Julie S. Shaeff - Chief Accounting Officer and Senior Vice President Brian E.

Lane - Chief Executive Officer, President and Director William George - Chief Financial Officer and Executive Vice President

Adam R. Thalhimer - BB&T Capital Markets, Research Division Saagar Parikh - KeyBanc Capital Markets Inc., Research Division John B.

Rogers - D.A. Davidson & Co., Research Division

Thanks, Alex. Good morning, everyone.

Welcome to Comfort Systems USA's third quarter earnings call. Our comments this morning, as well as our press release, contain forward-looking statements within the meaning of the Private Securities Litigation Act of 1995.

What we will say today is based on the current plans and expectations of Comfort Systems USA. Those plans and expectations involve risks and uncertainties that could cause actual future activities and results of our operations to be materially different from those set forth in our comments.

You can read a more detailed listing and commentary concerning our specific risk factors in our most recent Form 10-K and Form 10-Q, as well as in our press release covering these earnings. A slide presentation will accompany the prepared remarks and has been posted on the Investor Relations section of the company's website, found at www.comfortsystemsusa.com.

Joining me on the call today is Brian Lane, our President and Chief Executive Officer; and Bill George, our Chief Financial Officer. Brian will open our remarks.

Thank you, Julie. Good morning, everyone, and welcome to our third quarter earnings call.

I would like to start by thanking all of the Comfort Systems USA employees who are on the call today for their continued hard work and dedication. Let me start with the highlights of the quarter and then Bill will discuss our financial results in more detail.

I'll wrap up with a discussion of backlog and outlook. For the third quarter of 2013, we are pleased to report another solidly profitable quarter.

Revenue for the quarter was $350 million, a 4% increase compared to the third quarter of 2012. This quarter is typically our busiest, and I am happy with the terrific execution across the board at our operating companies.

Thanks to strong operating performance, we achieved significant year-over-year improvement. For the third quarter of 2013, we reported earnings of $0.30 per share compared to $0.15 per share in the third quarter of 2012.

We also had very strong cash flow for both the quarter and the year, and we are on track to deliver our 15th straight calendar year of generating positive free cash flow. Overall, we are very pleased with the continued growth in both earnings and cash flow.

Even though there's mixed demand, most markets are stable, and I'm optimistic about our prospects. Before I get into that, let me turn this call over to Bill for some financial comments.

Thanks, Brian. I'm going to take a few minutes and discuss our quarterly results.

If you're online and have access to our slides, you can refer to Slides 2 through 6 as I review our financial results. Revenue this quarter was up slightly compared to a year ago, as we reported $350 million of revenue compared to $335 million in the third quarter of 2012.

During the first and second quarters of this year, we reported flat to slightly down revenues influenced by the fact that the first 2 quarters of 2012 included a fast and large data center project in Central Virginia. The third quarter of 2012 was a more normal comparable.

And in light of that, we achieved an increase over the same quarter last year, and that increase was large enough even to overcome the declines earlier in the year. And as a result, our 9-month 2013 revenues are ahead of the same period a year ago.

The largest increases arose from projects in Arizona and North Carolina. As Brian mentioned, our net income for the third quarter was up significantly.

We earned $11.4 million or $0.30 per diluted share compared to net income of $5.7 million or $0.15 per diluted share in the third quarter of 2012. As we noted in our press release, the $0.30 per share reported this quarter includes 2 items that we want to flag, that taken together, added $0.05 to our current quarter earnings.

First, during the third quarter, we reassessed the fair value of an earn-out liability related to one of our acquisitions, which resulted in a gain of $0.02 per share. In addition, we recognized income that should've been reported in prior periods, as we discovered that one of our subsidiaries was engaging in a revenue recognition practice that had delayed the recording of a significant amount of earnings beyond the period in which they should have been recognized.

That discovery resulted in the recording this quarter of $2.1 million of pretax operating income or $0.03 per share in the current quarter. We have determined that this additional income should have been recognized in prior years with most of the impact dating to years prior to 2010.

Excluding this prior period adjustment, our gross profit percentage for the quarter would have been 18.6% as compared to the 19.1% that we reported. With or without the effect of the prior period income, gross profit this quarter reflects a strong increase from the third quarter of 2012 when we reported 16.6%.

OI margin was also up, rising to 5.1% from last year's 2.9%. As Brian mentioned, we had solid performance from the vast majority of our operating companies, including good contributions from both ColonialWebb and EAS, and our Northeast and Upper Midwest companies continue to demonstrate exceptionally strong performance.

Our gross margin is also strongly benefited by the mix of business between service and construction as the continued low activity levels in project work and the ongoing relative street of service work has led to an overall mix of business that includes a much higher proportion of service work than usual. Because service has significantly higher gross margins, service is a greater proportion of our revenues that benefits overall margins.

SG&A expense was $49.4 million for the third quarter of 2013 compared to $45.9 million for the third quarter of 2012. SG&A, as a percentage of revenue, increased from 13.7% during the third quarter of 2012 to 14.1% during the third quarter of 2013.

The increase in SG&A percentage is also influenced by the higher service mix as service includes additional selling, bidding, dispatch and other management costs. Because we're continuing to make net incremental investments in service growth, we continue to expect SG&A to increase later this year and next year, and we believe these investments will benefit us for years to come.

Our tax rate for the quarter was 36.1%, and we currently expect the full-year tax rate to be in the 38% to 42% range. Free cash flow for the quarter was $22 million, which is a significant improvement compared to the third quarter of last year.

On a year-to-date basis, we have positive free cash flow of $12 million, which is about $17 million better than the prior year. Overall, we feel good about our cash prospects for the balance of 2013.

We repurchased 76,000 shares in the third quarter at an average price of $15.56. We remain open to opportunistic and price-sensitive share repurchases.

Since we began our program, we have purchased over 6 million of our shares at an average price of $11. As our financial performance improves, we are seeing the per-share benefit of these repurchases.

With the shrinkage in our share base and with the numerous acquisitions we completed over the course of the recession, we believe that we are well positioned to benefit from improving markets. As markets have solidified, we expect to be more open to possible acquisitions.

It has been a long recession, but we like our positioning. We are eager to invest in growing our existing businesses.

We're open to adding new businesses, and we're committed to dividend and stock repurchases to return capital to our business owners. That's all I have on financials, Brian.

Okay, thanks, Bill. Let me start with backlog and activity in various sectors and markets.

Please turn to Slide 7, and start with backlog. Backlog at the end of the third quarter was $571 million, a 3% decrease compared to the second quarter of 2013.

We were not surprised to see flat backlog as we continue to see mixed overall demand in nonresidential construction markets. Pricing, while relatively stable, is still competitive overall.

We feel optimistic that at least some recovery and project activity is developing. However, as most of you on this call are aware, we tend to be a late cycle participant in construction recoveries.

At this point, although underlying activity levels are solid, we do not see an increase in bookings that would support meaningful revenue increases over the next few quarters. Please turn to Slide 8 for a look at our end use sectors.

The institutional markets, which are government, health care and education, made up 46% of our revenue for the first 9 months of 2013. These sectors made up 51% of our backlog as of the third quarter of 2013 compared to 65% to 70% levels back in the 2010, 2011 periods.

Institutional projects, on average, tend to be much larger than our average project size and tend to remain in our backlog longer. Meanwhile, the industrial, and to some extent other commercial sectors, seem to be strengthening, albeit from low activity levels.

We believe that our lower backlog has been a result of the trend away from institutional work and resulting decline in average project size. Overall, we continue to win our fair share of small to midsize projects.

However, customers are still reluctant to commit to larger, longer-term projects. Let's look at what we're seeing across the country.

As I mentioned earlier, there is mixed demand. The markets for operations in the west are stable and are recovering from very low activity levels.

We've seen some improvement in south and southeast. There are pockets of weakness in the mid-Atlantic region, mainly in Virginia.

However, the northeast region, which includes our companies in the upper Midwest, remains relatively strong and continues to be our most profitable region. If you turn to Slide 9, you can see our current revenue mix.

Pure service, which is maintenance and repair, was strong at 17% of revenue for the first 9 months of 2013; and service, repair, and retrofit, again, exceeded 50% of revenue. Overall, our maintenance space has increased approximately 10% since the beginning of this year.

For the quarter, and for the year, our service businesses provided solid returns. We have invested in our business throughout the recession.

As we turn our focus towards growth, we have made incremental investments in our service businesses this year. And we are increasing those investments in line with the plan we have to grow our service business.

We expect the benefits from these investments to materialize in coming years. This month, we marked an important milestone as we hired a senior level executive to lead our service business and position us for growth.

James Mylett, a seasoned service leader in our industry and most recently from Johnson Controls, has joined Comfort Systems as Senior Vice President of Service. I'm extremely excited about James joining us.

We believe that his arrival and leadership will accelerate our already intense focus on service growth. We expect to continue these incremental investments for the next several years.

Finally, since it is late in the year, let me describe our general approach to the overall market and comment on our outlook for 2014. We are deeply gratified by the improvements our operations have achieved for the first 9 months of the year.

We are experiencing gradual improvement in more and more of our markets. We believe that we are positioned to take advantage if construction demand improves in the coming quarters.

And our assessment of the underlying conditions in our markets give us optimism that activity levels are susceptible to growth over the next few years. We are financially sound and solidly profitable.

However, at this point, our revenues reflect the fact that our nation is building far fewer nonresidential buildings as was the norm prior to the recession. Although we are hopeful that new construction activity levels will improve, in light of our backlog, we currently expect that Comfort Systems' 2014 revenues and earnings will be similar to or modestly higher than 2013.

For now, we remain focused on project selection, estimating and execution, and we are also making significant investments in our future growth. Whatever the conditions are, we plan to use our resources to compete, improve and especially to grow.

Finally, and again, I'd like to thank all of our 6,700-plus team members for their efforts. I'll now turn it back over to Alex for questions.

Thank you.

I want to ask first question and this has been the hardest thing to peg down the last couple of quarters, but the gross margin -- I mean, what are your thoughts broadly on gross margin for Q4 and for 2014?

We gave a little more guidance than we normally do about why we thought our gross margins are doing what they're doing. Our gross margins are approaching the levels we last saw in 2008.

But there's a world of difference between the source of those margins. In 2008, we were 60% projects, construction -- new construction project revenues.

And now we're closer to 40% than we are to 60%. So one of the sources for those higher margins is the fact that the proportion of our work that is service is much higher.

Service also comes with more SG&A. You have to have higher gross margins because you have to pay commissions, and you have salesmen, and you bill, and you dispatch.

So I guess, the single biggest factor that would determine what happens to our margin over the next few quarters is what happens to that business mix for the next couple of quarters apart from seasonality, right? In the first quarter, we'll typically see lower margins simply from seasonality, but it -- compared to the same periods in prior years, I think we'll continue to see higher gross margins like we've been seeing because I think our service mix will stay higher.

I don't know if we'll be able to hit the execution that we hit the last -- the last 2 quarters were just really good quarters. But I think that the trend will stay similar to what it is until -- once project revenues start to pick up, that will just average down those margins, at first, especially, but that will be for a good reason; we'll have more total earnings dollars.

So that's a long answer, but I think that question deserves a long answer.

And Adam, I just want to chime in, it's Brian, that -- Bill talked about service, but on the construction front. Anything can happen as you go forward, but we've spent a lot of time, as we've talked about training, being disciplined in what we've taken, and I think it's paying off for us right now.

So -- and I'm pretty optimistic going forward we'll have some stability in our margins.

Okay, great. And then, like you said, very strong cash flow quarter.

The net cash is piling up. And I guess, the likelihood is that cash won't be used for share repurchases, I would think, with the stock moving up like this.

But, what are your thoughts on uses of cash maybe for the next 6 quarters or so?

For a while, we've been continuing to look at what we call tuck-in acquisitions in service and controls. We had gotten a little -- we had communicated to the markets and been a little less aggressive in seeking big full-service mechanicals and construction operations.

I think that there's enough stability in the markets that we're becoming open again to looking at some of those acquisitions, I think, that you'll see us. Obviously, we'll consult with our board about this.

We have strategy sessions at year end, but I suspect you'll see us seeking out those acquisitions. And I think, we hope to get some.

I will say, people that we would be buying, they're companies we've known for a long time, many of them we've targeted. We expect to just own them some day.

They're aware that the markets are improving as well. So I'm optimistic we could get some acquisitions done.

But on the other hand, we're very disciplined and we'll continue to be disciplined as well. Brian, I...

And we'll also continue to pay out dividends. We'll get a little extra CapEx this quarter.

We had to buy more vehicles. We talked about that in prior calls.

But we'll be prudent going forward and use the cash wisely.

Okay. And then last question, I just wanted to think longer term about -- let's assume there is a non-res recovery -- a meaningful non-res recovery.

What -- I mean, what are your thoughts on the competitive landscape? Because one of the things you talked about -- both of you talked about early on in this downturn was "Hey, if it's a really bad, long downturn, we'll come out with half as many competitors as we had going in."

And that's played out, so what are your thoughts on competition if you had an up cycle?

Well, I'll probably take a first shot at that. We haven't seen a decrease in the number of competitors that we would've expected after a 5-year recession.

Some have gone, Adam, I'm not going to tell you they're not -- I think going forward, the challenge for the industry, Adam, and we've talked about this, is labor. Texas, which -- we're hearing Houston is experiencing it right now, getting people in the field to actually do the work.

I think that's going to be in 2 to 3 years, a real issue. That will impact on pricing, sure.

Bill, do you have anything you want to add on?

Yes. I think that -- I agree with everything Brian just said.

And I would say, there are 2 effects of -- if demand moves up, supply will be less. It will be less both because of companies exiting or reconfiguring themselves more towards smaller projects.

It will also be lower because of less labor. And we're -- obviously, we're -- our number one focus is trying to get our arms around and gather as much of this valuable labor -- earn the loyalty of the valuable labor.

There is another source of growth, and that's growth in margins. And I think that the key for us will be to be -- across our company will be to be -- have the courage to raise prices to appropriate levels as the scarcity helpfully develops.

And I'm also anticipating -- it's Brian again. As we've also mentioned that one, as business does improve, a lot of companies -- and we know this -- have really struggled to through this recession.

I thank God, Bob -- Bill does such a great job with our balance sheet, keeping our debt down. A lot of companies not in this position.

They're going to struggle to get working capital when things get better. And I think, you'll see more go out then than what have gone out in, actually, in the recession.

I apologize, I missed the beginning of the call due to some phone issues. So if I ask anything that you guys have gone over, already, I apologize.

First off, are you guys still comfortable, it seems like that your non-rest market is gradually improving, and that's going to continue going into 2014. Can you just give us some more data around that, what you guys specifically looking at?

Maybe some indicators, or maybe what you're hearing from folks in operations?

Okay I'll start, then Bill can give you his. Obviously, you look at the architecture billing index, it’s been up over 50 about the last 15 months, which is a good sign.

We're still seeing, say, a good pipeline flow. We've had a good month of bookings in October.

So we're seeing some gradual improvement. Dodge is forecasting improvement.

Next year, of course, we'll be at the back end of that, late cycle for sure. But there are signs of improvement.

I don't think it's going to be a spike. I think it will be a lot in gradual like we've called for the last few years.

Bill, anything else on that you want to add?

No, that's exactly what I would say.

And then second question, really around execution, as you guys have gone over on the call, strong margin performance, a portion of that is due to tremendous execution in your operations. What have you guys really done and what have you implemented since 2011 and the beginning of 2012 that have led to the better execution?

And what gives you confidence that, that can continue going forward?

Yes, it's Brian again, I don't know if we've done anything differently. I think this was in place long before I got here.

Just keep working on the blocking and tackling. And we've talked a lot about prefabrication, doing as much work in shop as we can.

We have everybody doing that now, top to bottom. We're seeing the benefits of that.

We're seeing just improvement efficiency out in the field. We've done a lot of productivity work.

I had to make demand in the field, top to bottom, more productive and giving them the tools to do that. So I just think we're working on the stuff we know we need to do.

We got marginalization, and we've talked about that with you, with folks in Greensboro. So there's probably 20 things we're doing to nip away at it and we just keep on trying to get better every day at it.

Okay, and then last question really around average project sizes. You mentioned that the industrial manufacturing work as that's become bigger part of backlog has led to a smaller average project size.

Can you just give us an idea of what was your average project sizes were in the prior cycle in '07, '08, in that upturn and versus what they are now and what they -- what your kind of target range would be?

I will -- so I have to confess something. We changed the way that we measured average project size.

And between the 2 times, one of the things that influences your average project size is how long you leave projects open. So if you were to go and pull the actual numbers from back then, I don't think they're very comparable.

We were probably understating the size of our projects several years ago. Having said all of that, I don't really -- I don't think that the average project size is going down much on an average basis for what's on the POC.

But the project -- the average size is smaller. They just perform more quickly and get off the POC more quickly.

So I believe the average project size has gone down. I think the average project size, as reported in the 10-Q, is deceptively similar to what we've seen over the last couple of years.

But when we look inside it, the way that we get to that number has changed because there's more -- there's more -- the projects are moving through in and out more quickly. So I'm sorry for the complicated answer there, but I want to make sure that when you go back and look at numbers, if you happen to, and I know you have them, you'll understand why they show up the way they do.

A couple of things, Bill. I guess, first of all, just relative to margins, again, the -- I understand the mix shift from new construction to service and maintenance, but given the magnitude of the jump, is the service and maintenance and replacement work really that much higher in margin than new construction?

Or was there anything else that was going on in the project closeouts or just lack of bad projects in the quarter?

I think it was a combination of 3 factors. One is excellent execution.

It really was. The projects have high -- the projects that are performing have higher margins -- that's obvious, I guess.

The second thing is there -- I will say there was not closeout. We did not have closeouts that benefited us, probably less than usual.

It's the third quarter, what's ended, there aren't that many large projects. Third part of your question was there was truly was an absence of bad news.

And that's been a theme happily for us for several quarters. The reason for the focus on the switch, the service mix, is not so much to say that explains all of the margin improvement is to keep people from really failing to understand why our margins could be as high -- nearly as high as they've ever been, and that's not the earning more than $1 a share the way we would do in the past when we showed margins like this.

So all of your points are right, and I -- it's not the only factor, it's just -- I think it bridges the final gap to understand how they could be this high and still show the results that we're showing.

And so as we think about, hopefully, a recovery in new construction, how much risk is there if margins pull back with that as revenue ramps?

Right. I don't like the word risk, because it would only be...

Yes.

But having said that, there are a couple of other things going on. Even our service itself is being performed at higher margins than it ever has in the history of our company.

The percentage of companies that are hitting our targets for what we consider excellent -- excellent service execution is higher than it's ever been. So I actually think -- I believe right at first, if we start to get new work, we'll load that work at conservative margins, you could see 100 basis points dip.

If we came out of the recession the way we did in 2008, you might see 150 or 200 basis points. But that's not likely, but that would mean our backlog would be going up very quickly.

But I do think that the peak margins during this cycle, I have every reason to believe they would be higher than the peak margins during the last cycle because we're better -- we're doing better at service, we have more service, and we think we're still good at construction.

Hey, John, you know what gives me my optimism? Our operators aren't sitting there.

They are working on their business both from a quality of the product we're delivering to our customer and working on process improvement every day. It's -- it really makes me proud to be here.

And gives me a lot of optimism going forward about their work they're doing to deliver a better product to our customer. And that's what gives me the optimism about our margins.

Okay, that's helpful. And Brian, just relative to the construction market, I mean, you mentioned the ABI index, and hopefully, we'll see some improvement.

It sounds like, I mean, given where you are, in sort of the project chain, maybe the second half of next year, we could see some improvement, but are your guys tracking projects that are opportunities? Sort of are -- what's their feeling out in the field and when we'll see that construction start to have an impact on Comfort?

As you can imagine, John, that's probably a question I ask every once in a while. The pipelines are good.

What we're still seeing, John, is what I'm calling soft backlog, right? You bid it and just takes a while to get it to contracts where we can report it.

In my distant memory, we have more of that type of backlog right now than I can ever remember. But I think the field is cautionary, but they're working on a lot opportunities, trying to get it, closure and built is still a long process.

But I probably would agree if we sit here right now, I'll probably eat his words at the end of next year. But at the end of next year, if things keep going, you should start seeing some improvement, I believe.

But time will tell, as you and I have talked, we probably -- thought that was going to happen in the last 4 years, and every time May comes, there's been a slowdown. But if you look at the opportunities we're looking at right now, that would lend itself to maybe at the end of next year, some improvement, John.

And I think they would agree with me, the operators that I talked to.

Okay, thanks, Alex. Hey, thanks, everybody for listening to our call and your interest in Comfort Systems.

This was a terrific quarter, and I'm really proud of the work done by the field. We are poised for growth by investing in our service business, and we're ready for construction growth as the markets improve.

Bill and I look forward to seeing everybody out in the road in the near future. We hope you have a safe and happy Halloween tonight.

Take care. See you soon.

Thank you.