A. O. Smith Corporation — FY 2010 Form 10-K
Business context and reporting period. Annual report for the year ended December 31, 2010; fourth-quarter figures are unaudited. The continuing business is Water Products, including residential and commercial water heaters, boilers, water treatment products and related systems. The Electrical Products business is presented as discontinued operations because its sale was pending at year-end.
Financial performance
| Metric | FY 2010 | FY 2009 |
|---|---|---|
| Continuing-operations sales | $1,489.3 million | $1,375.0 million |
| Gross profit margin, continuing operations | 29.9% | 28.7% |
| Earnings from continuing operations | $57.1 million | $60.5 million |
| Continuing-operations diluted EPS | $1.24 | $1.48 |
| Net earnings attributable to A. O. Smith | $111.7 million | $81.3 million |
| Total diluted EPS | $2.42 | $2.36 |
| Cash provided by continuing operating activities | $63.3 million | $122.9 million |
| Capital expenditures, continuing operations | $53.5 million | $42.7 million |
| Total debt at year-end | $261.0 million | $253.2 million |
- Electrical Products generated $701.8 million of 2010 sales and $54.4 million of after-tax earnings, both reported as discontinued operations. Including that business, reported company sales were $2,191.1 million.
- Water Products operating earnings were $132.9 million, down from $148.9 million. The 2010 figure included the effect of a $35.4 million pretax flood-related charge.
- Year-end cash and cash equivalents were $118.9 million, versus $76.3 million. Continuing-operations working capital was $209.5 million, up from $121.7 million.
- Debt-to-total-capitalization was 22.8%, versus 24.3%. The company reported $283.4 million of available capacity under its $425 million revolving facility and compliance with its financial covenants.
- Fourth-quarter 2010 continuing sales were $370.2 million, versus $362.2 million; continuing earnings were $20.5 million, versus $17.5 million.
Changes and management commentary
- Continuing sales increased 8.3%, driven mainly by 30% growth in China water-heater sales and a full year of water-treatment sales following the 2009 acquisition. North American residential and commercial sales were essentially flat for 2010; new construction remained weak.
- Gross margin improved due to higher volume, cost containment and lower warranty costs. Higher selling and administrative costs, largely supporting China growth and new product lines, also affected results.
- Continuing earnings and EPS declined year over year. Management attributed the decline in Water Products operating earnings principally to the Tennessee flood, which more than offset growth in China and selected other markets.
- Operating cash flow from continuing operations fell by $59.6 million, primarily because working-capital requirements increased. Receivables and inventory rose as sales grew and the company supported new businesses and product launches.
- The company completed its purchase of the remaining 20% of its China water-treatment business, bringing ownership to 100%. That business grew more slowly than expected and recorded a small loss in 2010; management announced a move of its operations to Nanjing.
Sale, outlook and material items
- In December 2010, the company agreed to sell Electrical Products to Regal Beloit for $700 million cash and approximately 2.83 million Regal Beloit shares. The transaction was expected to close in the first half of 2011, subject to regulatory approvals and customary closing conditions. The Regal shares were valued at approximately $189 million at December 31, 2010.
- Management forecast 2011 continuing-operations EPS of $1.90 to $2.10, excluding future acquisitions, and expected continued double-digit growth in Asia. It did not anticipate a substantial near-term recovery in U.S. housing or commercial construction.
- Management expected approximately $70–$80 million of 2011 capital spending, including about $20 million toward a second Nanjing water-heater plant. It expected 2011 operating activities from continuing operations to use approximately $10 million, including a planned, tax-deductible pension contribution of approximately $200 million contingent on the Electrical Products sale.
- The defined-benefit pension plans were underfunded by $221.3 million at year-end. Management forecast no pension contribution in 2012 if the planned 2011 contribution is made; actual funding needs remain subject to plan and transaction conditions.
- The May 2010 Cumberland River flood caused $67.3 million in direct costs, partly offset by $31.9 million of insurance proceeds, for a net charge of $35.4 million. The facility resumed production in June and recovery was essentially complete by year-end. Government assistance totaled approximately $7 million.
Risks, contingencies and other considerations
- The sale may be delayed, changed, or fail to close; expected debt repayment, pension funding and strategic investment plans depend in part on its proceeds.
- Five largest Water Products customers represented approximately 43% of continuing net sales. The filing also identifies competition, steel-price volatility and supplier concentration as risks.
- International exposure includes China and other markets: approximately 35.5% of 2010 net sales came from products manufactured outside the United States. Risks include economic slowdown, currency movements and regulatory or political changes.
- Other material exposures include weak construction markets, product liability and warranty claims, pension funding and assumptions, and possible goodwill or intangible-asset impairment. The company recorded a $3.3 million trademark impairment related to water treatment in 2010.
- The company reported ordinary-course legal, environmental and product-liability matters and stated that, based on available information, reserves and insurance, it did not expect them to materially affect its financial position or results. It was pursuing litigation against a supplier and recorded a $13.8 million receivable related to expected recoveries.
- Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting; management also concluded disclosure controls and internal controls were effective at year-end.
Investor verification priorities
- Confirm whether the Electrical Products divestiture closed, the final cash and share consideration, and how proceeds were applied to debt, pensions and investment.
- Track whether the planned pension contribution was made, the resulting funded status, and the sensitivity of obligations and expense to discount rates and asset returns.
- Assess the sustainability and cash conversion of China growth, and progress toward profitability and integration of the water-treatment business.
- Monitor continuing-operations margins and cash flow, especially working-capital levels, pricing and recovery of steel and other input-cost increases.
- Review customer concentration and any developments in the supplier litigation, product-liability reserves, and other legal or environmental contingencies.