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Quarterly Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended August 31, 2004



OR

| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission file number 0-12490



ACR GROUP, INC.

(Exact name of
registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Texas                                                          |  | 74-2008473                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



|                                               |  |           
|---------------------------------------------- |  | ----------
|3200 Wilcrest Drive, Suite 440, Houston, Texas |  | 77042-6039
|(Address of principal executive offices)       |  | (Zip Code)



(713) 780-8532

(Registrants telephone number, including area code)



Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    
No ̈



Indicate by check mark whether the registrant is an accelerated filer (as filed in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



Shares of Common Stock outstanding at September 30, 2004 - 10,712,294.



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##### Table of Contents

ACR GROUP, INC. AND SUBSIDIARIES



INDEX TO QUARTERLY REPORT ON FORM 10-Q



|               |  |                       |  |                                                                                                                                           |  |     
|-------------- |  | --------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|               |  |                       |  |                                                                                                                                           |  | Page
|PART I         |  | FINANCIAL INFORMATION |  |                                                                                                                                          
|               |  |                       | 
|               |  | Item 1.               |  | Financial Statements                                                                                                                      |  |     
|               |  |                       | 
|               |  |                       |  | Condensed Consolidated Balance Sheets  August 31, 2004 (Unaudited) and February 29, 2004 (Restated)                                      |  | 3   
|               |  |                       | 
|               |  |                       |  | Condensed Consolidated Statements of Operations (Unaudited)  Quarter and Six Months Ended August 31, 2004 and August 31, 2003 (Restated) |  | 5   
|               |  |                       | 
|               |  |                       |  | Condensed Consolidated Statements of Cash Flows (Unaudited)  Six Months Ended August 31, 2004 and August 31, 2003 (Restated)             |  | 6   
|               |  |                       | 
|               |  |                       |  | Notes to Condensed Consolidated Financial Statements                                                                                      |  | 7   
|               |  |                       | 
|               |  | Item 2.               |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                     |  | 13  
|               |  |                       | 
|               |  | Item 3.               |  | Quantitative and Qualitative Disclosures about Market Risk                                                                                |  | 19  
|               |  |                       | 
|               |  | Item 4.               |  | Controls and Procedures                                                                                                                   |  | 19  
|               |  |                      
|PART II        |  | OTHER INFORMATION     |  |                                                                                                                                          
|               |  |                       | 
|               |  | Item 1.               |  | Legal Proceedings                                                                                                                         |  | 20  
|               |  |                       | 
|               |  | Item 4.               |  | Items Submitted to a Vote of Security Holders                                                                                             |  | 20  
|               |  |                       | 
|               |  | Item 6.               |  | Exhibits and Reports on Form 8-K                                                                                                          |  | 20  
|               | 
|SIGNATURES     |  | 22                   
|               | 
|CERTIFICATIONS |  | 23                   



2



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##### Table of Contents

PART IFINANCIAL INFORMATION



Item 1. Financial Statements



ACR GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)



ASSETS



|                                                                               |  |                |        |                  |   |       
|------------------------------------------------------------------------------ |  | -------------- | ------ | ---------------- | - | ------
|                                                                               |  | August 31,2004 |        | February 29,2004
|                                                                               |  | (Unaudited)    |        |                 
|Current assets:                                                                |  |                |        |                  |   |       
|Cash                                                                           |  | $              | 42     |                  | $ | 52    
|Accounts receivable, net of allowance for doubtful accounts of $1,187 and $793 |  |                | 24,472 |                  |   | 18,120
|Inventory                                                                      |  |                | 32,721 |                  |   | 27,833
|Prepaid expenses and other                                                     |  |                | 602    |                  |   | 1,120 
|Deferred income taxes                                                          |  |                | 1,683  |                  |   | 1,167 
|                                                                               |  |                |        |                  |   |       
|Total current assets                                                           |  |                | 59,520 |                  |   | 48,292
|                                                                               |  |                |        |                  |   |       
|Property and equipment, net of accumulated depreciation                        |  |                | 4,398  |                  |   | 4,461 
|Goodwill, net of accumulated amortization                                      |  |                | 5,258  |                  |   | 5,258 
|Other assets                                                                   |  |                | 787    |                  |   | 716   
|                                                                               |  |                |        |                  |   |       
|Total assets                                                                   |  | $              | 69,963 |                  | $ | 58,727
|                                                                               |  |                |        |                  |   |       



The accompanying notes
are an integral part

of these condensed financial statements.



3



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ACR GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)



LIABILITIES AND SHAREHOLDERS EQUITY



|                                                                      |  |                |         |   |                  |   |         |  
|--------------------------------------------------------------------- |  | -------------- | ------- | - | ---------------- | - | ------- | -
|                                                                      |  | August 31,2004 |         |   | February 29,2004 |  
|                                                                      |  | (Unaudited)    |         |   | (Restated)       |  
|Current liabilities:                                                  |  |                |         |   |                  |   |         |  
|Current maturities of long-term debt and capital lease obligations    |  | $              | 398     |   |                  | $ | 407     |  
|Accounts payable                                                      |  |                | 21,301  |   |                  |   | 18,756  |  
|Interest derivative liabilities                                       |  |                | 233     |   |                  |   |        |  
|Accrued expenses and other liabilities                                |  |                | 5,408   |   |                  |   | 3,248   |  
|                                                                      |  |                |         |   |                  |   |         |  
|Total current liabilities                                             |  |                | 27,340  |   |                  |   | 22,411  |  
|                                                                      |  |                |         |   |                  |   |         |  
|Revolving line of credit                                              |  |                | 24,483  |   |                  |   | 21,086  |  
|Long-term debt and capital lease obligations, less current maturities |  |                | 1,447   |   |                  |   | 1,645   |  
|Interest derivative liabilities                                       |  |                |        |   |                  |   | 464     |  
|Deferred income taxes                                                 |  |                | 246     |   |                  |   | 63      |  
|                                                                      |  |                |         |   |                  |   |         |  
|Total long-term obligations                                           |  |                | 26,176  |   |                  |   | 23,258  |  
|                                                                      |  |                |         |   |                  |   |         |  
|Shareholders equity:                                                 |  |                |         |   |                  |   |         |  
|Common stock                                                          |  |                | 118     |   |                  |   | 107     |  
|Additional paid-in capital                                            |  |                | 43,952  |   |                  |   | 41,691  |  
|Unearned compensationrestricted stock                                |  |                | (2,077  | ) |                  |   |        |  
|Accumulated deficit                                                   |  |                | (25,546 | ) |                  |   | (28,740 | )
|                                                                      |  |                |         |   |                  |   |         |  
|Total shareholders equity                                            |  |                | 16,447  |   |                  |   | 13,058  |  
|                                                                      |  |                |         |   |                  |   |         |  
|Total liabilities and shareholders equity                            |  | $              | 69,963  |   |                  | $ | 58,727  |  
|                                                                      |  |                |         |   |                  |   |         |  



The accompanying notes
are an integral part

of these condensed financial statements.



4



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##### Table of Contents

ACR GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)



|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|----------------------------------------- |  | ----------------------------- | ------ | - | --------------------------- | - | ------ | ---- |  | - | ---------- | - |  | - | ------ | -
|                                          |  | Three Months Ended August 31, |        |   | Six months Ended August 31, |  
|                                          |  | 2004                          |        |   | 2003                        |   |        | 2004 |  |   | 2003       |  
|                                          |  |                               |        |   | (Restated)                  |   |        |      |  |   | (Restated) |  
|Sales                                     |  | $                             | 59,538 |   |                             | $ | 51,543 |      |  | $ | 109,583    |   |  | $ | 93,860 |  
|Cost of sales                             |  |                               | 45,889 |   |                             |   | 40,195 |      |  |   | 84,776     |   |  |   | 73,207 |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Gross profit                              |  |                               | 13,649 |   |                             |   | 11,348 |      |  |   | 24,807     |   |  |   | 20,653 |  
|Selling, general and administrative costs |  |                               | 10,134 |   |                             |   | 8,795  |      |  |   | 19,381     |   |  |   | 17,028 |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Operating income                          |  |                               | 3,515  |   |                             |   | 2,553  |      |  |   | 5,426      |   |  |   | 3,625  |  
|Interest expense                          |  |                               | 280    |   |                             |   | 266    |      |  |   | 535        |   |  |   | 542    |  
|Interest derivative loss (gain)           |  |                               | 7      |   |                             |   | (58    | )    |  |   | (23        | ) |  |   | 21     |  
|Other non-operating (income)              |  |                               | (171   | ) |                             |   | (122   | )    |  |   | (313       | ) |  |   | (226   | )
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Income before income taxes                |  |                               | 3,399  |   |                             |   | 2,467  |      |  |   | 5,227      |   |  |   | 3,288  |  
|Provision for income taxes:               |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Current                                   |  |                               | 1,680  |   |                             |   | 442    |      |  |   | 2,364      |   |  |   | 596    |  
|Deferred                                  |  |                               | (346   | ) |                             |   | 487    |      |  |   | (331       | ) |  |   | 646    |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Net income                                |  | $                             | 2,065  |   |                             | $ | 1,538  |      |  | $ | 3,194      |   |  | $ | 2,046  |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Earnings per share:                       |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Basic                                     |  | $                             | .19    |   |                             | $ | .14    |      |  | $ | .30        |   |  | $ | .19    |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Diluted                                   |  | $                             | .19    |   |                             | $ | .14    |      |  | $ | .30        |   |  | $ | .19    |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Weighted average shares outstanding:      |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Basic                                     |  |                               | 10,681 |   |                             |   | 10,681 |      |  |   | 10,681     |   |  |   | 10,681 |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  
|Diluted                                   |  |                               | 10,847 |   |                             |   | 10,681 |      |  |   | 10,789     |   |  |   | 10,681 |  
|                                          |  |                               |        |   |                             |   |        |      |  |   |            |   |  |   |        |  



The accompanying notes
are an integral part

of these condensed financial statements.



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ACR GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                      |  |                             |        |   |            |   |        |  
|------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---------- | - | ------ | -
|                                                                                      |  | Six months ended August 31, |       
|                                                                                      |  | 2004                        |        |   | 2003       |  
|Operating activities:                                                                 |  |                             |        |   | (Restated) |  
|Net income                                                                            |  | $                           | 3,194  |   |            | $ | 2,046  |  
|Adjustments to reconcile net income to net cash provided by operating activities:     |  |                             |        |   |            |   |        |  
|Depreciation and amortization                                                         |  |                             | 473    |   |            |   | 513    |  
|Provision for doubtful accounts                                                       |  |                             | 394    |   |            |   | 354    |  
|Market value of interest derivative                                                   |  |                             | (231   | ) |            |   | (198   | )
|Deferred income taxes                                                                 |  |                             | (331   | ) |            |   | 645    |  
|Amortization of restricted stock compensation                                         |  |                             | 194    |   |            |   |       |  
|Other                                                                                 |  |                             | (1     | ) |            |   | (5     | )
|Changes in operating assets and liabilities:                                          |  |                             |        |   |            |   |        |  
|Accounts receivable, net                                                              |  |                             | (6,746 | ) |            |   | (6,033 | )
|Inventory                                                                             |  |                             | (4,888 | ) |            |   | (1,352 | )
|Prepaid expenses and other assets                                                     |  |                             | 447    |   |            |   | (614   | )
|Accounts payable                                                                      |  |                             | 2,545  |   |            |   | 3,019  |  
|Accrued expenses and other liabilities                                                |  |                             | 2,159  |   |            |   | 1,401  |  
|                                                                                      |  |                             |        |   |            |   |        |  
|Net cash (used in) operating activities                                               |  |                             | (2,791 | ) |            |   | (224   | )
|                                                                                      |  |                             |        |   |            |   |        |  
|Investing activities:                                                                 |  |                             |        |   |            |   |        |  
|Acquisition of property and equipment                                                 |  |                             | (412   | ) |            |   | (231   | )
|Proceeds from disposition of assets                                                   |  |                             | 2      |   |            |   | 181    |  
|                                                                                      |  |                             |        |   |            |   |        |  
|Net cash (used in) investing activities                                               |  |                             | (410   | ) |            |   | (50    | )
|                                                                                      |  |                             |        |   |            |   |        |  
|Financing activities:                                                                 |  |                             |        |   |            |   |        |  
|Net borrowings on revolving credit facility                                           |  |                             | 3,254  |   |            |   | 428    |  
|Payments on long-term debt                                                            |  |                             | (63    | ) |            |   | (217   | )
|                                                                                      |  |                             |        |   |            |   |        |  
|Net cash provided by provided by financing activities                                 |  |                             | 3,191  |   |            |   | 211    |  
|                                                                                      |  |                             |        |   |            |   |        |  
|Net (decrease) in cash                                                                |  |                             | (10    | ) |            |   | (63    | )
|Cash at beginning of year                                                             |  |                             | 52     |   |            |   | 104    |  
|                                                                                      |  |                             |        |   |            |   |        |  
|Cash at end of period                                                                 |  | $                           | 42     |   |            | $ | 41     |  
|                                                                                      |  |                             |        |   |            |   |        |  
|Non-cash sale of subsidiaries inventory, property and equipment and other net assets |  | $                           |       |   |            | $ | 804    |  
|                                                                                      |  |                             |        |   |            |   |        |  



The accompanying notes
are an integral part

of these condensed financial statements.



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ACR GROUP, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1 - Basis of Presentation



The accompanying unaudited condensed historical financial statements of the
Company have been prepared in accordance with accounting principles generally accepted in the United States. Accordingly, they do not include all of the information and footnotes required for complete financial statements, and therefore, should be
reviewed in conjunction with the financial statements and related notes thereto contained in the Companys annual report for the year ended February 29, 2004 filed on Form 10-K/A with the Securities and Exchange Commission. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Actual operating results for the three months ended and six months ended August 31, 2004, are not necessarily
indicative of the results that may be expected for the fiscal year ended February 28, 2005.



Certain reclassifications were made to the prior years financial statements to conform with current year presentation.



2 - Summary of Significant Accounting Policies



For a detailed description of these policies, refer to Note 1 of the Notes to Consolidated Financial Statements included in the Companys Annual
Report on Form 10-K/A for the year ended February 29, 2004 and to Item 2, Managements Discussion and Analysis of Financial Condition and Results of Operations, below.



In accordance with the provisions of Statement of Financial Accounting Standards (SFAS) Number 123,
Accounting for Stock-Based Compensation, as amended by SFAS 148, Accounting for Stock-Based Compensation  Transition and Disclosure  an amendment of FASB Statement No. 123, the Company has elected to follow the
Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its employees stock-based compensation plans. Under APB 25, if the exercise price of
employee stock options equals or exceeds the fair value of the underlying stock on the date of grant, no compensation expense is recognized.



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##### Table of Contents

Had compensation expense been determined consistent with SFAS 123, the Companys net income and
earnings per share would have been changed to the following pro forma amounts:



|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ----- | -------------------------- | - | ----- |  | ---------- | ----- |  | - | -----
|                                                                                                   |  | Three Months EndedAugust 31, |       | Six Months EndedAugust 31,
|                                                                                                   |  | 2004                         |       | 2003                       |   | 2004  |  | 2003      
|                                                                                                   |  |                              |       | (Restated)                 |   |       |  | (Restated)
|Net income applicable to common shareholders as reported                                           |  | $                            | 2,065 |                            | $ | 1,538 |  | $          | 3,194 |  | $ | 2,046
|Total stock-based employee compensation expense under fair value method for all awards, net of tax |  |                              | 38    |                            |   |      |  |            | 76    |  |   | 1    
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|Pro forma income applicable to common                                                              |  |                              |       |                            |   |       |  |            |       |  |   |      
|Shareholders                                                                                       |  | $                            | 2,027 |                            | $ | 1,538 |  | $          | 3,118 |  | $ | 2,045
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|Basic earnings per share:                                                                          |  |                              |       |                            |   |       |  |            |       |  |   |      
|As reported                                                                                        |  | $                            | .19   |                            | $ | .14   |  | $          | .30   |  | $ | .19  
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|Pro forma                                                                                          |  | $                            | .19   |                            | $ | .14   |  | $          | .29   |  | $ | .19  
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|Diluted earnings per share:                                                                        |  |                              |       |                            |   |       |  |            |       |  |   |      
|As reported                                                                                        |  | $                            | .19   |                            | $ | .14   |  | $          | .30   |  | $ | .19  
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      
|Pro forma                                                                                          |  | $                            | .19   |                            | $ | .14   |  | $          | .29   |  | $ | .19  
|                                                                                                   |  |                              |       |                            |   |       |  |            |       |  |   |      



3 - Restatement



The Company filed a restated annual report on Form 10-K/A on October 15,
2004. Prior quarterly results were restated in Note 10, Quarterly Results, of the Form 10-K/A. The Company had concluded that it improperly accounted for certain interest rate derivative instruments that were originally entered into in September
2000 and April 2001. The Company did not properly record the fair value of the derivative and the change to the fair value of the derivative as an unrealized gain or loss in the statements of operations for the periods affected.



In connection with the restatement, the Company has reclassified payments
made on derivative instruments from interest expense to interest derivative gain or loss; recorded changes in the fair value of such instruments as interest derivative gain or loss; and the related effect of such changes in fair value. The net
effect of all the restatement adjustments is as follows:



|                                                                               |  |                             |     |                           |   |    
|------------------------------------------------------------------------------ |  | --------------------------- | --- | ------------------------- | - | ---
|                                                                               |  | Three MonthsEndedAugust 31, |     | Six MonthsEndedAugust 31,
|                                                                               |  | 2003                        |     | 2003                     
|Increase to net income due to restatement to record unrealized derivative gain |  | $                           | 110 |                           | $ | 130
|                                                                               |  |                             |     |                           |   |    
|Increase to earnings per share:                                                |  |                             |     |                           |   |    
|Basic                                                                          |  | $                           | .01 |                           | $ | .01
|                                                                               |  |                             |     |                           |   |    
|Diluted                                                                        |  | $                           | .01 |                           | $ | .01
|                                                                               |  |                             |     |                           |   |    



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4 - Contingent Liabilities



The Company has an arrangement with an HVACR equipment manufacturer and a bonded warehouse agent whereby HVACR equipment is
held for sale in bonded warehouses located at the premises of certain of the Companys operations, with payment due only when products are sold. The supplier retains legal title and substantial management control with respect to the consigned
inventory. The Company is responsible for damage to and loss of inventory that may occur at its premises. The Company has the ability to return consigned inventory, at its sole discretion, to the supplier for a specified period of time after receipt
of the inventory. Such inventory is accounted for as consigned merchandise and is not recorded on the Companys balance sheet. As of August 31, 2004, the cost of such inventory held in the bonded warehouses was approximately $4,655,000.



The terms of the consignment agreement further provide that
the Company may be required to purchase inventory not sold within a specified period of time. Historically, most consigned inventory is sold before the specified purchase date, and prior to August 31, 2004, the supplier had never enforced its right
to demand payment, instead permitting such inventory to remain on consignment. At August 31, 2004, the Company agreed to purchase approximately $300,000 of inventory that had been on consignment more than one year. The Company expects that most of
this equipment will be sold before the end of fiscal 2005.



5 - Goodwill



Goodwill represents the excess cost of companies acquired
over the fair value of their tangible net assets. The Company accounts for goodwill in accordance with SFAS No. 142. Goodwill attributable to each of the Companys reporting units is tested for impairment by comparing the fair value of each
reporting unit with its carrying value. These impairment tests are performed at least annually. On an ongoing basis (absent any impairment indicators), the Company performs the annual impairment test as of the end of its fiscal year.



6 - Interest Rate Derivative Instruments



The Company has an interest rate derivative that does not qualify as a
hedge, in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The fair value of the derivative instrument is reflected on the Companys balance sheets, and changes in the fair value of such
derivatives are recorded as unrealized gains or losses, as applicable, in the Companys statements of operations as interest derivative loss or gain. Payments received or paid by the Company during the term of the derivative contract as a
result of differences between the fixed interest rate of the derivative and the market interest rate are also recorded as interest derivative loss or gain.



The derivative instrument is an interest rate swap whereby the Company has agreed to exchange, at specified intervals, the difference between a fixed rate
of 6.33% and a variable rate based upon LIBOR, amounts as calculated by reference to a notional principal amount of $8 million. The interest rate swap was scheduled to mature in April 2005. However, the Company elected to terminate the agreement
early and settle the remaining outstanding liability with a payment of $238,000 in September 2004 as part of the refinancing arrangement discussed in Note 8. The fair value of the derivative is represented by a liability of $233,000 and $464,000, at
August 31, 2004 and February 29, 2004, respectively.



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##### Table of Contents

7 - Stock Option Agreements and Equity Transactions



Effective March 1, 2004, both the Chief Financial Officer and the General Counsel of the Company entered into employment
contracts that each provide for the contingent issuance of 500,000 shares of restricted stock upon both continuation of employment and attainment of specified financial performance objectives by the Company. After the end of the first quarter, it
was recognized that certain provisions of the agreements led to differing interpretations of the timing and number of shares that could vest under certain financial performance conditions. A process commenced at that time to amend the agreements to
clarify the terms. In September 2004, the agreements were revised to extend the vesting period and eliminate the performance criteria. Under the revised agreements, the restricted stock will vest ratably over six years beginning March 1, 2004,
subject only to continuation of employment of the officers. As a result of this revision, September 27, 2004 established a new measurement date for valuing the restricted stock. On that date the Companys share price was $2.15, and accordingly,
the Company has recorded $2,150,000 as deferred compensation, which will be amortized on a straight-line basis as compensation expense over the six-year vesting period of the grants. As the amendment clarified provisions identified at the end of the
first quarter, and adjustment was made in the second quarter to reflect year-to-date compensation expense based on the new terms. For the three and six-month periods ended August 31, 2004, compensation expense recognized under the agreements was
$70,000 and $179,000, respectively.



Effective March 1, 2004,
the two outside directors of the Company each received restricted stock grants of 42,000 shares, subject to continuation of service as a director for four years. Such shares will vest annually pro-rata over such period. The Company will recognize
$122,000 as compensation expense ratably over the four-year period for the restricted stock grants. For the three and six-month periods ended August 31, 2004, the Company recognized $8,000 and $15,000, respectively, as compensation expense related
to the directors restricted stock grants.



The Company
has a stock option plan for key employees and directors of the Company and its subsidiaries. The plan provides for the granting of up to 500,000 non-qualified and/or incentive stock options. The options expire after five years and can be extended
for a period of up to five years. On March 23, 2004, the expiration date of 93,500 options granted under the plan in March 1999 was extended until March 23, 2006. The extension created a new measurement date for valuing the options. No compensation
expense has been recognized since, at the date of grant, the market price of the stock was equal to the option price on the date of extension.



8- Debt



The Company has a revolving line of credit arrangement with a commercial bank. The maximum amount that may be borrowed under the revolving line of credit was increased from $25 million to $30 million during the
quarter ended August 31, 2004, and an additional $1 million may be borrowed for capital expenditures. At August 31, 2004, the Company had available credit of $2.2 and $0.2 million under the revolving credit line and the capital expenditure term loan
facility, respectively. The terms of the agreement allow the line of credit to be extended for one year unless either party gives notification. In June 2004, the Company notified the bank of its intention to terminate the arrangement.



On September 7, 2004, the Company entered into a direct financing agreement
(Agreement) with another commercial bank. The Agreement provides to the Company a $30 million revolving line of credit and a $5 million credit line that may be used for capital expenditures or to purchase real estate. The Agreement
replaces the Companys previous financing arrangement noted above.



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The amount that may be borrowed under the new revolving credit line is limited to a borrowing base
consisting of 85% of eligible accounts receivable, and from 50% to 65% of eligible inventory, depending on the time of year. As of September 7, 2004, the Companys borrowing base exceeded $30 million. The Company initially borrowed $26.5
million under the revolving credit line and $0.8 million under the credit line for capital expenditures and real estate to repay its obligations to the former lender.



The interest rate under the Agreement is initially LIBOR plus 1.625%, which is 0.625% less than under the Companys
previous borrowing arrangement, or the Prime Rate less 0.125%. The Company has initially elected to use the LIBOR rate option for substantially all of its borrowings. The incremental percentage above LIBOR may vary depending on the Companys
leverage and financial performance. The Agreement also requires the Company to pay monthly a fee of 0.25% per annum on the average unused portion of the revolving credit line. All of the Companys assets are pledged as collateral for borrowings
under the Agreement.



The Agreement contains customary loan
covenants with respect to the Companys net worth, fixed charge coverage, leverage ratio, and ratio of funded debt to earnings before interest, income tax, depreciation, amortization and non-cash compensation expense. At the inception of the
Agreement, the Company is in compliance with all such covenants. The Agreement also contains various affirmative and negative covenants unrelated to the Companys financial performance, including a prohibition on payment of dividends. Failure
to comply with any financial or non-financial covenant, if not promptly cured, constitutes an Event of Default under the Agreement. Certain other specified events and any Material Adverse Change, as determined by the bank, also constitute an Event
of Default. The existence of an Event of Default gives the bank a right to accelerate all outstanding indebtedness under the Agreement.



The Agreement does not require the Company to use lockbox or similar arrangements pursuant to which the bank would exercise control over collection
proceeds and the discretion to reduce indebtedness under the Agreement. If an Event of Default exists, the bank may offset against the Companys indebtedness all funds of the Company that are held in accounts at the bank. The Company is not
required to maintain deposit balances at the bank, although the Company has initially elected to utilize the banks treasury management services.



9 - New Accounting Pronouncements



In January 2003, the Emerging Issues Task Force (EITF) reached a final consensus on EITF Issue No. 02-16, Accounting by a Customer (Including a
Reseller) for Certain Consideration Received from a Vendor. EITF 02-16 clarifies certain aspects for accounting and recording of consideration received from vendors. Certain provisions of the EITF are effective for fiscal years beginning after
December 15, 2002, and other provisions of the EITF are effective for arrangements entered into after November 21, 2003. The Companys accounting for consideration received from vendors is consistent with the provisions of EITF 02-16 as of
August 31, 2004.



In January 2003, the FASB issued
Interpretation 46, Consolidation of Variable Interest Entities. In general, a Variable Interest Entity is a corporation, partnership, trust, or other legal structure used for business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject
to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or both. The Interpretation is effective for all Variable Interest Entities created after
January 31, 2003, and is effective for special purpose entities created before



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February 1, 2003 for the first reporting period after December 15, 2003 and for non-special purpose entities for the first reporting period beginning after
March 15, 2004. The adoption of the Interpretation did not have nor is expected to have a material impact on the Companys financial statements.



10 - Income Taxes



The Company and its subsidiaries file a consolidated federal income tax return. The Company uses the liability method in accounting for income taxes.
Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when
the differences are expected to reverse.



11 - Earnings Per Share



The following table sets forth the computation of basic and
diluted earnings per share for the six months and the three months ended August 31, 2004 and 2003 (in thousands except per share data):



|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       
|--------------------------------------------------------------------------------------------------- |  | ----------------------------- | ------ | --------------------------- | - | ------ |  | ---------- | ------ |  | - | ------
|                                                                                                    |  | Three Months Ended August 31, |        | Six Months Ended August 31,
|                                                                                                    |  | 2004                          |        | 2003                        |   | 2004   |  | 2003      
|                                                                                                    |  |                               |        | (Restated)                  |   |        |  | (Restated)
|Numerator for basic and diluted earnings per share                                                  |  |                               |        |                             |   |        |  |            |        |  |   |       
|Net income                                                                                          |  | $                             | 2,065  |                             | $ | 1,538  |  | $          | 3,194  |  | $ | 2,046 
|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       
|Denominator:                                                                                        |  |                               |        |                             |   |        |  |            |        |  |   |       
|Denominator for basic earnings per shareweighted average shares                                    |  |                               | 10,681 |                             |   | 10,681 |  |            | 10,681 |  |   | 10,681
|Effect of dilutive securities:                                                                      |  |                               |        |                             |   |        |  |            |        |  |   |       
|Stock options                                                                                       |  |                               | 105    |                             |   |       |  |            | 75     |  |   |      
|Restricted stock grants                                                                             |  |                               | 72     |                             |   |       |  |            | 39     |  |   |      
|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       
|Denominator for diluted earnings per shareadjusted weighted average shares and assumed conversions |  |                               | 10,847 |                             |   | 10,681 |  |            | 10,789 |  |   | 10,681
|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       
|Basic earnings per share                                                                            |  | $                             | .19    |                             | $ | .14    |  | $          | .30    |  | $ | .19   
|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       
|Diluted earnings per share                                                                          |  | $                             | .19    |                             | $ | .14    |  | $          | .30    |  | $ | .19   
|                                                                                                    |  |                               |        |                             |   |        |  |            |        |  |   |       

|
|

|
|

|
|



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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations



INTRODUCTION



ACR Group, Inc. and its subsidiaries (collectively, the Company) is an independent distributor of heating, air conditioning and refrigeration (HVACR) equipment and related parts and supplies.
The Company is among the ten largest such distributors in the United States. Substantially all of the Companys sales are to contractor dealers and institutional end-users. Generally accepted accounting principles allow the aggregation of an
enterprises segments if they are similar. Although the Company operates in different geographic areas, we have reviewed the aggregation criteria and determined that the Company operates as a single segment based on the high degree of
similarity of the Companys operations.



This report on
Form 10-Q includes certain statements that may be deemed to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements, which are other than statements of historical facts. Forward-looking
statements involve risks and uncertainties that could cause actual results or outcomes to differ materially. Such risks and uncertainties may include the availability of debt or equity capital to fund the Companys working capital requirements,
unusual weather conditions, the effects of competitive pricing, the strength of construction markets and general economic conditions. Our expectations and beliefs are expressed in good faith and we believe there is a reasonable basis for them, but
there can be no assurance that our expectations, beliefs or projections will be achieved or accomplished. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided under the securities laws.



RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED AUGUST 31, 2004 COMPARED TO THE
SIX MONTHS ENDED AUGUST 31, 2003



The Company recognized net
income of $3,194,000 for the six months ended August 31, 2004 (fiscal 2005) compared to $2,046,000 for the six months ended August 31, 2003 (fiscal 2004) an increase of 56%. The Companys financial improvement was broad-based, as each of the
Companys six business units, except for the Texas-based unit, generated operating income at least 40% greater than the preceding year. The Texas-based unit was adversely affected by unusually high rainfall and relatively mild temperatures
throughout the summer, which reduced demand for the Companys products. Business units based in Colorado and California generated the highest rate of growth in net income over the previous year. A resurgence in economic development in Colorado
enabled that business unit to earn its highest six-month income since fiscal 2002. The California business unit sustained the momentum it developed in fiscal 2004.



Consolidated sales increased 17% during the six months ended August 31, 2004 compared to the six months ended August 31,
2003. Same-store sales increased 15% over the same fiscal periods. For the first eight months of calendar 2004, same-store sales growth was also 15%, compared to a 6% increase in industry-wide product shipments during the same period based on data
compiled by a leading industry trade association. Same-store comparisons exclude two non-core business units that were sold in fiscal 2004, a branch closed in fiscal 2004 and four new branches opened since June 2003. Growth was strongest in
California and Florida, which benefited from the growth curve usually associated with recently opened branches. Other than in Texas, summer weather patterns were close to normal and the Companys business units experienced the customary
seasonal increase in sales. Sales under a contract with a customer that commenced in the second quarter of fiscal 2004 represented 3 percentage points of the increase in consolidated and same-store sales in the first six months of fiscal 2005.



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The Companys consolidated gross margin percentage on sales was 22.6% for the six months ended
August 31, 2004, compared to 22.0% for the six months ended August 31, 2003. The increase in gross margin percentage resulted from continuous improvement in purchasing and payment terms with suppliers and customer pricing disciplines across all
business units. The Company earns a relatively low gross margin percentage on the large volume contract described in the preceding paragraph; sales under this contract decreased consolidated gross margin percentage for the six-month period ended
August 31, 2004 by 0.6 percentage points.



Selling, general and
administrative (SG&A) expenses increased by 14% in the six months ended August 31, 2004, compared to the same period of 2003. Same-store SG&A expenses increased 12% over the same periods, generally because of the much higher
sales volumes in fiscal 2005. Expressed as a percentage of sales, SG&A expenses decreased in the six months ended August 31, 2004 to 17.7% from 18.1% in 2003.



Interest expense decreased 1% in the six-month period ended August 31, 2004 from the same period ended August 31, 2003 as a
result of a decrease in the average interest rate on the Companys variable rate indebtedness. Average funded indebtedness increased 7% in the six months ended August 31, 2004, compared to the preceding year, as the Company used its revolving
credit line for working capital requirements associated with the increase in sales over the preceding year and, upon increasing the credit line in July 2004, to access more favorable payment terms with suppliers.



The Company has an effective combined federal and state income tax rate of
38.9% for the six months ended August 31, 2004, compared to 37.8% for the six months ended August 31, 2003. In fiscal 2004, slightly less than half of the provision for income taxes was charged to deferred taxes because of federal income tax loss
carryforwards. The Company has no loss carryforwards to utilize in fiscal 2005.



RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED AUGUST 31, 2004 COMPARED TO THE THREE MONTHS ENDED AUGUST 31, 2003



The Company recognized net income of $2,065,000 for the quarter ended August 31, 2004 (fiscal 2005) compared to $1,538,000 for the quarter ended August
31, 2003 (fiscal 2004), an increase of 34%. Each of the Companys six business units generated operating income at least 15% greater than the preceding year.



Consolidated and same-store sales increased 15% and 16%, respectively, during the quarter ended August 31, 2004
compared to the quarter ended August 31, 2003. Consistent with the six-month period ended August 31, sales growth was greatest in California and Florida. All business units generated increases in sales over fiscal 2004, although sales in Texas were
generally flat because of the weather conditions described above. The hurricanes that hit Florida in August and September 2004 somewhat impacted business at the end of the second quarter. Although the Companys facilities in Florida suffered no
physical damage, the evacuations that preceded the storms and the subsequent utility disruptions effectively halted business for several days. However, the forthcoming repairs to, and replacement of, HVAC systems as a result of hurricane damage are
likely to generate additional business for the Company over the next several months.



The Companys consolidated gross margin percentage on sales increased to 22.9% for the quarter ended August 31, 2004, compared to 22.0% for the quarter ended August 31, 2003, as a result of the



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initiatives described in the analysis of six-month results above. Excluding sales under the large volume contract described above, gross margin percentage
for the quarter ended August 31, 2004 was 23.3%.



Selling,
general and administrative (SG&A) expenses increased by 15% in the quarter ended August 31, 2004 compared to the same quarter of 2003. Same-store SG&A expenses increased 13% over the same periods, generally because of the much
higher sales volumes in fiscal 2005. Expressed as a percentage of sales, SG&A expenses decreased in the second quarter from 17.1% in 2003 to 17.0% in 2004.



Interest expense increased 4% in the quarter ended August 31, 2004, compared to same quarter in 2003. Higher average borrowings offset lower average
interest rates. Average funded indebtedness increased 11% in the quarter ended August 31, 2004, compared to the preceding year, as the Company utilized funds available from an increase in its revolving credit line to negotiate and take advantage of
favorable payment terms with certain suppliers.



The Company
has an effective a combined federal and state income tax rate of 39.2% for the quarter ended August 31, 2004, compared to 37.7% for the quarter ended August 31, 2003, with the difference attributable to additional state income taxes.



LIQUIDITY AND CAPITAL RESOURCES



In the six months ended August 31, 2004, the Company used cash flow in
operations of $2,791,000, compared to $224,000 in the same period of 2003, as cash was utilized for working capital needed to support new branches and higher sales volumes. Gross accounts receivable represented 41 days of gross sales as of August
31, 2004, compared to 40 days at August 31, 2003. Inventory at August 31, 2004 was $7.2 million greater than at August 31, 2003. Of such increase, approximately $1.4 million was at three branches opened in the past year; $1.4 million represented
product that the Company expects to sell in the third quarter and purchased in advance of an announced price increase by a supplier; $1.0 million was attributable to a new equipment product line to be distributed in California; $2.0 million
represented purchases of HVAC equipment inventory pursuant to favorable terms from a supplier that otherwise would have been purchased in the third quarter; and $0.7 million represented coil steel inventory at the Companys sheet metal
manufacturing plant that was purchased to ensure adequate raw material inventory in light of the volatile steel market. Management expects total inventories to decline significantly during the last two quarters of the fiscal year.



At August 31, 2004, the Company had credit facilities with a commercial bank
that included a $30 million revolving line of credit, and $1 million for capital expenditures. The limit on the revolving credit line was increased from $25 million to $30 million in July 2004. At August 31, 2004, the Company had available credit of
$2.2 and $0.2 million under the revolving credit line and the capital expenditure term loan facility, respectively. At August 31, 2004, the interest rate on each facility was either the prime rate or LIBOR plus 2.25%, and the Company had elected the
LIBOR option on substantially all outstanding variable rate borrowings. As of August 31, 2004, the average interest rate on all borrowings was 3.71%.



On September 7, 2004, the Company entered into a direct financing agreement (Agreement) with another commercial bank. The new Agreement
provides to the Company a $30 million revolving line of credit and a $5 million credit line that may be used for capital expenditures or to purchase real estate. The Agreement replaces the Companys previous financing arrangement noted above.



The amount that may be borrowed under the new revolving credit
line is limited to a borrowing base consisting of 85% of eligible accounts receivable, and from 50% to 65% of eligible inventory, depending on the time of year. As of September 7, 2004, the Companys borrowing base exceeded $30



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million. The Company initially borrowed $26.5 million under the revolving credit line and $0.8 million under the credit line for capital expenditures and
real estate to repay its obligations to the former lender.



The
interest rate under the Agreement is initially LIBOR plus 1.625%, which is 0.625% less than under the Companys previous borrowing arrangement, or the Prime Rate less 0.125%. The Company has initially elected to use the LIBOR rate option for
substantially all of its borrowings. The incremental percentage above LIBOR may vary depending on the Companys leverage and financial performance. The Agreement also requires the Company to pay monthly a fee of 0.25% per annum on the average
unused portion of the revolving credit line. All of the Companys assets are pledged as collateral for borrowings under the Agreement.



The Agreement contains customary loan covenants with respect to the Companys net worth, fixed charge coverage, leverage ratio, and ratio of funded
debt to earnings before interest, income tax, depreciation, amortization and non-cash compensation expense. At the inception of the Agreement, the Company is in compliance with all such covenants. The Agreement also contains various affirmative and
negative covenants unrelated to the Companys financial performance, including a prohibition on payment of dividends. Failure to comply with any financial or non-financial covenant, if not promptly cured, constitutes an Event of Default under
the Agreement. Certain other specified events and any Material Adverse Change, as determined by the bank, also constitute an Event of Default. The existence of an Event of Default gives the bank a right to accelerate all outstanding indebtedness
under the Agreement.



The Agreement does not require the
Company to use lockbox or similar arrangements pursuant to which the bank would exercise control over collection proceeds and the discretion to reduce indebtedness under the Agreement. If an Event of Default exists, the bank may offset against the
Companys indebtedness all funds of the Company that are held in accounts at the bank. The Company is not required to maintain deposit balances at the bank, although the Company has initially elected to utilize the banks treasury
management services.



Management believes that availability
under the new revolving credit facility is adequate to meet the Companys working capital requirements of its existing operations, debt service requirements and anticipated capital expenditures. In addition to reducing the average interest rate
on borrowings, the new loan agreement provides funds to both finance additional growth through new branch operations or small acquisitions and enables the Company to take advantage of certain advantageous payment terms with suppliers.



SEASONALITY



The Companys sales volume and, accordingly, its operating income vary significantly during its fiscal year. The
highest levels of sales occur during the times of the year when climatic conditions require the greatest use of air conditioning, since the Companys operations are concentrated in the warmer sections of the United States. Accordingly, sales
will be highest in the Companys second quarter ended August 31, and will be lowest in its fourth quarter.



INFLATION



The Company does not believe that inflation has had a material effect on its results of operations in recent years. Generally, manufacturer price increases attributable to inflation uniformly affect both the Company
and its competitors, and such increases are passed through to customers as an increase in sales prices.



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##### Table of Contents

|NEW | ACCOUNTING PRONOUNCEMENTS
|--- | -------------------------



In January 2003, the Emerging Issues Task Force (EITF) reached a final consensus on EITF Issue No. 02-16, Accounting by a Customer (Including a
Reseller) for Certain Consideration Received from a Vendor. EITF 02-16 clarifies certain aspects for accounting and recording of consideration received from vendors. Certain provisions of the EITF are effective for fiscal years beginning after
December 15, 2002, and other provisions of the EITF are effective for arrangements entered into after November 21, 2003. The Companys accounting for consideration received from vendors is consistent with the provisions of EITF 02-16 as of
August 31, 2004.



In January 2003, the FASB issued
Interpretation 46, Consolidation of Variable Interest Entities. In general, a Variable Interest Entity is a corporation, partnership, trust, or other legal structure used for business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject
to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or both. The Interpretation is effective for all Variable Interest Entities created after
January 31, 2003, and is effective for special purpose entities created before February 1, 2003 for the first reporting period after December 15, 2003 and for non-special purpose entities for the first reporting period beginning after March 15,
2004. The adoption of the Interpretation did not have nor is expected to have a material impact on the Companys financial statements.



CRITICAL ACCOUNTING POLICIES



The accounting policies discussed below are critical to the Companys business operations and an understanding of the Companys financial
statements. The financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make assumptions and estimates that affect the
reported amounts of assets, liabilities, revenues and expenses in each reporting period. Management bases its estimates on historical experience and other factors that are believed to be reasonable under the circumstances. Actual results, once
known, may vary from managements estimates.



Revenue Recognition



The Companys revenues consist of sales of HVACR
products. The Company recognizes revenue when the following criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the amounts recognized are fixed and determinable, and (4) collectibility is reasonably
assured.



Vendor Rebates



The Company receives rebates from certain vendors based on the volume of
product purchased from the vendor. The Company records rebates when they are earned, and when specified purchase volume levels are reached. Vendor rebates attributable to unsold inventory are carried as a reduction of the carrying value of inventory
until such inventory is sold, at which time the related rebates are used to reduce cost of sales.



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Allowance for Doubtful Accounts



The Company records an allowance for doubtful accounts for estimated losses resulting from the inability to collect accounts receivable from customers.
The Company establishes the allowance based on historical experience, credit risk of specific customers and transactions, and other factors. Management believes that the lack of customer concentration is a significant factor that mitigates the
Companys accounts receivable credit risk. Three customers represented 2.1%, 1.7% and 1.6% of consolidated fiscal 2004 sales, respectively, and no other customer comprised as much as 1% of sales. The number of customers and their distribution
across the geographic areas served by the Company help to reduce the Companys credit exposure to a single customer or to economic events that affect a particular geographic region. Although the Company believes that its allowance for doubtful
accounts is adequate, any future condition that would impair the ability of a broad section of the Companys customer base to make payments on a timely basis may require the Company to record additional allowances



Inventory



Inventories consist of HVACR equipment, parts and supplies and are valued at the lower of cost or market value using the
average cost method. Substantially all inventories represent finished goods held for sale; raw materials represent less than 1% of inventories. When necessary, the carrying value of obsolete or excess inventory is reduced to estimated net realizable
value. The process for evaluating the value of obsolete or excess inventory requires estimates by management concerning future sales levels and the quantities and prices at which such inventory can be sold in the ordinary course of business.



The Company holds a substantial amount of HVACR equipment
inventory at several branches on consignment from a supplier. The terms of this arrangement provide that the inventory is held for sale in bonded warehouses at the branch premises, with payment due only when products are sold. The supplier retains
legal title and substantial management control with respect to the consigned inventory. The Company is responsible for damage to and loss of inventory that may occur at its premises. The Company has the ability to return consigned inventory, at its
sole discretion, to the supplier for a specified period of time after receipt of the inventory. The terms of the arrangement further provide that the supplier may require the Company to purchase consigned inventory not sold within a specified period
of time. Historically, most consigned inventory is sold before the specified purchase date, and the supplier has never enforced its right to demand payment, instead permitting such inventory to remain on consignment.



This consignment arrangement allows the Company to have inventory available
for sale to customers without incurring a payment obligation for the inventory prior to a sale. Because of the control retained by the supplier and the uncertain time when a payment obligation will be incurred, the Company does not record the
consigned inventory as an asset upon receipt with a corresponding liability. Rather, the Company records a liability to the supplier only upon sale of the inventory to a customer. The amount of the consigned inventory is disclosed in the
Companys financial statements as a contingent obligation.



Interest Rate
Derivative Instruments



The Company has an interest rate
derivative that does not qualify as a hedge, in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. The fair value of the derivative instrument is
reflected on the Companys balance sheets, and changes in the fair value of such derivatives are recorded as unrealized gains or losses, as applicable, in the Companys statements of operations as interest derivative loss or gain. Payments
received or paid by the Company during the term of the derivative contract as a result of



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differences between the fixed interest rate of the derivative and the market interest rate are also recorded as interest derivative loss or gain.



Item 3.Quantitative and Qualitative Disclosures About Market Risk



The Company was subject to market risk exposure related to changes in interest rates on its senior credit facility, which included revolving credit and
term notes. These instruments bear interest at a pre-agreed upon percentage point spread from either the prime interest rate or LIBOR. Under its senior credit facility the Company may, at its option, elect the interest rate for certain borrowings to
be based on a spread over LIBOR for 30 days to three months. At August 31, 2004 the Company had $24.5 million outstanding under its senior credit facility, of which $16.5 million is subject to variable interest rates. Based on this balance, an
immediate change of one percent in the interest rate would cause a change in annualized interest expense of approximately $165,000, or $.02 per share, on an annual basis.



As discussed in Note 8, subsequent to the end of the second quarter, the Company entered into a direct financing agreement
with another commercial bank. In connection with the refinancing of the Companys previous credit facility, the value of the Companys interest rate swap was paid in full (See Note 6, above). Under the new agreement all of the principal
balance is subject to variable interest rates. Based on the outstanding balance at August 31, an immediate change of one percent in the interest rate would cause a change in interest expense of approximately $245,000, or $.02 per basic share, on an
annual basis.



Item 4.Controls and Procedures



The Company carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 of the Securities Exchange Act) as of the end of the period covered by
this report. This evaluation was performed under the supervision and with the participation of the Companys management, including the Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, the Chief Executive Officer
and Chief Financial Officer concluded that these disclosure controls and procedures are effective in producing the timely recording, processing, summarizing and reporting of information and in accumulating and communicating of information to
management as appropriate to allow for timely decisions with regard to required disclosure.



No changes were made to the Companys internal control over financial reporting during the last fiscal quarter that materially affected, or are reasonably likely to materially affect the Companys internal
control over the financial reporting.



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PART IIOTHER INFORMATION



Item 1.Legal Proceedings



| |  |      |  | 
| |  | ---- |  | 
| |  | None |  | 



Item 4.Submission of Matters to a Vote of Security Holders



| |  |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |    
| |  | (a) |  | The Companys 2004 Annual Meeting was held on August 19, 2004.                                                                                                                                                                                                                                                                                                                                                                                
| |  |    
| |  | (b) |  | The Companys management solicited proxies pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to the managements nominees
as listed in the proxy statement. The following nominees were elected as indicated in the proxy statement pursuant to the vote of the shareholders; Alex Trevino, Jr., Anthony R. Maresca, A. Stephen Trevino,
Alan D. Feinsilver, and Roland H. St. Cyr.



Item 6.Exhibits and Reports on Form 8-K



|                |  |        |  |                                                                                                                                                                                                          
|--------------- |  | ------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a)    Exhibits
|                |  |       
|                |  | 10.3B  |  | Amendment to Exhibit A of the Employment Agreement between the Company and Anthony R. Maresca effective as of March 1, 2004.                                                                           
|                |  |       
|                |  | 10.19A |  | Amendment to Exhibit A of the Employment Agreement between the Company and A. Stephen Trevino effective as of March 1, 2004.                                                                           
|                |  |       
|                |  | 10.20  |  | Credit Agreement between the Company and Wells Fargo Bank, NA dated September 7, 2004.                                                                                                                   
|                |  |       
|                |  | 31.1   |  | Certificate of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 dated October
15, 2003,
|                |  |       
|                |  | 31.2   |  | Certificate of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 dated October
15, 2003,
|                |  |       
|                |  | 32.1   |  | Certification from the Chief Executive Officer of ACR Group, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                              
|                |  |       
|                |  | 32.2   |  | Certification from the Chief Financial Officer of ACR Group, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                              



|(b) | Reports on Form 8-K.
|--- | --------------------



The Company filed an 8-K on July 6, 2004, filing its financial results for its first fiscal quarter ended May 31, 2004. A copy of the
Companys press release was attached as Exhibit 99.1 to the Form 8-K.



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The Company filed an 8-K on
September 13, 2004, under Item 2.03, Creation of a Direct Financing Agreement.



The Company filed an 8-K on October 8, 2004, under Item 4.02(a), Non- Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review, and Item 9.01, Financial Statements and
Exhibits, filing a press release. A copy of the Companys press release was attached as Exhibit 99.1 to the Form 8-K.



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SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                 |  |  |  |                                                                     
|---------------- |  |  |  | --------------------------------------------------------------------
|                 |  |  |  | ACR GROUP, INC.                                                     
|                 |  | 
|October 15, 2004 |  |  |  | /s/ Anthony R. Maresca                                              
|Date             |  |  |  | Anthony R. Maresca Senior Vice-President and Chief Financial Officer



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