A. O. Smith Corporation — Q3 2013 Form 10-Q
Business context and period. The filing covers the quarter and nine months ended September 30, 2013. A. O. Smith manufactures water heaters, boilers and water treatment products, reporting North America and Rest of World segments. Financial statement amounts are unaudited; dollar figures are in millions except per-share data.
Financial performance
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Net sales | $536.2 | $462.2 | $1,594.9 | $1,415.0 |
| Gross profit | $196.6 | $156.8 | $573.9 | $466.4 |
| Gross margin | 36.7% | 33.9% | 36.0% | 33.0% |
| Net earnings | $46.2 | $37.0 | $127.3 | $119.4 |
| Diluted EPS | $0.50 | $0.40 | $1.37 | $1.28 |
| Operating cash flow, continuing operations | — | — | $189.8 | $101.0 |
- Q3 sales rose 16%; nine-month sales rose 13%. Growth reflected higher U.S. water heater and boiler sales and stronger sales of A. O. Smith-branded products in China.
- Q3 net earnings increased 25%; nine-month net earnings increased 7%. Nine-month adjusted earnings were $143.2 versus $101.8, and adjusted diluted EPS was $1.54 versus $1.09. Adjusted figures exclude specified pension costs and unusual items; they are non-GAAP measures.
- Cash provided by operating activities, including discontinued operations, was $188.0 for the first nine months, compared with $73.7 in 2012. Capital expenditures were $65.7 versus $44.5.
- At September 30, cash and cash equivalents were $374.1 and marketable securities were $102.7. Current assets were $1,165.0; current liabilities were $535.2; reported working capital was $629.8.
- Total debt was $227.8, down from $243.7 at year-end 2012. Total debt to total capitalization was 15.4%, versus 16.9%. Long-term debt included $14.4 due within one year and $213.4 classified as long-term.
- Stockholders’ equity was $1,252.6. The company repurchased approximately 1.24 million shares in Q3 for $52.5 and paid $31.6 in dividends during the first nine months.
Segment results and changes
- North America: Q3 sales were $370.1, up about 10%; operating earnings were $51.5 versus $50.7. Nine-month sales were $1,137.8 and operating earnings were $160.6, up 7.9% from $144.1. Management cited U.S. housing recovery, replacement demand and higher water heater and boiler volumes.
- Rest of World: Q3 sales were $175.2, up about 31%; operating earnings more than doubled to $26.9 from $12.7. Nine-month sales were $483.0 and operating earnings were $67.6, up 72.4%. China-branded product growth, higher-value product mix and smaller losses in non-branded water treatment contributed.
- Company gross margin improved in both periods, primarily on higher volumes and product mix. SG&A increased by $22.2 in Q3 and $59.6 for nine months, reflecting selling and advertising costs and higher pension costs.
- Q3 GAAP earnings include a $3.0 benefit from higher-than-previously-estimated tax benefits. Nine-month 2012 results included a $27.2 pre-tax gain on the sale of Regal Beloit shares; that gain did not recur in 2013.
Outlook, unusual items and risks
- Management raised 2013 guidance to GAAP diluted EPS of $1.78–$1.82 and adjusted EPS of $2.00–$2.04. Adjusted guidance excludes non-operating pension costs, Canadian plant restructuring and impairment expenses, and supplier settlement income; it excludes potential future acquisitions.
- Management expected approximately $250 of full-year cash flow from continuing operations, capital expenditures of $90–$100, and depreciation and amortization of $55–$60. Planned capital spending includes about $40 for China and India expansion and about $20 for ERP implementation.
- Management expected 2013 U.S. residential and commercial water heater industry unit shipments to grow about 6%; Lochinvar-branded sales to grow at least 10%; and China A. O. Smith-branded sales to increase approximately $100 versus 2012.
- The Fergus, Ontario production transfer generated $18.2 of pre-tax restructuring and impairment expense in the first nine months; another approximately $1.5 was expected for the remainder of 2013. Management estimated pre-tax savings of about $5 in 2013 and $10 annually in 2014.
- A former-supplier settlement produced an $11.0 pre-tax gain in Q1. The MiM Turkish water treatment acquisition cost $4.0 net cash, with assumed debt and contingent consideration; its results were not material.
- Pension expense was $20.9 for nine months, versus $10.3 in 2012; management projected $27.9 for full-year 2013. Pension liabilities were $188.1. No U.S. pension contribution was anticipated in 2013.
- The $400 revolving credit facility expires in 2017; $233.7 of borrowing capacity was available. The company reported compliance with its leverage and interest-coverage covenants.
- Risks identified include weaker U.S. construction or replacement markets, a Chinese slowdown, competition and pricing pressure, raw-material volatility, currency movements, execution and cost risks for the Canadian rationalization and ERP project, acquisition execution, and adverse economic or capital-market conditions. Product liability self-insured retention increased from $5.0 to $7.5 for 2013.
Investor verification points
- Track whether the company delivers its 2013 GAAP and adjusted EPS guidance, and assess the reconciliation between those measures.
- Verify China sales growth and product mix, and whether planned China and India capacity investments translate into sustained demand and returns.
- Monitor Canadian restructuring costs, completion timing and realized savings against management’s estimates.
- Assess cash conversion, planned capital expenditures, share repurchases, and continued debt and covenant headroom.
- Review pension expense and assumptions, warranty accruals (liability of $131.7 at September 30), and exposure to foreign exchange and commodity costs.