10-Q 1 h00833e10vq.txt COMFORT SYSTEMS USA, INC.- SEPTEMBER 30, 2002 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-13011 COMFORT SYSTEMS USA, INC. (Exact name of registrant as specified in its charter) DELAWARE 76-0526487 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.)
777 POST OAK BOULEVARD SUITE 500 HOUSTON, TEXAS 77056 (Address of Principal Executive Offices) (Zip Code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (713) 830-9600 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the issuer's common stock, as of November 1, 2002 was 37,910,144. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- COMFORT SYSTEMS USA, INC. INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2002
PAGE ---- PART I -- FINANCIAL INFORMATION Item 1 -- Financial Statements COMFORT SYSTEMS USA, INC. Consolidated Balance Sheets.......................... 2 Consolidated Statements of Operations................ 3 Consolidated Statements of Stockholders' Equity...... 4 Consolidated Statements of Cash Flows................ 5 Condensed Notes to Consolidated Financial Statements.......................................... 6 Item 2 -- Management's Discussion and Analysis of Financial Condition and Results of Operations... 18 Item 3 -- Quantitative and Qualitative Disclosures about Market Risk............................................ 28 PART II -- OTHER INFORMATION Item 1 -- Legal Proceedings............................... 29 Item 2 -- Recent Sales of Unregistered Securities......... 29 Item 6 -- Exhibits and Reports on Form 8-K................ 29 Signatures................................................ 30
1 COMFORT SYSTEMS USA, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31, SEPTEMBER 30, 2001 2002 ------------ ------------- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents................................. $ 3,924 $ 10,625 Accounts receivable, less allowance of $9,633 and $5,922................................................. 175,028 168,398 Other receivables......................................... 5,572 4,132 Inventories............................................... 14,553 12,508 Prepaid expenses and other................................ 13,174 8,217 Costs and estimated earnings in excess of billings........ 19,384 20,359 Assets related to discontinued operations................. 327,820 1,248 -------- --------- Total current assets.............................. 559,455 225,487 PROPERTY AND EQUIPMENT, net................................. 18,812 16,543 GOODWILL.................................................... 297,033 113,427 OTHER NONCURRENT ASSETS..................................... 1,325 13,789 -------- --------- Total assets...................................... $876,625 $ 369,246 ======== ========= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Current maturities of long-term debt...................... $ 73 $ 89 Current maturities of notes to affiliates and former owners................................................. 2,374 1,500 Accounts payable.......................................... 57,489 57,915 Accrued compensation and benefits......................... 23,611 23,232 Billings in excess of costs and estimated earnings........ 26,663 27,713 Income taxes payable...................................... 5,606 12,811 Other current liabilities................................. 23,468 25,711 Liabilities related to discontinued operations............ 140,746 143 -------- --------- Total current liabilities......................... 280,030 149,114 LONG-TERM DEBT, NET OF CURRENT MATURITIES................... 164,012 450 NOTES TO AFFILIATES AND FORMER OWNERS, NET OF CURRENT MATURITIES................................................ 15,569 14,318 OTHER LONG-TERM LIABILITIES................................. 3,193 25 -------- --------- Total liabilities................................. 462,804 163,907 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, $.01 par, 5,000,000 shares authorized, none issued and outstanding............................ -- -- Common stock, $.01 par, 102,969,912 shares authorized, 39,258,913 shares issued............................... 393 393 Treasury stock, at cost, 1,749,334 and 1,423,769 shares, respectively........................................... (10,924) (8,718) Additional paid-in capital................................ 340,186 338,776 Deferred compensation..................................... -- (532) Retained earnings (deficit)............................... 84,166 (124,580) -------- --------- Total stockholders' equity........................ 413,821 205,339 -------- --------- Total liabilities and stockholders' equity........ $876,625 $ 369,246 ======== =========
The accompanying notes are an integral part of these consolidated financial statements. 2 COMFORT SYSTEMS USA, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- -------------------- 2001 2002 2001 2002 -------- -------- -------- --------- REVENUES.................................................. $234,070 $214,691 $664,629 $ 616,053 COST OF SERVICES.......................................... 189,426 174,668 540,493 506,843 -------- -------- -------- --------- Gross profit..................................... 44,644 40,023 124,136 109,210 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES.............. 35,449 32,046 106,371 95,029 GOODWILL AMORTIZATION..................................... 2,056 -- 6,170 -- RESTRUCTURING CHARGES..................................... -- -- 238 1,878 -------- -------- -------- --------- Operating income................................. 7,139 7,977 11,357 12,303 OTHER INCOME (EXPENSE): Interest income......................................... 30 20 81 59 Interest expense........................................ (1,870) (959) (6,843) (3,961) Other................................................... 50 115 372 1,229 -------- -------- -------- --------- Other income (expense)........................... (1,790) (824) (6,390) (2,673) -------- -------- -------- --------- INCOME BEFORE INCOME TAXES................................ 5,349 7,153 4,967 9,630 INCOME TAX EXPENSE........................................ 3,929 3,378 4,639 4,551 -------- -------- -------- --------- INCOME FROM CONTINUING OPERATIONS......................... 1,420 3,775 328 5,079 DISCONTINUED OPERATIONS: Operating income (loss), net of applicable income tax benefit (expense) of $(2,835), $20, $(6,664) and $1,942................................................ 4,222 (35) 9,705 (148) Estimated loss on disposition, including income tax expense of $25,887.................................... -- -- -- (11,156) -------- -------- -------- --------- INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE.................................... 5,642 3,740 10,033 (6,225) CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF INCOME TAX BENEFIT OF $26,317........................ -- -- -- (202,521) -------- -------- -------- --------- NET INCOME (LOSS)......................................... $ 5,642 $ 3,740 $ 10,033 $(208,746) ======== ======== ======== ========= INCOME (LOSS) PER SHARE: Basic -- Income from continuing operations..................... $ 0.04 $ 0.10 $ 0.01 $ 0.14 Discontinued operations -- Income (loss) from operations...................... 0.11 -- 0.26 -- Estimated loss on disposition...................... -- -- -- (0.30) Cumulative effect of change in accounting principle... -- -- -- (5.37) -------- -------- -------- --------- Net income (loss)..................................... $ 0.15 $ 0.10 $ 0.27 $ (5.53) ======== ======== ======== ========= Diluted -- Income from continuing operations..................... $ 0.04 $ 0.10 $ 0.01 $ 0.13 Discontinued operations -- Income (loss) from operations...................... 0.11 -- 0.26 (0.01) Estimated loss on disposition...................... -- -- -- (0.29) Cumulative effect of change in accounting principle... -- -- -- (5.30) -------- -------- -------- --------- Net income (loss)..................................... $ 0.15 $ 0.10 $ 0.27 $ (5.47) ======== ======== ======== ========= SHARES USED IN COMPUTING INCOME (LOSS) PER SHARE: Basic................................................... 37,468 37,834 37,411 37,736 ======== ======== ======== ========= Diluted................................................. 37,773 38,131 37,449 38,192 ======== ======== ======== =========
The accompanying notes are an integral part of these consolidated financial statements. 3 COMFORT SYSTEMS USA, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
COMMON STOCK TREASURY STOCK ADDITIONAL DEFERRED RETAINED TOTAL ------------------- --------------------- PAID-IN COMPEN- EARNINGS STOCKHOLDERS' SHARES AMOUNT SHARES AMOUNT CAPITAL SATION (DEFICIT) EQUITY ---------- ------ ---------- -------- ---------- -------- --------- ------------- BALANCE AT DECEMBER 31, 2000....................... 39,258,913 $393 (2,002,629) $(13,119) $341,923 $ -- $ 71,042 $ 400,239 Issuance of Treasury Stock: Issuance of Employee Stock Purchase Plan shares................ -- -- 398,287 2,570 (1,737) -- -- 833 Shares received from sale of businesses............ -- -- (144,992) (375) -- -- -- (375) Net income................. -- -- -- -- -- -- 13,124 13,124 ---------- ---- ---------- -------- -------- ----- --------- --------- BALANCE AT DECEMBER 31, 2001....................... 39,258,913 393 (1,749,334) (10,924) 340,186 -- 84,166 413,821 Issuance of Treasury Stock: Issuance of shares for options exercised (unaudited)........... -- -- 234,796 1,454 (779) -- -- 675 Issuance of restricted stock (unaudited)..... -- -- 200,000 1,239 (413) (826) -- -- Shares exchanged in repayment of notes receivable (unaudited)... -- -- (49,051) (204) -- -- -- (204) Shares received from sale of business (unaudited).............. -- -- (55,882) (263) -- -- -- (263) Shares received from settlement with former owner (unaudited)........ -- -- (4,298) (20) -- -- -- (20) Amortization of deferred compensation (unaudited).............. -- -- -- -- (218) 294 -- 76 Net loss (unaudited)....... -- -- -- -- -- -- (208,746) (208,746) ---------- ---- ---------- -------- -------- ----- --------- --------- BALANCE AT SEPTEMBER 30, 2002 (unaudited)................ 39,258,913 $393 (1,423,769) $ (8,718) $338,776 $(532) $(124,580) $ 205,339 ========== ==== ========== ======== ======== ===== ========= =========
The accompanying notes are an integral part of these consolidated financial statements. 4 COMFORT SYSTEMS USA, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- --------------------- 2001 2002 2001 2002 -------- -------- --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)................................. $ 5,642 $ 3,740 $ 10,033 $(208,746) Adjustments to reconcile net income (loss) to net cash provided by operating activities -- Cumulative effect of change in accounting principle.................................... -- -- -- 202,521 Estimated loss on disposition of discontinued operations................................... -- -- -- 11,156 Restructuring charges........................... -- -- 238 1,878 Depreciation and amortization expense........... 6,130 1,695 18,072 5,570 Bad debt expense................................ 2,258 451 5,041 2,982 Deferred tax expense............................ (811) 1,943 1,638 3,669 Gain on sale of assets.......................... (66) (49) (195) (950) Deferred compensation expense................... -- 14 -- 76 Changes in operating assets and liabilities -- (Increase) decrease in -- Receivables, net........................... (14,315) 6,731 (8,246) 13,243 Inventories................................ (589) 662 (477) 2,039 Prepaid expenses and other current assets.................................. (2,217) (830) (1,142) 3,610 Costs and estimated earnings in excess of billings................................ (713) (22) (2,547) (3,250) Other noncurrent assets.................... 702 (40) (367) 386 Increase (decrease) in -- Accounts payable and accrued liabilities... 13,321 (573) 8,482 (22,241) Billings in excess of costs and estimated earnings................................ 574 (1,358) 11,803 2,093 Other, net................................. (144) (250) (555) (229) -------- -------- --------- --------- Net cash provided by operating activities............................ 9,772 12,114 41,778 13,807 -------- -------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment............. (1,494) (974) (4,642) (4,044) Proceeds from sales of property and equipment... 106 196 460 1,330 Proceeds from businesses sold, net of cash sold and transaction costs........................ 10 (66) 964 154,499 -------- -------- --------- --------- Net cash provided by (used in) investing activities............................ (1,378) (844) (3,218) 151,785 -------- -------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Payments on long-term debt...................... (56,063) (28,549) (186,373) (269,171) Borrowings of long-term debt.................... 45,385 15,240 146,094 102,904 Proceeds from issuance of common stock.......... 267 -- 833 -- Proceeds from exercise of options............... -- 40 -- 675 -------- -------- --------- --------- Net cash used in financing activities... (10,411) (13,269) (39,446) (165,592) -------- -------- --------- --------- NET DECREASE IN CASH AND CASH EQUIVALENTS......... (2,017) (1,999) (886) -- CASH AND CASH EQUIVALENTS, beginning of period -- continuing operations and discontinued operations...................................... 17,152 12,624 16,021 10,625 -------- -------- --------- --------- CASH AND CASH EQUIVALENTS, end of period.......... $ 15,135 $ 10,625 $ 15,135 $ 10,625 ======== ======== ========= =========
The accompanying notes are an integral part of these consolidated financial statements. 5 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2002 (UNAUDITED) 1. BUSINESS AND ORGANIZATION Comfort Systems USA, Inc., a Delaware corporation ("Comfort Systems" and collectively with its subsidiaries, the "Company"), is a national provider of comprehensive heating, ventilation and air conditioning ("HVAC") installation, maintenance, repair and replacement services within the mechanical services industry. The Company operates primarily in the commercial and industrial HVAC markets, and performs most of its services within office buildings, retail centers, apartment complexes, manufacturing plants, and healthcare, education and government facilities. In addition to standard HVAC services, the Company provides specialized applications such as building automation control systems, fire protection, process cooling, electronic monitoring and process piping. Certain locations also perform related services such as electrical and plumbing. Approximately 52% of the Company's consolidated 2002 revenues were attributable to installation of systems in newly constructed facilities, with the remaining 48% attributable to maintenance, repair and replacement services. The Company's consolidated 2002 revenues related to the following service activities: HVAC -- 74%, plumbing -- 11%, building automation control systems -- 5%, electrical -- 2%, fire protection -- 1% and other -- 7%. These service activities are within the mechanical services industry which is the single industry segment served by Comfort Systems. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION These interim statements should be read in conjunction with the historical Consolidated Financial Statements and related notes of Comfort Systems included in the Annual Report on Form 10-K as filed with the Securities and Exchange Commission for the year ended December 31, 2001 (the "Form 10-K"). The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," which is discussed in Note 4 and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which is discussed in Note 3 during the first quarter of 2002. There were no other significant changes in the accounting policies of the Company during the period. For a description of the significant accounting policies of the Company, refer to Note 2 of Notes to Consolidated Financial Statements of Comfort Systems included in the Form 10-K. The accompanying unaudited consolidated financial statements were prepared using generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and applicable rules of Regulation S-X. Accordingly, these financial statements do not include all information or footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the Form 10-K. The Company believes all adjustments necessary for a fair presentation of these interim statements have been included and are of a normal and recurring nature. The results of operations for interim periods are not necessarily indicative of the results for the fiscal year. The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions by management in determining the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates used in the Company's financial statements include revenue and cost recognition for construction contracts, allowance for doubtful accounts and self-insurance accruals. 6 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CASH FLOW INFORMATION Cash paid for interest for the nine months ended September 30, 2001 and 2002 was approximately $16.5 million and $4.5 million, respectively. Cash paid for income taxes for the nine months ended September 30, 2001 and 2002 was approximately $6.3 million and $9.0 million, respectively. NEW ACCOUNTING PRONOUNCEMENTS In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 establishes new accounting and reporting requirements for goodwill and other intangible assets. The Company adopted this new standard effective January 1, 2002. See Note 4 for further discussion. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company adopted SFAS No. 144 effective January 1, 2002. Under SFAS No. 144, the operating results of companies sold or held for sale meeting certain criteria, as well as any gain or loss on the sale of these operations, are presented as discontinued operations in the Company's statements of operations. See Note 3 for a discussion of the Company's discontinued operations. The operating results for companies which were sold or shut down during 2001 are presented as continuing operations through the date of disposition. The adoption of SFAS No. 144 did affect the presentation of discontinued operations in the consolidated financial statements; however, it did not have a material financial impact on the Company's results of operations, financial position or cash flows. SEGMENT DISCLOSURE Comfort Systems' activities are within the mechanical services industry which is the single industry segment served by the Company. Under SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," each operating subsidiary represents an operating segment and these segments have been aggregated, as no individual operating unit is material and the operating units meet a majority of SFAS No. 131's aggregation criteria. RECLASSIFICATIONS Certain reclassifications have been made in prior period financial statements to conform to current period presentation. These reclassifications have not resulted in any changes to previously reported net income for any periods. 3. DISCONTINUED OPERATIONS On February 11, 2002, the Company entered into an agreement with Emcor Group, Inc. ("Emcor") to sell 19 operations. This transaction closed on March 1, 2002. Under the terms of the agreement, the total purchase price was $186.25 million, including the assumption by Emcor of approximately $22.1 million of subordinated notes to former owners of certain of the divested companies. The transaction with Emcor provided for a post-closing adjustment based on a final accounting, done after the closing of the transaction, of the net assets of the operations that were sold to Emcor. That accounting indicated that the net assets transferred to Emcor were approximately $7 million greater than a target amount that had been agreed to with Emcor. In accordance with the transaction agreement, Emcor paid the Company that amount, and released $2.5 million that had been escrowed in connection with this element of the transaction during the second quarter. An additional $5 million of Emcor's purchase price was deposited into an escrow account to secure potential obligations on the Company's part to indemnify Emcor for future claims and contingencies arising 7 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) from events and circumstances prior to closing, all as specified in the transaction documents. Because these escrow funds secure future claims and contingencies, the Company does not know whether it will ultimately receive any of such funds, and if it does, how much it will receive. Therefore, the Company has not recognized a receivable for this escrowed portion of the Emcor transaction purchase price. If the Company ultimately receives any of these escrowed funds, a corresponding gain will be recorded as a component of discontinued operations when received. The net cash proceeds of approximately $164 million received to date from the Emcor transaction have been used to reduce debt outstanding under the Company's credit facility. An estimated tax liability of $16 million related to this transaction is due in March 2003. Under SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which took effect for the Company on January 1, 2002, the operating results of the companies sold to Emcor as well as the loss on the sale of these operations have been presented as discontinued operations in the Company's statements of operations. The Company realized a loss of $10.6 million including related tax expense related to the sale of these operations. As a result of the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," the Company also recognized a goodwill impairment charge related to these operations of $32.4 million, net of taxes, as of January 1, 2002. The reporting of the Company's aggregate goodwill impairment charge in connection with adopting SFAS No. 142 is discussed further in Note 4. In March 2002, the Company also decided to divest of an additional operating company. This unit's operating loss for the first three quarters of 2002 of $0.1 million, net of taxes, has been reported in discontinued operations under "Operating income (loss), net of applicable income taxes" in the Company's statement of operations. In addition, an estimate of the loss the Company will realize upon divestiture of this operation of $0.6 million has been included in "Estimated loss on disposition, including income taxes" during the first quarter of 2002 in the Company's statement of operations. During the second quarter of 2002, the Company sold a division of one of its operations. The operating loss for this division for the first two quarters of 2002 of $0.3 million, net of taxes, has been reported in discontinued operations under "Operating income (loss), net of applicable income taxes" in the Company's statement of operations. The Company realized a loss of $0.3 million on the sale of this division which is included in "Estimated loss on disposition, including income taxes" during the second quarter of 2002 in the Company's statement of operations. 8 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Assets and liabilities related to discontinued operations were as follows (in thousands):
DECEMBER 31, SEPTEMBER 30, 2001 2002 ------------ ------------- Accounts receivable, net.................................... $140,768 $ 762 Other current assets........................................ 30,477 388 Property and equipment, net................................. 13,968 98 Goodwill, net............................................... 141,415 -- Other noncurrent assets..................................... 1,192 -- -------- ------ Total assets...................................... $327,820 $1,248 ======== ====== Current maturities of debt and notes........................ $ 1,262 $ -- Accounts payable............................................ 44,077 122 Other current liabilities................................... 68,676 21 Long-term debt and notes.................................... 21,842 -- Other long-term liabilities................................. 4,889 -- -------- ------ Total liabilities................................. $140,746 $ 143 ======== ======
Revenues and pre-tax income (loss) related to discontinued operations were as follows (in thousands):
NINE MONTHS ENDED SEPTEMBER 30, ------------------ 2001 2002 -------- ------- Revenues.................................................... $504,575 $98,424 Pre-tax income (loss)....................................... $ 16,369 $(2,090)
4. GOODWILL Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires companies to assess goodwill asset amounts for impairment each year, and more frequently if circumstances suggest an impairment may have occurred. In addition to discontinuing the regular charge, or amortization, of goodwill against income, the new standard also introduces more rigorous criteria for determining how much goodwill should be reflected as an asset in a company's balance sheet. To perform the transitional impairment testing required by SFAS No. 142 under its new, more rigorous impairment criteria, the Company broke its operations into "reporting units," as prescribed by the new standard, and tested each of these reporting units for impairment by comparing the unit's fair value to its carrying value. The fair value of each reporting unit was estimated using a discounted cash flow model combined with market valuation approaches. Significant estimates and assumptions were used in assessing the fair value of reporting units. These estimates and assumptions involved future cash flows, growth rates, discount rates, weighted average cost of capital and estimates of market valuations for each of the reporting units. As provided by SFAS No. 142, the transitional impairment loss identified by applying the standard's new, more rigorous valuation methodology upon initial adoption of the standard was reflected as a cumulative effect of a change in accounting principle in the Company's statement of operations. The resulting non-cash charge was $202.5 million, net of taxes. Impairment charges recognized after the initial adoption, if any, generally are to be reported as a component of operating income. 9 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The changes in the carrying amount of goodwill for the nine months ended September 30, 2002 are as follows (in thousands): Goodwill balance as of January 1, 2002(a)................... $ 438,448 Impairment adjustment....................................... (228,838) Goodwill related to sale of operations...................... (96,183) --------- Goodwill balance as of September 30, 2002................... $ 113,427 =========
--------------- (a) A portion of this goodwill balance is included in assets related to discontinued operations in the Company's consolidated balance sheet. The unaudited results of operations presented below (in thousands) for the three months and nine months ended September 30, 2001 and 2002 reflect the adoption of the non-amortization provisions of SFAS No. 142 effective January 1, 2001 and exclude the impact of the cumulative effect of change in accounting principle recorded in the first quarter of 2002. Therefore, the component of the cumulative effect of change in accounting principle related to the operations sold to Emcor is included in the estimated loss on disposition for purposes of this table.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- -------------------- 2001 2002 2001 2002 ------- ------- ------- -------- Income from continuing operations................. $1,420 $3,775 $ 328 $ 5,079 Add: Goodwill amortization, net of tax............ 1,895 -- 5,685 -- ------ ------ ------- -------- Adjusted income from continuing operations........ 3,315 3,775 6,013 5,079 Discontinued operations -- Operating income (loss), net of tax............... 4,222 (35) 9,705 (148) Add: Goodwill amortization, net of tax............ 758 -- 2,274 -- ------ ------ ------- -------- Adjusted operating income (loss), net of tax...... 4,980 (35) 11,979 (148) Estimated loss on disposition, including tax...... -- -- -- (45,124) ------ ------ ------- -------- Adjusted net income (loss)........................ $8,295 $3,740 $17,992 $(40,193) ====== ====== ======= ======== Adjusted income (loss) per share: Basic -- Income from continuing operations............ $ 0.09 $ 0.10 $ 0.16 $ 0.14 Discontinued operations -- Income (loss) from operations.............. 0.13 -- 0.32 -- Estimated loss on disposition.............. -- -- -- (1.20) ------ ------ ------- -------- Net income (loss)............................ $ 0.22 $ 0.10 $ 0.48 $ (1.06) ====== ====== ======= ======== Diluted -- Income from continuing operations............ $ 0.09 $ 0.10 $ 0.16 $ 0.13 Discontinued operations -- Income (loss) from operations.............. 0.13 -- 0.32 (0.01) Estimated loss on disposition.............. -- -- -- (1.18) ------ ------ ------- -------- Net income (loss)............................ $ 0.22 $ 0.10 $ 0.48 $ (1.06) ====== ====== ======= ========
10 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. RESTRUCTURING CHARGES During the first quarter of 2002, the Company recorded restructuring charges of approximately $1.9 million. These charges included approximately $0.8 million for severance costs primarily associated with the reduction in corporate overhead in light of the Company's smaller size following the Emcor transaction. The severance costs related to the termination of 33 employees, all of whom were terminated as of March 31, 2002. In addition, these charges include approximately $0.7 million for costs associated with decisions to merge or close three smaller divisions and realign regional operating management. These restructuring charges are primarily cash obligations but did include approximately $0.3 million of non-cash writedowns associated with long-lived assets. During the first quarter of 2001, the Company recorded restructuring charges of approximately $0.2 million, primarily related to contractual severance obligations of two operating presidents in connection with the Company's significant restructuring program in the second half of 2000. These restructuring charges are net of a gain of approximately $0.1 million related to management's decision to sell a small operation during the first quarter of 2001. During the second half of 2000, the Company recorded restructuring charges of approximately $25.3 million primarily associated with restructuring efforts at certain underperforming operations. Management performed an extensive review of its operations during the second half of 2000 and as part of this review management decided to cease operating at three locations, sell four operations (including two smaller satellite operations), and merge two companies into other operations. The restructuring charges were primarily non-cash and included goodwill impairments of approximately $11.5 million and the writedown of other long-lived assets of approximately $8.5 million. The remaining items in these restructuring charges primarily included severance and lease termination costs. Aggregated financial information for 2001 related to the operations addressed by the 2000 and 2001 restructuring charges is as follows (in thousands):
NINE MONTHS ENDED SEPTEMBER 30, 2001 ----------------- Revenues.................................................... $ 6,337 Operating loss.............................................. $(2,666)
The following table shows the remaining liabilities associated with the cash portion of the restructuring charges as of September 30, 2002 (in thousands):
BALANCE AT BALANCE AT JANUARY 1, SEPTEMBER 30, 2002 ADDITIONS PAYMENTS 2002 ---------- --------- -------- ------------- Severance.................................. $ 210 $ 846 $(1,015) $ 41 Lease termination costs and other.......... 1,148 704 (754) 1,098 ------ ------ ------- ------ Total...................................... $1,358 $1,550 $(1,769) $1,139 ====== ====== ======= ======
11 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. LONG-TERM DEBT OBLIGATIONS Long-term debt obligations consist of the following (in thousands):
DECEMBER 31, SEPTEMBER 30, 2001 2002 ------------ ------------- (UNAUDITED) Revolving credit facility................................... $163,700 $ -- Notes to affiliates and former owners....................... 17,943 15,818 Other....................................................... 385 539 -------- ------- Total debt.................................................. 182,028 16,357 Less: current maturities.................................. 2,447 1,589 -------- ------- $179,581 $14,768 ======== =======
CREDIT FACILITY The Company's primary current debt financing capacity consists of a $55 million senior credit facility (the "Facility") provided by General Electric Capital Corporation ("GE"), a subsidiary of the General Electric Corporation. The Facility includes a $20 million sublimit for letters of credit. The Facility is secured by substantially all the assets of the Company. The Facility was entered into on October 11, 2002 and replaces the Company's previous revolving credit facility with a group of banks, which was scheduled to expire in January 2003. The Facility consists of two parts: a term loan and a revolving credit facility. The term loan under the Facility (the "Term Loan") is $15 million, which the Company borrowed upon the closing of Facility on October 11, 2002. The Term Loan must be repaid in quarterly installments over five years beginning December 31, 2002. The amount of each quarterly installment increases annually. The Facility requires certain prepayments of the Term Loan. Approximately half of any free cash flow (primarily cash from operations less capital expenditures) in excess of scheduled principal payments and voluntary prepayments must be used to pay down the Term Loan. This requirement is measured annually based on full-year results. The Company has not reflected any additional prepayments in current maturities of debt in connection with this requirement as it cannot yet determine if there is a significant probability that cash flows measured through yearend 2002 will require such prepayments. In addition, proceeds in excess of $250,000 from any individual asset sales, or in excess of $1 million for a full year's asset sales, must be used to pay down the Term Loan. Proceeds from asset sales that are less than these individual transaction or annual aggregate levels must also be used to pay down the Term Loan unless they are reinvested in long-term assets within six months of the receipt of such proceeds. All prepayments under the Term Loan, whether required or voluntary, are applied to scheduled principal payments in inverse order, i.e. to the last scheduled principal payment first, followed by the second-to-last, etc. All principal payments under the Term Loan permanently reduce the original $15 million capacity under this portion of the Facility. The Facility also includes a three-year revolving credit facility (the "Revolving Loan") that allows the Company to borrow up to $40 million in addition to the Term Loan. INTEREST RATES AND FEES The Company has a choice of two interest rate options for borrowings under the Facility. Under one option, the interest rate is determined based on the higher of the Federal Funds Rate plus 0.5% or the prime rate of at least 75% of the US's 30 largest banks, as published each business day by the Wall Street Journal. 12 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) An additional margin of 2.25% is then added to the higher of these two rates for borrowings under the Revolving Loan, while an additional margin of 2.75% is added to the higher of these two rates for borrowings under the Term Loan. Under the other interest rate option, borrowings bear interest based on designated rates that are described in various general business media sources as the London Interbank Offered Rate or "LIBOR." Revolving Loan borrowings using this interest rate option then have 3.25% added to LIBOR, while Term Loan borrowings have 3.75% added to LIBOR. The rates underlying these interest rate options are floating interest rates determined by the broad financial markets, meaning they can and do move up and down from time to time. The Facility requires that the Company enter into agreements to convert these floating interest rate terms on at least half of the Term Loan to fixed rate terms by December 10, 2002. Depending on their ultimate terms, such agreements might qualify as "derivatives" for financial reporting purposes. If so, any increases or decreases in the value of such agreements resulting from changes in market interest rates in any given period will be reflected in interest expense for that period, even though the agreements may not have been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. Commitment fees of 0.5% per annum are payable on the unused portion of the Revolving Loan. The Company also incurred certain financing and professional costs in connection with the arrangement and the closing of the Facility. These costs will be amortized to interest expense over the term of the Facility in the amount of approximately $0.3 million per quarter. To the extent prepayments of the Term Loan are made, the Company may have to accelerate amortization of these deferred financing and professional costs. In connection with the Facility, the Company granted GE a warrant to purchase 409,051 shares of Company common stock for nominal consideration. In addition, GE may "put," or require the Company to repurchase, these shares at the higher of market price, appraised price or book value per share, during the fifth and final year of the Facility -- October 11, 2006 to October 11, 2007. This put may be accelerated under certain circumstances including a change of control of the Company, full repayment of amounts owing under the Facility, or a public offering of shares by the Company. This warrant and put are discussed in greater detail in Note 8, "Stockholders' Equity." The value of this warrant and put as of the start of the Facility of $2.9 million will be reflected as a discount of the Company's obligation under the Facility and will be amortized over the term of the Facility, as described above. The value of this warrant and put will change over time, principally in response to changes in the market price of the Company's common stock. The warrant and the put qualify as a derivative for financial reporting purposes. Accordingly, such changes in the value of the warrant and put in any given period will be reflected in interest expense for that period, even though the warrant and put may not have been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. The interest rate that the Company currently pays on the Term Loan is 7.5% per annum. This rate does not include amortization of debt financing and arrangement costs, or mark-to-market adjustments for derivatives. The interest rate that the Company currently pays on the Revolving Loan is 7.0% per annum. This rate does not include amortization of debt financing and arrangement costs, or mark-to-market adjustments for derivatives. RESTRICTIONS AND COVENANTS Borrowings under the Facility are specifically limited by the Company's ratio of total debt to earnings before interest, taxes, depreciation, and amortization ("EBITDA") and by the Company's ratio of EBITDA less taxes and capital expenditures to interest expense and scheduled principal payments, also known as the 13 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) fixed charge coverage ratio. The Facility's definition of debt for purposes of the ratio of total debt to EBITDA includes aggregate letters of credit outstanding less $10 million. The definition of EBITDA under the Facility excludes certain items, generally noncash amounts and transactions reported in Other Income and Expense, that are otherwise included in the determination of earnings under generally accepted accounting principles in the Company's financial statements. As such, EBITDA as determined under the Facility's definition could be less than EBITDA as derived from the Company's financial statements in the future. The Company is currently not aware of any items that would result in EBITDA as determined under the Facility's definition being significantly less than EBITDA as derived from the Company's financial statements in the future. The financial covenants under the Facility are summarized below. EBITDA amounts are in thousands.
FINANCIAL COVENANTS ----------------------------------------- MINIMUM MINIMUM FIXED TRAILING MAXIMUM CHARGE MINIMUM 12 MONTHS DEBT TO COVERAGE INTEREST FOR THE QUARTER ENDING EBITDA EBITDA RATIO COVERAGE ---------------------- --------- ------- -------- -------- ACTUAL September 30, 2002.......................... $30,014 0.54 5.11 7.75 COVENANT September 30, 2002.......................... $25,650 1.75 2.30 3.00 December 31, 2002........................... $25,650 1.75 2.30 3.00 March 31, 2003.............................. $27,000 1.75 2.50 3.00 June 30, 2003............................... $27,000 1.75 2.50 3.00 September 30, 2003.......................... $27,000 1.50 2.70 3.00 December 31, 2003........................... $27,000 1.50 2.70 3.00 March 31, 2004.............................. $29,000 1.50 3.00 3.00 June 30, 2004............................... $29,000 1.50 3.00 3.00 September 30, 2004.......................... $29,000 1.25 3.00 3.00 December 31, 2004........................... $29,000 1.25 3.00 3.00 All quarters thereafter..................... $31,000 1.25 3.00 3.00
The Company must achieve $6,042 of EBITDA in the fourth quarter of 2002 to remain in compliance with the minimum trailing twelve months EBITDA covenant shown above. The Facility prohibits payment of dividends and the repurchase of shares by the Company, limits annual lease expense and non-Facility debt, and restricts outlays of cash by the Company relating to certain investments, acquisitions and subordinate debt. NOTES TO AFFILIATES AND FORMER OWNERS Subordinated notes were issued to former owners of certain purchased companies as part of the consideration used to acquire their companies. These notes had an outstanding balance of $15.8 million as of September 30, 2002. In October 2002, $10.7 million of this balance was repaid with proceeds from the Term Loan. As of November 1, 2002, a balance of $4.7 million remains outstanding on these notes, substantially all of which is due in April 2003. The remaining notes bear interest, payable quarterly, at an interest rate of 14 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10.0%. As these notes were refinanced with proceeds from the Term Loan, they are reflected as long-term as of September 30, 2002, net of amounts that are current under the Term Loan. AMOUNTS OUTSTANDING AND CAPACITY The following recaps the Company's debt amounts outstanding and capacity (in thousands):
UNUSED CAPACITY AS OF AS OF AS OF SEPTEMBER 30, 2002 NOVEMBER 1, 2002 NOVEMBER 1, 2002 ------------------ ---------------- ---------------- Revolving loan........................ $ -- $ 3,700 $18,546 Term loan............................. -- 15,000 n/a Notes to affiliates................... 15,818 4,746 n/a Other debt............................ 539 533 n/a ------- ------- ------- Total debt.......................... 16,357 23,979 18,546 Less: discount on Facility.......... -- (2,930) n/a ------- ------- ------- Total debt, net of discount......... $16,357 $21,049 $18,546
7. COMMITMENTS AND CONTINGENCIES CLAIMS AND LAWSUITS The Company is party to litigation in the ordinary course of business. The Company has estimated and provided accruals for probable losses and related legal fees associated with certain of these actions in the accompanying consolidated financial statements. There are currently no pending legal proceedings that, in management's opinion, would have a material adverse effect on the Company's operating results or financial condition. SELF-INSURANCE The Company retains the risk of worker's compensation, employer's liability, auto liability, general liability and employee group health claims resulting from uninsured deductibles per accident or occurrence. Losses up to the deductible amounts are estimated and accrued based upon the Company's known claims incurred and an estimate of claims incurred but not reported. The accruals are based upon known facts and historical trends, and management believes such accruals to be adequate. A wholly-owned insurance company subsidiary reinsures a portion of the risk associated with surety bonds issued by a third party insurance company. Because no claims have been made against these financial instruments in the past, management does not expect that these instruments will have a material effect on the Company's consolidated financial statements. 8. STOCKHOLDERS' EQUITY RESTRICTED STOCK GRANT The Company awarded 200,000 shares of restricted stock to its Chief Executive Officer on March 22, 2002 under its 2000 Equity Incentive Plan. The shares are subject to forfeiture if the Company does not meet certain performance measures for the twelve-month period ending March 31, 2003 or if the executive leaves voluntarily or is terminated for cause. Such forfeiture provisions lapse upon achievement of the performance measures and pro rata over a four-year period. Compensation expense relating to this grant will be charged to earnings over the four-year period. The initial value of the award was established based on the market price on the date of grant. The unearned compensation is shown as a reduction of stockholders' equity in the accompanying consolidated balance sheet and is being amortized against earnings based upon the market 15 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) value of the stock until the achievement of performance measures for the twelve-month period ending March 31, 2003 is determined. The value of the stock grant remaining after this determination will be amortized ratably over the remaining three years of the restricted period. RESTRICTED COMMON STOCK In March 1997, Notre Capital Ventures II, L.L.C. exchanged 2,742,912 shares of Common Stock for an equal number of shares of restricted voting common stock ("Restricted Voting Common Stock"). The holders of Restricted Voting Common Stock are entitled to elect one member of the Company's Board of Directors and 0.55 of one vote for each share on all other matters on which they are entitled to vote. Holders of Restricted Voting Common Stock are not entitled to vote on the election of any other directors. Each share of Restricted Voting Common Stock will automatically convert to Common Stock on a share-for-share basis (i) in the event of a disposition of such share of Restricted Voting Common Stock by the holder thereof (other than a distribution which is a distribution by a holder to its partners or beneficial owners, or a transfer to a related party of such holders (as defined in Sections 267, 707, 318 and/or 4946 of the Internal Revenue Code of 1986, as amended)), (ii) in the event any person acquires beneficial ownership of 15% or more of the total number of outstanding shares of Common Stock of the Company, or (iii) in the event any person offers to acquire 15% or more of the total number of outstanding shares of Common Stock of the Company. After July 1, 1998, the Board of Directors may elect to convert any remaining shares of Restricted Voting Common Stock into shares of Common Stock in the event 80% or more of the originally outstanding shares of Restricted Voting Common Stock have been previously converted into shares of Common Stock. As of September 30, 2002, there were 1,156,112 shares of Restricted Voting Common Stock remaining. EARNINGS PER SHARE Basic earnings per share ("EPS") is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted EPS is computed considering the dilutive effect of stock options and convertible subordinated notes. Options to purchase 3.3 million shares of the Company's Common Stock ("Common Stock") at prices ranging from $3.86 to $21.44 per share and options to purchase 2.7 million shares of Common Stock at prices ranging from $4.24 to $21.44 per share were outstanding for the three months and nine months ended September 30, 2002, respectively, but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the Common Stock. Options to purchase 4.0 million shares of Common Stock at prices ranging from $3.63 to $21.44 per share were outstanding for the three months and nine months ended September 30, 2001, but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the Common Stock. Diluted EPS is also computed by adjusting both net earnings and shares outstanding as if the conversion of the convertible subordinated notes occurred on the first day of the year. The convertible subordinated notes had an anti-dilutive effect during the three months ended September 30, 2001 and the nine months ended September 30, 2001 and 2002, and therefore, are not included in the diluted EPS calculations. The convertibility provisions of the remaining convertible subordinated notes expired during the first quarter of 2002. 16 COMFORT SYSTEMS USA, INC. CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table reconciles the number of shares outstanding with the number of shares used in computing basic and diluted earnings per share for each of the periods presented (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2001 2002 2001 2002 ------- ------- ------- ------- Common shares outstanding, end of period........ 37,510 37,835 37,510 37,835 Effect of using weighted average common shares outstanding................................... (42) (1) (99) (99) ------ ------ ------ ------ Shares used in computing earnings per share -- basic................................ 37,468 37,834 37,411 37,736 Effect of shares issuable under stock plans based on the treasury stock method............ 305 297 38 456 ------ ------ ------ ------ Shares used in computing earnings per share -- diluted....................................... 37,773 38,131 37,449 38,192 ====== ====== ====== ======
WARRANT In connection with the arrangement of the Company's new debt facility as described above in Note 6, "Long-Term Debt Obligations," the Company granted GE, its lender, a warrant to purchase 409,051 shares of Company common stock for nominal consideration. The warrant agreement also provides for the following: - In most situations where the Company issues shares, options or warrants, GE may acquire additional shares or warrants on equivalent terms to maintain the proportionate interest its warrant shares represent in comparison to the Company's total shares outstanding. - GE may require the Company to register its warrant shares. - GE may include its warrant shares in any public offering of stock by the Company. - GE may "put," or require the Company to repurchase, some or all of its warrant shares at the higher of market price, appraised price or book value per share, during the fifth and final year of the debt facility -- October 11, 2006 to October 11, 2007. This put may be accelerated under certain circumstances including a change of control of the Company, full repayment of amounts owing under the Facility, or a public offering of shares by the Company. The initial value of this warrant and put of $2.9 million will be reflected as a discount of the Company's obligations under its debt facility with GE and as a separate obligation in long-term liabilities. The value of this warrant and put will change over time, principally in response to changes in the market price of the Company's common stock. The warrant and the put qualify as a derivative for financial reporting purposes. Accordingly, such changes in the value of the warrant and put in any given period will be reflected in interest expense for that period and in the Company's long-term warrant obligations, even though the warrant and put may not have been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. 17 COMFORT SYSTEMS USA, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The following discussion should be read in conjunction with the historical Consolidated Financial Statements of Comfort Systems USA, Inc. ("Comfort Systems" and collectively with its subsidiaries, the "Company") and related notes thereto included elsewhere in this Form 10-Q and the Annual Report on Form 10-K as filed with the Securities and Exchange Commission for the year ended December 31, 2001 (the "Form 10-K"). This discussion contains forward-looking statements regarding the business and industry of Comfort Systems USA within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current plans and expectations of the Company and involve risks and uncertainties that could cause actual future activities and results of operations to be materially different from those set forth in the forward-looking statements. Important factors that could cause actual results to differ include risks set forth in "Factors Which May Affect Future Results," included in the Form 10-K. The Company is a national provider of comprehensive heating, ventilation and air conditioning ("HVAC") installation, maintenance, repair and replacement services within the mechanical services industry. The Company operates primarily in the commercial and industrial HVAC markets, and performs most of its services within office buildings, retail centers, apartment complexes, manufacturing plants, and healthcare, education and government facilities. In addition to standard HVAC services, the Company provides specialized applications such as building automation control systems, fire protection, process cooling, electronic monitoring and process piping. Certain locations also perform related services such as electrical and plumbing. Approximately 52% of the Company's consolidated 2002 revenues were attributable to installation of systems in newly constructed facilities, with the remaining 48% attributable to maintenance, repair and replacement services. The Company's consolidated 2002 revenues related to the following service activities: HVAC -- 74%, plumbing -- 11%, building automation control systems -- 5%, electrical -- 2%, fire protection -- 1% and other -- 7%. These service activities are within the mechanical services industry which is the single industry segment served by Comfort Systems. In response to the Securities and Exchange Commission's Release No. 33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting Policies," the Company identified its critical accounting policies based upon the significance of the accounting policy to the Company's overall financial statement presentation, as well as the complexity of the accounting policy and its use of estimates and subjective assessments. The Company concluded that its critical accounting policy is its revenue recognition policy. This accounting policy, as well as others, are described in Note 2 to the Consolidated Financial Statements included in the Form 10-K. The Company enters into construction contracts with general contractors or end-use customers based upon negotiated contracts and competitive bids. As part of the negotiation and bidding processes, the Company estimates its contract costs, which include all direct materials (net of estimated rebates), labor and subcontract costs and indirect costs related to contract performance such as indirect labor, supplies, tools, repairs and depreciation costs. Revenues from construction contracts are recognized on the percentage-of-completion method in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." Under this method, the amount of total contract revenue recognizable at any given time during a contract is determined by multiplying total contract revenue by the percentage of contract costs incurred at any given time to total estimated contract costs. Accordingly, contract revenues recognized in the statements of operations can and usually do differ from amounts that can be billed or invoiced to the customer at any given point during the contract. Changes in job performance, job conditions, estimated profitability and final contract settlements may result in revisions to estimated costs and, therefore, revenues. Such revisions are frequently based on estimates and subjective assessments. The effects of these revisions are recognized in the period in which the revisions are determined. When such revisions lead to a conclusion that a loss will be recognized on a contract, the full 18 amount of the estimated ultimate loss is recognized in the period such a conclusion is reached, regardless of what stage of completion the contract has reached. Depending on the size of a particular project, variations from estimated project costs could have a significant impact on the Company's operating results. Revenues associated with maintenance, repair and monitoring services and related contracts are recognized as services are performed. Approximately 52% of the Company's consolidated 2002 revenues were attributable to installation of systems in newly constructed facilities. As a result, if general economic activity in the U.S. slows significantly from current levels, and leads to a corresponding decrease in new nonresidential building construction, the Company's operating results could suffer. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets." Under this new standard, which is discussed in "Results of Operations" and "New Accounting Pronouncements" below, new requirements for assessing whether goodwill assets have been impaired involve market-based information. This information, and its use in assessing goodwill, entails some degree of subjective assessments. Additionally, amortization of goodwill has been discontinued in 2002 operating results as a result of this standard. Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Under this new standard, the operating results of companies which were sold or held for sale as of September 30, 2002, have been reported as discontinued operations in the accompanying consolidated statements of operations. However, the operating results for companies which were sold or shut down during 2001 are presented as continuing operations through the date of disposition. RESULTS OF OPERATIONS (IN THOUSANDS)
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------ ------------------------------------- 2001 2002 2001 2002 ---------------- ---------------- ---------------- ----------------- Revenues................... $234,070 100.0% $214,691 100.0% $664,629 100.0% $ 616,053 100.0% Cost of services........... 189,426 80.9% 174,668 81.4% 540,493 81.3% 506,843 82.3% -------- -------- -------- --------- Gross profit............... 44,644 19.1% 40,023 18.6% 124,136 18.7% 109,210 17.7% Selling, general and administrative expenses................. 35,449 15.1% 32,046 14.9% 106,371 16.0% 95,029 15.4% Goodwill amortization...... 2,056 0.9% -- -- 6,170 0.9% -- -- Restructuring charges...... -- -- -- -- 238 -- 1,878 0.3% -------- -------- -------- --------- Operating income........... 7,139 3.0% 7,977 3.7% 11,357 1.7% 12,303 2.0% Other expense, net......... (1,790) 0.8% (824) (0.4)% (6,390) (1.0)% (2,673) (0.4)% -------- -------- -------- --------- Income before income taxes.................... 5,349 2.3% 7,153 3.3% 4,967 0.7% 9,630 1.6% Income tax expense......... 3,929 3,378 4,639 4,551 -------- -------- -------- --------- Income from continuing operations............... 1,420 0.6% 3,775 1.8% 328 -- 5,079 0.8% Discontinued operations -- Operating results, net of tax.................... 4,222 (35) 9,705 (148) Estimated loss on disposition, net of tax.................... -- -- -- (11,156) Cumulative effect of change in accounting principle, net of tax............... -- -- -- (202,521) -------- -------- -------- --------- Net income (loss).......... $ 5,642 $ 3,740 $ 10,033 $(208,746) ======== ======== ======== =========
Revenues -- Revenues decreased $19.4 million, or 8.3%, to $214.7 million for the third quarter of 2002 and decreased $48.6 million, or 7.3%, to $616.1 million for the first nine months of 2002 compared to the same periods in 2001. The 8.3% decline in revenues for the quarter was comprised of a 7.6% decline in revenues at 19 ongoing operations and a 0.7% decline in revenues related to operations that were sold or shut down during 2001. The 7.3% decline in revenues for the first nine months of 2002 was comprised of a 6.4% decline in revenues at ongoing operations and a 0.9% decline in revenues related to operations that were sold or shut down during 2001. The Company's decline in revenues at ongoing operations in 2002 resulted primarily from the lagged effect of the general economic slowdown that began last year which slowed decisions to proceed on both new and retrofit projects. This general economic slowdown has also led to a more competitive pricing environment. The Company's decline in revenue is also consistent with management's decreased emphasis on revenue growth in favor of improvement in profit margins, operating efficiency, and cash flow. There can be no assurance, however, that this strategy will lead to improved profit margins in the near term. In view of these factors, particularly decreased economic activity and increased price competition affecting the Company's industry, the Company may continue to experience only modest revenue growth or revenue declines in upcoming periods. In addition, if general economic activity in the U.S. slows significantly from current levels, the Company may realize further decreases in revenue and lower operating margins. Backlog primarily contains installation, retrofit project work and service and maintenance agreements. These projects generally last less than a year. Service work and short duration projects are generally billed as performed and therefore do not flow through backlog. Accordingly, backlog represents only a portion of the Company's revenues for any given future period, and it represents revenues that are likely to be reflected in the Company's operating results over the next six to twelve months. As a result, the Company believes the predictive value of backlog information is limited to indications of general revenue direction over the near term, and should not be interpreted as indicative of ongoing revenue performance over several quarters. The Company's backlog associated with continuing operations as of September 30, 2002 was $475.9 million, a 10.1% increase from September 30, 2001 backlog of $432.2 million, and a 2.0% increase from June 30, 2002 backlog of $466.5 million. Gross Profit -- Gross profit decreased $4.6 million, or 10.4%, to $40.0 million for the third quarter of 2002 and decreased $14.9 million, or 12.0%, to $109.2 million for the first nine months of 2002 compared to the same periods in 2001. As a percentage of revenues, gross profit decreased from 19.1% for the three months ended September 30, 2001 to 18.6% for the three months ended September 30, 2002 and decreased from 18.7% for the nine months ended September 30, 2001 to 17.7% for the nine months ended September 30, 2002. The decline in gross profit for the quarter is primarily due to a more competitive pricing environment as a result of the general economic slowdown which began in the latter part of 2001. This slowdown also resulted in project delays at a number of the Company's operations as decisions to start new construction activities as well as retrofit projects were delayed in the fourth quarter of 2001. These delays significantly affected the Company's revenue volume and profitability during the first part of 2002. Selling, General and Administrative Expenses ("SG&A") -- SG&A decreased $3.4 million, or 9.6%, to $32.0 million for the third quarter of 2002 and decreased $11.3 million, or 10.7%, to $95.0 million for the first nine months of 2002 compared to the same periods in 2001. As a percentage of revenues, SG&A decreased from 15.1% for the three months ended September 30, 2001 to 14.9% for the three months ended September 30, 2002 and decreased from 16.0% for the nine months ended September 30, 2001 to 15.4% for the nine months ended September 30, 2002. The decrease in SG&A is primarily due to a concerted effort to reduce SG&A throughout the Company. In response to the smaller size of the Company following the sale of 19 units to Emcor as discussed further below under "Discontinued Operations," the Company reduced corporate overhead at the end of the first quarter of 2002. The cost of this workforce reduction is included in restructuring charges recorded in March 2002. The Company has realized lower corporate overhead costs as a result of these steps. In addition, during the second quarter of 2002, the Company reversed $0.8 million of bad debt reserves that were established in the fourth quarter of 2001 related to the Company's receivables with Kmart based upon a post-bankruptcy petition settlement with Kmart. 20 SG&A as a percentage of revenues for periods prior to the Emcor transaction is higher than historical levels because the financial statements do not allocate any corporate overhead to the discontinued operations. As a result, SG&A for continuing operations reflects substantially the full amount of corporate office overhead that was in place to support the Company's operations prior to the sale of these operations. Goodwill Amortization -- Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." This pronouncement discontinued goodwill amortization. See "Cumulative Effect of Change in Accounting Principle" for further discussion. Restructuring Charges -- During the first quarter of 2002, the Company recorded restructuring charges of approximately $1.9 million. These charges included approximately $0.8 million for severance costs primarily associated with the reduction in corporate overhead in light of the Company's smaller size following the Emcor transaction. The severance costs related to the termination of 33 employees, all of whom were terminated as of March 31, 2002. In addition, these charges include approximately $0.7 million for costs associated with decisions to merge or close three smaller divisions and realign regional operating management. These restructuring charges are primarily cash obligations but did include approximately $0.3 million of non-cash writedowns associated with long-lived assets. During the first quarter of 2001, the Company recorded restructuring charges of approximately $0.2 million, primarily related to contractual severance obligations of two operating presidents in connection with the Company's significant restructuring program in the second half of 2000. These restructuring charges are net of a gain of approximately $0.1 million related to management's decision to sell a small operation during the first quarter of 2001. Other Expense, Net -- Other expense, net, primarily includes interest expense, and decreased $1.0 million, or 54.0%, to $0.8 million for the third quarter of 2002 and decreased $3.7 million, or 58.2%, to $2.7 million for the first nine months of 2002. A portion of the Company's actual interest expense in both years has been allocated to the discontinued operations caption based upon the Company's net investment in these operations. Therefore, interest expense relating to continuing operations does not reflect the pro forma reduction of interest expense from applying the proceeds from the sale of these operations to reduce debt in any earlier period. Interest expense allocated to the discontinued operations for the three months ended September 30, 2001 was $3.3 million and for the nine months ended September 30, 2001 and 2002 was $11.0 million and $1.5 million, respectively. In addition, first quarter 2002 interest expense in continuing operations includes a non-cash writedown of $0.6 million, before taxes, of loan arrangement costs in connection with the reduction in the Company's borrowing capacity following the Emcor transaction. Other expense, net, for the second quarter of 2002 also includes a gain of $0.6 million on the sale of the residential portion of one of the Company's operations. Income Tax Expense -- The Company's effective tax rates associated with results from continuing operations for the nine months ended September 30, 2001 and 2002 were 93.4% and 47.3%, respectively. As a result of the discontinuation of goodwill amortization as a result of the adoption of SFAS No. 142 effective January 1, 2002, there is no longer a permanent difference related to the non-deductible goodwill amortization in the 2002 effective tax rate. Discontinued Operations -- On February 11, 2002, the Company entered into an agreement with Emcor Group, Inc. ("Emcor") to sell 19 operations. This transaction closed on March 1, 2002. Under the terms of the agreement, the total purchase price was $186.25 million, including the assumption by Emcor of approximately $22.1 million of subordinated notes to former owners of certain of the divested companies. The transaction with Emcor provided for a post-closing adjustment based on a final accounting, done after the closing of the transaction, of the net assets of the operations that were sold to Emcor. That accounting indicated that the net assets transferred to Emcor were approximately $7 million greater than a target amount that had been agreed to with Emcor. In accordance with the transaction agreement, Emcor paid the Company that amount, and released $2.5 million that had been escrowed in connection with this element of the transaction during the second quarter. 21 An additional $5 million of Emcor's purchase price was deposited into an escrow account to secure potential obligations on the Company's part to indemnify Emcor for future claims and contingencies arising from events and circumstances prior to closing, all as specified in the transaction documents. Because these escrow funds secure future claims and contingencies, the Company does not know whether it will ultimately receive any of such funds, and if it does, how much it will receive. Therefore, the Company has not recognized a receivable for this escrowed portion of the Emcor transaction purchase price. If the Company ultimately receives any of these escrowed funds, a corresponding gain will be recorded as a component of discontinued operations when received. The net cash proceeds of approximately $164 million received to date from the Emcor transaction have been used to reduce debt outstanding under the Company's credit facility. An estimated tax liability of $16 million related to this transaction is due in March 2003. Under SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which took effect for the Company on January 1, 2002, the operating results of the companies sold to Emcor as well as the loss on the sale of these operations have been presented as discontinued operations in the Company's statements of operations. The Company realized a loss of $10.6 million including related tax expense related to the sale of these operations. As a result of the adoption of SFAS No. 142 "Goodwill and Other Intangible Assets," the Company also recognized a goodwill impairment charge related to these operations of $32.4 million, net of taxes, as of January 1, 2002. The reporting of the Company's aggregate goodwill impairment charge in connection with adopting SFAS No. 142 is discussed further below under "Cumulative Effect of Change in Accounting Principle." In March 2002, the Company also decided to divest of an additional operating company. This unit's operating loss for the first three quarters of 2002 of $0.1 million, net of taxes, has been reported in discontinued operations under "Operating results, net of tax" in the Company's results of operations. In addition, an estimate of the loss the Company will realize upon divestiture of this operation of $0.6 million has been included in "Estimated loss on disposition, net of tax" during the first quarter of 2002 in the Company's results of operations. During the second quarter of 2002, the Company sold a division of one of its operations. The operating loss for this division for the first two quarters of 2002 of $0.3 million, net of taxes, has been reported in discontinued operations under "Operating results, net of tax" in the Company's results of operations. The Company realized a loss of $0.3 million on the sale of this division which is included in "Estimated loss on disposition, net of tax" during the second quarter of 2002 in the Company's results of operations. Cumulative Effect of Change in Accounting Principle -- Effective January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires companies to assess goodwill asset amounts for impairment each year, and more frequently if circumstances suggest an impairment may have occurred. In addition to discontinuing the regular charge, or amortization, of goodwill against income, the new standard also introduces more rigorous criteria for determining how much goodwill should be reflected as an asset in a company's balance sheet. To perform the transitional impairment testing required by SFAS No. 142 under its new, more rigorous impairment criteria, the Company broke its operations into "reporting units", as prescribed by the new standard, and tested each of these reporting units for impairment by comparing the unit's fair value to its carrying value. The fair value of each reporting unit was estimated using a discounted cash flow model combined with market valuation approaches. Significant estimates and assumptions were used in assessing the fair value of reporting units. These estimates and assumptions involved future cash flows, growth rates, discount rates, weighted average cost of capital and estimates of market valuations for each of the reporting units. As provided by SFAS No. 142, the transitional impairment loss identified by applying the standard's new, more rigorous valuation methodology upon initial adoption of the standard was reflected as a cumulative effect of a change in accounting principle in the Company's statement of operations. The resulting non-cash charge 22 was $202.5 million, net of taxes. Impairment charges recognized after the initial adoption, if any, generally are to be reported as a component of operating income. LIQUIDITY AND CAPITAL RESOURCES Cash Flow -- Cash provided by operating activities less customary capital expenditures plus the proceeds from asset sales is generally called free cash flow. Positive free cash flow represents funds available to invest in significant operating initiatives, to acquire other companies or to reduce a company's outstanding debt or equity. If free cash flow is negative, additional debt or equity is generally required to fund the outflow of cash. For the three months ended September 30, 2002, the Company had positive free cash flow of $11.3 million as compared to $8.4 million for the same period in 2001. The Company has now generated positive free cash flow in nine of the last ten quarters. For the nine months ended September 30, 2002, the Company had positive free cash flow of $11.1 million as compared to $37.6 million for the same period in 2001. The 2001 cash flow amounts include the 19 operations the Company sold to Emcor in 2002. This sale primarily accounts for the lower cash flow amounts in 2002. The transaction with Emcor provided for a post-closing adjustment based on a final accounting, done after the closing of the transaction, of the net assets of the operations that were sold to Emcor. That accounting indicated that the net assets transferred to Emcor were approximately $7 million greater than a target amount that had been agreed to with Emcor. In accordance with the transaction agreement, Emcor paid the Company that amount, and released $2.5 million that had been escrowed in connection with this element of the transaction during the second quarter. This amount is included in "Proceeds from businesses sold, net of cash sold and transaction costs" in the Company's statement of cash flows. The proceeds received at the closing of the Emcor transaction, the post-closing adjustment and related escrow received from Emcor, and free cash flow from the Company's operations were all used to reduce the Company's debt. Credit Facility -- The Company's primary current debt financing capacity consists of a $55 million senior credit facility (the "Facility") provided by General Electric Capital Corporation ("GE"), a subsidiary of the General Electric Corporation. The Facility includes a $20 million sublimit for letters of credit. The Facility is secured by substantially all the assets of the Company. The Facility was entered into on October 11, 2002 and replaces the Company's previous revolving credit facility with a group of banks, which was scheduled to expire in January 2003. The Facility consists of two parts: a term loan and a revolving credit facility. The term loan under the Facility (the "Term Loan") is $15 million, which the Company borrowed upon the closing of Facility on October 11, 2002. The Term Loan must be repaid in quarterly installments over five years beginning December 31, 2002. The amount of each quarterly installment increases annually. These scheduled payments are recapped below under Amounts Outstanding, Capacity and Maturities. The Facility requires certain prepayments of the Term Loan. Approximately half of any free cash flow (primarily cash from operations less capital expenditures) in excess of scheduled principal payments and voluntary prepayments must be used to pay down the Term Loan. This requirement is measured annually based on full-year results. The Company has not reflected any additional prepayments in current maturities of debt in connection with this requirement as it cannot yet determine if there is a significant probability that cash flows measured through yearend 2002 will require such prepayments. In addition, proceeds in excess of $250,000 from any individual asset sales, or in excess of $1 million for a full year's asset sales, must be used to pay down the Term Loan. Proceeds from asset sales that are less than these individual transaction or annual aggregate levels must also be used to pay down the Term Loan unless they are reinvested in long-term assets within six months of the receipt of such proceeds. All prepayments under the Term Loan, whether required or voluntary, are applied to scheduled principal payments in inverse order, i.e. to the last scheduled principal payment first, followed by the second-to-last, etc. All principal payments under the Term Loan permanently reduce the original $15 million capacity under this portion of the Facility. 23 The Facility also includes a three-year revolving credit facility (the "Revolving Loan") that allows the Company to borrow up to $40 million in addition to the Term Loan. Interest Rates and Fees -- The Company has a choice of two interest rate options for borrowings under the Facility. Under one option, the interest rate is determined based on the higher of the Federal Funds Rate plus 0.5% or the prime rate of at least 75% of the US's 30 largest banks, as published each business day by the Wall Street Journal. An additional margin of 2.25% is then added to the higher of these two rates for borrowings under the Revolving Loan, while an additional margin of 2.75% is added to the higher of these two rates for borrowings under the Term Loan. Under the other interest rate option, borrowings bear interest based on designated rates that are described in various general business media sources as the London Interbank Offered Rate or "LIBOR." Revolving Loan borrowings using this interest rate option then have 3.25% added to LIBOR, while Term Loan borrowings have 3.75% added to LIBOR. The rates underlying these interest rate options are floating interest rates determined by the broad financial markets, meaning they can and do move up and down from time to time. The Facility requires that the Company enter into agreements to convert these floating interest rate terms on at least half of the Term Loan to fixed rate terms by December 10, 2002. Depending on their ultimate terms, such agreements might qualify as "derivatives" for financial reporting purposes. If so, any increases or decreases in the value of such agreements resulting from changes in market interest rates in any given period will be reflected in interest expense for that period, even though the agreements may not have been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. Commitment fees of 0.5% per annum are payable on the unused portion of the Revolving Loan. The Company also incurred certain financing and professional costs in connection with the arrangement and the closing of the Facility. These costs will be amortized to interest expense over the term of the Facility in the amount of approximately $0.3 million per quarter. To the extent prepayments of the Term Loan are made, the Company may have to accelerate amortization of these deferred financing and professional costs. In connection with the Facility, the Company granted GE a warrant to purchase 409,051 shares of Company common stock for nominal consideration. In addition, GE may "put," or require the Company to repurchase, these shares at the higher of market price, appraised price or book value per share, during the fifth and final year of the Facility -- October 11, 2006 to October 11, 2007. This put may be accelerated under certain circumstances including a change of control of the Company, full repayments of amounts owing under the Facility, or a public offering of shares by the Company. This warrant and put are discussed in greater detail in Note 8, "Stockholders' Equity," to the Consolidated Financial Statements. The value of this warrant and put as of the start of the Facility of $2.9 million will be reflected as a discount of the Company's obligation under the Facility and will be amortized over the term of the Facility, as described above. The value of this warrant and put will change over time, principally in response to changes in the market price of the Company's common stock. The warrant and the put qualify as a derivative for financial reporting purposes. Accordingly, such changes in the value of the warrant and put in any given period will be reflected in interest expense for that period, even though the warrant and put may not have been terminated and settled in cash during the period. Such adjustments are known as mark-to-market adjustments. The interest rate that the Company currently pays on the Term Loan is 7.5% per annum. This rate does not include amortization of debt financing and arrangement costs, or mark-to-market adjustments for derivatives. The interest rate that the Company currently pays on the Revolving Loan is 7.0% per annum. This rate does not include amortization of debt financing and arrangement costs, or mark-to-market adjustments for derivatives. Restrictions and Covenants -- Borrowings under the Facility are specifically limited by the Company's ratio of total debt to earnings before interest, taxes, depreciation, and amortization ("EBITDA") and by the Company's ratio of EBITDA less taxes and capital expenditures to interest expense and scheduled principal 24 payments, also known as the fixed charge coverage ratio. The Facility's definition of debt for purposes of the ratio of total debt to EBITDA includes aggregate letters of credit outstanding less $10 million. The definition of EBITDA under the Facility excludes certain items, generally noncash amounts and transactions reported in Other Income and Expense, that are otherwise included in the determination of earnings under generally accepted accounting principles in the Company's financial statements. As such, EBITDA as determined under the Facility's definition could be less than EBITDA as derived from the Company's financial statements in the future. The Company is currently not aware of any items that would result in EBITDA as determined under the Facility's definition being significantly less than EBITDA as derived from the Company's financial statements in the future. The financial covenants under the Facility are summarized below. EBITDA amounts are in thousands.
FINANCIAL COVENANTS ----------------------------------------- MINIMUM MINIMUM FIXED TRAILING MAXIMUM CHARGE MINIMUM 12 MONTHS DEBT TO COVERAGE INTEREST FOR THE QUARTER ENDING EBITDA EBITDA RATIO COVERAGE ---------------------- --------- ------- -------- -------- ACTUAL September 30, 2002.......................... $30,014 0.54 5.11 7.75 COVENANT September 30, 2002.......................... $25,650 1.75 2.30 3.00 December 31, 2002........................... $25,650 1.75 2.30 3.00 March 31, 2003.............................. $27,000 1.75 2.50 3.00 June 30, 2003............................... $27,000 1.75 2.50 3.00 September 30, 2003.......................... $27,000 1.50 2.70 3.00 December 31, 2003........................... $27,000 1.50 2.70 3.00 March 31, 2004.............................. $29,000 1.50 3.00 3.00 June 30, 2004............................... $29,000 1.50 3.00 3.00 September 30, 2004.......................... $29,000 1.25 3.00 3.00 December 31, 2004........................... $29,000 1.25 3.00 3.00 All quarters thereafter..................... $31,000 1.25 3.00 3.00
The Company must achieve $6,042 of EBITDA in the fourth quarter of 2002 to remain in compliance with the minimum trailing twelve months EBITDA covenant shown above. The Facility prohibits payment of dividends and the repurchase of shares by the Company, limits annual lease expense and non-Facility debt, and restricts outlays of cash by the Company relating to certain investments, acquisitions and subordinate debt. Notes to Affiliates and Former Owners -- Subordinated notes were issued to former owners of certain purchased companies as part of the consideration used to acquire their companies. These notes had an outstanding balance of $15.8 million as of September 30, 2002. In October 2002, $10.7 million of this balance was repaid with proceeds from the Term Loan. As of November 1, 2002, a balance of $4.7 million remains outstanding on these notes, substantially all of which is due in April 2003. The remaining notes bear interest, payable quarterly, at an interest rate of 10.0%. As these notes were refinanced with proceeds from the Term Loan, they are reflected as long-term as of September 30, 2002, net of amounts that are current under the Term Loan. Other Commitments -- As is common in the Company's industry, the Company has entered into certain off-balance sheet arrangements in the ordinary course of business that result in risks not directly reflected in the Company's balance sheets. The Company's most significant off-balance sheet transactions include 25 liabilities associated with noncancelable operating leases. The Company also has other off-balance sheet obligations involving letters of credit and surety guarantees. The Company enters into noncancelable operating leases for many of its facility, vehicle and equipment needs. These leases allow the Company to conserve cash by paying a monthly lease rental fee for use of facilities, vehicles and equipment rather than purchasing them. At the end of the lease, the Company has no further obligation to the lessor. The Company may decide to cancel or terminate a lease before the end of its term. Typically the Company is liable to the lessor for the remaining lease payments under the term of the lease. Some customers require the Company to post letters of credit to guarantee performance under the Company's contracts and to ensure payment to the Company's subcontractors and vendors under those contracts. Certain of the Company's vendors also require letters of credit to ensure reimbursement for amounts they are disbursing on behalf of the Company, such as to beneficiaries under the Company's self-funded insurance programs. Such letters of credit are generally issued by a bank or similar financial institution. The letter of credit commits the issuer to pay specified amounts to the holder of the letter of credit if the holder demonstrates that the Company has failed to perform specified actions. If this were to occur, the Company would be required to reimburse the issuer of the letter of credit. Depending on the circumstances of such a reimbursement, the Company may also have to record a charge to earnings for the reimbursement. To date the Company has not had a claim made against a letter of credit that resulted in payments by the issuer of the letter of credit or by the Company. The Company believes that it is unlikely that it will have to fund claims under a letter of credit in the foreseeable future. Many customers, particularly in connection with new construction, require the Company to post performance and payment bonds issued by a financial institution known as a surety. These bonds provide a guarantee to the customer that the Company will perform under the terms of a contract and that the Company will pay subcontractors and vendors. If the Company fails to perform under a contract or to pay subcontractors and vendors, the customer may demand that the surety make payments or provide services under the bond. The Company must reimburse the surety for any expenses or outlays it incurs. To date, the Company has not had any significant reimbursements to its surety for bond-related costs. The Company believes that it is unlikely that it will have to fund claims under its surety arrangements in the foreseeable future. Amounts Outstanding, Capacity and Maturities -- The following recaps the Company's debt amounts outstanding and capacity (in thousands):
UNUSED CAPACITY AS OF AS OF AS OF SEPTEMBER 30, 2002 NOVEMBER 1, 2002 NOVEMBER 1, 2002 ------------------ ---------------- ---------------- Revolving loan........................ $ -- $ 3,700 $18,546 Term loan............................. -- 15,000 n/a Notes to affiliates................... 15,818 4,746 n/a Other debt............................ 539 533 n/a ------- ------- ------- Total debt.......................... 16,357 23,979 18,546 Less: discount on Facility.......... -- (2,930) n/a ------- ------- ------- Total debt, net of discount......... $16,357 $21,049 $18,546 Letters of credit..................... $ 7,063 $ 6,757 $13,243
26 The following recaps the future maturities of this debt along with other contractual obligations. Debt maturities in this recap are based on amounts outstanding as of November 1, 2002 while operating lease maturities are based on amounts outstanding as of September 30, 2002 (in thousands).
TWELVE MONTHS ENDED SEPTEMBER 30, ------------------------------------------- 2003 2004 2005 2006 2007 THEREAFTER TOTAL ------- ------ ------ ------ ------ ---------- ------- Revolving loan........ $ -- $ -- $3,700 $ -- $ -- $ -- $ 3,700 Term loan............. 1,500 2,250 3,000 3,750 4,500 -- 15,000 Notes to affiliates... 4,746 -- -- -- -- -- 4,746 Other debt............ 83 114 62 60 57 157 533 ------- ------ ------ ------ ------ ------- ------- Total debt.......... $ 6,329 $2,364 $6,762 $3,810 $4,557 $ 157 $23,979 Less: discount on Facility......... (2,930) ------- Total debt, net of discount......... $21,049 Operating lease obligations......... $10,589 $8,551 $6,171 $4,901 $3,972 $13,867 $48,051
The Company's letter of credit commitments as of September 30, 2002 expire as follows (in thousands):
TWELVE MONTHS ENDED SEPTEMBER 30, ------------------------------------- 2003 2004 2005 2006 2007 THEREAFTER TOTAL ------ ---- ----- ----- ----- ---------- ------ Letters of credit............... $6,539 $524 $ -- $ -- $ -- $ -- $7,063
Outlook -- As noted above, the Company has generated positive free cash flow in most recent periods, and it currently has a relatively low level of debt. The Company does have approximately $16 million in tax payments resulting from the Emcor transaction that are due in March 2003. The Company anticipates that free cash flow from operations and borrowing capacity under the Facility will provide the Company with sufficient liquidity to fund these tax payments and to support its operations for the foreseeable future. The Company currently has $6.8 million in letters of credit outstanding. The Company self insures a significant portion of its workers compensation, auto liability and general liability risks. The Company uses third parties to manage this self insurance and to retain some of these risks. As is customary under such arrangements, these third parties can require letters of credit as security for amounts they fund or risks they might potentially absorb on the Company's behalf. Under its current self-insurance arrangements, the Company expects that it will be required to post approximately $4.8 million in letters of credit before yearend, and approximately $2.4 million per quarter during the first three quarters of 2003. The Company does expect to recover at least $5 million of letters of credit currently outstanding over the next year. However, if the Company does not recover any of the letters of credit currently outstanding, then based on the potential insurance-related letter of credit requirements described above, the Company may have potential letter of credit requirements of approximately $18.9 million over the next year. In addition, the Company may receive other letter of credit requests in the ordinary course of business, and it may have a net increase in the amount of insurance-related letters of credit it must post when it renews its insurance arrangements in the fourth quarter of next year. Accordingly, the Company's letter of credit requirements over the next year may exceed the current letter of credit sublimit of $20 million under the Company's credit facility. If so, the Company may have to seek additional letter of credit capacity or post different forms of security such as bonds or cash in lieu of letters of credit. The Company believes that its relatively low levels of debt in comparison to its EBITDA and free cash flows would enable it to obtain additional letter of credit capacity or to otherwise meet financial security requirements of third parties if necessary, but there can be no absolute assurance that the Company would be successful in doing so. As described above, the Company must comply with a number of financial covenants in connection with the Facility. While the Company currently complies with all of the Facility's covenants, the minimum EBITDA covenant is set at levels that leave only moderate room for variance based on the Company's recent 27 performance. If the Company violates the Facility's minimum EBITDA covenant or any other of the Facility's covenants, it may have to negotiate new borrowing terms under the Facility or obtain new financing. While the Company believes that its relatively low levels of debt in comparison to its EBITDA and free cash flows would enable it to negotiate new borrowing terms under the Facility or to obtain new financing from other sources if necessary, there can be no absolute assurance that the Company would be successful in doing so. SEASONALITY AND CYCLICALITY The HVAC industry is subject to seasonal variations. Specifically, the demand for new installation and replacement is generally lower during the winter months (the first quarter of the year) due to reduced construction activity during inclement weather and less use of air conditioning during the colder months. Demand for HVAC services is generally higher in the second and third calendar quarters due to increased construction activity and increased use of air conditioning during the warmer months. Accordingly, the Company expects its revenues and operating results generally will be lower in the first and fourth calendar quarters. Historically, the construction industry has been highly cyclical. As a result, the Company's volume of business may be adversely affected by declines in new installation projects in various geographic regions of the United States. NEW ACCOUNTING PRONOUNCEMENTS In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 establishes new accounting and reporting requirements for goodwill and other intangible assets. The Company adopted this new standard effective January 1, 2002. See Note 4 of the Consolidated Financial Statements for further discussion. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company adopted SFAS No. 144 effective January 1, 2002. Under SFAS No. 144, the operating results of companies sold or held for sale meeting certain criteria, as well as any gain or loss on the sale of these operations, are presented as discontinued operations in the Company's statements of operations. See Note 3 of the Consolidated Financial Statements for a discussion of the Company's discontinued operations. The operating results for companies which were sold or shut down during 2001 are presented as continuing operations through the date of disposition. The adoption of SFAS No. 144 did affect the presentation of discontinued operations in the consolidated financial statements; however, it did not have a material financial impact on the Company's results of operations, financial position or cash flows. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risk primarily related to potential adverse changes in interest rates. Management is actively involved in monitoring exposure to market risk and continues to develop and utilize appropriate risk management techniques. 28 COMFORT SYSTEMS USA, INC. PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is subject to certain claims and lawsuits arising in the normal course of business and maintains various insurance coverages to minimize financial risk associated with these claims. The Company has estimated and provided accruals for probable losses and legal fees associated with certain of these actions in its consolidated financial statements. In the opinion of management, uninsured losses, if any, resulting from the ultimate resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations. ITEM 2. RECENT SALES OF UNREGISTERED SECURITIES On October 11, 2002 the Company granted a Stock Purchase Warrant (the "Warrant") to General Electric Capital Corporation for 409,051 shares of the Company's stock, at a purchase price per share of $0.01. The Warrant was given as consideration in connection with the Company's long-term debt financing. The Warrant was issued without registration under the Securities Act in reliance on the exemption provided by Section 4(2) of the Securities Act. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.1 Credit Agreement dated as of October 11, 2002 by and among the Company, as Borrower, and the other persons party thereto that are designated as credit parties, and General Electric Capital Corporation, as Agent, L/C Issuer and a Lender, and the other financial institutions party thereto, as Lenders. (Filed Herewith). 10.2 Stock Purchase Warrant and Repurchase Agreement dated October 11, 2002 granted by the Company to General Electric Capital Corporation. (Filed Herewith). 10.3 Registration Rights Agreement dated October 11, 2002 by and among the Company and General Electric Capital Corporation. (Filed Herewith). 10.4 Employment Agreement dated November 4, 2002 by and among Comfort Systems USA (Texas), L.P. and Norman C. Chambers. (Filed Herewith). 10.5 Restricted Stock Award Agreement dated November 1, 2002 from the Company to Norman C. Chambers. (Filed Herewith). 99.1 Certification of William F. Murdy, Chief Executive Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002. (Filed herewith). 99.2 Certification of J. Gordon Beittenmiller, Chief Financial Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002. (Filed herewith).
(b) Reports on Form 8-K None 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COMFORT SYSTEMS USA, INC. /s/ WILLIAM F. MURDY -------------------------------------- William F. Murdy Chairman of the Board and Chief Executive Officer November 4, 2002 /s/ J. GORDON BEITTENMILLER -------------------------------------- J. Gordon Beittenmiller Executive Vice President, Chief Financial Officer and Director November 4, 2002 30 CERTIFICATION I, William F. Murdy, Chairman of the Board and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Comfort Systems USA, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated November 4, 2002 /s/ WILLIAM F. MURDY ------------------------------------------------ William F. Murdy Chairman of the Board and Chief Executive Officer
CERTIFICATION I, J. Gordon Beittenmiller, Executive Vice President and Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Comfort Systems USA, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated November 4, 2002 /s/ J. GORDON BEITTENMILLER ------------------------------------------------ J. Gordon Beittenmiller Executive Vice President and Chief Financial Officer
EXHIBIT INDEX
EXHIBIT DESCRIPTION OF EXHIBIT ------- ---------------------- 10.1 Credit Agreement dated as of October 11, 2002 by and among the Company, as Borrower, and the other persons party thereto that are designated as credit parties, and General Electric Capital Corporation, as Agent, L/C Issuer and a Lender, and the other financial institutions party thereto, as Lenders. (Filed Herewith). 10.2 Stock Purchase Warrant and Repurchase Agreement dated October 11, 2002 granted by the Company to General Electric Capital Corporation. (Filed Herewith). 10.3 Registration Rights Agreement dated October 11, 2002 by and among the Company and General Electric Capital Corporation. (Filed Herewith). 10.4 Employment Agreement dated to be effective as of November 4, 2002 by and among Comfort Systems USA (Texas), L.P. and Norman C. Chambers. (Filed Herewith). 10.5 Restricted Stock Award Agreement dated November 1, 2002 from the Company to Norman C. Chambers. (Filed Herewith). 99.1 Certification of William F. Murdy, Chief Executive Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002. (Filed herewith). 99.2 Certification of J. Gordon Beittenmiller, Chief Financial Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002. (Filed herewith).