. For the fourth quarter, we currently expect double-digit same-store revenue growth, although there are more variables than usual. Gross profit was $202 million for the third quarter of 2022, a $43 million increase compared to last year and the first time we have ever reported over $200 million of gross profit in a single quarter. Our gross profit percentage was 18.1% this quarter compared to 19.1% for the third quarter of 2021. The decrease in gross profit percentage resulted from the change in project mix, including the pass-through of inflated materials and equipment costs. Gross profit percentage was impacted by a decline in gross profit margins in our Mechanical segment compared to extraordinary performance last year, partially offset by a strong increase in the Electrical segment, which was further enhanced by a job-related litigation gain. SG&A expense for the quarter was $121 million or 10.8% of revenue compared to $95 million or 11.4% of revenue for the third quarter of 2021. Most of the dollar increase is from new companies. Our operating income increased by 27% or $17 million as compared to the third quarter of 2021. Our tax rate for the quarter was 17.4%. During the current quarter, we filed our 2021 federal tax return and we included the R&D tax credit in this original return. As a result, we increased our estimated tax benefit related to the R&D tax credit for the current year, as well as for the years 2019 to 2021. That was a gain of $0.04 for the third quarter of 2022 that related to prior years. We continue to view our normalized tax rate to be approximately 22% to 23%. Net income for the third quarter of 2022 was $62 million or $1.71 per share. The $1.71 per share includes the 10% net gain related to legal matters and $0.04 related to the revised estimate for the R&D tax credit related to 2019 to 2021. Net income for the third quarter of 2021 was $46 million or $1.27 per share by comparison. EBITDA increased from $82 million in the third quarter last year to $101 million this quarter, a 23% year-over-year EBITDA increase. As Brian pointed out, this is the first time in our history that we've achieved over $100 million of EBITDA in a single quarter. Free cash flow for the first 9 months of 2022 was $137 million, including the $33 million refund from the IRS tax credit in the first quarter. This is strong cash flow considering the investments we're making in working capital as we fund our growth. Our debt at the end of September was $381 million and our debt-to-EBITDA ratio at quarter end stands at. We are actively repurchasing our shares. In the first 9 months of 2022, we have repurchased 425,000 shares for approximately $36 million. So go ahead, Brian.

Brian Lane, President and CEO

All right. Thanks, Bill. I am going to spend a few minutes discussing our backlog and markets, and I will comment on our outlook for the rest of 2022 and 2023, and on inflation and supply chain considerations. Our backlog at the end of September was $3.25 billion. Year-over-year, our same-store backlog is up $1.1 billion or 57%, with increases across most of our operations. Sequentially, our same-store backlog increased $443 million, which is remarkable for a third quarter as we are also burning backlog at record levels. In addition to strong demand in technology and other industrial sectors, an important factor driving our backlog higher is that our customers are committing orders to lock in our labor so that we can place equipment orders earlier in order to allow for exceptionally long lead times from manufacturers. Industrial revenue was 47% of our revenue in the first 9 months of 2022. This sector, which includes technology, life sciences and food processing remains strong and is very 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 remains active. But without changing mix, it is now a smaller part of our business at about 21% 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 was particularly strong during the third quarter. Overall, 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 $674 million, a 33% increase with same-store service revenue up by 16%. 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 encouraging and supporting 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 we expect continued challenges in the cost and availability of the inputs that we use to serve our customers. Although conditions are hard to predict 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, while seeking to collaborate with customers to share supply risk and to mitigate these challenges. We have a very 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, given ongoing demand, our record backlog and strength in the industrial and institutional sectors, we anticipate continued strong earnings and cash flow in the coming quarters. As we look ahead, our priority is 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. With the highest backlog in the history of Comfort Systems USA, we will continue to invest in our workforce, technology and execution capabilities. Thanks to our amazing workforce, we are optimistic about the remainder of 2022 and 2023. I want to end by thanking our 14,000 employees for their hard work and dedication. I'll now turn it back over to Anthony for questions. Thank you.

Operator, Operator

Our first question will come from Julio Romero with Sidoti & Co.

Julio Romero, Analyst

Starting on the revenue, the organic growth, it's the second straight quarter of 20%-plus growth, broke $1 billion in organic sales, in sales, I should say. Just talk about the trend line for organic growth, exit cost pass-throughs. I know you mentioned same-store headcount of up 8%. Is that kind of the baseline for organic growth?

William George, Chief Financial Officer

I wouldn't consider that as the baseline because we're charging more for that 8%, which reflects inflation. Additionally, our temporary labor costs have increased significantly, by more than 8%. Our best estimate suggests that roughly half of our same-store growth is due to inflation and market factors, while the other half is driven by our increased efforts and genuine underlying growth. Regarding the trend line, we experienced relatively soft comparisons compared to last year as we were still recovering from COVID. The comparisons will become more challenging in the fourth and first quarters, but there are still very favorable comparisons if you're focused solely on same-store revenue growth. By the second quarter of next year, we'll be compared against the significant numbers we are reporting now, with our second quarter showing a 25% increase. A year from now, depending on inflation, it will be much harder to predict growth from that point. If inflation does decrease, it might lead to some changes in that dynamic, but we do not believe it would result in earning less money. In fact, it could be somewhat beneficial if prices improve. You would likely see lower revenue growth, but the margins would improve due to a reduction in material pass-through costs. It’s a complex situation, and I apologize for the lengthy response.

Julio Romero, Analyst

No, totally. And I appreciate the comprehensive answer there. Just on the increase in bookings, it's up almost $500 million sequentially. Just how much of that, are you able to parse out how much of that is driven by the larger industrial projects that are kind of committing earlier?

Brian Lane, President and CEO

Yes, Julio, it's Brian. We have seen a broad-based increase in backlog. We are definitely experiencing increased bookings, and this trend will continue into the fourth quarter. The increase in backlog is quite honestly widespread.

William George, Chief Financial Officer

Service saw the same percentage increase year-over-year as construction. The gains are widespread. However, you can expect to see more contribution from industrial bookings in the upcoming quarters due to their significant size. Additionally, the third quarter traditionally performs well for service.

Julio Romero, Analyst

Understood. And then maybe last one for me is on the segments. This is the first time that electrical gross margins outpaced mechanical. Is that kind of an inflection point for the electrical segment? Have you kind of reached some critical mass where you start to see some better operating leverage there?

Brian Lane, President and CEO

Yes. Well, I mean, we've had pretty consistent steady state growth in gross margins. I mean I think we have really terrific electrical companies. We had a challenging job a few years ago, they got helped by litigation pickup for sure, but we have improved significantly better across the board in electrical. And I'm pretty optimistic we'll continue to see improvement in the gross margins as we go forward.

Operator, Operator

Our next question will come from Sean Eastman with KeyBanc.

Sean Eastman, Analyst

Fantastic quarter. Many complements. So this kind of early project commitments dynamic that is part of the momentum in the bookings we're seeing in the quarter, how would you characterize the duration of the backlog at this point? And does this early commitment on order suggests there's some pull forward in the bookings we're seeing this quarter? Or is the message that, that bookings momentum still continues post quarter end?

William George, Chief Financial Officer

There is definitely a shift in timing with bookings. Customers are committing earlier than they typically would. The question remains whether they will keep booking at this pace. At some point, customers might stop booking earlier if lead times for equipment shorten or if the market starts to soften. Currently, there are no signs of that happening in our business. However, we cannot predict that it won’t change in the future. Right now, it seems very strong.

Brian Lane, President and CEO

Yes, it's very strong. We're even seeing our backlog increase to the highest level we've had in over a year. It's been the opposite of what we expected; in fact, it seems to have picked up.

William George, Chief Financial Officer

We have companies that aren't selling for 2023, they're full. And as you think about that, that's why people are committing earlier because we understand, oh, these guys are getting full. If we want a building, we better get.

Brian Lane, President and CEO

And equipment is one aspect, but labor is also important. They need to ensure there are enough people to handle it.

Sean Eastman, Analyst

Yes. So kind of fair to say that pretty abnormally high visibility for 2023 at this point?

William George, Chief Financial Officer

Unprecedented.

Brian Lane, President and CEO

At least since I’ve been here for 20 years, for sure.

Sean Eastman, Analyst

Okay. Understood. Regarding the idea of securing your labor resources early, it seems there is a notable scarcity in the system. Labor is a crucial limited resource in the project life cycle. I'm curious about your strategy for monetizing the early commitment of these resources, especially in the current uncertain cost environment.

William George, Chief Financial Officer

If someone in one of the many cities where we operate is very busy, you will need to compensate them well to get the work done. Our numbers reflect this.

Brian Lane, President and CEO

Yes. You can see it in the results, Sean. We are very fortunate here. At the operating company level, these folks have a really good handle on the markets they are playing in, in terms of all facets of the business. And we're very fortunate with the companies we have today.

Sean Eastman, Analyst

Yes, we can see that. And maybe one last quick one for Bil on M&A., obviously, the last couple of years has been quite active. It's been quite a good story for you guys. Any message on say, the next 1 to 2 years in terms of what's in the pipeline and what we could expect to see?

William George, Chief Financial Officer

We have a couple of things happening in M&A. One is that we have relationships with people we've known for years, and when they decide to sell, we’re ready. We've been preparing for this over time, so you might see some M&A activity. However, we believe the market is shifting. The cost of capital influences how much people are willing to invest, and currently, there are many companies for sale, particularly those owned by private investors. I've noticed there are three times as many pitches being made now than I’ve ever seen before. This feels like a significant turning point, and we plan to proceed with caution. We've always maintained that we don’t need to complete a deal every year; our goal is to create value over the long term. So, while my response might seem a bit uncertain, there are two main aspects to consider, and we will be very observant in this current environment.

Brian Lane, President and CEO

Sean, Bill keeps his track that he's had for the last 10 years, we'll be in good shape.

Sean Eastman, Analyst

Yes. Yes. No doubt about that.

Operator, Operator

Our next question will come from Adam Thalhimer with Thompson, Davis.

Adam Thalhimer, Analyst

Just out of curiosity, can you just follow-up on that, Bill, on the 3x the amount of book floating around? Why do you think that is?

William George, Chief Financial Officer

I believe that if you are an investment firm that considers a business primarily as inventory, having a significant amount of inventory might make you hesitant to hold on to it for the coming year. Therefore, you may want to at least explore the market. I find it quite remarkable. I may be speaking out of turn, but generally speaking, everything is available for sale. Everything owned by those who trade businesses appears to be at least being tested in the market. Do I think they are successfully selling these businesses? It's possible, but I can't say for sure since we're not very actively involved. We take a close look at some top-tier options, but typically we don't engage in that day-to-day activity. We prefer to build relationships over the years, which is not usually how that process works. We've been very cautious. We fully recognize the challenges in putting together businesses that can be sustainable for decades. To date, we have never purchased a company or a contractor from anyone other than a person who owned it, lived in it, and had a passion for it. We’ve never done that.

Adam Thalhimer, Analyst

What would be the appetite? I mean you added electrical and you're doing well there. What would be the appetite to add something else to the portfolio?

William George, Chief Financial Officer

Well, there's not much need to for the foreseeable future. So it would have to be something we really felt like we had a reason to expect synergy from, right? And by the way, we did. We added a labor company. But in a way that matters to you that creates a new segment, I just, I think, we're just barely getting started with a...

Brian Lane, President and CEO

I think we see a lot of opportunity, Adam, and just continuing to improve the mechanical electrical businesses that we're in. I think there's constant improvement, and it's pretty exciting. So we'll keep it that, I think.

Adam Thalhimer, Analyst

Okay. I have a more detailed question regarding the margin outlook. What are your expectations for margins in Q4 and next year? This ties into the status of some large projects that were started over the past year to year and a half and when they will be completed.

Brian Lane, President and CEO

Well, I'm really happy with the margins that we're cranking out right now. We are 18.1%, as I said, probably a trillion times, you're 17.5%, 18%, above that, I think you're really performing well in the field. I think we're getting terrific productivity. I think we can maintain that level. You might get a little improvement as service continues to grow, right? We're getting some good margin help from there. But if we continue to perform in the field, that 18% range is definitely doable. And I think that's a really good number for us to be around.

William George, Chief Financial Officer

So Adam, there's a variable here that we don't know, which is that our volumes are currently lower due to the nature of our costs. Materials and equipment costs are higher, which affects our margins negatively. One way to look at the situation is that we are very pleased with our current labor margins and would be content if they remained consistent. However, there are some mix issues, and if I had to predict, I would expect our margins to improve next year, assuming inflation is brought under control.

Operator, Operator

Our next question will come from Brent Thielman with D.A. Davidson.

Brent Thielman, Analyst

Just sort of tailed with Adam's question, I think Julio's as well in that. I guess, more around the electrical business. If you just take away the inflationary element, have your longer-term expectations for margins in that business change just given the performance years of late? And of course, what would those be if they have?

Brian Lane, President and CEO

The goal of everything we do operationally is to improve our margins, productivity, efficiency, quality, and safety. We are continuing to work on the electrical business, and we've seen consistent improvement. It's important to follow through on this. While I can't say exactly where we'll end up, I am optimistic about the margin improvement in the electrical business.

William George, Chief Financial Officer

I want to clarify that we are not now expecting higher margins; we had anticipated higher margins last year and the year before, but experienced some softness. One noteworthy development this quarter was a favorable outcome in a significant job-related litigation in electrical. Essentially, as the arbitrator, I ruled that they were inadequately compensated for the work done over the last two years, starting the previous year. We actually performed better in electrical, and that money should be refunded to them. I believe they are currently operating at their normal margins, and there is potential for further upside in electrical margins. However, please note that the 19% margin includes the gain from that litigation, and when excluding that gain, the margins remain slightly below those in mechanical. Overall, they are relatively close together.

Brian Lane, President and CEO

But I think they can get there to be the same.

William George, Chief Financial Officer

Yes. I think on the construction side, electrical is just as profitable.

Brian Lane, President and CEO

I'm very optimistic about our electrical companies, Brent.

Brent Thielman, Analyst

Yes. Really helpful. Just a follow-up. I wanted to get your thoughts, the 179D energy efficiency deduction, I think, got revised with the IRA, Inflation Reduction Act. Any thoughts on the potential implications here for the industry?

William George, Chief Financial Officer

Yes. Looking back at the last several years, we haven't highlighted it separately, but it's there if you look closely. We've gained a few cents from that. With the 179D deduction, the customer benefits, except in cases where it's a public entity. In those situations, we can take that deduction and provide some benefits to them. We've seen a small direct impact on EPS from 179D over time. Additionally, it motivates customers to undertake more projects, particularly renovations, and it seems that the incentives have more than doubled. We believe this may lead to an increase in renovation projects, which would be advantageous for us. However, the direct benefit we receive could remain modest, as it was initially small and might not grab as much attention. It's likely that if it becomes significant, there may be higher demands associated with it. Overall, we see this as a positive development, but it’s just one of many positives; a more significant factor is reshoring. Several trends are aligning positively in our favor.

Operator, Operator

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

Brian Lane, President and CEO

All right. Thank you. In closing, I really want to thank again our tremendous workforce, and it's throughout the organization. We're getting tremendous performance from everybody, and I really appreciate it. We also really thank everybody for your interest in Comfort Systems and your time today. We are grateful for the questions and the interest for sure. So everybody be safe out there and hope you enjoy the upcoming holiday season. Thanks, and have a great day.

William George, Chief Financial Officer

Thanks.

Operator, Operator

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