Business Context and Reporting Period
Company: A. O. Smith Corporation (SMITH A O CORP)
Filing Type: Form 10-Q (Quarterly Report)
Reporting Period: Quarter and nine months ended September 30, 2007
Business Overview: The company operates in two primary segments: Water Products (water heaters) and Electrical Products (motors and pumps). The company is a large accelerated filer incorporated in Delaware.
Key Financial Metrics
| Metric (in millions) | Q3 2007 | Q3 2006 | 9M 2007 | 9M 2006 |
|---|---|---|---|---|
| Net Sales | $553.5 | $564.0 | $1,742.2 | $1,617.7 |
| Gross Profit | $120.1 | $115.4 | $377.7 | $340.9 |
| Gross Margin | 21.7% | 20.5% | 21.7% | 21.1% |
| Net Earnings | $24.7 | $17.0 | $71.2 | $57.6 |
| Diluted EPS | $0.79 | $0.55 | $2.29 | $1.86 |
| Cash from Operations (9M) | $94.8 | $63.7 | ||
| Total Debt | $426.7 (as of Sept 30, 2007) | |||
| Cash & Equivalents | $36.3 (as of Sept 30, 2007) | |||
| Working Capital | $348.0 (as of Sept 30, 2007) |
Material Changes vs. Prior Period
- Revenue: Q3 2007 sales declined 1.9% year-over-year due to a slowdown in the residential housing market affecting water heater sales. However, year-to-date (9M) sales increased 7.7%, driven by the inclusion of three additional months of sales from the GSW Inc. acquisition.
- Profitability: Net earnings increased 45% in Q3 and 24% for the 9M period. Gross margins improved to 21.7% in both periods compared to 20.5% and 21.1% in 2006, attributed to higher-margin product sales.
- Tax Rate: The effective tax rate dropped significantly to 15.1% in Q3 (from 24.9% in 2006) and 22.4% for the 9M period (from 28.6% in 2006). This was due to a $3.1 million tax benefit from settled audits and lower tax rates on income from China.
- Segment Performance:
- Water Products: Q3 sales declined, but operating earnings rose 15% due to synergies and lower SG&A expenses.
- Electrical Products: Q3 sales were flat, but operating earnings increased 46% due to reduced restructuring charges and cost savings.
Guidance, Outlook, and Risks
Outlook and Guidance
- 2007 Earnings Forecast: Management narrowed the full-year 2007 earnings forecast to $2.85 - $2.95 per share, excluding an estimated $0.25 per share fourth-quarter restructuring charge.
- Restructuring Actions: The company announced plans to close motor manufacturing operations in Scottsville, KY; Mebane, NC; and Budapest, Hungary.
- Q4 2007 Impact: Anticipated pre-tax charge of ~$13 million for North American closures and ~$9 million for the Budapest closure. A $10 million tax benefit is expected from the Budapest write-off. Total estimated after-tax impact is ~$8 million ($0.25/share).
- 2008 Impact: Additional pre-tax charge of ~$12 million expected for North American closures ($0.24/share) and ~$2 million after-tax for Budapest ($0.06/share).
- Savings: Expected to generate $5 million in savings in 2008 and $20 million annually starting in 2009.
- Liquidity: Cash from operations is projected to be ~$150 million for the full year 2007. Capital expenditures are projected at $70-$75 million. The company maintains a $425 million credit facility with $182.2 million available capacity.
Risks and Contingencies
- Legal Proceedings: On October 18, 2007, a jury returned a $50 million verdict against the company in a product liability lawsuit involving a gas water heater explosion. The company has a $5 million self-insured retention and believes it has sufficient insurance to cover the remainder. The company plans to appeal.
- Market Conditions: Continued weakness in the housing market is expected to impact residential water heater and motor sales. High raw material costs (steel and copper) remain a concern.
Investor Verification Checklist
- Restructuring Charges: Verify the timing and magnitude of the $22 million+ in anticipated pre-tax restructuring charges for 2007 and 2008 related to facility closures.
- Legal Exposure: Monitor the status of the $50 million product liability verdict and the company's appeal process.
- Housing Market Sensitivity: Assess the correlation between new housing starts and the company's Water Products segment revenue.
- Tax Rate Volatility: Confirm the sustainability of the low effective tax rate (projected 14% for 2007) which includes one-time benefits from audit settlements and foreign income.
- Debt Covenants: Review compliance with financial covenants under the $425 million credit facility, particularly given the planned restructuring costs.