A. O. Smith Corporation — FY 2011 Form 10-K
Reporting period: Fiscal year ended December 31, 2011. Although the request references 2011 Q4, this is an annual filing; fourth-quarter figures are noted separately where provided. Unless stated otherwise, financial amounts are in U.S. dollars and millions.
Business context and reporting period
A. O. Smith manufactures residential and commercial water heaters, boilers, and water treatment products. Its two reporting segments are North America and Rest of World. In August 2011, it sold its Electrical Products business (EPC) to Regal Beloit Corporation (RBC); EPC is presented as discontinued operations for all periods. In August, it also acquired boiler manufacturer Lochinvar for approximately $421 million, plus a contingent payment of up to $35 million.
Following these transactions, the company reorganized its reporting structure in Q4 2011 into geographic segments; historical segment information was revised accordingly.
Key financial metrics
| Metric | FY 2011 | FY 2010 | Change / context |
|---|---|---|---|
| Continuing-operations sales | $1,710.5 | $1,489.3 | Up 14.9% |
| Gross profit margin, continuing operations | 30.0% | 29.9% | Broadly stable |
| Continuing-operations earnings | $111.2 | $57.1 | Diluted EPS: $2.39 vs. $1.24 |
| Net earnings attributable to A. O. Smith | $305.7 | $111.7 | Diluted EPS: $6.57 vs. $2.42; includes discontinued operations and EPC sale gain |
| Operating cash flow, continuing operations | $61.0 | $63.3 | Lower despite stronger earnings, principally due to pension funding |
| Capital expenditures, continuing operations | $53.5 | $53.5 | Unchanged |
| Cash and cash equivalents | $463.4 | $118.9 | $463.3 held by foreign subsidiaries at year-end |
| Total debt | $461.6 | $261.0 | Increase primarily related to Lochinvar acquisition |
| Working capital | $720.3 | $209.5 | Increase primarily reflects EPC sale proceeds, net of acquisition spending |
| Total stockholders’ equity | $1,085.8 | $881.4 | Up year over year |
Fourth-quarter 2011 continuing sales were $475.8 million, compared with $370.2 million in Q4 2010; continuing-operations earnings were $31.5 million versus $20.5 million. Net earnings were $32.1 million in each quarter.
Segment results: North America sales were $1,289.5 million and operating earnings were $154.0 million, compared with $1,155.4 million and $91.2 million in 2010. Rest of World sales were $455.6 million and operating earnings were $42.7 million, compared with $368.9 million and $42.4 million. Rest of World operating margin fell to 9.4% from 11.5%, mainly due to losses and relocation costs at water treatment subsidiary SWT.
Material changes versus the prior comparable period
- Continuing sales rose 14.9%, driven principally by China growth, Lochinvar’s partial-year contribution, pricing actions, higher commercial water heater volumes, and a full year of North American tankless sales.
- China A. O. Smith-branded product sales increased 29% to $371.7 million. India water heater sales more than doubled to $18.1 million.
- Continuing-operations earnings improved, while gross margin was essentially unchanged. Higher-margin Lochinvar and China sales were offset by higher material costs and weaker water treatment margins.
- 2011 reported net earnings include $194.5 million from discontinued operations: $43.0 million of EPC operating earnings and a $151.5 million after-tax gain on sale. The sale generated approximately $760 million cash and 2.83 million RBC shares, valued at $140.6 million at closing. Thus, reported net earnings and EPS are not directly representative of continuing-business performance.
- In 2010, a flood at the Ashland City, Tennessee plant caused a $35.4 million pretax charge after insurance proceeds; the recovery was essentially complete by year-end 2010.
Liquidity, debt, and cash flow
The company reported $61.0 million of cash from continuing operating activities in 2011, versus $63.3 million in 2010. Management attributed the decline mainly to pension contributions; the company elected to contribute $175 million in 2011 despite only a minimal required contribution. The U.S. pension plan was underfunded by approximately $138 million at year-end. No required or voluntary contribution was planned for 2012, but future funding needs are uncertain.
Total debt was $461.6 million, including $18.6 million due within one year. The company had a $425 million revolving credit facility expiring in November 2013 and $61.1 million of available borrowing capacity at year-end. It reported compliance with its leverage and interest-coverage covenants. A substantial $382.5 million of scheduled debt maturities falls in 2013. Management stated that cash, borrowing capacity, anticipated RBC share proceeds, and operating cash flow would fund operations for the foreseeable future.
Guidance, management commentary, risks, and unusual items
- 2012 outlook: Diluted EPS guidance of $2.65–$2.85, excluding potential future acquisitions and RBC share activity. Management expected Lochinvar to add $0.40–$0.50 per share and grow more than 10% in 2012.
- Management forecast 2012 operating cash flow, less the expected Lochinvar earnout, of approximately $145–$155 million; capital expenditures of $80–$90 million; and depreciation and amortization of approximately $55 million.
- Planned capital spending includes approximately $40 million to start a second Nanjing, China water heater plant, expected to add 50% capacity, and expansion of the India plant.
- Management expected China branded sales to grow approximately twice as fast as China GDP; North American residential water heater industry units to be flat and commercial units to decline modestly. A Q4 2011 Southern California regulatory-related pre-buy could weigh on 2012 commercial volumes.
- 2012 pension expense was estimated at approximately $13.5 million, up from $3.3 million in 2011, reflecting lower discount-rate and expected-return assumptions.
- Unusual 2011 items include a $19.8 million net other-income benefit associated with RBC shares and the equity collar, and an $11.2 million pretax vendor settlement gain, partly offset by an $8.2 million warranty provision for a similar component issue in Canada. The RBC collar expires in March 2012; the company did not intend to retain the shares long term.
- Key risks include weak U.S. housing and commercial construction, a Chinese economic slowdown, volatile steel and other input costs, foreign exchange and international operating risks, customer concentration (the five largest customers represented about 38% of continuing sales), competition, pension funding, and the ability to integrate Lochinvar and realize expected growth and synergies. SWT continued to incur losses, and management described its progress as slower than expected.
- The company reported ordinary-course legal, product-liability, and environmental matters and believed reserves and insurance were adequate; it stated that unresolved matters were not expected to materially affect financial position or results. Actual outcomes remain uncertain.
Most important facts for investors to verify
- Separate recurring continuing-business results from the EPC disposal gain and other RBC-related valuation effects when assessing 2011 earnings and EPS.
- Track Lochinvar’s sales growth, acquisition accretion, contingent earnout, and realization of the stated $10–$15 million synergies over the following years.
- Monitor China demand and capacity expansion, and whether SWT can reduce losses and improve margins.
- Review 2012 cash-flow, capital-spending, pension-expense, and EPS outcomes against management’s forecasts, including the large 2013 debt maturities and available refinancing capacity.
- Assess the concentration of cash in foreign subsidiaries, RBC share-sale proceeds and restrictions, and the effect of currency, raw-material, and customer-concentration risks.
- Note that the financial-statement audit opinion was unqualified, but the 2011 internal-control assessment and audit excluded Lochinvar, which contributed $75.9 million of revenue and $5.6 million of net income.