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AOS > SEC Filings for AOS > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for SMITH A O CORP

Form 10-Q for SMITH A O CORP


6-Nov-2012

Quarterly Report


ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a leading manufacturer of water heaters and boilers, serving a diverse mix of residential and commercial end markets principally in North America and China. During the fourth quarter of 2011, we reorganized our management reporting structure to reflect our current business activities and reconsidered our reporting segments. Historical information has been revised to reflect our current structure. Our company is comprised of two reporting segments: North America and Rest of World. Both segments manufacture and market comprehensive lines of residential gas, gas tankless and electric water heaters and commercial water heating equipment. Both segments primarily serve their respective regions of the world. The North America segment also manufactures and markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. The Rest of World segment also manufactures and markets water treatment products, primarily for China.

On August 22, 2011, we sold our Electrical Products Company (EPC) to Regal Beloit Corporation (RBC) for approximately $760 million in cash and approximately 2.83 million shares of RBC shares. As a consequence of the sale, EPC has been reflected as a discontinued operation in the accompanying financial statements for all periods presented. For further information about EPC, see Note 3 to the Condensed Consolidated Financial Statements.

On August 26, 2011, we acquired Lochinvar Corporation (Lochinvar) for approximately $421 million plus an earn-out of up to $35 million if certain objectives are achieved by November 30, 2012. Lochinvar's sales for the twelve months ended November 30, 2011 (Lochinvar's former fiscal year end) were approximately $200 million and have grown at an eight percent compounded annual growth rate over the last five years. Lochinvar is a leader in the manufacture of high-efficiency, hydronic boilers used in commercial and residential applications.

Sales in our North America segment grew approximately eight percent in the third quarter of 2012. Our Lochinvar acquisition added $60.7 million to third quarter sales compared to $20.8 million for the partial third quarter of 2011 from the date we acquired Lochinvar. Driven by a transition in the boiler industry from non-condensing boilers to condensing boilers, we expect Lochinvar sales growth to be approximately ten percent in 2012. The residential and commercial markets for our water heaters have been impacted for the last several years by the relatively low number of housing starts and lack of commercial construction activity, although we expect a significant portion of our sales will continue to be for replacement. We expect residential and commercial water heater industry unit shipments to be flat to slightly down in 2012 compared to 2011.

Sales in our Rest of World segment grew approximately 21 percent in the third quarter of 2012, primarily as a result of growth in sales of A. O. Smith branded products in China. We expect A. O. Smith branded products sales in China to continue to grow at a rate of approximately two times the growth in China gross domestic product (GDP) as geographic expansion, market share gains and new product introductions contribute to our growth. This segment also includes our operations in Europe, India and the Middle East.


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RESULTS OF OPERATIONS

THIRD QUARTER AND FIRST NINE MONTHS OF 2012 COMPARED TO 2011

Our sales from continuing operations for the third quarter of 2012 were $462.2 million or 12.2 percent higher than sales of $412.0 million in the third quarter of 2011. Sales from continuing operations for the first nine months of 2012 were $1,415.0 million or 14.6 percent higher than sales of $1,234.7 million in the same period of 2011. The sales increases for the third quarter and first nine months of 2012 included incremental sales from our Lochinvar acquisition completed on August 26, 2011 of $42.6 million and $146.7 million over their respective periods in 2011. Sales in the third quarter and first nine months of 2012 also benefitted from higher sales of A. O. Smith branded products in China and higher U.S. commercial volumes which were partially offset by lower sales of tankless product in the U.S. In addition, sales in the third quarter of 2012 were impacted by lower residential volumes.

Our gross profit margin in the third quarter of 2012 increased to 33.9 percent from 28.8 percent in the third quarter of 2011. The gross profit margin for the first nine months of 2012 increased to 33.0 percent from 29.0 percent in the same period of 2011. The higher margins in both the third quarter and first nine months of 2012 were due mostly to the impact of the addition of relatively higher margin sales from our Lochinvar acquisition and increased sales of A. O. Smith branded products in China.

Selling, general and administrative expenses (SG&A) in the third quarter and first nine months of 2012 were higher than the same periods in 2011 by $19.3 million and $59.1 million, respectively. SG&A increased in both the third quarter and first nine months of 2012 due to incremental SG&A associated with our Lochinvar operations, increased selling and advertising costs in China in support of higher volumes and higher pension costs.

Interest expense in the third quarter of 2012 was $1.9 million or $0.6 million lower than the third quarter of 2011. The lower interest expense was due to the application of the proceeds from the first quarter of 2012 sale of RBC shares we received from the sale of EPC to repay debt acquired to purchase Lochinvar in August 2011. Interest expense for the first nine months of 2012 was $7.1 million or $0.7 million higher than the same period in 2011. The increased interest expense for the first nine months of 2012 was due to higher debt levels in the first quarter of 2012 primarily as a result of the Lochinvar acquisition.

We have significant pension benefit costs and credits that are developed from actuarial valuations. The valuations reflect key assumptions, principally discount rates, expected return on assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumptions for the expected rate of return on plan assets is 8.50 percent in 2012 compared to 8.75 percent in 2011. The discount rate used to determine net periodic costs decreased from 5.35 percent in 2011 to 4.90 percent in 2012. Pension expense for continuing operations for the first nine months of 2012 was $10.3 million or $7.9 million higher than the first nine months of 2011. Total pension expense for 2012 is expected to be $13.7 million compared to $3.3 million in 2011. Our pension costs are reflected in cost of products sold and SG&A.

Other income in the third quarter of 2012 was $2.2 million and is comprised mostly of interest income derived from investing the foreign proceeds from the 2011 sale of EPC. Other income in the third quarter of 2011 was $15.8 million due mostly to a $16.4 million net gain associated with the increase in value of an equity collar contract purchased to protect a portion of appreciation on


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50 percent of the RBC shares received from the sale of EPC as offset by a decline in the market value of the remaining RBC shares not covered by the collar contract. Other income in the first nine months of 2012 was $32.5 million of which $27.2 million was due to the pretax gain on the sale of RBC shares received from the sale of EPC, with most of the remainder resulting from interest income on investments resulting from the sale of EPC. Other income in the first nine months of 2011 was $18.7 million resulting mostly from the net gain on the aforementioned equity collar contract and RBC share activity.

Our effective tax rates for the third quarter of 2012 and 2011 were 28.8 percent and 32.4 percent, respectively. The lower rate in the third quarter of 2012 was due to larger than anticipated tax deductions resulting from our U.S. domestic manufacturing activity. Our effective tax rate for the first nine months of 2012 was 30.8 percent, slightly higher than the 30.4 percent effective rate in the same period of 2011.

North America

Sales for our North America segment were $335.7 million in the third quarter of 2012 or $25.5 million higher than sales of $310.2 million in the third quarter of 2011. Sales for the first nine months of 2012 increased by $119.4 million to $1,054.9 million from $935.5 million in the same period last year. Included in our third quarter and first nine month of 2012 sales for this segment were incremental sales of $39.9 million and $139.3 million, respectively from Lochinvar. Lochinvar was acquired in August 2011. The segment also benefitted from higher U.S. commercial volume which was more than offset by lower sales of residential water heaters and tankless product.

Third quarter operating earnings for our North America segment were $50.7 million or $19.8 million higher than the third quarter of 2011. Operating earnings for the first nine months of 2012 were $144.1 million or $36.8 million higher than the same period in 2011. Lochinvar operations contributed $11.9 million and $32.1 million of incremental operating earnings to the third quarter and first nine months of 2012, respectively. This segment's operating earnings also include a $6.4 million favorable pre-tax adjustment to the contingent consideration payable to the former owners of Lochinvar. The acquisition agreement contemplated contingent consideration based on Lochinvar achieving a specified sales amount from December 1, 2011 through November 30, 2012 and the fair value of the contingent payment was estimated to be $16.8 million at the closing of the acquisition based on an projected 16 percent increase in sales. Based on our current estimate of a 12 percent increase in sales, we recorded a $6.4 million pre-tax gain in the third quarter of 2012 resulting from the decrease in the fair value of the contingent payment. This adjustment is reflected as "Contingent consideration adjustment" in the accompanying financial statements. Our North America operating earnings also benefitted from the impact of higher commercial volume and material costs that were lower than their relatively high levels last year which more than offset the earnings impact of the volume decline in residential water heaters. Results from the first nine months of 2011 include an $11.2 million pre-tax gain for recovery of costs and damages due to an issue with a component part supplied by one of our vendors. This gain is reflected in the "Settlement income" line in the accompanying financial statements. The $11.2 million pre-tax gain was partially offset by $8.2 million of product warranty expense associated with a similar component issue in Canada and recorded as cost of products sold in the second quarter of 2011. Both of these issues related to water heaters sold primarily in 2007 through 2009 (See Note 15).


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Rest of World

Sales for our Rest of World segment were $133.8 million in the third quarter of 2012 or $23.3 million higher than sales of $110.5 million in the third quarter of 2011. Sales for the first nine months of 2012 were $385.3 million or $59.2 million higher than the same period in 2011. The increases in sales were due to double digit growth in sales of A. O. Smith branded products in China resulting from geographic expansion, market share gains and new product introductions. Sales of A. O. Smith branded products in China increased approximately 22 percent in the third quarter 2012 due to continued distribution expansion into Tier 2 and Tier 3 cities, greater acceptance of gas tankless water heaters and water treatment systems and continued market share gains.

Third quarter operating earnings for our Rest of World segment increased $3.7 million to $12.7 million from $9.0 million in the third quarter of 2011. Operating earnings for the first nine months of 2012 were $39.2 million or $8.4 million higher than the same period in 2011. The improved earnings were due to sales growth in China and lower losses from our China water treatment business. Third quarter operating margin improved to 9.5 percent in 2012 from 8.1 percent in the third quarter of 2011.

Outlook

We continue to pursue our strategy to become a global water technology company. The integration of the Lochinvar acquisition is essentially complete and our pipeline of possible acquisition candidates remains active. We continue to pursue water heater and water treatment investments all over the world and we are committed to investments that increase shareholder value. With more than $400 million in cash and with additional borrowing capacity, we believe we have sufficient resources to take advantage of the right opportunities when they come along.

Our businesses continue to perform well in a challenging global economy. Our focus on customers, combined with disciplined cost management, is paying off throughout the organization. We expect this strong performance to carry through to the end of the year. Consequently, we are raising our earnings guidance for the full year to between $2.85 and $2.95 per share. This does not include the potential impact from any future acquisitions, the first quarter gain from the sale of our RBC shares, or adjustments to the estimate of the fair value of the Lochinvar contingent consideration.

Liquidity & Capital Resources

Our working capital for continuing operations of $629.9 million at September 30, 2012 was $98 million lower than at December 31, 2011, primarily due to the sale of our RBC shares which were received as a result of our divestiture of EPC. The proceeds from the share sale were used to repay debt. The sale of the shares more than offsets the $9.8 million increase in inventories primarily related to higher seasonal sales at Lochinvar and the $13.1 million decline in accounts payable balances, primarily related to timing of certain payments.

Cash provided by continuing operating activities through the third quarter of 2012 was $100.7 million compared with $67.9 million used during the same period last year. The improvement in cash flow is primarily related to higher earnings in 2012 and the impact through nine months of 2011 of pension contributions of approximately $140 million. For the total year 2012, we expect our total cash provided by continuing operations operating activities to be approximately $155 to $165 million. Cash used by discontinued operations through the third quarter of 2012 included $34.4 million of income tax and other payments partially offset by a $7.4 million final working capital adjustment we received from RBC.


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Our capital expenditures totaled $44.5 million through the first nine months of 2012, compared with $36.7 million spent one year ago. We project 2012 capital expenditures to be between $65 and $75 million, including approximately $35 million for the construction of a second water heater manufacturing plant in Nanjing, China and expansion of our manufacturing plant in India to meet local demand. The new plant in China which is expected to be completed in mid 2013 is expected to eventually add 50 percent more capacity to our China water heater operations. The India manufacturing plant expansion which we expect to complete in 2013 will allow us to accommodate more water heater models, in-source some component manufacturing and meet local demand. Full year depreciation and amortization is expected to be approximately $55 million.

During the first quarter of 2012, we sold all of our shares of RBC for $187.6 million or an average of $66.19 per share. The proceeds from the sale were used to pay down borrowings under our revolving credit facility.

During the first nine months of 2012, we invested $202.6 million of our cash located in China into bank certificates of deposits with maturities ranging from 180 days to 360 days, which resulted in a reclassification from cash to marketable securities.

In November 2010, we completed a $425 million multi-currency credit facility with eight banks which expires in November 2013. The facility has an accordion provision which allows it to be increased up to $525 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of September 30, 2012.

The facility backs up commercial paper and credit line borrowings. As a result of the long-term nature of this facility, our commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. At September 30, 2012, we had available borrowing capacity of $226.6 million under this facility. We believe the combination of available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt decreased $182.0 million from $461.6 million at December 31, 2011 to $279.6 million at September 30, 2012, primarily related to the application of proceeds from the sale of our RBC shares. Our leverage, as measured by the ratio of total debt to total capitalization, was 19.0 percent at the end of the quarter, compared with 29.8 percent at the end of last year.

Our pension plan continues to meet all funding requirements under ERISA regulations. We do not expect to make contributions to the plan in 2012. We contributed $175 million to the plan in 2011.

In December 2010, our board of directors ratified its authorization of a stock repurchase program in the amount of 1,500,000 shares of our common stock. During the first half of 2012, we repurchased 218,389 shares, at $44.51 per share for a total of $9.7 million. We did not repurchase any shares in the third quarter 2012 or 2011. A total of approximately 670,000 shares remain in the existing repurchase authority.


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On October 8, 2012, our board of directors declared our regular cash dividend of $.20 per share on our common stock and Class A common stock. The dividend is payable on November 15, 2012 to shareholders of record on October 31, 2012.

Critical Accounting Policies

The preparation of our consolidated financial statements is in conformity with accounting principles generally accepted in the United States which requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The critical accounting policies that we believe could have the most significant effect on our reported results or require complex judgment by management are contained in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the year ended December 31, 2011. We believe that at September 30, 2012 there has been no material change to this information.

Recent Accounting Pronouncements

In September 2011, the FASB issued ASU No. 2011-08, "Testing of Goodwill for Impairment (Topic 350)". ASU No. 2011-08 allows companies to assess qualitative factors to determine whether the two-step quantitative goodwill impairment test needs to be performed. Under the option, an entity no longer would be required to calculate the fair value of a reporting unit unless it determines, based on that qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The ASU may change how a company tests goodwill for impairment but should not change the timing or measurement of goodwill impairments. ASU 2011-08 will be effective for the year ending December 31, 2012. Adoption of this ASU will not have an impact on our consolidated financial condition, results of operations or cash flows.

In July 2012, the FASB issued ASU 2012-02, "Testing Indefinite-Lived Intangible Assets for Impairment." ASU 2012-02 allows an entity to first assess qualitative factors in determining whether events and circumstances indicate that it is more-likely-than not that an indefinite-lived intangible asset is impaired. If an entity determines that it is not more-likely-than not that the indefinite-lived intangible asset is impaired, then the entity is not required to perform a quantitative impairment test. ASU 2012-02 will be effective for the year ending December 31, 2013. Adoption of this ASU will not have an impact on our consolidated financial condition, results of operations or cash flows.

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