Edgar Filing: COMFORT SYSTEMS USA INC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q/A

(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, 2002

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

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 1-13011

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

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

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

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

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

The number of shares outstanding of the issuer's common stock, as of August
12, 2002 was 37,834,219.

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This Amendment No. 1 to Form 10-Q for the period ended June 30, 2002 is
being filed to correct an error that occurred in two places in the initial
filing of the Form 10-Q after the market closed on August 13, 2002. The initial
filing incorrectly indicated that the covenant under the Company's principal
long-term revolving credit facility relating to minimum earnings before
interest, taxes, depreciation and amortization ("EBITDA") for the third quarter
of 2003 is $9.2 million. This amount appeared in two places in the initial
filing -- Footnote No. 6 "Long-Term Debt Obligations" in Item 1 -- Financial
Statements -- "Condensed Notes to Consolidated Financial Statements June 30,
2002" and in "Liquidity and Capital Resources" in Item 2 -- "Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
correct amount for the covenant under the Company's Credit Facility relating to
minimum EBITDA for the third quarter of 2003 is $11.2 million. All other
disclosure is unchanged.

COMFORT SYSTEMS USA, INC.

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

PAGE
----

PART I

FINANCIAL INFORMATION
Item 1 -- Financial Statements
COMFORT SYSTEMS USA, INC.
Consolidated Balance Sheets............................... 2
Consolidated Statements of Operations..................... 3
Consolidated Statements of Stockholders' Equity........... 4
Consolidated Statements of Cash Flows..................... 5
Condensed Notes to Consolidated Financial Statements...... 6
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 17
Item 3 -- Quantitative and Qualitative Disclosures about Market
Risk........................................................ 26

PART II

OTHER INFORMATION
Item 1 -- Legal Proceedings........................................... 27
Item 2 -- Recent Sales of Unregistered Securities..................... 27
Item 4 -- Submission of Matters to a Vote of Security Holders......... 27
Item 6 -- Exhibits and Reports on Form 8-K............................ 28
Signatures............................................................. 29

COMFORT SYSTEMS USA, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

DECEMBER 31, JUNE 30,
2001 2002
------------ -----------
(UNAUDITED)

ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 3,924 $ 12,624
Accounts receivable, less allowance of $9,633 and
$6,111................................................. 175,028 175,778
Other receivables......................................... 5,572 3,136
Inventories............................................... 14,553 13,170
Prepaid expenses and other................................ 13,174 9,783
Costs and estimated earnings in excess of billings........ 19,384 20,283
Assets related to discontinued operations................. 327,820 1,458
-------- ---------
Total current assets.............................. 559,455 236,232
PROPERTY AND EQUIPMENT, net................................. 18,812 17,314
GOODWILL.................................................... 297,033 113,427
OTHER NONCURRENT ASSETS..................................... 1,325 14,389
-------- ---------
Total assets...................................... $876,625 $ 381,362
======== =========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt...................... $ 73 $ 12,991
Current maturities of notes to affiliates and former
owners................................................. 2,374 16,251
Accounts payable.......................................... 57,489 62,647
Accrued compensation and benefits......................... 23,611 19,813
Billings in excess of costs and estimated earnings........ 26,663 29,071
Income taxes payable...................................... 5,606 12,373
Other current liabilities................................. 23,468 25,748
Liabilities related to discontinued operations............ 140,746 224
-------- ---------
Total current liabilities......................... 280,030 179,118
LONG-TERM DEBT, NET OF CURRENT MATURITIES................... 164,012 426
NOTES TO AFFILIATES AND FORMER OWNERS, NET OF CURRENT
MATURITIES................................................ 15,569 --
OTHER LONG-TERM LIABILITIES................................. 3,193 273
-------- ---------
Total liabilities................................. 462,804 179,817
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, $.01 par, 5,000,000 shares authorized,
none issued and outstanding............................ -- --
Common stock, $.01 par, 102,969,912 shares authorized,
39,258,913 shares issued............................... 393 393
Treasury stock, at cost, 1,749,334 and 1,437,819 shares,
respectively........................................... (10,924) (8,804)
Additional paid-in capital................................ 340,186 339,208
Deferred compensation..................................... -- (932)
Retained earnings (deficit)............................... 84,166 (128,320)
-------- ---------
Total stockholders' equity........................ 413,821 201,545
-------- ---------
Total liabilities and stockholders' equity........ $876,625 $ 381,362
======== =========

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

COMFORT SYSTEMS USA, INC.

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

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- --------------------
2001 2002 2001 2002
-------- -------- -------- ---------

REVENUES............................................... $227,667 $211,900 $430,559 $ 401,362
COST OF SERVICES....................................... 184,523 173,166 351,067 332,175
-------- -------- -------- ---------
Gross profit....................................... 43,144 38,734 79,492 69,187
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES........... 35,553 30,554 70,922 62,983
GOODWILL AMORTIZATION.................................. 2,057 -- 4,114 --
RESTRUCTURING CHARGES.................................. -- -- 238 1,878
-------- -------- -------- ---------
Operating income................................... 5,534 8,180 4,218 4,326
OTHER INCOME (EXPENSE):
Interest income...................................... 15 8 51 38
Interest expense..................................... (2,536) (1,102) (4,973) (3,001)
Other................................................ 236 804 322 1,114
-------- -------- -------- ---------
Other income (expense)............................. (2,285) (290) (4,600) (1,849)
-------- -------- -------- ---------
INCOME (LOSS) BEFORE INCOME TAXES...................... 3,249 7,890 (382) 2,477
INCOME TAX EXPENSE..................................... 2,032 2,692 710 1,173
-------- -------- -------- ---------
INCOME (LOSS) FROM CONTINUING OPERATIONS............... 1,217 5,198 (1,092) 1,304
DISCONTINUED OPERATIONS:
Operating income (loss), net of applicable income tax
benefit (expense) of $(1,504), $141, $(3,829) and
$1,922............................................. 2,074 (261) 5,483 (113)
Estimated loss on disposition, including income tax
benefit (expense) of $91 and $(25,887)............. -- (169) -- (11,156)
-------- -------- -------- ---------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE................................. 3,291 4,768 4,391 (9,965)
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE,
NET OF INCOME TAX BENEFIT OF $26,317................. -- -- -- (202,521)
-------- -------- -------- ---------
NET INCOME (LOSS)...................................... $ 3,291 $ 4,768 $ 4,391 $(212,486)
======== ======== ======== =========
INCOME (LOSS) PER SHARE:
Basic --
Income (loss) from continuing operations........... $ 0.03 $ 0.14 $ (0.03) $ 0.03
Discontinued operations --
Income (loss) from operations................... 0.06 (0.01) 0.15 --
Estimated loss on disposition................... -- -- -- (0.30)
Cumulative effect of change in accounting
principle....................................... -- -- -- (5.37)
-------- -------- -------- ---------
Net income (loss).................................. $ 0.09 $ 0.13 $ 0.12 $ (5.64)
======== ======== ======== =========
Diluted --
Income (loss) from continuing operations........... $ 0.03 $ 0.13 $ (0.03) $ 0.03
Discontinued operations --
Income (loss) from operations................... 0.06 (0.01) 0.15 --
Estimated loss on disposition................... -- -- -- (0.29)
Cumulative effect of change in accounting
principle....................................... -- -- -- (5.30)
-------- -------- -------- ---------
Net income (loss).................................. $ 0.09 $ 0.12 $ 0.12 $ (5.56)
======== ======== ======== =========
SHARES USED IN COMPUTING INCOME (LOSS) PER SHARE:
Basic........................................... 37,381 37,839 37,383 37,687
======== ======== ======== =========
Diluted......................................... 37,431 38,476 37,383 38,237
======== ======== ======== =========

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

COMFORT SYSTEMS USA, INC.

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

COMMON STOCK TREASURY STOCK ADDITIONAL DEFERRED RETAINED TOTAL
------------------- --------------------- PAID-IN COMPEN- EARNINGS STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL SATION (DEFICIT) EQUITY
---------- ------ ---------- -------- ---------- --------- --------- -------------

BALANCE AT DECEMBER 31, 2000... 39,258,913 $393 (2,002,629) $(13,119) $341,923 $ -- $ 71,042 $ 400,239
Issuance of Treasury Stock:
Issuance of Employee Stock
Purchase Plan shares.... -- -- 398,287 2,570 (1,737) -- -- 833
Shares received from sale of
businesses................. -- -- (144,992) (375) -- -- -- (375)
Net income................... -- -- -- -- -- -- 13,124 13,124
---------- ---- ---------- -------- -------- ----- --------- ---------
BALANCE AT DECEMBER 31, 2001... 39,258,913 393 (1,749,334) (10,924) 340,186 -- 84,166 413,821
Issuance of Treasury Stock:
Issuance of shares for
options exercised
(unaudited)............. -- -- 220,746 1,368 (733) -- -- 635
Issuance of restricted
stock (unaudited)....... -- -- 200,000 1,239 (413) (826) -- --
Shares exchanged in repayment
of notes receivable
(unaudited)................ -- -- (49,051) (204) -- -- -- (204)
Shares received from sale of
business (unaudited)....... -- -- (55,882) (263) -- -- -- (263)
Shares received from
settlement with former
owner (unaudited).......... -- -- (4,298) (20) -- -- -- (20)
Amortization of deferred
compensation (unaudited)... -- -- -- -- 168 (106) -- 62
Net loss (unaudited)......... -- -- -- -- -- -- (212,486) (212,486)
---------- ---- ---------- -------- -------- ----- --------- ---------
BALANCE AT JUNE 30, 2002
(unaudited).................. 39,258,913 $393 (1,437,819) $ (8,804) $339,208 $(932) $(128,320) $ 201,545
========== ==== ========== ======== ======== ===== ========= =========

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

COMFORT SYSTEMS USA, INC.

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

SIX MONTHS ENDED
JUNE 30,
---------------------
2001 2002
--------- ---------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)........................................... $ 4,391 $(212,486)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities --
Cumulative effect of change in accounting principle....... -- 202,521
Estimated loss on disposition of discontinued
operations............................................. -- 11,156
Restructuring charges..................................... 238 1,878
Depreciation and amortization expense..................... 11,942 3,875
Bad debt expense.......................................... 2,783 2,531
Deferred tax expense...................................... 2,449 1,726
Gain on sale of assets.................................... (129) (901)
Deferred compensation expense............................. -- 62
Changes in operating assets and liabilities --
(Increase) decrease in --
Receivables, net..................................... 6,069 6,512
Inventories.......................................... 112 1,377
Prepaid expenses and other current assets............ 1,075 4,440
Costs and estimated earnings in excess of billings... (1,834) (3,228)
Other noncurrent assets.............................. (1,069) 426
Increase (decrease) in --
Accounts payable and accrued liabilities............. (4,839) (21,668)
Billings in excess of costs and estimated earnings... 11,229 3,451
Other, net........................................... (411) 21
--------- ---------
Net cash provided by operating activities.............. 32,006 1,693
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment....................... (3,148) (3,070)
Proceeds from sales of property and equipment............. 354 1,134
Proceeds from businesses sold, net of cash sold and
transaction costs...................................... 954 154,565
--------- ---------
Net cash provided by (used in) investing activities.... (1,840) 152,629
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments on long-term debt................................ (130,310) (240,622)
Borrowings of long-term debt.............................. 100,709 87,664
Proceeds from issuance of common stock.................... 566 --
Proceeds from exercise of options......................... -- 635
--------- ---------
Net cash used in financing activities.................. (29,035) (152,323)
--------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS................... 1,131 1,999
CASH AND CASH EQUIVALENTS, beginning of period -- continuing
operations and discontinued operations.................... 16,021 10,625
--------- ---------
CASH AND CASH EQUIVALENTS, end of period.................... $ 17,152 $ 12,624
========= =========

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

COMFORT SYSTEMS USA, INC.

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

1. BUSINESS AND ORGANIZATION

Comfort Systems USA, Inc., a Delaware corporation ("Comfort Systems" and
collectively with its subsidiaries, the "Company"), is a national provider of
comprehensive heating, ventilation and air conditioning ("HVAC") installation,
maintenance, repair and replacement services within the mechanical services
industry. The Company operates primarily in the commercial and industrial HVAC
markets, and performs most of its services within office buildings, retail
centers, apartment complexes, manufacturing plants, and healthcare, education
and government facilities. In addition to standard HVAC services, the Company
provides specialized applications such as building automation control systems,
fire protection, process cooling, electronic monitoring and process piping.
Certain locations also perform related services such as electrical and plumbing.
Approximately 55% of the Company's consolidated 2002 revenues were attributable
to installation of systems in newly constructed facilities, with the remaining
45% attributable to maintenance, repair and replacement services. The Company's
consolidated 2002 revenues related to the following service activities:
HVAC-73%, plumbing-12%, building automation control systems-5%, electrical-2%,
fire protection-1% and other-7%. These service activities are within the
mechanical services industry which is the single industry segment served by
Comfort Systems.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

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

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

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

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

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CASH FLOW INFORMATION

Cash paid for interest for the six months ended June 30, 2001 and 2002 was
approximately $11.6 million and $3.7 million, respectively. Cash paid for income
taxes for the six months ended June 30, 2001 and 2002 was approximately $2.1
million and $7.6 million, respectively.

NEW ACCOUNTING PRONOUNCEMENTS

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

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

SEGMENT DISCLOSURE

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

RECLASSIFICATIONS

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

3. DISCONTINUED OPERATIONS

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

The transaction with Emcor provided for a post-closing adjustment based on
a final accounting, done after the closing of the transaction, of the net assets
of the operations that were sold to Emcor. That accounting indicated that the
net assets transferred to Emcor were approximately $7 million greater than a
target amount that had been agreed to with Emcor. In accordance with the
transaction agreement, Emcor paid the Company that amount, and released $2.5
million that had been escrowed in connection with this element of the
transaction. The total of these two amounts, $9.5 million, was reflected as a
receivable in the Company's March 31, 2002 financial statements. The Company
received this payment during the second quarter.

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

The net cash proceeds of approximately $164 million received to date from
the Emcor transaction have been used to reduce debt outstanding under the
Company's credit facility. An estimated tax liability of $16 million related to
this transaction was recorded at March 31, 2002 and is due in March 2003.

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

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

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

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

DECEMBER 31, JUNE 30,
2001 2002
------------ ------------

Accounts receivable, net.................................... $140,768 $ 564
Other current assets........................................ 30,477 772
Property and equipment, net................................. 13,968 122
Goodwill, net............................................... 141,415 --
Other noncurrent assets..................................... 1,192 --
-------- --------
Total assets........................................... $327,820 $ 1,458
======== ========
Current maturities of debt and notes........................ $ 1,262 $ --
Accounts payable............................................ 44,077 182
Other current liabilities................................... 68,676 42
Long-term debt and notes.................................... 21,842 --
Other long-term liabilities................................. 4,889 --
-------- --------
Total liabilities...................................... $140,746 $ 224
======== ========

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

SIX MONTHS ENDED
JUNE 30,
------------------
2001 2002
-------- -------

Revenues.................................................... $329,710 $97,784
Pre-tax income (loss)....................................... $ 9,312 $(2,035)

4. GOODWILL

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

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

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

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

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

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

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

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

THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
2001 2002 2001 2002
------- -------- ------- --------

Income (loss) from continuing operations..... $ 1,217 $ 5,198 $(1,092) $ 1,304
Add: Goodwill amortization, net of tax....... 1,895 -- 3,790 --
------- -------- ------- --------
Adjusted income from continuing operations... 3,112 5,198 2,698 1,304
Discontinued operations --
Operating income (loss), net of tax.......... 2,074 (261) 5,483 (113)
Add: Goodwill amortization, net of tax....... 758 -- 1,516 --
------- -------- ------- --------
Adjusted operating income (loss), net of
tax........................................ 2,832 (261) 6,999 (113)
Estimated loss on disposition, including
tax........................................ -- (1,571) -- (45,124)
------- -------- ------- --------
Adjusted net income (loss)................... $ 5,944 $ 3,366 $ 9,697 $(43,933)
======= ======== ======= ========
Adjusted income (loss) per share:
Basic --
Income from continuing operations....... $ 0.08 $ 0.14 $ 0.07 $ 0.03
Discontinued operations --
Income (loss) from operations......... 0.08 (0.01) 0.19 --
Estimated loss on disposition......... -- (0.04) -- (1.20)
------- -------- ------- --------
Net income (loss)....................... $ 0.16 $ 0.09 $ 0.26 $ (1.17)
======= ======== ======= ========
Diluted --
Income from continuing operations....... $ 0.08 $ 0.14 $ 0.07 $ 0.03
Discontinued operations --
Income (loss) from operations......... 0.08 (0.01) 0.19 --
Estimated loss on disposition......... -- (0.04) -- (1.18)
------- -------- ------- --------
Net income (loss)....................... $ 0.16 $ 0.09 $ 0.26 $ (1.15)
======= ======== ======= ========

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

5. RESTRUCTURING CHARGES

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

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

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

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

SIX MONTHS ENDED
JUNE 30, 2001
----------------

Revenues.................................................... $ 4,715
Operating loss.............................................. $(1,937)

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

BALANCE AT BALANCE AT
JANUARY 1, JUNE 30,
2002 ADDITIONS PAYMENTS 2002
---------- --------- -------- ----------

Severance.................................... $ 210 $ 846 $(1,015) $ 41
Lease termination costs and other............ 1,148 704 (591) 1,261
------ ------ ------- ------
Total........................................ $1,358 $1,550 $(1,606) $1,302
====== ====== ======= ======

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. LONG-TERM DEBT OBLIGATIONS

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

DECEMBER 31, JUNE 30,
2001 2002
------------ ------------
(UNAUDITED)

Revolving credit facility................................... $163,700 $ 12,900
Notes to affiliates and former owners....................... 17,943 16,251
Other....................................................... 385 517
-------- --------
Total debt............................................. 182,028 29,668
Less: current maturities............................... 2,447 29,242
-------- --------
$179,581 $ 426
======== ========

REVOLVING CREDIT FACILITY

The Company's principal current debt financing and operating liquidity is
provided by a revolving credit facility (the "Credit Facility" or the
"Facility") with Bank One, Texas, N.A. ("Bank One") and other banks (including
Bank One, the "Bank Group"). The Facility's general terms allow for the Company
to borrow up to the lesser of $100 million or 80% of accounts receivable, net of
reserves ("Net Receivables"). Borrowings under the Facility are also effectively
limited by a requirement that they not result in the Company's ratios of
earnings before interest, taxes, depreciation and amortization ("EBITDA") to
interest expense and debt to EBITDA exceeding certain levels. Based on the most
restrictive of these ratio-related limits, effective borrowing capacity under
the Facility is currently $70.4 million. Borrowings under the Facility are
secured by accounts receivable, inventory, fixed assets other than real estate,
and the shares of capital stock of the Company's subsidiaries. The Credit
Facility expires on January 1, 2003, at which time all amounts outstanding are
due.

The Company has a choice of two interest rate options under the Facility.
Under one option, the interest rate is determined based on the higher of the
Federal Funds Rate plus 0.5% or Bank One's prime rate. An additional margin of
1% to 2% is then added to the higher of these two rates. Under the other
interest rate option, borrowings bear interest based on designated short-term
Eurodollar rates (which generally approximate London Interbank Offered Rates or
"LIBOR") plus 2.5% to 3.5%. The additional margin for both options depends on
the ratio of the Company's debt to EBITDA, as defined. Commitment fees of 0.375%
to 0.5% per annum, also depending on the ratio of debt to EBITDA, are payable on
the unused portion of the Facility.

The Credit Facility prohibits payment of dividends and the repurchase of
shares by the Company, limits certain non-Bank Group debt, and restricts outlays
of cash by the Company relating to certain investments, capital expenditures,
vehicle leases, acquisitions and subordinate debt. The Credit Facility also
contains covenants providing for the maintenance of certain levels of
shareholder equity and EBITDA, and for the maintenance of certain ratios of the
Company's EBITDA to interest expense and debt to EBITDA.

In the fourth quarter of 2001, the Company estimated and recorded an
allowance of $3.5 million against its receivables with the Kmart Corporation
based on Kmart's bankruptcy filing in January 2002. Including this reserve, the
Company's fourth quarter 2001 EBITDA did not meet the Facility's minimum EBITDA
covenant. The Bank Group agreed to exclude the Kmart reserve from covenant
calculations. In addition, the Company's first quarter 2002 EBITDA did not meet
the Facility's minimum EBITDA covenant. The Bank Group waived that covenant
violation. As a result, the Company has no unresolved covenant violations under
the Facility.

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

As a result of its substantial reduction in debt following the Emcor
transaction, the Company currently complies with the Facility's debt to EBITDA
and EBITDA to interest expense covenants by comfortable margins. The Bank Group
agreed to adjust the Facility's minimum EBITDA covenants to reflect the
Company's reduced size following the Emcor transaction. While the Company
expects to be in compliance with the Facility's EBITDA requirements in the third
and fourth quarters, these covenants allow less room for variance than the
Facility's other financial covenants. If the Company violates the Facility's
minimum EBITDA covenants or any other of the Facility's covenants in the future,
it may have to negotiate new borrowing terms under the Facility or obtain new
financing. While the Company believes that its improved creditworthiness
following the Emcor transaction would enable it to negotiate new terms under the
Facility or obtain new financing from other sources if necessary, there can be
no absolute assurance that the Company would be successful in doing so.

The financial covenants to which the Company is subject under the Facility
are as follows:

Minimum EBITDA:
For the three months ended September 30, 2002............. $11.2 million
For the three months ended December 31, 2002.............. $ 7.7 million

The Company's actual EBITDA for the three months ended June 30, 2002,
as determined in accordance with the Facility, was $10.0 million.

EBITDA to Interest Expense.................................. 3.00

The Company's actual EBITDA to interest expense as of June 30, 2002,
as determined in accordance with the Facility, was 4.99.

Senior Debt to EBITDA....................................... 2.50

The Company's actual senior debt to EBITDA as of June 30, 2002, as
determined in accordance with the Facility, was 0.45.

Total Debt to EBITDA........................................ 3.00

The Company's actual total debt to EBITDA as of June 30, 2002, as
determined in accordance with the Facility, was 1.00.

Net Worth -- a base amount of net worth, or stockholders' equity, set
in the first quarter of 2001, plus 75% of net income thereafter,
excluding the effects on both net income and stockholders' equity of
adopting SFAS No. 142 relating to goodwill and the impairment
adjustment that arose from that adoption; additionally, any amounts
realized from raising new equity would also increase the covenant
amount. The net worth covenant amount resulting from these conditions
as of June 30, 2002 was $367.8 million. The Company's actual net worth
measurement as of June 30, 2002 using the same conditions was $404.1
million.

Capital Expenditures -- the lesser of 2% of revenues or $22 million
for any fiscal year. Based on year-to-date revenues through June 30,
2002, the 2% limitation is $8.0 million. The Company's actual
year-to-date capital expenditures were $3.1 million.

As of June 30, 2002, the Company had $12.9 million in borrowings and $1.6
million in letters of credit outstanding under the Credit Facility. The
Company's unused borrowing capacity under the Facility, as measured by the most
restrictive covenant in the Facility, was $57.4 million as of June 30, 2002. The
Facility's interest rate terms as summarized above currently result in a
floating interest rate under the Facility of approximately 4.3%. In addition,
$0.6 million of remaining deferred Facility arrangement costs will be amortized
to interest expense over the remainder of this year up to the Facility's
maturity on January 1, 2003.

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

As of August 12, 2002, $8.9 million in borrowings and $1.5 million in letters of
credit were outstanding under the Facility, and $61.5 million in unused capacity
was available as measured by the Facility's most restrictive covenant.

NOTES TO AFFILIATES AND FORMER OWNERS

Subordinated notes were issued to former owners of certain purchased
companies as part of the consideration used to acquire their companies. These
notes had an outstanding balance of $16.3 million as of June 30, 2002, and bear
interest, payable quarterly, at a weighted average interest rate of 9.81%. As of
August 12, 2002, there had been no change in the outstanding balance of these
notes. Substantially all of this debt is due on April 10, 2003, but is subject
to standstill terms that do not allow the debt to be accelerated until at least
one year after its current due date.

OTHER LONG-TERM OBLIGATION DISCLOSURES

As of June 30, 2002, the Company had total debt outstanding of $29.7
million, and total letters of credit outstanding of $1.6 million. Of these
amounts, $12.9 million was bank debt under the Credit Facility and $16.3 million
was subordinate debt. As of August 12, 2002, the Company had total debt
outstanding of approximately $25.7 million, and total letters of credit
outstanding of $1.5 million. Of these amounts, $8.9 million was bank debt under
the Credit Facility and $16.3 million was subordinate debt. As of August 12,
2002, $61.5 million in unused borrowing capacity was available under the Credit
Facility as measured by the Facility's most restrictive covenant. Bank debt
under the Credit Facility is due January 1, 2003. Substantially all of the
subordinate debt is due April 10, 2003, but is subject to standstill terms that
do not allow this debt to be accelerated until at least one year after its
current due date.

The Company expects that free cash flow over upcoming quarters will result
in a minimal level of debt under the Credit Facility as of yearend. However, the
Company has a $16 million tax payment due in March 2003. In addition, the
Company may be called upon at any time under certain insurance arrangements to
post letters of credit totaling as much as $5.1 million as security for entities
that fund insurance costs on behalf of the Company. This insurance-related
letter of credit requirement will increase by $1.3 million per quarter through
the second quarter of 2003, for a cumulative total of $10.3 million that could
be required to be posted as of July 1, 2003. As a result, the Company expects
that, even if it succeeds in retiring all of its bank debt, it will continue to
need financing as of and subsequent to the January 1, 2003 maturity of its
current Credit Facility and the April 10, 2003 maturity of substantially all of
its subordinate debt.

In view of the impending maturities of its debt and in view of the
importance of being able to offer long-term bonds on certain kinds of project
work, the Company is negotiating refinancing options both with its existing bank
group and with new financial institutions. Based on these negotiations as well
as on the Company's significantly improved financial position following the
Emcor transaction, management believes that it will be able to refinance a
significant portion of its debt in the current year, even though general
conditions in the financing markets are challenging. Accordingly, there can be
no absolute assurance that the Company will be able to complete this refinancing
when needed or on terms the Company deems acceptable.

As noted above, the Company has agreed to relatively tight restrictions
under the Credit Facility. If the Company violates any of these restrictions, it
will be required to negotiate new terms with its banks. There can be no absolute
assurance that in that event, the Company will receive satisfactory new terms
from its banks, or that if the Company needs additional financing, that such
financing can be secured when needed or on terms the Company deems acceptable.

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

7. COMMITMENTS AND CONTINGENCIES

CLAIMS AND LAWSUITS

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

SELF-INSURANCE

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

8. STOCKHOLDERS' EQUITY

RESTRICTED STOCK GRANT

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

RESTRICTED COMMON STOCK

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

Each share of Restricted Voting Common Stock will automatically convert to
Common Stock on a share-for-share basis (i) in the event of a disposition of
such share of Restricted Voting Common Stock by the holder thereof (other than a
distribution which is a distribution by a holder to its partners or beneficial
owners, or a transfer to a related party of such holders (as defined in Sections
267, 707, 318 and/or 4946 of the Internal Revenue Code of 1986, as amended)),
(ii) in the event any person acquires beneficial ownership of 15% or more of the
total number of outstanding shares of Common Stock of the Company, or (iii) in
the event any person offers to acquire 15% or more of the total number of
outstanding shares of Common Stock of

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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, 2002, there were 1,171,112 shares of Restricted Voting Common
Stock remaining.

EARNINGS PER SHARE

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

Options to purchase 2.7 million shares of the Company's Common Stock
("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 because the options' exercise prices
were greater than the average market price of the Common Stock. Options to
purchase 4.2 million shares of Common Stock at prices ranging from $3.63 to
$21.44 per share were outstanding for the three months ended June 30, 2001, but
were not included in the computation of diluted EPS because the options'
exercise prices were greater than the average market price of the Common Stock.
Options to purchase 7.1 million shares of Common Stock at prices ranging from
$2.14 to $21.44 per share were outstanding for the six months ended June 30,
2001, but were not included in the computation of diluted EPS because the
options had an anti-dilutive effect since the Company reported a loss from
continuing operations during the period.

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

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):

THREE MONTHS SIX MONTHS ENDED
ENDED JUNE 30, JUNE 30,
--------------- -----------------
2001 2002 2001 2002
------ ------ ------- -------

Common shares outstanding, end of period........... 37,381 37,821 37,381 37,821
Effect of using weighted average common shares
outstanding...................................... -- 18 2 (134)
------ ------ ------ ------
Shares used in computing earnings per
share -- basic................................... 37,381 37,839 37,383 37,687
Effect of shares issuable under stock plans based
on the treasury stock method..................... 50 637 -- 550
------ ------ ------ ------
Shares used in computing earnings per share --
diluted.......................................... 37,431 38,476 37,383 38,237
====== ====== ====== ======

COMFORT SYSTEMS USA, INC.

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

INTRODUCTION

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

The Company is a national provider of comprehensive heating, ventilation
and air conditioning ("HVAC") installation, maintenance, repair and replacement
services within the mechanical services industry. The Company operates primarily
in the commercial and industrial HVAC markets, and performs most of its services
within office buildings, retail centers, apartment complexes, manufacturing
plants, and healthcare, education and government facilities. In addition to
standard HVAC services, the Company provides specialized applications such as
building automation control systems, fire protection, process cooling,
electronic monitoring and process piping. Certain locations also perform related
services such as electrical and plumbing. Approximately 55% of the Company's
consolidated 2002 revenues were attributable to installation of systems in newly
constructed facilities, with the remaining 45% attributable to maintenance,
repair and replacement services. The Company's consolidated 2002 revenues
related to the following service activities: HVAC-73%, plumbing-12%, building
automation control systems-5%, electrical-2%, fire protection-1% and other-7%.
These service activities are within the mechanical services industry which is
the single industry segment served by Comfort Systems.

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

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

Changes in job performance, job conditions, estimated profitability and
final contract settlements may result in revisions to estimated costs and,
therefore, revenues. Such revisions are frequently based on estimates and
subjective assessments. The effects of these revisions are recognized in the
period in which the revisions are determined. When such revisions lead to a
conclusion that a loss will be recognized on a contract, the full
17

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

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

Approximately 55% of the Company's consolidated 2002 revenues were
attributable to installation of systems in newly constructed facilities. As a
result, if general economic activity in the U.S. slows significantly from
current levels, and leads to a corresponding decrease in new nonresidential
building construction, the Company's operating results could suffer.

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

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

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
----------------------------------- ------------------------------------
2001 2002 2001 2002
---------------- ---------------- ---------------- -----------------
(IN THOUSANDS)

Revenues...................... $227,667 100.0% $211,900 100.0% $430,559 100.0% $ 401,362 100.0%
Cost of services.............. 184,523 81.0% 173,166 81.7% 351,067 81.5% 332,175 82.8%
-------- -------- -------- ---------
Gross profit.................. 43,144 19.0% 38,734 18.3% 79,492 18.5% 69,187 17.2%
Selling, general and
administrative expenses..... 35,553 15.6% 30,554 14.4% 70,922 16.5% 62,983 15.7%
Goodwill amortization......... 2,057 0.9% -- -- 4,114 1.0% -- --
Restructuring charges......... -- -- -- -- 238 0.1% 1,878 0.5%
-------- -------- -------- ---------
Operating income.............. 5,534 2.4% 8,180 3.9% 4,218 1.0% 4,326 1.1%
Other expense, net............ (2,285) (1.0)% (290) (0.1)% (4,600) (1.1)% (1,849) (0.5%)
-------- -------- -------- ---------
Income (loss) before income
taxes....................... 3,249 1.4% 7,890 3.7% (382) -- 2,477 0.6%
Income tax expense............ 2,032 2,692 710 1,173
-------- -------- -------- ---------
Income (loss) from continuing
operations.................. 1,217 0.5% 5,198 2.5% (1,092) (0.3)% 1,304 0.3%
Discontinued operations --
Operating results, net of
tax....................... 2,074 (261) 5,483 (113)
Estimated loss on
disposition, net of tax... -- (169) -- (11,156)
Cumulative effect of change in
accounting principle, net of
tax......................... -- -- -- (202,521)
-------- -------- -------- ---------
Net income (loss)............. $ 3,291 $ 4,768 $ 4,391 $(212,486)
======== ======== ======== =========

Revenues -- Revenues decreased $15.8 million, or 6.9%, to $211.9 million
for the second quarter of 2002 and decreased $29.2 million, or 6.8%, to $401.4
million for the first six months of 2002 compared to the same

periods in 2001. The 6.9% decline in revenue for the quarter was comprised of a
6.1% decline in revenues at ongoing operations and a 0.8% decline in revenues
related to operations that were sold or shut down during 2001. The 6.8% decline
in revenues for the first six months of 2002 was comprised of a 5.7% decline in
revenues at ongoing operations and a 1.1% decline in revenues related to
operations that were sold or shut down during 2001.

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

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

The Company's backlog associated with continuing operations as of June 30,
2002 was $466.5 million, a 13.0% increase as compared to December 31, 2001
backlog of $412.8 million and a 1.0% decrease from June 30, 2001 backlog of
$471.0 million.

Gross Profit -- Gross profit decreased $4.4 million, or 10.2%, to $38.7
million for the second quarter of 2002 and decreased $10.3 million, or 13.0%, to
$69.2 million for the first six months of 2002 compared to the same periods in
2001. As a percentage of revenues, gross profit decreased from 19.0% for the
three months ended June 30, 2001 to 18.3% for the three months ended June 30,
2002 and decreased from 18.5% for the six months ended June 30, 2001 to 17.2%
for the six months ended June 30, 2002.

The decline in gross profit was primarily due to market-driven project
delays at a number of the Company's operations. These project delays affected
the Company's revenue volume and profitability throughout the first quarter of
2002, and continued to affect operations during the first part of the second
quarter. In addition, the Company recorded lower margins on certain of its
projects that were completed at one of its operating locations in the West
during the first quarter of 2002 as a result of execution shortfalls.

Selling, General and Administrative Expenses ("SG&A") -- SG&A decreased
$5.0 million, or 14.1%, to $30.6 million for the second quarter of 2002 and
decreased $7.9 million, or 11.2%, to $63.0 million for the first six months of
2002 compared to the same periods in 2001. As a percentage of revenues, SG&A
decreased from 15.6% for the three months ended June 30, 2001 to 14.4% for the
three months ended June 30, 2002 and decreased from 16.5% for the six months
ended June 30, 2001 to 15.7% for the six months ended June 30, 2002. The
decrease in SG&A is primarily due to a concerted effort to reduce SG&A
throughout the Company. In response to the smaller size of the Company following
the sale of 19 units to Emcor as discussed further below under "Discontinued
Operations," the Company reduced corporate overhead at the end of the first
quarter of 2002. The cost of this workforce reduction is included in
restructuring charges recorded in March 2002. The Company realized lower
corporate overhead costs during the second quarter of 2002 as a result of these
steps. In addition, during the second quarter of 2002, the Company reversed $0.8
million of bad debt reserves that were established in the fourth quarter of 2001
related to the Company's receivables with Kmart based upon a post-bankruptcy
petition settlement agreement which was recently executed with Kmart.

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

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

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

Other Expense, Net -- Other expense, net, primarily includes interest
expense, and decreased $2.0 million, or 87.3%, to $0.3 million for the second
quarter of 2002 and decreased $2.8 million, or 59.8%, to $1.8 million for the
first six months of 2002. A portion of the Company's actual interest expense in
both years has been allocated to the discontinued operations caption based upon
the Company's net investment in these operations. Therefore, interest expense
relating to continuing operations does not reflect the pro forma reduction of
interest expense from applying the proceeds from the sale of these operations to
reduce debt in any earlier period. Interest expense allocated to the
discontinued operations for the three months ended June 30, 2001 was $3.9
million and for the six months ended June 30, 2001 and 2002 was $7.7 million and
$1.5 million, respectively. In addition, first quarter 2002 interest expense in
continuing operations includes a non-cash writedown of $0.6 million, before
taxes, of loan arrangement costs in connection with the reduction in the
Company's borrowing capacity following the Emcor transaction, as discussed
further below under "Liquidity and Capital Resources." Other expense, net, for
the second quarter of 2002 also includes a gain of $0.6 million on the sale of
the residential portion of one of the Company's operations.

Income Tax Expense -- The Company's effective tax rates associated with
results from continuing operations for the six months ended June 30, 2001 and
2002 were (185.9)% and 47.4%, respectively. As a result of the discontinuation
of goodwill amortization as a result of the adoption of SFAS No. 142 effective
January 1, 2002, there is no longer a permanent difference related to the
non-deductible goodwill amortization in the 2002 effective tax rate.

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

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

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

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

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

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

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

LIQUIDITY AND CAPITAL RESOURCES

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

For the three months ended June 30, 2002, the Company had positive free
cash flow of $11.0 million as compared to $23.7 million for the same period in
2001. For the six months ended June 30, 2002, the Company had negative free cash
flow of $0.2 million as compared to positive free cash flow of $29.2 million for
the same period in 2001. The 2001 cash flow amounts include the 19 operations
the Company sold to Emcor in 2002. This primarily accounts for the lower amounts
in 2002.

The transaction with Emcor provided for a post-closing adjustment based on
a final accounting, done after the closing of the transaction, of the net assets
of the operations that were sold to Emcor. That accounting indicated that the
net assets transferred to Emcor were approximately $7 million greater than a
target amount that had been agreed to with Emcor. In accordance with the
transaction agreement, Emcor paid the Company that amount, and released $2.5
million that had been escrowed in connection with this element of the
transaction. The total of these two amounts, $9.5 million, was reflected as a
receivable in the Company's March 31, 2002 financial statements. This payment
was received by the Company during the second quarter and is included in
"Proceeds from businesses sold, net of cash sold and transaction costs" in the
Company's statement of cash flows.

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

Revolving Credit Facility -- The Company's principal current debt financing
and operating liquidity is provided by a revolving credit facility (the "Credit
Facility" or the "Facility") with Bank One, Texas, N.A. ("Bank One") and other
banks (including Bank One, the "Bank Group"). The Facility's general terms allow
for the Company to borrow up to the lesser of $100 million or 80% of accounts
receivable, net of reserves ("Net Receivables"). Borrowings under the Facility
are also effectively limited by a requirement that they not result in the
Company's ratios of earnings before interest, taxes, depreciation and
amortization ("EBITDA") to interest expense and debt to EBITDA exceeding certain
levels. Based on the most restrictive of these ratio-related limits, effective
borrowing capacity under the Facility is currently $70.4 million. Borrowings
under the Facility are secured by accounts receivable, inventory, fixed assets
other than real estate, and the shares of capital stock of the Company's
subsidiaries. The Credit Facility expires on January 1, 2003, at which time all
amounts outstanding are due.