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 and electric water heaters, boilers, tanks, and water
treatment products. Both segments primarily manufacture and market in their
respective region of the world. Our Rest of World segment also manufactures and
markets
in-home
air purifier products in China.
In January 2020, an outbreak of a novel coronavirus
(COVID-19)
surfaced in Wuhan, China. As a result of the outbreak, the Chinese government
required businesses to close and restricted certain travel within the country.
In cooperation with the government authorities, our operations in China closed
for approximately four weeks before resuming production before the end of the
first quarter. In March 2020,
COVID-19
was declared a global pandemic and we saw pressure in our other end markets
worldwide. Through the date of this filing, our global manufacturing operations
of essential water heating and water treatment products continue without
material disruption to our operations. As a result of the
COVID-19
pandemic and in support of continuing our manufacturing efforts, we have
undertaken numerous and meaningful steps to protect our employees, suppliers,
and customers. These important steps, which in certain cases reduce efficiency,
include continuous communication and training to our employees on living and
working safely in a
COVID-19
environment, plant accommodations and reconfigurations to maintain social
distancing, masks for all employees, implementation of sanitizing stations,
temperature taking and regular, proactive deep cleaning and sanitization of our
facilities, among others. As we receive guidance from governmental authorities,
we adjust our safety measures to meet or exceed those guidelines. The majority
of our customers in the U.S. are also deemed essential under Cybersecurity and
Infrastructure Security Agency (CISA) guidance and are operating their
businesses under varying state and local governmental guidance.
Our global supply chain management team continues to monitor and manage our
ability to operate effectively as
COVID-19
cases in the U.S. and elsewhere periodically surge. To date, we have not seen
any meaningful disruptions to our supply chain. Ongoing communications with our
suppliers to identify and mitigate risk of potential disruptions and to manage
inventory levels continue.
While we believe our balance sheet and capital position are strong, proactive
management of discretionary spending and cost structure will continue. In
addition, the members of our Board of Directors have voluntarily reduced the
cash component of their board compensation by 25 percent and our chairman and
chief executive officer (CEO) has voluntarily reduced his base salary by
25 percent. Our CEO's staff, which includes our other named executive officers,
have also volunteered a 15 percent reduction in base salary. We also continue to
focus on aligning our cost structure in China through headcount reductions,
store closures, cuts in advertising and other cost saving measures, as well as
in North America through headcount reductions.
We estimate that between 80 to 85 percent of our water heater and boiler units
sold in the U.S. relate to replacement business. While we expect that our
replacement business in both water heating and boilers will provide a buffer in
any economic downturn resulting from
COVID-19
in a similar manner to what we have seen historically, the impacts of the
pandemic on consumer spending are difficult to predict.

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We expect sales of North America water treatment products to increase by 20 to
22 percent in 2020, compared to 2019, primarily due to volume growth and a full
year of sales from our Water-Right, Inc. (Water-Right) acquisition, which we
completed in April 2019. We expect higher water treatment sales will be more
than offset by expected declines in commercial water heaters and boilers volumes
due to pandemic-related temporarily closed job sites and deferrals of
discretionary replacement installations. We expect residential water heater
demand will be flat in 2020 compared with 2019.
In our Rest of World segment, we expect 2020 China sales to decline between 18
and 20 percent in local currency compared with 2019, as pandemic-related
closures in that region and further reductions in customer inventory levels
negatively impacted the first half of 2020. In addition, we believe our mix of
products sold in China is shifting to more
mid-price
range products from our historical mix of higher priced products.
Combining all of these factors, we expect our consolidated sales to decline
approximately seven to eight percent in 2020. Our guidance assumes the
conditions of our business environment and that of our suppliers and customers
are similar for the remainder of the year to what we are experiencing currently
and does not deteriorate as a result of further restrictions or shut downs due
to the
COVID-19
pandemic.
RESULTS OF OPERATIONS
SECOND QUARTER AND FIRST SIX MONTHS OF 2020 COMPARED TO 2019
Sales in the second quarter of 2020 were $664 million or approximately
13 percent lower than sales of $765 million in the second quarter of 2019. Sales
in the first six months of 2020 were $1,301 million or approximately 14 percent
lower than $1,514 million in the same period last year. Our sales decline in the
second quarter and first half of 2020 compared to the same periods last year was
primarily driven by lower sales in China and lower commercial water heater and
boiler volumes in North America. The decreased demand in both periods more than
offset higher water treatment volumes in North America, which included
incremental sales of $16 million in the first six months of 2020 from
Water-Right, acquired on April 8, 2019.
Gross profit margin in the second quarter of 2020 of 37.3 percent was lower than
the gross profit margin of 40.3 percent in the second quarter of 2019. Gross
profit margin in the first six months of 2020 of 37.4 percent was lower than the
gross profit margin of 39.7 percent in the first six months of 2019. The lower
gross profit margin was primarily due to lower sales volumes.
Selling, general and administrative (SG&A) expenses in the second quarter and
first six months of 2020 decreased by $22.8 million and $33.7 million,
respectively, as compared to the prior year periods. The decrease in SG&A
expenses in the second quarter and first six months of 2020 was primarily due to
lower selling and advertising expenses.
During the second quarter of 2020, to align our business to current market
conditions, we recognized $6.1 million of
pre-tax
severance and restructuring expenses, which were comprised of $5.2 million of
severance costs and $0.9 million of other restructuring expenses. These
activities are reflected in "severance and restructuring expenses" in the
accompanying financial statements.
We are providing
non-GAAP
measures (adjusted earnings, adjusted earnings per share, and adjusted segment
earnings) that exclude severance and restructuring expenses. Reconciliations to
measures on a GAAP basis are provided later in this section. We believe that the
measures of adjusted earnings, adjusted EPS and adjusted segment earnings
provide useful information to investors about our performance and allow
management and our investors to better compare our performance period over
period.

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Interest expense in the second quarter of 2020 was $2.5 million compared to
$3.4 million in the same period last year. Interest expense in the first half of
2020 was $4.7 million compared to $5.4 million in the same period last year. The
decrease in interest expense in the second quarter of 2020 was primarily due to
lower interest rates and lower average debt levels than the prior year period.
The decrease in interest expense in the first half of 2020 was primarily due to
lower interest rates, which was partially offset by higher average debt levels.
Other income was $4.0 million in the second quarter of 2020, compared to
$5.6 million in the same period last year. Other income in the first six months
of 2020 was $8.2 million compared to $11.1 million in the first half of 2019.
The decrease in other income in the second quarter and first half of 2020
compared to the same periods last year was primarily due to lower interest
income.
Our pension costs and credits are developed from actuarial valuations. The
valuations reflect key assumptions regarding, among other things, discount
rates, expected return on plan 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 6.75 percent in 2020 compared to 7.15 percent in 2019. The discount
rate used to determine net periodic pension costs decreased to 3.18 percent in
2020 from 4.32 percent in 2019. Pension income for the second quarter and first
half of 2020 was $2.0 million and $4.1 million, respectively, compared to
$2.2 million and $4.3 million in the second quarter and first half of 2019,
respectively. The service cost component of our pension income is reflected in
cost of products sold and SG&A expenses. All other components of our pension
income are reflected in other income.
Our effective income tax rates for the second quarter and first six months of
2020 were 22.1 percent and 22.8 percent, respectively. Our effective income tax
rates for the second quarter and first six months of 2019 were 22.8 percent and
21.5 percent, respectively. Our effective income tax rate in the first half of
2020 was higher than the effective income tax rate in the same period of 2019
primarily due to a change in geographic earnings mix. We estimate that our
annual effective income tax rate for the full year 2020 will be between 23.0 and
23.5 percent.
North America
Sales in the North America segment were $481 million in the second quarter of
2020 or $43 million lower than sales of $524 million in the second quarter of
2019. Sales for the first six months of 2020 were $1,013 million or $33 million
lower than sales of $1,046 million in the same period last year. The decrease in
sales in the second quarter and first six months of 2020 was primarily due to
lower commercial water heater volumes, lower boiler volumes and a water heater
sales mix composed of more electric models which have a lower selling price. The
sales decline in both periods was partially offset by organic growth of
approximately 19 percent and 17 percent in our North America water treatment
products in the second quarter and first half of 2020, respectively. Water-Right
added approximately $16 million of incremental sales to in the first half of
2020.
North America segment earnings were $105.4 million in the second quarter of 2020
or approximately 14 percent lower than segment earnings of $122.9 million in the
same period of 2019. Segment earnings in the first six months of 2020 were
$232.5 million or approximately three percent lower than segment earnings of
$238.9 million in the first six months of 2019. Segment margin of 21.9 percent
in the second quarter of 2020 was lower than 23.5 percent in the same period
last year. Segment margin of 22.9 percent in the first six months of 2020 was
essentially equal to the same period last year. Adjusted

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segment earnings and adjusted segment margin in the second quarter of 2020 were
$107.6 million and 22.4 percent, respectively. Adjusted segment earnings and
adjusted segment margin in the first half of 2020 were $234.7 million and
23.2 percent, respectively. Lower segment earnings and segment margin in the
second quarter were primarily driven by lower volumes of commercial water
heaters and boilers and a mix skew to electric water heaters. Segment earnings
and margin were also adversely impacted by certain costs related to the
pandemic, including temporarily moving production from Mexico to the U.S.,
paying employees during temporary plant shutdowns, proactively deep cleaning
facilities, paying benefits during employee furloughs and other costs, which
were approximately $5.5 million in the second quarter. These unfavorable factors
more than offset lower steel costs in the quarter compared with last year. Lower
segment earnings and segment margin in the first six months of 2020 were
primarily driven by the factors identified above, partially offset by lower
steel costs, and improvement in the profitability of water treatment sales,
including incremental profit from Water-Right. We expect full year segment
margin to be between 22.5 and 23.0 percent in 2020.
Adjusted segment earnings and adjusted segment margin in 2020 exclude
$2.2 million of
pre-tax
severance and restructuring expenses associated with an initiative to align our
business to current market conditions.
Rest of World
Sales in the Rest of World segment were $190 million in the second quarter of
2020 or $59 million lower than sales of $249 million in the second quarter of
2019. Sales in the first six months of 2020 were $300 million or $181 million
lower than sales of $481 million in the first six months of 2019. Sales in China
declined approximately 23 percent in U.S. dollar terms and 20 percent in local
currency in the second quarter of 2020 and declined approximately 40 percent in
U.S. dollar terms and 38 percent in local currency in the first six months of
2020 compared to the same period last year. The decrease in China sales in the
second quarter of 2020 was primarily due to a higher sales mix of
mid-price
products and further reductions in customer inventory levels. Consumer demand
for water heater and water treatment products in China was flat to slightly
positive compared with the second quarter of 2019. India sales declined
significantly as the economy was shut down during a majority of the second
quarter to minimize the spread of the virus. The decrease in Rest of World sales
in the first half of 2020 was primarily due to
COVID-19
pandemic-related weak consumer demand and the factors identified above. In
addition, our sales in China were adversely impacted by currency translation of
approximately $6 million and $9 million in the second quarter and first half of
2020, respectively, compared to the same periods last year, due to the
depreciation of the Chinese currency compared to the U.S. dollar.
Rest of World segment losses were $5.8 million in the second quarter of 2020,
compared to earnings of $22.4 million in the second quarter of 2019. Segment
losses in the first six months of 2020 were $48.0 million, compared to earnings
of $34.7 million in the first half of 2019. Adjusted segment losses in the
second quarter and first half of 2020 were $1.9 million and $44.1 million,
respectively. The unfavorable impact from lower China sales and a higher mix of
mid-price
products, which have lower margins compared to our historical mix of higher
priced products, was partially offset by the benefits from lower SG&A expenses
in that region. As a result of these factors, the segment margin and adjusted
segment margin in the second quarter and first half of 2020 was negative
compared with 9.0 percent and 7.2 percent in the same periods of 2019,
respectively. We expect full year segment margin to be between (2.5) percent and
(1.0) percent in 2020.
Adjusted segment earnings in 2020 exclude $3.9 million of
pre-tax
severance and restructuring expenses associated with an initiative to align our
business to current market conditions.

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Outlook


We project consolidated sales will decline by approximately seven to eight
percent in 2020 compared to 2019 due to declines in sales in China as well as
lower commercial water heater and boiler volumes in the U.S. which will more
than offset an expected 20 to 22 percent sales growth in North America water
treatment products. We believe we will achieve full-year earnings of between
$1.69 and $1.83 per share, which excludes the potential impact from future
acquisitions. We believe we will achieve full-year adjusted earnings of between
$1.72 and $1.86 per share, which excludes severance and restructuring expenses
and the potential impact from future acquisitions. Our guidance assumes the
conditions of our business environment and that of our suppliers and customers
are similar for the remainder of the year to what we are experiencing currently
and does not deteriorate as a result of further restrictions or shut downs due
to the
COVID-19
pandemic.
Liquidity & Capital Resources
Working capital of $709.0 million at June 30, 2020 was $24.9 million lower than
at December 31, 2019, driven by lower sales-related accounts receivable and
accounts payable balances and higher liabilities for income taxes, primarily due
to the deferral of our April 2020 estimated federal income tax payment to July
2020. As of June 30, 2020, approximately $327 million of the $568.7 million of
cash, cash equivalents and marketable securities was held by our foreign
subsidiaries. We repatriated $178 million in cash to the U.S. in the first half
of 2020.
Cash provided by operations in the first six months of 2020 was $179.3 million
compared with $143.7 million provided during the same period last year. Lower
investments in working capital compared with the same period in 2019, which were
partially offset by lower earnings, resulted in higher cash provided by
operations. We continue to monitor developments on an
on-going
basis and have taken proactive measures to focus on cash, manage working capital
and reduce costs. For the full year 2020, we expect cash provided by operating
activities will be approximately $350 million, compared with $456.2 million in
2019.
Capital expenditures totaled $24.8 million in the first six months of 2020,
compared with $36.5 million in the year ago period. We project our 2020 capital
expenditures to be between $60 and $70 million, lower than our approximately
$80 million average annual spending in the last three years. We expect full year
depreciation and amortization will be approximately $80 million.
We have a $500 million multi-currency credit facility with a group of nine
banks, which expires in December 2021. The facility has an accordion provision,
which allows us to increase it up to $700 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, 2020.
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, 2020, we had available borrowing capacity of $332 million
under this facility. We believe the combination of available borrowing capacity
and operating cash flows will provide sufficient funds to finance our existing
operations for the foreseeable future.
Our total debt declined slightly from $284.0 million at December 31, 2019 to
$281.1 million at June 30, 2020. Our leverage, as measured by the ratio of total
debt to total capitalization, calculated excluding operating lease liabilities,
was 14.5 percent at the end of the second quarter in 2020, compared with
14.6 percent at the end of last year.

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Our pension plan continues to meet all funding requirements under ERISA
regulations. We are not required to make a contribution and we do not plan to
make any voluntary contributions to the plan in 2020.
In the second quarter of 2019, our Board of Directors approved adding three
million 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 a 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 half of
2020, we repurchased 1,348,391 shares of our stock at a total cost of
$56.7 million. At June 30, 2020, we had 1,613,824 million shares remaining on
the board share repurchase authority. Due to the uncertainty surrounding the
impact of the global
COVID-19
pandemic, we suspended our share repurchases on March 18, 2020.
On July 13, 2020, our Board of Directors declared a regular quarterly cash
dividend of $0.24 per share on our Common Stock and Class A common stock. The
five-year compound annual growth rate of our dividend is approximately
20 percent. The dividend is payable on August 17, 2020 to shareholders of record
on July 31, 2020.
Non-GAAP
Financial Information
We provide
non-GAAP
measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted
segment earnings) that exclude severance and restructuring expenses in 2020.
We believe that the measures of adjusted earnings, adjusted EPS and adjusted
segment earnings provide useful information to investors about our performance
and allow management and our investors to better compare our performance period
over period.

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                            A. O. SMITH CORPORATION
                       Adjusted Earnings and Adjusted EPS
                  (dollars in millions, except per share data)
                                  (unaudited)
The following is a reconciliation of net earnings and diluted EPS to adjusted
earnings
(non-GAAP)
and adjusted EPS
(non-GAAP):


                                                       Three Months Ended           Six Months Ended

                                                            June 30,                    June 30,
                                                       2020           2019          2020         2019
Net Earnings (GAAP)                                  $    67.8       $ 102.1      $  119.5      $ 191.4
Severance and restructuring expenses, before tax           6.1            -            6.1           -
Tax effect of severance and restructuring
expenses                                                  (1.1 )          -           (1.1 )         -

Adjusted Earnings                                    $    72.8       $ 102.1      $  124.5      $ 191.4

Diluted EPS (GAAP)                                   $    0.42       $  0.61      $   0.74      $  1.14
Severance and restructuring expenses, per diluted
share                                                     0.04            -           0.04           -
Tax effect of severance and restructuring
expenses per diluted share                               (0.01 )          -          (0.01 )         -

Adjusted EPS                                         $    0.45       $  0.61      $   0.77      $  1.14



                            A. O. SMITH CORPORATION
                           Adjusted Segment Earnings
                             (dollars in millions)
                                  (unaudited)
The following is a reconciliation of reported segment earnings to adjusted
segment earnings
(non-GAAP):


                                       Three Months Ended           Six Months Ended
                                            June 30,                    June 30,
                                       2020           2019          2020         2019
Segment Earnings (GAAP)
North America                        $   105.4       $ 122.9      $  232.5      $ 238.9
Rest of World                             (5.8 )        22.4         (48.0 )       34.7
Inter-segment earnings elimination        (0.3 )        (0.1 )        (0.3 )       (0.1 )

Total Segment Earnings (GAAP)        $    99.3       $ 145.2      $  184.2      $ 273.5

Adjustments
North America
(1)                                  $     2.2       $    -       $    2.2      $    -
Rest of World
(2)                                        3.9            -            3.9           -

Total Adjustments                    $     6.1       $    -       $    6.1      $    -

Adjusted Segment Earnings
North America                        $   107.6       $ 122.9      $  234.7      $ 238.9
Rest of World                             (1.9 )        22.4         (44.1

) 34.7 Inter-segment earnings elimination (0.3 ) (0.1 ) (0.3 ) (0.1 )

Total Adjusted Segment Earnings $ 105.4 $ 145.2 $ 190.3

    $ 273.5

(1) In the second quarter of 2020, the Company recognized $2.2 million of

severance and restructuring expenses. For additional information, see Note 4

of the notes to the financial statements.

(2) In the second quarter of 2020, the Company recognized $3.9 million of

severance and restructuring expenses. For additional information, see Note 4


    of the notes to the financial statements.



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                            A. O. SMITH CORPORATION
                    Adjusted EPS and Adjusted 2020 Guidance
                                  (unaudited)
The following is a reconciliation of diluted EPS to adjusted EPS
(non-GAAP):

                                                             2020 Guidance         2019
Diluted EPS (GAAP)                                           $  1.69 - 1.83       $ 2.22
Severance and Restructuring expenses per diluted share,
net of tax                                                             0.03           -

Adjusted EPS                                                 $  1.72 - 1.86       $ 2.22



Critical Accounting Policies
Our consolidated financial statements are prepared 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, 2019. We believe that at June 30, 2020, there
has been no material change to this information.
Recent Accounting Pronouncements
Refer to
Recent Accounting Pronouncements
in Note 1 - Basis of Presentation in the notes to our condensed consolidated
financial statements included in Part 1 Financial Information.
Forward Looking Statements
This filing contains statements that the Company believes 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," "continue," "guidance" or words of similar meaning. 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:
negative impacts to the Company's business, including demand for its products,
operations and work-force dislocation and disruption, supply chain disruption
and liquidity as a result of the severity and duration of the
COVID-19
pandemic; a failure to recover or a further weakening of the Chinese economy
and/ or a failure to recover or a further decline in the growth rate of consumer
spending or housing sales in China; negative impact to the Company's businesses
from international tariffs and trade disputes; potential further weakening in
the high efficiency boiler segment in the U.S.; significant volatility in raw
material availability and prices; inability of the Company to implement or
maintain pricing actions; a failure to recover or further weakening in U.S.
residential or commercial construction or instability in the Company's
replacement markets; foreign currency fluctuations; the Company's inability to
successfully integrate or achieve its strategic objectives resulting from
acquisitions; competitive pressures on the Company's businesses; the impact of
potential information technology or data security breaches; changes in
government regulations or regulatory requirements; and adverse developments in
general economic, political and business conditions in key regions of the world.
Forward-looking statements included in this filing are made only as of the date
of this filing, and the Company is under no obligation to update these
statements to reflect subsequent events or circumstances. All subsequent written
and oral forward-looking statements attributed to the Company, or persons acting
on its behalf, are qualified entirely by these cautionary statements.

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