# WATSCO INC (WSO) FY 2023 MD&A Verbatim Item 7 Management's Discussion and Analysis from WATSCO INC's 10-K for fiscal year 2023. SEC filing source: https://www.sec.gov/Archives/edgar/data/105016/000119312524044609/d104765d10k.htm Accession: 0001193125-24-044609 Filing date: 2024-02-23 Report date: 2023-12-31 Extracted from a later financial-section MD&A body after the formal Item 7 span was a short reference. Source document followed from filing index: d104765dex13.htm. Confidence: high Company profile: /company/WSO/ All MD&A years: /company/WSO/mda/ Previous year: /company/WSO/mda/fy2022/ (FY 2022) Next year: /company/WSO/mda/fy2024/ (FY 2024) MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This Annual Report on Form 10-K contains or incorporates by reference statements that are not historical in nature and that are intended to be, and are hereby identified as, “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Statements which are not historical in nature, including the words “anticipate,” “estimate,” “could,” “should,” “may,” “plan,” “seek,” “expect,” “believe,” “intend,” “target,” “will,” “project,” “focused,” “outlook,” “goal,” “designed,” and variations of these words and negatives thereof and similar expressions are intended to identify forward-looking statements, including statements regarding, among others, (i) economic conditions, (ii) business and acquisition strategies, (iii) potential acquisitions and/or joint ventures and investments in unconsolidated entities, (iv) financing plans, and (v) industry, demographic and other trends affecting our financial condition or results of operations. These forward-looking statements are based on management’s current expectations, are not guarantees of future performance and are subject to a number of risks, uncertainties, and changes in circumstances, certain of which are beyond our control. Actual results could differ materially from these forward-looking statements as a result of several factors, including, but not limited to: [[GREPCENT_TABLE]] [["","\u2022","","general economic conditions, both in the United States and in the international markets we serve;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","competitive factors within the HVAC/R industry;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","effects of supplier concentration, including conditions that impact the supply chain;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","fluctuations in certain commodity costs;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","consumer spending;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","consumer debt levels;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","new housing starts and completions;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","capital spending in the commercial construction market;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","access to liquidity needed for operations;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","seasonal nature of product sales;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","weather patterns and conditions;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","insurance coverage risks;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","federal, state, and local regulations impacting our industry and products;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","prevailing interest rates;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","the effect of inflation;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","foreign currency exchange rate fluctuations;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","international risk;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","cybersecurity risk; and"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","the continued viability of our business strategy."]] [[/GREPCENT_TABLE]] We believe these forward-looking statements are reasonable; however, you should not place undue reliance on any forward-looking statements, which are based on current expectations. For additional information regarding important factors that may affect our operations and could cause actual results to vary materially from those anticipated in the forward-looking statements, please see the discussion included in Item 1A “Risk Factors” of this Annual Report on Form 10-K, as well as the other documents and reports that we file with the SEC. Forward-looking statements speak only as of the date the statements were made. We assume no obligation to update forward-looking information or the discussion of such risks and uncertainties to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking information, except as required by applicable law. We qualify any and all of our forward-looking statements by these cautionary factors. This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity for the year ended December 31, 2023. This discussion should be read in conjunction with the information contained in Item 1A, “Risk Factors” and the consolidated financial statements, including the notes thereto, included under Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for the year ended December 31, 2023. 1 Table of Contents Company Overview Watsco, Inc. was incorporated in Florida in 1956, and, together with its subsidiaries (collectively, “Watsco,” the “Company,” or “we,” “us,” or “our”) is the largest distributor of air conditioning, heating, and refrigeration equipment, and related parts and supplies (“HVAC/R”) in the HVAC/R distribution industry in North America. At December 31, 2023, we operated from 690 locations in 42 U.S. States, Canada, Mexico, and Puerto Rico with additional market coverage on an export basis to portions of Latin America and the Caribbean. 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 are variable and correlate to changes in sales. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts, and facility rent, a majority of which we operate under non-cancelable operating leases. Sales of residential central air conditioners, heating equipment, and parts and supplies are seasonal. Furthermore, profitability can be impacted favorably or unfavorably based on weather patterns, particularly during the Summer and Winter selling seasons. Demand related to the residential central air conditioning replacement market is typically highest in the second and third quarters, and demand for heating equipment is usually highest in the first and fourth quarters. Demand related to the new construction sectors throughout most of the markets we serve tends to be fairly evenly distributed throughout the year and depends largely on housing completions and related weather and economic conditions. Climate Change and Reductions in CO 2 e Emissions We believe that our business plays an important and significant role in the drive to lower CO 2 e emissions. According to the United States Department of Energy, heating and air conditioning accounts for roughly half of household energy consumption in the United States. As such, replacing older, less efficient HVAC systems with higher efficiency systems is one of the most meaningful steps homeowners can take to reduce their electricity costs and carbon footprints. The overwhelming majority of new HVAC systems that we sell replace systems that likely operate below current minimum efficiency standards in the United States and may use more harmful refrigerants that have been, or are being, phased-out. As consumers replace HVAC systems with new, higher-efficiency systems, homeowners will consume less energy, save costs, and reduce their carbon footprints. The sale of high-efficiency systems has long been a focus of ours, and we have invested in tools and technology intended to capture an increasingly richer sales mix over time. In addition, regulatory mandates will likely periodically increase the required minimum Seasonal Energy Efficiency Ratio rating, referred to as SEER, thus providing a catalyst for greater sales of higher-efficiency systems. Recently enacted regulations increased the current minimum SEER beginning in 2023 (generally, to 14 SEER from 13 SEER in the Northern U.S. and to 15 SEER from 14 SEER for the Southern U.S.). In addition, the American Innovation and Manufacturing Act of 2020 gave the U.S. Environmental Protection Agency regulatory authority to address hydrofluorocarbon (“HFC”) refrigerants. HFCs were developed to replace certain refrigerants, such as chlorofluorocarbons and hydrochlorofluorocarbons that were harmful to the ozone layer, but are considered potent greenhouse gases as a result of their global warming potential. As a result, regulations are in effect that mandate a 30% phase down of HFC refrigerants currently used in older HVAC systems along with the introduction of new HVAC systems in 2024 that contain more environmentally friendly refrigerants. We offer a broad variety of systems that operate above the minimum SEER standards, ranging from base-level efficiency to systems that exceed 20 SEER. Based on estimates validated by independent sources, we averted an estimated 19.2 million metric tons of CO 2 e emissions from January 1, 2020 to December 31, 2023 through the sale of replacement residential HVAC systems at higher-efficiency standards. Federal Tax Credits and State Incentives Demand for higher-efficiency products, such as variable-speed systems and heat pumps, is expected to increase due to the passage of the U.S. Inflation Reduction Act of 2022 (the “IRA”) in August 2022. This legislation is intended, in part, to promote the replacement of existing systems in favor of high-efficiency heat pump systems that reduce greenhouse gas emissions, as compared to older systems, and thereby combat climate change. Programs under the IRA include enhanced tax credits for homeowners who install qualifying HVAC equipment and tax deductions for owners of commercial buildings that are upgraded to achieve defined energy savings. The IRA also sets aside $4.3 billion for state-administered consumer rebate programs designed to promote energy savings for low and medium-income households, including HVAC systems. Further details, including qualifying products, specific programs, states participating, and other regulatory requirements contemplated by the IRA are still being finalized. 2 Table of Contents Economic and Marketplace Dynamics The global economic recovery from the COVID-19 pandemic has included challenges such as inflationary pressure and supply chain disruptions. Certain of our manufacturers and suppliers experienced some level of supply chain disruptions caused by reduced component availability, labor shortages, transportation delays, and other logistical challenges, resulting in longer lead times and constrained availability of some HVAC/R products. These challenges were exacerbated by the regulatory transition to higher SEER products that became effective on January 1, 2023. Revenues for 2023 reflected temporary production and availability delays by one of our primary OEM partners that persisted through the third quarter of 2023. We estimate that revenues were negatively impacted by approximately 2% for 2023 due to constrained availability of inventory. We believe our OEMs are working to improve their supply chains and product availability in order to help us meet our customers’ needs. We cannot estimate the future impact of supply chain disruptions, but we continue to take proactive steps to limit the impact of these disruptions and are working closely with our suppliers to ensure the availability of products. Also, we continue to actively monitor the situation and may take further actions that alter our business. Joint Ventures with Carrier Global Corporation In 2009, we formed a joint venture with Carrier Global Corporation (“Carrier”), which we refer to as Carrier Enterprise I, in which Carrier contributed company-owned locations in the Sun Belt states and Puerto Rico, and its export division in Miami, Florida, and we contributed certain locations that distributed Carrier products. We have an 80% controlling interest in Carrier Enterprise I, and Carrier has a 20% non-controlling interest. In 2019, Carrier Enterprise I acquired substantially all of the HVAC assets and assumed certain of the liabilities of Peirce-Phelps, Inc., an HVAC distributor operating in Pennsylvania, New Jersey, and Delaware. The export division, Carrier InterAmerica Corporation (“CIAC”), redomesticated from the U.S. Virgin Islands to Delaware in 2019, following which CIAC became a separate operating entity in which we have an 80% controlling interest and Carrier has a 20% non-controlling interest. Carrier Enterprise I has a 38.4% ownership interest in Russell Sigler, Inc. (“RSI”), an HVAC distributor operating from 34 locations in the Western U.S. RSI is Carrier’s second largest independent North American distributor and had sales of approximately $1.2 billion in 2023. In 2011, we formed a second joint venture with Carrier, which we refer to as Carrier Enterprise II, in which Carrier contributed company-owned locations in the Northeast U.S., and we contributed certain locations operating as Homans Associates LLC (“Homans”), a Watsco subsidiary, in the Northeast U.S. Subsequently, Carrier Enterprise II purchased Carrier’s distribution operations in Mexico. We have an 80% controlling interest in Carrier Enterprise II, and Carrier has a 20% non-controlling interest. In 2019, we repurchased the 20% ownership interest in Homans from Carrier Enterprise II and have since solely owned and operated Homans. In 2012, we formed a third joint venture with Carrier, which we refer to as Carrier Enterprise III, to which Carrier contributed company-owned locations in Canada. We have a 60% controlling interest in Carrier Enterprise III, and Carrier has a 40% non-controlling interest. In 2021, we acquired certain assets and assumed certain liabilities comprising the HVAC distribution business of Temperature Equipment Corporation, one of Carrier’s independent distributors with locations in Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri and Wisconsin. We formed a new joint venture with Carrier, TEC Distribution LLC (“TEC”), that owns and operates this business. We have an 80% controlling interest in TEC, and Carrier has a 20% non-controlling interest. Critical Accounting Estimates Management’s discussion and analysis of financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated 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 revenues and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. At least quarterly, management 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. 3 Table of Contents Our significant accounting policies are discussed in Note 1 to our audited consolidated financial statements included in this Annual Report on Form 10-K. Management believes that the following accounting estimates include a higher degree of judgment and/or complexity and are reasonably likely to have a material impact on our financial condition or results of operations and, thus, are considered critical accounting estimates. Management has discussed the development and selection of critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the disclosures relating to critical accounting estimates. Allowance for Doubtful Accounts An allowance for doubtful accounts is maintained for estimated losses resulting from the inability of customers to make the required payments. We typically do not require our customers to provide collateral. Accounting for doubtful accounts contains uncertainty because management must use judgment to assess the collectability of these accounts. When preparing these estimates, management considers several factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends, and other information, including potential impacts of business and economic conditions. Our business and our customers’ businesses are 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 $21.5 million and $18.3 million at December 31, 2023 and 2022, respectively, an increase of $3.2 million, which was primarily due to a decline in the underlying quality of our accounts receivable portfolio at December 31, 2023. Accounts receivable balances greater than 90 days past due as a percent of accounts receivable at December 31, 2023 increased to 2.7% from 2.4% at December 31, 2022. Although we believe the allowance for doubtful accounts is sufficient, a decline in economic conditions could lead to the deterioration in the financial condition of our customers, resulting in an impairment of their ability to make payments and requiring additional allowances that could materially impact our consolidated results of operations. We believe our exposure to customer credit risk is limited due to the large number of customers comprising our customer base and their dispersion across many different geographical regions. Additionally, we mitigate credit risk through credit insurance programs. Inventories Inventory adjustments are established to report inventories at the lower of cost using the weighted-average and the first-in, first-out methods, or net realizable value. As part of the valuation process, inventories are adjusted to reflect excess, slow-moving, and damaged goods. The valuation process contains uncertainty because management must make estimates and use judgment to determine the future salability of inventories. Inventory policies are reviewed periodically, reflecting current risks, trends, and changes in industry conditions. A reserve for estimated inventory shrinkage is 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. Valuation of Goodwill, Indefinite Lived Intangible Assets and Long-Lived Assets The recoverability of goodwill is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount may not be recoverable. We have one reporting unit that is subject to goodwill impairment testing. In performing the goodwill impairment test, we use a two-step approach. The first step compares the reporting unit’s fair value to its carrying value. If the carrying value exceeds the fair value, a second step is performed to measure the amount of impairment loss. The identification and measurement of goodwill impairment involves the estimation of the fair value of our reporting unit and contains uncertainty because management must use judgment in determining appropriate assumptions to be used in the measurement of fair value. On January 1, 2024, we performed our annual evaluation of goodwill impairment and determined that the estimated fair value of our reporting unit exceeded its carrying value. The recoverability of indefinite lived intangibles and long-lived assets are also evaluated on an annual basis or more often if deemed necessary. Indefinite lived intangibles and long-lived assets not subject to amortization are assessed for impairment by comparing the fair value of the intangible asset or long-lived asset to its carrying amount to determine if a write-down to fair value is required. Our annual evaluation did not indicate any impairment of indefinite lived intangibles or long-lived assets. 4 Table of Contents The estimates of fair value of our reporting unit, indefinite lived intangibles, and long-lived assets are based on the best information available as of the date of the assessment and incorporates management’s assumptions about expected future cash flows and contemplates other valuation techniques. Future cash flows can be affected by changes in the industry, a declining economic environment, or market conditions. There have been no events or circumstances from the date of our assessments that would have had an impact on this conclusion. The carrying amounts of goodwill, intangibles, and long-lived assets were $1,337.3 million and $1,189.5 million at December 31, 2023 and 2022, respectively, an increase of $147.8 million, primarily related to our acquisition of Gateway Supply Company, Inc. (“GWS”) in September 2023 and higher renewal lease rates for our warehouse facilities. Although no impairment losses have been recorded to date, there can be no assurance that impairments will not occur in the future. An adjustment to the carrying value of goodwill, intangibles, and long-lived assets could materially adversely impact the consolidated results of operations. Loss Contingencies Accruals are recorded for various contingencies including self-insurance, legal proceedings, environmental matters, and other claims that arise in the normal course of business. The estimation process contains uncertainty because accruals are based on judgment, the probability of losses and, where applicable, the consideration of opinions of external legal counsel and actuarially determined estimates. Additionally, we record receivables from third party insurers when recovery has been determined to be probable. Self-insurance reserves are maintained relative to company-wide casualty insurance and health benefit programs. The level of exposure from catastrophic events is limited by the purchase of stop-loss and aggregate liability reinsurance coverage. When estimating the self-insurance liabilities and related reserves, management considers several 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 self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occur and exceed these estimates, additional reserves may be required and could materially impact the consolidated results of operations. 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. Reserves in the amounts of $9.7 million and $12.3 million at December 31, 2023 and 2022, respectively, were established related to such insurance programs. The decrease in self-insurance reserves was primarily due to a decrease in the frequency of claims reported and the settlement of claims during 2023. 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 $10.5 million and $8.2 million was recorded at December 31, 2023 and 2022, respectively. The increase was primarily attributable to the impact on U.S. deferred tax assets from share-based compensation deduction limitations related to the expansion of IRC Section 162(m). See Note 9 to our audited consolidated financial statements included in this Annual Report on Form 10-K. The valuation allowance is based on several factors including, but not limited to, estimates of future taxable income by jurisdiction in which the deferred tax assets will be recoverable. These estimates can be affected by several factors, including changes to tax laws, or possible tax audits, or general economic conditions, or competitive pressures that could affect future taxable income. Although management believes that the estimates 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 consolidated results of operations. New Accounting Standards There were no new accounting standards made effective during 2023 that have significance, or potential significance, to our consolidated financial statements. Refer to Note 1 to our audited consolidated financial statements included in this Annual Report on Form 10-K for a discussion of recently issued accounting standards not yet adopted. 5 Table of Contents Results of Operations The following table summarizes information derived from our audited consolidated statements of income, expressed as a percentage of revenues, for the years ended December 31, 2023, 2022, and 2021: [[GREPCENT_TABLE]] [["","","2023","","","2022","","","2021"],["Revenues","","","100.0","%","","","100.0","%","","","100.0","%"],["Cost of sales","","","72.6","","","","72.1","","","","73.4"],["Gross profit","","","27.4","","","","27.9","","","","26.6"],["Selling, general and administrative expenses","","","16.8","","","","16.8","","","","16.9"],["Other income","","","0.4","","","","0.3","","","","0.3"],["Operating income","","","10.9","","","","11.4","","","","10.0"],["Interest expense, net","","","0.1","","","","0.0","","","","0.0"],["Income before income taxes","","","10.8","","","","11.4","","","","10.0"],["Income taxes","","","2.1","","","","1.7","","","","2.1"],["Net income","","","8.7","","","","9.7","","","","7.9"],["Less: net income attributable to non-controlling interest","","","1.3","","","","1.4","","","","1.3"],["Net income attributable to Watsco, Inc.","","","7.4","%","","","8.3","%","","","6.7","%"]] [[/GREPCENT_TABLE]] Note: Due to rounding, percentages may not total 100. The following narratives reflect our acquisitions of GWS in September 2023, Capitol District Supply Co., Inc. (“Capitol”) in March 2023, Makdad Industrial Supply Co., Inc. (“MIS”) in August 2021, Acme Refrigeration of Baton Rouge LLC (“ACME”) in May 2021, and Temperature Equipment Corporation in April 2021. In the following narratives, computations and other information referring to “same-store basis” exclude the effects of locations closed, acquired, or locations opened, in each case during the immediately preceding 12 months, unless such locations are within close geographical proximity to existing locations. At December 31, 2023 and 2022, three and eight locations, respectively, that we opened during the immediately preceding 12 months were near existing locations and were therefore included in “same-store basis” information. The table below summarizes the changes in our locations for 2023 and 2022: [[GREPCENT_TABLE]] [["","","Number of Locations"],["December 31, 2021","","","671"],["Opened","","","11"],["Closed","","","(9",")"],["December 31, 2022","","","673"],["Opened","","","6"],["Acquired","","","19"],["Closed","","","(8",")"],["December 31, 2023","","","690"]] [[/GREPCENT_TABLE]] Tax Benefit from Fourth Quarter 2022 Vesting of Restricted Stock Our 2022 results reflect the vesting of 975,622 shares of Class B restricted stock previously granted to our Chief Executive Officer (“CEO”) during the period from 1997 to 2011. The vesting occurred on October 15, 2022 and provided a $49.0 million tax benefit and $3.6 million in incremental selling, general and administrative expenses, primarily related to employment taxes. The net benefit to 2022 diluted earnings per share was $1.21. Due to the infrequent nature of this event, certain key performance metrics in 2022 are presented on an “adjusted basis” to exclude the impact. Please see “Non-GAAP Financial Measures” below. 2023 Compared to 2022 Revenues [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Revenues","","$","7,283.8","","","$","7,274.3","","","$","9.5","","","","0","%"]] [[/GREPCENT_TABLE]] 6 Table of Contents Revenues for 2023 were flat and included $70.8 million attributable to new locations acquired and $8.7 million from other locations opened during the preceding 12 months, offset by $7.5 million from locations closed. [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Same-store sales","","$","7,204.2","","","$","7,266.9","","","$","(62.7",")","","","(1",")%"]] [[/GREPCENT_TABLE]] The following table presents our revenues, by major product lines and the related percentage change from the prior year: [[GREPCENT_TABLE]] [["","","% of Sales","","","% Change"],["","","2023","","","2022","","","2023","","","2022"],["HVAC equipment","","","69","%","","","68","%","","","0","%","","","14","%"],["Other HVAC products","","","27","%","","","28","%","","","(5",")%","","","16","%"],["Commercial refrigeration products","","","4","%","","","4","%","","","5","%","","","24","%"]] [[/GREPCENT_TABLE]] HVAC equipment sales reflect a 4% decrease in residential products, which is composed of unitary compressor-bearing systems, furnaces, and other indoor components, (4% decrease in U.S. markets and a 5% increase in international markets) and a 15% increase in sales of commercial HVAC equipment (13% increase in U.S. markets and a 22% increase in international markets). Domestic sales of unitary compressor-bearing systems declined 4%, reflecting an 11% decrease in units and an 8% increase in average selling price. Gross Profit [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Gross profit","","$","1,992.1","","","$","2,030.3","","","$","(38.2",")","","","(2",")%"],["Gross margin","","","27.4","%","","","27.9","%"]] [[/GREPCENT_TABLE]] Gross profit margin declined 50 basis-points primarily due to the impact of less beneficial pricing actions taken by our HVAC equipment suppliers in 2023 as compared to 2022. Selling, General and Administrative Expenses [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Selling, general and administrative expenses","","$","1,223.5","","","$","1,221.4","","","$","2.1","","","","0","%"],["Selling, general and administrative expenses as a percentage of revenues","","","16.8","%","","","16.8","%"]] [[/GREPCENT_TABLE]] Selling, general and administrative expenses for 2023 were flat. On a same-store basis, selling, general and administrative expenses decreased 1% as compared to 2022 and as a percentage of sales decreased to 16.7% versus 16.8% in 2022, primarily due to a decrease in variable expenses and improved operating efficiencies. Other Income Other income of $26.2 million and $22.7 million for 2023 and 2022, respectively, represented our share of the net income of RSI. Operating Income [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Operating income","","$","794.8","","","$","831.6","","","$","(36.8",")","","","(4",")%"],["Operating margin","","","10.9","%","","","11.4","%"]] [[/GREPCENT_TABLE]] On a same-store basis operating income decreased 5% and operating margin was 11.0% in 2023 as compared to 11.4% in 2022. 7 Table of Contents Interest Expense, Net Interest expense, net for 2023 increased $2.8 million, or 127%, to $4.9 million, primarily as a result of a higher effective interest rate and an increase in average outstanding borrowings, in each case under our revolving credit facility, for the 2023 period as compared to 2022. Income Taxes [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022","","","Change"],["Income taxes","","$","155.8","","","$","125.7","","","$","30.1","","","","24","%"],["Effective income tax rate","","","22.3","%","","","17.2","%"]] [[/GREPCENT_TABLE]] Income taxes represent a composite of the income taxes attributable to our wholly owned operations and income taxes attributable to our joint ventures with Carrier, which are primarily taxed as partnerships for income tax purposes; therefore, Carrier is responsible for its proportionate share of income taxes attributable to its share of earnings from these joint ventures. The majority of the increase in the effective income tax rate was primarily due to the decrease in share-based compensation deduction in 2023 as compared to 2022. In 2022, the share-based compensation deduction was impacted by the vesting of 975,622 shares of Class B restricted stock on October 15, 2022, which provided a $49.0 million tax benefit that lowered our effective income tax rate. In 2023, the share-based compensation deduction was partially offset by the addition of a valuation allowance on the deferred tax asset related to share-based compensation. Lower state income taxes and higher federal and state tax credits partially reduced the 2023 effective tax rate as compared to 2022 adjusted for the impact of the vesting of restricted stock on October 15, 2022. Net Income Attributable to Watsco, Inc. Net income attributable to Watsco in 2023 decreased $64.8 million, or 11%, to $536.3 million. The decrease was primarily driven by lower operating income and an increase in income taxes, partially offset by a decrease in the net income attributable to the non-controlling interest and an increase in other income. Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2022 for a discussion of results of operations for the year ended December 31, 2022 compared to the year ended December 31, 2021. Non-GAAP Financial Measures We disclose operating income, operating margin, and diluted earnings per share on an adjusted, non-GAAP basis to exclude the impact caused by the vesting of restricted stock on October 15, 2022 as described above. We believe that these adjusted, non-GAAP financial measures provide greater comparability regarding our ongoing operating performance. These measures should not be considered an alternative to measurements required by U.S. GAAP. Adjusted, non-GAAP measures are useful to assist our investors in evaluating our ongoing operating performance for the current reporting period and, where provided, over different reporting periods. Adjusted, non-GAAP measures should not be considered in isolation or as a substitute for income statement data prepared in accordance with GAAP and our presentation of adjusted, non-GAAP measures may not be comparable to similarly-titled measures used by other companies. The reconciliation of operating income, a GAAP measure, to operating income on an adjusted basis, a non-GAAP measure is as follows: [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["(in millions)","","2023","","","2022"],["Operating income","","$","794.8","","","$","831.6"],["Primarily employment taxes related to the vesting of restricted stock","","","\u2014","","","","3.6"],["Operating income on an adjusted basis","","$","794.8","","","$","835.2"],["Operating margin","","","10.9","%","","","11.4","%"],["Operating margin on an adjusted basis","","","10.9","%","","","11.5","%"]] [[/GREPCENT_TABLE]] 8 Table of Contents The reconciliation of diluted earnings per share for Common and Class B common stock, a GAAP measure, to diluted earnings per share for Common and Class B common stock on an adjusted basis, a non-GAAP measure is as follows: [[GREPCENT_TABLE]] [["","","Years Ended December 31,"],["","","2023","","","2022"],["Diluted earnings per share for Common and Class B common stock","","$","13.67","","","$","15.41"],["Primarily employment taxes related to the vesting of restricted stock","","","\u2014","","","","0.08"],["Tax related benefit from the vesting of restricted stock","","","\u2014","","","","(1.29",")"],["Diluted earnings per share for Common and Class B common stock on an adjusted basis","","$","13.67","","","$","14.20"]] [[/GREPCENT_TABLE]] Liquidity and Capital Resources We assess our liquidity in terms of our ability to generate cash to execute our business strategy and fund operating and investing activities, taking into consideration the seasonal demand for HVAC/R products, which peaks in the months of May through August. Significant factors that could affect our liquidity include the following: [[GREPCENT_TABLE]] [["","\u2022","","cash needed to fund our business (primarily working capital requirements);"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","borrowing capacity under our revolving credit facility;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","the ability to attract long-term capital with satisfactory terms;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","acquisitions, including joint ventures and investments in unconsolidated entities;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","dividend payments;"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","capital expenditures; and"]] [[/GREPCENT_TABLE]] [[GREPCENT_TABLE]] [["","\u2022","","the timing and extent of common stock repurchases."]] [[/GREPCENT_TABLE]] Sources and Uses of Cash We rely on cash flows from operations and borrowing capacity under our revolving credit agreement to fund seasonal working capital needs and for other general corporate purposes in the short-term and the long-term, including dividend payments (if and as declared by our Board of Directors), capital expenditures, business acquisitions, and development of our long-term operating and technology strategies. Additionally, we may also generate cash through the issuance and sale of our Common stock. As of December 31, 2023, we had $210.1 million of cash and cash equivalents, of which $187.0 million was held by foreign subsidiaries. The repatriation of cash balances from our foreign subsidiaries could have adverse tax impacts or be subject to capital controls; however, these balances are generally available to fund the ordinary business operations of our foreign subsidiaries without legal restrictions. We believe that our operating cash flows, cash on hand, funds available for borrowing under our revolving credit agreement, and funds available from sales of our Common stock under our ATM Program (as defined below), each of which is described below, will be sufficient to meet our liquidity needs for the foreseeable future. However, there can be no assurance that our current sources of available funds will be sufficient to meet our cash requirements. Our access to funds under our revolving credit agreement depends on the ability of the syndicate banks to meet their respective funding commitments. Disruptions in the credit and capital markets could adversely affect our ability to draw on our revolving credit agreement and may also adversely affect the determination of interest rates, particularly rates based on the Secured Overnight Financing Rate (“SOFR”), which is one of the base rates under our revolving credit agreement. SOFR has limited historical data and is a secured lending rate (whereas our revolving credit agreement is unsecured, and had primarily used LIBOR, an unsecured lending rate, as a base rate prior to the discontinuation of LIBOR in 2023), which could give rise to uncertainties and volatility in the benchmark rates. Additionally, disruptions in the credit and capital markets could also result in increased borrowing costs or reduced borrowing capacity under our revolving credit agreement. Working Capital Working capital increased to $1,679.9 million at December 31, 2023, which included 16 locations added by the acquisition of GWS in 2023 that added $38.5 million of working capital. Excluding these acquired locations, working capital increased 18% to $1,641.4 million at December 31, 2023 from $1,392.2 million at December 31, 2022 due to: (i) a reduction of accounts payable due to timing of payments; (ii) higher accounts receivable driven by a decrease in the underlying quality of our accounts receivable portfolio; and (iii) paydown of borrowings (borrowings under our revolving credit agreement were classified as a long-term liability at December 31, 2022). 9 Table of Contents Cash Flows The following table summarizes our cash flow activity for 2023 and 2022 (in millions): [[GREPCENT_TABLE]] [["","","2023","","","2022","","","Change"],["Cash flows provided by operating activities","","$","562.0","","","$","572.0","","","$","(10.0",")"],["Cash flows used in investing activities","","$","(41.3",")","","$","(33.8",")","","$","(7.5",")"],["Cash flows used in financing activities","","$","(460.1",")","","$","(504.0",")","","$","43.9"]] [[/GREPCENT_TABLE]] The individual items contributing to cash flow changes for the years presented are detailed in the audited consolidated statements of cash flows included in this Annual Report on Form 10-K. Operating Activities The decrease in net cash provided by operating activities was primarily due to lower net income in 2023 as compared to 2022 and the impact of changes in working capital discussed above. Investing Activities Net cash used in investing activities was higher primarily due to cash consideration paid for acquisitions and investments in 2023. We acquired no businesses in 2022. Financing Activities The decrease in net cash used in financing activities was attributable to the payment of withholding tax obligations in 2022 primarily upon the vesting of restricted stock previously granted to our CEO and proceeds from the sale and issuance of Common stock used for repayments under our revolving credit agreement in 2023, partially offset by an increase in dividends paid and an increase in distributions to the non-controlling interest in 2023. Revolving Credit Agreement On March 16, 2023, we entered into an unsecured, five-year $600.0 million syndicated multicurrency revolving credit agreement, which replaced in its entirety our prior five-year $560.0 million unsecured revolving credit agreement that was nearing maturity. Proceeds from the new facility were used to repay the $235.5 million outstanding under the prior facility. Additional borrowings under the new facility may be used for, among other things, funding seasonal working capital needs and for other general corporate purposes, including acquisitions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases, and issuances of letters of credit. The revolving credit facility has a seasonal component from October 1 to March 31, during which the borrowing capacity may be reduced to $500.0 million at our discretion (which effectively reduces fees payable in respect of the unused portion of the commitment), and we effected this reduction on October 1, 2023. Included in the revolving credit facility are a $125.0 million swingline loan sublimit, a $10.0 million letter of credit sublimit, a $75.0 million alternative currency borrowing sublimit, and an $10.0 million Mexican borrowing subfacility. The revolving credit agreement matures on March 16, 2028. Borrowings under the revolving credit facility bear interest at either Term SOFR or Daily Simple SOFR-based rates plus 0.10%, plus a spread which ranges from 100.0 to 137.5 basis-points (Term SOFR and Daily Simple SOFR plus 100.0 basis-points at December 31, 2023), depending on our ratio of total debt to EBITDA, or on rates based on the highest of the Federal Funds Effective Rate plus 0.50%, the Prime Rate or Term SOFR plus 1.0%, in each case plus a spread which ranges from 0 to 50.0 basis-points (0 basis-points at December 31, 2023), depending on our ratio of total debt to EBITDA. We pay a variable commitment fee on the unused portion of the commitment under the revolving credit agreement, ranging from 12.5 to 27.5 basis-points (12.5 basis-points at December 31, 2023). We paid fees of $0.8 million in connection with entering into the revolving credit agreement, which are being amortized ratably through the maturity of the facility in March 2028. At December 31, 2023, $15.4 million was outstanding under the revolving credit agreement. The revolving credit agreement contains customary affirmative and negative covenants, including financial covenants with respect to consolidated leverage and interest coverage ratios, and other customary restrictions. We believe we were in compliance with all covenants at December 31, 2023. 10 Table of Contents At-the-Market Offering Program We are party to a sales agreement with Robert W. Baird & Co. Inc., which enables the Company to issue and sell shares of Common stock in one or more negotiated transactions or transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), for a maximum aggregate offering amount of up to $300.0 million (the “ATM Program”). The offer and sale of our Common stock pursuant to the ATM Program has been registered under the Securities Act pursuant to our automatically effective shelf registration statement on Form S-3 (File No. 333-260758). During 2023, we issued and sold 45,000 shares of Common stock under the ATM Program for net proceeds of $15.2 million. Direct costs of $0.4 million incurred in connection with the offering were charged against the proceeds from the sale of Common stock and reflected as a reduction of paid-in capital. At December 31, 2023, $284.7 million remained available for sale under the ATM Program. Contractual Obligations At December 31, 2023, operating lease liabilities for real property, vehicles, and equipment totaled $372.5 million and expire at various dates through 2033. Refer to Note 2 to our audited consolidated financial statements included in this Annual Report on Form 10-K for information on our operating lease liabilities and related maturities. Commercial obligations outstanding at December 31, 2023 under our revolving credit agreement consisted of borrowings totaling $15.4 million. Refer to Note 8 to our audited consolidated financial statements included in this Annual Report on Form 10-K for additional information on our debt. At December 31, 2023, we were obligated under various non-cancelable purchase orders with our key suppliers for goods aggregating approximately $50.0 million, of which approximately $48.0 million is with Carrier and its affiliates. These purchase obligations represent commitments under purchase orders for goods in the ordinary course of business that are enforceable and legally binding with defined terms as to price, quantity, and delivery. The total amount of unrecognized tax benefits (net of the federal benefit received from state positions) relating to various tax positions we have taken, the timing of which is uncertain, was $6.6 million at December 31, 2023. Refer to Note 9 to our audited consolidated financial statements included in this Annual Report on Form 10-K for additional information on our unrecognized tax benefits. Off-Balance Sheet Arrangements Refer to Note 15 to our audited consolidated financial statements included in this Annual Report on Form 10-K, under the caption “Off-Balance Sheet Financial Instruments,” for a discussion of a standby letter of credit and performance bonds for which we were contingently liable at December 31, 2023. Investment in Unconsolidated Entity Carrier Enterprise I, one of our joint ventures with Carrier, in which we have an 80% controlling interest, has a 38.4% ownership interest in RSI, an HVAC distributor operating from 34 locations in the Western U.S. Our proportionate share of the net income of RSI is included in other income in our consolidated statements of income. Effective December 18, 2023, Carrier Enterprise I acquired an additional 0.3% ownership interest in RSI for cash consideration of $2.8 million, of which we contributed $2.3 million, and Carrier contributed $0.5 million. This acquisition increased Carrier Enterprise I’s ownership interest in RSI from 38.1% to 38.4%. Carrier Enterprise I is a party to a shareholders’ agreement (the “Shareholders’ Agreement”) with RSI and its shareholders, consisting of five Sigler second generation family siblings and their affiliates, who collectively own 55.4% of RSI (the “RSI Majority Holders”) and certain next-generation Sigler family members and an employee, who collectively own 6.2% of RSI (the “RSI Minority Holders” and, together with the RSI Majority Holders, the “RSI Shareholders”). Pursuant to the Shareholders’ Agreement, the RSI Shareholders have the right to sell, and Carrier Enterprise I has the obligation to purchase, their respective shares of RSI for a purchase price determined based on the higher of book value or a multiple of EBIT, the latter of which Carrier Enterprise I used to calculate the price for its 38.4% investment held in RSI. The RSI Shareholders may transfer their respective shares of RSI common stock only to members of the Sigler family or to Carrier Enterprise I, and, at any time from and after the date on which Carrier Enterprise I owns 85% or more of RSI’s outstanding common stock, it has the right, but not the obligation, to purchase from the RSI Shareholders the remaining outstanding shares of RSI common stock. At December 31, 2023, using the criteria set forth in the Shareholders’ Agreement, the valuation of the RSI Shareholders’ RSI common stock was approximately $408.0 million. We believe that our operating cash flows, cash on hand, funds available for borrowing under our revolving credit agreement, or use of the ATM Program would be sufficient to purchase any additional ownership interests in RSI for cash pursuant to the agreement described in the following paragraph. 11 Table of Contents On July 28, 2023, Watsco, Carrier Enterprise I, and the RSI Majority Holders entered into an agreement that (1) provides Carrier Enterprise I the discretion, but not the obligation, to fund up to 80% of any purchase from the RSI Majority Holders of their RSI common stock, as required under the Shareholders’ Agreement, using Watsco Common stock (the “Offered Shares”), (2) provides that any Offered Shares actually issued would be valued based on the average volume-weighted average price of Watsco’s Common stock for the ten trading days immediately preceding the payment date for the applicable RSI shares, and (3) limits the amount of RSI shares that may be collectively sold by the RSI Majority Holders to Carrier Enterprise I under the Shareholders’ Agreement to $125.0 million during any rolling 12-month period. We have not issued or sold any Offered Shares, and there is no assurance that we will issue and sell any Offered Shares, nor is the number of Offered Shares that may be issued and sold currently determinable. Acquisitions On February 1, 2024, one of our wholly owned subsidiaries acquired Commercial Specialists, Inc., a distributor of HVAC products with annual sales of approximately $13.0 million, operating from two locations in Cincinnati, Ohio. Consideration for the purchase consisted of $6.0 million in cash, 1,904 shares of Common stock having a fair value of $0.8 million, and $0.6 million for repayment of indebtedness, net of cash acquired of $1.3 million. On September 1, 2023, we acquired substantially all the assets and assumed certain of the liabilities of GWS, a plumbing and HVAC distributor with annual sales of approximately $180.0 million, operating from 16 locations in South Carolina and North Carolina. Consideration for the net purchase price consisted of $4.0 million in cash, net of cash acquired of $3.1 million, and 280,215 shares of Common stock having a fair value of $101.6 million, net of a discount for lack of marketability. On March 3, 2023, one of our wholly owned subsidiaries acquired Capitol, a distributor of plumbing and air conditioning and heating products with annual sales of approximately $13.0 million, operating from three locations in New York. Consideration for the purchase consisted of $1.2 million in cash, net of cash acquired of $0.1 million, and $1.9 million for repayment of indebtedness. On August 20, 2021, one of our wholly owned subsidiaries acquired MIS, a distributor of air conditioning and heating products operating from six locations in Pennsylvania. Consideration for the purchase consisted of $3.2 million in cash and the issuance of 3,627 shares of Common stock having a fair value of $1.0 million, net of cash acquired of $0.2 million. On May 7, 2021, we acquired certain assets and assumed certain liabilities of ACME, a distributor of air conditioning, heating, and refrigeration products, operating from 18 locations in Louisiana and Mississippi, for $22.9 million less certain average revolving indebtedness. Consideration for the purchase consisted of $18.1 million in cash, 8,492 shares of Common stock having a fair value of $2.6 million, and $3.1 million repayment of indebtedness, net of cash acquired of $1.3 million. On April 9, 2021, we acquired certain assets and assumed certain liabilities comprising the HVAC distribution business of Temperature Equipment Corporation, an HVAC distributor operating from 32 locations in Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri, and Wisconsin. We formed a new, stand-alone joint venture with Carrier, TEC, which operates this business. We have an 80% controlling interest in TEC, and Carrier has a 20% non-controlling interest. Consideration for the purchase was paid in cash, consisting of $105.2 million paid to Temperature Equipment Corporation (Carrier contributed $21.0 million and we contributed $84.2 million) and $1.5 million for repayment of indebtedness. We continually evaluate potential acquisitions and/or joint ventures and investments in unconsolidated entities. We routinely hold discussions with several acquisition candidates. Should suitable acquisition opportunities arise that would require additional financing, we believe our financial position and earnings history provide a sufficient basis for us to either obtain additional debt financing at competitive rates and on reasonable terms or raise capital through the issuance of equity securities. Common Stock Dividends We paid cash dividends of $9.80, $8.55, and $7.625 per share of Common stock and Class B common stock in 2023, 2022, and 2021, respectively. On January 2, 2024, our Board of Directors declared a regular quarterly cash dividend of $2.45 per share of both Common and Class B common stock that was paid on January 31, 2024 to shareholders of record as of January 17, 2024. On January 25, 2024, our Board of Directors approved an increase to the annual cash dividend per share of Common and Class B common stock to $10.80 per share from $9.80 per share, effective with the quarterly dividend that will be paid in April 2024. Future dividends and/or changes in dividend rates are at the sole discretion of the Board of Directors and depend upon factors including, but not limited to, cash flow generated by operations, profitability, financial condition, cash requirements, prospects, and other factors deemed relevant by our Board of Directors. 12 Table of Contents Company Share Repurchase Program In September 1999, our Board of Directors authorized the repurchase, at management’s discretion, of up to 7,500,000 shares of common stock in the open market or via private transactions. Shares repurchased under the program are accounted for using the cost method and result in a reduction of shareholders’ equity. We last repurchased shares under this plan in 2008. In aggregate, 6,370,913 shares of Common and Class B common stock have been repurchased at a cost of $114.4 million since the inception of the program. At December 31, 2023, there were 1,129,087 shares remaining authorized for repurchase under the program. The IRA includes, among other provisions, a 1% excise tax on stock repurchases effective January 1, 2023. In considering any further stock repurchases under our repurchase program, we intend to evaluate the impact of the IRA’s 1% excise tax.