WSO

Watsco, Inc. 10-Q Summary: Period Ended June 30, 2005

Business Context and Reporting Period

This Form 10-Q covers the quarterly and six-month periods ended June 30, 2005, 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

Note: Debt consists of $10,081 current portion of long-term obligations, $30,000 revolving credit borrowings, and $10,000 long-term notes.

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 19% ($70.4 million) for the quarter and 21% ($137.6 million) for the six months compared to the prior year. This was driven by a $57.7 million contribution from the acquisition of East Coast Metal Distributors, Inc. (completed Jan 3, 2005) and a 4% same-store revenue increase due to strong demand and price increases.
• Profitability: Net income rose 16% ($3.0 million) for the quarter and 21% ($5.5 million) for the six months. Operating leverage improved, with SG&A expenses as a percentage of revenue decreasing to 16.8% (quarter) and 18.5% (six months) from 17.1% and 18.9% in 2004, respectively.
• Margins: Gross profit margin decreased slightly by 60 basis points for the quarter and 50 basis points for the six months, attributed to the lower-margin profile of the acquired East Coast business and commodity pricing.
• Cash Flow: Net cash used in operating activities improved to $6.5 million (six months) from $13.3 million in the prior year, despite a significant cash outflow of $49.8 million for the East Coast acquisition.

Guidance, Outlook, and Risks

Management Commentary: Management attributes growth to strong demand for residential and light-commercial HVAC products and the sale of higher-efficiency systems. The company maintains a $100 million revolving credit facility (with $62.8 million available) and a $125 million private placement shelf facility to fund operations and acquisitions.

Dividends: A quarterly dividend of $0.14 per share was declared in July 2005. Total dividends paid for the six months ended June 30, 2005, were $0.28 per share.

Risks and Contingencies:

• Seasonality and Weather: Results are heavily dependent on weather patterns during summer and winter selling seasons.
• Acquisition Integration: The recent acquisition of East Coast introduces integration risks and has temporarily impacted gross margins.
• Accounting Changes: The company anticipates adopting SFAS No. 123(R) in 2006, which is estimated to reduce diluted EPS by $0.04 to $0.06.
• Self-Insurance: Reserves for self-insurance programs increased to $3.6 million, reflecting the addition of East Coast.

Investor Verification Checklist

• Acquisition Impact: Verify the long-term margin accretion of the East Coast Metal Distributors acquisition, which currently suppresses gross margins.
• Working Capital Trends: Monitor the significant increase in accounts receivable ($208.8 million) and inventories ($254.5 million) relative to the seasonal peak to ensure collection and obsolescence risks are managed.
• Debt Covenants: Confirm continued compliance with debt covenants regarding leverage and interest coverage ratios, particularly given the $30 million outstanding on the revolving credit line.
• Stock-Based Compensation: Review the impact of the upcoming SFAS No. 123(R) adoption on future earnings per share.
• Share Repurchases: Track the remaining capacity under the share repurchase program (1.9 million shares authorized remaining) and its impact on liquidity.