SMITH A O CORP quarterly report, Q2 FY2018

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A. O. Smith Corporation — Q2 2018 Form 10-Q

Reporting period: Three and six months ended June 30, 2018. The company manufactures water heaters, boilers and water-treatment products, with North America and Rest of World reporting segments; Rest of World is primarily China, Europe and India. Amounts below are in U.S. dollars unless stated otherwise.

Financial performance

  • Q2 revenue: $833.3 million, up 13% from $738.2 million. First-half revenue was $1.621 billion, up 10% from $1.478 billion.
  • Profit: Q2 net earnings were $114.5 million versus $92.4 million; diluted EPS was $0.66 versus $0.53. First-half net earnings were $213.3 million versus $180.1 million; diluted EPS was $1.23 versus $1.03. First-half adjusted EPS, excluding restructuring and impairment costs, was $1.26 versus $1.03.
  • Margins: Gross margin was 40.9% in both Q2 and the first half, compared with 41.2% in Q2 2017 and 40.9% in first-half 2017. Higher steel and other input costs offset sales mix and U.S. pricing benefits. Q2 North America segment margin was 23.4% versus 23.2%; Rest of World was 11.3% versus 11.9%.
  • Segments: Q2 North America sales were $534.2 million, up from $470.7 million, and segment earnings were $124.9 million versus $109.2 million. Rest of World sales were $308.1 million versus $272.8 million; segment earnings were $34.7 million versus $32.5 million. First-half segment earnings were $230.9 million in North America and $70.7 million in Rest of World, versus $213.4 million and $65.0 million, respectively.
  • Cash flow: First-half operating cash flow was $173.2 million versus $73.2 million. Capital expenditures were $39.5 million versus $36.3 million. Cash and cash equivalents fell to $260.0 million from $346.6 million at year-end; marketable securities were $398.4 million.
  • Liquidity and debt: Working capital was $884.6 million, down $88.5 million from year-end. Total debt was $248.1 million, down $162.3 million; debt-to-total-capitalization was 12.5%, versus 20% at year-end. The $500 million revolving facility had $374.6 million of available capacity, and the company reported compliance with its financial covenants. It said substantially all of its $658.4 million in cash, cash equivalents and marketable securities was held by foreign subsidiaries.
  • Shareholder returns: First-half dividends paid were $61.8 million and share repurchases were $69.7 million. The quarterly dividend was $0.18 per share, up from $0.14 a year earlier. In July, the board authorized an additional 2.5 million shares for repurchase.

Changes, outlook and management commentary

  • Q2 and first-half growth reflected higher North American water-heater and boiler sales, pricing, and China revenue. China sales rose about 12% in reported dollars in both periods, including favorable currency translation of approximately $19 million in Q2 and $40 million in the first half; local-currency growth was about 4%.
  • Management forecast 2018 consolidated sales growth of 9.5%–10%, GAAP EPS of $2.56–$2.60, and adjusted EPS of $2.59–$2.63. The adjusted measure excludes restructuring and impairment expenses and potential future acquisitions. Expected operating cash flow was approximately $475 million; capital expenditures approximately $100 million.
  • Expected 2018 North America adjusted segment margin was 22.25%–22.5%. Management expected Rest of World full-year margin to be equal to or slightly below 2017’s 13.4%. China local-currency sales were expected to grow about 5% for the year, with approximately 6% growth in the second half; management cited high channel inventory and slower housing-market growth as concerns. India sales were expected to grow more than 40%, while India losses were forecast to decline from $7.5 million in 2017 to $5 million in 2018.
  • North America water-treatment sales were expected to grow more than 75%, supported by the Hague acquisition and new Lowe’s business. Management expected approximately $15 million of Lowe’s sales and a $1 million–$2 million loss from startup and transition costs in 2018. The brand transition was to begin in August.
  • The company recorded $6.7 million of first-half restructuring and impairment costs for moving production from Renton, Washington, including severance, lease-exit costs and asset impairment; the move was substantially complete by June 30. First-half adjusted results add back the net-of-tax effect of these charges.
  • The effective tax rate was 21.6% in Q2 and 21.4% in the first half, compared with 27.8% and 27.5% a year earlier. Management expected a full-year 2018 rate of approximately 21.5%–22%, primarily reflecting U.S. tax reform. The company was still evaluating the accounting policy for GILTI; no tax-reform adjustment was recorded in the first half against the provisional 2017 amounts.

Risks, contingencies and other notable items

  • Management identified risks including slower Chinese economic, housing or consumer growth; elevated China channel inventory; raw-material price volatility and inability to sustain pricing; weaker U.S. construction or replacement demand; foreign-exchange movements; tariffs and trade disputes; competition; acquisition integration; cybersecurity incidents; and regulatory or tax changes.
  • Foreign-currency and commodity exposures are managed with derivatives; the company said it does not speculate. No commodity futures contracts were outstanding at June 30. Foreign-currency movements contributed to reported China sales and earnings comparisons.
  • The warranty liability was $142.9 million at June 30, 2018, versus $140.8 million a year earlier. The company reported $6.2 million of unrecognized tax benefits and ongoing potential U.S., state and non-U.S. tax examinations. It reported no material changes to previously disclosed legal and environmental matters.
  • The company adopted the new revenue-recognition standard using the full retrospective method, recording a $3.9 million after-tax reduction to opening retained earnings as of January 1, 2016; adoption did not materially affect the reported financial statements. Management said interim results are not necessarily indicative of full-year results.

Important facts for investors to verify

  • Whether U.S. pricing actions offset steel, freight and other cost inflation without further gross-margin pressure.
  • Whether China local-currency demand, channel inventories and air-purifier and e-commerce sales develop in line with management’s outlook, and how currency translation affects reported results.
  • Whether the Lowe’s water-treatment launch delivers forecast sales and whether startup costs and Hague-related growth affect margins as expected.
  • Whether the company achieves its 2018 sales, EPS, cash-flow, capital-expenditure and segment-margin guidance.
  • How much of the reported cash and marketable securities held by foreign subsidiaries is available for U.S. needs, and the subsequent pace of debt reduction, dividends and share repurchases.
  • Developments in tax-reform and GILTI estimates, tax examinations, and the adequacy of warranty and other contingencies.