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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

~~(Mark One)~~
ý	~~QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934~~
~~For the quarterly period ended September 30, 2004~~
(Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2005 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to �� OR
o	~~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~~ 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)		~~(I.R.S. Employer~~ Identification No.)
777 Post Oak Boulevard
Suite 500
Houston, Texas 77056
(Address of Principal Executive Offices) (Zip Code)
~~Registrant's~~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 ýx No o.

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

The number of shares outstanding of the ~~issuer's~~issuer’s common stock, as of ~~October 29, 2004~~May 2, 2005 was ~~39,158,292.~~39,434,983.

COMFORT SYSTEMS USA, INC.
INDEX TO FORM 10-Q
FOR THE QUARTER ENDED ~~SEPTEMBER 30, 2004~~MARCH 31, 2005

					Page
Part I—Financial Information
	Item 1—Financial Statements
			COMFORT SYSTEMS USA, INC.
		Consolidated Balance Sheets		1
		Consolidated Statements of Operations		2
		Consolidated Statements of ~~Stockholders'~~Stockholders’ Equity		3
		Consolidated Statements of Cash Flows		4
		Condensed Notes to Consolidated Financial Statements		5
	Item 2—~~Management's~~Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
	Item 3—Quantitative and Qualitative Disclosures about Market Risk			41
	Item 4—Controls and Procedures			41
Part II—Other Information
	Item 1—Legal Proceedings			42
	Item 2—Recent Sales of Unregistered Securities			42
	Item 6—Exhibits and Reports on Form 8-K			42
	Signatures			44

COMFORT SYSTEMS USA, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share Amounts)

December 31,

March 31,

December 31,
2003
September 30,
2004

2004

2005

(Unaudited)

(Unaudited)

ASSETS ASSETS

CURRENT ASSETS: CURRENT ASSETS:

Cash and cash equivalents $ 10,129 $ 20,493
Accounts receivable, less allowance for doubtful accounts of $5,010 and $4,723 167,567 176,227
Other receivables 5,171 4,888
Inventories 9,825 10,510
Costs and estimated earnings in excess of billings 16,162 22,825
Prepaid expenses and other 13,675 10,547
Assets related to discontinued operations 973 —

Total current assets 223,502 245,490
Cash and cash equivalents

$
32,576

$
22,454

Accounts receivable, less allowance for doubtful accounts of $6,050 and $4,389, respectively

174,682

178,979

Other receivables

4,103

2,730

Inventories

10,590

10,376

Costs and estimated earnings in excess of billings

25,440

25,734

Prepaid expenses and other

13,338

13,986

Total current assets

260,729

254,259

PROPERTY AND EQUIPMENT, net PROPERTY AND EQUIPMENT, net 13,223 12,529

12,988

13,958

GOODWILL, net 103,470 103,470
GOODWILL

100,123

100,123

OTHER NONCURRENT ASSETS OTHER NONCURRENT ASSETS 10,915 9,262

9,276

8,738

Total assets $ 351,110 $ 370,751

LIABILITIES AND STOCKHOLDERS' EQUITY

Total assets

$
383,116

$
377,078

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES: CURRENT LIABILITIES:

Current maturities of long-term debt $ 1,594 $ 2,076
Accounts payable 58,516 58,894
Accrued compensation and benefits 22,664 21,670
Billings in excess of costs and estimated earnings 29,657 35,213
Income taxes payable — 1,701
Other current liabilities 26,746 29,864
Liabilities related to discontinued operations 122 —

Total current liabilities 139,299 149,418
Current maturities of long-term debt

$
2,071

$
2,068

Accounts payable

64,771

60,005

Accrued compensation and benefits

22,834

20,271

Billings in excess of costs and estimated earnings

37,104

40,015

Income taxes payable

3,700

471

Other current liabilities

29,288

29,686

Total current liabilities

159,768

152,516

LONG-TERM DEBT, NET OF CURRENT MATURITIES LONG-TERM DEBT, NET OF CURRENT MATURITIES 8,809 7,273

6,751

6,235

OTHER LONG-TERM LIABILITIES 2,342 2,800

Total liabilities 150,450 159,491
Total liabilities

166,519

158,751

COMMITMENTS AND CONTINGENCIES 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, 1,041,864 and 508,765 shares, respectively (6,305 ) (3,060 )
Additional paid-in capital 337,605 337,230
Deferred compensation (540 ) (1,517 )
Retained earnings (deficit) (130,493 ) (121,786 )

Total stockholders' equity 200,660 211,260

Total liabilities and stockholders' equity $ 351,110 $ 370,751

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 and 39,520,539 shares issued, respectively

393

396

Treasury stock, at cost, 24,462 shares

(148
)

—

Additional paid-in capital

337,719

339,237

Deferred compensation

(1,587
)

(2,055
)
Retained earnings (deficit)

(119,780
)

(119,251
)
Total stockholders’ equity

216,597

218,327

Total liabilities and stockholders’ equity

$
383,116

$
377,078

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)

Three Months Ended
March 31,

2004

2005

REVENUES

$
192,801

$
204,690

COST OF SERVICES

162,777

175,377

Gross profit

30,024

29,313

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

27,055

28,077

GAIN ON SALE OF ASSETS

(36
)
(34
)
Operating income

3,005

1,270

OTHER INCOME (EXPENSE):

Interest income

31

128

Interest expense

(528
)
(375
)
Other

(702
)
11

Other income (expense)

(1,199
)
(236
)
INCOME BEFORE INCOME TAXES

1,806

1,034

INCOME TAX EXPENSE

796

505

INCOME FROM CONTINUING OPERATIONS

1,010

529

DISCONTINUED OPERATIONS:

Operating income, net of income tax expense of $23

33

—

NET INCOME

$
1,043

$
529

INCOME PER SHARE:

Basic—

Income from continuing operations

$
0.03

$
0.01

Discontinued operations—

Income from operations

—

—

Net income

$
0.03

$
0.01

Diluted—

Income from continuing operations

$
0.03

$
0.01

Discontinued operations—

Income from operations

—

—

Net income

$
0.03

$
0.01

SHARES USED IN COMPUTING INCOME PER SHARE:

Basic

38,136

38,990

Diluted

39,443

40,062

~~(Unaudited)~~

Three Months Ended
September 30,
Nine Months Ended
September 30,

2003
2004
2003
2004

REVENUES $ 207,740 $ 211,530 $ 585,808 $ 608,279
COST OF SERVICES 172,900 178,250 490,079 511,854

Gross profit 34,840 33,280 95,729 96,425

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

27,825

26,687

86,999

79,459

RESTRUCTURING CHARGES 949 — 3,223 —

Operating income 6,066 6,593 5,507 16,966

OTHER INCOME (EXPENSE):

Interest income 29 40 80 83
Interest expense (1,107 ) (374 ) (2,752 ) (1,196 )
Write-off of debt costs — — (823 ) —
Other 42 (135 ) (105 ) (405 )

Other income (expense) (1,036 ) (469 ) (3,600 ) (1,518 )

INCOME BEFORE INCOME TAXES 5,030 6,124 1,907 15,448
INCOME TAX EXPENSE 2,435 2,634 1,005 6,643

INCOME FROM CONTINUING OPERATIONS 2,595 3,490 902 8,805

DISCONTINUED OPERATIONS:

Operating income, net of income tax expense of $229, $0, $454 and $27 353 — 715 39
Estimated loss on disposition, including income tax expense of $43, $0, $274 and $235 (2,773 ) — (3,685 ) (137 )

NET INCOME (LOSS) $ 175 $ 3,490 $ (2,068 ) $ 8,707

INCOME (LOSS) PER SHARE:
Basic—
Income from continuing operations $ 0.07 $ 0.09 $ 0.02 $ 0.23
Discontinued operations—
Income from operations 0.01 — 0.02 —
Estimated loss on disposition (0.08 ) — (0.09 ) —

Net income (loss) $ — $ 0.09 $ (0.05 ) $ 0.23

Diluted—
Income from continuing operations $ 0.07 $ 0.09 $ 0.02 $ 0.22
Discontinued operations—
Income from operations 0.01 — 0.02 —
Estimated loss on disposition (0.08 ) — (0.09 ) —

Net income (loss) $ — $ 0.09 $ (0.05 ) $ 0.22

SHARES USED IN COMPUTING INCOME (LOSS) PER SHARE:
Basic 37,713 38,418 37,659 38,298

Diluted 38,454 39,455 38,081 39,457

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

COMFORT SYSTEMS USA, INC.

CONSOLIDATED STATEMENTS OF ~~STOCKHOLDERS'~~STOCKHOLDERS’ EQUITY
(In Thousands, Except Share Amounts)

Common Stock
Treasury Stock

Additional
Paid-In
Capital
Deferred
Compensation
Retained
Earnings
(Deficit)
Total
Stockholders'
Equity

Shares
Amount
Shares
Amount

BALANCE AT DECEMBER 31, 2002 39,258,913 $ 393 (1,341,419 ) $ (8,214 ) $ 338,606 $ (785 ) $ (124,914 ) $ 205,086
Issuance of Treasury Stock:
Issuance of shares for options exercised including tax benefit — — 332,041 2,009 (907 ) — — 1,102
Shares received from sale of assets — — (32,486 ) (100 ) — — — (100 )
Amortization of deferred compensation — — — — (69 ) 245 — 176
Other — — — — (25 ) — — (25 )
Net loss — — — — — — (5,579 ) (5,579 )

BALANCE AT DECEMBER 31, 2003 39,258,913 393 (1,041,864 ) (6,305 ) 337,605 (540 ) (130,493 ) 200,660
Issuance of Treasury Stock:
Issuance of shares for options exercised including tax benefit (unaudited) — — 364,349 2,200 (633 ) — — 1,567
Issuance of restricted stock (unaudited) — — 225,000 1,353 361 (1,714 ) — —
Forfeiture of unvested restricted stock (unaudited) — — (56,250 ) (308 ) — 259 — (49 )
Amortization of deferred compensation (unaudited) — — — — (128 ) 478 — 350
Other (unaudited) — — — — 25 — — 25
Net income (unaudited) — — — — — — 8,707 8,707

BALANCE AT SEPTEMBER 30, 2004 (unaudited) 39,258,913 $ 393 (508,765 ) $ (3,060 ) $ 337,230 $ (1,517 ) $ (121,786 ) $ 211,260

Common Stock

Treasury Stock

Additional
Paid-In

Deferred

Retained
Earnings

Total
Stockholders’

Shares

Amount

Shares

Amount

Capital

Compensation

(Deficit)

Equity

BALANCE AT DECEMBER 31, 2003

39,258,913

$
393

(1,041,864
)

$
(6,305
)

$
337,605

$
(540
)

$
(130,493
)

$
200,660

Issuance of Stock:

Issuance of shares for options exercised including tax benefit

—

—

440,508

2,658

(724
)

—

—

1,934

Issuance of restricted stock

—

—

225,000

1,353

361

(1,714
)

—

—

Forfeiture of unvested restricted stock

—

—

(56,250
)

(308
)

—

259

—

(49
)

Amortization of deferred compensation

—

—

—

—

115

408

—

523

Shares issued for exercise of warrant

—

—

408,144

2,454

337

—

—

2,791

Other

—

—

—

—

25

—

—

25

Net income

—

—

—

—

—

—

10,713

10,713

BALANCE AT DECEMBER 31, 2004

39,258,913

393

(24,462
)

(148
)

337,719

(1,587
)

(119,780
)

216,597

Issuance of Stock:

Issuance of shares for options exercised including tax benefit (unaudited)

179,126

2

24,162

145

772

—

—

919

Issuance of restricted stock
(unaudited)

82,500

1

—

—

574

(575
)

—

—

Amortization of deferred compensation (unaudited)

—

—

—

—

175

107

—

282

Other (unaudited)

—

—

300

3

(3
)

—

—

—

Net income (unaudited)

—

—

—

—

—

—

529

529

BALANCE AT MARCH 31, 2005 (UNAUDITED)

39,520,539

$
396

—

$
—

$
339,237

$
(2,055
)

$
(119,251
)

$
218,327

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)

Three Months Ended
September 30,
Nine Months Ended
September 30,

Three Months Ended
March 31,

2003
2004
2003
2004

2004

2005

Net income (loss) $ 175 $ 3,490 $ (2,068 ) $ 8,707
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities—
Estimated loss on disposition of discontinued operations 2,773 — 3,685 137
Restructuring charges 949 — 3,223 —
Write-off of debt costs — — 823 —
Depreciation expense 1,301 1,315 4,024 3,617
Bad debt expense 420 428 1,888 1,623
Deferred tax expense 1,009 1,813 2,222 1,950
Amortization of debt financing costs 178 104 634 300
Loss (gain) on sale of assets (31 ) 34 184 (33 )
Deferred compensation expense 61 138 96 199
Mark-to-market warrant obligation 280 86 188 457
Amortization of debt discount 150 — 450 —
Changes in operating assets and liabilities, net of effects of divestitures—
(Increase) decrease in—
Receivables, net (7,401 ) (10,161 ) (5,938 ) (10,336 )
Inventories 184 269 1,617 (684 )
Prepaid expenses and other current assets (954 ) (1,741 ) (16 ) 970
Costs and estimated earnings in excess of billings (559 ) (554 ) 1,196 (6,665 )
Other noncurrent assets (30 ) 438 138 573
Increase (decrease) in—
Accounts payable and accrued liabilities (4,000 ) 3,432 607 6,409
Billings in excess of costs and estimated earnings (942 ) 6,030 2,580 5,557
Other, net — — (19 ) —
Taxes paid related to the sale of businesses — — (10,371 ) —

Net cash provided by (used in) operating activities (6,437 ) 5,121 5,143 12,781

CASH FLOWS FROM OPERATING ACTIVITIES:

Net income

$
1,043

$
529

Adjustments to reconcile net income to net cash used in operating activities—

Depreciation expense

1,138

1,065

Bad debt expense

679

(274
)
Deferred tax expense (benefit)

(38
)
269

Tax benefit from exercise of options

285

348

Amortization of debt financing costs

96

120

Loss (gain) on sale of assets or operations

(36
)
(34
)
Deferred compensation expense

53

187

Mark-to-market warrant obligation

711

—

Changes in operating assets and liabilities, net of effects of acquisitions and divestitures—

(Increase) decrease in—

Receivables, net

2,731

1,305

Inventories

(790
)
103

Prepaid expenses and other current assets

(373
)
970

Costs and estimated earnings in excess of billings

(2,476
)
862

Other noncurrent assets

106

112

Increase (decrease) in—

Accounts payable and accrued liabilities

(5,071
)
(13,840
)
Billings in excess of costs and estimated earnings

(2,791
)
2,737

Net cash used in operating activities

(4,733
)
(5,541
)
CASH FLOWS FROM INVESTING ACTIVITIES: CASH FLOWS FROM INVESTING ACTIVITIES:

Purchases of property and equipment (714 ) (963 ) (2,661 ) (3,180 )
Proceeds from sales of property and equipment 208 — 319 283
Proceeds from businesses sold, net of cash sold and transaction costs (4 ) 156 (2,754 ) 1,266

Net cash used in investing activities (510 ) (807 ) (5,096 ) (1,631 )

Purchases of property and equipment

(1,317
)
(2,043
)
Proceeds from sales of property and equipment

129

148

Proceeds from businesses sold, net of cash sold and transaction costs

933

205

Cash paid for acquisition, including cash acquired

—

(2,943
)
Net cash used in investing activities

(255
)
(4,633
)
CASH FLOWS FROM FINANCING ACTIVITIES: CASH FLOWS FROM FINANCING ACTIVITIES:

Net borrowings (payments) on revolving line of credit 3,779 — 3,672 —
Payments on other long-term debt (399 ) (533 ) (1,402 ) (1,086 )
Borrowings of other long-term debt — — 18 32
Debt financing costs (158 ) (30 ) (835 ) (808 )
Proceeds from exercise of options 130 37 216 1,069

Net cash provided by (used in) financing activities 3,352 (526 ) 1,669 (793 )

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (3,595 ) 3,788 1,716 10,357
Net borrowings on revolving line of credit

—

—

Payments on other long-term debt

(21
)
(519
)
Debt financing costs

(709
)
—

Proceeds from exercise of options

701

571

Net cash provided by (used in) financing activities

(29
)
52

NET DECREASE IN CASH AND CASH EQUIVALENTS

(5,017
)
(10,122
)
CASH AND CASH EQUIVALENTS, beginning of period—continuing operations and discontinued operations CASH AND CASH EQUIVALENTS, beginning of period—continuing operations and discontinued operations 11,415 16,705 6,104 10,136

10,136

32,576

CASH AND CASH EQUIVALENTS, end of period—continuing operations and discontinued operations CASH AND CASH EQUIVALENTS, end of period—continuing operations and discontinued operations $ 7,820 $ 20,493 $ 7,820 $ 20,493

$
5,119

$
22,454

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

COMFORT SYSTEMS USA, INC.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
~~September 30, 2004~~
~~(Unaudited)~~
1.   Business and Organization
Comfort Systems USA, Inc., a Delaware corporation ("(“Comfort ~~Systems"~~Systems” and collectively with its subsidiaries, the ~~"Company"~~“Company”), is a national provider of comprehensive heating, ventilation and air conditioning ~~("HVAC"~~(“HVAC”) installation, maintenance, repair and replacement services within the mechanical services industry. The Company operates primarily in the commercial, industrial and institutional 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 55% of the ~~Company's~~Company’s consolidated ~~2004~~2005 revenues to date are attributable to installation of systems in newly constructed facilities, with the remaining 45% attributable to maintenance, repair and replacement services. The following service activities account for the ~~Company's~~Company’s consolidated ~~2004~~2005 revenues to date: ~~HVAC—74%~~HVAC - 71%, ~~plumbing—13%~~plumbing - 16%, building automation control ~~systems—~~systems – 6%, and ~~other—~~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 ~~("SEC"~~(“SEC”) for the year ended December 31, ~~2003~~2004 (the ~~"Form 10-K"~~“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 of the SEC. Accordingly, these financial statements do not include all the 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.
Cash Flow Information
Cash paid for interest for continuing and discontinued operations for the ~~nine~~three months ended ~~September 30, 2003~~March 31, 2004 and ~~2004~~2005 was approximately ~~$1.4~~$0.1 million and ~~$0.7~~$0.2 million, respectively. Cash paid for income taxes for continuing operations for the ~~nine~~three months ended ~~September 30, 2003~~March 31, 2004 and ~~2004~~2005 was approximately ~~$1.8~~$0.2 million and ~~$4.4~~$3.1 million, respectively. Cash paid for income taxes for discontinued operations for both of the ~~nine~~three months ended ~~September 30, 2003~~March 31, 2004 and ~~2004~~2005 was approximately $9.0 million and $0.4 million, respectively. The cash tax payments for 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 theless than $0.1 million.

~~caption "Taxes paid related to the sale of businesses" in the accompanying Consolidated Statement of Cash Flows.~~
Segment Disclosure
Comfort ~~Systems'~~Systems’ activities are within the mechanical services industry which is the single industry segment served by the Company. Under Statement of Financial Accounting Standards ~~("SFAS"~~(“SFAS”) No. 131, ~~"Disclosures~~“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~~131’s aggregation criteria.
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~~Company’s financial statements ~~include~~affect revenue and cost recognition for construction contracts, the allowance for doubtful accounts, self-insurance accruals, deferred tax assets, warranty accruals, and the quantification of fair value for reporting units in connection with the ~~Company's~~Company’s goodwill impairment testing.
Income Taxes
The Company files a consolidated return for federal income tax purposes. Income taxes are provided for under the liability method in accordance with SFAS No. 109, ~~"Accounting~~“Accounting for Income Taxes,"” which takes into account differences between financial statement treatment and tax treatment of certain transactions. Deferred tax assets represent the tax effect of activity that has been reflected in the financial statements but which will not be deductible for tax purposes until future periods. Deferred tax liabilities represent the tax effect of activity that has been reflected in the financial statements but which will not be taxable until future periods.
The ~~Company's~~Company regularly evaluates valuation allowances established for deferred tax assets for which future realization is uncertain. The Company performs this evaluation at least annually at the end of each fiscal year. Estimations of required valuation allowances include estimates of future taxable income. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the activity underlying these assets becomes deductible. The Company considers projected future taxable income and tax planning strategies in making this assessment. If actual future taxable income differs from our estimates, the Company may not realize deferred tax assets to the extent it has estimated.
The effective tax rate associated with results from continuing operations ~~for the third quarter of 2004~~ was ~~43.0%~~48.8%, as compared to ~~48.4%~~44.1% in ~~2003. For the first nine months of 2004 and 2003, the Company's corresponding~~2004. The Company’s effective tax ~~rates were 43.0% and 52.7%, respectively. The Company's effective~~ rate is generally higher than statutory rates because of the effect of certain expenses that ~~it incurs that~~ are not deductible for tax ~~purposes,~~purposes. In addition, adjustments to tax reserves are analyzed and ~~due~~adjusted quarterly as events occur to warrant such changes. Adjustments to tax reserves ~~that~~are a component of the effective tax rate.
New Accounting Pronouncements
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” (“Statement 123(R)”) which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation (“Statement 123”).” Statement 123(R) supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“Opinion 25”) and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee

stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Statement 123(R) must be adopted no later than January 1, 2006. Early adoption will be permitted for periods in which financial statements have not yet been issued. The Company ~~has established against certain deferred tax assets~~expects to adopt Statement 123(R) on January 1, 2006.
Statement 123(R) permits public companies to adopt its requirements using one of two methods:
1.                A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the ~~possibility~~requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.
2.                A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
The Company plans to adopt Statement 123(R) using the modified prospective method.
As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options in its statement of operations. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on the Company’s reported results of operations, although it will ~~not~~have no impact on the Company’s cash flows. The impact of adoption of Statement 123(R) cannot be ~~able to ultimately realize~~predicted at this time because it will depend on levels of share-based payments granted in the ~~tax benefit for certain losses it has incurred, primarily at~~future. However, had the ~~state income tax level. In addition, since the Company's recent pre-tax profit margins have been relatively low on a historical and an absolute basis,~~Company adopted Statement 123(R) in prior periods, the impact of ~~non-deductible expenses~~that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and ~~deferred tax reserves on the Company's effective rate is magnified. This latter impact also contributes~~earnings per share in Note 2 to the ~~higher level~~Company’s consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in both of the ~~Company's 2003 effective rates as compared to~~first quarters of 2004 ~~as its pre-tax profit levels were noticeably lower in 2003 than in 2004.~~and 2005 for such tax benefits was $0.3 million.

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").~~Opinion 25. Under this accounting method, no expense in connection with the ~~Company's~~Company’s stock option plans 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 ~~Financial Accounting Standards Board ("FASB")~~FASB issued ~~SFAS No.~~Statement 123, ~~"Accounting for Stock-Based Compensation,"~~ which requires that if a company accounts for stock-based compensation in accordance with ~~APB~~Opinion 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~~

company’s statement of operations. These effects for the Company are as follows (in thousands, except per share data):

Three Months Ended
September 30,
Nine Months Ended
September 30,

2003
2004
2003
2004

Net Income (Loss) as reported $ 175 $ 3,490 $ (2,068 ) $ 8,707
Add: Stock-based compensation included in reported net income, net of tax 40 90 62 129
Less: Compensation expense per SFAS No. 123, net of tax (479 ) (95 ) (1,953 ) (1,027 )

Pro forma Net Income (Loss) $ (264 ) $ 3,485 $ (3,959 ) $ 7,809

Net Income (Loss) Per Share—Basic
Net Income (Loss) per share as reported $ — $ 0.09 $ (0.05 ) $ 0.23
Pro forma Net Income (Loss) per share $ (0.01 ) $ 0.09 $ (0.11 ) $ 0.20

Net Income (Loss) Per Share—Diluted

Net Income (Loss) per share as reported $ — $ 0.09 $ (0.05 ) $ 0.22
Pro forma Net Income (Loss) per share $ (0.01 ) $ 0.09 $ (0.10 ) $ 0.20

Three Months Ended
March 31,

    2004

    2005

Net Income as reported

$
1,043

$
529

Add: Stock-based compensation included in reported net income, net of tax

34

122

Less: Compensation expense per Statement 123, net of tax

(443
)

(376
)

Pro Forma Net Income

$
634

$
275

Net Income Per Share—Basic

Net Income per share as reported

$
0.03

$
0.01

Pro Forma Net Income per share

$
0.02

$
0.01

Net Income Per Share—Diluted

Net Income per share as reported

$
0.03

$
0.01

Pro Forma Net Income per share

$
0.02

$
0.01

One element of determining the pro forma expense for stock-based compensation per SFAS No. 123 included in the above table is an estimate of the amount of forfeitures of stock-based compensation awards the Company will experience. The Company updated its estimates of forfeitures during the third quarter to more fully reflect the forfeiture activity it has observed over recent periods. This update resulted in an increase in forfeiture estimates, which in turn resulted in a lower pro forma expense amount for the third quarter than the Company generally experiences. Management believes that the effect of these increased forfeiture estimates and corresponding decreases in pro forma expense are not material.
Stock Option Plans—The effects of applying ~~SFAS No.~~Statement 123 in the pro forma disclosure may not be indicative of future amounts, as additional option awards in future years are anticipated. The Company did not grant any options during the three months ended March 31, 2004. The fair value of ~~each option grant~~options granted during the three months ended March 31, 2005 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

2003
2004
Expected dividend yield 0.00% 0.00%
Expected stock price volatility 62.08% 61.30%
Risk-free interest rate 2.94%-3.64% 3.96%-4.38%
Expected life of options 7 years 7 years
2005
Expected dividend yield
0.00
%
Expected stock price volatility
61.23
%
Risk-free interest rate
3.97
%
Expected life of options
7 years
Restricted Stock—The Company has awarded shares of restricted stock to members of management, as discussed in Note 8, “Stockholders’ Equity.” The fair value of shares awarded during the first quarter of 2005 was $5.58. The Company did not grant any shares of restricted stock during the first quarter of 2004.
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.   Acquisition
On January 17, 2005, the Company completed the acquisition of Granite State Plumbing & Heating (“Granite”), an HVAC contractor located near Manchester, New Hampshire. This acquisition will increase the Company’s presence in the Northeast, specifically in the Boston region and southern New Hampshire. The total consideration paid in this transaction was approximately $2.9 million, comprised entirely of cash, including cash acquired. The fair value of the tangible net assets acquired exceeded the total consideration paid. As a result, the long-term fixed assets of the acquisition were reduced by this excess amount. The consolidated balance sheet of Comfort Systems includes an allocation of the purchase price to the assets acquired and liabilities assumed based on preliminary estimates of fair value and are subject to final adjustment. The Company is reviewing the values assigned to certain assumed liabilities, and does not expect that these adjustments will be material. The purchase price was preliminarily allocated as follows (amounts in thousands):
Accounts receivable, net

$
5,223

Costs and estimated earnings in excess of billings

1,156

Other current assets

284

Property and equipment

210

Less:   Accounts payable

(2,983
)
Less:   Billings in excess of costs and estimated earnings

(175
)
Less:   Other current liabilities

(747
)
Less:   Other long-term liabilities

(25
)
Cash paid, including cash acquired

$
2,943

The results of operations of Granite are included in the Company’s consolidated financial statements from January 17, 2005 through March 31, 2005.
The unaudited pro forma data presented below reflect the results of operations of Comfort Systems and the acquisition of Granite assuming the transaction was completed on January 1, 2004 (in thousands, except per share data):

Three Months Ended
March 31,

2004

2005

Revenues

$
198,611

$
205,760

Net income

$
1,137

$
519

Net income per share—basic

$
0.03

$
0.01

Net income per share—diluted

$
0.03

$
0.01

4.Discontinued Operations
        ~~Individual Sales of Operating Companies~~~~—During the second quarter of~~In 2004, the Company sold a small operating company. ~~This unit's~~The after-tax income of ~~$0.1 million~~this company for the first ~~nine months~~quarter of ~~2003 and~~2004 was less than $0.1 million ~~for the first six months of 2004~~and has been reported in discontinued operations under ~~"Operating~~“Operating income, net of income tax ~~expense".~~expense.” The loss recognized by the Company ~~recorded a loss~~ on the sale of this unit ~~of $0.5 million, including taxes,~~ in the second quarter of 2004 was $0.5 million, including tax expense, and was reported in discontinued operations under ~~"Estimated~~

“Estimated loss on disposition, including income ~~tax expense". The~~taxes.” This loss primarily resulted from the non-cash writeoff of goodwill associated with this unit. ~~The~~This goodwill writeoff was not tax deductible.

        During the fourth quarter of 2003, the Company sold a small operating company. This unit's after-tax income of $0.3 million for the nine months ended September 30, 2003 has been reported in discontinued operations under "Operating income, net of income tax expense." The Company recorded a loss of $1.5 million, net of tax benefit, in the fourth quarter of 2003 in discontinued operations under "Estimated loss on disposition, including income tax expense." The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        During the third quarter of 2003, the Company committed to a plan to divest of a small operating company. This unit's after-tax income of $0.2 million for the nine months ended September 30, 2003 has been reported in discontinued operations under "Operating income, net of income tax expense." The Company recorded an estimated loss of $2.8 million, including taxes, in the third quarter of 2003 related to this planned disposition in discontinued operations under "Estimated loss on disposition, including income tax expense" based upon an estimated sales price. The final loss as measured at the closing of this sale in the fourth quarter of 2003 was not materially different than the estimate recorded in the preceding quarter. The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        During the first quarter of 2003, the Company committed to a plan to divest of a small operating company. This unit's after-tax income of $0.1 million for the six months ended June 30, 2003 has been reported in discontinued operations under "Operating income, net of income tax expense." The Company recorded an estimated loss of $0.9 million, including tax expense, in the first quarter of 2003 related to this transaction in discontinued operations under "Estimated loss on disposition, including income tax expense." The final loss as measured at the closing of this sale in the second quarter of 2003 was not materially different than the estimate recorded in the preceding quarter. The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        ~~Assets~~Revenues and ~~liabilities~~pre-tax income related to the operation ~~sold~~discontinued in ~~the second quarter of~~ 2004 were as follows (in thousands):

December 31,
2003
Cash $ 7
Accounts receivable, net 372
Other current assets 22
Property and equipment, net 8
Goodwill, net 564

Total assets $ 973

Accounts payable

$
50
Other current liabilities 72

Total liabilities $ 122

Three Months Ended
March 31, 2004

Revenues

$
422

Pre-tax income

$
56

        ~~Revenues~~
The Company’s consolidated statements of operations and ~~pre-tax income~~the related earnings per share amounts have been restated to reflect the ~~operations~~effects of the discontinued ~~in 2003 and 2004 were as follows (in thousands):~~operation.

Nine Months Ended
September 30,

2003
2004
Revenues $ 12,753 $ 684
Pre-tax income $ 1,169 $ 66
Sale of Companies to Emcor—On March 1, 2002, the Company sold 19 operations to Emcor Group, Inc. ~~("Emcor"~~(“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 Company has realized an aggregate loss of ~~$11.5~~$10.9 million, including related tax expense, in connection with the sale of these operations. As a result of the adoption of SFAS No. 142, ~~"Goodwill~~“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 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~~Emcor’s purchase price, $5 million was deposited into an escrow account to secure potential obligations on the ~~Company's~~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~~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 were used to reduce the ~~Company's~~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 discontinued operations under ~~"Estimated~~“Estimated loss on disposition, including income ~~tax expense"~~taxes” in connection with the Emcor transaction. This charge primarily ~~relates~~related to a settlement with Emcor for reimbursement of impaired assets and additional liabilities associated with the operations acquired from the Company. The gross amount of the settlement, before application of any escrow amounts or related tax benefits, was $7.9 million. 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~~The Company ~~paid $2.7 million in cash to Emcor associated with this settlement. The settlement agreement also included the use of $2.5~~applied $4 million of the $5 million general 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, of which $0.8 million was paid from escrow during September 2003 and an additional $0.2 million was paid from escrow during May 2004.reduce its liability under this settlement. 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.~~the net of the settlement amount and the application of the escrow. In addition, the ~~$1.2~~Company also recognized a separate tax credit of $1.3 million ~~charge recognized during~~in 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 estimated when the transaction originally closed in the first quarter ~~of 2002.~~

of 2002. These fourth quarter 2002 charges are recapped below along with all other activity related to the Company’s aggregate loss on disposition recognized on the Emcor transaction.
The fourth quarter 2002 settlement with Emcor described above has been funded through $2.7 million of direct payments by the Company in 2003, and by the application of $3.3 million in escrow funds to date.
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.
There are ongoing open matters relating to this transaction that the Company continues to address with Emcor. The Company does not believe these open matters, either individually or in the aggregate, will have a material effect on the ~~Company's~~Company’s financial position when ultimately resolved. The Company maintains reserves for these matters, net of amounts receivable from escrow that it believes will ultimately be applied in settling these matters. During the second quarter of 2004, the Company concluded that the related reserves should be reduced by $0.3 million, net of tax benefit. ~~This amount was~~Additionally, during the fourth quarter of 2004, the Company reduced these reserves by $0.2 million, net of tax. These amounts are reflected in discontinued operations in ~~the second quarter of~~ 2004 as a reduction in the estimated loss on disposition of discontinued operations.
4.Recap of Income Statement Activity Affecting Loss on Disposition of Companies to Emcor (in thousands):

Activity
During
Indicated
Quarters

Cumulative
Loss On
Disposition

First Quarter 2002

Purchase Price

$
186,250

Less escrow

(5,000
)

Less book basis in net assets of companies sold

(163,576
)

Less transaction wrap-up costs

(2,106
)

Plus estimated tax liability associated with transaction

(26,180
)

Loss recognized during First Quarter 2002

(10,612
)

$
(10,612
)

Fourth Quarter 2002

Settlement with Emcor for reimbursement of impaired assets and additional liabilities associated with companies sold to Emcor

(7,884
)

Application of escrow in the settlement

4,000

Tax benefit of settlement

1,359

Reduction in estimated tax liability on sale transaction as a whole

1,371

Other

(67
)

Loss recognized during Fourth Quarter 2002

(1,221
)

(11,833
)

Second Quarter 2004

Reduction in reserves needed for ongoing matters related to transaction

512

Taxes related to reduction in reserves

(179
)

Reduction to loss recognized in Second Quarter 2004

333

(11,500
)

Fourth Quarter 2004

Reduction in reserves needed for ongoing matters related to transaction

371

Taxes related to reduction in reserves

(130
)

Reduction in estimated tax liability on sale transaction as a whole

377

Reduction to loss recognized in Fourth Quarter 2004

618

$
(10,882
)

11

Recap of Cash Proceeds on Emcor Transaction (in thousands):

   Cumulative
Cash
Proceeds

Purchase Price

$
186,250

Less escrow for post-closing balance sheet adjustment

(2,500
)

Less general escrow

(5,000
)

Less debt and accrued interest transferred to Emcor relating to companies sold to Emcor

(22,479
)

Initial cash proceeds

156,271

Additional proceeds received in Second Quarter 2002 relating to post-closing balance sheet adjustment, net of related escrow

7,050

Recovery in Second Quarter 2002 of escrow for post-closing balance sheet adjustment

2,500

Direct payments by the Company in 2003 related to Fourth Quarter 2002 settlement for reimbursement of impaired assets and additional liabilities of companies sold to Emcor

(2,744
)

Payment of income taxes in 2003 in connection with the transaction

(10,371
)

Payment of transaction and wrap-up costs

(2,427
)

Recovery of a portion of general escrow in 2004 in connection with reduction of reserves needed for ongoing matters related to transaction

400

Other

(557
)

Net cash proceeds received as of March 31, 2005

$
150,122

Recap of Use of General Escrow in Emcor Transaction (in thousands):
Escrow Income Statement Recognition

Original general escrow—not recognized in income statement determination of loss on disposition of companies to Emcor

$
5,000

Application of escrow in Fourth Quarter 2002 to reduce additional loss on transaction in connection with settlement involving reimbursement for impaired assets and additional liabilities of companies sold to Emcor

(4,000
)
Remaining escrow available as of March 31, 2005 to be applied against any income statement charges associated with future claims that may arise in connection with the transaction

$
1,000

Escrow Funds Use

Original general escrow

$
5,000

Use in 2003 in connection with settlement in Fourth Quarter 2002 involving reimbursement for impaired assets and additional liabilities of companies sold to Emcor

(3,339
)
Use in 2004 in connection with the settlement of other matters

(196
)
Recovery of a portion of general escrow in 2004 in connection with reduction of reserves needed for ongoing matters related to transaction

(400
)
Remaining escrow balance as of March 31, 2005, available to be applied to future claims that may arise in connection with transaction

$
1,065

5.   Restructuring Charges
During the first three quarters of 2003, the Company recorded restructuring charges of approximately $3.2 million pre-tax. These charges included approximately $1.5 million for severance costs and retention bonuses primarily associated with the curtailment of the ~~Company's~~Company’s energy efficiency marketing activities, a reorganization of the ~~Company's~~Company’s national accounts operations as well as a reduction in corporate personnel. The severance costs and retention bonuses related to the termination of 88 employees, all of whom had left the Company by December 31, 2003. The restructuring charges for this period also included

approximately $1.6 million for remaining lease obligations and $0.1 million of other costs recorded in connection with the actions described above. The Company increased its accrual for these remaining lease obligations by ~~$0.5~~$0.6 million in 2004 based on revised estimates of when and to what extent it believes it can sublease the related facilities. These increases to the accrual were included in ~~"Cost~~“Cost of ~~Services"~~Services” and in ~~"Selling,~~“Selling, General and Administrative ~~Expenses"~~Expenses” in the ~~Company's~~Company’s consolidated statement of operations.
        ~~The Company also recorded restructuring charges in 2000 and 2002. As of December 31, 2003 and September 30, 2004, accrued~~Accrued lease termination costs ~~of $0.6 million and $0.3 million, respectively, remain that were associated with the~~remaining from past restructuring charges ~~recorded during 2000 and 2002.~~are expected to be completed by 2009.
The following table shows the remaining liabilities associated with the cash portion of the restructuring charges as of December 31, ~~2003~~2004 and ~~September 30, 2004~~March 31, 2005 (in thousands):

Balance at
Beginning of Period
Additions
Payments
Balance at
End of Period
Year Ended December 31, 2003:
Severance $ — $ 1,507 $ (1,507 ) $ —
Lease termination costs and other 1,000 1,716 (971 ) 1,745

Total $ 1,000 $ 3,223 $ (2,478 ) $ 1,745

Nine Months Ended September 30, 2004:
Lease termination costs and other $ 1,745 $ 478 (a) $ (877 ) $ 1,346

Balance at
Beginning of Period

Additions

Payments

Balance at
End of Period

Year Ended December 31, 2004:

Lease termination costs and other

$
1,745

$
610
(a)

$
(1,074
)

$
1,281

Three Months Ended March 31, 2005:

Lease termination costs and other

$
1,281

$
—

$
(247
)

$
1,034

(a)
These charges were included in ~~"Cost~~“Cost of ~~Services"~~Services” and in ~~"Selling,~~“Selling, General and Administrative ~~Expenses"~~Expenses” in the ~~Company's~~Company’s consolidated statement of operations.

5.     6.   Long-Term Debt Obligations
Long-term debt obligations consist of the following (in thousands):

December 31,
2003
September 30,
2004

Revolving credit facility $ — $ —
Term loan 10,000 9,000
Other 403 349

Total debt 10,403 9,349
Less—current maturities (1,594 ) (2,076 )

Total long-term portion of debt $ 8,809 $ 7,273

December 31,

  March 31,

2004

2005

Revolving credit facility

$
—

$
—

Term loan

8,500

8,000

Other

322

303

Total debt

8,822

8,303

Less—current maturities

(2,071
)

(2,068
)

Total long-term portion of debt

$
6,751

$
6,235

Credit Facility
On December 31, 2003, the Company entered into a senior credit facility (the ~~"Facility"~~“Facility”) provided by a syndicate of banks. As of ~~September 30, 2004~~March��31, 2005, the total of the Facility was ~~$54.0~~$53.0 million, with ~~$26.3~~$8.0 million in borrowings ~~and~~outstanding, $18.6 million in letters of credit outstanding, and ~~$27.7~~$26.4 million of credit available. As of ~~October 29, 2004,~~May 2, 2005, the total of the Facility was ~~$53.5~~$52.5 million, with ~~$25.8~~$7.5 million in borrowings ~~and~~outstanding, $19.4 million in letters of credit outstanding, and ~~$27.7~~$25.6 million of credit available. The Facility consists of two parts: a term loan and a revolving credit facility.
The original term loan under the Facility (the ~~"Term Loan"~~“Term Loan”) was $10 million, which the Company borrowed upon the closing of the Facility. The Term Loan must be repaid in installments of $0.5 million payable at the beginning of each quarter over five years, the first installment of which was paid in the second quarter of 2004. The Facility requires prepayments of the Term Loan in certain circumstances generally involving the sale of assets. All principal payments under the Term Loan permanently reduce the original $10 million capacity under this portion of the Facility.
The Facility also included a three-year $40 million revolving credit facility (the ~~"Revolving Loan"~~“Revolving Loan”) available for borrowings or letters of credit. This was increased to $45 million in the second quarter of 2004. The Facility requires that borrowings outstanding under the Revolving Loan must be less than $2 million for ten consecutive business days at least once during each year. The Company has already satisfied this condition for ~~2004.~~2005.

Certain of the ~~Company's~~Company’s vendors require letters of credit to ensure reimbursement for amounts they are disbursing on the ~~Company's~~Company’s behalf, such as to beneficiaries under the ~~Company's~~Company’s self-funded insurance programs. The Company has also occasionally used letters of credit to guarantee performance under its contracts and to ensure payment to its subcontractors and vendors under those contracts. The ~~Company's~~Company’s lenders issue such letters of credit through the Revolving Loan portion of the Facility. A letter of credit commits the lenders 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 lenders for amounts they fund to honor the letter of credit ~~holder's~~holder’s claim. Absent a claim, there is no payment or reserving of funds by the Company in connection with a letter of credit. However, because a claim on a letter of credit would require immediate reimbursement by the Company to its lenders, letters of credit are treated as a use of Facility capacity just the same as actual borrowings. Depending on the circumstances of such a reimbursement, the Company may also have to record a charge to earnings for the reimbursement. Claims against letters of credit are rare in the ~~Company's~~Company’s industry. The Company has never had a claim made against a letter of credit that resulted in payments by ~~the issuer of the letter of credit~~a lender 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's~~Company’s borrowings and letters of credit outstanding under the Facility at each monthend must be less than a borrowing base measured as of the same monthend. The borrowing base is defined under the

Facility as 60% of the following: total trade receivables including costs and estimated earnings in excess of billings, less allowances for doubtful accounts, less receivables related to projects that are subject to payment or performance bonds. The borrowing base as of ~~September 30, 2004~~March 31, 2005 was ~~$92.8~~$87.2 million. This borrowing base is substantially greater than the current ~~$53.5~~$52.5 million face-value limit of the Facility. The Company does not expect that this borrowing base provision will limit credit available under the Facility in the foreseeable future.
The ~~Company's~~Company’s borrowing and letter of credit capacity under the Revolving Loan portion of the Facility at any given time is $45 million less borrowings and letters of credit outstanding, subject to the borrowing base described above. The Facility contains financial covenants defining various financial measures and the levels of these measures with which the Company must comply, as discussed below under Covenants and Restrictions. Covenant compliance is measured as of each quarterend. While the ~~Facility's~~Facility’s financial covenants do not specifically govern capacity under the Facility, if the ~~Company's~~Company’s debt level under the Facility at a quarterend covenant compliance measurement date caused the Company to violate the ~~Facility's debt-to-EBITDA~~Facility’s debt-to-Credit Facility Adjusted EBITDA covenant (described in more detail below) the ~~Company's~~Company’s borrowing capacity under the Facility could be restricted by the lenders. Accordingly, available capacity amounts shown below are presented both on a financial covenant basis and on a Facility face value basis.

As of
March 31,
2005

As of
May 2,
2005

(in thousands)

Amounts Outstanding

Revolving loan

$
—

$
—

Term loan

8,000

7,500

Other non-Facility debt

303

297

Total debt

$
8,303

$
7,797

Letters of credit

$
18,619

$
19,369

Available Capacity

Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million

$
26,381

$
25,631

Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-Credit Facility Adjusted EBITDA covenant

$
26,381

n/a

As of
September 30,
2004
As of
October 29,
2004

(in thousands)

Amounts Outstanding
Revolving loan $ — $ —
Term loan 9,000 8,500
Other non-Facility debt 349 346

Total debt $ 9,349 $ 8,846

Letters of credit $ 17,280 $ 17,280

Available Capacity

Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million $ 27,720 $ 27,720
Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-EBITDA covenant $ 27,720 n/a

        ~~If the Company voluntarily terminates the Facility in full before December 31, 2004, it would owe the Facility's lenders a termination fee of $0.5 million.~~ The Company may ~~voluntarily~~ terminate the Facility in full ~~on or after~~at any time. If the Company elects to partially reduce the Facility during the year ended December 31, ~~2004 without a termination fee. Short of a full termination,~~2005, such reduction cannot exceed $5 million. If the Company ~~may not~~elects to partially reduce the ~~Revolving Loan commitment within~~Facility during the ~~Facility prior to~~year ended December 31, 2004. During the second year of the Facility, the Company may voluntarily reduce the Revolving Loan commitment by as much as $5 million. During the third year of the Facility, the Company may voluntarily reduce the Revolving Loan commitment by as much as2006, such reduction cannot exceed $10 million, less any reductions it made prior to ~~the third year of the Facility.~~that year.
Collateral
The Facility is secured by first liens on substantially all the assets of the Company except for assets related to projects subject to surety bonds. The Facility is secured by a second lien on these assets, which are discussed further below. The ~~Company's~~Company’s assets are primarily held by its subsidiaries. Accordingly, the Facility is also secured by the capital stock of current and future subsidiaries, and these entities guarantee repayment of amounts due under the Facility.
A common practice in the ~~Company's~~Company’s industry is the posting of payment and performance bonds with customers. These bonds are offered 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~~Company’s contractual obligations and for the payment of the ~~Company's~~Company’s vendors on the projects subject to the bonds. In cooperation with its lenders, the Company has granted its surety a first lien on assets such as receivables, costs and estimated earnings in excess of billings, and equipment specifically identifiable to projects for which bonds are outstanding, as collateral for potential obligations under bonds. As of ~~September 30, 2004,~~March 31, 2005, the amount of these assets was approximately ~~$44.2~~$59.3 million.
Interest Rates and Fees
The Company has a choice of two interest rate options for borrowings under the Facility. Under one option termed the Base Rate Option, the interest rate is determined based on the higher of the Federal Funds Rate plus 0.5% or the prime lending rate offered by Citibank, N.A. (not one of the banks providing the Facility to the Company). Additional margins are then added to the higher of these two rates for Term Loan and Revolving Loan borrowings, respectively. These additional margins are determined based on the ratio of the ~~Company's~~Company’s total debt outstanding as of a given quarterend to its earnings before interest, taxes, depreciation and amortization ~~("EBITDA"~~(“Credit Facility Adjusted EBITDA”) for the twelve months ending as of that quarterend, as shown below. Credit Facility Adjusted EBITDA as defined under the Facility is discussed in more detail below underCovenants and Restrictions.
Under the other interest rate option termed the Eurodollar Rate Option, borrowings bear interest based on designated one to six-month Eurodollar rates that correspond very closely to rates described in various general business media sources as the London Interbank Offered Rate or ~~"LIBOR."~~“LIBOR.” Additional margins are then added to LIBOR for Term Loan and Revolving Loan borrowings, respectively, based on the ~~Company's~~Company’s ratio of debt to Credit Facility Adjusted EBITDA, as shown below.
Letter of credit fees under the Facility are also based on the ~~Company's~~Company’s ratio of debt to Credit Facility Adjusted EBITDA, as shown below.

The interest rates underlying the Base Rate and Eurodollar Rate Options under the Facility are floating rates determined by the broad financial markets, meaning they can and do move up and down from time to time. For illustrative purposes, the following are the respective market rates as of ~~September 30, 2004~~March 31, 2005 relating to interest options under the Facility:
Base Rate Option—The higher of:
Federal Funds Rate plus 0.50% 2.25 %
Citibank, N.A. Prime Rate 4.75 %

Eurodollar Rate Option

One-month LIBOR 1.84 %
Six-month LIBOR 2.20 %

Debt to EBITDA

Less than 0.75
0.75 to 1.50
1.50 or greater

Additional Per Annum Interest
Margin Added Under:

Term Loan—

Base Rate Option 1.75 % 2.25 % 2.75 %
Eurodollar Rate Option 2.75 % 3.25 % 3.75 %

Revolving Loan—

Base Rate Option

1.50
%
2.00
%
2.50
%
Eurodollar Rate Option 2.50 % 3.00 % 3.50 %

Per Annum Letter of Credit Fees (not added to underlying Base Rate or Eurodollar Rate)

1.875
%
2.25
%
2.625
%

Base Rate Option—The higher of:

Federal Funds Rate plus 0.50%
3.25
%
Citibank, N.A. Prime Rate
5.75
%
Eurodollar Rate Option:
One-month LIBOR
2.87
%
Six-month LIBOR
3.40
%

Debt to Credit Facility Adjusted EBITDA

Less than 0.75

0.75 to 1.50

1.50 or greater

Additional Per Annum Interest
Margin Added Under:

Term Loan—

Base Rate Option

1.75
%

2.25
%

2.75
%

Eurodollar Rate Option

2.75
%

3.25
%

3.75
%

Revolving Loan—

Base Rate Option

1.50
%

2.00
%

2.50
%

Eurodollar Rate Option

2.50
%

3.00
%

3.50
%

Per Annum Letter of Credit Fees
(not added to underlying Base Rate or Eurodollar Rate)

1.875
%

2.25
%

2.625
%

Commitment fees of 0.375% per annum are payable on the portion of Revolving Loan capacity not in use for borrowings or letters of credit at any given time.
The Company incurred approximately ~~$1.2~~$1.5 million in financing and professional costs in connection with the arrangement ~~and the closing~~ of the Facility. These costs will be amortized as a ~~noncash~~non-cash charge to interest expense over the term of the Facility in an amount of approximately ~~$0.4~~$0.5 million per year ~~for the first three years of the Facility,~~during 2005 and ~~less than~~2006 and $0.1 million per year during ~~the fourth~~2007 and ~~fifth years of the Facility.~~2008. 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.
        ~~The~~During the first quarter of 2005, the Company paid interest on Facility borrowings at a weighted average interest rate ~~that the Company has paid on borrowings under the Facility during 2004 is 5.2%~~of 5.3% per annum. This weighted average rate reflects a combination of ~~borrowings under~~ both interest rate options that apply to term loan borrowings as described ~~above, as well as a transaction in which~~above. The Company had no revolving credit borrowings during the ~~interest~~first quarter of 2005. The weighted average rate ~~relating to $10 million in principal value of debt was fixed at 5.12% through early July, 2004. These rates do~~does not include amortization of debt financing and arrangement ~~costs or mark-to-market adjustments for derivatives. Following the expiration in early July, 2004 of the fixed interest commitment referred to above, the Company~~costs. The company estimates that ~~its~~the weighted average interest rate ~~now entirely on a floating basis,~~currently applicable to all borrowings under the Facility is ~~currently~~ approximately ~~4.6%~~5.7%.
Covenants and Restrictions
The Facility contains financial covenants defining various financial measures and the levels of these measures with which the Company must comply. Covenant compliance is assessed as of each quarterend. Credit Facility Adjusted EBITDA is defined under the Facility for financial covenant purposes as net earnings for the four quarters ending as of any given quarterly covenant compliance measurement date,

plus the corresponding amounts for (a) interest expense; (b) income taxes; (c) depreciation and amortization; and (d) other non-cash charges. The ~~Facility's~~following is a reconciliation of Credit Facility Adjusted EBITDA to net income (in thousands):
Net income

$
10,199

Discontinued operations—estimated gain on dispositions, net

(481
)
Income taxes—continuing operations and discontinued operations

7,980

Mark-to-market warrant obligation

(262
)
Interest expense, net

1,144

Depreciation expense

4,612

Goodwill impairment

3,347

Credit Facility Adjusted EBITDA

$
26,539

The Facility’s principal financial covenants include:
Debt Service Coverage Ratio—The Facility requires that the ratio of Credit Facility Adjusted EBITDA to the sum of interest expense and scheduled principal payments be at least 2.50. Interest expense is defined under the Facility for purposes of this covenant as interest expense for the four quarters ending as of any given quarterly covenant compliance measurement date, excluding corresponding twelve-month amounts for (a) amortization of deferred debt arrangement costs; and (b) mark-to-market interest expense. Scheduled principal payments for this ratio are also measured for the twelve months ending as of any given quarterly covenant compliance measurement date. The Facility provides, however, that during the first three quarters of 2004, interest expense and scheduled principal payments used in this ratio will be the annualized amounts of actual year-to-date interest expense and scheduled principal payments, instead of actual amounts for these items for the twelve months then ended. The Company'sCompany’s debt service coverage ratio as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~7.56~~8.94 as compared to a minimum covenant requirement of 2.50.
Tangible Net Worth—The Facility requires that the ~~Company's~~Company’s tangible net worth not be less than the sum of (a) $75.4 million; (b) 75% of net income earned beginning October 1, 2003; and (c) the net proceeds of any equity transactions. For purposes of this ratio, the Facility defines tangible net worth as ~~stockholders~~stockholders’ equity less the book value of the following intangible assets: goodwill, patents, copyrights, licenses, franchises, trade names, trade secrets, and operating leases. The Facility also provides that for purposes of this ratio, net income excludes any goodwill impairment charges. The ~~Company's~~Company’s tangible net worth as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~$107.8~~$118.2 million, as compared to a covenant minimum of ~~$84.3~~$92.8 million.
Debt to Credit Facility Adjusted EBITDA—The Facility requires that the ~~Company's~~Company’s ratio of debt to Credit Facility Adjusted EBITDA not exceed 2.0. The ~~Company's debt-to-EBITDA~~Company’s debt-to-Credit Facility Adjusted EBITDA ratio as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~0.37.~~0.31.
Capital Expenditures—The Facility limits capital expenditures to $8.0 million per year. The ~~Company's~~Company’s capital expenditures during the ~~nine~~three months ended ~~September 30, 2004~~March 31, 2005 were ~~$3.2~~$2.0 million.

Surety—The Facility contains provisions that may have the practical effect of limiting the Company’s use of surety bonding in excess of $145 million of bonded backlog to the lesser of (a) the amount of surety bonds outstanding which results in the ratio of receivables relating to bonded contracts to total receivables not exceeding 35%; and (b) $275 million in bonded backlog. As of March 31, 2005, the Company’s ratio of bonded receivables to total receivables was 29.0%, and its bonded backlog was $165.1 million.
Other Restrictions—The Facility prohibits payment of dividends and repurchase of shares by the Company, and limits non-Facility debt, capital lease obligations, acquisitions, investments, and sales of assets. The Facility also includes a customary provision under which the lenders may demand immediate repayment of borrowings and disposition of letters of credit if they conclude that the ~~Company's~~Company’s business or financial position has suffered a material adverse change. However, the Facility does not include any

mechanisms allowing the lenders immediate access to the ~~Company's~~Company’s ongoing cash flow in the event of a default or an immediate repayment demand by the lenders. In view of the ~~Company's~~Company’s financial position, and what management believes are its prospects for profitability and positive cash flow in the future, the Company believes that the probability that its lenders will invoke the ~~Facility's~~Facility’s material adverse change provision in the foreseeable future is remote. As a result, debt under the Facility is classified as long-term, other than amounts due within one year.
Interest Expense and Related Charges
        ~~The credit facility that preceded the Company's current one was in place from October, 2002 to December, 2003.~~ Interest expense for the three months ended March 31, 2004 and ~~nine months ended September 30, 2003 and 2004~~2005 included the following primary elements (in thousands):

Three Months Ended
September 30,
Nine Months Ended
September 30,

Three Months Ended
March 31,

2003
2004
2003
2004

    2004

    2005

Interest expense on borrowings, and unused commitment fees Interest expense on borrowings, and unused commitment fees $ 349 $ 140 $ 1,125 $ 557

$
225

$
146

Letter of credit fees Letter of credit fees 150 130 355 339

207

109

Amortization of deferred debt arrangement costs and discount 328 104 1,084 300
Mark-to-market adjustments on derivatives 280 — 188 —

Total $ 1,107 $ 374 $ 2,752 $ 1,196

Amortization of deferred debt arrangement costs

96

120

Total

$
528

$
375

When the Company's previous credit facilities were reduced in size or terminated, corresponding amounts of deferred debt arrangement costs were written off. During the three months ended March 31, 2003, the Company wrote off $0.8 million of deferred financing fees due to a reduction in the size of the Company's credit facility. This charge is reported as "Write-off of debt costs" in the Company's consolidated statement of operations.
6.     7.   Commitments and Contingencies
Claims and Lawsuits
The Company is party to litigation in the ordinary course of business. The largest single unresolved matter to which the Company is party involves a construction project. If this matter were ultimately resolved on the least favorable terms to the Company, management estimates that it would incur a liability of approximately $2.5 million. However, management believes the likelihood of such a least-favorable outcome is remote, and believes its asset balances and accruals relating to this matter appropriately reflect a probable outcome. The ~~Company's~~Company’s remaining litigation involves matters with significantly smaller individual potential losses.
The Company has estimated and provided accruals for probable losses and related legal fees associated with certain of its litigation in the accompanying consolidated financial statements. In ~~management's~~management’s opinion, uninsured losses resulting from the ultimate resolution of these matters will not have a material adverse effect on the ~~Company's~~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~~If the Company ~~will~~fails to perform under the terms of a contract ~~and that the Company will~~or to pay subcontractors and vendors who provided goods ~~and~~or 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~~sureties for any expenses or outlays ~~it incurs.~~they incur. To date, the Company is not aware of any losses to its ~~surety~~sureties in connection with bonds the ~~surety has~~sureties have posted on the ~~Company's~~Company’s behalf, and does not expect such losses to be incurred in the foreseeable future.
18

Surety market conditions are currently ~~difficult~~challenging 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~~Company’s business has required bonds. While the Company has enjoyed a longstanding relationship with its primary surety and has recently added another surety to further support its bonding needs, current market conditions as well as changes in the ~~surety's~~sureties’ assessment of the ~~Company's~~Company’s operating and financial risk could cause the ~~surety~~sureties to decline to issue bonds for the ~~Company's~~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~~characteristics, including a significantly greater amount of cash on its balance sheet than debt, would enable it to ultimately respond effectively to an interruption in the availability of bonding capacity, such an interruption would likely cause the ~~Company's~~Company’s revenues and profits to decline in the near term.
Self-Insurance
The Company is substantially self-insured for ~~worker's~~worker’s compensation, ~~employer's~~employer’s liability, auto liability, general liability and employee group health claims, in view of the relatively high per-incident deductibles the Company absorbs under its insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends and industry averages. Loss estimates associated with the larger and longer-developing risks—~~worker's~~worker’s compensation, auto liability and general ~~liability,~~ liability—are reviewed by a third-party actuary ~~semi-annually.~~quarterly.
~~7.     Stockholders' Equity~~The Company’s self-insurance arrangements currently are as follows:
Worker’s Compensation—The per-incident deductible for worker’s compensation is $500,000. Losses above that amount are determined by statutory rules on a state-by-state basis, and are fully covered by excess worker’s compensation insurance.
General and Employer’s Liability—For general liability and employer’s liability, the Company self-insures the first $500,000 of each loss, is fully insured for the next $500,000 of each loss, then has a single, aggregate excess loss insurance policy that covers losses up to $50 million across both these risk areas (as well as auto liability noted below).
Auto Liability—For auto liability, the Company self-insures the first $500,000 of each loss, has insurance coverage for the next $500,000, then again self-insures for the loss amounts between $1 million and $2 million, at which point the Company’s $50 million aggregate excess loss coverage picks up coverage.
Employee Medical—The Company’s per-incident deductible for employee group health claims is $300,000. Insurance then covers any Company responsibility for medical claims in excess of the deductible amount.
It is important to note that the Company’s $50 million of aggregate excess loss coverage above applicable per-incident deductibles represents one policy limit that applies to all lines of risk. In other words, the Company does not have a separate $50 million of excess loss coverage for each of general liability, employer’s liability and auto liability.

8.   Stockholders’ Equity
Restricted Stock Grants
The Company awarded 82,500 shares of restricted stock to nine members of management on January 21, 2005 under its 2000 Equity Incentive Plan. The shares are subject to full forfeiture if the Company does not meet certain performance levels for the twelve-month period ending March 31, 2006. The grants are also subject to forfeiture if a grantee leaves voluntarily or is terminated for cause. The latter forfeiture provisions lapse pro rata over four-year periods that started on the date of the respective grants.
The Company awarded 225,000 shares of restricted stock to five members of senior management on June 8, 2004 under its 2000 Equity Incentive Plan. The shares are subject to full forfeiture if the Company does not meet certain performance levels for the twelve-month period ending June 30, 2005. The grants are also subject to forfeiture if a grantee leaves voluntarily or is terminated for cause. The latter forfeiture provisions lapse pro rata over a three-year or four-year ~~period~~periods that started on the date of ~~grant.~~the respective 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 were subject to forfeiture if the Company had not achieved certain performance levels for the twelve-month period ending March 31, 2003. These performance levels 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 that started on the date of grant.
Compensation expense relating to the grants is charged to earnings over the respective three-year or four-year periods during which their forfeiture provisions lapse. The initial value of each award was established based on the market price on the date of grant, and was reflected as a reduction of ~~stockholders'~~stockholders’ equity for unearned compensation at that time. This value, and the related compensation expense, is adjusted up or down based on the market price of the ~~Company's~~Company’s stock during the first year following each respective grant while the performance conditions are in effect. Once the performance conditions are met, the value of the award is fixed based on the market price of the ~~Company's~~Company’s stock at that time, and is charged to earnings over the remaining two-year or three-year period during which remaining forfeiture provisions lapse.

Warrant
In connection with a previous credit facility, the Company granted a lender a warrant to purchase 409,051 shares of Company common stock (“Common Stock”) for nominal consideration. The warrant was exercised in October ~~2004.~~2004 in a cashless transaction, whereby the Company issued 408,444 shares upon exercise of the warrant.
When the warrant was originally issued, it carried additional rights involving increases in, registration of, and sale of shares related to the warrant. The warrant holder also had the right to ~~"put,"~~“put,” or require the Company to repurchase, some or all of the shares related to the warrant in certain circumstances. Some of these rights were waived in December 2003 when the credit facility in connection with which the warrant was originally issued was terminated.
The value of the warrant and put when originally issued of $2.9 million was reflected as a discount of the ~~Company's~~Company’s obligations under the previous credit facility, and as an obligation in long-term liabilities. When this credit facility was terminated in December 2003, the discount reflected against debt under the facility was written off and included in ~~"Write-off~~“Write-off of debt costs and discount, ~~net"~~net” in the ~~Company's~~Company’s consolidated statement of operations. Also upon the termination of the credit facility, the warrant holder waived certain of the additional rights under the warrant and put. In connection with this waiver, the Company recognized a $1.3 million gain in December 2003 associated with the reduction in the value of

the warrant and put obligation. This gain was also included in the ~~"Write-off~~“Write-off of debt costs and discount, ~~net"~~net” caption.
As noted above, the warrant was exercised in a cashless transaction in October 2004. As a result of the exercise, all additional rights under the warrant described above have terminated. Also as a result of the exercise, the remaining value of the warrant ~~$2.8 million reflected under Other Long-Term Liabilities as of September 30, 2004, has been~~was eliminated as an obligation and added to ~~stockholders'~~stockholders’ equity in ~~October.~~October 2004.
While the warrant and put were outstanding, their value changed over time, principally in response to changes in the market price of the ~~Company's common stock.~~Common Stock. The warrant and the put qualified as a derivative for financial reporting purposes. Accordingly, such changes in the value of the warrant and put in any given period were included in the ~~Company's~~Company’s statement of operations for that period and in the ~~Company's~~Company’s long-term liabilities, even though the warrant and put had not been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. During the ~~nine~~three months ended ~~September 30, 2003,~~March 31, 2004, these adjustments were a loss of ~~$0.2~~$0.7 million, and were included in interest expense because the warrant and put related to the Company's then-existing credit facility. Because the warrant and put did not relate to the Company's current credit facility, mark-to-market adjustments during the nine months ended September 30, 2004, which were losses of $0.5 million, are reflected as other income (expense) in the ~~Company's~~Company’s statement of operations. Now that the warrant and put are no longer outstanding, there will be no further mark-to-market adjustments to income associated with them.
Restricted Common Stock
In March 1997, Notre Capital Ventures II, L.L.C. ~~("Notre"~~(“Notre”) exchanged 2,742,912 shares of Common Stock for an equal number of shares of restricted voting common stock ("(“Restricted Voting Common ~~Stock"~~Stock”). The holders of Restricted Voting Common Stock are entitled to elect one member of the ~~Company's~~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.~~Stock. 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~~are converted into shares of Common Stock. As of ~~September 30, 2004,~~March 31, 2005, there were ~~1,067,099~~1,054,888 shares of Restricted Voting Common Stock remaining.
Earnings Per Share
Basic earnings per share ~~("EPS"~~(“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, warrants and contingently issuable restricted stock.
Under EPS calculation methods established by generally accepted accounting principles, including the effect of options whose exercise price exceeds the average market price of the ~~Company's common stock ("~~Common ~~Stock")~~Stock for a given period would increase calculated EPS. This impact is called ~~"anti-dilutive."~~“anti-dilutive.” Generally accepted accounting principles for determining EPS ~~also~~ require that any options or other common stock equivalents whose inclusion in determining EPS would have an anti-dilutive effect be excluded. Accordingly, options to purchase ~~0.9~~0.6 million shares of Common Stock at prices ranging from ~~$6.64~~$7.625 to $21.438 per share which were outstanding for the three months ended ~~September 30, 2004,~~March 31, 2005, and options to purchase ~~1.6~~1.9 million shares at

prices ranging from ~~$7.00~~$6.75 to $21.438 per share which were outstanding for the ~~nine~~three months ended ~~September 30,~~March 31, 2004, were not included in the computation of diluted EPS because they were anti-dilutive. Options to purchase 3.0 million shares of Common Stock at prices ranging from $3.8125 to $21.438 per share which were outstanding for the three months ended September 30, 2003, and options to purchase 3.1 million shares at prices ranging from $3.39 to $21.438 per share which were outstanding for the nine months ended September 30, 2003, were not included in the computation of diluted EPS because they were anti-dilutive.

The following table summarizes information regarding the ~~Company's~~Company’s outstanding stock options as of ~~September 30, 2003~~March 31, 2004 and ~~2004:~~2005:

Number of Options Outstanding

Number of Options
Outstanding

Exercise Price
September 30,
2003
September 30,
2004

March 31,
2004

March 31,
2005

$1.90 952,000 710,250
$1.90

872,000

657,750

$2.14 10,000 10,000
$2.14

10,000

10,000

$2.19 10,000 10,000
$2.19

10,000

10,000

$2.25 327,500 232,500
$2.25

240,000

188,875

$2.34 52,000 500
$2.34

2,000

500

$2.36 50,000 50,000
$2.36

50,000

50,000

$2.43 10,000 10,000
$2.43

10,000

10,000

$2.875 1,535,058 1,056,735
$2.875

1,129,725

777,488

$3.39 110,000 10,000
$3.39

110,000

10,000

$3.8125 500,000 500,000
$3.8125

500,000

500,000

$3.86 79,000 79,000
$3.86

79,000

72,750

$4.18 — 102,500
$4.18

102,500

102,500

$4.24 15,000 15,000
$4.24

15,000

15,000

$4.77 40,000 40,000
$4.77

40,000

40,000

$6.00 193,500 153,000
$6.00

164,000

147,800

$6.62
$6.62

—

39,000

$6.64 — 55,000
$6.64

—

55,000

$6.75 5,000 5,000
$6.75

5,000

5,000

$6.97
$6.97

—

120,000

$7.00 — 50,000
$7.00

—

50,000

$7.625 37,700 34,700
$7.625

37,100

32,200

All other outstanding options with prior grant dates with exercise prices ranging from $11.75 to $21.438 2,142,031 826,059
All other outstanding options with prior grant dates with exercise prices ranging from $11.75 to $21.438

1,895,374

475,025

5,271,699

3,368,888

6,068,789 3,950,244

As noted above under Warrant, the Company issued a warrant to purchase 409,051 shares of ~~Company common stock~~Common Stock along with related put rights for nominal consideration. The dilutive impact of this warrant was computed assuming the issuance of shares equal to the value of the warrant obligation at the end of ~~the reporting~~any given period while it was outstanding, and excluding the income effect for the period of any mark-to-market adjustments made in connection with valuing the warrant. As this impact was anti-dilutive for the three months ~~and nine months~~ ended ~~September 30, 2003 and~~March 31, 2004, the effect of the warrant was excluded from earnings per share amounts for ~~those periods.~~this period. As a result of the ~~warrant's~~warrant’s exercise in October 2004, its related shares have now become part of the ~~Company's issued and~~Company’s outstanding ~~common shares.~~Common Stock.

        The following tables reconcile the income from continuing operations and the net income (loss) on the statement of operations with the corresponding earnings (losses) that are used in computing basic and diluted earnings per share for each of the periods presented (in thousands):

Three Months Ended
September 30,
Nine Months Ended
September 30,

2003
2004
2003
2004
Income from continuing operations used in computing earnings per share—basic $ 2,595 $ 3,490 $ 902 $ 8,805
Mark-to-market adjustment related to warrant and put obligation (after tax) — — — —

Income from continuing operations used in computing earnings per share—diluted $ 2,595 $ 3,490 $ 902 $ 8,805

Net income (loss) used in computing earnings per share—basic $ 175 $ 3,490 $ (2,068 ) $ 8,707
Mark-to-market adjustment related to warrant and put obligation (after tax) — — — —

Net income (loss) used in computing earnings per share—diluted $ 175 $ 3,490 $ (2,068 ) $ 8,707

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 Ended
September 30,
Nine Months Ended
September 30,

Three Months Ended
March 31,

2003
2004
2003
2004

2004

2005

Common shares outstanding, end of period(a) 37,738 38,425 37,738 38,425

38,293

39,163

Effect of using weighted average common shares outstanding (25 ) (7 ) (79 ) (127 )

(157
)
(173
)

Shares used in computing earnings per share—basic 37,713 38,418 37,659 38,298

38,136

38,990

Effect of shares issuable under stock option plans based on the treasury stock method 516 998 197 1,108

1,151

1,006

Effect of shares issuable related to warrants — — — —
Effect of contingently issuable restricted shares 225 39 225 51

156

66

Shares used in computing earnings per share—diluted 38,454 39,455 38,081 39,457

39,443

40,062

(a)
Excludes ~~225,000~~156,250 and ~~325,000~~357,500 shares of unvested contingently issuable restricted stock outstanding as of ~~September 30, 2003~~March 31, 2004 and ~~2004,~~2005, respectively (see ~~"Restricted~~“Restricted Stock ~~Grants"~~Grants” above).
23

COMFORT SYSTEMS USA, INC.
Item 2.~~Management's~~Management’s Discussion and Analysis of Financial Condition and Results of Operations
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, ~~2003~~2004 (the ~~"Form 10-K"~~“Form 10-K”). This discussion contains ~~"forward-looking statements"~~“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~~“Factors Which May Affect Future Results,"” included in our Form 10-K.
Introduction and Overview
We are a national provider of comprehensive heating, ventilation and air conditioning ~~("HVAC"~~(“HVAC”) installation, maintenance, repair and replacement services within the mechanical services industry. The services we provide address a very broad need, as air is circulated through almost all commercial, industrial and institutional buildings virtually year-round. We operate primarily in the commercial, industrial and institutional 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.
Nature and Economics of Our Business
Approximately 80% of our revenues are earned on a project basis for installation of HVAC systems in newly constructed facilities or for replacement of HVAC systems in existing facilities. Customers hire us to ensure such systems deliver specified or generally expected heating, cooling, conditioning and circulation of air in a facility. This entails installing core system equipment such as packaged heating and air conditioning units, or in the case of larger facilities, separate core components such as chillers, boilers, air handlers, and cooling towers. We also typically install connecting and distribution elements such as piping and ducting. Our responsibilities usually require conforming the systems to pre-established engineering drawings and equipment and performance specifications, which we frequently participate in establishing. Our project management responsibilities include staging equipment and materials to project sites, deploying labor to perform the work, and coordinating with other service providers on the project, including any subcontractors we might use to deliver our portion of the work.
When competing for project business, we usually estimate the costs we will incur on a project, then propose a bid to the customer that includes a contract price and other performance and payment terms. Our bid price and terms are intended to cover our estimated costs on the project and provide a profit margin to us commensurate with the value of the installed system to the customer, the risk that project costs or duration will vary from estimate, the schedule on which we will be paid, the opportunities for other work that we might forego by committing capacity to this project, and other costs that we incur more broadly to support our operations but which are not specific to the project. Typically customers will seek bids from competitors for a given project. While the criteria on which customers select the winning bid vary widely and include factors such as quality, technical expertise, on-time performance, post-project support and service, and company history and financial strength, we believe that price is the most influential factor for most customers in choosing an HVAC installation and service provider.

After a customer accepts our bid, we generally enter into a contract with the customer that specifies what we will deliver on the project, what our related responsibilities are, and how much and when we will

be paid. Our overall price for the project is typically set at a fixed amount in the contract, although changes in project specifications or work conditions that result in unexpected additional work are usually subject to additional payment from the customer via what are commonly known as change orders. Project contracts typically provide for periodic billings to the customer as we meet progress milestones or incur cost on the project. Project contracts in our industry also frequently allow for a small portion of progress billings or contract price to be withheld by the customer until after we have completed the work, typically for six months. Amounts withheld under this practice are known as retention or retainage.
Labor and overhead costs account for the majority of our cost of service. Accordingly, labor management and utilization have the most impact on our project performance. Given the fixed price nature of much of our project work, if our initial estimate of project costs is wrong or we incur cost overruns that cannot be recovered in change orders, we can experience reduced profits or even significant losses on ~~fixed-price~~fixed price project work. We also perform some project work on a cost-plus or a ~~time-and-materials~~time and materials basis, under which we are paid our costs incurred plus an agreed-upon profit margin. These margins are typically less than fixed-price contract margins because there is less risk of unrecoverable cost overruns in cost-plus or ~~time-and-materials~~time and materials work.
As of ~~September 30, 2004,~~March 31, 2005, we had ~~4,690~~4,483 projects in process. Our average project takes three to six months to complete, with an average contract price of approximately ~~$226,000.~~$264,000. Our projects generally require working capital funding of equipment and labor costs. Customer payments on periodic billings generally do not recover these costs until late in the job. Our average project duration together with typical retention terms as discussed above generally allow us to complete the realization of revenue and earnings in cash within one year. Because of the integral nature of HVAC and related controls systems to most buildings, we have the legal right in almost all cases to attach liens to buildings or related funding sources when we have not been fully paid for installing systems, except with respect to some government buildings. The service work that we do, which is discussed further below, usually does not give rise to lien rights.
We also perform larger HVAC projects. As of ~~September 30, 2004,~~March 31, 2005, we had ~~one project~~two projects in process with a contract price of ~~$20.5~~between $15 and $25 million, ~~six~~five projects between $10 million and $15 million, ~~eleven~~20 projects between $5 million and $10 million, and ~~161~~157 projects between $1 million and $5 million. Taken together, projects with contract prices of $1 million or more totaled ~~$503.3~~$594.5 million of aggregate contract value as of ~~September 30, 2004,~~March 31, 2005, or approximately 50.3%, out of a total contract value for all projects in progress of ~~$1,061.7~~$1,181.9 million. Generally, projects closer in size to $1 million will be completed in aone year or less. It is unusual for us to work on a project that exceeds two years in length.
In addition to project work, approximately 20% of our revenues represent maintenance and repair service on already-installed HVAC and controls systems. This kind of work usually takes from a few hours to a few days to perform. Prices to the customer are usually based on the equipment and materials used in the service as well as technician labor time. We usually bill the customer for service work when it is complete, typically with payment terms of up to thirty days. We also provide maintenance and repair service under ongoing contracts. Under these contracts, we are paid regular monthly or quarterly amounts and provide specified service based on customer requirements. These agreements typically cover periods ranging from one to three years and are cancelable on 30 to 60 days notice.
A relatively small but growing portion of our revenues comes from national and regional account customers. These customers typically have multiple sites, and contract with us to perform maintenance and repair service. These contracts may also provide for us to perform new or replacement systems installation. We operate a national call center to dispatch technicians to sites requiring service. We perform the majority of this work with our own employees, with the balance being subcontracted to third parties that meet our performance qualifications. We will also typically use proprietary information systems to

maintain information on the ~~customer's~~customer’s sites and equipment, including performance and service records, and related cost data. These systems track the status of ongoing service and installation work, and may also monitor system performance data. Under these contractual relationships, we usually provide consolidated billing and credit payment terms to the customer.

Profile and Management of Our Operations
Our company was originally formed in 1997 through an initial public offering, or IPO, and simultaneous acquisition of 12 companies engaged in our business. From the time we completed our IPO through December 1999, we acquired 107 HVAC and complementary businesses, of which 26 were ~~"tuck-in"~~“tuck-in” operations that were integrated upon acquisition with existing operations. ~~Since December 1999,~~From 2000 through 2004 we ~~have~~did not ~~acquired~~acquire any additional ~~companies. Further, since that time, we have sold or ceased operations at 35 companies. We have consolidated another 14~~ companies ~~into other operations, such that today we have 44 operating units.~~
        ~~Beginning in the fourth quarter of 1999, we~~but rather shifted our strategy from an emphasis on acquisition-based growth to a focus on improving the performance of our existing operations. ~~Significantly, on March 1, 2002,~~During that time, we sold 19or ceased operations to Emcor Group, Inc. for $186.25 million, including Emcor's assumption of approximately $22.1 million of subordinated notes to former owners of certain of the divested companies. We used the proceeds from this sale to reduce debt. We recognizedat 35 companies and consolidated another 13 companies into other operations. In January 2005 we acquired a loss, including taxes, of $11.5 million and a goodwill impairment charge prior to the sale of $32.4 million, net of taxes, related to the sold operations. For a further discussion of this sale, see Note 3, "Discontinued Operations,"business in ~~the notes to the historical consolidated Financial Statements.~~New England. Today we have 45 operating units.
We manage our operations based on a variety of factors. Financial measures we emphasize include profitability, and use of capital as indicated by cash flow and by other measures of working capital principally involving project cost, billings and receivables. We also monitor selling, general, administrative and indirect project support expense, backlog, workforce size and mix, growth in revenues and profits, variation of actual project cost from original estimate, and overall financial performance in comparison to budget and updated forecasts. Operational factors we emphasize include project selection, estimating, pricing, management and execution practices, labor utilization, safety, training, and the make-up of both existing backlog as well as new business being pursued, in terms of project size, technical application and facility type, end-use customers and industries, and location of the work.
Most of our operations compete on a local or regional basis. Attracting and retaining effective operating unit managers is an important factor in our business, particularly in view of the relative uniqueness of each market and operation, the importance of relationships with customers and other market participants such as architects and consulting engineers, and the high degree of competition and low barriers to entry in most of our markets. Accordingly, we devote considerable attention to operating unit management quality, stability, and contingency planning, including related considerations of compensation, and non-competition protection where applicable.
Economic and Industry Factors
As an HVAC and building controls services provider, we operate in the broader nonresidential construction services industry and are affected by trends in this sector. While we do not have operations in all major cities of the US, we believe our national presence is sufficiently large that we experience trends in demand for and pricing of our services that are consistent with trends in the national nonresidential construction sector. As a result, we monitor the views of major construction sector forecasters along with macroeconomic factors they believe drive the sector, including trends in gross domestic product, interest rates, business investment, employment, demographics, and the general fiscal condition of federal, state and local governments. Although nonresidential construction activity has demonstrated periods of both significant growth and decline, it has grown at a compound annual rate of approximately ~~4.5%~~4.2% over the last ~~two decades.~~twenty-five years.
Spending decisions for building construction, renovation and system replacement are generally made on a project basis, usually with some degree of discretion as to when and if projects proceed. With larger amounts of capital, time, and discretion involved, spending decisions are affected to a significant degree by uncertainty, particularly concerns about macroeconomic and geopolitical trends. We have experienced

periods of time, such as after the terrorist incidents on September 11, 2001 in the US, and prior to and

during the war in Iraq that occurred in early 2003, when uncertainty caused a significant slowdown in decisions to proceed with installation and replacement project work.
Most of the HVAC equipment we install is provided by four large manufacturers. We regularly seek the views of these manufacturers about trends in the commercial HVAC sector. We also evaluate HVAC equipment shipment statistics reported monthly by the Air Conditioning and Refrigeration Institute, which is the principal industry organization of HVAC equipment manufacturers. We believe that many owners of installed HVAC equipment have deferred maintenance and replacement activity during the very challenging economic conditions of the last several years. We also believe that this trend will not continue indefinitely due to the fundamental mechanical nature and requirements of the equipment. The large HVAC manufacturers have each made public statements supporting this view. However, there can be no assurance of whether or when we might actually experience increased demand for HVAC service and replacement.
Operating Environment and Management Emphasis
Nonresidential building construction and renovation activity, as reported by the ~~Federal Government,~~federal government, declined over the three year period of 2001 to 2003 in response to the broader US recession as well as uncertainty relating to international events. This was a more extended period of contraction than the sector has experienced in other recent recessions, with particularly steep declines in the commercial and industrial portions of the industry. As a result, like most nonresidential HVAC service providers, we experienced decreasing volume, prices, and therefore gross profits during this period. We responded to these market challenges by pursuing work in sectors less affected by this downturn, such as government, educational, and health care facilities, and by establishing marketing initiatives that take advantage of our size and range of expertise. These initiatives include our regional and national multi-location service efforts, our energy efficiency capabilities, and collaboration among our operating units to seek joint project opportunities. As a result of these responses, the decreases we saw in revenues over the last three years have been less than the overall decline in activity experienced by the broader nonresidential sector. We also responded to declining gross profits over recent years by reducing our selling, general, and administrative expenses, and our indirect project and service overhead costs. We believe our efforts in these areas have partially offset the decline in our profitability over this period. We began to see ~~improvement~~improvements in both industry activity as well as our own results in late 2003 and ~~in the first half of 2004, as~~throughout 2004. As discussed further under ~~"Results~~“Results of ~~Operations" below.~~Operations” below, during the first quarter of 2005, our results were negatively impacted by the effects of extended inclement weather in California and uneven customer schedules and job underperformance at a large operation with significant backlog.
In addition to addressing revenues and costs more broadly, we also evaluate our operations on a by-unit and by-market basis. A number of our units have experienced significantly lower results at various points over the last three years, including ten units that incurred operating losses in ~~2003.~~2003, and four units that incurred operating losses in 2004. While the difficult market conditions over this period of time certainly influenced the performance of these units, we also experienced operational execution shortfalls that contributed to lower results. The majority of such underperforming operations have been closed, sold, merged with stronger operations, or reduced in size or operating scope. We also replaced management at most ongoing operations in this group. ~~Our efforts~~The aggregate losses at units that lost money in ~~this area continued~~2004 were significantly less than the aggregate losses at units that lost money in the quarter just ended, as we took further steps to consolidate operations and reduce costs at our Northern California and Salt Lake City units, both of which have been underperforming operations for some time. We believe these operations are now at or near breakeven levels and should produce profits over upcoming quarters, although there can be no assurance that we will achieve this outcome.2003. We currently have 4445 operating units. During the first quarter of 2005 we had 12 units that experienced operating losses which, for seven of the units, were nominal. The first quarter has traditionally been our slowest seasonal quarter during the year and these units generally improved their results toward the end of the quarter. While it would be unusual in a group of this size to have no underperforming units even in better market conditions, we expect to ~~have fewer units with significantly decreased operating results or~~again reduce aggregate full-year losses in 2004 than we had in 2003. During the first nine months of 2004 we have experienced operating losses at four units, and those losses in the aggregate have been significantly less than the losses we incurred in 2003.2005 as compared to 2004.

With the difficult market conditions in our industry over recent years along with the integration challenges we encountered following our substantial acquisition growth during the period from 1997 to

1999, we also operated in an environment of relatively tight credit restrictions from our lenders. In addition, we have had to more actively manage our relationships with the surety market, through which we procure payment and performance bonds required for approximately 25% of our work. Accordingly, cash flow and debt reduction ~~have been~~were particularly high priorities for us over this period of time. As a result of our sale of certain operations to Emcor in early 2002 as well as our continued strong emphasis on cash flow, our debt outstanding, net of cash, is now at zero. At the end of 2003, we put a new credit facility in place with considerably less restrictive and more traditional terms than those of our previous facilities. ~~Further,~~In addition, we have recently added a second surety to further support our bonding needs, and we believe our ~~relationship~~relationships with ~~our~~the surety ~~provider,~~markets, which ~~has~~have been effective over recent years, ~~continues~~continue to improve in light of our strong ~~recent~~current results and financial position. We have generated positive free cash flow in ~~fourteen~~each of the last ~~eighteen quarters,~~five calendar years, and will continue our emphasis in this area. ~~However, we expect~~We believe that ~~we will have~~the relative size and strength of our balance sheet and surety support as compared to ~~devote noticeably fewer management and organizational resources to debt and capital structure matters~~most companies in ~~2004 than we have in recent years.~~our industry represent competitive advantages for us.
As discussed at greater length in ~~"Results~~“Results of ~~Operations"~~Operations” below, we have seen increased activity levels in our industry in 2004, along with indications that increases may continue inthroughout 2005. We expect price competition to continue to be strong, as local and regional competitors respond cautiously to changing conditions. We will continue our efforts to find the more active sectors in our markets, and to increase our regional and national account business. However, our primary emphasis for ~~2004~~2005 will be on internal execution and margin improvement, rather than on revenue growth. In addition to the work we have done on our underperforming units as described above, we have increased our focus on project qualification, estimating, pricing and management, and on service performance. This focus includes significant increases in unit level training.
        There has been substantial cost inflation in 2004 in certain commodities that are used in construction activity, including steel, iron, copper, lumber, and poly-vinyl chloride ("PVC") pipe. We estimate that direct purchase of these commodities, principally steel, iron and copper, comprises between 10% and 15% of our average project cost. As noted below in "Results of Operations," for some of the project work we have performed in 2004, the actual cost of certain commodities necessary for these projects was significantly greater than the commodity cost estimates we used when we committed to prices for these projects, which typically was done in 2003 before commodity cost inflation became apparent. We experienced most of the negative effect of this unrecovered commodity cost inflation in the second quarter of this year. On an ongoing basis, we began taking steps early in 2004 to reduce future commodity cost exposure, such as early buying of commodities for particular projects, or for general inventory, as well as including escalation and escape provisions in project bids and contracts. Based on our project experience so far as well as the mitigating steps we have taken, we believe the negative effect of commodity cost inflation specific to our activity will only have a modest impact on our 2004 results. Following our second quarter impact, we experienced virtually no unrecovered cost inflation in the third quarter. However, commodity markets remain unsettled, and while we are taking steps as noted above to minimize unrecoverable commodity cost inflation, these steps cannot guarantee that we will avoid all such exposure. More broadly, it is also possible that further increases in or uncertainty about commodity costs will decrease demand for nonresidential construction activity, which could in turn reduce our future revenues. To date, though, we have not seen an identifiable negative effect of commodity costs on activity in our industry.
Based on indications of stabilizing industry conditions and on our emphasis on internal execution and margin improvement, we expect that our ~~2004~~2005 results will be ~~significantly~~ better than our ~~2003~~2004 results, ~~and that we have reasonable prospects for continued profitability in 2005,~~ although there can be no assurance that we will achieve ~~these outcomes.~~this outcome. Over the longer term, if industry conditions are stable to improving, we believe we will experience more periods of increased revenues. In addition, ~~while we would not rule out growth by acquisition, particularly in view~~given the size and fragmentation of ~~how fragmented~~ our industry, ~~is,~~ we ~~have no current acquisition plans, and~~ believe it ~~is likely that any acquisitions~~makes sense for us to consider acquisition possibilities. However, we ~~might consider during the near term would~~plan to do so on a very selective, opportunistic basis, and expect our growth in 2005 will largely be ~~relatively modest.~~generated internally.

Critical Accounting Policies
In response to the ~~Securities and Exchange Commission's~~Commission’s Release No. 33-8040, ~~"Cautionary~~“Cautionary Advice Regarding Disclosure About Critical Accounting ~~Policies"~~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, valuation of deferred tax assets 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
Approximately 80% of our revenues were earned on a project basis and recognized through the percentage of completion method of accounting. Under this method as provided by American Institute of Certified Public Accountants Statement of Position 81-1, ~~"Accounting~~“Accounting for Performance of Construction-Type and Certain Production-Type Contracts,"” contract revenue recognizable at any time during the life of a contract isis determined by multiplying expected total contract revenue by the percentage of contract costs incurred at any 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~~(exclusive of ~~estimated~~ rebates), labor and subcontract costs and indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs and depreciation costs. These contract costs are included in the Company’s results of operations under the caption “Cost of Services.” 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. ~~This~~Labor costs are considered to be incurred as the work is performed. Subcontractor labor is recognized as the work is performed, but is generally subjected to approval as to milestones or other evidence of completion. Non-labor project cost consists of purchased equipment, prefabricated materials and other materials. Purchased equipment on the Company’s projects are substantially all produced to job specifications and are a value added element to our work. The costs are considered to be incurred when title is transferred to the Company, which typically is upon delivery to the work site. Prefabricated materials, such as ductwork and piping, are generally performed at our shops and recognized as contract costs when fabricated for the unique specifications of the job. Other materials cost are not significant and are generally recorded when delivered to the work site. The measurement and comparison process requires updates to the estimate of total costs to complete the contract, and these updates may include subjective assessments.
Our contracts typically provide for a schedule of billings or invoices to the customer based on reaching ~~agreed~~agreed- upon milestones or as we incur ~~costs, although the billing schedule~~costs. The schedules for such billings usually ~~does~~do not precisely match the schedule on which we incur costs. 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. Amounts by which cumulative contract revenues recognized on a contract as of a given date exceed cumulative billings to the customer under the contract are reflected as a current asset in our balance sheet under the caption “Costs and estimated earnings in excess of billings.” Amounts by which cumulative billings to the customer under a contract as of a given date exceed cumulative contract revenues recognized on the contract are reflected as a current liability in our balance sheet under the caption “Billings in excess of costs and estimated earnings.”
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. 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.
Revisions to project costs and conditions can give rise to change orders under which the customer agrees to pay additional contract price. Revisions can also result in claims we might make against the customer to recover project variances that have not been satisfactorily addressed through change orders with the customer. WeExcept in certain circumstances, we do not recognize revenues or margin based on change orders or claims until they have been agreed upon with the ~~customer,~~customer. The amount of revenue or deferral of costs associated with ~~immaterial exceptions.~~unapproved change orders and claims is currently immaterial. Variations

from estimated project costs could have a significant impact on our operating results, depending on project size, and the recoverability of the variation via additional customer payments.

Accounting for Allowance for Doubtful Accounts
We are required to estimate the collectibility of accounts ~~receivable. Inherent in the assessment of the~~receivable and provide an allowance for doubtful accounts ~~are~~for receivable amounts we believe we will not ultimately collect. This requires us to make certain judgments and estimates ~~including,~~involving, among others, the creditworthiness of the customer, our prior collection history with the customer, ~~the~~ ongoing relationships with the customer, 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~~worker’s compensation, ~~employer's~~employer’s liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles we absorb 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. Loss estimates associated with the larger and longer-developing risks—~~worker's~~worker’s compensation, auto liability and general ~~liability,~~ liability—are reviewed by a third party actuary ~~semi-annually.~~quarterly. We believe these accruals are 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, ongoing treatment or loss mitigation, general trends in litigation recovery outcomes 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~~such experience becomes known.
Accounting for Deferred Tax Assets
We regularly evaluate valuation allowances established for deferred tax assets for which future realization is uncertain. We perform this evaluation at least annually at the end of each fiscal year. ~~The estimation~~Estimations of required valuation allowances ~~includes~~include estimates of future taxable income. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the activity underlying these assets becomes deductible. We consider ~~the scheduled reversal of deferred tax liabilities,~~ projected future taxable income and tax planning strategies in making this assessment. If actual future taxable income differs from our estimates, we may not realize deferred tax assets to the extent we have estimated.
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.
We are required to assess our goodwill asset amounts for impairment each year, and more frequently if circumstances suggest an impairment may have occurred. Impairment must be reflected when the value of a given business unit in excess of its tangible and intangible net assets falls below the goodwill asset balance carried for that unit on our books. If other business units have had increases in the value of their respective goodwill balances, such increases may not be recorded under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” Accordingly, such increases may not be netted

against impairments at other business units. The 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 assessment.

Results of Operations (in thousands):

Three Months Ended
March 31,

2004

2005

Revenues

$
192,801

100.0
%
$
204,690

100.0
%
Cost of services

162,777

84.4
%
175,377

85.7
%
Gross profit

30,024

15.6
%
29,313

14.3
%
Selling, general and administrative expenses

27,055

14.0
%
28,077

13.7
%
Gain on sale of assets

(36
)
—

(34
)
—

Operating income

3,005

1.6
%
1,270

0.6
%
Interest expense, net

(497
)
(0.3
)%
(247
)
(0.1
)%
Other income (expense)

(702
)
(0.4
)%
11

—

Income before income taxes

1,806

0.9
%
1,034

0.5
%
Income tax expense

796

505

Income from continuing operations

1,010

0.5
%
529

0.3
%
Discontinued operations—

Operating results, net of tax

33

—

Net income

$
1,043

$
529

~~Table 1—Historical Results~~Revenues

Three Months Ended
September 30,
Nine Months Ended
September 30,

2003
2004
2003
2004

Revenues $ 207,740 100.0 % $ 211,530 100.0 % $ 585,808 100.0 % $ 608,279 100.0 %
Cost of services 172,900 83.2 % 178,250 84.3 % 490,079 83.7 % 511,854 84.1 %

Gross profit 34,840 16.8 % 33,280 15.7 % 95,729 16.3 % 96,425 15.9 %
Selling, general and administrative expenses 27,825 13.4 % 26,687 12.6 % 86,999 14.9 % 79,459 13.1 %
Restructuring charges 949 0.5 % — — 3,223 0.6 % —

Operating income 6,066 2.9 % 6,593 3.1 % 5,507 0.9 % 16,966 2.8 %
Interest expense, net (1,078 ) (0.5 )% (334 ) (0.2 )% (2,672 ) (0.5 )% (1,113 ) (0.2 )%
Write-off of debt costs — — — — (823 ) (0.1 )% — —
Other expense (income) 42 — (135 ) (0.1 )% (105 ) — (405 ) (0.1 )%

Income before income taxes 5,030 2.4 % 6,124 2.9 % 1,907 0.3 % 15,448 2.5 %
Income tax expense 2,435 2,634 1,005 6,643

Income from continuing operations 2,595 1.2 % 3,490 1.6 % 902 0.2 % 8,805 1.4 %
Discontinued operations—
Operating results, net of tax 353 — 715 39
Estimated loss on disposition, including tax (2,773 ) — (3,685 ) (137 )

Net income (loss) $ 175 $ 3,490 $ (2,068 ) $ 8,707

~~Table 2—Supplemental Non-GAAP Disclosure—Operating Results of Ongoing Operations Excluding Certain Items~~
        The following table presents information excluding operations we have sold or shut down that did not qualify for presentation as discontinued operations under generally accepted accounting principles in our historical income statement. This table also excludes from operating income restructuring charges and goodwill impairment charges in 2003.
        We have included this table because we believe it offers an additional view of the core results of our ongoing operations in a way we find useful in managing these operations, and in a way which also responds to frequent questions we receive about the Company from third parties. However, this presentation of operating income is not in accordance with generally accepted accounting principles, and should not be considered an alternative to income as determined under generally accepted accounting principles and presented above in Table 1—Historical Results. In particular, while this table excludes restructuring charges, we have recorded them in each of the previous three years. In addition, impairment charges under the recently changed goodwill accounting rules are generally expected to occur periodically as goodwill recognized in connection with the acquisition of businesses responds over time to changes in those businesses' markets and operations.

2003

Q1
%
O2
%
Q3
%
Q4
%
Total
%

Revenues $ 179,269 $ 198,799 $ 207,740 $ 197,363 $ 783,171
Divested units not reflected in discontinued operations (4,037 ) — (4 ) — (4,041 )

Revenues from ongoing operations 175,232 100.0 % 198,799 100.0 % 207,736 100.0 % 197,363 100.0 % 779,130 100.0 %

Cost of services 152,277 164,902 172,900 167,246 657,325
Divested units not reflected in discontinued operations (4,021 ) (16 ) (9 ) — (4,046 )

Cost of services from ongoing operations 148,256 84.6 % 164,886 82.9 % 172,891 83.2 % 167,246 84.7 % 653,279 83.8 %

Gross profit from ongoing operations 26,976 15.4 % 33,913 17.1 % 34,845 16.8 % 30,117 15.3 % 125,851 16.2 %

Selling, general and administrative expenses 30,412 28,762 27,825 27,031 114,030
Divested units not reflected in discontinued operations (723 ) (20 ) (11 ) — (754 )

Selling, general and administrative expenses from ongoing operations 29,689 16.9 % 28,742 14.5 % 27,814 13.4 % 27,031 13.7 % 113,276 14.5 %

Operating income (loss) from ongoing operations excluding goodwill impairment and restructuring charges (2,713 ) (1.5 )% 5,171 2.6 % 7,031 3.4 % 3,086 1.6 % 12,575 1.6 %
Interest expense, net (542 ) (0.3 )% (1,052 ) (0.5 )% (1,078 ) (0.5 )% (1,155 ) (0.6 )% (3,827 ) (0.5 )%
Other income (expense) (249 ) (0.1 )% 102 0.1 % 42 — (73 ) — (178 ) —

Income (loss) from ongoing operations before income taxes excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net (3,504 ) 4,221 5,995 1,858 8,570
Income tax expense (benefit) (1,114 ) 1,028 2,775 (277 ) 2,412

Income (loss) from ongoing operations (after tax), excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net $ (2,390 ) (1.4 )% $ 3,193 1.6 % $ 3,220 1.6 % $ 2,135 1.1 % $ 6,158 0.8 %

Income (loss) from continuing operations (after tax) $ (4,140 ) $ 2,447 $ 2,595 $ (2,038 ) $ (1,136 )
Divested units not reflected in discontinued operations (after tax) 460 23 8 — 491
Restructuring charges (after tax) 755 723 617 — 2,095
Goodwill impairment (after tax) — — — 2,460 2,460
Writeoff of debt costs and discount (after tax) 535 — — 1,713 2,248

Income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net $ (2,390 ) (1.4 )% $ 3,193 1.6 % $ 3,220 1.6 % $ 2,135 1.1 % $ 6,158 0.8 %

Diluted earnings per share—income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net $ (0.07 ) $ 0.08 $ 0.08 $ 0.05 $ 0.16

2004

Q1
%
Q2
%
Q3
%

Revenues $ 192,801 $ 203,948 $ 211,530
Divested units not reflected in discontinued operations — — —

Revenues from ongoing operations 192,801 100.0 % 203,948 100.0 % 211,530 100.0 %

Cost of services 162,777 170,827 178,250
Divested units not reflected in discontinued operations — — —

Cost of services from ongoing operations 162,777 84.4 % 170,827 83.8 % 178,250 84.3 %

Gross profit from ongoing operations 30,024 15.6 % 33,121 16.2 % 33,280 15.7 %

Selling, general and administrative expenses 27,055 25,717 26,687
Divested units not reflected in discontinued operations — — —

Selling, general and administrative expenses from ongoing operations 27,055 14.0 % 25,717 12.6 % 26,687 12.6 %

Operating income (loss) from ongoing operations excluding goodwill impairment and restructuring charges 2,969 1.5 % 7,404 3.6 % 6,593 3.1 %
Interest expense, net (497 ) (0.3 )% (282 ) (0.1 )% (334 ) (0.2 )%
Other income (expense) (666 ) (0.3 )% 396 0.2 % (135 ) (0.1 )%

Income (loss) from ongoing operations before income taxes excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net 1,806 7,518 6,124
Income tax expense (benefit) 796 3,213 2,634

Income (loss) from ongoing operations (after tax), excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net $ 1,010 $ 4,305 $ 3,490

Income (loss) from continuing operations (after tax) $ 1,010 $ 4,305 $ 3,490
Divested units not reflected in discontinued operations (after tax) — — —
Restructuring charges (after tax) — — —
Writeoff of debt costs (after tax) — — —

Income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net $ 1,010 0.5 % $ 4,305 2.1 % $ 3,490 1.6 %

Diluted earnings per share—income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net $ 0.03 $ 0.10 $ 0.09
        ~~Revenues~~—Revenues increased ~~$3.8~~$11.9 million, or ~~1.8%~~6.2%, to ~~$211.5~~$204.7 million for the ~~third~~first quarter of ~~2004~~2005 as compared to the same period in ~~2003. This~~2004. Approximately 3.3% of the increase in revenues related to internal growth and the remaining 2.9% resulted from the acquisition of Granite State Plumbing & Heating (“Granite”) in January 2005. The internal revenue growth ~~in our~~stemmed primarily from generally improving nonresidential facilities and multi-family ~~sector activity, primarily~~housing markets in the ~~Washington D.C. area, Atlanta, New England~~Sunbelt (increase of approximately $12.1 million) and ~~Florida,~~our Phoenix operation (approximately $4.3 million). These gains were offset to a lesser degree by ~~a decline~~lower revenues relating to our operations in ~~our San Diego operations, where we have combined three companies~~Southern California (approximately $7.3 million) that were impacted by extended inclement weather, and ~~where we have seen a decrease~~an operation in ~~bio-tech and pharmaceutical building activity, and by a decline in our Phoenix operations,~~Washington D.C. (approximately $3.3 million) which had a ~~relatively strong activity level~~reduction in large project work in the ~~third quarter of 2003. Our Southeast operations also experienced a modest impact on~~current quarter.
Backlog reflects revenues ~~this quarter in connection with the four hurricanes that struck this part of the US this quarter.~~
        ~~Revenues increased $22.5 million,~~still to be recognized under contracted or 3.8%, to $608.3 million for the first nine months of 2004 as compared to the same period in 2003. Excluding operations that were sold in 2003 and not reflected in discontinued operations, revenues increased 4.6% at ongoing operations for the first nine months of 2004. This gain in revenues also stemmed from our growth in our multi-family activity, primarily in the Washington D.C. area, Atlanta, New England and Florida, offset to a lesser degree by consolidation of certain underperforming operations in Western Colorado, along with declines off historically high activity levels in 2003 in certain of our Alabama and New York State operations.

        Following the three-year period of industry activity declines noted previously, we saw modest year-over-year revenue increases at our ongoing operations beginning in the third and fourth quarters of 2003 and continuing in each of the first three quarters of 2004. We continue to see signs that activity levels in our industry may increase in 2004 and 2005 as compared to the levels of the last three years. These observations are based on nonresidential construction spending trends, shipment data from HVAC equipment manufacturers, and anecdotal indications of renewed project consideration.
        We and other industry participants also believe that there has been a general deferral of maintenance and replacement activity in the installed base of commercial, industrial, and institutional HVAC equipment, in response to the more difficult economy of the last several years. We and other industry participants believe this trend will not continue indefinitely due to the fundamental mechanical nature of the equipment, but it is not clear when maintenance and replacement activity might increase. While we believe these trends and expectations are positive, there can be no assurance that industry activity levels will actually increase this year or in the foreseeable future.
        Also as noted in the introduction above, there has been significant inflation in the first half of 2004 in the cost of certain commodities used in the construction sector, including steel, iron, copper, lumber, PVC pipe, and motor vehicle fuel. This inflation does not appear to have affected our revenues or backlog, and is expected to have only a modest impact on our profitability, as discussed further below under~~Gross Profit~~. However, more broadly, it is possible that further increases in or uncertainty about commodity costs will decrease demand for nonresidential construction activity, which could in turn reduce our future revenues. To date, though, we have not seen any negative effect of commodity costs on demand for our services.
        In view of all of these factors, we may continue to experience only modest revenue growth or revenue declines in upcoming periods. In addition, if general economic activity in the US slows significantly from current levels, we may realize decreases in revenue and lower operating margins.
        ~~Backlog primarily contains~~committed installation and replacement project work, and ~~maintenance~~under service agreements. ~~These projects~~Project work generally ~~last~~lasts less than aone 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 ~~September 30, 2004~~March 31, 2005 was ~~$516.3~~$629.6 million (including $15.8 million from the acquisition of Granite), a ~~27.8%~~9.8% increase from December 31, ~~2003~~2004 backlog of ~~$403.9~~$573.4 million, and a ~~17.4%~~33.1% increase from ~~comparable September 30, 2003~~March 31, 2004 backlog of ~~$439.6~~$473.2 million. In addition to the Granite acquisition, the increase in backlog from the prior yearend is primarily from significant new office building and hotel work in Washington D.C., along with manufacturing-related bookings in Michigan and education work in Texas.
31

Following the three-year period of industry activity declines from 2001-2003 noted previously, we saw modest year-over-year revenue increases at our ongoing operations beginning in the third and fourth quarters of 2003 and continuing throughout 2004 and early 2005. We continue to see signs that activity levels in our industry may continue to increase throughout 2005. These observations are based on nonresidential construction spending trends, shipment data from HVAC equipment manufacturers, forecasts from construction industry analysts, and anecdotal indications of renewed project consideration.
We and other industry participants also believe that there was a general deferral of maintenance and replacement activity in the installed base of commercial, industrial, and institutional HVAC equipment, in response to the more difficult economic conditions of 2001-2003. We and other industry participants believe this trend may be diminishing due to both the mechanical nature and requirements of the equipment, as well as improving economic conditions, but it is not clear when maintenance and replacement activity might increase. While we believe these trends and expectations are positive, there can be no assurance that industry activity levels will actually increase throughout 2005 or in the foreseeable future.
Along with the indications noted above that suggest industry activity is improving, there remain the following cautionary factors in the industry environment, each of which is discussed at greater length in the introduction above. Since HVAC and related installation and replacement decisions are capital decisions usually involving some amount of discretion, they tend to be affected to a greater degree by macroeconomic or geopolitical uncertainty. Negative developments or events in these arenas, should they occur, will likely cause end users to defer HVAC and related spending decisions, thereby reducing our revenues.
We continue to experience a noticeable amount of price competition in our markets, which restrains our ability to increase revenues.
While we believe we will see increased industry activity levels throughout 2005, in view of all of the foregoing factors, we may continue to experience only modest revenue growth or revenue declines in upcoming periods. In addition, if general economic activity in the US slows significantly from current levels, we may realize decreases in revenue and lower operating margins.
Gross Profit—Gross profit decreased ~~$1.6~~$0.7 million, or ~~4.5%~~2.4%, to ~~$33.3~~$29.3 million for the ~~third~~first quarter of ~~2004~~2005 as compared to the same period in 2003. As a percentage of revenues, gross profit for the third quarter of 2004 was 15.7%, down from 16.8% in the third quarter of 2003, and 16.8% for the same period at ongoing operations. This decline resulted from decreased profitability in our Tennessee operations, costs associated with operational consolidations in our Northern California and Salt Lake City operations, reserves on a project in our Florida operations where we are in discussions with parties to the project which we believe will lead to significant recovery of those reserves, and the impact of the four hurricanes that struck the Southeastern US this quarter. These factors were offset to a lesser extent by an improvement from sharply curtailing operations this year in Western Colorado, which were unprofitable in the third quarter of 2003.
        ~~Gross profit increased $0.7 million, or 0.7%, to $96.4 million for the first nine months of 2004 compared to the same period in 2003.~~2004. As a percentage of revenues, historical gross profit for the first ~~nine months~~quarter of ~~2004~~2005 was ~~15.9%~~14.3%, down from ~~16.3%~~15.6% in the first ~~nine months of 2003, and 16.5% for the same period at ongoing operations. In addition to reduced profitability at our operations in Tennessee, Northern~~

California and Salt Lake City described above, this decline also resulted from increases in the prices for certain commodity materials that we could not recover in higher prices to our customers, the principal impact of which was in the second quarter of ~~this year. Commodity cost trends are discussed further below.~~
        ~~For some of the projects we performed~~2004. The decrease in the first nine months of 2004, the actual cost of certain commodities necessary for these projects, principally steel, iron and copper, was significantly greater than the commodity cost estimates we used when we committed to prices for these projects, which typically was done in 2003 before commodity price inflation became apparent. We estimate that unrecovered commodity inflation had a negative effect of approximately $1.0 million on year-to-date 2004 gross profit or 0.2% of year-to-date revenues, most of which occurred during the second quarter. We began taking steps early in 2004 to reduce future commodity cost exposure, such as early buying of commodities for particular projects, or for general inventory, as well as including escalationpercentage resulted primarily from uneven customer schedules and escape provisions in project bids and contracts. Following our second quarter impact, we experienced virtually no unrecovered cost inflation in the third quarter. However, commodity markets remain unsettled, and while we are taking steps as noted above to minimize unrecoverable commodity cost inflation, these steps cannot guarantee that we will avoid all such exposure.job underperformance at a large operation with significant backlog (approximately $1.6 million).
Gross profit indications in our backlog as of ~~September 30, 2004~~March 31, 2005 were ~~marginally~~130 basis points lower than they were at ~~the end~~December 31, 2004. These declines result in part from significant additions of project work, much of which was larger, longer-term projects which tend to have lower margins and more subcontracted components. We believe that these indications may have also been negatively impacted by management’s increased emphasis on providing contingency for labor cost increases. Approximately one-third of the ~~preceding quarter. However, these~~decline in gross profit indications ~~are generally consistent~~in our backlog stems from revised assessments with respect to the ~~levels~~underperformance at a large operation with significant backlog that we ~~have seen over the last year. Nonetheless, we~~discussed above. We remain cautious about gross profit expectations in coming periods. While we believe industry activity levels are increasing, ~~they appear to be doing so at only a modest rate, and still remain at relatively low levels following the three years of decline the industry experienced from 2001 to 2003. We~~we expect continuing price competition in this environment until noticeably higher activity levels are reached and until the majority of our competition becomes convinced that industry growth is more than temporary. Additionally, with regard to gross profit indications in backlog, as noted above underRevenues~~Revenues~~, a significant portion of our activity is not captured in backlog at any given quarterend due to the amount of service and short-duration project work we do. Further, we can and have experienced lower final gross profit margins when work in backlog is ultimately completed, as compared to the gross profit indications that work had when it was only partially completed or new to backlog. Accordingly, ~~while~~ gross

profit information in backlog ~~provides some indication of general direction of gross profit, it~~ does not assure future levels or trends in consolidated gross profit percentage.
As noted in theIntroduction~~Introduction~~ above, we are currently placing a ~~particular~~greater emphasis ~~in 2004~~ on internal execution and margin improvement ~~rather~~ than on revenue growth. This includes a strong focus on those of our units that have underperformed, along with increased training efforts on project qualification, estimating, pricing and management, and on service performance. While we believe these efforts will help us increase gross profits, we cannot assure that this will occur. In the quarter just ended, for example, our gross profit decreased over the comparable period last year, due in significant part to continued strong steps to consolidate operations and reduce costs at our Northern California and Salt Lake City units, both of which have been underperforming operations for some time. We believe these operations are now at or near breakeven levels and should produce profits over upcoming quarters. We also believe we will improve the lowered level of profitability in our Tennessee operations within the next several quarters. However, we cannot assure we will be successful in achieving these results, or that they will occur in the reasonably near future. Further, if we are successful in these efforts, we cannot assure that they will offset adverse industry trends, if such trends occur.
Selling, General and Administrative Expenses ("(“SG~~&A"~~&A”)—SG&A ~~decreased $1.1~~increased $1.0 million, or ~~4.1%~~3.8%, to ~~$26.7~~$28.1 million for the ~~third~~first quarter of 2004 as compared to the third quarter of 2003, and as a percentage of revenues, declined from 13.4% in last year's third quarter to 12.6% this year. These decreases resulted primarily from consolidation of certain operating units in San Diego, Colorado, and Northern California, offset to a lesser extent by higher corporate incentive compensation accruals and increased accounting and auditing fees associated with the requirements of the Sarbanes-Oxley Act.

        ~~For the nine months ended September 30, 2004, SG&A decreased $7.5 million, or 8.7%, to $79.5 million~~2005 as compared to the same period in ~~2003,~~2004, and as a percentage of revenues, SG&A declined from ~~14.9%~~14.0% in 2003 to 13.1% in 2004. These decreases resulted primarily from consolidation of certain operating units in San Diego, Salt Lake City, and Colorado, as well as from the sale or closure of certain units that did not qualify for discontinued operations presentation.
        ~~Restructuring Charges~~~~—During~~ the first ~~three quarters~~quarter of ~~2003, we recorded restructuring charges~~2004 to 13.7% in the first quarter of 2005. The decrease in SG&A as a percentage of revenue is due to the reduction in bad debt expense of approximately ~~$3.2~~$1.0 million ~~pre-tax. These charges included approximately $1.5 million for severance costs and retention bonuses~~ primarily ~~associated with~~due to favorable developments in the curtailment of our energy efficiency marketing activities, a reorganization of our national accounts operations as well as a reduction in corporate personnel. The severance costs and retention bonuses related to the termination of 88 employees, all of whom had left the Company by December 31, 2003. The restructuring charges for this period also included approximately $1.6 million for remaining lease obligations and $0.1 million of other costs recorded in connection with the actions described above. We increased our accrual for these remaining lease obligations by $0.5 million in 2004 basedcurrent quarter on revised estimates of when and to what extent we believe we can sublease the related facilities. These increases to the accrual were included in "Cost of Services" and in "Selling, General and Administrative Expenses" in our results of operations.certain disputed receivables.
Interest Expense, Net—~~Interest~~The decrease in interest expense, net is a result of payments on the term loan throughout 2004 and 2005 thereby reducing our average debt outstanding, and interest income earned from higher cash balances in the current year. See “Liquidity and Capital Resources” for a detail of the components of interest expense, net for the three months ~~and nine months~~ ended ~~September 30, 2003 and 2004 included the following primary elements (in thousands):~~

Three Months Ended
September 30,
Nine Months Ended
September 30,

2003
2004
2003
2004

Interest expense on borrowings, and unused commitment fees $ 349 $ 140 $ 1,125 $ 557
Letter of credit fees 150 130 355 339
Amortization of deferred debt arrangement costs and discount 328 104 1,084 300
Mark-to-market adjustments on derivatives 280 — 188 —
Interest income (29 ) (40 ) (80 ) (83 )

Total $ 1,078 $ 334 $ 2,672 $ 1,113

        Interest expense is significantly lower in 2004 as compared to 2003 as a result of much lower debt levels in 2004 stemming from increased cash flows during current year periods, and because our current credit facility cost noticeably less in upfront fees when it was established in the fourth quarter of 2003, thereby resulting in lower ongoing amortization of these fees in the current year.
        ~~Other Expense (Income)~~~~—Other expense was $0.1 million for the third quarter of~~March 31, 2004 and ~~other~~2005.
Other Income (Expense)—Other income was less than $0.1 million for the ~~third~~first quarter of ~~2003. Other~~2005 and other expense was ~~$0.4~~$0.7 million for the first ~~nine months~~quarter of ~~2004 and $0.1 million~~2004. Other expense for the first ~~nine months of 2003. The third~~ quarter of 2004 ~~and the first nine months of 2004 include~~includes losses of ~~$0.1~~$0.7 million ~~and $0.5 million, respectively,~~ resulting from mark-to-market adjustments on a warrant that was outstanding with a third party to buy shares of our stock. The warrant also carried a put obligation. This warrant was exercised in October 2004. This exercise also terminated the related put obligation. As a result, there will be no further mark-to-market adjustments relating to this warrant and put subsequent to the third quarter of 2004.
        ~~The first quarter of 2003 includes a loss of $0.3 million on the disposition of a division of one of our operations.~~

        ~~Write-off of Debt Costs~~~~—The first quarter of 2003 reflects a non-cash charge of $0.8 million for deferred debt costs that were associated with previously higher levels of capacity under our previous credit facility.~~
Income Tax Expense ~~(Benefit)~~—~~Our~~The effective tax rate associated with results from continuing operations ~~for the third quarter of 2004~~ was ~~43.0%~~48.8%, as compared to ~~48.4%~~44.1% in ~~2003. For the first nine months of 2004 and 2003, our corresponding~~2004. Our effective tax ~~rates were 43.0% and 52.7%, respectively. Our effective~~ rate is generally higher than statutory rates because of the effect of certain expenses that ~~we incur that~~ are not deductible for tax purposes, and due to reserves that we have established against certain deferred tax assets based on the possibility that we will not be able to ultimately realize the tax benefit for certain losses we have incurred, primarily at the state income tax level.purposes. In addition, ~~since our recent pre-tax profit margins have been relatively low on a historical and an absolute basis, the impact of non-deductible expenses and deferred~~adjustments to tax reserves onare analyzed and adjusted quarterly as events occur to warrant such changes. Adjustments to tax reserves are a component of the effective tax rate.
During 2004, the American Jobs Creation Act of 2004 was signed into law. The primary effect of this legislation will be to permit us to claim a deduction for 3% of earnings related to certain of our construction-related activities beginning in 2005. This deduction is expected to modestly decrease our effective tax rate. We currently estimate that our effective tax rate ~~is magnified. This latter impact also contributes to the higher level of our 2003 effective rates as compared to 2004, as our pre-tax profit levels were noticeably lower in 2003 than in 2004.~~for full-year 2005 will be between 40% and 45%.
Discontinued Operations—~~Individual Sales of Operating Companies~~~~—During the second quarter of~~In 2004, we sold a small operating company. ~~This unit's~~The after-tax income of ~~$0.1 million~~this company for the first ~~nine months~~quarter of ~~2003 and~~2004 was less than $0.1 million ~~for the first six months of 2004~~and has been reported in discontinued operations under ~~"Operating income,~~“Operating results, net of ~~income tax expense"~~tax”. ~~We recorded a~~The loss recognized on the sale of this unit ~~of $0.5 million, including taxes,~~ in the second quarter of 2004 was $0.5 million, including tax expense, and was reported in discontinued operations under ~~"Estimated~~“Estimated loss on disposition, including income ~~tax expense". The~~taxes.” This loss primarily resulted from the non-cash writeoff of goodwill associated with this unit. ~~The goodwill writeoff was not tax deductible.~~
        ~~During the fourth quarter of 2003, we sold a small operating company.~~ This unit's after-tax income of $0.3 million for the nine months ended September 30, 2003 has been reported in discontinued operations under "Operating results, net of tax." We recorded a loss of $1.5 million, net of tax benefit, in the fourth quarter of 2003 in discontinued operations under "Estimated loss on disposition, including tax." The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        During the third quarter of 2003, we committed to a plan to divest of a small operating company. This unit's after-tax income of $0.2 million for the nine months ended September 30, 2003 has been reported in discontinued operations under "Operating results, net of tax." We recorded an estimated loss of $2.8 million, including taxes, in the third quarter of 2003 related to this planned disposition in "Estimated loss on disposition, including tax" based upon an estimated sales price. The final loss as measured at the closing of this sale in the fourth quarter of 2003 was not materially different than the estimate recorded in the preceding quarter. The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        During the first quarter of 2003, we committed to a plan to divest of a small operating company. This unit's after-tax income of $0.1 million for the six months ended June 30, 2003 has been reported in discontinued operations under "Operating results, net of tax." We recorded an estimated loss of $0.9 million, including taxes, in the first quarter of 2003 related to this transaction in "Estimated loss on disposition, including tax." The final loss as measured at the closing of this sale in the second quarter of 2003 was not materially different than the estimate recorded in the preceding quarter. The loss resulted from the non-cash writeoff of goodwill associated with this unit. The goodwill writeoff was not tax deductible.
        ~~Discontinued Operations—Sale of Companies to Emcor~~Outlook—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. We realized an aggregate loss of $11.5 million, including related tax expense, in connection with the sale of

these operations. As a result of the adoption of Statement of Financial Accounting Standards ("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 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 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 were 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 discontinued operations under "Estimated loss on disposition, including tax" in connection with the Emcor transaction. This charge primarily related 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 includes 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, of which $0.8 million was paid from escrow in September 2003 and an additional $0.2 million was paid from escrow during May 2004. 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 estimated when the transaction originally closed in the first quarter of 2002.
        There are ongoing open matters relating to this transaction that we continue to address with Emcor. We do not believe these open matters, either individually or in the aggregate, will have a material effect on our financial position when ultimately resolved. We maintain reserves for these matters, net of amounts receivable from escrow that we believe will ultimately be applied in settling these matters. During the second quarter of 2004, we concluded that the related reserves should be reduced by $0.3 million, net of tax benefit. This amount was reflected in discontinued operations in the second quarter of 2004 as a reduction in the estimated loss on disposition of discontinued operations.
        ~~Outlook~~—As noted earlier in this review, while we see signs that industry activity levels are ~~increasing in 2004 and may continue~~continuing to ~~do so~~increase in 2005, our primary emphasis for this year is on margin improvement ~~rather~~more so than revenue growth. Our ongoing margin ~~improvement~~ efforts include a focus on ~~reducing~~improving the ~~number~~results of ~~our~~ units ~~with significantly decreased operating results~~that incurred losses or ~~losses~~subpar income in 2004, ~~as compared to 2003,~~ and on intensified project and service performance training at the unit level. While these efforts have contributed to increased operating profit margins in the three preceding quarters, we did not achieve increased operating profit margins in the quarter just ended, when the effect of 2003 restructuring charges

is excluded. This was due in significant part to continued steps to consolidate operations and reduce costs at our Northern California and Salt Lake City units, both of which have been underperforming operations for some time. We believe these operations are now at or near breakeven levels and should produce profits over upcoming quarters. We also believe we will improve the lowered level of profitability in our Tennessee operations within the next several quarters. Our primary near-term emphasis remains margin improvement, and given our expectations for improved results in these particular operations, we are optimistic that we will be successful again at increasing margins in coming periods, although there can be no assurance of this.
Based on these margin improvement efforts and developments, on our increased level of backlog as compared to

recent periods, and on our belief that industry and economic conditions are improving, we expect that our full-year ~~2004~~2005 results will be ~~significantly~~ better than our ~~2003~~2004 results, ~~and that we have reasonable prospects for continued profitability in 2005,~~ although there can be no assurance that we will achieve ~~these outcomes.~~this outcome.
Liquidity and Capital Resources

Three Months Ended
September 30,
Nine Months Ended
September 30,

Three Months Ended
March 31,

2003
2004
2003
2004

2004

2005

(in thousands)

(in thousands)

(in thousands)

Cash provided by (used in): Cash provided by (used in):

Operating activities $ (6,437 ) $ 5,121 $ 5,143 $ 12,781
Investing activities $ (510 ) $ (807 ) $ (5,096 ) $ (1,631 )
Financing activities $ 3,352 $ (526 ) $ 1,669 $ (793 )
Operating activities

$
(4,733
)
$
(5,541
)
Investing activities

$
(255
)
$
(4,633
)
Financing activities

$
(29
)
$
52

Free cash flow:
Free cash flow:

Cash provided by (used in) operating activities $ (6,437 ) $ 5,121 $ 5,143 $ 12,781
Taxes paid related to the sale of businesses — — 10,371 —
Purchases of property and equipment (714 ) (963 ) (2,661 ) (3,180 )
Proceeds from sales of property and equipment 208 — 319 283

Cash used in operating activities

$
(4,733
)
$
(5,541
)
Purchases of property and equipment

(1,317
)
(2,043
)
Proceeds from sales of property and equipment

129

148

Free cash flow Free cash flow $ (6,943 ) $ 4,158 $ 13,172 $ 9,884

$
(5,921
)
$
(7,436
)

Cash ~~Flow~~Flow——We define free cash flow as cash provided by operating activities, ~~excluding items related to sales of businesses,~~ less 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~~company’s outstanding debt or equity. If free cash flow is negative, ~~and exceeds on-hand balances,~~ additional debt or equity ~~is generally~~may be required to fund the outflow of cash. Free cash flow may be defined differently by other companies.
Our business does not require significant amounts of investment in long-term fixed assets. The substantial majority of the capital used in our business is working capital that funds our costs of labor and installed equipment deployed in project work until our customers pay us. Customary terms in our industry allow customers to withhold a small portion of the contract price until after we have completed the work, typically for six months. Amounts withheld under this practice are known as retention or retainage. Our average project duration together with typical retention terms generally allow us to complete the realization of revenue and earnings in cash within one year. Accordingly, we believe free cash flow, by encompassing both profit margins and the use of working capital over our approximately ~~one-year~~one year working capital cycle, is an effective measure of operating effectiveness and efficiency. We have included free cash

flow information here for this reason, and because we are often asked about it by third parties evaluating the Company. However, free cash flow is not considered under generally accepted accounting principles to be a primary measure of an ~~entity's~~entity’s financial results, and accordingly free cash flow should not be considered an alternative to operating income, net income, or amounts shown in our consolidated statements of cash flows as determined under generally accepted accounting principles.
For the three months ended ~~September 30, 2004,~~March 31, 2005, we had ~~positive~~negative free cash flow of ~~$4.2~~$7.4 million, as compared to negative free cash flow of ~~$6.9~~$5.9 million during the ~~third~~first quarter of ~~2003.~~2004. This decrease primarily resulted from the funding of yearend compensation accruals and an increase ~~resulted primarily from a somewhat better billing and collection cycle, and from a somewhat reduced pace of non-payroll disbursements,~~ in ~~the quarter just ended as compared to last year's third quarter. For the nine months ended September 30, 2004, we had free cash flow of $9.9 million~~income tax payments following very strong fourth quarter ~~2003~~2004 cash flow, as compared to free cash flow of $13.2 million during the first nine months of 2003. This decrease resulted from the requirement of $4.2 million in working capital primarily relating to early buying of metal commodities due to volatile conditions in the markets for these materials, and due to an increase in the proportion of projects that are in early stages when the lag between labor and equipment cash requirements and contractual billing dates is typically the greatest. This compares to a recovery of $0.2 million of working capital from our operations in the first nine months of 2003 following comparatively low cash flow in the fourth quarter of 2002.flow.
        During the first quarter of 2003, free cash flow as well as borrowings from our credit facility were used to pay final tax payments of $10.4 million associated with the sale of the operations to Emcor.
Credit ~~Facility~~Facility——On December 31, 2003, we entered into a senior credit facility (the ~~"Facility"~~“Facility”) provided by a syndicate of banks. As of ~~September 30, 2004~~March 31, 2005 the total of the Facility was ~~$54.0~~$53.0 million, with ~~$26.3~~$8.0 million in borrowings ~~and~~outstanding, $18.6 million in letters of credit outstanding, and ~~$27.7~~$26.4 million of credit available. In addition to this credit capacity, as of March 31, 2005, we had $22.5 million in cash. As of ~~October 29, 2004,~~May 2, 2005, the total of the Facility was ~~$53.5~~$52.5 million, with ~~$25.8~~$7.5 million in borrowings ~~and~~outstanding, $19.4 million in letters of credit outstanding, and ~~$27.7~~$25.6 million of credit available. The Facility is secured by

substantially all of our assets, including the capital stock of all our current and future subsidiaries and substantially all of their assets. Amounts due under the Facility are also guaranteed by our current and future subsidiaries. The Facility consists of two parts: a term loan and a revolving credit facility.
The original term loan under the Facility (the ~~"Term Loan"~~“Term Loan”) was $10 million, which the Company borrowed upon the closing of the Facility. The Term Loan must be repaid in installments of $0.5 million payable at the beginning of each quarter over five years, the first installment of which was paid in the second quarter of 2004. The Facility requires prepayments of the Term Loan in certain circumstances generally involving the sale of assets. All principal payments under the Term Loan permanently reduce the original $10 million capacity under this portion of the Facility.
The Facility also included a three-year $40 million revolving credit facility (the ~~"Revolving Loan"~~“Revolving Loan”) available for borrowings or letters of credit. This was increased to $45 million in the second quarter of 2004. Letters of credit are discussed at greater length below underOff-Balance Sheet Arrangements andOther Commitments.The Facility requires that borrowings outstanding under the Revolving Loan must be less than $2 million for ten consecutive business days at least once during each year. We have already satisfied this condition for ~~2004.~~2005.
The interest rates under the Facility are floating rates determined by the broad financial markets, meaning they can and do move up and down from time to time. During the first quarter of 2005, we paid interest on Facility borrowings at a weighted average interest rate of 5.3% per annum. This weighted average rate reflects a combination of both interest rate options under the Facility that apply to term loan borrowings as described in Note 6 of the “Condensed Notes to Consolidated Financial Statements.” We had no revolving credit borrowings during the first quarter of 2005. The weighted average rate does not include amortization of debt financing and arrangement costs. We estimate that the weighted average interest rate currently applicable to all borrowings under the Facility is approximately 5.7%. Commitment fees of 0.375% per annum are also payable on the portion of the Revolving Loan capacity not in use for borrowings or letters of credit at any given time.
Interest expense, net for the three months ended March 31, 2004 and 2005 included the following primary elements (in thousands):

Three Months Ended
March 31,

    2004

    2005

Interest expense on borrowings, and unused commitment fees

$
225

$
146

Letter of credit fees

207

109

Amortization of deferred debt arrangement costs

96

120

Interest income

(31
)

(128
)

Total

$
497

$
247

See Note 6 of the “Condensed Notes to Consolidated Financial Statements” for a detailed discussion of the interest rates and fees associated with the Facility.
Our borrowings and letters of credit outstanding under the Facility at each monthend must be less than a borrowing base measured as of the same monthend. The borrowing base is defined under the Facility as 60% of the following: total trade receivables including costs and estimated earnings in excess of billings, less allowances for doubtful accounts, less receivables related to projects that are subject to payment or performance bonds. The borrowing base as of ~~September 30, 2004~~March 31, 2005 was ~~$92.8~~$87.2 million. This borrowing base is substantially greater than the current ~~$53.5~~$52.5 million face-value limit of the Facility. We do not expect that this borrowing base provision will limit credit available under the Facility in the foreseeable future.
35

Our borrowing and letter of credit capacity under the Revolving Loan portion of the Facility at any given time is $45 million less borrowings and letters of credit outstanding, subject to the borrowing base described above. The Facility contains financial covenants defining various financial measures and the levels of these measures with which we must comply, as discussed further below. .Covenant compliance is measured as of each quarterend. While the ~~Facility's~~Facility’s financial covenants do not specifically govern capacity under the Facility, if our debt level under the Facility at a quarterend covenant compliance measurement date caused us to violate the ~~Facility's debt-to-EBITDA~~Facility’s debt-to-Credit Facility Adjusted EBITDA covenant (described in more detail below) our borrowing capacity under the Facility could be restricted by the lenders. Accordingly, available capacity amounts shown below are presented both on a financial covenant basis and on a Facility face value basis.

As of
September 30,
2004
As of
October 29,
2004

As of
March 31,
2005

As of
May 2,
2005

(in thousands)

(in thousands)

Amounts Outstanding Amounts Outstanding

Revolving loan Revolving loan $ — $ —

$
—

$
—

Term loan Term loan 9,000 8,500

8,000

7,500

Other non-Facility debt Other non-Facility debt 349 346

303

297

Total debt $ 9,349 $ 8,846

Total debt

$
8,303

$
7,797

Letters of credit Letters of credit $ 17,280 $ 17,280

$
18,619

$
19,369

Available Capacity
Available Capacity

Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million $ 27,720 $ 27,720

$
26,381

$
25,631

Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-EBITDA covenant $ 27,720 n/a
Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-Credit Facility Adjusted EBITDA covenant

$
26,381

n/a

The Facility contains financial covenants defining various financial measures and the levels of these measures with which we must comply. Covenant compliance is assessed as of each quarterend. ~~Earnings~~Credit facility adjusted earnings before interest, taxes, depreciation and amortization ~~("EBITDA"~~(“Credit Facility Adjusted EBITDA”) is defined under the Facility for financial covenant purposes as net earnings for the four quarters ending as of any given quarterly covenant compliance measurement date, plus the corresponding amounts for (a) interest expense; (b) income taxes; (c) depreciation and amortization; and (d) other non-cash charges. The ~~Facility's~~following is a reconciliation of Credit Facility Adjusted EBITDA to net income (in thousands):
Net income

$
10,199

Discontinued operations—estimated gain on dispositions, net

(481
)
Income taxes—continuing operations and discontinued operations

7,980

Mark-to-market warrant obligation

(262
)
Interest expense, net

1,144

Depreciation expense

4,612

Goodwill impairment

3,347

Credit Facility Adjusted EBITDA

$
26,539

The Facility’s principal financial covenants include:
Debt Service Coverage Ratio—The Facility requires that the ratio of Credit Facility Adjusted EBITDA to the sum of interest expense and scheduled principal payments be at least 2.50. Interest expense is defined under the Facility for purposes of this covenant as interest expense for the four

quarters ending as of any given quarterly covenant compliance measurement date, excluding corresponding twelve-month amounts for (a) amortization of deferred debt arrangement costs; and (b) mark-to-market interest expense. Scheduled principal payments for this ratio are also measured for the twelve months ending as of any given quarterly covenant compliance measurement date. The Facility provides, however, that during the first three quarters of 2004, interest expense and scheduled principal payments used in this ratio will be the annualized amounts of actual year-to-date interest expense and scheduled principal payments, instead of actual amounts for these items for the twelve months then ended. The Company'sCompany’s debt service coverage ratio as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~7.56~~8.94 as compared to a minimum covenant requirement of 2.50.
Tangible Net Worth—The Facility requires that our tangible net worth not be less than the sum of (a) $75.4 million; (b) 75% of net income earned beginning October 1, 2003; and (c) the net proceeds of any equity transactions. For purposes of this ratio, the Facility defines tangible net worth as ~~stockholders~~stockholders’ equity less the book value of the following intangible assets: goodwill, patents, copyrights, licenses, franchises, trade names, trade secrets, and operating leases. The Facility also provides that

for purposes of this ratio, net income excludes any goodwill impairment charges. The ~~Company's~~Company’s tangible net worth as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~$107.8~~$118.2 million, as compared to a covenant minimum of ~~$84.3~~$92.8 million.
Debt to Credit Facility Adjusted EBITDA—The Facility requires that our ratio of debt to Credit Facility Adjusted EBITDA not exceed 2.0. Our ~~debt-to-EBITDA~~debt-to-Credit Facility Adjusted EBITDA ratio as of ~~September 30, 2004~~March 31, 2005 as measured under this covenant was ~~0.37.~~0.31.
Capital Expenditures—The Facility limits capital expenditures to $8.0 million per year. Our capital expenditures during the ~~nine~~three months ended ~~September 30, 2004~~March 31, 2005 were ~~$3.2~~$2.0 million.
Surety—Surety bonding is discussed in more depth later in this section. The Facility contains provisions that may have the practical effect of limiting our use of surety bonding in excess of $145 million of bonded backlog to the lesser of (a) the amount of surety bonds outstanding which results in the ratio of receivables relating to bonded contracts to total receivables not exceeding 35%; and (b) $275 million in bonded backlog. As of March 31, 2005, our ratio of bonded receivables to total receivables was 29.0%, and our bonded backlog was $165.1 million.
Other Restrictions—The Facility prohibits payment of dividends and repurchase of shares by the Company, and limits non-Facility debt, capital lease obligations, acquisitions, investments, and sales of assets. The Facility also includes a customary provision under which the lenders may demand immediate repayment of borrowings and disposition of letters of credit if they conclude that our business or financial position has suffered a material adverse change. However, the Facility does not include any mechanisms allowing the lenders immediate access to our ongoing cash flow in the event of a default or an immediate repayment demand by the lenders. In view of our financial position, and what we believe are our prospects for profitability and positive cash flow in the future, we believe that the probability that our lenders will invoke the material adverse change provision of the Facility in the foreseeable future is remote. As a result, debt under the Facility is classified as long-term, other than amounts due within one year.
Off-Balance Sheet Arrangements andOther 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. If we decide to cancel or terminate a lease before the end of its term, we would typically owe the lessor 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. We have also occasionally used letters of credit to guarantee performance under our contracts and to ensure payment to our subcontractors and vendors under those contracts. The letters of credit we provide are actually issued by our lenders through ~~our Credit~~the Facility as described above. A letter of credit commits the lenders 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 lenders. Depending on the circumstances of such a reimbursement, we may also have to record a charge to earnings for the reimbursement. Absent a claim, there is no payment or reserving of funds by ~~the Company~~us in connection with a letter of credit. However, because a claim on a letter of credit would require immediate reimbursement by us to our lenders, letters of credit are treated as a use of ~~Credit Facility~~the Facility’s capacity just the same as actual borrowings. Claims against letters of credit are rare in our industry. To date we have not had a claim made against a letter of credit that resulted in payments by ~~our lenders~~a lender 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~~If we fail to ~~the customer that we will~~ perform under the terms of a contract ~~and that we will~~or to pay subcontractors and vendors who provided goods ~~and~~or 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~~sureties for any expenses or outlays ~~it incurs.~~they incur. To date, we are not

aware of any losses to our ~~surety~~sureties in connection with bonds the ~~surety has~~sureties have posted on our behalf, and we do not expect such losses to be incurred in the foreseeable future.
Surety market conditions are currently ~~difficult~~challenging 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 primary surety and we have recently added another surety to further support our bonding needs, current market conditions as well as changes in our ~~surety's~~sureties’ assessment of our operating and financial risk could cause our ~~surety~~sureties 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 participants as to our creditworthiness. While we believe our general operating and financial ~~performance~~characteristics, including a significantly greater amount of cash on our balance sheet than debt, 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.

The following recaps the future maturities of our debt along with other contractual obligations as of ~~September 30, 2004~~March 31, 2005 (in thousands):

Twelve Months Ended September 30,

Twelve Months Ended March 31,

2005
2006
2007
2008
2009
Thereafter
Total

2006

2007

2008

2009

2010

Thereafter

Total

Revolving loan Revolving loan $ — $ — $ — $ — $ — $ — $ —

$
—

$
—

$
—

$
—

$
—

$
—

$
—

Term loan Term loan 2,000 2,000 2,000 2,000 1,000 — 9,000

2,000

2,000

2,000

2,000

—

—

8,000

Other debt Other debt 76 77 67 62 36 31 349

73

68

68

44

37

13

303

Total debt $ 2,076 $ 2,077 $ 2,067 $ 2,062 $ 1,036 $ 31 $ 9,349

Total debt

2,073

2,068

2,068

2,044

37

13

8,303

Interest payments

450

356

215

63

3

1

1,088

Operating lease obligations
Operating lease obligations

$
8,030

$
6,515

$
5,554

$
4,458

$
3,193

$
12,790

$
40,540

8,710

7,380

6,682

4,977

3,527

12,475

43,751

Total

$
11,233

$
9,804

$
8,965

$
7,084

$
3,567

$
12,489

$
53,142

To estimate future interest payments, we used certain financial institution forecasts that project modest increases in the interest rate over the remaining term of the loans. Absent any significant commitments of capital for items such as capital expenditures, acquisitions, dividends and share repurchases, it is reasonable to expect the Company to continue to maintain excess cash on its balance sheet. Therefore, we assumed that the Company would continue its current status of not utilizing any borrowings under its revolving loan.
As of ~~September 30, 2004~~March 31, 2005 we also have ~~$17.3~~$18.6 million of letter of credit commitments, of which ~~$16.9 million expire in 2004 and the remaining~~ $0.4 million expire in ~~2005.~~2005 and $18.2 million expire in 2006. The substantial majority of these letters of credit are posted with insurers who disburse funds on our behalf in connection with our ~~worker's~~worker’s compensation, auto liability and general liability insurance program. These letters of credit provide additional security to the insurers that sufficient financial resources will be available to fund claims on our behalf, many of which develop over long periods of time, should we ever encounter financial duress. Posting of letters of credit for this purpose is a common practice for entities that manage their self-insurance programs through third-party insurers as we do.
While the majority of these letter of credit commitments expire in ~~2004,~~2006, we expect nearly all of them, particularly those supporting our insurance programs, will be renewed annually. In addition, given the estimated size and duration of funding of claims under our ~~worker's~~worker’s compensation, auto liability and general liability insurance programs, we recently agreed with our insurers that we will increase the amount of letters of credit posted with them in quarterly installments beginning in November 2004 and aggregating to an additional $3$1.50 million in letters of credit outstanding in August of 2005.
Other than the operating lease obligations noted above, we have no significant purchase or operating commitments outside of commitments to deliver equipment and provide labor in the ordinary course of performing project work. In addition, Other Long-Term Liabilities on our balance sheet is comprised of $2.8 million associated with a warrant and put obligation. This warrant was exercised in October, 2004, which also resulted in the termination of the related put obligation. Accordingly, the $2.8 million value of the warrant and related put as of September 30, 2004 have been eliminated as an obligation and added to

~~stockholders' equity in October, with no cash outlay required of us. As a result, this obligation was not included in the table of commitments above.~~
Outlook—We have generated positive net free cash flow in ~~fourteen~~each of the last ~~eighteen quarters in~~five calendar years, most of which occurred during challenging economic and industry conditions. We also have a relatively low level of debt, significant borrowing capacity under our credit facility, and cash balances that exceed our total ~~debt.~~debt by a sizable amount. We ~~anticipate that free cash flow from operations and credit capacity under the Facility~~believe these factors will provide us with sufficient liquidity to fund our operations for the foreseeable future.
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 and replacement projects in various geographic regions of the United States.
New Accounting Pronouncements
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No.123 (revised 2004), “Share-Based Payment,” (“Statement 123(R)”) which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“Statement 123”). Statement 123(R) supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“Opinion 25”) and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Statement 123(R) must be adopted no later than January 1, 2006. Early adoption will be permitted for periods in which financial statements have not yet been issued. We expect to adopt Statement 123(R) on January 1, 2006.
Statement 123(R) permits public companies to adopt its requirements using one of two methods:
1.     A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.
2.     A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
We plan to adopt Statement 123(R) using the modified prospective method.
As permitted by Statement 123, we currently account for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options in our results of operations. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on our reported results of operations, although it will have no impact on our cash flows. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to our consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in both of the first quarters of 2004 and 2005 for such tax benefits was $0.3 million.

ITEM 3.    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. We are not exposed to any other significant financial market risks including commodity price risk, ~~(except as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations"),~~ 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.    4.                Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The ~~Company's~~Company’s executive management is responsible for ~~insuring~~ensuring the effectiveness of the design and operation of our disclosure controls and procedures. We carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the most recent fiscal year. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective at the reasonable assurance level to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported in accordance with and within the time periods specified in Securities and Exchange Commission rules and forms.
Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting during the three months ended ~~September 30, 2004~~March 31, 2005 that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.
41

COMFORT SYSTEMS USA, INC.
PART II—OTHER INFORMATION
Item 1.Legal Proceedings
The Company is party to litigation in the ordinary course of business. The largest single unresolved matter to which the Company is party involves a construction project. If this matter were ultimately resolved on the least favorable terms to the Company, management estimates that it would incur a liability of approximately $2.5 million. However, management believes the likelihood of such a least-favorable outcome is remote, and believes its asset balances and accruals relating to this matter appropriately reflect a probable outcome. The ~~Company's~~Company’s remaining litigation involves matters with significantly smaller individual potential losses.
The Company has estimated and provided accruals for probable losses and related legal fees associated with certain of its litigation in the accompanying consolidated financial statements. In ~~management's~~management’s opinion, uninsured losses resulting from the ultimate resolution of these matters will not have a material adverse effect on the ~~Company's~~Company’s operating results or financial condition.

Item 2.Recent Sales of Unregistered Securities
On October 11, 2002, the Company issued a warrant to General Electric Capital Corporation as consideration for loans and credit commitments. On October 26, 2004, General Electric Capital Corporation exercised its rights under that instrument and the Company formally issued 408,144 shares of the Company’s common stock. Subsequent to this issuance, General Electric Capital Corporation informed the Company that the October 26^th issuance contained a three hundred share inadvertent discrepancy. On January 24, 2005, General Electric Capital Corporation returned 408,144 shares to the Company, and then on January 26, 2005, the Company issued 408,444 shares to General Electric Capital Corporation, thereby correcting the prior inadvertent three hundred share discrepancy.
        ~~None.~~

Item 6.Exhibits and Reports on Form 8-K
(a)
Exhibits

~~31.1~~
10.1
Side Letter to Amended and Restated Credit Agreement dated as of December 31, 2003, which side letter is effective as of March 1, 2005 by and among the Company; Bank of Texas, N.A., individually and as administrative agent; Hibernia National Bank, as Documentation Agent; and the Lenders and Guarantors.
10.2
Description of Comfort Systems USA, Inc.’s 2005 Incentive Compensation Plan for Executive Officers.
31.1
Rule 13a-14(a) Certification of William F. Murdy pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Rule 13a-14(a) Certification of ~~J. Gordon Beittenmiller~~William George pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Section 1350 Certification of William F. Murdy pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Section 1350 Certification of ~~J. Gordon Beittenmiller~~William George pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b)
Reports on Form 8-K
during the quarter ended March 31, 2005.
(i)             The Company filed a report on Form 8-K with the Securities and Exchange Commission on ~~August 3, 2004. Under Item 7~~January 18, 2005 under Items 8.01 and 9.01. The report related to the Company’s issuance of ~~that report the Company announced that on August 2, 2004, the Company issued~~

a press release reporting ~~Comfort's~~the Company’s acquisition of Granite State Plumbing & Heating, LLC.
(ii)         The Company filed a report on Form 8-K with the Securities and Exchange Commission on March 3, 2005 under Items 2.02 and 9.01. The report related to the Company’s announcement of a press release describing the Company’s financial results for the ~~second~~fourth quarter of 2004 and for the year ended December 31, 2004.

(iii) The Company filed a report on Form 8-K with the Securities and Exchange Commission on March 21, 2005 under Items 1.01 and 5.02. The report related to the Company’s adoption of its 2005 Incentive Compensation Plan for Executive Officers, and the Company’s announcement of the departure of directors and a principal officer, along with the appointment of certain principal officers.
43

SIGNATURES
~~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.

~~November 2, 2004~~

By:

~~By:~~
/s/ WILLIAM F. MURDY
May 4, 2005
William F. Murdy
Chairman of the Board and
Chief Executive Officer

~~November 2, 2004~~
May 4, 2005

By:

~~By:~~
/s/ WILLIAM GEORGE
William George
~~J. GORDON BEITTENMILLER~~
~~J. Gordon Beittenmiller~~
Executive Vice President
and
Chief Financial Officer ~~and Director~~

44

									December 31,				March 31,
			December 31, 2003			September 30, 2004			2004				2005
						(Unaudited)							(Unaudited)
ASSETS	ASSETS
CURRENT ASSETS:	CURRENT ASSETS:
	Cash and cash equivalents		$	10,129		$	20,493
	Accounts receivable, less allowance for doubtful accounts of $5,010 and $4,723			167,567			176,227
	Other receivables			5,171			4,888
	Inventories			9,825			10,510
	Costs and estimated earnings in excess of billings			16,162			22,825
	Prepaid expenses and other			13,675			10,547
	Assets related to discontinued operations			973			—

		Total current assets		223,502			245,490
Cash and cash equivalents										$	32,576		$	22,454
Accounts receivable, less allowance for doubtful accounts of $6,050 and $4,389, respectively										174,682			178,979
Other receivables										4,103			2,730
Inventories										10,590			10,376
Costs and estimated earnings in excess of billings										25,440			25,734
Prepaid expenses and other										13,338			13,986
Total current assets										260,729			254,259
PROPERTY AND EQUIPMENT, net	PROPERTY AND EQUIPMENT, net			13,223			12,529			12,988			13,958
GOODWILL, net				103,470			103,470
GOODWILL										100,123			100,123
OTHER NONCURRENT ASSETS	OTHER NONCURRENT ASSETS			10,915			9,262			9,276			8,738

		Total assets	$	351,110		$	370,751

LIABILITIES AND STOCKHOLDERS' EQUITY
Total assets										$	383,116		$	377,078
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:	CURRENT LIABILITIES:
	Current maturities of long-term debt		$	1,594		$	2,076
	Accounts payable			58,516			58,894
	Accrued compensation and benefits			22,664			21,670
	Billings in excess of costs and estimated earnings			29,657			35,213
	Income taxes payable			—			1,701
	Other current liabilities			26,746			29,864
	Liabilities related to discontinued operations			122			—

		Total current liabilities		139,299			149,418
Current maturities of long-term debt										$	2,071		$	2,068
Accounts payable										64,771			60,005
Accrued compensation and benefits										22,834			20,271
Billings in excess of costs and estimated earnings										37,104			40,015
Income taxes payable										3,700			471
Other current liabilities										29,288			29,686
Total current liabilities										159,768			152,516
LONG-TERM DEBT, NET OF CURRENT MATURITIES	LONG-TERM DEBT, NET OF CURRENT MATURITIES			8,809			7,273			6,751			6,235
OTHER LONG-TERM LIABILITIES				2,342			2,800

		Total liabilities		150,450			159,491
Total liabilities										166,519			158,751
COMMITMENTS AND CONTINGENCIES	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, 1,041,864 and 508,765 shares, respectively			(6,305	)		(3,060	)
	Additional paid-in capital			337,605			337,230
	Deferred compensation			(540	)		(1,517	)
	Retained earnings (deficit)			(130,493	)		(121,786	)

		Total stockholders' equity		200,660			211,260

		Total liabilities and stockholders' equity	$	351,110		$	370,751

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 and 39,520,539 shares issued, respectively										393			396
Treasury stock, at cost, 24,462 shares										(148		)	—
Additional paid-in capital										337,719			339,237
Deferred compensation										(1,587		)	(2,055		)
Retained earnings (deficit)										(119,780		)	(119,251		)
Total stockholders’ equity										216,597			218,327
Total liabilities and stockholders’ equity										$	383,116		$	377,078

	Three Months Ended March 31,
	2004			2005
REVENUES	$	192,801		$	204,690
COST OF SERVICES	162,777			175,377
Gross profit	30,024			29,313
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES	27,055			28,077
GAIN ON SALE OF ASSETS	(36		)	(34		)
Operating income	3,005			1,270
OTHER INCOME (EXPENSE):
Interest income	31			128
Interest expense	(528		)	(375		)
Other	(702		)	11
Other income (expense)	(1,199		)	(236		)
INCOME BEFORE INCOME TAXES	1,806			1,034
INCOME TAX EXPENSE	796			505
INCOME FROM CONTINUING OPERATIONS	1,010			529
DISCONTINUED OPERATIONS:
Operating income, net of income tax expense of $23	33			—
NET INCOME	$	1,043		$	529
INCOME PER SHARE:
Basic—
Income from continuing operations	$	0.03		$	0.01
Discontinued operations—
Income from operations	—			—
Net income	$	0.03		$	0.01
Diluted—
Income from continuing operations	$	0.03		$	0.01
Discontinued operations—
Income from operations	—			—
Net income	$	0.03		$	0.01
SHARES USED IN COMPUTING INCOME PER SHARE:
Basic	38,136			38,990
Diluted	39,443			40,062

				Three Months Ended September 30,						Nine Months Ended September 30,
				2003			2004			2003			2004
REVENUES				$	207,740		$	211,530		$	585,808		$	608,279
COST OF SERVICES					172,900			178,250			490,079			511,854

		Gross profit			34,840			33,280			95,729			96,425
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES					27,825			26,687			86,999			79,459
RESTRUCTURING CHARGES					949			—			3,223			—

		Operating income			6,066			6,593			5,507			16,966
OTHER INCOME (EXPENSE):
	Interest income				29			40			80			83
	Interest expense				(1,107	)		(374	)		(2,752	)		(1,196	)
	Write-off of debt costs				—			—			(823	)		—
	Other				42			(135	)		(105	)		(405	)

		Other income (expense)			(1,036	)		(469	)		(3,600	)		(1,518	)

INCOME BEFORE INCOME TAXES					5,030			6,124			1,907			15,448
INCOME TAX EXPENSE					2,435			2,634			1,005			6,643

INCOME FROM CONTINUING OPERATIONS					2,595			3,490			902			8,805
DISCONTINUED OPERATIONS:
	Operating income, net of income tax expense of $229, $0, $454 and $27				353			—			715			39
	Estimated loss on disposition, including income tax expense of $43, $0, $274 and $235				(2,773	)		—			(3,685	)		(137	)

NET INCOME (LOSS)				$	175		$	3,490		$	(2,068	)	$	8,707

INCOME (LOSS) PER SHARE:
	Basic—
		Income from continuing operations		$	0.07		$	0.09		$	0.02		$	0.23
		Discontinued operations—
			Income from operations		0.01			—			0.02			—
			Estimated loss on disposition		(0.08	)		—			(0.09	)		—

		Net income (loss)		$	—		$	0.09		$	(0.05	)	$	0.23

	Diluted—
		Income from continuing operations		$	0.07		$	0.09		$	0.02		$	0.22
		Discontinued operations—
			Income from operations		0.01			—			0.02			—
			Estimated loss on disposition		(0.08	)		—			(0.09	)		—

		Net income (loss)		$	—		$	0.09		$	(0.05	)	$	0.22

SHARES USED IN COMPUTING INCOME (LOSS) PER SHARE:
	Basic				37,713			38,418			37,659			38,298

	Diluted				38,454			39,455			38,081			39,457

			Common Stock			Treasury Stock
			Common Stock			Treasury Stock					Additional Paid-In Capital			Deferred Compensation			Retained Earnings (Deficit)			Total Stockholders' Equity
			Shares	Amount		Shares		Amount			Additional Paid-In Capital			Deferred Compensation			Retained Earnings (Deficit)			Total Stockholders' Equity
BALANCE AT DECEMBER 31, 2002			39,258,913	$	393	(1,341,419	)	$	(8,214	)	$	338,606		$	(785	)	$	(124,914	)	$	205,086
	Issuance of Treasury Stock:
		Issuance of shares for options exercised including tax benefit	—		—	332,041			2,009			(907	)		—			—			1,102
	Shares received from sale of assets		—		—	(32,486	)		(100	)		—			—			—			(100	)
	Amortization of deferred compensation		—		—	—			—			(69	)		245			—			176
	Other		—		—	—			—			(25	)		—			—			(25	)
	Net loss		—		—	—			—			—			—			(5,579	)		(5,579	)

BALANCE AT DECEMBER 31, 2003			39,258,913		393	(1,041,864	)		(6,305	)		337,605			(540	)		(130,493	)		200,660
	Issuance of Treasury Stock:
		Issuance of shares for options exercised including tax benefit (unaudited)	—		—	364,349			2,200			(633	)		—			—			1,567
	Issuance of restricted stock (unaudited)		—		—	225,000			1,353			361			(1,714	)		—			—
	Forfeiture of unvested restricted stock (unaudited)		—		—	(56,250	)		(308	)		—			259			—			(49	)
	Amortization of deferred compensation (unaudited)		—		—	—			—			(128	)		478			—			350
	Other (unaudited)		—		—	—			—			25			—			—			25
	Net income (unaudited)		—		—	—			—			—			—			8,707			8,707

BALANCE AT SEPTEMBER 30, 2004 (unaudited)			39,258,913	$	393	(508,765	)	$	(3,060	)	$	337,230		$	(1,517	)	$	(121,786	)	$	211,260

	Common Stock				Treasury Stock						Additional Paid-In				Deferred				Retained Earnings			Total Stockholders’
	Shares	Amount			Shares		Amount				Capital				Compensation				(Deficit)			Equity
BALANCE AT DECEMBER 31, 2003	39,258,913		$	393	(1,041,864	)		$	(6,305	)		$	337,605			$	(540	)	$	(130,493	)		$	200,660
Issuance of Stock:
Issuance of shares for options exercised including tax benefit	—		—		440,508			2,658				(724		)		—			—				1,934
Issuance of restricted stock	—		—		225,000			1,353				361				(1,714		)	—				—
Forfeiture of unvested restricted stock	—		—		(56,250	)		(308		)		—				259			—				(49		)
Amortization of deferred compensation	—		—		—			—				115				408			—				523
Shares issued for exercise of warrant	—		—		408,144			2,454				337				—			—				2,791
Other	—		—		—			—				25				—			—				25
Net income	—		—		—			—				—				—			10,713				10,713
BALANCE AT DECEMBER 31, 2004	39,258,913		393		(24,462	)		(148		)		337,719				(1,587		)	(119,780		)		216,597
Issuance of Stock:
Issuance of shares for options exercised including tax benefit (unaudited)	179,126		2		24,162			145				772				—			—				919
Issuance of restricted stock (unaudited)	82,500		1		—			—				574				(575		)	—				—
Amortization of deferred compensation (unaudited)	—		—		—			—				175				107			—				282
Other (unaudited)	—		—		300			3				(3		)		—			—				—
Net income (unaudited)	—		—		—			—				—				—			529				529
BALANCE AT MARCH 31, 2005 (UNAUDITED)	39,520,539		$	396	—			$	—			$	339,237			$	(2,055	)	$	(119,251	)		$	218,327

				Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
				2003			2004			2003			2004			2004			2005
Net income (loss)				$	175		$	3,490		$	(2,068	)	$	8,707
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities—
	Estimated loss on disposition of discontinued operations				2,773			—			3,685			137
	Restructuring charges				949			—			3,223			—
	Write-off of debt costs				—			—			823			—
	Depreciation expense				1,301			1,315			4,024			3,617
	Bad debt expense				420			428			1,888			1,623
	Deferred tax expense				1,009			1,813			2,222			1,950
	Amortization of debt financing costs				178			104			634			300
	Loss (gain) on sale of assets				(31	)		34			184			(33	)
	Deferred compensation expense				61			138			96			199
	Mark-to-market warrant obligation				280			86			188			457
	Amortization of debt discount				150			—			450			—
	Changes in operating assets and liabilities, net of effects of divestitures—
		(Increase) decrease in—
			Receivables, net		(7,401	)		(10,161	)		(5,938	)		(10,336	)
			Inventories		184			269			1,617			(684	)
			Prepaid expenses and other current assets		(954	)		(1,741	)		(16	)		970
			Costs and estimated earnings in excess of billings		(559	)		(554	)		1,196			(6,665	)
			Other noncurrent assets		(30	)		438			138			573
		Increase (decrease) in—
			Accounts payable and accrued liabilities		(4,000	)		3,432			607			6,409
			Billings in excess of costs and estimated earnings		(942	)		6,030			2,580			5,557
			Other, net		—			—			(19	)		—
			Taxes paid related to the sale of businesses		—			—			(10,371	)		—

		Net cash provided by (used in) operating activities			(6,437	)		5,121			5,143			12,781

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income																$	1,043		$	529
Adjustments to reconcile net income to net cash used in operating activities—
Depreciation expense																1,138			1,065
Bad debt expense																679			(274		)
Deferred tax expense (benefit)																(38		)	269
Tax benefit from exercise of options																285			348
Amortization of debt financing costs																96			120
Loss (gain) on sale of assets or operations																(36		)	(34		)
Deferred compensation expense																53			187
Mark-to-market warrant obligation																711			—
Changes in operating assets and liabilities, net of effects of acquisitions and divestitures—
(Increase) decrease in—
Receivables, net																2,731			1,305
Inventories																(790		)	103
Prepaid expenses and other current assets																(373		)	970
Costs and estimated earnings in excess of billings																(2,476		)	862
Other noncurrent assets																106			112
Increase (decrease) in—
Accounts payable and accrued liabilities																(5,071		)	(13,840		)
Billings in excess of costs and estimated earnings																(2,791		)	2,737
Net cash used in operating activities																(4,733		)	(5,541		)
CASH FLOWS FROM INVESTING ACTIVITIES:	CASH FLOWS FROM INVESTING ACTIVITIES:
	Purchases of property and equipment				(714	)		(963	)		(2,661	)		(3,180	)
	Proceeds from sales of property and equipment				208			—			319			283
	Proceeds from businesses sold, net of cash sold and transaction costs				(4	)		156			(2,754	)		1,266

		Net cash used in investing activities			(510	)		(807	)		(5,096	)		(1,631	)

Purchases of property and equipment																(1,317		)	(2,043		)
Proceeds from sales of property and equipment																129			148
Proceeds from businesses sold, net of cash sold and transaction costs																933			205
Cash paid for acquisition, including cash acquired																—			(2,943		)
Net cash used in investing activities																(255		)	(4,633		)
CASH FLOWS FROM FINANCING ACTIVITIES:	CASH FLOWS FROM FINANCING ACTIVITIES:
	Net borrowings (payments) on revolving line of credit				3,779			—			3,672			—
	Payments on other long-term debt				(399	)		(533	)		(1,402	)		(1,086	)
	Borrowings of other long-term debt				—			—			18			32
	Debt financing costs				(158	)		(30	)		(835	)		(808	)
	Proceeds from exercise of options				130			37			216			1,069

		Net cash provided by (used in) financing activities			3,352			(526	)		1,669			(793	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS					(3,595	)		3,788			1,716			10,357
Net borrowings on revolving line of credit																—			—
Payments on other long-term debt																(21		)	(519		)
Debt financing costs																(709		)	—
Proceeds from exercise of options																701			571
Net cash provided by (used in) financing activities																(29		)	52
NET DECREASE IN CASH AND CASH EQUIVALENTS																(5,017		)	(10,122		)
CASH AND CASH EQUIVALENTS, beginning of period—continuing operations and discontinued operations	CASH AND CASH EQUIVALENTS, beginning of period—continuing operations and discontinued operations				11,415			16,705			6,104			10,136		10,136			32,576

CASH AND CASH EQUIVALENTS, end of period—continuing operations and discontinued operations	CASH AND CASH EQUIVALENTS, end of period—continuing operations and discontinued operations			$	7,820		$	20,493		$	7,820		$	20,493		$	5,119		$	22,454

	2003	2004
Expected dividend yield	0.00%	0.00%
Expected stock price volatility	62.08%	61.30%
Risk-free interest rate	2.94%-3.64%	3.96%-4.38%
Expected life of options	7 years	7 years

	2005
Expected dividend yield	0.00	%
Expected stock price volatility	61.23	%
Risk-free interest rate	3.97	%
Expected life of options	7 years

Accounts receivable, net	$	5,223
Costs and estimated earnings in excess of billings	1,156
Other current assets	284
Property and equipment	210
Less: Accounts payable	(2,983		)
Less: Billings in excess of costs and estimated earnings	(175		)
Less: Other current liabilities	(747		)
Less: Other long-term liabilities	(25		)
Cash paid, including cash acquired	$	2,943

		December 31, 2003
Cash		$	7
Accounts receivable, net			372
Other current assets			22
Property and equipment, net			8
Goodwill, net			564

	Total assets	$	973

Accounts payable		$	50
Other current liabilities			72

	Total liabilities	$	122

	Three Months Ended March 31, 2004
Revenues		$	422
Pre-tax income		$	56

	Activity During Indicated Quarters			Cumulative Loss On Disposition
First Quarter 2002
Purchase Price	$	186,250
Less escrow	(5,000		)
Less book basis in net assets of companies sold	(163,576		)
Less transaction wrap-up costs	(2,106		)
Plus estimated tax liability associated with transaction	(26,180		)
Loss recognized during First Quarter 2002	(10,612		)		$	(10,612	)
Fourth Quarter 2002
Settlement with Emcor for reimbursement of impaired assets and additional liabilities associated with companies sold to Emcor	(7,884		)
Application of escrow in the settlement	4,000
Tax benefit of settlement	1,359
Reduction in estimated tax liability on sale transaction as a whole	1,371
Other	(67		)
Loss recognized during Fourth Quarter 2002	(1,221		)		(11,833		)
Second Quarter 2004
Reduction in reserves needed for ongoing matters related to transaction	512
Taxes related to reduction in reserves	(179		)
Reduction to loss recognized in Second Quarter 2004	333				(11,500		)
Fourth Quarter 2004
Reduction in reserves needed for ongoing matters related to transaction	371
Taxes related to reduction in reserves	(130		)
Reduction in estimated tax liability on sale transaction as a whole	377
Reduction to loss recognized in Fourth Quarter 2004	618				$	(10,882	)

	Cumulative Cash Proceeds
Purchase Price		$	186,250
Less escrow for post-closing balance sheet adjustment		(2,500		)
Less general escrow		(5,000		)
Less debt and accrued interest transferred to Emcor relating to companies sold to Emcor		(22,479		)
Initial cash proceeds		156,271
Additional proceeds received in Second Quarter 2002 relating to post-closing balance sheet adjustment, net of related escrow		7,050
Recovery in Second Quarter 2002 of escrow for post-closing balance sheet adjustment		2,500
Direct payments by the Company in 2003 related to Fourth Quarter 2002 settlement for reimbursement of impaired assets and additional liabilities of companies sold to Emcor		(2,744		)
Payment of income taxes in 2003 in connection with the transaction		(10,371		)
Payment of transaction and wrap-up costs		(2,427		)
Recovery of a portion of general escrow in 2004 in connection with reduction of reserves needed for ongoing matters related to transaction		400
Other		(557		)
Net cash proceeds received as of March 31, 2005		$	150,122

Escrow Income Statement Recognition
Original general escrow—not recognized in income statement determination of loss on disposition of companies to Emcor	$	5,000
Application of escrow in Fourth Quarter 2002 to reduce additional loss on transaction in connection with settlement involving reimbursement for impaired assets and additional liabilities of companies sold to Emcor	(4,000		)
Remaining escrow available as of March 31, 2005 to be applied against any income statement charges associated with future claims that may arise in connection with the transaction	$	1,000
Escrow Funds Use
Original general escrow	$	5,000
Use in 2003 in connection with settlement in Fourth Quarter 2002 involving reimbursement for impaired assets and additional liabilities of companies sold to Emcor	(3,339		)
Use in 2004 in connection with the settlement of other matters	(196		)
Recovery of a portion of general escrow in 2004 in connection with reduction of reserves needed for ongoing matters related to transaction	(400		)
Remaining escrow balance as of March 31, 2005, available to be applied to future claims that may arise in connection with transaction	$	1,065

	Balance at Beginning of Period		Additions			Payments			Balance at End of Period
Year Ended December 31, 2003:
Severance	$	—	$	1,507		$	(1,507	)	$	—
Lease termination costs and other		1,000		1,716			(971	)		1,745

Total	$	1,000	$	3,223		$	(2,478	)	$	1,745

Nine Months Ended September 30, 2004:
Lease termination costs and other	$	1,745	$	478	(a)	$	(877	)	$	1,346

	Balance at Beginning of Period			Additions				Payments				Balance at End of Period
Year Ended December 31, 2004:
Lease termination costs and other		$	1,745		$	610	(a)		$	(1,074	)		$	1,281
Three Months Ended March 31, 2005:
Lease termination costs and other		$	1,281		$	—			$	(247	)		$	1,034

		December 31, 2003			September 30, 2004
Revolving credit facility		$	—		$	—
Term loan			10,000			9,000
Other			403			349

	Total debt		10,403			9,349
	Less—current maturities		(1,594	)		(2,076	)

	Total long-term portion of debt	$	8,809		$	7,273

	As of March 31, 2005			As of May 2, 2005
	(in thousands)
Amounts Outstanding
Revolving loan		$	—	$	—
Term loan		8,000		7,500
Other non-Facility debt		303		297
Total debt		$	8,303	$	7,797
Letters of credit		$	18,619	$	19,369
Available Capacity
Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million		$	26,381	$	25,631
Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-Credit Facility Adjusted EBITDA covenant		$	26,381	n/a

			Debt to EBITDA
Base Rate Option—The higher of:
	Federal Funds Rate plus 0.50%		2.25	%
	Citibank, N.A. Prime Rate		4.75	%
Eurodollar Rate Option
	One-month LIBOR		1.84	%
	Six-month LIBOR		2.20	%

			Less than 0.75		0.75 to 1.50		1.50 or greater
Additional Per Annum Interest
Margin Added Under:
	Term Loan—
		Base Rate Option	1.75	%	2.25	%	2.75	%
	Eurodollar Rate Option		2.75	%	3.25	%	3.75	%
Revolving Loan—
	Base Rate Option		1.50	%	2.00	%	2.50	%
	Eurodollar Rate Option		2.50	%	3.00	%	3.50	%
Per Annum Letter of Credit Fees (not added to underlying Base Rate or Eurodollar Rate)			1.875	%	2.25	%	2.625	%

Eurodollar Rate Option:
One-month LIBOR	2.87	%
Six-month LIBOR	3.40	%

	Debt to Credit Facility Adjusted EBITDA
	Less than 0.75			0.75 to 1.50			1.50 or greater
Additional Per Annum Interest Margin Added Under:
Term Loan—
Base Rate Option		1.75	%		2.25	%		2.75	%
Eurodollar Rate Option		2.75	%		3.25	%		3.75	%
Revolving Loan—
Base Rate Option		1.50	%		2.00	%		2.50	%
Eurodollar Rate Option		2.50	%		3.00	%		3.50	%
Per Annum Letter of Credit Fees (not added to underlying Base Rate or Eurodollar Rate)		1.875	%		2.25	%		2.625	%

Net income	$	10,199
Discontinued operations—estimated gain on dispositions, net	(481		)
Income taxes—continuing operations and discontinued operations	7,980
Mark-to-market warrant obligation	(262		)
Interest expense, net	1,144
Depreciation expense	4,612
Goodwill impairment	3,347
Credit Facility Adjusted EBITDA	$	26,539

	Number of Options Outstanding			Number of Options Outstanding
Exercise Price	September 30, 2003	September 30, 2004		March 31, 2004	March 31, 2005
$1.90	952,000	710,250	$1.90	872,000	657,750
$2.14	10,000	10,000	$2.14	10,000	10,000
$2.19	10,000	10,000	$2.19	10,000	10,000
$2.25	327,500	232,500	$2.25	240,000	188,875
$2.34	52,000	500	$2.34	2,000	500
$2.36	50,000	50,000	$2.36	50,000	50,000
$2.43	10,000	10,000	$2.43	10,000	10,000
$2.875	1,535,058	1,056,735	$2.875	1,129,725	777,488
$3.39	110,000	10,000	$3.39	110,000	10,000
$3.8125	500,000	500,000	$3.8125	500,000	500,000
$3.86	79,000	79,000	$3.86	79,000	72,750
$4.18	—	102,500	$4.18	102,500	102,500
$4.24	15,000	15,000	$4.24	15,000	15,000
$4.77	40,000	40,000	$4.77	40,000	40,000
$6.00	193,500	153,000	$6.00	164,000	147,800
$6.62			$6.62	—	39,000
$6.64	—	55,000	$6.64	—	55,000
$6.75	5,000	5,000	$6.75	5,000	5,000
$6.97			$6.97	—	120,000
$7.00	—	50,000	$7.00	—	50,000
$7.625	37,700	34,700	$7.625	37,100	32,200
All other outstanding options with prior grant dates with exercise prices ranging from $11.75 to $21.438	2,142,031	826,059	All other outstanding options with prior grant dates with exercise prices ranging from $11.75 to $21.438	1,895,374	475,025
				5,271,699	3,368,888
	6,068,789	3,950,244

		2003
		Q1			%		O2			%		Q3			%		Q4			%		Total			%
Revenues		$	179,269				$	198,799				$	207,740				$	197,363				$	783,171
	Divested units not reflected in discontinued operations		(4,037	)				—					(4	)				—					(4,041	)

Revenues from ongoing operations			175,232		100.0	%		198,799		100.0	%		207,736		100.0	%		197,363		100.0	%		779,130		100.0	%

Cost of services			152,277					164,902					172,900					167,246					657,325
	Divested units not reflected in discontinued operations		(4,021	)				(16	)				(9	)				—					(4,046	)

Cost of services from ongoing operations			148,256		84.6	%		164,886		82.9	%		172,891		83.2	%		167,246		84.7	%		653,279		83.8	%

Gross profit from ongoing operations			26,976		15.4	%		33,913		17.1	%		34,845		16.8	%		30,117		15.3	%		125,851		16.2	%

Selling, general and administrative expenses			30,412					28,762					27,825					27,031					114,030
	Divested units not reflected in discontinued operations		(723	)				(20	)				(11	)				—					(754	)

Selling, general and administrative expenses from ongoing operations			29,689		16.9	%		28,742		14.5	%		27,814		13.4	%		27,031		13.7	%		113,276		14.5	%

Operating income (loss) from ongoing operations excluding goodwill impairment and restructuring charges			(2,713	)	(1.5	)%		5,171		2.6	%		7,031		3.4	%		3,086		1.6	%		12,575		1.6	%
Interest expense, net			(542	)	(0.3	)%		(1,052	)	(0.5	)%		(1,078	)	(0.5	)%		(1,155	)	(0.6	)%		(3,827	)	(0.5	)%
Other income (expense)			(249	)	(0.1	)%		102		0.1	%		42		—			(73	)	—			(178	)	—

Income (loss) from ongoing operations before income taxes excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net			(3,504	)				4,221					5,995					1,858					8,570
Income tax expense (benefit)			(1,114	)				1,028					2,775					(277	)				2,412

Income (loss) from ongoing operations (after tax), excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net		$	(2,390	)	(1.4	)%	$	3,193		1.6	%	$	3,220		1.6	%	$	2,135		1.1	%	$	6,158		0.8	%

Income (loss) from continuing operations (after tax)		$	(4,140	)			$	2,447				$	2,595				$	(2,038	)			$	(1,136	)
Divested units not reflected in discontinued operations (after tax)			460					23					8					—					491
Restructuring charges (after tax)			755					723					617					—					2,095
Goodwill impairment (after tax)			—					—					—					2,460					2,460
Writeoff of debt costs and discount (after tax)			535					—					—					1,713					2,248

Income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net		$	(2,390	)	(1.4	)%	$	3,193		1.6	%	$	3,220		1.6	%	$	2,135		1.1	%	$	6,158		0.8	%

Diluted earnings per share—income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net		$	(0.07	)			$	0.08				$	0.08				$	0.05				$	0.16

		2004
		Q1			%		Q2			%		Q3			%
Revenues		$	192,801				$	203,948				$	211,530
	Divested units not reflected in discontinued operations		—					—					—

Revenues from ongoing operations			192,801		100.0	%		203,948		100.0	%		211,530		100.0	%

Cost of services			162,777					170,827					178,250
	Divested units not reflected in discontinued operations		—					—					—

Cost of services from ongoing operations			162,777		84.4	%		170,827		83.8	%		178,250		84.3	%

Gross profit from ongoing operations			30,024		15.6	%		33,121		16.2	%		33,280		15.7	%

Selling, general and administrative expenses			27,055					25,717					26,687
	Divested units not reflected in discontinued operations		—					—					—

Selling, general and administrative expenses from ongoing operations			27,055		14.0	%		25,717		12.6	%		26,687		12.6	%

Operating income (loss) from ongoing operations excluding goodwill impairment and restructuring charges			2,969		1.5	%		7,404		3.6	%		6,593		3.1	%
Interest expense, net			(497	)	(0.3	)%		(282	)	(0.1	)%		(334	)	(0.2	)%
Other income (expense)			(666	)	(0.3	)%		396		0.2	%		(135	)	(0.1	)%

Income (loss) from ongoing operations before income taxes excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net			1,806					7,518					6,124
Income tax expense (benefit)			796					3,213					2,634

Income (loss) from ongoing operations (after tax), excluding goodwill impairment, restructuring charges and the writeoff of debt costs and discount, net		$	1,010				$	4,305				$	3,490

Income (loss) from continuing operations (after tax)		$	1,010				$	4,305				$	3,490
Divested units not reflected in discontinued operations (after tax)			—					—					—
Restructuring charges (after tax)			—					—					—
Writeoff of debt costs (after tax)			—					—					—

Income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net		$	1,010		0.5	%	$	4,305		2.1	%	$	3,490		1.6	%

Diluted earnings per share—income (loss) from ongoing operations (after tax), excluding restructuring charges, goodwill impairment and the writeoff of debt costs and discount, net		$	0.03				$	0.10				$	0.09

		As of September 30, 2004		As of October 29, 2004		As of March 31, 2005			As of May 2, 2005
		(in thousands)				(in thousands)
Amounts Outstanding	Amounts Outstanding
Revolving loan	Revolving loan	$	—	$	—		$	—	$	—
Term loan	Term loan		9,000		8,500		8,000		7,500
Other non-Facility debt	Other non-Facility debt		349		346		303		297

	Total debt	$	9,349	$	8,846

Total debt							$	8,303	$	7,797
Letters of credit	Letters of credit	$	17,280	$	17,280		$	18,619	$	19,369
Available Capacity	Available Capacity
Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million	Unused Revolving Loan and letter of credit capacity based on Revolving Loan face value of $45 million	$	27,720	$	27,720		$	26,381	$	25,631
Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-EBITDA covenant		$	27,720		n/a
Unused Revolving Loan and letter of credit capacity based on quarterend debt-to-Credit Facility Adjusted EBITDA covenant							$	26,381	n/a

		Twelve Months Ended September 30,														Twelve Months Ended March 31,
		2005		2006		2007		2008		2009		Thereafter		Total		2006		2007		2008		2009		2010		Thereafter			Total
Revolving loan	Revolving loan	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—		$	—	$	—
Term loan	Term loan		2,000		2,000		2,000		2,000		1,000		—		9,000	2,000		2,000		2,000		2,000		—			—		8,000
Other debt	Other debt		76		77		67		62		36		31		349	73		68		68		44		37			13		303

	Total debt	$	2,076	$	2,077	$	2,067	$	2,062	$	1,036	$	31	$	9,349

Total debt																2,073		2,068		2,068		2,044		37			13		8,303
Interest payments																450		356		215		63		3			1		1,088
Operating lease obligations	Operating lease obligations	$	8,030	$	6,515	$	5,554	$	4,458	$	3,193	$	12,790	$	40,540	8,710		7,380		6,682		4,977		3,527			12,475		43,751
Total																$	11,233	$	9,804	$	8,965	$	7,084	$	3,567		$	12,489	$	53,142

~~31.1~~ 10.1		Side Letter to Amended and Restated Credit Agreement dated as of December 31, 2003, which side letter is effective as of March 1, 2005 by and among the Company; Bank of Texas, N.A., individually and as administrative agent; Hibernia National Bank, as Documentation Agent; and the Lenders and Guarantors.
10.2		Description of Comfort Systems USA, Inc.’s 2005 Incentive Compensation Plan for Executive Officers.
31.1		Rule 13a-14(a) Certification of William F. Murdy pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Rule 13a-14(a) Certification of ~~J. Gordon Beittenmiller~~William George pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Section 1350 Certification of William F. Murdy pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Section 1350 Certification of ~~J. Gordon Beittenmiller~~William George pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

			COMFORT SYSTEMS USA, INC.
~~November 2, 2004~~	By:	~~By:~~	/s/ WILLIAM F. MURDY
May 4, 2005	William F. Murdy
	Chairman of the Board and
	Chief Executive Officer
~~November 2, 2004~~ May 4, 2005	By:	~~By:~~	/s/ WILLIAM GEORGE
	William George
	~~J. GORDON BEITTENMILLER~~ ~~J. Gordon Beittenmiller~~ Executive Vice President and
	Chief Financial Officer ~~and Director~~