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COMFORT SYSTEMS USA INC - Quarter Report: 2017 September (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10‑Q

 

 

(Mark One)

 

QUARTERLY REPORT PURSUANT TO SECTION 13, OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to            

Commission file number: 1‑13011

COMFORT SYSTEMS USA, INC.

(Exact name of registrant as specified in its charter)

 

 

DELAWARE
(State or other jurisdiction of
Incorporation or Organization)

76‑0526487
(I.R.S. Employer
Identification No.)

675 Bering Drive
Suite 400
Houston, Texas 77057
(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (713) 830‑9600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒  No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S‑T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒  No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

 

 

 

Large accelerated filer 

Accelerated filer 

Non‑accelerated filer 
(Do not check if a
smaller reporting company)

Smaller reporting company 

Emerging growth company 

 

 

 

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b‑2). Yes ☐  No ☒

The number of shares outstanding of the issuer’s common stock as of October 19, 2017 was 37,134,226 (excluding treasury shares of 3,989,139).

 

 

 

 


 

Table of Contents

COMFORT SYSTEMS USA, INC.

INDEX TO FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2017

 

 

 

 

 

    

Page

Part I—Financial Information

 

 

Item 1—Financial Statements

 

 

Consolidated Balance Sheets 

 

1

Consolidated Statements of Operations 

 

2

Consolidated Statements of Stockholders’ Equity 

 

3

Consolidated Statements of Cash Flows 

 

4

Condensed Notes to Consolidated Financial Statements 

 

5

Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations 

 

13

Item 3—Quantitative and Qualitative Disclosures about Market Risk 

 

23

Item 4—Controls and Procedures 

 

23

Part II—Other Information 

 

24

Item 1—Legal Proceedings 

 

24

Item 1A—Risk Factors 

 

24

Item 2—Unregistered Sales of Equity Securities and Use of Proceeds 

 

24

Item 6—Exhibits 

 

26

Signatures 

 

27

 

 

 

 

 


 

Table of Contents

COMFORT SYSTEMS USA, INC.

CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Amounts)

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

    

2017

    

2016

 

 

 

(Unaudited)

 

 

 

 

ASSETS

 

 

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

29,496

 

$

32,074

 

Accounts receivable, less allowance for doubtful accounts of $4,328 and $4,288, respectively

 

 

390,497

 

 

318,837

 

Other receivables

 

 

13,651

 

 

20,363

 

Inventories

 

 

10,778

 

 

9,208

 

Prepaid expenses and other

 

 

11,622

 

 

6,106

 

Costs and estimated earnings in excess of billings

 

 

39,333

 

 

29,369

 

Total current assets

 

 

495,377

 

 

415,957

 

PROPERTY AND EQUIPMENT, NET

 

 

74,883

 

 

68,195

 

GOODWILL

 

 

203,771

 

 

149,208

 

IDENTIFIABLE INTANGIBLE ASSETS, NET

 

 

78,527

 

 

42,435

 

DEFERRED INCOME TAX ASSETS

 

 

27,282

 

 

27,170

 

OTHER NONCURRENT ASSETS

 

 

4,747

 

 

5,938

 

Total assets

 

$

884,587

 

$

708,903

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

 

 

Current maturities of long-term debt

 

$

618

 

$

600

 

Current maturities of long-term capital lease obligations

 

 

90

 

 

163

 

Accounts payable

 

 

122,203

 

 

103,440

 

Accrued compensation and benefits

 

 

68,294

 

 

61,712

 

Billings in excess of costs and estimated earnings

 

 

103,049

 

 

83,985

 

Accrued self-insurance

 

 

32,774

 

 

33,520

 

Other current liabilities

 

 

46,774

 

 

34,261

 

Total current liabilities

 

 

373,802

 

 

317,681

 

LONG-TERM DEBT

 

 

80,951

 

 

1,955

 

LONG-TERM CAPITAL LEASE OBLIGATIONS

 

 

33

 

 

93

 

DEFERRED INCOME TAX LIABILITIES

 

 

2,289

 

 

2,289

 

OTHER LONG-TERM LIABILITIES

 

 

15,583

 

 

10,252

 

Total liabilities

 

 

472,658

 

 

332,270

 

COMMITMENTS AND CONTINGENCIES

 

 

 

 

 

 

 

STOCKHOLDERS’ EQUITY:

 

 

 

 

 

 

 

Preferred stock, $.01 par, 5,000,000 shares authorized, none issued and outstanding

 

 

 —

 

 

 —

 

Common stock, $.01 par, 102,969,912 shares authorized, 41,123,365 and 41,123,365 shares issued, respectively

 

 

411

 

 

411

 

Treasury stock, at cost, 3,989,139 and 3,914,251 shares, respectively

 

 

(64,312)

 

 

(57,387)

 

Additional paid-in capital

 

 

312,312

 

 

309,625

 

Retained earnings

 

 

163,518

 

 

123,984

 

Total stockholders’ equity

 

 

411,929

 

 

376,633

 

Total liabilities and stockholders’ equity

 

$

884,587

 

$

708,903

 

 

The accompanying notes are an integral part of these consolidated financial statements.

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COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Per Share Data)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2017

    

2016

    

2017

    

2016

 

REVENUE

 

$

480,851

 

$

428,760

 

$

1,326,850

 

$

1,242,240

 

COST OF SERVICES

 

 

379,993

 

 

335,944

 

 

1,054,300

 

 

986,496

 

Gross profit

 

 

100,858

 

 

92,816

 

 

272,550

 

 

255,744

 

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

 

 

66,707

 

 

61,032

 

 

196,553

 

 

180,245

 

GOODWILL IMPAIRMENT

 

 

 —

 

 

 —

 

 

1,105

 

 

 —

 

GAIN ON SALE OF ASSETS

 

 

(184)

 

 

(166)

 

 

(464)

 

 

(523)

 

Operating income

 

 

34,335

 

 

31,950

 

 

75,356

 

 

76,022

 

OTHER INCOME (EXPENSE):

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

16

 

 

 3

 

 

55

 

 

 6

 

Interest expense

 

 

(961)

 

 

(563)

 

 

(2,392)

 

 

(1,870)

 

Changes in the fair value of contingent earn-out obligations

 

 

2,469

 

 

804

 

 

1,845

 

 

468

 

Other

 

 

10

 

 

80

 

 

57

 

 

455

 

Other income (expense)

 

 

1,534

 

 

324

 

 

(435)

 

 

(941)

 

INCOME BEFORE INCOME TAXES

 

 

35,869

 

 

32,274

 

 

74,921

 

 

75,081

 

INCOME TAX EXPENSE

 

 

13,585

 

 

11,803

 

 

27,188

 

 

27,052

 

NET INCOME

 

$

22,284

 

$

20,471

 

$

47,733

 

$

48,029

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

INCOME PER SHARE:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.60

 

$

0.55

 

$

1.28

 

$

1.28

 

Diluted

 

$

0.59

 

$

0.54

 

$

1.27

 

$

1.27

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SHARES USED IN COMPUTING INCOME PER SHARE:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

37,232

 

 

37,360

 

 

37,259

 

 

37,380

 

Diluted

 

 

37,626

 

 

37,821

 

 

37,684

 

 

37,854

 

DIVIDENDS PER SHARE

 

$

0.075

 

$

0.070

 

$

0.220

 

$

0.205

 

The accompanying notes are an integral part of these consolidated financial statements.

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COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In Thousands, Except Share Amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Non-

 

Total

 

 

    

Common Stock

    

Treasury Stock

    

Paid-In

 

Retained

    

Controlling

    

Stockholders’

 

 

    

Shares

    

Amount

    

Shares

    

Amount

    

Capital

    

Earnings

    

Interests

    

Equity

 

BALANCE AT DECEMBER 31, 2015

 

41,123,365

 

$

411

 

(3,696,781)

 

$

(46,845)

 

$

323,765

 

$

69,390

 

$

18,284

 

$

365,005

 

Cumulative effect of change in accounting principle

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(38)

 

 

 —

 

 

(38)

 

Net income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

64,896

 

 

 —

 

 

64,896

 

Issuance of Stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of shares for options exercised

 

 —

 

 

 —

 

111,761

 

 

1,568

 

 

10

 

 

 —

 

 

 —

 

 

1,578

 

Issuance of restricted stock & performance stock

 

 —

 

 

 —

 

172,727

 

 

2,282

 

 

(306)

 

 

 —

 

 

 —

 

 

1,976

 

Shares received in lieu of tax withholding payment on vested restricted stock

 

 —

 

 

 —

 

(41,788)

 

 

(1,304)

 

 

 —

 

 

 —

 

 

 —

 

 

(1,304)

 

Stock-based compensation

 

 —

 

 

 —

 

 —

 

 

 —

 

 

3,502

 

 

 —

 

 

 —

 

 

3,502

 

Dividends

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(10,264)

 

 

 —

 

 

(10,264)

 

Acquisition of noncontrolling interest

 

 —

 

 

 —

 

 —

 

 

 —

 

 

(17,346)

 

 

 —

 

 

(18,284)

 

 

(35,630)

 

Share repurchase

 

 —

 

 

 —

 

(460,170)

 

 

(13,088)

 

 

 —

 

 

 —

 

 

 —

 

 

(13,088)

 

BALANCE AT DECEMBER 31, 2016

 

41,123,365

 

 

411

 

(3,914,251)

 

 

(57,387)

 

 

309,625

 

 

123,984

 

 

 —

 

 

376,633

 

Net income (unaudited)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

47,733

 

 

 —

 

 

47,733

 

Issuance of Stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of shares for options exercised (unaudited)

 

 —

 

 

 —

 

90,498

 

 

1,366

 

 

(70)

 

 

 —

 

 

 —

 

 

1,296

 

Issuance of restricted stock & performance stock (unaudited)

 

 —

 

 

 —

 

134,646

 

 

2,037

 

 

(421)

 

 

 —

 

 

 —

 

 

1,616

 

Shares received in lieu of tax withholding payment on vested restricted stock (unaudited)

 

 —

 

 

 —

 

(39,335)

 

 

(1,419)

 

 

 —

 

 

 —

 

 

 —

 

 

(1,419)

 

Stock-based compensation (unaudited)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

3,178

 

 

 —

 

 

 —

 

 

3,178

 

Dividends (unaudited)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(8,199)

 

 

 —

 

 

(8,199)

 

Share repurchase (unaudited)

 

 —

 

 

 —

 

(260,697)

 

 

(8,909)

 

 

 —

 

 

 —

 

 

 —

 

 

(8,909)

 

BALANCE AT SEPTEMBER 30, 2017 (unaudited)

 

41,123,365

 

$

411

 

(3,989,139)

 

$

(64,312)

 

$

312,312

 

$

163,518

 

$

 —

 

$

411,929

 

The accompanying notes are an integral part of these consolidated financial statements.

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COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

    

2017

    

2016

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

 

 

Net income

 

$

47,733

 

$

48,029

 

Adjustments to reconcile net income to net cash provided by operating activities—

 

 

 

 

 

 

 

Amortization of identifiable intangible assets

 

 

12,622

 

 

6,227

 

Depreciation expense

 

 

14,714

 

 

13,444

 

Goodwill impairment

 

 

1,105

 

 

 —

 

Bad debt expense (benefit)

 

 

29

 

 

(177)

 

Deferred tax benefit

 

 

(112)

 

 

(606)

 

Amortization of debt financing costs

 

 

282

 

 

273

 

Gain on sale of assets

 

 

(464)

 

 

(523)

 

Changes in the fair value of contingent earn-out obligations

 

 

(1,845)

 

 

(468)

 

Stock-based compensation

 

 

4,317

 

 

3,868

 

Changes in operating assets and liabilities, net of effects of acquisitions and divestitures—

 

 

 

 

 

 

 

(Increase) decrease in—

 

 

 

 

 

 

 

Receivables, net

 

 

(38,051)

 

 

(4,301)

 

Inventories

 

 

(1,059)

 

 

(298)

 

Prepaid expenses and other current assets

 

 

(608)

 

 

(3,648)

 

Costs and estimated earnings in excess of billings

 

 

(7,348)

 

 

(3,726)

 

Other noncurrent assets

 

 

913

 

 

(128)

 

Increase (decrease) in—

 

 

 

 

 

 

 

Accounts payable and accrued liabilities

 

 

22,595

 

 

1,628

 

Billings in excess of costs and estimated earnings

 

 

10,309

 

 

(10,928)

 

Other long-term liabilities

 

 

560

 

 

1,088

 

Net cash provided by operating activities

 

 

65,692

 

 

49,754

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(16,830)

 

 

(17,257)

 

Proceeds from sales of property and equipment

 

 

784

 

 

847

 

Cash paid for acquisitions, net of cash acquired

 

 

(94,860)

 

 

(58,510)

 

Net cash used in investing activities

 

 

(110,906)

 

 

(74,920)

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

 

 

Proceeds from revolving line of credit

 

 

140,000

 

 

144,000

 

Payments on revolving line of credit

 

 

(74,000)

 

 

(129,000)

 

Payments on other debt

 

 

(798)

 

 

(567)

 

Payments on capital lease obligations

 

 

(133)

 

 

(194)

 

Debt financing costs

 

 

 —

 

 

(789)

 

Payments of dividends to stockholders

 

 

(8,199)

 

 

(7,663)

 

Share repurchase

 

 

(8,909)

 

 

(10,977)

 

Shares received in lieu of tax withholding

 

 

(1,419)

 

 

(1,304)

 

Proceeds from exercise of options

 

 

1,296

 

 

733

 

Deferred acquisition payments

 

 

(2,802)

 

 

 —

 

Payments for contingent consideration arrangements

 

 

(2,400)

 

 

(200)

 

Net cash provided by (used in) financing activities

 

 

42,636

 

 

(5,961)

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

 

(2,578)

 

 

(31,127)

 

CASH AND CASH EQUIVALENTS, beginning of period

 

 

32,074

 

 

56,464

 

CASH AND CASH EQUIVALENTS, end of period

 

$

29,496

 

$

25,337

 

 

The accompanying notes are an integral part of these consolidated financial statements.

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COMFORT SYSTEMS USA, INC.

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

September 30, 2017

 

(Unaudited)

1. Business and Organization

 

Comfort Systems USA, Inc., a Delaware corporation, provides comprehensive mechanical contracting services, which principally includes heating, ventilation and air conditioning (“HVAC”), plumbing, piping and controls, as well as off-site construction, electrical, monitoring and fire protection. We install, maintain, repair and replace products and systems throughout the United States. Approximately 37% of our consolidated 2017 revenue is attributable to installation of systems in newly constructed facilities, with the remaining 63% attributable to maintenance, repair and replacement services.

 

Our consolidated 2017 revenue was derived from the following service activities, all of which are in the mechanical services industry, the single industry segment we serve:

 

 

 

 

 

 

 

 

 

 

Revenue

 

Service Activity

    

$ in thousands

    

%

 

HVAC and Plumbing

 

$

1,207,434

 

91

%

Building Automation Control Systems

 

 

66,343

 

 5

%

Other

 

 

53,073

 

 4

%

Total

 

$

1,326,850

 

100

%

 

 

 

2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

These interim statements should be read in conjunction with the historical Consolidated Financial Statements and related notes of Comfort Systems included in the Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”) for the year ended December 31, 2016 (the “Form 10-K”).

 

The accompanying unaudited consolidated financial statements were prepared using generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and applicable rules of Regulation S-X of the SEC. Accordingly, these financial statements do not include all the footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the Form 10-K. We believe all adjustments necessary for a fair presentation of these interim statements have been included and are of a normal and recurring nature. The results of operations for interim periods are not necessarily indicative of the results for the full fiscal year.

 

Use of Estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions by management in determining the reported amounts of assets and liabilities, revenue and expenses and disclosures regarding contingent assets and liabilities. Actual results could differ from those estimates. The most significant estimates used in our financial statements affect revenue and cost recognition for construction contracts, the allowance for doubtful accounts, self-insurance accruals, deferred tax assets, warranty accruals, fair value accounting for acquisitions and the quantification of fair value for reporting units in connection with our goodwill impairment testing.

 

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Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASU 2014-09 provides a framework that replaces the existing revenue recognition guidance. The guidance can be applied on a full retrospective or modified retrospective basis whereby the entity records a cumulative effect of initially applying this update on the adoption date. We plan to use the modified retrospective basis on the adoption date. ASU 2014-09 is effective for annual periods beginning after December 15, 2017, including interim periods within that reporting period. While we are still evaluating the potential impact of this authoritative guidance on our consolidated financial statements, we currently believe the areas that may impact us the most include accounting for variable consideration, capitalization of incremental costs of obtaining a contract and the guidance on the number of performance obligations contained in a contract. The impact on our consolidated financial statements upon adoption of ASU 2014-09 will be determined in large part by the contracts in progress on our adoption date; however, we currently do not believe the adoption will have a material impact on our consolidated financial statements.

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)”. The standard requires lessees to recognize assets and liabilities for most leases. ASU 2016-02 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. Early adoption is permitted. ASU 2016-02’s transition provisions are applied using a modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements. Full retrospective application is prohibited. We are currently evaluating the potential impact of this authoritative guidance on our consolidated financial statements.

 

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments”. This standard provides guidance on how certain cash receipts and cash payments are presented and classified in the statement of cash flows and is intended to reduce diversity in practice with respect to these items.  The standard is applied using a retrospective transition method and is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. We currently do not believe the adoption will have a material impact on our consolidated financial statements.

 

In January 2017, the FASB issued ASU No. 2017-04, “Intangibles – Goodwill and other (Topic 350): Simplifying the Accounting for Goodwill Impairment”. This standard removes Step 2 of the goodwill impairment test, which required a hypothetical purchase price allocation. A goodwill impairment will be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. Additionally, entities will be required to disclose the amount of goodwill at reporting units with zero or negative carrying amounts.  The standard is applied prospectively and is effective for fiscal years beginning after December 15, 2019, including annual or interim goodwill impairment tests within those fiscal years. Early adoption is permitted for interim and annual goodwill impairment tests performed on testing dates after January 1, 2017. We early adopted ASU 2017-04 in the first quarter of 2017, which did not have a material impact on our consolidated financial statements. 

 

Financial Instruments

 

Our financial instruments consist of cash and cash equivalents, accounts receivable, other receivables, accounts payable, life insurance policies, notes to former owners, capital leases and a revolving credit facility. We believe that the carrying values of these instruments on the accompanying balance sheets approximate their fair values.

 

Segment Disclosure

 

Our activities are within the mechanical services industry, which is the single industry segment we serve. Each operating unit represents an operating segment and these segments have been aggregated, as the operating units meet all of the aggregation criteria.

 

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3. Fair Value Measurements

 

We classify and disclose assets and liabilities carried at fair value in one of the following three categories:

 

·

Level 1—quoted prices in active markets for identical assets and liabilities;

 

·

Level 2—observable market based inputs or unobservable inputs that are corroborated by market data; and

 

·

Level 3—significant unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

 

The following table summarizes the fair values, and levels within the fair value hierarchy in which the fair value measurements fall, for assets and liabilities measured on a recurring basis as of September 30, 2017 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance

 

Fair Value Measurements at Reporting Date

 

 

 

September 30,

 

 

 

 

 

 

 

 

    

2017

    

Level 1

    

Level 2

    

Level 3

 

Cash and cash equivalents

 

$

29,496

 

$

29,496

 

$

 —

 

$

 —

 

Life insurance—cash surrender value

 

$

3,180

 

$

 —

 

$

3,180

 

$

 —

 

Contingent earn-out obligations

 

$

9,863

 

$

 —

 

$

 —

 

$

9,863

 

 

Cash and cash equivalents consist primarily of highly rated money market funds at a variety of well‑known institutions with original maturities of three months or less. The original cost of these assets approximates fair value due to their short-term maturity. The carrying value of our borrowings associated with the Revolving Credit Facility approximate its fair value due to the variable rate on such debt.

 

One of our operations has life insurance policies covering 44 employees with a combined face value of $37.3 million. The policy is invested in mutual funds and the fair value measurement of the cash surrender balance associated with these policies is determined using Level 2 inputs within the fair value hierarchy and will vary with investment performance. The cash surrender value of these policies was $3.2 million as of September 30, 2017 and $3.7 million as of December 31, 2016. These assets are included in “Other Noncurrent Assets” in our consolidated balance sheets.

 

We value contingent earn-out obligations using a probability weighted discounted cash flow method. This fair value measurement is based on significant unobservable inputs in the market and thus represents a Level 3 measurement within the fair value hierarchy. This analysis reflects the contractual terms of the purchase agreements (e.g., minimum and maximum payments, length of earn-out periods, manner of calculating any amounts due, etc.) and utilizes assumptions with regard to future cash flows, probabilities of achieving such future cash flows and a discount rate. The contingent earn-out obligations are measured at fair value each reporting period and changes in estimates of fair value are recognized in earnings.

 

The table below presents a reconciliation of the fair value of our contingent earn-out obligations that use significant unobservable inputs (Level 3) (in thousands).

 

 

 

 

 

 

Balance at beginning of year

    

$

2,531

 

Issuances

 

 

11,755

 

Settlements

 

 

(2,578)

 

Adjustments to fair value

 

 

(1,845)

 

Balance at September 30, 2017

 

$

9,863

 

 

We measure certain assets at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. During the first quarter of 2017, we recorded a goodwill impairment charge of $1.1 million based on Level 3 measurements. See Note 5 “Goodwill” for further discussion. We

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did not recognize any other impairments, in the first nine months of 2017, on those assets required to be measured at fair value on a nonrecurring basis.

 

4. Acquisitions

 

On April 1, 2017, we acquired all of the issued and outstanding stock of BCH Holdings, Inc. and each of its wholly-owned subsidiaries (collectively “BCH”) for $100 million, comprised of $85.7 million in cash at closing and $14.3 million in a note payable to the former owners, plus an earn‑out that we will pay if certain financial targets are met after the acquisition date and a working capital adjustment. The preliminary acquisition date fair value of consideration transferred for this acquisition was $122.6 million, of which $97.9 million was allocated to goodwill and identifiable intangible assets. Our consolidated operating results included revenue of $73.2 million for the six months from the acquisition date. BCH is an integrated, single-source provider of mechanical service, maintenance and construction with headquarters in Tampa, Florida and operations throughout the southeastern region of the United States, which reports as a separate operating location.

 

We completed two acquisitions in the first quarter of 2016. We acquired the remaining 40% noncontrolling interest in Environmental Air Systems, LLC (“EAS”) on January 1, 2016 for $46.6 million, including $42.0 million funded on the closing date plus a holdback, an earn-out that will be earned if certain financial targets are met after the acquisition date and a working capital adjustment. Due to our majority ownership and control over EAS on the acquisition date, the difference between the purchase price and the noncontrolling interest liability was recorded in Additional Paid-In Capital in our Balance Sheet.

 

Additionally in the first quarter of 2016, we acquired 100% of the ShoffnerKalthoff family of companies (collectively, “Shoffner”), which reports as a separate operating location in the Knoxville, Tennessee area. The acquisition date fair value of consideration transferred for this acquisition was $19.8 million, of which $14.8 million was allocated to goodwill and identifiable intangible assets. The purchase price included $15.5 million funded on the closing date plus a note payable to the former owners, an earn-out that we will pay if certain financial targets are met after the acquisition date and a working capital adjustment.

 

In addition to the BCH acquisition, we completed three additional acquisitions in the second quarter of 2017.  We completed one acquisition in the third quarter of 2017.  The total purchase price for these acquisitions, including earn-outs, was $9.6 million for the nine months ended September 30, 2017.  These acquisitions were not material and were “tucked-in” with existing operations.

 

The results of operations of acquisitions are included in our consolidated financial statements from their respective acquisition dates. Our consolidated balance sheet includes preliminary allocations of the purchase price to the assets acquired and liabilities assumed for the applicable acquisition pending the completion of the final valuation of intangible assets and accrued liabilities. The acquisitions completed in the current and prior year were not material, individually or in the aggregate.  Additional contingent purchase price (“earn-out”) has been or will be paid if certain acquisitions achieve predetermined profitability targets. Such earn-outs are not subject to the continued employment of the sellers.

 

5. Goodwill

 

The changes in the carrying amount of goodwill are as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

    

2017

    

2016

 

Balance at beginning of year

 

$

149,208

 

$

143,874

 

Additions (See Note 4)

 

 

55,668

 

 

5,334

 

Impairment adjustment

 

 

(1,105)

 

 

 —

 

Balance at end of period

 

$

203,771

 

$

149,208

 

 

We recorded a goodwill impairment charge of $1.1 million during the first quarter of 2017. Based on changes to our market strategy that occurred in March 2017 related to our reporting unit based in California, we reevaluated our

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projected future earnings for this operating location. When the carrying value of a given reporting unit exceeds its fair value, a goodwill impairment loss is recorded for this difference, not to exceed the carrying amount of goodwill. Based upon our projected future earnings for this location, we could no longer support the related goodwill balance and therefore the goodwill associated with this location was fully impaired. The fair value was estimated using a discounted cash flow model.

 

 

 

6. Debt Obligations

 

Debt obligations consist of the following (in thousands):

 

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

    

2017

    

2016

 

Revolving credit facility

 

$

66,000

 

$

 —

 

Notes to former owners

 

 

15,330

 

 

2,250

 

Other debt

 

 

239

 

 

305

 

Capital lease obligations

 

 

123

 

 

256

 

Total debt

 

 

81,692

 

 

2,811

 

Less—current portion

 

 

(708)

 

 

(763)

 

Total long-term portion of debt

 

$

80,984

 

$

2,048

 

 

Revolving Credit Facility

 

We have a $325.0 million senior credit facility (the “Facility”) provided by a syndicate of banks, with a $100 million accordion option. The Facility, which is available for borrowings and letters of credit, expires in February 2021 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 a second lien on our assets related to projects subject to surety bonds. As of September 30, 2017, we had $66.0 million of outstanding borrowings, $39.6 million in letters of credit outstanding and $219.4 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.

 

The following is a summary of the additional margins:

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Total Indebtedness to

 

 

 

Credit Facility Adjusted EBITDA

 

 

    

Less than 0.75

    

0.75 to 1.50

    

1.50 to 2.25

    

2.25 or greater

 

Additional Per Annum Interest Margin Added Under:

 

 

 

 

 

 

 

 

 

Base Rate Loan Option

 

0.25

%  

0.50

%  

0.75

%  

1.00

%

Eurodollar Rate Loan Option

 

1.25

%

1.50

%

1.75

%

2.00

%

 

The weighted average interest rate applicable to the borrowings under the Facility was approximately 2.6% as of September 30, 2017.

 

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 a claim is 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, as defined in the credit agreement.

 

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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, as defined in the credit agreement.

 

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:

 

Leverage Ratio—The Facility requires that the ratio of our Consolidated Total Indebtedness to our Credit Facility Adjusted EBITDA not exceed (i) 3.00 to 1.00 as of the end of each fiscal quarter through September 30, 2017, and (ii) 2.75 to 1.00 as of the end of each fiscal quarter thereafter through maturity. The leverage ratio as of September 30, 2017 was 0.5.

 

Fixed Charge Coverage Ratio—The Facility requires that the ratio of (a) Credit Facility Adjusted EBITDA, less non-financed capital expenditures, tax provision, dividends and amounts used to repurchase stock to (b) the sum of interest expense and scheduled principal payments of indebtedness be at least 2.00 to 1.00; provided that the calculation of the fixed charge coverage ratio excludes stock repurchases and the payment of dividends at any time that the Company’s Net Leverage Ratio does not exceed 1.50 to 1.00. The Facility also allows the fixed charge coverage ratio not to be reduced for stock repurchases through September 30, 2015 in an aggregate amount not to exceed $25 million and for stock repurchases made after February 22, 2016 but on or prior to December 31, 2017 in an aggregate amount not to exceed $25 million, if at the time of and after giving effect to such repurchase the Company’s Net Leverage Ratio was less than or equal to 1.50 to 1.00. Capital expenditures, tax provision, dividends and stock repurchase 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 of September 30, 2017 was 29.5.

 

Other Restrictions—The Facility permits acquisitions of up to $30.0 million per transaction, provided that the aggregate purchase price of all such acquisitions in the same fiscal year does not exceed $65.0 million. However, these limitations only apply when the Company’s Total Leverage Ratio is greater than 2.00 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 September 30, 2017.

 

Notes to Former Owners

 

As part of the consideration used to acquire two companies, we have outstanding notes to the former owners. These notes had an outstanding balance of $15.3 million as of September 30, 2017. In conjunction with the BCH acquisition in the second quarter of 2017, we issued a promissory note to former owners with an outstanding balance of $14.3 million as of September 30, 2017 that bears interest, payable quarterly, at a weighted average interest rate of 3.0%.  The principal is due in equal installments in April 2020 and 2021. In conjunction with the Shoffner acquisition in the first quarter of 2016, we issued a subordinated note to former owners with an outstanding balance of $1.0 million as of September 30, 2017 that bears interest, payable quarterly, at a weighted average interest rate of 3.0%. The principal is due in equal installments in February 2018 and 2019.

 

Other Debt

 

As part of the Shoffner acquisition, we acquired debt with an outstanding balance at the acquisition date of $0.4 million with principal and interest due the last day of every month; ending on the December 30, 2019 maturity date. The interest rate is the one month LIBOR rate plus 2.25%. As of September 30, 2017, $0.2 million of the note was outstanding, of which $0.1 million was considered current.

 

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In addition, with one of our acquisitions we acquired capital lease obligations. As of September 30, 2017, $0.1 million of capital lease obligations were outstanding, of which $0.1 million was considered current.

 

7. Commitments and Contingencies

 

Claims and Lawsuits

 

We are subject to certain legal and regulatory claims, including lawsuits arising in the normal course of business. We maintain various insurance coverages to minimize financial risk associated with these claims. We have estimated and provided accruals for probable losses and related legal fees associated with certain litigation in the accompanying consolidated financial statements. While we cannot predict the outcome of these proceedings, in management’s opinion and based on reports of counsel, any liability arising from these matters individually and in the aggregate will not have a material effect on our operating results, cash flows or financial condition, after giving effect to provisions already recorded.

 

Surety

 

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 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 surety for any expenses or outlays it incurs. To date, we are not aware of any losses to our sureties in connection with bonds the sureties have posted on our behalf, and do not expect such losses to be incurred in the foreseeable future.

 

Surety market conditions have seen some strengthening as the commercial construction markets have started to rebound. Bonding capacity remains adequate in the current market conditions along with acceptable terms and conditions. Historically, approximately 20% to 30% of our business has required bonds. While we currently have strong surety relationships to support our bonding needs, future market conditions or changes in the sureties’ assessment of our operating and financial risk could cause the sureties to decline to issue bonds for our work. If that were to occur, the 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.

 

Self-Insurance

 

We are substantially self‑insured for workers’ compensation, employer’s liability, auto liability, general liability and employee group health claims, in view of the relatively high per‑incident deductibles we absorb under our insurance arrangements for these risks. Losses are estimated and accrued based upon known facts, historical trends and industry averages. Estimated losses in excess of our deductible, which have not already been paid, are included in our accrual with a corresponding receivable from our insurance carrier. Loss estimates associated with the larger and longer‑developing risks, such as workers’ compensation, auto liability and general liability, are reviewed by a third‑party actuary quarterly.

 

8. Stockholders’ Equity

 

Earnings Per Share

 

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted EPS is computed considering the dilutive effect of stock options, restricted stock, restricted stock units and performance stock units. The vesting of unvested contingently issuable performance stock units is based on the achievement of certain earnings per share targets and total shareholder return. These shares are considered contingently issuable shares for purposes of calculating diluted earnings per share.

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These shares are not included in the diluted earnings per share denominator until the performance criteria are met, if it is assumed that the end of the reporting period was the end of the contingency period.

 

Unvested restricted stock, restricted stock units and performance stock units are included in diluted earnings per share, weighted outstanding until the shares and units vest. Upon vesting, the vested restricted stock, restricted stock units and performance stock units are included in basic earnings per share weighted outstanding from the vesting date.

 

There were less than 0.1 million anti-dilutive stock options for the three and nine months ended September 30, 2017. There were approximately 0.1 million anti-dilutive stock options excluded from the calculation of diluted EPS for the three and nine months ended September 30, 2016.   

 

The following table reconciles the number of shares outstanding with the number of shares used in computing basic and diluted earnings per share for each of the periods presented (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2017

    

2016

    

2017

    

2016

 

Common shares outstanding, end of period

 

37,134

 

37,230

 

37,134

 

37,230

 

Effect of using weighted average common shares outstanding

 

98

 

130

 

125

 

150

 

Shares used in computing earnings per share—basic

 

37,232

 

37,360

 

37,259

 

37,380

 

Effect of shares issuable under stock option plans based on the treasury stock method

 

293

 

319

 

312

 

331

 

Effect of restricted and contingently issuable shares

 

101

 

142

 

113

 

143

 

Shares used in computing earnings per share—diluted

 

37,626

 

37,821

 

37,684

 

37,854

 

 

Share Repurchase Program

 

On March 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 approved extensions of the program to acquire additional shares. Since the inception of the repurchase program, the Board has approved 8.1 million shares to be repurchased. As of September 30, 2017, we have repurchased a cumulative total of 7.6 million shares at an average price of $13.75 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. The Board may modify, suspend, extend or terminate the program at any time. During the nine months ended September 30, 2017, we repurchased 0.3 million shares for approximately $8.9 million at an average price of $34.18 per share. 

 

 

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

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 Securities and Exchange Commission for the year ended December 31, 2016 (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 to Comfort Systems USA, Inc. or Comfort Systems USA, Inc. and its consolidated subsidiaries, as appropriate in the context.

 

Introduction and Overview

 

We are a national provider of comprehensive mechanical installation, renovation, maintenance, repair and replacement services within the mechanical services industry. We operate primarily in the commercial, industrial and institutional HVAC markets and perform most of our services within office buildings, retail centers, apartment complexes, manufacturing plants, and healthcare, education and government facilities.

 

Nature and Economics of Our Business

 

Approximately 80% of our revenue is earned on a project basis for installation of mechanical systems in newly constructed facilities or for replacement of systems in existing facilities. Customers hire us to ensure such 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. 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.

 

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 installation and service provider.

 

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.

 

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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, 2017 we had 5,210 projects in process. Our average project takes six to nine months to complete, with an average contract price of approximately $457,000. 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 believe is 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 HVAC and related controls systems 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 not give rise to lien rights.

 

A stratification of projects in progress as of September 30, 2017, by contract price, is as follows:

 

 

 

 

 

 

 

 

 

    

 

    

Aggregate

 

 

 

 

 

Contract

 

 

 

No. of

 

Price Value

 

Contract Price of Project

 

Projects

 

(millions)

 

Under $1 million

 

4,722

 

$

546.7

 

$1 million - $5 million

 

387

 

 

856.8

 

$5 million - $10 million

 

70

 

 

469.5

 

$10 million - $15 million

 

19

 

 

233.8

 

Greater than $15 million

 

12

 

 

273.7

 

Total

 

5,210

 

$

2,380.5

 

 

In addition to project work, approximately 20% of our revenue represents maintenance and repair service on already installed HVAC 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 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,

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training, and the make‑up of both existing backlog as well as new business being pursued, in terms of project size, technical application and 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 building controls 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 the 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 general 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 2015 and 2016, there was an increase in overall activity levels and these improved levels have continued during 2017.

 

As a result of our continued strong emphasis on cash flow, at September 30, 2017 we had a strong financial position, as discussed further in “Liquidity and Capital Resources” below. We have a credit facility in place with considerably less restrictive terms than those of our previous facilities; this facility does not expire until February 2021. 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 solid current results and financial position. We have generated positive free cash flow in each of the last eighteen calendar years and will continue our emphasis in this area. We believe that the relative size and strength of our balance sheet and surety support as compared to most companies in our industry represent competitive advantages for us.

 

As discussed at greater length in “Results of Operations” below, we expect price competition to continue as our customers and local and regional competitors respond cautiously to improved market conditions. We will continue our efforts 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 2017 has been on execution and cost control, but we are seeking growth based on our belief that industry conditions will continue to be strong in the near term, and we believe that activity levels will permit us to earn improved profits while preserving and developing our workforce. We continue to focus on project qualification, estimating, pricing and management; and we are investing in growth and improved performance.

 

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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 United States during periods of economic weakness.

 

The HVAC industry is 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 HVAC 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 September 30,

 

 

 

    

2017

    

2016

    

2017

    

2016

 

 

Revenue

 

$

480,851

    

100.0

%  

$

428,760

    

100.0

%  

$

1,326,850

    

100.0

%  

$

1,242,240

    

100.0

%

 

Cost of services

 

 

379,993

 

79.0

%

 

335,944

 

78.4

%

 

1,054,300

 

79.5

%

 

986,496

 

79.4

%

 

Gross profit

 

 

100,858

 

21.0

%

 

92,816

 

21.6

%

 

272,550

 

20.5

%

 

255,744

 

20.6

%

 

Selling, general and administrative expenses

 

 

66,707

 

13.9

%

 

61,032

 

14.2

%

 

196,553

 

14.8

%

 

180,245

 

14.5

%

 

Goodwill impairment

 

 

 —

 

 —

 

 

 —

 

 —

 

 

1,105

 

0.1

%

 

 —

 

 —

 

 

Gain on sale of assets

 

 

(184)

 

 —

 

 

(166)

 

 —

 

 

(464)

 

 —

 

 

(523)

 

 —

 

 

Operating income

 

 

34,335

 

7.1

%

 

31,950

 

7.5

%

 

75,356

 

5.7

%

 

76,022

 

6.1

%

 

Interest income

 

 

16

 

 —

 

 

 3

 

 —

 

 

55

 

 —

 

 

 6

 

 —

 

 

Interest expense

 

 

(961)

 

(0.2)

%

 

(563)

 

(0.1)

%

 

(2,392)

 

(0.2)

%

 

(1,870)

 

(0.2)

%

 

Changes in the fair value of contingent earn-out obligations

 

 

2,469

 

0.5

%

 

804

 

0.2

%

 

1,845

 

0.1

%

 

468

 

 —

 

 

Other income (expense)

 

 

10

 

 —

 

 

80

 

 —

 

 

57

 

 —

 

 

455

 

 —

 

 

Income before income taxes

 

 

35,869

 

7.5

%

 

32,274

 

7.5

%

 

74,921

 

5.6

%

 

75,081

 

6.0

%

 

Income tax expense

 

 

13,585

 

 

 

 

11,803

 

 

 

 

27,188

 

 

 

 

27,052

 

 

 

 

Net income

 

$

22,284

 

4.6

%

$

20,471

 

4.8

%

$

47,733

 

3.6

%

$

48,029

 

3.9

%

 

 

We had 35 operating locations as of December 31, 2016. We completed one acquisition in the second quarter of 2017, known as “BCH”, that reports as a separate location in the Tampa, Florida area. Other than the addition of BCH, we did not make any changes to operating locations during the first nine months of 2017. As of September 30, 2017, we had 36 operating locations. Acquisitions are included in our results of operations from the respective acquisition date. The same‑store comparison from 2017 to 2016, as described below, excludes six months of results for BCH, which was acquired in April 2017 as well as the first month of 2017 for Shoffner, which was acquired in February 2016. An operating location is included in the same‑store comparison on the first day it has comparable prior year operating data.

 

Revenue—Revenue increased $52.1 million, or 12.1%, to $480.9 million for the third quarter of 2017 compared to the same period in 2016. The increase included an 8.0% increase related to the acquisition of BCH and a 4.1% increase in revenue related to same‑store activity. The same‑store revenue increase is primarily due to an increase in activity at one of our Virginia operations ($9.3 million) and our Wisconsin operation ($4.8 million).

 

Revenue increased $84.6 million, or 6.8%, to $1.33 billion for the first nine months of 2017 compared to the same period in 2016. The increase included a 6.4% increase related to the acquisitions of BCH and Shoffner and a 0.4% increase in revenue related to same‑store activity. The same‑store revenue increase is primarily due to an increase in

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activity at our New Hampshire operation ($16.3 million) and our Wisconsin operation ($11.4 million). This was partially offset by a decrease at our North Carolina operation ($11.7 million) and one of our Virginia operations ($9.1 million).

 

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.

 

Backlog as of September 30, 2017 was $901.2 million, a 3.9% decrease from June 30, 2017 backlog of $937.8 million, and a 25.3% increase from September 30, 2016 backlog of $719.3 million. Sequential backlog decreased primarily due to the completion of project work at one of our Texas operations ($13.3 million), one of our Virginia operations ($10.4 million) and one of our Florida operations ($10.4 million).  The year‑over‑year backlog increase included the acquisition of BCH ($31.8 million) and a same-store increase of $150.1 million or 20.9%.  Same-store backlog increased primarily due to increased project bookings at our Colorado operation ($50.6 million), one of our Virginia operations ($41.4 million), our North Carolina operation ($22.3 million) and our Arizona operation ($22.1 million).

 

Gross Profit—Gross profit increased $8.0 million, or 8.7%, to $100.9 million for the third quarter of 2017 as compared to the same period in 2016. The increase included a 6.1% increase related to the acquisition of BCH and a  2.6% increase in same‑store activity. The same‑store increase in gross profit was primarily due to increased volumes at one of our Virginia operations ($1.4 million) compared to the prior year as well as improved project execution at one of our Texas operations ($1.2 million). As a percentage of revenue, gross profit decreased from 21.6% in 2016 to 21.0% in 2017 due to an increase in backlog amortization as a result of the BCH acquisition.

 

Gross profit increased $16.8 million, or 6.6%, to $272.6 million for the first nine months of 2017 as compared to the same period in 2016. The increase included a 5.5% increase related to the acquisitions of BCH and Shoffner and a  1.1% increase in same‑store activity. The same‑store increase in gross profit was primarily due to increased volumes at our Wisconsin operation ($3.5 million). As a percentage of revenue, gross profit decreased slightly from 20.6% in 2016 to 20.5% in 2017 due to an increase in backlog amortization as a result of the BCH acquisition.

 

Selling, General and Administrative Expenses (“SG&A”)—SG&A increased $5.7 million, or 9.3%, to $66.7 million for the third quarter of 2017 as compared to 2016. On a same‑store basis, excluding amortization expense, SG&A increased $0.6 million, or 1.0%. This increase is primarily due to the increase in same-store revenue in the current year period.  Amortization expense increased $1.9 million during the period as a result of the BCH acquisition. As a percentage of revenue, SG&A decreased from 14.2% in 2016 to 13.9% in 2017.

 

SG&A increased $16.3 million, or 9.0%, to $196.6 million for the first nine months of 2017 as compared to 2016. On a same‑store basis, excluding amortization expense, SG&A increased $5.4 million, or 3.1%. This increase is primarily due to $0.8 million in compensation costs related to leadership changes, investments in service and an increase in bad debt expense of $0.2 million due to the collection of aged receivables in the prior year period.  Additionally, we incurred $0.4 million in expenses in the first quarter of 2017 related to the acquisition of BCH completed on April 1, 2017. Amortization expense increased $3.4 million during the period primarily as a result of the BCH acquisition. As a percentage of revenue, SG&A increased from 14.5% in 2016 to 14.8% in 2017 primarily due to the factors discussed above.

 

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

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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,

 

 

    

2017

    

2016

    

2017

    

2016

 

 

 

(in thousands)

 

(in thousands)

 

SG&A

 

$

66,707

 

$

61,032

 

$

196,553

 

$

180,245

 

Less: SG&A from companies acquired

 

 

(3,185)

 

 

 —

 

 

(7,516)

 

 

 —

 

Less: Amortization expense

 

 

(3,394)

 

 

(1,515)

 

 

(8,072)

 

 

(4,649)

 

Same-store SG&A, excluding amortization expense

 

$

60,128

 

$

59,517

 

$

180,965

 

$

175,596

 

 

Goodwill Impairment—We recorded a goodwill impairment charge of $1.1 million during the first quarter of 2017. Based on changes to our market strategy that occurred in March 2017 related to our reporting unit based in California, we reevaluated our projected future earnings for this operating location. When the carrying value of a given reporting unit exceeds its fair value, a goodwill impairment loss is recorded for this difference, not to exceed the carrying amount of goodwill. Based upon our projected future earnings for this location, we could no longer support the related goodwill balance and therefore the goodwill associated with this location was fully impaired. The fair value was estimated using a discounted cash flow model.

 

Interest Expense—Interest expense increased $0.4 million, or 70.7%, to $1.0 million for the third quarter of 2017 as compared to the same period in 2016. Interest expense increased $0.5 million, or 27.9%, to $2.4 million for the first nine months of 2017 as compared to the same period in 2016. The increase reflects the increased borrowings on the revolving credit facility as well as notes to former owners used to fund the BCH acquisition during the second quarter of 2017.

 

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 2017 increased $1.7 million as compared to the same period in 2016.  This increase was the result of reducing our obligation related to the BCH acquisition primarily due to third quarter results being below the initial estimate as a result of the impact of Hurricane Irma and less project activity in the quarter than previously estimated. In the third quarter of 2016, based on updated measurements of estimated future cash flows for our contingent obligations, we reduced our obligation related to the EAS acquisition resulting in a gain of $0.8 million. 

Income from changes in the fair value of contingent earn‑out obligations for the first nine months of 2017 increased $1.4 million as compared to the same period in 2016. This increase was the result of reducing our obligation related to the BCH acquisition primarily due to third quarter results being below the initial estimate as a result of the impact of Hurricane Irma and less project activity in the quarter than previously estimated. In the third quarter of 2016, based on updated measurements of estimated future cash flows for our contingent obligations, we reduced our obligation related to the EAS acquisition resulting in a gain of $0.8 million. 

 

Income Tax Expense—We perform work throughout the United States in virtually all fifty states. Our effective tax rate varies based on our relative profitability, or lack thereof, in states with varying tax rates and rules. In addition, discrete items, judgments and legal structures can change our effective tax rate. These items can include the tax treatment for impairment of goodwill and other intangible assets, changes in fair value of acquisition-related assets and liabilities, tax reserves for uncertain tax positions, accounting for losses associated with underperforming operations and noncontrolling interests.

 

For the nine months ended September 30, 2017, our income tax expense was $27.2 million with an effective tax rate of 36.3% as compared to income tax expense of $27.1 million with an effective tax rate of 36.0% for the same period in 2016. The effective tax rate for 2017 was higher than the 35.0% federal statutory rate primarily due to net state income taxes (3.6%) and nondeductible expenses (1.1%) partially offset by benefits from deductions for stock-based compensation (1.2%) and the domestic production activities deduction (1.9%).  The effective tax rate for 2016 was higher than the 35.0% federal statutory rate primarily due to net state income taxes (3.6%) and nondeductible expenses (0.8%)

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partially offset by the domestic production activities deduction (1.8%) and a decrease in valuation allowances (0.4%).  We currently estimate our effective tax rate for the full year 2017 will be between 35% and 38%.

 

Outlook

 

We have seen industry conditions improve during 2015 and 2016. Our emphasis for 2017 is on execution, including a focus on cost discipline and efficient project performance, labor force development, and investing in growth, particularly in service and small projects. Based on our recent acquisitions, we expect that our 2017 revenues will be above levels we experienced in 2016. Additionally, in light of economic conditions for our industry, we expect that profitability in 2017 will continue to be strong and at levels similar to what we experienced in 2016.

 

Liquidity and Capital Resources (in thousands):

 

 

 

 

 

 

 

 

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

    

2017

    

2016

 

 

 

 

 

 

 

 

 

Cash provided by (used in):

 

 

 

 

 

 

 

Operating activities

 

$

65,692

 

$

49,754

 

Investing activities

 

 

(110,906)

 

 

(74,920)

 

Financing activities

 

 

42,636

 

 

(5,961)

 

Net increase (decrease) in cash and cash equivalents

 

$

(2,578)

 

$

(31,127)

 

Free cash flow:

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

65,692

 

$

49,754

 

Purchases of property and equipment

 

 

(16,830)

 

 

(17,257)

 

Proceeds from sales of property and equipment

 

 

784

 

 

847

 

Free cash flow

 

$

49,646

 

$

33,344

 

 

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 $65.7 million during the first nine months of 2017 compared with $49.8 million during the same period in 2016. The $15.9 million increase is primarily due to a $21.0 million increase in accounts payable and accrued liabilities and a $21.2 million increase in billings in excess of costs and estimated earnings, primarily due to the timing of billings and various project work. The $21.0 million increase in accounts payable and accrued liabilities included approximately $6.0 million for postponed income tax payments without penalty due to relief granted by the IRS for companies affected by Hurricane Harvey. This was offset by $33.8 million increase in receivables related to project work timing and the schedule for billings as well as the increase in revenue compared to the same period in 2016.

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Cash Used in Investing Activities—During the first nine months of 2017, cash used in investing activities was $110.9 million compared to $74.9 million during the same period in 2016. The $36.0 million increase in cash used primarily relates to cash paid (net of cash acquired) for the BCH acquisition in 2017 of $86.1 million compared to the EAS and Shoffner acquisitions in 2016 ($56.3 million).

 

Cash Provided by (Used in) Financing Activities—Cash provided by financing activities was $42.6 million for the first nine months of 2017 compared to cash used in financing activities of $6.0 million during the same period in 2016. The $48.6 million increase in cash provided by financing activities is primarily due to $51.0 million of additional net proceeds from the revolving line of credit during the first nine months of 2017.

 

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 March 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 approved extensions of the program to acquire additional shares. Since the inception of the repurchase program, the Board has approved 8.1 million shares to be repurchased. As of September 30, 2017, we have repurchased a cumulative total of 7.6 million shares at an average price of $13.75 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. The Board may modify, suspend, extend or terminate the program at any time. During the nine months ended September 30, 2017, we repurchased 0.3 million shares for approximately $8.9 million at an average price of $34.18 per share.

 

Debt

 

Revolving Credit Facility

 

We have a $325.0 million senior credit facility (the “Facility”) provided by a syndicate of banks, with a $100 million accordion option. The Facility, which is available for borrowings and letters of credit, expires in February 2021 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 a second lien on our assets related to projects subject to surety bonds. As of September 30, 2017, we had $66.0 million of outstanding borrowings, $39.6 million in letters of credit outstanding and $219.4 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 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 a claim is unlikely in the

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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, as 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, as defined in the credit agreement.

 

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:

 

Leverage Ratio—The Facility requires that the ratio of our Consolidated Total Indebtedness to our Credit Facility Adjusted EBITDA not exceed (i) 3.00 to 1.00 as of the end of each fiscal quarter through September 30, 2017, and (ii) 2.75 to 1.00 as of the end of each fiscal quarter thereafter through maturity. The leverage ratio as of September 30, 2017 was 0.5.

 

Fixed Charge Coverage Ratio—The Facility requires that the ratio of (a) Credit Facility Adjusted EBITDA, less non‑financed capital expenditures, tax provision, dividends and amounts used to repurchase stock to (b) the sum of interest expense and scheduled principal payments of indebtedness be at least 2.00 to 1.00; provided that the calculation of the fixed charge coverage ratio excludes stock repurchases and the payment of dividends at any time that the Company’s Net Leverage Ratio does not exceed 1.50 to 1.00. The Facility also allows the fixed charge coverage ratio not to be reduced for stock repurchases through September 30, 2015 in an aggregate amount not to exceed $25 million and for stock repurchases made after February 22, 2016 but on or prior to December 31, 2017 in an aggregate amount not to exceed $25 million, if at the time of and after giving effect to such repurchase the Company’s Net Leverage Ratio was less than or equal to 1.50 to 1.00. Capital expenditures, tax provision, dividends and stock repurchase 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 of September 30, 2017 was 29.5.

 

Other Restrictions—The Facility permits acquisitions of up to $30.0 million per transaction, provided that the aggregate purchase price of all such acquisitions in the same fiscal year does not exceed $65.0 million. However, these limitations only apply when the Company’s Total Leverage Ratio is greater than 2.00 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 September 30, 2017.

 

Notes to Former Owners

 

As part of the consideration used to acquire two companies, we have outstanding notes to the former owners. These notes had an outstanding balance of $15.3 million as of September 30, 2017. In conjunction with the BCH acquisition in the second quarter of 2017, we issued a promissory note to former owners with an outstanding balance of $14.3 million as of September 30, 2017 that bears interest, payable quarterly, at a weighted average interest rate of 3.0%.  The principal is due in equal installments in April 2020 and 2021. In conjunction with the Shoffner acquisition in the first quarter of 2016, we issued a subordinated note to former owners with an outstanding balance of $1.0 million as of September 30, 2017 that bears interest, payable quarterly, at a weighted average interest rate of 3.0%. The principal is due in equal installments in February 2018 and 2019.

 

Other Debt

 

As part of the Shoffner acquisition, we acquired debt with an outstanding balance at the acquisition date of $0.4 million with principal and interest due the last day of every month; ending on the December 30, 2019 maturity date. The

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interest rate is the one month LIBOR rate plus 2.25%. As of September 30, 2017, $0.2 million of the note was outstanding, of which $0.1 million was considered current.

 

In addition, with one of our acquisitions we acquired capital lease obligations. As of September 30, 2017, $0.1 million of capital lease obligations were outstanding, of which $0.1 million was considered current.

 

Outlook

 

We have generated positive net free cash flow for the last eighteen 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

 

As is common in our industry, we have entered into certain off‑balance sheet arrangements in the ordinary course of business that result in risks not directly reflected in our balance sheets. Our most significant off‑balance sheet transactions include liabilities associated with noncancelable operating leases. We also have other off‑balance sheet obligations involving letters of credit and surety guarantees.

 

We enter into noncancelable operating leases for many of our facility, vehicle and equipment needs. These leases allow us to conserve cash by paying a monthly lease rental fee for use of facilities, vehicles and equipment rather than purchasing them. At the end of the lease, we have no further obligation to the lessor. If we decide to cancel or terminate a lease before the end of its term, we would typically owe the lessor the remaining lease payments under the term of the lease.

 

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 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 20% to 30% 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

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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 September 30, 2017, we have $39.6 million in letter of credit commitments, of which $11.3 million will expire in 2017 and $28.3 million will expire in 2018. The substantial majority of these letters of credit are posted with insurers who 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 2017, we expect nearly all of them, particularly those supporting our insurance programs, will be renewed annually.

 

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

We are exposed to market risk primarily related to potential adverse changes in interest rates as discussed below. We are actively involved in monitoring exposure to market risk and continue to develop and utilize appropriate risk management techniques. We are not exposed to any other significant financial market risks including commodity price risk, foreign currency exchange risk or interest rate risks from the use of derivative financial instruments. We do not use derivative financial instruments.

 

We have exposure to changes in interest rates under our revolving credit facility. We have a modest level of indebtedness under our debt facility and our indebtedness could increase in the future. Our debt with fixed interest rates consists of notes to former owners of acquired companies.

 

The weighted average interest rate applicable to borrowings under the Facility was approximately 2.6% as of September 30, 2017.

 

We measure certain assets at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. During the first quarter of 2017 we recorded a goodwill impairment charge of $1.1 million based on Level 3 measurements. See Note 5 “Goodwill” for further discussion. We did not recognize any other impairments, in the first nine months of 2017, on those assets required to be measured at fair value on a nonrecurring basis.

 

The valuation of our contingent earn‑out payments is determined using a probability weighted discounted cash flow method. This analysis reflects the contractual terms of the purchase agreements (e.g., minimum and maximum payment, length of earn‑out periods, manner of calculating any amounts due, etc.) and utilizes assumptions with regard to future cash flows, probabilities of achieving such future cash flows and a discount rate.

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

Our executive management is responsible for ensuring the effectiveness of the design and operation of our disclosure controls and procedures. We carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) of the Securities Exchange Act of 1934) are effective as of the end of the period covered by this report.

 

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Changes in Internal Control over Financial Reporting

 

There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a‑15(f) and 15d‑15(f) under the Securities Exchange Act of 1934) during the three months ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II—OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

We are subject to certain claims and lawsuits arising in the normal course of business. We maintain various insurance coverages to minimize financial risk associated with these claims. We have estimated and provided accruals for probable losses and related legal fees associated with certain litigation in our consolidated financial statements. While we cannot predict the outcome of these proceedings, in our opinion and based on reports of counsel, any liability arising from these matters individually and in the aggregate will not have a material effect on our operating results, cash flows or financial condition, after giving effect to provisions already recorded.

 

Item 1A.  Risk Factors

 

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part 1, “Item 1A. Risk Factors” in our Annual Report on Form 10‑K for the year ended December 31, 2016, which could materially affect our business, financial condition, or future results. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, or future results.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

Recent Sales of Unregistered Securities

 

None.

 

Issuer Purchases of Equity Securities

 

On March 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 approved extensions of the program to acquire additional shares. Since the inception of the repurchase program, the Board has approved 8.1 million shares to be repurchased. As of September 30, 2017, we have repurchased a cumulative total of 7.6 million shares at an average price of $13.75 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. The Board may modify, suspend, extend or terminate the program at any time. During the nine months ended September 30, 2017, we repurchased 0.3 million shares for approximately $8.9 million at an average price of $34.18 per share.

 

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During the quarter ended September 30, 2017, we purchased our common shares in the following amounts at the following average prices:

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

 

    

Total Number of Shares

    

Maximum Number of

 

 

 

 

 

 

 

 

Purchased as Part of

 

Shares that May Yet Be

 

 

 

Total Number of

 

Average Price

 

Publicly Announced Plans

 

Purchased Under the Plans

 

Period

 

Shares Purchased

 

Paid Per Share

 

or Programs

 

or Programs

 

July 1 - July 31

 

 —

 

$

 —

 

7,449,784

 

662,709

 

August 1 - August 31

 

143,667

 

$

33.18

 

7,593,451

 

519,042

 

September 1 - September 30

 

9,737

 

$

33.56

 

7,603,188

 

509,305

 

 

 

153,404

 

$

33.20

 

7,603,188

 

509,305

 

 

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Item 6.  Exhibits

 

 

 

 

 

 

 

 

 

 

 

 

Incorporated by Reference
to the Exhibit Indicated Below
and to the Filing with the
Commission Indicated Below

Exhibit
Number

    

Description of Exhibits

    

Exhibit
Number

    

Filing or
File Number

3.1

 

Second Amended and Restated Certificate of Incorporation of the Registrant

 

3.1

 

333‑24021

3.2

 

Certificate of Amendment dated May 21, 1998

 

3.2

 

1998 Form 10‑K

3.3

 

Certificate of Amendment dated July 9, 2003

 

3.3

 

2003 Form 10‑K

3.4

 

Certificate of Amendment dated May 20, 2016

 

3.1

 

May 20, 2016

Form 8‑K

3.5

 

Amended and Restated Bylaws of Comfort Systems USA, Inc.

 

3.1

 

March 25, 2016 Form 8‑K

31.1

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes‑Oxley Act of 2002

 

 

 

Filed Herewith

31.2

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes‑Oxley Act of 2002

 

 

 

Filed Herewith

32.1

 

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002

 

 

 

Furnished Herewith

32.2

 

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002

 

 

 

Furnished Herewith

101.INS

 

XBRL Instance Document

 

 

 

 

101.SCH

 

XBRL Taxonomy Extension Schema Document

 

 

 

 

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document

 

 

 

 

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document

 

 

 

 

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document

 

 

 

 

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase

 

 

 

 


 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

 

 

Comfort Systems USA, Inc.

 

 

 

October 26, 2017

By:

/s/ Brian E. Lane

 

 

Brian E. Lane

 

 

President, Chief Executive Officer and Director

 

 

 

October 26, 2017

By:

/s/ William George

 

 

William George

 

 

Executive Vice President and Chief Financial Officer

 

 

 

October 26, 2017

By:

/s/ Julie S. Shaeff

 

 

Julie S. Shaeff

 

 

Senior Vice President and Chief Accounting Officer

 

 

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