A. O. Smith Corporation — Q3 2015 Form 10-Q
Reporting period: Three and nine months ended September 30, 2015. The company manufactures water heaters and related products, boilers, water-treatment products and, primarily in Asia, air purifiers. It reports North America and Rest of World segments. Financial amounts below are in millions of dollars except per-share data.
Financial performance
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Net sales | $625.1 | $581.6 | $1,897.1 | $1,729.2 |
| Gross profit | $256.7 | $215.3 | $749.2 | $627.4 |
| Gross margin | 41.1% | 37.0% | 39.5% | 36.3% |
| Net earnings | $73.6 | $50.6 | $203.1 | $154.6 |
| Diluted earnings per share | $0.82 | $0.56 | $2.26 | $1.69 |
| Cash from operating activities | Not stated for quarter | Not stated for quarter | $231.3 | $163.8 |
Sales rose approximately 7% in Q3 and 10% in the first nine months. Net earnings increased about 45% and 31%, respectively. Management attributed improved gross margins principally to North American price increases, a more favorable commercial-product mix, lower steel costs and reduced pension costs. Q3 comprehensive earnings were $59.1 million versus $55.0 million; the nine-month totals were $184.6 million versus $159.2 million, with foreign-currency translation losses weighing on comprehensive earnings.
Segments and material changes
- North America: Q3 sales were $417.4 million, up from $392.4 million; operating earnings were $90.5 million versus $53.0 million. Nine-month sales were $1,289.3 million versus $1,191.0 million, and operating earnings were $247.7 million versus $171.5 million. Management cited pricing, commercial water-heater and boiler growth, lower steel costs and lower pension costs. Q3 residential water-heater volumes declined amid channel inventory adjustment following first-quarter pre-buying.
- Rest of World: Q3 sales were $217.1 million versus $198.5 million, while operating earnings declined to $27.4 million from $30.0 million. Nine-month sales were $634.3 million versus $564.9 million; operating earnings were essentially flat at $84.5 million versus $84.3 million. China growth was a key sales driver; currency effects, product mix and higher selling, advertising and engineering costs pressured profitability.
- SG&A increased $4.6 million in Q3 and $43.8 million for the first nine months, primarily reflecting China-related selling, advertising and engineering costs; Q3 costs were partly offset by lower ERP implementation expenses.
- The effective tax rate was 31.3% for Q3 and 30.7% year to date, above the comparable 2014 rates. Management cited geographic earnings mix; 2014 also included a one-time tax benefit.
- Pension expense was $0.1 million for the first nine months, versus $19.8 million in 2014, mainly because the pension plan sunset for most employees at year-end 2014. The company said it did not expect or plan to make a 2015 pension contribution.
Cash, debt and liquidity
At September 30, 2015, cash and cash equivalents were $282.9 million and marketable securities were $323.5 million, totaling $606.4 million; essentially all were held by foreign subsidiaries. The company had accrued $50.7 million for the cost of repatriating a portion of the funds. Working capital was $789.7 million, up $75.9 million from year-end 2014.
Nine-month cash provided by operating activities was $231.3 million, including $232.3 million from continuing operations. Capital expenditures were $53.1 million. Investing activities used $161.5 million and financing activities used $106.3 million; the company repurchased $104.3 million of shares and paid $50.9 million in dividends. Cash declined $36.5 million from year-end 2014.
Total debt increased to $260.8 million from $223.8 million at December 31, 2014; debt included $13.1 million due within one year and $247.7 million of long-term debt. Total debt to total capitalization was 15.5%, compared with 13.9% at year-end. The company had $241.8 million of available capacity under its $400 million revolving credit facility, expiring in December 2017, and reported compliance with its covenants. A $75 million term-note issuance in January carried a 3.52% rate, with principal payments beginning in 2020 and maturity in 2030.
Outlook, risks and other notable items
- Management raised 2015 guidance to diluted earnings of $3.08–$3.12 per share, excluding potential future acquisitions. It estimated organic worldwide revenue growth of about 9% and operating cash flow of about $300 million.
- 2015 expectations included approximately 15% China sales growth in local currency, approximately 10% growth in Lochinvar-branded sales, and essentially flat U.S. residential water-heater industry unit shipments. Management expected U.S. commercial water-heater industry shipments to be about 6% above 2014.
- Projected 2015 capital expenditures were $85–$90 million, including about $17 million for ERP and $30 million for capacity expansion in China and the U.S. The company anticipated about $128 million of 2015 share repurchases; it repurchased 1,579,227 shares for $104.3 million in the first nine months. The board declared a $0.19-per-share dividend payable November 16, 2015.
- Risks identified include ERP implementation costs, savings and timing; slower U.S. high-efficiency boiler growth; raw-material price volatility; competition and pricing execution; residential and commercial construction and replacement-market conditions; slower Chinese economic growth; currency fluctuations; acquisitions; and adverse economic or capital-market conditions.
- The company uses currency forwards and copper futures to hedge exposures and stated that it does not speculate. No material change in market-risk disclosures or legal matters was reported. Management concluded disclosure controls were effective as of September 30, 2015.
- The filing says adoption of the revised debt-issuance-cost presentation standard was not expected to have a material impact. The company was still assessing the impact of the new revenue-recognition standard.
Important facts for investors to verify
- Whether raised full-year EPS guidance and China growth expectations were achieved, and how currency movements affected reported results.
- Whether North American pricing and commercial-product growth offset residential volume softness, and whether Rest of World margins recovered from Q3 pressure.
- How much of the $606.4 million held abroad can be used domestically, including repatriation costs and tax implications.
- Whether planned capital spending, ERP implementation and share repurchases remained within expectations, and their effects on cash and debt.
- Potential exposure to raw-material costs, pension assumptions, warranty claims and the identified economic and operating risks.