A. O. Smith Corporation — Q2 2014 Form 10-Q
Business context and reporting period. Unaudited results cover the three and six months ended June 30, 2014, compared with the same 2013 periods. A. O. Smith manufactures water heaters, boilers and water-treatment products. Its reporting segments are North America and Rest of World, with China a significant source of growth.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Net sales | $595.4 million | $549.1 million | $1,147.6 million | $1,058.7 million |
| Gross profit | $216.2 million | $198.0 million | $412.1 million | $377.3 million |
| Gross margin | 36.3% | 36.1% | 35.9% | 35.6% |
| Net earnings | $57.3 million | $42.1 million | $104.0 million | $81.1 million |
| Diluted EPS | $0.63 | $0.45 | $1.14 | $0.87 |
| Operating cash flow | Not presented quarterly | $89.8 million | $105.0 million |
- Sales increased about 8% in both Q2 and the first half; net earnings rose about 36% in Q2 and 28% in the first half. Growth was led by China, with additional Q2 contributions from U.S. water heaters and Lochinvar products.
- Q2 SG&A was $137.4 million versus $131.6 million; first-half SG&A was $268.3 million versus $251.6 million. Management attributed the increases mainly to selling and advertising supporting higher China volumes.
- Q2 total segment operating earnings were $92.5 million versus $77.4 million; first-half amounts were $172.9 million versus $149.8 million. North America Q2 sales rose about 5% and operating earnings rose about 15%. Rest of World sales rose about 14% and operating earnings about 31%, with China sales up 17% in Q2 and 21% in the first half.
- Adjusted diluted EPS, a non-GAAP measure excluding specified items and non-operating pension costs, was $0.66 versus $0.52 in Q2 and $1.20 versus $1.00 for the first half.
Liquidity, debt and capital allocation
- At June 30, cash and cash equivalents were $393.7 million and marketable securities were $102.9 million, totaling $496.6 million. Almost all was held by foreign subsidiaries; the company had accrued $54.8 million for repatriation of a portion of the funds.
- Current assets were $1,233.9 million and current liabilities $550.0 million. Working capital was $683.9 million, up $69.2 million from year-end 2013.
- Total debt was $250.4 million, up $58.5 million from December 31, 2013; debt-to-total-capitalization increased to 15.6% from 12.6%. A $400 million revolving facility expires in December 2017; available borrowing capacity was $197.5 million. The company reported compliance with its leverage and interest-coverage covenants.
- First-half capital expenditures were $50.8 million versus $38.2 million. The company repurchased 1.28 million shares for $60.8 million in the first half and expected about $110 million of repurchases for full-year 2014. The quarterly dividend increased to $0.15 per share from $0.12.
Outlook, commentary and risks
- Management raised 2014 guidance to GAAP EPS of $2.20–$2.26 and adjusted EPS of $2.34–$2.40. It forecast $240–$250 million of full-year operating cash flow and $75–$85 million of capital expenditures, including about $20 million for an ERP system implementation.
- For 2015, management raised its earnings outlook for the existing business portfolio to $2.60 per share, retained revenue expectations above $2.5 billion and projected 7%–9% annual organic growth. Segment margin forecasts were 16% for North America and 14% for Rest of World.
- Management cited a still-elusive sustained North American housing recovery, while noting strength in replacement water heaters, commercial volumes, Lochinvar products and China. It expected 2014 residential and commercial water-heater industry shipments to grow about 4% and 3%, respectively, and Lochinvar sales to grow about 10%.
- First-half operating cash flow declined from $105.0 million to $89.8 million, primarily because of higher working-capital requirements, partly offset by higher earnings. First-half investing cash use was $50.7 million; financing cash use was $26.1 million.
- Notable comparability items: 2013 included $16.9 million of first-half restructuring and impairment charges related to the Fergus, Ontario production transfer, and an $11.0 million supplier-settlement gain. No restructuring expense was recorded in 2014 in the periods shown.
- The effective tax rate was 27.1% for Q2 and 27.5% for the first half, versus 31.3% and 31.5% in 2013. Management cited earnings mix and a one-time benefit from a revised prior-year domestic manufacturers’ deduction. It expected a 2014 full-year rate of 27%–28%.
- Disclosed risks include weaker U.S. construction or boiler demand, slower Chinese growth, raw-material price volatility, foreign-exchange movements, competition, pricing execution, ERP implementation costs and adverse economic or capital-market conditions. Derivatives were used to hedge currency and commodity exposures, not for speculation.
Important facts for investors to verify
- Whether China’s growth and profitability gains persist, and how much segment growth reflects volume, pricing, mix or currency effects.
- Progress against 2014 EPS, cash-flow and capital-spending guidance and the 2015 outlook, including the ERP implementation’s cost and timing.
- Working-capital trends, foreign-held cash and the costs or constraints associated with repatriation.
- Debt growth, revolver availability and continued covenant compliance, alongside the pace of share repurchases and dividends.
- The treatment and assumptions behind adjusted EPS and segment measures, and the effect of the 2013 restructuring and settlement items on comparisons.
- The potential impact of the revenue-recognition standard expected to become effective in 2017; the company had not yet determined its impact.