A. O. Smith Corporation — Q2 2019 Form 10-Q
Reporting period: Three and six months ended June 30, 2019. Unaudited results; dollars in millions except per-share data.
Business context and performance
A. O. Smith manufactures water heaters, boilers, tanks and water treatment products. Its two reporting segments are North America and Rest of World, with China a major market in the latter.
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Net sales | $765.4 | $833.3 | $1,513.6 | $1,621.3 |
| Gross profit | $308.7 | $341.0 | $601.5 | $662.5 |
| Gross margin | 40.3% | 40.9% | 39.7% | 40.9% |
| Net earnings | $102.1 | $114.5 | $191.4 | $213.3 |
| Diluted EPS | $0.61 | $0.66 | $1.14 | $1.23 |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $143.7 | $173.2 |
Q2 sales declined about 8% and net earnings about 11% year over year. First-half sales declined about 7% and net earnings about 10%. The filing attributes the decreases principally to weaker China sales and lower North American water-heater volumes. Currency translation reduced China sales by about $16 million in Q2 and $28 million in the first half. Lower China volumes also weighed on consolidated gross margin.
Segments, acquisition and capital position
- North America: Q2 sales were $524.0 million versus $534.2 million; first-half sales were $1,045.8 million versus $1,035.9 million. Q2 segment earnings fell to $122.9 million from $124.9 million; first-half earnings rose to $238.9 million from $230.9 million. Water-Right contributed about $14 million of sales after its April 8 acquisition.
- Rest of World: Q2 sales were $249.1 million versus $308.1 million; first-half sales were $481.2 million versus $601.9 million. Segment earnings declined to $22.4 million from $34.7 million in Q2, and to $34.7 million from $70.7 million in the first half. China weakness reflected prior-year channel inventory build, weak consumer demand and currency depreciation; India sales grew.
- Water-Right: Acquired for $107.0 million cash, net of cash acquired. The preliminary purchase-price allocation included $33.7 million of goodwill and $57.6 million of identifiable intangibles. Management said the acquisition’s 2019 earnings impact would be minimal.
- Liquidity and debt at June 30: Cash and cash equivalents were $281.6 million and marketable securities $296.2 million; substantially all were held by foreign subsidiaries. Total debt was $358.6 million, up from $221.4 million at year-end, and debt-to-capitalization was 17.2%, versus 11.4%. The $500 million revolving facility had $263.3 million available; the company reported compliance with its financial covenants.
- Cash uses and investment: First-half operating cash flow was $143.7 million; capital expenditures were $36.5 million; acquisition spending was $107.0 million. The company repurchased $132.6 million of shares and paid $74.0 million in dividends. Working capital was $866.0 million. Operating lease liabilities totaled $51.9 million.
Outlook, risks and unusual items
- Management forecast 2019 consolidated sales down approximately 2%–2.5% in U.S. dollars and 1%–1.5% in local currency; China sales down 19%–20% in U.S. dollars and 16%–17% in local currency.
- Full-year diluted EPS guidance was $2.35–$2.41, excluding potential future acquisitions. Management expected North America segment margin of 23.5%–23.75%, Rest of World segment margin of about 6%, operating cash flow of about $400 million, capital expenditures of about $85 million and depreciation and amortization of about $75 million.
- Management cited elevated China channel inventory and weak consumer demand, with distributors expected to reduce third-quarter orders. It also identified risks including tariffs and trade disputes, raw-material price volatility, construction-market weakness, currency movements, competition, acquisition integration, cybersecurity and regulatory changes.
- The company expected to spend approximately $300 million on share repurchases in 2019, subject to market and business conditions. The board declared a $0.22-per-share quarterly dividend payable August 15, 2019.
- A putative securities class action filed in May 2019 was voluntarily dismissed by the named plaintiff in August, but another putative class member sought appointment as lead plaintiff. The filing does not quantify a potential loss.
- Prior-year results included $6.7 million of restructuring and impairment charges related to moving Renton, Washington manufacturing operations; no such charges were recorded in the 2019 periods presented. The 2019 effective tax rate was 21.5% for the first half; management estimated about 22% for full-year 2019.
Important facts for investors to verify
- Whether China inventory normalization and demand trends support the stated sales and EPS outlook, and whether currency movements differ from assumptions.
- Whether North America water-heater volumes, pricing and input costs—and Water-Right integration and growth—deliver the projected segment performance.
- Whether cash generation, foreign-held liquidity, debt levels and planned share repurchases remain consistent with the company’s capital plans and credit-facility covenants.
- The status and potential financial exposure of the securities litigation and the China distributor inventory repurchase arrangements; the latter had gross potential repurchases of approximately $72.5 million before specified offsets, with estimated-loss reserves reported as immaterial.
- The reported Q2 diluted EPS is $0.61 in the financial statements; confirm the comparable prior-year figure of $0.66 and the company’s full-year guidance basis.