Company Overview

Watsco, Inc. and its subsidiaries (collectively, the “Company” or “Watsco”) is the largest independent distributor of air conditioning, heating and refrigeration equipment and related parts and supplies (“HVAC”) in the United States. The Company has two business segments – the HVAC distribution (“Distribution”) segment, which accounted for 98% of the Company revenues for the quarter ended March 31, 2004, and a temporary staffing and permanent placement services (“Staffing”) segment.

        Revenue for the Company primarily consists of sales of air conditioning, heating and refrigeration equipment and related parts and supplies and service fee revenue from the Company’s Staffing segment. The Company’s selling, general and administrative expenses primarily consist of selling expenses, the largest components of which are salaries, commissions and marketing expenses which tend to be variable in nature and relate to sales growth. Other significant selling expenses relate to warehouse facilities and trucks, which are under non-cancelable operating leases.

Sales of residential central air conditioners, heating equipment and parts and supplies distributed by the Company have historically been seasonal. Furthermore, the Company’s results of operations can be impacted favorably or

9 of 18

Table of Contents

unfavorably based on the severity or mildness of weather patterns during summer or winter selling seasons. Demand related to the residential central air conditioning replacement market is highest in the second and third quarters with demand for heating equipment usually highest in the fourth quarter. Demand related to the new construction sectors throughout most of the Sunbelt markets is fairly even during the year except for dependence on housing completions and related weather and economic conditions.

In addition, the Company continues to pursue its acquisition strategy which is focused on acquiring businesses that complement the Company’s presence in existing markets or establishing a presence in new markets.

Critical Accounting Policies

Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenue and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. Management frequently reevaluates its judgments and estimates which are based on historical experience, current trends and various other assumptions that are believed to be reasonable under the circumstances.

The Company’s significant accounting policies are discussed in Note 1 to the Company’s consolidated financial statements included in Form 10-K for the year ended December 31, 2003 and filed on March 15, 2004. Management believes that the following accounting policies include a higher degree of judgment and/or complexity and, thus, are considered to be critical accounting policies. Management has discussed the development and selection of the Company’s critical accounting policies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the Company’s disclosures relating to them. The Company believes there have been no significant changes during the quarter ended March 31, 2004 to the critical accounting policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2003.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company’s accounting for doubtful accounts contains uncertainty because management must use judgment to assess the collectibility of these accounts. When preparing these estimates, management considers a number of factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other information. The Company’s business is seasonal, and the Company’s customers’ businesses are also seasonal. Sales are lowest during the first and fourth quarters and the Company’s past due accounts receivable balance as a percentage of total trade receivables generally increases during these quarters. The Company reviews its accounts receivable reserve policy periodically, reflecting current risks, trends and changes in industry conditions.

The allowance for doubtful accounts was $3.1 million and $3.0 million at March 31, 2004 and December 31, 2003, respectively. Compared to March 31, 2003, the allowance for doubtful accounts decreased by approximately $.5 million from $3.6 million. The decrease from March 31, 2003 reflects the improvement in the underlying quality of accounts receivable. In terms of accounts receivable write-offs, recent trends also show improvement as a result of these dynamics. This improved asset quality primarily reflects tighter credit standards and increased collection activity.

Although the Company believes its allowance is sufficient, if the financial condition of the Company’s customers were to unexpectedly deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required that could materially impact the Company’s consolidated financial statements. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of customers comprising the Company’s customer base and their dispersion across many different geographical regions.

10 of 18

Table of Contents

Inventory Valuation

Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies and are valued at the lower of cost or market on a first-in, first-out basis. As part of this valuation process, excess, slow-moving and damaged inventories are reduced to their estimated net realizable value. The Company’s accounting for excess, slow-moving and damaged inventory contains uncertainty because management must use judgment to estimate when the inventory will be sold and the quantities and prices at which the inventory will be sold in the normal course of business. The Company reviews its inventory reserve policy periodically, reflecting current risks, trends and changes in industry conditions. The Company also maintains a provision for estimated inventory shrinkage and conducts cycle counts and physical inventories to calculate actual shrinkage and inventory on hand. When preparing these estimates, management considers historical results, inventory levels and current operating trends. The valuation reserve at March 31, 2004 was approximately $3.4 million, a $.3 million increase over December 31, 2003. The level of reserve estimated is affected by a number of factors including general economic conditions and other factors affecting demand for the Company’s inventory. The increase in the inventory valuation reserve at March 31, 2004 versus December 31, 2003 is primarily associated with the seasonally higher level of inventory. In the event the Company’s estimates differ from actual results, the allowance for excess, slow-moving and damaged inventories may be adjusted and could materially impact the Company’s consolidated financial statements.

Goodwill

Goodwill is no longer amortized and is subject to impairment testing at least annually using a fair value-based approach. The identification and measurement of goodwill impairment involves the estimation of the fair value of reporting units. The Company’s accounting for impairment contains uncertainty because management must use judgment in determining appropriate assumptions to be used in the measurement of fair value. The estimates of fair value of reporting units are based on the best information available as of the date of the assessment and incorporate management assumptions about expected future cash flows and contemplate other valuation techniques. Future cash flows can be affected by changes in industry or market conditions.

The Company evaluates the recoverability of goodwill for impairment at least annually, as required, and when events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. On January 1, 2004, the Company performed the required annual impairment test and determined there was no impairment. No factors have developed since the last impairment test that would indicate that the carrying value of goodwill may not be recoverable. The Company continues to monitor the success of the Staffing segment’s efforts to return to profitability after completing a number of measures to reduce costs in response to a decline in demand for services. The carrying amount of goodwill at March 31, 2004 and December 31, 2003 for the Staffing segment was $4.0 million. Although no goodwill impairment has been recorded to date, there can be no assurances that future goodwill impairments will not occur. An adjustment to the carrying value of goodwill could materially impact the Company’s consolidated financial statements.

Self-Insurance Reserves

The Company maintains self-insured retentions for its health benefits and casualty insurance programs and limits its exposure by maintaining stop-loss and aggregate liability coverages. The estimate of the Company’s self-insurance liability contains uncertainty since management must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. When estimating the Company’s self-insurance liability, management considers a number of factors, which include historical claim experience, demographic factors, severity factors and valuations provided by independent third-party actuaries. At March 31, 2004, the Company had accrued approximately $2.2 million related to its health benefit and casualty insurance programs versus $1.4 million at December 31, 2003. The increase in insurance reserves is due to increased claims activity. Management reviews its assumptions with its independent third-party actuaries to evaluate whether the self-insurance liability is adequate. If actual claims exceed these estimates, additional reserves may be required.

Income Taxes

Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are recovered or settled. The use of estimates by management is required to determine income tax expense, deferred tax

11 of 18

Table of Contents

assets and any related valuation allowance and deferred tax liabilities. The Company has recorded a valuation allowance of $.3 million at March 31, 2004 and December 31, 2003, due to uncertainties related to the ability to utilize a portion of the deferred tax assets. The valuation allowance is based on the Company’s estimates of future taxable income by jurisdiction in which the deferred tax assets will be recoverable. These estimates can be affected by a number of factors, including possible tax audits or general economic conditions or competitive pressures that could affect the Company’s future taxable income. Although management believes that the estimates discussed above are reasonable and the related calculations conform to accounting principles generally accepted in the United States, if management’s estimates of future taxable income differ from actual taxable income, the deferred tax asset and any related valuation allowance will need to be adjusted. An adjustment to the deferred tax asset and any related valuation allowance could materially impact the Company’s consolidated financial statements.

The following table sets forth revenue (in thousands) by business segment for the quarters ended March 31, 2004 and 2003:

The following narratives include the results of operations acquired during 2003. The acquisitions were accounted for under the purchase method of accounting and, accordingly, their results of operations have been included in the Company’s consolidated results beginning on their respective dates of acquisition. Data presented in the following narratives referring to “same-store basis” exclude the effects of locations acquired or locations opened and closed during the prior twelve months.

Revenue for the quarter ended March 31, 2004 increased $21.3 million, or 8%, compared to the same period in 2003. As illustrated in the table above, the Distribution segment accounts for 98% of 2004 revenue, compared to 97% in 2003.

Distribution segment revenue for the quarter ended March 31, 2004 increased $23.2 million, or 9%, over the same period in 2003 including a $12.7 million contribution from locations acquired in 2003. The increase in revenue also reflects pricing initiatives implemented by the Company, increase in pricing of certain commodity products and sales growth of higher efficiency equipment products, which sell at higher prices. On a same-store

12 of 18

Table of Contents

basis, revenue in the Distribution segment includes a 5% increase in same-store sales of residential and light-commercial HVAC products and a 5% decline in same-store sales to the manufactured housing market. Sales to the manufactured housing market, which represents 4% of the Distribution segment’s revenue for the quarter ended March 31, 2004, continue to be affected by a tightened financing market for dealers and consumers.

Staffing segment revenues for the quarter ended March 31, 2004 decreased $1.9 million, or 28%, compared to the same period in 2003. This decrease is attributable to lower sales demand due to economic conditions affecting labor markets in the United States and the effect of locations closed in the third quarter of 2003 in connection with a variety of profit improvement activities. Such activities included the relocation of the Staffing Segment’s headquarter, a reduction in administrative headcount and the closure of underperforming locations. The implementation of these profit improvement activities led to a $0.4 million improvement in operating results for the Staffing Segment compared to the same period in 2003.

The Company’s gross profit for the first quarter of 2004 increased $7.7 million, or 12%, compared to the same period in 2003, primarily as a result of the aforementioned revenue increase and improved selling margins in the Distribution segment. Gross profit margin for the quarter ended March 31, 2004 increased 80 basis-points to 25.6% in 2004 versus 24.8% in 2003, primarily due to higher markups on certain product offerings as compared to 2003 and the Company’s ability to generate higher gross profit margins on certain commodity products that have experienced an upward move in market price during the quarter.

Selling, general and administrative expenses as a percent of revenue for the quarter ended March 31, 2004 decreased to 21.4% in 2004 from 21.9% in 2003, primarily as a result of effective leveraging of operating costs as compared to 2003. Selling, general and administrative expenses for the quarter ended March 31, 2004 increased $3.4 million, or 6%, compared to the same period in 2003, primarily due to higher employee costs associated with operations acquired in 2003 offset in part by a reduction in bad debt expense of $.5 million. On a same-store basis, operating expenses were up 2% compared to the same period in 2003.

Net interest expense for the quarter ended March 31, 2004 decreased $.4 million, or 24%, compared to the same period in 2003, primarily due to lower outstanding borrowings during the quarter.

The effective tax rate was 37.7% for the quarter ended March 31, 2004 and 37.0% for the quarter ended March 31, 2003. The increase in the Company’s effective income tax rate for the first quarter of 2004 compared to the same period in 2003 is primarily related to the Company’s ability to utilize a higher level of net operating loss carryforwards to reduce its state income taxes in 2003 compared to 2004.

Net income for the first quarter ended March 31, 2004 increased $2.8 million, or 74%, compared to the same period in 2003. The increase in net income was primarily driven by the higher revenue and gross margin levels as well as by the decrease in interest expense discussed above.

Liquidity and Capital Resources

Management assesses the Company’s liquidity in terms of its ability to generate cash to execute its business strategy, fund its operating and investing activities and takes into consideration the seasonal demand of the Company’s products, which peaks in the months of May through August. Significant factors affecting liquidity include the adequacy of available bank lines of credit and the ability to attract long-term capital with satisfactory terms, cash flows generated from operating activities, capital expenditures, acquisitions, the timing and extent of common stock repurchases and dividend policy.

The Company maintains a bank-syndicated, unsecured revolving credit agreement that provides for borrowings of up to $225.0 million, expiring in April 2005. At March 31, 2004, $30.0 million was outstanding under the revolving credit agreement. Borrowings under the agreement are used to fund seasonal working capital needs and for other general corporate purposes, including acquisitions. Borrowings under the revolving credit agreement bear interest at primarily LIBOR-based rates plus a spread that is dependent upon the Company’s financial performance (LIBOR plus 1.0% at March 31, 2004). The Company pays a variable commitment fee on the unused portion of the commitment. While the Company’s bank-syndicated credit agreement is scheduled to mature in April 2005, the Company has the ability and intent to either extend the agreement until April 2006 or refinance the revolving agreement on a long-term basis.

The Company also has a $125.0 million unsecured private placement shelf facility. The uncommitted shelf facility provides the Company with a source of long-term, fixed-rate financing as a complement to the variable rate

13 of 18

Table of Contents

borrowings available under its existing revolving credit agreement through January 2006. The Company has $30.0 million Senior Series A Notes (“Notes”) outstanding under its private placement shelf facility, bearing interest at 7.07%. The Notes have an average life of 5 years with repayment in equal installments of $10.0 million beginning on April 9, 2005 until the final maturity on April 9, 2007. Interest is paid on a quarterly basis. The Notes allow for redemption prior to maturity subject to a redemption premium and other restrictions.

Both the revolving credit agreement and the private placement shelf facility contain customary affirmative and negative covenants including certain financial covenants with respect to the Company’s consolidated net worth, interest and debt coverage ratios and limits capital expenditures, dividends and share repurchases in addition to other restrictions. The Company is in compliance with all covenants and financial ratios at March 31, 2004.

At March 31, 2004, the Company had one interest rate swap agreement with a notional value of $30.0 million to manage its net exposure to interest rate changes related to all of the borrowings under the revolving credit agreement. The interest rate swap agreement effectively converts the Company’s LIBOR-based variable rate borrowings into fixed rate borrowings. The Company continuously monitors developments in the capital markets and only enters into swap transactions with established counterparties having investment grade ratings. See Note 5 to the condensed consolidated financial statements for further information.

At March 31, 2004, the Company is contingently liable under standby letters of credit aggregating approximately $7.3 million that are primarily used as collateral to cover possible future assessments pertaining to a self-insurance program maintained by the Company. The Company does not expect any material losses to result from the issuance of the standby letters of credit because claims are not expected to exceed premiums paid. Accordingly, the estimated fair value of these instruments is zero at March 31, 2004.

Working capital increased to $275.4 million at March 31, 2004 from $269.5 million at December 31, 2003, primarily due to the Company’s seasonal buildup of inventory in preparation for the spring and summer selling seasons, higher accounts receivable driven by increased sales volume and a decrease in accounts payable and accrued liabilities. This increase was funded by cash on hand.

Net cash used in operating activities was $25.4 million in 2004 compared to net cash used in operating activities of $1.0 million in 2003, an increase of $24.4 million. This increase is primarily attributable to the aforementioned increase in working capital.

Net cash used in investing activities decreased to $.7 million in 2004 from $1.9 million in 2003, primarily as a result of the purchase of the 25% minority interest in a consolidated subsidiary for $1.3 million in 2003.

Net cash provided by financing activities was $.2 million in 2004 compared to net cash used in financing activities of $3.8 million in 2003, reflecting higher proceeds from the issuance of common stock in connection with stock option exercises for the quarter ended March 31, 2004, offset by an increase in the dividend rate to 8 cents from 4 cents. In addition, during the first quarter of 2004, the Company did not repurchase any of its common stock compared to $3.0 million of purchases during the first quarter of 2003. The Company’s Board of Directors has authorized the repurchase, at management’s discretion, of 7.5 million shares to be repurchased in the open market or via private transactions. Through March 31, 2004, the Company has repurchased 5.4 million shares of Common Stock and Class B Common Stock at a cost of $66.3 million. The remaining 2.1 million shares authorized for repurchase are subject to certain restrictions included in the Company’s credit agreements.

Cash dividends on Common Stock and Class B Common Stock of 8 cents and 4 cents per share were paid during the quarters ended March 31, 2004 and 2003, respectively. In February 2004, the Company’s Board of Directors declared and increased the quarterly cash dividend to 10 cents per share on Common Stock and Class B Common Stock beginning with the April 2004 payment. The dividend totaled $2.7 million and is included in accrued liabilities at March 31, 2004 in the accompanying condensed consolidated balance sheet. Future dividends will be at the sole discretion of the Board of Directors and will depend upon such factors as the Company’s profitability, financial condition, cash requirements, restrictions existing on the Company’s credit agreements, future prospects and other factors deemed relevant by the Company’s Board of Directors.

As of March 31, 2004, the Company had $10.4 million of cash and cash equivalents and $195.0 million of unused borrowing capacity under its existing revolving credit agreement and $95.0 million available under the Company’s

14 of 18

Table of Contents

private placement shelf facility (subject to certain borrowing limitations) to fund present operations and anticipated growth, including expansion in its current and targeted market areas. The Company continually evaluates potential acquisitions and has ongoing discussions with a number of acquisition candidates. Should suitable acquisition opportunities or working capital needs arise that would require additional financing, the Company believes that its financial position and earnings history provide a solid base for obtaining additional financing resources at competitive rates and terms.

The Company believes it has adequate availability of capital from operations and current credit facilities to fund its working capital requirements and support the development of its short-term and long-term operating strategies. Additionally, the Company has the ability to raise funds through the issuance of common or preferred stock if required.