A. O. Smith Corporation — Q1 2016 Form 10-Q
Business context and reporting period: The filing covers the three months ended March 31, 2016, compared with the three months ended March 31, 2015. A. O. Smith manufactures water heaters, boilers, water system tanks, water treatment products, and in-home air purifiers. Its reporting segments are North America and Rest of World, primarily China, Europe, and India. Figures below are in U.S. dollars; financial statement amounts are in millions except per-share data.
Financial performance
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Net sales | $636.9 | $618.5 | Up 3% (about 5% excluding currency effects) |
| Gross profit / margin | $262.7 / 41.2% | $229.2 / 37.1% | Margin up 4.1 percentage points |
| Operating earnings | $103.6 before corporate expenses and interest; $118.7 segment total | $82.8 before corporate expenses and interest; $97.4 segment total | Consolidated pre-tax earnings rose 25% |
| Net earnings | $73.5 | $58.4 | Up 26% |
| Diluted EPS | $0.83 | $0.65 | Up 28% |
| Operating cash flow | $26.5 | $(0.4) | Improved |
| Capital expenditures | $19.4 | $14.9 | Up $4.5 |
Gross-margin improvement primarily reflected April 2015 price increases in the U.S. and Canada and lower material costs. SG&A was $159.4 million, up $12.2 million, mainly from China selling and engineering costs and ERP implementation. Interest expense was $1.7 million versus $1.9 million; other income was $2.0 million versus $2.7 million. The effective tax rate was 29.0% versus 29.5%.
Segments
- North America: Sales of $423.9 million, down 1%; operating earnings of $91.9 million versus $71.2 million. Operating margin increased to 21.7% from 16.6%, as pricing and lower material costs more than offset lower U.S. water-heater volumes.
- Rest of World: Sales of $217.4 million, up 11%; operating earnings of $26.9 million versus $26.2 million. Operating margin fell to 12.4% from 13.4%. China sales rose 12% in U.S. dollars and 17% in local currency; currency translation reduced segment earnings by about $1.5 million.
Balance sheet, debt, and liquidity
At March 31, 2016, cash and cash equivalents were $305.5 million and marketable securities were $335.3 million, totaling $640.8 million; essentially all were held by foreign subsidiaries. Working capital was $823.9 million. Total assets were $2,650.6 million and stockholders’ equity was $1,478.5 million.
Total debt was $287.3 million, up from $249.0 million at December 31, 2015; debt-to-total-capitalization rose to 16.3% from 14.7%. The company had $215.7 million of available borrowing capacity under its $400 million revolving credit facility, which expires in December 2017, and reported compliance with its financial covenants. Management said available capacity and operating cash flows should fund operations for the foreseeable future. The company accrued $44.4 million for repatriation of a portion of foreign funds.
Cash declined by $18.1 million to $305.5 million. Investing used $30.5 million; financing used $14.1 million, including $30.5 million of share repurchases and $21.2 million of dividends, partly offset by $37.4 million of long-term debt incurred.
Changes, outlook, and management commentary
- Management expected 2016 business growth of 9%–9.5% in local currency and 7%–7.5% in U.S. dollars; China sales growth of about 15% in local currency; and Lochinvar-branded product growth of about 10%.
- After the first-quarter results, management raised the midpoint of full-year EPS guidance to $3.47–$3.55, excluding potential acquisitions. It expected North America operating margin of 20.5%–21.0% and Rest of World operating margin of about 13%.
- Management forecast 2016 operating cash flow of about $330 million, capital expenditures of $110–$120 million, and depreciation and amortization of about $70 million. It expected approximately $175 million of share repurchases for the year, subject to business and market factors.
- The company expected U.S. residential water-heater industry shipments to be modestly higher and commercial shipments about 5% higher in 2016. It cited a 2015 pre-buy ahead of price increases as a factor in lower year-over-year North America volumes.
- ERP implementation expenses were projected at about $24 million in 2016, versus $16 million in 2015; nearly all North American plant sites were expected to be converted by year-end. The company completed another implementation phase in Q1 and said the program involves changes to financial-reporting controls.
Risks, contingencies, and unusual items
- Steel prices had increased by more than $150 per ton since January 1, 2016; management expected a negative margin impact beginning in the second half. Other cited risks included China economic slowdown, weakening U.S. boiler or construction markets, commodity and foreign-exchange volatility, competition, and ERP cost, savings, and timing uncertainty.
- The company uses foreign-currency forwards and commodity futures to hedge exposures, not for speculation. Most hedge amounts were expected to be reclassified into earnings within one year. Derivative contract amounts were generally short-term; commodity contract amounts were described as immaterial at quarter-end.
- Early adoption of share-based compensation guidance produced a $2.5 million discrete income-tax benefit in Q1 and changed diluted-share calculations. The company applied the cash-flow classification change retrospectively, reclassifying $3 million of 2015 cash taxes paid from operating to financing activities.
- A change in the pension-cost estimation method reduced service and interest components by about $1.8 million in Q1. Pension income was $1.7 million versus minimal pension expense in Q1 2015; no 2016 pension contribution was expected or planned.
- U.S. federal tax returns for 2014–2015, state and local returns for 2000–2015, and non-U.S. returns for 2007–2015 were subject to examination. The filing reported no material changes in previously disclosed legal and environmental matters.
- The company was assessing the effects of new lease and revenue-recognition accounting standards. Management stated interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Whether the expected second-half steel-cost pressure is offset by pricing, and whether North America margins meet guidance.
- Whether China growth, currency effects, and higher expansion-related selling costs align with the Rest of World outlook.
- Whether ERP implementation costs, milestones, and control changes remain within management’s expectations.
- Whether foreign-held cash is practically available for U.S. needs, including the cost and tax effects of repatriation.
- Whether operating cash flow, capital spending, debt growth, and planned share repurchases develop as forecast.
- Whether the $3.47–$3.55 full-year EPS outlook remains achievable, considering tax benefits, commodity prices, foreign exchange, and market risks.