A. O. Smith Corporation — FY 2013 Form 10-K
Reporting period: Fiscal year ended December 31, 2013. The filing also reports fourth-quarter results. Unless otherwise indicated, amounts are in millions of dollars.
Business context and reporting period
A. O. Smith manufactures residential and commercial water heaters, boilers and related products, with operations reported in North America and Rest of World. Rest of World is led by China, with operations also in Europe, India and other markets. The Electrical Products business was sold in 2011 and is reported as discontinued operations.
Financial results and liquidity
| Metric | FY 2013 | FY 2012 |
|---|---|---|
| Net sales | $2,153.8 | $1,939.3 |
| Gross profit / gross margin | $773.8 / 35.9% | $652.0 / 33.6% |
| Earnings from continuing operations | $169.7 | $162.6 |
| Diluted continuing-operations EPS | $1.83 | $1.75 |
| Operating cash flow from continuing operations | $282.2 | $171.8 |
| Capital expenditures | $97.7 | $69.9 |
| Total debt | $191.9 | $243.7 |
| Cash and marketable securities | $486.0 | $462.9 |
- Sales increased 11.1%; growth reflected China and higher U.S. water-heater and boiler volumes. The effective tax rate declined to 28.2% from 30.4%.
- North America sales were $1,520.0, up 6.2%; segment operating earnings were $211.9 versus $199.8, with a 13.9% reported margin. Adjusted segment earnings were $237.7 and adjusted margin was 15.6%.
- Rest of World sales were $668.0, up 23.1%; segment operating earnings rose to $88.0 from $59.6, and margin improved to 13.2% from 11.0%. China-branded sales increased 26.1% to $565.2.
- Working capital was $614.7 versus $608.3. Year-end total debt to total capitalization was 12.6%, compared with 16.9% a year earlier. The company reported $267.5 of available borrowing capacity under its $400 million revolving facility and compliance with its covenants.
- All $486.0 of cash, cash equivalents and marketable securities were held by foreign subsidiaries. The company reported repatriation costs and related accruals; see the tax and liquidity discussion below.
Material changes and unusual items
- Gross margin improved by 2.3 percentage points, attributed to U.S. volume growth, lower U.S. material costs, and stronger China sales and product mix.
- Cash provided by continuing operations increased by $110.4, primarily from higher operating earnings and lower working-capital outlays. Capital expenditures rose to $97.7, including investment in China, India and the new ERP system.
- The company recorded $22.0 of pre-tax restructuring and impairment costs for the transfer of residential water-heater production from Fergus, Ontario. Management forecast approximately $10 of pre-tax savings in 2014.
- A $11.0 pre-tax supplier settlement gain was recorded in 2013. The 2012 comparison included a $27.2 gain on the sale of Regal Beloit shares and other investment income; that share-sale gain did not recur in 2013.
- Reported diluted continuing EPS was $1.83; company-defined adjusted EPS, a non-GAAP measure, was $2.06. The reconciliation adjusts for pension costs, restructuring and impairment, and settlement income, among other items.
- The company repurchased 1.77 million shares for $73.7 and paid $42.6 in dividends. It declared a two-for-one stock split in 2013; share and per-share data are restated in the filing.
Fourth-quarter results
Fourth-quarter 2013 sales were $558.9 versus $524.2 in the prior-year quarter. Continuing-operations earnings were $42.4 versus $43.1; diluted continuing EPS was $0.46 in both periods. The filing does not provide a clear quarterly explanation for the year-over-year earnings decline.
Guidance, outlook, risks and contingencies
- For 2014, management forecast GAAP EPS of $2.01–$2.16 and adjusted EPS of $2.15–$2.30, excluding potential acquisitions. It expected operating cash flow of $235–$245, capital expenditures of $75–$85, and depreciation and amortization of approximately $65.
- Management anticipated North American residential and commercial water-heater industry unit growth of 1%–2% each, Lochinvar-branded sales growth above 10%, and China sales growth at approximately twice China GDP growth. Its 2015 aspirations were organic sales above $2.5 billion and GAAP EPS of $2.50 for the existing business portfolio.
- Management cited approximately $10 of incremental 2014 ERP costs and a higher effective tax rate as offsets to growth and restructuring savings. The new Nanjing plant, opened in October 2013, is expected to add 50% capacity when fully utilized.
- Key risks include China economic and growth exposure; customer concentration (the five largest customers represented approximately 38% of sales); steel and other input-price volatility; competition and pricing; execution of the ERP rollout; foreign exchange and international operating risks; regulatory energy-efficiency standards taking effect in 2015; and product liability, warranty and impairment exposure.
- The U.S. defined-benefit pension plan was underfunded by approximately $114.7 at year-end. No contribution was forecast for 2014, but future contributions may be required. Pension expense was $27.9 in 2013; management estimated approximately $28.3 for 2014.
- Cash held by foreign subsidiaries was approximately $486 at year-end; the filing reports $699.6 of undistributed foreign earnings, of which $428.6 was considered permanently reinvested. Repatriation may incur tax costs. Legal and environmental matters were described as ordinary-course matters with reserves and insurance; management did not expect a material adverse effect.
- The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting. Management also concluded disclosure controls and internal control over financial reporting were effective at year-end.
Important facts for investors to verify
- Whether China sales growth and utilization of the new Nanjing capacity meet management’s expectations, and how China’s economic conditions affect demand.
- Whether ERP implementation costs, timing and expected benefits align with guidance, and whether the system causes operational disruption.
- Whether restructuring savings, U.S. volume growth, material costs and the 2014 effective tax rate support the EPS and cash-flow forecasts.
- The location, accessibility and potential repatriation tax cost of foreign cash, including the distinction between cash balances and permanently reinvested earnings.
- Customer concentration, pension funding assumptions and obligations, and changes in product-liability or warranty reserves.
- That adjusted EPS and adjusted segment results are non-GAAP measures; compare them with GAAP results and review the company’s reconciliation and adjustment definitions.