A. O. Smith Corporation — Q1 2017 Form 10-Q
Business context and period: Unaudited results for the three months ended March 31, 2017, compared with the same 2016 period. The company manufactures and markets water heaters, water-treatment products, boilers, water-system tanks and, in China, air purifiers. Its reporting segments are North America and Rest of World.
Financial performance
- Revenue: $740.0 million, up 16% from $636.9 million; up approximately 18% excluding the effect of U.S.-dollar appreciation against Chinese currency.
- Profit: Gross profit was $302.3 million versus $262.7 million. Gross margin was 40.9%, down from 41.2%, with higher steel and other input costs cited. Net earnings rose to $87.7 million from $73.5 million. Diluted EPS was $0.50 versus $0.41; dividends per share were $0.14 versus $0.12.
- Cash flow: Operating activities used $11.5 million, compared with $26.5 million provided a year earlier, as working-capital outlays more than offset higher earnings. Capital expenditures were $16.8 million versus $19.4 million.
- Liquidity: Cash and cash equivalents were $293.4 million and marketable securities $428.9 million, totaling $722.3 million. Working capital was $885.0 million. Management said essentially all cash, cash equivalents and marketable securities were held by foreign subsidiaries; $37.8 million was accrued for repatriation of a portion of the funds.
- Debt: Total debt was $369.4 million at quarter-end, up $45.8 million from year-end 2016; debt-to-total-capitalization was 19.1%, versus 17.6%. Available borrowing capacity under the $500 million revolving facility was $265.0 million. The company reported compliance with facility covenants.
- Segments: North America sales were $487.3 million (up from $423.9 million) and operating earnings $104.2 million (up from $91.9 million); operating margin was 21.4% versus 21.7%. Rest of World sales were $259.5 million (up from $217.4 million) and operating earnings $32.5 million (up from $26.9 million); operating margin was 12.5% versus 12.4%.
Material changes and management commentary
- North America growth reflected higher U.S. and Canadian residential and commercial water-heater volumes, pricing actions, and $10.3 million of sales from Aquasana, acquired in August 2016. Higher volumes and pricing lifted segment earnings, partly offset by input costs. Aquasana’s lower margins weighed on segment margin.
- Rest of World growth was driven largely by China: sales rose 20% in U.S.-dollar terms and 27% in local currency, including customer pre-buying ahead of a price increase. Higher China selling and advertising costs partially offset sales growth; currency translation reduced segment earnings by approximately $2 million.
- Q1’s 27.2% effective tax rate was below 29.0% a year earlier, primarily due to discrete tax benefits on settled stock-based awards and a more favorable geographic earnings mix. Management estimated a full-year 2017 rate of approximately 28.75%–29%.
- Q1 comprehensive earnings were $98.7 million, compared with $82.6 million. The filing reports foreign-currency translation adjustments, derivative gains/losses and pension-related changes in other comprehensive earnings.
Outlook, risks and notable items
- Management forecast 2017 total sales growth of 9%–10%, or 10.5%–11.5% in local-currency terms, and raised the midpoint of full-year EPS guidance to $2.03–$2.09, excluding potential future acquisitions.
- Company forecasts included approximately $375 million of operating cash flow, approximately $100 million of capital expenditures (including about $45 million for China capacity expansion), and approximately $70 million of depreciation and amortization. Management expected North America operating margin of 21.5%–22% and Rest of World margin above 14%.
- Management expected China sales growth above 15% in local currency, India sales growth above 30%, and Aquasana to add nearly $40 million to 2017 sales. These are forecasts, not reported results.
- The company repurchased 606,850 shares for $30.1 million during Q1 and expected to spend approximately $135 million on repurchases through its automatic trading plan in 2017, with possible additional opportunistic repurchases of $65 million. The board declared a $0.14-per-share dividend payable May 15, 2017.
- Key stated risks include slower Chinese economic or consumer-spending growth, weaker U.S. construction or replacement demand, raw-material price volatility, inability to sustain pricing, foreign-exchange movements, competition, acquisition integration, cybersecurity, regulatory changes and adverse economic or political conditions.
- The filing reported no material change in legal and environmental matters from the 2016 Form 10-K. Management reported disclosure controls effective as of March 31, 2017, with no significant quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether sales growth and EPS guidance were achieved, and how much growth depended on China, customer pre-buying, pricing and acquisitions.
- Whether higher steel and other input costs, pricing actions, and Aquasana’s lower margins changed subsequent gross and segment margins.
- Whether working-capital demands reversed and operating cash flow approached management’s $375 million full-year forecast.
- How foreign-held liquidity, repatriation costs, debt levels, planned buybacks and the $265 million available facility capacity affected capital flexibility.
- The filing says the company was not required to contribute to its U.S. pension plan and did not anticipate a 2017 contribution; elsewhere in MD&A it says a contribution was required but no voluntary contribution was planned. Clarify this apparent inconsistency.