A. O. Smith Corporation — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017. Interim financial statements are unaudited. The company manufactures and markets water heaters, boilers, water treatment products and, in China, air purifiers. Its reporting segments are North America and Rest of World.
Financial performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net sales | $749.9 million | $683.9 million | $2,228.1 million | $1,987.8 million |
| Gross profit | $306.7 million | $283.3 million | $914.9 million | $829.7 million |
| Net earnings | $93.7 million | $83.2 million | $273.8 million | $243.8 million |
| Diluted EPS | $0.54 | $0.47 | $1.57 | $1.38 |
| Gross margin | 40.9% | 41.4% | 41.1% | 41.7% |
- Sales rose about 10% in Q3 and 12% year to date. Earnings grew about 13% in Q3 and 12% year to date.
- Higher steel costs more than offset pricing actions, reducing gross margin. SG&A increased $11.1 million in Q3 and $51.1 million year to date, mainly due to selling and advertising, brand-building and retail expansion spending.
- North America segment sales were $486.0 million in Q3 and $1,444.0 million year to date; segment earnings were $110.3 million and $323.7 million, respectively. Rest of World sales were $270.1 million and $802.4 million; segment earnings were $33.8 million and $98.8 million.
- Nine-month operating cash flow was $150.2 million, down from $263.6 million. Working-capital outflows were $154.5 million, compared with $23.5 million in the prior-year period. Investing cash use was $111.5 million; financing cash use was $47.2 million. Cash and equivalents ended at $321.9 million.
- At September 30, cash and equivalents plus marketable securities totaled $767.9 million; essentially all were held by foreign subsidiaries. Working capital was $966.4 million. Total debt was $449.7 million, up from $323.6 million at year-end 2016; debt to total capitalization increased to 21.3% from 17.6%. The company had $177.8 million of available capacity under its $500 million revolving facility and reported compliance with its covenants.
Material changes and notable items
- On September 5, the company acquired Hague Quality Water International for $43.1 million net of acquired cash, expanding its North America water-treatment business. Preliminary purchase accounting included $21.3 million of goodwill and $12.8 million of intangibles. Hague contributed $2.2 million of revenue from acquisition through quarter-end.
- North America sales growth reflected higher water-heater and boiler volumes, pricing actions and water-treatment acquisitions. Rest of World growth was led by China; Chinese sales increased 13% in Q3 and 20% year to date in local currency. Currency translation reduced nine-month sales by about $26 million and Rest of World segment earnings by about $3.6 million.
- The company repurchased 1.94 million shares for $103.3 million during the first nine months and paid $72.8 million in dividends. It made a voluntary $30 million pension contribution despite no required 2017 contribution.
- The effective tax rate was 28.8% for Q3 and 27.9% year to date, versus 29.7% and 29.6% in 2016, primarily due to lower state income taxes.
Outlook, risks and contingencies
- Management forecast 2017 sales growth of 11%–12% and raised the midpoint of its full-year earnings guidance to $2.12–$2.14 per share, excluding potential future acquisitions. It expected about $325 million of full-year operating cash flow and $100 million of capital expenditures.
- Management expected 2017 North America segment margin to be similar to 2016’s 22.1%, despite an estimated 40-basis-point headwind from water treatment. Rest of World segment margin was expected to be similar to 2016’s 13.4%.
- Key stated risks include slower Chinese economic or consumer-spending growth, weakening U.S. construction or boiler markets, raw-material price volatility and inability to sustain pricing, foreign-exchange movements, acquisition integration, competition, data-security incidents, regulatory changes and adverse economic or political conditions.
- The company reported $4.2 million of unrecognized tax benefits; U.S. federal, state/local and non-U.S. tax years remain subject to examination. Hague’s purchase-price allocation was preliminary, and contingent consideration of up to $2.0 million depends on product growth through June 30, 2019. The company accrued $37.8 million for repatriation costs on a portion of foreign funds.
- Management said adoption of several upcoming accounting standards was not expected to have a material impact, except that the lease standard’s impact was still being assessed. Revenue-standard implementation analysis was ongoing; management did not expect a change in revenue-recognition pattern.
Investor verification priorities
- Confirm whether sales and EPS guidance were achieved, and whether steel-cost pressures and pricing affected margins as expected.
- Assess working-capital recovery and operating cash conversion after the substantial year-to-date outflow.
- Track Hague integration, its contribution to growth and margins, and final purchase-price allocation.
- Review foreign cash availability and repatriation costs, debt levels, and continued covenant compliance.
- Monitor China demand and currency effects, acquisition-related risks, and tax examinations or other contingencies.