A. O. Smith Corporation — Q3 2019 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2019. Unaudited results; amounts in millions except per-share data.
Business context and results
The company makes residential and commercial water heaters, boilers, tanks and water-treatment products. Its reporting segments are North America and Rest of World, with China the main Rest of World market. Results were pressured by weak Chinese demand and elevated channel inventories; North America grew.
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net sales | $728.2 | $754.1 | $2,241.8 | $2,375.4 |
| Gross profit | $284.2 | $306.0 | $885.7 | $968.5 |
| Gross margin | 39.0% | 40.6% | 39.5% | 40.8% |
| Net earnings | $87.3 | $104.6 | $278.7 | $317.9 |
| Diluted EPS | $0.53 | $0.61 | $1.66 | $1.84 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $280.0 | $289.2 |
Financial position, cash flow and capital allocation
- At September 30, cash and equivalents were $219.4 and marketable securities were $294.4, or $513.8 combined; the company said essentially all were held by foreign subsidiaries. Working capital was $774.0, down $79.2 from year-end 2018.
- Total debt was $319.2, up $97.8 from December 31, 2018, primarily to fund the Water-Right acquisition. Debt due within one year was $6.8; long-term debt was $312.4. Debt to total capitalization, excluding operating lease liabilities, was 16.2%, versus 11.4% at year-end.
- The $500 million revolving credit facility expires in December 2021; available borrowing capacity was $300.7. The company reported compliance with its leverage and interest-coverage covenants.
- Nine-month investing cash use was $75.8, including $50.3 of capital expenditures and $107.0 for Water-Right, partly offset by net marketable-security proceeds. Financing cash use was $244.5, including $230.0 of share repurchases and $110.0 of dividends; net debt incurred was $97.9.
- Cash and equivalents declined $40.3 from year-end to $219.4. Management expected approximately $400 of full-year operating cash flow and $80 of capital expenditures.
- The company repurchased 4.92 million shares for $230.0 in the first nine months and expected approximately $300 of full-year repurchases. The board raised the quarterly dividend to $0.24 per share in October, payable November 15, 2019.
Material changes and segment performance
- Consolidated sales declined 3% in Q3 and 6% for the first nine months. Net earnings fell 17% and 12%, respectively. Lower China sales more than offset North American growth; foreign-currency translation reduced China sales by approximately $6 in Q3 and $35 year to date.
- North America: Sales rose to $514.6 from $486.9 in Q3 and to $1,560.4 from $1,522.8 year to date. Segment earnings increased to $121.6 from $105.6 in Q3 and to $360.5 from $336.5 year to date. Higher volumes, pricing actions, lower steel costs and Water-Right contributed.
- Rest of World: Sales fell to $220.3 from $274.1 in Q3 and to $701.5 from $876.0 year to date. Segment earnings dropped to $4.1 from $39.1 in Q3 and to $38.8 from $109.8 year to date. China weakness, a less favorable product mix and currency effects were key factors; India sales grew.
- Water-Right was acquired April 8 for $107.0 cash. It contributed $29.9 of revenue and $5.0 of pretax earnings for the nine-month period, including $0.4 of acquisition-related costs. The purchase-price allocation remained preliminary.
- Operating lease accounting was adopted in 2019. At September 30, operating lease assets were $48.3 and lease liabilities were $51.8; the company said adoption did not materially affect its financial statements.
Outlook, risks and contingencies
- Management forecast 2019 consolidated sales down approximately 5% in U.S. dollars and 3.5% in local currency; China sales down 23% in U.S. dollars and 19% in local currency. Full-year diluted EPS guidance was $2.25–$2.28, excluding potential future acquisitions. The same range was presented as adjusted EPS because the 2019 guidance excluded no restructuring charge.
- Management expected North America segment margin of 23.5%–23.75%, Rest of World segment margin of approximately 4.25%, and a full-year effective tax rate of approximately 22%.
- Risks cited include further deterioration in China demand or housing, tariffs and trade disputes, raw-material volatility, inability to sustain pricing, weaker U.S. construction or replacement markets, foreign-exchange movements, acquisition integration, competition, cybersecurity and regulatory or broader economic developments.
- For China distributor-financing arrangements, the company could be required to repurchase inventory if specified conditions are met. Gross potential repurchases were approximately $56.3, contingent on default of all outstanding loans; the provider is required to indemnify the company, and estimated loss reserves were immaterial.
- A securities class action filed in May 2019 and a related shareholder derivative action filed in August 2019 were pending. Both involve allegations against the company and certain current or former officers; the filing does not quantify potential exposure.
- The company reported effective disclosure controls and no material changes in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether China demand, channel inventories and currency movements tracked management’s 2019 assumptions, given the steep decline in Rest of World earnings.
- Whether the EPS, sales, segment-margin and cash-flow outlooks were achieved, and whether North American growth offset weakness elsewhere.
- Water-Right’s finalized purchase-price allocation, integration progress and contribution to growth and margins.
- Debt, credit-facility capacity, share repurchases and foreign-held cash in assessing liquidity and capital-allocation flexibility.
- Developments in the pending lawsuits and China distributor-financing repurchase exposure.
- The filing notes that its corrected Q3 2018 non-GAAP segment table differs from the figures in the October 29, 2019 earnings release, which had mistakenly shown Q2 2018 results; verify comparisons against the corrected filing presentation.