[00:02:57] Shawn O’Malley: But of course, we are here to determine today whether the company is attractive enough at current prices to earn a spot in our intrinsic value portfolio. While the underlying business doesn’t grow a ton, comfort Systems has found success in allocating its capital through a holding company structure where management snaps out these regional contracting businesses that are mostly focused on either electrical work, HVAC services, and plumbing, and then it integrates them into a broader conglomerate and it provides backend support for them.

[00:03:28] Daniel Mahnke: I just quickly look at these numbers for our comfort systems. What stands out to me is that this is a company that has had positive free cash flow for over 26 years in a row, and it has grown dividends for 13 years straight, and all of that was supporting what you might call a pristine balance sheet with very little debt, and then plenty of cash to support operations, buybacks and also dividends.

[00:03:55] Daniel Mahnke: This puts it into the same ballpark as some of the greatest capital allocators ever. One that immediately comes to my mind is the nowadays famous Canadian serial acquirer Constellation Software. Constellation focuses on acquiring small niche software companies, and they have had positive free cash flows every single year since its inception in 1995.

[00:04:19] Daniel Mahnke: While comfort systems operates in an entirely different sector. It looks similarly effective in buying small businesses and then integrating them into its larger umbrella of companies.

[00:04:31] Shawn O’Malley: Exactly. It’s the same playbook that they’re running. And beneath that financial success is a stellar reputation with customers, which is perhaps the most important thing of all out of 600 specialty contractors.

[00:04:42] Shawn O’Malley: Last year, the industry publication engineer news record ranked them sixth, so that’s a pretty ringing endorsement of just how well they’re perceived across the country. And at any given moment, the company has roughly 8,000 projects ongoing nationwide with projects typically taking between six and nine months to complete.

[00:05:00] Shawn O’Malley: And the average contract size being about $1.8 million. So not huge projects by any means for most of these projects too. They will estimate the cost upfront with a target profit margin built in, but there’s always the risk of cost overrun so they can’t recoup. So this is a company that does not have a ton of room for error.

[00:05:19] Shawn O’Malley: One concern is that they have to continue being operationally excellent to earn attractive returns on capital. There aren’t extremely deep moats around this business that enable them to make mistakes and recover without any issues.

[00:05:35] Daniel Mahnke: It’s not surprising that such a strong reputation will then also result in remarkable financial performance.

[00:05:42] Daniel Mahnke: What is surprising to me though is that a company so focused on m and a has such a positive reputation ’cause merging businesses that previously had no connection often leads to some operational headaches, and it’s one of the main tasks for the management of the holding company to create a structure and then an environment where then all of those companies can still work with the same effectiveness and in the best case scenario, become even more efficient than they have been before.

[00:06:13] Daniel Mahnke: That’s kind of what differentiates a company like Comfort Systems from less successful competitors. Sure it’s not a classical mode as it’s a bit subjective and also hard to pinpoint, but still with two decades of exceptional performance, I guess it’s fair to say that comfort’s management understands how to incorporate businesses successfully.

[00:06:35] Daniel Mahnke: Now getting to the operational side of the business, could you give us an overview of what Comfort Systems operations exactly look like?

[00:06:43] Shawn O’Malley: Comfort Systems is one of the largest contracting companies in the US specializing in the installation, maintenance, and upgrading of hvac, plumbing and electrical systems.

[00:06:53] Shawn O’Malley: That’s sort of how I would explain it simply. And, and with that comes 18,000 skilled employees operating, and what they break out is 179 markets across the US and earning $7 billion in revenue. This was a company that was founded in 1997 through this consolidation of 12 regional contracting businesses that decided to kind of merge together and we’re hoping to bring together decades of different experiences and various niches to give themselves a nationwide platform for leveraging the efficiencies of centralizing their administrative operations while still being able to tap into their local expertise.

[00:07:31] Shawn O’Malley: As such, they’ve continued that legacy of consolidation by making over 45 acquisitions across the us, broadening the company’s presence in sectors like manufacturing and healthcare over the years. And that playbook has obviously worked exceptionally well as a has compounded at over 20% a year since 2001.

[00:07:53] Daniel Mahnke: You’ve mentioned that they serve all sorts of different customers, ranging from hospitals to apartment complexes, and even data centers. Could you paint some more color around this wide range of customers and what in detail they need comfort systems for?

[00:08:09] Shawn O’Malley: As you said, it’s a pretty diverse set of customers. Data centers and semiconductor manufacturing facilities in particular are of growing importance to the company’s revenues, though they’ve risen from 19% of sales in 2023 to over 30% in 2024. And that has made the company closely tied to the AI hype cycle and the massive investments that companies are making to develop AI technology from ensuring that the highest quality HVAC systems possible are installed properly into pharmaceutical labs, which require extremely sanitary environments to providing critical electrical support for data centers and creating customized mechanical systems for food manufacturing companies that meet FDA standards, like I’ve been saying, they provide essential services at a very diverse range of industrial customers across the us.

[00:08:57] Shawn O’Malley: These industrial customers make up around 60% of the company’s revenues. They also have less industrial customers like hospitals where precise climate control is crucial for patient care in universities where vast numbers of students, classrooms and sensitive research facilities are housed. And these institutions comprise roughly 20% of revenues as these kind of non-industrial organizational customers.

[00:09:23] Shawn O’Malley: And then beyond that, they also provide specialized mechanical systems services for an array of government agencies and the buildings that they operate out of. So the last chunk here of the revenues also about 20%, comes from what they referred to as commercial customers, which are those places like office buildings, retail stores, restaurants, entertainment venues, and even multifamily real estate.

[00:09:47] Shawn O’Malley: All of which have their own sophisticated plumbing, HVAC, and electrical needs in comfort systems across its different subsidiaries caters to those specialized needs. Behind the recent boom in Comfort Systems business is that there’s very much a trend in reshoring that’s bringing major construction projects back to the US and it’s perfectly positioned as a company to benefit from those trends since they enable the behind the scenes infrastructure supporting many of these properties, whether it be with the Biden Administration’s CHIPS Act, which unveiled massive subsidies for domestic industrial companies, or the Inflation Reduction Act, or from the Trump administration’s tariffs that are meant to boost US producers and induce more investment in US manufacturing capabilities.

[00:10:31] Shawn O’Malley: As I said, there are a handful of powerful macroeconomic forces that are combining together to kind of generate this boom of construction, all of which, or most of which leads to an increase in comfort systems business, especially in these more specialized areas like with semiconductors and data centers.

[00:10:54] Daniel Mahnke: It’s fascinating to see how much momentum there is right now between AI infrastructure, semiconductor projects, and all the policy tailwinds. It really does feel like we are in the middle of, of a manufacturing renaissance in the us. But I wonder how much of this is structural versus cyclical. Like with the CHIPS Act for example, it’s clearly unlocked a wave of new investment, but it also raises the question, at least to me, of whether companies like comfort systems are now structurally tied to this kind of government backed industrial policy.

[00:11:30] Daniel Mahnke: All of these projects are more of a one of search. Over the past few years, over 700,000 new manufacturing jobs have reportedly been created in the us, and more than $900 billion in private investment has flowed into the sector. And that is driven by reassuring, as you mentioned, AI infrastructure and these major federal initiatives like the Chips and Science Act that you’ve also mentioned before, that legislation alone is helping to fund over 20 new semiconductor manufacturing projects, and it is sparked a broader industrial resurgence.

[00:12:07] Daniel Mahnke: It’s not just about chips now, it’s about rebuilding entire supply chains domestically in the us, which naturally also creates demand for advanced HVAC plumbing and electric infrastructure. So saying all of this, I’m curious, how have those tailwinds, whether from AI, semiconductors, or even sustainability efforts actually change the structure of comfort systems business and has it reshaped the type of customers comfort systems serves or the kinds of projects they’re taking on?

[00:12:42] Shawn O’Malley: Thanks to some of those tailwinds from booming construction that we’ve both mentioned, the company’s revenues have been growing very, very fast, compounding at over 30% per year. Lately. While profit margins have also been expanding too, because some of this more specialized work is just higher margin. AI driven data centers, for example, have particularly robust appetites for advanced eight track and liquid cooling systems.

[00:13:04] Shawn O’Malley: Due to the substantial amount of processing power they use, that generates a lot of heat. Part of the solution for this has been to rely on cooling pipes that are integrated directly into server racks. And again, this requires expert level precision to install. Otherwise these data centers could jeopardize the computer servers they host.

[00:13:23] Shawn O’Malley: So they take that risk very seriously. And then with the semiconductor manufacturing, given its direct role in modern life and the digital products we all rely on and are recording this podcast on, it has become a hot button issue since the pandemic, right? It, it became clear then that the US was overly dependent on China as well as Taiwan for computer chips.

[00:13:43] Shawn O’Malley: And that is a serious geopolitical vulnerability in the 21st century that the Pentagon and the US federal government more broadly have been very keen to address the CHIPS Act, which provided $50 billion in funding tax incentives and subsidies was the first major government led initiative to accelerate the shift of semiconductor manufacturing back to the us.

[00:14:03] Shawn O’Malley: But there have been a number of public and private initiatives focused on a manufacturing renaissance in America. Further supporting comfort systems business is the fact that companies, governments, and other institutions are all trying to minimize their carbon footprints with new construction projects that meet certain energy efficiency standards, or by upgrading existing buildings to meet those same industry standards, HVAC systems can easily account for 40% of a building’s energy use, if not more.

[00:14:31] Shawn O’Malley: So HVAC installation is hugely important to ensuring these organizations meet their carbon targets, which is where comfort system comes in and thrives.

[00:14:39] Daniel Mahnke: I wouldn’t have thought of comfort systems as a huge beneficiary of this sustainability movement, but it turns out oftentimes companies that you wouldn’t suspect to be the most beneficiary of this movement actually are, and they’re at the helm of benefiting from it.

[00:14:56] Daniel Mahnke: I’ve also brought up the term serial acquirer once or twice already, and I compared comfort systems to how Constellation software works, at least in some ways. In theory, the business model of a serial acquirer sounds relatively easy, make the holding company grow by buying good businesses. In practice, we both know it’s a lot more difficult than that, and at the beginning when there’s no exceptional track record yet, markets are often skeptical of their success and sometimes they even apply discount rate to those companies.

[00:15:30] Daniel Mahnke: There are several reasons for that. For one, holding companies and acquirers often operate with decentralized structures, and they are making it harder to evaluate the performance of each individual unit. That can make it difficult for you and me as investors to assess the real organic growth that a business has versus the acquisition driven growth.

[00:15:52] Daniel Mahnke: The second risk is that the acquirer, perhaps over pace or also acquires lower quality companies that would then diminish the company’s quality overall. On the other hand, if managed well, they can earn premium variations and the acquisitions turn the holding company into a compounding machine, which is what happened for Comfort Systems in the last two decades.

[00:16:17] Daniel Mahnke: Many successful serial acquirers operate in fragmented industries or markets. They focus on companies with strong local market share and customer loyalty. In my opinion, this sounds a lot like comfort systems. Would you call Comfort Systems a serial acquirer, and what’s the company’s take on that term?

[00:16:39] Shawn O’Malley: I don’t totally understand why, but the company’s, CEO doesn’t like the term serial acquirer and has tried to say they aren’t one.

[00:16:46] Shawn O’Malley: And maybe there’s a case for that, but whether he likes it or not, I think it’s a pretty useful framework to think of the company through, even if they’re not quite as prolific at doing acquisitions as maybe a Constellation software. So as is true with many great compounders comfort systems is something of a serial acquire, meaning that it frequently acquires smaller but related businesses to roll up into its operations given the company’s track record in generating high returns on capital.

[00:17:14] Shawn O’Malley: In light of these acquisitions, they’re clearly buying attractive businesses at fair prices to sort of invoke buffet there. Showing that management likely does understand capital allocation very well. Three quarters of comfort systems, free cash flows are typically reinvested into acquisitions, and given that the company’s market share is only two to 4% of the broader industry of mechanical contracting, you could say there’s seemingly plenty of room to continue doing those kinds of acquisitions going forward.

[00:17:40] Shawn O’Malley: Again, as you’ll see with many great serial acquirers, and as Buffet has famously shown with Berkshire, a decentralized management structure can be a competitive advantage. The structure allows management at the top to make the major capital allocation decisions while empowering lower level managers to run their business as they see fit with little direct oversight from above and no micromanagement.

[00:18:03] Shawn O’Malley: And as long as the people at the very top making those major capital allocation decisions know what they’re doing, it can work out pretty well. And for one, this is just practical because the subsidiary companies operate in all of these highly niche areas. So of course, the lower level managers specializing in HVAC systems at specific hospitals will know how to run their business better than the folks sitting in corporate headquarters.

[00:18:27] Shawn O’Malley: But this allows a company to have a nationwide scale, yet also a personalized touch that relies heavily on reputation and relationships on the ground. And as you know Daniel, it is sort of the same model at Berkshire.

[00:18:40] Daniel Mahnke: That’s true, although Buffet in his early days also invested as an activist. So sometimes he actually took over control and then he changed or turned around the company.

[00:18:51] Daniel Mahnke: But later on it became more and more important to Buffet to have strong managers, mostly because he just didn’t want to run the companies himself or act as some form of shadow CEO. And as you said, it kind of fits into his circle of competence framework that he knows the most capable people are already running the business, and he just wants to keep it that way and not get in their way and diminish the quality of the business.

[00:19:17] Shawn O’Malley: Right? Buffett doesn’t micromanage people. Instead, he relies on an incredibly strict filter to determine who he will work with, what types of businesses he’ll invest in, and then he provides the capital to buy out the business. But from there. He lets the same people who have been running the business continue doing what they have done so well for many years, and that’s what he is hoping they’ll do.

[00:19:38] Shawn O’Malley: Otherwise, he wouldn’t have invested in them. He, he doesn’t wanna mess things up. Or at least later on in his career, that became more of his strategy. So that doesn’t mean he gives them infinite grace, though, to not generate satisfactory returns. But I do think there’s a big difference between reporting your results to your boss once a year and reviewing what happened, and having someone literally breathing down your neck every week with deadlines and reports.

[00:20:02] Shawn O’Malley: Comfort systems, as we’ve said, takes more of the former approach like Berkshire investing in profitable businesses and then mostly asking them to change nothing of consequence other than their ownership structure. And if the parent company can provide any synergies to help reduce costs, like helping them borrow at lower interest rates, that’s all great and boost profitability even further.

[00:20:22] Shawn O’Malley: But it’s not like the model you hear horror stories about in private equity where some ruthless investment firm comes in and is just gutting family businesses.

[00:20:32] Daniel Mahnke: From a company standpoint as well as from an investor standpoint, everything that you just said makes a lot of sense. Looking at the numbers and having a triple engine of organic growth, acquisition and buybacks, the business model is perfect for a quality compounder.

[00:20:50] Daniel Mahnke: But if we take the perspective of the employees, what do they get out of it? Like, why are they not just running their own business doing electrical work or plumbing? An important question.

[00:21:02] Shawn O’Malley: A lot of their employees would otherwise be independent contractors who would maybe have to pay for their own healthcare.

[00:21:07] Shawn O’Malley: So by working through comfort systems, they can get access to much better benefits and presumably more stable employment given comfort systems, reputations and relationships, and just wider book of business. Not that healthcare and 4 0 1 Ks are the sole reason. Everyone who works at Comfort Systems chooses to do so, but rather than running their own business, I do think it’s an important factor for many people to consider.

[00:21:30] Shawn O’Malley: Most people like the stability and predictability that traditional corporate jobs come with. And why should blue collar workers feel any differently? So we know to some extent why people may want to work for comfort systems rather than on their own or for much smaller companies. And then the question is, how does this become an advantage for comfort systems?

[00:21:49] Shawn O’Malley: And going back to the idea behind their decentralized structure, the company CEO has said he believes decisions should be made closest to where the customer is, which is why most day-to-day stuff is handled locally instead of filtering back to the parent company, freeing the comfort systems management team to focus on bigger picture issues back in the Houston headquarters, for example.

[00:22:09] Shawn O’Malley: While labor shortages for skilled trade workers have been a major problem for the industry, comfort Systems acquired a labor contracting agency a few years ago that allows ’em to tap into this network of 3,500 flexible workers who don’t necessarily work full time, but instead work on a case by case basis.

[00:22:25] Shawn O’Malley: And the investment has already paid for itself in just eight months. So by overseeing all these subsidiary trade businesses, management at the top can transfer workers between companies and projects as needed in, in other words, you could think of this as they can pull workers from one area, working for one part of the company and ask ’em to assist with a project in another part of the country where labor shortages may be more acute.

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[00:25:51] Daniel Mahnke: That’s a good framework to think about it. You know, I’ve got a bit of a perspective on the sector since my granddad founded a plumbing business. So I’ve seen how hard it can be to find skilled labor and to keep up with the demand.

[00:26:06] Daniel Mahnke: Having the scale, and therefore the possibilities that comfort system has is a huge benefit. At the same time, acquisitions and especially in that sector can be twiggy. Could you tell us a bit more about the acquisition philosophy and how comfort systems prevents the fundamental risk of overpaying for growth?

[00:26:26] Shawn O’Malley: Acquisitions are obviously the center of their growth plan, but they’re very slow acquirers at the same time, which is maybe counterintuitive. Most of their deals are typically done completely in-house without external financing and bankers involved, and they’re often done with companies they’ve known for 10 or 20 years.

[00:26:44] Shawn O’Malley: They’re extremely patient and intentional about who they wanna work with, or at least that’s my impression. In assessing deals, they targeted 12% rate of return, which doesn’t account for any kind of synergies, so it’s kind of a conservative calculation. Every deal is also vetted by a third party that verifies the target company’s operational capabilities, and that just helps reduce some of the uncertainty from comfort systems perspective, but 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.

[00:27:30] Shawn O’Malley: 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.

[00:27:45] Shawn O’Malley: It’s a very slight one, but I do think it is a real one. A, again, smaller companies who are probably at least spending 10 or 20% of their time distracted by back office stuff.

[00:27:59] Daniel Mahnke: All 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 SubT 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 check instead of just growing as fast as possible.

[00:28:24] Daniel Mahnke: And still, I’ve mentioned that successful serial acquirers in the business tend to focus on small and local companies. It seems like Comfort Systems does that as well. And you mentioned they only have two to 4% market share, but I’m still asking myself how many great small local companies are there to acquire.

[00:28:44] Daniel Mahnke: So 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?

[00:28:54] Shawn O’Malley: The company CEO, Brian Lane has said there’s a long runway to continue making attractive acquisitions. One that extends well beyond his lifetime and his words.

[00:29:03] Shawn O’Malley: 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.

[00:29:30] Shawn O’Malley: 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.

[00:29:39] Daniel Mahnke: 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?

[00:29:54] Daniel Mahnke: 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 comfort systems handling that?

[00:30:13] Shawn O’Malley: I keep referencing their CEO here, but he’s probably the best person to learn about the business from.

[00:30:18] Shawn O’Malley: 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 two 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.

[00:30:38] Shawn O’Malley: This also explains why they’re so focused on making acquisitions at attractive prices to really grow the parent companies overall revenues and size. With acquisitions, he feels like an 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.

[00:31:02] Shawn O’Malley: 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 at six or nine months later proved 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.

[00:31:21] Shawn O’Malley: Not 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 to align 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 we’ll be very patient for a while.

[00:31:41] Shawn O’Malley: 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, and there’s just no good way to break into that, which is again, why they rely on acquisitions.

[00:32:12] Shawn O’Malley: I. 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 a hundred million dollars a year in revenue.

[00:32:33] Daniel Mahnke: 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, so I guess that’s a big part of the competition, if you can call 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.

[00:32:55] Daniel Mahnke: 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?

[00:33:08] Shawn O’Malley: Industry is basically the textbook definition of fragmentation. With lots of mom and pop companies operating in maybe these a hundred mile square radius areas.

[00:33:18] Shawn O’Malley: 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 Emcor with the ticker EME. The 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 that 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.

[00:33:56] Shawn O’Malley: Then these service agreements might get signed for three or five years. So there can be an element of stickiness to them. Another 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 wanna ensure that that same quality of work goes into their other projects that might be going on nationwide.

[00:34:21] Shawn O’Malley: So just to continue to 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.

[00:34:38] Shawn O’Malley: And trying to meet the local mechanical contractors who may or may not be able to consistently meet certain quality thresholds. And then on top of that, going back to the advantages of their conglomerate structure, their scale makes ’em a much more reliable partner to work with throughout the entire business cycle in recessions or during disruptions.

[00:34:56] Shawn O’Malley: Like Covid Comfort Systems has the balance sheet to comfortably navigate volatility in their business, and that’s very reassuring to their clients who wanna 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.

[00:35:20] Shawn O’Malley: And that’s exactly what you’d hope for. When planning a multi-year construction project that costs millions of dollars.

[00:35:28] Daniel Mahnke: 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.

[00:35:46] Daniel Mahnke: 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. You 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.

[00:36:14] Daniel Mahnke: 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.

[00:36:37] Daniel Mahnke: 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, and 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.

[00:37:04] Shawn O’Malley: There’s a revenue MCO is about twice the size of comfort systems, but since 2014, comfort Systems has grown revenue at around twice the rate that MCO has. The market generally places a higher premium though on Comfort Systems stock. So despite MCO having twice the amount of revenues, their market capitalizations are actually not that far apart.

[00:37:24] Shawn O’Malley: Suggesting that investors either see comfort systems as a better business or a business with more growth potential or maybe both. I 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 cashflow margins.

[00:37:44] Shawn O’Malley: 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. Emcor 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, EMCOR was actually ranked ahead of them in second place.

[00:38:16] Shawn O’Malley: And I should add also that MCO 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 Emcor.

[00:38:34] Daniel Mahnke: Yeah. Not just whether they have a moat, but if so, how wide is it and does it protect them from MCO 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.

[00:38:49] Shawn O’Malley: To answer that, maybe we should consider the best way to assess moats, which is to compare the company’s return on invested capital.

[00:38:56] Shawn O’Malley: That 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.

[00:39:18] Shawn O’Malley: 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. But if a company has a positive spread between the returns and 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 suggest they have some sort of advantages supporting that excess profitability that aren’t arbitraged away by competitors.

[00:39:50] Shawn O’Malley: I think in different ways, we’ve already touched on some of the qualitative factors that may form something that 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.

[00:40:11] Shawn O’Malley: I 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 outta the pandemic.

[00:40:45] Daniel Mahnke: It’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.

[00:41:09] Daniel Mahnke: 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.

[00:41:27] Daniel Mahnke: I think we spend 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 mode is that protection. It’s crucial because if your superior value proposition can be easily copied, it’ll be gone soon after.

[00:41:50] Daniel Mahnke: And with it also the potential to compound intrinsic value, I think the term mode was popularized by Warren Buffet 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.

[00:42:11] Shawn O’Malley: I completely agree, and I did kinda dodge part of your previous question though, which wasn’t just on moats, but also whether MCO and comfort systems compete head to head. I should also mention quickly too, to bring it back to moats again, that MCO 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.

[00:42:38] Shawn O’Malley: So that does give you some pause, and because of that, I can’t say with the same confidence that Emcor has as strong of a moat around its business, even though it is a bigger company. And maybe if I did a deeper deep dive into Emcor, 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.

[00:43:00] Shawn O’Malley: A slightly different story for Emcor. 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 Emcor and Comfort Systems as their possible moats. They both have their own network of relationships in cities and regions.

[00:43:16] Shawn O’Malley: They more or less dominate, and that probably enables ’em both to have a high degree of switching costs over their customers. You could probably imagine that a commercial builder who has worked with comfort systems for 15 years is very unlikely to switch to a competitor. And the same is probably true with Emcor, such that they both have very sticky customer bases without directly stepping on each other’s toes too much.

[00:43:39] Shawn O’Malley: And then just practically speaking, my understanding is that Comfort Systems services tend to be a bit more specialized, which is why they don’t always compete all that directly with Emcor. And actually also why I prefer Comfort Systems as an investment specialization generally lends itself more to being able to consistently earn excess returns.

[00:43:59] Shawn O’Malley: Maybe the last thing I’ll mention about Imco is, is 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 nine 11 and how those attacks had rippled through the economy.

[00:44:18] Shawn O’Malley: And with $205 million of debt coming due, they actually had to sell 19 of their subsidiaries to Emcor for $164 million. Otherwise, the company probably would’ve 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.

[00:44:39] Daniel Mahnke: Well, 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.

[00:45:03] Daniel Mahnke: So in an age of ai, how does a company like Comfort Systems incorporate technology to boost productivity? For example.

[00:45:12] Shawn O’Malley: 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.

[00:45:23] Shawn O’Malley: And 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 went 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.

[00:45:44] Shawn O’Malley: For things like HVAC duct work, mechanical piping, and other plumbing and electrical assemblies, which can then be shipped around the country is needed. By utilizing prefab and modular construction in this way, they can also use more automated technologies such as machines that do automated welding, and that reduces the labor intensity behind parts of their business.

[00:46:07] Shawn O’Malley: Still though, you can only automate so much and comfort system, CEO has a 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.

[00:46:32] Daniel Mahnke: Given that comfort systems as a business reliant on the construction sector and therefore also interest rates and consumer sentiment, which kind of came to haunt them after nine 11. How economically sensitive or cyclical is the business in general?

[00:46:49] Shawn O’Malley: Really interesting question because it’s not as straightforward as you might think.

[00:46:53] Shawn O’Malley: Your gut reaction would probably typically be to say, well, is 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.

[00:47:17] Shawn O’Malley: 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. But 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.

[00:47:42] Daniel Mahnke: 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 comfort system does.

[00:48:01] Shawn O’Malley: Many of the projects they work on have long life cycles, and since the bulk of the work that comfort systems 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 recession at a delay for a while after the general economy has already improved.

[00:48:21] Shawn O’Malley: And the AutoZone 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, rather than sales completely falling off at different points in the business cycle.

[00:48:43] Shawn O’Malley: 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.

[00:49:00] Shawn O’Malley: 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. And 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 buildings AC system that aren’t strictly economic in nature.

[00:49:26] Daniel Mahnke: A part of the advantage that comes with comfort system scale is. 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? Or is there something else that we haven’t yet talked about that is worth a mention?

[00:50:00] Shawn O’Malley: What’s really the most promising thing about comfort systems business is that even the 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, meaning they have more demand from customers than they can even meet.

[00:50:18] Shawn O’Malley: 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. So I don’t exactly think growth of the company is going to suddenly drop off. We know there’s a ton of pent up demand for the company’s services.

[00:50:38] Shawn O’Malley: Comfort Systems backlog nearly quadrupled from $1.5 billion in 2020 to $6 billion in 2024. And crucially, many of these backlog projects for data center 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 its services, giving it some float to earn interest on.

[00:51:03] Shawn O’Malley: Management actually called it a very substantial amount of unearned customer cash. Well, that is good for float and working capital. It is gonna 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.

[00:51:25] Daniel Mahnke: 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. And that’s different for comfort systems with all their flexible resources and their general scale.

[00:51:48] Daniel Mahnke: 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.

[00:52:07] Daniel Mahnke: 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.

[00:52:22] Shawn O’Malley: In the economy are sensitive to government spending. And comfort systems is certainly two, which is a bit of a glaring risk during a time when everyone is talking about government efficiency.

[00:52:32] Shawn O’Malley: Beyond 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 and data center construction has hugely lifted the business, it has also made them very dependent on data center construction.

[00:52:55] Shawn O’Malley: 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. And while I do think the world will probably only need more data centers, it’s not going to be perfectly linear growth during the.com bubble in the nineties, for example, a lot of things people expected to happen to the world, like anticipating the rise of e-commerce were completely spot on.

[00:53:20] Shawn O’Malley: 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.

[00:53:37] Shawn O’Malley: And there are some fears of those corrections starting to come through 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.

[00:53:56] Shawn O’Malley: 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 onto customers, but you just never know To invert my thinking on tariffs. I, I certainly don’t think tariffs are doing their profit margins any favors.

[00:54:20] Daniel Mahnke: Without going too much into politics now. Tariffs really make the investment world and 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 pitched next week.

[00:54:35] Daniel Mahnke: But because it fits so well right now, I might give my first hint now, which is that when 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?

[00:54:57] Daniel Mahnke: We’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.

[00:55:22] Daniel Mahnke: 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. And 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.

[00:55:48] Shawn O’Malley: 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.

[00:56:06] Shawn O’Malley: Historically, contractors often consume cash when growing as they build up receivables and inventory for new projects. But 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.

[00:56:32] Shawn O’Malley: 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 an 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.

[00:56:53] Shawn O’Malley: But I have to imagine that that can’t sustain forever either. Things will probably balance 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.

[00:57:11] Shawn O’Malley: 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 advance 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.

[00:57:34] Daniel Mahnke: It 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.

[00:57:53] Daniel Mahnke: Alright. That gives us a solid understanding of how the business actually operates. So let’s shift gears and talks some valuation. What did you come up with and what do you see as the key drivers of intrinsic value for comfort systems?

[00:58:10] Shawn O’Malley: One of the things I wanna 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 In 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 R-O-I-I-C.

[00:58:31] Shawn O’Malley: 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.

[00:58:50] Shawn O’Malley: 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, so 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.

[00:59:18] Shawn O’Malley: In other words, if a hundred dollars 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. I. 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.

[00:59:41] Shawn O’Malley: So it really helps in assessing the sustainability of a company’s competitive advantages and long term compounding potential.

[00:59:50] Daniel Mahnke: It especially makes sense for a company that grows predominantly through acquisitions using return on incremental invested capital makes a ton of sense then, ’cause it shifts the focus from evaluating the quality of the existing business, which is what our, I see measures to assessing how effectively new capital can be deployed.

[01:00:12] Daniel Mahnke: For a typical compounder growing organically. RI see is a great metric because it reflects the efficiency of the existing business model. But when growth is driven by m and a, it’s the incremental returns on the new investments that actually matter. So. R-O-I-I-C 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?

[01:00:43] Shawn O’Malley: 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%.

[01:01:03] Shawn O’Malley: As one of my favorite investors, John Hubbert 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.

[01:01:21] Shawn O’Malley: So if you take Comfort Systems reinvestment rate and multiply it by their R-O-I-I-C, 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 SOC has compounded by roughly the same amount, which makes sense, or even just a bit more since the company’s valuation.

[01:01:52] Shawn O’Malley: Multiple has also increased in that time as the market has recognized just how high quality of a company Comfort Systems is. Another 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 that further boosting returns to existing shareholders.

[01:02:21] Shawn O’Malley: 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 systems growth.

[01:02:41] Daniel Mahnke: Now, 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 you do with these numbers? So how would you think about them after modeling them through?

[01:03:08] Shawn O’Malley: I mainly went through that exercise just to better understand their capital allocations and confirm that comfort systems is in fact a, they’re a high quality company, which helps to provide some context for us as we think about their future growth.

[01:03:20] Shawn O’Malley: Rates 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.

[01:03:51] Shawn O’Malley: So 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.

[01:04:11] Shawn O’Malley: 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.

[01:04:25] Daniel Mahnke: No valuation is a mix of the mathematical side of investing and the part that is often called an art and perhaps variation is more an art than math.

[01:04:37] Daniel Mahnke: 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 shares worth. 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.

[01:05:00] Daniel Mahnke: The best way to learn about how to approach a valuation 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 Shawn said a minute ago.

[01:05:13] Shawn O’Malley: To put this all into context further, just because comfort system continues to have quite attractive returns on capital, it also doesn’t mean it’s a great buy at today’s prices.

[01:05:24] Shawn O’Malley: 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 normalize in five years and profit margins return closer to historical averages while growth slows, then not only would we be left holding a less attractive business with reduced earnings power, we might also feel the pain further as the multiple declines dramatically.

[01:05:53] Shawn O’Malley: That 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.

[01:06:19] Shawn O’Malley: 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.

[01:06:43] Daniel Mahnke: You’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.

[01:06:56] Shawn O’Malley: That is the million dollar question. I could be shortchanging how long the data center boom tailwind could benefit comfort systems.

[01:07:04] Shawn O’Malley: 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.

[01:07:22] Shawn O’Malley: 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 it’s more traditional clienteles like school buildings or government buildings. And as a result of everything we’ve said, I get an intrinsic value target of around $290 per share.

[01:07:44] Shawn O’Malley: 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 recorded, trading at the time of recording.

[01:08:05] Shawn O’Malley: 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%. Not to say you couldn’t earn a better return, but that’s the idea. Between three 20 and three 40, you’re probably just gonna get an average return, and at any price much higher than that, you risk earning a below average return.

[01:08:27] Shawn O’Malley: 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.

[01:08:44] Shawn O’Malley: If some things in your thesis go against you, you 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.

[01:09:05] Shawn O’Malley: 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. And with all that, why don’t you tell me, Daniel, what do you make of comfort systems and the valuation? I just took us thorough.

[01:09:27] Daniel Mahnke: 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 the 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 have discussed coming from government backed contracts.

[01:09:55] Daniel Mahnke: And that can be more sustainable than it sounds at first glance. I 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.

[01:10:21] Daniel Mahnke: And I mentioned that with polling 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.

[01:10:44] Daniel Mahnke: So if it gets into this territory where the market seems to price in a downturn and is not seeing comfort system as this perfectly run business, I could see us grabbing some shares. 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.

[01:11:05] Daniel Mahnke: And at the same time, comfort’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 the cheaper stock because investors do not fully trust that this is actually happening.

[01:11:26] Daniel Mahnke: So yeah, you can see I’m kind of going back and forth here. I would agree with you price target, and I always like these serial acquirers of course, because both you and I have a strong bias toward Buffet and what he did with Berkshire Hathaway.

[01:11:41] Shawn O’Malley: Yeah, it’s kind of, the playbook is, it sounds tantalizingly simple, right?

[01:11:45] Shawn O’Malley: When, when you break it out of Oh yeah, just acquire great businesses at fair prices. Uh, 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.

[01:12:03] Shawn O’Malley: The 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.

[01:12:20] Shawn O’Malley: So, as always, the market is pretty efficient and, and is, uh, pretty quick to sniff out how trends elsewhere in the economy will ripple through, in effect companies like Comfort Systems, who is probably not your first thought, uh, to be as a, you know, a company that can benefit from or be negatively impacted from changes in AI related CapEx spending.

[01:12:42] Daniel Mahnke: That’s definitely true, and I mean, an advantage of this company is that I. Sewell 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.

[01:13:03] Daniel Mahnke: So the lack of a catalyst sometimes give 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.

[01:13:31] Shawn O’Malley: We’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, a good price given how much they stand to benefit from some of these really big tailwinds in construction in the us. That’s enough for now on Comfort Systems.

[01:13:48] Shawn O’Malley: 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?

[01:13:59] Daniel Mahnke: Yeah, it has definitely been fun, and I 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 to get to.

[01:14:10] Daniel Mahnke: 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 from my home country, Germany. And perhaps when I say all of that, some of you might have guessed the industry already.

[01:14:34] Daniel Mahnke: So my third hint should probably be tailored to the exact company. And then I would say I. It might have one of the most iconic logos in the world. I think this is all I’ll give you, so let me know your guesses in the comments, and I’m curious to see if anyone gets it right.

[01:14:54] Shawn O’Malley: I’m looking forward to it. With that, let me leave you as always with a quote before we go. Warren Buffet 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.