A. O. Smith Corporation — Q1 2012 Form 10-Q
Reporting period: Three months ended March 31, 2012; unaudited. A. O. Smith manufactures water heaters, boilers and water treatment products, principally in North America and China. Results are reported in North America and Rest of World segments. The 2011 Electrical Products Company (EPC) business is presented as discontinued operations.
Financial performance
| Metric | Q1 2012 | Q1 2011 |
|---|---|---|
| Net sales | $468.6 million | $417.4 million |
| Gross profit / gross margin | $149.1 million / 31.8% | $127.0 million / 30.4% |
| SG&A expense | $105.3 million | $89.3 million |
| Earnings from continuing operations | $47.5 million | $24.2 million |
| Net earnings | $47.5 million | $41.0 million, including $16.8 million from discontinued EPC operations |
| Diluted EPS | $1.02 | $0.88, including $0.36 from discontinued operations |
| Operating cash flow, continuing operations | $15.0 million | $(52.3) million |
| Operating cash flow, including discontinued operations | $(3.5) million | $(52.2) million |
- Sales rose 12.3% year over year, including $49.3 million from Lochinvar, acquired in August 2011. Gross margin improved by 1.4 percentage points, attributed to Lochinvar’s relatively higher-margin sales and growth in China.
- Continuing-operations earnings included a $27.2 million pretax net gain related to the sale of Regal Beloit Corporation (RBC) shares. That gain substantially affects the year-over-year earnings comparison; the filing does not provide adjusted earnings excluding it.
- Segment sales and operating earnings were $353.3 million and $42.2 million for North America, versus $321.7 million and $38.1 million; and $124.2 million and $14.2 million for Rest of World, versus $105.2 million and $10.8 million. Segment operating margins were approximately 11.9% and 11.4%, respectively, in Q1 2012.
- Cash from continuing operations improved from a use of $52.3 million to generation of $15.0 million, reflecting higher earnings and improved working capital; the 2011 period included a $45 million pension contribution. Total operating cash flow remained negative in Q1 2012, partly because discontinued operations used $18.5 million, including EPC-related tax payments.
Liquidity, debt and capital
- At March 31, 2012, cash and cash equivalents were $367.2 million; marketable securities were $60.9 million; and $64.7 million of RBC sale proceeds was recorded as a receivable. Working capital for continuing operations was $617.7 million.
- Total debt was $319.2 million, down from $461.6 million at December 31, 2011, primarily after RBC share-sale proceeds were used to repay borrowings. Debt to total capitalization fell to 21.9% from 29.8%. Available capacity under the $425 million revolving facility was $204.2 million; the company reported compliance with its leverage and interest-coverage covenants.
- Capital expenditures were $13.1 million in the quarter. Management projected full-year capital expenditures of $80 million to $90 million, including approximately $40 million to begin a second water-heater plant in Nanjing, China. The revolving facility expires in November 2013.
Outlook, commentary and risks
- Management raised its 2012 earnings estimate to $2.75–$2.90 per share, excluding the Q1 RBC-share gain and potential future acquisitions. It projected $145 million–$155 million of full-year cash provided by continuing operations and approximately $55 million of depreciation and amortization.
- Management expected U.S. residential water-heater industry sales to be essentially flat and commercial water-heater industry sales slightly negative for 2012. It expected Lochinvar growth above 10% over historical performance and continued growth in China-branded sales at roughly twice China GDP growth.
- Management cited limited expected benefit from new U.S. construction in 2012, continued strength in replacement water heaters, and lower U.S. residential and commercial volumes and higher steel costs affecting North America. China growth reflected expanded distribution and some customer purchases ahead of a planned price increase.
- Risks identified include Lochinvar integration and performance, boiler-market conditions and the shift to condensing boilers, execution of the acquisition strategy, raw-material volatility, competition and pricing, weakness in housing or commercial construction, and a slowdown in China or broader economic deterioration.
- Lochinvar’s acquisition agreement includes a contingent payment of up to $35 million tied to sales through November 30, 2012; its estimated fair value was $16.8 million at March 31. The company also estimated an additional $10.6 million of EPC-sale-related income-tax payments in 2012. It had accrued $56.5 million for tax on certain foreign earnings related to the sale.
- The company sold all RBC shares in Q1 for net proceeds of $187.6 million, recording the $27.2 million pretax gain. The equity collar expired in March 2012 with no value. The company does not use derivatives for speculation and reported no material changes to market-risk disclosures or internal controls.
Important facts for investors to verify
- How much of reported earnings growth reflects recurring operations versus the RBC-share gain, and how reported sales compare with a full-period Lochinvar baseline.
- Whether management’s 2012 EPS and cash-flow outlook is achieved, given construction-market weakness, pricing, material costs and China demand.
- Lochinvar sales performance and the final contingent-payment amount, which depends on sales through November 30, 2012.
- Cash conversion and debt reduction, including the use of the remaining RBC proceeds and the company’s available revolver capacity.
- Exposure to EPC-related tax obligations, warranty claims and pension assumptions; Q1 pension expense was $3.4 million versus $1.6 million in Q1 2011, and no 2012 pension contribution was anticipated.