Watsco
Annual Report 2021

Plain-text annual report

ANNUAL REPORT 2021 WATSCO GOOD GOOD FOR THE PLANET FOR BUSINESS 2665 South Bayshore Drive, Suite 901 Miami, FL 33133 USA 305-714-4100 www.watsco.com ROUGHLY 117 MILLION METRIC TONS OF CARBON DIOXIDE ARE RELEASED INTO THE AIR EACH YEAR FROM HVAC SYSTEMS INSTALLED IN U.S. HOMES. WATSCO HAS REVOLUTIONIZED THE HVAC/R INDUSTRY AND IS NOW LEADING THE CHARGE IN COMBATTING CLIMATE CHANGE. IT’S THE RIGHT THING TO DO. FOR THE PLANET. FOR WATSCO. FINANCIAL HIGHLIGHTS TOTAL REVENUES (in millions) $4,342 $4,547 $4,770 $5,055 $6,280 (in thousands, except per share data) 2017 2018(1) 2019(2) 2020 2021 2017 2018 2019 2020 2021 Revenues Operating income EBITDA(3) Net Income $ 4,341,955 353,874 375,907 $ 4,546,653 $ 4,770,362 366,884 391,396 372,082 394,177 $ 5,054,928 401,034 426,942 $ 6,280,192 628,528 656,655 attributable to Watsco, Inc. 208,221 Diluted earnings per share 5.81 Adjusted diluted earnings per share(4) 5.54 4.60 Dividends per share 306,520 Operating cash flow 2,046,877 Total assets 242,932 6.49 6.49 5.60 170,557 2,161,033 245,950 6.50 6.50 6.40 335,771 2,556,161 269,579 7.01 7.01 6.925 534,379 2,484,347 418,945 10.78 10.78 7.625 349,566 3,085,861 Borrowings under revolving credit agreement Shareholders’ equity 21,800 1,550,977 135,200 1,601,713 155,700 1,714,767 — 1,779,761 89,000 1,997,415 (1) Effective January 1, 2018, we adopted the provisions of accounting guidance related to revenue recognition. Amounts prior to January 1, 2018 have not been adjusted and remain as originally reported for such periods. (2) Effective January 1, 2019, we adopted the provisions of accounting guidance related to leases. Amounts prior to January 1, 2019 have not been adjusted and remain as originally reported for such periods. (3) EBITDA is defined as earnings before interest expense, net, income taxes, depreciation and amortization. Amortization of debt costs is included in interest expense, net. (4) On December 2017, the Tax Cuts and Job Act of 2017 (the “TCJA”) was signed into law. Adjusted diluted earnings per share for 2017 2 WATSCO, INC. 2020 ANNUAL REPORT excludes the one-time tax benefit recognized by the company in the application of the TCJA. OPERATING INCOME (in millions) $629 $354 $372 $367 $401 2017 2018 2019 2020 2021 ADJUSTED DILUTED EARNINGS PER SHARE $10.78 $6.49 $6.50 $7.01 $5.54 2017 2018 2019 2020 2021 2 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 3 TO OUR VALUED SHAREHOLDERS: 2021 was an outstanding year for Watsco as we achieved record results yet again. Watsco began its journey as a distributor of air conditioning and heating products in 1989, and since then has become the industry leader delivering a 32-year cumulative total shareholder return of 26,442%, a 19% compounded annual growth rate, ranking us among the most successful U.S. public companies according to data provided by FactSet. We believe this success is the result of our entrepreneurial culture and unique business model, which we established decades ago and continues to drive our performance today. The core values of our culture include: – managing and investing with a long-term perspective – empowering entrepreneurs to make local decisions with local customers in mind – creating a sustainable competitive edge through our industry-leading technology platforms – respecting entrepreneurs and management teams that join our company via acquisition – promoting an ownership culture with long-term equity among key leaders – providing excellent wellness and retirement benefits for our employees – establishing strong and respectful relationships with our OEM partners – instilling a growth mindset and culture of continuous improvement – sustaining financial strength through conservative management of our balance sheet 4 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 5 Looking ahead, these core values coupled with our devoted customer focus can be put to work in the global fight to stem climate change. According to estimates by the Department of Energy, HVAC systems account for approximately half of U.S. household energy consumption. Furthermore, the installed base of HVAC systems includes tens of millions of systems that operate under outdated efficiency standards and contain refrigerants that may be detrimental to our climate. Our company and our customers are all capable of driving change that is good for the consumer, good for the environment, and good for our business. The products we sell have a direct and meaningful impact on overall energy consumption and CO2e emissions. As consumers replace older existing systems, particularly with high-efficiency systems, consumers save on energy costs and reduce greenhouse gas emissions. Upcoming federal regulatory changes will influence what products consumers choose from and how contractors present innovative solutions to homeowners. To that end, we are partnering with OEMs and suppliers to invest in more tools, technology and training for our customers to capitalize on this important opportunity. Our industry has much to contribute to this endeavor – and as a leader we are committed to do our part. In terms of 2021 performance, we achieved record sales and earnings, with nearly all other performance metrics at all-time levels. We continued to make progress in deploying the industry’s leading technologies to more customers. Watsco is fortunate to work with more than 350,000 HVAC contractors and technicians across 671 locations in North America who in turn service countless homeowners and businesses. Watsco continues to revolutionize how contractors do business in the digital age with the industry’s most robust, customer- obsessed platforms to support them, deepen our relationship and drive growth. The community of customers using our digital tools and platforms expanded in 2021 with active users generating stronger overall growth rates and considerably less attrition year over year. We continue to innovate and add functionality while actively engaging with more and more customers to drive greater adoption. We welcomed three new companies to the Watsco family during 2021, adding 56 locations and approximately $460 million in annualized revenues. Our acquisition of Temperature Equipment Corporation expanded Watsco’s reach into four Midwestern states. Our acquisition of Acme Refrigeration increased our penetration in a core sunbelt market. Finally, the purchase of Makdad Supply extended our reach into the refrigeration market. We are so pleased that more entrepreneurs have joined forces with us and that our shareholders will benefit from these investments in the long-term. Yet we believe we are only scratching the surface of what is possible. The spirit of innovation and entrepreneurism is alive and well at Watsco and we remain focused on what we believe will be the long-term drivers of success: continued innovation and adoption of technology by customers at scale, a strong financial foundation that positions us well in any environment and a sharpened focus on contributing to global efforts on climate change. The pages in this year’s annual report highlight our opportunities to impact climate change at this important moment in time. We are very optimistic about the future of the Company and the growth trajectory that lies ahead. Aaron (A.J.) Nahmad President 6 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 7 118,000,000 homes in the U.S., most of which have installed HVAC systems. The overwhelming majority of new HVAC systems sold by Watsco replace systems that likely operate well below current U.S. minimum efficiency standards and may use more harmful refrigerants that have been, or are being, phased-out. As consumers replace old, energy-intensive HVAC systems with new, higher-efficiency, eco-friendly systems, they will use less energy, decrease operating costs, and reduce their carbon footprint over time. 8 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 9 10,000,000+ estimated metric tons of CO2e emissions averted in 2020 - 2021 through our sale of higher-efficiency replacement residential HVAC systems. That represents the equivalent of removing nearly 2.2 million passenger vehicles from the roads over the course of one year. Since roughly half of a typical U.S. home’s energy consumption is used for heating and cooling, upgrading to higher efficiency HVAC systems is one of the most meaningful steps homeowners can take to reduce their electricity costs and CO2e emissions. 10 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 11 670+ branches across North America give us the scale to drive change since the products we sell have a direct and consequential impact on energy consumption and CO2e emissions. We are creating more awareness of the benefits of high-efficiency systems, developing training for contractors and technicians, and investing in technologies that help our customers sell, finance, install, and service more high- efficiency replacement systems and related accessories. 12 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 13 120,000+ active contractor and dealer customers in our network that play a crucial role in highlighting the benefits of high efficiency systems and energy-saving accessories. Education is key to building awareness around how equipment choices impact household energy consumption. We believe spreading the message of the advantages of high-efficiency HVAC systems, and the related reduction of CO2e emissions, benefits our customers, consumers, Watsco, and the planet. 14 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 15 3,000,000+ residential HVAC outdoor and indoor equipment units were sold by Watsco in 2021 from approximately 16 million square feet of warehousing and distribution facilities with our fleet of more than 800 ground transport vehicles. Each unit, square foot, and vehicle uses electricity or fuel and as a result, offers opportunities to reduce CO2e emissions. We are laying a foundation to improve our own carbon footprint, by gathering the appropriate data and determining the right methodology to set realistic and achievable targets. 16 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 13 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 Shareholder Return Performance Shareholder Information 20 33 34 36 38 38 39 40 42 43 67 68 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,” “goal,” “designed,” and variations of these words and negatives thereof and similar expressions are intended to identify forward-looking state- ments, including statements regarding, among others, (i) economic conditions, (ii) business and acquisi- tion strategies, (iii) potential acquisitions and/or joint ventures and investments in unconsolidated entities, (iv) financing plans, and (v) industry, demographic and other trends affecting our financial condition or results of operations. These forward-looking statements are based on management’s current expectations, are not guarantees of future performance and are subject to a number of risks, uncertainties, and changes in circumstances, certain of which are beyond our control. Actual results could differ materially from these forward-looking statements as a result of several factors, including, but not limited to: • general economic conditions, both in the United States and in the international markets we serve; • competitive factors within the HVAC/R industry; • effects of supplier concentration; • fluctuations in certain commodity costs; • consumer spending; • consumer debt levels; • the continued impact of the COVID-19 pandemic; • new housing starts and completions; • capital spending in the commercial construction market; • access to liquidity needed for operations; • seasonal nature of product sales; • weather patterns and conditions; • insurance coverage risks; • federal, state, and local regulations impacting our industry and products; • prevailing interest rates; • foreign currency exchange rate fluctuations; • international 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 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 statements were made. We assume no obligation to update forward-looking information or the discussion of such risks and uncertainties to reflect actual results, changes in assumptions, or changes in other factors affecting for- ward-looking information, except as required by applicable law. We qualify any and all of our forward- looking statements by these cautionary factors. This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity for the year ended December 31, 2021. This discussion should be read in con- junction with the information contained in Item 1A, “Risk Factors” and the consolidated financial state- ments, including the notes thereto, included in this Annual Report to Shareholders for the year ended December 31, 2021. 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, 2021, we operated from 671 locations in 42 U.S. States, Canada, Mexico, and Puerto Rico with additional market coverage on an export basis to portions of Latin America and the Caribbean. Revenues primarily consist of sales of air conditioning, heating, and refrigeration equipment, and related parts and supplies. Selling, general and administrative expenses primarily consist of selling expenses, the largest components of which are salaries, commissions, and marketing expenses that are variable and correlate to changes in sales. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts, and facility rent, a majority of which we operate under non-cancelable operating leases. Sales of residential central air conditioners, heating equipment, and parts and supplies are seasonal. Furthermore, profitability can be impacted favorably or unfavorably based on weather patterns, particu- larly during the Summer and Winter selling seasons. Demand related to the residential central air condi- tioning replacement market is typically highest in the second and third quarters, and demand for heating equipment is usually highest in the first and fourth quarters. Demand related to the new construction sec- tors throughout most of the markets we serve tends to be fairly evenly distributed throughout the year and depends largely on housing completions and related weather and economic conditions. COVID-19 PANDEMIC The COVID-19 pandemic continues to have widespread, rapidly-evolving and unpredictable impacts on financial markets and business practices. As conditions fluctuate, governments and organizations have responded by adjusting their restrictions and guidelines accordingly. Although we have learned to navigate COVID-19 while maintaining our operations in all material respects, our focus remains on promoting employee health and safety, serving our customers and ensuring business continuity. In response to the pandemic, we implemented plans intended to preserve adequate liquidity and ensure that our business continued to operate during this uncertain time. In addition, we took actions to reduce costs, including reductions in compensation, rent abatement, changes to vendor terms and other austerity measures to curtail discretionary spending in light of the circumstances in 2020. As restrictions have eased and normal economic conditions have largely resumed, our various austerity measures to curtail discretionary spending have eased. As economic activity has been recovering and the effects of the pandemic lessened in 2021, the impact of the pandemic on our business has been more reflective of greater economic and marketplace dynamics rather than pandemic-related issues, such as location closures, mandated restrictions and employee ill- ness. Manufacturers experienced some level of supply chain disruptions caused by constrained compo- nent availability, labor shortages, transportation delays, and other logistical challenges, all of which impacted typical lead times and overall availability of HVAC/R products. These supply chain disruptions impacted our ability to fulfill contractor demand at various points during 2021. Despite these disruptions, we experienced growth in sales of residential units during the year. As of the date of this filing, product availability has improved in recent months and more typical inventory levels are being reestablished to meet the continued strong end-market demand. Notwithstanding the recent resurgence of economic activity, in light of variant strains of the virus and the continued rate of viral infections that exists as of the date of this filing, there remains uncertainty concern- ing the magnitude of the impact and duration of the COVID-19 pandemic. The full impact of the COVID- 19 pandemic on our financial condition and results of operations will continue to depend on future developments, such as the ultimate duration and scope of the pandemic, its impact on our employees, customers and suppliers, potential subsequent waves of COVID-19 infection or potential new variants, the effectiveness and adoption of COVID-19 vaccines and therapeutics, the broader implications of the macro-economic recovery on our business, and the extent to which normal economic and operating condi- 20 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 21 tions are impacted, and whether the pandemic exacerbates the risks disclosed in Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2021. We intend to continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employ- ees, customers, suppliers and shareholders. CLIMATE CHANGE AND REDUCTIONS IN CO2e EMISSIONS We believe that our business plays an important and significant role in the drive to lower CO2e emissions. According to the United States Department of Energy, heating and air conditioning accounts for roughly half of household energy consumption in the United States. As such, replacing HVAC systems at higher efficiency levels is one of the most meaningful steps homeowners can take to reduce their electricity costs and carbon footprint over time. The overwhelming majority of new HVAC systems that we sell replace systems that likely operate well below current minimum efficiency standards in the United States and may use more harmful refrigerants that have been, or are being, phased-out. As consumers replace HVAC systems with new, higher-effi- ciency systems, homeowners will consume less energy, save costs and reduce the carbon footprint over time. The sale of high-efficiency systems has long been a focus of ours, and we have invested in tools and tech- nology intended to capture an increasingly richer sales mix over time. In addition, regulatory mandates will periodically increase the required minimum SEER, thus providing a catalyst for greater sales of higher-efficiency systems. We offer a broad variety of systems that operate beyond the minimum SEER standards, including systems that operate at more than 20 SEER. Our sales of higher-efficiency residential HVAC systems grew 26% organically in 2021, outpacing the overall growth rate of 17% for residential HVAC equipment in the United States. Based on estimates validated by independent sources, we averted an estimated 10.1 mil- lion metric tons of CO2e emissions during 2020 and 2021 through the sale of replacement residential HVAC systems at higher-efficiency standards. JOINT VENTURES WITH CARRIER GLOBAL CORPORATION In 2009, we formed a joint venture with Carrier, which we refer to as Carrier Enterprise I, in which Carrier contributed company-owned locations in the Sun Belt states and Puerto Rico, and its export divi- sion in Miami, Florida, and we contributed certain locations that distributed Carrier products. We have an 80% controlling interest in Carrier Enterprise I, and Carrier has a 20% non-controlling interest. The export division, Carrier InterAmerica Corporation, redomesticated from the U.S. Virgin Islands to Delaware effec- tive December 31, 2019, following which Carrier InterAmerica Corporation became a separate operating entity in which we have an 80% controlling interest and Carrier has a 20% non-controlling interest. On August 1, 2019, Carrier Enterprise I acquired substantially all of the HVAC assets and assumed certain of the liabilities of Peirce-Phelps, Inc. (“PPI”), an HVAC distributor operating from 19 locations in Pennsylvania, New Jersey, and Delaware. In 2011, we formed a second joint venture with Carrier, which we refer to as Carrier Enterprise II, in which Carrier contributed company-owned locations in the Northeast U.S., and we contributed certain locations operating as Homans Associates LLC (“Homans”), a Watsco subsidiary, in the Northeast U.S. Subsequently, Carrier Enterprise II purchased Carrier’s distribution operations in Mexico. We have an 80% controlling interest in Carrier Enterprise II, and Carrier has a 20% non-controlling interest. Effective May 31, 2019, we repurchased the 20% ownership interest in Homans from Carrier Enterprise II, follow- ing which we own 100% of Homans. Homans previously operated as a division of Carrier Enterprise II and subsequent to the purchase operates as a wholly owned subsidiary of the Company. In 2012, we formed a third joint venture with Carrier, which we refer to as Carrier Enterprise III. Carrier contributed 35 of its company-owned locations in Canada to Carrier Enterprise III. We have a 60% con- trolling interest in Carrier Enterprise III, and Carrier has a 40% non-controlling interest. On April 9, 2021, we acquired certain assets and assumed certain liabilities comprising the HVAC distri- bution business of Temperature Equipment Corporation, an HVAC distributor operating from 32 locations in Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri and Wisconsin. We formed a new, stand- alone joint venture with Carrier, TEC Distribution LLC (“TEC”), that operates this business. We have an 80% controlling interest in TEC, and Carrier has a 20% non-controlling interest. CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results may differ from these 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 assumptions 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 in this Annual Report to Shareholders. Management believes that the following account- ing estimates include a higher degree of judgment and/or complexity and are reasonably likely to have a material impact on our financial condition or results of operations and, thus, are considered critical accounting estimates. Management has discussed the development and selection of critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the disclosures relating to 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, including potential impacts of business and economic conditions. Our business and our customers’ businesses are seasonal. Sales are lowest during the first and fourth quarters, and past due accounts receivable balances as a percentage of total trade receivables generally increase during these quarters. We review our accounts receivable reserve policy periodically, reflecting current risks, trends, and changes in industry conditions. The allowance for doubtful accounts was $11.3 million and $7.1 million at December 31, 2021 and 2020, respectively, an increase of $4.2 million, which is primarily due to an account delinquent in their payments due to us as of December 31, 2021. Accounts receivable balances greater than 90 days past due as a percent of accounts receivable at December 31, 2021 decreased to 0.9% from 1.4% at December 31, 2020, primarily attributable to an improvement in the underlying quality of our accounts receivable portfolio at December 31, 2021. 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- 22 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 23 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. The identification and measurement of goodwill impairment involves the estimation of the fair value of our reporting unit and contains uncertainty because management must use judgment in determining appropriate assump- tions to be used in the measurement of fair value. On January 1, 2022, we performed our annual evalua- tion of goodwill impairment and determined that the estimated fair value of our reporting unit exceeded its carrying value. The recoverability of indefinite lived intangibles and long-lived assets are also evaluated on an annual basis or more often if deemed necessary. Indefinite lived intangibles and long-lived assets not subject to amortization are assessed for impairment by comparing the fair value of the intangible asset or long-lived asset to its carrying amount to determine if a write-down to fair value is required. Our annual evaluation did not indicate any impairment of indefinite lived intangibles or long-lived assets. 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 $1,124.5 million and $999.9 million at December 31, 2021 and 2020, respectively, an increase of $124.6 million, primarily reflecting newly acquired businesses. Although no impairment losses have been recorded to date, there can be no assurance that impairments will not occur in the future. An adjustment to the carrying value of goodwill, intangibles, and long-lived assets could materially adversely impact the consolidated results of operations. Loss Contingencies Accruals are recorded for various contingencies including self-insurance, legal proceedings, environmental matters, and other claims that arise in the normal course of business. The estimation process contains uncertainty because accruals are based on judgment, the probability of losses and, where applicable, the consideration of opinions of external legal counsel and actuarially determined estimates. Additionally, we record receivables from third party insurers when recovery has been determined to be probable. Self-insurance reserves are maintained relative to company-wide casualty insurance and health benefit programs. The level of exposure from catastrophic events is limited by the purchase of stop-loss and aggregate liability reinsurance coverage. When estimating the self-insurance liabilities and related reserves, management considers several factors, which include historical claims experience, demographic factors, severity factors, and valuations provided by independent third-party actuaries. Management reviews its assumptions with its independent third-party actuaries to evaluate whether self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occur and exceed these estimates, additional reserves may be required and could materially impact the consolidated results of operations. The estimation process contains uncertainty since management must use judgment to esti- mate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. Reserves in the amounts of $7.3 million and $5.4 million at December 31, 2021 and 2020, 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. A valuation allowance of $5.1 million and $0.7 million was recorded at December 31, 2021 and 2020, respectively. The increase was primarily attributable to the impact on U.S. deferred tax assets from share-based compensation deduction limitations related to the expansion of IRC Section 162(m). See Note 9 to our audited consolidated financial statements included in this Annual Report to Shareholders. The valuation allowance is based on several factors including, but not limited to, estimates of future taxable income by jurisdiction in which the deferred tax assets will be recoverable. These esti- mates can be affected by several factors, including changes to tax laws, or possible tax audits, or general economic conditions, or competitive pressures that could affect future taxable income. Although manage- ment believes that the estimates are reasonable, the deferred tax asset and any related valuation allowance will need to be adjusted if management’s estimates of future taxable income differ from actual taxable income. An adjustment to the deferred tax asset and any related valuation allowance could mate- rially impact the consolidated results of operations. NEW ACCOUNTING STANDARDS There have been no new accounting standards made effective during 2021 that have significance, or potential significance, to our consolidated financial statements. 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, 2021, 2020 and 2019. 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 2021 2020 2019 100.0% 73.4 100.0% 75.8 100.0% 75.7 26.6 16.9 0.3 10.0 0.0 10.0 2.1 7.9 1.3 24.2 16.5 0.2 7.9 0.0 7.9 1.5 6.4 1.1 24.3 16.8 0.2 7.7 0.1 7.6 1.4 6.2 1.0 Net income attributable to Watsco, Inc. 6.7% 5.3% 5.2% Note: Due to rounding, percentages may not add up to 100. The following narratives reflect our acquisitions of Makdad Industrial Supply Co., Inc. (“MIS”) in August 2021, Acme Refrigeration of Baton Rouge LLC (“ACME”) in May 2021, and Temperature Equipment Corporation in April 2021. In the following narratives, computations and other information referring to “same-store basis” exclude the effects of locations closed, acquired, or locations opened, in each case during the immediately preceding 24 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 25 12 months, unless such locations are within close geographical proximity to existing locations. At December 31, 2021 and 2020, four and two locations, respectively, that we had opened during the immediately preceding 12 months were near existing locations and were therefore included in “same- store basis” information. The table below summarizes the changes in our locations for 2021 and 2020: December 31, 2019 Opened Closed December 31, 2020 Opened Acquired Closed December 31, 2021 Number of Locations 606 3 (9) 600 24 56 (9) 671 2021 Compared to 2020 Revenues Revenues for 2021 increased $1,225.3 million, or 24%, to $6,280.2 million, including $326.5 million attributable to new locations acquired and $19.1 million from other locations opened during the preced- ing 12 months, offset by $8.0 million from locations closed. Sales of HVAC equipment (69% of sales) increased 23%, sales of other HVAC products (28% of sales) increased 22% and sales of commercial refrigeration products (3% of sales) increased 29%. On a same-store basis, revenues increased $887.7 million, or 18%, as compared to 2020, reflecting an 18% increase in sales of HVAC equipment (69% of sales), which included an 18% increase in residential HVAC equipment (17% increase in U.S. markets and a 26% increase in international markets) and a 17% increase in sales of commercial HVAC equip- ment (16% increase in U.S. markets and a 20% increase in international markets), a 17% increase in sales of other HVAC products (27% of sales), and a 29% increase in sales of commercial refrigeration products (4% of sales). For HVAC equipment, the increase in revenues was primarily due to strong demand for residential HVAC equipment, the realization of price increases, and a greater mix of high-effi- ciency air conditioning and heating systems, which sell at higher unit prices. During 2021, the unit vol- ume for residential unitary air conditioning equipment increased 8% and the average selling price increased 9%. Gross Profit Gross profit for 2021 increased $444.7 million, or 36%, to $1,667.5 million, primarily as a result of increased revenues. Gross profit margin improved 240 basis-points to 26.6% in 2021 versus 24.2% in 2020, primarily due to the benefits of pricing actions implemented using technologies to optimize pricing and margins to pass on price increases from our suppliers to our customers and an improved sales mix of higher-efficiency HVAC systems. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2021 increased $225.3 million, or 27%, to $1,058.3 mil- lion, primarily due to increased revenues and newly acquired locations. Selling, general and administrative expenses as a percentage of revenues for 2021 increased to 16.9% versus 16.5% in 2020. On a same- store basis, selling, general and administrative expenses increased 19% as compared to 2020 and as a per- centage of sales increased to 16.6% versus 16.5% in 2020. The increase was primarily related to increased higher variable selling costs driven by the increase in revenues, investments in employee headcount and per- formance-based compensation costs (commissions and bonuses throughout the Company), increased logis- tics costs in response to strong demand and continuing supply chain disruptions, and increased rent expense associated with new locations opened. Selling, general and administrative expenses in 2021 also reflect a $7.6 million increase in spending for ongoing technology initiatives. Other Income Other income of $19.3 million and $11.3 million for 2021 and 2020, respectively, represented our share of the net income of Russell Sigler, Inc. (“RSI”), in which we have a 38.1% equity interest. Operating Income Operating income for 2021 increased $227.5 million, or 57%, to $628.5 million. Operating margin improved 210 basis-points to 10.0% in 2021 from 7.9% at 2020. On a same-store basis, operating margin was 10.1% in 2021 as compared to 7.9% in 2020. Interest Expense, Net Interest expense, net for 2021 decreased $0.2 million, or 20%, to $1.0 million, primarily as a result of a decrease in average outstanding borrowings for the 2021 period, as compared to the same period in 2020. Income Taxes Income taxes increased 68% to $128.8 million and represent a composite of the income taxes attributa- ble to our wholly owned operations and income taxes attributable to the Carrier joint ventures, which are primarily taxed as partnerships for income tax purposes; therefore, Carrier is responsible for its proportion- ate share of income taxes attributable to its share of earnings from these joint ventures. The effective income tax rates attributable to us were 23.4% and 22.0% for 2021 and 2020, respectively. The increase was primarily due to the addition of a valuation allowance on the deferred tax asset related to share-based compensation, higher state income taxes, and proportionately higher income in 2021 as compared to tax credits and share-based compensation deductions in 2020. Net Income Attributable to Watsco, Inc. Net income attributable to Watsco in 2021 increased $149.4 million, or 55%, to $418.9 million. The increase was primarily driven by higher revenues and expanded profit margins, partially offset by higher selling, general and administrative expenses, income taxes, and an increase in the net income attributable to the non-controlling interest. Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2020 for a discussion of results of opera- tions for the year ended December 31, 2020 compared to the year ended December 31, 2019. 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 revolving credit facility; • 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. Sources and Uses of Cash We rely on cash flows from operations and borrowing capacity under our revolving credit agreement to fund seasonal working capital needs and for other general corporate purposes in the short-term and the long-term, including dividend payments (if and as declared by our Board of Directors), capital expendi- tures, 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, 2021, we had $118.3 million of cash and cash equivalents, of which $103.6 million 26 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 27 was held by foreign subsidiaries. The repatriation of cash balances from our foreign subsidiaries could have adverse tax impacts or be subject to capital controls; however, these balances are generally avail- able to fund the ordinary business operations of our foreign subsidiaries without legal restrictions. We believe that our operating cash flows, cash on hand, funds available for borrowing under our revolving credit agreement, and funds available from sales of our Common stock under our at-the-market offering program, each of which is described below, will be sufficient to meet our liquidity needs for the foresee- able future. However, there can be no assurance that our current sources of available funds will be suffi- cient 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. On March 5, 2021, the United Kingdom Financial Conduct Authority, which regulates LIBOR, confirmed that LIBOR will either cease to be provided by any administrator or will no longer be representative after June 30, 2023 for USD LIBOR reference rates. Our revolving credit agree- ment provides that it may be amended to replace LIBOR with an alternate benchmark rate. The impact of such an amendment cannot be entirely predicted but could result in an increase in the cost of our debt. Additionally, 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 increased to $1,234.7 million at December 31, 2021, which includes 56 locations added by acquisitions in 2021 that in aggregate added $91.1 million of working capital. Excluding these acquired locations, working capital increased 15% to $1,143.6 million at December 31, 2021 from $997.3 million at December 31, 2020, primarily due to higher accounts receivable consistent with over- all increased sales and higher levels of inventory in support of stronger business conditions. Cash Flows The following table summarizes our cash flow activity for 2021 and 2020 (in millions): Cash flows provided by operating activities Cash flows used in investing activities Cash flows used in financing activities 2021 2020 Change $ $ $ 349.6 (148.6) (228.6) $ $ $ 534.4 (16.3) (448.5) $ $ $ (184.8) (132.3) 219.9 The individual items contributing to cash flow changes for the years presented are detailed in the audited consolidated statements of cash flows included in this Annual Report to Shareholders. Operating Activities The decrease in net cash provided by operating activities was primarily due to higher levels of inventory in support of strong business conditions and higher accounts receivable driven by increased sales, partially offset by timing of vendor payments in 2021 as compared to 2020. Investing Activities Net cash used in investing activities was higher primarily due to cash consideration paid for acquisitions. Financing Activities The decrease in net cash used in financing activities was primarily attributable to net borrowings under our revolving credit agreement in 2021 versus net repayments in 2020 and $21.0 million in proceeds from the non-controlling interest for its contribution to the acquisition of Temperature Equipment Corporation in 2021, partially offset by an increase in dividends paid in 2021. Revolving Credit Agreement We maintain an unsecured, $560.0 million syndicated multicurrency revolving credit agreement, which we use to fund seasonal working capital needs and for other general corporate purposes, including acquisi- tions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases and issuances of letters of credit. The credit facility has a seasonal component from October 1 to March 31, during which the borrowing capacity may be reduced to $460.0 million at our discretion (which effectively reduces fees payable in respect of the unused portion of the commitment), and we effected this reduction in 2021. Included in the credit facility are a $100.0 million swingline subfacility, a $10.0 million letter of credit subfacility, a $75.0 million alternative currency borrowing sublimit and an $8.0 million Mexican borrowing sublimit. The credit agreement matures on December 5, 2023. Borrowings under the credit facility bear interest at either LIBOR-based rates plus a spread, which ranges from 87.5 to 150.0 basis-points (LIBOR plus 87.5 basis-points at December 31, 2021), depending on our ratio of total debt to EBITDA, or on rates based on the highest of the Federal Funds Effective Rate plus 0.5%, the Prime Rate or the Eurocurrency Rate plus 1.0%, in each case plus a spread which ranges from 0 to 50.0 basis-points (0 basis-points at December 31, 2021), 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 7.5 to 20.0 basis-points (7.5 basis-points at December 31, 2021). At December 31, 2021 $89.0 million was outstanding under the revolving credit agreement. At December 31, 2020 there was no outstanding balance 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, 2021. At-the-Market Offering Program On August 6, 2021, we entered into a sales agreement with Robert W. Baird & Co. Inc. (“Baird”), which enables the Company to issue and sell shares of Common stock in one or more negotiated transactions or transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), for a maximum aggregate offering amount of up to $300.0 million (the “ATM Program”). The offer and sale of our Common stock pursuant to the ATM Program has been registered under the Securities Act pursuant to our automatically effective shelf regis- tration statement on Form S-3 (File No. 333-260758). As of December 31, 2021, no shares of Common stock had been sold under the ATM Program. On February 25, 2022, we amended our sales agreement with Baird to include Goldman Sachs & Co. LLC as an additional sales agent. See Item 9B of our Annual Report on Form 10-K for additional information. Contractual Obligations At December 31, 2021, operating lease liabilities for real property, vehicles and equipment totaled $269.0 million and expire at various dates through 2031. Refer to Note 2 to our audited consolidated financial statements included in this Annual Report to Shareholders for information on our operating lease liabilities and related maturities. On October 15, 2022, 975,622 shares of Class B restricted stock held by our Chief Executive Officer (“CEO”) will vest. The CEO may elect to satisfy the tax withholding obligations in connection with the vesting of restricted stock either by the Company’s withholding of shares otherwise deliverable to the CEO, or in cash, or any combination of the two. If the CEO elects to withhold shares, we would satisfy the withholding tax obligations in cash. Based on the closing price of Watsco’s Class B common stock and withholding tax rates in effect at December 31, 2021, the estimated withholding tax obligation would have been approximately $118.0 million had the shares vested on December 31, 2021. Commercial obligations outstanding at December 31, 2021 under our revolving credit agreement con- sisted of borrowings totaling $89.0 million with revolving maturities of nine days. 28 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 29 At December 31, 2021, we were obligated under various non-cancelable purchase orders with our key suppliers for goods aggregating approximately $45.0 million, of which approximately $31.0 million is with Carrier and its affiliates. These purchase obligations represent commitments under purchase orders for goods in the ordinary course of business that are enforceable and legally binding with defined terms as to price, quantity, and delivery. The total amount of unrecognized tax benefits (net of the federal benefit received from state positions) relating to various tax positions we have taken, the timing of which is uncertain, was $5.6 million at December 31, 2021. Refer to Note 9 to our audited consolidated financial statements included in this Annual Report to Shareholders for additional information on our unrecognized tax benefits. Off-Balance Sheet Arrangements Refer to Note 16 to our audited consolidated financial statements included in this Annual Report to Shareholders, under the caption “Off-Balance Sheet Financial Instruments,” for a discussion of a standby letter of credit and performance bonds for which we were contingently liable at December 31, 2021. Investment in Unconsolidated Entity Carrier Enterprise I has a 38.1% ownership interest in RSI, an HVAC distributor operating from 34 loca- tions in the Western U.S. Our proportionate share of the net income of RSI is included in other income in our consolidated statements of income. Carrier Enterprise I is a party to 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 com- mon stock, it has the right, but not the obligation, to purchase from RSI’s shareholders the remaining out- standing shares of RSI common stock. At December 31, 2021, the estimated purchase amount we would be contingently liable for was approximately $315.0 million. We believe that our operating cash flows, cash on hand, and funds available for borrowing under our revolving credit agreement would be sufficient to purchase any additional ownership interests in RSI. Acquisitions On August 20, 2021, one of our wholly owned subsidiaries acquired MIS, a distributor of air conditioning and heating products operating from six locations in Pennsylvania. Consideration for the purchase price consisted of $3.1 million in cash and the issuance of 3,627 shares of Common stock having a fair value of $1.0 million, net of cash acquired of $0.2 million. On May 7, 2021, we acquired certain assets and assumed certain liabilities of ACME, a distributor of air conditioning, heating, and refrigeration products, operating from 18 locations in Louisiana and Mississippi, for $22.9 million less certain average revolving indebtedness. Consideration for the net pur- chase price consisted of $18.1 million in cash, 8,492 shares of Common stock having a fair value of $2.6 million, and $3.1 million repayment of indebtedness, net of cash acquired of $1.3 million. On April 9, 2021, we acquired certain assets and assumed certain liabilities comprising the HVAC distri- bution business of Temperature Equipment Corporation, an HVAC distributor operating from 32 locations in Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri and Wisconsin. We formed a new, stand- alone joint venture with Carrier, TEC, that operates this business. We have an 80% controlling interest in TEC, and Carrier has a 20% non-controlling interest. Consideration for the purchase was paid in cash, consisting of $105.2 million paid to Temperature Equipment Corporation (Carrier contributed $21.0 mil- lion and we contributed $84.2 million) and $1.5 million for repayment of indebtedness. We continually evaluate potential acquisitions and/or joint ventures and investments in unconsolidated entities. We routinely hold discussions with several acquisition candidates. Should suitable acquisition opportunities arise that would require additional financing, we believe our financial position and earnings history provide a sufficient basis for us to either obtain additional debt financing at competitive rates and on reasonable terms or raise capital through the issuance of equity securities. Common Stock Dividends We paid cash dividends of $7.625, $6.925 and $6.40 per share of Common stock and Class B common stock in 2021, 2020, and 2019, respectively. On January 3, 2022, our Board of Directors declared a regular quarterly cash dividend of $1.95 per share of both Common and Class B common stock that was paid on January 31, 2022 to shareholders of record as of January 14, 2022. On February 8, 2022, our Board of Directors approved an increase to the annual cash dividend per share of Common and Class B common stock to $8.80 per share from $7.80 per share, effective with the quarterly dividend that will be paid in April 2022. 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 opera- tions, profitability, financial condition, cash requirements, and future prospects. Company Share Repurchase Program In September 1999, our Board of Directors authorized the repurchase, at management’s discretion, of up to 7,500,000 shares of common stock in the open market or via private transactions. Shares repurchased under the program are accounted for using the cost method and result in a reduction of shareholders’ equity. We last repurchased shares under this plan in 2008. In aggregate, 6,370,913 shares of Common and Class B common stock have been repurchased at a cost of $114.4 million since the inception of the program. At December 31, 2021, 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 2%, respectively, of our total revenues for 2021. 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. We had only one foreign exchange contract at December 31, 2021, the total notional value of which was $5.7 million, and such contract expired during January 2022. For the year ended December 31, 2021, foreign currency transac- tion 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 $4.0 million impact to our financial position and results of operations for 2021. Historically, fluctuations in these exchange rates have not materially impacted our results of operations. Our exposure to currency rate fluctuations could be material in the future if these fluctuations become significant or if our Canadian and Mexican markets grow and represent a larger percentage of our total revenues. 30 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 31 See Note 17 to our audited consolidated financial statements included in this Annual Report to Shareholders 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, 2021 and determined that a 100 basis-point change in interest rates would result in an impact to income before income taxes of approximately $0.9 million. See Note 8 to our audited consolidated financial statements included in this Annual Report to Shareholders for further information about our debt. Management’s Report on Internal Control Over Financial Reporting 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. In accordance with the rules and regulations of the SEC, we have not yet assessed the internal control over financial reporting of Makdad Industrial Supply Co., Inc. (“MIS”), Acme Refrigeration LLC (“ACME”), or TEC Distribution LLC (“TEC”), which collectively represented approximately 8% of our consolidated assets at December 31, 2021 and approximately 5% of our consolidated revenues for the year ended December 31, 2021. From the respective acquisition dates of August 20, 2021, May 7, 2021, and April 9, 2021 to December 31, 2021, the processes and systems of MIS, ACME, and TEC did not impact the internal controls over financial reporting for our other consolidated subsidiaries. Under the supervision and with the participation of our management, including our Chief Executive Officer, Executive Vice President and Chief Financial Officer, we conducted an assessment of the effec- tiveness of our internal control over financial reporting as of December 31, 2021. 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 assessment under the COSO framework, our management concluded that our internal control over finan- cial reporting was effective as of December 31, 2021. The effectiveness of our internal control over finan- cial reporting as of December 31, 2021 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report that is included herein. 32 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 33 Report of Independent Registered Public Accounting Firm 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, 2021, 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, 2021, 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, 2021 and 2020, 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, 2021, and the related notes (collectively, the consolidated financial statements), and our report dated February 25, 2022 expressed an unqualified opinion on those consolidated financial statements. The Company acquired Makdad Industrial Supply Co., Inc. (“MIS”), Acme Refrigeration LLC (“ACME”), and TEC Distribution LLC (“TEC”) during 2021, and management excluded from its assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2021, the MIS, ACME, and TEC’s internal control over financial reporting associated with total assets of 8% and total revenues of 5% included in the consolidated financial statements of the Company as of and for the year ended December 31, 2021. Our audit of internal control over financial reporting of the Company also excluded an evaluation of the internal control over financial reporting of MIS, ACME, and TEC. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial report- ing and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We 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 assur- ance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of man- agement and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect mis- statements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Miami, Florida February 25, 2022 KPMG LLP 34 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 35 Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors Watsco, Inc.: Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated balance sheets of Watsco, Inc. and subsidiaries (the Company) as of December 31, 2021 and 2020, the related consolidated statements of income, compre- hensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2021, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2021, in conformity with U.S. gener- ally 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, 2021, 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 February 25, 2022 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 management. 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 independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regula- tions 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. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the con- solidated financial statements that was communicated or required to be communicated to the audit com- mittee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communi- cation of a critical audit matter does not alter in any way our opinion on the consolidated financial state- ments, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. Evaluation of inventory net realizable value adjustments related to excess and slow-moving inventory As discussed in Note 1 to the consolidated financial statements, the Company values its inventory at the lower of cost using weighted-average cost basis and first-in, first-out methods, or net realizable value. The Company adjusts excess, slow-moving, and damaged inventory to their estimated net real- izable value. As of December 31, 2021, the Company’s inventory balance was $1,115,469 thou- sand. We identified the evaluation of inventory net realizable value adjustments related to excess and slow- moving inventory as a critical audit matter due to the amount of judgment required by the Company in making such estimates. As a result, there was a high degree of subjective auditor judgment in assessing such estimates, specifically as it related to the future salability of inventories. The following are the primary procedures we performed to address this critical audit matter. We eval- uated the design and tested the operating effectiveness of certain internal controls over the Company’s process to estimate net realizable values related to excess and slow-moving inventory. This included controls related to the future salability of inventories, assumptions used for excess and slow-moving inventory, and the Company’s review of inventory net realizable value adjustments. We compared a selection of inventory units to historical performance to assess possible write-down indi- cations and future salability. We performed a sensitivity analysis under various scenarios and ana- lyzed trends of total adjustments to net realizable values in relation to total inventory to test the Company’s determination of the inventory valuation and adjustments related to excess and slow- moving inventory. We have served as the Company’s auditor since 2009. Miami, Florida February 25, 2022 KPMG LLP 36 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 37 CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) Years Ended December 31, 2021 2020 2019 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 $ 6,280,192 4,612,647 $ 5,054,928 3,832,107 $ 4,770,362 3,613,406 1,667,545 1,058,316 19,299 628,528 996 627,532 128,797 498,735 79,790 1,222,821 833,051 11,264 401,034 1,239 399,795 76,623 323,172 53,593 1,156,956 800,328 10,256 366,884 4,032 362,852 67,077 295,775 49,825 Net income attributable to Watsco, Inc. $ 418,945 $ 269,579 $ 245,950 Earnings per share for Common and Class B common stock: Basic Diluted See accompanying notes to consolidated financial statements. $ $ 10.83 10.78 $ $ 7.03 7.01 $ $ 6.51 6.50 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) Years Ended December 31, 2021 2020 2019 Net income Other comprehensive income, net of tax Foreign currency translation adjustment Unrealized gain (loss) on cash flow hedging instruments Reclassification of loss (gain) on cash flow hedging instruments into earnings Other comprehensive income $ 498,735 $ 323,172 $ 295,775 936 70 219 1,225 6,272 880 (418) 6,734 12,298 (1,461) (352) 10,485 Comprehensive income Less: comprehensive income attributable to non-controlling interest 499,960 80,324 329,906 56,144 306,260 53,392 Comprehensive income attributable to Watsco, Inc. $ 419,636 $ 273,762 $ 252,868 See accompanying notes to consolidated financial statements. December 31, ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets Total current assets Property and equipment, net Operating lease right-of-use assets Goodwill Intangible assets, net Investment in unconsolidated entity 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 Operating lease liabilities, net of current portion Finance lease liabilities, 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; 37,881,247 and 37,702,489 shares outstanding at December 31, 2021 and 2020, respectively Class B common stock, $0.50 par value, 10,000,000 shares authorized; 5,790,636 and 5,691,456 shares outstanding at December 31, 2021 and 2020, 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 shares of Common stock and 48,263 shares of Class B common stock at both December 31, 2021 and 2020, respectively Total Watsco, Inc. shareholders’ equity Non-controlling interest Total shareholders’ equity 2021 2020 $ 118,268 698,456 1,115,469 29,207 $ 146,067 535,288 781,299 21,791 1,961,400 1,484,445 111,019 268,528 434,019 186,896 114,808 9,191 98,225 209,169 412,486 169,929 97,847 12,246 $ 3,085,861 $ 2,484,347 $ 84,501 364,185 278,036 726,722 89,000 187,024 9,189 285,213 76,511 $ 71,804 251,553 163,788 487,145 — 139,527 4,811 144,338 73,103 18,941 18,851 2,895 — 1,003,932 (34,176) 760,796 2,846 — 950,915 (34,867) 636,373 (87,440) (87,440) 1,664,948 332,467 1,486,678 293,083 1,997,415 1,779,761 $ 3,085,861 $ 2,484,347 38 WATSCO, INC. 2021 ANNUAL REPORT See accompanying notes to consolidated financial statements. WATSCO, INC. 2021 ANNUAL REPORT 39 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In thousands, except share and per share data) Balance at December 31, 2018 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, $6.40 per share Common stock issued for Dunphey & Associates Supply Co., Inc. Investment in unconsolidated entity Decrease in non-controlling interest in Carrier Enterprise II Common stock issued for Peirce-Phelps, Inc. Investment in Peirce-Phelps, Inc. Common stock issued for N&S Supply of Fishkill, Inc. Distributions to non-controlling interest Balance at December 31, 2019 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, $6.925 per share Adjustment to fair value of Common stock issued for N&S Supply of Fishkill, Inc. Distributions to non-controlling interest Balance at December 31, 2020 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 Common stock released from escrow Share-based compensation Cash dividends declared and paid on Common and Class B common stock, $7.625 per share Common stock issued for Acme Refrigeration of Baton Rouge LLC Common stock issued for Makdad Industrial Supply Co., Inc. Investment in TEC Distribution LLC Distributions to non-controlling interest 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 37,461,643 $21,167 $832,121 $(45,968) 6,918 Retained Earnings $627,969 245,950 Treasury Stock Non-controlling Interest $(87,440) $253,864 49,825 3,567 173,940 (12,837) 30,715 105,288 (10,623) 50,952 372,543 22,435 87 (7) 15 53 (5) 25 186 12 (87) 7 4,259 13,411 (1,647) 16,537 6,866 (25,768) 58,158 4,020 (241,412) 38,194,056 21,533 907,877 (39,050) 632,507 269,579 (87,440) 4,183 184,265 (3,589) 25,216 144,894 (23,148) 92 (2) 13 72 (11) (92) 2 4,530 21,528 (4,631) 21,862 (161) (265,713) 38,521,694 21,697 950,915 (34,867) 636,373 418,945 (87,440) 691 194,643 (57,089) 22,752 136,641 (7,898) (23,230) 8,492 3,627 97 (28) 11 69 (4) (12) 4 2 (97) 28 5,143 22,111 (2,253) 12 24,531 2,547 995 522 (295,044) 988 (6,632) 17,000 (39,272) 279,340 53,593 2,551 (42,401) 293,083 79,790 534 21,040 (61,980) Total $1,601,713 295,775 10,485 — — 4,274 13,464 (1,652) 16,537 (241,412) 6,891 988 (32,400) 58,344 17,000 4,032 (39,272) 1,714,767 323,172 6,734 — — 4,543 21,600 (4,642) 21,862 (265,713) (161) (42,401) 1,779,761 498,735 1,225 — — 5,154 22,180 (2,257) 522 24,531 (295,044) 2,551 997 21,040 (61,980) Balance at December 31, 2021 See accompanying notes to consolidated financial statements. 40 WATSCO, INC. 2021 ANNUAL REPORT 38,799,632 $21,836 $1,003,932 $(34,176) $760,796 $(87,440) $332,467 $1,997,415 WATSCO, INC. 2021 ANNUAL REPORT 41 CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Notes to Consolidated Financial Statements (In thousands, except share and per share data) Years Ended December 31, 2021 2020 2019 $ 498,735 $ 323,172 $ 295,775 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 Non-cash contribution to 401(k) plan Provision for doubtful accounts Loss (gain) on sale of property and equipment Deferred income tax provision Other income from investment in unconsolidated entity Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable, net Inventories, net Accounts payable and other liabilities Other, net Net cash provided by operating activities Cash flows from investing activities: Business acquisitions, net of cash acquired Capital expenditures Other investment Investment in unconsolidated entity Proceeds from sale of property and equipment Proceeds from sale of equity securities Net cash used in investing activities Cash flows from financing activities: Dividends on Common and Class B common stock Distributions to non-controlling interest Net repayments of finance lease liabilities Repurchases of common stock to satisfy employee withholding tax obligations Payment of fees related to revolving credit agreement Purchase of additional ownership from non-controlling interest Proceeds from non-controlling interest for investment in unconsolidated entity Proceeds from non-controlling interest for investment in Peirce-Phelps, Inc. Net proceeds from issuances of common stock Proceeds from non-controlling interest for investment in TEC Distribution LLC Net proceeds (repayments) under revolving credit agreement 28,127 25,365 5,154 6,888 350 5,939 (19,299) (130,414) (243,660) 182,819 (10,438) 349,566 (129,462) (25,464) (1,000) — 1,356 5,993 (148,577) (294,522) (61,980) (2,040) (1,092) (22) — — — 21,014 21,040 89,000 25,908 22,129 4,543 2,688 17 40 (11,264) (3,559) 139,929 33,936 (3,160) 534,379 — (16,436) — — 94 — (16,342) (265,713) (42,401) (1,441) (2,299) (196) — — — 19,257 — (155,700) 24,512 17,032 4,274 3,948 (585) 1,278 (10,256) 8,457 (15,525) 12,734 (5,873) 335,771 (59,672) (17,805) — (4,940) 1,380 — (81,037) (241,412) (39,272) (1,240) (1,528) — (32,400) 988 17,000 13,341 — 20,500 Net cash used in financing activities Effect of foreign exchange rate changes on cash and cash equivalents Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year (228,602) (448,493) (264,023) (186) (27,799) 146,067 2,069 71,613 74,454 849 (8,440) 82,894 Cash and cash equivalents at end of year $ 118,268 $ 146,067 $ 74,454 Supplemental cash flow information (Note 22) 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, 2021, we operated from 671 locations in 42 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 sub- sidiaries, the accounts of four joint ventures with Carrier Global Corporation, which we refer to as Carrier, the accounts of Carrier InterAmerica Corporation, of which we have an 80% controlling interest and Carrier has a 20% non-controlling interest, and our 38.1% investment in Russell Sigler, Inc. (“RSI”), which is accounted for under the equity method of accounting. All significant intercompany balances and transactions have been eliminated in consolidation. Impact of COVID-19 Pandemic Since COVID-19 was declared a pandemic in March 2020, it has impacted our operations and the opera- tions of our customers and suppliers. Although we learned to navigate COVID-19 while maintaining our operations in all material respects, the pandemic continued to impact our business and operating results throughout 2020 and into 2021. However, as economic activity has been recovering and the effects of the pandemic lessened in 2021, the impact of the pandemic on our business has been more reflective of greater economic and marketplace dynamics, which include supply chain disruptions and labor shortages, rather than pandemic-related issues such as quarantines, location closures, mandated restrictions, employee illnesses, and travel restrictions. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial condition will depend on future developments, which are highly uncertain and cannot be predicted, including, but not limited to, potential subsequent waves of COVID-19 infection or potential new variants, the effectiveness and adoption of COVID-19 vaccines and therapeutics, the ultimate duration and scope of the pandemic, its impact on our employees, customers and suppliers, the broader implications of the macro-economic recovery on our business, and the extent to which normal economic and operating conditions are impacted. Therefore, we cannot reasonably esti- mate the future impact at this time. 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 investment in unconsolidated 42 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 43 entity 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 under- lying net assets of the investee is attributed to certain fair value adjustments with the remaining portion recognized as goodwill. 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, net realizable value adjustments to inventories, income taxes, reserves related to loss contingencies and the valuation of goodwill, indefinite-lived intangible assets and long-lived assets. While we believe that these estimates are reasonable, actual results could differ from such estimates. Cash Equivalents All highly liquid instruments purchased with original maturities of three months or less are considered to be cash equivalents. Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable primarily consist of trade receivables due from customers and are stated at the invoiced amount less an allowance for doubtful accounts. An allowance for doubtful accounts is main- tained for estimated losses resulting from the inability of customers to make required payments. When preparing these estimates, we consider a number of factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other infor- mation, including potential impacts of business and economic conditions. Upon determination that an account is uncollectible, the receivable balance is written off. At December 31, 2021 and 2020, the allowance for doubtful accounts totaled $11,315 and $7,087, 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 first-in, first-out and weighted-average cost basis methods, 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 and Purchase Discounts 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, 2021 and 2020, we had $22,692 and $13,434, 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. Vendor rebates that are earned based on products sold are credited directly to cost of sales in our consolidated statements of income. We also have vendors that offer a cash discount when we pay their invoice within a specified period of time. We account for such cash discounts as a reduction of inventory until we sell the product at which time such cash discounts are reflected as a reduction of cost of sales in our consolidated statements of income. At December 31, 2021 and 2020, we had $17,893 and $12,029, respectively, of cash dis- counts recorded as a reduction of inventory. Equity Securities Investments in equity securities are recorded at fair value using the specific identification method and are included in other assets in our consolidated balance sheets. Changes in the fair value of equity securities and dividend income are recognized in our consolidated statements of income. 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. Machinery, vehicles, and equipment are depreciated over estimated useful lives ranging from 3-10 years. Computer hardware and software are depreciated over estimated useful lives ranging from 3-10 years. Furniture and fixtures are depreciated over estimated useful lives ranging from 5-7 years. Operating and Finance Leases We have operating leases for real property, vehicles and equipment, and finance leases primarily for vehi- cles. Operating leases are included in operating lease right-of-use (“ROU”) assets, current portion of long- term obligations, and operating lease liabilities, net of current portion in our consolidated balance sheets. Finance leases are not considered significant to our consolidated balance sheets or consolidated state- ments of income. Finance lease ROU assets at December 31, 2021 and 2020, of $11,489 and $6,232, respectively, are included in property and equipment, net in our consolidated balance sheets. Finance lease liabilities at December 31, 2021 and 2020, of $11,762 and $6,383, respectively, are included in current portion of long-term obligations and finance lease liabilities, net of current portion in our consoli- dated balance sheets. ROU assets represent our right to use an underlying asset for the lease term, and lease liabilities repre- sent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabili- ties are recognized at the applicable commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit interest rate, we use our incremental borrowing rate based on the information available at the commencement dates of the respective leases in determining the present value of the applicable lease payments. Operating lease ROU assets also include any lease pre-payments made and exclude lease incentives. Certain of our leases include variable payments, which are excluded from lease ROU assets and lease lia- bilities and expensed as incurred. Our leases have remaining lease terms of 1-10 years, some of which include options to extend the leases for up to five years. The exercise of lease renewal options is at our sole discretion, and our lease ROU assets and liabilities reflect only the options we are reasonably certain that we will exercise. Certain real property lease agreements have lease and non-lease components, which are generally accounted for as a single lease component. Lease expense for lease payments is rec- ognized on a straight-line basis over the lease term. Lease payments for short-term leases, which are 12 months or less without a purchase option that is likely to be exercised, are recognized as lease cost on a straight-line basis over the lease term. Practical Expedients We elected the practical expedients related to short-term leases and separating lease components from non-lease components for all underlying asset classes. 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 comparing the fair value of our reporting unit to its carry- ing value. If the fair value is determined to be less than the carrying value, an impairment charge would be recognized. On January 1, 2022, we performed our annual evaluation of goodwill impairment and determined that the estimated fair value of our reporting unit exceeded its carrying value. 44 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 45 Intangible assets primarily consist of the value of trade names and trademarks, distributor agreements, customer relationships and patented and unpatented technology. Indefinite lived intangibles not subject to amortization are assessed for impairment at least annually, or more frequently if events or changes in circumstances 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 recoverable. Recoverability is evaluated by determining whether the amortization of the balance over its remaining life can be recovered through undiscounted future operating cash flows. We measure the impairment loss based on projected discounted cash flows using a discount rate reflecting the average cost of funds and compared to the asset’s carrying value. As of December 31, 2021, there were no such events or circumstances. Fair Value Measurements We carry various assets and liabilities at fair value in the consolidated balance sheets. Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. Fair value measurements are classified based on the following fair value hierarchy: Level 1 Level 2 Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient fre- quency and volume to provide pricing information on an ongoing basis. Observable inputs other than Level 1 prices such as quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active; or model-driven valuations or other inputs that are observable or can be corroborated by observable market data for substan- tially the full term of the assets or liabilities. Level 3 Unobservable inputs for the asset or liability. These inputs reflect our own assumptions about the assumptions a market participant would use in pricing the asset or liability. Revenue Recognition Revenue primarily consists of sales of air conditioning, heating and refrigeration equipment, and related parts and supplies. We generate our revenue primarily from the sale of finished products to customers; therefore, the significant majority of our contracts are short-term in nature and have only a single perform- ance obligation to deliver products; therefore, we satisfy our performance obligation under such contracts when we transfer control of the product to the customer. Some contracts contain a combination of prod- uct sales and services, the latter of which is distinct and accounted for as a separate performance obliga- tion. We satisfy our performance obligations for services when we render the services within the agreed-upon service period. Total service revenue is not material and accounted for less than 1% of our consolidated revenues for all three years ended December 31, 2021, 2020 and 2019. Revenue is recognized when control transfers to our customers when products are picked up or via ship- ment of products or delivery of services. We measure revenue as the amount of consideration we expect to be entitled to receive in exchange for those goods or services, net of any variable considerations (e.g., rights to return product, sales incentives, others) and any taxes collected from customers and subse- quently remitted to governmental authorities. Revenue for shipping and handling charges is recognized when products are delivered to the customer. Product Returns We estimate product returns based on historical experience and record them on a gross basis on our bal- ance sheets. Substantially all customer returns relate to products that are returned under manufacturers’ warranty obligations. Accrued sales returns at December 31, 2021 and 2020 of $16,707 and $12,739, respectively, were included in accrued expenses and other current liabilities in our consolidated balance sheets. Sales Incentives We estimate sales incentives expected to be paid over the term of the program based on the most likely amounts. Sales incentives are accounted for as a reduction in the transaction price and are generally paid on an annual basis. Practical Expedients We generally expense sales commissions when incurred because the amortization period is one year or less. These costs are recorded within selling, general and administrative expenses. We do not disclose the value of unsatisfied performance obligations for contracts with an original expected length of one year or less. Advertising Costs Advertising costs are expensed as incurred. Advertising expense for the years ended December 31, 2021, 2020, and 2019, were $21,552, $12,588, and $16,587, 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 are included in selling, general and administrative expenses. Shipping and handling costs included in selling, general and administrative expenses for the years ended December 31, 2021, 2020, and 2019, were $70,453, $55,019, and $54,783, respectively. 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. Tax benefits resulting from tax deductions in excess of share-based compensation expense are recognized in our provision for income taxes in our consolidated statements of income. 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. 46 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 47 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: 2. LEASES The components of operating lease expense were as follows: Years Ended December 31, 2021 2020 2019 Lease cost Short-term lease cost Variable lease cost Sublease income $ $ 90,742 9,598 1,868 (332) $ 82,543 6,317 942 (228) 74,755 9,427 707 (226) $ 101,876 $ 89,574 $ 84,663 Supplemental balance sheet information related to operating leases were as follows: December 31, ROU assets Current portion of operating lease liabilities Operating lease liabilities Total operating lease liabilities Weighted Average Remaining Lease Term (in years) Weighted Average Discount Rate $ $ $ 2021 268,528 81,928 187,024 268,952 4.4 years 3.29% 2020 209,169 70,232 139,527 $ $ $ 209,759 3.5 years 4.00% Supplemental cash flow information related to operating leases were as follows: Years Ended December 31, 2021 2020 2019 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. Operating cash flows for the measurement of operating lease liabilities Operating lease ROU assets obtained in exchange for operating lease obligations $ $ 91,063 141,198 $ $ 80,921 59,093 $ $ 75,357 290,422 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 17 for additional information pertaining to derivative instruments. Loss Contingencies Accruals are recorded for various contingencies including self-insurance, legal proceedings, environmental matters, and other claims that arise in the normal course of business. The estimation process contains uncertainty because accruals are based on judgment, the probability of losses and, where applicable, the consideration of opinions of external legal counsel and actuarially determined estimates. Additionally, we record receivables from third party insurers when recovery has been determined to be probable. At December 31, 2021, maturities of operating lease liabilities over each of the next five years and there- after were as follows: 2022 2023 2024 2025 2026 Thereafter Total lease payments Less imputed interest Total lease liability $ 89,322 71,985 49,245 31,995 19,662 26,837 289,046 20,094 $ 268,952 At December 31, 2021, we had additional operating leases, primarily for real property, that had not yet commenced. Such leases had estimated future minimum rental commitments of approximately $39,700. These operating leases are expected to commence in 2022 with lease terms of 5-11 years. These undis- counted amounts are not included in the table above. 48 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 49 3. REVENUES Disaggregation of Revenues The following table presents our revenues disaggregated by primary geographical regions and major prod- uct lines within our single reporting segment: Years Ended December 31, Primary Geographical Regions: United States Canada Latin America and the Caribbean Major Product Lines: HVAC equipment Other HVAC products Commercial refrigeration products 2021 2020 2019 $ 5,636,929 386,780 256,483 $ 4,535,262 301,727 217,939 $ 4,184,206 294,040 292,116 $ 6,280,192 $ 5,054,928 $ 4,770,362 69% 28% 3% 100% 69% 28% 3% 100% 68% 28% 4% 100% 4. 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, 2021 2020 2019 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 $ 418,945 $ 269,579 $ 245,950 37,273 381,672 35,244,230 10.83 353,873 27,799 381,672 418,945 $ $ $ $ $ 23,140 246,439 35,069,516 7.03 228,361 18,078 246,439 269,579 $ $ $ $ $ 20,412 225,538 34,644,700 6.51 208,779 16,759 225,538 245,950 $ $ $ $ $ restricted common stock 37,222 23,140 20,411 Earnings allocated to Watsco, Inc. shareholders $ 381,723 $ 246,439 $ 225,539 Weighted-average common shares outstanding - Basic Effect of dilutive stock options 35,244,230 179,608 35,069,516 81,055 34,644,700 30,941 Weighted-average common shares outstanding - Diluted 35,423,838 35,150,571 34,675,641 Diluted earnings per share for Common and Class B common stock $ 10.78 $ 7.01 $ 6.50 Diluted earnings per share for our Common stock assumes the conversion of all our Class B common stock into Common stock as of the beginning of the fiscal year; therefore, no allocation of earnings to Class B common stock is required. At December 31, 2021, 2020, and 2019, our outstanding Class B common stock was convertible into 2,566,990, 2,572,536, and 2,574,336 shares of our Common stock, respec- tively. Diluted earnings per share excluded 40,529, 19,722, and 205,380 shares for the years ended December 31, 2021, 2020, and 2019, 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. 5. OTHER COMPREHENSIVE INCOME Other comprehensive income consists of the foreign currency translation adjustment associated with our Canadian operations’ use of the Canadian dollar as their functional currency and changes in the unrealized gains (losses) on cash flow hedging instruments. The tax effects allocated to each component of other comprehensive income were as follows: Years Ended December 31, 2021 2020 2019 Foreign currency translation adjustment $ 936 $ 6,272 $ 12,298 Unrealized gain (loss) on cash flow hedging instruments Income tax (expense) benefit Unrealized gain (loss) on cash flow hedging instruments, net of tax Reclassification of loss (gain) on cash flow hedging instruments into earnings Income tax (benefit) expense Reclassification of loss (gain) on cash flow hedging instruments into earnings, net of tax Other comprehensive income 97 (27) 70 305 (86) 219 1,205 (325) 880 (574) 156 (2,001) 540 (1,461) (482) 130 (418) (352) $ 1,225 $ 6,734 $ 10,485 The changes in each component of accumulated other comprehensive loss, net of tax, were as follows: Years Ended December 31, 2021 2020 2019 Foreign currency translation adjustment: Beginning balance Current period other comprehensive income Ending balance Cash flow hedging instruments: Beginning balance Current period other comprehensive income (loss) Reclassification adjustment Ending balance $ (34,694) 518 (34,176) $ (38,599) 3,905 $ (46,604) 8,005 (34,694) (38,599) (173) 43 130 — (451) 528 (250) (173) 636 (876) (211) (451) Accumulated other comprehensive loss, net of tax $ (34,176) $ (34,867) $ (39,050) 50 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 51 6. SUPPLIER CONCENTRATION Purchases from our top ten suppliers comprised 83%, 85%, and 83% of all purchases made in 2021, 2020, and 2019, respectively. Our largest supplier, Carrier and its affiliates, accounted for 61%, 63%, and 62% of all purchases made in 2021, 2020, and 2019, respectively. See Note 20. A significant interruption by Carrier, or any of our other key suppliers, in the delivery of products could impair our abil- ity to maintain current inventory levels and could materially impact our consolidated results of operations and consolidated financial position. At December 31, 2021, $78,454 was recorded as a reduction of inventory related to pricing claim advances, of which $59,644 was provided by Carrier and its affiliates. At December 31, 2020, $68,182 was recorded as a reduction of inventory related to pricing claim advances, of which $54,593 was provided by Carrier and its affiliates. 7. PROPERTY AND EQUIPMENT Property and equipment, net, consists of: December 31, Land Buildings and improvements Machinery, vehicles and equipment Computer hardware and software Furniture and fixtures Accumulated depreciation and amortization $ $ 2021 676 85,857 108,110 68,762 21,404 2020 741 80,877 92,577 62,776 19,077 284,809 (173,790) 256,048 (157,823) $ 111,019 $ 98,225 Depreciation and amortization expense related to property and equipment included in selling, general and administrative expenses for the years ended December 31, 2021, 2020, and 2019, were $22,566, $19,963, and $18,808, respectively. 8. DEBT We maintain an unsecured, $560,000 syndicated multicurrency revolving credit agreement, which we use to fund seasonal working capital needs and for other general corporate purposes, including acquisi- tions, dividends (if and as declared by our Board of Directors), capital expenditures, stock repurchases and issuances of letters of credit. The credit facility has a seasonal component from October 1 to March 31, during which the borrowing capacity may be reduced to $460,000 at our discretion (which effec- tively reduces fees payable in respect of the unused portion of the commitment), and we effected this reduction in 2021. Included in the credit facility are a $100,000 swingline subfacility, a $10,000 letter of credit subfacility, a $75,000 alternative currency borrowing sublimit and an $8,000 Mexican borrow- ing sublimit. The credit agreement matures on December 5, 2023. Borrowings under the credit facility bear interest at either LIBOR-based rates plus a spread, which ranges from 87.5 to 150.0 basis-points (LIBOR plus 87.5 basis-points at December 31, 2021), depending on our ratio of total debt to EBITDA, or on rates based on the highest of the Federal Funds Effective Rate plus 0.5%, the Prime Rate or the Eurocurrency Rate plus 1.0%, in each case plus a spread which ranges from 0 to 50.0 basis-points (0 basis-points at December 31, 2021), 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 7.5 to 20.0 basis-points (7.5 basis-points at December 31, 2021). During 2021 and 2020, we paid fees of $22 and $196, respectively, in connection with the increase in the aggregate borrowing capacity of our revolving credit agreement, which are being amortized ratably through the maturity of the facility in December 2023. At December 31, 2021 $89,000 was outstanding under the revolving credit agreement. At December 31, 2020 there was no outstanding balance 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, 2021. 9. INCOME TAXES The components of income tax expense from our wholly owned operations and investments and our con- trolling interest in CIAC and joint ventures with Carrier are as follows: Years Ended December 31, 2021 2020 2019 Current: U.S. Federal State Foreign Deferred: U.S. Federal State Foreign $ $ 91,162 20,703 10,993 122,858 $ 58,895 12,909 4,779 76,583 6,434 1,374 (1,869) 5,939 218 21 (199) 40 48,359 9,362 8,078 65,799 2,603 446 (1,771) 1,278 Income tax expense $ 128,797 $ 76,623 $ 67,077 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 CIAC and 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, 2021 2020 2019 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 GILTI FDII Change in valuation allowance Tax credits and other Effective income tax rate attributable to Watsco, Inc. Taxes attributable to non-controlling interest Effective income tax rate 21.0% 3.5 (1.7) 0.4 — (0.1) 0.8 (0.5) 23.4 (2.9) 20.5% 21.0% 3.3 (2.1) 0.3 — — — (0.5) 22.0 (2.8) 19.2% 21.0% 2.8 (1.8) 0.5 (0.1) — — (1.2) 21.2 (2.7) 18.5% 52 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 53 The following is a summary of the significant components of our net deferred tax liabilities: December 31, Deferred tax assets: Share-based compensation Capitalized inventory costs and inventory adjustments 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) $ 2021 2020 $ 30,854 3,449 1,328 1,027 6,081 3,959 46,698 (5,107) 41,591 27,223 3,189 949 518 5,090 2,930 39,899 (668) 39,231 (82,704) (18,744) (8,794) (78,288) (16,441) (7,050) (110,242) (101,779) $ (68,651) $ (62,548) (1) Net deferred tax liabilities have been included in the consolidated balance sheets in deferred income taxes and other liabilities. Provisions of the Tax Cuts and Jobs Act of 2017 (the “TCJA”) such as the one-time repatriation transition tax and the global intangible low-taxed income (GILTI) for years beginning in 2018, effectively taxed the undistributed earnings previously deferred from U.S. federal and certain state income taxes and eliminate any additional US taxation resulting from repatriation of earnings on non-US subsidiaries. GILTI is a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. We have elected to provide for the tax expense related to GILTI in the year the tax was incurred as a period expense. As of December 31, 2021, we have accumulated undistributed earnings generated by our for- eign subsidiaries of approximately $114,000. Any additional taxes due with respect to such previously taxed earnings, if repatriated, would generally be limited to certain state income taxes and foreign with- holding. Deferred taxes have been recorded for foreign withholding taxes on certain earnings of our foreign consolidated subsidiaries expected to be repatriated. We do not intend to distribute the remaining previ- ously taxed foreign earnings and therefore have not recorded deferred taxes for certain state income taxes and foreign withholding on such earnings. The amount of certain state income taxes and foreign withhold- ing that might be payable on the remaining amounts at December 31, 2021 is not practicable to estimate. On March 11, 2021, the America Rescue Plan Act of 2021 (the “ARPA”) was enacted. The ARPA expanded IRC Section 162(m) to include five additional most highly compensated individuals. The expan- sion of Section 162(m) coverage is effective for tax years beginning after December 31, 2026. Unlike the employees subject to Section 162(m) by virtue of being the Chief Executive Officer (“CEO”), Chief Financial Officer, or three most highly compensated named executive officers, an employee who is identi- fied as one of the “additional” five employees is not considered to be a covered employee indefinitely. The five additional employees will be subject to the annual $1,000 cap on compensation, and will be deter- mined annually. Valuation allowances are provided to reduce the related deferred income tax assets to an amount which will, more likely than not, be realized. The valuation allowance was $5,107 and $668 at December 31, 2021 and 2020, respectively. The increase was primarily attributable to the impact on U.S deferred tax assets from share-based compensation deduction limitations related to the expansion of IRC Section 162(m). At December 31, 2021, there were state net operating loss carryforwards of $15,595, which expire in varying amounts from 2026 through 2041. At December 31, 2021, there were foreign net operating loss carryforwards of $14,977, which expire in varying amounts from 2036 through 2041. These amounts are available to offset future taxable income. There were no federal net operating loss carryforwards at December 31, 2021. 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 2018. For the majority of states and foreign jurisdictions, we are no longer subject to tax examinations for tax years prior to 2017. At December 31, 2021 and 2020, the total amount of gross unrecognized tax benefits (excluding the fed- eral benefit received from state positions) was $6,727 and $6,505, respectively. Of these totals, $5,636 and $5,461, respectively, (net of the federal benefit received from state positions) represent the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our continuing practice is to recognize penalties within selling, general and administrative expenses and interest related to income tax matters in income tax expense in the consolidated statements of income. At December 31, 2021 and 2020, the cumulative amount of estimated accrued interest and penalties resulting from such unrecog- nized tax benefits was $1,211 and $982, respectively, and is included in deferred income taxes and other current liabilities in the accompanying consolidated balance sheets. The changes in gross unrecognized tax benefits were as follows: Balance at December 31, 2018 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2019 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2020 Additions based on tax positions related to the current year Reductions due to lapse of applicable statute of limitations Balance at December 31, 2021 $ 4,902 1,027 (562) 5,367 1,911 (773) 6,505 1,143 (921) $ 6,727 10. SHARE-BASED COMPENSATION AND BENEFIT PLANS Share-Based Compensation Plans We have two share-based compensation plans for employees. The 2021 Incentive Compensation Plan (the “2021 Plan”) provides for the award of a broad variety of share-based compensation alternatives such as non-vested restricted stock, non-qualified stock options, incentive stock options, performance awards, dividend equivalents, deferred stock and stock appreciation rights at no less than 100% of the market price on the date the award is granted. To date, awards under the 2021 Plan consist of non-qual- ified stock options and non-vested restricted stock. Under the 2021 Plan, the number of shares of Common and Class B common stock available for issuance is (i) 2,500,000, plus (ii) any shares of Common stock or Class B common stock that remained available for grant in connection with awards under the Watsco, Inc. 2014 Incentive Compensation Plan (the “2014 Plan”) on the date on which our shareholders approved the 2021 Plan (iii) shares underlying currently outstanding awards issued under the 2014 Plan, which shares become reissuable under the 2021 Plan to the extent that such underlying shares are not issued due to their forfeiture, expiration, ter- mination or otherwise. A total of 125,995 shares of Common and Class B common stock, net of cancel- lations, had been awarded under the 2021 Plan as of December 31, 2021. As of December 31, 2021, 2,381,332 shares of common stock were reserved for future grants under the 2021 Plan. Options under 54 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 55 the 2021 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 accel- erated in certain circumstances prior to the original vesting date. The 2014 Plan expired during 2021; therefore, no additional options may be granted. There were 498,138 options to exercise common stock outstanding under the 2014 Plan at December 31, 2021. Options under the 2014 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 2021 Plan and the 2014 Plan as of and for the year ended December 31, 2021: Options outstanding at December 31, 2020 Granted Exercised Forfeited Expired Options outstanding at December 31, 2021 Options exercisable at December 31, 2021 Weighted- Average Exercise Price 174.83 276.41 157.50 208.77 146.09 205.30 168.77 Options 585,116 163,550 (130,178) (15,500) (500) 602,488 105,665 $ $ $ Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value 3.11 1.95 $ $ 64,816 15,227 The following is a summary of non-vested restricted stock activity as of and for the year ended December 31, 2021: Non-vested restricted stock outstanding at December 31, 2020 Granted Vested Forfeited Weighted- Average Grant Date Fair Value 75.00 254.73 138.97 131.31 $ Shares 3,335,107 194,643 (13,000) (57,089) Non-vested restricted stock outstanding at December 31, 2021 3,459,661 $ 83.94 The weighted-average grant date fair value of non-vested restricted stock granted during 2021, 2020, and 2019 was $254.73, $193.89, and $151.58, respectively. The fair value of non-vested restricted stock that vested during 2021, 2020, and 2019 was $3,646, $7,354, and $4,931, respectively. During 2021, 3,858 shares of Class B common stock with an aggregate fair market value of $1,078 were withheld as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. During 2020, 11,693 shares of Common and Class B common stock with an aggregate fair market value of $2,299 were withheld as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. During 2019, 9,824 shares of Common and Class B common stock with an aggregate fair market value of $1,518 were withheld as payment in lieu of cash to satisfy tax withholding obligations in connection with the vesting of restricted stock. These shares were retired upon delivery. Share-Based Compensation Fair Value Assumptions The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing valuation model based on the weighted-average assumptions noted in the table below. The fair value of each stock option award, which is subject to graded vesting, is expensed, net of estimated forfei- tures, on a straight-line basis over the requisite service period for each separately vesting portion of the stock option. We use historical data to estimate stock option forfeitures. The expected term of stock option awards granted represents the period of time that stock option awards granted are expected to be outstanding and was calculated using the simplified method for plain vanilla options, which we believe provides a reasonable estimate of expected life based on our historical data. The risk-free rate for periods within the contractual life of the stock option award is based on the yield curve of a zero-coupon United States Treasury bond on the date the stock option award is granted with a maturity equal to the expected term of the stock option award. Expected volatility is based on historical volatility of our stock. The following table presents the weighted-average assumptions used for stock options granted: Years Ended December 31, Expected term in years Risk-free interest rate Expected volatility Expected dividend yield Grant date fair value 2021 2020 2019 4.25 0.79% 21.85% 2.97% 4.25 0.26% 20.89% 3.69% 4.25 1.64% 18.01% 3.99% $34.79 $20.76 $14.81 Exercise of Stock Options The total intrinsic value of stock options exercised during 2021, 2020, and 2019 was $16,903, $8,753, and $4,153, respectively. Cash received from the exercise of stock options during 2021, 2020, and 2019 was $19,338, $17,608, and $11,703, respectively. The tax benefit from stock option exer- cises during 2021, 2020, and 2019 was $3,595, $1,586, and $626, respectively. During 2021, 2020, and 2019, 4,040 shares of Common stock with an aggregate fair market value of $1,179, 11,455 shares of Common stock with an aggregate fair market value of $2,343 and 799 shares of Common stock with an aggregate fair market value of $134, 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 2021 2,908 22,457 25,365 $ $ 2020 2,447 19,682 22,129 $ $ 2019 2,440 14,592 17,032 $ $ At December 31, 2021, there was $5,770 of unrecognized pre-tax compensation expense related to stock options granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of approximately 1.9 years. The total fair value of stock options that vested during 2021, 2020, and 2019 was $2,621, $2,177, and $2,055, respectively. At December 31, 2021, there was $180,661 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 11.8 years. Of this amount, approximately $55,000 is related to awards granted to our CEO, of which approximately $1,000, $26,000, $27,000, and $1,000 vest in approximately 1, 5, 7, and 8 years upon his attainment of age 82, 86, 88, and 89, respectively, and approximately $31,000 is related to awards granted to our President, of which approximately $30,000 and $1,000 vest in approximately 22 and 24 years upon his attainment of age 62 and 64, respectively. In the event that vesting is acceler- ated for any circumstance, as defined in the related agreements, the remaining unrecognized share-based 56 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 57 compensation expense would be immediately recognized as a charge to earnings with a corresponding tax benefit. At December 31, 2021, we were obligated to issue 32,592 shares of non-vested restricted stock to our CEO that vest in 7 years, 31,668 shares of non-vested restricted stock to our President that vest in 22 years, and 18,540 shares of non-vested restricted stock to various key leaders that vest in 5-14 years in connection with 2021’s performance-based incentive compensation program. 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 employ- ees 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 2021, 2020, and 2019, employ- ees purchased 3,501, 5,121, and 5,676 shares of Common stock at an average price of $239.11, $171.89, and $145.09 per share, respectively. Cash dividends received by the ESPP were reinvested in Common stock and resulted in the issuance of 2,962, 3,964, and 5,087 additional shares during 2021, 2020, and 2019, respectively. We received net proceeds of $1,676, $1,649, and $1,638, respectively, during 2021, 2020, and 2019, for shares of our Common stock purchased under the ESPP. At December 31, 2021, 450,945 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, 2021, 2020, and 2019, we issued 22,752, 25,216, and 30,715 shares of Common stock, respectively, to the plan, representing the Common stock discretionary matching contribution of $5,154, $4,543 and $4,274, respectively. 11. PURCHASE OF REMAINING OWNERSHIP INTEREST IN JOINT VENTURE Effective May 31, 2019, we purchased an additional 20% ownership interest in Homans Associates II LLC (“Homans”) from our second joint venture with Carrier, Carrier Enterprise Northeast, LLC, which we refer to as Carrier Enterprise II, for cash consideration of $32,400, which increased our ownership in Homans to 100%. Homans previously operated as a division of Carrier Enterprise II and subsequent to the purchase operates as a wholly owned subsidiary of the Company with 25 locations in the Northeastern U.S. 12. 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 a 34.9% ownership interest in RSI, an HVAC distributor operating from 34 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 consid- eration of $63,600, of which we contributed $50,880 and Carrier contributed $12,720. Effective June 29, 2018, Carrier Enterprise I acquired an additional 1.4% ownership interest in RSI, which increased Carrier Enterprise I’s ownership interest in RSI to 36.3% for cash consideration of $3,760, of which we contributed $3,008 and Carrier contributed $752. Effective April 22, 2019, Carrier Enterprise I acquired an additional 1.8% ownership interest in RSI for cash consideration of $4,940, of which we contributed $3,952 and Carrier contributed $988. This acquisition increased Carrier Enterprise I’s ownership interest in RSI to 38.1%. Carrier Enterprise I is a party to 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 com- 58 WATSCO, INC. 2021 ANNUAL REPORT mon stock, it has the right, but not the obligation, to purchase from RSI’s shareholders the remaining out- standing 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 38.1% equity interest in RSI and its right to appoint two out of RSI’s six board members, this investment in RSI is accounted for under the equity method. 13. ACQUISITIONS Makdad Industrial Supply Co., Inc. On August 20, 2021, one of our wholly owned subsidiaries acquired Makdad Industrial Supply Co., Inc. (“MIS”), a distributor of air conditioning and heating products operating from six locations in Pennsylvania. Consideration for the purchase price consisted of $3,117 in cash and the issuance of 3,627 shares of Common stock having a fair value of $997, net of cash acquired of $204. The purchase price resulted in the recognition of $981 in goodwill. The tax basis of such goodwill is deductible for income tax purposes over 15 years. Acme Refrigeration of Baton Rouge LLC On May 7, 2021, we acquired certain assets and assumed certain liabilities of Acme Refrigeration of Baton Rouge LLC (“ACME”), a distributor of air conditioning, heating, and refrigeration products, operat- ing from 18 locations in Louisiana and Mississippi, for $22,855 less certain average revolving indebted- ness. We formed a new, wholly owned subsidiary, Acme Refrigeration LLC, that operates this business. Consideration for the net purchase price consisted of $18,051 in cash, 8,492 shares of Common stock having a fair value of $2,551, and $3,141 for repayment of indebtedness, net of cash acquired of $1,340. The purchase price resulted in the recognition of $3,710 in goodwill and intangibles. The fair value of the identified intangible assets was $2,124 and consisted of $1,508 in trade names and distri- bution rights, and $616 in customer relationships to be amortized over an 18-year period. The tax basis of such goodwill is deductible for income tax purposes over 15 years. Temperature Equipment Corporation On April 9, 2021, we acquired certain assets and assumed certain liabilities comprising the HVAC distri- bution business of Temperature Equipment Corporation, an HVAC distributor operating from 32 locations in Illinois, Indiana, Kansas, Michigan, Minnesota, Missouri and Wisconsin. We formed a new, stand- alone joint venture with Carrier, TEC Distribution LLC (“TEC”), that operates this business. We have an 80% controlling interest in TEC, and Carrier has a 20% non-controlling interest. Consideration for the purchase was paid in cash, consisting of $105,200 paid to Temperature Equipment Corporation (Carrier contributed $21,040 and we contributed $84,160) and $1,497 for repayment of indebtedness. The purchase price resulted in the recognition of $38,624 in goodwill and intangibles. The fair value of the identified intangible assets was $19,900 and consisted of $15,700 in trade names and distribution rights, and $4,200 in customer relationships to be amortized over an 18-year period. The tax basis of such goodwill is deductible for income tax purposes over 15 years. The table below presents the allocation of the total consideration to tangible and intangible assets acquired and liabilities assumed from the acquisition of our 80% controlling interest in TEC based on their respective fair values as of April 9, 2021: Accounts receivable Inventories Other current assets Property and equipment Operating lease ROU assets Goodwill Intangibles Accounts payable Accrued expenses and other current liabilities Operating lease liabilities, net of current portion Total $ 33,315 71,325 962 2,590 53,829 18,724 19,900 (25,393) (20,509) (48,046) $ 106,697 WATSCO, INC. 2021 ANNUAL REPORT 59 N&S Supply of Fishkill, Inc. On November 26, 2019, one of our wholly owned subsidiaries acquired certain assets and assumed cer- tain liabilities of N&S Supply of Fishkill, Inc. (“N&S”), a distributor of air conditioning, heating and plumb- ing products operating from seven locations in New York and Connecticut. The purchase price was composed of cash consideration of $12,000, the issuance of 22,435 shares of Common stock having a fair value of $3,871, net of a discount for lack of marketability, and the repayment of certain indebted- ness. The purchase price resulted in the recognition of $4,672 in goodwill and intangibles. The fair value of the identified intangible assets was $1,540 and consisted of $770 trade names and distribution rights, and $770 in customer relationships to be amortized over an 18-year period. The tax basis of such good- will is deductible for income tax purposes over 15 years. Peirce-Phelps, Inc. On August 1, 2019, Carrier Enterprise I acquired substantially all the HVAC assets and assumed certain of the liabilities of Peirce-Phelps, Inc. (“PPI”), an HVAC distributor operating from 19 locations in Pennsylvania, New Jersey, and Delaware, for $85,000 less certain average revolving indebtedness. Consideration for the net purchase price consisted of $10,000 in cash, 372,543 shares of Common stock having a fair value of $58,344, net of a discount for lack of marketability, and the repayment of certain average revolving indebtedness. Carrier contributed cash of $17,000 to Carrier Enterprise I in connection with the acquisition of PPI. The purchase price resulted in the recognition of $28,884 in goodwill and intangibles. The fair value of the identified intangible assets was $19,000 and consisted of $13,500 in trade names and distribution rights, and $5,500 in customer relationships to be amortized over an 18-year period. The tax basis of such goodwill is deductible for income tax purposes over 15 years. The table below presents the allocation of the total consideration to tangible and intangible assets acquired and liabilities assumed from the acquisition of PPI based on the respective fair values as of August 1, 2019: Cash and cash equivalents Accounts receivable Inventories Other current assets Property and equipment Operating lease ROU assets Goodwill Intangibles Other assets Accounts payable Accrued expenses and other current liabilities Operating lease liabilities, net of current portion Total $ 4,299 30,719 45,491 135 2,544 19,072 9,884 19,000 299 (11,079) (13,038) (14,100) $ 93,226 Dunphey & Associates Supply Co., Inc. On April 2, 2019, one of our wholly owned subsidiaries acquired certain assets and assumed certain lia- bilities of Dunphey & Associates Supply Co., Inc. (“DASCO”), a distributor of air conditioning and heating products operating from seven locations in New Jersey, New York and Connecticut, for cash consideration of $16,758 and the issuance of 50,952 shares of Common stock having a fair value of $6,891, net of a discount for lack of marketability. The purchase price resulted in the recognition of $8,974 in goodwill and intangibles. The fair value of the identified intangible assets was $5,300 and consisted of $2,500 trade names and trademarks, and $2,800 in customer relationships to be amortized over a 15-year period. The tax basis of such goodwill is deductible for income tax purposes over 15 years. The results of operations of these acquisitions have been included in the consolidated financial state- ments from their respective dates of acquisition. The pro forma effect of the acquisitions was not deemed significant to the consolidated financial statements. 14. GOODWILL AND INTANGIBLE ASSETS The changes in the carrying amount of goodwill are as follows: Balance at December 31, 2019 Acquired goodwill Foreign currency translation adjustment Balance at December 31, 2020 Acquired goodwill Foreign currency translation adjustment Balance at December 31, 2021 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 Patented and unpatented technology Trade name Accumulated amortization Finite lived intangible assets, net $ 411,217 410 859 412,486 21,291 242 $ 434,019 Estimated Useful Lives 2021 2020 7-18 years 7 years 10 years $ 158,389 $ 140,867 86,526 1,721 1,150 (60,890) 81,527 1,714 1,150 (55,329) 28,507 29,062 $ 186,896 $ 169,929 Amortization expense related to finite lived intangible assets included in selling, general and administrative expenses for the years ended December 31, 2021, 2020, and 2019, were $5,561, $5,945, and $5,704, respectively. Annual amortization of finite lived intangible assets for the next five years is expected to approximate the following: 2022 2023 2024 2025 2026 $ $ $ $ $ 4,500 3,900 3,700 3,700 3,500 15. 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. 60 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 61 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, 2021 or 2020. At-the-Market Offering Program On August 6, 2021, we entered into a sales agreement with Robert W. Baird & Co. Inc. (“Baird”), which enables the Company to issue and sell shares of Common stock in one or more negotiated transactions or transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), for a maximum aggregate offering amount of up to $300,000 (the “ATM Program”). The offer and sale of our Common stock pursuant to the ATM Program has been registered under the Securities Act pursuant to our automatically effective shelf registration statement on Form S-3 (File No. 333-260758). As of December 31, 2021, no shares of Common stock had been sold under the ATM Program. 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 2021, 2020 or 2019. We last repurchased shares under this plan during 2008. 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, 2021, there were 1,129,087 shares remaining authorized for repurchase under the program. Common Stock Released from Escrow On August 23, 2018 we issued 23,230 shares of Common stock into escrow as contingent consideration in connection with the acquisition of Alert Labs, Inc. The shares were subject to certain performance met- rics within a three-year measurement period. The shares, and related cash dividends paid during the three-year period, were released to us from escrow as the performance metrics were not met. These shares were retired upon delivery. 16. 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 and borrowings under our revolving credit agreement. At December 31, 2021 and 2020, the fair values 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 also approximate their carrying value based upon interest rates available for similar instruments with consistent terms and remaining maturities. Off-Balance Sheet Financial Instruments At December 31, 2021 and 2020, we were contingently liable under standby letters of credit for $150 and $1,075, respectively, which were required by leases for real property. Additionally, at December 31, 2021 and 2020, we were contingently liable under various performance bonds aggregating approximately $7,900 and $11,400, respectively, which are used as collateral to cover any contingencies related to our nonperformance under agreements with certain customers. We do not expect that any material losses or obligations will result from the issuance of the standby letter of credit or performance bonds because we expect to meet our obligations under our lease for real property and to certain customers in the ordinary course of business. 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. 17. 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. At December 31, 2021, no foreign currency forward contracts were designated as cash flow hedges. The impact from foreign exchange derivative instruments designated as cash flow hedges was as follows: Years Ended December 31, Gain recorded in accumulated other comprehensive loss Loss (gain) reclassified from accumulated other comprehensive loss into earnings 2021 $ $ 97 305 $ $ 2020 1,205 (574) At December 31, 2021, no pre-tax gain (loss) is expected to be reclassified into earnings related to 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. We had only one foreign cur- rency exchange contract not designated as a hedging instrument at December 31, 2021, the total notional value of which was $5,700, and such contract subsequently expired during January 2022. We recognized losses of $237, $490, and $540 from foreign currency forward and option contracts not designated as hedging instruments in our consolidated statements of income for 2021, 2020, and 2019, respectively. The following table summarizes the fair value of derivative instruments, which consist solely of foreign exchange contracts, included in accrued expenses and other current liabilities in our consolidated balance sheets. See Note 18. December 31, Derivatives designated as hedging instruments Derivatives not designated as hedging instruments Total derivative instruments Asset Derivatives Liability Derivatives 2021 2020 2021 2020 $ — — $ — $ — — $ 5 91 10 $ — $ — $ 5 $ 101 62 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 63 18. FAIR VALUE MEASUREMENTS The following tables present our assets and liabilities carried at fair value that are measured on a recur- ring basis: Assets: Equity securities Private equities Liabilities: Derivative financial instruments Assets: Equity securities Liabilities: Derivative financial instruments Balance Sheet Location Total Level 1 Level 2 Level 3 Fair Value Measurements at December 31, 2021 Using Other assets Other assets $ 1,790 1,000 $ $ 1,790 — — — $ — 1,000 Accrued expenses and other current liabilities $ 5 — $ 5 — Balance Sheet Location Total Level 1 Level 2 Level 3 Fair Value Measurements at December 31, 2020 Using Other assets $ 6,065 $ 6,065 — Accrued expenses and other current liabilities $ 101 — $ 101 — — 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: Equity securities – these investments are exchange-traded equity securities. Fair values for these invest- ments are based on closing stock prices from active markets and are therefore classified within Level 1 of the fair value hierarchy. Private equities – other investment in which fair value inputs are unobservable. Derivative financial instruments – these derivatives are foreign currency forward and option contracts. See Note 17. 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. During 2021, we recognized a realized gain of $3,815 recorded in our consolidated statement of income attributable to the sale of certain equity securities. There were no transfers in or out of Level 1 and Level 2 during 2020 or 2019. 19. COMMITMENTS AND CONTINGENCIES Litigation, Claims and Assessments We are involved in litigation incidental to the operation of our business. We vigorously defend all matters in which we or our subsidiaries are named defendants and, for insurable losses, maintain significant lev- els of insurance to protect against adverse judgments, claims or assessments that may affect us. Although the adequacy of existing insurance coverage and the outcome of any legal proceedings cannot be pre- dicted with certainty, based on the current information available, we do not believe the ultimate liability associated with any known claims or litigation will have a material adverse effect on our financial condi- tion or results of operations. 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 $7,253 and $5,404 at December 31, 2021 and 2020, 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, 2021, 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. At December 31, 2021, the maxi- mum exposure to loss related to our involvement with this entity is limited to approximately $6,200 and we have a cash deposit of approximately $2,600 with them as collateral to cover any contingency related to additional risk assessments pertaining to our self-insurance programs. See “Self-Insurance” above for further information on commitments associated with the insurance programs. At December 31, 2021, there were no other entities that met the definition of a VIE. Purchase Obligations At December 31, 2021, we were obligated under various non-cancelable purchase orders with our key suppliers for goods aggregating approximately $45,000, of which approximately $31,000 is with Carrier and its affiliates. 20. RELATED PARTY TRANSACTIONS Purchases from Carrier and its affiliates comprised 61%, 63%, and 62% of all inventory purchases made during 2021, 2020 and 2019, respectively. At December 31, 2021 and 2020, approximately $90,000 and $81,000, 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 2021, 2020, and 2019 included approximately $108,000, $103,000, and $91,000, 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 Senior Chairman of Greenberg Traurig, P.A., which serves as our principal outside counsel for compliance and acquisition-related legal services. During 2021, 2020, and 2019, fees for services performed were $225, $156, and $187, respectively, and $34 and $8 was payable at December 31, 2021 and 2020, respectively. 64 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 65 21. 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, Revenues: United States Canada Latin America and the Caribbean Total revenues December 31, Long-Lived Assets: United States Canada Latin America and the Caribbean Total long-lived assets 2021 2020 2019 $ 5,636,929 386,780 256,483 $ 4,535,262 301,727 217,939 $ 4,184,206 294,040 292,116 $ 6,280,192 $ 5,054,928 $ 4,770,362 2021 2020 $ 931,170 175,864 17,427 $ 799,665 180,518 19,719 $ 1,124,461 $ 999,902 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, operating lease ROU assets, property and equipment, and our investment in an unconsolidated entity. 22. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information was as follows: Years Ended December 31, Interest paid Income taxes net of refunds Common stock issued for MIS Common stock issued for ACME Common stock issued for N&S Common stock issued for PPI Common stock issued for DASCO 2021 2020 2019 $ $ $ $ $ $ 913 124,984 997 2,551 — $ — — $ $ 1,844 70,889 — — (161) $ — $ — $ 4,341 70,095 — — 4,032 58,344 6,891 23. SUBSEQUENT EVENTS On February 8, 2022, our Board of Directors approved an increase to the quarterly cash dividend per share of Common and Class B common stock to $2.20 per share from $1.95 per share, beginning with the dividend that will be paid in April 2022. 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 Russell 2000 index, the S&P MidCap 400 index, and the S&P 500 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 Russell 2000 index, the S&P MidCap 400 index, and the S&P 500 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, 2016 and its relative performance is tracked through December 31, 2021. 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, as amended, except to the extent we specifically incorporate this information by reference, and shall not otherwise be deemed filed under such acts. COMPARISON OF 5-YEAR CUMULATIVE TOTAL SHAREHOLDER RETURN* Among Watsco, Inc., the Russell 2000 Index, the S&P Midcap 400 Index and the S&P 500 Index $300 $250 $200 $150 $100 $50 12/16 12/17 12/18 12/19 12/20 12/21 Watsco, Inc. S&P MidCap 400 Watsco, Inc. Class B S&P 500 Russell 2000 *$100 invested on 12/31/16 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright© 2022 Standard & Poor's, a division of S&P Global. All rights reserved. Copyright© 2022 Russell Investment Group. All rights reserved. Watsco, Inc. Watsco, Inc. Class B Russell 2000 Index S&P MidCap 400 Index S&P 500 Index 12/31/16 12/31/17 12/31/18 12/31/19 12/31/20 12/31/21 100.00 100.00 100.00 100.00 100.00 118.36 117.11 114.65 116.24 121.83 99.99 96.73 102.02 103.36 116.49 134.94 135.33 128.06 130.44 153.17 176.11 180.41 153.62 148.26 181.35 250.19 244.52 176.39 184.96 233.41 66 WATSCO, INC. 2021 ANNUAL REPORT WATSCO, INC. 2021 ANNUAL REPORT 67 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 www.watsco.com EXECUTIVE OFFICERS Albert H. Nahmad Chief Executive Officer Aaron J. Nahmad President Barry S. Logan Executive 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. J. Michael Custer (1,3) Principal, Kaufman Rossin John A. Macdonald (1,2) Chairman of the Board, Parity, Inc. Denise Dickins (1,2) Professor of Accounting and Auditing, East Carolina University Bob L. Moss (3) Chairman and Chief Executive Officer, Moss & Associates LLC Aaron J. Nahmad (4) President Steven (Slava) Rubin (2,3) Co-Founder, humbition (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 American Stock Transfer & Trust Company is the transfer agent, registrar and dividend disbursing agent for Watsco’s common stock. Questions and communications from registered shareholders regarding address changes, dividend checks, account consolidation, registration changes, lost stock certificates and other shareholder inquiries, should be directed to: American Stock Transfer & Trust Company 6201 15th Avenue, Brooklyn, NY 11219 Toll-Free: (800) 937-5449, International: (718) 921-8124 Internet Site: astfinancial.com Email: help@astfinancial.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. INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM KPMG LLP 78 SW 7th Street, Suite 1200 Miami, FL 33130 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. 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