A. O. Smith Corporation — Q2 2011 Form 10-Q
Reporting period: Three and six months ended June 30, 2011. Amounts are in U.S. dollars; financial figures are in millions except per-share data. Interim statements are unaudited.
Business context and reporting period
A. O. Smith’s continuing business is Water Products, which makes water heaters, boilers, water treatment products and related equipment. The Electrical Products segment (EPC) is presented as discontinued operations under a pending sale to Regal Beloit Corporation (RBC). The reported continuing-operation sales and results below therefore exclude EPC.
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Continuing-operation sales | $405.3 | $375.0 | $822.7 | $741.7 |
| Gross profit | $111.9 | $114.2 | $238.9 | $222.5 |
| Gross margin | 27.6% | 30.5% | 29.0% | 30.0% |
| Operating earnings, Water Products | $49.3 | $7.8 | $98.2 | $51.6 |
| Continuing-operation earnings | $28.6 | $(0.9) | $52.8 | $20.4 |
| Total net earnings attributable to A. O. Smith | $50.3 | $16.6 | $91.3 | $47.5 |
| Diluted EPS, continuing operations | $0.62 | $(0.02) | $1.13 | $0.44 |
| Diluted EPS, total | $1.08 | $0.36 | $1.96 | $1.03 |
- Continuing-operation sales grew 8.1% in Q2 and $81.0 million in the first half. Higher China water-heater and commercial water-heater volumes, commodity-related price increases and the acquired Takagi tankless business more than offset lower North American residential volumes.
- Gross margin fell year over year, principally reflecting an $8.2 million Canadian component-related warranty provision in Q2 2011.
- Water Products operating earnings include an $11.2 million settlement gain and the $8.2 million warranty expense in 2011; 2010 comparatives include a $34.2 million flood charge. These items materially affect comparisons.
- EPC discontinued operations generated sales of $221.9 million and after-tax earnings of $21.7 million in Q2 2011, versus $197.5 million and $17.5 million a year earlier. First-half sales and after-tax earnings were $422.3 million and $38.5 million, respectively.
Cash flow: Continuing operations used $104.8 million of operating cash in the first half, compared with $42.1 million provided in the prior-year period. Including discontinued operations, operating cash use was $87.2 million versus $50.7 million provided. A $175.0 million pension contribution and higher working-capital requirements were the primary reasons for the deterioration. Capital expenditures were $24.3 million for continuing operations; total consolidated cash and equivalents declined to $108.2 million from $118.9 million at year-end 2010.
Balance sheet and liquidity: At June 30, 2011, total debt was $375.5 million, up from $261.0 million at December 31, 2010; debt to total capitalization was 28%, up from 23%. Cash was $108.2 million. Continuing-operation working capital was $283.1 million. The company reported $154.5 million of available capacity under its $425 million revolving facility, with financial covenants met during the quarter. The facility expires in November 2013. Total liabilities were $1,173.3 million and stockholders’ equity was $969.8 million.
Other metrics: The company contributed $175.0 million to its pension plan in the first half and said it expected no further contributions this year or in the next few years. Warranty liabilities were $130.0 million at June 30, 2011, compared with $110.9 million a year earlier. Dividends paid in the first half were $12.9 million; the board subsequently raised the regular dividend 14% to $0.16 per share.
Material changes versus the prior comparable period
- Continuing-operation revenue increased, but gross margins declined. Q2 continuing earnings improved from a loss to a profit; the comparison is influenced by the prior-year flood expense and current-year settlement and warranty items.
- First-half continuing operating cash flow shifted to a substantial use of cash, mainly due to pension funding and working-capital investment.
- Debt increased by $114.5 million from year-end, while the pension liability on the balance sheet decreased from $222.9 million to $50.9 million following the large plan contribution.
- China water-heater sales grew approximately 30% in the first half, while North American residential volumes remained weak. Management described North American residential and commercial industry sales growth for the year as essentially flat.
Outlook, commentary, risks and unusual items
- Management narrowed 2011 continuing-operations EPS guidance to $1.95–$2.05, excluding acquisitions, the $11.2 million vendor settlement, the $8.2 million warranty-reserve addition and quarterly mark-to-market effects of the RBC equity collar. It estimated full-year continuing operating cash flow of $40–$50 million and capital expenditures of $60–$70 million, including about $20 million for China capacity expansion.
- Management expected the 2011 effective tax rate to be consistent with the first-half rate of 29.3%. It warned that China water-treatment distribution-channel sales and North American higher-efficiency product sales were below plan; reduced federal tax incentives were cited as a factor in the latter.
- The pending EPC sale is for $700 million cash plus approximately 2.83 million RBC shares. Closing was expected in Q3 2011, subject to approvals and closing conditions; the Department of Justice had requested additional information. The company used an equity collar on half of the expected RBC shares. Mark-to-market accounting produced a $5.3 million noncash Q2 gain and a $3.7 million first-half gain.
- On July 18, 2011, the company agreed to acquire Lochinvar for approximately $418 million cash plus a potential earnout of up to $35 million. The proposed purchase was expected to close in Q3, subject to approvals, and be funded with cash and debt, including borrowings under the revolving facility.
- Other unusual items include the $11.2 million vendor settlement gain, an $8.2 million Canadian warranty provision, and a $4.8 million gain from EPC’s sale of a facility in China. The company also initiated legal action against suppliers relating to the Canadian component issue.
- Key stated risks include transaction approval or closing delays, acquisition integration and execution, housing and commercial construction weakness, China economic slowdown, commodity-price volatility, competitive and pricing pressures, and potential further warranty costs. The filing reports effective disclosure controls and no significant quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether the EPC sale and Lochinvar acquisition closed on the expected terms and timing, and the resulting cash, debt and share consideration.
- Whether warranty claims related to the Canadian component issue exceed the recorded provision, and the status and recoverability of supplier claims.
- Progress against the $1.95–$2.05 EPS outlook, including the stated exclusions and the impact of the RBC collar.
- Whether working-capital needs and pension funding continue to pressure operating cash flow, and whether projected cash flow and capital spending are achieved.
- Trends in China water-heater and water-treatment sales, North American higher-efficiency products, and residential and commercial end markets.