COMFORT SYSTEMS USA, INC. The following discussion and analysis should be read in conjunction with our
historical Consolidated Financial Statements and related notes included
elsewhere in this Form 10-Q and the Annual Report on Form 10-K filed with the
Introduction and Overview
We are a national provider of comprehensive mechanical and electrical installation, renovation, maintenance, repair and replacement services within the mechanical and electrical services industries. We operate primarily in the commercial, industrial and institutional markets and perform most of our services within office buildings, retail centers, apartment complexes, manufacturing plants, and healthcare, education and government facilities. We operate our business in two business segments: mechanical and electrical.
Nature and Economics of Our Business
In our mechanical business segment, customers hire us to ensure HVAC systems deliver specified or generally expected heating, cooling, conditioning and circulation of air in a facility. This entails installing core system equipment such as packaged heating and air conditioning units, or in the case of larger facilities, separate core components such as chillers, boilers, air handlers, and cooling towers. We also typically install connecting and distribution elements such as piping and ducting.
In our electrical business segment, our principal business activity is electrical construction and engineering in the commercial and industrial field. We also perform electrical logistics services, electrical service work, and electrical construction and engineering services.
In both our mechanical and electrical business segments, our responsibilities usually require conforming the systems to pre-established engineering drawings and equipment and performance specifications, which we frequently participate in establishing. Our project management responsibilities include staging equipment and materials to project sites, deploying labor to perform the work, and coordinating with other service providers on the project, including any subcontractors we might use to deliver our portion of the work.
Approximately 86.6% of our revenue is earned on a project basis for installation services in newly constructed facilities or for replacement of systems in existing facilities. When competing for project business, we usually estimate the costs we will incur on a project, and then propose a bid to the customer that includes a contract price and other performance and payment terms. Our bid price and terms are intended to cover our estimated costs on the project and provide a profit margin to us commensurate with the value of the installed system to the customer, the risk that project costs or duration will vary from estimate, the schedule on which we will be paid, the opportunities for other work that we might forego by committing capacity to this project, and other costs that we incur to support our operations but which are not specific to the project. Typically, customers will seek pricing from competitors for a given project. While the criteria on which customers select a service provider vary widely and include factors such as quality, technical expertise, on-time performance, post-project support and service, and company history and financial strength, we believe that price for value is the most influential factor for most customers in choosing a mechanical or electrical installation and service provider.
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After a customer accepts our bid, we generally enter into a contract with the customer that specifies what we will deliver on the project, what our related responsibilities are, and how much and when we will be paid. Our overall price for the project is typically set at a fixed amount in the contract, although changes in project specifications or work conditions that result in unexpected additional work are usually subject to additional payment from the customer via what are commonly known as change orders. Project contracts typically provide for periodic billings to the customer as we meet progress milestones or incur cost on the project. Project contracts in our industry also frequently allow for a small portion of progress billings or contract price to be withheld by the customer until after we have completed the work. Amounts withheld under this practice are known as retention or retainage.
Labor and overhead costs account for the majority of our cost of service. Accordingly, labor management and utilization have the most impact on our project performance. Given the fixed price nature of much of our project work, if our initial estimate of project costs is wrong or we incur cost overruns that cannot be recovered in change orders, we can experience reduced profits or even significant losses on fixed price project work. We also perform some project work on a cost-plus or a time and materials basis, under which we are paid our costs incurred plus an agreed-upon profit margin, and such projects are sometimes subject to a guaranteed maximum cost. These margins are frequently less than fixed-price contract margins because there is less risk of unrecoverable cost overruns in cost-plus or time and materials work.
As of
We also perform larger projects. Taken together, projects with contract prices
of
A stratification of projects in progress as ofMarch 31, 2020 , by contract price, is as follows: Aggregate Contract No. of Price Value Contract Price of Project Projects (millions) Under$1 million 4,801$ 654.8 $1 million -$5 million 574 1,262.7$5 million -$10 million 95 682.1$10 million -$15 million 43 530.2 Greater than$15 million 51 1,455.8 Total 5,564$ 4,585.6
In addition to project work, approximately 13.4% of our revenue represents maintenance and repair service on already installed HVAC, electrical, and controls systems. This kind of work usually takes from a few hours to a few days to perform. Prices to the customer are based on the equipment and materials used in the service as well as technician labor time. We usually bill the customer for service work when it is complete, typically with payment terms of up to thirty days. We also provide maintenance and repair service under ongoing contracts. Under these contracts, we are paid regular monthly or quarterly amounts and provide specified service based on customer requirements. These agreements typically are for one or more years and frequently contain thirty- to sixty-day cancellation notice periods.
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A relatively small portion of our revenue comes from national and regional account customers. These customers typically have multiple sites and contract with us to perform maintenance and repair service. These contracts may also provide for us to perform new or replacement systems installation. We operate a national call center to dispatch technicians to sites requiring service. We perform the majority of this work with our own employees, with the balance being subcontracted to third parties that meet our performance qualifications.
Profile and Management of Our Operations
We manage our 35 operating units based on a variety of factors. Financial measures we emphasize include profitability and use of capital as indicated by cash flow and by other measures of working capital principally involving project cost, billings and receivables. We also monitor selling, general, administrative and indirect project support expense, backlog, workforce size and mix, growth in revenue and profits, variation of actual project cost from original estimate, and overall financial performance in comparison to budget and updated forecasts. Operational factors we emphasize include project selection, estimating, pricing, management and execution practices, labor utilization, safety, training, and the make-up of both existing backlog as well as new business being pursued, in terms of project size, technical application, facility type, end-use customers and industries and location of the work.
Most of our operations compete on a local or regional basis. Attracting and retaining effective operating unit managers is an important factor in our business, particularly in view of the relative uniqueness of each market and operation, the importance of relationships with customers and other market participants, such as architects and consulting engineers, and the high degree of competition and low barriers to entry in most of our markets. Accordingly, we devote considerable attention to operating unit management quality, stability, and contingency planning, including related considerations of compensation and non-competition protection where applicable.
Economic and Industry Factors
As a mechanical and electrical services provider, we operate in the broader
nonresidential construction services industry and are affected by trends in this
sector. While we do not have operations in all major cities of
Spending decisions for building construction, renovation and system replacement are generally made on a project basis, usually with some degree of discretion as to when and if projects proceed. With larger amounts of capital, time, and discretion involved, spending decisions are affected to a significant degree by uncertainty, particularly concerns about economic and financial conditions and trends. We have experienced periods of time when economic weakness caused a significant slowdown in decisions to proceed with installation and replacement project work.
Operating Environment and Management Emphasis
Nonresidential building construction and renovation activity, as reported by the federal government, declined steeply over the four-year period from 2009 to 2012, and 2013 and 2014 activity levels were relatively stable at the low levels of the preceding years. During the five-year period from 2015 to 2019, there was an increase in overall activity levels.
We have a credit facility in place with terms we believe are favorable that does
not expire until
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As discussed at greater length in "Results of Operations" below, we expect price competition to continue as our customers and local and regional competitors compete for customers. We will continue to invest in our service business, to pursue the more active sectors in our markets, and to emphasize our regional and national account business. Our primary emphasis for 2020 is currently on right sizing our cost structure for our current business levels as well as focusing on efficiency on our jobs.
Cyclicality and Seasonality
Historically, the construction industry has been highly cyclical. As a result,
our volume of business, particularly in new construction projects and
renovation, may be adversely affected by declines in new installation and
replacement projects in various geographic regions of
The mechanical and electrical contracting industries are subject to seasonal variations. The demand for new installation and replacement is generally lower during the winter months (the first quarter of the year) due to reduced construction activity during inclement weather and less use of air conditioning during the colder months. Demand for our services is generally higher in the second and third calendar quarters due to increased construction activity and increased use of air conditioning during the warmer months. Accordingly, we expect our revenue and operating results generally will be lower in the first calendar quarter.
Results of Operations (dollars in thousands):
Three Months Ended March 31,
2020 2019
Revenue $ 700,131 100.0 % $ 538,473 100.0 %
Cost of services 583,038 83.3 % 431,808 80.2 %
Gross profit 117,093 16.7 % 106,665 19.8 %
Selling, general and administrative
expenses 92,924 13.3 % 78,905 14.7 %
Gain on sale of assets (554) (0.1) % (219) -
Operating income 24,723 3.5 % 27,979 5.2 %
Interest income 64 - 25 -
Interest expense (2,617) (0.4) % (1,062) (0.2) %
Changes in the fair value of
contingent earn-out obligations 2,272 0.3 % (158) -
Other income (expense) 25 - 15 -
Income before income taxes 24,467 3.5 % 26,799 5.0 %
Provision for income taxes 6,751 6,933
Net income $ 17,716 2.5 % $ 19,866 3.7 %
We had 35 operating locations as of
Revenue-Revenue for the first quarter of 2020 increased
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The following table presents our operating segment revenue (in thousands, except
percentages):
Three Months Ended March 31,
2020 2019
Revenue:
Mechanical Services $ 565,464 80.8 % $ 534,585 99.3 %
Electrical Services 134,667 19.2 % 3,888 0.7 %
Total $ 700,131 100.0 % $ 538,473 100.0 %
Revenue for our mechanical services segment increased
Revenue for our electrical services segment increased
Backlog reflects revenue still to be recognized under contracted or committed installation and replacement project work. Project work generally lasts less than one year. Service agreement revenue and service work and short duration projects, which are generally billed as performed, do not flow through backlog. Accordingly, backlog represents only a portion of our revenue for any given future period, and it represents revenue that is likely to be reflected in our operating results over the next six to twelve months. As a result, we believe the predictive value of backlog information is limited to indications of general revenue direction over the near term, and should not be interpreted as indicative of ongoing revenue performance over several quarters.
The following table presents our operating segment backlog (in thousands, except
percentages):
March 31, December 31, March 31,
2020 2019 2019
Backlog:
Mechanical Services $ 1,376,952 85.1 % $ 1,348,651 84.2 % $ 1,118,711 97.9 %
Electrical Services 241,443 14.9 % 253,135 15.8 % 23,800 2.1 %
Total $ 1,618,395 100.0 % $ 1,601,786 100.0 % $ 1,142,511 100.0 %
Backlog as of
Gross Profit-Gross profit increased
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16.7% in 2020 primarily due to the factors discussed above, but was also
attributable to lower margins on the Walker acquisition. Additionally,
preventative and protective actions taken on projects, such as the social
distancing and other procedure adjustments caused by COVID-19, did have some
negative impact on margins in the month of
Selling, General and Administrative Expenses ("SG&A")-SG&A increased
We have included same-store SG&A, excluding amortization, because we believe it is an effective measure of comparative results of operations. However, same-store SG&A, excluding amortization, is not considered under generally accepted accounting principles to be a primary measure of an entity's financial results, and accordingly, should not be considered an alternative to SG&A as shown in our consolidated statements of operations.
Three Months Ended
March 31,
2020 2019
(in thousands)
SG&A $ 92,924 $ 78,905
Less: SG&A from companies acquired (8,015) -
Less: Amortization expense (5,770) (4,388)
Same-store SG&A, excluding amortization expense
Interest Expense-Interest expense increased
Changes in the Fair Value of Contingent Earn-out Obligations-The contingent
earn-out obligations are measured at fair value each reporting period, and
changes in estimates of fair value are recognized in earnings. Income from
changes in the fair value of contingent earn-out obligations for the first
quarter of 2020 increased
Provision for Income Taxes-Our provision for income taxes for the three months
ended
We currently estimate our effective tax rate for the full year 2020 will be between 25% and 30%. However, our effective tax rate in 2020 could be on the low end of this range due to the extension of the 179D deduction through 2020 under the Taxpayer Certainty and Disaster Tax Relief Act of 2019.
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Outlook
Industry conditions improved during the four-year period from 2016 to 2019, and
at the beginning of 2020 we expected this strong activity to continue during
2020. However, during the second half of March we experienced negative impacts
to our business due to the business disruption caused by Coronavirus Disease
2019 ("COVID-19"). In
Our service business experienced the first and most pronounced negative impacts,
largely as a result of building closures or decisions by customers to limit
building access. Although our construction activities have been classified as
essential services in most markets, we have had certain jobs temporarily close
due to government action, decisions by owners, or upon positive tests for
COVID-19 of workers at various sites. We have also experienced delays in the
award of new work in some instances and we have been informed of some instances
of delayed starts; however, to date we have not experienced material
cancellations in our backlog. In addition, we have implemented safety
precautions and other COVID-19 related guidelines that have added cost or
inefficiency as we work to create a safe environment for our team members and
our communities. The Company considered the impact of COVID-19 on the
assumptions and estimates used to determine our results and asset valuations as
of
We expect COVID-19 to have an even more negative impact on our second quarter results, especially in the April and May timeframe. At this time it is impossible to quantify the potential impact to our second quarter because we do not know how the pandemic and related governmental decisions will unfold, but assuming the pandemic does not materially worsen the economic outlook of our markets, we expect our earnings to be positive but far below the levels we achieved in the second quarter of 2019. We also expect our earnings for the third and fourth quarters will trend upwards from lower levels in the second quarter, but we do not currently expect third and fourth quarter results of operation to approach the record earnings levels that we achieved in the same quarters of 2019.
Liquidity and Capital Resources (in thousands):
Three Months Ended
March 31,
2020 2019
Cash provided by (used in):
Operating activities $ 21,920 $ 991
Investing activities (15,536) (9,800)
Financing activities 76,092 (7,681)
Net increase (decrease) in cash and cash equivalents
$ 21,920 $ 991 Purchases of property and equipment (7,497) (8,844) Proceeds from sales of property and equipment 690 357 Free cash flow$ 15,113 $ (7,496) Cash Flow
Our business does not require significant amounts of investment in long-term fixed assets. The substantial majority of the capital used in our business is working capital that funds our costs of labor and installed equipment deployed in project work until our customer pays us. Customary terms in our industry allow customers to withhold a small portion of the contract price until after we have completed the work, typically for six months. Amounts withheld under this practice are known as retention or retainage. Our average project duration, together with typical retention terms, generally allow us to complete the realization of revenue and earnings in cash within one year.
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Cash Provided by Operating Activities-Cash flow from operations is primarily influenced by demand for our services and operating margins but can also be influenced by working capital needs associated with the various types of services that we provide. In particular, working capital needs may increase when we commence large volumes of work under circumstances where project costs, primarily associated with labor, equipment and subcontractors, are required to be paid before the receivables resulting from the work performed are billed and collected. Working capital needs are generally higher during the late winter and spring months as we prepare and plan for the increased project demand when favorable weather conditions exist in the summer and fall months. Conversely, working capital assets are typically converted to cash during the late summer and fall months as project completion is underway. These seasonal trends are sometimes offset by changes in the timing of major projects, which can be impacted by the weather, project delays or accelerations and other economic factors that may affect customer spending.
Cash provided by operating activities was
Cash Used in Investing Activities-During the first three months of 2020, cash
used in investing activities was
Cash Provided by (Used in) Financing Activities-Cash provided by financing
activities was
Free Cash Flow-We define free cash flow as cash provided by operating activities, less customary capital expenditures, plus the proceeds from asset sales. We believe free cash flow, by encompassing both profit margins and the use of working capital over our approximately one year working capital cycle, is an effective measure of operating effectiveness and efficiency. We have included free cash flow information here for this reason, and because we are often asked about it by third parties evaluating us. However, free cash flow is not considered under generally accepted accounting principles to be a primary measure of an entity's financial results, and accordingly free cash flow should not be considered an alternative to operating income, net income, or amounts shown in our consolidated statements of cash flows as determined under generally accepted accounting principles. Free cash flow may be defined differently by other companies.
Share Repurchase Program
On
The share repurchases will be made from time to time at our discretion in the
open market or privately negotiated transactions as permitted by securities laws
and other legal requirements, and subject to market conditions and other
factors. In an exercise of such discretion, commencing on
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the three months ended
Debt
Revolving Credit Facility and Term Loan
We have a
There are two interest rate options for borrowings under the Facility, the Base Rate Loan option and the Eurodollar Rate Loan option. These rates are floating rates determined by the broad financial markets, meaning they can and do move up and down from time to time. Additional margins are then added to these two rates.
Certain of our vendors require letters of credit to ensure reimbursement for amounts they are disbursing on our behalf, such as to beneficiaries under our self-funded insurance programs. We have also occasionally used letters of credit to guarantee performance under our contracts and to ensure payment to our subcontractors and vendors under those contracts. Our lenders issue such letters of credit through the Facility for a fee. We have never had a claim made against a letter of credit that resulted in payments by a lender or by us and believe such claims are unlikely in the foreseeable future. The letter of credit fees range from 1.25% to 2.00% per annum, based on the ratio of Consolidated Total Indebtedness to "Credit Facility Adjusted EBITDA", which shall mean Consolidated EBITDA as such term is defined in the credit agreement.
Commitment fees are payable on the portion of the revolving loan capacity not in use for borrowings or letters of credit at any given time. These fees range from 0.20% to 0.35% per annum, based on the ratio of Consolidated Total Indebtedness to Credit Facility Adjusted EBITDA.
The Facility contains financial covenants defining various financial measures and the levels of these measures with which we must comply. Covenant compliance is assessed as of each quarter end.
The Facility's principal financial covenants include:
Total Leverage Ratio-The Facility requires that the ratio of our Consolidated
Total Indebtedness to our Credit Facility Adjusted EBITDA not exceed 3.00 to
1.00 as of the end of each fiscal quarter. The total leverage ratio as of
Fixed Charge Coverage Ratio-The Facility requires that the ratio of (a) Credit Facility Adjusted EBITDA, less non-financed capital expenditures, provision for income taxes, dividends, and amounts used to repurchase stock when the Company's Total Leverage Ratio exceeds 2.00 to 1.00, to (b) the sum of interest expense and scheduled principal payments of indebtedness be at least 1.50 to 1.00. Credit Facility Adjusted EBITDA, capital expenditures, provision for income taxes, dividends, stock repurchase payments, interest expense, and scheduled principal payments are defined
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under the Facility for purposes of this covenant, to be amounts for the four
quarters ending as of any given quarterly covenant compliance measurement date.
The fixed charge coverage ratio as of
Other Restrictions-The Facility permits acquisitions of up to
While the Facility's financial covenants do not specifically govern capacity under the Facility, if our debt level under the Facility at a quarter-end covenant compliance measurement date were to cause us to violate the Facility's leverage ratio covenant, our borrowing capacity under the Facility and the favorable terms that we currently have could be negatively impacted by the lenders.
We were in compliance with all of our financial covenants as of
Notes to Former Owners
As part of the consideration used to acquire six companies, we have outstanding
notes to the former owners. These notes had an outstanding balance of
Outlook
We have generated positive net free cash flow for the last twenty-one calendar years, much of which occurred during challenging economic and industry conditions. We also continue to have significant borrowing capacity under our credit facility, and we maintain what we feel are reasonable cash balances. We believe these factors will provide us with sufficient liquidity to fund our operations for the foreseeable future.
Off-Balance Sheet Arrangements and Other Commitments
Certain of our vendors require letters of credit to ensure reimbursement for amounts they are disbursing on our behalf, such as to beneficiaries under our self-funded insurance programs. We have also occasionally used letters of credit to guarantee performance under our contracts and to ensure payment to our subcontractors and vendors under those contracts. The letters of credit we provide are actually issued by our lenders through the Facility as described above. A letter of credit commits the lenders to pay specified amounts to the holder of the letter of credit if the holder demonstrates that we have failed to perform specified actions. If this were to occur, we would be required to reimburse the lenders. Depending on the circumstances of such a reimbursement, we may also have to record a charge to earnings for the reimbursement. Absent a claim, there is no payment or reserving of funds by us in connection with a letter of credit. However, because a claim on a letter of credit would require immediate reimbursement by us to our lenders, letters of credit are treated as a use of the Facility's capacity just the same as actual borrowings. Claims against letters of credit are rare in our industry. To date, we have not had a claim made against a letter of credit that resulted in payments by a lender or by us. We believe that it is unlikely that we will have to fund claims under a letter of credit in the foreseeable future.
Many customers, particularly in connection with new construction, require us to post performance and payment bonds issued by a financial institution known as a surety. If we fail to perform under the terms of a contract or to pay
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subcontractors and vendors who provided goods or services under a contract, the customer may demand that the surety make payments or provide services under the bond. We must reimburse the sureties for any expenses or outlays they incur. To date, we are not aware of any losses to our sureties in connection with bonds the sureties have posted on our behalf, and we do not expect such losses to be incurred in the foreseeable future.
Under standard terms in the surety market, sureties issue bonds on a project-by-project basis, and can decline to issue bonds at any time. Historically, approximately 15% to 25% of our business has required bonds. While we currently have strong surety relationships to support our bonding needs, future market conditions or changes in our sureties' assessment of our operating and financial risk could cause our sureties to decline to issue bonds for our work. If that were to occur, our alternatives include doing more business that does not require bonds, posting other forms of collateral for project performance, such as letters of credit or cash, and seeking bonding capacity from other sureties. We would likely also encounter concerns from customers, suppliers and other market participants as to our creditworthiness. While we believe our general operating and financial characteristics would enable us to ultimately respond effectively to an interruption in the availability of bonding capacity, such an interruption would likely cause our revenue and profits to decline in the near term.
Contractual Obligations
As of
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