A. O. Smith Corporation — Q3 2020 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2020. The company manufactures and markets water heaters, boilers, water treatment products and, in China, air-purification products. Its reporting segments are North America and Rest of World. Amounts below are in millions of dollars except per-share data.
Financial performance
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Net sales | $760.0 | $728.2 | $2,060.8 | $2,241.8 |
| Gross profit | $297.1 | $284.2 | $784.1 | $885.7 |
| Gross margin | 39.1% | 39.0% | 38.0% | 39.5% |
| Net earnings | $105.4 | $87.3 | $224.9 | $278.7 |
| Diluted EPS | $0.65 | $0.53 | $1.38 | $1.66 |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $330.4 | $280.0 |
Q3 sales increased about 4% and net earnings increased about 21% year over year. Nine-month sales declined about 8% and net earnings declined about 19%. Nine-month gross margin fell 1.5 percentage points, primarily reflecting lower sales volumes. SG&A declined $12.9 million in Q3 and $46.6 million year to date, mainly due to lower selling and advertising expenses in China. Interest expense also fell, principally from lower average debt and interest rates.
Segment results: North America sales were $544.0 million in Q3 (up 6%) and $1,557.4 million year to date (approximately flat). North America segment earnings were $133.1 million in Q3 and $365.6 million year to date. Rest of World sales were $221.4 million in Q3 (essentially flat) and $521.3 million year to date (down from $701.5 million); segment earnings were $16.7 million in Q3 versus $4.1 million, but a year-to-date loss of $31.3 million versus earnings of $38.8 million.
Cash, debt and capital
Nine-month operating cash flow was $330.4 million. Investing activities provided $12.4 million, while financing activities used $338.9 million, including $170.1 million of net debt repayment, $116.5 million of dividends and $56.7 million of share repurchases. Cash and cash equivalents ended at $377.9 million, versus $374.0 million at year-end 2019; cash, cash equivalents and marketable securities totaled $509.0 million.
Total debt declined to $113.9 million from $284.0 million at December 31, 2019. The company reported $500 million of available capacity under its $500 million revolving facility, which expires in December 2021, and said it was in compliance with its financial covenants. Working capital was $624.4 million, down $109.5 million from year-end. Approximately $410 million of cash, cash equivalents and marketable securities was held by foreign subsidiaries. The company stated that available borrowing capacity and operating cash flow should fund operations for the foreseeable future.
Outlook, commentary and notable items
- Management projected 2020 consolidated sales to decline approximately 6%–7%; GAAP EPS of $1.91–$1.94 and adjusted EPS of $1.95–$1.98, excluding future acquisitions. Guidance assumes business conditions do not deteriorate due to additional COVID-19 restrictions or shutdowns.
- 2020 outlook included North America residential water-heater industry volume growth of about 4%, water-treatment sales growth of 22%–24%, and China sales decline of 18%–19% in local currency. Expected full-year segment margins were 23.0%–23.5% for North America and negative 2.0% to negative 1.0% for Rest of World.
- Management forecast approximately $400 million of full-year operating cash flow and $50–$55 million of capital expenditures. It expected a 2020 effective tax rate of 23.0%–23.5%.
- COVID-19 caused weak demand, job-site disruptions and lower commercial water-heater and boiler sales; China operations had closed for about four weeks early in the year. The company reported no material supply-chain disruption to date, but noted extended U.S. manufacturing lead times and pandemic-related costs. Lead times were improving into Q4.
- The company recorded $7.7 million of year-to-date severance and restructuring costs, primarily to align costs with market conditions; most actions were completed by the end of Q3. Adjusted results exclude these costs.
- Share repurchases were suspended on March 18, 2020; 1.35 million shares were repurchased for $56.7 million during the first nine months. On October 12, the quarterly dividend was raised 8% to $0.26 per share.
- A securities class action and two related derivative lawsuits were dismissed without settlement consideration. A China distributor-financing arrangement could require inventory repurchases if specified conditions are met; gross potential repurchases were approximately $9.1 million before offsets, and estimated loss reserves were immaterial.
Key investor verification points
- Assess whether China demand, product mix and cost reductions support the projected Rest of World recovery and margin range.
- Track COVID-19 effects on commercial demand, manufacturing efficiency, customer inventory and supply-chain continuity against management’s guidance assumptions.
- Monitor North America residential replacement demand, commercial water-heater and boiler trends, and expected customer destocking.
- Verify cash generation, capital spending, debt levels and liquidity as the revolving credit facility approaches its December 2021 maturity.
- Review the assumptions behind adjusted EPS and segment guidance, including restructuring exclusions, and the potential exposure under the China inventory-repurchase arrangements.