Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Company Overview

Watsco, Inc. and its subsidiaries (collectively, “Watsco”, which may be referred to as we , us or our ) is the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies (“HVAC”) in the United States. Watsco has two business segments – the HVAC distribution (“Distribution”) segment, which accounted for 98% of revenues for the quarter ended March 31, 2005, and a temporary staffing and permanent placement services (“Staffing”) segment.

Revenues primarily consist of sales of air conditioning, heating and refrigeration equipment and related parts and supplies. Selling, general and administrative expenses primarily consist of selling expenses, the largest components of which are salaries, commissions and marketing expenses that tend to be variable in nature and correlate to sales growth. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts and facility rent, which are payable under non-cancelable operating leases.

Sales of residential central air conditioners, heating equipment and parts and supplies are seasonal. Furthermore, results of operations can be impacted favorably or 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 markets is fairly even during the year except for dependence on housing completions and related weather and economic conditions.

Critical Accounting Policies

Management’s discussion and analysis of Watsco’s financial condition and results of operations is based upon the condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. 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 condensed consolidated financial statements and the reported amount of revenues 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.

Our significant accounting policies are discussed in Note 1 to the consolidated financial statements included in Form 10-K for the year ended December 31, 2004 and filed on March 16, 2005. 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 critical accounting policies with Watsco’s Audit Committee of the Board of Directors and the Audit Committee has reviewed the disclosures relating to them. We believe that there have been no significant changes during the quarter ended March 31, 2005 to the critical accounting policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2004.

Allowance for Doubtful Accounts

An allowance for doubtful accounts is maintained for estimated losses resulting from the inability of customers to make required payments. 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. Our business is seasonal and our customers’ businesses are also seasonal. Sales are lowest during the first and fourth quarters and past due accounts receivable balances as a percentage of total trade receivables generally increase during these quarters. We review our accounts receivable reserve policy periodically, reflecting current risks, trends and changes in industry conditions.

The allowance for doubtful accounts was $3.0 million and $2.3 million at March 31, 2005 and December 31, 2004, respectively, an increase of $.7 million. This increase is primarily due to the acquisition of East Coast Metal Distributors, Inc. (“East Coast”) and additional reserves associated with a customer’s filing for bankruptcy protection in the first quarter of 2005.

11 of 19

Table of Contents

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

Inventory Valuation

Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies. Inventories are valued at the lower of cost or market on a weighted-average cost basis. As part of the valuation process, excess, slow-moving and damaged inventories are reduced to their estimated net realizable value. The valuation process 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. Inventory reserve policies are periodically reviewed, reflecting current risks, trends and changes in industry conditions. A reserve for estimated inventory shrinkage is also maintained and reflects the results of cycle count programs and physical inventories. When preparing these estimates, management considers historical results, inventory levels and current operating trends.

Inventory reserves of $3.0 million and $2.0 million at March 31, 2005 and December 31, 2004, respectively, have been established. The increase in the inventory reserve is primarily due to the acquisition of East Coast in the first quarter of 2005 and reflects higher amounts of slow-moving inventory on hand at March 31, 2005 than at December 31, 2004. Inventory reserves are affected by a number of factors, including general economic conditions and other factors affecting demand as well as the effectiveness of the inventory management process for controlling inventory shrinkage. In the event the estimates differ from actual results, inventory-related reserves may be adjusted and could materially impact the condensed consolidated results of operations.

Goodwill

The recoverability of goodwill for impairment is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The identification and measurement of goodwill impairment involves the estimation of the fair value of reporting units and 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.

On January 1, 2005, the annual impairment test was performed and it was 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 carrying amount of goodwill at March 31, 2005 was $164.0 million, consisting of $160.5 million attributable to the Distribution segment and $3.5 million attributable to the Staffing segment. 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 impact the condensed consolidated results of operations.

Self-Insurance Reserves

Self-insured reserves are maintained relative to company-wide casualty insurance programs and select subsidiaries’ health benefit programs. The level of exposure from catastrophic events is limited by the purchase of stop-loss and aggregate liability reinsurance coverages. When estimating the self-insurance liabilities and related reserves, management considers a number of factors, which include historical claims experience, demographic factors, severity factors and valuations provided by independent third-party actuaries. Management reviews its assumptions with its independent third-party actuaries to evaluate whether the self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occurs and exceed these estimates, additional reserves may be required. The estimation process 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. At March 31, 2005, approximately $3.7 million of reserves were established related to such insurance programs versus $3.4 million at December 31, 2004, reflecting self-insured health benefits of East Coast.

12 of 19

Table of Contents

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 assets and any related valuation allowance and deferred tax liabilities. A valuation allowance of $.4 million has been recorded at March 31, 2005 and December 31, 2004 due to uncertainties related to the ability to utilize a portion of the deferred tax assets primarily arising from state net operating loss carryforwards. The valuation allowance is based on 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, general economic conditions or competitive pressures that could affect future taxable income. Although management believes that the estimates discussed above are reasonable, the deferred tax asset and any related valuation allowance will need to be adjusted if management’s estimates of future taxable income differ from actual taxable income. An adjustment to the deferred tax asset and any related valuation allowance could materially impact the condensed consolidated results of operations .

The following narratives include the results of operations for East Coast acquired on January 3, 2005. The acquisition was accounted for under the purchase method of accounting and, accordingly, the results of operations have been included in the condensed consolidated results beginning on the date of acquisition. In the following narratives, computations and disclosure information referring to “same-store basis” exclude the effects of locations acquired or locations opened or closed during the prior twelve months unless within the same geographic market. The results of the Staffing segment are not considered to be material to the results of operations in 2005 or 2004. See Segment Information in Note 9 to the condensed consolidated financial statements.

Revenues for the first quarter of 2005 increased $67.2 million, or 24%, compared to the same period in 2004, including a $48.1 million contribution from locations acquired and opened during the quarter ended March 31, 2005. On a same-store basis, revenues increased $19.1 million, or 7%, over the same period in 2004, benefiting from a strong demand for residential and light-commercial HVAC products and the sale of higher efficiency air conditioning systems, which sell at higher unit prices.

Gross profit for the quarter ended March 31, 2005 increased $16.0 million, or 22%, compared to the same period in 2004, primarily as a result of the aforementioned increase in revenues. Gross profit margin decreased 30 basis-points to 25.3% in 2005 versus 25.6% in 2004 which primarily was associated with the acquisition of East Coast during the quarter ended March 31, 2005. On a same-store basis, gross profit increased $5.0 million, or 7%, over the same period in 2004.

Selling, general and administrative expenses as a percent of revenues for the quarter ended March 31, 2005 decreased to 20.7% in 2005 from 21.4% in 2004, primarily as a result of the effective leveraging of operating costs as compared to 2004. Selling, general and administrative expenses for the quarter ended March 31, 2005 increased

13 of 19

Table of Contents

$12.0 million, or 20%, compared to the same period in 2004, reflecting primarily the impact of higher revenues and $8.6 million of operating costs at locations acquired in 2005 and 2004. On a same-store basis, operating expenses were up 6% compared to the same period in 2004.

Net interest expense for the quarter ended March 31, 2005 decreased $.1 million, or 10%, compared to the same period in 2004, primarily due to a lower effective interest rate during the quarter as a result of the refinancing of the revolving credit agreement in December 2004.

The effective tax rate was 38.0% for the quarter ended March 31, 2005 and 37.7% for the quarter ended March 31, 2004. The increase in the effective income tax rate for the first quarter of 2005 compared to the same period in 2004 primarily relates to higher state income tax expense.

Net income for the first quarter ended March 31, 2005 increased $2.5 million, or 38%, compared to the same period in 2004. The increase in net income was primarily driven by the higher revenues and gross margin levels as well as by the lower levels of selling, general and administrative expenses as a percent of revenues discussed above.

Segment Reporting

As previously discussed, we have two business segments, Distribution and Staffing with the Distribution segment representing 98% of revenues for the quarter ended March 31, 2005. The Distribution segment has similar products, customers, marketing strategies and operations. The Distribution segment includes the results of East Coast from January 3, 2005, the acquisition date. During 2004, we changed our methodology for accounting for inter-segment services provided by the Staffing segment to the Distribution segment as if the services were provided to third parties, at market-competitive prices. Prior period information reflects this change. The following table sets forth revenues (in thousands) by business segment for the quarters ended March 31, 2005 and 2004:

Liquidity and Capital Resources

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

Watsco maintains a bank-syndicated, unsecured revolving credit agreement that provides for borrowings of up to $100.0 million, expiring in December 2009. Borrowings are used to fund seasonal working capital needs, for other general corporate purposes, including acquisitions and issuance of letters of credit. Borrowings bear interest at primarily LIBOR-based rates plus a spread that is dependent upon Watsco’s financial performance (LIBOR plus .625% at March 31, 2005 and December 31, 2004). A variable commitment fee is paid on the unused portion of the credit line (.15% at March 31, 2005 and December 31, 2004). At March 31, 2005 and December 31, 2004, $35.0 million and $30.0 million, respectively, were outstanding under the revolving credit agreement.

A $125.0 million unsecured private placement shelf facility is also maintained as a source of borrowings. The uncommitted shelf facility provides long-term, fixed-rate financing as a complement to the variable rate borrowings available under the revolving credit agreement through December 2007. $30.0 million of Senior Series A Notes (“Notes”) were outstanding at March 31, 2005 and December 31, 2004 under the facility bearing interest at 7.07%.

14 of 19

Table of Contents

The Notes will be repaid in equal installments of $10.0 million on April 9, 2005, April 9, 2006 and April 9, 2007. Accordingly, $10.0 million is classified as “current” in the condensed consolidated balance sheet at March 31, 2005. Interest is paid on a quarterly basis. The Notes may be redeemed 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 consolidated leverage, interest and debt coverage ratios and limit capital expenditures, dividends and share repurchases in addition to other restrictions. Under the terms of these debt agreements, Watsco is restricted beginning in 2004 through December 2009, from issuing aggregate dividends in excess of $100.0 million plus 50% of consolidated net income earned in the previous fiscal year with any excess net income not used for dividends during the year to be carried forward to the subsequent year. Management believes Watsco is in compliance with all covenants and financial ratios at March 31, 2005.

At March 31, 2005 and December 31, 2004, one interest rate swap agreement was in effect with a notional value of $30.0 million to manage the net exposure to interest rate changes related to $30.0 million of borrowings under the revolving credit agreement. The interest rate swap agreement, which expires in October 2007, effectively converts the LIBOR-based variable rate borrowings into fixed rate borrowings. Developments in the capital markets are continuously monitored and swap transactions are entered into solely with established counterparties having investment grade ratings. See Note 5 to the condensed consolidated financial statements and Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” of Watsco’s December 31, 2004 Annual Report on Form 10-K for further information.

Working capital decreased to $301.0 million at March 31, 2005 from $310.5 million at December 31, 2004.

Net cash used in operating activities was $30.0 million in 2005 compared to $25.4 million in 2004. The increase was primarily due to the paydown of accounts payable and accrued expenses partially offset by lower inventory purchases in the first quarter of 2005.

Net cash used in investing activities increased to $51.2 million in 2005 from $.7 million in 2004, primarily due to Watsco’s acquisition of East Coast for cash consideration of approximately $49.7 million, net of cash acquired, and the issuance of 145,536 shares of unregistered Common Stock having a fair value of approximately $4.3 million.

Net cash provided by financing activities of $2.8 million in 2005 resulted primarily from net borrowings under the revolving credit agreement, cash received from the exercise of stock options and from purchases under an employee stock purchase plan partially offset by the payment of cash dividends on common stock.

Cash dividends of 14 cents and 8 cents per share of Common Stock and Class B Common Stock were paid during the quarters ended March 31, 2005 and 2004, respectively. In January 2005, Watsco’s Board of Directors approved an increase in the quarterly cash dividend to 14 cents per share from 10 cents per share of Common Stock and Class B Common Stock. Future dividends and/or dividend rate increases will be at the sole discretion of the Board of Directors and will depend upon such factors as profitability, financial condition, cash requirements, restrictions under debt agreements, future prospects and other factors deemed relevant by Watsco’s Board of Directors.

We believe there is adequate availability of capital from operations and current credit facilities to fund working capital requirements and support the development of our short-term and long-term operating strategies. As of March 31, 2005, we had $6.7 million of cash and cash equivalents, $59.8 million of additional borrowing capacity under the revolving credit agreement and $95.0 million available under the private placement shelf facility (subject to certain borrowing limitations) to fund present operations and anticipated growth, including expansion in our current and targeted market areas. Potential acquisitions are continually evaluated and discussions are conducted with a number of acquisition candidates. Should suitable acquisition opportunities or working capital needs arise that would require additional financing, we believe that our financial position and earnings history provide a solid base for obtaining additional financing resources at competitive rates and terms or gives us the ability to raise funds through the issuance of equity securities if required.

15 of 19

Table of Contents