TIVP017: Comfort Systems (FIX): Blue-Collar Compounder w/ Shawn O’Malley & Daniel Mahnke

27:09But from the perspective of the person selling their plumbing or HVAC business, Comfort Systems can help them get lower insurance rates, or they can take over the back office operations that small business owners usually aren't interested in anyways, like cash management and banking, as well as IT infrastructure and cybersecurity, or even just doing tax returns. A lot of these things are major headaches for the companies that sell themselves to Comfort Systems. And immediately, Comfort Systems can take all of those things off their plate and enable them to focus on just completely running their business as well as possible, which is sort of a hidden competitive advantage.

27:46It's a very slight one, but I do think it is a real one against smaller companies who are probably at least spending 10 or 20 % of their time distracted by back office stuff.

27:59All of that sounds pretty good. And as I said, the competitive advantages or the mode of comfort systems might be a bit hard to pinpoint, but it's these small subtle areas where they have the advantage over the competition. And it sounds like the management, unsurprisingly knows about the risks coming from acquisitions and is focusing on keeping them in instead of just growing as fast as possible. And still, I've mentioned that successful serial acquirers in the business tend to focus on small and local companies. It seems like Comfit Systems does that as well and you mentioned they only have 2-4 % market share but I'm still asking myself how many great small local companies are there to acquire?

28:45So how sustainable is it to make these kind of acquisitions? And is there a risk that there will be fewer and fewer good deals to make in the future? The company's CEO, Brian Lane, has said there's a long runway to continue making attractive acquisitions. One that extends well beyond his lifetime, in his words. Many of the businesses they acquire are run by founders who have maybe recently turned 60 and are thinking about retirement. In the old days, their kids might have taken things over, but that's increasingly less common and has created an opportunity for companies like Comfort Systems to come in and enable people to sell the business they've been building over a lifetime to a trusted partner with a good reputation who they know won't run in their life's work into the ground.

29:30And Comfort Systems has a lot of scale, but there's also large swaths of this country that they haven't tapped into yet either for further acquisitions. so that does sound like the acquisition strategy is still on solid footing for now but what about organic growth and perhaps when you answer this could you also give some short insights about how the management is incentivized from my experience incentives are crucial for serial acquirers because good incentives foster sustainable and profitable growth while bad incentives often end up resulting in unprofitable top-line growth. So how would you say is Comfit Systems handling that?

30:14I keep referencing their CEO here, but he's probably the best person to learn about the business from. So I did try to study him closely. And in interviews, he has said that the company can probably sustainably grow its existing business at about 2 % to 4 % a year, which is basically GDP plus maybe a little more. And that's not super inspiring. There's nothing too exciting about that, but at least it's not in decline and likely isn't ever to be in decline either. This also explains why they're so focused on making acquisitions at attractive prices to really grow the parent company's overall revenues and size.

30:48With acquisitions, he feels they can average upper single-digit growth going forward. And it would be very tempting for them to focus on the top line, but they make a very intentional effort to not do that because it's really dangerous in this industry. They could go around, for example, and offer cheap bids on construction projects, and business may suddenly seem like it's booming, but most of that jump in sales would be from projects that six or nine months later prove to be unprofitable. That's why at every level, management compensation is tied to performance targets related to earnings growth per share and free cash flow.

31:21Not only does that turn people into owners of the business who have real stakes in it, since the bonuses are paid in units of stock, but also it aligns incentives to not try and grow the business at all costs. Growth then really only comes when it makes sense to do so and they opportunistically take advantage of certain trends and then will be very patient for a while again. Organic growth, especially new areas, is not viable at all for this business. Everything is so relationship-based, as you can imagine, and every town has its own local company that's already established. So if they want to, say, expand more in Oklahoma and target some small city, they'd be coming in cold against local companies who have operated there for two decades, where the employees have been part of the community, going to church together, or sending their kids to the same schools.

32:08And there's just no good way to break into that, which is again why they rely on acquisitions. It makes much more sense for them to go in and acquire the biggest player in a new market for expansion than it does to try and build a new competitor there from scratch. And most of the acquisitions they're doing, by the way, are relatively small by most standards. These are businesses maybe doing 10, 50 or$100 million a year in revenue. Which doesn't even sound so small if you consider the industry they're operating in. Now, we've already talked about the many local companies and you just mentioned them again.

32:43So I guess that's a big part of the competition, if you can call it that, because perhaps it's also an opportunity since those are the main acquisition targets. And if there's anything more to add on that, please do so. But otherwise, how does competition look on a larger scale? Are there other companies like Comfort Systems, or are there nationwide operators who compete with them head to head? Sure, it's basically the textbook definition of fragmentation, with lots of mom and pop companies operating in maybe these 100 mile square radius areas. While there are some regional players, though, and then they're really their main nationwide competitor that's probably the most similar to them is a company called MCOR with the ticker EME.

33:28The way in which they compete, though, varies for different parts of comfort systems business. For construction projects, they often rely on the relationships with general contractors, whereas with the service business for doing maintenance, they're almost going door to door, trying to pitch people on the maintenance they need to do because every building has a unique service agreement. So it requires a more direct sales force to speak to the nuances of what's needed for a given facility. And then these service agreements might get signed for three or five years. So there can be an element of stickiness to them.

34:03Another strength of the national brand that helps them against competitors is that, for example, if there is a businessman with, let's say, a construction project in Texas who works with Comfort Systems on that, if they're satisfied, they may want to ensure that that same quality of work goes into their other projects that might be going on nationwide. So just to continue the hypothetical, maybe they're building condos in Detroit too. And Comfort Systems can refer them to their local operations there and streamline everything as a business partner, as opposed to, from this guy's perspective, needing to start from scratch in every city he does business in and trying to meet the local mechanical contractors who may or may not be able to consistently meet certain quality thresholds.

34:46And then on top of that, going back to the advantages of their conglomerate structure, their scale makes them a much more reliable partner to work with throughout the entire business cycle. In recessions or during disruptions like COVID, Comfort Systems has the balance sheet to comfortably navigate volatility in their business. And that's very reassuring to their clients who want to ensure that the people they begin a project with can be the same ones who finish it. To say that another way, when working with Comfort Systems, customers can rest well assured that the company isn't going anywhere and won't be forced to shut down or pause operations for financial reasons.

35:21And that's exactly what you'd hope for when planning a multi-year construction project that costs millions of dollars. That safety is kind of the most important part of the business. I still have unfinished construction outside of my apartment, which costs hundreds of millions, and you just don't find a company that could finish it. Because the mechanical contracting industry has historically been tough and a low-margin business. It's extremely fragmented with thousands of small competitors, which leads to intense price competition. And on top of that, it's a very labor-intensive and project-based industry, where contracts are often awarded to the lowest bidder.

36:01You could even say that services have become mostly commoditized, so it's hard to actually build pricing power. And with fixed bid contracts, even a small cost overrun could erode profits quickly and entirely. As a result of that, operating margins have only been around 5 % across the industry. That said, during the pandemic and the following recovery, contractors had unusual pricing power, which led to higher than normal margins. But now that conditions are normalizing again, we could see some of that profitability to come back down. And given how challenging the industry usually is, it's interesting to look at the few players that have managed to operate at scale and consistently outperform.

36:49And one of them is Comfort Systems. The other one, as you mentioned, is Amcor. They are their primary nationwide competitor. And perhaps it makes sense for you to tell us more about how their business differs from Comfort Systems in detail. Here's a revenue. MCOR is about twice the size of Comfort Systems. But since 2014, Comfort Systems has grown revenue at around twice the rate that MCOR has. The market generally places a higher premium, though, on Comfort Systems stock. So despite MCOR having twice the amount of revenues, their market capitalizations are actually not that far apart, suggesting that investors either see Comfort Systems as a better business or a business with more growth potential or maybe both.

37:33I think it's probably both actually, because as I said, Comfort Systems is growing faster, but they also have higher margins on just about every measure of profitability from gross margins to net income and free cash flow margins. And to put that another way, Comfort Systems converts a higher percentage of each dollar it earns into bottom line profits. And it's also growing faster. So that is a powerful combination for creating relatively more intrinsic value for shareholders over time. MCOR has a really good reputation too, though. And in that same industry ranking I mentioned earlier, with Comfort Systems being placed as the sixth best specialty contractor in the US, MCOR was actually ranked ahead of them in second place.

38:16And I should add also that MCOR is something of a serial acquirer too. They've done a number of acquisitions over the years, but I think the question you probably really want to know about is their moats and how it differs between the two companies and whether Comfort Systems' moat can protect itself from MCOR. Yeah, not just whether they have a moat, but if so, how wide is it? And does it protect them from MCOR, like you just mentioned? Or do they compete in sufficiently different niches that they aren't really going head to head? That's kind of what I'm getting at, yeah. To answer that, maybe we should consider the best way to assess moats, which is to compare the company's return on invested capital.

38:57That is basically the profit they can generate off each dollar that's invested in the business relative to their opportunity costs, which some people refer to as the cost of capital, maybe in a finance class. In other words, though, if your company generates a 7 % return on the money invested in it, while you could historically earn 10 % a year on average by just owning an index fund, then there's a three percentage point opportunity cost there that's sort of hidden, where the business is generating a lower return than you could have earned elsewhere on your money. And as an investor, you're the one who's missing out.

39:32But if a company has a positive spread between the returns on capital relative to the opportunity costs, and they can sustain that for a very long time, well, that's a great company to own and suggests they have some sort of advantages supporting that excess profitability. that aren't arbitraged away by competitors. I think in different ways, we've already touched on some of the qualitative factors that may form something of a maybe narrow moat around Comfort Systems business. And to validate that, we can just look at the numbers and see that for pretty much every year in recent memory, they've earned a positive spread over just about any reasonable way to estimate the opportunity costs of capital.

40:11I prefer 10 % as just a really basic rule of thumb, but when you account for the effects of debt financing, that can bring the cost of capital estimates down further and increase the positive spread that Comfort Systems is earning with its returns on invested capital. But either way, Comfort Systems has sustainably earned excess returns, as you might say, providing evidence that they do, in fact, have at least a small moat around their business. And that moat may actually be growing as their returns on capital have only increased further since 2021, which was a weak point for the business coming out of the pandemic.

40:45It's definitely great to see a positive trend on that end. In my Nike episode, I discussed how modes need to be reflected in the numbers. And as you just pointed out, comfort systems is a great example of that. When you look at companies like Nike or Apple, it's kind of intuitive to understand that their brands will have an impact on consumers' decisions. And it's easy to understand how that would affect their financials and their fundamentals. It's less intuitive for a company like Comfort Systems and that's why it's even more important to look at the numbers and see where the mode shows. Maybe some listeners even wonder why we are so keen on finding the mode.

41:28I think we spent another 10 minutes just today on defining it and pointing it out in the business. And the main reason is that sustainable outperformance, which is needed to compound intrinsic value has to be protected. And a moat is that protection. It's crucial because if your superior value proposition can be easily copied, it will be gone soon after. And with it also the potential to compound intrinsic value. I think the term moat was popularized by Warren Buffett and it already shows you that it's about protection. And that's what the competitive advantages of each business are for. And that's also why we spend so much time defining them and pointing them out for each of the businesses that we research.

42:12I completely agree. And I did kind of dodge part of your previous question though, which wasn't just on moats, but also whether MCOR and Comfort Systems compete head to head. I should also mention quickly too, to bring it back to moats again, that MCOR has also earned some very high returns on capital of late. But in the last decade, I see at least three years where they pretty clearly earned a return below their cost of capital, which is not true for comfort systems. So that does give me some pause. And because of that, I can't say with the same confidence that MCOR has as strong of a moat around its business, even though it is a bigger company.

42:48And maybe if I did a deeper deep dive into MCOR, I'd be able to say that with more confidence. But the point being, I couldn't tell you exactly what makes their competitive advantages less durable, other than to say that the numbers paint a slightly different story for MCOR. There are a few different things that go into moats and competition, but one of them is switching costs. And that's what really comes to mind with MCOR and Comfort Systems as their possible moats. They both have their own network of relationships in cities and regions they more or less dominate. And that probably enables them both to have a high degree of switching costs over their customers.

43:23You could probably imagine that a commercial builder who has worked with Comfort Systems for 15 years is very unlikely to switch to a competitor. The same is probably true for with MCOR, such that they both have very sticky customer bases without directly stepping on each other's toes too much. And then just practically speaking, my understanding is that comfort system services tend to be a bit more specialized, which is why they don't always compete all that directly with MCOR and actually also why I prefer comfort systems as an investment. Specialization generally lends itself more to being able to consistently earn excess returns.

43:59And maybe the last thing I'll mention about MCOR, is it's sort of an interesting story that their fate in some ways became intertwined with Comfort Systems fairly early on. Just a few years after forming in 2002, Comfort Systems found itself reeling from the effects of 9-11 and how those attacks had rippled through the economy. And with$205 million of debt coming due, they actually had to sell 19 of their subsidiaries to MCOR for$164 million. Otherwise, the company probably would have gone bankrupt and we would not be talking about it here today. And obviously the company is much more stable and a completely different footing than it was back then.

44:39Well, that might've been painful back then, but considering the success of the business now, it seemed to be the right decision. In my preparation for this episode, I also read about how Brian Lane's plans to implement new technology whenever it makes sense for them, which sounds reasonable, but at the same time, a bit hard to do for a business like Comfort Systems. So in an age of AI, how does a company like Comfort Systems incorporate technology to boost productivity, for example? There was a study a few years ago from McKinsey that concluded basically that the agriculture and construction industries historically implemented the least amount of technology into their operations.

45:24And so that's something Brian Lane has said he remains very sensitive to. As much as reasonably possible, he wants to embrace technology to accelerate worker productivity when out in the field. One of the main ways at the holding company level they've embraced technology is by implementing systems to construct prefabricated units in their production centers for things like HVAC ductwork, mechanical piping, and other plumbing and electrical assemblies, which can then be shipped around the country as needed. By utilizing prefab and modular construction in this way, they can also use more automated technologies, such as machines that do automated welding.

46:03And that reduces the labor intensity behind parts of their business. Still, though, you can only automate so much. And Comfort System CEO has said 85 % of their employees have some kind of tool in their hands. That said, they're not out here trying to reinvent the wheel by any means with technology. I think their general philosophy is more along the lines of instead of trying to hit home runs, they really just aim to hit a bunch of singles and doubles. Given that Comfort Systems is a business reliant on the construction sector and therefore also interest rates and consumer sentiment, which kind of came to haunt them after 9-11, how economically sensitive or cyclical is the business in general?

46:50Really interesting question because it's not as straightforward as you might think. Your gut reaction would probably typically be to say, well, it's a construction adjacent business. And as such, the business probably fluctuates with the economy. And that is definitely true. But at the same time, their business uniquely adapts itself to different points in the economic cycle. A little over half of their sales come from newly constructed buildings, yet more than 40 % come from renovations, expansions, maintenance, and repairs. And if there's an economic slowdown or financing is too expensive due to a rise in interest rates, the new construction projects might slow, which would hurt that part of the business.

47:27But also, if new construction plans are being delayed, that means people are trying to get more out of their existing facilities, so they might opt to spend more on repairs or renovations in the meantime to partially address their needs without swallowing a huge spending pill during an uncertain time. This kind of reminds me a bit of your pitch on AutoZone, where their business actually improves during recessions just because people delay to buy a new car and spend more time on maintaining their old cars, which plays directly into what AutoZone does, and in this case, kind of what ComfortSystem does.

48:01Many of the projects they work on have long life cycles. And since the bulk of the work that ComfortSystems does is toward the end of a construction project, once everything else is built out, they experience economic trends at a lag. So they might still be feeling the effects of a recession at a delay for a while after the general economy has already improved. And the auto zone comparison is a pretty good one to use, at least to understand the maybe counterintuitive idea that some businesses can benefit from recessions and experience them differently from the broader economy. But in Comfort Systems' case, that means dramatic shifts in the type of work they do.

48:39Rather than sales completely falling off at different points in the business cycle, it's more accurate to say their business mix shifts from new construction to maintenance services, which helps make the company a bit more resilient than it otherwise would be. And maybe one other thing here to mention is that as HVAC systems age, they become less and less energy efficient, especially compared to the new technology available. So to ensure not only that clean air is being recycled through buildings, comfort system customers may also want to have new systems replaced to reduce their carbon footprint.

49:10And that kind of spending does not perfectly map on to the ups and downs of the business cycle. with the idea there being that there are other considerations that may go into the decisions to say place a building's ac system that aren't strictly economic in nature a part of the advantage that comes with comfort system scale is that you mentioned how they got more efficient in allocating resources so not only financially but also human capital and this reminds me now how they got better at handling business mix shifts. Is this what makes you most optimistic about the company? The fact that they can now handle economic shifts much better than they used to, and perhaps even more better compared to the smaller competitors in the fragmented market?

49:56Or is there something else that we haven't yet talked about that is worth a mention? What's really the most promising thing about Comfort Systems business is that even though growth has been bananas in the last three years, I'm a little less afraid of reversion than I otherwise would be because they have this massive backlog of customer orders. I mean, they have more demand from customers than they can even meet. I think they have something like an entire year's worth of revenues waiting to be earned from backlogged orders. And having at least the next 12 months of work already under contract is not a bad position to be in.

50:30So I don't exactly we think growth for the company is going to suddenly drop off, we know there's a ton of pent-up demand for the company's services. Comfort Systems' backlog nearly quadrupled from$1.5 billion in 2020 to$6 billion in 2024. And crucially, many of these backlogged projects for data centers and semiconductor fabs are multi-year programs that will sustain revenue beyond just any one-year pop. And relatedly, the company has collected a ton of cash in advance of providing it services, giving it some float to earn interest on. Management actually called it a very substantial amount of unearned customer cash.

51:08While that is good for float and working capital, it is going to be a bit of a headwind to free cash flows over the next year or two probably, since comfort systems will be working on projects that they've already partially collected payment for and are trying to earn those revenues for accounting purposes. And still, generally, I would say this is a very good position to be in. And kind of what I was hinting at when talking about how these smaller operators mostly have problems with finding enough workers. The order book is full, but they don't have enough employees to fulfill all the orders.

51:43That's different for comfort systems with all their flexible resources and their general scale. And while all of that sounds very promising, as always, we should also consider the risks, which we've already done a bit by talking about the fluctuations in the business cycle. But what else could go wrong for comfort systems? For example, we talked about the possibility of being too government dependent. And I've read that 5 % of revenues come from government spending directly. So changes in federal and state spending could both directly and indirectly hurt comfort systems, right? The economy are sensitive to government spending and comfort systems is certainly too, which is a bit of a glaring risk during a time when everyone is talking about government efficiency.

52:32Beyond that, Comfort Systems has a real specialty in servicing data centers, and data centers enable cloud computing and artificial intelligence. And those are likely going to increasingly be important parts of the modern world. So that is a real advantage. And while this boom in data center construction has hugely lifted the business, it has also made them very dependent on data center construction. According to the company's annual filing from last year, a third of its revenues came from the technology industry, which is presumably customers like data centers and semiconductor manufacturing facilities.

53:06And while I do think the world will probably only need more data centers, it's not going to be perfectly linear growth. During the dot-com bubble in the 90s, for example, a lot of things people expected to happen to the world, like anticipating the rise of e-commerce, were completely spot on. It's just that all the excitement got pulled forward into a moment in time, when in reality, much of those developments would take another 10 or 15 years to really manifest. My point here is to just say that, and I'm no expert on data center needs, but whenever you have a boom, it's just natural for things to correct.

53:37And there are some fears of those corrections starting to come to fruition. And we may realize in 18 months that demand for data centers is not lining up with expectations. And much of what's being anticipated is perhaps actually five years away. I should also add that this is a company with a good deal of exposure to tariffs, which is a timely topic as well. I'd imagine they use a lot of aluminum in some of their projects, and aluminum has been hit with some particularly high tariffs. They also use copper and all kinds of materials that are sensitive to tariffs and inflation more generally. So I'd think they can mostly pass these costs on to customers, but you just never know.

54:13To invert my thinking on tariffs, I certainly don't think tariffs are doing their profit margins any favors. Without going too much into politics now, tariffs really make the investment world an even more interesting place at the moment. And on that note, usually at the end of each episode, we give three hints about the company we pitch next week. But because it fits so well right now, I might give my first hint now, which is that my next pitch is also in an industry that got hit particularly hard by the tariff announcements. But enough of that, let's get back to Comfort Systems. And my next question to you, which is, how has the company been able to convert net income into cash flow?

54:58We've seen already that the 2024 cash flows far exceeded net income. And that's not too unusual. There are many reasons for discrepancies between reported earnings and operating cash flows. I mean, out of the back of my head, I could think of non-cash expenses like depreciation, amortization or stock-based compensation that reduce earnings but do not involve cash. And then there are one-time expenses that can impact earnings but not operating cash flows since they're not part of the usual business. Well, and then you have timing of revenues and expenses and especially important for comfort systems, at least in my opinion, changes in working capital.

55:40And that's because you briefly touched on that already. But tell me if I'm wrong on that guess and Comfort Systems is benefiting from something else. I'd say an important aspect of Comfort Systems' recent performance, at least in terms of free cash flow generation, has had to do with working capital management, as we talked about a bit with their prepayments and order backlog. And as just a reminder to the audience, free cash flow encompasses both changes in earnings and working capital. Historically, contractors often consume cash when growing as they build up receivables and inventory for new projects.

56:13But Comfort has managed to convert earnings to cash at a very high rate recently. 2024 operating cash flow was$850 million versus$520 million for net income. And that is primarily due to those advanced payments on big projects that we've mentioned, where the company has already collected the cash. So it's reflected on the cash flow statement, yet they haven't actually earned it by providing installation or maintenance services. So that backlog can't be recognized as net income by generally accepted accounting standards. So because we are going through this boom period where there's so much demand for services from Comfort Systems, that gives them the leverage to pressure customers to pay in advance.

56:53But I have to imagine that that can't sustain forever either. Things will probably bounce out again such that we'll see a fall off in reported cash flows when growth in the backlog normalizes and they collect less in prepayments relative to the number of projects they can actually complete in a year. Over a five-year span, these timing effects may even out, but investors shouldn't assume free cash flow will always track at 100 % of earnings. If there are big changes to the order backlog and how much they collect in advanced billings relative to the cash they collect when completing projects, that can cause fluctuations in the amount of accounting earnings they report versus free cash flow.

57:34It probably looks a lot different for these bigger contracts like data centers or other government-backed orders. But for smaller companies in the industry, prepayments are more of a dream than reality. More often than not, your local plumber has to wait for months to get the money, even after the job was done. Alright, that gives us a solid understanding of how the business actually operates. So let's shift gears and talk some valuation. What did you come up with and what do you see as the key drivers of intrinsic value for Comfort Systems? One of the things I want to say at the top about Comfort Systems is that I really wanted to understand how efficiently this company has allocated capital since they've made so many acquisitions.

58:21In my model for Comfort Systems, which you can download by signing up for our free weekly newsletter, I add in a separate tab for calculating ROIIC. ROIC. That stands for returns on incremental invested capital as opposed to ROIC. And it is similar to returns on invested capital, which is a very important metric for understanding whether companies are creating value for shareholders, but it zooms in on the returns generated by the additional investments they've made. Sometimes the company might have a very high average ROIC over the long term, but that could be distorted by abnormally high profits from long ago, for example, while the more recent investments they've made are considerably less profitable.

59:04So returns on incremental capital are a way to assess how their profitability has evolved over time relative to the amount of capital, either in the form of equity or debt, that must be put into the business to generate those returns. In other words, if$100 were to be invested into the business, how much of a return would we expect on that money? That is, in a nutshell, how to think of returns on incremental invested capital. Measuring the return on that incremental investment helps us determine whether a company is still able to reinvest capital at high rates of returns or if its returns are deteriorating.

59:42So it really helps in assessing the sustainability of a company's competitive advantages and long-term compounding potential. It especially makes sense for a company that grows predominantly through acquisitions. using return on incremental invested capital makes a ton of sense then because it shifts the focus from evaluating the quality of the existing business which is what ROIC measures to assessing how effectively new capital can be deployed for a typical compounder growing organically ROIC is a great metric because it reflects the efficiency of the existing business model But when growth is driven by M &A, it's the incremental returns on the new investments that actually matter.

1:00:29So ROIIC becomes the more telling indicator. So it's great that you pointed that out because I feel like many people are not familiar with that term yet. And it's a huge help in valuing businesses like this one. Probably right that not enough people are familiar with thinking through incremental returns on capital. And to get back to Comfort Systems, I show how to calculate returns on incremental capital for them in my model. And I found that the company has had some attractive rates of return on its investments since 2015, with incremental returns on capital north of 20%. As one of my favorite investors, John Huber, puts it, the intrinsic value compounding formula is simply the return on incremental invested capital times the reinvestment rate, which is a percentage of earnings that's being plowed back into growing the business rather than being returned to shareholders via dividends or share repurchases.

1:01:21So if you take Comfort Systems Reinvestment Rate and multiply it by their ROIIC, the takeaway is that the company has compounded intrinsic value at 27 % per year since 2015. And that's possible because they basically reinvest almost all of their retained earnings into acquisition. Nonetheless, compounding intrinsic value at almost 30 % a year over a decade is a very impressive rate. And the stock has compounded by roughly the same amount, which makes sense, or even just a bit more since the company's valuation multiple has also increased in that time as the market has recognized just how high quality of a company Comfort Systems is.

1:02:00Another one of my favorite investors, Chris Mayer, refers to this dynamic as the twin engines of shareholder returns, where not only is the company growing its returns by compounding intrinsic value at high rates, but as their track record of doing so gets longer, the market recognizes this quality and pays a higher premium to own shares in it, further boosting the returns to existing shareholders. Yet I should say that it is a capital-intensive business in some ways, as they have to put most of their free cash flow toward acquisitions, meaning if they ever tried to dramatically increase their dividend or share repurchase programs, it would come at the expense of the amount of acquisitions they can make, which would handicap Comfort System's growth.

1:02:41Now, these are phenomenal numbers. And if we just take these at face value, it looks like a no-brainer investment. A company that compounds intrinsic value at almost 30 % for a decade is more than just hard to find. But we know that it's not that easy in investing. So could you maybe tell us about the context and on what to do with these numbers? So how would you think about them after modeling them through? I mainly went through that exercise just to better understand their capital allocations and confirm that Comfort Systems is, in fact, a very high-quality company, which helps to provide some context for us as we think about their future growth.

1:03:21Rates of return will inevitably come down, especially since we're in this period of elevated demand for data centers and there's all this hype around AI that has boosted its business. So we do want to account for that. We can't expect the company to grow at such a high rate if it shifts to distributing all of its free cash flows to dividends, for example, down the road, because well, they wouldn't be investing in new capital to generate those incremental returns to drive the business. And their incremental returns aren't high enough for them to be able to compound at an attractive rate without heavy reinvestment.

1:03:52So you have to consider historically how much they have reinvested in expanding the business, namely through acquisitions, with the incremental returns on capital they've earned. And that can set some guardrails on how much we would expect the business to grow. For example, I shouldn't model them growing by 40 % a year if I don't account for them reinvesting much more into the business. And if so, I'd have to explain why they're suddenly going to reinvest more. As in, are there suddenly more acquisitions for them to make for some reason? And that just doesn't seem plausible, which is why I'm not forecasting them to grow by 40 % a year.

1:04:25You know, valuation is a mix of the mathematical side of investing and the part that is often called an art. And perhaps valuation is more an art than math. I say that because these models, they can give us a sense of security. At the end, they seem to tell us exactly how much a share is worth. But once you start changing up some inputs just slightly, you quickly realize how sensitive these models are to even the slightest changes. And they are a powerful tool, but they can mislead. The best way to learn about how to approach evaluation is to just get practice in, which is why you can download all of our models and adjust them to fit your assumptions, just like Sean said a minute ago.

1:05:14To put this all into context further, just because ComfortSystem continues to have quite attractive returns on capital, it also doesn't mean it's a great buy. at today's prices. The market surely realizes everything that I've uncovered here, and no matter how fast a business is growing or how capital light it is, there's always a price that is too high. If we pay 25 times earnings for a company that grows quickly for two years but see its business normalized in five years and profit margins return closer to historical averages while gross slows, then not only would we be left holding a less attractive business with reduced earnings power, but we might also feel the pain further as the multiple declines dramatically.

1:05:54That same company might only trade at 15 times earnings. And that journey from starting with a 25 times earnings multiple to a 15 times multiple would probably more than eliminate any excess returns we earned from when the business was booming. The point being with Comfort Systems, I'm really wary of buying into a business that looks really great today, but could revert back to the mean, at least to some extent, bringing down both its earnings potential and valuation multiple. And that is a dangerous combination. You have the twin engines of growth working against you in that scenario. So yes, I like comfort systems a lot, but I'm not sure I love the price given that it's well above its historical norms in both price to earnings and price to free cash flow terms due to all the optimism about how tech customers like data centers supporting AI can boost the business, which is not guaranteed to last forever.

1:06:44you've already mentioned the price now and we have said all our usual disclaimers so tell us according to your model what would be an attractive price to add comfort systems to our portfolio for example that is the million dollar question i could be shortchanging how long the data center boom tailwind could benefit comfort systems i don't think i could feel like i was being honest with myself if i didn't account for any reversion where the expansion of new data centers and semiconductor fabs didn't slow down a bit. So in my model, I'm trying to account for something of a return to normal while also recognizing that the business is perhaps structurally more profitable than it was five or 10 years ago, because all these data centers have been built out and will need someone to continue servicing them, which happens to be more profitable work than, say, the margins comfort systems can earn with some of its more traditional clienteles like school buildings or government buildings.

1:07:38And as a result of everything we've said, I get an intrinsic value target of around$290 per share. At that point, we'd be snapping up shares at about 16 times their projected earnings per share for 2025, which I think is a more than fair entry point for a company like this, if we can get it. I actually think the fair value for Comfort Systems is probably about$320 per share. And unsurprisingly, that's where the stock is trading at the time of recording. And what that means is that, at least in theory, at that price, you'd be expecting to earn the same return as the broader market, which has historically averaged around 8%.

1:08:14Not to say you couldn't earn a better return, but that's the idea. Between 320 and 340, you're probably just going to get an average return. And at any price much higher than that, you risk earning a below average return. And then at around$290 per share, which is the target I set, I calculate and expect a return north of 10 % per year. And obviously there's some room for higher returns than that if some of the more bullish scenarios unfold for the company over the next few years, while leaving some breathing room for earning at least an average return if some things in your thesis go against you.

1:08:48You might see it differently, Daniel, but if I can find a company with evidence of a moat, a simple to understand business model, and a track record of operational excellence with shareholder-friendly incentives for management and an expected return of at least 10 % a year or more without even accounting for some of the more optimistic scenarios for the company, I tend to think that's a pretty attractive risk reward profile. I don't think it's a grand slam by any means, and we aren't guaranteed to even get that share price that I suggest as an intrinsic value target. But that's sort of how I think of it.

1:09:20And with all that, why don't you tell me, Daniel, what do you make of Comfort Systems and the valuation I just took us through? If you sum it up like that, it definitely sounds attractive. And you undeniably have a fantastic management team and a very good company portfolio. And because that's a successful combination in this sector, the stock has had a stellar performance over the last decade. But the stock chart also shows how much of the performance has happened just in the last few years with the tailwinds that we've discussed coming from government-backed contracts. And that can be more sustainable than it sounds at first glance.

1:09:59I mean, you mentioned that there might be a short dip in data centers, but the long-term trend still looks promising and also intact. My problem is that the market knows about the outlook very well. And you just mentioned that your fair value target is also where the stock is currently trading at. And the multiple has already expanded in recent years. And I mentioned that with holding companies, you mostly have either a discount attached to it or a premium. And for Comfort Systems, it looks like it has been a premium at this point and also for the last few years. But our timing isn't too bad. The stock is currently down 40 % from its highs in January and approaching your fair value target.

1:10:45So if it gets into this territory where the market seems to price in a downturn and is not seeing Comfit system as this perfectly run business, I could see us grabbing some shares. And it's a difficult industry, which is why the market's perception can quickly turn. We've seen that multiple times with other companies as well. And at the same time, Comfit's management team knows how to handle these business cycles. So you could get the best of both worlds, a competent management team that probably makes the company and the stock coming out stronger out of a recession or even a slow downturn and a cheaper stock because investors do not fully trust that this is actually happening.

1:11:27So yeah, you can see I'm kind of going back and forth here. I would agree with your price target. And I always like these serial acquirers, of course, because both you and I have a strong bias toward Buffett and what he did with Berkshire Hathaway. Yeah, it's kind of the playbook is it sounds tantalizingly simple, right? When you break it out of, oh yeah, just acquire great businesses at fair prices, it seems like there's a simple formula for beating the market. And obviously there's so much more going on behind the scenes than that. And as we found with comfort systems, even for a really, really high quality company, the price you pay still matters a lot.

1:12:04The stock has come down a lot as there have been these fears about the AI bubble popping, which will mean less CapEx spinning from companies like Microsoft and Google, which will mean fewer data centers, which will directly ripple through to the new construction and maintenance business that Comfort Systems has over the next five years. So as always, the market is pretty efficient and is pretty quick to sniff out how trends elsewhere in the economy will ripple through and affect companies like Comfort Systems, who is probably not your first thought to be as a company that can benefit from or be negatively impacted from changes in AI-related CapEx spending.

1:12:43That's definitely true. And I mean, an advantage of this company is that serial acquirers, like I said, often have either a premium or a discount, and it can quickly change because you do not have these typical catalysts. There's nothing that an investor could see and immediately knows if this happens, the stock price will rise. So the lack of a catalyst sometimes gives you the opportunity to buy these businesses at cheaper prices just because they tend to forget the longer term underlying trend. And if this is what happens to comfort systems, if it comes out of a economically worse phase than we might have seen in the last couple of years, I could definitely see us grabbing some shares at a much more attractive price, which we're currently really getting close to.

1:13:32we'll hold off on adding comfort systems to the portfolio for now it sounds like but man is it a compelling company if you can get it at a good price given how much they stand to benefit from some of these really big tailwinds in construction in the u.s but that's enough for now on comfort systems we've done a pretty thorough breakdown and it's been fun with you here today daniel why don't you give us a little sneak peek into your pitch for next week's episode Yeah, it has definitely been fun. And thank you for pitching this company. I must admit, I've never heard of it like two months ago. So it was definitely an interesting one.

1:14:10To get to my hints for the next episode, I mean, I've already given you the first one in the episode, which was that the industry my next pitch operates in was hit extremely hard by the Trump tariffs. And a second hint would be that it's a company or it's a brand that is for my home country, Germany. And perhaps when I say all of that, some of you might have guessed the industry already. So my third hint should probably be tailored to the exact company. And then I would say it might have one of the most iconic logos in the world. I think this is all I will give you. So let me know your guesses in the comments.

1:14:51And I'm curious to see if anyone guessed it right. I'm looking forward to it. With that, let me leave you, as always, with a quote before we go. Warren Buffett reminds us that the American economy is going to do fine, but it won't do fine every year and every week and every month. And if you don't believe that, forget about buying stocks anyway. It's a positive sum game long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market. Some timely wisdom there in a time of market turbulence from the Oracle of Omaha. We'll see you all again next week.