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. 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. InMarch 2020 , COVID-19 was declared a global pandemic and we experienced impacts to our business and other markets worldwide. 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. As we continue to receive guidance from governmental authorities, we adjust our safety measures to meet or exceed those guidelines. Our global supply chain management team continued to navigate through supply chain and logistics challenges. We have seen supply constraints for certain components and raw materials used in our operations, as well as limited container and trucking capacity, and port congestion and delays. We expect those challenges to continue for the foreseeable future and we remain in close communication with our suppliers. In ourNorth America segment, we expect residential water heater industry volumes will increase approximately six percent in 2021 compared with 2020, driven by continued growth in replacement demand and new home construction. We believe that commercial water heater industry volumes will increase approximately ten percent in 2021 as pandemic-impacted businesses continue to re-open and new construction and replacement installations increase. We continue to experience significant inflation across our supply chain, particularly steel and logistics costs. In response to continued material and logistics cost increases, we have implemented price increases, including our announced fifth price increase in 2021 on water heaters in September, effective onNovember 15, 2021 . When fully realized at the end of 2021, the five announced inflation-related price increases on water heaters compound to approximately 50 percent. We expect our boiler sales to grow by approximately 13 percent in 2021 compared to 2020 due to pandemic-related pent-up demand as well as our new product introductions. We expect sales of ourNorth America water treatment products to increase by approximately 12 percent in 2021, compared to 2020, primarily driven by consumer demand for our point of use and point of entry water treatment systems. In our Rest of World segment, we expectChina sales in 2021 to increase 20 to 22 percent in local currency terms compared with 2020 due to higher volumes and increased consumer demand for our higher priced products across all of our product categories driven by differentiated new products we launched in the last 12 to 24 months. Our sales inChina were negatively impacted by COVID-19 pandemic related shutdowns in 2020. We assumeChina currency rates will stay at current levels and add approximately$54 million and$4 million to sales and earnings in 2021, respectively. RESULTS OF OPERATIONS THIRD QUARTER AND FIRST NINE MONTHS OF 2021 COMPARED TO 2020 Sales in the third quarter of 2021 were$915 million , or approximately 20 percent higher than sales of$760 million in the third quarter of 2020. Sales in the first nine months of 2021 were$2,543 million or approximately 23 percent higher than sales of$2,061 million in the same period last year. Both periods in 2020 were negatively impacted by the COVID-19 pandemic. Our sales increases in the third quarter and first nine months of 2021 compared to the same periods of the previous year were primarily driven by inflation-related pricing actions and higher water heater, boiler, and water treatment volumes inNorth America as well as higher sales inChina . Our sales inChina also benefited from currency translation of approximately$14 million and$49 million in the third quarter and first nine months of 2021, respectively, due to the appreciation of the Chinese currency against theU.S. Dollar. Gross profit margin in the third quarter of 2021 was 37.2 percent compared to gross profit margin of 39.1 percent in the same period last year. Gross profit margin in the first nine months of 2021 was 37.4 percent compared to the gross profit margin of 38.0 percent in the first nine months of 2020. The lower gross margin in both periods of 2021 compared to 2020 was primarily due to higher steel and other material costs which outpaced our pricing actions. Selling, general, and administrative (SG&A) expenses in the third quarter and first nine months of 2021 increased by$18.2 million and$28.1 million , respectively, compared to the prior-year periods. The increase in SG&A expenses in the third quarter and first nine months of 2021 was primarily due to higher advertising, engineering and selling expenses and higher 19 -------------------------------------------------------------------------------- Table of Contents management incentive expenses related to higher earnings compared to the same periods last year. Higher SG&A expenses in both the third quarter and first nine months of 2021 were partially offset by lower spending inChina associated with headcount reductions, store closures and other cost-saving measures previously implemented during 2020. During the third quarter and first nine months of 2020, aligning our business to market conditions, we recognized$1.6 million and$7.7 million , respectively, of pre-tax severance and restructuring expenses. These expenses were primarily comprised of$1.6 million of severance expenses in the third quarter of 2020 and$6.8 million of severance costs and$0.9 million of other restructuring expenses in the first nine months of 2020. 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. Interest expense in the third quarter of 2021 was$1.0 million compared to$1.6 million in the same period last year. Interest expense in the first nine months of 2021 was$2.9 million compared to$6.3 million in the same period the previous year. The decrease in interest expense in the third quarter and first nine months of 2021 compared to the same periods last year was primarily due to lower debt levels. Other income was$4.7 million in the third quarter of 2021, higher than$2.8 million in the same period last year. Other income in the first nine months of 2021 was$13.6 million compared to$11.0 million in the first nine months of 2020. The increase in other income in the third quarter and first nine months of 2021 compared to the same periods last year was primarily due to higher pension income. The third quarter of 2021 also benefited from higher 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 6.25 percent in 2021 compared to 6.75 percent in 2020. The discount rate used to determine net periodic pension costs decreased to 2.45 percent in 2021 from 3.18 percent in 2020. Pension income for the third quarter and first nine months of 2021 was$2.9 million and$8.7 million , respectively, compared to$1.8 million and$5.9 million in the third quarter and first nine months of 2020, 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 third quarter and first nine months of 2021 were 20.9 percent and 21.7 percent, respectively. Our effective income tax rates for the third quarter and first nine months of 2020 were 23.2 percent and 23.0 percent, respectively. Our effective income tax rates in the third quarter and first nine months of 2021 were lower than the effective income tax rates in the same periods of 2020 primarily due to a change in geographic earnings mix as well as a favorable tax impact of 4.2 million related to amending a previously filed tax return. We estimate that our annual effective income tax rate for the full year 2021 will be approximately 22.0 percent.North America Sales in theNorth America segment were$658 million in the third quarter of 2021, or$114 million higher than sales of$544 million in the third quarter of 2020. Sales in the first nine months of 2021 were$1,815 million or$258 million higher than sales of$1,557 million in the same period last year. The increases in sales in the third quarter and first nine months 2021 compared to the prior-year periods were primarily due to the impact of pricing actions, largely on water heaters, implemented to offset higher steel, other material and logistics costs, as well as higher water heater, boiler, and water treatment volumes.North America segment earnings were$151.8 million in the third quarter of 2021, or approximately 14 percent higher than segment earnings of$133.1 million in the same period of 2020. Segment earnings in the first nine months of 2021 were$423.9 million , or approximately 16 percent higher than segment earnings of$365.6 million in the first nine months of 2020. Segment margin of 23.1 percent in the third quarter of 2021 was lower than segment margin of 24.5 percent in the same period last year. Segment margin of 23.4 percent in the first nine months of 2021 was slightly lower than segment margin of 23.5 percent in the same period last year. Adjusted segment earnings and adjusted segment margin in the third quarter of 2020 were$133.6 million and 24.6 percent, respectively. Adjusted segment earnings and adjusted segment margin in the first nine months of 2020 were$368.3 million and 23.6 percent, respectively. Higher segment earnings in the third quarter and first nine months of 2021 compared to the prior-year periods were primarily driven by inflation-related price increases implemented to offset higher costs as well as higher volumes, partially offset by higher material and freight costs. Segment earnings and margin in the prior-year periods were also adversely impacted by certain costs related to the pandemic. These costs included temporarily moving production fromMexico to theU.S. , paying employees during temporary plant shutdowns, proactively deep cleaning facilities, 20 -------------------------------------------------------------------------------- Table of Contents paying benefits during employee furloughs, and other costs, which were approximately$1.1 million and$6.6 million for the three and nine months ended 2020, respectively. We expect 2021 full-year segment margin to be between 22.75 and 23.0 percent. Adjusted segment earnings and adjusted segment margin in the third quarter and first nine months of 2020 exclude$0.5 million and$2.7 million , respectively, of pre-tax severance and restructuring expenses associated with an initiative to align our business to market conditions. Rest of World Sales in the Rest of World segment were$263 million in the third quarter of 2021,$42 million higher than sales of$221 million in the third quarter of 2020. Sales in the first nine months of 2021 were$749 million ,$228 million higher than sales of$521 million in the first nine months of 2020. Sales inChina increased approximately 19 percent inU.S. dollar terms and 12 percent in local currency in the third quarter of 2021 and increased approximately 46 percent inU.S. dollar terms and 36 percent in local currency in the first nine months of 2021 compared to the same periods last year. The increase in Rest of World sales in the third quarter and first nine months of 2021 was primarily due to sales growth in each of our major product lines inChina compared to the same periods last year. In addition, sales inChina benefited from currency translation of approximately$14 million and$49 million in the third quarter and first nine months of 2021, respectively, compared to the same periods last year, due to the appreciation of the Chinese currency compared to theU.S. dollar. Rest of World segment earnings were$26.8 million in the third quarter of 2021, compared to earnings of$16.7 million in the third quarter of 2020. Segment earnings in the first nine months of 2021 were$60.9 million , compared to losses of$31.3 million in the first nine months of 2020. Segment margin was 10.2 percent and 8.1 percent in the third quarter and first nine months of 2021, compared to 7.5 percent in the third quarter of 2020 and negative margin in the first nine months of 2020. Adjusted segment earnings in the third quarter of 2020 were$17.8 million and adjusted segment losses were$26.3 million in the first nine months of 2020. Higher segment earnings and segment margin in the third quarter and first nine months of 2021 compared to the prior-year periods were primarily driven by higher volumes that were partially offset by higher employee incentive costs and brand building-related advertising costs inChina compared to the same periods last year. In both periods in 2021, higher segment earnings and margins were partially offset by the absence of social insurance waivers, which we received inChina in the prior-year periods. We expect full-year segment margin to be approximately eight percent in 2021. Adjusted segment earnings in the third quarter and first nine months of 2020 exclude$1.1 million and$5.0 million , respectively, of pre-tax severance and restructuring expenses associated with an initiative to align our business to market conditions. Outlook Excluding the impact of our recent acquisition ofGiant Factories, Inc. (Giant), we expect our consolidated sales to grow between 20 and 21 percent in 2021 on inflation-related pricing actions and strongChina ,North America water heater, water treatment and boiler volumes. Our sales growth projection includes approximately$54 million of benefit fromChina currency translation. We increased the midpoint of our EPS guidance for 2021 and we believe we will achieve full-year net earnings of between$2.86 and$2.90 per share. Our 2021 guidance excludes the potential impacts from future acquisitions. Liquidity & Capital Resources Working capital of$756 million as ofSeptember 30, 2021 , was$24 million higher than atDecember 31, 2020 . The change in working capital was driven by sales-related increases to accounts receivable balances and higher inventories that were partially offset by higher accounts payable balances. As ofSeptember 30, 2021 , approximately$520 million of our$685 million of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. In the first nine months of 2021, we repatriated approximately$160 million of cash from our foreign subsidiaries. We used the proceeds to repurchase shares of our common stock. Cash provided by operations in the first nine months of 2021 was$376.8 million compared with$330.4 million during the same period last year. The impact of higher earnings was partially offset by higher investments in working capital compared with the same period in 2020. For the full year 2021, we expect cash provided by operating activities will be between$550 and$575 million , similar to 2020 cash provided by operating activities of$562 million primarily due to higher earnings in 2021 being offset by higher investments in working capital compared to last year. Capital expenditures totaled$45.3 million in the first nine months of 2021, compared with$36.7 million in the year-ago period. We project 2021 capital expenditures will be between$70 and$75 million , and full-year depreciation and amortization expense will be approximately$80 million . 21 -------------------------------------------------------------------------------- Table of Contents During the second quarter of 2021, we renewed and amended our$500 million revolving credit facility, which now expires onApril 1, 2026 . The renewed and amended facility, with a group of nine banks, has an accordion provision that allows it to be increased up to$850 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 ofSeptember 30, 2021 . We did not have borrowings on this facility as ofSeptember 30, 2021 . The facility backs up commercial paper and credit line borrowings. AtSeptember 30, 2021 , we had an available borrowing capacity of$500 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 decreased by$6.8 million from$113.2 million atDecember 31, 2020 to$106.4 million atSeptember 30, 2021 . Our leverage, as measured by the ratio of total debt to total capitalization, calculated excluding operating lease liabilities, was 5.3 percent atSeptember 30, 2021 , compared with 5.8 percent atDecember 31, 2020 . 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 2021. In the first quarter of 2021, our Board of Directors approved adding 7,000,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock 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 nine months of 2021, we repurchased 3,177,467 shares of our stock at a total cost of$212.0 million . As ofSeptember 30, 2021 , we had 5,436,357 shares remaining on the share repurchase authority. After a black out period on share repurchase activity in the third quarter related to the Giant acquisition, we plan to resume our repurchase program in early November. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we expect to spend approximately$400 million on stock repurchases in 2021 through a combination of our Rule 10b5-1 automatic trading plan and opportunistic repurchases in the open market. OnOctober 11, 2021 , our Board of Directors increased the rate of our quarterly cash dividend of$0.28 per share on our Common Stock and Class A common stock. The dividend is payable onNovember 15, 2021 , to shareholders of record onOctober 29, 2021 . OnOctober 19, 2021 , we acquired Giant, aCanada -based manufacturer of residential and commercial water heaters for approximately$192 million using a combination of debt and cash. Giant manufactures water heaters at two facilities inMontreal, Canada and sells water heating products under the Giant brand acrossCanada . Giant had trailing twelve-month annual sales of approximately$105 million . 22 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Financial Information We provide a non-GAAP measure, adjusted earnings per share (EPS) that excludes severance and restructuring expenses in 2020. We believe that this measure of adjusted EPS provides useful information to investors about our performance and allows management and our investors to better compare our performance period over period.A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited)
The following is a reconciliation of net earnings and diluted EPS to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP):
Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 Net Earnings (GAAP)$ 131.6 $ 105.4 $ 347.5 $ 224.9 Severance and restructuring expenses, before tax - 1.6 - 7.7 Tax effect of severance and restructuring expenses - (0.3) - (1.4) Adjusted Earnings$ 131.6 $ 106.7 $ 347.5 $ 231.2 Diluted EPS (GAAP)$ 0.82 $ 0.65 $ 2.15 $ 1.38 Severance and restructuring expenses, per diluted share -$ 0.01 - 0.05 Tax effect of severance and restructuring expenses per diluted share - $ - - (0.01) Adjusted EPS$ 0.82 $ 0.66 $ 2.15 $ 1.42 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 Nine Months Ended September 30, September 30, 2021 2020 2021 2020 Segment Earnings (GAAP) North America$ 151.8 $ 133.1 $ 423.9 $ 365.6 Rest of World 26.8 16.7 60.9 (31.3) Inter-segment earnings elimination (0.1) - (0.1) (0.3) Total Segment Earnings (GAAP)$ 178.5 $ 149.8 $ 484.7 $ 334.0 Adjustments North America(1) $ -$ 0.5 $ -$ 2.7 Rest of World(2) - 1.1 - 5.0 Total Adjustments $ -$ 1.6 $ -$ 7.7 Adjusted Segment Earnings North America$ 151.8 $ 133.6 $ 423.9 $ 368.3 Rest of World 26.8 17.8 60.9 (26.3) Inter-segment earnings elimination (0.1) - (0.1) (0.3) Total Adjusted Segment Earnings$ 178.5 $ 151.4 $
484.7
(1) In the third quarter and first nine months of 2020, the Company recognized$0.5 million and$2.7 million of severance and restructuring expenses, respectively. For additional information, see Note 3 of the notes to the financial statements. (2) In the third quarter and first nine months of 2020, the Company recognized$1.1 million and$5.0 million of severance and restructuring expenses, respectively. For additional information, see Note 3 of the notes to the financial statements. 23
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A. O. SMITH CORPORATION 2021 EPS Guidance and 2020 Adjusted EPS (unaudited) The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP): 2021 Guidance 2020 Diluted EPS (GAAP)$2.86 - 2.90$ 2.12 Severance and restructuring expenses per diluted share, net of tax - 0.04 Adjusted EPS$2.86 - 2.90$ 2.16 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, 2020 . We believe that atSeptember 30, 2021 , there has been no material change to this information. Recent Accounting Pronouncement Refer to Recent Accounting Pronouncement 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: the Company's ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to the Company's businesses, including demand for its products, particularly commercial products, operations and workforce dislocation and disruption as a result of the severity and duration of the COVID-19 pandemic; inability of the Company to implement or maintain pricing actions; an uneven recovery of the Chinese economy or decline in the growth rate of consumer spending or housing sales inChina ; negative impact to the Company's businesses from international tariffs, trade disputes and geopolitical differences; potential weakening in the high-efficiency boiler segment in theU.S. ; substantial defaults in payment, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer, including from the result of COVID-19; a 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.
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