A. O. Smith Corporation — Q3 2011 Form 10-Q
Reporting period: Three and nine months ended September 30, 2011. Amounts are in U.S. dollars; financial statement amounts are in millions except per-share data. EPC is presented as discontinued operations following its sale.
Business context and significant transactions
- The continuing business is Water Products, manufacturing water heaters, boilers and related products, principally in North America and China.
- On August 22, 2011, the company sold its Electrical Products segment (EPC) to Regal Beloit for $752.5 million in cash and 2.83 million Regal Beloit shares. EPC results are classified as discontinued operations.
- On August 26, the company acquired Lochinvar, a boiler manufacturer, for approximately $418.1 million net of cash acquired. The agreement includes a contingent payment of up to $35 million; the estimated amount at September 30 was $16.7 million.
Key financial results
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Continuing net sales | $412.0 | $377.4 | $1,234.7 | $1,119.1 |
| Gross profit | $118.7 | $107.2 | $357.6 | $329.7 |
| Gross margin | 28.8% | 28.4% | 29.0% | 29.5% |
| Earnings from continuing operations | $26.9 | $16.2 | $79.7 | $36.6 |
| Diluted continuing EPS | $0.58 | $0.35 | $1.71 | $0.79 |
| Net earnings attributable to A. O. Smith | $182.3 | $32.0 | $273.6 | $79.5 |
| Diluted total EPS | $3.91 | $0.69 | $5.87 | $1.72 |
- Q3 continuing sales increased 9.2%; nine-month sales rose 10.3%. Management attributed growth to Lochinvar, stronger China and India sales, North American gas instantaneous products and pricing actions, partly offset in Q3 by lower U.S. residential and commercial water-heater volumes.
- Q3 Water Products operating earnings were $39.9 million versus $37.6 million. Nine-month operating earnings were $138.1 million versus $89.3 million; the prior period included $34.2 million of flood expense, while 2011 included an $11.2 million supplier-settlement gain and an $8.2 million Canadian warranty provision.
- Q3 net earnings included $150.3 million after tax from the EPC sale. Nine-month discontinued operations contributed $193.9 million after tax, including $43.6 million of operating earnings and the $150.3 million sale gain. Total net earnings therefore substantially exceed continuing-operations earnings.
Cash flow, liquidity and debt
- Cash and cash equivalents were $440.6 million at September 30, compared with $118.9 million at year-end 2010. Total assets were $2,358.7 million and stockholders’ equity was $1,123.5 million.
- Total debt was $394.9 million, up from $261.0 million at year-end; debt to total capitalization was 26%, versus 23%. The company had $132 million of available capacity under its $425 million revolving credit facility and reported compliance with its leverage and interest-coverage covenants.
- Working capital from continuing operations was $765.5 million. Management attributed its increase primarily to EPC sale proceeds, partly offset by the Lochinvar purchase, and to other balance-sheet changes.
- Continuing operating activities used $67.9 million of cash in the first nine months, compared with providing $36.6 million in 2010. The company made $175 million of pension contributions during the period. Total operating cash flow, including discontinued operations, was negative $69.4 million.
- Continuing investing activities used $454.8 million, including $418.1 million for Lochinvar and $36.7 million of capital expenditures. Financing activities provided $118.1 million, including $152.9 million of debt proceeds and $20.3 million of dividends paid.
Outlook, risks and unusual items
- Management raised full-year 2011 EPS guidance to $2.00–$2.10, including an estimated net $0.04 per-share benefit from Lochinvar. Guidance excludes potential future acquisitions, the supplier settlement and related warranty-reserve addition, and the impact of the hedged Regal Beloit shares.
- Management expected Lochinvar to contribute approximately $0.14 per share from operations, offset by about $0.10 per share in non-recurring purchase-accounting charges and acquisition fees. It cited a roughly 8% expected sales growth rate for Lochinvar over the next several years.
- Management expected North American residential water-heater industry unit growth to be essentially flat for 2011 and commercial units to increase modestly. China water-heater sales grew approximately 17% in Q3; management expected continued growth at two to three times China GDP growth.
- Management forecast full-year operating cash flow of approximately $10–$15 million, December 2011 tax payments of about $105 million, capital expenditures of approximately $60 million, and depreciation and amortization of approximately $45 million. It did not expect further pension contributions this year or in the next few years.
- Notable accounting and market exposures include a $60 million tax accrual related to foreign earnings from the EPC sale; the Regal Beloit shares and an equity collar expiring in March 2012; and a preliminary Lochinvar purchase-price allocation subject to refinement. The filing reports a $26.1 million year-to-date gain on the collar and related valuation activity.
- Risks identified include acquisition integration and expected returns, boiler-market demand and the shift to high-efficiency products, housing and commercial construction weakness, raw-material volatility, pricing and competition, China’s economic outlook, and investment-value fluctuations. The filing says disclosure controls were effective; Lochinvar was not yet included in the 2011 internal-control evaluation.
Important facts for investors to verify
- Separate recurring continuing-business performance from the EPC sale gain, Regal Beloit mark-to-market effects, supplier settlement, warranty charges and prior-year flood expense.
- Track Lochinvar integration, acquisition accounting, the estimated $16.7 million contingent payment and the expected EPS contribution.
- Monitor operating cash conversion, pension-related tax effects, the forecast tax payment, debt levels and remaining revolver capacity.
- Review the final tax, working-capital and purchase-price allocations, and the timing and marketability of the Regal Beloit shares.
- Assess whether North American demand, China growth, pricing and material costs develop in line with management’s outlook and EPS guidance.