A. O. Smith Corporation — Q3 2012 Form 10-Q
Reporting period: Three and nine months ended September 30, 2012; compared with the corresponding 2011 periods. Dollar figures are in millions except per-share amounts. The company manufactures water heaters, boilers and water-treatment products, reporting North America and Rest of World segments. EPC was sold in August 2011 and is presented as discontinued operations.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Continuing-operations sales | $462.2 | $412.0 | $1,415.0 | $1,234.7 |
| Gross profit | $156.8 | $118.7 | $466.4 | $357.6 |
| Gross margin | 33.9% | 28.8% | 33.0% | 29.0% |
| Earnings from continuing operations | $37.0 | $26.9 | $119.4 | $79.7 |
| Diluted continuing-operations EPS | $0.79 | $0.58 | $2.57 | $1.71 |
| Net earnings | $37.0 | $182.3 | $119.4 | $273.6 |
- Q3 continuing sales rose 12.2%; nine-month sales rose 14.6%. Lochinvar contributed incremental sales of $42.6 million and $146.7 million, respectively, versus the comparable 2011 periods.
- Higher gross margins primarily reflected Lochinvar’s relatively higher-margin business and growth in branded products in China. SG&A increased $19.3 million in Q3 and $59.1 million year to date, including acquisition costs, China selling and advertising, and higher pension expense.
- Q3 net earnings in 2011 included $5.1 million of EPC earnings and a $150.3 million after-tax gain on the EPC sale; nine-month 2011 net earnings included $43.6 million of EPC earnings and the same sale gain. Thus, reported net earnings comparisons are not representative of continuing-business performance.
- Other income included a $27.2 million pretax gain from selling RBC shares in Q1 2012. Q3 2012 also included a $6.4 million favorable pretax adjustment to Lochinvar contingent consideration; the nine-month 2011 period included an $11.2 million settlement gain, partly offset by an $8.2 million Canadian warranty provision.
Cash flow, balance sheet and capital
- For the first nine months, continuing operating cash flow was $100.7 million, versus $67.9 million used in 2011. Total operating cash flow, including discontinued operations, was $73.7 million, versus $69.4 million used. Capital expenditures were $44.5 million.
- At September 30, cash was $279.6 million and marketable securities were $202.6 million, compared with $463.4 million cash and no marketable securities at year-end 2011. The filing says China cash was invested in bank certificates of deposit; confirm liquidity and availability of those funds.
- Total debt declined to $279.6 million from $461.6 million at December 31, 2011, primarily following the RBC-share sale and debt repayment. Debt to total capitalization was 19.0%, versus 29.8% at year-end. The company reported $226.6 million of available capacity under its $425 million revolving facility and compliance with its leverage and interest-coverage covenants.
- Working capital for continuing operations was $629.9 million, down about $98 million from year-end. Stockholders’ equity was $1,191.4 million, versus $1,085.8 million at year-end.
- Dividends were $0.20 per share in Q3; $0.52 per share was paid for the first nine months. The company repurchased $9.7 million of shares during the first half and none in Q3.
Segments, outlook and risks
- North America Q3 sales increased to $335.7 million from $310.2 million; operating earnings rose to $50.7 million from $30.9 million. Rest of World sales increased to $133.8 million from $110.5 million; operating earnings rose to $12.7 million from $9.0 million. China branded-product sales and market-share gains were key growth drivers.
- Management raised full-year 2012 EPS guidance to $2.85–$2.95. This excludes future acquisitions, the Q1 RBC-share sale gain and future adjustments to Lochinvar contingent consideration. Management expected 2012 continuing operating cash flow of $155–$165 million and capital spending of $65–$75 million; expected full-year depreciation and amortization was about $55 million.
- Management expected residential and commercial water-heater industry shipments to be flat to slightly down in 2012, while forecasting Lochinvar sales growth of about 10% and China branded-product sales growth at approximately twice China GDP growth. It cited challenging global conditions but said business performance was strong.
- Risks identified include weaker U.S. construction and replacement markets, a slowdown in China, boiler-market weakness, raw-material price volatility, competitive pressures, currency movements, execution of acquisitions and global expansion, and adverse economic or capital-market conditions. The company uses currency and commodity hedges and states it does not speculate.
- The Lochinvar earn-out could reach $35 million based on sales through November 30, 2012; its estimated fair value was $10.4 million at September 30, after the $6.4 million Q3 reduction. EPC-related tax and other obligations remained, including an estimated additional $2.5 million of 2012 income taxes. No material changes to previously reported legal and environmental matters were disclosed.
- Management estimated 2012 pension expense at $13.7 million, compared with $3.3 million in 2011, and did not expect a 2012 pension contribution. Management reported effective disclosure controls and no significant change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Reconcile continuing-operations growth and EPS with the nonrecurring RBC-share gain and Lochinvar earn-out adjustment; assess EPS guidance on a comparable basis.
- Confirm the location, maturity and practical availability of the $202.6 million in marketable securities, and monitor debt capacity and the November 2013 revolving-facility expiration.
- Track Lochinvar sales against the earn-out measurement period and management’s growth assumptions, and assess integration and boiler-market risks.
- Review China growth, planned capacity expansion and capital-spending execution, alongside the stated construction, currency, commodity and warranty risks.
- Assess pension-cost sensitivity and remaining EPC tax, warranty and other obligations; the filing does not provide a clear final amount for all such future obligations.