Watsco
Annual Report 2015

Plain-text annual report

2665 South Bayshore Drive, Suite 901 Miami, FL 33133 USA 305-714-4100 www.watsco.com R E V O L U T I O N 2015 L A U N N A T R O P E R O C S T A W FINANCIAL HIGHLIGHTS (in thousands, except per share data) 2011 2012 2013 2014 2015 Revenues Operating income EBITDA(1) $ 2,977,759 $ 3,431,712 $ 3,743,330 $ 3,944,540 $ 4,113,239 199,050 210,775 2.74 2.74 2.23 224,908 240,819 103,334 2.70 3.03 7.48 271,209 288,915 127,723 3.68 3.68 1.15 305,747 323,674 151,387 4.32 4.32 2.00 336,748 355,865 172,929 4.90 4.90 2.80 61,452 173,343 150,269 144,980 221,383 1,268,148 1,682,055 1,669,531 1,791,067 1,788,442 — 316,196 230,557 303,885 245,814 1,001,710 1,022,040 1,127,392 1,132,039 1,203,721 Net Income attributable to Watsco, Inc. 90,450 Diluted earnings per share Adjusted diluted earnings per share(2) Dividends per share Operating cash flow Total assets Long-term obligations Shareholders’ equity (1) EBITDA is defined as earnings before interest expense, net, income taxes, depreciation and amortization. Amortization of debt acquisition costs is included in interest expense, net. (2) In October 2012, the Company paid a special dividend of $5.00 per share. The calculation of adjusted diluted earnings per share excludes the impact of the special dividend. TOTAL REVENUES (in millions) 2011 2012 2013 2014 2015 $2,978 $3,432 $3,743 $3,945 $4,113 OPERATING INCOME (in millions) 2011 2012 2013 2014 2015 $199 $225 $271 $306 $337 ADJUSTED DILUTED EARNINGS (per share) 2011 2012 2013 2014 2015 $2.74 $3.03 $3.68 $4.32 $4.90 WATSCO, INC. 2015 ANNUAL REPORT 1 DEAR SHAREHOLDERS We are pleased that 2015 was another outstanding year as records were set for sales, operating profit, operating margins, earnings per share and cash flow as you will see in our accompanying financial statements. We started in the HVAC/R distribution business about 25 years ago and have scaled our company to be the largest in the industry. Today, we are in a very exciting time in our history as the pace and impact of our technological evolution ramp up. We listened to our customers, worked with supplier partners, invested in best of breed technologies and have developed and launched a number of innovations, some of which are highlighted in the following pages of this year’s annual report. Watsco’s strategy and unique culture continue to thrive. The strategic principles that have driven our performance are: Operate as local businesses by empowering leaders in the field and enabling great service through a dense network of locations. Compete by forging long-term supplier partnerships and by motivating and retaining our leadership teams for the duration of their careers. Concentrate our focus and efforts on HVAC/R products to build the largest depository of industry knowledge and to adapt and respond in ways that cannot be matched by our competition. Remain conservative and risk averse with our finances to provide the flexibility to invest in any opportunity at a low cost of capital. Instill an entrepreneurial spirit and culture of innovation to continually improve our performance and revolutionize our customers’ businesses. WATSCO, INC. 2015 ANNUAL REPORT 3 As a result of our initiatives, strategy and culture, Watsco generated excellent long- term returns for our shareholders as shown below. WATSCO TOTAL SHAREHOLDER RETURN COMPARED TO VARIOUS INDICES Watsco’s 25-year compounded annual growth rate of 19.6% measured as stock appreciation plus dividends is impressive, especially when compared to the perform- ance of other public companies summarized below. Number of U.S. public companies with a market capitalization of greater than $2 billion at December 31, 2015 1,296 Number of these companies that exceed 10% CAGR for 25-year total shareholder return 343 Number of these companies that exceed 18% CAGR for 25-year total shareholder return 64 Watsco’s rank for total shareholder return out of the 1,296 companies studied #40 (Source: FactSet Systems, Inc.) At the core of our success are entrepreneurial leaders and team members who have the competency to drive the long-term growth that has become typical for Watsco. We work hard to attract, motivate and retain high-caliber talent and have developed a unique ownership culture. We plan to strengthen our industry leadership position and continue to build market share with our long-term supplier partners. The market for HVAC/R products, on an installed-basis, is an estimated $80 billion in North America and we look forward to exciting years ahead. It must be noted that we could not have achieved our success without the efforts of the great Watsco employees. Your passion, dedication, and innovative spirit have catapulted us to the top of our industry. We thank you for your many contributions. Albert H. Nahmad Chairman & Chief Executive Officer % 4 8 1 . % 5 . 2 % 6 . 3 % 6 . 4 % 7 7 1 . % 9 . 2 % 8 . 3 % 5 . 4 % 9 0 1 . % 1 . 2 % 0 . 3 % 7 . 2 % 6 9 1 . % 6 . 3 % 0 . 0 % 6 . 3 3 YEAR TSR 5 YEAR TSR 10 YEAR TSR 25 YEAR TSR Russell 2000 S&P MidCap400 S&P 500 Watsco 4 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 5 FROM THE PRESIDENT evolution in the HVAC/R industry began in 1989 when Watsco entered distribution. We have since built the largest distribution business in the industry. We remain hyper ambitious. Call it evolution or call it revolution. Either way, there is no resting on our laurels at Watsco. We are transforming our business into a modern, data-based power- house poised to outperform in the digital era. Our core principals remain sound – expand our network, compete in partnership with great brands and manufacturers, cultivate entrepreneurs that run and lead our local businesses, and maintain a conservative financial position that provides flexibility to invest in almost any-sized opportunity at a low cost of capital. To that, we are adding focus and investment in step-change enhancements of our customer experience, the efficiency of our operations, and platforms to create incremental profit streams. This is a transformation story… 6 WATSCO, INC. 2015 ANNUAL REPORT Aaron (A.J.) Nahmad President Less paper, more productive MAKING IT EASIER TO DO BUSINESS WITH WATSCO HVAC contractors have options on where to buy the products they need for their jobs. Our thesis is that being the easiest company for those contractors to work with is a critical determinant of who earns their business. Our goal is for contractors to enjoy the shopping experience with Watsco to such an extent, that they only want to pur- chase from Watsco. To that end, we continue to add features and functionality to our mobile apps and ecommerce platforms to make contractors’ work in the field and placement of orders with our locations simple. Previously… An HVAC contractor hired to diagnose a homeowner’s HVAC problem would have to open up the unit, read and write down the model number of the required part, inform the homeowner that the problem may be either no expense or high cost depending on the warranty status, drive to the nearest distribution branch (assuming it’s during business hours), wait in line on a busy day, confer with one of our counter sales associates or technical specialists, purchase the needed product, drive back to the job site, search through a dozen binders of product literature to find wiring instructions, and then install the part. Now… That same contractor can simply type the model or serial number of the HVAC unit into our mobile application, see every component of that system, tap on the needed part, see availability in every Watsco location, inform the homeowner whether the system is under warranty, issue a warranty claim and get a real-time response, view the wiring diagram or technical spec sheet for that unit, and place an order for the required product on-line (which is open 24 hours a day, every day) with their customer-specific pricing. Powering this is a Product Information Management tool in which over 300,000 SKUs (and growing) have been mastered with rich, detailed information encompass- ing not only the physical attributes of each product, but also high-resolution imagery, product documentation and literature, and “fitment” details such as component details, complimentary products, accessories, etc. 8 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 9 Giving contactors an hour back INCREASING THE CONTRACTOR’S PRODUCTIVITY Our mobile apps and ecommerce make finding the products a contractor needs and getting them ordered easy, but that’s only half of the equation; we also need to fill that order. The faster we fill the order, the faster the contractor is back to work. And of course, time is money, for both our customer and us. Previously… A contractor would walk into one of our locations, potentially wait in line, speak to a counter sales associate, receive a paper “pick ticket” with details about his order, walk around to the back of the store, and hand that piece of paper to a warehouse manger. Then, when it’s that order’s turn to be filled, a Watsco staff member will pick the ordered products off the warehouse racks and ultimately load the contractor’s truck. Now… Before the contractor has even left the job site he’s placed an order using our ecommerce tools. Immediately, our warehouse staff is alerted to that order on the mobile application we’ve built to streamline the order fulfillment process. The warehouse staff will pick the order and get it ready for delivery or stage it for the contractor to pick up. When the contractor arrives, he goes straight to the Fulfillment Fast Lane, his truck is loaded and off he goes. With this capability, orders are picked off the racks faster, and more importantly, the contractors can get back out in the field more quickly so they can do more jobs, which of course means more orders for us to fill. Multiply those efficiency gains over the 7,000,000 orders we fill and there will be an impact. 10 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 11 From green screen to any screen MORE DATA, BETTER DECISIONS From knowledge comes wisdom. In today’s world, knowledge comes in the form of digital data. For a business to know the who, what, when, where and why about their customers, their sales, their supply chain, etc., data must be organized and made available for analysis – at a moment’s notice. Previously… If our business leaders had questions about their business, it was a laborious process to get answers. A request went to the IT department, a SQL query was run against the ERP system, a printed report was provided sometime later that day or later that week. And in many cases, the report was stale upon delivery. Now… Watsco’s 600+ P&L managers can access relevant data about their local business in real-time, on any device, anywhere in the world. With our Business Intelligence and Data Analytics capabilities, our leaders can torture the data to reveal trends, patterns, anomalies, and outliers that provide insight into the business. Managers can then change behavior on the ground, serve customers more effectively and generate greater profits for the company. This data-driven approach provides literally infinite opportunity to influence and enhance our business. 12 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 13 Less expense, better service REALIZING SUPPLY CHAIN EFFICIENCY Our customers count on us to have the right product, in the right location, at the right time and give it to them quickly. At our scale, that means Watsco carrying inventory of more than 300,000 SKU’s from over 1,000 suppliers in nearly 600 locations. In 2015 we carried nearly $900 million of inventory during peak season and spent about $100 million to operate 13 million square feet of warehouse space. By applying ad- vanced math and modern processes to this puzzle, we can be much more efficient. Previously… Our purchasing departments were tasked to make procurement decisions based largely on their experience, veteran intuition, and a daily print of reams of paper. At the same time, our warehouse associates were mostly reliant on manual, paper processes and suboptimal distribution center layouts. These factors resulted in a need to stock more inventory, in larger facilities, in order to meet the daily needs of our customers. Now… The Watsco purchasing processes revolves around world-class software that employs predictive analytics and a configurable user interface that together optimize inventory levels and simplify the decision making process. Also, in our warehouses, we are now employing continuous improvement processes to streamline the receiving and fulfillment processes. Together, these result in lower inventory requirements, smaller warehouse foot- prints, and, most importantly for our customers, more efficient and accurate fulfillment of orders. 14 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 15 FINANCIAL REVIEW Management’s Discussion and Analysis Management’s Report on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Consolidated Financial Statements: Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Balance Sheets Consolidated Statements of Shareholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Selected Quarterly Financial Data Information on Common Stock Shareholder Return Performance 5-Year Summary of Selected Consolidated Financial Data Corporate & Shareholder Information 18 28 29 30 31 32 33 34 36 37 56 57 58 59 60 WATSCO, INC. 2015 ANNUAL REPORT 17 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This Annual Report to Shareholders contains or incorporates by reference statements that are not histori- cal 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” and variations of these words and neg- atives thereof and similar expressions are intended to identify forward-looking statements, including state- ments regarding, among others, (i) economic conditions, (ii) business and acquisition strategies, (iii) potential acquisitions and/or joint ventures, (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: • general economic conditions; • competitive factors within the HVAC/R industry; • effects of supplier concentration; • fluctuations in certain commodity costs; • consumer spending; • consumer debt levels; • new housing starts and completions; • capital spending in the commercial construction market; • access to liquidity needed for operations; • seasonal nature of product sales; • weather conditions; • insurance coverage risks; • federal, state and local regulations impacting our industry and products; • prevailing interest rates; • foreign currency exchange rate fluctuations; • international political risk; • cybersecurity risk; and • the continued viability of our business strategy. 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 infor- mation regarding other 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 our Annual Report on Form 10-K for the year ended December 31, 2015, 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 assump- tions 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. The following information should be read in conjunction with the information contained in Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2015 and the consoli- dated financial statements, including the notes thereto, included in this Annual Report to Shareholders. COMPANY OVERVIEW Watsco, Inc. was incorporated in Florida in 1956, and, together with its subsidiaries (collectively, “Watsco,” 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, 2015, we operated from 566 locations in 37 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 cor- relate 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, which are payable mostly 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 weather patterns, primarily 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 fourth quarter. Demand related to the new construction mar- ket is fairly consistent during the year, subject to weather and economic conditions, including their effect on the number of housing completions. JOINT VENTURES WITH CARRIER CORPORATION In 2009, we formed a joint venture with Carrier Corporation (“Carrier”), which we refer to as Carrier Enterprise I, in which Carrier contributed 95 of its company-owned locations in 13 Sun Belt states and Puerto Rico and its export division in Miami, Florida, and we contributed 15 locations that distributed Carrier products. In July 2012, we exercised our option to acquire an additional 10% ownership interest in Carrier Enterprise I, which increased our ownership interest to 70%; and, on July 1, 2014, we exer- cised our last remaining option to acquire an additional 10% ownership interest in Carrier Enterprise I, which increased our controlling interest in Carrier Enterprise I to 80%. Neither Watsco nor Carrier has any remaining options to purchase additional ownership interests in Carrier Enterprise I or any of our other joint ventures with Carrier, which are described below. In 2011, we formed a second joint venture with Carrier and completed two additional transactions. In April 2011, Carrier contributed 28 of its company-owned locations in eight Northeast U.S. States, and we contributed 14 locations in the Northeast U.S. In July 2011, we purchased Carrier’s distribution oper- ations in Mexico, which included seven locations. Collectively, the Northeast locations and the Mexico operations are referred to as Carrier Enterprise II. We have a 60% controlling interest in Carrier Enterprise II, and Carrier has a 40% non-controlling interest. In 2012, we formed a third joint venture, which we refer to as Carrier Enterprise III, with UTC Canada Corporation, referred to as UTC Canada, an affiliate of Carrier. Carrier contributed 35 of its company- owned locations in Canada to Carrier Enterprise III. We have a 60% controlling interest in Carrier Enterprise III, and UTC Canada has a 40% non-controlling interest. CRITICAL ACCOUNTING POLICIES 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 esti- 18 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 19 mates under different assumptions or conditions. At least quarterly, management reevaluates its judg- ments and estimates, which are based on historical experience, current trends and various other assump- tions that are believed to be reasonable under the circumstances. Our significant accounting policies are discussed in Note 1 to our audited consolidated financial state- ments included with this Annual Report on Form 10-K. Management believes that the following account- ing 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 poli- cies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the disclo- sures relating to them. ALLOWANCE FOR DOUBTFUL ACCOUNTS An allowance for doubtful accounts is maintained for estimated losses resulting from the inability of customers to make 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 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 low- est 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 periodi- cally, reflecting current risks, trends and changes in industry conditions. The allowance for doubtful accounts was $5.3 million and $5.5 million at December 31, 2015 and 2014, respectively, a decrease of $0.2 million. Accounts receivable balances greater than 90 days past due as a percent of accounts receivable at December 31, 2015 decreased to 1.4% compared to 1.6% at December 31, 2014. These decreases were primarily attributable to an improvement in the underlying quality of our accounts receiv- able portfolio at December 31, 2015. 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 additional allowances may be required 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 com- prising our customer base and their dispersion across many different geographical regions. Additionally, we miti- gate credit risk through credit insurance programs. INVENTORY VALUATION RESERVES Inventory valuation reserves are established in order to report inventories at the lower of weighted-average cost or market and the first-in, first-out method. As part of the valuation process, inventories are adjusted to reflect excess, slow-moving and damaged inventories at their estimated net realizable value. The valua- tion process for excess, slow-moving and damaged inventory 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 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. VALUATION OF GOODWILL AND INDEFINITE LIVED INTANGIBLE 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, if any. The identifi- cation 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, 2016, we performed our annual goodwill impairment test and determined that the estimated fair value of our reporting unit significantly exceeded its carrying value. The recoverability of indefinite lived intangibles is also evaluated on an annual basis or more often if deemed necessary. Indefinite lived intangibles not subject to amortization are assessed for impairment by comparing the fair value of the intangible asset to its carrying amount to determine if a write-down to fair value is required. Our annual impairment tests did not result in any impairment of our indefinite lived intangibles. The estimates of fair value of our reporting unit and indefinite lived intangibles 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 and intangibles were $538.8 million and $573.8 million at December 31, 2015 and 2014, respectively. Although no impairment has been recorded to date, there can be no assurances that future impairments will not occur. An adjustment to the carrying value of good- will and intangibles could materially impact the consolidated results of operations. SELF-INSURANCE RESERVES 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 a number of factors, which include historical claims experience, demo- graphic 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 occur 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. Reserves in the amounts of $3.2 million and $4.6 million at December 31, 2015 and 2014, respectively, were established related to such insurance programs. 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. No valuation allowance was recorded at December 31, 2015 or 2014. 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 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 mate- rially impact the consolidated results of operations. NEW ACCOUNTING STANDARDS Refer to Note 1 to our audited consolidated financial statements included in this Annual Report on Form 10-K for a discussion of new accounting standards. 20 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 21 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, 2015, 2014 and 2013. tial and commercial HVAC equipment. Revenues from sales of residential HVAC equipment also benefited from an improved sales mix of higher-efficiency air conditioning and heating systems, which sell at higher unit prices. Revenues Cost of sales Gross profit Selling, general and administrative expenses Operating income Interest expense, net Income before income taxes Income taxes Net income Less: net income attributable to non-controlling interest 2015 2014 2013 100.0% 75.5 100.0% 75.8 24.5 16.3 8.2 0.1 8.1 2.5 5.5 1.3 24.2 16.5 7.8 0.1 7.6 2.3 5.3 1.5 100.0% 76.0 24.0 16.8 7.2 0.1 7.1 2.1 5.0 1.6 Net income attributable to Watsco, Inc. 4.2% 3.8% 3.4% Note: Due to rounding, percentages may not add up to 100. The following narratives reflect our additional 10% ownership interest in Carrier Enterprise I, which became effective on July 1, 2014. We did not acquire any businesses during 2015, 2014 or 2013. 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 immediately preceding 12 months unless they are within close geographical proximity to existing locations. At December 31, 2015 and 2014, 26 and 31 locations, respectively, were excluded from “same-store basis” information. The table below summarizes the changes in our locations for 2015 and 2014: December 31, 2013 Opened Closed December 31, 2014 Opened Closed December 31, 2015 Number of Locations 569 17 (14) 572 10 (16) 566 2015 COMPARED TO 2014 REVENUES Revenues for 2015 increased $168.7 million, or 4%, to $4,113.2 million, including $4.9 million from locations opened during the preceding 12 months, offset by $32.8 million from locations closed. On a same-store basis, revenues increased $196.6 million, or 5%, as compared to 2014, reflecting a 7% increase in sales of HVAC equipment (66% of sales), which included a 6% increase in residential HVAC equipment and an 8% increase in commercial HVAC equipment, a 2% increase in sales of other HVAC products (29% of sales) and a 2% increase in sales of commercial refrigeration products (5% of sales). The increase in same-store revenues was primarily due to strong demand for the replacement of residen- GROSS PROFIT Gross profit for 2015 increased $51.0 million, or 5%, to $1,007.4 million, primarily as a result of increased revenues. Gross profit margin improved 30 basis-points to 24.5% in 2015 from 24.2% in 2014, primarily due to higher realized gross margins for non-HVAC equipment products. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for 2015 increased $20.0 million, or 3%, to $670.6 million, primarily due to increased revenues. Selling, general and administrative expenses as a percentage of rev- enues decreased to 16.3% for 2015 from 16.5% for 2014. The decrease in selling, general, and adminis- trative expenses as a percentage of revenues was primarily due to improved leveraging of fixed operating costs as compared to 2014. Selling, general and administrative expenses included $7.1 million of addi- tional costs for 2015 in excess of 2014 for ongoing technology initiatives. On a same-store basis, selling, general and administrative expenses increased 4% as compared to 2014. OPERATING INCOME Operating income for 2015 increased $31.0 million, or 10%, to $336.7 million. Operating margin improved 40 basis-points to 8.2% in 2015 from 7.8% in 2014. The increase was driven by higher rev- enues, expanded gross profit margin and reduced selling, general and administrative expenses as a per- cent of revenues, as discussed above. INTEREST EXPENSE, NET Interest expense, net, for 2015 increased $0.3 million, or 7%, to $5.5 million, primarily as a result of an increase in average outstanding borrowings, partially offset by a lower effective interest rate in 2015, in each case as compared to 2014. INCOME TAXES Income taxes increased to $104.7 million for 2015, as compared to $91.8 million for 2014 and are a composite of the income taxes attributable to our wholly owned operations and income taxes attributable to the Carrier joint ventures, which are primarily taxed as partnerships for income tax purposes. The effec- tive income tax rate attributable to us was 37.0% in both 2015 and 2014. NET INCOME ATTRIBUTABLE TO WATSCO, INC. Net income attributable to Watsco in 2015 increased $21.5 million, or 14%, to $172.9 million. The increase was primarily driven by higher revenues, expanded profit margins and reduced selling, general and administrative expenses as a percent of revenues, as discussed above, and by a reduction in the net income attributable to the non-controlling interest related to Carrier Enterprise I following our purchase of an additional 10% ownership interest in Carrier Enterprise I in July 2014. 2014 COMPARED TO 2013 REVENUES Revenues for 2014 increased $201.2 million, or 5%, to $3,944.5 million, including $1.9 million from locations opened during the preceding 12 months, partially offset by $5.7 million from closed locations. On a same-store basis, revenues increased $205.0 million, or 5%, as compared to 2013, reflecting a 7% increase in sales of HVAC equipment (64% of sales), which included an 8% increase in residential HVAC equipment and a 3% increase in commercial HVAC equipment, a 2% increase in sales of other HVAC products (31% of sales) and a 7% increase in sales of commercial refrigeration products (5% of sales). The increase in same-store revenues is primarily due to higher demand for the replacement of residential HVAC equipment and higher demand related to the new construction market. Sales of residential HVAC equipment also benefited from an improved sales mix of higher-efficiency air conditioning and heating systems, which sell at higher unit prices. 22 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 23 GROSS PROFIT Gross profit for 2014 increased $57.1 million, or 6%, to $956.4 million, primarily as a result of increased revenues. Gross profit margin improved 20 basis-points to 24.2% in 2014 from 24.0% in 2013, primarily due to higher realized gross margins for residential HVAC equipment. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for 2014 increased $22.6 million, or 4%, to $650.7 million, primarily as a result of increased revenues and additional headcount. Selling, general and administrative expenses as a percentage of revenues decreased to 16.5% for 2014 from 16.8% for 2013. The decrease in selling, general, and administrative expenses as a percentage of revenues was primarily due to improved leveraging of fixed operating costs as compared to 2013. OPERATING INCOME Operating income for 2014 increased $34.5 million, or 13%, to $305.7 million. Operating margin improved 60 basis-points to 7.8% in 2014 from 7.2% in 2013. INTEREST EXPENSE, NET Interest expense, net, for 2014 decreased $0.6 million, or 11%, to $5.2 million, primarily as a result of a lower effective interest rate, partially offset by increased average outstanding borrowings in 2014, in each case as compared to 2013. INCOME TAXES Income taxes increased to $91.8 million for 2014, as compared to $77.7 million for 2013 and are a composite of the income taxes attributable to our wholly owned operations and income taxes attributable to the Carrier joint ventures, which are primarily taxed as partnerships for income tax purposes. The effec- tive income tax rate attributable to us was 37.0% in 2014 and 2013. NET INCOME ATTRIBUTABLE TO WATSCO, INC. Net income attributable to Watsco in 2014 increased $23.7 million, or 19%, to $151.4 million. The increase was primarily driven by higher revenues, expanded profit margins and reduced selling, general and administrative expenses as a percent of revenues, as discussed above, and by a reduction in the net income attributable to the non-controlling interest related to Carrier Enterprise I following our purchase of an additional 10% ownership interest in Carrier Enterprise I in July 2014. 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: • cash needed to fund our business (primarily working capital requirements); • borrowing capacity under our bank line of credit; • the ability to attract long-term capital with satisfactory terms; • acquisitions, including joint ventures; • dividend payments; • capital expenditures; and • the timing and extent of common stock repurchases. 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, including dividend pay- ments, if and as declared by our Board of Directors, capital expenditures, business acquisitions and devel- opment of our long-term operating and technology strategies. As of December 31, 2015, we had $35.2 million of cash and cash equivalents, of which, $32.7 million was held by foreign subsidiaries. The repatriation of cash balances from our foreign subsidiaries could have adverse tax consequences or be subject to capital controls; however, those balances are generally available without legal restrictions to fund ordinary business operations. Refer to Note 7 to our consoli- dated financial statements included in this Annual Report on Form 10-K for a discussion of undistributed earnings of our foreign subsidiaries. We believe that our operating cash flows, cash on hand and funds available for borrowing under our line of credit will be sufficient to meet our liquidity needs in 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 line of credit 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 line of credit and may also adversely affect the determination of interest rates, par- ticularly rates based on LIBOR, which is one of the base rates under our line of credit. Disruptions in the credit and capital markets could also result in increased borrowing costs and/or reduced borrowing capac- ity under our line of credit. WORKING CAPITAL Working capital increased 5% to $911.0 million at December 31, 2015 from $870.3 million at December 31, 2014, primarily reflecting higher levels of accounts receivable commensurate with our increase in overall business volume. CASH FLOWS The following table summarizes our cash flow activity for 2015 and 2014 (in millions): Cash flows provided by operating activities Cash flows used in investing activities Cash flows used in financing activities 2015 2014 Change $ $ $ 221.4 (22.9) (186.3) $ $ $ 145.0 (19.1) (120.2) $ $ $ 76.4 (3.8) (66.1) The individual items contributing to cash flow changes for the years presented are detailed in the audited consolidated statements of cash flows contained in this Annual Report on Form 10-K. OPERATING ACTIVITIES The increase in net cash provided by operating activities was primarily due to lower increases in inventory and accounts receivable and higher net income in 2015 as compared to 2014, partially offset by the tim- ing of payments for accounts payable and other liabilities. INVESTING ACTIVITIES The increase in net cash used in investing activities in 2015 as compared to 2014 was primarily due to higher capital expenditures of $2.2 million in 2015. FINANCING ACTIVITIES The increase in net cash used in financing activities was primarily attributable to net repayments under our revolving credit agreement and an increase in dividends paid in 2015 as compared to 2014, partially offset by the exercise of our second option to acquire an additional 10% ownership interest in Carrier Enterprise I for $87.7 million in 2014 and a decrease in distributions to the non-controlling interest in 2015. REVOLVING CREDIT AGREEMENT We maintain an unsecured, syndicated revolving credit agreement that provides for borrowings of up to $600.0 million. Borrowings are used to fund seasonal working capital needs and for other general corpo- rate purposes, including acquisitions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases and issuances of letters of credit. Included in the facility are a $90.0 mil- lion swingline subfacility, a $50.0 million letter of credit subfacility and a $75.0 million multicurrency bor- rowing sublimit. The credit agreement matures on July 1, 2019. Borrowings under the credit facility bear interest at either LIBOR-based rates plus a spread, which ranges from 87.5 to 250.0 basis-points (LIBOR plus 100.0 basis-points at December 31, 2015), depending on 24 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 25 our ratio of total debt to EBITDA, or on rates based on the higher of the Prime rate or the Federal Funds Rate, in each case plus a spread which ranges from 0 to 150.0 basis-points (0 basis-points at December 31, 2015), 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 35.0 basis- points (15.0 basis-points at December 31, 2015). At December 31, 2015 and 2014, $245.3 million and $303.2 million were outstanding under the revolv- ing credit agreement, respectively. The revolving credit agreement contains customary affirmative and neg- ative 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, 2015. CONTRACTUAL OBLIGATIONS As of December 31, 2015, our significant contractual obligations were as follows (in millions): Payments due by Period Contractual Obligations Operating leases (1) Purchase obligations (2) $ 2016 68.0 18.9 Total $ 86.9 2017 52.4 — 52.4 $ $ 2018 36.0 — 36.0 $ $ 2019 22.1 — 22.1 $ $ 2020 Thereafter Total $ $ 12.6 — 12.6 $ $ 10.4 $ — 201.5 18.9 10.4 $ 220.4 (1) Represents future minimum payments associated with real property, equipment, vehicles and a corporate aircraft under non-cancelable operating leases. We are committed to pay a portion of the actual operating expenses under certain of these lease agreements and these operating expenses are excluded from the table above. (2) Purchase obligations include amounts committed under purchase orders for goods with defined terms as to price, quantity and delivery. Purchase orders made in the ordinary course of business that are cancelable are excluded from the above table. Any amounts for which we are liable under purchase orders for goods received are reflected in Accounts Payable in our audited consolidated balance sheets and are excluded from the above table. Commercial obligations outstanding at December 31, 2015 under our revolving credit agreement con- sisted of borrowings totaling $245.3 million with revolving maturities of seven days. OFF-BALANCE SHEET ARRANGEMENTS Refer to Note 12 to our audited consolidated financial statements, under the caption “Off-Balance Sheet Financial Instruments,” for a discussion of standby letters of credit and performance bonds for which we were contingently liable under at December 31, 2015. Such discussion is incorporated herein by reference. PURCHASE OF OWNERSHIP INTEREST IN JOINT VENTURE On July 1, 2014, we exercised our second option to acquire an additional 10% ownership interest in Carrier Enterprise I for cash consideration of $87.7 million, following which we have an 80% controlling interest in Carrier Enterprise I. Neither we nor Carrier has any remaining options to purchase additional ownership interests in Carrier Enterprise I or any of our other joint ventures with Carrier. ACQUISITIONS We continually evaluate potential acquisitions and/or joint ventures and routinely hold discussions with a number of acquisition candidates. Should suitable acquisition opportunities arise that would require addi- tional 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 $2.80, $2.00 and $1.15 per share of Common stock and Class B common stock in 2015, 2014 and 2013, respectively. On January 4, 2016, our Board of Directors declared a reg- ular quarterly cash dividend of $0.85 per share of Common and Class B common stock that was paid on January 29, 2016 to shareholders of record as of January 15, 2016. Future dividends and/or changes in dividend rates will be at the sole discretion of the Board of Directors and will depend upon such factors as cash flow generated by operations, profitability, financial condition, cash requirements, future prospects and other factors deemed relevant by our Board of Directors. 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 repur- chased under the program are accounted for using the cost method and result in a reduction of share- holders’ equity. No shares were repurchased in 2015, 2014 or 2013. 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, 2015, there were 1,129,087 shares remaining authorized for repurchase under the program. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to market risks, including fluctuations in foreign currency exchange rates and interest rates. To manage certain of these exposures, we use derivative instruments, including forward contracts and swaps. We use derivative instruments as risk management tools and not for trading purposes. FOREIGN CURRENCY EXPOSURE We are exposed to cash flow and earnings fluctuations resulting from currency exchange rate variations. These exposures are transactional and translational in nature. The foreign currency exchange rates to which we are exposed are the Canadian dollar and Mexican peso. Revenues in these markets accounted for 6% and 4%, respectively, of our total revenues for 2015. Our transactional exposure primarily relates to purchases by our Canadian operations in currencies other than their local currency. To mitigate the impact of currency exchange rate movements on these pur- chases, we use foreign currency forward contracts. By entering into these foreign currency forward con- tracts, we lock in exchange rates that would otherwise cause losses should the U.S. dollar strengthen and gains should the U.S. dollar weaken, in each case against the Canadian dollar. The total notional value of our foreign currency forward contracts as of December 31, 2015 was $38.5 million, and such contracts have varying terms expiring through June 2016. We have exposure related to the translation of financial statements of our Canadian operations into U.S. dollars, our functional currency. Currently, we do not hold any derivative contracts that hedge our foreign currency translational exposure. Historically, fluctuations in these exchange rates have not materially impacted our results of operations. Our exposure to currency rate fluctuations could be material in the future if these fluctuations become significant or if our Canadian and Mexican markets grow and represent a larger percentage of our total revenues. See Note 13 to our audited consolidated financial statements included in this Annual Report to Shareholders for further information on our derivatives. INTEREST RATE EXPOSURE Our revolving credit facility exposes us to interest rate risk because borrowings thereunder accrue interest at one or more variable interest rates. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower overall borrowing costs. To achieve these objectives, we have historically entered into interest rate swap agreements with financial institutions that have investment grade credit ratings, thereby minimizing credit risk associated with these instruments. We do not currently hold any such swap agreements or any other derivative contracts that hedge our interest rate exposure, but we may enter into such instruments in the future. We have evaluated our exposure to interest rates based on the amount of variable debt outstanding under our revolving credit agreement at December 31, 2015, and determined that a 100 basis-point change in interest rates would result in an impact to income before taxes of approximately $2.5 million. See Note 6 to our audited consolidated financial statements included in this Annual Report to Shareholders for further information about our debt. 26 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 27 Management’s Report on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Our internal control system was designed to provide reasonable assurance to our management and Board of Directors regarding the relia- bility of financial reporting and the preparation and fair presentation of our published consolidated finan- cial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective may not prevent or detect misstatements and can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inade- quate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Under the supervision and with the participation of our management, including our Chief Executive Officer, Senior Vice President and Chief Financial Officer, we conducted an assessment of the effective- ness of our internal control over financial reporting as of December 31, 2015. The assessment was based on criteria established in the framework Internal Control — Integrated Framework (2013), issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission. Based on this assess- ment under the COSO framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2015. The effectiveness of our internal control over financial reporting as of December 31, 2015 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report that is included herein. The Board of Directors and Shareholders Watsco, Inc.: We have audited Watsco, Inc.’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Watsco, Inc.’s management is responsi- ble for maintaining effective internal control over financial reporting and for its assessment of the effective- ness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a rea- sonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assur- ance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of man- agement and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect mis- statements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Watsco, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Watsco, Inc. and subsidiaries as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, share- holders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2015, and our report dated February 29, 2016 expressed an unqualified opinion on those consolidated financial statements. Miami, Florida February 29, 2016 Certified Public Accountants KPMG LLP 28 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 29 Report of Independent Registered Public Accounting Firm CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) The Board of Directors and Shareholders Watsco, Inc.: We have audited the accompanying consolidated balance sheets of Watsco, Inc. and subsidiaries as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2015. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by man- agement, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Watsco, Inc. and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Watsco, Inc.’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 29, 2016 expressed an unqualified opinion on the effectiveness of the Company’s internal control over finan- cial reporting. Miami, Florida February 29, 2016 Certified Public Accountants KPMG LLP Years Ended December 31, 2015 2014 2013 Revenues Cost of sales Gross profit Selling, general and administrative expenses Operating income Interest expense, net Income before income taxes Income taxes Net income Less: net income attributable to non-controlling interest $ 4,113,239 3,105,882 $ 3,944,540 2,988,138 $ 3,743,330 2,844,077 1,007,357 670,609 336,748 5,547 331,201 104,677 226,524 53,595 956,402 650,655 305,747 5,206 300,541 91,839 208,702 57,315 899,253 628,044 271,209 5,830 265,379 77,660 187,719 59,996 Net income attributable to Watsco, Inc. $ 172,929 $ 151,387 $ 127,723 Earnings per share for Common and Class B common stock: Basic Diluted See accompanying notes to consolidated financial statements. $ $ 4.91 4.90 $ $ 4.33 4.32 $ $ 3.69 3.68 30 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 31 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) Years Ended December 31, Net income Other comprehensive loss, net of tax Foreign currency translation adjustment Unrealized gain on cash flow hedging instruments Reclassification of gain on cash flow hedging instruments into earnings Unrealized (loss) gain on available-for-sale securities Other comprehensive loss Comprehensive income Less: comprehensive income attributable to non-controlling interest 2015 2014 2013 $ 226,524 $ 208,702 $ 187,719 (39,378) 2,713 (1,993) (8) (38,666) 187,858 38,086 (21,117) 280 — 1 (20,836) 187,866 48,752 (16,365) — — 24 (16,341) 171,378 53,027 Comprehensive income attributable to Watsco, Inc. $ 149,772 $ 139,114 $ 118,351 See accompanying notes to consolidated financial statements. December 31, ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories Other current assets Total current assets Property and equipment, net Goodwill Intangible assets, net Other assets LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities: Current portion of other long-term obligations Accounts payable Accrued expenses and other current liabilities Total current liabilities Long-term obligations: Borrowings under revolving credit agreement Other long-term obligations, net of current portion Total long-term obligations Deferred income taxes and other liabilities Commitments and contingencies Watsco, Inc. shareholders’ equity: 2015 2014 $ 35,229 451,079 673,967 20,990 $ 24,447 434,234 677,990 20,664 1,181,265 1,157,335 62,715 378,310 160,481 5,671 53,480 387,311 186,476 6,465 $ 1,788,442 $ 1,791,067 $ 184 145,162 124,955 270,301 245,300 514 245,814 68,606 $ 169 173,360 113,493 287,022 303,199 686 303,885 68,121 Common stock, $0.50 par value, 60,000,000 shares authorized; 36,616,197 and 36,444,289 shares outstanding at December 31, 2015 and 2014, respectively Class B common stock, $0.50 par value, 10,000,000 shares authorized; 5,066,209 and 4,933,245 shares outstanding at December 31, 2015 and 2014, respectively Preferred stock, $0.50 par value, 10,000,000 shares authorized; no shares issued Paid-in capital Accumulated other comprehensive loss, net of tax Retained earnings Treasury stock, at cost, 6,322,650 shares of Common stock and 48,263 shares of Class B common 18,308 18,222 2,533 — 602,522 (46,904) 495,276 2,467 — 580,564 (23,747) 420,879 stock at both December 31, 2015 and 2014 Total Watsco, Inc. shareholders’ equity Non-controlling interest Total shareholders’ equity See accompanying notes to consolidated financial statements. (114,425) (114,425) 957,310 246,411 883,960 248,079 1,203,721 1,132,039 $ 1,788,442 $ 1,791,067 32 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 33 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In thousands, except share and per share data) Balance at December 31, 2012 Net income Other comprehensive loss Issuances of non-vested restricted shares of common stock Forfeitures of non-vested restricted shares of common stock Common stock contribution to 401(k) plan Stock issuances from exercise of stock options and employee stock purchase plan Retirement of common stock Share-based compensation Excess tax benefit from share-based compensation Cash dividends declared and paid on Common and Class B common stock, $1.15 per share Distributions to non-controlling interest Balance at December 31, 2013 Net income Other comprehensive loss Issuances of non-vested restricted shares of common stock Forfeitures of non-vested restricted shares of common stock Common stock contribution to 401(k) plan Stock issuances from exercise of stock options and employee stock purchase plan Retirement of common stock Share-based compensation Excess tax benefit from share-based compensation Cash dividends declared and paid on Common and Class B common stock, $2.00 per share Decrease in non-controlling interest in Carrier Enterprise I Distributions to non-controlling interest Balance at December 31, 2014 Net income Other comprehensive loss Issuances of non-vested restricted shares of common stock Forfeitures of non-vested restricted shares of common stock Common stock contribution to 401(k) plan Stock issuances from exercise of stock options and employee stock purchase plan Retirement of common stock Share-based compensation Excess tax benefit from share-based compensation Cash dividends declared and paid on Common and Class B common stock, $2.80 per share Distributions to non-controlling interest Balance at December 31, 2015 See accompanying notes to consolidated financial statements. Common Stock, Class B Common Stock and Preferred Stock Shares Common Stock, Class B Common Stock and Preferred Stock Amount Accumulated Other Comprehensive Loss Paid-In Capital 34,521,310 $20,446 $592,820 $(2,102) (9,372) 124,043 (10,000) 22,551 87,193 (17,976) 62 (5) 11 44 (9) (62) 5 1,678 3,340 (1,668) 8,760 1,511 34,727,121 20,549 606,384 (11,474) (12,273) 218,725 (5,000) 18,309 73,948 (26,482) 109 (2) 9 37 (13) (109) 2 1,750 4,629 (2,602) 12,006 1,828 (43,324) Retained Earnings $251,475 127,723 Treasury Stock Non-controlling Interest $(114,425) $273,826 59,996 (6,969) (39,836) 339,362 151,387 (114,425) (69,870) (39,857) 286,996 57,315 (8,563) (44,411) (43,258) 248,079 53,595 (15,509) Total $1,022,040 187,719 (16,341) — — 1,689 3,384 (1,677) 8,760 1,511 (39,836) (39,857) 1,127,392 208,702 (20,836) — — 1,759 4,666 (2,615) 12,006 1,828 (69,870) (87,735) (43,258) 1,132,039 226,524 (38,666) — — 1,963 8,632 (4,140) 13,233 2,422 (98,532) (39,754) 35,006,621 20,689 580,564 (23,747) 420,879 172,929 (114,425) (23,157) 200,479 (5,000) 18,343 124,262 (33,212) 100 (2) 9 62 (17) (100) 2 1,954 8,570 (4,123) 13,233 2,422 35,311,493 $20,841 $602,522 $(46,904) $495,276 $(114,425) $246,411 $1,203,721 (98,532) (39,754) 34 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 35 CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years Ended December 31, 2015 2014 2013 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share data) $ 226,524 $ 208,702 $ 187,719 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Share-based compensation Deferred income tax provision Provision for doubtful accounts Non-cash contribution to 401(k) plan Gain on sale of property and equipment Excess tax benefits from share-based compensation Changes in operating assets and liabilities: Accounts receivable Inventories Accounts payable and other liabilities Other, net Net cash provided by operating activities Cash flows from investing activities: Capital expenditures Proceeds from sale of property and equipment Net cash used in investing activities Cash flows from financing activities: Dividends on Common and Class B common stock Net (repayments) proceeds under revolving credit agreement Distributions to non-controlling interest Net (repayments) proceeds from other long-term obligations Purchase of additional ownership from non-controlling interest Payment of fees related to revolving credit agreement Excess tax benefits from share-based compensation Net proceeds from issuances of common stock 19,117 12,596 4,687 2,688 1,963 (487) (2,422) (26,121) (3,652) (13,225) (285) 17,927 11,473 289 2,609 1,759 (1,292) (1,828) (41,068) (98,741) 45,242 (92) 17,706 9,967 8,589 961 1,689 (156) (1,511) (25,846) (40,575) (7,256) (1,018) 221,383 144,980 150,269 (23,698) 760 (22,938) (98,532) (56,256) (39,754) (157) — — 2,422 5,957 (21,512) 2,388 (19,124) (69,870) 74,729 (43,258) 235 (87,735) (381) 1,828 4,245 (14,580) 323 (14,257) (39,836) (83,559) (69,494) 602 — (458) 1,511 2,185 Net cash used in financing activities (186,320) (120,207) (189,049) Effect of foreign exchange rate changes on cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year (1,343) 10,782 24,447 (680) 4,969 19,478 (1,255) (54,292) 73,770 Cash and cash equivalents at end of year $ 35,229 $ 24,447 $ 19,478 Supplemental cash flow information (Note 18) See accompanying notes to consolidated financial statements. ORGANIZATION, CONSOLIDATION AND PRESENTATION Watsco, Inc. (collectively with its subsidiaries, “Watsco,” “we,” “us” or “our”) was incorporated in Florida in 1956 and 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, 2015, we operated from 566 locations in 37 U.S. states, Canada, Mexico and Puerto Rico with addi- tional market coverage on an export basis to portions of Latin America and the Caribbean. The consolidated financial statements include the accounts of Watsco, all of its wholly owned subsidiaries and the accounts of three joint ventures with Carrier Corporation (“Carrier”), in each of which Watsco maintains a controlling interest. All significant intercompany balances and transactions have been elimi- nated in consolidation. FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS The functional currency of our operations in Canada is the Canadian dollar. Foreign currency denominated assets and liabilities are translated into U.S. dollars at the exchange rates in effect at the balance sheet date, and income and expense items are translated at the average exchange rates in effect during the applicable period. The aggregate effect of foreign currency translation is recorded in accumulated other comprehensive loss in our consolidated balance sheets. Our net investment in our Canadian operations is recorded at the historical rate and the resulting foreign currency translation adjustments are included in accumulated other comprehensive loss in our consolidated balance sheets. Gains or losses resulting from transactions denominated in U.S. dollars are recognized in earnings primarily within cost of sales in our consolidated statements of income. Our operations in Mexico consider their functional currency to be the U.S. dollar because the majority of their transactions are denominated in U.S. dollars. Gains or losses resulting from transactions denomi- nated in Mexican pesos are recognized in earnings primarily within selling, general and administrative expenses in our consolidated statements of income. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclo- sure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Significant estimates include valua- tion reserves for accounts receivable, inventories and income taxes, reserves related to self-insurance pro- grams and the valuation of goodwill and indefinite lived intangible assets. While we believe that these estimates are reasonable, actual results could differ from such estimates. CASH EQUIVALENTS All highly liquid instruments purchased with original maturities of three months or less are considered to be cash equivalents. ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS Accounts receivable primarily consist of trade receivables due from customers and are stated at the invoiced amount less an allowance for doubtful accounts. An allowance for doubtful accounts is main- tained for estimated losses resulting from the inability of customers to make required payments. When preparing these estimates, we consider a number of factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other infor- mation. Upon determination that an account is uncollectible, the receivable balance is written off. At December 31, 2015 and 2014, the allowance for doubtful accounts totaled $5,305 and $5,461, respectively. 36 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 37 INVENTORIES Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies and are valued at the lower of cost or market using a weighted-average cost basis and the first-in, first-out methods. As part of the valuation process, inventories are adjusted to reflect excess, slow-moving and damaged inventories at their estimated net realizable value. Inventory policies are reviewed periodically, reflecting current risks, trends and changes in industry conditions. A reserve for estimated inventory shrinkage is also maintained to consider inventory shortages determined from cycle counts and physical inventories. VENDOR REBATES We have arrangements with several vendors that provide rebates payable to us when we achieve any of a number of measures, generally related to the volume level of purchases. We account for such rebates as a reduction of inventory until we sell the product, at which time such rebates are reflected as a reduction of cost of sales in our consolidated statements of income. Throughout the year, we estimate the amount of the rebate based on our estimate of purchases to date relative to the purchase levels that mark our progress toward earning the rebates. We continually revise our estimates of earned vendor rebates based on actual purchase levels. At December 31, 2015 and 2014, we had $8,086 and $10,088, respec- tively, of rebates recorded as a reduction of inventory. Substantially all vendor rebate receivables are col- lected within three months immediately following the end of the year. MARKETABLE SECURITIES Investments in marketable equity securities are classified as available-for-sale and are included in other assets in our consolidated balance sheets. These equity securities are recorded at fair value using the spe- cific identification method with unrealized holding losses, net of deferred taxes, included in accumulated other comprehensive loss within shareholders’ equity. Dividend and interest income are recognized in the statements of income when earned. PROPERTY AND EQUIPMENT Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization of property and equipment is computed using the straight-line method. Buildings and improvements are depreciated or amortized over estimated useful lives ranging from 3-40 years. Leasehold improvements are amortized over the shorter of the respective lease terms or estimated useful lives. Furniture and fixtures are depreciated over estimated useful lives ranging from 5-7 years. Estimated useful lives for other depreciable assets range from 3-10 years. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill is recorded when the purchase price paid for an acquisition exceeds the fair value of the net identified tangible and intangible assets acquired. We evaluate goodwill for impairment annually or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. We test goodwill for impairment by first comparing the fair value of our reporting unit to its carrying value. If the fair value is determined to be less than the carrying value, a second step is per- formed to measure the amount of impairment loss. Other intangible assets primarily consist of the value of trade names and trademarks, distributor agree- ments, customer relationships and non-compete agreements. Indefinite lived intangibles not subject to amortization are assessed for impairment at least annually, or more frequently if events or changes in cir- cumstances indicate they may be impaired, by comparing the fair value of the intangible asset to its car- rying amount to determine if a write-down to fair value is required. Finite lived intangible assets are amortized using the straight-line method over their respective estimated useful lives. We perform our annual impairment tests each year and have determined there to be no impairment for any of the periods presented. There were no events or circumstances identified from the date of our assessment that would require an update to our annual impairment tests. LONG-LIVED ASSETS Long-lived assets, other than goodwill, are reviewed for impairment whenever events or changes in cir- cumstances indicate that the carrying amount of the assets may not be recoverable. Recoverability is evaluated by determining whether the amortization of the balance over its remaining life can be recovered through undiscounted future operating cash flows. We measure the impairment loss based on projected discounted cash flows using a discount rate reflecting the average cost of funds and compared to the asset’s carrying value. As of December 31, 2015, there were no such events or circumstances. FAIR VALUE MEASUREMENTS We carry various assets and liabilities at fair value in the consolidated balance sheets. Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. Fair value measurements are classified based on the following fair value hierarchy: Level 1 Level 2 Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient fre- quency and volume to provide pricing information on an ongoing basis. Observable inputs other than Level 1 prices such as quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active; or model-driven valuations or other inputs that are observable or can be corroborated by observable market data for substan- tially the full term of the assets or liabilities. Level 3 Unobservable inputs for the asset or liability. These inputs reflect our own assumptions about the assumptions a market participant would use in pricing the asset or liability. REVENUE RECOGNITION Revenue primarily consists of sales of air conditioning, heating and refrigeration equipment and related parts and supplies and is recorded when shipment of products or delivery of services has occurred. Substantially all customer returns relate to products that are returned under warranty obligations under- written by manufacturers, effectively mitigating our risk of loss for customer returns. Taxes collected from our customers and remitted to governmental authorities are presented in our consolidated statements of income on a net basis. ADVERTISING COSTS Advertising costs are expensed as incurred. Advertising expense for the years ended December 31, 2015, 2014 and 2013, were $21,150, $19,754 and $22,418, respectively. SHIPPING AND HANDLING Shipping and handling costs associated with inbound freight are capitalized to inventories and relieved through cost of sales as inventories are sold. Shipping and handling costs associated with the delivery of products is included in selling, general and administrative expenses. Shipping and handling costs included in selling, general and administrative expenses for the years ended December 31, 2015, 2014 and 2013, were $41,345, $43,324 and $39,395, respectively. SHARE-BASED COMPENSATION The fair value of stock option and non-vested restricted stock awards are expensed on a straight-line basis over the vesting period of the awards. Share-based compensation expense is included in selling, general and administrative expenses in our consolidated statements of income. Cash flows from the tax benefits resulting from tax deductions in excess of the compensation expense recognized for those options (wind- fall tax benefits) are classified as financing cash flows. Tax benefits resulting from tax deductions in excess of share-based compensation expense recognized are credited to paid-in capital in the consoli- dated balance sheets. 38 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 39 INCOME TAXES We record United States federal, state and foreign income taxes currently payable, as well as deferred taxes due to temporary differences between reporting income and expenses for financial statement pur- poses versus tax purposes. Deferred tax assets and liabilities reflect the temporary differences between the financial statement and income tax basis of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates is recog- nized as income or expense in the period that includes the enactment date. We and our eligible sub- sidiaries file a consolidated United States federal income tax return. As income tax returns are generally not filed until well after the closing process for the December 31 financial statements is complete, the amounts recorded at December 31 reflect estimates of what the final amounts will be when the actual income tax returns are filed for that calendar year. In addition, estimates are often required with respect to, among other things, the appropriate state income tax rates to use in the various states that we and our subsidiaries are required to file, the potential utilization of operating loss carryforwards and valuation allowances required, if any, for tax assets that may not be realizable in the future. We recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the “more-likely-than-not” threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the relevant tax authority. EARNINGS PER SHARE We compute earnings per share using the two-class method. The two-class method of computing earnings per share is an earnings allocation formula that determines earnings per share for common stock and any participating securities according to dividends declared (whether paid or unpaid) and participation rights in undistributed earnings. Shares of our non-vested restricted stock are considered participating securities because these awards contain a non-forfeitable right to dividends irrespective of whether the awards ulti- mately vest. Under the two-class method, earnings per common share for our Common and Class B com- mon stock is computed by dividing the sum of distributed earnings to common shareholders and undistributed earnings allocated to common shareholders by the weighted-average number of shares of Common and Class B common stock outstanding for the period. In applying the two-class method, undis- tributed earnings are allocated to Common stock, Class B common stock and participating securities based on the weighted-average shares outstanding during the period. Diluted earnings per share reflects the dilutive effect of potential common shares from stock options. The dilutive effect of outstanding stock options is computed using the treasury stock method, which assumes any proceeds that could be obtained upon the exercise of stock options, would be used to purchase com- mon stock at the average market price for the period. The assumed proceeds include the purchase price the optionee pays, the windfall tax benefit that we receive upon assumed exercise and the unrecognized compensation expense at the end of each period. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITY We have used derivative instruments, including forward contracts and swaps, to manage our exposure to fluctuations in foreign currency exchange rates and interest rates. The use of these derivative instruments modifies the exposure of these risks with the intent to reduce the risk or cost to us. We use derivative instruments as risk management tools and not for trading purposes. All derivatives, whether designated as hedging relationships or not, are recorded on the balance sheet at fair value. Cash flows from derivative instruments are classified in the consolidated statements of cash flows in the same category as the cash flows from the items subject to the designated hedge or undesignated (economic) hedge relationships. The hedging designation may be classified as one of the following: No Hedging Designation. The gain or loss on a derivative instrument not designated as an accounting hedging instrument is recognized in earnings. Cash Flow Hedge. A hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability is considered a cash flow hedge. The effective portion of the change in the fair value of a derivative that is designated as a cash flow hedge is recorded in other com- prehensive income and reclassified to earnings as a component of cost of sales in the period for which the hedged transaction affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. Fair Value Hedge. A hedge of a recognized asset or liability or an unrecognized firm commitment is con- sidered a fair value hedge. Fair value hedges, both the effective and ineffective portions of the changes in the fair value of the derivative, along with the gain or loss on the hedged item that is attributable to the hedged risk, are recorded in earnings. See Note 13 for additional information pertaining to derivative instruments. NEW ACCOUNTING STANDARDS Revenue Recognition In May 2014, the Financial Accounting Standards Board (the “FASB”) issued a standard on revenue recognition that provides a single, comprehensive revenue recognition model for all contracts with cus- tomers. The standard is principle-based and provides a five-step model to determine the measurement of revenue and timing of when it is recognized. The core principle is that a company will recognize revenue to reflect the transfer of goods or services to customers at an amount that the company expects to be enti- tled to in exchange for those goods or services. In July 2015, the FASB deferred the effective date of this standard by one year. As a result, this standard is effective for our interim and annual reporting periods beginning after December 15, 2017, with early adoption permitted for annual reporting periods beginning after December 15, 2016. We will adopt this guidance on January 1, 2018, and are currently evaluating the impact on our consolidated financial statements. Presentation of Debt Issuance Costs In April 2015, the FASB issued guidance that will require debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the carrying amount of that debt liability, rather than as an asset. This guidance is to be applied retrospectively and will be effective for interim and annual reporting periods beginning after December 15, 2015. We do not expect the adop- tion of this guidance to have a material impact on our consolidated financial statements. Measurement of Inventory In July 2015, the FASB issued guidance that simplifies the measurement of inventory by replacing the lower of cost or market test with a lower of cost and net realizable value test. The guidance applies to all inventory that is measured using first-in, first-out or average cost methods. This guidance must be applied prospectively and will be effective for interim and annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. Classification of Deferred Taxes In November 2015, the FASB issued guidance that requires deferred tax assets and liabilities to be classi- fied as noncurrent in a classified balance sheet. This guidance can be applied either prospectively or ret- rospectively and will be effective for interim and annual reporting periods beginning after December 15, 2016, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. 40 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 41 2. EARNINGS PER SHARE The following table presents the calculation of basic and diluted earnings per share for our Common and Class B common stock: Years Ended December 31, 2015 2014 2013 3. OTHER COMPREHENSIVE LOSS Other comprehensive loss consists of the foreign currency translation adjustment associated with our Canadian operations’ use of the Canadian dollar as its functional currency and changes in the unrealized gains (losses) on cash flow hedging instruments and available-for-sale securities. The tax effects allocated to each component of other comprehensive loss were as follows: Basic Earnings per Share: Net income attributable to Watsco, Inc. shareholders Less: distributed and undistributed earnings allocated to non-vested restricted common stock Earnings allocated to Watsco, Inc. shareholders Weighted-average common shares outstanding - Basic Basic earnings per share for Common and Class B common stock Allocation of earnings for Basic: Common stock Class B common stock Diluted Earnings per Share: Net income attributable to Watsco, Inc. shareholders Less: distributed and undistributed earnings allocated to non-vested $ 172,929 $ 151,387 $ 127,723 13,634 159,295 32,435,961 4.91 146,037 13,258 159,295 172,929 $ $ $ $ $ 11,444 139,943 32,308,073 4.33 128,214 11,729 139,943 151,387 $ $ $ $ $ 9,064 118,659 32,195,598 3.69 108,690 9,969 118,659 127,723 $ $ $ $ $ restricted common stock 13,626 11,435 9,053 Earnings allocated to Watsco, Inc. shareholders $ 159,303 $ 139,952 $ 118,670 Weighted-average common shares outstanding - Basic Effect of dilutive stock options 32,435,961 44,395 32,308,073 50,781 32,195,598 62,470 Years Ended December 31, 2015 2014 2013 Foreign currency translation adjustment $ (39,378) $ (21,117) $ (16,365) Unrealized gain on cash flow hedging instruments Income tax expense Unrealized gain on cash flow hedging instruments, net of tax Reclassification of gain on cash flow hedging instruments into earnings Income tax expense Reclassification of gain on cash flow hedging instruments into earnings, net of tax Unrealized (loss) gain on available-for-sale securities Income tax benefit (expense) Unrealized (loss) gain on available-for-sale securities, net of tax 3,716 (1,003) 2,713 (2,730) 737 (1,993) (12) 4 (8) 384 (104) 280 — — — 1 — 1 — — — — — — 39 (15) 24 Other comprehensive loss $ (38,666) $ (20,836) $ (16,341) The changes in each component of accumulated other comprehensive loss, net of tax, were as follows: Weighted-average common shares outstanding - Diluted 32,480,356 32,358,854 32,258,068 Years Ended December 31, 2015 2014 2013 Diluted earnings per share for Common and Class B common stock $ 4.90 $ 4.32 $ 3.68 Diluted earnings per share for our Common stock assumes the conversion of all of our Class B common stock into Common stock as of the beginning of the fiscal year; therefore, no allocation of earnings to Class B com- mon stock is required. At December 31, 2015, 2014 and 2013, our outstanding Class B common stock was convertible into 2,699,710, 2,707,725 and 2,704,832 shares of our Common stock, respectively. Diluted earnings per share excluded 67,014, 9,984 and 1,066 shares for the years ended December 31, 2015, 2014 and 2013, respectively, related to stock options with an exercise price per share greater than the average market value, resulting in an anti-dilutive effect on diluted earnings per share. Foreign currency translation adjustment: Beginning balance Current period other comprehensive loss Ending balance Cash flow hedging instruments: Beginning balance Current period other comprehensive income Less reclassification adjustment Ending balance Available-for-sale securities: Beginning balance Current period other comprehensive (loss) income Ending balance $ $ (23,623) (23,581) (47,204) (11,181) (12,442) (23,623) $ (1,785) (9,396) (11,181) 168 1,628 (1,196) 600 (292) (8) (300) — 168 — 168 (293) 1 (292) — — — — (317) 24 (293) Accumulated other comprehensive loss, net of tax $ (46,904) $ (23,747) $ (11,474) 42 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 43 4.SUPPLIER CONCENTRATION Purchases from our top ten suppliers comprised 84%, 82% and 81% of all purchases made in 2015, 2014 and 2013, respectively. Our largest supplier, Carrier and its affiliates, accounted for 62%, 61% and 59% of all purchases made in 2015, 2014 and 2013, respectively. See Note 16. A significant interrup- tion by Carrier, or any of our other key suppliers, in the delivery of products could impair our ability to maintain current inventory levels and could materially impact our consolidated results of operations and consolidated financial position. 5. PROPERTY AND EQUIPMENT Property and equipment, net, consists of: December 31, Land Buildings and improvements Machinery, vehicles and equipment Furniture and fixtures Computer hardware and software Accumulated depreciation and amortization $ $ 2015 820 69,675 43,150 14,311 38,876 2014 853 58,915 43,124 14,001 33,314 166,832 (104,117) 150,207 (96,727) 7.INCOME TAXES The components of income tax expense from our wholly-owned operations and investments and our con- trolling interest in joint ventures with Carrier are as follows: Years Ended December 31, U.S. Federal State Foreign Current Deferred 2015 85,585 9,431 9,661 104,677 99,990 4,687 104,677 $ $ $ $ $ $ $ $ 2014 74,561 10,325 6,953 91,839 91,550 289 91,839 $ $ $ $ 2013 62,616 9,234 5,810 77,660 69,071 8,589 77,660 We calculate our income tax expense and our effective tax rate for 100% of income attributable to our wholly-owned operations and for our controlling interest of income attributable to our joint ventures with Carrier, which are primarily taxed as partnerships for income tax purposes. Following is a reconciliation of the effective income tax rate: $ 62,715 $ 53,480 Years Ended December 31, U.S. federal statutory rate State income taxes, net of federal benefit and other Tax effects on foreign income Effective income tax rate attributable to Watsco, Inc. Taxes attributable to non-controlling interest 2015 2014 2013 35.0% 2.3 (0.3) 37.0 (5.4) 35.0% 3.0 (1.0) 37.0 (6.4) 35.0% 3.3 (1.3) 37.0 (7.7) Effective income tax rate 31.6% 30.6% 29.3% Depreciation and amortization expense related to property and equipment included in selling, general and administrative expenses for the years ended December 31, 2015, 2014 and 2013, were $13,802, $12,158 and $11,677, respectively. 6.DEBT We maintain an unsecured, syndicated revolving credit agreement that provides for borrowings of up to $600,000. Borrowings are used to fund seasonal working capital needs and for other general corporate purposes, including acquisitions, dividends (if and as declared by our Board of Directors), capital expendi- tures, stock repurchases and issuances of letters of credit. The credit agreement matures on July 1, 2019. Included in the credit facility are a $90,000 swingline subfacility, a $50,000 letter of credit subfa- cility and a $75,000 multicurrency borrowing sublimit. Borrowings under the credit facility bear interest at either LIBOR-based rates plus a spread, which ranges from 87.5 to 250.0 basis-points (LIBOR plus 100.0 basis-points at December 31, 2015), depending on our ratio of total debt to EBITDA, or on rates based on the higher of the Prime rate or the Federal Funds Rate, in each case plus a spread which ranges from 0 to 150.0 basis-points (0 basis-points at December 31, 2015), 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 35.0 basis-points (15.0 basis-points at December 31, 2015). At December 31, 2015 and 2014, $245,300 and $303,199, respectively, were 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, 2015. 44 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 45 The following is a summary of the significant components of our current and long-term deferred tax assets and liabilities: December 31, Current deferred tax assets: Capitalized inventory costs and inventory reserves Self-insurance reserves Allowance for doubtful accounts Other current deferred tax assets Total current deferred tax assets (1) Long-term deferred tax assets: Share-based compensation Other long-term deferred tax assets Net operating loss carryforwards Valuation allowance Total long-term deferred tax assets (2) Current deferred tax liabilities: Other current deferred tax liabilities Total current deferred tax liabilities (1) Long-term deferred tax liabilities: Deductible goodwill Depreciation Other long-term deferred tax liabilities Total long-term deferred tax liabilities (2) Net deferred tax liabilities $ 2015 2014 $ 1,794 519 1,053 1,921 5,287 23,603 352 207 24,162 — 24,162 (686) (686) (83,868) (3,774) (1,533) (89,175) 3,262 759 992 1,588 6,601 20,108 746 221 21,075 — 21,075 (536) (536) (80,404) (2,992) (1,320) (84,716) $ (60,412) $ (57,576) (1) Current deferred tax assets and liabilities have been included in the consolidated balance sheets in other current assets. (2) Long-term deferred tax assets and liabilities have been included in the consolidated balance sheets in deferred income taxes and other liabilities. Amounts earned by foreign subsidiaries are generally subject to United States income taxation upon repa- triation. United States income taxes have not been provided on undistributed earnings of our foreign sub- sidiaries. The cumulative undistributed earnings related to foreign operations were approximately $113,000 at December 31, 2015. It is not practicable to estimate the amount of tax that might be payable. Our intention is to indefinitely reinvest these earnings outside of the United States or to repatri- ate the earnings only when it is tax effective to do so. Management has determined that no valuation allowance was necessary at both December 31, 2015 and 2014. At December 31, 2015, there were state and other net operating loss carryforwards of $6,771, which expire in varying amounts from 2016 through 2035. These amounts are available to off- set future taxable income. There were no federal net operating loss carryforwards at December 31, 2015. We are subject to United States federal income tax, income tax of multiple state jurisdictions and foreign income tax. We are subject to tax audits in the various jurisdictions until the respective statutes of limita- tions expire. We are no longer subject to United States federal tax examinations for tax years prior to 2012. For the majority of states, we are no longer subject to tax examinations for tax years prior to 2011. As of December 31, 2015 and 2014, the total amount of gross unrecognized tax benefits (excluding the federal benefit received from state positions) was $3,513 and $3,719, respectively. Of these totals, $2,416 and $2,417, respectively, (net of the federal benefit received from state positions) represent the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our continuing practice is to recognize penalties within selling, general and administrative expenses and interest related to income tax matters in income tax expense in the consolidated statements of income. As of December 31, 2015 and 2014, the cumulative amount of estimated accrued interest and penalties resulting from such unrecognized tax benefits was $384 and $729, respectively, and is included in deferred income taxes and other liabilities in the accompanying consolidated balance sheets. The changes in gross unrecognized tax benefits are as follows: Balance at December 31, 2012 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2013 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2014 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations and tax assessments Balance at December 31, 2015 $ 2,474 673 (12) 3,135 751 (167) 3,719 871 (1,077) $ 3,513 8. SHARE-BASED COMPENSATION AND BENEFIT PLANS SHARE-BASED COMPENSATION PLANS We have two share-based compensation plans for employees. The 2014 Incentive Compensation Plan (the “2014 Plan”) provides for the award of a broad variety of share-based compensation alternatives such as non-vested restricted stock, non-qualified stock options, incentive stock options, performance awards, dividend equivalents, deferred stock and stock appreciation rights at no less than 100% of the market price on the date the award is granted. To date, awards under the 2014 Plan consist of non-qual- ified stock options and non-vested restricted stock. Under the 2014 Plan, the number of shares of Common and Class B common stock available for issuance is (i) 2,000,000, plus (ii) 45,421 shares of Common stock or Class B common stock that remained available for grant in connection with awards under the Watsco, Inc. Amended and Restated 2001 Incentive Compensation Plan (the “2001 Plan”) on the date on which our shareholders approved the 2014 Plan plus (iii) shares underlying currently outstanding awards issued under the 2001 Plan, which shares become reissuable under the 2014 Plan to the extent that such underlying shares are not issued due to their forfeiture, expiration, termination or otherwise. A total of 212,450 shares of Common stock, net of cancellations, and 150,979 shares of Class B common stock, had been awarded under the 2014 Plan as of December 31, 2015. As of December 31, 2015, 1,681,992 shares of common stock were reserved for future grants under the 2014 Plan. Options under the 2014 Plan vest over two to four years of service and have contractual terms of five years. Awards of non-vested restricted stock, which are granted at no cost to the employee, vest upon attainment of a certain age, generally toward the end of an employee’s career. Vesting may be accelerated in certain circumstances prior to the original vesting date. The 2001 Plan expired during 2014; therefore, no additional options may be granted. There were 97,500 options to exercise common stock outstanding under the 2001 Plan at December 31, 2015. Options under the 2001 Plan vest over two to four years of service and have contractual terms of five years. The following is a summary of stock option activity under the 2014 Plan and the 2001 Plan as of and for the year ended December 31, 2015: 46 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 47 Options outstanding at December 31, 2014 Granted Exercised Forfeited Options outstanding at December 31, 2015 Options exercisable at December 31, 2015 Weighted- Average Exercise Price 73.62 123.59 65.65 118.50 102.96 73.89 Options 241,450 153,250 (114,616) (22,750) 257,334 33,834 $ $ $ Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value 3.36 1.53 $ $ 4,494 1,491 The following is a summary of non-vested restricted stock activity as of and for the year ended December 31, 2015: Non-vested restricted stock outstanding at December 31, 2014 Granted Vested Forfeited Weighted- Average Grant Date Fair Value 45.21 114.55 49.36 110.36 $ Shares 2,643,717 200,479 (20,000) (5,000) Non-vested restricted stock outstanding at December 31, 2015 2,819,196 $ 49.99 The weighted-average grant date fair value of non-vested restricted stock granted during 2015, 2014 and 2013 was $114.55, $96.84 and $80.21, respectively. The fair value of non-vested restricted stock that vested during 2015 and 2014 was $2,468 and $5,789, respectively. The tax benefits realized from non- vested restricted stock that vested during 2015 and 2014 totaled $911 and $2,142, respectively. No non-vested restricted stock vested during 2013. During 2015, 7,206 shares of Common stock with an aggregate fair market value of $889 were withheld as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. During 2014, 21,028 shares of Common stock with an aggregate fair market value of $2,125 were withheld as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. These shares were retired upon delivery. SHARE-BASED COMPENSATION FAIR VALUE ASSUMPTIONS The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing valuation model based on the weighted-average assumptions noted in the table below. The fair value of each stock option award, which is subject to graded vesting, is expensed, net of estimated forfei- tures, on a straight-line basis over the requisite service period for each separately vesting portion of the stock option. We use historical data to estimate stock option forfeitures. The expected term of stock option awards granted represents the period of time that stock option awards granted are expected to be outstanding and was calculated using the simplified method for plain vanilla options, which we believe provides a reasonable estimate of expected life based on our historical data. The risk-free rate for periods within the contractual life of the stock option award is based on the yield curve of a zero-coupon United States Treasury bond on the date the stock option award is granted with a maturity equal to the expected term of the stock option award. Expected volatility is based on historical volatility of our stock. The following table presents the weighted-average assumptions used for stock options granted: Years Ended December 31, Expected term in years Risk-free interest rate Expected volatility Expected dividend yield Grant date fair value 2015 2014 2013 4.25 1.25% 20.96% 2.29% 4.25 1.35% 22.07% 1.69% 4.25 0.82% 24.56% 2.20% $17.17 $15.75 $13.33 EXERCISE OF STOCK OPTIONS The total intrinsic value of stock options exercised during 2015, 2014 and 2013 was $7,525, $3,746 and $2,753, respectively. Cash received from the exercise of stock options during 2015, 2014 and 2013 was $4,850, $3,324 and $1,554, respectively. During 2015, 2014 and 2013, 26,006 shares of Class B common stock with an aggregate fair market value of $3,251, 5,454 shares of Common stock with an aggregate fair market value of $490 and 4,749 shares of Common stock with an aggregate fair market value of $450, respectively, were withheld as payment in lieu of cash for stock option exercises and related tax withholdings. During 2013, 13,227 shares of common stock with an aggregate fair market value of $1,227 were delivered as payment in lieu of cash for stock option exercises and related tax with- holdings. These shares were retired upon delivery. In connection with stock option exercises, the tax ben- efits realized from share-based compensation plans totaled $2,469, $936 and $1,557, for the years ended December 31, 2015, 2014 and 2013, respectively. SHARE-BASED COMPENSATION EXPENSE The following table provides information on share-based compensation expense: Years Ended December 31, Stock options Non-vested restricted stock Share-based compensation expense 2015 952 11,644 12,596 $ $ 2014 801 10,672 11,473 $ $ $ $ 2013 884 9,083 9,967 At December 31, 2015, there was $1,816 of unrecognized pre-tax compensation expense related to stock options granted under the 2014 Plan and 2001 Plan, which is expected to be recognized over a weighted-average period of approximately 1.8 years. The total fair value of stock options that vested dur- ing 2015, 2014 and 2013 was $856, $1,145 and $822, respectively. At December 31, 2015, there was $83,762 of unrecognized pre-tax compensation expense related to non-vested restricted stock, which is expected to be recognized over a weighted-average period of approx- imately 11.3 years, of which, approximately $56,000 is related to awards granted to our Chief Executive Officer (“CEO”), which vest in approximately 11 years upon his attainment of age 86. In the event that vesting is accelerated for any circumstance, as defined in the related agreements, the remaining unrecog- nized share-based compensation expense would be immediately recognized as a charge to earnings with a corresponding tax benefit. At December 31, 2015, we were obligated to issue 58,893 shares of non- vested restricted stock in connection with our CEO’s 2015 performance based incentive compensation. EMPLOYEE STOCK PURCHASE PLAN The Watsco, Inc. Fourth Amended and Restated 1996 Qualified Employee Stock Purchase Plan (the “ESPP”) provides for up to 1,500,000 shares of Common stock to be available for purchase by our full- time employees with at least 90 days of service. The plan allows participating employees to purchase shares of Common stock with a discount of 5% of the fair market value at specified times. During 2015, 2014 and 2013, employees purchased 6,463, 6,995 and 5,844 shares of Common stock at an average price of $112.53, $90.89 and $79.46 per share, respectively. Cash dividends received by the ESPP were reinvested in Common stock and resulted in the issuance of 3,183, 2,953 and 1,899 additional shares during 2015, 2014 and 2013, respectively. We received net proceeds of $1,107, $921 and 48 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 49 $631, respectively, during 2015, 2014 and 2013, for shares of our Common stock issued under the ESPP. At December 31, 2015, 505,558 shares remained available for purchase under the ESPP. 401(K) PLAN We have a profit sharing retirement plan for our employees that is qualified under Section 401(k) of the Internal Revenue Code. Annual matching contributions are made based on a percentage of eligible employee compensation deferrals. The contribution has historically been made with the issuance of Common stock to the plan on behalf of our employees. For the years ended December 31, 2015, 2014 and 2013, we issued 18,343, 18,309 and 22,551 shares of Common stock, respectively, to the plan, representing the Common stock discretionary matching contribution of $1,963, $1,759 and $1,689, respectively. 9. PURCHASE OF OWNERSHIP INTEREST IN JOINT VENTURE On July 1, 2014, we exercised our second option to acquire an additional 10% ownership interest in Carrier Enterprise, LLC (“Carrier Enterprise I”) for cash consideration of $87,735, following which we have an 80% controlling interest in Carrier Enterprise I. Neither we nor Carrier has any remaining options to pur- chase additional ownership interests in Carrier Enterprise I, or any of our other joint ventures with Carrier. 10. GOODWILL AND OTHER INTANGIBLE ASSETS The changes in the carrying amount of goodwill are as follows: Balance at December 31, 2013 Foreign currency translation adjustment Balance at December 31, 2014 Foreign currency translation adjustment Balance at December 31, 2015 Other intangible assets are comprised of the following: December 31, Indefinite lived intangible assets - Trade names, trademarks and distribution rights Finite lived intangible assets: Customer relationships Trade name Non-compete agreements Accumulated amortization Finite lived intangible assets, net $ 392,610 (5,299) 387,311 (9,001) $ 378,310 Estimated Useful Lives 2015 2014 10-15 years 10 years 7 years $ 118,205 $ 131,271 68,981 1,150 369 (28,224) 76,595 1,150 369 (22,909) 42,276 55,205 $ 160,481 $ 186,476 Amortization expense related to finite lived intangible assets included in selling, general and administrative expenses for the years ended December 31, 2015, 2014 and 2013, were $5,315, $5,769 and $6,029, respectively. Amortization of finite lived intangible assets for 2016 through 2020 is expected to be approxi- mately $5,100 per year. 11. SHAREHOLDERS’ EQUITY COMMON STOCK Common stock and Class B common stock share equally in earnings and are identical in most other respects except (i) Common stock is entitled to one vote on most matters and each share of Class B com- mon stock is entitled to ten votes; (ii) shareholders of Common stock are entitled to elect 25% of the Board of Directors (rounded up to the nearest whole number) and Class B shareholders are entitled to elect the balance of the Board of Directors; (iii) cash dividends may be paid on Common stock without paying a cash dividend on Class B common stock and no cash dividend may be paid on Class B common stock unless at least an equal cash dividend is paid on Common stock and (iv) Class B common stock is convertible at any time into Common stock on a one-for-one basis at the option of the shareholder. PREFERRED STOCK We are authorized to issue preferred stock with such designation, rights and preferences as may be deter- mined from time to time by our Board of Directors. Accordingly, the Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights which could adversely affect the voting power or other rights of the holders of our Common stock and Class B common stock and, in certain instances, could adversely affect the market price of this stock. We had no preferred stock outstanding at December 31, 2015 or 2014. STOCK REPURCHASE PLAN 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. No shares were repurchased during 2015, 2014 or 2013. In aggregate, 6,322,650 shares of Common stock and 48,263 shares of Class B common stock have been repurchased at a cost of $114,425 since the inception of the program. At December 31, 2015, there were 1,129,087 shares remaining authorized for repurchase under the program. 12. FINANCIAL INSTRUMENTS RECORDED FINANCIAL INSTRUMENTS Recorded financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, the current portion of long-term obligations, borrowings under our revolving credit agreement and debt instruments included in other long-term obligations. At December 31, 2015 and 2014, the fair val- ues of cash and cash equivalents, accounts receivable, accounts payable and the current portion of long- term obligations approximated their carrying values due to the short-term nature of these instruments. The fair values of variable rate borrowings under our revolving credit agreement and debt instruments included in long-term obligations also approximate their carrying value based upon interest rates available for similar instruments with consistent terms and remaining maturities. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS At December 31, 2015 and 2014, we were contingently liable under standby letters of credit aggregating $2,690 and $2,662, respectively, which are primarily used as collateral to cover any contingency related to additional risk assessments pertaining to our self-insurance programs. Additionally, at December 31, 2015 and 2014, we were contingently liable under various performance bonds aggregating approximately $4,000 and $2,300, respectively, which are used as collateral to cover any contingencies related to our nonperformance under agreements with certain customers. We do not expect that any material losses or obligation will result from the issuance of the standby letters of credit or performance bonds because we expect to meet our obligations under our self-insurance programs and to certain customers in the ordinary course of business. Accordingly, the estimated fair value of these instruments is zero. 50 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 51 CONCENTRATIONS OF CREDIT RISK Financial instruments which potentially subject us to concentrations of credit risk consist principally of accounts receivable. Concentrations of credit risk are limited due to the large number of customers com- prising the customer base and their dispersion across many different geographical regions. We also have access to credit insurance programs which are used as an additional means to mitigate credit risk. 13. DERIVATIVES We enter into foreign currency forward contracts to offset the earnings impact that foreign exchange rate fluctuations would otherwise have on certain monetary liabilities that are denominated in nonfunctional currencies. CASH FLOW HEDGING INSTRUMENTS We enter into foreign currency forward contracts that are designated as cash flow hedges. The settlement of these derivatives results in reclassifications from accumulated other comprehensive loss to earnings for the period in which the settlement of these instruments occur. The maximum period for which we hedge our cash flow using these instruments is 12 months. Accordingly, at December 31, 2015, all of our open foreign currency forward contracts had maturities of one year or less. The total notional value of our for- eign currency exchange contracts designated as cash flow hedges at December 31, 2015 was $23,500, and such contracts have varying terms expiring through June 2016. The impact from foreign exchange derivative instruments designated as cash flow hedges were as follows: Years Ended December 31, Gain recorded in accumulated other comprehensive loss Gain reclassified from accumulated other comprehensive loss into earnings 2015 $ $ 3,716 (2,730) $ $ 2014 384 — At December 31, 2015, we expected an estimated $1,370 pre-tax gain to be reclassified into earnings to reflect the fixed prices obtained from foreign exchange hedging within the next 12 months. DERIVATIVES NOT DESIGNATED AS HEDGING INSTRUMENTS We have also entered into foreign currency forward contracts that are either not designated as hedges or did not qualify for hedge accounting. These derivative instruments were effective economic hedges for all of the periods presented. The fair value gains and losses on these contracts are recognized in earnings as a component of selling, general and administrative expenses. The total notional value of our foreign cur- rency exchange contracts not designated as hedging instruments at December 31, 2015 was $15,000, and such contracts have varying terms expiring through March 2016. We recognized gains of $2,552, $142 and $315 from foreign currency forward contracts not designated as hedging instruments in our consolidated statements of income for 2015, 2014 and 2013, respectively. The following table summarizes the fair value of derivative instruments, which consist solely of foreign currency forward contracts, included in other current assets and accrued expenses and other current lia- bilities in our consolidated balance sheets. See Note 14. December 31, Derivatives designated as hedging instruments Derivatives not designated as hedging instruments Total derivative instruments Asset Derivatives Liability Derivatives 2015 2014 2015 2014 $ 923 326 $ 384 260 $ 3 4 $ — — $ 1,249 $ 644 $ 7 $ — 14. FAIR VALUE MEASUREMENTS The following tables present our assets and liabilities carried at fair value that are measured on a recur- ring basis: Assets: Available-for-sale securities Derivative financial instruments Liabilities: Derivative financial instruments Balance Sheet Location Total Level 1 Level 2 Level 3 Fair Value Measurements at December 31, 2015 Using Other assets Other current assets $ 254 $ 1,249 $ 254 $ — $ 1,249 $ — $ — $ — Accrued expenses and other current liabilities $ 7 $ — $ 7 $ — Balance Sheet Location Total Level 1 Level 2 Level 3 Fair Value Measurements at December 31, 2014 Using Assets: Available-for-sale securities Derivative financial instruments Other assets Other current assets $266 $644 $266 — — $644 — — The following is a description of the valuation techniques used for these assets and liabilities, as well as the level of input used to measure fair value: Available-for-sale securities – these investments are exchange-traded equity securities. Fair values for these investments are based on closing stock prices from active markets and are therefore classified within Level 1 of the fair value hierarchy. Derivative financial instruments – these derivatives are foreign currency forward contracts. See Note 13. Fair value is based on observable market inputs, such as forward rates in active markets; therefore, we classify these derivatives within Level 2 of the valuation hierarchy. There were no transfers in or out of Level 1 and Level 2 during 2015 or 2014. 15. COMMITMENTS AND CONTINGENCIES LITIGATION, CLAIMS AND ASSESSMENTS In December 2015, a purported Watsco shareholder, Nelson Gaskins, filed a derivative lawsuit in the U.S. District Court for the Southern District of Florida against Watsco’s Board of Directors. The Company is a nominal defendant. The lawsuit alleges breach of fiduciary duties regarding CEO incentive compensa- tion and seeks to recover alleged excessive incentive compensation and unspecified damages. The defen- dants believe the claims are entirely without merit and intend to vigorously defend against them. We believe the ultimate outcome of this matter will not have a material adverse effect on our consolidated results of operations and consolidated financial position. We are involved in litigation incidental to the operation of our business. We vigorously defend all matters in which we or our subsidiaries are named defendants and, for insurable losses, maintain significant lev- els of insurance to protect against adverse judgments, claims or assessments that may affect us. Although the adequacy of existing insurance coverage and the outcome of any legal proceedings cannot be pre- dicted with certainty, based on the current information available, we do not believe the ultimate liability associated with any known claims or litigation will have a material adverse effect on our financial condi- tion or results of operations. 52 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 53 SELF-INSURANCE 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 a number of factors, which include historical claims experience, demo- graphic 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 occur and exceed these estimates, additional reserves may be required. Reserves in the amounts of $3,214 and $4,630 at December 31, 2015 and 2014, respectively, were established related to such programs and are included in accrued expenses and other current liabilities in our consolidated balance sheets. VARIABLE INTEREST ENTITY As of December 31, 2015, in conjunction with our casualty insurance programs, limited equity interests are held in a captive insurance entity. The programs permit us to self-insure a portion of losses, to gain access to a wide array of safety-related services, to pool insurance risks and resources in order to obtain more competitive pricing for administration and reinsurance and to limit risk of loss in any particular year. The entity meets the definition of Variable Interest Entity (“VIE”); however, we do not meet the require- ments to include this entity in the consolidated financial statements. The maximum exposure to loss related to our involvement with this entity is limited to approximately $4,500. See “Self-Insurance” above for further information on commitments associated with the insurance programs and Note 12, under the caption “Off-Balance Sheet Financial Instruments,” for further information on standby letters of credit. At December 31, 2015, there were no other entities that met the definition of a VIE. OPERATING LEASES We are obligated under various non-cancelable operating lease agreements for real property, equipment, vehicles and a corporate aircraft used in our operations with varying terms through 2025. We are com- mitted to pay a portion of the actual operating expenses under certain of these lease agreements. These operating expenses are not included in the table below. Some of these arrangements have free or escalat- ing rent payment provisions. We recognize rent expense under such arrangements on a straight-line basis over the lease term. At December 31, 2015, future minimum payments under non-cancelable operating leases over each of the next five years and thereafter were as follows: 2016 2017 2018 2019 2020 Thereafter Total minimum payments $ 67,959 52,405 35,991 22,112 12,639 10,398 $ 201,504 Rental expense for the years ended December 31, 2015, 2014 and 2013, was $82,581, $81,155 and $79,585, respectively. PURCHASE OBLIGATIONS At December 31, 2015, we were obligated under various non-cancelable purchase orders with Carrier and its affiliates for goods aggregating approximately $19,000. 16. RELATED PARTY TRANSACTIONS Purchases from Carrier and its affiliates comprised 62%, 61% and 59% of all inventory purchases made during 2015, 2014 and 2013, respectively. At December 31, 2015 and 2014, approximately $85,000 and $61,000, respectively, was payable to Carrier and its affiliates, net of receivables. Our joint ventures with Carrier also sell HVAC products to Carrier and its affiliates. Revenues in our consolidated statements of income for 2015, 2014 and 2013 included $61,656, $38,195 and $30,819, respectively, of sales to Carrier and its affiliates. We believe these transactions are conducted at arm’s-length in the ordinary course of business. 17. INFORMATION ABOUT GEOGRAPHIC AREAS Our operations are primarily within the United States, including Puerto Rico, Canada and Mexico. Products are also sold from the United States on an export-only basis to portions of Latin America and the Caribbean Basin. The following tables set forth revenues and long-lived assets by geographical area: Years Ended December 31, 2015 2014 2013 Revenues: United States Canada Mexico Total revenues December 31, Long-Lived Assets: United States Canada Mexico Total long-lived assets $ 3,710,977 263,908 138,354 $ 3,525,176 300,289 119,075 $ 3,325,114 318,165 100,051 $ 4,113,239 $ 3,944,540 $ 3,743,330 2015 2014 $ 441,656 154,437 5,413 $ 434,910 187,064 5,293 $ 601,506 $ 627,267 Revenues are attributed to countries based on the location of the store from which the sale occurred. Long-lived assets consist of property and equipment, goodwill and intangible assets. 18. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information was as follows: Years Ended December 31, Interest paid Income taxes net of refunds 2015 2014 2013 $ $ 4,993 103,261 $ $ 4,393 82,850 $ $ 5,334 73,168 54 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 55 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (In thousands, except per share data) Year Ended December 31, 2015 Revenues (1) Gross profit Net income attributable to Watsco, Inc. Earnings per share for Common and Class B common stock (2): Basic Diluted Year Ended December 31, 2014 Revenues (1) Gross profit Net income attributable to Watsco, Inc. Earnings per share for Common and Class B common stock (2): Basic Diluted 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total $ $ $ $ $ $ $ $ 808,972 204,225 23,048 $ 1,223,439 295,245 65,423 $ $ 1,177,012 285,846 57,968 $ 0.65 0.65 $ $ 1.86 1.85 $ $ 1.64 1.64 762,568 188,069 16,753 $ 1,170,186 279,273 56,101 $ $ 1,134,999 274,765 54,461 $ 0.48 0.48 $ $ 1.60 1.60 $ $ 1.56 1.56 $ $ $ $ $ $ $ $ 903,816 222,041 26,490 $ 4,113,239 1,007,357 172,929 $ 0.75 0.75 $ $ 4.91 4.90 876,787 214,295 24,072 $ 3,944,540 956,402 151,387 $ 0.69 0.69 $ $ 4.33 4.32 (1) Sales of residential central air conditioners, heating equipment and parts and supplies are seasonal. Demand related to the residen- tial central air conditioning replacement market is typically highest in the second and third quarters, and demand for heating equip- ment is 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. (2) Quarterly and year-to-date earnings per share are calculated on an individual basis; therefore, the sum of earnings per share amounts for the quarters may not equal earnings per share amounts for the year. INFORMATION ON COMMON STOCK (UNAUDITED) Our Common stock is traded on the New York Stock Exchange (“NYSE”) under the ticker symbol WSO. Our Class B common stock is traded on the NYSE under the ticker symbol WSOB. The following table presents the high and low prices of our Common stock and Class B common stock, as reported by the NYSE. Also presented below are dividends paid per share for each quarter during the years ended December 31, 2015 and 2014. At February 23, 2016, there were 240 Common stock registered share- holders and 96 Class B common stock registered shareholders. Common Class B Common Cash Dividend High Low High Low Common Class B Year Ended December 31, 2015: First quarter Second quarter Third quarter Fourth quarter Year Ended December 31, 2014: First quarter Second quarter Third quarter Fourth quarter $ $ 125.70 128.49 131.81 131.89 100.47 104.84 104.16 108.20 $ $ 104.92 120.14 118.13 116.24 91.12 96.93 85.53 86.14 $ $ 124.80 127.15 130.15 131.21 99.94 105.22 104.90 107.12 $ $ 104.50 120.74 118.91 113.49 91.42 96.68 87.41 87.41 $ $ $ $ 0.70 0.70 0.70 0.70 0.40 0.40 0.60 0.60 0.70 0.70 0.70 0.70 0.40 0.40 0.60 0.60 56 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 57 5-YEAR SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with the consolidated financial statements, including the notes thereto, and the information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report to Shareholders. (In thousands, except per share data) 2015 2014 2013 2012 (1) 2011 FOR THE YEAR Revenues Gross profit Operating income Net income Less: net income attributable to non-controlling interest Net income attributable to Watsco, Inc. Diluted earnings per share for Common and Class B common stock Cash dividends per share: Common stock Class B common stock Weighted-average Common and Class B common shares - Diluted AT YEAR END Total assets Total long-term obligations Total shareholders’ equity Number of employees $ 4,113,239 1,007,357 336,748 226,524 $ 3,944,540 956,402 305,747 208,702 $ 3,743,330 899,253 271,209 187,719 $ 3,431,712 814,395 224,908 157,601 $ 2,977,759 728,294 199,050 137,742 53,595 172,929 4.90 2.80 2.80 $ $ $ $ 57,315 151,387 4.32 2.00 2.00 $ $ $ $ 59,996 127,723 3.68 1.15 1.15 $ $ $ $ 54,267 103,334 2.70 7.48 7.48 $ $ $ $ $ $ $ $ 47,292 90,450 2.74 2.23 2.23 32,480 32,359 32,258 31,744 30,753 $ 1,788,442 $ 245,814 $ 1,203,721 5,000 $ 1,791,067 $ 303,885 $ 1,132,039 5,000 $ 1,669,531 $ 230,557 $ 1,127,392 4,800 $ 1,682,055 $ 316,196 $ 1,022,040 4,600 $ 1,268,148 $ — $ 1,001,710 4,300 (1) On October 31, 2012, we paid a special dividend of $5.00 per share of Common and Class B common stock that resulted in a $0.33 per share reduction in diluted earnings per share. SHAREHOLDER RETURN PERFORMANCE (UNAUDITED) The following graph compares the cumulative five-year total shareholder return attained by holders of our Common stock and Class B common stock relative to the cumulative total returns of the NYSE MKT Composite index, the S&P Midcap 400 index and a prior peer group of companies. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock, in each index and in the prior peer group on December 31, 2010 and its relative performance is tracked through December 31, 2015. We have determined that the companies contained in the prior peer group are not comparable to us given our position as the largest distributor of HVAC/R equipment, parts and supplies in North America, their dissimilarity relative to our unique, sole line of business, the nature of our customers (air conditioning and heating contractors) and the products and markets that we serve. For the foregoing reasons, we further determined that we cannot reasonably identify an appropriate peer group and have therefore, included the performance of the S&P Midcap 400 index in the graph below, which contains companies with similar market capitalizations to our own. The performance graph shall not be deemed incorporated by reference by any general statement incorporating by reference this annual report into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incor- porate this information by reference, and shall not otherwise be deemed filed under such acts. COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN AMONG WATSCO, INC., THE NYSE MKT COMPOSITE INDEX, THE S&P MIDCAP 400 INDEX AND A PEER GROUP $260 $240 $220 $200 $180 $160 $140 $120 $100 $80 12/10 12/11 12/12 12/13 12/14 12/15 Watsco, Inc. Watsco, Inc. Class B NYSE MKT Composite S&P MidCap 400 Prior Peer Group Copyright© 2016 S&P, a division of McGraw Hill Financial. All rights reserved. Watsco, Inc. Watsco, Inc. Class B NYSE MKT Composite S&P MidCap 400 Prior Peer Group* 12/10 12/11 12/12 12/13 12/14 12/15 100.00 100.00 100.00 100.00 100.00 107.75 107.48 104.50 98.27 97.55 136.39 141.36 110.18 115.84 141.07 177.26 185.76 118.63 154.64 200.21 201.72 210.34 120.72 169.75 193.61 226.01 238.86 107.77 166.05 217.99 *Consists of Beacon Roofing Supply, Inc., Lennox International Inc., Pool Corp. and Wesco International, Inc. 58 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 59 CORPORATE & SHAREHOLDER INFORMATION CORPORATE OFFICE Watsco, Inc. 2665 South Bayshore Drive, Suite 901 Miami, FL 33133 Telephone: (305) 714-4100, Fax: (305) 858-4492, E-mail: info@watsco.com EXECUTIVE OFFICERS Albert H. Nahmad Chief Executive Officer Aaron J. Nahmad President Barry S. Logan Senior Vice President & Secretary Ana M. Menendez Chief Financial Officer & Treasurer BOARD OF DIRECTORS Albert H. Nahmad Chairman of the Board and Chief Executive Officer David C. Darnell Vice Chairman, Bank of America Denise Dickins (1,2,3) Associate Professor of Accounting and Auditing, East Carolina University Steven R. Fedrizzi (2) Chief Executive Officer, U.S. Green Building Council Barry S. Logan Senior Vice President and Secretary Paul F. Manley (1,2) Retired Executive Director, Holland & Knight Bob L. Moss (3) Chairman and Chief Executive Officer, Moss & Associates LLC Aaron J. Nahmad President George P. Sape (1,3) Retired Managing Partner of Epstein Becker and Green, P.C. (1) Audit Committee (2) Compensation Committee (3) Nominating & Governance Committee STOCK INFORMATION Common stock: New York Stock Exchange. Ticker Symbol: WSO Class B common stock: New York Stock Exchange. Ticker Symbol: WSOB TRANSFER AGENT AND REGISTRAR For address changes, dividend checks, account consolidation, registration changes, lost stock certificates and other shareholder inquiries, please contact: American Stock Transfer & Trust Company 6201 15th Avenue, Brooklyn, NY 11219 Toll-Free: (800) 937-5449, International: (718) 921-8124 Internet Site: www.amstock.com Email: info@amstock.com PUBLICATIONS Our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q are available free of charge upon request to our corporate office. INTERNET SITES Our website at www.watsco.com offers information about Watsco including our most recent quarterly results and news releases. Also, visit www.acdoctor.com to get information on energy efficiency and indoor air quality, compare HVAC systems, find a licensed contractor and search for available rebates. INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM KPMG LLP 200 South Biscayne Boulevard, Suite 2000 Miami, FL 33131 This page is left intentionally blank. 60 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 61 This page is left intentionally blank. This page is left intentionally blank. 62 WATSCO, INC. 2015 ANNUAL REPORT WATSCO, INC. 2015 ANNUAL REPORT 63 Strict guidelines were adhered to in the production of the paper used in this annual report, both in the forest and in the mills. In doing so, the cause for renewable forests, preservation of natural resources, wildlife protection, and pollution and energy reduction are advanced. Apple, the Apple logo, the iPhone and the iPad are trademarks of Apple, Inc., registered in the U.S. and other countries. Design: Suissa Design info@suissadesign.com 64 WATSCO, INC. 2015 ANNUAL REPORT 

Continue reading text version or see original annual report in PDF format above