A. O. Smith Corporation — Q3 2016 Form 10-Q
Business context and period: The filing reports the three and nine months ended September 30, 2016, compared with the corresponding 2015 periods. A. O. Smith manufactures and markets water heaters and related products, with North America and Rest of World reporting segments. Share and per-share figures have been adjusted for the October 5, 2016 two-for-one stock split.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net sales | $683.9 million | $625.1 million | $1,987.8 million | $1,897.1 million |
| Gross profit | $283.3 million | $255.6 million | $829.7 million | $747.2 million |
| Gross margin | 41.4% | 40.9% | 41.7% | 39.4% |
| Net earnings | $83.2 million | $73.6 million | $243.8 million | $203.1 million |
| Diluted EPS | $0.47 | $0.41 | $1.38 | $1.13 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $263.6 million | $237.1 million |
- Q3 sales rose about 9%; nine-month sales rose about 5%. Excluding currency effects, sales increased about 11% and 7%, respectively.
- Q3 and nine-month net earnings increased about 13% and 20%, respectively. Q3 diluted EPS rose about 15%; nine-month diluted EPS rose about 22%.
- Q3 North America sales were $450.8 million and operating earnings $100.5 million; Rest of World sales were $240.3 million and operating earnings $31.1 million. Nine-month North America operating margin was 22.7%, versus 19.2%; Rest of World margin was 13.0%, versus 13.3%.
- SG&A increased $15.7 million in Q3 and $28.5 million year to date, primarily from selling, advertising and engineering support for growth in China. Q3 interest expense rose to $2.1 million from $1.6 million, principally reflecting acquisition-related borrowing.
Liquidity, debt and capital allocation
- At September 30, cash and cash equivalents were $269.3 million and marketable securities were $409.5 million. Working capital was $825.5 million. The company said essentially all of its $678.8 million in cash, cash equivalents and marketable securities was held by foreign subsidiaries; repatriation would incur costs, with $44.4 million accrued for repatriation of a portion.
- Total debt was $336.2 million, up $87.2 million from year-end 2015, primarily due to the Aquasana acquisition. Debt-to-total-capitalization was 18.1%, versus 14.7%. The $400 million revolving facility had $153.4 million of available capacity; the company reported compliance with its financial covenants.
- Nine-month investing cash use was $246.5 million, including $58.7 million of capital expenditures and $90.5 million for acquisitions. The company made $100.2 million of share repurchases and paid $63.2 million in dividends. Cash and cash equivalents ended at $269.3 million, down $54.3 million from year-end.
- The company made a voluntary $30 million pension contribution, although no 2016 contribution was required.
Material developments, outlook and risks
- In August, the company acquired Aquasana, entering the U.S. water-treatment market, for $84.8 million net of acquired cash. Aquasana contributed $6.2 million of sales from acquisition through quarter-end; reported pre-tax loss was $1.2 million, including acquisition costs and interest. Purchase-price allocation remained preliminary. The company also acquired certain water-heater assets for $5.7 million and recorded an estimated $5.2 million contingent-payment liability.
- Management forecast 2016 sales growth of 8%–8.25% in local currency and 6%–6.25% in U.S. dollars, and full-year EPS of $1.81–$1.83. China sales were expected to grow more than 16% in local currency. Expected full-year North America operating margin was 21.75%–22.0%; Rest of World margin was expected to be slightly above 13%.
- Management expected about $325 million of full-year operating cash flow, $95–$100 million of capital expenditures, and approximately $135 million of 2016 share repurchases. ERP implementation expense was projected at about $25 million for 2016, including an expected Q4 increase of about $7 million versus the prior-year quarter.
- Management noted slower-than-expected Lochinvar product growth: projected condensing-boiler growth of about 10% was expected to be offset by declines in water heaters and non-condensing boilers, resulting in minimal Lochinvar sales growth for 2016. China growth and earnings face currency-translation effects and higher selling and advertising costs.
- Disclosed risks include slower Chinese economic or consumer-spending growth, weaker U.S. boiler or construction markets, raw-material price volatility, inability to sustain pricing, ERP implementation costs and timing, currency movements, acquisition execution, competition, and adverse economic or capital-market conditions. The filing reported no material change in legal proceedings and no significant change in internal control over financial reporting.
Important facts for investors to verify
- Whether the full-year sales and EPS guidance, China growth expectations, and segment margin forecasts were achieved.
- Final Aquasana purchase-price allocation, acquisition performance, and any contingent payments tied to the additional water-heater asset purchase.
- Cash availability and potential tax or other costs associated with repatriating foreign-held funds.
- ERP implementation spending, schedule, and any effects on operating results or controls.
- Execution of planned capital spending, share repurchases, and the effects of currency, steel costs, and China demand on margins and cash flow.