A. O. Smith Corporation — Q1 2018 Form 10-Q
Business context and reporting period. Unaudited results cover the three months ended March 31, 2018, compared with Q1 2017. A. O. Smith manufactures water heaters, boilers and water treatment products. Its reporting segments are North America and Rest of World, principally China, Europe and India. The company adopted the revenue recognition standard using the full retrospective method; it reported no material impact on its financial statements.
Financial performance
| Metric | Q1 2018 | Q1 2017 |
|---|---|---|
| Net sales | $788.0 million | $740.0 million |
| Gross profit / margin | $321.5 million / 40.8% | $300.9 million / 40.7% |
| Earnings before income taxes | $125.4 million | $120.4 million |
| Net earnings | $98.8 million | $87.7 million |
| Diluted EPS | $0.57 | $0.50 |
| Operating cash flow | $43.2 million provided | $11.5 million used |
| Capital expenditures | $17.3 million | $16.8 million |
- Net sales grew 6.5%; net earnings rose about 13% and diluted EPS rose 14%. The effective tax rate fell to 21.2% from 27.2%, primarily reflecting U.S. tax reform.
- North America sales were $501.7 million, up from $487.3 million; segment earnings were $106.0 million versus $104.2 million. Reported segment margin was 21.1%, compared with 21.4%; adjusted margin was 22.5%.
- Rest of World sales were $293.8 million, up from $259.5 million; segment earnings were $36.1 million versus $32.5 million. Segment margin eased to 12.3% from 12.5%.
- Cash and cash equivalents were $241.9 million and marketable securities were $437.8 million at quarter-end. Working capital was $902.2 million. Total debt was $293.2 million, down from $410.4 million at year-end; debt to total capitalization declined to 14.6% from 20%.
- The company reported $122.6 million of comprehensive earnings, including $18.4 million of foreign currency translation adjustments.
Material changes and notable items
- Rest of World sales growth was led by China. China sales increased 13%, including approximately $21 million from currency translation; currency translation added about $3 million to Rest of World segment earnings.
- North America growth reflected higher boiler volumes, pricing actions and the addition of Hague water treatment sales. Water treatment added approximately $8 million of North America sales.
- Q1 included $6.7 million of restructuring and impairment expenses for the planned transfer of production from the Renton, Washington facility to other U.S. plants: $4.0 million severance and compensation, $2.1 million lease exit costs and $0.6 million asset impairment. Most of the consolidation was expected in the first half of 2018. Adjusted earnings and adjusted EPS, which exclude the charge, were $103.8 million and $0.60, respectively, versus GAAP net earnings of $98.8 million and diluted EPS of $0.57.
- Operating cash flow improved year over year, primarily due to higher earnings and lower working-capital outlays. The company used approximately $212 million of repatriated foreign cash primarily to repay floating-rate debt, and also funded repurchases and dividends. Essentially all $679.7 million of cash, cash equivalents and marketable securities was held by foreign subsidiaries.
- Q1 share repurchases totaled 520,400 shares for $33.1 million; dividends paid were $31.0 million. The board declared a $0.18-per-share dividend payable May 15, 2018.
Outlook, risks and contingencies
- Management forecast 2018 consolidated sales growth of 10%–10.75%; GAAP EPS of $2.52–$2.58 and adjusted EPS of $2.55–$2.61, excluding potential future acquisitions. The midpoint of EPS guidance was increased following Q1 performance and expected organic growth.
- Expected 2018 operating cash flow was approximately $475 million; capital expenditures approximately $100 million; depreciation and amortization approximately $80 million. Management expected a full-year effective tax rate of about 22%.
- North America outlook included expected 3%–3.5% industry unit growth for residential water heaters and about 10% boiler sales growth. A roughly 10% U.S. wholesale water-heater price increase was to take effect in early June to address steel, freight and other cost inflation. Management expected water treatment sales to rise more than 75%, supported by Hague, organic growth and new Lowe’s business; it projected approximately $15 million of Lowe’s sales and $1–$2 million of related startup and transition losses in 2018.
- Management expected China sales growth of about 9%–10% in local currency, or over 14% in U.S. dollar terms, and India sales growth of over 40%. Full-year Rest of World segment margin was expected to exceed 2017 by 30–40 basis points; North America adjusted segment margin guidance was 21.75%–22.25%.
- Risks cited include slower Chinese economic or consumer growth, weaker U.S. construction or replacement markets, raw-material price volatility and inability to sustain pricing, foreign-exchange movements, tariffs and trade disputes, competition, acquisition integration, cybersecurity and regulatory changes, and uncertainty in tax-reform effects.
- The company had $334.2 million of available borrowing capacity under its $500 million revolving credit facility and reported compliance with its leverage and interest-coverage covenants. Management believed liquidity and operating cash flows would fund operations for the foreseeable future. No material changes to previously reported legal and environmental matters were disclosed; tax returns remain subject to examination.
Important facts for investors to verify
- Whether planned price increases offset steel, freight and other cost inflation, and whether segment margins meet guidance.
- Execution and profitability of the Lowe’s transition, including the projected sales and startup losses, and completion costs or savings from the Renton consolidation.
- China and India growth assumptions, including the effects of currency translation, customer pre-buying and weaker air-purification sales.
- Cash generation, foreign cash availability and use of funds for debt repayment, dividends and the planned share repurchases.
- Final tax-reform and GILTI accounting effects, and the company’s ability to achieve its 2018 EPS and tax-rate guidance.