Smith a O Corp: Form 10-Q for the period ended Jun 30, 2015

OVERVIEW

Our Company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets water treatment products and markets air purifier products, primarily for Asia.

Sales in our North America segment grew approximately eight percent in the second quarter of 2015 driven by a price increase effective in April for both commercial and residential water heaters in the U.S., as well as higher sales of Lochinvar-branded products. New government regulations under the National Appliance Energy Conservation Act that mandate increasing the minimum energy efficiency standards for residential water heaters in the U.S., commonly referred to as NAECA III, went into effect on April 16, 2015. Compliance with the regulations caused an increase in our cost to manufacture our products. This resulted in price increases associated with NAECA III products. Our NAECA III transition was completed in the second quarter of 2015. We expect the residential water heater industry’s unit shipments to be approximately two percent higher in 2015 compared to 2014 due to an improving construction market and expanded replacement demand. We continue to see strength in U.S. commercial water heater volumes, and we expect the industry’s unit shipments will be approximately four percent higher than last year. Driven by a transition in the boiler industry from non-condensing boilers to condensing boilers as well as new product introductions, we expect sales of Lochinvar-branded products to grow approximately ten percent in 2015.

Sales in our Rest of World segment grew approximately 14 percent in the second quarter of 2015, primarily as a result of 15 percent growth in sales in China. We expect sales in China to grow at a rate of approximately two times the rate of growth in China’s gross domestic product (GDP) driven by expected continued overall water heater market growth, market share gains, improved product mix and water treatment product growth significantly higher than two times GDP growth.

RESULTS OF OPERATIONS

SECOND QUARTER AND FIRST SIX MONTHS OF 2015 COMPARED TO 2014

Sales for the second quarter of 2015 were $653.5 million or approximately ten percent higher than sales of $595.4 million in the second quarter of 2014. Sales in the first six months of 2015 increased to $1,272.0 million from $1,147.6 million in the same period last year. The increase in sales in both the second quarter and first six months of 2015 is primarily due to higher prices in North America, higher sales of Lochinvar-branded products and higher sales of water heaters and water treatment products in China. Sales in China grew 15 percent in both the second quarter and first six months of 2015 as compared to the same periods of 2014. The first six months of 2015 also benefitted from higher volumes of water heaters in the U.S.

Gross profit margin in the second quarter of 2015 of 40.3 percent was higher than the gross profit margin of 36.3 percent in the second quarter of 2014. Gross profit margin in the first six months of 2015 increased to 38.7 percent from 35.9 percent in the first six months of 2014. Margins in the second quarter of 2015 and first six months of 2015 benefitted from price increases in the U.S. and Canada, higher boilers sales and a reduction in pension related costs. Margins in the second quarter of 2015 also benefitted from lower steel costs.

Selling, general and administrative (SG&A) expenses in the second quarter and first six months of 2015 increased by $22.9 million and $39.2 million, respectively, as compared to the same periods last year. The increase in SG&A expenses in both periods in 2015 was primarily due to higher selling, advertising and engineering costs in support of increased volumes in China and expected higher incremental enterprise resource planning (ERP) implementation costs.

Interest expense in the second quarter of 2015 was $2.5 million compared to $1.4 million in the same period last year. Interest expense in the first six months of 2015 was $4.4 million compared to $2.8 million in the same period last year. The increase in interest expense in the second quarter and first six months of 2015 was primarily related to interest rates on term debt issued in January 2015 that are higher than the interest rate on the revolving credit facility that it replaced as well as higher overall debt levels primarily related to share repurchases.

Other income was $2.7 million in the second quarter of 2015, up from $1.2 million in the same period last year. Other income in the first six months of 2015 was $5.4 million, up from $2.5 million in the first six months of 2014. The increase in other income in the second quarter and first six months of 2015 was primarily due to increased interest income as compared to the same periods last year.

Our pension costs and credits are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on assets, retirement ages, and years of service. We consider current market conditions including changes in interest rates in making these assumptions. Our assumption for the expected rate of return on plan assets is 7.75 percent in 2015, consistent with 2014. The discount rate used to determine net periodic pension costs decreased to 4.05 percent in 2015 from 4.85 percent in 2014. Pension expense for the first six months of 2015 was minimal compared to $13.2 million in the first six months of 2014. The significant decrease in pension expense in the first six months of 2015 compared to the same period last year was due to the sunset of the plan for the majority of our employees on December 31, 2014. Beginning in 2015, we are making additional Company contributions to a defined contribution plan in lieu of benefits earned in our pension plan. Our pension costs are reflected in cost of products sold and SG&A expense.

Our effective tax rates for the second quarter and first six months of 2015 were 31.1 percent and 30.4 percent, respectively. Our effective tax rates for the second quarter and first six months of 2014 were 27.1 percent and 27.5 percent, respectively. The higher effective tax rates in both periods of 2015 were primarily due to a change in geographic earnings mix as compared to the same periods in the prior year. The 2014 effective tax rates were also impacted by a one-time tax benefit associated with a revised domestic manufacturers’ deduction from a prior year resulting in an increased income tax benefit on an amended prior year tax return filed in the second quarter of 2014.

North America

Sales in the North America segment were $442.7 million in the second quarter of 2015 or $32.6 million higher than sales of $410.1 million in the second quarter of 2014. Sales for the first six months of 2015 were $871.9 million or $73.3 million higher than sales of $798.6 million in the same period last year. The increased sales in the second quarter and first six months of 2015 were primarily due to higher prices in North America as well as higher sales of Lochinvar-branded products. The increased sales in the first six months of 2015 also benefitted from higher volumes of water heaters in the U.S.

North America operating earnings were $86.0 million in the second quarter of 2015 or approximately 36 percent higher than earnings of $63.2 million in the same period of 2014. Operating earnings in the first six months of 2015 were $157.2 million or approximately 33 percent higher than operating earnings of $118.5 million in the first six months of 2014. Operating margin of 19.4 percent in the second quarter of 2015 was higher than 15.4 percent in the same period last year. Operating margin of 18.0 percent in the first six months of 2015 was higher than 14.8 percent in the same period in 2014. The higher operating earnings and operating margins in both periods of 2015 were primarily due to higher water heater prices, increased volumes of boilers in the U.S. and lower pension related costs that were partially offset by expected higher ERP implementation costs. In addition, the second quarter operating earnings and operating margins benefitted from lower steel costs.

Rest of World

Sales in the Rest of World segment were $221.3 million in the second quarter of 2015 or $27.7 million higher than sales of $193.6 million in the second quarter of 2014. Sales in the first six months of 2015 were $417.2 million or $50.8 million higher than sales of $366.4 million in the first six months of 2014. Sales of water heaters and water treatment products in China grew 15 percent in both the second quarter and first six months of 2015 as compared to the same periods in 2014.

Rest of World operating earnings were $30.9 million in the second quarter of 2015 or approximately five percent higher than operating earnings of $29.3 million in the second quarter of 2014. Operating earnings in the first six months of 2015 were $57.1 million, approximately five percent higher than operating earnings of $54.4 million in the first six months of 2014. The higher operating earnings in the second quarter and first six months of 2015 were primarily due to higher profits in China. The 2015 second quarter operating margin of 14.0 percent was lower than the operating margin of 15.1 percent in the same period last year. Operating margin of 13.7 percent in the first six months of 2015 was lower than the operating margin of 14.8 percent in the same period last year. Operating margins in both the second quarter and first six months of 2015 were lower than the same periods last year primarily due to higher selling, advertising and engineering costs as a percentage of sales in China, including promotion related to the new air purifier products, and higher costs in India to support the launch of water treatment products.

Outlook

We continue to expect improvement in residential and commercial water heater demand in the U.S. compared to last year, as well as continued lower material costs. We expect Lochinvar-branded sales to grow approximately ten percent in 2015, well ahead of GDP growth in the U.S., as we expect the Lochinvar brand to continue to benefit from a transition from lower efficiency, non-condensing boilers to high efficiency, condensing boilers. We expect sales in China to grow at twice the rate of China’s GDP growth in 2015. We estimate our organic worldwide revenue growth will be approximately 11 percent in 2015. Given these factors, we have increased our guidance for 2015. We believe A. O. Smith Corporation will achieve full-year GAAP earnings of between $3.04 and $3.09 per share. These estimates do not include the potential impact from future acquisitions.

Liquidity & Capital Resources

Working capital of $820.9 million at June 30, 2015 was $107.1 million higher than at December 31, 2014 primarily due to higher inventory balances, sales-related increases in accounts receivable in the U.S., and lower accounts payable balances, primarily in China. As of June 30, 2015, all of the $552.4 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have accrued $50.7 million for the repatriation of a portion of these funds.

Cash provided by continuing operating activities in the first six months of 2015 was $58.8 million compared with $90.9 million of cash provided by continuing operations during the same period last year. Higher earnings were more than offset by larger outlays for working capital in the 2015 period. For the full year 2015, we expect total cash provided by continuing operating activities to be approximately $300 million.

Capital expenditures totaled $31.0 million in the first six months of 2015, compared with $50.8 million spent in the year ago period. We are projecting 2015 capital expenditures between $100 million to $110 million, including approximately $20 million to support our ERP implementation and approximately $30 million related to capacity expansion in China and in the U.S., with the U.S. portion in support of Lochinvar-branded sales. We expect full year depreciation and amortization to be approximately $65 million.

In December 2012, we completed a $400 million multi-currency credit facility with a group of eight banks which expires in December 2017. The facility has an accordion provision which allows it to be increased up to $500 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 June 30, 2015.

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 June 30, 2015, 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.

In January 2015, we issued $75 million of fixed rate term notes to an insurance company. Principal payments commence in 2020 and the notes mature in 2030. The notes have an interest rate of 3.52 percent. We used proceeds of the notes to pay down borrowings under our revolving credit facility.

Our total debt increased $55.8 million from $223.8 million at December 31, 2014 to $279.6 million at June 30, 2015. Our leverage, as measured by the ratio of total debt to total capitalization, was 16.3 percent at the end of the second quarter in 2015, compared with 13.9 percent at the end of last year.

Our pension plan continues to meet all funding requirements under ERISA regulations. We forecast that we will not be required to make a contribution to the plan in 2015, and we do not plan to make any voluntary contributions to the plan in 2015.

In 2014, our Board of Directors approved adding 3,500,000 shares of common stock to an existing discretionary share repurchase authority. Under the share repurchase program, our common stock may be purchased through a combination of Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During the first six months of 2015, we repurchased 728,787 shares of our stock at a total cost of $47.3 million. A total of 1,769,206 shares remained of the existing repurchase authority at June 30, 2015.

Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we now anticipate spending approximately $125 million on stock repurchase activity in 2015.

On July 13, 2015, our Board of Directors declared a regular cash dividend of $.19 per share on our Common Stock and Class A common stock. The dividend is payable on August 17, 2015 to shareholders of record on July 31, 2015.

Critical Accounting Policies

The preparation of our consolidated financial statements is in conformity with accounting principles generally accepted in the U.S. 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, 2014. We believe that as of June 30, 2015 there has been no material change to this information.

Recent Accounting Pronouncements

In April 2015, the Financial Accounting Standards Board (FASB) amended Accounting Standard Codification (ASC) 835-30, Interest - Imputation of Interest (issued under Accounting Standards No. 2015-03). This amendment to ASC 835-30 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs is not affected by this amendment. The amendment is effective for the year beginning January 1, 2016 and requires using a retrospective approach. We do not expect the adoption of amended ASC 835-30 will have a material impact on our consolidated financial condition, results of operations or cash flows.

In May 2014, the FASB issued ASC 606-10, Revenue from Contracts with Customers (issued under Accounting Standards No. 2014-09). ASC 606-10 will replace all existing revenue recognition guidance when effective. On July 9, 2015, the FASB approved a one year deferral of the effective date, with application permitted as of the original effective date which is periods beginning January 1, 2017. Either full retrospective adoption or modified retrospective adoption is allowed under ASC 606-10. We are in the process of determining whether the adoption of ASC 606-10 will have an impact on our consolidated financial condition, results of operations or cash flows.

As is more fully described in our Annual Report on Form 10-K for the year ended December 31, 2014, we are exposed to various types of market risks, including currency and certain commodity risks. Our quantitative and qualitative disclosures about market risk have not materially changed since that report was filed. We monitor our currency and commodity risks on a continuous basis and generally enter into forward and futures contracts to minimize these exposures. The majority of the contracts are for periods of less than one year. We do not engage in speculation in our derivative strategies. It is important to note that gains and losses from our forward and futures contract activities are offset by changes in the underlying costs of the transactions being hedged.

Evaluation of disclosure controls and procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the principal executive officer and principal financial officer concluded that the disclosure controls and procedures were effective as of June 30, 2015 to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time period specified in the SEC rules and forms, and to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow timely decisions regarding disclosure.

Changes in internal control over financial reporting

In the second quarter of 2015, we completed a significant implementation phase of our global enterprise resource planning system. This multi-year initiative is being conducted in phases and includes modifications to the design and operation of controls over financial reporting. We are testing internal controls over financial reporting for design effectiveness prior to implementation of each phase, and we have monitoring controls in place over the implementation of these changes.

Except as described above, there have been no other changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act) during the quarter ended June 30, 2015 that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting.

Forward Looking Statements

This filing contains statements that we believe are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All statements regarding 2015 outlook are forward-looking statements. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: uncertain costs, savings and timeframes associated with the implementation of the new enterprise resource planning system; potential weakening in the high efficiency boiler segment in the U.S.; the ability to execute our acquisition strategy; significant volatility in raw material prices; competitive pressures on our businesses; inability to implement and maintain pricing actions; instability in our replacement markets; strength or duration of any recoveries in U.S. residential or commercial construction; a further slowdown in the growth of the Chinese economy; foreign currency fluctuations; and adverse general economic conditions and capital market deterioration in the U.S., Canada or China.

Forward-looking statements included in this filing are made only as of the date of this filing, and we are under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to us, or persons acting on our behalf, are qualified entirely by these cautionary statements.