A. O. Smith Corporation — Q2 2012 Form 10-Q
Business context and reporting period
Reports the three and six months ended June 30, 2012. A. O. Smith manufactures water heaters, boilers and related products, with reporting segments in North America and Rest of World. EPC was sold in August 2011 and is reported as a discontinued operation; Lochinvar, acquired in August 2011, is included in current results. These transactions affect comparability with 2011.
Key financial metrics
| Metric | Q2 2012 | Q2 2011 | First half 2012 | First half 2011 |
|---|---|---|---|---|
| Net sales | $484.2 million | $405.3 million | $952.8 million | $822.7 million |
| Gross profit | $160.5 million | $111.9 million | $309.6 million | $238.9 million |
| Gross margin | 33.1% | 27.6% | 32.5% | 29.0% |
| Earnings from continuing operations | $35.0 million | $28.6 million | $82.5 million | $52.8 million |
| Net earnings | $35.0 million | $50.3 million | $82.5 million | $91.3 million |
| Diluted EPS from continuing operations | $0.75 | $0.62 | $1.77 | $1.13 |
| Operating cash flow, continuing operations | Not separately presented | Not separately presented | $30.2 million | $(104.8) million |
Q2 sales increased 19.5%; management attributed growth to Lochinvar, China branded-product sales and higher North American water-heater volumes ahead of a June price increase. Lochinvar contributed $54.8 million of Q2 sales and $104.1 million in the first half. Higher gross margins reflected Lochinvar’s product mix, China growth and North American pre-buy volumes; 2011 margins were also burdened by an $8.2 million Canadian warranty provision.
SG&A rose $23.8 million in Q2 and $39.8 million in the first half, primarily due to Lochinvar, China selling and advertising, and investment in India. First-half interest expense was $5.2 million, up $1.3 million, mainly reflecting higher first-quarter debt. First-half other income included a $27.2 million pretax gain on RBC shares sold in Q1. The prior-year periods included $11.2 million of settlement income and discontinued EPC earnings, contributing to lower reported total net earnings in 2012 despite higher continuing-operations earnings.
Liquidity, debt and capital allocation
At June 30, 2012, cash and cash equivalents were $259.6 million and marketable securities were $180.1 million. Working capital for continuing operations was $598.8 million. Total debt was $284.6 million, down from $461.6 million at year-end 2011; debt-to-total-capitalization was 19.7%, versus 29.8%. Proceeds from the RBC share sale were used to repay debt. The company reported $222.4 million of available capacity under its $425 million revolving facility, which expires in November 2013, and was in compliance with its financial covenants.
First-half capital expenditures were $30.3 million. The company reported total operating cash flow of $3.6 million, including $30.2 million from continuing operations and a $26.6 million outflow from discontinued operations. The balance-sheet decline in cash also reflected debt repayment and investment of $180.1 million of China cash in bank certificates of deposit. The company repurchased $9.7 million of stock in Q2. On July 9, the board raised the quarterly dividend 25% to $0.20 per share.
Outlook, risks and unusual items
- Management raised its 2012 EPS outlook to $2.80–$2.90, excluding the Q1 RBC-share gain and potential future acquisitions. It expected Lochinvar sales growth above 10% for 2012.
- Management expected 2012 operating cash flow from continuing operations of $155–$165 million and capital expenditures of $75–$80 million, including about $30 million for a second water-heater plant in Nanjing, China. The plant is expected to be completed in mid-2013 and eventually increase China water-heater capacity by 50%.
- Management anticipated lower U.S. residential and commercial volumes in Q3 following the Q2 pre-buy, but expected full-year U.S. volumes to be similar to 2011. It expected residential water-heater industry sales to be essentially flat and commercial industry sales slightly negative in 2012; China branded-product sales were expected to grow at twice China GDP growth.
- Lochinvar’s acquisition agreement provides for a contingent cash payment of up to $35 million if sales exceed specified thresholds; the estimated fair value was $16.8 million at June 30, 2012. Verify the remaining measurement period and earnout outcome.
- Management expected 2012 pension expense of $13.7 million, versus $3.3 million in 2011, and anticipated no pension contribution in 2012. The company had a $132.0 million warranty liability. A legal action seeking recovery over a Canadian component issue remained outstanding; the filing reports no material changes to other legal matters previously disclosed.
- Disclosed risks include weaker U.S. construction or replacement markets, lower demand for high-efficiency boilers, a China slowdown, foreign-exchange and raw-material volatility, competitive pressure, inability to implement pricing, and execution or synergy risks related to Lochinvar and future acquisitions. The company stated it does not use derivatives for speculation.
Important facts for investors to verify
- Whether reported sales and margin growth persists after the Q2 North American pre-buy and as the full-year contribution from Lochinvar becomes comparable.
- Progress toward the $2.80–$2.90 EPS outlook and $155–$165 million continuing-operations cash-flow forecast, including the impact of the RBC gain excluded from guidance.
- Cash accessibility and liquidity, including China certificates of deposit, revolver availability and compliance with the facility’s leverage and interest-coverage covenants.
- The Lochinvar earnout exposure, Canadian component-related litigation and warranty costs, and the timing and amount of remaining EPC-sale tax payments.
- Execution, utilization and returns on the China and India capacity investments, alongside the risks identified in management’s forward-looking statements.