COMFORT SYSTEMS USA INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

OR

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

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 1-13011

COMFORT SYSTEMS USA, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 76-0526487
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

777 POST OAK BOULEVARD
SUITE 500
HOUSTON, TEXAS 77056
(Address of Principal Executive Offices) (Zip Code)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(713) 830-9600

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

The number of shares outstanding of the issuer's common stock, as of
November 1, 2002 was 37,910,144.

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COMFORT SYSTEMS USA, INC.

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002

1

COMFORT SYSTEMS USA, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial
statements.
2

COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

The accompanying notes are an integral part of these consolidated financial
statements.
3

COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial
statements.
4

COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

The accompanying notes are an integral part of these consolidated financial
statements.
5

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
(UNAUDITED)

1. BUSINESS AND ORGANIZATION

Comfort Systems USA, Inc., a Delaware corporation ("Comfort Systems" and
collectively with its subsidiaries, the "Company"), is a national provider of
comprehensive heating, ventilation and air conditioning ("HVAC") installation,
maintenance, repair and replacement services within the mechanical services
industry. The Company operates primarily in the commercial and industrial HVAC
markets, and performs most of its services within office buildings, retail
centers, apartment complexes, manufacturing plants, and healthcare, education
and government facilities. In addition to standard HVAC services, the Company
provides specialized applications such as building automation control systems,
fire protection, process cooling, electronic monitoring and process piping.
Certain locations also perform related services such as electrical and plumbing.
Approximately 52% of the Company's consolidated 2002 revenues were attributable
to installation of systems in newly constructed facilities, with the remaining
48% attributable to maintenance, repair and replacement services. The Company's
consolidated 2002 revenues related to the following service activities:
HVAC -- 74%, plumbing -- 11%, building automation control systems -- 5%,
electrical -- 2%, fire protection -- 1% and other -- 7%. These service
activities are within the mechanical services industry which is the single
industry segment served by Comfort Systems.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

These interim statements should be read in conjunction with the historical
Consolidated Financial Statements and related notes of Comfort Systems included
in the Annual Report on Form 10-K as filed with the Securities and Exchange
Commission for the year ended December 31, 2001 (the "Form 10-K").

The Company adopted Statement of Financial Accounting Standards ("SFAS")
No. 142, "Goodwill and Other Intangible Assets," which is discussed in Note 4
and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets," which is discussed in Note 3 during the first quarter of 2002. There
were no other significant changes in the accounting policies of the Company
during the period. For a description of the significant accounting policies of
the Company, refer to Note 2 of Notes to Consolidated Financial Statements of
Comfort Systems included in the Form 10-K.

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

The preparation of financial statements in conformity with generally
accepted accounting principles requires the use of estimates and assumptions by
management in determining the reported amounts of assets and liabilities,
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. The most
significant estimates used in the Company's financial statements include revenue
and cost recognition for construction contracts, allowance for doubtful accounts
and self-insurance accruals.

6

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CASH FLOW INFORMATION

Cash paid for interest for the nine months ended September 30, 2001 and
2002 was approximately $16.5 million and $4.5 million, respectively. Cash paid
for income taxes for the nine months ended September 30, 2001 and 2002 was
approximately $6.3 million and $9.0 million, respectively.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 establishes new
accounting and reporting requirements for goodwill and other intangible assets.
The Company adopted this new standard effective January 1, 2002. See Note 4 for
further discussion.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." The Company adopted SFAS No. 144
effective January 1, 2002. Under SFAS No. 144, the operating results of
companies sold or held for sale meeting certain criteria, as well as any gain or
loss on the sale of these operations, are presented as discontinued operations
in the Company's statements of operations. See Note 3 for a discussion of the
Company's discontinued operations. The operating results for companies which
were sold or shut down during 2001 are presented as continuing operations
through the date of disposition. The adoption of SFAS No. 144 did affect the
presentation of discontinued operations in the consolidated financial
statements; however, it did not have a material financial impact on the
Company's results of operations, financial position or cash flows.

SEGMENT DISCLOSURE

Comfort Systems' activities are within the mechanical services industry
which is the single industry segment served by the Company. Under SFAS No. 131,
"Disclosures About Segments of an Enterprise and Related Information," each
operating subsidiary represents an operating segment and these segments have
been aggregated, as no individual operating unit is material and the operating
units meet a majority of SFAS No. 131's aggregation criteria.

RECLASSIFICATIONS

Certain reclassifications have been made in prior period financial
statements to conform to current period presentation. These reclassifications
have not resulted in any changes to previously reported net income for any
periods.

3. DISCONTINUED OPERATIONS

On February 11, 2002, the Company entered into an agreement with Emcor
Group, Inc. ("Emcor") to sell 19 operations. This transaction closed on March 1,
2002. Under the terms of the agreement, the total purchase price was $186.25
million, including the assumption by Emcor of approximately $22.1 million of
subordinated notes to former owners of certain of the divested companies.

The transaction with Emcor provided for a post-closing adjustment based on
a final accounting, done after the closing of the transaction, of the net assets
of the operations that were sold to Emcor. That accounting indicated that the
net assets transferred to Emcor were approximately $7 million greater than a
target amount that had been agreed to with Emcor. In accordance with the
transaction agreement, Emcor paid the Company that amount, and released $2.5
million that had been escrowed in connection with this element of the
transaction during the second quarter.

An additional $5 million of Emcor's purchase price was deposited into an
escrow account to secure potential obligations on the Company's part to
indemnify Emcor for future claims and contingencies arising

7

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

from events and circumstances prior to closing, all as specified in the
transaction documents. Because these escrow funds secure future claims and
contingencies, the Company does not know whether it will ultimately receive any
of such funds, and if it does, how much it will receive. Therefore, the Company
has not recognized a receivable for this escrowed portion of the Emcor
transaction purchase price. If the Company ultimately receives any of these
escrowed funds, a corresponding gain will be recorded as a component of
discontinued operations when received.

The net cash proceeds of approximately $164 million received to date from
the Emcor transaction have been used to reduce debt outstanding under the
Company's credit facility. An estimated tax liability of $16 million related to
this transaction is due in March 2003.

Under SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," which took effect for the Company on January 1, 2002, the
operating results of the companies sold to Emcor as well as the loss on the sale
of these operations have been presented as discontinued operations in the
Company's statements of operations. The Company realized a loss of $10.6 million
including related tax expense related to the sale of these operations. As a
result of the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets,"
the Company also recognized a goodwill impairment charge related to these
operations of $32.4 million, net of taxes, as of January 1, 2002. The reporting
of the Company's aggregate goodwill impairment charge in connection with
adopting SFAS No. 142 is discussed further in Note 4.

In March 2002, the Company also decided to divest of an additional
operating company. This unit's operating loss for the first three quarters of
2002 of $0.1 million, net of taxes, has been reported in discontinued operations
under "Operating income (loss), net of applicable income taxes" in the Company's
statement of operations. In addition, an estimate of the loss the Company will
realize upon divestiture of this operation of $0.6 million has been included in
"Estimated loss on disposition, including income taxes" during the first quarter
of 2002 in the Company's statement of operations.

During the second quarter of 2002, the Company sold a division of one of
its operations. The operating loss for this division for the first two quarters
of 2002 of $0.3 million, net of taxes, has been reported in discontinued
operations under "Operating income (loss), net of applicable income taxes" in
the Company's statement of operations. The Company realized a loss of $0.3
million on the sale of this division which is included in "Estimated loss on
disposition, including income taxes" during the second quarter of 2002 in the
Company's statement of operations.

8

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Assets and liabilities related to discontinued operations were as follows
(in thousands):

Revenues and pre-tax income (loss) related to discontinued operations were
as follows (in thousands):

4. GOODWILL

Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and
Other Intangible Assets." SFAS No. 142 requires companies to assess goodwill
asset amounts for impairment each year, and more frequently if circumstances
suggest an impairment may have occurred. In addition to discontinuing the
regular charge, or amortization, of goodwill against income, the new standard
also introduces more rigorous criteria for determining how much goodwill should
be reflected as an asset in a company's balance sheet.

To perform the transitional impairment testing required by SFAS No. 142
under its new, more rigorous impairment criteria, the Company broke its
operations into "reporting units," as prescribed by the new standard, and tested
each of these reporting units for impairment by comparing the unit's fair value
to its carrying value. The fair value of each reporting unit was estimated using
a discounted cash flow model combined with market valuation approaches.
Significant estimates and assumptions were used in assessing the fair value of
reporting units. These estimates and assumptions involved future cash flows,
growth rates, discount rates, weighted average cost of capital and estimates of
market valuations for each of the reporting units.

As provided by SFAS No. 142, the transitional impairment loss identified by
applying the standard's new, more rigorous valuation methodology upon initial
adoption of the standard was reflected as a cumulative effect of a change in
accounting principle in the Company's statement of operations. The resulting
non-cash charge was $202.5 million, net of taxes. Impairment charges recognized
after the initial adoption, if any, generally are to be reported as a component
of operating income.

9

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The changes in the carrying amount of goodwill for the nine months ended
September 30, 2002 are as follows (in thousands):

Goodwill balance as of January 1, 2002(a)................... $ 438,448
Impairment adjustment....................................... (228,838)
Goodwill related to sale of operations...................... (96,183)
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Goodwill balance as of September 30, 2002................... $ 113,427
=========

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(a) A portion of this goodwill balance is included in assets related to
discontinued operations in the Company's consolidated balance sheet.

The unaudited results of operations presented below (in thousands) for the
three months and nine months ended September 30, 2001 and 2002 reflect the
adoption of the non-amortization provisions of SFAS No. 142 effective January 1,
2001 and exclude the impact of the cumulative effect of change in accounting
principle recorded in the first quarter of 2002. Therefore, the component of the
cumulative effect of change in accounting principle related to the operations
sold to Emcor is included in the estimated loss on disposition for purposes of
this table.

10

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

5. RESTRUCTURING CHARGES

During the first quarter of 2002, the Company recorded restructuring
charges of approximately $1.9 million. These charges included approximately $0.8
million for severance costs primarily associated with the reduction in corporate
overhead in light of the Company's smaller size following the Emcor transaction.
The severance costs related to the termination of 33 employees, all of whom were
terminated as of March 31, 2002. In addition, these charges include
approximately $0.7 million for costs associated with decisions to merge or close
three smaller divisions and realign regional operating management. These
restructuring charges are primarily cash obligations but did include
approximately $0.3 million of non-cash writedowns associated with long-lived
assets.

During the first quarter of 2001, the Company recorded restructuring
charges of approximately $0.2 million, primarily related to contractual
severance obligations of two operating presidents in connection with the
Company's significant restructuring program in the second half of 2000. These
restructuring charges are net of a gain of approximately $0.1 million related to
management's decision to sell a small operation during the first quarter of
2001.

During the second half of 2000, the Company recorded restructuring charges
of approximately $25.3 million primarily associated with restructuring efforts
at certain underperforming operations. Management performed an extensive review
of its operations during the second half of 2000 and as part of this review
management decided to cease operating at three locations, sell four operations
(including two smaller satellite operations), and merge two companies into other
operations. The restructuring charges were primarily non-cash and included
goodwill impairments of approximately $11.5 million and the writedown of other
long-lived assets of approximately $8.5 million. The remaining items in these
restructuring charges primarily included severance and lease termination costs.

Aggregated financial information for 2001 related to the operations
addressed by the 2000 and 2001 restructuring charges is as follows (in
thousands):

The following table shows the remaining liabilities associated with the
cash portion of the restructuring charges as of September 30, 2002 (in
thousands):

11

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. LONG-TERM DEBT OBLIGATIONS

Long-term debt obligations consist of the following (in thousands):

CREDIT FACILITY

The Company's primary current debt financing capacity consists of a $55
million senior credit facility (the "Facility") provided by General Electric
Capital Corporation ("GE"), a subsidiary of the General Electric Corporation.
The Facility includes a $20 million sublimit for letters of credit. The Facility
is secured by substantially all the assets of the Company. The Facility was
entered into on October 11, 2002 and replaces the Company's previous revolving
credit facility with a group of banks, which was scheduled to expire in January
2003. The Facility consists of two parts: a term loan and a revolving credit
facility.

The term loan under the Facility (the "Term Loan") is $15 million, which
the Company borrowed upon the closing of Facility on October 11, 2002. The Term
Loan must be repaid in quarterly installments over five years beginning December
31, 2002. The amount of each quarterly installment increases annually.

The Facility requires certain prepayments of the Term Loan. Approximately
half of any free cash flow (primarily cash from operations less capital
expenditures) in excess of scheduled principal payments and voluntary
prepayments must be used to pay down the Term Loan. This requirement is measured
annually based on full-year results. The Company has not reflected any
additional prepayments in current maturities of debt in connection with this
requirement as it cannot yet determine if there is a significant probability
that cash flows measured through yearend 2002 will require such prepayments. In
addition, proceeds in excess of $250,000 from any individual asset sales, or in
excess of $1 million for a full year's asset sales, must be used to pay down the
Term Loan. Proceeds from asset sales that are less than these individual
transaction or annual aggregate levels must also be used to pay down the Term
Loan unless they are reinvested in long-term assets within six months of the
receipt of such proceeds.

All prepayments under the Term Loan, whether required or voluntary, are
applied to scheduled principal payments in inverse order, i.e. to the last
scheduled principal payment first, followed by the second-to-last, etc. All
principal payments under the Term Loan permanently reduce the original $15
million capacity under this portion of the Facility.

The Facility also includes a three-year revolving credit facility (the
"Revolving Loan") that allows the Company to borrow up to $40 million in
addition to the Term Loan.

INTEREST RATES AND FEES

The Company has a choice of two interest rate options for borrowings under
the Facility. Under one option, the interest rate is determined based on the
higher of the Federal Funds Rate plus 0.5% or the prime rate of at least 75% of
the US's 30 largest banks, as published each business day by the Wall Street
Journal.

12

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

An additional margin of 2.25% is then added to the higher of these two rates for
borrowings under the Revolving Loan, while an additional margin of 2.75% is
added to the higher of these two rates for borrowings under the Term Loan.

Under the other interest rate option, borrowings bear interest based on
designated rates that are described in various general business media sources as
the London Interbank Offered Rate or "LIBOR." Revolving Loan borrowings using
this interest rate option then have 3.25% added to LIBOR, while Term Loan
borrowings have 3.75% added to LIBOR.

The rates underlying these interest rate options are floating interest
rates determined by the broad financial markets, meaning they can and do move up
and down from time to time. The Facility requires that the Company enter into
agreements to convert these floating interest rate terms on at least half of the
Term Loan to fixed rate terms by December 10, 2002. Depending on their ultimate
terms, such agreements might qualify as "derivatives" for financial reporting
purposes. If so, any increases or decreases in the value of such agreements
resulting from changes in market interest rates in any given period will be
reflected in interest expense for that period, even though the agreements may
not have been terminated and settled in cash during the period. Such adjustments
are known as mark-to-market adjustments.

Commitment fees of 0.5% per annum are payable on the unused portion of the
Revolving Loan.

The Company also incurred certain financing and professional costs in
connection with the arrangement and the closing of the Facility. These costs
will be amortized to interest expense over the term of the Facility in the
amount of approximately $0.3 million per quarter. To the extent prepayments of
the Term Loan are made, the Company may have to accelerate amortization of these
deferred financing and professional costs.

In connection with the Facility, the Company granted GE a warrant to
purchase 409,051 shares of Company common stock for nominal consideration. In
addition, GE may "put," or require the Company to repurchase, these shares at
the higher of market price, appraised price or book value per share, during the
fifth and final year of the Facility -- October 11, 2006 to October 11, 2007.
This put may be accelerated under certain circumstances including a change of
control of the Company, full repayment of amounts owing under the Facility, or a
public offering of shares by the Company. This warrant and put are discussed in
greater detail in Note 8, "Stockholders' Equity." The value of this warrant and
put as of the start of the Facility of $2.9 million will be reflected as a
discount of the Company's obligation under the Facility and will be amortized
over the term of the Facility, as described above. The value of this warrant and
put will change over time, principally in response to changes in the market
price of the Company's common stock. The warrant and the put qualify as a
derivative for financial reporting purposes. Accordingly, such changes in the
value of the warrant and put in any given period will be reflected in interest
expense for that period, even though the warrant and put may not have been
terminated and settled in cash during the period. Such adjustments are known as
mark-to-market adjustments.

The interest rate that the Company currently pays on the Term Loan is 7.5%
per annum. This rate does not include amortization of debt financing and
arrangement costs, or mark-to-market adjustments for derivatives.

The interest rate that the Company currently pays on the Revolving Loan is
7.0% per annum. This rate does not include amortization of debt financing and
arrangement costs, or mark-to-market adjustments for derivatives.

RESTRICTIONS AND COVENANTS

Borrowings under the Facility are specifically limited by the Company's
ratio of total debt to earnings before interest, taxes, depreciation, and
amortization ("EBITDA") and by the Company's ratio of EBITDA less taxes and
capital expenditures to interest expense and scheduled principal payments, also
known as the

13

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

fixed charge coverage ratio. The Facility's definition of debt for purposes of
the ratio of total debt to EBITDA includes aggregate letters of credit
outstanding less $10 million.

The definition of EBITDA under the Facility excludes certain items,
generally noncash amounts and transactions reported in Other Income and Expense,
that are otherwise included in the determination of earnings under generally
accepted accounting principles in the Company's financial statements. As such,
EBITDA as determined under the Facility's definition could be less than EBITDA
as derived from the Company's financial statements in the future. The Company is
currently not aware of any items that would result in EBITDA as determined under
the Facility's definition being significantly less than EBITDA as derived from
the Company's financial statements in the future.

The financial covenants under the Facility are summarized below. EBITDA
amounts are in thousands.

7. COMMITMENTS AND CONTINGENCIES

CLAIMS AND LAWSUITS

The Company is party to litigation in the ordinary course of business. The
Company has estimated and provided accruals for probable losses and related
legal fees associated with certain of these actions in the accompanying
consolidated financial statements. There are currently no pending legal
proceedings that, in management's opinion, would have a material adverse effect
on the Company's operating results or financial condition.

SELF-INSURANCE

The Company retains the risk of worker's compensation, employer's
liability, auto liability, general liability and employee group health claims
resulting from uninsured deductibles per accident or occurrence. Losses up to
the deductible amounts are estimated and accrued based upon the Company's known
claims incurred and an estimate of claims incurred but not reported. The
accruals are based upon known facts and historical trends, and management
believes such accruals to be adequate. A wholly-owned insurance company
subsidiary reinsures a portion of the risk associated with surety bonds issued
by a third party insurance company. Because no claims have been made against
these financial instruments in the past, management does not expect that these
instruments will have a material effect on the Company's consolidated financial
statements.

8. STOCKHOLDERS' EQUITY

RESTRICTED STOCK GRANT

The Company awarded 200,000 shares of restricted stock to its Chief
Executive Officer on March 22, 2002 under its 2000 Equity Incentive Plan. The
shares are subject to forfeiture if the Company does not meet certain
performance measures for the twelve-month period ending March 31, 2003 or if the
executive leaves voluntarily or is terminated for cause. Such forfeiture
provisions lapse upon achievement of the performance measures and pro rata over
a four-year period. Compensation expense relating to this grant will be charged
to earnings over the four-year period. The initial value of the award was
established based on the market price on the date of grant. The unearned
compensation is shown as a reduction of stockholders' equity in the accompanying
consolidated balance sheet and is being amortized against earnings based upon
the market

15

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

value of the stock until the achievement of performance measures for the
twelve-month period ending March 31, 2003 is determined. The value of the stock
grant remaining after this determination will be amortized ratably over the
remaining three years of the restricted period.

RESTRICTED COMMON STOCK

In March 1997, Notre Capital Ventures II, L.L.C. exchanged 2,742,912 shares
of Common Stock for an equal number of shares of restricted voting common stock
("Restricted Voting Common Stock"). The holders of Restricted Voting Common
Stock are entitled to elect one member of the Company's Board of Directors and
0.55 of one vote for each share on all other matters on which they are entitled
to vote. Holders of Restricted Voting Common Stock are not entitled to vote on
the election of any other directors.

Each share of Restricted Voting Common Stock will automatically convert to
Common Stock on a share-for-share basis (i) in the event of a disposition of
such share of Restricted Voting Common Stock by the holder thereof (other than a
distribution which is a distribution by a holder to its partners or beneficial
owners, or a transfer to a related party of such holders (as defined in Sections
267, 707, 318 and/or 4946 of the Internal Revenue Code of 1986, as amended)),
(ii) in the event any person acquires beneficial ownership of 15% or more of the
total number of outstanding shares of Common Stock of the Company, or (iii) in
the event any person offers to acquire 15% or more of the total number of
outstanding shares of Common Stock of the Company. After July 1, 1998, the Board
of Directors may elect to convert any remaining shares of Restricted Voting
Common Stock into shares of Common Stock in the event 80% or more of the
originally outstanding shares of Restricted Voting Common Stock have been
previously converted into shares of Common Stock. As of September 30, 2002,
there were 1,156,112 shares of Restricted Voting Common Stock remaining.

EARNINGS PER SHARE

Basic earnings per share ("EPS") is computed by dividing net income by the
weighted average number of shares of common stock outstanding during the year.
Diluted EPS is computed considering the dilutive effect of stock options and
convertible subordinated notes.

Options to purchase 3.3 million shares of the Company's Common Stock
("Common Stock") at prices ranging from $3.86 to $21.44 per share and options to
purchase 2.7 million shares of Common Stock at prices ranging from $4.24 to
$21.44 per share were outstanding for the three months and nine months ended
September 30, 2002, respectively, but were not included in the computation of
diluted EPS because the options' exercise prices were greater than the average
market price of the Common Stock. Options to purchase 4.0 million shares of
Common Stock at prices ranging from $3.63 to $21.44 per share were outstanding
for the three months and nine months ended September 30, 2001, but were not
included in the computation of diluted EPS because the options' exercise prices
were greater than the average market price of the Common Stock.

Diluted EPS is also computed by adjusting both net earnings and shares
outstanding as if the conversion of the convertible subordinated notes occurred
on the first day of the year. The convertible subordinated notes had an
anti-dilutive effect during the three months ended September 30, 2001 and the
nine months ended September 30, 2001 and 2002, and therefore, are not included
in the diluted EPS calculations. The convertibility provisions of the remaining
convertible subordinated notes expired during the first quarter of 2002.

16

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

WARRANT

In connection with the arrangement of the Company's new debt facility as
described above in Note 6, "Long-Term Debt Obligations," the Company granted GE,
its lender, a warrant to purchase 409,051 shares of Company common stock for
nominal consideration. The warrant agreement also provides for the following:

- In most situations where the Company issues shares, options or warrants,
GE may acquire additional shares or warrants on equivalent terms to
maintain the proportionate interest its warrant shares represent in
comparison to the Company's total shares outstanding.

- GE may require the Company to register its warrant shares.

- GE may include its warrant shares in any public offering of stock by the
Company.

- GE may "put," or require the Company to repurchase, some or all of its
warrant shares at the higher of market price, appraised price or book
value per share, during the fifth and final year of the debt
facility -- October 11, 2006 to October 11, 2007. This put may be
accelerated under certain circumstances including a change of control of
the Company, full repayment of amounts owing under the Facility, or a
public offering of shares by the Company.

The initial value of this warrant and put of $2.9 million will be reflected
as a discount of the Company's obligations under its debt facility with GE and
as a separate obligation in long-term liabilities. The value of this warrant and
put will change over time, principally in response to changes in the market
price of the Company's common stock. The warrant and the put qualify as a
derivative for financial reporting purposes. Accordingly, such changes in the
value of the warrant and put in any given period will be reflected in interest
expense for that period and in the Company's long-term warrant obligations, even
though the warrant and put may not have been terminated and settled in cash
during the period. Such adjustments are known as mark-to-market adjustments.

17

COMFORT SYSTEMS USA, INC.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

INTRODUCTION

The following discussion should be read in conjunction with the historical
Consolidated Financial Statements of Comfort Systems USA, Inc. ("Comfort
Systems" and collectively with its subsidiaries, the "Company") and related
notes thereto included elsewhere in this Form 10-Q and the Annual Report on Form
10-K as filed with the Securities and Exchange Commission for the year ended
December 31, 2001 (the "Form 10-K"). This discussion contains forward-looking
statements regarding the business and industry of Comfort Systems USA within the
meaning of the Private Securities Litigation Reform Act of 1995. These
statements are based on the current plans and expectations of the Company and
involve risks and uncertainties that could cause actual future activities and
results of operations to be materially different from those set forth in the
forward-looking statements. Important factors that could cause actual results to
differ include risks set forth in "Factors Which May Affect Future Results,"
included in the Form 10-K.

The Company is a national provider of comprehensive heating, ventilation
and air conditioning ("HVAC") installation, maintenance, repair and replacement
services within the mechanical services industry. The Company operates primarily
in the commercial and industrial HVAC markets, and performs most of its services
within office buildings, retail centers, apartment complexes, manufacturing
plants, and healthcare, education and government facilities. In addition to
standard HVAC services, the Company provides specialized applications such as
building automation control systems, fire protection, process cooling,
electronic monitoring and process piping. Certain locations also perform related
services such as electrical and plumbing. Approximately 52% of the Company's
consolidated 2002 revenues were attributable to installation of systems in newly
constructed facilities, with the remaining 48% attributable to maintenance,
repair and replacement services. The Company's consolidated 2002 revenues
related to the following service activities: HVAC -- 74%, plumbing -- 11%,
building automation control systems -- 5%, electrical -- 2%, fire
protection -- 1% and other -- 7%. These service activities are within the
mechanical services industry which is the single industry segment served by
Comfort Systems.

In response to the Securities and Exchange Commission's Release No.
33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting
Policies," the Company identified its critical accounting policies based upon
the significance of the accounting policy to the Company's overall financial
statement presentation, as well as the complexity of the accounting policy and
its use of estimates and subjective assessments. The Company concluded that its
critical accounting policy is its revenue recognition policy. This accounting
policy, as well as others, are described in Note 2 to the Consolidated Financial
Statements included in the Form 10-K.

The Company enters into construction contracts with general contractors or
end-use customers based upon negotiated contracts and competitive bids. As part
of the negotiation and bidding processes, the Company estimates its contract
costs, which include all direct materials (net of estimated rebates), labor and
subcontract costs and indirect costs related to contract performance such as
indirect labor, supplies, tools, repairs and depreciation costs. Revenues from
construction contracts are recognized on the percentage-of-completion method in
accordance with the American Institute of Certified Public Accountants Statement
of Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." Under this method, the amount of total contract
revenue recognizable at any given time during a contract is determined by
multiplying total contract revenue by the percentage of contract costs incurred
at any given time to total estimated contract costs. Accordingly, contract
revenues recognized in the statements of operations can and usually do differ
from amounts that can be billed or invoiced to the customer at any given point
during the contract.

Changes in job performance, job conditions, estimated profitability and
final contract settlements may result in revisions to estimated costs and,
therefore, revenues. Such revisions are frequently based on estimates and
subjective assessments. The effects of these revisions are recognized in the
period in which the revisions are determined. When such revisions lead to a
conclusion that a loss will be recognized on a contract, the full
18

amount of the estimated ultimate loss is recognized in the period such a
conclusion is reached, regardless of what stage of completion the contract has
reached. Depending on the size of a particular project, variations from
estimated project costs could have a significant impact on the Company's
operating results.

Revenues associated with maintenance, repair and monitoring services and
related contracts are recognized as services are performed.

Approximately 52% of the Company's consolidated 2002 revenues were
attributable to installation of systems in newly constructed facilities. As a
result, if general economic activity in the U.S. slows significantly from
current levels, and leads to a corresponding decrease in new nonresidential
building construction, the Company's operating results could suffer.

Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets."
Under this new standard, which is discussed in "Results of Operations" and "New
Accounting Pronouncements" below, new requirements for assessing whether
goodwill assets have been impaired involve market-based information. This
information, and its use in assessing goodwill, entails some degree of
subjective assessments. Additionally, amortization of goodwill has been
discontinued in 2002 operating results as a result of this standard.

Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets." Under this new standard,
the operating results of companies which were sold or held for sale as of
September 30, 2002, have been reported as discontinued operations in the
accompanying consolidated statements of operations. However, the operating
results for companies which were sold or shut down during 2001 are presented as
continuing operations through the date of disposition.

RESULTS OF OPERATIONS (IN THOUSANDS)

Revenues -- Revenues decreased $19.4 million, or 8.3%, to $214.7 million
for the third quarter of 2002 and decreased $48.6 million, or 7.3%, to $616.1
million for the first nine months of 2002 compared to the same periods in 2001.
The 8.3% decline in revenues for the quarter was comprised of a 7.6% decline in
revenues at
19

ongoing operations and a 0.7% decline in revenues related to operations that
were sold or shut down during 2001. The 7.3% decline in revenues for the first
nine months of 2002 was comprised of a 6.4% decline in revenues at ongoing
operations and a 0.9% decline in revenues related to operations that were sold
or shut down during 2001.

The Company's decline in revenues at ongoing operations in 2002 resulted
primarily from the lagged effect of the general economic slowdown that began
last year which slowed decisions to proceed on both new and retrofit projects.
This general economic slowdown has also led to a more competitive pricing
environment. The Company's decline in revenue is also consistent with
management's decreased emphasis on revenue growth in favor of improvement in
profit margins, operating efficiency, and cash flow. There can be no assurance,
however, that this strategy will lead to improved profit margins in the near
term. In view of these factors, particularly decreased economic activity and
increased price competition affecting the Company's industry, the Company may
continue to experience only modest revenue growth or revenue declines in
upcoming periods. In addition, if general economic activity in the U.S. slows
significantly from current levels, the Company may realize further decreases in
revenue and lower operating margins.

Backlog primarily contains installation, retrofit project work and service
and maintenance agreements. These projects generally last less than a year.
Service work and short duration projects are generally billed as performed and
therefore do not flow through backlog. Accordingly, backlog represents only a
portion of the Company's revenues for any given future period, and it represents
revenues that are likely to be reflected in the Company's operating results over
the next six to twelve months. As a result, the Company believes the predictive
value of backlog information is limited to indications of general revenue
direction over the near term, and should not be interpreted as indicative of
ongoing revenue performance over several quarters.

The Company's backlog associated with continuing operations as of September
30, 2002 was $475.9 million, a 10.1% increase from September 30, 2001 backlog of
$432.2 million, and a 2.0% increase from June 30, 2002 backlog of $466.5
million.

Gross Profit -- Gross profit decreased $4.6 million, or 10.4%, to $40.0
million for the third quarter of 2002 and decreased $14.9 million, or 12.0%, to
$109.2 million for the first nine months of 2002 compared to the same periods in
2001. As a percentage of revenues, gross profit decreased from 19.1% for the
three months ended September 30, 2001 to 18.6% for the three months ended
September 30, 2002 and decreased from 18.7% for the nine months ended September
30, 2001 to 17.7% for the nine months ended September 30, 2002.

The decline in gross profit for the quarter is primarily due to a more
competitive pricing environment as a result of the general economic slowdown
which began in the latter part of 2001. This slowdown also resulted in project
delays at a number of the Company's operations as decisions to start new
construction activities as well as retrofit projects were delayed in the fourth
quarter of 2001. These delays significantly affected the Company's revenue
volume and profitability during the first part of 2002.

Selling, General and Administrative Expenses ("SG&A") -- SG&A decreased
$3.4 million, or 9.6%, to $32.0 million for the third quarter of 2002 and
decreased $11.3 million, or 10.7%, to $95.0 million for the first nine months of
2002 compared to the same periods in 2001. As a percentage of revenues, SG&A
decreased from 15.1% for the three months ended September 30, 2001 to 14.9% for
the three months ended September 30, 2002 and decreased from 16.0% for the nine
months ended September 30, 2001 to 15.4% for the nine months ended September 30,
2002. The decrease in SG&A is primarily due to a concerted effort to reduce SG&A
throughout the Company. In response to the smaller size of the Company following
the sale of 19 units to Emcor as discussed further below under "Discontinued
Operations," the Company reduced corporate overhead at the end of the first
quarter of 2002. The cost of this workforce reduction is included in
restructuring charges recorded in March 2002. The Company has realized lower
corporate overhead costs as a result of these steps. In addition, during the
second quarter of 2002, the Company reversed $0.8 million of bad debt reserves
that were established in the fourth quarter of 2001 related to the Company's
receivables with Kmart based upon a post-bankruptcy petition settlement with
Kmart.

20

SG&A as a percentage of revenues for periods prior to the Emcor transaction
is higher than historical levels because the financial statements do not
allocate any corporate overhead to the discontinued operations. As a result,
SG&A for continuing operations reflects substantially the full amount of
corporate office overhead that was in place to support the Company's operations
prior to the sale of these operations.

Goodwill Amortization -- Effective January 1, 2002, the Company adopted
SFAS No. 142, "Goodwill and Other Intangible Assets." This pronouncement
discontinued goodwill amortization. See "Cumulative Effect of Change in
Accounting Principle" for further discussion.

Restructuring Charges -- During the first quarter of 2002, the Company
recorded restructuring charges of approximately $1.9 million. These charges
included approximately $0.8 million for severance costs primarily associated
with the reduction in corporate overhead in light of the Company's smaller size
following the Emcor transaction. The severance costs related to the termination
of 33 employees, all of whom were terminated as of March 31, 2002. In addition,
these charges include approximately $0.7 million for costs associated with
decisions to merge or close three smaller divisions and realign regional
operating management. These restructuring charges are primarily cash obligations
but did include approximately $0.3 million of non-cash writedowns associated
with long-lived assets.

During the first quarter of 2001, the Company recorded restructuring
charges of approximately $0.2 million, primarily related to contractual
severance obligations of two operating presidents in connection with the
Company's significant restructuring program in the second half of 2000. These
restructuring charges are net of a gain of approximately $0.1 million related to
management's decision to sell a small operation during the first quarter of
2001.

Other Expense, Net -- Other expense, net, primarily includes interest
expense, and decreased $1.0 million, or 54.0%, to $0.8 million for the third
quarter of 2002 and decreased $3.7 million, or 58.2%, to $2.7 million for the
first nine months of 2002. A portion of the Company's actual interest expense in
both years has been allocated to the discontinued operations caption based upon
the Company's net investment in these operations. Therefore, interest expense
relating to continuing operations does not reflect the pro forma reduction of
interest expense from applying the proceeds from the sale of these operations to
reduce debt in any earlier period. Interest expense allocated to the
discontinued operations for the three months ended September 30, 2001 was $3.3
million and for the nine months ended September 30, 2001 and 2002 was $11.0
million and $1.5 million, respectively. In addition, first quarter 2002 interest
expense in continuing operations includes a non-cash writedown of $0.6 million,
before taxes, of loan arrangement costs in connection with the reduction in the
Company's borrowing capacity following the Emcor transaction. Other expense,
net, for the second quarter of 2002 also includes a gain of $0.6 million on the
sale of the residential portion of one of the Company's operations.

Income Tax Expense -- The Company's effective tax rates associated with
results from continuing operations for the nine months ended September 30, 2001
and 2002 were 93.4% and 47.3%, respectively. As a result of the discontinuation
of goodwill amortization as a result of the adoption of SFAS No. 142 effective
January 1, 2002, there is no longer a permanent difference related to the
non-deductible goodwill amortization in the 2002 effective tax rate.

Discontinued Operations -- On February 11, 2002, the Company entered into
an agreement with Emcor Group, Inc. ("Emcor") to sell 19 operations. This
transaction closed on March 1, 2002. Under the terms of the agreement, the total
purchase price was $186.25 million, including the assumption by Emcor of
approximately $22.1 million of subordinated notes to former owners of certain of
the divested companies.

The transaction with Emcor provided for a post-closing adjustment based on
a final accounting, done after the closing of the transaction, of the net assets
of the operations that were sold to Emcor. That accounting indicated that the
net assets transferred to Emcor were approximately $7 million greater than a
target amount that had been agreed to with Emcor. In accordance with the
transaction agreement, Emcor paid the Company that amount, and released $2.5
million that had been escrowed in connection with this element of the
transaction during the second quarter.

21

An additional $5 million of Emcor's purchase price was deposited into an
escrow account to secure potential obligations on the Company's part to
indemnify Emcor for future claims and contingencies arising from events and
circumstances prior to closing, all as specified in the transaction documents.
Because these escrow funds secure future claims and contingencies, the Company
does not know whether it will ultimately receive any of such funds, and if it
does, how much it will receive. Therefore, the Company has not recognized a
receivable for this escrowed portion of the Emcor transaction purchase price. If
the Company ultimately receives any of these escrowed funds, a corresponding
gain will be recorded as a component of discontinued operations when received.

The net cash proceeds of approximately $164 million received to date from
the Emcor transaction have been used to reduce debt outstanding under the
Company's credit facility. An estimated tax liability of $16 million related to
this transaction is due in March 2003.

Under SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," which took effect for the Company on January 1, 2002, the
operating results of the companies sold to Emcor as well as the loss on the sale
of these operations have been presented as discontinued operations in the
Company's statements of operations. The Company realized a loss of $10.6 million
including related tax expense related to the sale of these operations. As a
result of the adoption of SFAS No. 142 "Goodwill and Other Intangible Assets,"
the Company also recognized a goodwill impairment charge related to these
operations of $32.4 million, net of taxes, as of January 1, 2002. The reporting
of the Company's aggregate goodwill impairment charge in connection with
adopting SFAS No. 142 is discussed further below under "Cumulative Effect of
Change in Accounting Principle."

In March 2002, the Company also decided to divest of an additional
operating company. This unit's operating loss for the first three quarters of
2002 of $0.1 million, net of taxes, has been reported in discontinued operations
under "Operating results, net of tax" in the Company's results of operations. In
addition, an estimate of the loss the Company will realize upon divestiture of
this operation of $0.6 million has been included in "Estimated loss on
disposition, net of tax" during the first quarter of 2002 in the Company's
results of operations.

During the second quarter of 2002, the Company sold a division of one of
its operations. The operating loss for this division for the first two quarters
of 2002 of $0.3 million, net of taxes, has been reported in discontinued
operations under "Operating results, net of tax" in the Company's results of
operations. The Company realized a loss of $0.3 million on the sale of this
division which is included in "Estimated loss on disposition, net of tax" during
the second quarter of 2002 in the Company's results of operations.

Cumulative Effect of Change in Accounting Principle -- Effective January 1,
2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets."
SFAS No. 142 requires companies to assess goodwill asset amounts for impairment
each year, and more frequently if circumstances suggest an impairment may have
occurred. In addition to discontinuing the regular charge, or amortization, of
goodwill against income, the new standard also introduces more rigorous criteria
for determining how much goodwill should be reflected as an asset in a company's
balance sheet.

To perform the transitional impairment testing required by SFAS No. 142
under its new, more rigorous impairment criteria, the Company broke its
operations into "reporting units", as prescribed by the new standard, and tested
each of these reporting units for impairment by comparing the unit's fair value
to its carrying value. The fair value of each reporting unit was estimated using
a discounted cash flow model combined with market valuation approaches.
Significant estimates and assumptions were used in assessing the fair value of
reporting units. These estimates and assumptions involved future cash flows,
growth rates, discount rates, weighted average cost of capital and estimates of
market valuations for each of the reporting units.

As provided by SFAS No. 142, the transitional impairment loss identified by
applying the standard's new, more rigorous valuation methodology upon initial
adoption of the standard was reflected as a cumulative effect of a change in
accounting principle in the Company's statement of operations. The resulting
non-cash charge

22

was $202.5 million, net of taxes. Impairment charges recognized after the
initial adoption, if any, generally are to be reported as a component of
operating income.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flow -- Cash provided by operating activities less customary capital
expenditures plus the proceeds from asset sales is generally called free cash
flow. Positive free cash flow represents funds available to invest in
significant operating initiatives, to acquire other companies or to reduce a
company's outstanding debt or equity. If free cash flow is negative, additional
debt or equity is generally required to fund the outflow of cash.

For the three months ended September 30, 2002, the Company had positive
free cash flow of $11.3 million as compared to $8.4 million for the same period
in 2001. The Company has now generated positive free cash flow in nine of the
last ten quarters. For the nine months ended September 30, 2002, the Company had
positive free cash flow of $11.1 million as compared to $37.6 million for the
same period in 2001. The 2001 cash flow amounts include the 19 operations the
Company sold to Emcor in 2002. This sale primarily accounts for the lower cash
flow amounts in 2002.

The transaction with Emcor provided for a post-closing adjustment based on
a final accounting, done after the closing of the transaction, of the net assets
of the operations that were sold to Emcor. That accounting indicated that the
net assets transferred to Emcor were approximately $7 million greater than a
target amount that had been agreed to with Emcor. In accordance with the
transaction agreement, Emcor paid the Company that amount, and released $2.5
million that had been escrowed in connection with this element of the
transaction during the second quarter. This amount is included in "Proceeds from
businesses sold, net of cash sold and transaction costs" in the Company's
statement of cash flows.

The proceeds received at the closing of the Emcor transaction, the
post-closing adjustment and related escrow received from Emcor, and free cash
flow from the Company's operations were all used to reduce the Company's debt.

Credit Facility -- The Company's primary current debt financing capacity
consists of a $55 million senior credit facility (the "Facility") provided by
General Electric Capital Corporation ("GE"), a subsidiary of the General
Electric Corporation. The Facility includes a $20 million sublimit for letters
of credit. The Facility is secured by substantially all the assets of the
Company. The Facility was entered into on October 11, 2002 and replaces the
Company's previous revolving credit facility with a group of banks, which was
scheduled to expire in January 2003. The Facility consists of two parts: a term
loan and a revolving credit facility.

The term loan under the Facility (the "Term Loan") is $15 million, which
the Company borrowed upon the closing of Facility on October 11, 2002. The Term
Loan must be repaid in quarterly installments over five years beginning December
31, 2002. The amount of each quarterly installment increases annually. These
scheduled payments are recapped below under Amounts Outstanding, Capacity and
Maturities.

The Facility requires certain prepayments of the Term Loan. Approximately
half of any free cash flow (primarily cash from operations less capital
expenditures) in excess of scheduled principal payments and voluntary
prepayments must be used to pay down the Term Loan. This requirement is measured
annually based on full-year results. The Company has not reflected any
additional prepayments in current maturities of debt in connection with this
requirement as it cannot yet determine if there is a significant probability
that cash flows measured through yearend 2002 will require such prepayments. In
addition, proceeds in excess of $250,000 from any individual asset sales, or in
excess of $1 million for a full year's asset sales, must be used to pay down the
Term Loan. Proceeds from asset sales that are less than these individual
transaction or annual aggregate levels must also be used to pay down the Term
Loan unless they are reinvested in long-term assets within six months of the
receipt of such proceeds.

All prepayments under the Term Loan, whether required or voluntary, are
applied to scheduled principal payments in inverse order, i.e. to the last
scheduled principal payment first, followed by the second-to-last, etc. All
principal payments under the Term Loan permanently reduce the original $15
million capacity under this portion of the Facility.

23

The Facility also includes a three-year revolving credit facility (the
"Revolving Loan") that allows the Company to borrow up to $40 million in
addition to the Term Loan.

Interest Rates and Fees -- The Company has a choice of two interest rate
options for borrowings under the Facility. Under one option, the interest rate
is determined based on the higher of the Federal Funds Rate plus 0.5% or the
prime rate of at least 75% of the US's 30 largest banks, as published each
business day by the Wall Street Journal. An additional margin of 2.25% is then
added to the higher of these two rates for borrowings under the Revolving Loan,
while an additional margin of 2.75% is added to the higher of these two rates
for borrowings under the Term Loan.

Under the other interest rate option, borrowings bear interest based on
designated rates that are described in various general business media sources as
the London Interbank Offered Rate or "LIBOR." Revolving Loan borrowings using
this interest rate option then have 3.25% added to LIBOR, while Term Loan
borrowings have 3.75% added to LIBOR.

The rates underlying these interest rate options are floating interest
rates determined by the broad financial markets, meaning they can and do move up
and down from time to time. The Facility requires that the Company enter into
agreements to convert these floating interest rate terms on at least half of the
Term Loan to fixed rate terms by December 10, 2002. Depending on their ultimate
terms, such agreements might qualify as "derivatives" for financial reporting
purposes. If so, any increases or decreases in the value of such agreements
resulting from changes in market interest rates in any given period will be
reflected in interest expense for that period, even though the agreements may
not have been terminated and settled in cash during the period. Such adjustments
are known as mark-to-market adjustments.

Commitment fees of 0.5% per annum are payable on the unused portion of the
Revolving Loan.

The Company also incurred certain financing and professional costs in
connection with the arrangement and the closing of the Facility. These costs
will be amortized to interest expense over the term of the Facility in the
amount of approximately $0.3 million per quarter. To the extent prepayments of
the Term Loan are made, the Company may have to accelerate amortization of these
deferred financing and professional costs.

In connection with the Facility, the Company granted GE a warrant to
purchase 409,051 shares of Company common stock for nominal consideration. In
addition, GE may "put," or require the Company to repurchase, these shares at
the higher of market price, appraised price or book value per share, during the
fifth and final year of the Facility -- October 11, 2006 to October 11, 2007.
This put may be accelerated under certain circumstances including a change of
control of the Company, full repayments of amounts owing under the Facility, or
a public offering of shares by the Company. This warrant and put are discussed
in greater detail in Note 8, "Stockholders' Equity," to the Consolidated
Financial Statements. The value of this warrant and put as of the start of the
Facility of $2.9 million will be reflected as a discount of the Company's
obligation under the Facility and will be amortized over the term of the
Facility, as described above. The value of this warrant and put will change over
time, principally in response to changes in the market price of the Company's
common stock. The warrant and the put qualify as a derivative for financial
reporting purposes. Accordingly, such changes in the value of the warrant and
put in any given period will be reflected in interest expense for that period,
even though the warrant and put may not have been terminated and settled in cash
during the period. Such adjustments are known as mark-to-market adjustments.

The interest rate that the Company currently pays on the Term Loan is 7.5%
per annum. This rate does not include amortization of debt financing and
arrangement costs, or mark-to-market adjustments for derivatives.

The interest rate that the Company currently pays on the Revolving Loan is
7.0% per annum. This rate does not include amortization of debt financing and
arrangement costs, or mark-to-market adjustments for derivatives.

Restrictions and Covenants -- Borrowings under the Facility are
specifically limited by the Company's ratio of total debt to earnings before
interest, taxes, depreciation, and amortization ("EBITDA") and by the Company's
ratio of EBITDA less taxes and capital expenditures to interest expense and
scheduled principal

24

payments, also known as the fixed charge coverage ratio. The Facility's
definition of debt for purposes of the ratio of total debt to EBITDA includes
aggregate letters of credit outstanding less $10 million.

The definition of EBITDA under the Facility excludes certain items,
generally noncash amounts and transactions reported in Other Income and Expense,
that are otherwise included in the determination of earnings under generally
accepted accounting principles in the Company's financial statements. As such,
EBITDA as determined under the Facility's definition could be less than EBITDA
as derived from the Company's financial statements in the future. The Company is
currently not aware of any items that would result in EBITDA as determined under
the Facility's definition being significantly less than EBITDA as derived from
the Company's financial statements in the future.

The financial covenants under the Facility are summarized below. EBITDA
amounts are in thousands.

The Company must achieve $6,042 of EBITDA in the fourth quarter of 2002 to
remain in compliance with the minimum trailing twelve months EBITDA covenant
shown above.

The Facility prohibits payment of dividends and the repurchase of shares by
the Company, limits annual lease expense and non-Facility debt, and restricts
outlays of cash by the Company relating to certain investments, acquisitions and
subordinate debt.

Notes to Affiliates and Former Owners -- Subordinated notes were issued to
former owners of certain purchased companies as part of the consideration used
to acquire their companies. These notes had an outstanding balance of $15.8
million as of September 30, 2002. In October 2002, $10.7 million of this balance
was repaid with proceeds from the Term Loan. As of November 1, 2002, a balance
of $4.7 million remains outstanding on these notes, substantially all of which
is due in April 2003. The remaining notes bear interest, payable quarterly, at
an interest rate of 10.0%. As these notes were refinanced with proceeds from the
Term Loan, they are reflected as long-term as of September 30, 2002, net of
amounts that are current under the Term Loan.

Other Commitments -- As is common in the Company's industry, the Company
has entered into certain off-balance sheet arrangements in the ordinary course
of business that result in risks not directly reflected in the Company's balance
sheets. The Company's most significant off-balance sheet transactions include

25

liabilities associated with noncancelable operating leases. The Company also has
other off-balance sheet obligations involving letters of credit and surety
guarantees.

The Company enters into noncancelable operating leases for many of its
facility, vehicle and equipment needs. These leases allow the Company to
conserve cash by paying a monthly lease rental fee for use of facilities,
vehicles and equipment rather than purchasing them. At the end of the lease, the
Company has no further obligation to the lessor. The Company may decide to
cancel or terminate a lease before the end of its term. Typically the Company is
liable to the lessor for the remaining lease payments under the term of the
lease.

Some customers require the Company to post letters of credit to guarantee
performance under the Company's contracts and to ensure payment to the Company's
subcontractors and vendors under those contracts. Certain of the Company's
vendors also require letters of credit to ensure reimbursement for amounts they
are disbursing on behalf of the Company, such as to beneficiaries under the
Company's self-funded insurance programs. Such letters of credit are generally
issued by a bank or similar financial institution. The letter of credit commits
the issuer to pay specified amounts to the holder of the letter of credit if the
holder demonstrates that the Company has failed to perform specified actions. If
this were to occur, the Company would be required to reimburse the issuer of the
letter of credit. Depending on the circumstances of such a reimbursement, the
Company may also have to record a charge to earnings for the reimbursement. To
date the Company has not had a claim made against a letter of credit that
resulted in payments by the issuer of the letter of credit or by the Company.
The Company believes that it is unlikely that it will have to fund claims under
a letter of credit in the foreseeable future.

Many customers, particularly in connection with new construction, require
the Company to post performance and payment bonds issued by a financial
institution known as a surety. These bonds provide a guarantee to the customer
that the Company will perform under the terms of a contract and that the Company
will pay subcontractors and vendors. If the Company fails to perform under a
contract or to pay subcontractors and vendors, the customer may demand that the
surety make payments or provide services under the bond. The Company must
reimburse the surety for any expenses or outlays it incurs. To date, the Company
has not had any significant reimbursements to its surety for bond-related costs.
The Company believes that it is unlikely that it will have to fund claims under
its surety arrangements in the foreseeable future.

Amounts Outstanding, Capacity and Maturities -- The following recaps the
Company's debt amounts outstanding and capacity (in thousands):

26

The following recaps the future maturities of this debt along with other
contractual obligations. Debt maturities in this recap are based on amounts
outstanding as of November 1, 2002 while operating lease maturities are based on
amounts outstanding as of September 30, 2002 (in thousands).

The Company's letter of credit commitments as of September 30, 2002 expire
as follows (in thousands):

Outlook -- As noted above, the Company has generated positive free cash
flow in most recent periods, and it currently has a relatively low level of
debt. The Company does have approximately $16 million in tax payments resulting
from the Emcor transaction that are due in March 2003. The Company anticipates
that free cash flow from operations and borrowing capacity under the Facility
will provide the Company with sufficient liquidity to fund these tax payments
and to support its operations for the foreseeable future.

The Company currently has $6.8 million in letters of credit outstanding.
The Company self insures a significant portion of its workers compensation, auto
liability and general liability risks. The Company uses third parties to manage
this self insurance and to retain some of these risks. As is customary under
such arrangements, these third parties can require letters of credit as security
for amounts they fund or risks they might potentially absorb on the Company's
behalf. Under its current self-insurance arrangements, the Company expects that
it will be required to post approximately $4.8 million in letters of credit
before yearend, and approximately $2.4 million per quarter during the first
three quarters of 2003. The Company does expect to recover at least $5 million
of letters of credit currently outstanding over the next year. However, if the
Company does not recover any of the letters of credit currently outstanding,
then based on the potential insurance-related letter of credit requirements
described above, the Company may have potential letter of credit requirements of
approximately $18.9 million over the next year. In addition, the Company may
receive other letter of credit requests in the ordinary course of business, and
it may have a net increase in the amount of insurance-related letters of credit
it must post when it renews its insurance arrangements in the fourth quarter of
next year. Accordingly, the Company's letter of credit requirements over the
next year may exceed the current letter of credit sublimit of $20 million under
the Company's credit facility. If so, the Company may have to seek additional
letter of credit capacity or post different forms of security such as bonds or
cash in lieu of letters of credit. The Company believes that its relatively low
levels of debt in comparison to its EBITDA and free cash flows would enable it
to obtain additional letter of credit capacity or to otherwise meet financial
security requirements of third parties if necessary, but there can be no
absolute assurance that the Company would be successful in doing so.

As described above, the Company must comply with a number of financial
covenants in connection with the Facility. While the Company currently complies
with all of the Facility's covenants, the minimum EBITDA covenant is set at
levels that leave only moderate room for variance based on the Company's recent

27

performance. If the Company violates the Facility's minimum EBITDA covenant or
any other of the Facility's covenants, it may have to negotiate new borrowing
terms under the Facility or obtain new financing. While the Company believes
that its relatively low levels of debt in comparison to its EBITDA and free cash
flows would enable it to negotiate new borrowing terms under the Facility or to
obtain new financing from other sources if necessary, there can be no absolute
assurance that the Company would be successful in doing so.

SEASONALITY AND CYCLICALITY

The HVAC industry is subject to seasonal variations. Specifically, the
demand for new installation and replacement is generally lower during the winter
months (the first quarter of the year) due to reduced construction activity
during inclement weather and less use of air conditioning during the colder
months. Demand for HVAC services is generally higher in the second and third
calendar quarters due to increased construction activity and increased use of
air conditioning during the warmer months. Accordingly, the Company expects its
revenues and operating results generally will be lower in the first and fourth
calendar quarters.

Historically, the construction industry has been highly cyclical. As a
result, the Company's volume of business may be adversely affected by declines
in new installation projects in various geographic regions of the United States.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 establishes new
accounting and reporting requirements for goodwill and other intangible assets.
The Company adopted this new standard effective January 1, 2002. See Note 4 of
the Consolidated Financial Statements for further discussion.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." The Company adopted SFAS No. 144
effective January 1, 2002. Under SFAS No. 144, the operating results of
companies sold or held for sale meeting certain criteria, as well as any gain or
loss on the sale of these operations, are presented as discontinued operations
in the Company's statements of operations. See Note 3 of the Consolidated
Financial Statements for a discussion of the Company's discontinued operations.
The operating results for companies which were sold or shut down during 2001 are
presented as continuing operations through the date of disposition. The adoption
of SFAS No. 144 did affect the presentation of discontinued operations in the
consolidated financial statements; however, it did not have a material financial
impact on the Company's results of operations, financial position or cash flows.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk primarily related to potential
adverse changes in interest rates. Management is actively involved in monitoring
exposure to market risk and continues to develop and utilize appropriate risk
management techniques.

28

COMFORT SYSTEMS USA, INC.

PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company is subject to certain claims and lawsuits arising in the normal
course of business and maintains various insurance coverages to minimize
financial risk associated with these claims. The Company has estimated and
provided accruals for probable losses and legal fees associated with certain of
these actions in its consolidated financial statements. In the opinion of
management, uninsured losses, if any, resulting from the ultimate resolution of
these matters will not have a material adverse effect on the Company's financial
position or results of operations.

ITEM 2. RECENT SALES OF UNREGISTERED SECURITIES

On October 11, 2002 the Company granted a Stock Purchase Warrant (the
"Warrant") to General Electric Capital Corporation for 409,051 shares of the
Company's stock, at a purchase price per share of $0.01. The Warrant was given
as consideration in connection with the Company's long-term debt financing. The
Warrant was issued without registration under the Securities Act in reliance on
the exemption provided by Section 4(2) of the Securities Act.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.1 Credit Agreement dated as of October 11, 2002 by and among
the Company, as Borrower, and the other persons party
thereto that are designated as credit parties, and General
Electric Capital Corporation, as Agent, L/C Issuer and a
Lender, and the other financial institutions party thereto,
as Lenders. (Filed Herewith).
10.2 Stock Purchase Warrant and Repurchase Agreement dated
October 11, 2002 granted by the Company to General Electric
Capital Corporation. (Filed Herewith).
10.3 Registration Rights Agreement dated October 11, 2002 by and
among the Company and General Electric Capital Corporation.
(Filed Herewith).
10.4 Employment Agreement dated November 4, 2002 by and among
Comfort Systems USA (Texas), L.P. and Norman C. Chambers.
(Filed Herewith).
10.5 Restricted Stock Award Agreement dated November 1, 2002 from
the Company to Norman C. Chambers. (Filed Herewith).
99.1 Certification of William F. Murdy, Chief Executive Officer,
pursuant to Section 1350, Chapter 63 of Title 18, United
States Code, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act Of 2002. (Filed herewith).
99.2 Certification of J. Gordon Beittenmiller, Chief Financial
Officer, pursuant to Section 1350, Chapter 63 of Title 18,
United States Code, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act Of 2002. (Filed herewith).

(b) Reports on Form 8-K

None

29

SIGNATURES

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

COMFORT SYSTEMS USA, INC.

/s/ WILLIAM F. MURDY
--------------------------------------
William F. Murdy
Chairman of the Board and
Chief Executive Officer

November 4, 2002

/s/ J. GORDON BEITTENMILLER
--------------------------------------
J. Gordon Beittenmiller
Executive Vice President,
Chief Financial Officer and Director

November 4, 2002

30

CERTIFICATION

I, William F. Murdy, Chairman of the Board and Chief Executive Officer,
certify that:

1. I have reviewed this quarterly report on Form 10-Q of Comfort Systems
USA, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a)
designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared; b) evaluated the
effectiveness of the registrant's disclosure controls and procedures as of a
date within 90 days prior to the filing date of this quarterly report (the
"Evaluation Date"); and c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions): a) all significant deficiencies in the design or
operation of internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in internal
controls; and b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Dated November 4, 2002 /s/ WILLIAM F. MURDY
------------------------------------------------
William F. Murdy
Chairman of the Board and
Chief Executive Officer

CERTIFICATION

I, J. Gordon Beittenmiller, Executive Vice President and Chief Financial
Officer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Comfort Systems
USA, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a)
designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared; b) evaluated the
effectiveness of the registrant's disclosure controls and procedures as of a
date within 90 days prior to the filing date of this quarterly report (the
"Evaluation Date"); and c) presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions): a) all significant deficiencies in the design or
operation of internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in internal
controls; and b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Dated November 4, 2002 /s/ J. GORDON BEITTENMILLER
------------------------------------------------
J. Gordon Beittenmiller
Executive Vice President and
Chief Financial Officer

EXHIBIT INDEX