OVERVIEW
Our company is comprised of two reporting segments:North America and Rest of World. Our Rest of World segment is primarily comprised ofChina ,Europe andIndia . 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 inChina . InJanuary 2020 , an outbreak of a novel coronavirus (COVID-19) surfaced inWuhan, 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 inChina closed for approximately four weeks before resuming production before the end of the first quarter. InMarch 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 theU.S. are also deemed essential underCybersecurity 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 theU.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 inChina through headcount reductions, store closures, cuts in advertising and other cost saving measures, as well as inNorth America through headcount reductions. We estimate that between 80 to 85 percent of our water heater and boiler units sold in theU.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. 25 -------------------------------------------------------------------------------- We expect sales ofNorth 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 ourWater-Right, Inc. (Water-Right) acquisition, which we completed inApril 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 inChina 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 inChina and lower commercial water heater and boiler volumes inNorth America . The decreased demand in both periods more than offset higher water treatment volumes inNorth America , which included incremental sales of$16 million in the first six months of 2020 from Water-Right, acquired onApril 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. 26 -------------------------------------------------------------------------------- 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 theNorth 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 ourNorth 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 27 -------------------------------------------------------------------------------- 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 fromMexico to theU.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 inChina declined approximately 23 percent inU.S. dollar terms and 20 percent in local currency in the second quarter of 2020 and declined approximately 40 percent inU.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 inChina 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 inChina 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 inChina 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 theU.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 lowerChina 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. 28
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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 inChina as well as lower commercial water heater and boiler volumes in theU.S. which will more than offset an expected 20 to 22 percent sales growth inNorth 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 atJune 30, 2020 was$24.9 million lower than atDecember 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 ourApril 2020 estimated federal income tax payment toJuly 2020 . As ofJune 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 theU.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 inDecember 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 ofJune 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. AtJune 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 atDecember 31, 2019 to$281.1 million atJune 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. 29 -------------------------------------------------------------------------------- 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 . AtJune 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 onMarch 18, 2020 . OnJuly 13, 2020 , our Board of Directors declared a regular quarterly cash dividend of$0.24 per share on our Common Stock and Class A common stock. The five-year compound annual growth rate of our dividend is approximately 20 percent. The dividend is payable onAugust 17, 2020 to shareholders of record onJuly 31, 2020 . Non-GAAP Financial Information We provide non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment earnings) that exclude severance and restructuring expenses in 2020. We believe that the measures of adjusted earnings, adjusted EPS and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better compare our performance period over period. 30 -------------------------------------------------------------------------------- A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted EPS to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP): Three Months Ended Six Months Ended June 30, June 30, 2020 2019 2020 2019 Net Earnings (GAAP)$ 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
$ 273.5
(1) In the second quarter of 2020, the Company recognized
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
severance and restructuring expenses. For additional information, see Note 4
of the notes to the financial statements. 31
-------------------------------------------------------------------------------- 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 theU.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 endedDecember 31, 2019 . We believe that atJune 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 inChina ; negative impact to the Company's businesses from international tariffs and trade disputes; potential further weakening in the high efficiency boiler segment in theU.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 inU.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. 32
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