A. O. Smith Corporation — 2012 Form 10-K
Reporting period: Fiscal year ended December 31, 2012. The company manufactures water heaters, boilers and water treatment products. Continuing operations report in North America and Rest of World segments. Electrical Products was sold in August 2011 and is presented as a discontinued operation.
Financial performance
| Metric | 2012 | 2011 | Change |
|---|---|---|---|
| Continuing-operations sales | $1,939.3 million | $1,710.5 million | +13.4% |
| Gross margin | 33.6% | 30.0% | +3.6 percentage points |
| Continuing-operations earnings | $162.6 million | $111.2 million | +46.2% |
| Diluted EPS from continuing operations | $3.49 | $2.39 | +$1.10 |
| Net earnings, including discontinued operations | $158.7 million | $305.7 million | Down; 2011 included the EPC sale gain |
| Continuing-operations cash from operating activities | $171.2 million | $61.0 million | +$110.2 million |
- Segment results: North America sales were $1,430.8 million, up 11.0%, with operating earnings of $199.8 million versus $154.0 million. Rest of World sales were $542.5 million, up 19.1%, with operating earnings of $59.6 million versus $42.7 million.
- Growth drivers: Lochinvar contributed $225.7 million in 2012 sales, compared with $75.9 million for its partial 2011 ownership period. China A. O. Smith-branded sales rose 20.5% to $448.3 million. Higher U.S. residential and commercial water-heater volumes also contributed.
- Costs and margins: Gross-margin expansion reflected Lochinvar and China product mix, along with lower manufacturing and warranty costs. SG&A increased $77.7 million, including additional Lochinvar costs, China selling and advertising, and higher pension expense.
- Balance sheet and liquidity: At year-end, cash and cash equivalents were $266.9 million and marketable securities were $196.0 million; working capital was $611.3 million. Total debt was $243.7 million, down from $461.6 million, and debt to total capitalization fell to 16.9% from 29.8%. Stockholders’ equity was $1,194.1 million.
- Investment and shareholder returns: Capital expenditures were $69.9 million. The company paid $0.72 per share in dividends and repurchased 426,490 shares for $22.0 million. Research and development spending was $51.7 million.
Material changes and unusual items
- 2012 net earnings include a $3.9 million after-tax loss related to the prior EPC sale. Continuing-operations other income included a $27.2 million pre-tax gain from selling Regal Beloit shares, alongside other items. The filing also identifies a $3.9 million pre-tax Canadian supplier settlement gain and a $3.3 million pre-tax favorable Lochinvar contingent-consideration adjustment.
- 2011 net earnings included $194.5 million from discontinued operations, principally reflecting the EPC disposal. Accordingly, total net earnings are not directly comparable; continuing-operations results better show the ongoing business trend.
- Working capital declined $116.6 million year over year, primarily because Regal Beloit shares were sold and proceeds used to repay debt. Foreign subsidiaries held $457.1 million in cash, cash equivalents and marketable securities; the company accrued $65.1 million for estimated tax costs associated with repatriation of foreign earnings.
- The U.S. pension plans were underfunded by approximately $187.2 million at year-end. The company expected no required pension contribution in 2013 and planned no voluntary contribution, but forecast pension expense to rise to approximately $27.6 million in 2013 from $13.8 million in 2012.
- Management reported no goodwill impairment in 2012. The auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective.
Outlook, risks and contingencies
- 2013 guidance: GAAP diluted EPS of $3.00–$3.20 and adjusted diluted EPS of $3.25–$3.45, both excluding potential future acquisitions. Management forecast operating cash flow of $200–$220 million and capital expenditures of $80–$90 million.
- Management expected China-branded sales growth of about 15%, Lochinvar sales growth of about 10%, North American residential water-heater industry unit growth of 1–2%, and flat commercial industry units. China plant expansion was expected to add 50% capacity and begin operation in mid-2013.
- Key risks include a Chinese economic slowdown, fragile North American construction markets, intense competition, steel and other material-price volatility, foreign-exchange and international operating exposures, product defects and liability claims, and execution risks for acquisitions and the global ERP rollout.
- The five largest customers accounted for approximately 36% of 2012 net sales. The filing also identifies the pension deficit, goodwill and intangible-asset impairment exposure, and the Smith family’s significant voting influence as investor considerations.
- Ordinary-course legal, product-liability and environmental matters were disclosed. Management believed reserves and insurance were adequate and did not expect the unresolved matters to materially affect financial position or results; outcomes remain uncertain.
Important facts for investors to verify
- Separate ongoing earnings growth from EPC disposal effects and the listed gains and adjustments; confirm the definition and reconciliation of adjusted EPS.
- Assess whether China and Lochinvar can sustain expected growth, and monitor demand, new capacity utilization and water-treatment profitability.
- Track pension assumptions, the funded deficit and projected expense, especially sensitivity to discount rates and asset returns.
- Review the location and repatriation costs of overseas cash, customer concentration, and the terms and covenant headroom of the $400 million revolving credit facility.
- Monitor execution of the $80–$90 million 2013 capital program and the stated earnings and cash-flow guidance against actual results.