Watsco Annual Report 2017

Plain-text annual report

2665 South Bayshore Drive, Suite 901 Miami, FL 33133 USA 305-714-4100 www.watsco.com DON’T ASK US... WATSCO ANNUAL REPORT 2017 The HVAC/R industry has never evolved at a rapid pace. Until now. Watsco is the driving force. We are revolutionizing how business can be done with technology platforms that serve one purpose – to help our HVAC/R contractor customers. When they win, we win. Together we are developing a new paradigm to win with speed, eﬃciency, expertise and customer service. Early results of these technology investments are exciting. The adoption by customers at scale will take time. Beneﬁts will occur over the long-term. That’s how we see it… but how do our customers feel about our technology and what are their experiences so far? Well, don’t ask us... ASK OUR CUSTOMERS. Mobile Apps E-Commerce Platforms Warehouse Optimization Business Intelligence Predictive Analytics Watsco Ventures Dear Shareholders: Watsco’s ambitious, talented and dedicated team produced record results in 2017, building on a long-term track record that has been consistent now for many years. We achieved record sales, proﬁts, earnings per share and cash ﬂow. Our total shareholder return in 2017 was 18%, and we again increased dividends, extending our dividend payout streak to 43 years. Our past letters to shareholders have summarized ﬁve key principles of our culture – principles that are non-negotiable in our approach to business: –Instill a passion for entrepreneurism, innovation and continuous improvement. –Operate as a local business, no matter how great our scale, by empowering leaders in the ﬁeld to make local decisions. –Think and act long-term with an equity ownership culture that motivates and retains great performers for the duration of their careers. –Lead the HVAC/R industry, build the largest depository of product expertise and partner with manufacturers in ways that cannot be matched by our competitors. –Remain conservative and risk averse with our ﬁnances, which provides the ﬂexibility to invest in any size opportunity at a low cost of capital. Of course we continue to evolve, and in recent years have invested over $100 million in a variety of technologies to revolutionize how customers do business with us. Given this investment and the customer response we are witnessing, we have added another principle to our list of non-negotiables: –Develop, launch and iterate the industry’s most customer-obsessed suite of technology platforms that become so valuable that contractors will only want to do business with Watsco. The key words in that statement are customer-obsessed, which has always been our mindset, but given our massive investment and focus on technology we have new and exciting means to please our customers. Watsco’s e-commerce, mobile apps, supply chain and order fulﬁllment technologies are rooted in the belief that speed, productivity and eﬃciency will be ever more critical as the digital era progresses. We track several performance indicators to measure progress and a great deal was accomplished in 2017: E-Commerce and App Usage Progress in 2017 E-commerce sales 50% growth in online sales to over $900 million E-commerce transactions 57% increase in transactions Unique iOS or Android app users 34% increase in users Products (SKUs) digitized and available online 30% increase to over 650,000 SKUs Line items per order online versus in-store 33% more line items per order Sales attrition rate for users versus non-users Attrition rate is 2.5X less for active users Business Intelligence Platform Increase in internal BI users Average number of BI queries per week per user 11% increase to over 1,500 weekly-users 30% increase in queries Number of total user inquiries during the year 46% increase to 17.9 million queries 2 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 3 Warehouse Eﬃciency Number of wireless locations 461 locations Wi-Fi enabled versus 359 last year Locations with Order Fulﬁllment (OF) soware 329 locations versus 150 locations last year Number of orders ﬁlled with OF 2.1 million versus 750,000 last year Delivery truck miles tracked and analyzed 4.2 million miles versus 880,000 miles last year Locations with express pickup 134 locations versus 68 locations last year Supply Chain Optimization Inventory turns for fully-adopted locations 80 basis-point improvement over last 2 years Fill-rates for fully-adopted locations Fill-rates of 97% (up 300 basis- points from inception) Reduction of real estate requirements 487,000 sq. . (1 million square feet over 2 years) We are inspired by the initial progress and we are anxious to see adoption at scale, which will take time. As far as “scale”, across our footprint of 560 locations, we serv- ice approximately 250,000 contractors and technicians and complete over 7 million sale transactions a year. In other words, we have merely scratched the surface of what is possible in terms of value creation and realization. What’s nice is that these invest- ments are helping our customers win, and when our customers win, we win. In the following pages, we highlight several ambitious, early-adopter customers that are transforming their business with the help of our technology tools. We are thankful to them for sharing their experience with our shareholders. As always, I want to extend my gratitude to our employees for their many contributions and recognize them for their ongoing commitment to exceed the expectations of our contractor customers. Their dedication and innovative spirit have made us the leader in the industry and will serve us well as we continue to build and transform our company. Aaron (A.J.) Nahmad President 4 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 5 FINANCIAL HIGHLIGHTS TOTAL REVENUES (in millions) $3,743 2013 $3,945 2014 $4,113 2015 $4,221 2016 $4,342 2017 (in thousands, except per share data) 2013 2014 2015 2016 2017 OPERATING INCOME (in millions) Revenues Operating income EBITDA(1) Net Income $ 3,743,330 271,209 288,915 $ 3,944,540 $ 4,113,239 336,748 355,865 305,747 323,674 $ 4,220,702 345,632 365,698 $4,341,955 353,874 375,907 attributable to Watsco, Inc. 127,723 Diluted earnings per share 3.68 Adjusted diluted earnings per share(2) 3.68 1.15 Dividends per share 150,269 Operating cash flow 1,669,531 Total assets 230,557 Long-term obligations 1,127,392 Shareholders’ equity 151,387 4.32 4.32 2.00 144,980 1,791,067 303,885 1,132,039 172,929 4.90 4.90 2.80 222,848 1,788,442 245,814 1,203,721 182,810 5.15 5.15 3.60 281,731 1,874,649 235,642 1,251,748 208,221 5.81 5.54 4.60 306,520 2,046,877 22,085 1,550,977 (1) EBITDA is defined as earnings before interest expense, net, income taxes, depreciation and amortization. Amortization of debt costs is included in interest expense, net. (2) On December 2017, the Tax Cuts and Job Act of 2017 (the “TCJA”) was signed into law. Adjusted diluted earnings per share for 2017 excludes the one-time tax benefit recognized by the company in the application of the TCJA. $271 2013 $306 2014 $337 2015 $346 2016 $354 2017 ADJUSTED DILUTED EARNINGS (per share) $3.68 2013 $4.32 2014 $4.90 2015 $5.15 2016 $5.54 2017 6 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 7 Gary Wright. Owner, Gulf Shore Cooling, Fort Myers, FL Gary believes part of his success is due to customer satisfaction. His company prides itself with providing 100% satisfaction. “We won’t collect a penny until everything is working correctly.” Gary relies on Watsco’s e-commerce to ensure quicker job completion for his customers and to give him a leg up on his competition. “IT’S NOT HOW MUCH IT’S HOW FAST. We live in real time. In today’s world, customer’s expections are unbelievable, every- thing has to happen now. If we wait until tomorrow, it’s too late. Because of the heat index down here, it’s critical to make every- thing happen right away. The minute a job is sold, the soware notiﬁes our internal people, and allows them to expedite the job. We can even schedule the work with our client right then and there. It’s sell today, done tomorrow.” WATSCO, INC. 2017 ANNUAL REPORT 9 Jerry Mannix. Owner, Mannix Heating & Cooling, Chantilly, VA Aer working for 18 years with a large HVAC outﬁt, Jerry opened his own shop in 2010 from his basement. His company now has 20 employees working out of two locations. In September 2017, Jerry implemented OnCall Air’s sales system for sales force and service estimators. OnCall Air – a Watsco Ventures business – oﬀers soware to help HVAC contractors grow their business. “IT’S TRANSFORMED OUR BUSINESS. Just look at our sales method for example. We submit proposals in a fraction of the time, with more ease and they look so professional. 99% of our proposals are done this way now. And the data the soware provides gives me more control than ever. I can adjust my pricing instantaneously depending on the workﬂow. ” WATSCO, INC. 2017 ANNUAL REPORT 11 Steve Nugent. John Nugent & Sons, Sterling, VA Photo of John Kiesel, Installation Foreman Established in 1975, Nugent & Sons has built their family business on excellence. They’re committed to educating their employees with current technology, not only to make their technicians most qualiﬁed, but to use technology such as Watsco’s to run all facets of their business more eﬃciently and proﬁtably. “THE DIFFERENCE IS NIGHT AND DAY. 90% of our equipment is now ordered online. Our installation foreman, John Kiesel, loves the system. He’s so much more productive and happier too. Ordering product is quicker, easier and there’s less room for error. He’s no longer wasting time waiting on the phone. The faster we order product, the faster we can start a job. ” ” 12 WATSCO, INC. 2017 ANNUAL REPORT Gayland McMullen. McMullen Service, Waco, TX Photo of Jason, Nathan, Clint, Gayland and Kevin McMullen Started in 1970 by their father, the McMullens have been serving the Waco community since 1970. As a small, family-owned and operated outﬁt, all three brothers are fully involved in every aspect of their business. “THE APP HAS BECOME MY GO-TO FOR ALL THINGS TECHNICAL. I’d miss the app if I didn’t have it. I use the mobile app constantly. For ratings matchup, sizing, ﬁguring out eﬃciences. It helps me in informing my clients as to exactly what they require and what they’re buying. I get all the technical information I need and it allows me to provide good service.” 14 WATSCO, INC. 2017 ANNUAL REPORT 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 19 30 31 32 33 34 35 36 38 39 61 62 63 64 IBC 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 and investments in unconsolidated entities, (iv) financing plans, and (v) industry, demographic and other trends affecting our financial condition or results of opera- tions. These forward-looking statements are based on management’s current expectations, are not guar- antees 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, as well as the other documents and reports that we file with the SEC. Forward-looking statements speak only as of the date the state- ments were made. We assume no obligation to update forward-looking information or the discussion of such risks and uncertainties to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking information, except as required by applicable law. We qualify any and all of our forward-looking statements by these cautionary factors. 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 and the consolidated financial statements, including the notes thereto, included in this Annual Report to Shareholders. 18 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 19 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, 2017, we operated from 560 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 correlate to changes in sales. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts, and facility rent, 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 evenly distributed throughout 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 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 the Northeast U.S., and we con- tributed 14 locations in the Northeast U.S. In July 2011, we purchased Carrier’s distribution operations in Mexico, which included seven locations. Collectively, the Northeast locations and the Mexico opera- tions are referred to as Carrier Enterprise II. On November 29, 2016, we purchased an additional 10% ownership interest in Carrier Enterprise II, and, on February 13, 2017, we again purchased an additional 10% ownership interest in Carrier Enterprise II, which together increased our controlling interest to 80%. 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- 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 cus- tomers 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 several fac- tors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other information. Our business is seasonal and our customers’ businesses are also seasonal. Sales are lowest during the first and fourth quarters, and past due accounts receivable balances as a percentage of total trade receivables generally increase during these quarters. We review our accounts receivable reserve policy periodically, reflecting current risks, trends, and changes in industry conditions. The allowance for doubtful accounts was $6.1 million and $6.2 million at December 31, 2017 and 2016, respectively, a decrease of $0.1 million. Accounts receivable balances greater than 90 days past due as a percent of accounts receivable at December 31, 2017 decreased to 1.3% from 1.6% at December 31, 2016. These decreases were primarily attributable to an improvement in the underlying quality of our accounts receivable portfolio at December 31, 2017. Although we believe the allowance for doubtful accounts is sufficient, a decline in economic conditions could lead to the deterioration in the financial condition of our customers, resulting in an impairment of their ability to make payments and requiring additional allowances that could materially impact our con- solidated results of operations. We believe our exposure to customer credit risk is limited due to the large number of customers comprising our customer base and their dispersion across many different geographi- cal regions. Additionally, we mitigate credit risk through credit insurance programs. Inventory Valuation Reserves Inventory valuation reserves are established to report inventories at the lower of cost using the weighted- average and the first-in, first-out methods, or net realizable value. As part of the valuation process, inven- tories are adjusted to reflect excess, slow-moving, and damaged goods. The valuation process contains uncertainty because management must make estimates and use judgment to determine the future salabil- ity 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, Indefinite Lived Intangible Assets and Long-Lived Assets The recoverability of goodwill is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount may not be recoverable. We have one reporting unit that is subject to goodwill impairment testing. In performing the goodwill impairment test, we use a two-step approach. The first step compares the reporting unit’s fair value to its carrying value. If the carrying value exceeds the fair value, a second step is performed to measure the amount of impairment loss, 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, 2018, we performed our annual evaluation of goodwill impairment and determined that the estimated fair value of our reporting unit sig- nificantly exceeded its carrying value. 20 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 21 The recoverability of indefinite lived intangibles and long-lived assets are also evaluated on an annual basis or more often if deemed necessary. Indefinite lived intangibles and long-lived assets not subject to amortization are assessed for impairment by comparing the fair value of the intangible asset or long-lived asset to its carrying amount to determine if a write-down to fair value is required. Our annual evaluation did not indicate any impairment of indefinite lived intangibles or long-lived assets. The estimates of fair value of our reporting unit, indefinite lived intangibles, and long-lived assets are based on the best information available as of the date of the assessment and incorporates management’s assumptions about expected future cash flows and contemplates other valuation techniques. Future cash flows can be affected by changes in the industry, a declining economic environment, or market condi- tions. There have been no events or circumstances from the date of our assessments that would have had an impact on this conclusion. The carrying amounts of goodwill, intangibles, and long-lived assets were $611.3 million and $538.3 million at December 31, 2017 and 2016, respectively. Although no impair- ment losses have been recorded to date, there can be no assurance that impairments will not occur in the future. An adjustment to the carrying value of goodwill, intangibles, and long-lived assets could materially adversely impact the consolidated results of operations. 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 several factors, which include historical claims experience, demographic factors, severity factors, and valuations provided by independent third-party actuaries. Management reviews its assumptions with its independent third-party actuaries to evaluate whether self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occur and exceed these estimates, additional reserves may be required and could materially impact the consolidated results of operations. The estimation process contains uncertainty since management must use judgment to estimate the ulti- mate 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 $2.3 million and $3.0 million at December 31, 2017 and 2016, 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, 2017 or 2016. 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 several factors, including changes to tax laws, or possible tax audits, or general economic conditions, or competitive pressures that could affect future tax- able 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 valua- tion allowance could materially 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 recently adopted and to be adopted accounting standards. 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, 2017, 2016 and 2015. Revenues Cost of sales Gross profit Selling, general and administrative expenses Other income Operating income Interest expense, net Income before income taxes Income taxes Net income Less: net income attributable to non-controlling interest 2017 2016 2015 100.0% 75.5 100.0% 75.5 100.0% 75.5 24.5 16.5 0.1 8.2 0.1 8.0 2.1 5.9 1.1 24.5 16.3 – 8.2 0.1 8.1 2.5 5.6 1.3 24.5 16.3 – 8.2 0.1 8.1 2.5 5.5 1.3 Net income attributable to Watsco, Inc. 4.8% 4.3% 4.2% Note: Due to rounding, percentages may not add up to 100. The following narratives reflect our approximate 35% ownership interest in Russell Sigler, Inc. (“RSI”) purchased in June 2017, our additional 10% ownership interest in Carrier Enterprise II, which became effective on February 13, 2017, and our additional 10% ownership interest in Carrier Enterprise II, which became effective on November 29, 2016. We did not make any material acquisitions of businesses dur- ing 2017, 2016 or 2015. In the following narratives, computations and other 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, 2017 and 2016, 35 and 21 locations, respectively, were excluded from “same-store basis” information. The table below summarizes the changes in our locations for 2017 and 2016: December 31, 2015 Opened Closed December 31, 2016 Opened Closed December 31, 2017 Number of Locations 566 10 (11) 565 15 (20) 560 2017 Compared to 2016 Revenues Revenues for 2017 increased $121.3 million, or 3%, to $4,342.0 million, including $5.7 million from locations opened during the preceding 12 months, offset by $24.5 million from locations closed. On a same-store basis, revenues increased $140.1 million, or 3%, as compared to 2016, reflecting a 4% increase in sales of HVAC equipment (67% of sales), which included a 5% increase in residential HVAC 22 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 23 equipment and a 2% increase in commercial HVAC equipment, a 1% increase in sales of other HVAC products (28% of sales), and flat sales of commercial refrigeration products (5% of sales). The increase in revenues was primarily due to demand for the replacement of residential HVAC equipment. Gross Profit Gross profit for 2017 increased $31.1 million, or 3%, to $1,065.7 million, primarily as a result of increased revenues. Gross profit margin remained consistent at 24.5% in 2017 as compared to 2016. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2017 increased $26.7 million, or 4%, to $715.7 million, primarily due to increased revenues, additional sales and service-related headcount, and increased costs related to ongoing technology initiatives. Selling, general and administrative expenses as a percentage of rev- enues for 2017 increased to 16.5% versus 16.3% in 2016. Other Income Other income of $3.9 million for 2017 represents our approximate 35% share of the net income of RSI, purchased in June 2017. Operating Income Operating income for 2017 increased $8.2 million, or 2%, to $353.9 million. Operating margin remained consistent at 8.2% in 2017 as compared to 2016. Interest Expense, Net Interest expense, net, for 2017 increased $2.7 million, or 71%, to $6.4 million, primarily as a result of an increase in average outstanding borrowings and a higher effective interest rate in 2017, in each case as compared to 2016. Income Taxes Income taxes decreased to $90.2 million for 2017, as compared to $105.9 million for 2016, 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 rates attributable to Watsco were 29.8% and 36.0% in 2017 and 2016, respectively. On December 22, 2017 Public Law 115-97 “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” was enacted. This law is com- monly referred to as the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The 2017 effective income tax rate attributable to us reflects a decrease in income taxes due to the revaluation of our U.S. deferred income taxes, partially offset by an increase in income taxes related to previously undistributed earnings of our foreign subsidiaries because of the TCJA. The decrease in 2017’s effective rate also reflects higher share- based payment deductions in 2017 as compared to 2016. Refer to Note 7 to our audited consolidated financial statements included in this Annual Report on Form 10-K for further discussion of the TCJA’s impact on us. We currently estimate our 2018 effective income tax rate attributable to Watsco will be approximately 24% to 25%, and our 2018 effective income tax rate, net of taxes attributable to the non-controlling interest, to be approximately 21% to 22%, subject to the refinement of provisional adjustments related to the TCJA. The rate may also change due to additional guidance and interpretations related to the TCJA, as well as the impact of the prospective tax related to certain global intangible low-taxed income of for- eign subsidiaries. We anticipate some variability in the tax rate quarter to quarter in 2018 from potential discrete items. Net Income Attributable to Watsco, Inc. Net income attributable to Watsco in 2017 increased $25.4 million, or 14%, to $208.2 million. The increase was primarily driven by higher revenues and other income, as discussed above, a reduction in income taxes, and increase in net income attributable to the non-controlling interest related to Carrier Enterprise II following our purchases of additional 10% ownership interests in both November 2016 and February 2017. 2016 Compared to 2015 Revenues Revenues for 2016 increased $107.5 million, or 3%, to $4,220.7 million, including $1.4 million from locations opened during the preceding 12 months, offset by $18.4 million from locations closed. On a same-store basis, revenues increased $124.5 million, or 3%, as compared to 2015, reflecting a 3% increase in sales of HVAC equipment (66% of sales), which included a 4% increase in residential HVAC equipment and a 1% increase in commercial HVAC equipment, a 1% increase in sales of other HVAC products (29% of sales), and a 6% increase in sales of commercial refrigeration products (5% of sales). The increase in revenues was primarily due to demand for the replacement of residential HVAC equip- ment. Gross Profit Gross profit for 2016 increased $27.2 million, or 3%, to $1,034.6 million, primarily as a result of increased revenues. Gross profit margin remained consistent at 24.5% in 2016 as compared to 2015. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2016 increased $18.3 million, or 3%, to $689.0 million, primarily due to increased revenues as well as $3.3 million of additional costs related to ongoing technology initiatives. Selling, general and administrative expenses as a percentage of revenues remained consistent at 16.3% in 2016 as compared to 2015. Operating Income Operating income for 2016 increased $8.9 million, or 3%, to $345.6 million. Operating margin remained consistent at 8.2% in 2016 as compared to 2015. Interest Expense, Net Interest expense, net, for 2016 decreased $1.8 million, or 33%, to $3.7 million, primarily as a result of a decrease in average outstanding borrowings, partially offset by a higher effective interest rate in 2016, in each case as compared to 2015. Income Taxes Income taxes increased to $105.9 million for 2016, as compared to $104.7 million for 2015, 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 rates attributable to Watsco were 36.0% and 37.0% in 2016 and 2015, respectively. The decrease was primarily due to a $2.9 million benefit from share-based payment deductions in 2016. Net Income Attributable to Watsco, Inc. Net income attributable to Watsco in 2016 increased $9.9 million, or 6%, to $182.8 million. The increase was primarily driven by higher revenues and by a reduction in the net income attributable to the non-controlling interest related to Carrier Enterprise II following our purchase of an additional 10% owner- ship interest in Carrier Enterprise II in November 2016. 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 and investments in unconsolidated entities; • dividend payments; • capital expenditures; and • the timing and extent of common stock repurchases. 24 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 25 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 (to the extent declared by our Board of Directors), capital expenditures, business acquisitions, and development of our long-term operating and technology strategies. Additionally, we may also generate cash through the issuance and sale of our Common stock. As of December 31, 2017, we had $80.5 million of cash and cash equivalents, of which $75.9 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, these balances are generally available without legal restrictions to fund the ordinary business operations of our foreign subsidiaries. We believe that our operating cash flows, cash on hand, and funds available for borrowing under our revolving credit agreement are 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 revolving credit agreement depends on the ability of the syndicate banks to meet their respective funding commitments. Disruptions in the credit and capital markets could adversely affect our ability to draw on our revolving credit agreement and may also adversely affect the determina- tion of interest rates, particularly rates based on LIBOR, which is one of the base rates under our revolv- ing credit agreement. Disruptions in the credit and capital markets could also result in increased borrowing costs and/or reduced borrowing capacity under our revolving credit agreement. Working Capital Working capital decreased to $920.9 million at December 31, 2017 from $925.3 million at December 31, 2016. Cash Flows The following table summarizes our cash flow activity for 2017 and 2016 (in millions): Cash flows provided by operating activities Cash flows used in investing activities Cash flows used in financing activities 2017 2016 Change $ $ $ 306.5 (81.3) (202.1) $ $ $ 281.7 (42.8) (217.9) $ $ $ 24.8 (38.5) 15.8 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 Net cash provided by operating activities increased primarily due to higher net income in 2017 as com- pared to 2016. Investing Activities Net cash used in investing activities increased primarily due to the purchase of an ownership interest in RSI for $63.6 million, partially offset by a decrease in capital expenditures in 2017. Financing Activities Net cash used in financing activities decreased primarily due to $247.7 million in proceeds from the sale of Common stock used for repayments under our revolving credit agreement, an increase in dividends paid, and higher distributions paid to the non-controlling interest in 2017. At-the-Market Offering Program On August 23, 2017, we entered into a sales agreement with Robert W. Baird & Co. Inc., which enabled the Company to issue and sell shares of Common stock in one or more negotiated transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), for a maximum aggregate offering amount of up to $250.0 million (the “ATM Program”). The offer and sale of our Common stock pursuant to the ATM Program was registered under the Securities Act pursuant to our automatically effective shelf registration statement on Form S-3 (File No. 333-207831). During 2017, we sold 1,498,662 shares of Common stock under the ATM Program for net proceeds of $247.7 million. Direct costs of $0.3 million incurred in connection with the offering were charged against the proceeds from the sale of Common stock and reflected as a reduction of paid-in capital. As of December 31, 2017, we had completed the offering of shares under the ATM Program. The net proceeds were primarily used to repay outstanding debt and for general corporate purposes. Revolving Credit Agreement We maintain an unsecured, syndicated revolving credit agreement, which we use 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 expenditures, stock repurchases, and issuances of letters of credit. Effective February 5, 2018, we decreased the borrowing capacity under this credit agreement from $600.0 million to $300.0 million. Included in the credit facility are a $90.0 million swingline subfacility, a $10.0 million letter of credit subfacility and a $75.0 million multicurrency borrowing 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 87.5 basis-points at December 31, 2017), 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, 2017), 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 (12.5 basis-points at December 31, 2017). At December 31, 2017 and 2016, $21.8 million and $235.3 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, 2017. Contractual Obligations As of December 31, 2017, our significant contractual obligations were as follows (in millions): Payments due by Period Contractual Obligations 2018 2019 2020 2021 2022 Thereafter Total Operating leases (1) Purchase obligations (2) Total $ $ 69.1 11.0 80.1 $ $ 51.7 — 51.7 $ $ 36.1 — 36.1 $ $ 22.4 — 22.4 $ $ 13.0 — 13.0 $ $ 5.8 $ — 198.1 11.0 5.8 $ 209.1 (1) Represents future minimum payments associated with real property, equipment, and vehicles 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. We have not included in the contractual obligations table above approximately $3.5 million of net liabili- ties for unrecognized tax benefits relating to various tax positions we have taken, the timing of which is uncertain. Commercial obligations outstanding at December 31, 2017 under our revolving credit agreement con- sisted of borrowings totaling $21.8 million with revolving maturities of seven days. 26 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 27 Off-Balance Sheet Arrangements Refer to Note 13 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, 2017. Such discussion is incorporated herein by reference. Purchase of Additional Ownership Interest in Joint Venture On February 13, 2017, we purchased an additional 10% ownership interest in Carrier Enterprise II for cash consideration of $42.7 million, which increased our controlling interest in Carrier Enterprise II to 80%. We used borrowings under our revolving credit agreement to finance this acquisition, which we subsequently repaid using a portion of the proceeds from the ATM program. Investment in Unconsolidated Equity On June 21, 2017, Carrier Enterprise I acquired an approximately 35% ownership interest in RSI, an HVAC distributor operating from 30 locations in the Western U.S. for cash consideration of $63.6 million, of which we contributed $50.9 million, and Carrier contributed $12.7 million. Carrier Enterprise I entered into a shareholders agreement (the “Shareholders Agreement”) with RSI and its shareholders. Pursuant to the Shareholders Agreement, RSI’s shareholders have the right to sell, and Carrier Enterprise I has the obligation to purchase, their respective shares of RSI for a purchase price determined based on either book value or a multiple of EBIT, the latter of which Carrier Enterprise I used to calculate the price paid for its investment in RSI. RSI’s shareholders may transfer their respective shares of RSI common stock only to members of the Sigler family or to Carrier Enterprise I, and, at any time from and after the date on which Carrier Enterprise I owns 85% or more of RSI’s outstanding common stock, it has the right, but not the obligation, to purchase from RSI’s shareholders the remaining outstanding shares of RSI common stock. We believe that our operating cash flows, cash on hand, and funds available for borrowing under our revolving credit agreement will be sufficient to purchase any additional ownership interests in RSI. Acquisitions We continually evaluate potential acquisitions, including joint ventures and investments in unconsolidated entities, and routinely hold discussions with a number of acquisition candidates. Should suitable acquisi- tion opportunities arise that would require additional financing, we believe our financial position and earn- ings 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 $4.60, $3.60 and $2.80 per share of Common stock and Class B common stock in 2017, 2016 and 2015, respectively. On January 2, 2018, our Board of Directors declared a reg- ular quarterly cash dividend of $1.25 per share of Common and Class B common stock that was paid on January 31, 2018 to shareholders of record as of January 16, 2018. On February 6, 2018, our Board of Directors approved an increase to the quarterly cash dividend per share of Common and Class B common stock to $1.45 per share from $1.25 per share, beginning with the dividend that will be paid in April 2018. Future dividends and/or changes in dividend rates are at the sole discretion of the Board of Directors and depend upon factors including, but not limited to, cash flow generated by operations, profitability, financial condition, cash requirements, and future prospects. Company Share 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 2017, 2016 or 2015. 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 incep- tion of the program. At December 31, 2017, 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 and option 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 2017. 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 exchange contracts as of December 31, 2017 was $40.7 million, and such contracts have varying terms expiring through September 2018. For the year ended December 31, 2017, foreign cur- rency transaction gains and losses did not have a material impact on our results of operations. We have exposure related to the translation of financial statements of our Canadian operations into U.S. dollars, our functional currency. We do not currently hold any derivative contracts that hedge our foreign currency translational exposure. A 10% change in the Canadian dollar would have had an estimated $1.7 million impact to net income for the year ended December 31, 2017. 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 sig- nificant or if our Canadian and Mexican markets grow and represent a larger percentage of our total rev- enues. See Note 14 to our audited consolidated financial statements included in this Annual Report on Form 10-K for further information on our derivative instruments. 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, 2017 and determined that a 100 basis-point change in interest rates would result in an impact to income before taxes of approximately $0.2 million. See Note 6 to our audited consolidated financial statements included in this Annual Report on Form 10-K for further information about our debt. 28 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 29 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, 2017. 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, 2017. The effectiveness of our internal control over financial reporting as of December 31, 2017 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report that is included herein. 30 WATSCO, INC. 2017 ANNUAL REPORT To the Shareholders and Board of Directors Watsco, Inc.: Opinion on Internal Control Over Financial Reporting We have audited Watsco, Inc. and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, 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, 2017, and the related notes (collectively, the consolidated financial statements), and our report dated March 1, 2018 expressed an unqualified opinion on those consolidated financial statements. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial report- ing, 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 are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. 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 of internal control over financial reporting 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 reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance 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 poli- cies 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 com- pany are being made only in accordance with authorizations of management 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. Miami, Florida March 1, 2018 Certified Public Accountants KPMG LLP WATSCO, INC. 2017 ANNUAL REPORT 31 Report of Independent Registered Public Accounting Firm CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) Years Ended December 31, 2017 2016 2015 Revenues Cost of sales Gross profit Selling, general and administrative expenses Other Income Operating income Interest expense, net Income before income taxes Income taxes Net income Less: net income attributable to non-controlling interest $ 4,341,955 3,276,296 $ 4,220,702 3,186,118 $ 4,113,239 3,105,882 1,065,659 715,671 3,886 353,874 6,363 347,511 90,221 257,290 49,069 1,034,584 688,952 — 345,632 3,713 341,919 105,936 235,983 53,173 1,007,357 670,609 — 336,748 5,547 331,201 104,677 226,524 53,595 Net income attributable to Watsco, Inc. $ 208,221 $ 182,810 $ 172,929 Earnings per share for Common and Class B common stock: Basic Diluted See accompanying notes to consolidated financial statements. $ $ 5.81 5.81 $ $ 5.16 5.15 $ $ 4.91 4.90 To the Shareholders and Board of Directors Watsco, Inc.: Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated bal- ance sheets of Watsco, Inc. and subsidiaries (the “Company”) as of December 31, 2017 and 2016, 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, 2017, and the related notes (collec- tively, the “consolidated financial statements”). In our opinion, the consolidated financial statements pres- ent fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2017, 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) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 1, 2018 expressed an unqualified opinion on the effectiveness of the Company’s internal control over finan- cial reporting. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s man- agement. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independ- ent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included perform- ing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated finan- cial statements. We believe that our audits provide a reasonable basis for our opinion. We have served as the Company’s auditor since 2009. Miami, Florida March 1, 2018 Certified Public Accountants KPMG LLP 32 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 33 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) Years Ended December 31, 2017 2016 2015 Net income Other comprehensive gain (loss), net of tax Foreign currency translation adjustment Unrealized (loss) gain on cash flow hedging instruments Reclassification of (gain) loss on cash flow hedging instruments into earnings Unrealized (loss) gin on available-for-sale securities Other comprehensive gain (loss) 15,993 (702) (358) (15) 14,918 6,211 (965) 323 14 5,583 $ 257,290 $ 235,983 $ 226,524 Comprehensive income Less: comprehensive income attributable to non-controlling interest 272,208 54,678 241,566 55,382 Comprehensive income attributable to Watsco, Inc. $ 217,530 $ 186,184 $ 149,772 See accompanying notes to consolidated financial statements. (39,378) 2,713 (1,993) (8) (38,666) 187,858 38,086 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: Common stock, $0.50 par value, 60,000,000 shares authorized; 36,825,128 and 36,682,562 shares outstanding at December 31, 2017 and 2016, respectively Class B common stock, $0.50 par value, 10,000,000 shares authorized; 5,275,838 and 5,218,754 shares outstanding at December 31, 2017 and 2016, 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, 4,823,988 and 6,322,650 shares of Common stock and 48,263 and 48,263 shares of Class B common stock at December 31, 2017 and 2016, respectively Total Watsco, Inc. shareholders’ equity Non-controlling interest Total shareholders’ equity See accompanying notes to consolidated financial statements. 2017 2016 $ 80,496 478,133 761,314 17,454 $ 56,010 475,974 685,011 23,161 1,337,397 1,240,156 91,198 382,729 161,065 74,488 90,502 379,737 158,564 5,690 $ 2,046,877 $ 1,874,649 $ $ 244 230,476 185,757 416,477 21,800 285 22,085 57,338 200 185,482 129,206 314,888 235,294 348 235,642 72,371 18,412 18,341 2,638 — 804,008 (34,221) 594,556 2,610 — 592,350 (43,530) 550,482 (87,440) (114,425) 1,297,953 253,024 1,005,828 245,920 1,550,977 1,251,748 $ 2,046,877 $ 1,874,649 34 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORTT 35 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In thousands, except share and per share data) 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 Net income Other comprehensive gain 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 Cash dividends declared and paid on Common and Class B common stock, $3.60 per share Decrease in non-controlling interest in Carrier Enterprise II Distributions to non-controlling interest Balance at December 31, 2016 Net income Other comprehensive gain 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 Net proceeds from the sale of Common stock Cash dividends declared and paid on Common and Class B common stock, $4.60 per share Investment in unconsolidated entity Decrease in non-controlling interest in Carrier Enterprise II Distributions to non-controlling interest Balance at December 31, 2017 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 35,006,621 $20,689 $580,564 $(23,747) (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) 3,374 183,144 (26,000) 20,045 72,482 (30,761) 92 (13) 10 36 (15) (92) 13 2,338 5,660 (4,003) 11,848 (25,936) Retained Earnings $420,879 172,929 Treasury Stock Non-controlling Interest $(114,425) $248,079 53,595 (15,509) (98,532) 495,276 182,810 (114,425) (127,604) 35,530,403 20,951 592,350 (43,530) 550,482 208,221 (114,425) 9,309 176,899 (10,000) 16,389 49,166 (32,804) 1,498,662 88 (5) 8 24 (16) (88) 5 2,420 5,263 (4,701) 13,536 220,448 (25,225) 26,985 (164,147) Total $1,132,039 226,524 (38,666) — — 1,963 8,632 (4,140) 13,233 2,422 (98,532) (39,754) 1,203,721 235,983 5,583 — — 2,348 5,696 (4,018) 11,848 (127,604) (42,909) (38,900) 1,251,748 257,290 14,918 — — 2,428 5,287 (4,717) 13,536 247,433 (164,147) 12,720 (42,688) (42,831) (39,754) 246,411 53,173 2,209 (16,973) (38,900) 245,920 49,069 5,609 12,720 (17,463) (42,831) 37,228,715 $21,050 $804,008 $(34,221) $594,556 $(87,440) $253,024 $1,550,977 36 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 37 CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Notes to Consolidated Financial Statements (In thousands, except share and per share data) Years Ended December 31, 2017 2016 2015 $ 257,290 $ 235,983 $ 226,524 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 (benefit) provision Provision for doubtful accounts Non-cash contribution to 401(k) plan Other income from investment in unconsolidated entity Loss (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: Investment in unconsolidated entity Capital expenditures Proceeds from sale of property and equipment Net cash used in investing activities Cash flows from financing activities: Net repayments under revolving credit agreement Dividends on Common and Class B common stock Purchase of additional ownership from non-controlling interest Distributions to non-controlling interest Repurchases of common stock to satisfy employee withholding tax obligations Net repayments of other long-term obligations Excess tax benefits from share-based compensation Net proceeds from issuances of common stock Proceeds from non-controlling interest for investment in unconsolidated entity Net proceeds from the sale of Common stock 22,033 13,293 (10,735) 1,991 2,428 (3,886) 115 — (1,676) (73,403) 99,956 (886) 20,066 12,319 2,720 3,487 2,348 — (189) — (26,941) (9,729) 43,734 (2,067) 19,117 12,596 4,687 2,688 1,963 — (487) (2,422) (26,121) (3,652) (11,760) (285) 306,520 281,731 222,848 (63,600) (17,876) 168 (81,308) (213,494) (164,147) (42,688) (42,831) (4,674) (19) — 5,244 12,720 247,744 — (43,577) 744 (42,833) (10,006) (127,604) (42,909) (38,900) (3,975) (150) — 5,653 — — — (23,698) 760 (22,938) (56,256) (98,532) — (39,754) (1,465) (157) 2,422 5,957 — — Net cash used in financing activities (202,145) (217,891) (187,785) Effect of foreign exchange rate changes on cash and cash equivalents Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year 1,419 24,486 56,010 (226) 20,781 35,229 (1,343) 10,782 24,447 Cash and cash equivalents at end of year $ 80,496 $ 56,010 $ 35,229 Supplemental cash flow information (Note 19) 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, 2017, we operated from 560 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. Equity Method Investments Investments in which we have the ability to exercise significant influence, but do not control, are accounted for under the equity method of accounting and are included in other assets in our consolidated balance sheets. Under this method of accounting, our proportionate share of the net income or loss of the investee is included in other income in our consolidated statements of income. The excess, if any, of the carrying amount of our investment over our ownership percentage in the underlying net assets of the investee is attributed to certain fair value adjustments with the remaining portion recognized as goodwill. Reclassifications Certain reclassifications of prior year amounts have been made to conform to the 2017 presentation. These reclassifications had no effect on net income or earnings per share as previously reported. 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. 38 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 39 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, 2017 and 2016, the allowance for doubtful accounts totaled $6,049 and $6,169, respectively. Inventories Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies and are valued at the lower of cost using the weighted-average cost basis and the first-in, first-out meth- ods, or net realizable value. 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, 2017 and 2016, we had $11,621 and $9,926, 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 gains and losses, net of deferred taxes, included in accumulated other comprehensive loss within shareholders’ equity. Dividend and interest income are rec- ognized 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 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. On January 1, 2018, we performed our annual evalu- ation of goodwill impairment and determined that the estimated fair value of our reporting unit significantly exceeded its carrying value. Intangible assets primarily consist of the value of trade names and trademarks, distributor agreements, customer relationships and non-compete agreements. Indefinite lived intangibles not subject to amortiza- tion are assessed for impairment at least annually, or more frequently if events or changes in circum- stances indicate they may be impaired, by comparing the fair value of the intangible asset to its carrying 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 and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recover- able. Recoverability is evaluated by determining whether the amortization of the balance over its remain- ing 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, 2017 there were no such events or cir- cumstances. 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, 2017, 2016 and 2015, were $24,677, $22,242 and $21,150, 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, 2017, 2016 and 2015, were $47,670, $42,809 and $41,345, respectively. 40 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 41 Share-Based Compensation The fair value of stock option and non-vested restricted stock awards are expensed net of estimated forfei- tures 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 recog- nized for those options (windfall tax benefits) were classified as financing cash flows for the year ended December 31, 2015. Tax benefits resulting from tax deductions in excess of share-based compensation expense realized in 2017 and 2016 are recognized in our provision for income taxes in the consolidated statements of income. Tax benefits resulting from tax deductions in excess of share-based compensation expense recognized were credited to paid-in capital in the consolidated balance sheet for the year ended December 31, 2015. Income Taxes We record U.S. 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 purposes versus tax purposes. Deferred tax assets and liabilities reflect the temporary differences between the financial state- ment 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 recognized as income or expense in the period that includes the enactment date. We and our eligible subsidiaries file a consoli- dated U.S. federal income tax return. As income tax returns are generally not filed until well after the clos- ing 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 appropri- ate 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 and option 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 cate- gory 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 within selling, general and administrative expenses. 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 14 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. In 2015 and 2016, the FASB issued various updates to this standard. The standard and its related amendments (collectively, the “New Revenue Standard”) are effec- tive for interim and annual reporting periods beginning after December 15, 2017. The New Revenue Standard is effective for us on January 1, 2018. We will adopt the New Revenue Standard using the modified retrospective approach. The adoption of the New Revenue Standard will not have a material impact on the amount and timing of our revenue recognition. The New Revenue Standard requires ongoing incremental disclosures, including the disaggregation of revenue into categories that depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors. 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 became effective for interim and annual reporting periods beginning after December 15, 2016. The adoption of this guidance did not have a material impact on our consolidated financial state- ments. 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 may be applied either prospectively or ret- rospectively and became effective for interim and annual reporting periods beginning after December 15, 2016. The adoption of this guidance on January 1, 2017 using the prospective approach did not have a material impact on our consolidated financial statements. 42 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 43 Financial Instruments In January 2016, the FASB issued guidance related to certain aspects of recognition, measurement, pres- entation and disclosure of financial instruments. Most prominent among the changes to the standard is the requirement for changes in the fair value of equity investments, with certain exceptions, to be recog- nized through net income rather than other comprehensive income. This guidance will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings and is effec- tive for interim and annual periods beginning after December 15, 2017. A cumulative-effect adjustment will capture any previously held unrealized gains and losses related to our equity investments carried at fair value. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. Leases In February 2016, the FASB issued guidance on accounting for leases, which requires lessees to recog- nize most leases on their balance sheets for the rights and obligations created by those leases. The guid- ance requires enhanced disclosures regarding the amount, timing and uncertainty of cash flows arising from leases. This guidance will be applied using a modified retrospective approach and is effective for interim and annual periods beginning after December 15, 2018 with early adoption permitted. We will adopt this guidance on January 1, 2019. While we are still evaluating the impact of adopting this guid- ance on our consolidated financial statements, including the option to elect certain practical expedients, we expect that, upon adoption, the right-of-use assets and lease liabilities recorded could be material to our consolidated balance sheets. However, we do not expect a material impact on our consolidated state- ments of income. Intangibles – Goodwill and Other In January 2017, the FASB issued guidance to simplify the subsequent measurement of goodwill by elim- inating Step 2 from the goodwill impairment test. Under this updated standard, an entity should recog- nize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, but the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity also should consider income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if any. This guidance is effec- tive prospectively and is effective for interim and annual periods beginning after December 15, 2019 with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. Stock Compensation In May 2017, the FASB issued guidance to clarify when to account for a change to the terms or condi- tions of a share-based payment award as a modification. Under the new guidance, modification account- ing is required only if the fair value, the vesting conditions or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This guidance is effective prospectively and is effective for interim and annual periods beginning after December 15, 2017 with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. Derivatives and Hedging In August 2017, the FASB issued guidance to simplify the accounting for hedging derivatives. This guid- ance is effective prospectively and is effective for interim and annual periods beginning after December 15, 2018 with early adoption permitted. We do not expect the adoption of this guidance to have a mate- rial impact on our consolidated financial statements. 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, 2017 2016 2015 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 $ 208,221 $ 182,810 $ 172,929 17,430 190,791 32,824,947 5.81 175,667 15,124 190,791 208,221 $ $ $ $ $ 14,806 168,004 32,582,385 5.16 154,021 13,983 168,004 182,810 $ $ $ $ $ 13,634 159,295 32,435,961 4.91 146,037 13,258 159,295 172,929 $ $ $ $ $ restricted common stock 17,427 14,801 13,626 Earnings allocated to Watsco, Inc. shareholders $ 190,794 $ 168,009 $ 159,303 Weighted-average common shares outstanding - Basic Effect of dilutive stock options 32,824,947 37,686 32,582,385 34,119 32,435,961 44,395 Weighted-average common shares outstanding - Diluted 32,862,633 32,616,504 32,480,356 Diluted earnings per share for Common and Class B common stock $ 5.81 $ 5.15 $ 4.90 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, 2017, 2016 and 2015, our outstanding Class B common stock was convertible into 2,601,996, 2,711,811 and 2,699,710 shares of our Common stock, respectively. Diluted earnings per share excluded 11,664, 31,839 and 67,014 shares for the years ended December 31, 2017, 2016 and 2015, 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. 44 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 45 3. OTHER COMPREHENSIVE GAIN (LOSS) Other comprehensive gain (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: Years Ended December 31, 2017 2016 2015 Foreign currency translation adjustment $ 15,993 $ 6,211 $ (39,378) Unrealized (loss) gain on cash flow hedging instruments Income tax benefit (expense) Unrealized (loss) gain on cash flow hedging instruments, net of tax Reclassification of (gain) loss on cash flow hedging instruments into earnings Income tax expense (benefit) Reclassification of (gain) loss on cash flow hedging instruments into earnings, net of tax Unrealized gain (loss) on available-for-sale securities Income tax (expense) benefit Unrealized (loss) gain on available-for-sale securities, net of tax (961) 259 (702) (491) 133 (358) 51 (66) (15) (1,321) 356 (965) 442 (119) 323 27 (13) 14 3,716 (1,003) 2,713 (2,730) 737 (1,993) (12) 4 (8) Other comprehensive gain (loss) $ 14,918 $ 5,583 $ (38,666) The changes in each component of accumulated other comprehensive loss, net of tax, were as follows: Years Ended December 31, 2017 2016 2015 Foreign currency translation adjustment: Beginning balance Current period other comprehensive gain (loss) Ending balance Cash flow hedging instruments: Beginning balance Current period other comprehensive (loss) income Less reclassification adjustment Ending balance Available-for-sale securities: Beginning balance Current period other comprehensive (loss) income Ending balance $ (43,459) 9,960 $ (47,204) $ 3,745 (23,623) (23,581) (33,499) (43,459) (47,204) 215 (421) (215) (421) (286) (15) (301) 600 (579) 194 215 (300) 14 (286) 168 1,628 (1,196) 600 (292) (8) (300) Accumulated other comprehensive loss, net of tax $ (34,221) $ (43,530) $ (46,904) 4.SUPPLIER CONCENTRATION Purchases from our top ten suppliers comprised 84%, 85% and 84% of all purchases made in 2017, 2016 and 2015, respectively. Our largest supplier, Carrier and its affiliates, accounted for 62% of all pur- chases made in 2017, 2016 and 2015. See Note 17. A significant interruption 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 $ $ 2017 820 74,486 76,117 15,282 47,377 2016 820 71,082 74,640 15,090 42,515 214,082 (122,884) 204,147 (113,645) $ 91,198 $ 90,502 Depreciation and amortization expense related to property and equipment included in selling, general and administrative expenses for the years ended December 31, 2017, 2016 and 2015, were $16,770, $14,853 and $13,802, respectively. 6. DEBT We maintain an unsecured, syndicated revolving credit agreement, which we use to fund seasonal work- ing capital needs and for other general corporate purposes, including acquisitions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases and issuances of letters of credit. Effective February 5, 2018, we decreased the borrowing capacity under this credit agreement from $600,000 to $300,000. Included in the credit facility are a $90,000 swingline subfacility, a $10,000 letter of credit subfacility and a $75,000 multicurrency borrowing 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 87.5 basis-points at December 31, 2017), 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, 2017), 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 (12.5 basis-points at December 31, 2017). At December 31, 2017 and 2016, $21,800 and $235,294, 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, 2017. 7. INCOME TAXES On December 22, 2017, Public Law 115-97 “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” was enacted. This law is com- monly referred to as the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The TCJA made broad and complex changes to the U.S. tax code including but not limited to, reducing the U.S. federal corporate tax rate 46 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 47 from 35% to 21% effective January 1, 2018 and requiring a one-time repatriation transition tax on cer- tain undistributed earnings of foreign subsidiaries. The TCJA also put in place new tax laws that will apply prospectively, which include, but are not limited to, generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries and a new provision designed to tax U.S. allocated expenses as well as currently taxing certain global intangible low-taxed income (“GILTI”) of foreign subsidiaries. GILTI is a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. We have not yet determined our policy election with respect to whether to record deferred taxes for basis differ- ences expected to reverse as a result of the GILTI provisions in future years, or in the period in which that tax was incurred. U.S. GAAP requires the impact of tax legislation to be recorded in the period of enactment. As a result, our 2017 effective income tax rate reflects a net income tax benefit of $9,955 attributable to the passage of the TCJA. This amount includes an income tax benefit from the revaluation of U.S. deferred income taxes, partially offset by an estimate for income tax expense to record U.S. federal, state and foreign with- holding tax on previously undistributed earnings of our foreign subsidiaries. Due to the enactment date and tax complexities of the TCJA, we have not completed the accounting related to these items. In accor- dance with Staff Accounting Bulletin 118, provisional amounts have been recorded for the U.S. income tax attributable to the TCJA’s deemed repatriation provision and the revaluation of U.S. deferred taxes. These estimates may be impacted by the need for further analysis and future clarification and guidance regarding available tax accounting methods and elections, earnings and profits computations, and state tax conformity to federal tax changes. 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 2017 69,079 10,643 10,499 90,221 100,956 (10,735) 90,221 $ $ $ $ 2016 86,719 9,801 9,416 105,936 103,216 2,720 105,936 $ $ $ $ 2015 85,585 9,431 9,661 104,677 99,990 4,687 104,677 $ $ $ $ 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: Years Ended December 31, 2017 2016 2015 U.S. federal statutory rate State income taxes, net of federal benefit and other Excess tax benefits from share-based compensation Tax effects on foreign income Tax credits and other Repatriation transition tax Deferred tax impact of enacted tax rate changes Effective income tax rate attributable to Watsco, Inc. Taxes attributable to non-controlling interest Effective income tax rate 48 WATSCO, INC. 2017 ANNUAL REPORT 35.0% 2.4 (2.7) (1.0) (0.6) 3.0 (6.3) 29.8 (3.8) 35.0% 2.3 (1.0) (0.1) (0.2) — — 36.0 (5.0) 35.0% 2.4 — (0.3) (0.1) — — 37.0 (5.4) 26.0% 31.0% 31.6% The following is a summary of the significant components of our net deferred tax liabilities: December 31, Current deferred tax assets: Share-based compensation Capitalized inventory costs and inventory reserves Allowance for doubtful accounts Self-insurance reserves Other Net operating loss carryforwards Valuation allowance Total deferred tax assets Deferred tax liabilities: Deductible goodwill Depreciation Other Total deferred tax liabilities Net deferred tax liabilities (1) $ 2017 2016 $ 18,977 2,107 929 153 2,423 291 24,880 — 24,880 26,239 2,301 1,379 500 2,227 209 32,855 — 32,855 (67,246) (5,519) (5,189) (77,954) (88,581) (5,883) (1,633) (96,097) $ (53,074) $ (63,242) (1) At December 31, 2017, net deferred tax liabilities have been included in the consolidated balance sheet in deferred income taxes and other liabilities. At December 31, 2016, net current deferred tax assets and liabilities of $5,485 are included in the consolidated bal- ance sheet in other current assets and net long-term deferred tax assets and liabilities of $68,727 are included in the consolidated balance sheet in deferred income taxes and other liabilities. Prior to enactment of the TCJA, U.S. income taxes had not been provided on undistributed earnings of our foreign subsidiaries as we had intended to reinvest such earnings permanently outside the U.S. or to repa- triate such earnings only when it was tax effective to do so. As a result of the enactment of the TCJA, we have provided an estimate related to the repatriation transition tax and foreign withholding tax on certain undistributed earnings of our foreign subsidiaries at December 31, 2017. Our intent going forward is to indefinitely reinvest undistributed earnings outside of the U.S. or to repatriate the earnings only when it is tax effective to do so. Valuation allowances are provided to reduce the related deferred income tax assets to an amount which will, more likely than not, be realized. As a result of our assessment of the realization of deferred income tax assets, we have concluded that it is more likely than not that all of our deferred income tax assets will be realized and thus no valuation allowance was necessary at both December 31, 2017 and 2016. At December 31, 2017, there were state net operating loss carryforwards of $7,606, which expire in vary- ing amounts from 2018 through 2037. These amounts are available to offset future taxable income. There were no federal net operating loss carryforwards at December 31, 2017. 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 2014. For the majority of states and foreign jurisdictions, we are no longer subject to tax examinations for tax years prior to 2013. As of December 31, 2017 and 2016, the total amount of gross unrecognized tax benefits (excluding the federal benefit received from state positions) was $4,225 and $3,695, respectively. Of these totals, $3,457 and $2,573, 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 WATSCO, INC. 2017 ANNUAL REPORT 49 to income tax matters in income tax expense in the consolidated statements of income. As of December 31, 2017 and 2016, the cumulative amount of estimated accrued interest and penalties resulting from such unrecognized tax benefits was $540 and $414, 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, 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 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2016 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2017 $ 3,719 871 (1,077) 3,513 547 (365) 3,695 801 (271) $ 4,225 8. SHARE-BASED COMPENSATION AND BENEFIT PLANS Share-Based Compensation Plans We maintain the 2014 Incentive Compensation Plan (the “2014 Plan”) that 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-qualified stock options and non-vested restricted stock. The 2014 Plan replaced the Watsco, Inc. Amended and Restated 2001 Incentive Compensation Plan (the “2001 Plan”) upon its expiration in 2014. 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 2001 Plan as of the date our share- holders 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 439,534 shares of Common stock, net of cancellations, and 493,522 shares of Class B common stock, had been awarded under the 2014 Plan as of December 31, 2017. As of December 31, 2017, 1,112,365 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 specified age, generally toward the end of an employee’s career at age 62 or older. Vesting may be accelerated in certain circum- stances prior to the original vesting date. The 2001 Plan expired during 2014; therefore, no additional options may be granted. There were 12,750 options to exercise common stock outstanding under the 2001 Plan at December 31, 2017. 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, 2017: Options outstanding at December 31, 2016 Granted Exercised Forfeited Expired Options outstanding at December 31, 2017 Options exercisable at December 31, 2017 Weighted- Average Exercise Price 122.80 150.35 98.05 139.40 67.25 136.44 121.65 Options 294,250 179,750 (39,751) (34,166) (1,250) 398,833 33,919 $ $ $ Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value 3.47 2.80 $ $ 13,401 1,641 The following is a summary of non-vested restricted stock activity as of and for the year ended December 31, 2017: Non-vested restricted stock outstanding at December 31, 2016 Granted Vested Forfeited Weighted- Average Grant Date Fair Value 54.13 149.47 50.05 134.71 $ Shares 2,898,890 176,899 (80,550) (10,000) Non-vested restricted stock outstanding at December 31, 2017 2,985,239 $ 51.22 The weighted-average grant date fair value of non-vested restricted stock granted during 2017, 2016 and 2015 was $149.47, $130.01 and $114.55, respectively. The fair value of non-vested restricted stock that vested during 2017, 2016 and 2015 was $11,580, $10,096 and $2,468, respectively. During 2017, 32,454 shares of Common stock with an aggregate fair market value of $4,664 were with- held as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. During 2016, 30,413 shares of Common and Class B common stock with an aggregate fair market value of $3,967 were withheld as payment in lieu of cash to satisfy tax withholding obliga- tions in connection with the vesting of restricted stock. 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 with- holding 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 50 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 51 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 2017 2016 2015 4.25 1.77% 17.41% 2.82% 4.25 1.24% 18.65% 2.54% 4.25 1.25% 20.96% 2.29% $17.23 $16.37 $17.17 Exercise of Stock Options The total intrinsic value of stock options exercised during 2017, 2016 and 2015 was $2,296, $4,123 and $6,691, respectively. Cash received from the exercise of stock options during 2017, 2016 and 2015 was $3,855, $4,447 and $4,850, respectively. During 2017, 2016 and 2015, 350 shares of Common stock with an aggregate fair market value of $53, 348 shares of Common stock with an aggregate fair market value of $51 and 26,006 shares of Class B common stock with an aggregate fair market value of $3,251, respectively, were withheld as payment in lieu of cash for stock option exercises and related tax withholdings. These shares were retired upon delivery. 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 2017 1,451 11,842 13,293 $ $ 2016 1,149 11,170 12,319 $ $ 2015 952 11,644 12,596 $ $ At December 31, 2017, there was $2,703 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 2017, 2016 and 2015 was $754, $736 and $856, respectively. At December 31, 2017, there was $109,297 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 years. Of this amount, approximately $59,000 is related to awards granted to our Chief Executive Officer (“CEO”), of which approximately $11,000 and $48,000 vest in approximately 5 and 9 years upon his attainment of age 82 and 86, respectively. In the event that vesting is accelerated for any circumstance, as defined in the related agreements, the remaining unrecognized share-based compensa- tion expense would be immediately recognized as a charge to earnings with a corresponding tax benefit. At December 31, 2017, we were obligated to issue 42,871 shares of non-vested restricted stock to our CEO that vest in 9 years and 13,779 shares of non-vested restricted stock to our President that vest in 26 years in connection with 2017 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 ESPP allows participating employees to purchase shares of Common stock at a 5% discount to the fair market value at specified times. During 2017, 2016 and 2015, employees purchased 5,571, 5,956 and 6,463 shares of Common stock at an average price of $144.58, $125.84 and $112.53 per share, respectively. Cash dividends received by the ESPP were reinvested in Common stock and resulted in the issuance of 3,844, 3,442 and 3,183 additional shares during 2017, 2016 and 2015, respectively. We received net proceeds of $1,389, $1,206 and $1,107, respectively, during 2017, 2016 and 2015, for shares of our Common stock purchased under the ESPP. At December 31, 2017, 486,745 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, 2017, 2016 and 2015, we issued 16,389, 20,045 and 18,343 shares of Common stock, respectively, to the plan, representing the Common stock discretionary matching contribution of $2,428, $2,348 and $1,963, respectively. 9. PURCHASE OF ADDITIONAL OWNERSHIP INTEREST IN JOINT VENTURE In 2011, we formed a joint venture with Carrier, Carrier Enterprise Northeast LLC, which we refer to as Carrier Enterprise II. Carrier Enterprise II had sales of approximately $545,000 in 2017 from 40 locations in the northeastern United States and 14 locations in Mexico. We initially owned a 60% controlling inter- est in Carrier Enterprise II. On November 29, 2016, we purchased an additional 10% ownership interest for cash consideration of $42,909, and, on February 13, 2017, we purchased an additional 10% owner- ship interest for cash consideration of $42,688, which together increased our controlling interest in Carrier Enterprise II to 80%. 10. INVESTMENT IN UNCONSOLIDATED ENTITY On June 21, 2017, our first joint venture with Carrier, Carrier Enterprise, LLC, which we refer to as Carrier Enterprise I, acquired an approximately 35% ownership interest in Russell Sigler, Inc. (“RSI”), an HVAC distributor with annual sales of approximately $650,000, operating from 30 locations in the Western U.S. We have an 80% controlling interest in Carrier Enterprise I, and Carrier has a 20% non-controlling interest. Carrier Enterprise I acquired its ownership interest in RSI for cash consideration of $63,600, of which we contributed $50,880 and Carrier contributed $12,720. Carrier Enterprise I entered into a shareholders agreement (the “Shareholders Agreement”) with RSI and its shareholders. Pursuant to the Shareholders Agreement, RSI’s shareholders have the right to sell, and Carrier Enterprise I has the obligation to pur- chase, their respective shares of RSI for a purchase price determined based on either book value or a mul- tiple of EBIT, the latter of which Carrier Enterprise I used to calculate the price paid for its investment in RSI. RSI’s shareholders may transfer their respective shares of RSI common stock only to members of the Sigler family or to Carrier Enterprise I, and, at any time from and after the date on which Carrier Enterprise I owns 85% or more of RSI’s outstanding common stock, it has the right, but not the obligation, to pur- chase from RSI’s shareholders the remaining outstanding shares of RSI common stock. Additionally, Carrier Enterprise I has the right to appoint two of RSI’s six board members. Given Carrier Enterprise I’s 35% voting equity interest in RSI and its right to appoint two out of RSI’s six board members, this invest- ment in RSI is accounted for under the equity method. 52 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 53 11. GOODWILL AND INTANGIBLE ASSETS The changes in the carrying amount of goodwill are as follows: Balance at December 31, 2015 Foreign currency translation adjustment Balance at December 31, 2016 Foreign currency translation adjustment Balance at December 31, 2017 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 $ 378,310 1,427 379,737 2,992 $ 382,729 Estimated Useful Lives 2017 2016 10-15 years 10 years 7 years $ 125,194 $ 120,288 73,053 1,150 — (38,332) 70,194 1,150 369 (33,437) 35,871 38,276 $ 161,065 $ 158,564 Amortization expense related to finite lived intangible assets included in selling, general and administrative expenses for the years ended December 31, 2017, 2016 and 2015, were $5,263, $5,213 and $5,315, respectively. Annual amortization of finite lived intangible assets for the next five years is expected to approximate the following. 2018 2019 2020 2021 2022 $ $ $ $ $ 4,900 4,900 4,900 4,200 3,500 12. 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, 2017 or 2016. At-the-Market Offering Program On August 23, 2017, we entered into a sales agreement with Robert W. Baird & Co. Inc., which enabled the Company to issue and sell shares of Common stock in one or more negotiated transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), for a maximum aggregate offering amount of up to $250,000 (the “ATM Program”). The offer and sale of our Common stock pursuant to the ATM Program was registered under the Securities Act pursuant to our automatically effective shelf registration statement on Form S-3 (File No. 333-207831). During 2017, we sold 1,498,662 shares of Common stock under the ATM Program for net proceeds of $247,744. Direct costs of $311 incurred in connection with the offering were charged against the pro- ceeds from the sale of Common stock and reflected as a reduction of paid-in capital. As of December 31, 2017, we had completed the offering of shares under the ATM Program. The net proceeds were primarily used to repay outstanding debt and for general corporate purposes. 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 2017, 2016 or 2015. 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, 2017, there were 1,129,087 shares remaining authorized for repurchase under the program. 13. 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, 2017 and 2016, 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 both December 31, 2017 and 2016, we were contingently liable under standby letters of credit aggre- gating $2,430, 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, 2017 and 2016, we were contingently liable under various performance bonds aggregating approximately $4,000 and $8,000, respectively, which are used as collateral to cover any contingencies related to our nonperfor- mance under agreements with certain customers. We do not expect that any material losses or obligations 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. 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. 54 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 55 14. DERIVATIVES We enter into foreign currency forward and option 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 occurs. The maximum period for which we hedge our cash flow using these instruments is 12 months. Accordingly, at December 31, 2017, 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, 2017 was $29,500, and such contracts have varying terms expiring through September 2018. The impact from foreign exchange derivative instruments designated as cash flow hedges were as follows: Years Ended December 31, Loss recorded in accumulated other comprehensive loss Gain (loss) reclassified from accumulated other comprehensive loss into earnings 2017 $ $ (961) (491) $ $ 2016 (1,321) 442 At December 31, 2017, we expected an estimated $962 pre-tax loss 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 and option 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 currency exchange contracts not designated as hedging instruments at December 31, 2017 was $11,200, and such contracts have varying terms expiring through August 2018. We recognized (losses) gains of $(829), $(306) and $2,552 from foreign currency forward and option contracts not designated as hedging instruments in our consolidated statements of income for 2017, 2016 and 2015, respectively. The following table summarizes the fair value of derivative instruments, which consist solely of foreign exchange contracts, included in other current assets and accrued expenses and other current liabilities in our consolidated balance sheets. See Note 15. December 31, Derivatives designated as hedging instruments Derivatives not designated as hedging instruments Total derivative instruments Asset Derivatives Liability Derivatives 2017 2016 2017 2016 $ 70 180 $ 227 14 $ 773 184 $ 250 $ 241 $ 957 $ $ 35 4 39 15. 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, 2017 Using Other assets Other current assets $ 332 $ 250 $ 332 $ — $ 250 $ — $ — $ — Accrued expenses and other current liabilities $ 957 $ — $ 957 $ — Balance Sheet Location Total Level 1 Level 2 Level 3 Fair Value Measurements at December 31, 2016 Using Assets: Available-for-sale securities Derivative financial instruments Other assets Other current assets $ 281 $ 241 $ 281 $ — $ 241 $ — $ — $ — Liabilities: Derivative financial instruments Accrued expenses and other current liabilities $ 39 $ — $ 39 $ — 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 and option contracts. See Note 14. 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 2017 or 2016. 16. COMMITMENTS AND CONTINGENCIES Litigation, Claims and Assessments In December 2015, a purported Watsco shareholder, Nelson Gaskins (the “Plaintiff”), filed a derivative lawsuit in the U.S. District Court for the Southern District of Florida (the “Court”) against Watsco’s Board of Directors. The Company was a nominal defendant. The lawsuit alleged breach of fiduciary duties regarding CEO incentive compensation and sought to recover alleged excessive incentive compensation and unspecified damages. The Court dismissed this action, and the Plaintiff filed a notice of appeal to the U.S. Court of Appeals for the Eleventh Circuit (the “Appellate Court”). In May 2017, the Appellate Court dismissed the Plaintiff’s appeal and the action with prejudice. Neither the Plaintiff nor the Plaintiff’s lawyers received any payment from, or on behalf of, Watsco or its Directors in connection with this law- suit and the related appeal. 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- 56 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 57 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. 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 $2,344 and $2,951 at December 31, 2017 and 2016, 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, 2017, 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 $4,200. See “Self-Insurance” above for further information on commitments associated with the insurance programs and Note 13, under the caption “Off-Balance Sheet Financial Instruments,” for further information on standby letters of credit. At December 31, 2017, 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 and vehicles used in our operations with varying terms through 2028. We are committed 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 escalating rent payment provi- sions. We recognize rent expense under such arrangements on a straight-line basis over the lease term. At December 31, 2017, future minimum payments under non-cancelable operating leases over each of the next five years and thereafter were as follows: 2018 2019 2020 2021 2022 Thereafter Total minimum payments $ 69,136 51,645 36,127 22,434 12,985 5,824 $ 198,151 Rental expense for the years ended December 31, 2017, 2016 and 2015, was $84,076, $83,260 and $82,581, respectively. Purchase Obligations At December 31, 2017, we were obligated under various non-cancelable purchase orders with our key suppliers for goods aggregating approximately $11,000. 17. RELATED PARTY TRANSACTIONS Purchases from Carrier and its affiliates comprised 62% of all inventory purchases made during 2017, 2016 and 2015. At December 31, 2017 and 2016, approximately $75,000 and $63,000, 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 2017, 2016 and 2015 included approximately $64,000, $56,000 and $62,000, respectively, of sales to Carrier and its affiliates. We believe these transactions are conducted on terms equivalent to an arm’s-length basis in the ordinary course of business. A member of our Board of Directors is the Chairman and Chief Executive Officer of Moss & Associates LLC, which serves as general contractor for the remodeling of our Miami headquarters. We paid Moss & Associates LLC $951 and $291 for construction services performed during 2017 and 2016, respectively, and $131 was payable at December 31, 2017. A member of our Board of Directors is the Senior Chairman of Greenberg Traurig, P.A., which serves as our principal outside counsel and receives customary fees for legal services. During 2017, we paid this firm $475 for services performed and $0 was payable at December 31, 2017. 18. 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, 2017 2016 2015 Revenues: United States Canada Mexico Total revenues December 31, Long-Lived Assets: United States Canada Mexico Total long-lived assets $ 3,919,684 269,603 152,668 $ 3,813,204 267,220 140,278 $ 3,710,977 263,908 138,354 $ 4,341,955 $ 4,220,702 $ 4,113,239 2017 2016 $ 540,136 163,944 5,400 $ 467,728 155,758 5,317 $ 709,480 $ 628,803 Revenues are attributed to countries based on the location of the store from which the sale occurred. Long-lived assets consist primarily of goodwill and intangible assets, property and equipment, and our investment in an unconsolidated entity. 19. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information was as follows: Years Ended December 31, Interest paid Income taxes net of refunds 2017 5,773 48,056 $ $ 2016 2015 $ $ 3,362 99,006 $ $ 4,993 103,261 58 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 59 20. SUBSEQUENT EVENTS On January 2, 2018, our Board of Directors declared a regular quarterly cash dividend of $1.25 per share of Common and Class B common stock that was paid on January 31, 2018 to shareholders of record as of January 16, 2018. Effective February 5, 2018, we decreased the borrowing capacity under our credit agreement from $600,000 to $300,000. See Note 6. On February 6, 2018, our Board of Directors approved an increase to the quarterly cash dividend per share of Common and Class B common stock to $1.45 per share from $1.25 per share, beginning with the dividend that will be paid in April 2018. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (In thousands, except per share data) Year Ended December 31, 2017 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, 2016 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 $ $ $ $ $ $ $ $ $ $ 872,095 218,556 26,181 $ 1,275,924 310,278 $ 73,756 $ $ 1,229,591 295,895 $ 65,029 $ 0.71 0.71 $ $ 2.07 2.07 $ $ 1.82 1.82 851,424 212,447 25,537 $ 1,214,435 291,861 $ 64,621 $ $ 1,241,232 302,204 $ 63,099 $ 0.71 0.71 $ $ 1.82 1.82 $ $ 1.78 1.78 $ $ $ $ $ $ $ $ $ $ 964,345 240,930 43,255 $ 4,341,955 $ 1,065,659 208,221 $ 1.19 1.19 $ $ 5.81 5.81 913,611 228,072 29,553 $ 4,220,702 $ 1,034,584 182,810 $ 0.81 0.81 $ $ 5.16 5.15 (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 evenly distributed throughout 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. 60 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 61 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, 2017 and 2016. At February 23, 2018, there were 216 Common stock registered share- holders and 121 Class B common stock registered shareholders. Common Class B Common Cash Dividend High Low High Low Common Class B Year Ended December 31, 2017: First quarter Second quarter Third quarter Fourth quarter Year Ended December 31, 2016: First quarter Second quarter Third quarter Fourth quarter $ $ 156.69 155.46 161.07 171.38 134.84 140.69 149.64 159.03 $ $ 143.00 135.45 142.30 159.30 108.09 129.00 138.37 130.88 $ $ 153.02 157.14 160.15 170.22 131.58 139.84 148.67 157.72 $ $ 143.00 134.10 146.26 160.15 108.25 129.17 138.85 131.01 $ $ $ $ 1.05 1.05 1.25 1.25 0.85 0.85 0.85 1.05 1.05 1.05 1.25 1.25 0.85 0.85 0.85 1.05 R 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 S&P MidCap 400 index, the S&P 500 index, and the Russell 2000 index. Given our position as the largest distributor of HVAC/R equipment, parts and supplies in North America, our unique, sole line of business, the nature of our customers (air conditioning and heating contractors), and the products and markets we serve, we cannot reasonably identify an appropriate peer group; therefore, we have included in the graph below the performance of the S&P MidCap 400 index, the S&P 500 index, and the Russell 2000 index, which con- tain companies with market capitalizations similar to our own. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock and in each index on December 31, 2012 and its relative performance is tracked through December 31, 2017. 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 SHAREHOLDER RETURN* $300 $250 $200 $150 $100 $50 12/12 12/13 12/14 12/15 12/16 12/17 Watsco, Inc. S&P MidCap 400 Watsco Class B Russell 2000 Index S&P 500 Index *$100 invested on 12/31/12 in stock or index, including reinvestment of dividends.Fiscal year ending December 31. Copyright© 2018 Standard & Poor's, a division of S&P Global. All rights reserved. Watsco, Inc. Watsco Class B S&P MidCap 400 Index S&P 500 Index Russell 2000 Index 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 100.00 100.00 100.00 100.00 100.00 129.97 131.41 133.50 132.39 138.82 147.90 148.80 146.54 150.51 145.62 165.71 168.98 143.35 152.59 139.19 215.42 217.36 173.08 170.84 168.85 254.97 254.55 201.20 208.14 193.58 62 WATSCO, INC. 2017 ANNUAL REPORT WATSCO, INC. 2017 ANNUAL REPORT 63 5-YEAR SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA (UNAUDITED) The following selected consolidated financial data should be read in conjunction with the audited consoli- dated 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) 2017 2016 2015 2014 2013 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 $ 4,341,955 1,065,659 353,874 257,290 $ 4,220,702 1,034,584 345,632 235,983 $ 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 49,069 208,221 5.81 4.60 4.60 $ $ $ $ 53,173 182,810 5.15 3.60 3.60 $ $ $ $ 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 $ $ $ $ 32,863 32,617 32,480 32,359 32,258 $ 2,046,877 $ 22,085 $ 1,550,977 5,200 $ 1,874,649 $ 235,642 $ 1,251,748 5,050 $ 1,788,442 $ 245,814 $ 1,203,721 4,950 $ 1,791,067 $ 303,885 $ 1,132,039 4,950 $ 1,669,531 $ 230,557 $ 1,127,392 4,750 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 (4) Chairman of the Board and Chief Executive Officer Cesar L. Alvarez (4) Senior Chairman, Greenberg Traurig, P.A. Denise Dickins (1,2,3) Professor of Accounting and Auditing, East Carolina University Jason Epstein (2,3) Managing Partner, Columbus Nova Brian E. Keeley (1,4) President and Chief Executive Officer, Baptist Health South Florida, Inc. Bob L. Moss (3) Chairman and Chief Executive Officer, Moss & Associates LLC Aaron J. Nahmad (4) President Steven Rubin (4) Co-Founder, Indiegogo, Inc. George P. Sape (1,2) Retired Managing Partner of Epstein Becker and Green, P.C. (1) Audit Committee (2) Compensation Committee (3) Nominating & Governance Committee (4) Strategy 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 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. 64 WATSCO, INC. 2017 ANNUAL REPORT Design: Suissa Design info@suissadesign.com

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