A. O. Smith Corporation — Q3 2018 Form 10-Q
Business context and reporting period
Quarter ended September 30, 2018; filed November 8, 2018. A. O. Smith manufactures and markets water heaters, boilers and water-treatment products. Its two reporting segments are North America and Rest of World, primarily China, Europe and India. Unless noted otherwise, financial amounts below are in millions of dollars.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net sales | $754.1 | $749.9 | $2,375.4 | $2,228.1 |
| Gross profit | $306.0 | $305.0 | $968.5 | $910.1 |
| Gross margin | 40.6% | 40.7% | 40.8% | 40.8% |
| Net earnings | $104.6 | $93.7 | $317.9 | $273.8 |
| Diluted EPS | $0.61 | $0.54 | $1.84 | $1.57 |
| Cash provided by operating activities | Not presented for quarter | Not presented for quarter | $289.2 | $150.2 |
Q3 sales were approximately 1% higher year over year; nine-month sales rose about 7%. Net earnings rose about 12% for the quarter and 16% year to date. The lower effective tax rates—20.5% for Q3 and 21.1% for the nine months, versus 28.8% and 27.9% in 2017—were primarily attributable to U.S. Tax Reform and contributed to earnings growth. Nine-month 2018 results include $6.7 million of restructuring and impairment expense ($0.03 per diluted share net of tax); adjusted nine-month diluted EPS was $1.87 versus GAAP EPS of $1.84.
Q3 North America sales were $486.9 million, essentially flat, while segment earnings fell to $105.6 million from $110.3 million and segment margin declined to 21.7% from 22.7%. Rest of World sales were $274.1 million, up from $270.1 million; segment earnings increased to $39.1 million from $33.8 million and margin rose to 14.3% from 12.5%. For the first nine months, North America sales and segment earnings were $1,522.8 million and $336.5 million; Rest of World sales and earnings were $876.0 million and $109.8 million.
Balance sheet, cash flow and liquidity
- At September 30, cash and cash equivalents were $233.0 million and marketable securities were $384.8 million, totaling $617.8 million. The filing says essentially all were held by foreign subsidiaries.
- Total debt was $193.3 million, down from $410.4 million at December 31, 2017; total-debt-to-capitalization was 9.9%, versus 20% at year-end. The company repaid $217.1 million of debt during the first nine months.
- Working capital was $859.8 million, $113.3 million below year-end. The $500 million revolving credit facility, expiring December 2021, had $426.0 million of available borrowing capacity; the company reported compliance with its financial covenants.
- Nine-month operating cash flow was $289.2 million. Capital expenditures were $58.5 million. Financing cash outflows included $106.0 million of share repurchases and $92.5 million of dividends. Cash declined $113.6 million to $233.0 million.
- Management attributed the cash decline partly to repatriating nearly $300 million from outside the U.S., used for debt reduction, repurchases and dividends. It stated that available borrowing capacity and operating cash flows should fund existing operations for the foreseeable future.
Material changes, outlook and risks
- North America nine-month sales growth reflected higher water-heater and boiler volumes and pricing actions. In Q3, lower water-heater volumes and higher steel and freight costs pressured North America segment results; pricing actions partly offset costs. The Lowe’s water-treatment launch also incurred about $2 million of Q3 expense.
- Rest of World nine-month sales benefited from approximately $35 million of favorable currency translation in China. Q3 China growth was slower than expected amid weak housing growth; currency translation reduced Q3 China sales by about $6 million versus the prior year.
- The Renton, Washington manufacturing consolidation was completed in Q3. The company recorded $6.7 million of restructuring and impairment charges in Q1, mainly severance, lease exit costs and asset impairment; $2.0 million remained in the restructuring reserve at September 30.
- For 2018, management expected consolidated sales growth of approximately 7%, GAAP diluted EPS of $2.54–$2.57 and adjusted EPS of $2.57–$2.60. It forecast operating cash flow of approximately $475 million, capital expenditures of approximately $85 million, and full-year North America adjusted segment margin of approximately 22.5% and Rest of World segment margin of approximately 13%.
- Management’s preliminary 2019 outlook anticipated China sales growth of 3% in local currency, with approximately $50 million of sales and more than $7 million of earnings headwinds from currency depreciation versus 2018. It projected organic growth of 5.5%–7% in local currency and 4%–5.5% in U.S. dollars.
- Risks identified include slower Chinese economic, housing or consumer growth; U.S. construction and replacement-market weakness; raw-material volatility and inability to sustain pricing; currency movements; tariffs and trade disputes; competition; acquisition integration; cybersecurity incidents; regulatory changes; and tax-law uncertainty. The company reported no material change in its market-risk disclosures and no material change in legal proceedings.
The board approved an additional 2.5 million shares for repurchase in July; 3.16 million shares remained authorized at quarter-end. Management expected approximately $135 million of repurchases through its trading plan and up to $65 million of opportunistic open-market purchases in 2018. On October 9, the quarterly dividend was raised 22% to $0.22 per share.
Important facts for investors to verify
- Whether 2018 sales and EPS guidance was achieved, and how actual results compared with the stated adjusted measures.
- Whether China demand, currency movements and the projected 2019 sales and earnings headwinds developed as anticipated.
- Whether North America pricing sufficiently offset steel, freight and other input-cost inflation, and whether segment margins recovered.
- Whether Lowe’s water-treatment rollout delivered expected sales and whether its transition costs remained limited.
- The location, accessibility and practical availability of foreign-held cash, alongside debt repayment, buybacks and dividend funding.
- Potential developments in tax examinations, unrecognized tax benefits, GILTI accounting and other disclosed business risks.