A. O. Smith Corporation — FY 2016 Form 10-K
Business and reporting period. Annual report for the fiscal year ended December 31, 2016. The company manufactures water heaters, boilers, water treatment products and, in China, air purification products. Its reporting segments are North America and Rest of World, principally China, Europe and India.
Financial performance
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Net sales | $2,685.9 million | $2,536.5 million | +5.9% |
| Gross margin | 41.7% | 39.8% | +1.9 percentage points |
| Net earnings | $326.5 million | $282.9 million | +15.4% |
| Diluted EPS | $1.85 | $1.58 | +17.1% |
| Cash from operating activities | $446.6 million | $351.7 million | +$94.9 million |
| Capital expenditures | $80.7 million | $72.7 million | +$8.0 million |
- North America sales were $1,743.2 million, up 2.4%; operating earnings were $385.9 million and operating margin was 22.1%, versus 20.0% in 2015.
- Rest of World sales were $965.6 million, up 11.5%; operating earnings were $129.1 million and operating margin was 13.4%, versus 13.0% in 2015. China sales rose 12.5% in U.S. dollars and 18.9% excluding currency effects.
- At year-end, cash and cash equivalents were $330.4 million and marketable securities were $424.2 million. Working capital was $796.4 million, compared with $750.1 million in 2015. Nearly all cash and marketable securities were held by foreign subsidiaries.
- Total debt was $323.6 million, up from $249.0 million; debt-to-capitalization was 17.6%, compared with 14.7%. The company had $310.8 million of available borrowing capacity under its credit facility.
Changes, outlook and material matters
- Growth reflected stronger China sales, U.S. pricing and higher U.S. commercial water heater and boiler volumes; lower U.S. residential water heater volumes partly offset these gains. Gross margin improved with U.S. pricing, lower first-half material costs and favorable product mix.
- 2016 included the August acquisition of Aquasana for $85.1 million net of cash acquired. Aquasana contributed $18.4 million of sales and a reported $0.1 million pre-tax loss, including acquisition costs. The company also acquired assets of a small electric water heater manufacturer.
- Operating cash flow benefited from unusually favorable fourth-quarter China working-capital movements, including large customer receipts, higher trade payables and cash received in advance. Management expects 2017 operating cash flow of about $350 million and approximately $800 million over 2016–2017 combined.
- 2017 guidance: sales growth of 8%–9.5% (9.5%–11% in local currencies) and diluted EPS of $1.98–$2.08. Management expects China sales growth of about 15% in local currency, with currency translation a projected $40 million sales headwind. North America operating margin is forecast at 21.5%–22.25%; Rest of World margin is expected to exceed 14%. Forecasts exclude potential acquisitions.
- Management projected 2017 capital expenditures of $90–$100 million, including about $40 million for a new Nanjing facility, and expected steel prices to remain volatile and above the 2016 average. Planned 2017 share repurchases were about $135 million, potentially up to an additional $65 million; the dividend was increased 17% in January 2017.
- Key risks include China growth and currency exposure, steel-price volatility and ability to pass through costs, dependence on a small number of customers (the five largest represented about 37% of 2016 sales), competitive pressures, construction and replacement-market demand, product liability and warranty exposure, and cybersecurity. About $752 million of cash, cash equivalents and marketable securities were held abroad; the company accrued $42.3 million for repatriation taxes on a portion.
- The pension plans were underfunded by approximately $109 million at year-end; no 2017 contribution was forecast, though future funding needs may change. Legal and environmental matters were described as ordinary-course matters, with management believing reserves and insurance adequate and no material adverse outcome expected.
- Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting. Management and the auditor excluded Aquasana from the 2016 internal-control assessment.
Investor verification priorities
- Assess the sustainability of China growth and the projected currency headwind, including the concentration of foreign-held liquidity and potential repatriation costs.
- Track whether pricing offsets higher steel and other input costs, and whether North American residential demand and segment-margin forecasts are achieved.
- Review the drivers and repeatability of fourth-quarter working-capital cash generation against management’s lower 2017 cash-flow outlook.
- Monitor Aquasana integration, profitability and acquisition-related goodwill and intangible-asset valuations.
- Verify customer concentration, pension funding assumptions and the adequacy of warranty and product-liability reserves.