A. O. Smith Corporation — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. 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. Dollar amounts are in millions unless noted.
Financial performance
| Metric | Q2 2017 | Q2 2016 | First half 2017 | First half 2016 |
|---|---|---|---|---|
| Net sales | $738.2 | $667.0 | $1,478.2 | $1,303.9 |
| Gross profit | $305.9 | $283.7 | $608.2 | $546.4 |
| Gross margin | 41.4% | 42.5% | 41.1% | 41.9% |
| Net earnings | $92.4 | $87.1 | $180.1 | $160.6 |
| Diluted earnings per share | $0.53 | $0.49 | $1.03 | $0.91 |
| Operating cash flow | Not separately presented for the quarter | $73.2 | $155.1 |
- Q2 sales increased about 11%; first-half sales increased about 13%. Excluding the effect of the stronger U.S. dollar against the Chinese currency, growth was approximately 12% and 15%, respectively.
- Higher steel prices more than offset pricing actions, weighing on gross margins. SG&A rose $17.3 in Q2 and $40.0 in the first half, mainly from increased selling and advertising to support growth and retail expansion in China.
- Q2 North America sales increased to $470.7 from $432.8; segment earnings rose to $109.2 from $104.2. North America segment margin declined to 23.2% from 24.1%.
- Q2 Rest of World sales increased to $272.8 from $239.8, while segment earnings declined to $32.5 from $33.0. Segment margin fell to 11.9% from 13.8%, reflecting steel costs, currency translation, higher SG&A and product mix.
Liquidity, debt and capital allocation
- At June 30, cash and cash equivalents were $306.6 and marketable securities were $434.3, totaling $740.9. Essentially all were held by foreign subsidiaries; the company accrued $37.8 for repatriation of a portion of these funds.
- Working capital was $934.5, up $138.1 from year-end, mainly due to higher receivables and inventory and lower customer cash advances in China.
- Total debt was $375.1, up $51.5 from December 31, 2016; long-term debt was $367.7 and debt due within one year was $7.4. Debt-to-total-capitalization rose to 18.9% from 17.6%. The $500 million revolving facility expires in December 2021, and available borrowing capacity was $255.0; the company reported compliance with its financial covenants.
- First-half operating cash flow fell to $73.2 from $155.1, as working-capital outlays more than offset higher earnings. Investing cash use was $36.2, including $36.3 of capital expenditures; financing cash use was $60.8, including $66.2 of share repurchases and $48.6 of dividends.
- The company repurchased 1,278,850 shares for $66.2 in the first half and expected to spend about $135 on planned repurchases in 2017, with up to an additional $65 of opportunistic repurchases. The quarterly dividend was $0.14 per share.
Outlook, risks and notable items
- Management expected 2017 sales growth of 10%–11%, or 11.5%–12.5% in local-currency terms, and full-year diluted EPS of $2.07–$2.11, excluding potential future acquisitions. Management said it raised the midpoint of EPS guidance after record first- and second-quarter earnings.
- Other stated 2017 expectations included operating cash flow of about $375, capital expenditures of about $100 (including an estimated $45 for China capacity expansion), and depreciation and amortization of about $70. The expected full-year effective tax rate was approximately 28.5%.
- Management projected full-year North America segment margin of 21.75%–22.0% and Rest of World segment margin of approximately 14%. It cited steel-price volatility, Aquasana’s lower margins, and expected second-half improvement in China pricing and advertising leverage.
- China sales growth, U.S. construction and replacement demand, boiler-market conditions, steel and other input costs, the ability to maintain pricing, foreign exchange, competition, acquisition integration, cybersecurity, regulation and broader economic conditions were identified as risks to results.
- Aquasana, acquired in August 2016, contributed $13.0 of Q2 and $23.3 of first-half North America sales. The company expected to pay its $1.7 acquisition holdback liability in Q3 2017. Contingent consideration for another 2016 asset acquisition was estimated at $5.2.
- Tax authorities could examine U.S. federal returns for 2014–2016, state and local returns for 2001–2016, and non-U.S. returns for 2008–2016. The filing reported $4.2 of unrecognized tax benefits. No material change to previously disclosed legal and environmental matters was reported.
Important facts for investors to verify
- Whether steel-cost inflation and pricing actions improve gross and segment margins as management expected.
- Whether China demand, local-currency growth and retail expansion support the sales and Rest of World margin outlook.
- Whether working-capital needs normalize and operating cash flow approaches management’s $375 full-year estimate.
- How much foreign-held cash is practically available for U.S. uses after repatriation costs, and whether debt and planned buybacks affect leverage.
- Progress integrating Aquasana, including its contribution to sales and effect on North America margins.