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 theSecurities and Exchange Commission for the year endedDecember 31, 2019 (the "Form 10-K"). This discussion contains "forward-looking statements" regarding our business and industry within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on our current plans and expectations and involve risks and uncertainties that could cause our actual future activities and results of operations to be materially different from those set forth in the forward-looking statements. Important factors that could cause actual results to differ include risks set forth in "Item 1A. Risk Factors" included in our Form 10-K. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. The terms "Comfort Systems," "we," "us," or the "Company," refer toComfort Systems USA, Inc. orComfort Systems USA, Inc. and its consolidated subsidiaries, as appropriate in the context.
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 87.2% 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 September 30, 2020 , we had 6,022 projects in process. Our average project
takes six to nine months to complete, with an average contract price of
approximately $835,000 . Our projects generally require working capital funding
of equipment and labor costs. Customer payments on periodic billings generally
do not recover these costs until late in the job. Our average project duration,
together with typical retention terms as discussed above, generally allow us to
complete the realization of revenue and earnings in cash within one year. We
have what we consider to be a well-diversified distribution of revenue across
end-use sectors that we believe reduces our exposure to negative developments in
any given sector. Because of the integral nature of our services to most
buildings, we have the legal right in almost all cases to attach liens to
buildings or related funding sources when we have not been fully paid for
installing systems, except with respect to some government buildings. The
service work that we do, which is discussed further below, usually does notgive rise to lien rights. We also perform larger projects. Taken together, projects with contract prices of$1 million or more totaled$4.4 billion of aggregate contract value as ofSeptember 30, 2020 , or approximately 87% of a total contract value for all projects in progress, totaling$5.0 billion . It is unusual for us to work on a project that exceeds two years in length. A stratification of projects in progress as ofSeptember 30, 2020 , by contract price, is as follows: Aggregate Contract No. of Price Value Contract Price of Project Projects (millions) Under$1 million 5,214$ 662.6 $1 million -$5 million 595 1,326.1$5 million -$10 million 102 740.3$10 million -$15 million 58 710.1 Greater than$15 million 53 1,588.0 Total 6,022$ 5,027.1
In addition to project work, approximately 12.8% 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.
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
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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 36 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 ofthe United States , we believe our national presence is sufficiently large that we experience trends in demand for and pricing of our services that are consistent with trends in the national nonresidential construction sector. As a result, we monitor the views of major construction sector forecasters along with macroeconomic factors they believe drive the sector, including trends in gross domestic product, interest rates, business investment, employment, demographics and the fiscal condition of federal, state and local governments. 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 untilJanuary 2025 . As ofSeptember 30, 2020 , we had$332.9 million of credit available to borrow under our credit facility. We have strong surety relationships to support our bonding needs, and we believe our relationships with the surety markets are strong and benefit from our operating history and financial position. We have generated positive free cash flow in each of the last twenty-one calendar years and will continue our emphasis in this area. We believe that the relative size and strength of our Balance Sheet and surety relationships, as compared to most companies in our industry, represent competitive advantages for us. 25 Table of Contents
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. 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 ofthe United States during periods of economic weakness. 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 September 30 , Nine
Months Ended
2020 2019 2020 2019
Revenue $ 714,099 100.0 % $ 706,918 100.0 % $ 2,157,698 100.0 % $ 1,895,693 100.0 %
Cost of
services 566,903 79.4 % 564,216 79.8 % 1,747,714 81.0 % 1,526,310 80.5 %Gross profit 147,196 20.6 % 142,702 20.2 % 409,984 19.0 % 369,383 19.5 % Selling, general and administrative expenses 90,888 12.7 % 90,006 12.7 % 268,857 12.5 % 253,417 13.4 % Gain on sale of assets (377) (0.1) % (708) (0.1) % (1,243) (0.1) % (1,119) (0.1) % Operating income 56,685 7.9 % 53,404 7.6 % 142,370 6.6 % 117,085 6.2 % Interest income 7 - 82 - 99 - 174 - Interest expense (1,733) (0.2) % (2,779) (0.4) % (6,904) (0.3) % (6,891) (0.4) %
Changes in the fair value of contingent earn-out obligations 3,423 0.5 % (2,004) (0.3) % 1,824 0.1 % (3,924) (0.2) % Other income (expense) (15) - 3 - 10 - 167 - Income before income taxes 58,367 8.2 % 48,706 6.9 % 137,399 6.4 % 106,611 5.6 % Provision for income taxes 8,279 12,473 30,100 26,339
Net income
5.0 %$ 80,272 4.2 % We had 35 operating locations as ofDecember 31, 2019 . In the second quarter of 2020, we completed the acquisition of TAS, which reports as a separate operating location. As ofSeptember 30, 2020 , we had 36 operating locations. Acquisitions are included in our results of operations from the respective acquisition date. The same-store comparison from 2020 to 2019, as described below, excludes three months of results for Walker, which was acquiredApril 1, 2019 , eight months of results for our electrical contractor inNorth Carolina , which was acquiredFebruary 1, 2020 and reports together with our existingNorth Carolina operation and six months of results for TAS, which was acquired onApril 1, 2020 . An operating location is included in the same-store comparison on the first day it has comparable prior year operating data, except for immaterial acquisitions that were absorbed and integrated, or "tucked-in," with existing operations. While the electrical contractor inNorth Carolina is tucked-in with our existingNorth Carolina operation, due to the size of the acquired operations, we have elected to exclude their results from our same-store comparison. 26 Table of Contents Revenue-Revenue for the third quarter of 2020 increased$7.2 million , or 1.0%, to$714.1 million compared to the same period in 2019. The increase included a 6.8% increase related to theNorth Carolina electrical contractor and TAS acquisitions and a 5.8% decrease in revenue related to same-store activity. The following table presents our operating segment revenue (in thousands, except percentages): Three Months Ended September 30, 2020 2019 Revenue: Mechanical Services$ 621,140 87.0 %$ 590,016 83.5 % Electrical Services 92,959 13.0 % 116,902 16.5 % Total$ 714,099 100.0 %$ 706,918 100.0 % Revenue for our mechanical services segment increased$31.1 million , or 5.3%, to$621.1 million for the third quarter of 2020 compared to the same period in 2019. The increase included the acquisition of TAS inApril 2020 ($28.6 million ) as well as an increase in activity in the education sector at one of ourVirginia operations ($14.2 million ). This increase was offset by a decrease in activity in the education sector at ourNorth Carolina operation ($7.0 million ) and in the healthcare sector at one of ourTexas operations ($6.1 million ). Revenue for our electrical services segment decreased$23.9 million to$93.0 million for the third quarter of 2020 compared to the same period in 2019. The decrease related to the impact of Coronavirus Disease 2019 ("COVID-19") as well as expected decreases driven by a higher volume of large jobs in the prior period at our Walker operation ($42.3 million ). The decrease was partially offset by the acquisition of the electrical contractor inNorth Carolina ($19.6 million ). Revenue for the first nine months of 2020 increased$262.0 million , or 13.8%, to$2.16 billion compared to the same period in 2019. The increase included a 13.5% increase related to the TAS,North Carolina electrical contractor and Walker acquisitions and a 0.3% increase in revenue related to same-store activity. The following table presents our operating segment revenue (in thousands, except percentages): Nine Months Ended September 30, 2020 2019 Revenue: Mechanical Services$ 1,809,304 83.9 %$ 1,677,632 88.5 % Electrical Services 348,394 16.1 % 218,061 11.5 % Total$ 2,157,698 100.0 %$ 1,895,693 100.0 % Revenue for our mechanical services segment increased$131.7 million , or 7.8%, to$1.81 billion for the first nine months of 2020 compared to the same period in 2019. Of this increase,$84.3 million was attributable to the TAS acquisition. The same-store revenue increase included an increase in activity in the industrial sector at ourNorth Carolina operation ($16.5 million ), in the education sector at ourArizona operation ($13.6 million ) and at one of ourVirginia operations ($13.3 million ), and in the government sector at one of ourTennessee operations ($12.9 million ). This increase was offset by the sale of the majority of the assets and ongoing business of ourCalifornia operation in the third quarter of 2019 ($13.8 million ). Revenue for our electrical services segment increased$130.3 million to$348.4 million for the first nine months of 2020 compared to the same period in 2019. The increase related to the acquisition of Walker inApril 2019 as well as the acquisition of the electrical contractor inNorth Carolina inFebruary 2020 . 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
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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):
September 30, December 31, September 30,
2020 2019 2019
Backlog:
Mechanical Services $ 1,226,146 85.8 % $ 1,348,651 84.2 % $ 1,312,396 81.6 %
Electrical Services 202,441 14.2 % 253,135 15.8 %
296,601 18.4 %
Total $ 1,428,587 100.0 % $ 1,601,786 100.0 % $ 1,608,997 100.0 %
Backlog as of September 30, 2020 was $1.43 billion , a 6.7% decrease from June
30, 2020 backlog of $1.53 billion , and an 11.2% decrease from September 30, 2019
backlog of $1.61 billion . The sequential backlog decrease was broad-based, and
was primarily as a result of completion of project work at two of our Virginia
operations ($27.2 million ), one of our Florida operations ($15.9 million ), our
Colorado operation ($10.0 million ) and our Wisconsin operation ($8.2 million ).
Additionally, we had increased project bookings at one of our Texas operations
($6.8 million ). The year-over-year backlog decrease included a same-store
decrease of $271.1 million , or 16.8% partially offset by the TAS acquisition
($40.1 million ) and the acquisition of the electrical contractor in North
Carolina ($50.6 million ). Same-store year-over-year backlog decreased primarily
due to completion of project work at Walker ($141.7 million ), our North Carolina
operation ($37.5 million ), one of our Texas operations ($28.8 million ) and our
Arizona operation ($21.7 million ). Additionally, we had increased project
bookings at one of our Indiana operations ($22.4 million ).
Gross Profit-Gross profit increased $4.5 million , or 3.1%, to $147.2 million for
the third quarter of 2020 as compared to the same period in 2019. The increase
included a 2.1% increase related to the TAS and North Carolina electrical
contractor acquisitions and a 1.0% increase in same-store activity. The
same-store increase in gross profit was primarily due to improvements in project
execution at one of our Indiana operations ($5.3 million ) and one of our
Tennessee operations ($2.9 million ), partially offset by a decrease at our
Arkansas operation ($2.5 million ) compared to the prior year. Additionally, we
had increased volumes at one of our Virginia operations ($4.2 million ), offset
by a decrease in volumes at Walker ($7.4 million ). As a percentage of revenue,
gross profit for the third quarter increased from 20.2% in 2019 to 20.6% in 2020
primarily due to a broad-based improvement in project execution, as discussed
above.
Gross profit increased $40.6 million , or 11.0%, to $410.0 million for the first
nine months of 2020 as compared to the same period in 2019. The increase
included a 4.9% increase related to the TAS, North Carolina electrical
contractor and Walker acquisitions and a 6.1% increase in same-store activity.
The same-store increase in gross profit was primarily due to improvements in
project execution at our North Carolina operation ($14.9 million ) and one of our
Indiana operations ($7.0 million ), partially offset by a decrease at one of our
Florida operations ($7.0 million ) compared to the prior year. Additionally, we
had increased volumes at one of our Virginia operations ($3.2 million ). As a
percentage of revenue, gross profit for the nine-month period decreased from
19.5% in 2019 to 19.0% in 2020 primarily due to the factors discussed above and
lower margins on the Walker acquisition, which was acquired in April 2019 .
Additionally, preventative and protective actions taken on projects, such as the
social distancing and other procedure adjustments caused by COVID-19, negatively
impacted margins starting in March 2020 .
Selling, General and Administrative Expenses ("SG&A")-SG&A increased
$0.9 million , or 1.0%, to $90.9 million for the third quarter of 2020 as
compared to 2019. On a same-store basis, excluding amortization expense, SG&A
decreased $3.8 million , or 4.5%. This decrease is primarily due to the reduction
in same-store revenue for the period, as well as reductions in travel-related
expenses ($1.2 million ) as a result of COVID-19 and lower bad debt expense of
$0.6 million in the third quarter of 2020. These decreases were partially offset
by increases in tax consulting fees in the third quarter of 2020 which totaled
$2.8 million , as compared to $0.9 million in the same period in 2019.
Amortization expense increased $0.8 million during the period, primarily as a
result of the TAS and North Carolina electrical contractor acquisitions. As a
percentage of revenue, SG&A for the third quarter remained steady at 12.7%
in
both 2019 and 2020.
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SG&A increased$15.4 million , or 6.1%, to$268.9 million for the first nine months of 2020 as compared to 2019. On a same-store basis, excluding amortization expense, SG&A decreased$3.3 million , or 1.4%. This decrease is primarily due to the sale of the majority of the assets and ongoing business of ourCalifornia operation in the third quarter of 2019 ($5.0 million ) as well as due to a reduction in travel-related expenses as a result of COVID-19 ($2.8 million ). These decreases were partially offset by an increase in bad debt expense of$2.3 million , mainly driven by concerns about collectability of certain receivables due to the business interruptions caused by COVID-19, specifically with respect to receivables with retail, restaurants and entertainment companies. Furthermore, tax consulting fees increased from$1.3 million in the first nine months of 2019 to$2.8 million in the same period in 2020. Amortization expense increased$3.0 million during the period, primarily as a result of the Walker, TAS andNorth Carolina electrical contractor acquisitions. As a percentage of revenue, SG&A for the nine-month period decreased from 13.4% in 2019 to 12.5% in 2020 due to the factors discussed above and due to the acquisition of Walker, which has lower SG&A as a percentage
of
revenue.
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 Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(in thousands) (in thousands)
SG&A $ 90,888 $ 90,006 $ 268,857 $ 253,417 Less: SG&A from companies acquired (3,813) - (15,730)
-
Less: Amortization expense (6,889) (6,065) (19,596) (16,575)
Same-store SG&A, excluding
amortization expense $ 80,186 $ 83,941 $ 233,531 $ 236,842
Interest Expense-Interest expense decreased $1.0 million , or 37.6%, to
$1.7 million for the third quarter of 2020 as compared to the same period in
2019. The decrease in interest expense is due to a reduction in our average
interest rate on our outstanding borrowings in the third quarter of 2020
compared to the prior year. Interest expense remained steady at $6.9 million for
the first nine months of both 2020 and 2019. Increases in borrowings on the
senior credit facility and notes to former owners for our recent acquisitions,
including TAS, were offset by a reduction in our average interest rate on
outstanding borrowings for the first nine months of 2020 as compared to 2019.
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 third
quarter of 2020 increased $5.4 million as compared to the same period in 2019.
Income from changes in the fair value of contingent earn-out obligations for the
first nine months of 2020 increased $5.7 million as compared to the same period
in 2019. The increases were caused by higher expenses in the prior year as a
result of increasing our obligation for the BCH acquisition as earnings exceeded
forecast in the prior year as well as a reduction in our obligation for Walker
in the current year caused by project delays, the impact of COVID-19 and lower
than forecasted earnings in the current quarter.
Provision for Income Taxes-Our provision for income taxes for the nine months
ended September 30, 2020 was $30.1 million with an effective tax rate of 21.9%
as compared to a provision for income taxes of $26.3 million with an effective
tax rate of 24.7% for the same period in 2019. The effective tax rate for 2020
was higher than the 21% federal statutory rate primarily due to net state income
taxes (4.8%) and nondeductible expenses, including nondeductible expenses
related to TAS (2.2%), partially offset by a decrease in unrecognized tax
benefits as a result of settlement with the Internal Revenue Service (the "IRS")
upon completion of its examination of our amended federal returns for 2014 and
2015 (6.0%). The effective tax rate for 2019 was higher than the 21% federal
statutory rate primarily due to net state income taxes (4.4%) and nondeductible
expenses (1.7%) partially offset by benefits from the filing, and expected
filing, of amended returns to claim the energy efficient commercial buildings
deduction (the "179D deduction") allocated to us (1.9%) and deductions for
stock-based compensation (0.4%).
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We currently estimate our effective tax rate for the full year 2020 will be between 22% and 25%, which includes the tax benefits from theIRS settlement of 2014 and 2015 tax years. Starting in 2021, we expect our effective tax rate will be between 25% and 30%, as we cannot reasonably estimate the tax benefits from the credit for increasing research activities (the "R&D tax credit") or 179D deduction at this time. 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 the current year. However, starting at the end of the first quarter of this year, we experienced negative impacts to our business due to the business disruption caused by COVID-19. InMarch 2020 , theWorld Health Organization categorized COVID-19 as a pandemic, andthe United States declared the COVID-19 outbreak a national emergency. Our service business experienced the first and most pronounced negative impacts, largely because of building closures or decisions by customers to limit building access. As of the end of the third quarter, the majority of our service operations had returned to levels that are at or near normal functioning. Our construction activities have generally been classified as essential services in the substantial majority of our markets, although we have had certain jobs temporarily or partially close due to government action, decisions by owners, or upon positive tests for COVID-19 of workers at various sites. We have experienced delays in the award of new construction work in certain instances, and we have also experienced limited instances of delayed starts. Additionally, we have had some delays or cancellations of work in less than 5% of our backlog. Across our operations 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 ongoing impact of COVID-19 on the assumptions and estimates used to determine our results and asset valuations as ofSeptember 30, 2020 and determined that there were no material or systematic adverse impacts on the Company's third quarter except for diminished revenue, operational inefficiency, and adjustments in bad debt expense due to the potential for nonpayment by customers in industries more directly impacted by COVID-19. At this time, it is impossible to quantify the impact of COVID-19 in the upcoming quarters because we do not know how the pandemic and related governmental decisions will unfold, nor how the pandemic may impact decisions of our customers. The impact of COVID-19 creates more uncertainty than usual in our business outlook, and we currently expect that in some markets we will experience additional delays in the award or commencement of a portion of our projects that is likely to impact activity levels in the coming quarters and particularly during the first half of 2021. Nevertheless, assuming COVID-19 does not materially worsen, we expect that that we will continue to achieve substantial positive earnings and cash flow in the fourth quarter of 2020 and in 2021, and we continue to prepare for a wide range of economic circumstances. 30 Table of Contents
Liquidity and Capital Resources (in thousands):
Nine Months Ended
September 30,
2020 2019
Cash provided by (used in):
Operating activities $ 216,400 $ 99,715
Investing activities (130,514) (216,053)
Financing activities (66,134) 111,081Net increase (decrease) in cash and cash equivalents$ 19,752 $ (5,257) Free cash flow: Cash provided by operating activities$ 216,400 $
99,715
Purchases of property and equipment (19,459)
(22,641)
Proceeds from sales of property and equipment 1,890
1,447 Free cash flow$ 198,831 $ 78,521 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. 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$216.4 million during the first nine months of 2020 compared with$99.7 million during the same period in 2019. This increase was primarily driven by a$65.0 million change in receivables, net driven by strong collections in the current year, an$18.0 million change in other long-term liabilities, a$14.0 million change in prepaid expenses and other current assets and an$8.9 million change in billings in excess of costs, which was driven by timing of payments and project billings. Operating cash flows in the current year benefited by approximately$20.9 million from the deferral of payroll taxes allowed by the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") that normally would have been paid by September
30, 2020. Cash Used in Investing Activities-During the first nine months of 2020, cash used in investing activities was$130.5 million compared to$216.1 million during the same period in 2019. The$85.6 million decrease in cash used primarily relates to cash paid (net of cash acquired) for acquisitions in 2020 compared to the same period in 2019. Cash Provided by (Used in) Financing Activities-Cash used in financing activities was$66.1 million for the first nine months of 2020 compared to cash provided by financing activities of$111.1 million during the same period in 2019. The$177.2 million decrease in cash provided by financing activities is primarily due to a decrease in net proceeds from the debt compared to the prior year, which was driven by stronger operating cash flows in the current year that allowed us to pay down more debt. 31 Table of Contents 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 OnMarch 29, 2007 , our Board of Directors (the "Board") approved a stock repurchase program to acquire up to 1.0 million shares of our outstanding common stock. Subsequently, the Board has from time to time increased the number of shares that may be acquired under the program and approved extensions of the program. OnNovember 19, 2019 , the Board approved an extension to the program by increasing the shares authorized for repurchase by 0.8 million shares. Since the inception of the repurchase program, the Board has approved 9.5 million shares to be repurchased. As ofSeptember 30, 2020 , we have repurchased a cumulative total of 9.1 million shares at an average price of$18.89 per share under the repurchase program. 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, we suspended share repurchases fromMarch 27, 2020 toMay 26, 2020 in response to the uncertainty surrounding the current COVID-19 pandemic, as more fully described in "Item 1A. Risk Factors" herein. The Board may modify, suspend, extend or terminate the program at any time. During the nine months endedSeptember 30, 2020 , we repurchased 0.4 million shares for approximately$18.8 million at an average price of$41.90 per share. Debt
Revolving Credit Facility and Term Loan
We have a$600.0 million senior credit facility (the "Facility") provided by a syndicate of banks. The Facility is composed of a revolving credit line in the amount of$450.0 million and a$150.0 million term loan, and the Facility provides for a$150.0 million accordion or increase option for the revolving portion of the Facility. The Facility also includes a sublimit of up to$160.0 million issuable in the form of letters of credit. The Facility expires inJanuary 2025 and is secured by a first lien on substantially all of our personal property except for assets related to projects subject to surety bonds and assets held by certain unrestricted subsidiaries and our wholly owned captive insurance company and a second lien on our assets related to projects subject to surety bonds. In 2019, we incurred approximately$1.4 million in financing and professional costs in connection with an amendment to the Facility, which are being amortized over the remaining term of the Facility. Of this amount,$0.4 million is attributable to the term loan and is being amortized using the effective interest method. The remaining$1.0 million is attributable to the revolving credit line, which combined with the previous unamortized costs of$1.3 million , is being amortized over the remaining term of the Facility on a straight-line basis as a non-cash charge to interest expense. For the term loan, we are required to make quarterly payments increasing over time from 1.25% to 3.75% of the original aggregate principal amount of the term loan, with the balance due inJanuary 2025 . As ofSeptember 30, 2020 , we had$61.5 million of outstanding borrowings on the revolving credit facility,$55.6 million in letters of credit outstanding and$332.9 million of credit available. 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 32
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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 ofSeptember 30, 2020 was 0.8. 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 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 ofSeptember 30, 2020 was 6.6.
Other Restrictions-The Facility permits acquisitions of up to$5.0 million per transaction, provided that the aggregate purchase price of such an acquisition and of acquisitions in the same fiscal year does not exceed$10.0 million . However, these limitations only apply when the Company's Total Leverage Ratio is greater than 2.50 to 1.00. 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 four companies, we have outstanding notes to the former owners. These notes had an outstanding balance of$26.1 million as ofSeptember 30, 2020 . In conjunction with the acquisition of TAS in the second quarter of 2020, we issued a promissory note to former owners with an outstanding balance of$8.0 million as ofSeptember 30, 2020 that bears interest, payable quarterly, at a stated interest rate of 3.5%. The principal is due inApril 2022 . In conjunction with the acquisition of the electrical contractor inNorth Carolina in the first quarter of 2020, we issued a promissory note to former owners with an outstanding balance of$8.0 million as ofSeptember 30, 2020 that bears interest, payable quarterly, at a stated interest rate of 3.0%. The principal is due in equal installments inFebruary 2023 andFebruary 2024 . In conjunction with the Walker acquisition in the second quarter of 2019, we issued a promissory note to former owners with an outstanding balance of$10.0 million as ofSeptember 30, 2020 that bears interest, payable quarterly, at a stated interest rate of 4.0%. The principal is due inApril 2023 . In conjunction with one immaterial acquisition in 2019, we issued a note to former owners with an outstanding balance of$0.1 million as ofSeptember 30, 2020 that bears interest, payable quarterly, at a stated interest rate of 3.0%. The principal is due inJanuary 2021 . 33 Table of Contents 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 subcontractors and vendorswho 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 ofSeptember 30, 2020 , we have$55.6 million in letter of credit commitments, of which$14.8 million will expire in 2020 and$40.8 million will expire in 2021. The substantial majority of these letters of credit are posted with insurerswho disburse funds on our behalf in connection with our workers' compensation, auto liability and general liability insurance program. These letters of credit provide additional security to the insurers that sufficient financial resources will be available to fund claims on our behalf, many of which develop over long periods of time, should we ever encounter financial duress. Posting of letters of credit for this purpose is a common practice for entities that manage their self-insurance programs through third-party insurers as we do. While many of these letter of credit commitments expire in the next twelve months, we expect nearly all of them, particularly those supporting our insurance programs, will be renewed annually. 34 Table of Contents
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