A. O. Smith Corporation — Q2 2013 Form 10-Q
Business context and reporting period. The filing covers the quarter and six months ended June 30, 2013. A. O. Smith manufactures water heaters, boilers and water-treatment products. Its reporting segments are North America and Rest of World, with the latter including China, India, Europe and the Middle East. Comparative per-share figures reflect the two-for-one stock split paid in May 2013.
Financial performance
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Net sales | $549.1 million | $484.2 million | $1,058.7 million | $952.8 million |
| Gross profit margin | 36.1% | 33.1% | 35.6% | 32.5% |
| Net earnings | $42.1 million | $35.0 million | $81.1 million | $82.5 million |
| Diluted EPS | $0.45 | $0.38 | $0.87 | $0.89 |
| Cash provided by operating activities | Not separately provided | Not separately provided | $105.0 million | $3.6 million |
- Q2 sales rose 13.4%; first-half sales rose 11.1%. Higher U.S. water-heater and boiler sales and China growth drove the increase.
- Gross margin improved on volume, China product mix and pricing. Q2 SG&A was $131.6 million, up $22.7 million year over year, mainly reflecting higher selling and advertising costs and pension costs.
- Q2 net earnings increased 20.3%. First-half net earnings declined despite higher sales and segment operating earnings, in part because first-half 2012 included a $27.2 million pre-tax gain from selling Regal Beloit shares. First-half 2013 also included restructuring charges and a supplier settlement gain.
- Segment sales and operating earnings: North America sales were $389.0 million in Q2 (+6.3%) and $767.7 million in the first half; Rest of World sales were $169.5 million in Q2 (+33.3%) and $307.8 million in the first half. Q2 operating earnings were $55.0 million and $22.4 million, respectively.
- First-half operating cash flow from continuing operations was $106.4 million, compared with $30.2 million. Total operating cash flow was $105.0 million after $1.4 million used by discontinued operations. Capital expenditures were $38.2 million.
- At June 30, cash and cash equivalents were $366.1 million and marketable securities were $97.8 million. Working capital was $635.5 million. Total debt was $209.3 million, down from $243.7 million at year-end 2012; debt-to-total-capitalization was 14.3%, versus 16.9% at year-end.
- The company reported $256.5 million of available capacity under its $400 million revolving credit facility, which expires in December 2017. It was in compliance with its leverage and interest-coverage covenants. Total liabilities were $1,038.7 million; current liabilities were $490.1 million.
Material changes, outlook and risks
- Restructuring and settlement: The company is transferring residential water-heater production from Fergus, Ontario, to other North American facilities. First-half restructuring and impairment charges were $16.9 million pre-tax; a further approximately $2.5 million of equipment-relocation costs was expected for the rest of 2013. Management estimated $3–$4 million of pre-tax savings in 2013, excluding restructuring costs, and about $10 million annually in 2014. A first-quarter settlement with a former supplier produced an $11.0 million pre-tax gain.
- Guidance: Management said it increased its 2013 outlook and forecast GAAP EPS of $1.62–$1.68 and adjusted EPS of $1.84–$1.90. Adjusted EPS excludes non-operating pension costs, Canadian plant-rationalization charges and the supplier settlement gain. The filing also estimated $5 million of 2013 ERP implementation expense and approximately $15 million of ERP-related capital expenditures; North American implementation was expected to finish by late 2015.
- Operating outlook: Management expected 2013 U.S. residential water-heater industry shipments to grow about 5%, commercial water-heater shipments about 4%, and Lochinvar sales about 10%. It expected A. O. Smith-branded China sales to grow about 18%. Full-year continuing-operations operating cash flow was estimated at $240–$260 million and capital expenditures at $80–$90 million.
- Investment and spending: Planned capital projects include additional water-heater capacity in Nanjing, China and expansion near Bangalore, India. The new China plant’s first phase was expected to be completed in the third quarter and, when complete, to add 50% more China water-heater capacity. The February acquisition of Turkish water-treatment company MIM had a $4.0 million cash purchase price net of cash received; its results were not material.
- Key risks: The filing identifies uncertainty in Canadian restructuring and ERP costs, savings and timing; possible weakening in the U.S. high-efficiency boiler market; execution of acquisitions; raw-material price volatility; competition and pricing; housing and replacement-market conditions; a further China slowdown; foreign-exchange fluctuations; and broader economic or capital-market deterioration. The company uses currency and commodity derivatives to hedge exposures and states it does not speculate.
- Other notable items: Pension expense was $14.0 million in the first half versus $6.9 million a year earlier; full-year 2013 pension expense was estimated at $27.9 million. Management did not expect a U.S. pension contribution in 2013. Product-warranty liabilities were $129.8 million at June 30. The company’s self-insured retention for product-liability insurance increased from $5.0 million to $7.5 million for 2013. Disclosure controls were assessed as effective, with no significant quarterly change in internal control over financial reporting.
Most important facts for investors to verify
- Whether sales and margin growth—particularly in China and North America—continued, and whether the 2013 EPS and cash-flow guidance was achieved.
- Actual restructuring and ERP costs versus estimates, and whether anticipated plant-rationalization savings were realized.
- How much of the first-half earnings comparison reflects recurring operations versus the 2013 settlement gain, restructuring charges and 2012 Regal Beloit share-sale gain.
- Debt, revolving-credit availability and covenant compliance, alongside planned capital spending and share repurchases.
- Developments in pension expense and obligations, warranty claims, and product-liability exposure following the higher self-insured retention.