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 JUNE 30, 2003

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 [ ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ].

The number of shares outstanding of the issuer's common stock, as of August
1, 2003 was 37,919,758.

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COMFORT SYSTEMS USA, INC.

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003

COMFORT SYSTEMS USA, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial
statements.
1

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.
2

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.
3

COMFORT SYSTEMS USA, INC.

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

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

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(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 activities such as electrical service and
plumbing. Approximately 53% of the Company's consolidated 2003 revenues to date
are attributable to installation of systems in newly constructed facilities,
with the remaining 47% attributable to maintenance, repair and replacement
services. The Company's consolidated 2003 revenues to date relate to the
following service activities: HVAC -- 73%, plumbing -- 11%, building automation
control systems -- 7%, and other -- 9%. 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, 2002 (the "Form 10-K").

There were no significant changes in the accounting policies of the Company
during the current 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 full fiscal year.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally
accepted accounting principles requires the use of estimates and assumptions by
management in determining the reported amounts of assets and liabilities,
revenues and expenses and disclosures regarding contingent assets and
liabilities. 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.

CASH FLOW INFORMATION

Cash paid for interest for continuing and discontinued operations for the
six months ended June 30, 2002 and 2003 was approximately $3.7 million and $0.9
million, respectively. Cash paid for income taxes for continuing and
discontinued operations for the six months ended June 30, 2002 and 2003 was
approximately
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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

$7.6 million and $9.6 million, respectively. The cash tax payments for the six
months ended June 30, 2003 include approximately $10.4 million associated with
the sale in 2002 of 19 operations to Emcor Group, Inc. ("Emcor"). These taxes
are included in the caption "Taxes paid related to the sale of businesses" in
the accompanying Consolidated Statement of Cash Flows.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 146, Accounting for
Costs Associated with Exit or Disposal Activities ("SFAS No. 146"). SFAS No. 146
addresses financial accounting and reporting for costs associated with exit or
disposal activities, such as restructurings, involuntarily terminating
employees, and consolidating facilities, where those activities were initiated
after December 31, 2002. The implementation of SFAS No. 146 does not require the
restatement of previously issued financial statements. See Note 5 for a
discussion of restructuring charges recorded during 2003 in accordance with SFAS
No. 146.

In November 2002, the FASB issued Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). It clarifies that a guarantor
is required to recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken in issuing the guarantee, including its
ongoing obligation to stand ready to perform over the term of the guarantee in
the event that the specified triggering events or conditions occur. The
objective of the initial measurement of the liability is the fair value of the
guarantee at its inception. The initial recognition and initial measurement
provisions of FIN 45 are effective for the Company for guarantees issued after
December 31, 2002. Although the Company from time to time guarantees the
performance of systems or designs it provides, the Company does not currently
have any material guarantees.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure." SFAS 148 amends FASB Statement No.
123, "Accounting for Transition for Stock-Based Compensation" to provide
alternative methods of transition for a voluntary change to the fair value-based
method of accounting for stock-based employee compensation. In addition, SFAS
148 amends the disclosure requirements of SFAS 123 to require prominent
disclosures in both annual and interim financial statements of the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. SFAS 148 is effective for fiscal years ending after
December 15, 2002 and the footnote disclosure provisions were adopted by the
Company in the fourth quarter of 2002.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"). FIN 46 expands upon and strengthens
existing accounting guidance that addresses when a company should include in its
financial statements the assets, liabilities and activities of another entity. A
variable interest entity is a corporation, partnership, trust, or any other
legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. FIN 46
requires a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or is entitled to receive a majority of the entity's
residual returns or both. FIN 46 is effective for all new variable interest
entities created or acquired after January 31, 2003. For variable interest
entities created or acquired prior to February 1, 2003, the provisions of FIN 46
must be applied for the first interim or annual period beginning after June 15,
2003. The Company is currently evaluating the effect that adoption of FIN 46
will have on its consolidated financial condition or results of operations.

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
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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

been aggregated, as no individual operating unit is material and the operating
units meet a majority of the aggregation criteria.

STOCK-BASED COMPENSATION

The Company accounts for its stock-based compensation using the intrinsic
value method under Accounting Principles Board Statement No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"). Under this accounting method, no expense
in connection with the stock option plan is recognized in the consolidated
statements of operations when the exercise price of the stock options is greater
than or equal to the value of the Common Stock on the date of grant. In October
1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation,"
which requires that if a company accounts for stock-based compensation in
accordance with APB 25, the company must also disclose the effects on its
results of operations as if an estimate of the value of stock-based compensation
at the date of grant was recorded as an expense in the company's statement of
operations. These effects for the Company are as follows (in thousands, except
per share data):

Stock Option Plans -- The effects of applying SFAS No. 123 in the pro forma
disclosure may not be indicative of future amounts as additional option awards
in future years are anticipated. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following assumptions:

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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

During the second quarter of 2003, the Company sold an operating company.
This unit's operating income of $0.1 million, net of taxes, in each of the first
six months of 2002 and 2003 has been reported in discontinued operations under
"Operating income (loss), net of applicable income taxes" in the Company's
statement of operations. In the first quarter of 2003, the Company recorded an
estimated loss of $0.9 million, including taxes, related to this transaction in
"Estimated loss on disposition, including income taxes" in the Company's
statement of operations.

On March 1, 2002, the Company sold 19 operations to Emcor. 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 the second quarter of 2002,
Emcor paid the Company that amount, and released $2.5 million that had been
escrowed in connection with this element of the transaction.

Of Emcor's purchase price, $5 million 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. Of this escrow, $4
million has been applied in determining the Company's liability to Emcor in
connection with the settlement of certain claims as described subsequently in
this section. The remaining $1 million of escrow is available for book purposes
to apply to any future claims and contingencies in connection with this
transaction, and has not been recognized as part of the Emcor transaction
purchase price.

The net cash proceeds of approximately $150 million received to date from
the Emcor transaction have been used to reduce the Company's debt. The Company
paid $10.4 million of taxes related to this transaction in March 2003.

In the fourth quarter of 2002, the Company recognized a charge of $1.2
million, net of tax benefit of $2.7 million, in "Estimated loss on disposition,
including income taxes" in the Company's statement of operations in connection
with the Emcor transaction. This charge primarily relates to a settlement with
Emcor for reimbursement of impaired assets and additional liabilities associated
with the operations acquired from the Company. Under this settlement, the
Company was released from liability on all other outstanding receivables and
issues relating to the profitability of projects that were in process at the
time Emcor acquired these operations. During May 2003, the Company paid $2.7
million in cash to Emcor associated with this settlement. The settlement
agreement also included the use of $2.5 million of the $5 million escrow
described above to fund settled claims. The Company further recognized an
additional $1.5 million of the remaining escrow applicable to elements of the
settlement still to be funded. Accordingly, for book purposes, $1.0 million of
escrow remains available to apply against future claims that may arise from
Emcor in connection with this transaction. The Company recorded a tax benefit of
$1.4 million related to this additional charge. In addition, the $1.2 million
charge recognized during the fourth quarter of 2002 is also net of a tax credit
of $1.3 million as a result of lower final tax liabilities in connection with
the overall Emcor transaction than were originally estimated in the first
quarter of 2002.
8

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 for all periods presented
through the sale, 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 an aggregate loss of $11.8 million, including related tax
expense, in connection with 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 tax benefit, as of January 1, 2002. The reporting of the
Company's aggregate initial 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. In the first quarter of 2002, the Company recorded an
estimated loss of $0.4 million, net of tax benefit, from this planned
disposition in "Estimated loss on disposition, including income taxes" in the
Company's statement of operations. In the fourth quarter of 2002, the Company
reversed this estimated loss because the Company decided not to sell this unit.

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 tax benefit, 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 $0.2
million, net of tax benefit, on the sale of this division. This loss is included
in "Estimated loss on disposition, including income taxes" during the second
quarter of 2002 in the Company's statement of operations.

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):

Interest expense allocated to the discontinued operations in the first
quarter of 2002 was $1.5 million. This amount was allocated based upon the
Company's net investment in these operations.

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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

4. GOODWILL

In most businesses the Company has acquired, the value paid to buy the
business was greater than the value of specifically identifiable net assets in
the business. Under generally accepted accounting principles, this excess is
termed goodwill and is recognized as an asset at the time the business is
acquired. It is generally expected that future net earnings from an acquired
business will exceed the goodwill asset recognized at the time the business is
bought. Under previous generally accepted accounting principles, goodwill was
required to be amortized, or regularly charged to the Company's operating
results in its statement of operations.

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 tax benefit, and was recorded during
the first quarter of 2002. Impairment charges recognized after the initial
adoption, if any, generally are to be reported as a component of operating
income.

The changes in the carrying amount of goodwill for the year ended December
31, 2002 and the six months ended June 30, 2003 are as follows (in thousands):

Goodwill balance as of January 1, 2002 (a).................. $ 438,448
Impairment adjustment....................................... (229,056)
Goodwill related to sale of operations...................... (95,965)
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Goodwill balance as of December 31, 2002(a)................. 113,427
Goodwill related to sale of operation....................... (882)
---------
Goodwill balance as of June 30, 2003........................ $ 112,545
=========

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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.

5. RESTRUCTURING CHARGES

During the first two quarters of 2003, the Company recorded restructuring
charges of approximately $2.3 million pre-tax. These charges included
approximately $1.3 million for severance costs and stay bonuses primarily
associated with the curtailment of the Company's energy efficiency activities, a
reorganization of the Company's national accounts operations as well as a
reduction in corporate personnel. The severance costs and stay bonuses related
to the termination of 87 employees (81 of these employees had been terminated as
of June 30, 2003). In addition, these charges include approximately $0.9 million
for remaining lease obligations
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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

and $0.1 million of other costs recorded in connection with the actions
described above. An additional $0.3 to $0.7 million is expected to be incurred
during the second half of 2003 for additional severance costs and remaining
lease obligations associated with these restructuring actions.

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
office overhead in light of the Company's smaller size following the Emcor
transaction. The severance costs related to the termination of 33 employees,
none of whom were employed 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 second half of 2000, the Company recorded restructuring charges
of approximately $25.3 million primarily associated with restructuring efforts
at certain underperforming operations and its decision to cease its e-commerce
activities at Outbound Services, a subsidiary of the Company. As of December 31,
2002 and June 30, 2003, accrued lease termination costs of $0.8 million and $0.6
million, respectively, remain that were associated with these restructuring
charges.

The following table shows the remaining liabilities associated with the
cash portion of the restructuring charges as of December 31, 2002 and June 30,
2003 (in thousands):

6. LONG-TERM DEBT OBLIGATIONS

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

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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CREDIT FACILITY

The Company's primary current debt financing capacity consists of a $54
million senior credit facility (the "Facility") provided by a syndicate of three
financial institutions led by General Electric Capital Corporation ("GE"). 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 replaced the Company's previous revolving credit
facility. The Facility consists of two parts: a term loan and a revolving credit
facility.

The term loan under the Facility (the "Term Loan") was originally $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 prepayments of the Term Loan in certain
circumstances. Approximately half of any free cash flow (as defined in the
Facility agreement -- 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 did not have any prepayments of the Term Loan due
as of December 31, 2002 under this requirement, primarily as a result of the
significant amount of voluntary prepayments of debt made by the Company during
2002. 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. As of June 30, 2003, $13.7
million was outstanding under the Term Loan.

The Facility also includes a three-year $40 million revolving credit
facility (the "Revolving Loan"). Under this revolving credit facility, the
Company can borrow up to $20 million, with the difference between actual
borrowings and $40 million available for letter of credit issuance up to a
maximum of $20 million in letters of credit. Capacity under the Revolving Loan
is also limited by the leverage and fixed charge coverage covenants described
below under "Restrictions and Covenants" and "Amounts Outstanding and Capacity."
As noted in the latter section, under the most restrictive of these capacity
provisions, the Company's current borrowing capacity, on a monthend measurement
basis, is $5.0 million. Borrowing capacity can be greater than this amount on an
intra-month basis. Letters of credit currently outstanding are $19.7 million.

A common practice in the Company's industry is the posting of payment and
performance bonds with customers. These bonds are provided by financial
institutions known as sureties, and provide assurance to the customer that in
the event the Company encounters significant financial or operational
difficulties, the surety will arrange for the completion of the Company's
contractual obligations on a project and the payment of the Company's vendors on
the project. The Company has reached a preliminary agreement with its surety and
GE to grant the surety a secured interest in assets such as receivables, costs
incurred in excess of billings, and equipment related to projects for which
bonds are outstanding as collateral for potential obligations under bonds. As of
June 30, 2003, the amount of these assets is approximately $39.6 million. The
Company has also posted a $5 million letter of credit as collateral for
potential obligations under bonds.

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
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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

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 $0.4 million per quarter. To the extent prepayments of
the Term Loan are made or the size of the Facility is reduced, the Company may
have to accelerate amortization of these deferred financing and professional
costs. During the first quarter of 2003, the Company charged approximately $0.8
million of deferred financing costs to interest expense that were associated
with higher levels of capacity under the Facility than the current total of $54
million.

The weighted average interest rate that the Company currently pays on
borrowings under the Facility is 5.5% per annum. This reflects a combination of
borrowings under both interest rate options described above, as well as the swap
of floating rates to a fixed rate described above. This rate does not include
amortization of debt financing and arrangement costs, or adjustments for
derivatives.

INTEREST RATE DERIVATIVE

The rates underlying the interest rate terms of the Facility 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 required that the Company
convert these floating interest rate terms on at least half of the original Term
Loan to fixed rates for at least a one-year term. In January 2003, the Company
converted $10 million of principal value to a fixed LIBOR-based interest rate of
5.62% for an eighteen-month term. This was done via a transaction known as a
"swap" under which the Company agreed to pay fixed interest rate payments on $10
million for eighteen months to a bank in exchange for receiving from the bank
floating LIBOR interest rate payments on $10 million for the same term.

This transaction is a derivative and has been designated a cash flow
hedging instrument under applicable generally accepted accounting principles.
Changes in market interest rates in any given period may increase or decrease
the valuation of the Company's obligations to the bank under this swap versus
the bank's obligations to the Company. So long as the instrument remains
"effective" as defined under applicable generally accepted accounting
principles, such changes in market valuation are reflected in stockholders'
equity as other comprehensive income (loss) for that period, and not in the
Company's statement of operations. If the swap is terminated earlier than its
eighteen-month term, any gain or loss on settlement will be reflected in the
Company's statement of operations. The swap was effective as a hedge for
accounting purposes from its inception through June 30, 2003, and the Company
expects it to continue to be effective throughout its term.

During the six months ended June 30, 2003, a reduction to stockholders'
equity of $0.1 million, net of tax, was recorded through other comprehensive
income (loss) and is included in other current liabilities in the Company's
consolidated balance sheet. The counterparty to the above derivative agreement
is a major bank. Based on its continuing review of the financial position of
this bank, the Company believes there is minimal risk that the bank will not
meet its obligations to the Company under this swap.

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COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CREDIT FACILITY WARRANT

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, less amortization to date of $0.3 million, is reflected as a discount
of the Company's obligation under the Facility and is being amortized over the
term of the Facility, as described above. This warrant and put obligation are
also recorded as a liability in the Company's balance sheet. 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 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 gain
included in interest expense related to the warrant's mark-to-market obligation
during the six months ended June 30, 2003 was $0.1 million.

The table below provides an indication of the potential effect on the
valuation of this derivative that might result from changes in the market price
for the Company's stock. In this table, the value of the warrant has been
calculated based upon the stock price being $1 lower and $1 higher than the
Company's closing stock price at June 30, 2003 (value of warrant and put
obligation in thousands).

- ---------------

(a) This was the Company's closing stock price on June 30, 2003.

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") also known as the leverage covenant, and by the
Company's ratio of EBITDA less taxes and capital expenditures to interest
expense and scheduled principal 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 and excludes cash balances in certain of the Company's bank accounts.

The definition of EBITDA under the Facility excludes certain items,
generally non-cash 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.

14

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The financial covenants under the Facility are summarized below. Covenant
compliance is measured on a monthly basis. Intra-quarter monthly covenants are
at either the same or very similar levels to the quarter-end covenants shown
below. EBITDA amounts are in thousands.

The Company's trailing twelve months EBITDA as of December 31, 2002 as
determined under the Facility did not comply with the covenant then in effect.
The Company's lenders waived this violation and agreed to modify the Company's
minimum EBITDA, leverage and fixed charge covenants for 2003. Even at these
modified levels, these covenants leave only moderate room for variance based on
the Company's recent performance. If the Company again violates a covenant under
the Facility, the Company may have to negotiate new borrowing terms under the
Facility or obtain new financing. While the Company believes that its levels of
debt in comparison to its EBITDA and its cash flows would enable the Company to
negotiate new borrowing terms under the Facility or to obtain new financing from
other sources if necessary, there can be no assurance that the Company would be
successful in doing so.

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

15

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

AMOUNTS OUTSTANDING AND CAPACITY

Apart from the Term Loan, the Company's available credit capacity under the
Facility is governed by the nominal limits of the Facility, and by calculated
limits based on the leverage and fixed charge coverage covenants described
above. Available credit capacity is limited to the most restrictive of these
measures. The nominal limits are in effect at all times. The leverage provision
limits borrowings that can be outstanding at monthend. The fixed charge
provision limits amounts that can be outstanding at monthend, or at any other
time that GE requests that this covenant be measured. Even though available
credit capacity under the leverage provision is only measured at monthend, it is
presented below because it is the most restrictive of these limitations as of
recent monthends. Available capacity under the Revolving Loan can be greater
than the amount below on an intra-month basis.

The following recaps the Company's debt amounts outstanding and capacity
(in thousands):

OTHER LONG-TERM OBLIGATIONS DISCLOSURES

The Company has generated positive cash flow in most recent periods, and it
currently has a moderate level of debt. The Company anticipates that cash flow
from operations and credit capacity under the Facility will provide the Company
with sufficient liquidity to fund its operations for the foreseeable future.
However, the Company does not have a significant amount of excess credit
capacity in comparison to expected working capital requirements over the balance
of 2003. The Company believes that its levels of debt in comparison to its
EBITDA and its cash flows would enable it to obtain new financing if necessary,
but there can be no assurance that it would be successful in doing so.

As described above, the financial covenants under the Company's credit
facility leave only moderate room for variance based on the Company's recent
performance. If the Company again violates a covenant under the Facility, the
Company may have to negotiate new borrowing terms under the Facility or obtain
new financing. While the Company believes that its levels of debt in comparison
to its EBITDA and its cash flows would enable the Company to negotiate new
borrowing terms under the Facility or to obtain new financing from other sources
if necessary, there can be no assurance that the Company would be successful in
doing so.

Certain of the Company's vendors require letters of credit to ensure
reimbursement for amounts they are disbursing on the Company's behalf, such as
to beneficiaries under its self-funded insurance programs. Some customers also
require the Company to post letters of credit to guarantee performance under its
contracts and to ensure payment to its subcontractors and vendors under those
contracts. 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

16

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

The Company currently has $19.7 million in letters of credit outstanding.
The Company self-insures a significant portion of its worker's 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 has
posted $13.2 million in letters of credit. 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 2003.
Accordingly, the Company's letter of credit requirements over the next year may
exceed the current letter of credit sublimits 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 levels of debt in comparison to
its EBITDA and its 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 assurance that the Company would be
successful in doing so.

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.

SURETY

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 who provided goods and services under a
contract. 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.

Surety market conditions are currently difficult as a result of significant
losses incurred by many sureties in recent periods, both in the construction
industry as well as in certain larger corporate bankruptcies. As a result, less
bonding capacity is available in the market and terms have become more
restrictive. Further, under standard terms in the surety market, sureties issue
bonds on a project-by-project basis, and can decline to issue bonds at any time.
Historically, approximately 25% of the Company's business has required bonds.
While the company has enjoyed a longstanding relationship with its surety,
current market conditions as well as changes in the surety's assessment of the
Company's operating and financial risk could cause the surety to decline to
issue bonds for the Company's work. If that were to occur, the alternatives
include doing more business that does not require bonds, posting other forms of
collateral for project performance such as letters of credit or cash, and
seeking bonding capacity from other sureties. The Company would likely also
encounter concerns from customers, suppliers and other market participants as to
its creditworthiness. While the Company believes its general operating and
financial performance would enable it to ultimately respond effectively to an
17

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

interruption in the availability of bonding capacity, such an interruption would
likely cause the Company's revenues and profits to decline in the near term.

SELF-INSURANCE

The Company is substantially self-insured for worker's compensation,
employer's liability, auto liability, general liability and employee group
health claims in view of the relatively high deductibles under the Company's
insurance arrangements for these risks. Losses up to deductible amounts are
estimated and accrued based upon known facts, historical trends and industry
averages. A third-party actuary reviews these estimates annually.

A wholly-owned insurance company subsidiary reinsures a portion of the risk
associated with surety bonds that were issued on the Company's behalf from 1998
through 2000 by a third-party insurance company. No significant claims have been
made against these bonds and management does not expect any material claims will
be made in connection with these bonds in the foreseeable future.

8. STOCKHOLDERS' EQUITY

RESTRICTED STOCK GRANTS

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 certain performance measures for the twelve-month period
ending March 31, 2003 which were met by the Company. The shares are subject to
forfeiture if the executive leaves voluntarily or is terminated for cause. Such
forfeiture provisions lapse pro rata over a four-year period.

The Company awarded 75,000 shares of restricted stock to its President on
November 1, 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 December 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 the grants 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, and was reflected as a reduction of
stockholders' equity for unearned compensation. This value, and the related
compensation expense, will be adjusted up or down based on the market price of
the Company's stock during the first year following each respective grant while
the performance conditions are in effect. If the performance conditions are met,
the value of the award will then be fixed based on the market price of the
Company's stock at that time, and charged to earnings over the remaining
three-year vesting period.

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
18

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 is reflected as a
discount of the Company's obligations under its debt facility with GE, less
amortization to date of $0.3 million, and as an 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 obligation, 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 gain included in interest expense
related to the warrant's mark-to-market obligation for the six months ended June
30, 2003 was $0.1 million.

RESTRICTED COMMON STOCK

In March 1997, Notre Capital Ventures II, L.L.C. ("Notre") 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 to 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 June 30, 2003, there
were 1,127,612 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,
convertible subordinated notes, warrants and contingently issuable restricted
stock.

The exercise prices for options to purchase 4.8 million shares of the
Company's Common Stock ("Common Stock") at prices ranging from $2.875 to $21.44
per share were greater than the average market price of the Common Stock for the
three months ended June 30, 2003. Under the calculations normally required by
generally accepted accounting principles for determining EPS, including the
effect of these options would increase diluted EPS, or have an "anti-dilutive"
effect. When this situation occurs, generally accepted accounting principles
require that such options or other common stock equivalents be excluded from the
determination of diluted EPS. Accordingly, they have been excluded. Options to
purchase 2.7 million shares of Common Stock at prices ranging from $6.00 to
$21.44 per share were outstanding for the three months and six months ended June
30, 2002, but were not included in the computation of diluted EPS for the same
reason.

19

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Options had an anti-dilutive effect for the six months ended June 30, 2003
because the Company reported a loss from continuing operations during this
period. Accordingly, options were not included in the diluted EPS calculation
for this period. The Company would have included 103,949 shares related to the
dilutive impact of options for this period if it were not for the loss from
continuing operations during the period.

As noted above, the Company granted GE, its primary lender, a warrant to
purchase 409,051 shares of Company common stock for nominal consideration. The
dilutive impact of these warrants is computed assuming the issuance of shares
required to fulfill the warrant obligation at the end of the reporting period
and excluding the effect on the income statement for the period of any
mark-to-market adjustments made in connection with valuing the warrants. When
this is done for the three months ended June 30, 2003, the warrants have an
anti-dilutive effect on diluted EPS and accordingly they are not included in the
determination of diluted EPS. Had the warrants not been anti-dilutive, the
Company would have included 1,173,183 shares in the diluted EPS calculation for
the three months ended June 30, 2003. The after-tax gain related to the
warrant's mark-to-market adjustment was $0.1 million for the six months ended
June 30, 2003 and this amount is added to net income for purposes of calculating
diluted EPS.

The shares associated with contingently issuable restricted stock grants
described above are included in the diluted EPS calculation for the three months
ended June 30, 2003 because it is probable that the performance requirements for
the issuance of these shares will be met. These shares had an anti-dilutive
effect for the six months ended June 30, 2003 since the Company had a loss from
continuing operations for the period. Accordingly, these shares were not
included in the determination of diluted EPS for that period.

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):

- ---------------

(a) Excludes 225,000 shares of contingently issuable restricted stock
outstanding as of June 30, 2003 (see "Restricted Stock Grant" paragraphs
above).

20

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 our historical
Consolidated Financial Statements 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, 2002 (the
"Form 10-K"). This discussion contains "forward-looking statements" regarding
our business and industry within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements are based on our current plans
and expectations and involve risks and uncertainties that could cause our actual
future activities and results of operations to be materially different from
those set forth in the forward-looking statements. Important factors that could
cause actual results to differ include risks set forth in "Factors Which May
Affect Future Results," included in our Form 10-K.

We are a national provider of comprehensive heating, ventilation and air
conditioning ("HVAC") installation, maintenance, repair and replacement services
within the mechanical services industry. We operate primarily in the commercial
and industrial HVAC markets and perform most of our services within office
buildings, retail centers, apartment complexes, manufacturing plants, and
healthcare, education and government facilities. In addition to standard HVAC
services, we provide specialized applications such as building automation
control systems, fire protection, process cooling, electronic monitoring and
process piping. Certain locations also perform related activities such as
electrical service and plumbing. The segment of the HVAC industry we serve can
be broadly divided into two service functions: installation in newly constructed
facilities, which has provided approximately 53% of our 2003 revenues to date,
and maintenance, repair and replacement, which has provided the remaining 47% of
our 2003 revenues to date. Our consolidated 2003 revenues to date are derived
from the following service activities, all of which are in the mechanical
services industry, the single industry segment we serve:

In response to the Securities and Exchange Commission's Release No.
33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting
Policies", we identified our critical accounting policies based upon the
significance of the accounting policy to our overall financial statement
presentation, as well as the complexity of the accounting policy and our use of
estimates and subjective assessments. We have concluded that our most critical
accounting policy is our revenue recognition policy. As discussed elsewhere in
this report, our business has two service functions: (i) installation, which we
account for under the percentage of completion method, and (ii) maintenance,
repair and replacement, which we account for as the services are performed, or
in the case of replacement, under the percentage of completion method. In
addition, we identified other critical accounting policies related to our
allowance for doubtful accounts receivable, the recording of our self-insurance
liabilities and the assessment of goodwill impairment. These accounting
policies, as well as others, are described in Note 2 to the Consolidated
Financial Statements included in our Form 10-K.

PERCENTAGE OF COMPLETION METHOD OF ACCOUNTING

Under the percentage of completion method of accounting as provided by
American Institute of Certified Public Accountants Statement of Position 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts," contract revenue recognizable at any time during the life of a
contract is determined by multiplying expected total contract revenue by the
percentage of contract costs incurred at any
21

time to total estimated contract costs. More specifically, as part of the
negotiation and bidding process in which we engage in connection with obtaining
installation contracts, we estimate our 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. Then, as we perform under those contracts, we
measure such costs incurred, compare them to total estimated costs to complete
the contract, and recognize a corresponding proportion of contract revenue. As a
result, contract revenues recognized in the statement of operations can and
usually do differ from amounts that can be billed or invoiced to the customer at
any point during the contract.

The percentage of completion method of accounting is also affected by
changes in job performance, job conditions, and final contract settlements.
These factors may result in revisions to estimated costs and, therefore,
revenues. Such revisions are frequently based on further estimates and
subjective assessments, and we recognize these revisions in the period in which
they are determined. If such revisions lead us to conclude that we will
recognize a loss on a contract, the full amount of the estimated ultimate loss
is recognized in the period we reach that conclusion, regardless of the
percentage of completion of the contract. Depending on the size of a project,
variations from estimated project costs could have a significant impact on our
operating results.

ACCOUNTING FOR ALLOWANCE FOR DOUBTFUL ACCOUNTS

We are required to estimate the collectibility of accounts receivable.
Inherent in the assessment of the allowance for doubtful accounts are certain
judgments and estimates including, among others, the creditworthiness of the
customer, our prior collection history with the customer, the ongoing
relationships with our customers, the aging of past due balances, our lien
rights, if any, in the property where we performed the work, and the
availability, if any, of payment bonds applicable to our contract. These
estimates are re-evaluated and adjusted as additional information is received.

ACCOUNTING FOR SELF-INSURANCE LIABILITIES

We are substantially self-insured for worker's compensation, employer's
liability, auto liability, general liability and employee group health claims in
view of the relatively high deductibles under our insurance arrangements for
these risks. Losses up to deductible amounts are estimated and accrued based
upon known facts, historical trends and industry averages. A third-party actuary
reviews these estimates annually. We believe such accruals to be adequate.
However, insurance liabilities are difficult to estimate due to unknown factors,
including the severity of an injury, the determination of our liability in
proportion to other parties, timely reporting of occurrences and the
effectiveness of safety and risk management programs. Therefore, if actual
experience differs from the assumptions and estimates used for recording the
liabilities, adjustments may be required and would be recorded in the period
that the experience becomes known.

ACCOUNTING FOR GOODWILL AND OTHER INTANGIBLE ASSETS

In most businesses we have acquired, the value we paid to buy the business
was greater than the value of specifically identifiable net assets in the
business. Under generally accepted accounting principles, this excess is termed
goodwill and is recognized as an asset at the time the business is acquired. It
is generally expected that future net earnings from an acquired business will
exceed the goodwill asset recognized at the time the business is bought. Under
previous generally accepted accounting principles, goodwill was required to be
amortized, or regularly charged to our operating results in our statement of
operations.

Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets." This new
standard has two effects. First, we are no longer required to amortize goodwill
against our operating results. Second, we are required to regularly test the
goodwill on our books to determine whether its value has been impaired, and if
it has, to immediately write off, as a component of operating income, the amount
of the goodwill that is impaired.

More specifically, we are required to assess our goodwill asset amounts for
impairment each year, and more frequently if circumstances suggest an impairment
may have occurred. The new requirements for
22

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.

As part of the adoption of SFAS No. 142, we were required to make a
one-time determination of any transitional impairment loss by applying the
standard's new, more rigorous valuation methodology. The result of this
transitional analysis was a $202.5 million charge, net of tax benefit, reflected
as a cumulative effect of a change in accounting principle in our statement of
operations in the first quarter of 2002.

RESULTS OF OPERATIONS

Revenues -- Revenues decreased $9.1 million, or 4.3%, to $202.4 million for
the second quarter of 2003 and decreased $16.4 million, or 4.1%, to $384.8
million for the first six months of 2003 compared to the same periods in 2002.
The 4.3% decline in revenue for the quarter was comprised of a 3.4% decline in
revenue at ongoing operations and a 0.9% decline in revenue related to
operations that were sold during 2003. The 4.1% decline in revenue for the first
six months of 2003 was comprised of a 3.2% decline in revenue at ongoing
operations and a 0.9% decline in revenue related to operations that were sold
during 2003.

The decline in revenues at ongoing operations in 2003 resulted primarily
from continued economic weakness in several markets. In addition, the general
economic slowdown in the U.S. which began in 2001 led to deferrals in both new
and replacement project activity, and has also resulted in a more competitive
pricing environment. This slowdown worsened in late 2002 and early 2003 based on
renewed uncertainty about the economy and international events. We and other
industry participants believe that there has been a general deferral of
maintenance and replacement activity in the installed base of
commercial/industrial HVAC equipment in response to the more difficult economy.
We and other industry participants believe this trend will not continue
indefinitely due to the fundamental operating needs of the equipment, but it is
not clear when maintenance and replacement activity might increase. In addition,
while we have seen some signs that activity levels in our industry may increase
over the next year as compared to current levels, there can be no assurance

23

that this will occur. In view of the decreased economic activity and increased
price competition affecting our industry, we 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,
we may realize further decreases in revenue and lower operating margins.

Backlog primarily contains installation and replacement project work, 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
our revenues for any given future period, and it represents revenues that are
likely to be reflected in our operating results over the next six to twelve
months. As a result, we believe the predictive value of backlog information is
limited to indications of general revenue direction over the near term, and
should not be interpreted as indicative of ongoing revenue performance over
several quarters.

Backlog associated with continuing operations as of June 30, 2003 was
$457.4 million, a 5.1% increase from December 31, 2002 backlog of $435.1 million
and a decrease of $3.6 million, or 0.8%, from June 30, 2002 backlog of $461.0
million. During the fourth quarter of 2002, we removed $16.0 million from
backlog that related to a project that we now believe will not proceed. This
project was first reflected in backlog in the third quarter of 2001. If this
project is excluded from June 30, 2002 backlog, our backlog reflected an
increase of 2.8% from an adjusted June 30, 2002 backlog of $445.0 million.

Gross Profit -- Gross profit decreased $3.7 million, or 9.6%, to $34.8
million for the second quarter of 2003 and decreased $6.2 million, or 9.0%, to
$62.6 million for the first six months of 2003 compared to the same periods in
2002. As a percentage of revenues, gross profit decreased from 18.2% for the
three months ended June 30, 2002 to 17.2% for the three months ended June 30,
2003 and decreased from 17.1% for the six months ended June 30, 2002 to 16.3%
for the six months ended June 30, 2003.

The decline in gross profit in the second quarter of 2003 as compared to
the second quarter of 2002 is primarily due to lower industry activity levels
and increased price competition. These factors also contributed to the decline
in gross profit for the first six months of 2003 as compared to the same period
in 2002, along with adverse cost developments on certain projects in two of our
operations during the first quarter of 2003.

Selling, General and Administrative Expenses ("SG&A") -- SG&A decreased
$1.1 million, or 3.5%, to $29.4 million for the second quarter of 2003 and
decreased $2.5 million, or 4.0%, to $60.3 million for the first six months of
2003 compared to the same periods in 2002. As a percentage of revenues, SG&A
increased from 14.4% for the three months ended June 30, 2002 to 14.5% for the
three months ended June 30, 2003 and remained flat at 15.7% for the six months
ended June 30, 2003 compared to the six months ended June 30, 2002. During the
second quarter of 2002, we reversed $0.8 million of the bad debt reserves that
were established in the fourth quarter of 2001 related to our receivables with
Kmart as a result of a settlement with Kmart. Accordingly, the decrease in
normal SG&A from 2002 to 2003 was greater by this amount. The decrease is
primarily due to a concerted effort to reduce SG&A throughout our company. This
effort included a reduction in corporate overhead at the end of the first
quarter of 2002 in response to our smaller size following the sale of 19 units
to Emcor as discussed further below under "Discontinued Operations." We also
initiated further steps in the second quarter of 2003 to reduce overhead both in
our corporate office and in our field operations based on continuing weakness in
industry activity levels and pricing.

Restructuring Charges -- During the first two quarters of 2003, we recorded
restructuring charges of approximately $2.3 million pre-tax. These charges
included approximately $1.3 million for severance costs and stay bonuses
primarily associated with the curtailment of our energy efficiency activities, a
reorganization of our national accounts operations as well as a reduction in
corporate personnel. The severance costs and stay bonuses related to the
termination of 87 employees (81 of these employees had been terminated as of
June 30, 2003). In addition, these charges include approximately $0.9 million
for remaining lease obligations and $0.1 million of other costs recorded in
connection with the actions described above. An additional $0.3 to $0.7 million
is expected to be incurred during the second half of 2003 for additional
severance costs and remaining lease obligations associated with these
restructuring actions.

24

During the first quarter of 2002, we 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 office
overhead in light of our smaller size following the Emcor transaction. The
severance costs related to the termination of 33 employees, none of whom were
employed 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.

Other Expense, Net -- Other expense, net, primarily includes interest
expense, and increased $0.7 million to $1.0 million for the second quarter of
2003 and increased $0.7 million to $2.6 million for the first six months of 2003
compared to the same periods in 2002. Interest expense for the first quarter of
2003 includes a charge of $0.8 million for deferred financing costs that were
associated with previously higher levels of capacity under our credit facility.
In addition, first quarter 2003 includes a loss of $0.3 million on the
disposition of a division of one of our operations. A portion of our actual
interest expense in the first quarter of 2002 was allocated to the discontinued
operations caption based upon our 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 March 31,
2002 was $1.5 million. 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 our
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 our operations.

Income Tax Expense (Benefit) -- Our effective tax rates associated with
results from continuing operations for the six months ended June 30, 2002 and
2003 were 49.1% and 47.0%, respectively. These effective rates are higher than
statutory rates because of the effect of certain expenses that we incur that are
not deductible for tax purposes. In addition, since our current pre-tax profit
margins are relatively low on a historical and an absolute basis, the impact of
these non-deductible expenses on our effective rate is increased.

During the first quarter of 2003, we reported an effective tax rate of only
33.0%, as we incurred a pre-tax loss during that period and believed it more
conservative to limit the amount of tax benefit recognized when a loss is
incurred early in the year. Because we now believe we will report pre-tax income
for the year as a whole, we adjusted our year-to-date effective tax rate to
47.0%, the level we currently expect to be applicable for our full-year results.
As a result of this year-to-date adjustment, our effective rate for the second
quarter was 21.8%. During quarters in which we report pre-tax profits, it is
more typical for our effective tax rate for the quarter to be similar to our
current year-to-date effective rate.

Discontinued Operations -- During the second quarter of 2003, we sold an
operating company. This unit's operating income of $0.1 million, net of taxes,
in each of the first six months of 2002 and 2003 has been reported in
discontinued operations under "Operating results, net of tax" in our results of
operations. In the first quarter of 2003, we recorded an estimated loss of $0.9
million, including taxes, related to this transaction in "Estimated loss on
disposition, including tax" in our results of operations.

On March 1, 2002, we sold 19 operations to Emcor Group. 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 the second quarter of 2002,
Emcor paid us that amount, and released $2.5 million that had been escrowed in
connection with this element of the transaction.

Of Emcor's purchase price, $5 million was deposited into an escrow account
to secure potential obligations on our part to indemnify Emcor for future claims
and contingencies arising from events and

25

circumstances prior to closing, all as specified in the transaction documents.
Of this escrow, $4 million has been applied in determining the Company's
liability to Emcor in connection with the settlement of certain claims as
described subsequently in this section. The remaining $1 million of escrow is
available for book purposes to apply to any future claims and contingencies in
connection with this transaction, and has not been recognized as part of the
Emcor transaction purchase price.

The net cash proceeds of approximately $150 million received to date from
the Emcor transaction have been used to reduce our debt. We paid $10.4 million
of taxes related to this transaction in March 2003.

In the fourth quarter of 2002, we recognized a charge of $1.2 million, net
of tax benefit of $2.7 million, in "Estimated loss on disposition, including
tax" in our results of operations in connection with the Emcor transaction. This
charge primarily relates to a settlement with Emcor for reimbursement of
impaired assets and additional liabilities associated with the operations
acquired from us. Under this settlement, we were released from liability on all
other outstanding receivables and issues relating to the profitability of
projects that were in process at the time Emcor acquired these operations from
us. During May 2003, we paid $2.7 million in cash to Emcor associated with this
settlement. The settlement agreement also included the use of $2.5 million of
the $5 million escrow described above to fund settled claims. We further
recognized an additional $1.5 million of the remaining escrow applicable to
elements of the settlement still to be funded. Accordingly, for book purposes,
$1.0 million of escrow remains available to apply against future claims that may
arise from Emcor in connection with this transaction. We recorded a tax benefit
of $1.4 million related to this additional charge. In addition, the $1.2 million
charge recognized during the fourth quarter of 2002 is also net of a tax credit
of $1.3 million as a result of lower final tax liabilities in connection with
the overall Emcor transaction than we originally estimated in the first quarter
of 2002.

Under SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," which took effect for us on January 1, 2002, the operating
results of the companies sold to Emcor for all periods presented through the
sale, as well as the loss on the sale of these operations, have been presented
as discontinued operations in our results of operations. We realized an
aggregate loss of $11.8 million, including related tax expense, in connection
with the sale of these operations. As a result of the adoption of SFAS No. 142
"Goodwill and Other Intangible Assets," we also recognized a goodwill impairment
charge related to these operations of $32.4 million, net of tax benefit, as of
January 1, 2002. The reporting of our aggregate initial 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, we also decided to divest of an additional operating
company. In the first quarter of 2002, we recorded an estimated loss of $0.4
million, net of tax benefit, from this planned disposition in "Estimated loss on
disposition, including tax" in our results of operations. In the fourth quarter
of 2002, we reversed this estimated loss because we decided not to sell this
unit.

During the second quarter of 2002, we sold a division of one of our
operations. The operating loss for this division for the first two quarters of
2002 of $0.3 million, net of tax benefit, has been reported in discontinued
operations under "Operating results, net of tax" in our results of operations.
We realized a loss of $0.2 million, net of tax benefit, on the sale of this
division. This loss is included in "Estimated loss on disposition, including
tax" during the second quarter of 2002 in our results of operations.

Cumulative Effect of Change in Accounting Principle -- Effective January 1,
2002, we adopted SFAS No. 142, "Goodwill and Other Intangible Assets," which
required a transitional assessment of our goodwill assets.

To perform the transitional impairment testing required by SFAS No. 142
under its new, more rigorous impairment criteria, we broke our 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.
26

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 our results of operations. The resulting non-cash charge
was $202.5 million, net of tax benefit, and was recorded during the first
quarter of 2002.

Outlook -- As noted above, we have reported lower earnings in 2003 than in
2002. This resulted from several factors that coincided with what is
traditionally our period of lower seasonal activity during the year. Foremost
among these factors, as noted above, were adverse cost developments in certain
projects in two of our operations, and reduced activity levels and increased
price competition stemming from the general economic slowdown which began in
2001 and which worsened in late 2002 and early 2003 based on renewed uncertainty
about the economy and international events.

We and other industry participants believe that there has been a general
deferral of maintenance and replacement activity in the installed base of
commercial/industrial HVAC equipment in response to the more difficult economy.
We and other industry participants believe this trend will not continue
indefinitely due to the fundamental operating needs of the equipment, but it is
not clear when maintenance and replacement activity might increase. In addition,
while we have seen some signs that activity levels in our industry may increase
over the next year as compared to current levels, there can be no assurance that
this will occur. Based on these indications as well as significant cost
reductions we have initiated, we expect to be profitable in 2003 as a whole.
Because industry conditions have not improved to the degree we expected when we
commented on our 2003 outlook in our first quarter reports, we now believe our
full-year 2003 results will be comparable to 2002's results, rather than higher
than 2002 results as indicated in our first quarter reports. However, these
factors also lead us to expect that our 2004 results will be significantly
better than our 2003 results.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flow -- We define free cash flow as cash provided by operating
activities less items related to nonrecurring transactions such as sales of
businesses and customary capital expenditures plus the proceeds from asset
sales. 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. Free cash flow
may be defined differently by other companies. Free cash flow is presented
because it is a financial measure that is frequently requested by capital market
participants in evaluating our company. However, free cash flow is not
considered under generally accepted accounting principles to be a primary
measure of an entity's financial results, and accordingly free cash flow should
not be considered an alternative to operating income, net income, or cash flows
as determined under generally accepted accounting principles and as reported by
us.

For the three months ended June 30, 2003, we had positive free cash flow of
$13.1 million as compared to $11.0 million for the same period in 2002. We have
now generated positive free cash flow in eleven of the last

27

thirteen quarters. For the six months ended June 30, 2003, we had positive free
cash flow of $20.1 million as compared to negative free cash flow of $0.2
million for the same period in 2002.

For the three months ended March 31, 2003, free cash flow from operations
as well as borrowings from the credit facility discussed below, were used to pay
final tax payments of $10.4 million associated with the sale of the operations
to Emcor. The net proceeds received at the closing of the Emcor transaction in
the first quarter of 2002 were all used to reduce our debt.

Credit Facility -- Our primary current debt financing capacity consists of
a $54 million senior credit facility, or the Facility, provided by a syndicate
of three financial institutions led by General Electric Capital Corporation, or
GE. The Facility includes a $20 million sublimit for letters of credit. The
Facility is secured by substantially all of our assets. The Facility was entered
into on October 11, 2002 and replaced our previous revolving credit facility.
The Facility consists of two parts: a term loan and a revolving credit facility.

The term loan under the Facility, or the Term Loan, was originally $15
million, which we borrowed upon the closing of the 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 prepayments of the Term Loan in certain
circumstances. Approximately half of any free cash flow (as defined in the
Facility agreement -- 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. We did not have any prepayments of the Term Loan due as of
December 31, 2002 under this requirement, primarily as a result of our
significant amount of voluntary prepayments of debt during 2002. 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. As of June 30, 2003, $13.7
million was outstanding under the Term Loan.

The Facility also includes a three-year $40 million revolving credit
facility, the Revolving Loan. Under this revolving credit facility we can borrow
up to $20 million, with the difference between actual borrowings and $40 million
available for letter of credit issuance up to a maximum of $20 million in
letters of credit. Capacity under the Revolving Loan is also limited by the
leverage and fixed charge coverage covenants described below under Restrictions
and Covenants and Amounts Outstanding, Capacity, and Maturities. As noted in the
latter section, under the most restrictive of these capacity provisions, our
current borrowing capacity, on a monthend measurement basis, is $5.0 million.
Borrowing capacity can be greater than this amount on an intra-month basis.
Letters of credit currently outstanding are $19.7 million.

Interest Rates and Fees -- We have 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 U.S.'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.

28

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

We 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 $0.4 million per quarter. To the extent prepayments of the Term
Loan are made or the size of the Facility is reduced, we may have to accelerate
amortization of these deferred financing and professional costs. During the
first quarter of 2003, we charged approximately $0.8 million of deferred
financing costs to interest expense that were associated with higher levels of
capacity under the Facility than the current total of $54 million.

The weighted average interest rate that we currently pay on borrowings
under the Facility is 5.5% per annum. This reflects a combination of borrowings
under both interest rate options described above, as well as the swap of
floating rates to a fixed rate described above. This rate does not include
amortization of debt financing and arrangement costs, or adjustments for
derivatives.

Interest Rate Derivative -- The rates underlying the interest rate terms of
the Facility 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 required that we convert these floating interest rate terms on at least
half of the original Term Loan to fixed rates for at least a one-year term. In
January 2003, we converted $10 million of principal value to a fixed LIBOR-based
interest rate of 5.62% for an eighteen-month term. This was done via a
transaction known as a "swap" under which we agreed to pay fixed interest rate
payments on $10 million for eighteen months to a bank in exchange for receiving
from the bank floating LIBOR interest rate payments on $10 million for the same
term.

This transaction is a derivative and has been designated a cash flow
hedging instrument under applicable generally accepted accounting principles.
Changes in market interest rates in any given period may increase or decrease
the valuation of our obligations to the bank under this swap versus the bank's
obligations to us. So long as the instrument remains "effective" as defined
under applicable generally accepted accounting principles, such changes in
market valuation are reflected in stockholders' equity as other comprehensive
income (loss) for that period, and not in our results of operations. If the swap
is terminated earlier than its eighteen-month term, any gain or loss on
settlement will be reflected in our statement of operations. The swap was
effective as a hedge for accounting purposes from its inception through June 30,
2003, and we expect it to continue to be effective throughout its term.

During the six months ended June 30, 2003, a reduction to stockholders'
equity of $0.1 million, net of tax, was recorded through other comprehensive
income (loss) and is included in other current liabilities in our consolidated
balance sheet. The counterparty to the above derivative agreement is a major
bank. Based on our continuing review of the financial position of this bank, we
believe there is minimal risk that it will not meet its obligations to us under
this swap.

Credit Facility Warrant -- In connection with the Facility, we granted GE a
warrant to purchase 409,051 shares of our common stock for nominal
consideration. In addition, GE may "put," or require us 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 our company, full repayments of amounts owing under the
Facility, or a public offering of shares by us. 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, less amortization to date of $0.3 million, is reflected as a discount
of our obligation under the Facility and is being amortized over the term of the
Facility, as described above. This warrant and put obligation are also recorded
as a liability in the Company's balance sheet. The value of this warrant and put
will change over time, principally in response to changes in the market price of
our common stock.

The warrant and 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
29

adjustments are known as mark-to-market adjustments. The gain included in
interest expense related to the warrant's mark-to-market obligation during the
six months ended June 30, 2003 was $0.1 million.

The table below provides an indication of the potential effect on the
valuation of this derivative that might result from changes in the market price
of our stock. In this table, the value of the warrant has been calculated based
upon the stock price being $1 lower and $1 higher than our closing stock price
at June 30, 2003 (value of warrant and put obligation in thousands).

- ---------------

(a) This was our closing stock price on June 30, 2003.

Restrictions and Covenants -- Borrowings under the Facility are
specifically limited by our ratio of total debt to earnings before interest,
taxes, depreciation, and amortization ("EBITDA") also known as the leverage
covenant, and by our ratio of EBITDA less taxes and capital expenditures to
interest expense and scheduled principal 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 and excludes cash balances in certain of our bank accounts.

The definition of EBITDA under the Facility excludes certain items,
generally non-cash amounts and transactions reported in Other Income and
Expense, that are otherwise included in the determination of earnings under
generally accepted accounting principles in our financial statements. As such,
EBITDA as determined under the Facility's definition could be less than EBITDA
as derived from our financial statements in the future.

The financial covenants under the Facility are summarized below. Covenant
compliance is measured on a monthly basis. Intra-quarter monthly covenants are
at either the same or very similar levels to the quarter-end covenants shown
below. EBITDA amounts are in thousands:

Our trailing twelve months EBITDA as of December 31, 2002 as determined
under the Facility did not comply with the covenant then in effect. Our lenders
waived this violation and agreed to modify our minimum EBITDA, leverage and
fixed charge covenants for 2003. Even at these modified levels, these covenants
leave only moderate room for variance based on our recent performance. If we
again violate a covenant under the Facility, we may have to negotiate new
borrowing terms under the Facility or obtain new financing. While we

30

believe that our levels of debt in comparison to our EBITDA and our cash flows
would enable us to negotiate new borrowing terms under the Facility or to obtain
new financing from other sources if necessary, there can be no assurance that we
would be successful in doing so.

The Facility prohibits us from paying dividends, repurchasing shares, and
making acquisitions. It also limits annual lease expense and non-Facility debt,
and restricts outlays of cash by us relating to certain investments and
subordinate debt.

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

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

Certain of our vendors require letters of credit to ensure reimbursement
for amounts they are disbursing on our behalf, such as to beneficiaries under
our self-funded insurance programs. Some customers also require us to post
letters of credit to guarantee performance under our contracts and to ensure
payment to our subcontractors and vendors under those contracts. 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 we have failed to perform
specified actions. If this were to occur, we would be required to reimburse the
issuer of the letter of credit. Depending on the circumstances of such a
reimbursement, we may also have to record a charge to earnings for the
reimbursement. To date we have not had a claim made against a letter of credit
that resulted in payments by the issuer of the letter of credit or by us. We
believe that it is unlikely that we will have to fund claims under a letter of
credit in the foreseeable future.

Many customers, particularly in connection with new construction, require
us to post performance and payment bonds issued by a financial institution known
as a surety. These bonds provide a guarantee to the customer that we will
perform under the terms of a contract and that we will pay subcontractors and
vendors who provided goods and services under a contract. If we fail 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. We must
reimburse the surety for any expenses or outlays it incurs. To date, we have not
had any significant reimbursements to our surety for bond-related costs. We
believe that it is unlikely that we will have to fund claims under our surety
arrangements in the foreseeable future.

We have reached a preliminary agreement with our surety and GE to grant the
surety a secured interest in assets such as receivables, costs incurred in
excess of billings, and equipment related to projects for which bonds are
outstanding as collateral for potential obligations under bonds. As of June 30,
2003, the amount of these assets is approximately $39.6 million. We have also
posted a $5 million letter of credit as collateral for potential obligations
under bonds.

Surety market conditions are currently difficult as a result of significant
losses incurred by many sureties in recent periods, both in the construction
industry as well as in certain larger corporate bankruptcies. As a result, less
bonding capacity is available in the market and terms have become more
restrictive. Further, under standard terms in the surety market, sureties issue
bonds on a project-by-project basis, and can decline to issue bonds at any time.
Historically, approximately 25% of our business has required bonds. While we
have enjoyed a longstanding relationship with our surety, current market
conditions as well as changes in our surety's assessment of our operating and
financial risk could cause our surety to decline to issue bonds for our work. If
that were to occur, our alternatives include doing more business that does not
require bonds, posting other forms of collateral for project performance such as
letters of credit or cash, and seeking bonding capacity from other sureties. We
would likely also encounter concerns from customers, suppliers and other market

31

participants as to our creditworthiness. While we believe our general operating
and financial performance would enable us to ultimately respond effectively to
an interruption in the availability of bonding capacity, such an interruption
would likely cause our revenues and profits to decline in the near term.

Amounts Outstanding, Capacity and Maturities -- Apart from the Term Loan,
our available credit capacity under the Facility is governed by the nominal
limits of the Facility, and by calculated limits based on the leverage and fixed
charge coverage covenants described above. Available credit capacity is limited
to the most restrictive of these measures. The nominal limits are in effect at
all times. The leverage provision limits borrowings that can be outstanding at
monthend. The fixed charge provision limits amounts that can be outstanding at
monthend, or at any other time that GE requests that this covenant be measured.
Even though available credit capacity under the leverage provision is only
measured at monthend, it is presented below because it is the most restrictive
of these limitations as of recent monthends. Available capacity under the
Revolving Loan can be greater than the amount below on an intra-month basis.

The following recaps the Company's debt amounts outstanding and capacity
(in thousands):

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 August 1, 2003 while operating lease maturities are based on
amounts outstanding as of June 30, 2003 (in thousands).

As of June 30, 2003, we also have $14.1 million of letter of credit
commitments, all of which will expire in 2003.

Outlook -- As noted above, we have generated positive free cash flow in
most recent periods, and we currently have a moderate level of debt. We
anticipate that free cash flow from operations and credit capacity under the
Facility will provide us with sufficient liquidity to fund our operations for
the foreseeable future. However, we do not have a significant amount of excess
credit capacity in comparison to expected working capital requirements over the
balance of 2003. We believe that our levels of debt in comparison to our EBITDA
and our cash flows would enable us to obtain new financing if necessary, but
there can be no assurance that we would be successful in doing so.

32

We currently have $19.7 million in letters of credit outstanding. We
self-insure a significant portion of our workers compensation, auto liability
and general liability risks. We use 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 our behalf. Under our current
self-insurance arrangements, we have posted $13.2 million in letters of credit.
In addition, we may receive other letter of credit requests in the ordinary
course of business, and we may have a net increase in the amount of
insurance-related letters of credit we must post when we renew our insurance
arrangements in the fourth quarter of 2003. Accordingly, our letter of credit
requirements over the next year may exceed the current letter of credit
sublimits of $20 million under our credit facility. If so, we 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. We believe that our levels of debt
in comparison to our EBITDA and free cash flows would enable us to obtain
additional letter of credit capacity or to otherwise meet financial security
requirements of third parties if necessary, but there can be no assurance that
we would be successful in doing so.

As described above, the financial covenants under our credit facility leave
only moderate room for variance based on our recent performance. If we again
violate a covenant under the Facility, we may have to negotiate new borrowing
terms under the Facility or obtain new financing. While we believe that our
levels of debt in comparison to our EBITDA and cash flows would enable us to
negotiate new borrowing terms under the Facility or to obtain new financing from
other sources if necessary, there can be no assurance that we 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, we expect our 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, our 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 2002, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS
No. 146"). SFAS No. 146 addresses financial accounting and reporting for costs
associated with exit or disposal activities, such as restructurings,
involuntarily terminating employees, and consolidating facilities, where those
activities were initiated after December 31, 2002. The implementation of SFAS
No. 146 does not require the restatement of previously issued financial
statements. See Note 5 of the Consolidated Financial Statements for a discussion
of restructuring charges recorded during 2003 in accordance with SFAS No. 146.

In November 2002, the FASB issued Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45"). It clarifies that a guarantor
is required to recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken in issuing the guarantee, including its
ongoing obligation to stand ready to perform over the term of the guarantee in
the event that the specified triggering events or conditions occur. The
objective of the initial measurement of the liability is the fair value of the
guarantee at its inception. The initial recognition and initial measurement
provisions of FIN 45 are effective for us for guarantees issued after December
31, 2002. Although we from time to time guarantee the performance of systems or
designs we provide, we currently have no material guarantees.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure." SFAS 148 amends FASB Statement No.
123, "Accounting for Transition for
33

Stock-Based Compensation" to provide alternative methods of transition for a
voluntary change to the fair value-based method of accounting for stock-based
employee compensation. In addition, SFAS 148 amends the disclosure requirements
of SFAS 123 to require prominent disclosures in both annual and interim
financial statements of the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. SFAS 148 is
effective for fiscal years ending after December 15, 2002 and the footnote
disclosure provisions were adopted by us in the fourth quarter of 2002.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"). FIN 46 expands upon and strengthens
existing accounting guidance that addresses when a company should include in its
financial statements the assets, liabilities and activities of another entity. A
variable interest entity is a corporation, partnership, trust, or any other
legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. FIN 46
requires a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or is entitled to receive a majority of the entity's
residual returns or both. FIN 46 is effective for all new variable interest
entities created or acquired after January 31, 2003. For variable interest
entities created or acquired prior to February 1, 2003, the provisions of FIN 46
must be applied for the first interim or annual period beginning after June 15,
2003. We are currently evaluating the effect that adoption of FIN 46 will have
on our consolidated financial condition or results of operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are 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. In January 2003, we converted $10 million of our Term
Loan to a fixed interest rate of 5.62% for an eighteen-month term. This was done
via a transaction known as a "swap" under which we agree to pay fixed
LIBOR-based interest rate payments on $10 million for eighteen months to a bank
in exchange for receiving from the bank floating LIBOR-based interest rate
payments on $10 million for the same term. This transaction is a derivative and
qualifies for hedge accounting treatment. We are not exposed to any other
significant financial market risks including commodity price risk, foreign
currency exchange risk or interest rate risks from the use of derivative
financial instruments. Management does not use derivative financial instruments
for trading or to speculate on changes in interest rates or commodity prices.

ITEM 4. CONTROLS AND PROCEDURES

Within 90 days before the date of this report on Form 10-Q, under the
supervision and with the participation of our management, including our Chairman
of the Board and Chief Executive Officer (our principal executive officer) and
our Chief Financial Officer (our principal financial officer), we evaluated the
effectiveness of our disclosure controls and procedures (as defined under Rule
13a-14(c) of the Securities Exchange Act of 1934, as amended (the "Exchange
Act")). Based on this evaluation, our Chairman of the Board and Chief Executive
Officer and our Chief Financial Officer believe that our disclosure controls and
procedures are effective to ensure that information we are required to disclose
in the reports that we file or submit under the Exchange Act fairly represents,
in all material respects, our financial condition, results of operations and
cash flows.

There were no significant changes in our internal controls or in other
factors that could significantly affect these controls subsequent to the date of
such evaluation.

34

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

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its annual meeting of stockholders in Houston, Texas on
May 22, 2003. The following sets forth matters submitted to a vote of
stockholders:

(a) The following individuals were elected to the Board of Directors as
stated in the Company's Proxy Statement dated April 23, 2003, for terms
expiring at the next annual stockholders' meeting or until their
successors have been elected and qualified -- Fred J. Giardinelli,
Vincent J. Costantini, and Norman C. Chambers. Every director was
elected by a majority of the outstanding shares of Common Stock of the
Company. Out of a potential 36,795,882 shares of Common Stock
outstanding, Mr. Giardinelli had 33,457,481 shares voted in favor, with
468,251 shares withheld. Mr. Costantini had 33,456,374 shares voted in
favor, with 468,358 shares withheld, and Mr. Chambers had 33,428,885
shares voted in favor, with 496,847 shares withheld.

(b) A majority of the outstanding shares of Common Stock of the Company
approved the amendment to the Certificate of Incorporation to eliminate
the classification of the Board of Directors. Shares voted in favor
33,762,881, with 589,578 shares withheld, and 20,803 shares abstained.

(c) Stockholder proposal against the Company's use of EBITDA for
"performance-based" compensation. Shares voted in favor 3,485,534, with
16,628,540 shares withheld, and 164,892 shares abstained.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.1 Employment Agreement between Fred Giardenelli, Jr. and Eastern Heating &
Cooling, Inc. dated June 1, 2003. (Filed herewith).

31.1 Certification of William F. Murdy pursuant to Section 302 of the
Sarbanes-Oxley Act Of 2002. (Filed herewith).

31.2 Certification of J. Gordon Beittenmiller pursuant to Section 302 of the
Sarbanes-Oxley Act Of 2002. (Filed herewith).

32.1 Certification of William F. Murdy, 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).

32.2 Certification of J. Gordon Beittenmiller, 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).

35

(b) Reports on Form 8-K

(i) The Company filed a report on Form 8-K with the Securities and
Exchange Commission on May 6, 2003. Under Item 7 of that report the Company
announced that on May 5, 2003, the Company issued a press release,
reporting Comfort's financial results for the first quarter of 2003.

36

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

August 5, 2003

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

August 5, 2003

37

INDEX TO EXHIBITS