A. O. Smith Corporation — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014; unaudited. The company manufactures residential and commercial water heaters and boilers, and water-treatment products. Its reporting segments are North America and Rest of World, including China, Europe, and India.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net sales | $581.6M | $536.2M | $1,729.2M | $1,594.9M |
| Gross profit | $215.3M | $196.6M | $627.4M | $573.9M |
| Gross margin | 37.0% | 36.7% | 36.3% | 36.0% |
| Earnings before tax | $69.3M | $61.3M | $212.8M | $179.7M |
| Net earnings | $50.6M | $46.2M | $154.6M | $127.3M |
| Diluted EPS | $0.56 | $0.50 | $1.69 | $1.37 |
- Q3 sales rose 8.5% and nine-month sales rose 8.4%; net earnings increased about 10% and 21%, respectively. Growth was driven by China and higher U.S. water-heater and boiler sales.
- North America Q3 sales increased 6% to $392.4M; segment operating earnings were $53.0M versus $51.5M. Rest of World sales increased 13% to $198.5M; operating earnings were $30.0M versus $26.9M. China sales grew 16% in Q3 and 19% for the nine-month period.
- Operating cash flow from continuing operations was $165.3M for the first nine months, down from $189.8M. Capital expenditures were $66.0M; operating cash flow less capital expenditures was approximately $99.3M.
- At September 30, cash and cash equivalents were $400.5M and marketable securities were $123.2M. Working capital was $707.5M. Total debt was $254.5M, up from $191.9M at year-end 2013; debt to total capitalization was 15.6%, versus 12.6%.
- The $400M revolving credit facility expires in December 2017; available borrowing capacity was $189.5M. The company reported compliance with its financial covenants. Almost all cash and marketable securities were held by foreign subsidiaries; $54.8M had been accrued for repatriation costs on a portion of funds.
Changes, unusual items, and management outlook
- SG&A increased $11.8M in Q3 and $28.5M year to date, mainly from China selling and advertising costs; Q3 also included $6M of planned ERP implementation costs. Higher steel prices and ERP costs weighed on North America adjusted operating performance and margins.
- Comparisons with 2013 include $18.2M of restructuring and impairment expenses for the Fergus, Ontario production transfer and an $11.0M supplier-settlement gain in the first nine months. Neither item recurred in 2014.
- Management raised full-year 2014 guidance to GAAP diluted EPS of $2.23–$2.27 and adjusted EPS of $2.37–$2.41. Adjusted EPS is a non-GAAP measure that excludes specified items, including non-operating pension costs. The company expected China revenue growth above 17%, Lochinvar sales growth of about 10%, operating cash flow of $225M–$235M, and capital expenditures of $80M–$90M, including about $30M for ERP.
- Management cited demand from U.S. housing recovery and commercial replacement activity, while describing its outlook as cautious regarding the developing U.S. recovery. Risks include slower Chinese growth, construction-market weakness, competition, raw-material price volatility, currency movements, pricing execution, and ERP cost, savings, timing, and control impacts.
- The company repurchased about 1.811M shares for $86.6M in the first nine months and expected approximately $110M of repurchases for 2014. It paid $41.0M in dividends during the period; a $0.15-per-share dividend was declared for payment in November.
- The company uses foreign-exchange and commodity derivatives to hedge exposures, not for speculation. Management said market-risk disclosures had not materially changed. Disclosure controls were deemed effective; phased ERP implementation entails modifications to financial-reporting controls, which the company said it was testing and monitoring.
Investor verification points
- Check whether full-year EPS and cash-flow guidance was achieved, and reconcile adjusted EPS to GAAP results.
- Assess whether China growth and customer inventory levels were sustainable, and whether U.S. end-market demand supported continued growth.
- Track ERP spending, implementation milestones, expected benefits, and any effects on internal controls.
- Review foreign-cash availability and repatriation costs, alongside debt growth, share repurchases, and covenant headroom.
- Monitor steel and other raw-material costs, segment margins, and warranty obligations; the warranty liability was $136.2M at September 30, 2014.