A. O. Smith Corporation — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019. A. O. Smith manufactures and markets residential and commercial water heaters, boilers, water-treatment products and related products. Its two reporting segments are North America and Rest of World, primarily China, Europe and India. Dollar amounts below are in millions except per-share data.
Financial performance
| Metric | Q1 2019 | Q1 2018 |
|---|---|---|
| Net sales | $748.2 | $788.0 |
| Gross profit / margin | $292.8 / 39.1% | $321.5 / 40.8% |
| SG&A | $184.7 | $192.9 |
| Restructuring and impairment | — | $6.7 |
| Earnings before income taxes | $111.6 | $125.4 |
| Net earnings | $89.3 | $98.8 |
| Diluted EPS | $0.53 | $0.57 |
| Dividends per share | $0.22 | $0.18 |
| Cash from operating activities | $21.6 | $43.2 |
| Capital expenditures | $20.9 | $17.3 |
- Sales fell about 5%; net earnings declined about 10%. Gross margin decreased 1.7 percentage points, which management attributed primarily to higher steel and other input costs.
- North America sales rose to $521.8 from $501.7, and segment earnings increased to $116.0 from $106.0. Segment margin was 22.2%, versus 21.1% reported in Q1 2018; the prior-year adjusted margin, excluding restructuring, was 22.5%.
- Rest of World sales fell to $232.1 from $293.8 and segment earnings to $12.3 from $36.1. Segment margin declined to 5.3% from 12.3%, mainly reflecting lower China sales. China sales decreased 23% in U.S. dollars and 18% in local currency; India sales grew approximately 30% in constant currency.
- Cash and cash equivalents were $337.8 at March 31, versus $259.7 at year-end; marketable securities were $295.5, versus $385.3. Together, cash and securities totaled $633.3, essentially all held by foreign subsidiaries. Working capital was $920.9.
- Total debt was $284.4, up $63.0 from year-end; debt due within one year was $6.8. Total debt to total capitalization, excluding operating lease liabilities, was 14.0%, versus 11.4% at year-end. The $500 revolving facility had $335.5 of available borrowing capacity, and the company reported compliance with its leverage and interest-coverage covenants.
- Operating cash flow was lower year over year, which management attributed to lower earnings and lower accounts payable balances. Financing included $45.6 of share repurchases and $37.1 of dividends; the company repurchased 911,800 shares.
Changes, outlook and notable items
- North America’s sales increase reflected water-heater pricing actions and higher boiler and water-treatment sales, partly offset by lower residential water-heater volumes. Rest of World weakness principally reflected the prior-year China channel inventory build not recurring, as well as currency translation.
- Management forecast 2019 consolidated sales growth of 2.5%–3.5% (3%–4% in local currencies) and EPS of $2.69–$2.75. It expected full-year North America segment margin of 23%–23.25% and Rest of World margin of 11.75%–12%.
- Management expected 2019 operating cash flow of $500–$525, capital expenditures of about $85 and depreciation and amortization of about $75. It anticipated approximately $200 of 2019 share repurchases and significant improvement in second-half year-over-year performance. These are forward-looking estimates, not results.
- Management expected China sales to decline 7%–9% in U.S. dollars for 2019, citing channel inventory, economic weakness and currency depreciation. It expected India sales to grow more than 30% from approximately $34 in 2018. North America water-treatment sales were projected to increase 75%–80%, with minimal 2019 earnings impact.
- On April 8, 2019, after quarter-end, the company acquired Water-Right for $107 cash. The acquisition was not reflected in March 31 balances.
- In Q1 2018, the company recorded $6.7 of restructuring and impairment costs related to moving production from its Renton, Washington facility; the consolidation was completed in 2018. There were no such costs in Q1 2019.
- Adoption of lease accounting in 2019 recorded $49.7 of operating lease assets and $53.4 of lease liabilities; the company said adoption had no material overall impact on its financial statements. It also reported $136.2 of product warranty liabilities.
- The effective tax rate was 20.0%, versus 21.2%; management attributed the decrease primarily to a change in estimate concerning U.S. Tax Reform provisions. It estimated a 21.5% full-year rate and disclosed $8.3 of unrecognized tax benefits. Tax examinations include U.S. federal years 2016–2019, state and local years 2002–2019, and non-U.S. years 2013–2019.
- Risks cited include further weakness in China, tariffs and trade disputes, raw-material price volatility, inability to implement pricing, changes in construction and replacement markets, foreign-exchange movements, acquisition integration, competition, cybersecurity, regulation and broader economic or political conditions. The company uses currency and commodity hedges and stated it does not speculate. No material changes to previously disclosed legal matters were reported.
Important facts for investors to verify
- Whether China demand, channel inventory and currency movements track management’s assumptions and sales outlook.
- Whether pricing and volume gains offset steel, freight, tariff-related and other input costs, supporting forecast margins and EPS.
- Whether operating cash flow reaches guidance, given Q1’s year-over-year decline and working-capital movements.
- Water-Right’s integration, purchase accounting and actual contribution to sales and earnings after the April acquisition.
- Cash accessibility and deployment: most cash and securities were held by foreign subsidiaries, while planned buybacks and dividends were substantial.