A. O. Smith Corporation — Q2 2015 Form 10-Q
Business context and period. The company manufactures residential and commercial water heaters and related products. Its two reporting segments are North America and Rest of World, which includes China, Europe, and India. This unaudited report covers the quarter and six months ended June 30, 2015; comparisons are with the corresponding 2014 periods.
Financial performance
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Net sales | $653.5 million | $595.4 million | $1,272.0 million | $1,147.6 million |
| Gross profit | $263.3 million | $216.2 million | $492.5 million | $412.1 million |
| Gross margin | 40.3% | 36.3% | 38.7% | 35.9% |
| Operating earnings | $116.9 million | $92.5 million | $214.3 million | $172.9 million |
| Net earnings | $71.1 million | $57.3 million | $129.5 million | $104.0 million |
| Diluted earnings per share | $0.79 | $0.63 | $1.44 | $1.14 |
- Q2 sales rose about 10% and six-month sales about 11%. Growth reflected North American pricing, stronger Lochinvar sales, and higher water-heater and water-treatment sales in China.
- Q2 operating margin was approximately 17.9%, versus 15.5%; for the first six months it was approximately 16.8%, versus 15.1%.
- Q2 North America sales increased 8% and operating earnings increased about 36%; six-month operating earnings rose about 33%. Higher prices, boilers, lower pension costs, and—in Q2—lower steel costs supported results.
- Rest of World sales increased about 14% in Q2, including 15% growth in China. Segment operating earnings increased about 5%, while its operating margin declined to 14.0% from 15.1% in Q2, largely due to higher China selling, advertising, and engineering expenses and India product-launch costs.
- SG&A increased $22.9 million in Q2 and $39.2 million in the first half, primarily reflecting China-related selling and engineering costs and expected higher ERP implementation costs. Interest expense also rose, partly due to higher debt and the cost of new term notes.
Cash, liquidity, and capital
- Cash and cash equivalents were $248.1 million at June 30, 2015, compared with $319.4 million at year-end. Marketable securities were $304.3 million, bringing cash and securities to $552.4 million; all were held by foreign subsidiaries. The company had accrued $50.7 million for repatriation of a portion of these funds.
- First-half cash provided by operating activities was $58.2 million ($58.8 million from continuing operations), down from $89.8 million ($90.9 million from continuing operations) in 2014. Higher earnings were more than offset by working-capital outlays. Working capital was $820.9 million, up $107.1 million from year-end.
- Capital expenditures were $31.0 million in the first half, versus $50.8 million a year earlier. Investing cash outflow was $112.6 million; financing cash outflow was $16.9 million. Cash declined $71.3 million during the period.
- Total debt was $279.6 million, up $55.8 million from year-end; debt-to-total-capitalization was 16.3%, versus 13.9%. The company issued $75 million of 3.52% term notes in January, maturing in 2030, and used the proceeds to reduce revolver borrowings.
- The $400 million revolving credit facility expires in December 2017; available borrowing capacity was $226.6 million. The company reported compliance with its leverage and interest-coverage covenants and expects available capacity and operating cash flow to fund operations.
- First-half share repurchases totaled $47.3 million, and dividends paid were $34.0 million. The company had 1,769,206 shares remaining under its repurchase authorization at June 30.
Outlook, risks, and notable items
- Management increased 2015 guidance to GAAP earnings of $3.04–$3.09 per share, excluding potential future acquisitions. It forecast organic worldwide revenue growth of about 11%, operating cash flow of about $300 million, capital expenditures of $100–$110 million, and depreciation and amortization of about $65 million.
- Management expected U.S. residential water-heater industry shipments to rise about 2%, commercial shipments about 4%, Lochinvar sales about 10%, and China sales to grow at about twice China GDP growth. It cited improving demand, product mix and market-share gains, and continued lower material costs.
- The NAECA III residential water-heater efficiency rules took effect April 16, 2015. The transition was completed in Q2; compliance raised manufacturing costs, with associated price increases.
- Pension expense was minimal in the first half, compared with $13.2 million in 2014, following the pension plan sunset for most employees at year-end 2014. The company expected no required or voluntary pension contribution in 2015.
- The 2015 effective tax rate was 30.4% for the first half; management estimated about 30.5% for the full year. The higher rate reflected geographic earnings mix; 2014 benefited from a one-time tax benefit.
- Key stated risks include ERP implementation costs, savings and timing; boiler-market weakness; raw-material price volatility; competitive and pricing pressures; construction and replacement-market demand; slower Chinese growth; currency fluctuations; acquisition execution; and adverse economic or capital-market conditions. The company uses currency and commodity hedges and states that it does not speculate.
- Management reported effective disclosure controls. A significant ERP implementation phase was completed in Q2, with controls tested and monitored. The filing reported no material changes to previously disclosed legal and environmental matters.
Important facts for investors to verify
- Whether the revenue and margin gains—especially in North America—persist after NAECA III-related pricing and lower steel costs.
- Whether Rest of World investment and launch costs moderate, and whether China growth and margins meet management’s expectations.
- Whether working-capital demands, overseas cash availability, and planned repurchases affect cash generation and borrowing needs.
- Whether the ERP rollout stays within expected cost and timing and whether associated control changes remain effective.
- Whether full-year EPS, revenue, operating-cash-flow, and capital-expenditure guidance is achieved; the filing cautions that forward-looking results are subject to risks.