The following information should be read in conjunction with the condensed consolidated unaudited financial statements included under Item 1, "Condensed Consolidated Unaudited Financial Statements" of this Quarterly Report on Form 10-Q.

Company Overview

Watsco, Inc. and its subsidiaries (collectively, "Watsco," which may be referred to as we, us or our) was incorporated in 1956 and is the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies ("HVAC/R") in the United States. On July 1, 2009, the completion of the newly formed joint venture, Carrier Enterprise, LLC ("Carrier Enterprise"), added 95 locations in the U.S. Sunbelt and Puerto Rico and the export division located in Miami, Florida. See Note 6 to the notes to condensed consolidated unaudited financial statements for a discussion on acquisitions. At September 30, 2009, we operated from 510 locations in 36 states.

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 tend to be variable in nature and correlate to changes in sales. Other significant selling, general and administrative expenses relate to the operation of warehouse facilities, including a fleet of trucks and forklifts and facility rent, which are payable mostly under non-cancelable operating leases.

Sales of residential central air conditioners, heating equipment and parts and supplies are seasonal. Furthermore, results of operations can be impacted favorably or unfavorably based on the severity or mildness of weather patterns during summer or winter selling seasons. Demand related to the residential central air conditioning replacement market is highest in the second and third quarters with demand for heating equipment usually highest in the fourth quarter. Demand related to the new construction sectors throughout most of the markets is fairly even during the year except for dependence on housing completions and related weather and economic conditions.

Items Affecting Comparability Between Periods

See Note 1 to the notes to condensed consolidated unaudited financial statements for a discussion of the impact of changes in accounting standards.

Critical Accounting Policies

Management's discussion and analysis of financial condition and results of operations is based upon the condensed consolidated unaudited financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these 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 condensed consolidated unaudited financial statements and the reported amount of revenues and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. At least quarterly, management reevaluates its judgments and estimates, which are based on historical experience, current trends and various other assumptions that are believed to be reasonable under the circumstances.

Our critical accounting policies are included in our 2008 Annual Report on Form 10-K as filed on February 27, 2009. We believe that there have been no significant changes during the quarter and nine months ended September 30, 2009 to the critical accounting policies disclosed in our 2008 Annual Report on Form 10-K.

Results of Operations

The following table summarizes information derived from the condensed
consolidated unaudited statements of income expressed as a percentage of
revenues:



                                                      Quarter                    Nine Months
                                                Ended September 30,          Ended September 30,
                                                 2009           2008          2009           2008

Revenues                                          100.0 %       100.0 %        100.0 %       100.0 %
Cost of sales                                      76.8          73.3           75.9          73.9


Gross profit                                       23.2          26.7           24.1          26.1
Selling, general and administrative
expenses                                           17.6          18.8           19.5          19.3


Operating income                                    5.6           7.9            4.6           6.8
Interest expense, net                               0.1           0.1            0.1           0.1


Income before income taxes                          5.5           7.8            4.5           6.7
Income taxes                                        1.8           2.9            1.6           2.5


Net income                                          3.7           4.9            2.9           4.2
Less: net income attributable to the
noncontrolling interest                             0.8            -             0.4            -


Net income attributable to Watsco, Inc.             2.9 %         4.9 %          2.5 %         4.2 %

The following narratives include the results of operations for businesses acquired during 2009. The acquisitions were accounted for using the purchase method of accounting and, accordingly, their results of operations have been included in the condensed consolidated unaudited statements of income beginning on their respective dates of acquisition. In the following narratives, computations and disclosure information referring to "same-store basis" exclude the effects of locations acquired or locations opened or closed during the prior twelve months unless they are within close geographical proximity to existing locations.

Third Quarter 2009 Compared to Third Quarter 2008

Revenues

Revenues increased $266.7 million, or 56%, compared to the same period in 2008, including a $339.4 million contribution from locations acquired and opened during the last twelve months partially offset by $2.4 million from closed locations. On a same-store basis, revenues declined $70.3 million, or 15%, and reflected a 9% decline in sales of HVAC equipment, a 24% decline in sales of other HVAC parts and supplies and a 17% decline in sales of refrigeration products. Revenues were impacted by lower demand experienced during the current economic conditions and lower pricing on certain commodity products that are sensitive to changes in commodity prices (copper tubing, galvanized sheet metal and refrigerant). The commodity products accounted for approximately $24.0 million of the same-store revenue decline and in aggregate represented 12% of revenues on a same-store basis.

Gross Profit

Gross profit increased $45.3 million, or 36%, compared to the same period in 2008, primarily as a result of higher revenues. Gross profit margin was 23.2% in 2009 versus 26.7% in 2008, reflecting lower gross margins achieved by Carrier Enterprise. On a same-store basis, gross profit margin declined 90 basis-points to 25.8% versus 26.7% for the same period in 2008. The decline in same-store gross profit margin primarily resulted from more competitive pricing conditions and a shift in sales mix toward HVAC equipment, which generates a lower gross profit margin versus non-equipment products.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $41.6 million, or 47%, compared to the same period in 2008. Selling, general and administrative expenses as a percent of revenues decreased to 17.6% from 18.8% for the same period in 2008, reflecting lower selling, general and administrative expenses achieved by Carrier Enterprise. On a same-store basis, selling, general and administrative expenses were down 14% primarily due to ongoing cost savings initiatives implemented in early 2008 and lower revenues.

Interest Expense, Net

Net interest expense increased $.4 million, or 63%, compared to the same period in 2008, primarily as a result of the additional amortization of costs of $.5 million related to the amendment of our revolving credit agreement and the establishment of the joint venture credit agreement, which are included in interest expense, partially offset by a 33% decrease in average outstanding borrowings as compared to 2008.

Income Taxes

Income taxes of $13.3 million consist of the income taxes attributable to Watsco's wholly-owned operations and 60% of income taxes attributable to Carrier Enterprise, which is taxed as a partnership for income tax purposes. Watsco's overall effective income tax rate was 38.2% in 2009 versus 37.1% in 2008, reflecting a higher state effective tax rate associated with Carrier Enterprise in 2009 and certain non-recurring tax benefits and credits realized in 2008.

Net Income Attributable to Watsco, Inc.

Net income attributable to Watsco decreased $2.2 million, or 9%, compared to the same period in 2008. The decrease was primarily driven by the lower gross profit margin partially offset by the lower levels of selling, general and administrative expenses as a percent of revenues discussed above.

Nine Months Ended 2009 Compared to Nine Months Ended 2008

Revenues

Revenues increased $72.8 million, or 5%, over the same period in 2008, including a $339.8 million contribution from locations acquired and opened during the last twelve months partially offset by $11.2 million from closed locations. On a same-store basis, revenues declined $255.8 million, or 19%, over the same period in 2008 and reflected a 14% decline of in sales of HVAC equipment, a 26% decline in sales of HVAC parts and supplies and a 16% decline in sales of refrigeration products. Revenues were impacted by lower demand experienced during the current economic conditions and lower pricing on certain commodity products that are sensitive to changes in commodity prices (copper tubing, galvanized sheet metal and refrigerant). These commodity products accounted for approximately $75.0 million of the same-store revenue decline and in aggregate represented 13% of revenues on a same-store basis.

Gross Profit

Gross profit decreased $8.5 million, or 2%, compared to the same period in 2008. Gross profit margin was 24.1% in 2009 versus 26.1% in 2008, reflecting lower gross margins achieved by Carrier Enterprise. On a same-store basis, gross profit margin for the nine months ended September 30, 2009 declined 70 basis-points to 25.4% versus 26.1% for the same period in 2008. The decline of same-store gross profit margin is primarily due to lower margins on certain commodity products that are sensitive to changes in commodity prices, a shift in sales mix toward HVAC equipment, which generates a lower gross profit margin versus non-equipment products and generally more competitive pricing conditions.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $18.2 million, or 7%, compared to the same period in 2008. Selling, general and administrative expenses as a percent of revenues increased to 19.5% from 19.3% for the same period in 2008. Selling, general and administrative expenses were impacted by $3.8 million of acquisition-related costs over the same period in 2008. On a same-store basis, selling, general and administrative expenses were down 13% compared to the same period in 2008, primarily due to ongoing cost savings initiatives implemented in early 2008.

Interest Expense, Net

Net interest expense increased $.1 million, or 6%, compared to the same period in 2008, primarily as a result of the additional amortization of costs related to the amendment of our revolving credit agreement and the establishment of the joint venture credit agreement, which are included in interest expense, partially offset by a 45% decrease in average outstanding borrowings as compared to 2008.

Income Taxes

Income taxes of $22.2 million consist of the income taxes attributable to Watsco's wholly-owned operations and 60% of income taxes attributable to Carrier Enterprise, which is taxed as a partnership for income tax purposes. Watsco's overall effective income tax rate was 37.8% in 2009 versus 37.5% in 2008. The increase is primarily due to a higher state effective tax rate associated with Carrier Enterprise.

Net Income Attributable to Watsco, Inc.

Net income attributable to Watsco decreased $20.8 million, or 36%, compared to the same period in 2008. The decrease was primarily driven by the lower gross profit margin and the higher levels of selling, general and administrative expenses as a percent of revenues discussed above.

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 of HVAC/R products, which peak in the months of May through August. Significant factors that could affect our liquidity include the following:

• cash flows generated from operating activities;

• the ability to attract long-term capital with satisfactory terms;

• acquisitions;

• dividend payments;

• the timing and extent of common stock repurchases; and

• capital expenditures.

We rely on cash flows from operations and our line of credit to fund seasonal working capital needs, financial commitments and short-term liquidity needs, including funds necessary for business acquisitions. Disruptions in the capital and credit markets, such as have been experienced during 2008 and 2009, could adversely affect our ability to draw on our line of credit. Our access to funds under the line of credit is dependent on the ability of the banks to meet their funding commitments. Recent disruptions in capital and credit markets have also affected the determination of interest rates for borrowers, particularly rates based on LIBOR, as is our line of credit. Continued disruptions in these markets and their affect on interest rates could result in increased borrowing costs under our line of credit. We believe that, at present, cash flows from operations combined with those available under our line of credit are sufficient to satisfy our current liquidity needs, including our anticipated dividend payments and capital expenditures.

Cash Flows

The following table summarizes our cash flow activity for the nine months ended
September 30, 2009 and 2008:



                                         2009        2008        Change

                 Operating activities   $ 38.5      $  37.1      $   1.4

                 Investing activities   $ (8.1 )    $  (3.0 )    $  (5.1 )

                 Financing activities   $ (6.6 )    $ (34.8 )    $  28.2

Operating Activities

The increase in net cash provided by operating activities was principally attributable to changes in operating assets and liabilities, which were primarily comprised of lower levels of accounts receivable and higher levels of accounts payable and other liabilities, partially offset by higher inventories and lower net income in 2009 versus 2008.

Investing Activities

The increase in net cash used in investing activities is primarily due to a business acquired in 2009 for $4.1 million and an increase in capital expenditures of $1.0 million.

Financing Activities

The decrease in net cash used in financing activities is primarily attributable to increased net borrowings of $20.0 million made in 2009 to fund a required capital contribution made to Carrier Enterprise in August of $48.0 million.

Working capital increased to $578.5 million at September 30, 2009 from $348.9 million at December 31, 2008 primarily due to the 95 new locations added by Carrier Enterprise in July 2009, which added $248.5 million of working capital. Excluding these new locations, working capital was $330.0 million.

Revolving Credit Agreements

We maintain a bank-syndicated, unsecured revolving credit agreement that provides for borrowings of up to $300.0 million. Borrowings are used to fund seasonal working capital needs and for other general corporate purposes, including acquisitions, dividends, stock repurchases and issuances of letters of credit. The credit facility matures in August 2012. At September 30, 2009 and December 31, 2008, $43.0 million and $20.0 million were outstanding under this revolving credit agreement.

On July 1, 2009, we amended our $300.0 million credit agreement to allow for the consummation of the Carrier Enterprise joint venture. We paid an amendment fee of $5.5 million, which is being amortized ratably through the maturity of the facility in August 2012. All other significant terms and conditions remained the same, including capacity, pricing and covenant structure.

In August 2009, we funded a required capital contribution to Carrier Enterprise in the amount of $48.0 million by incurring additional borrowings of $20.0 million under our revolving credit agreement and using cash on hand. A final working capital adjustment pursuant to the Purchase and Contribution Agreement dated May 3, 2009, as amended June 29, 2009, of approximately $6.0 million is expected to be made during the fourth quarter of 2009.

The revolving credit agreement contains customary affirmative and negative covenants including financial covenants with respect to consolidated leverage and interest coverage ratios and limits capital expenditures, dividends and share repurchases in addition to other restrictions. We believe we were in compliance with all covenants and financial ratios at September 30, 2009.

On July 1, 2009, Carrier Enterprise entered into a separate secured three-year $75.0 million revolving credit agreement with three lenders. Borrowings under the credit facility will be used by Carrier Enterprise for general corporate purposes, including working capital and permitted acquisitions. The credit facility is secured by all tangible and intangible assets of Carrier Enterprise. Carrier Enterprise paid $1.2 million of fees in connection with the credit agreement, which is being amortized ratably through the maturity of the facility in July 2012. As of September 30, 2009, no borrowings were outstanding under this credit facility.

The revolving credit agreement contains customary affirmative and negative covenants and warranties, including compliance with a monthly borrowing base certificate with advance rates on accounts receivable and inventory, two financial covenants with respect to Carrier Enterprise's leverage and interest coverage ratios and limits the level of capital expenditures in addition to other restrictions. We believe Carrier Enterprise was in compliance with all covenants and financial ratios at September 30, 2009.

Contractual Obligations and Off-Balance Sheet Arrangements

During the three months ended September 30, 2009, our contractual obligations
with regard to non-cancelable operating leases changed as a result of the 95 new
locations added by Carrier Enterprise. As of September 30, 2009, our significant
contractual obligations were as follows (in millions):



                                                                    Payments due by Period
Contractual Obligations                       Q4 2009     2010     2011     2012     2013    Thereafter     Total
Non-cancelable operating lease obligations   $    16.5   $ 53.7   $ 38.9   $ 26.1   $ 18.2   $      27.1   $ 180.5
Minimum royalty payments                           0.3      1.0      1.0       -        -             -        2.3
Other debt                                         0.1      0.1      0.1      0.1      0.1           0.4       0.9

Total contractual obligations                $    16.9   $ 54.8   $ 40.0   $ 26.2   $ 18.3   $      27.5   $ 183.7

Commercial obligations outstanding at September 30, 2009 under the credit agreements consist of borrowings totaling $43.0 million and standby letters of credit totaling $3.9 million. Borrowings under the credit agreements at September 30, 2009 had revolving maturities of 30 days and letters of credit had varying terms expiring through August 2010.

Standby letters of credit are primarily used as collateral under self-insurance programs and are not expected to result in any material losses or obligation as the obligations under the programs will be met in the ordinary course of business. Accordingly, the estimated fair value of these instruments is zero at September 30, 2009.

Company Share Repurchase Program

In September 1999, our Board of Directors authorized the repurchase, at management's discretion, of 7.5 million 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. In aggregate, 6.4 million shares of Common stock and Class B common stock have been repurchased at a cost of $114.4 million since the inception of the program. The remaining 1.1 million shares authorized for repurchase are subject to certain restrictions included in our debt agreement.

Common Stock Dividends

Cash dividends of $1.41 per share and $1.30 per share of Common stock and Class B common stock were paid during the nine months ended September 30, 2009 and 2008, respectively. On October 1, 2009, the Board of Directors declared a regular quarterly cash dividend of $0.48 per share of Common stock and Class B common stock that was paid on October 30, 2009 to shareholders of record as of October 15, 2009. Future dividends and/or dividend rate increases will be at the sole discretion of the Board of Directors and will depend upon such factors as profitability, financial condition, cash requirements, and restrictions under our debt agreement, future prospects and other factors deemed relevant by our Board of Directors.

Capital Resources

We believe we have adequate availability of capital from operations and our current credit facilities to fund working capital requirements and support the development of our short-term and long-term operating strategies. As of September 30, 2009, we had cash and cash equivalents on hand and additional borrowing capacity (subject to certain restrictions) under our credit agreements to fund present operations and anticipated growth, including expansion in our current and targeted market areas. Potential acquisitions are continually evaluated and discussions are conducted with a number of acquisition candidates. Should suitable acquisition opportunities or working capital needs arise that would require additional financing, we believe our financial position and earnings history provide a sufficient base for obtaining additional financing resources at competitive rates and terms or gives us the ability to raise funds through the issuance of equity securities.