FirstService Corp

TSX:FSV

Earnings Call Transcript 2018-Q2

[Operator]

Welcome to the Second Quarter Investments Conference Call. Today's call is being recorded. Legal counsel requires us to advise that the discussion scheduled to take place today may contain forward-looking statements that involve known and unknown risks and some uncertainties. Actual results may be materially different from any future results, performance or achievements contemplated in the forward-looking statements.Additional information concerning factors that could cause actual results to materially different from those in the forward-looking statements is contained in the company's Annual Information form, as filed with the Canadian Securities Administrators or in the company's annual report on Form 40-F, as filed with the U.S. Securities and Exchange Commission. As a reminder, today's call is being recorded. Today is July 25, 2018. I would like to turn the call over to Chief Executive Officer, Mr. Scott Patterson. Please go ahead, sir.

[D. Scott Patterson, President, CEO & Non]

Thank you, operator, and welcome, ladies and gentlemen to our second quarter conference call. Thank you for joining us. This morning, we announced another quarter of double-digit top and bottom line growth, driven by strong organic gains across the company, solid contribution from tuck-under acquisitions and margin improvement at both of our divisions. The results built on our strong first quarter and give us confidence as we head into the back half of the year. I will spend the next few minutes taking you through some of our operating highlights. And then Jeremy Rakusin, our CFO, will follow with our financial review.Revenues for the quarter were up 12% over the prior year with organic growth again, accounting for half at 6%. And the balance from tuck-under acquisitions closed over the last year. EBITDA grew significantly versus 2017, up 21%, driven primarily by efficiencies and margin improvement at FirstService Residential. And earnings per share for the quarter increased 43% to $0.86 from $0.60 in the prior year. We were very pleased with the results from FirstService Residential and FirstService Brands with both divisions exceeding internal plans. At FirstService Residential, our revenues grew by 8% with organic growth at 5%. Organic growth was broad-based geographically and largely driven by new contract wins in our larger markets with particular strength in South Florida, California, Toronto and Vancouver. Organic growth in the quarter also benefited from increases in ancillary services, including janitorial and pool maintenance and repair.At FirstService Brands, we reported revenue growth of 21% comprised of 8% organic growth and the balance from acquisitions closed over the last 12 months, including 2 California Closets franchises, 3 property restoration operations, and 2 fire service tuck-unders. The solid 8% organic growth at FirstService Brands was driven primarily by strong results at our home improvement businesses and Century Fire. A healthy housing and home improvement market continues to serve as a tailwind for California Closets, CertaPro Painters and Floor Coverings International, and they all delivered double-digit organic growth for the quarter.Century Fire also delivered very strong organic growth buoyed by a robust commercial construction market and, in particular, driven by increased traction in the repair, service and inspection component of their business. When we partner with the Century team, one of the key strategic initiatives we agreed on was to diversify and derisk revenues by driving the contractual service side of the business. And the Century team has been very successful in executing on those initiative in 2 ways: By selling service and repair contracts through existing newbuild and tenant finished relationships; and by developing a national account platform to sell and service contracts for multi-location enterprises, including retail and restaurant chains and large commercial property management companies.Century has increased the percentage of total revenues comprised by recurring service contracts every quarter since the acquisition. We're very pleased with our progress in this regard. Tempering organic growth in the Brands division was the more modest increase at Paul Davis, which reported a very strong second quarter in 2017, resulting from unusual tornado, hail storm and flood damage, which drove high insurance claim activity. We expect similarly modest increases or even flat comparisons in the third and fourth quarters for Paul Davis, due to hurricanes Harvey and Irma, which positively impacted our results in the back half of 2017.Organic growth during the quarter was also moderated by a very tight labor market, which has created capacity constraints across all our businesses, but is particularly acute within our FirstService Brands division. We have open positions within every service line and are being very deliberate and strategic about the business we take on. During the quarter, there were a few highlights of note within our FirstService Brands division. In April, we announced the acquisition of our leading Paul Davis franchise in Western Canada. The Alberta-based operation represents the first Paul Davis acquisition for us in Canada and serves as the launch of our Canadian company-owned strategy, which will mirror our U.S. strategy in terms of purpose and direction.We expect to add additional major market acquisitions in Canada with the goal of creating a national company-owned platform positioned to target national insurance companies and commercial accounts in Canada. Another highlight of note during the quarter was the June announcement of 2 tuck-under acquisitions by Century Fire. One of our key strategic priorities at Century is to fill out our service capability and become a full-service fire safety company at each of our 13 locations in the Southeast U.S. The acquisitions of ASA Fire Protection and Swift Fire Protection broadens our customer base and adds important alarm and extinguisher capability to our market-leading business in Georgia.The acquisitions represent the second and third tuck-unders for Century, since we partnered in 2016. On that note, I will hand out to Jeremy for the second quarter financial review and some comments on our outlook.

[Jeremy Alan Rakusin, Chief Financial Officer]

Thank you, Scott. As highlighted in this morning's press release and reaffirming Scott's prior comments, FirstService reported strong consolidated second quarter financial performance. For the quarter, revenues were $495 million, adjusted EBITDA was $57.1 million and adjusted EPS came in at $0.86, up 12%, 21% and 43%, respectively.During the 6 months year-to-date period, our consolidated financial results included: Revenues of $922 million, an increase of 12% over the $822 million last year with 6% organic growth and the balance from recent tuck-under acquisitions; adjusted EBITDA of $82.5 million, representing 23% growth over the $67.2 million last year with a margin of 9%, up from 8.2% in the prior year period; and adjusted EPS at $1.10, up 47% versus $0.75 per share reported during our same 6 months period last year.Our adjustments to operating earnings and GAAP EPS to calculate our adjusted EBITDA and adjusted EPS, respectively, have been summarized in this morning's press release and remain consistent with our approach and disclosure in prior periods. Furthermore, just as we disclosed in our first quarter of 2018, we highlighted in this morning's press release the financial impact of the new U.S. GAAP revenue recognition standard, which came into effect at the beginning of this year. As we noted in Q1, the quarterly effect of this accounting change is relatively insignificant to our consolidated financial results and has no impact on our cash flow. And this will also be the case for the balance of the year.We have recast our prior year period results in accordance with U.S. GAAP to allow for a clean operational base comparison to the current year results with the new standard in effect. The aggregate impact on the recast Q2 2017 consolidated results was a $6.8 million increase in revenues, a $500,000 decrease to the adjusted EBITDA line and $0.01 decrease to our adjusted EPS. Implied margin impacts on our recast consolidated and Brands division results are cited in this morning's press release. Now let's shift the focus to our segmented financial highlights and lead off with the FirstService Residential division, which delivered strong quarterly performance that exceeded internal expectations.Revenues in the second quarter were $327 million, an 8% increase over the prior year period. The segment recorded $33.4 million of EBITDA, up 16% year-over-year and yielding a margin of 10.2%, up 70 basis points from the 9.5% margin in the second quarter of last year. This margin expansion continues to be partially attributable to the streamlining initiatives within our operations that we have talked about previously at length. The other contributing component to note is the focus by our operators in maintaining a rigorous discipline around the economics of our client contracts, both property management and ancillary services. And to ensure that we realize a fair return on investment of our resources. These sustained efforts are also particularly important as we confront escalating wage pressures and limited availability of personnel in the current low unemployment environment.Moving on to our FirstService Brands division. Reported revenues for the segment were $168 million during the second quarter, a 21% increase over the second quarter last year. The division delivered $26.7 million of EBITDA for the quarter, up 24% year-over-year with our 15.8% margin modestly higher than the prior year quarter. The Brands segment margin performance will bounce around from period to period depending on the relative mix of our typically lower margin company-owned operations and our higher-margin franchise service lines. And therefore, despite the year-to-date margin increase over last year, we are not necessarily anticipating sustained meaningful margin improvement on this side of the business in the coming quarters.Turning now to our balance sheet. Net debt at June quarter end increased to $255 million, and our leverage currently stands at 1.4x, net debt to trailing 12 months EBITDA. Both of which ticked down from Q1, when our net debt stood at $262 million with leverage of 1.5x. We're currently at close to $150 million of total undrawn availability under our revolver and cash on hand. Our low leverage, abundant liquidity and significant debt capacity all amount to a very strong balance sheet aided by the strong free cash flow of our businesses.For the second quarter, we generated $44 million of operating cash flow before changes in working capital, up 36% versus the prior year quarter. Cash flow from operations inclusive of modest working capital usage was close to $40 million and relatively flat to Q2 2017. In terms of our investment activity, we incurred $9 million in capital expenditures during the second quarter in support of our operations. For the first half of this year, we have incurred just under $20 million of CapEx, a pace which keeps us right on trend with our full year estimated maintenance CapEx of $40 million provided at the outset of the year. During the second quarter, we deployed $14 million towards our tuck-under acquisition program. Year-to-date, we have invested $43 million towards several strategic acquisitions, a very healthy dose at the midway mark of the year. Contribution from this recent acquisition activity together with continued momentum with our existing operations have helped us drive to a 2018 first half performance of 12% total top line growth with 6% being organic. You've heard us refer several times before about the blueprint for our future growth. Average annual revenue growth of at least 10% with half ideally coming from organic growth and the balance topped up with tuck-under acquisitions. With the results over the first 2 quarters tracking in line with these metrics, we believe we are well-positioned to drive towards achieving our targets for the full year. That now concludes our prepared comments. I would ask the operator to please open up the call to questions. Thank you.

[Operator]

[Operator Instructions] Our first question comes from the line of Frederic Bastien of Raymond James.

[Frederic Bastien, Senior Vice President]

Guys, this was the first quarter of mid-single digit organic growth at FirstService Residential since, I guess, the first quarter of 2017. You mentioned new contract wins and growth in ancillary services as key to those drivers. But I was hoping to get some color on your retention rates on the property management. Are you still keeping them lower than what you've been averaging historically in order to boost profitability?

[D. Scott Patterson, President, CEO & Non]

We're not necessarily keeping them lower, Frederic, but they continue in the range they've been. And in large part, due to the price competitive nature of this business, the -- our competition is primarily small, family-owned local businesses. It's difficult for them to different or compete with us without competing on price. Our differentiators are significant. So increasingly, our competitors, our local competitors are competing on pricing. So the business that we're losing, generally, is price driven. And we are letting that business go, if you will, particularly with the tight labor market, not chasing that price down unless it's very, very strategic for us and reallocating our labor more effectively, so that the organic growth was a bit higher this quarter. But as you indicated, we don't necessarily see that as a sustainable shift or a trend. But we are winning -- continuing to win business to more than offset the losses.

[Frederic Bastien, Senior Vice President]

And can you share with us which specific metrics exceeded your own expectations. Was it the new contract wins?

[D. Scott Patterson, President, CEO & Non]

New contract wins margin, I would say, in both divisions, and the organic growth in Residential was a bit above expectation. And that was really driven in large part by some of our seasonal property services. And I'll highlight pool maintenance, repair and renovation. The market is strong if you have the people and we were able to recruit in crews and take advantage of that market, that seasonal market.

[Frederic Bastien, Senior Vice President]

All right. Just switching to FirstService Brands. It looks like your margins are finally leveling off after -- despite the change in revenue mix. And I guess, you've been guiding to the 15% target there. Are you happy with the cost savings that you've been able to generate out of your production facilities at California Closets?

[Jeremy Alan Rakusin, Chief Financial Officer]

Frederic, the production facility improvements, those are incremental. I mean, I think we still see a lot more of that coming to fruition, when we get them fully ramped up with the 25 Cali Closets company owned that we want. And we only have 16 today, and not all of those have been onboarded yet. So I don't think that is much of a component. First of all, just in terms of the margins, recasting last year, we did 14% on a full year basis for Brands. But for revenue recognition recasting purposes, the benchmark really off of last year's 12.9%, we're losing over 100 basis points because of accounting. And we -- the first 2 quarters of this year, we've been a little bit higher. But as I said in my prepared comments, I wouldn't necessarily extrapolate that as the trend. I think we would be happy being level with what we did last year on an apples-to-apples basis with the 12.9%. And that would be as good a trend as we could hope for going forward when we think about some of the dilution that's still going to occur as we bring in lower margin company-owned operations. It just hasn't played out in the first 2 quarters. But as I said, there are seasonal and other moving parts that also impact the stronger margin performance for the first half of this year.

[Operator]

Your next question comes from the line of Stephen MacLeod of BMO Capital Markets.

[Stephen MacLeod, Analyst]

Just wanted to follow up quickly on the FirstService Residential side of the business. The margins were quite strong in the quarter, and I'm just wondering if you can kind of delineate what the key drivers were there. And how much of it was related to the stronger top line and levering some of your cost versus you cited being smarter or reallocating some of your labor more effectively. I just wanted to hash that out and get some more detail around what the drivers were.

[Jeremy Alan Rakusin, Chief Financial Officer]

So Steve, we've talked about some of the operational efficiencies around the back office, the centralization of client accounting and so forth. So there's still some of that. And I would characterize that as being less than half of the 70 basis points. But the other 2 contributing factors are just further cementing our mindset around pricing discipline with our property management contracts to ensure the return on investment that we think it's fair. And we've extended that into some of our other service contracts. All of the ancillary services that we provide to maintain the property in question, that's janitorial, pool service and so on. So pricing discipline tickling through all of our property contracts that would have been another contributor to the margin improvement. And then on the edges, the seasonal surge, if you will, around some of our other ancillary services that Scott spoke about, where we got higher growth for the quarter, pool repair and maintenance being one of them and that gave us some operating leverage and enhanced the margins for the quarter.

[Stephen MacLeod, Analyst]

Right. Okay, okay. And when you think about getting into the back half of this year where you have some tougher comps, would you still expect, given some of the things that you've talked about around pricing discipline and the back office benefits that might still trickle through. Would you still expect to be up year-over-year in the back half of this year?

[Jeremy Alan Rakusin, Chief Financial Officer]

I think our objective, again, across this both sides of the business is always to incrementally grind out improved margins. We've got multiple service lines, it's hard to say what the margin improvements will be, but there are all of the businesses are working hard to achieve that. We believe we can be modestly up in the back half of the year. But as you do point out, Q3 and Q4 last year were big year-over-year performance versus 2016. So we think it's going to be much more measured and really banking on some of those continued operational improvements.

[Stephen MacLeod, Analyst]

Okay, that's great. And then just finally, just on the FirstService Brands business, when you think about the centralized manufacturing initiative, and you mentioned you're at, I think, roughly 16 California Closets locations. When do you expect to get to the 25 and how would you see those incremental benefits flowing through in terms of timing?

[Jeremy Alan Rakusin, Chief Financial Officer]

So to get to 25, I mean, we've said, we'd be pretty happy doing 2 to 3 California Closets acquisitions per year. So we've got 9 to 10 more to do. I would say, that's going to take at least 3 years, possibly 4. And we will onboard those ones as well as we've got about 3/4 of the 16 on our eastern and western manufacturing centers today. So those will get onboarded, we'll do the remaining 10-or-so odd acquisitions in that kind of 4 year-ish time frame, we should start to see the margin improvements, the 300 basis points or more that we've talked about previously, when we embarked on this strategy.

[Operator]

Your next question comes from the line of Stephen Sheldon of William Blair.

[Stephen Hardy Sheldon, Analyst]

I wanted to ask question about the Residential segment and the overall industry for condo and HOA management. I guess, in your view, why is the market still so fragmented? You guys are gaining market share and doing tuck-under acquisitions, but your share is still at give or take it's maybe 7% and you're by far the largest. Do you think there will be a broader trend towards consolidation here driven by scale benefits? And are there structural reasons why the pace of consolidation, I guess, industry-wide has been very gradual here?

[D. Scott Patterson, President, CEO & Non]

Well, steven, there are thousands of property management companies, but they are very small. On average, few million dollars in revenue, family-owned local companies. And that really hasn't changed over time. We've been at this now for 23 years. And so to -- for someone else to consolidate more aggressively, and if we assume that it's private equity with a 5 to 7-year time frame, I think, it would be very difficult to do. The other thing I would add in terms of if the question was more directed to why aren't we more aggressive or growing more quickly? I think, a lot of it has to do with the nature of these local businesses. I mean, are they large enough to acquire, number one. And the ones that are, again, they're family-owned and there really needs to be a compelling event that would cause that family to want to sell, whether that is a change in the family structure or health or age. But there needs to be a push that would cause that family to sell. And so it's very -- it's a very slow and measured growth strategy through acquisition, I would say.

[Stephen Hardy Sheldon, Analyst]

Got it. Very helpful. And then I guess wanted to get your thoughts on free cash flow conversion here, maybe some detail on the moving pieces. I think as a percentage of adjusted EBITDA, free cash flow conversion was about 50% last year. Is that a good ballpark range to think about moving forward over the next few years? And how are -- how you're thinking about the impact of working capital needs and CapEx here?

[Jeremy Alan Rakusin, Chief Financial Officer]

Steven, if you're using free cash flow after capital expenditures as a metric as a percent of EBITDA, plus or minus 50% is a good number. The way -- a couple of other metrics, cash flow, pre-working capital as a percentage of EBITDA, we look at it as kind of plus or minus 75% of EBITDA. And then working capital changes is in the order of 0.5% to 1% of revenues usage. And so that shaves about another 5% of that cash flow as a percent of EBITDA. So on a post-working capital basis, we're in and around 70%. And then you deduct the CapEx and you're in and around 50%. That's -- those are kind of rough guide post for cash flow conversion.

[Stephen Hardy Sheldon, Analyst]

Okay, great. And then I guess lastly, here. Interest expense has ticked up here, I guess, over the last couple of quarters. I guess, would you expect, I think, it was $3.2 million in 2Q, would you expect interest expense to turn down from here or there -- there's any guidance on interest expense?

[Jeremy Alan Rakusin, Chief Financial Officer]

I mean, all signs point to rates going up. Half of our debt is fixed with our long-term notes at 3.8%. And the other half is tied to LIBOR in and around just over 3.5% for that half of the debt. So 3% and 3.25% roughly, is our blended interest rate currently on a run rate going forward. And again, if the Fed raises rate another couple of times this year, we're probably going to have our interest costs tick up slightly on a run rate basis.

[Operator]

Your next question comes from the line of Michael Smith of RBC Capital Markets.

[Michael Smith, Analyst]

I just wanted to touch base on ancillary services. And I understand, there's some seasonal factors that helped it this quarter. But I was wondering, if you could give us some color on, is there a strategy going to increase this component of the res revenue?

[D. Scott Patterson, President, CEO & Non]

No, there is no strategy to increase it, Michael. It's part of our core offering. We're always looking to provide a full-service management offering that includes property and other ancillary services, where we are capable. So in a situation where we win a management contract only, we are focused on building that relationship and looking for opportunities to bring more value to that customer over time, that is compelling offer to that customer, whether that be an insurance product that provides greater coverage at lower cost or a property service, such as pool management or janitorial, where we believe we can provide a better service or perhaps a better price than their current provider. As you know, we always disclose the relationship and the Board can decide. And often, they are very open to having us provide other services and effectively putting our management contract at risk. Clearly, we have to deliver on the ancillary service offering, where we put the whole relationship at risk.

[Michael Smith, Analyst]

Sure. Understood. And just switching gears over to Century Fire, it sounds like you're very pleased with the way that has rolled out for the last couple of years since you made your first -- since you made that acquisition. Wondering if you could -- roughly, what percent of that revenue would be contractual in nature and what percent would be sort of, like, new installations from, I guess, new construction?

[D. Scott Patterson, President, CEO & Non]

It's about 50-50 right now. 50 service and 50 newbuild installation.

[Michael Smith, Analyst]

And do you have a target in terms of service?

[D. Scott Patterson, President, CEO & Non]

Yes, we're close to our target. We might get to 55, 60 service, but we really need that new installation to help drive everything. And so it's -- we're pretty close to where we want to be. We -- but we're cognizant of the fact that, that the new installation side of the business is susceptible to economic swing and Century Fire in a downturn, we will -- that will come through in the numbers that we're looking for.

[Operator]

Your next question comes from the line of Marc Riddick of Sidoti.

[Marc Frye Riddick, Research Analyst]

One quick question I wanted to cover, and this can be specific to yourself and maybe if you have any feedback that you're getting from folks you work with, that there's any specific direct impact from any tariff-related issues that you're seeing that we should be aware of.

[D. Scott Patterson, President, CEO & Non]

The one place we've seen it, Marc, is at Century Fire on steel pipe for sprinklers, sprinkler installation. It's up probably 30%. And so we are passing that on to our customers. But there is a period of disruption, I would say, as competitors deplete their inventories, there's -- and the judgment that they use as to how they want to price bids. So we are seeing some disruption, but that's the one place we see it right now. We may well see it at California Closets with some of our board from certain countries, and then other products that we offer and perhaps we'll see it at CertaPro and paint prices, but we haven't yet.

[Marc Frye Riddick, Research Analyst]

Okay, that's very helpful. And then switching gears to -- around Century Fire, you'd mentioned some of the progress you're making on the working of building out national accounts in that platform. I was wondering if you could share a little more detail on some of those efforts and maybe how long you think it will take to sort of get to where you would like to be when it comes to pursuing business on a national basis?

[D. Scott Patterson, President, CEO & Non]

Well, I think that's something we'll continue to work on. We are pleased with really from a standing start 2 years ago to where we are today. But we've invested pretty significantly in terms of the sales force and an infrastructure to support national accounts, call center, et cetera. But we are seeing the results and it's growing quarter-over-quarter. And we expect to continue to focus on it and build it over the long term.

[Marc Frye Riddick, Research Analyst]

Okay, great. And then one last thing from me. You did mention some of the progress that you're making with Century reaching out to and dealing with retailers, restaurant and things like that. I was wondering how should we think about that -- the current mix of business? How many would you say are kind of under that retail umbrella for Century Fire currently? And is there any particular target that you'd like to reach?

[D. Scott Patterson, President, CEO & Non]

I don't think we've really thought of that vertical necessarily and targeted an ideal number for the retail vertical. But it -- focusing on national accounts, you're looking for multi-location companies and so retail, restaurant chains, large commercial operators and owners. They are all ideal customers. So the focus is on multi-location entities and so that would -- national accounts would form a percentage of our service business, which has many, many one-offs, if you will, across our 13 locations. So I think the way to think of it is what we described earlier is that the service piece is about half and, whether it's coming from national accounts or one-offs, I mean, it's similar type business and we should think of it that way.

[Operator]

There are no further questions at this time. I will turn the call back over to the presenters.

[D. Scott Patterson, President, CEO & Non]

Thank you, operator, and thank you for joining us. We look forward to speaking again at the end of October for our third quarter. Thank you.

[Operator]

Ladies and gentlemen, this concludes the second quarter investors conference call. Thank you for your participation. Have a nice day.