WSO

Watsco, Inc. 10-Q Summary: Period Ended June 30, 2006

Business Context and Reporting Period

This Form 10-Q covers the quarterly and six-month periods ended June 30, 2006, for Watsco, Inc., the largest distributor of air conditioning, heating, and refrigeration (HVAC) equipment and related parts in the United States. The company operates two segments: Distribution (99% of revenue) and Staffing. The reporting period coincides with the peak seasonal demand for residential central air conditioning.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 16% ($69.0 million) for the quarter and 15% ($117.4 million) for the six months compared to 2005. Same-store revenue growth was 15% for both periods, driven by strong demand for residential HVAC products, price increases, and higher sales of high-efficiency systems.
• Margin Expansion: Gross profit margins improved by 70 basis points for the quarter (25.9% vs. 25.2%) and 50 basis points for the six months (25.7% vs. 25.2%), attributed to higher margins on new high-efficiency equipment and non-equipment products.
• Profitability: Net income rose 28% for the quarter and 32% for the six months. Operating leverage was achieved as Selling, General, and Administrative (SG&A) expenses as a percentage of revenue decreased to 16.7% (quarter) and 18.1% (six months) from 16.8% and 18.5% in the prior year.
• Cash Flow: Net cash used in operating activities was $19.2 million for the six months ended June 30, 2006, compared to $6.5 million in 2005. This increase in cash usage was primarily due to a seasonal buildup of inventory for the summer selling season and the transition to higher-efficiency equipment with longer lead times.

Guidance, Outlook, and Risks

Management Commentary: Management attributes performance to strong demand and successful pricing strategies. The company maintains a $100 million revolving credit facility (with $60 million outstanding) and a $125 million private placement shelf facility to fund working capital and acquisitions. The Board authorized a quarterly dividend of $0.25 per share in July 2006.

Accounting Changes: Effective January 1, 2006, the company adopted SFAS No. 123R (Share-Based Payment). This resulted in a reduction of net income of $302,000 for the quarter and $481,000 for the six months. Additionally, excess tax benefits from share-based compensation ($8.1 million) were reclassified from operating to financing cash flows.

Risks and Contingencies:

• Seasonality and Weather: Results are heavily dependent on weather patterns during summer and winter seasons.
• Supplier Concentration: The company relies on a limited number of suppliers for HVAC equipment.
• Interest Rates: The company uses interest rate swaps to manage exposure to variable rates on its revolving credit agreement.
• Legal: The company is involved in incidental litigation but does not expect material impact on financial condition.

Investor Verification Checklist

• Inventory Levels: Verify the sustainability of the $70.3 million increase in inventory (from $266.5M to $338.2M) and its impact on future cash flow.
• Debt Covenants: Confirm continued compliance with leverage and interest coverage ratios under the revolving credit agreement and private placement facility.
• Share Repurchases: Monitor the remaining 1.5 million shares authorized for repurchase under the 1999 program, noting restrictions tied to debt agreements.
• High-Efficiency Transition: Assess the long-term margin benefits of the shift to high-efficiency air conditioning systems versus potential supply chain constraints.
• Stock-Based Compensation: Review the impact of SFAS 123R on future earnings, noting $39.6 million of unrecognized expense related to non-vested stock.