A. O. Smith Corporation — 2010 Q3 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2010. Dollar amounts are in millions except per-share data. The filing is unaudited.
Business context and results
A. O. Smith manufactures water-heating and water-treatment products and electric motors through its Water Products and Electrical Products segments. Third-quarter sales rose 11.5% year over year to $559.4; nine-month sales rose 11.7% to $1,655.3. Growth reflected higher China water-heater sales, stronger global motor demand, North American customer inventory replenishment, and pricing actions.
- Water Products sales were $377.5 for the quarter and $1,119.1 year to date, up 12.1% and 10.5%, respectively. Operating earnings were $37.6 and $89.3.
- Electrical Products sales were $183.3 for the quarter and $539.4 year to date, up 10.5% and 14.3%. Operating earnings were $21.7 and $61.9.
Financial performance and position
- Profit: Third-quarter net earnings attributable to A. O. Smith were $32.0, down from $34.6; diluted EPS was $1.04 versus $1.14. Nine-month attributable earnings were $79.5 versus reported 2009 earnings of $58.6; diluted EPS was $2.59 versus $2.69.
- Comparability: 2009 nine-month results reflect the SICO merger accounting and share-count treatment. On the company’s non-GAAP comparable basis, 2009 earnings were $67.0 and diluted EPS $2.21, versus $79.5 and $2.59 in 2010.
- Margins: Gross margin was 26.7% in Q3 versus 27.6%; nine-month gross margin was 27.3% versus 24.5%. The quarterly decline reflected higher material costs and flood-related operating inefficiencies; year-to-date improvement reflected higher volume and lower operating costs, particularly in motors.
- Cash flow and investment: Nine-month operating cash flow was $68.8, down from $184.3, largely because of working-capital investment. Capital expenditures were $47.6 versus $37.9.
- Liquidity and debt: Cash was $109.1 at September 30, versus $76.3 at year-end 2009. Total debt was $276.6 versus $253.2; total debt to capitalization was 24%, unchanged. The company reported $267 of available capacity under its $425 revolving facility and compliance with its financial covenants. The facility expires in February 2011; management planned a replacement in Q4 2010 and anticipated no difficulty securing it.
- Working capital: $348.6 excluding short-term debt, up $99.9 from year-end, reflecting higher cash in China, receivables and inventories.
- Other: The board declared a $0.21-per-share cash dividend and a 3-for-2 stock split, payable November 15, 2010. The filing states the earnings outlook uses pre-split shares.
Material changes, outlook, and risks
- Tennessee flood: Flooding temporarily shut down the Ashland City water-heater plant in May. The company recorded a $34.2 net charge after $32.0 of insurance proceeds against $66.2 of direct costs. Production resumed in June and largely recovered by quarter-end, but inefficiencies remained; management expected normal efficiency by year-end. Some orders were lost, although all customers were retained. Approximately $7 of government assistance was expected in 2010; $1.4 was recorded in Q3.
- Guidance: Management raised full-year 2010 earnings guidance to $3.25–$3.35 per share, including the $0.68-per-share flood charge. It expected operating cash flow of $150–$160 and capital expenditures of $80–$90 for the year.
- Demand and costs: North American residential and commercial markets remained weak; management expected full-year sales growth there to be essentially flat. China water-heater growth was expected to continue at two to three times China GDP growth. Fourth-quarter motor volumes were expected to decline seasonally, while copper and steel prices were rising.
- Initiatives: The acquired China water-treatment business was progressing more slowly than expected and was projected to be approximately break-even in 2010. Residential water-heater production began at the new India plant in Q2. The company acquired North American tankless-water-heater marketing and manufacturing rights from Takagi effective July 1.
- Risks and contingencies: Disclosed risks include raw-material volatility, competitive and pricing pressure, housing and commercial construction weakness, economic and market uncertainty, China growth or slowdown, pension costs and contributions, integration and performance of acquisitions and the Takagi venture, and continuing flood impacts. A $13.1 vendor-related receivable was recorded amid Tennessee litigation; the company considered collection probable and noted possible additional recovery of $8–$17. The filing reported no material changes to previously disclosed legal matters.
- Other unusual items: Nine-month 2010 results included the $34.2 flood expense; the prior-year comparison included a $3.0 gain on sale of the Shenzhen motor facility and tax benefits. Nine-month 2010 pension expense was $7.9, and management estimated full-year pension expense of $10.5.
Key facts investors should verify
- Whether Ashland City operations returned to normal efficiency by year-end and whether any further flood costs or insurance/government recoveries arose.
- Whether full-year EPS, operating cash flow, and capital expenditure guidance was achieved, accounting for the stated pre-split share basis.
- Completion and terms of the replacement revolving credit facility before the February 2011 maturity.
- Working-capital conversion and debt levels, given lower year-to-date operating cash flow and increased inventories and receivables.
- Trends in steel and copper costs, North American demand, China growth, and the performance of the water-treatment and tankless-water-heater ventures.