EXHIBIT 13

WATSCO, INC. AND SUBSIDIARIES

SELECTED CONSOLIDATED FINANCIAL DATA

Years Ended December 31, (In thousands, except per share data)	2006 (1)		2005		2004		2003		2002
OPERATIONS
Revenues	$	1,800,759	$	1,682,724	$	1,315,024	$	1,232,908	$	1,181,136
Gross profit		462,900		423,030		336,935		305,083		287,276
Operating income		135,603		116,458		82,052		61,189		50,924
Net income		82,364		70,019		48,105		34,895		28,536
SHARE AND PER SHARE DATA
Diluted earnings per share	$	2.96	$	2.52	$	1.79	$	1.34	$	1.07
Cash dividends declared and paid per share:
Common stock	$	0.95	$	0.62	$	0.38	$	0.20	$	0.115
Class B common stock		0.95		0.62		0.38		0.20		0.115
Weighted average shares outstanding for diluted earnings per share		27,829		27,769		26,931		26,037		26,674
Common stock outstanding		27,833		27,463		26,855		26,324		26,032
BALANCE SHEET INFORMATION
Total assets	$	711,371	$	678,731	$	608,289	$	535,095	$	503,719
Long-term obligations		30,118		40,189		50,155		60,153		80,233
Shareholders’ equity		516,386		450,650		402,738		360,869		329,201

(1) Effective January 1, 2006, the provisions of SFAS No. 123R, “Share-Based Payment”, were adopted using the modified prospective transition method. The impact of adopting SFAS No. 123R was a reduction of our net income of $906 for the year ended December 31, 2006. Also, diluted earnings per share were reduced by $.03 for the year ended December 31, 2006, as a result of adopting SFAS No. 123R.

WATSCO, INC. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Company Overview

Watsco, Inc. and its subsidiaries (collectively, “Watsco”) was incorporated in 1956 and is the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies (“HVAC”) in the United States. We presently operate from 380 locations in 32 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 sales growth. 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 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.

Critical Accounting Policies

Management’s discussion and analysis of Watsco’s 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 financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenues and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. At least quarterly, management reevaluates its judgments and estimates which are based on historical experience, current trends and various other assumptions that are believed to be reasonable under the circumstances.

Our significant accounting policies are discussed in Note 1 to the consolidated financial statements. Management believes that the following accounting policies include a higher degree of judgment and/or complexity and, thus, are considered to be critical accounting policies. Management has discussed the development and selection of critical accounting policies with Watsco’s 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 customers to make required payments. Accounting for doubtful accounts contains uncertainty because management must use judgment to assess the collectibility of these accounts. When preparing these estimates, management considers a number of factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other information. Our business is seasonal and our customers’ businesses are also seasonal. Sales are 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 $3.1 million and $3.0 million at December 31, 2006 and 2005, respectively, an increase of $.1 million. The increase from December 31, 2005 is primarily due to an increase in the over 90 day balances. Accounts receivable balances greater than 90 days past due as a percent of accounts receivable at December 31, 2006 increased to 2.1% compared to 1.2% at December 31, 2005. This increase was driven by decreased sales volume. Accounts receivable net write-offs as a percent of sales increased for the year ended December 31, 2006 to .19% compared to .07% for the year ended December 31, 2005. This was primarily the result of a large 2006 write-off related to one customer, as well as lower bad debt recoveries in 2006.

Although we believe the allowance for doubtful accounts is sufficient, if the financial condition of customers were to unexpectedly deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required that could materially impact our consolidated results of operations. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of customers comprising the customer base and their dispersion across many different geographical regions. Watsco also has access to a credit insurance program which is used as an additional means to mitigate credit risk.

Inventory Valuation

Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies and are valued at the lower of cost or market on a weighted-average cost basis. As part of the valuation process, inventory reserves are established to state excess, slow-moving and damaged inventories at their estimated net realizable value. The valuation process for excess, slow-moving and damaged inventory contains uncertainty because management must use judgment to estimate when the inventory will be sold and the quantities and prices at which the inventory will be sold in the normal course of business. Inventory reserve policies are periodically reviewed, 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.

Inventory reserves of $3.8 million and $3.1 million at December 31, 2006 and 2005, respectively, have been established. The increase in inventory reserves is primarily due to the impact of higher amounts of excess and slow-moving inventory on hand at December 31, 2006 than at December 31, 2005, which is attributed to higher carrying values of inventory resulting from the transition into higher SEER and the introduction of new product lines. Inventory reserves are affected by a number of factors, including general economic conditions and other factors affecting demand as well as the effectiveness of the inventory management process for controlling inventory shrinkage. In the event the estimates differ from actual results, inventory-related reserves may be adjusted and could materially impact the consolidated results of operations.

Goodwill and Intangibles

The recoverability of goodwill and indefinite life intangibles is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount of goodwill and indefinite life intangibles may not be recoverable. The identification and measurement of goodwill impairment involves the estimation of the fair value of reporting units and contains uncertainty because management must use judgment in determining appropriate assumptions to be used in the measurement of fair value. Indefinite life intangibles not subject to amortization are assessed for impairment by comparing the fair value of the intangible asset to its carrying amount to determine if a write-down to fair value is required. The estimates of fair value of the reporting units and indefinite life intangibles are based on the best information available as of the date of the assessment and incorporate management assumptions about expected future cash flows and contemplate other valuation techniques. Future cash flows can be affected by changes in industry or market conditions.

On January 1, 2007, the annual impairment tests were performed and it was determined there was no impairment. No factors have developed since the last impairment tests that would indicate that the carrying value of goodwill and indefinite life intangibles may not be recoverable. The carrying amount of goodwill and intangibles at December 31, 2006 was $165.9 million. Although no impairment has been recorded to date, there can be no assurances that future impairments will not occur. An adjustment to the carrying value of goodwill and intangibles could materially impact the consolidated results of operations.

Self-Insurance Reserves

Self-insurance reserves are maintained relative to company-wide casualty insurance programs and for one subsidiary’s health benefit program. The level of exposure from catastrophic events is limited by the purchase of stop-loss and aggregate liability reinsurance coverages. When estimating the self-insurance liabilities and related reserves, management considers a number of 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 the self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occurs and exceed these estimates, additional reserves may be required that could materially impact the consolidated results of operations. The estimation process contains uncertainty since management must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. At December 31, 2006, a reserve of $5.7 million was established related to such insurance programs versus $5.2 million at December 31, 2005. The increase in the self-insurance reserves reflects the addition of the 2006 policy year.

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 $.4 million has been recorded at December 31, 2006 and 2005 due to uncertainties related to the ability to utilize a portion of the deferred tax assets primarily arising from state net operating loss carryforwards. The valuation allowance is based on estimates of future taxable income by jurisdiction in which the deferred tax assets will be recoverable. These estimates can be affected by a number of factors, including possible tax audits or general economic conditions or competitive pressures that could affect future taxable income. Although management believes that the estimates discussed above are reasonable, the deferred tax asset and any related valuation allowance will need to be adjusted if management’s estimates of future taxable income differ from actual taxable income. An adjustment to the deferred tax asset and any related valuation allowance could materially impact the consolidated results of operations.

Results of Operations

The following table presents information derived from the consolidated statements of income expressed as a percentage of revenues for the years ended December 31, 2006, 2005 and 2004:

	2006		2005		2004
Revenues	100.0	%	100.0	%	100.0	%
Cost of sales	74.3		74.9		74.4
Gross profit	25.7		25.1		25.6
Selling, general and administrative expenses	18.2		18.2		19.4
Operating income	7.5		6.9		6.2
Interest expense, net	.2		.2		.3
Income taxes	2.7		2.5		2.2
Net income	4.6	%	4.2	%	3.7	%

The following narratives include the results of operations for businesses acquired during 2006, 2005 and 2004. The acquisitions were accounted for under the purchase method of accounting and, accordingly, their results of operations have been included in the consolidated results 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.

Consolidated Comparison of Year Ended December 31, 2006 with Year Ended December 31, 2005

Revenues in 2006 increased $118.0 million, or 7%, as compared to 2005, including a $13.5 million contribution from locations acquired and opened during 2006 offset by $2.3 million from closed locations. On a same-store basis, revenues increased $106.8 million, or 6.4%, over 2005. The increase in same-store revenues reflects improving sales mix from the introduction of higher efficiency air conditioning systems, which sell at higher prices, and strong demand for commercial and refrigeration products.

Gross profit in 2006 increased $39.9 million, or 9%, over 2005, primarily as a result of increased revenues. Gross profit margin increased 60 basis-points to 25.7% in 2006 from 25.1% in 2005. This increase reflects higher margins on recently introduced higher efficiency air conditioning systems as well as improved margins for non-equipment products.

Selling, general and administrative expenses as a percent of revenues remained consistent at 18.2% in both 2006 and 2005. Selling, general and administrative expenses in 2006 increased $20.7 million, or 7%, over 2005. On a same-store basis, selling, general and administrative expenses were up 6% compared to 2005 primarily due to increases in certain variable expenses related to our increased revenues and gross profit, higher share-based compensation and increase in the provision for doubtful accounts.

Net interest expense in 2006 increased $.5 million, or 14%, compared to 2005, primarily due to higher outstanding borrowings.

The effective tax rate was 37.5% in 2006 and 38.1% in 2005. The decrease in the effective tax rate in 2006 is due to the realization of employment tax credits and various other initiatives.

Net income for 2006 increased $12.3 million, or 18%, compared to 2005. The increase in net income was primarily driven by the higher revenues and expansion of gross profit margin discussed above.

Consolidated Comparison of Year Ended December 31, 2005 with Year Ended December 31, 2004

Revenues in 2005 increased $367.7 million, or 28%, as compared to 2004, including a $227.0 million contribution from locations acquired and opened during 2005 offset by $1.7 million from closed locations. On a same-store basis, revenues increased $142.4 million, or 11%, over 2004, reflecting strong market conditions for the replacement of residential and light-commercial HVAC products.

Gross profit in 2005 increased $86.1 million, or 26%, over 2004, primarily as a result of increased revenues. Gross profit margin decreased 50 basis-points to 25.1% in 2005 from 25.6% in 2004. The decrease primarily results from the addition of East Coast Metal Distributors, Inc. (“East Coast”), which historically had lower gross profit margins than our consolidated margins, as well as a proportionately higher sales mix of HVAC equipment versus parts and supplies. On a same-store basis, gross profit increased $34.8 million, or 10%, over 2004.

Selling, general and administrative expenses as a percent of revenues decreased to 18.2% in 2005 from 19.4% in 2004, from leveraging of fixed operating costs. Selling, general and administrative expenses in 2005 increased $51.7 million, or 20%, over 2004, primarily due to the addition of East Coast. On a same-store basis, selling, general and administrative expenses were up 6% compared to 2004 primarily due to increases in certain variable expense items from higher revenues.

Net interest expense in 2005 decreased $1.1 million, or 24%, compared to 2004, primarily due to lower outstanding borrowings and higher interest income.

The effective tax rate was 38.1% in 2005 and 38.0% in 2004. The increase in the effective tax rate in 2005 primarily relates to higher state income tax expense.

Net income for 2005 increased $21.9 million, or 46%, compared to 2004. The increase in net income was primarily driven by the higher revenues as well as by the lower levels of selling, general and administrative expenses as a percent of revenues and decreased net interest expense discussed above.

Liquidity and Capital Resources

We assess liquidity in terms of our ability to generate cash to execute our business strategy and fund operating and investing activities and take into consideration the seasonal demand of HVAC products, which peak in the months of May through August. Significant factors affecting liquidity include cash flows generated from operating activities, the adequacy of available bank lines of credit and the ability to attract long-term capital with satisfactory terms, capital expenditures, acquisitions, the timing and extent of common stock repurchases and dividend policy.

We maintain a bank-syndicated, unsecured revolving credit agreement that provides for borrowings of up to $100.0 million, expiring in December 2009. Borrowings are used to fund seasonal working capital needs and for other general corporate purposes, including acquisitions and issuance of letters of credit. Borrowings bear interest at primarily LIBOR-based rates plus a spread that is dependent upon Watsco’s financial performance (LIBOR plus .475% and .625% at December 31, 2006 and 2005, respectively). A variable commitment fee is paid on the unused portion of the credit line (.125% and .15% at December 31, 2006 and 2005, respectively). At December 31, 2006 and 2005, $30.0 million was outstanding under the revolving credit agreement.

A $125.0 million unsecured private placement shelf facility is also maintained as a source of borrowings. The uncommitted shelf facility provides fixed-rate financing through December 2007 as a complement to the variable rate borrowings available under the revolving credit agreement. $10.0 million and $20.0 million, respectively, of Senior Series A Notes (“Notes”) were outstanding at December 31, 2006 and 2005, under the facility bearing interest at 7.07%. The Notes will be repaid on April 9, 2007. Accordingly, $10.0 million is classified as “current” in the consolidated balance sheet at December 31, 2006. Interest is paid on a quarterly basis. The Notes may be redeemed prior to maturity subject to a redemption premium and other restrictions.

Both the revolving credit agreement and the private placement shelf facility contain customary affirmative and negative covenants including certain financial covenants with respect to consolidated leverage, interest and debt coverage ratios and limits capital expenditures, dividends and share repurchases in addition to other restrictions. We believe that we are in compliance with all covenants and financial ratios at December 31, 2006.

At December 31, 2006 and 2005, one interest rate swap agreement was in effect with a notional value of $30.0 million to manage the net exposure to interest rate changes related to $30.0 million of borrowings under the revolving credit agreement. The interest rate swap agreement, which expires in October 2007, effectively converts the LIBOR-based variable rate borrowings into fixed rate borrowings. Developments in the capital markets are continuously monitored and swap transactions are entered into solely with established counterparties having investment grade ratings. See Note 10 to the consolidated financial statements and “Quantitative and Qualitative Disclosures about Market Risk,” for further information.

Working capital increased to $361.6 million at December 31, 2006 from $314.7 million at December 31, 2005, primarily due to increased inventory levels and lower accrued expenses. Working capital was also impacted by a higher cash balance at December 31, 2006 compared to December 31, 2005. The increase in working capital was primarily funded by operating cash flows.

Net cash provided by operating activities was $68.5 million in 2006 compared to $35.8 million in 2005. The 2005 operating cash flows were heavily impacted by the buildup of inventory in anticipation of the transition into the higher efficiency units and higher accounts receivable driven by increased sales volume. Operating cash flows for 2006 were also benefited from higher net income, offset by the classification of $8.4 million in excess tax benefits from share-based compensation as a financing cash inflow rather than an operating cash inflow as a result of adopting Statement of Financial Accounting Standards (“SFAS”) No. 123R on January 1, 2006. See Note 1 to the consolidated financial statements for further information on the impact of SFAS No. 123R to our consolidated statements of cash flows.

Net cash used in investing activities decreased to $22.3 million in 2006 from $54.7 million in 2005, primarily due to an acquisition in 2005.

In the fourth quarter of 2006, one of our subsidiaries completed two acquisitions. A&R Supply, Inc., a distributor of refrigeration products founded in 1957 and headquartered in Memphis, Tennessee, was acquired in October 2006, adding eight new locations to the western Tennessee, Mississippi and Arkansas markets. ASHA Distributing, Inc., a distributor of air conditioning and heating products founded in 1982 and headquartered in Omaha, Nebraska, was acquired in December 2006, adding 10 locations to the Nebraska, Missouri and Kansas markets.

In the first quarter of 2006, one of our subsidiaries completed the acquisition of a refrigeration equipment distributor with locations in Birmingham and Montgomery, Alabama. Also in the first quarter of 2006, another subsidiary completed the purchase of the net assets and business of a wholesale distributor of air conditioning and heating products operating from a single location in Kansas City, Missouri.

In January 2005, we acquired East Coast one of the nation’s largest distributors of air conditioning and heating products, with 27 locations in North Carolina, South Carolina, Georgia, Virginia and Tennessee for cash consideration of $49.5 million.

The results of operations of acquired locations have been included in the consolidated financial statements from their respective dates of acquisition. The proforma effect of these acquisitions was not deemed material to the consolidated financial statements for the years ended December 31, 2006, 2005 and 2004.

Net cash used in financing activities of $39.6 million in 2006 was primarily used for the payment of cash dividends, stock repurchases and a $10.0 million repayment of long-term notes, partially offset by $8.4 million in excess tax benefits from share-based compensation classified as a financing cash inflow that would have been classified as an operating cash inflow had we not adopted SFAS No. 123R and proceeds received from the exercise of stock options and from purchases under an employee stock purchase plan.

Watsco’s Board of Directors in 1999 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. Repurchases totaled 243,600 shares at a cost of $15.3 million in 2006, 347,600 shares at a cost of $17.7 million in 2005 and 29,900 shares at a cost of $.8 million in 2004. In aggregate, 6.0 million shares of Common stock and Class B common stock have been repurchased at a cost of $100.2 million since the inception of the program. The remaining 1.5 million shares authorized for repurchase are subject to certain restrictions included in the debt agreements.

Cash dividends of 95 cents, 62 cents and 38 cents per share of Common stock and Class B common stock were paid in 2006, 2005 and 2004, respectively. In April 2006, Watsco’s Board of Directors approved an increase in the quarterly cash dividend to 25 cents

per share from 20 cents per share of Common and Class B common stock. In February 2007, Watsco’s Board of Directors approved an increase in the quarterly cash dividend to 33 cents per share from 25 cents per share. 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, restrictions under debt agreements, future prospects and other factors deemed relevant by Watsco’s Board of Directors.

We believe there is adequate availability of capital from operations and current credit facilities to fund working capital requirements and support the development of our short-term and long-term operating strategies. As of December 31, 2006, we had $34.3 million of cash and cash equivalents, $65.4 million of additional borrowing capacity under the revolving credit agreement and $115.0 million available under the private placement shelf facility (subject to certain borrowing limitations) 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 that 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 if required.

Recent Events

Contractual Obligations and Off-Balance Sheet Arrangements

The following table summarizes our significant contractual obligations as of December 31, 2006 (in millions):

	Payments due by Period
Contractual Obligations	2007		2008		2009		2010		2011		Thereafter		Total
Non-cancelable operating lease obligations	$	39.2	$	32.5	$	25.0	$	17.2	$	10.9	$	17.7	$	142.5
Long-term debt		10.0		—		—		—		—		—		10.0
Minimum royalty payments		1.0		1.0		1.0		1.0		1.0		—		5.0
Other debt		0.1		0.1		—		—		—		—		0.2
Total Contractual Obligations	$	50.3	$	33.6	$	26.0	$	18.2	$	11.9	$	17.7	$	157.7

Commercial obligations outstanding at December 31, 2006 under the revolving credit agreement consist of borrowings totaling $30.0 million, standby letters of credit totaling $4.1 million and commercial letters of credit totaling $.5 million. Borrowings under the revolving credit agreement at December 31, 2006 had revolving maturities of 90 days and letters of credit have varying terms expiring through January 2008.

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 December 31, 2006. See Note 10 to the consolidated financial statements for further information.

Quantitative and Qualitative Disclosures about Market Risk

The primary market risk exposure for Watsco is interest rate risk. The objective in managing the exposure to interest rate changes is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve this objective, interest rate swaps are used to manage net exposure to interest rate changes to our borrowings. These swaps are entered into with financial institutions with investment grade credit ratings, thereby minimizing the risk of credit loss. All items described are non-trading. See Notes 1 and 10 to the consolidated financial statements for further information.

Interest rate swap agreements reduce the exposure to market risks from changing interest rates under the revolving credit agreements. Under the swap agreements, Watsco agrees to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to a notional principal amount. Any differences paid or received on interest rate swap agreements are recognized as adjustments to interest expense over the life of each swap, thereby adjusting the effective interest rate on the underlying obligation. Financial instruments are not held for trading purposes. Derivatives used for hedging purposes must be designated as, and effective as, a hedge of the identified risk exposure at the inception of the contract. Accordingly, changes in the fair value of the derivative contract must be highly correlated with changes in the fair value of the underlying hedged item at inception of the hedge and over the life of the hedge contract.

Swap agreements are accounted for based on the guidance of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Under SFAS No. 133, all derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive loss (“OCL”) and are recognized in the income statement when the hedged items affect earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings.

At December 31, 2006 and 2005, one interest rate swap agreement was in effect with a notional value of $30.0 million maturing in 2007, exchanging the variable rate of 90-day LIBOR to fixed interest rate payments of 6.25%. The interest rate swap was effective as a cash flow hedge and no charge to earnings was required in 2006, 2005 or 2004 for hedge ineffectiveness. The negative fair value of the derivative financial instrument was $.3 million and $.9 million at December 31, 2006 and 2005, respectively, and is included, net of accrued interest, in deferred income taxes and other liabilities in the consolidated balance sheets.

At December 31, 2006, 2005 and 2004, $.1 million, net of deferred tax benefits of $.08 million, $.5 million net of deferred tax benefits of $.3 million and $1.3 million net of deferred tax benefits of $.8 million was recorded in OCL associated with cash flow hedge. During 2006, 2005 and 2004, we recognized decreases in unrealized losses in OCL relating to cash flow hedges of $.3 million, net of income tax expense of $.2 million, $.9 million, net of income tax expense of $.5 million and $.8 million, net of income tax expense of $.4 million, respectively.

The change in OCL during 2006, 2005 and 2004, reflected the reclassification of $.2 million, net of income tax benefit of $.1 million, $.6 million, net of income tax benefit of $.3 million and $.9 million, net of income tax benefit of $.6 million, respectively, of losses from accumulated OCL to current period earnings (recorded in interest expense, net in the consolidated statements of income). The net deferred loss recorded in accumulated OCL will be reclassified to earnings on a quarterly basis as interest payments occur. As of December 31, 2006, approximately $.3 million in deferred losses on the derivative instrument accumulated in OCL is expected to be reclassified to earnings during the next twelve months using a current three month LIBOR-based average receive rate (5.17% at December 31, 2006).

At December 31, 2006 and 2005, Watsco’s exposure to interest rate changes was limited to variable rate lease payments which are indexed to one month LIBOR. To assess our exposure to changes in interest rates, we performed a sensitivity analysis to determine the impact to earnings associated with an immediate 100 basis point fluctuation from one month LIBOR. Based on the results of this simulation, as of December 31, 2006 and 2005, net income would decrease or increase by approximately $.1 million on an annual basis if there were an immediate 100 basis point increase or decrease, respectively, in one month LIBOR. This information constitutes a “forward-looking statement” and actual results may differ significantly based on actual borrowings and interest rates.

Recently Issued Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions of SFAS No. 157 are effective for us beginning January 1, 2008. We are currently evaluating the impact of adopting SFAS No. 157 on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB No. 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB No. 108 requires companies to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB No. 108 permits existing public companies to initially apply its provisions either by (i) restating prior financial statements as if the “dual approach” had always been used or (ii) recording the cumulative effect of initially applying the “dual approach” as adjustments to the carrying value of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings. Use of the “cumulative effect” transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. The adoption of SAB No. 108 did not have a material impact on our consolidated financial statements.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN No. 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This interpretation seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, it requires expanded disclosure with respect to the uncertainty in income taxes. FIN No. 48 is effective January 1, 2007 and is not expected to have a material impact on our consolidated financial statements.

Information about Forward-Looking Statements

This Annual Report contains or incorporates by reference statements that are not historical in nature and that are intended to be, and are hereby identified as, “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995, including statements regarding, among other items, (i) business and acquisition strategies, (ii) potential acquisitions, (iii) financing plans and (iv) industry, demographic and other trends affecting Watsco’s financial condition or results of operations. These forward-looking statements are based largely on management’s current expectations and are subject to a number of risks, uncertainties and changes in circumstances, certain of which are beyond their control.

Actual results could differ materially from these forward-looking statements as a result of several factors, including

• general economic conditions affecting general business spending,

• consumer spending,

• consumer debt levels,

• seasonal nature of product sales,

• weather conditions,

• effects of supplier concentration,

• competitive factors within the HVAC industry,

• insurance coverage risks,

• prevailing interest rates, and

• the continued viability of Watsco’s business strategy.

In light of these uncertainties, there can be no assurance that the forward-looking information contained herein will be realized or, even if substantially realized, that the information will have the expected consequences to or effects on Watsco or its business or operations. A discussion of certain of these risks and uncertainties that could cause actual results to differ materially from those predicted in such forward-looking statements is included in Watsco’s Annual Report to Shareholders for the fiscal year ended December 31, 2006 in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which section has been incorporated in the Form 10-K by reference. Forward-looking statements speak only as of the date the statement was made. Watsco assumes no obligation to update forward-looking information or the discussion of such risks and uncertainties to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information.

Corporate Governance

On June 13, 2006, Watsco submitted to the New York Stock Exchange (“NYSE”) the annual Chief Executive Officer Certification required under Section 303A 12(a) of the NYSE Listed Company Manual. In addition, Watsco filed with the Securities and Exchange Commission the certifications required under Section 302 of the Sarbanes-Oxley Act of 2002 as Exhibits 31.1, 31.2 and 31.3 to its Annual Report on Form 10-K for the year ended December 31, 2006.

WATSCO, INC. AND SUBSIDIARIES

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). Watsco’s internal control system was designed to provide reasonable assurance to our management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of our published consolidated financial 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 inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation of our management, including our Chief Executive Officer, Senior Vice President and Chief Financial Officer, we conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006. The assessment was based on criteria established in the framework Internal Control — Integrated Framework, 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 financial reporting was effective as of December 31, 2006. Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Grant Thornton LLP, an independent registered public accounting firm, as stated in their report that is included herein.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE FINANCIAL STATEMENTS

The Board of Directors and Shareholders of

Watsco, Inc.

We have audited the accompanying consolidated balance sheets of Watsco, Inc. (a Florida Corporation) and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the two years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Watsco, Inc. and subsidiaries as of December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the two years then ended in conformity with U.S. generally accepted accounting principles.

As discussed in Notes 1 and 6 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standard 123 (R) “Share-Based Payment” on a prospective basis on January 1, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Watsco, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission and our report dated March 1, 2007 expressed an unqualified opinion on both management’s assessment of Watsco, Inc.’s internal control over financial reporting and on the effectiveness of Watsco, Inc.’s internal control over financial reporting.

/s/ GRANT THORNTON LLP

Miami, Florida

March 1, 2007

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE FINANCIAL STATEMENTS

The Board of Directors and Shareholders of

Watsco, Inc.

We have audited the accompanying consolidated statements of income, shareholders’ equity and cash flows of Watsco, Inc. and subsidiaries for the year ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Watsco, Inc. and subsidiaries for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

/s/ ERNST & YOUNG LLP

     Certified Public Accountants

Miami, Florida

March 14, 2005

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Board of Directors and Shareholders of

Watsco, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Watsco, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Watsco, Inc. and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those 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 management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Watsco, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Watsco, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Watsco, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the two years then ended and our report dated March 1, 2007 expressed an unqualified opinion on those consolidated financial statements.

/s/ GRANT THORNTON LLP

Miami, Florida

March 1, 2007

WATSCO, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

	Years Ended December 31,
(In thousands, except per share data)	2006		2005		2004
Revenues	$	1,800,759	$	1,682,724	$	1,315,024
Cost of sales		1,337,859		1,259,694		978,089
Gross profit		462,900		423,030		336,935
Selling, general and administrative expenses		327,297		306,572		254,883
Operating income		135,603		116,458		82,052
Interest expense, net		3,820		3,342		4,413
Income before income taxes		131,783		113,116		77,639
Income taxes		49,419		43,097		29,534
Net income	$	82,364	$	70,019	$	48,105
Earnings per share for Common and Class B common stock:
Basic	$	3.15	$	2.69	$	1.89
Diluted	$	2.96	$	2.52	$	1.79
Weighted average Common and Class B common shares and equivalent shares used to calculate earnings per share:
Basic		26,150		26,049		25,507
Diluted		27,829		27,769		26,931

The accompanying notes to consolidated financial statements are an integral part of these statements.

WATSCO, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	December 31,
(In thousands, except share and per share data)	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	34,340		$	27,650
Accounts receivable, net		180,968			191,747
Inventories		291,024			266,543
Other current assets		11,476			8,051
Total current assets		517,808			493,991
Property and equipment, net		21,476			17,244
Goodwill		161,107			158,912
Other assets		10,980			8,584
	$	711,371		$	678,731
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term obligations	$	10,084		$	10,079
Accounts payable		103,210			100,829
Accrued expenses and other current liabilities		42,897			68,390
Total current liabilities		156,191			179,298
Long-term obligations:
Borrowings under revolving credit agreement		30,000			30,000
Long-term notes, net of current portion		—			10,000
Other long-term obligations, net of current portion		118			189
Total long-term obligations		30,118			40,189
Deferred income taxes and other liabilities		8,676			8,594
Commitments and contingencies (Notes 10 and 11)
Shareholders’ equity:
Common stock, $0.50 par value, 60,000,000 shares authorized in 2006 and 2005 and 30,116,262 and 29,860,948 shares issued in 2006 and 2005, respectively		15,059			14,931
Class B common stock, $0.50 par value, 10,000,000 shares authorized in 2006 and 2005 and 3,750,782 and 3,392,497 shares issued in 2006 and 2005, respectively		1,875			1,696
Paid-in capital		253,422			264,903
Deferred compensation on non-vested stock		—			(35,894	)
Accumulated other comprehensive loss, net of tax		(126	)		(478	)
Retained earnings		346,375			290,383
Treasury stock, at cost, 6,034,213 and 5,790,613 shares of Common and Class B common stock in 2006 and 2005, respectively		(100,219	)		(84,891	)
Total shareholders’ equity		516,386			450,650
	$	711,371		$	678,731

The accompanying notes to consolidated financial statements are an integral part of these statements.

WATSCO, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands, except share and per share data)	Common Stock and Class B Common Stock Shares		Amount			Paid-In Capital			Deferred Compensation on Non-Vested Stock			Accumulated Other Comprehensive Loss			Retained Earnings			Treasury Stock			Total
Balance at December 31, 2003	26,323,697		$	15,869		$	226,363		$	(12,294	)	$	(2,075	)	$	199,340		$	(66,334	)	$	360,869
Net income																48,105						48,105
Changes in unrealized gains and losses on available-for-sale securities and a derivative instrument, net of income taxes													807									807
Comprehensive income																						48,912
Retirement of common stock	(11,181	)		(6	)		(326	)														(332	)
Common stock contribution to 401(k) plan	62						1															1
Stock issuances from exercise of stock options and employee stock purchase plan	502,775			252			6,596															6,848
Tax benefit from stock-based compensation							2,746															2,746
Issuances of non-vested shares of common stock	150,000			75			4,214			(4,289	)											—
Forfeitures of non-vested shares of common stock	(80,000	)		(40	)		(967	)		1,007												—
Non-vested shares of common stock to be issued										(6,369	)											(6,369	)
Amortization of unearned compensation										1,002												1,002
Cash dividends declared on Common and Class B common stock, $0.38 per share																(10,103	)					(10,103	)
Purchase of treasury stock	(29,900	)																	(836	)		(836	)
Balance at December 31, 2004	26,855,453			16,150			238,627			(20,943	)		(1,268	)		237,342			(67,170	)		402,738
Net income																70,019						70,019
Changes in unrealized gains and losses on available-for-sale securities and a derivative instrument, net of income taxes													790									790
Comprehensive income																						70,809
Retirement of common stock	(115,614	)		(58	)		(5,754	)														(5,812	)
Common stock contribution to 401(k) plan	25,579			13			888															901
Stock issuances from exercise of stock options and employee stock purchase plan	589,926			294			7,747															8,041
Tax benefit from stock-based compensation							7,654															7,654
Issuances of non-vested shares of common stock	314,552			157			11,377			(5,165	)											6,369
Forfeitures of non-vested shares of common stock	(5,000	)		(2	)		(63	)		65												—
Common stock issued for acquisition	145,536			73			4,427															4,500
Non-vested shares of common stock to be issued										(12,379	)											(12,379	)
Amortization of unearned compensation										2,528												2,528
Cash dividends declared on Common and Class B common stock, $0.62 per share																(16,978	)					(16,978	)
Purchase of treasury stock	(347,600	)																	(17,721	)		(17,721	)
Balance at December 31, 2005	27,462,832			16,627			264,903			(35,894	)		(478	)		290,383			(84,891	)		450,650
Net income																82,364						82,364
Changes in unrealized gains and losses on available-for-sale securities and a derivative instrument, net of income taxes													352									352
Comprehensive income																						82,716
Retirement of common stock	(150,086	)		(75	)		(10,488	)														(10,563	)
Common stock contribution to 401(k) plan	19,055			10			1,130															1,140
Stock issuances from exercise of stock options and employee stock purchase plan	460,144			230			8,143															8,373
Excess tax benefit from stock-based compensation							8,371															8,371
Issuances of non-vested shares of common stock	287,359			144			12,235															12,379
Forfeitures of non-vested shares of common stock	(2,873	)		(2	)		2															—
Share-based compensation							5,020															5,020
Adoption of SFAS No. 123R, “Share-Based Payment”							(35,894	)		35,894												—
Cash dividends declared on Common and Class B common stock, $0.95 per share																(26,372	)					(26,372	)
Purchase of treasury stock	(243,600	)																	(15,328	)		(15,328	)
Balance at December 31, 2006	27,832,831		$	16,934		$	253,422			—		$	(126	)	$	346,375		$	(100,219	)	$	516,386

The accompanying notes to consolidated financial statements are an integral part of these statements.

WATSCO, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Years Ended December 31,
(In thousands)	2006			2005			2004
Cash flows from operating activities:
Net income	$	82,364		$	70,019		$	48,105
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,908			6,189			6,768
Share-based compensation		5,020			2,528			1,002
Provision for doubtful accounts		3,461			1,854			1,556
(Gain) loss on sale of property and equipment		(199	)		(1,460	)		214
Net gain on sale of available-for-sale securities		—			(106	)		—
Deferred income tax provision		(535	)		197			3,883
Non-cash contribution for 401(k) plan		1,140			1,181			922
Excess tax benefits from share-based compensation		(8,371	)		—			—
Tax benefits from share-based compensation		—			7,654			2,746
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		9,716			(26,000	)		(7,855	)
Inventories		(18,026	)		(33,271	)		(23,412	)
Accounts payable and other liabilities		(10,036	)		4,716			19,579
Other, net		(1,901	)		2,281			3,231
Net cash provided by operating activities		68,541			35,782			56,739
Cash flows from investing activities:
Capital expenditures		(9,992	)		(7,283	)		(4,846	)
Business acquisitions, net of cash acquired		(9,889	)		(49,481	)		(3,403	)
Purchases of marketable securities		(2,847	)		—			—
Proceeds from sale of available-for-sale securities		—			160			—
Proceeds from sale of property and equipment		448			1,876			4,946
Net cash used in investing activities		(22,280	)		(54,728	)		(3,303	)
Cash flows from financing activities:
Common and Class B common stock dividends		(26,372	)		(16,978	)		(10,103	)
Purchase of treasury stock		(15,328	)		(17,721	)		(836	)
Repayment of long-term notes		(10,000	)		(10,000	)		—
Net proceeds from (repayments of) other long-term obligations		(64	)		57			(114	)
Repayment under revolving credit agreement		—			—			(30,000	)
Proceeds from revolving credit agreement		—			—			30,000
Payment of debt acquisition costs		—			—			(346	)
Net proceeds from issuances of common stock		3,822			6,094			6,768
Excess tax benefits from share-based compensation		8,371			—			—
Net cash used in financing activities		(39,571	)		(38,548	)		(4,631	)
Net increase (decrease) in cash and cash equivalents		6,690			(57,494	)		48,805
Cash and cash equivalents at beginning of year		27,650			85,144			36,339
Cash and cash equivalents at end of year	$	34,340		$	27,650		$	85,144

The accompanying notes to consolidated financial statements are an integral part of these statements.

WATSCO, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share data)

1. Summary of Significant Accounting Policies

Nature of Operations

Watsco, Inc. and its subsidiaries (collectively, "Watsco", which may be referred to as we, us or our) is the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies (“HVAC”) in the United States. We operate from 380 locations in 32 states at December 31, 2006.

Basis of Consolidation

The consolidated financial statements include the accounts of Watsco and all of its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include valuation reserves for accounts receivable, inventory and income taxes, reserves related to self-insurance programs and valuation of goodwill. Actual results could differ from those estimates.

Accounting Change

At December 31, 2006, we had two share-based compensation plans for employees, which are described more fully in Note 6. Prior to January 1, 2006, we accounted for those plans in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” Prior to January 1, 2006, share-based compensation was recognized only for grants of non-vested (restricted) stock and share-based compensation expense was not recognized for stock options. Effective January 1, 2006, we adopted the provisions of SFAS No. 123R, “Share-Based Payment,” using the modified prospective transition method. Under this transition method, compensation expense recognized during the year ended December 31, 2006 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and (b) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods have not been restated.

The impact of adopting SFAS No. 123R on January 1, 2006 was a reduction of our income before income taxes and net income of $1,451 and $906, respectively, for the year ended December 31, 2006. Also, basic and diluted earnings per share were reduced by $.03 for the year ended December 31, 2006, as a result of adopting SFAS No. 123R.

Prior to the adoption of SFAS No. 123R, we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the consolidated statements of cash flows. SFAS No. 123R requires the cash flows from the tax benefits resulting from tax deductions in excess of the compensation expense recognized for those options (excess tax benefits) to be classified as financing cash flows. The excess tax benefits of $8,371 classified as a financing cash inflow would have been classified as an operating cash inflow if we had not adopted SFAS No. 123R.

Prior to the adoption of SFAS No. 123R, the intrinsic value of our non-vested stock was recorded as deferred compensation as of December 31, 2005. Upon the adoption of SFAS No. 123R on January 1, 2006, the deferred compensation balance of $35,894 was reclassified to paid-in capital.

In accordance with the modified prospective transition method, results for the years ended December 31, 2005 and 2004 have not been restated. Had compensation cost been determined based on the fair value method at the grant dates for awards under the stock-based compensation plans consistent with the method of SFAS No. 123, pro forma net income and earnings per share would be as follows:

Years Ended December 31,	2005			2004
Net income, as reported	$	70,019		$	48,105
Stock-based compensation expense included in net income, net of tax		1,567			621
Stock-based compensation expense determined under the fair value-based method, net of tax		(3,247	)		(2,258	)
Net income, pro forma	$	68,339		$	46,468
Basic earnings per share for Common and Class B common stock:
As reported	$	2.69		$	1.89
Pro forma	$	2.62		$	1.82
Diluted earnings per share for Common and Class B common stock:
As reported	$	2.52		$	1.79
Pro forma	$	2.46		$	1.73

Cash Equivalents

All highly liquid instruments purchased with an original maturity of three months or less are considered to be cash equivalents. Cash equivalents at December 31, 2006 and 2005 included $9,825 and $45, respectively, of municipal securities with put options of 7 days or less, which were considered to be cash equivalents for purposes of the consolidated financial statements. No individual municipal security equaled or exceeded 2% of total assets and such securities were investment grade and collateralized by a letter of credit issued by the remarketing agent.

Accounts Receivable Allowance

An allowance for doubtful accounts is maintained for estimated losses resulting from the inability of customers to make required payments. When preparing these estimates, Watsco’s management considers a number of factors, including the aging of a customer’s account, past transactions with customers, creditworthiness of specific customers, historical trends and other information. We typically do not require our customers to provide collateral. Accounts receivable reserve policies are reviewed periodically, reflecting current risks, trends and changes in industry conditions. The past due status of an account is determined based on stated payment terms. Upon determination that an account is uncollectible, Watsco writes off the receivable balance. At December 31, 2006 and 2005, the allowance for doubtful accounts totaled $3,140 and $3,019, respectively. Although we believe the allowance is sufficient, if the financial condition of our customers were to unexpectedly deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories

Inventories consist of air conditioning, heating and refrigeration equipment and related parts and supplies and are valued at the lower of cost or market on a weighted-average cost basis. As part of the valuation process, inventory reserves are established to state excess and slow-moving inventories at their estimated net realizable value. Inventory reserve 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. At December 31, 2006 and 2005, inventory reserves totaled $3,792 and $3,142, respectively.

Vendor Rebates

We account for vendor rebates in accordance with Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” 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 these estimates of earned vendor rebates based on actual purchase levels. At December 31, 2006 and 2005, we have $4,905 and $4,866, respectively, of rebates recorded as a reduction of inventory. Substantially all vendor rebate receivables are collected within three months immediately following the end of the year.

Marketable Securities

Investments in marketable equity securities of $2,863 at December 31, 2006 are included in other assets and are classified as available-for-sale. These securities are recorded at fair value with unrealized holding gains and losses, net of deferred taxes, reported in accumulated other comprehensive loss (“OCL”) within shareholders’ equity. Dividend and interest income are recognized in the statement of income when earned. At December 31, 2006, $10 of unrealized gains, net of deferred taxes of $6, was included in accumulated OCL. At December 31, 2005, we held no marketable equity securities. Net realized gains amounted to $106 for the year ended December 31, 2005.

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 being 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. Estimated useful lives for other depreciable assets range from 3-10 years. Depreciation and amortization expense related to property and equipment amounted to $5,846, $6,064 and $6,765 for the years ended December 31, 2006, 2005 and 2004, respectively.

Goodwill and Intangibles

Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” an annual impairment review is performed, or more frequently if indicators of potential impairment exist, to determine if the carrying value of the recorded goodwill is impaired. The impairment review process compares the fair value of the reporting unit in which goodwill resides to its carrying value. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the implied fair value of goodwill (as defined under SFAS No. 142) within the reporting unit is less than its carrying value (see Note 8).

Intangible assets primarily consist of the value of trade names, non-compete agreements and customer relationships. Indefinite life 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. Intangible assets with finite lives are amortized using the straight-line method over their respective estimated useful lives, which range from seven to ten years. Amortization expense related to intangible assets amounted to $62, $125 and $3 for the years ended December 31, 2006, 2005 and 2004, respectively. Based on the current amount of finite lived intangible assets, we estimate amortization expense to be approximately $60 for each of the next five years (see Note 8).

Recoverability of Long-Lived Assets

The recoverability of long-lived assets is evaluated when events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable. When events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable, a determination is made whether the amortization of the balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is measured 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, 2006, there were no such events or circumstances.

Revenue Recognition

Revenue is recognized in accordance with Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition” (which superceded SAB No. 101, “Revenue Recognition in Financial Statements,” as amended by SAB 101A and 101B). Revenue primarily consists of sales of air conditioning, heating and refrigeration equipment and related parts and supplies. SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the amounts recognized are fixed and determinable, and (4) collectibility is reasonably assured. Revenue is recorded when shipment of products or delivery of services has occurred. Assessment of collection is based on a number of factors, including past transactions, credit-worthiness of customers, historical trends and other information. Substantially all customer returns relate to products that are returned under warranty obligations underwritten by manufacturers, effectively mitigating the risk of loss for customer returns.

Advertising Costs

Advertising costs are expensed as incurred. Advertising expense amounted to $6,210, $5,975 and $4,477 for the years ended December 31, 2006, 2005 and 2004, respectively.

Shipping and Handling

Shipping and handling costs associated with inbound freight are capitalized to inventories and relieved through cost of sales as inventories are sold. Shipping and handling costs associated with the delivery of products is included in selling, general and administrative expenses. Shipping and handling costs included in selling, general and administrative expenses amounted to $6,914, $6,827 and $5,553 for the years ended December 31, 2006, 2005 and 2004, respectively.

Income Taxes

We record federal and state 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 statement and income tax bases 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. Watsco and its eligible subsidiaries file a consolidated United States federal income tax return. As income tax returns are generally not filed until well after the closing process for the December 31 financial statements is complete, the amounts recorded at December 31 reflect estimates of what the final amounts will be when the actual income tax returns are filed for that calendar year. In addition, estimates are often required with respect to, among other things, the appropriate state income tax rates to use in the various states that Watsco and its subsidiaries are required to file, the potential utilization of operating loss carry-forwards and valuation allowances required, if any, for tax assets that may not be realizable in the future.

Earnings per Share

We calculate earnings per share using the two-class method in accordance with SFAS No. 128, “Earnings Per Share,” as clarified by EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share.” EITF Issue No. 03-6 requires the income per share for each class of common stock to be calculated assuming 100% of our earnings are distributed as dividends to each class of common stock based on their respective dividend rights, even though we do not anticipate distributing 100% of our earnings as dividends. The effective result of EITF Issue No. 03-6 is that the calculation of earnings per share for each class of our common stock yields the same basic and diluted earnings per share.

Basic earnings per share for our Common and Class B common stock is computed by dividing net income allocated to Common stock and Class B common stock by the weighted-average number of shares of Common stock and Class B common stock outstanding, respectively. Non-vested stock is not included in the computation of basic earnings per share until the securities vest. Diluted earnings per share for our Common stock assumes the conversion of all the Class B common stock into Common stock and adjusts for the dilutive effects of outstanding stock options and non-vested shares of stock using the treasury stock method.

For the basic earnings per share calculation, net income available to Watsco’s shareholders is allocated among our two classes of common stock: Common stock and Class B common stock. The allocation among each class is based upon the two-class method on a one-for-one per share basis. The following table shows how net income is allocated using this method:

Years Ended December 31,	2006		2005		2004
Net income available to shareholders	$	82,364	$	70,019	$	48,105
Allocation of net income for Basic:
Common stock	$	73,630	$	64,050	$	42,862
Class B common stock		8,734		5,969		5,243
	$	82,364	$	70,019	$	48,105

The diluted earnings per share calculation assumes the conversion of all of Watsco’s Class B common stock into Common stock as of the beginning of the period, so no allocation of earnings to Class B common stock is required.

The following summarizes the weighted-average number of Common and Class B common shares outstanding during the year and is used to calculate earnings per share of Common and Class B common stock including the potentially dilutive impact of stock options and non-vested shares, calculated using the treasury method, as included in the calculation of diluted weighted-average shares:

Years Ended December 31,	2006	2005	2004
Weighted-average Common and Class B common shares outstanding for basic earnings per share	26,149,676	26,049,365	25,506,950
Weighted-average Common shares outstanding for basic earnings per share	23,376,839	23,828,624	22,727,096
Diluted shares resulting from:
Stock options	1,009,739	1,145,174	1,005,511
Non-vested stock	669,723	574,298	418,848
Effect of assuming conversion of Class B common shares into Common stock	2,772,837	2,220,741	2,779,854
Shares for diluted earnings per share	27,829,138	27,768,837	26,931,309

Diluted earnings per share excluded 153,500, 81,000 and 41,500 shares for the years ended December 31, 2006, 2005 and 2004, 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. In addition, 284,486, 60,000 and 145,000 shares for the years ended December 31, 2006, 2005 and 2004, respectively, related to non-vested stock were considered anti-dilutive.

Derivative Instruments

We apply the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the

balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in OCL and are recognized in the income statement when the hedged items affect earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. See Note 10 for further information regarding hedging activities.

Comprehensive Income

Comprehensive income consists of net income and changes in the unrealized (losses) gains on available-for-sale securities and the effective portion of a cash flow hedge as further discussed in Note 10. The components of comprehensive income are as follows:

Years Ended December 31,	2006		2005			2004
Net income	$	82,364	$	70,019		$	48,105
Changes in unrealized losses on derivative instrument, net of income tax expense of $205, $534 and $449, respectively		342		866			832
Changes in unrealized (losses) gains on available-for-sale securities arising during the period, net of income tax (expense) benefit of $(6), $5 and $14, respectively		10		(10	)		(25	)
Less: reclassification adjustment for net securities gains realized in net income, net of income tax expense of $0, $40 and $0, respectively		—		(66	)		—
Comprehensive income	$	82,716	$	70,809		$	48,912

Recently Issued Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions of SFAS No. 157 are effective for us beginning January 1, 2008. We are currently evaluating the impact of adopting SFAS No. 157 on our consolidated financial statements.

In September 2006, the SEC issued SAB No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB No. 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB No. 108 requires companies to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB No. 108 permits existing public companies to initially apply its provisions either by (i) restating prior financial statements as if the “dual approach” had always been used or (ii) recording the cumulative effect of initially applying the “dual approach” as adjustments to the carrying value of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings. Use of the “cumulative effect” transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. The adoption of SAB No. 108 did not have a material impact on our consolidated financial statements.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN No. 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This interpretation seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, it requires expanded disclosure with respect to the uncertainty in income taxes. FIN No. 48 is effective January 1, 2007 and is not expected to have a material impact on our consolidated financial statements.

Reclassifications

Certain reclassifications of prior year amounts have been made to conform to the 2006 presentation. These reclassifications had no effect on net income or earnings per share as previously reported.

2. Supplier Concentration

We have seven key suppliers of HVAC equipment products. Purchases from these seven suppliers comprised 47%, 48% and 45% of all purchases made in 2006, 2005 and 2004, respectively; with the largest supplier accounting for 17% of all purchases made in each of the years ended December 31, 2006, 2005 and 2004. Any significant interruption by the suppliers or a termination of a distribution agreement could disrupt the operations of certain subsidiaries.

3. Property and Equipment

Property and equipment, net, consists of:

December 31,	2006			2005
Land	$	665		$	654
Buildings and improvements		19,795			16,233
Machinery, vehicles and equipment		27,542			23,842
Furniture and fixtures		18,393			18,437
		66,395			59,166
Less: accumulated depreciation and amortization		(44,919	)		(41,922	)
	$	21,476		$	17,244

4. Long-Term Obligations

Revolving Credit Agreement and Long-Term Notes

We maintain a bank-syndicated, unsecured revolving credit agreement that provides for borrowings of up to $100,000, which expires in December 2009. Borrowings are used to fund seasonal working capital needs and for other general corporate purposes, including acquisitions and issuance of letters of credit. Borrowings bear interest at primarily LIBOR-based rates plus a spread that is dependent upon Watsco’s financial performance (LIBOR plus .475% and .625% at December 31, 2006 and 2005, respectively). A variable commitment fee is paid on the unused portion of the credit line (.125% and .15% at December 31, 2006 and 2005, respectively). At December 31, 2006 and 2005, $30,000 was outstanding under the revolving credit agreement.

A $125,000 unsecured private placement shelf facility is also maintained as a source of borrowings. The uncommitted shelf facility provides fixed-rate financing through December 2007 as a complement to the variable rate borrowings available under the revolving credit agreement. $10,000 and $20,000, respectively, of Senior Series A Notes (“Notes”) were outstanding at December 31, 2006 and 2005 under the facility bearing interest at 7.07%. The Notes will be repaid on April 9, 2007. Accordingly, $10,000 is classified as “current” in the consolidated balance sheet at December 31, 2006. Interest is paid on a quarterly basis. The Notes may be redeemed prior to maturity subject to a redemption premium and other restrictions.

Both the revolving credit agreement and the private placement shelf facility contain customary affirmative and negative covenants including certain financial covenants with respect to consolidated leverage, interest and debt coverage ratios and limits capital expenditures, dividends and share repurchases in addition to other restrictions. We believe that we are in compliance with all covenants and financial ratios at December 31, 2006.

Other Long-Term Obligations

Other long-term obligations, net of current portion, of $118 and $189 at December 31, 2006 and 2005, respectively, relate to capital leases on equipment. Interest rates on other debt range from 1.0% to 8.6% and mature at varying dates through 2010. Annual maturities of other long-term obligations for the years subsequent to December 31, 2006 are $84 in 2007, $72 in 2008, $41 in 2009 and $5 in 2010.

Total cash payments for interest were $4,345, $4,854 and $4,870 for the years ended December 31, 2006, 2005 and 2004, respectively.

5. Income Taxes

The components of income tax expense are as follows:

Years Ended December 31,	2006			2005		2004
Federal	$	45,472		$	39,439	$	27,146
State		3,947			3,658		2,388
	$	49,419		$	43,097	$	29,534
Current	$	49,954		$	42,900	$	25,651
Deferred		(535	)		197		3,883
	$	49,419		$	43,097	$	29,534

Following is a reconciliation of the effective income tax rate:

Years Ended December 31,	2006		2005		2004
Federal statutory rate	35.0	%	35.0	%	35.0	%
State income taxes, net of federal benefit and other	2.5		3.1		2.9
Change in valuation allowance	—		—		.1
	37.5	%	38.1	%	38.0	%

The following is a summary of the significant components of Watsco’s current and long-term deferred tax assets and liabilities:

December 31,	2006			2005
Current deferred tax assets:
Accounts receivable reserves	$	1,163		$	1,060
Capitalized inventory costs and inventory reserves		2,572			1,564
Other current deferred tax assets		707			825
Total current deferred tax assets (1)		4,442			3,449
Long-term deferred tax assets (liabilities):
Deductible goodwill		(16,853	)		(14,006	)
Net operating loss carryforwards		1,139			1,505
Unrealized loss on derivative instrument		82			294
Depreciation		1,302			472
Amortization of un-earned compensation		3,740			2,462
Self-insurance reserves		1,935			1,735
Other long-term net deferred tax assets		766			313
Total net long-term deferred tax liabilities		(7,889	)		(7,225	)
Less valuation allowance		(408	)		(396	)
Net deferred tax liabilities	$	(3,855	)	$	(4,172	)

(1) Current deferred tax assets of $4,442 and $3,449 have been included in the consolidated balance sheets in other current assets at December 31, 2006 and 2005, respectively.

SFAS No. 109, “Accounting for Income Taxes,” requires a valuation allowance to reduce the deferred tax assets reported if, based on the weight of the evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management has determined that $408 of valuation allowance at December 31, 2006 is necessary to reduce the deferred tax assets to the amount that will more likely than not be realized. There was a $12 increase in the valuation allowance for the current year. At December 31, 2006, there were state net operating loss carryforwards of $18,714, which expire in varying amounts from 2007 through 2026. These amounts are available to offset future taxable income. There were no federal net operating loss carryforwards at December 31, 2006.

The number of years that are open for tax audit vary depending on the tax jurisdiction. A number of years may elapse before a particular matter is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that the consolidated financial statements reflect the probable outcome of known tax contingencies.

Total cash payments, net of refunds, for income taxes were $47,961, $31,298 and $22,487 for the years ended December 31, 2006, 2005 and 2004, respectively.

6. Share-Based Compensation and Benefit Plans

Share-Based Compensation Plans

At December 31, 2006, we had two share-based compensation plans for employees. The 2001 Incentive Compensation Plan (the “2001 Plan”) provides for the award of a broad variety of stock-based compensation alternatives such as non-qualified stock options, incentive stock options, non-vested (restricted) stock, 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 2001 Plan consist of non-qualified stock options and non-vested stock. Under the 2001 Plan, awards for an aggregate of 3,000,000 shares of Common and Class B common stock may be granted. A total of 1,383,363 shares of Common stock, net of cancellations and 1,044,811 shares of Class B common stock, net of cancellations have been awarded under the 2001 Plan as of December 31, 2006. There were 571,826 shares of common stock reserved for future grants as of December 31, 2006 under the 2001 Plan. There are 996,958 options of common stock outstanding under the 2001 Plan at December 31, 2006.

Options under the 2001 Plan vest over two to five years of service and have contractual terms of five to ten years. Awards of non-vested stock, which are granted at no cost to the employee, vest upon attainment of a certain age, generally the employee’s respective retirement age. Vesting may be accelerated in certain circumstances prior to the original vesting date. We also maintain the 1991 Stock Option Plan (the “1991 Plan”), which expired during 2001; therefore, no additional options may be granted. Options as to 1,216,988 of common stock are outstanding under the 1991 Plan at December 31, 2006. Options under the 1991 Plan vest over two to five years of service and have contractual terms of ten years.

A summary of stock option activity under the 2001 Plan and 1991 Plan as of December 31, 2006, and changes during 2006, is as follows:

	Options		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Options outstanding at January 1, 2006	2,589,363		$	17.30
Granted	99,500			61.29
Exercised	(427,750	)		15.82
Expired	(16,200	)		16.15
Forfeited	(30,967	)		31.27
Options outstanding at December 31, 2006	2,213,946		$	19.35	3.25	$	63,317
Options exercisable at December 31, 2006	1,693,313		$	13.71	3.00	$	56,702

The weighted-average grant date fair value of stock options granted during 2006, 2005 and 2004 was $14.99, $11.70 and $9.33, respectively. The total intrinsic value of stock options exercised during 2006, 2005 and 2004 was $22,390, $19,088 and $7,200, respectively. The fair value of stock options vested during 2006, 2005 and 2004 was $497, $1,986 and $1,915, respectively.

A summary of non-vested stock issued as of December 31, 2006, and changes during 2006, is shown below:

	Shares		Weighted- Average Grant Date Fair Value
Non-vested stock outstanding at January 1, 2006	1,593,561		$	26.62
Granted	81,044			67.94
Vested	—			—
Forfeited	(2,873	)		70.83
Non-vested stock outstanding at December 31, 2006	1,671,732		$	28.55

The weighted-average grant date fair value of non-vested stock granted during 2006, 2005 and 2004 was $67.94, $52.17 and $31.86, respectively. The fair value of stock vested during 2005 and 2004 was $348 and $132, respectively. No non-vested stock vested during 2006.

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 following table. The fair value of the stock option awards, which are subject to graded vesting, is expensed on a straight-line basis over the vesting life of the stock options. Expected volatility is based on historical volatility of Watsco’s stock. 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 U.S. Treasury bond on the date the stock option award is granted with a maturity equal to the expected term of the stock option award. We use historical data to estimate stock option forfeitures within the valuation model. All of the awards granted during 2006 meet the definition of “plain vanilla” options, as defined in SEC Staff Accounting Bulletin No. 107. 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.

The weighted-average assumptions relating to the valuation of our stock options were as follows:

Years Ended December 31,	2006		2005		2004
Expected life in years	4.25		4.00		4.77
Risk-free interest rate	4.91	%	4.13	%	3.40	%
Expected volatility	24.08	%	34.03	%	36.93	%
Dividend yield	1.35	%	1.38	%	1.33	%

Share-Based Compensation Expense

The following table provides information on share-based compensation expense and tax benefits recognized:

Years Ended December 31,	2006			2005			2004
Share-based compensation expense	$	5,020		$	2,528		$	1,002
Income tax benefit		(1,883	)		(961	)		(381	)
Share-based compensation expense, net of tax	$	3,137		$	1,567		$	621

Cash received from Watsco Common and Class B common stock issued as a result of stock options exercised during 2006, 2005 and 2004, was $2,214, $3,528 and $5,553, respectively. During 2006 and 2005, 150,086 shares of Common stock with an aggregate market value of $10,563 and 115,614 shares of Common stock with an aggregate market value of $5,812, respectively, were delivered as payment in lieu of cash for stock option exercises. These shares were then retired. The actual tax benefit realized for the tax deductions from share-based compensation plans totaled $8,396, $7,654 and $2,746, for the years ended December 31, 2006, 2005 and 2004, respectively.

At December 31, 2006, there was $2,054 of unrecognized share-based compensation expense related to non-vested stock options granted under the 2001 Plan, which is expected to be recognized over a weighted-average period of 1.6 years. At December 31, 2006, there was $37,627 of unrecognized share-based compensation expense related to non-vested stock granted, which is expected to be recognized over a weighted-average period of 11.4 years. In the event that vesting is accelerated for any circumstance, as defined in the related agreements, the remaining unrecognized share-based compensation expense would be immediately recognized as a charge to earnings. Approximately $28,000 of the unrecognized share-based compensation for shares of non-vested stock is related to awards granted to Watsco’s Chief Executive Officer that vest in approximately 11 years upon his attainment of age 78.

Share-Based Compensation Modifications

On December 28, 2005, the Compensation Committee of the Board of Directors approved the vesting acceleration of 76,616 stock options for 25 employees. The decision to accelerate vesting of these options was made primarily to reward certain key employees for their performance in 2005 and to mitigate compensation expense that would have been required upon the adoption of SFAS No. 123R.

Employee Stock Purchase Plan

Effective July 1, 1996, we adopted the Watsco, Inc. Amended and Restated 1996 Qualified Employee Stock Purchase Plan (the “Watsco ESPP”) under which full-time employees with at least 90 days of service may purchase up to an aggregate of 900,000 shares of Common stock. The plan allows participating employees to purchase, through payroll deductions or lump-sum contribution, shares of Common stock at 85% of the fair market value at specified times subject to certain restrictions. In December 2005, the Watsco ESPP was amended to change the discount that employees can purchase shares of our Common stock to 5% of the fair market value and to remove certain restrictions, effective January 1, 2006. During 2006, 2005 and 2004 employees purchased 28,232, 76,632 and 54,076 shares of Common stock at an average price of $48.88, $31.51 and $20.75 per share, respectively. Cash dividends received by the Watsco ESPP were reinvested in Common stock and resulted in additional shares issued in the amount of 4,162, 3,335 and 3,361 for the years ended December 31, 2006, 2005 and 2004, respectively. We received net proceeds of $1,608, $2,566 and $1,215, respectively, during 2006, 2005 and 2004, for shares of Watsco Common stock issued under the Watsco ESPP. At December 31, 2006, 34,325 shares remained available for purchase under the plan.

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 is made in cash or by the issuance of Common stock to the plan on behalf of our employees. For the years ended December 31, 2006, 2005 and 2004, the aggregate contribution required to the plan was $1,140, $1,181 and $922, respectively. This contribution is made during the first quarter of the subsequent year.

7. Acquisitions

In December 2006, one of our subsidiaries completed the acquisition of a distributor of air conditioning and heating products with 10 locations in Nebraska, Missouri and Kansas. The purchase price of the acquisition included a cash payment of approximately $5,123.

In October 2006, one of our subsidiaries completed the acquisition of a wholesale distributor of refrigeration equipment with 8 locations in Tennessee, Mississippi and Arkansas. The purchase price of the acquisition included a cash payment of approximately $3,675.

In March 2006, one of our subsidiaries completed the acquisition of a refrigeration equipment distributor with locations in Birmingham and Montgomery, Alabama for cash consideration of $798, net of cash acquired.

In February 2006, one of our subsidiaries completed the purchase of the net assets and business of a wholesale distributor of air conditioning and heating products operating from a single location in Kansas City, Missouri for cash consideration or $293, net of cash acquired.

In January 2005, Watsco acquired East Coast Metal Distributors, Inc., one of the nation’s largest distributors of air conditioning and heating products, with 27 locations in North Carolina, South Carolina, Georgia, Virginia and Tennessee, for cash consideration of $49,481, net of cash acquired, and the issuance of 145,536 shares of unregistered Common stock having a fair value of $4,500. In connection with this acquisition, Watsco recorded $27,083 of goodwill, all of which is expected to be deductible for tax purposes.

In April 2004, one of Watsco’s subsidiaries completed the purchase of the net assets and business of two affiliated refrigeration equipment distributors with locations in Dallas and Austin, Texas. These acquisitions were funded by cash on hand totaling $3,403.

The results of operations of these locations have been included in the consolidated financial statements from their respective dates of acquisition. The proforma effects of these acquisitions were not deemed material to the consolidated financial statements for the years ended December 31, 2006, 2005 and 2004.

8. Goodwill and Intangibles

The recoverability of goodwill and indefinite life intangibles is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount of goodwill and indefinite life intangibles may not be recoverable. The identification and measurement of impairment involves the estimation of the fair value of reporting units and indefinite life intangibles and contains uncertainty because management must use judgment in determining appropriate assumptions to be used in the measurement of fair value. The estimates of fair value of the reporting units are based on the best information available as of the date of the assessment and incorporate management assumptions about expected future cash flows and contemplate other valuation techniques. Future cash flows can be affected by changes in industry or market conditions.

On January 1, 2007, the annual impairment tests were performed and it was determined there was no impairment. No factors have developed since the last impairment tests that would indicate that the carrying value of goodwill and indefinite life intangibles may not be recoverable. The carrying amount of goodwill and intangibles at December 31, 2006 was $165,916. Although no impairment has been recorded to date, there can be no assurances that future impairments will not occur. An adjustment to the carrying value of goodwill and intangibles could materially impact the consolidated results of operations.

The changes in the carrying amount of goodwill are as follows:

Balance at December 31, 2004	$	131,829
Acquired goodwill		27,083
Balance at December 31, 2005		158,912
Acquired goodwill		2,195
Balance at December 31, 2006	$	161,107

Intangible assets, net, included in other assets in the consolidated balance sheets consist of:

December 31,	2006			2005
Unamortizable intangible assets:
Trade name	$	4,413		$	4,413
Amortizable intangible assets:
Customer relationships		210			210
Non-compete agreements		321			224
Less: accumulated amortization		(135	)		(73	)
Amortizable intangible assets, net		396			361
	$	4,809		$	4,774

9. Shareholders’ Equity

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 common 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.

Watsco’s Board of Directors has authorized the repurchase, at management’s discretion, of 7,500,000 shares 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. 243,600 shares were repurchased at a cost of $15,328 in 2006, 347,600 shares at a cost of $17,721 in 2005 and 29,900 shares at a cost of $836 in 2004. In aggregate since the inception of the repurchase plan in 1999, 6,034,213 shares of Common stock and Class B common stock were repurchased at a cost of $100,219. The remaining 1,465,787 shares authorized for repurchase are subject to certain restrictions included in the debt agreements.

10. Financial Instruments

Recorded Financial Instruments

Recorded financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, the current portion of long-term obligations, borrowings under revolving credit agreement and debt instruments included in other long-term obligations. At December 31, 2006 and 2005, 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 the revolving credit agreement and debt instruments included in long-term obligations also approximate their carrying value based upon interest rates available for similar instruments with consistent terms and remaining maturities.

Derivative Financial Instruments

Periodically, we have entered into interest rate swap agreements to reduce our exposure to market risks from changing interest rates under our revolving credit agreement. Under the terms of the swap agreements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to the notional principal amount. Any differences paid or received on our interest rate swap agreements are recognized as adjustments to interest expense over the life of each swap, thereby adjusting the effective interest rate on the underlying obligation. Financial instruments are not held or issued for trading purposes. In order to obtain hedge accounting treatment, any derivatives used for hedging purposes must be designated as, and effective as, a hedge of an identified risk exposure at the inception of the contract. Accordingly, changes in the fair value of the derivative contract must be highly correlated with changes in the fair value of the underlying hedged item at inception of the hedge and over the life of the hedge contract. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties. Fair values were based on dealer quotations obtained by Watsco.

At December 31, 2006 and 2005, one interest rate swap agreement was in effect with a notional value of $30,000 maturing in 2007. The swap agreement exchanges the variable rate of 90-day LIBOR to fixed interest rate payments of 6.25%. The interest rate swap was effective as a cash flow hedge and no charge to earnings was required for hedge ineffectiveness in 2006, 2005 or 2004. The negative fair value of the derivative financial instrument was $279 and $927 at December 31, 2006 and 2005, respectively, and is included, net of accrued interest, in deferred income taxes and other liabilities in the consolidated balance sheets.

At December 31, 2006, 2005 and 2004, $136, net of deferred tax benefits of $82, $478 net of deferred tax benefits of $294 and $1,344 net of deferred tax benefits of $829 was recorded in OCL associated with the cash flow hedge. During 2006, 2005 and 2004, we recognized decreases in unrealized losses in OCL relating to cash flow hedges of $342, net of income tax expense of $205, $866, net of income tax expense of $534 and $832, net of income tax expense of $449, respectively.

The net change in OCL during 2006, 2005 and 2004, reflected the reclassification of $221, net of income tax benefit of $132, $555, net of income tax benefit of $342 and $905, net of income tax benefit of $556, respectively, of unrealized losses from accumulated OCL to current period earnings (recorded in interest expense, net in the consolidated statements of income). The net unrealized loss recorded in accumulated OCL will be reclassified to earnings on a quarterly basis as interest payments occur. We estimate that approximately $300 in unrealized losses on the derivative instrument accumulated in OCL is expected to be reclassified to earnings during 2007 using a current three month LIBOR-based average receive rate (5.17% at December 31, 2006).

Off-Balance Sheet Financial Instruments

At December 31, 2006 and 2005, we were contingently liable under standby letters of credit aggregating $4,078 and $4,346, respectively that are primarily used as collateral to cover any contingency related to additional risk assessments pertaining to the self-insurance programs. We do not expect any material losses to result from the issuance of the standby letters of credit because claims are not expected to exceed premiums paid. Accordingly, the estimated fair value of these instruments is zero.

Concentrations of Credit Risk

Financial instruments which potentially subject us to concentrations of credit risk consist principally of cash investments and accounts receivable. Temporary cash investments are placed with high credit quality financial institutions and we limit the amount of credit exposure to any one financial institution or investment. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of customers comprising the customer base and their dispersion across many different geographical regions.

11. Commitments and Contingencies

Litigation, Claims and Assessments

We are involved in litigation incidental to the operation of our business and we vigorously defend all matters in which Watsco or its subsidiaries are named defendants and, for insurable losses, maintain significant levels of insurance to protect against adverse judgments, claims or assessments that may affect us. In our opinion, although the adequacy of existing insurance coverage or the outcome of any legal proceedings cannot be predicted with certainty, the ultimate liability associated with any claims or litigation in which Watsco or its subsidiaries are involved will not materially affect our financial condition or results of operations.

Self-Insurance

Self-insurance reserves are maintained relative to company-wide casualty insurance programs and for one subsidiary’s health benefit program. The level of exposure from catastrophic events is limited by the purchase of stop-loss and aggregate liability reinsurance coverages. When estimating the self-insurance liabilities and related reserves, management considers a number of 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 the self-insurance reserves are adequate. If actual claims or adverse development of loss reserves occurs and exceed these estimates, additional reserves may be required. The estimation process contains uncertainty since management must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. Reserves of $5,664 at December 31, 2006 and $5,203 at December 31, 2005 were established related to such insurance programs.

Variable Interest Entities

As of December 31, 2006, in conjunction with our casualty insurance programs, limited equity interests is held in one 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 its risk of loss in any particular year. The entities meet the definition of variable interest entities (“VIEs”), however, based on the criteria set forth in FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51,” there is not a requirement to include these entities in the consolidated financial statements. The maximum exposure to loss related to our involvement with these entities is limited to approximately $6,440. See Note 11, “Self-Insurance,” for additional discussion of commitments associated with the insurance programs and Note 10, “Off-Balance Sheet Financial Instruments,” for further information on standby letters of credit. As of December 31, 2006, there are no other entities that met the definition of a VIE.

Minimum Royalty Payments

We are obligated under a licensing agreement with Whirlpool Corporation to make minimum annual royalty payments of $1,000 through 2011.

Operating Leases

At December 31, 2006, we are obligated under non-cancelable operating leases of real property, equipment, vehicles and a corporate aircraft used in our operations for minimum annual rentals of $39,230 in 2007, $32,514 in 2008, $25,020 in 2009, $17,216 in 2010, $10,880 in 2011 and $17,671 thereafter. Some of our leases contain renewal options, some of which involve rate increases. For leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize the total minimum lease payments on a straight-line basis over the lease term. The corporate aircraft lease is subject to adjustment from changes in LIBOR-based interest rates. Rental expense for the years ended December 31, 2006, 2005 and 2004 was $36,804, $34,360 and $27,835, respectively.

12. Segment Information

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires companies to provide certain information about their operating segments. Watsco has one reportable segment: the distribution of HVAC equipment and related

parts and supplies—which comprises 98%, 99% and 98% of revenues in 2006, 2005 and 2004, respectively. Our other segment represents our temporary staffing and permanent placement services business.

The segment information presented below follows the same accounting policies used for the consolidated financial statements as described in Note 1. Costs excluded from this profit measure are interest expense, net and income taxes. Corporate expenses are primarily comprised of corporate overhead expenses. Thus, operating income includes only the costs that are directly attributable to the operations of the individual segment. Assets not identifiable to an individual segment are corporate assets, which are primarily comprised of cash and cash equivalents, deferred taxes and certain property and equipment.

Years Ended December 31,	2006			2005			2004
Revenues:
Distribution	$	1,771,214		$	1,658,249		$	1,294,715
Other		29,912			25,292			21,251
Elimination of intersegment revenues		(367	)		(817	)		(942	)
Revenues from external customers	$	1,800,759		$	1,682,724		$	1,315,024
Operating income (loss):
Distribution	$	154,371		$	134,577		$	100,818
Other		209			(10	)		(1,100	)
Corporate expenses		(18,977	)		(18,109	)		(17,666	)
	$	135,603		$	116,458		$	82,052
Depreciation and amortization:
Distribution	$	5,555		$	5,737		$	5,029
Other		122			119			155
Corporate		231			333			1,584
	$	5,908		$	6,189		$	6,768
Assets:
Distribution	$	654,498		$	619,998		$	499,771
Other		7,581			7,235			8,861
Corporate		49,292			51,498			99,657
	$	711,371		$	678,731		$	608,289
Capital expenditures:
Distribution	$	7,379		$	7,104		$	4,118
Other		108			56			157
Corporate		2,505			123			571
	$	9,992		$	7,283		$	4,846

13. Related Party Transactions

A member of the Board of Directors is the President and Chief Executive Officer of Greenberg Traurig, P.A., which serves as our principal outside counsel and receives customary fees for legal services. During 2006, 2005 and 2004, this firm was paid $295, $172 and $89, respectively, for services performed.

14. Subsequent Event

In February 2007, Watsco’s Board of Directors approved an increase in the quarterly cash dividend to 33 cents per share from 25 cents per share.

WATSCO, INC. AND SUBSIDIARIES

SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

(In thousands, except per share data)	1st Quarter		2nd Quarter		3rd Quarter		4th Quarter		Total
Year Ended December 31, 2006
Revenues (1)	$	394,307	$	512,029	$	506,858	$	387,565	$	1,800,759
Gross profit		100,080		132,488		133,213		97,119		462,900
Net income (2)	$	13,047	$	28,748	$	29,051	$	11,519	$	82,364
Earnings per share for Common and Class B common stock (2)
Basic	$	0.50	$	1.10	$	1.11	$	0.44	$	3.15
Diluted	$	0.47	$	1.03	$	1.05	$	0.42	$	2.96
Year Ended December 31, 2005
Revenues (1)	$	345,952	$	443,030	$	477,553	$	416,189	$	1,682,724
Gross profit		87,425		111,525		120,118		103,962		423,030
Net income (2)	$	9,148	$	22,406	$	24,347	$	14,118	$	70,019
Earnings per share for Common and Class B common stock (2)
Basic	$	0.35	$	0.86	$	0.94	$	0.54	$	2.69
Diluted	$	0.33	$	0.81	$	0.88	$	0.50	$	2.52

(1) Sales of residential central air conditioners, heating equipment and related parts and supplies are seasonal. 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.

(2) Quarterly earnings per Common and Class B common share are calculated on an individual basis and, because of rounding and changes in the weighted average shares outstanding during the year, the summation of each quarter may not equal the amount calculated for the year as a whole.

WATSCO, INC. AND SUBSIDIARIES

INFORMATION ON COMMON STOCK

Watsco Common stock is traded on the New York Stock Exchange under the symbol WSO and our Class B common stock is traded on the American Stock Exchange under the symbol WSOB. The following table indicates the high and low prices of our Common stock and Class B common stock, as reported by the New York Stock Exchange and American Stock Exchange, respectively, and dividends paid per share for each quarter during the years ended December 31, 2006 and 2005. At February 15, 2007, excluding shareholders with stock in street name, there were 346 Common stock shareholders of record and 151 Class B common stock shareholders of record.

	Common				Class B				Cash Dividend
	High		Low		High		Low		Common		Class B
Year Ended December 31, 2006:
Fourth quarter	$	53.75	$	45.08	$	53.53	$	45.39	$	.25	$	.25
Third quarter		60.80		42.20		60.50		42.50		.25		.25
Second quarter		70.60		52.35		72.00		53.47		.25		.25
First quarter		72.25		63.24		73.05		63.50		.20		.20
Year Ended December 31, 2005:
Fourth quarter	$	66.90	$	49.19	$	66.51	$	50.00	$	.20	$	.20
Third quarter		53.11		40.46		52.60		41.75		.14		.14
Second quarter		45.81		39.15		45.55		40.50		.14		.14
First quarter		42.11		34.03		42.25		33.50		.14		.14