Comfort Systems USA, Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016; comparisons are with the same 2015 periods. Dollar amounts below are in millions unless noted.
Business context
Comfort Systems provides mechanical contracting services, primarily HVAC, plumbing, piping and controls, across U.S. commercial, industrial and institutional markets. It reported one mechanical-services segment and 35 operating locations. Management describes demand as improved from prior years but notes that construction is cyclical and HVAC activity is seasonal. The filing describes both 39% of 2016 revenue as installation in newly constructed facilities and approximately 81% as project-based installation or replacement work; these measures appear to use different definitions.
Financial performance
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Revenue | $428.8 | $410.6 | $1,242.2 | $1,196.7 |
| Gross profit | $92.8 | $87.5 | $255.7 | $234.2 |
| Gross margin | 21.6% | 21.3% | 20.6% | 19.6% |
| Operating income | $32.0 | $29.9 | $76.0 | $65.9 |
| Operating margin | 7.5% | 7.3% | 6.1% | 5.5% |
| Net income attributable to Comfort Systems | $20.5 | $17.7 | $48.0 | $36.1 |
| Diluted EPS | $0.54 | $0.46 | $1.27 | $0.96 |
- Revenue rose 4.4% in Q3 and 3.8% year to date. Shoffner contributed growth, while same-store revenue declined 0.3% in Q3 and 0.8% year to date, mainly from lower large-project activity at Environmental Air Systems (EAS).
- Gross profit increased 6.1% in Q3 and 9.2% year to date. Management attributed margin improvement to stronger project execution and higher volumes at several operations, partly offset by lower EAS volume.
- SG&A increased 5.4% in Q3 and 6.7% year to date; as a share of revenue it was 14.2% and 14.5%, respectively, versus 14.1% in both comparable periods. Higher compensation contributed to the increase.
- Q3 income included an $0.8 million gain from remeasurement of contingent acquisition earn-outs, primarily related to EAS. Interest expense also increased with higher revolving borrowings used mainly to fund acquisitions.
Cash flow, liquidity and capital
- For the first nine months, operating cash flow was $49.8 million versus $74.6 million; company-defined free cash flow was $33.3 million versus $60.3 million. Management cited timing-related reductions in billings in excess of costs and in accounts payable/accrued liabilities.
- Investing cash use was $74.9 million, including $58.5 million of acquisition payments; capital expenditures were $17.3 million. Cash declined $31.1 million to $25.3 million.
- At September 30, total debt including capital leases was $27.9 million, versus $11.5 million at year-end 2015. The revolving facility had $25.0 million drawn, $41.5 million of letters of credit outstanding and $258.5 million available. Its weighted-average borrowing rate was approximately 1.8%.
- Management reported compliance with credit covenants; leverage ratio was 0.2 and fixed-charge coverage ratio was 33.5. The amended facility expires in February 2021.
- The company paid $7.7 million in dividends and repurchased $11.0 million of shares during the nine months. The quarterly dividend was $0.070 per share, versus $0.065 a year earlier.
Material changes and notable items
- In Q1, Comfort Systems purchased the remaining 40% of EAS for stated consideration of $47.0 million and acquired Shoffner for preliminary consideration of $20.1 million. Shoffner contributed $55.3 million in revenue from its acquisition date through September 30.
- Purchasing the remaining EAS interest eliminated noncontrolling-interest income attribution in 2016. Year-to-date net income attributable to Comfort Systems therefore rose faster than consolidated net income.
- Backlog was $719.3 million at September 30, up 7.9% year over year but down 0.7% from June 30. Management cautions that backlog covers principally contracted installation/replacement work expected over roughly six to twelve months and is not a broad revenue forecast.
- The company early adopted stock-compensation accounting guidance in Q2; the reported cumulative retained-earnings adjustment was $38,000.
Outlook, risks and contingencies
Management expected 2016 revenue and profitability to exceed 2015 and said improved activity levels could continue into 2017. It gave no quantified forecast. Priorities included project execution, cost discipline, workforce development, and growth in service and small projects. Management estimated a 35%–38% effective tax rate for 2016; the nine-month rate was 36.0%.
Key risks include construction cyclicality, price competition, project cost overruns on fixed-price contracts, labor utilization and working-capital timing, floating-rate debt exposure, and potential loss or reduced availability of surety bonding. Historically, 20%–30% of business required bonds; management said current bonding capacity was adequate. The company also has self-insurance exposures and $41.5 million of letters of credit, most supporting insurance programs. Management said ordinary-course legal matters were not expected to have a material effect after recorded accruals. No nonrecurring fair-value impairments were recorded in the quarter.
Important facts for investors to verify
- Reconcile the filing’s revenue-mix descriptions: 39% new-construction installation versus approximately 81% project-based work and 19% service.
- Assess whether same-store trends, particularly reduced EAS manufacturing-project volume, and backlog conversion support the stated 2016–2017 outlook.
- Review the quality and timing of operating cash flow, which fell year over year despite higher earnings, and the effect of working-capital movements.
- Track acquisition integration, final purchase-price allocations, and future earn-out payments or fair-value adjustments.
- Monitor self-insurance claims, letters of credit, surety capacity, and covenant headroom; the filing says disclosure controls were effective and no material internal-control changes occurred in the quarter.