A. O. Smith Corporation — Q2 2020 Form 10-Q
Reporting period: Three and six months ended June 30, 2020. The company manufactures water heaters, boilers, water-treatment products and, in China, air purifiers. Its reporting segments are North America and Rest of World. Results were materially affected by the COVID-19 pandemic. Financial statements are unaudited.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net sales | $663.9 million | $765.4 million | $1,300.8 million | $1,513.6 million |
| Gross profit | $247.5 million | $308.7 million | $487.0 million | $601.5 million |
| Gross margin | 37.3% | 40.3% | 37.4% | 39.7% |
| Net earnings | $67.8 million | $102.1 million | $119.5 million | $191.4 million |
| Diluted EPS | $0.42 | $0.61 | $0.74 | $1.14 |
| Operating cash flow | Not separately stated for the quarter | $179.3 million | $143.7 million |
- Q2 sales decreased about 13%; first-half sales decreased about 14%. Lower China sales and lower North American commercial water-heater and boiler volumes were the main factors.
- Q2 SG&A fell $22.8 million year over year and first-half SG&A fell $33.7 million, primarily due to lower selling and advertising expenses. Q2 included $6.1 million of severance and restructuring charges ($5.0 million after tax); adjusted Q2 diluted EPS was $0.45 versus GAAP EPS of $0.42.
- First-half capital expenditures were $24.8 million, down from $36.5 million. Cash and cash equivalents were $442.7 million at June 30, compared with $374.0 million at year-end; marketable securities were $126.0 million, bringing cash and securities to $568.7 million.
- Total debt was $281.1 million, compared with $284.0 million at December 31, 2019. The company reported $332 million of available capacity under its $500 million revolving facility and compliance with its financial covenants. Debt-to-total-capitalization, excluding operating leases, was 14.5%.
- Working capital was $709.0 million, down $24.9 million from year-end. The company reported current assets of $1,444.4 million and current liabilities of $735.4 million.
Segment and period comparisons
- North America: Q2 sales were $480.5 million, down from $524.0 million; segment earnings were $105.4 million versus $122.9 million. Q2 segment margin was 21.9%, versus 23.5%. Water-treatment sales grew organically about 19% in Q2; lower commercial volumes and a shift toward lower-priced electric water heaters weighed on results. Pandemic-related costs were approximately $5.5 million in Q2. First-half sales were $1,013.4 million versus $1,045.8 million, and segment earnings were $232.5 million versus $238.9 million.
- Rest of World: Q2 sales were $189.7 million versus $249.1 million, and the segment recorded a $5.8 million loss versus earnings of $22.4 million. First-half sales were $299.9 million versus $481.2 million, and the segment recorded a $48.0 million loss versus earnings of $34.7 million. China sales declined 20% in local currency in Q2 and 38% in the first half; India was affected by shutdowns. Weaker demand, lower customer inventories, currency effects, and a shift toward mid-priced products contributed to declines.
- North America water-treatment growth, including $16 million of first-half incremental Water-Right sales, partially offset declines elsewhere. Water-Right was acquired in April 2019 for $107 million.
Outlook, commentary and risks
- Management projected 2020 consolidated sales to decline approximately 7%–8% from 2019. It expected North America water-treatment sales to grow 20%–22%, China sales to decline 18%–20% in local currency, and U.S. residential water-heater demand to be flat. Expected weakness in commercial water heaters and boilers was forecast to more than offset water-treatment growth.
- Full-year 2020 EPS guidance was $1.69–$1.83 GAAP and $1.72–$1.86 adjusted, excluding severance and restructuring costs and potential future acquisitions. Expected segment margins were 22.5%–23.0% for North America and negative 2.5% to negative 1.0% for Rest of World.
- Management expected approximately $350 million of operating cash flow, $60–$70 million of capital expenditures, and approximately $80 million of depreciation and amortization for 2020. Guidance assumed business conditions did not deteriorate further due to pandemic restrictions or shutdowns.
- China operations closed for about four weeks early in 2020; global manufacturing continued without material disruption through the filing date. Management reported no meaningful supply-chain disruption to date, but noted safety measures could reduce efficiency. It cited replacement demand as a potential buffer: an estimated 80%–85% of U.S. water-heater and boiler units sold relate to replacement business.
- Risks include the duration and severity of COVID-19 and its effects on demand, operations, suppliers and customers; China’s economic recovery and consumer spending; U.S. construction and boiler markets; raw-material price and availability volatility; foreign exchange; tariffs and trade disputes; competition; and cybersecurity. The company used currency and commodity hedges and stated it did not speculate in derivatives.
- The company suspended share repurchases on March 18, 2020; it repurchased 1.35 million shares for $56.7 million in the first half. The board declared a $0.24-per-share quarterly dividend payable August 17, 2020.
- A $500 million securities class action was dismissed in full by court order on June 24; final judgment for defendants was entered August 3, 2020. Two related shareholder derivative lawsuits remained stayed. The company reported that it was not required to make, and did not plan to make, a 2020 pension contribution.
Important facts for investors to verify
- Whether pandemic-related demand, operating costs, or renewed restrictions caused actual results to diverge from management’s 2020 guidance assumptions.
- Whether China sales, customer inventory levels, and the shift to mid-priced products recovered as expected, and whether Rest of World losses narrowed.
- Whether North America water-treatment growth and the Water-Right contribution offset commercial water-heater and boiler weakness.
- Whether operating cash flow, liquidity, and access to the revolving facility remained adequate; the filing reported $327 million of cash and securities held by foreign subsidiaries.
- Developments in the stayed derivative litigation and any changes in the company’s other disclosed risks or contingencies.