A. O. Smith Corporation — Q1 2020 Form 10-Q
Reporting period: Three months ended March 31, 2020. A. O. Smith manufactures and markets water heaters, boilers, water treatment products and, in China, air purifiers. Its reporting segments are North America and Rest of World. Results are unaudited.
Financial performance
| Metric | Q1 2020 | Q1 2019 | Change |
|---|---|---|---|
| Net sales | $636.9 million | $748.2 million | Down 15% |
| Gross profit / margin | $239.5 million / 37.6% | $292.8 million / 39.1% | Margin down 1.5 percentage points |
| Earnings before taxes | $67.7 million | $111.6 million | Down 39% |
| Net earnings | $51.7 million | $89.3 million | Down 42% |
| Diluted EPS | $0.32 | $0.53 | Down $0.21 |
| Cash provided by operating activities | $54.1 million | $21.6 million | Up $32.5 million |
North America sales rose to $532.9 million from $521.8 million; segment earnings were $127.1 million versus $116.0 million, with segment margin improving to 23.9% from 22.2%. Rest of World sales fell to $110.2 million from $232.1 million, and the segment recorded a $42.2 million loss versus $12.3 million of earnings. China sales declined 57% in U.S. dollar terms.
Balance sheet and cash flow
- At March 31, cash and cash equivalents were $416.1 million and marketable securities were $135.6 million, totaling $551.7 million. Working capital was $743.4 million.
- Total debt was $342.4 million, up from $284.0 million at December 31, 2019. The debt-to-total-capitalization ratio, excluding operating leases, was 17.5%, compared with 14.6% at year-end. The company reported compliance with its credit facility covenants.
- Cash provided by investing activities was $26.4 million; capital expenditures were $12.8 million. Financing activities used $38.4 million, including $56.7 million of share repurchases and $39.0 million of dividends, partly offset by $58.5 million of long-term debt incurred.
- Available borrowing capacity under the $500 million revolving facility was $270.8 million at March 31. The company reported approximately $850 million of liquidity as of April 30, including cash, marketable securities and undrawn facility capacity.
Material changes and management commentary
- COVID-19 drove weak consumer demand and a roughly four-week closure of the company’s China operations; operations had resumed by the filing date but remained below normal levels. The Juarez, Mexico plant was temporarily closed, and some water-heater production shifted to the U.S. Management reported minimal disruption to global manufacturing and no meaningful supply-chain disruption to date.
- Lower China sales more than offset North America growth. North America benefited from Water-Right, acquired in April 2019, including $16 million of incremental quarterly sales, and organic growth in water treatment products. Lower steel costs helped North America earnings; lower China volumes and product mix weighed on consolidated results.
- Management suspended its 2020 full-year outlook because the pandemic’s duration, severity and recovery could not be forecast with reasonable precision. It also said full-year cash flow could not be reasonably forecast.
- Management projected 2020 capital expenditures of $60–$70 million, below the approximately $80 million average annual spending of the prior three years, and depreciation and amortization of approximately $85 million.
- The company said approximately $295 million of its $551.7 million in cash, cash equivalents and marketable securities was held in local currency in China at quarter-end; it reported repatriating $125 million to the U.S. through the first four months of 2020.
- The company suspended share repurchases on March 18 due to pandemic uncertainty, after repurchasing 1,348,391 shares for $56.7 million in Q1. A quarterly dividend of $0.24 per share was declared in April.
Risks, contingencies and unusual items
- The filing added COVID-19 as a risk factor, citing possible operational shutdowns, shipping and supply interruptions, reduced or volatile demand, plant inefficiencies from safety measures, third-party failures and tighter financing markets. Management emphasized the uncertainty around the pandemic’s impact and recovery.
- A securities class action and two shareholder derivative actions concerning similar allegations were pending. The company had moved to dismiss the class action; the derivative actions were consolidated and stayed pending resolution of the class action. Outcomes and potential financial exposure are not quantified in the filing text.
- Under China distributor financing arrangements, the company could be required to repurchase inventory if specified conditions are met. The gross amount contingent on default of all outstanding loans was approximately $17.0 million at March 31, before potential offsets; reserves for estimated losses were immaterial.
- Other material risks identified include China economic weakness, tariffs and trade disputes, raw-material volatility, foreign-exchange movements, construction and replacement-market weakness, competition, cybersecurity and acquisition integration. The company uses derivatives to hedge currency and commodity exposures and states it does not speculate.
Important facts for investors to verify
- Whether China demand, operations and Rest of World profitability recover, and how the pandemic affects customer demand and supply chains.
- Whether North America growth and margins can offset weakness elsewhere, including the durability of Water-Right-related growth and lower-cost benefits.
- Cash generation, China-held funds and repatriation, debt levels, and continued compliance with credit facility covenants.
- Any return of full-year guidance, and changes to the stated capital expenditure outlook.
- Developments in the securities and derivative lawsuits and any change in the estimated exposure under distributor inventory repurchase arrangements.