A. O. Smith Corporation — FY 2019 Form 10-K
Business and period: The filing covers the fiscal year ended December 31, 2019; the company manufactures water heaters, boilers and water-treatment products in two segments, North America and Rest of World. Rest of World includes China, Europe and India and also includes air-purification products made in China. The filing also presents unaudited fourth-quarter results.
Financial performance and liquidity
- Revenue: $2,992.7 million, down 6.1% from $3,187.9 million in 2018. North America sales rose 1.9% to $2,083.5 million; Rest of World sales fell 20.3% to $935.8 million.
- Profit and margins: Net earnings were $370.0 million versus $444.2 million; diluted EPS was $2.22 versus $2.58. Gross margin declined to 39.5% from 41.0%. North America segment earnings rose to $488.9 million, with a 23.5% margin; Rest of World earnings dropped to $40.2 million, with a 4.3% margin, from $149.3 million and 12.7%.
- Fourth quarter: Sales were $750.9 million versus $812.5 million in fourth-quarter 2018; net earnings were $91.3 million versus $126.3 million, and diluted EPS was $0.56 versus $0.74.
- Cash flow and investment: Operating cash flow was $456.2 million, compared with $448.9 million. Capital expenditures were $64.4 million, down from $85.2 million.
- Liquidity and debt: Working capital was $733.9 million, versus $853.2 million. Cash, cash equivalents and marketable securities totaled $551.4 million, essentially all held by foreign subsidiaries. Total debt was $284.0 million, up from $221.4 million; debt to total capitalization was 14.6%, versus 11.4%. The company reported $336.0 million of available capacity under its revolving credit facility and said it was in compliance with its financial covenants.
- Capital returns: The company repurchased 6.1 million shares for $287.7 million and paid $0.90 per share in dividends, up from $0.76. It forecast approximately $200 million of share repurchases in 2020.
Material changes and management commentary
- China sales fell 23% in U.S. dollar terms (19% in local currency), reflecting weaker demand, elevated channel inventories during much of the year and a shift toward lower-priced products. China represented approximately 28% of 2019 net sales.
- Lower China sales and product mix reduced Rest of World earnings and margins. North America benefited from pricing, lower steel costs, water-treatment growth and Water-Right acquisition sales, partly offset by lower residential water-heater volumes.
- Water-Right was acquired in April 2019 for $107 million, net of cash acquired. It contributed $44.3 million in sales and $7.1 million in pretax earnings from acquisition through year-end.
- Management attributed the decline in net earnings to weaker results, especially in Rest of World. 2019 included no restructuring charge; 2018 included $6.7 million related to moving production from the Renton, Washington facility. The 2017 comparison included an $81.8 million one-time U.S. tax-reform charge.
Outlook, risks and contingencies
- At filing, management forecast 2020 consolidated sales growth of 4.5%–5.5% and earnings of $2.40–$2.50 per share, excluding potential future acquisitions. Forecasts anticipated approximately 6% North America sales growth, China sales growth of about 1% in U.S. dollars, and an approximately 5% Rest of World segment margin.
- The guidance was introduced January 28, 2020 and excluded coronavirus impacts. The company subsequently expected a material adverse effect on first-quarter 2020 operating results, while the full-year impact remained unquantified. China operations had resumed below normal levels; store closures, reduced customer traffic and limits on professional installation were reported.
- Other notable risks include reliance on China and foreign-currency exposure; customer concentration, with the five largest customers representing approximately 39% of sales; competitive and construction/replacement-market pressures; steel-price volatility and supplier concentration; product warranty and liability exposure; cybersecurity; regulation and trade restrictions; and acquisition integration and impairment risks.
- The company reported a $37 million shortfall between defined-benefit pension obligations and plan assets at year-end, but forecast no required pension contribution in 2020. It reported a $134.3 million warranty reserve. Management said ordinary-course legal matters were not expected to materially affect results; a securities class action and related shareholder derivative suits were pending.
- Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting. Management and the auditor excluded Water-Right from their internal-control assessments following its 2019 acquisition.
Important facts for investors to verify
- Actual 2020 results versus the sales and EPS outlook, especially the duration and financial impact of the coronavirus disruption.
- Whether China demand, product mix and channel inventories recover, and whether Rest of World margins improve as projected.
- North America replacement demand, pricing and water-treatment growth, including the performance and integration of Water-Right.
- Foreign cash availability and repatriation plans, debt levels, revolving-facility capacity and covenant compliance.
- Developments in the securities and derivative lawsuits, product warranty claims, and pension funding assumptions.