SMITH A O CORP 10-Q

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world. We seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. This includes focusing on acquisitions that are related to our core business. Consistent with this strategy, we acquired Giant Factories, Inc. (Giant), a Canada-based manufacturer of residential and commercial water heaters, on October 19, 2021, for $199 million, subject to customary adjustments, using a combination of debt and cash. The acquisition fits squarely in our core capabilities, supplements our presence in Canada and enhances our capacity and distribution in the region. Giant contributed $32.0 million of sales and approximately $0.02 in earnings per share (EPS) to our results in the first quarter of 2022. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our previous introductions of water treatment products in India and range hoods and cooktops in China. Our global supply chain management team continued to navigate through supply chain and logistics challenges in the first quarter of 2022. We have seen supply constraints for certain components and raw materials used in our operations, limited container and trucking capacity, and port congestion and delays. In addition, while steel indices moderated as we moved into 2022, they have recently risen again, as commodity prices and availability remain volatile. We remain in close contact with our suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks, as the environment remains unpredictable, particularly with the conflict in Ukraine. Our business also continues to experience impacts from the novel coronavirus (COVID-19) pandemic. Omicron variant-related absenteeism negatively impacted North American production early in the first quarter. In addition, to slow the spread of COVID-19 in China, targeted lockdowns began in certain cities late in the first quarter. In our North America segment, after approximately eight percent growth in 2021, we expect residential industry water heater volumes will be down approximately two percent in 2022 compared with 2021 as we believe that industry demand will normalize to more historical growth rates. We believe that commercial water heater industry volumes will be flat to slightly down in 2022 compared to 2021 as we anticipate that new construction and replacement installations will level off. We expect sales in 2022 will benefit from our 2021 price increases, which had a cumulative effect on our water heater prices of approximately 50 percent. We expect to see a 18 to 20 percent increase in our sales of boilers in 2022 compared to 2021 driven by increased pricing in response to higher input cost and higher demand. We anticipate sales of our North America water treatment products will increase 13 to 14 percent in 2022, compared to 2021, primarily driven by higher consumer demand for our point of use and point of entry water treatment systems. In our Rest of World segment, after strong growth in 2021, we expect 2022 sales in China to be flat in local currency compared with 2021 as a result of economic headwinds from COVID-19-related lockdowns. We assume China currency rates will stay at levels similar to 2021. Combining all of these factors, we expect our consolidated sales to increase between 14 and 16 percent in 2022. This guidance excludes the potential impacts from future acquisitions and assumes the COVID-19 related lockdowns in China subside during the second quarter of 2022, and that COVID-19 does not significantly impact our operations or our employees, customers or suppliers. 18 Table of Contents Results of Operations (dollars in millions) Three Months Ended March 31, 2022 2021 Net sales $ 977.7 $ 769.0 Cost of products sold 636.1 480.4 Gross profit 341.6 288.6 Gross profit margin % 34.9 % 37.5 % Selling, general and administrative expenses 179.8 166.5 Interest expense 1.5 1.0 Other expense (income) - net 3.7 (5.0) Earnings before provision for income taxes 156.6 126.1 Provision for income taxes 36.8 28.4 Net Earnings $ 119.8 $ 97.7 Our sales in the first quarter of 2022 were $977.7 million, or 27.1 percent higher than 2021 first quarter sales of $769.0 million. Compared to the prior year quarter, our sales increase was primarily driven by inflation-related pricing actions in North America as well as higher sales in China. Our acquisition of Giant added $32.0 million of incremental sales in 2022. In addition, our sales in China were favorably impacted by approximately $5 million in the first quarter of 2022 compared to the first quarter of 2021, due to the appreciation of the Chinese currency compared to the U.S. dollar. Our gross profit margin in the first quarter of 2022 was 34.9 percent and declined compared to 37.5 percent in the first quarter of 2021. The lower gross profit margin in the first quarter of 2022 was primarily due to higher steel and other material costs which outpaced our pricing actions. Selling, general, and administrative (SG&A) expenses were $179.8 million in the first quarter of 2022 or $13.3 million higher than the first quarter of 2021. The increase in SG&A expenses was primarily driven by higher selling expenses in North America due to higher sales compared to the prior year period. Interest expense in the first quarter of 2022 was $1.5 million, and higher compared to $1.0 million in the first quarter of 2021 primarily due to higher debt levels. Other expense was $3.7 million in the first quarter of 2022 compared to other income of ($5.0) million in the first quarter of 2021. Pension expense in the first quarter of 2022 was $3.6 million compared to pension income of $2.9 million in the first quarter of 2021. In 2021, our Board of Directors approved the termination of our largest defined benefit pension plan (the Plan) representing over 95 percent of our pension plan liabilities with a termination date of December 31, 2021. In April 2022, we received a determination letter from the IRS that allowed us to proceed with the termination process for the Plan. In 2022, we expect to annuitize the remaining Plan pension liability. The Plan settlement, which we expect to complete in the fourth quarter of 2022, will accelerate the recognition of approximately $445 million, or approximately $1.73 per share, of non-cash, pre-tax pension expenses. In addition, to protect the Plan’s funded status, the Plan transferred a significant portion of its assets to lower risk investments in 2021. The impact of this transition resulted in a lower expected rate of return on pension investments and accordingly, higher pension expenses in 2022, compared to previous years. 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 expense (income) are reflected in other expense (income). We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense) that exclude the impact of pension settlement expenses and non-operating pension income and expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the financial information included in this filing. We believe that the measures of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance. 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 19 Table of Contents conditions, including changes in interest rates, in making these assumptions. Our assumption for the expected rate of return on plan assets is 3.00 percent in 2022 compared to 6.25 percent in 2021. The discount rate used to determine net periodic pension costs increased to 2.72 percent in 2022 from 2.45 percent in 2021. Our effective income tax rate was 23.5 percent in the first quarter of 2022, compared with 22.5 percent in the first quarter of 2021. Our higher effective income tax rate was primarily due to a change in geographic earnings mix. We estimate that our annual effective income tax rate for the full year of 2022 will be between 23.5 and 24 percent. North America Segment (dollars in millions) Three Months Ended March 31, 2022 2021 Net Sales $ 730.1 $ 552.9 Segment Earnings 151.8 130.4 Segment margin 20.8 % 23.6 % Sales in our North America segment were $730.1 million in the first quarter 2022 or $177.2 million higher than sales of $552.9 million in the first quarter of 2021. The increased sales in the first quarter of 2022 were driven primarily by price increases, largely on water heaters, which were implemented in response to rising material and transportation costs. The first quarter of 2022 also benefited from higher volumes of boilers and water treatment products. Those increases were partially offset by lower commercial water heater volumes. In addition, our acquisition of Giant added $32.0 million of incremental sales in 2022. North America segment earnings were $151.8 million in the first quarter of 2022, an increase of 16 percent compared to segment earnings of $130.4 million in the first quarter of 2021. Segment margins were 20.8 percent and 23.6 percent in the first quarter of 2022 and 2021, respectively. Adjusted segment earnings and adjusted segment margin in the first quarter of 2022 were $154.4 million and 21.1 percent, respectively. Adjusted segment earnings and adjusted segment margin in the first quarter of 2021 were $127.8 million and 23.1 percent, respectively. Higher segment earnings in the first quarter of 2022 were primarily due to inflation-related price increases, partially offset by higher material and logistics costs. Segment margin was lower in the first quarter of 2022 primarily due to the rise in costs outpacing pricing actions and lower commercial volumes. We estimate our 2022 North America segment margin will be between 22.5 and 23.0 percent, excluding pension expense. Adjusted segment earnings and adjusted segment margin in the first quarter of 2022 and 2021 exclude $2.6 million and ($2.6) million of pension expense (income), respectively. Rest of World Segment (dollars in millions) Three Months Ended March 31, 2022 2021 Net Sales $ 256.0 $ 222.3 Segment Earnings 24.8 11.8 Segment margin 9.7 % 5.3 % Sales in our Rest of World segment were $256.0 million in the first quarter of 2022 or $33.7 million higher than sales of $222.3 million in the first quarter of 2021. Sales in China increased by 15 percent in U.S. dollar terms and 12 percent in local currency in the first quarter of 2022 compared to the first quarter of 2021. Higher sales in China were primarily driven by favorable mix in water heaters and water treatment products and higher sales for commercial water treatment products and replacement filters compared to the first quarter of 2021. Sales were also positively impacted by measures to distribute product into the market in advance of potential COVID-19 lockdowns in China, which have temporarily impacted transportation between impacted regions. In addition, our first quarter of 2022 sales in China were favorably impacted by approximately $5 million, due to the appreciation of the Chinese currency compared to the U.S. dollar. Rest of World segment earnings were $24.8 million in the first quarter of 2022, an increase of $13.0 million compared to segment earnings of $11.8 million in the first quarter of 2021. Segment margin was 9.7 percent in the first quarter of 2022, higher than segment margin of 5.3 percent in the prior year period. Higher segment earnings and segment margin compared to the prior year period were primarily driven by favorable mix, higher volumes and lower advertising and selling expenses in China. We expect full-year segment margin to be between 9.5 and 10 percent in 2022. 20 Table of Contents Outlook We expect our consolidated sales in 2022 to increase between 14 to 16 percent compared to 2021. Our higher expected sales are driven by pricing actions implemented in 2021 in North America and expected increased boiler and water treatment volumes within that region. We expect to achieve full-year earnings of between $1.56 and $1.76 per share and adjusted EPS between $3.35 and $3.55 per share. Our 2022 guidance excludes the potential impacts from future acquisitions and assumes the COVID-19 related lockdowns in China subside during the second quarter of 2022, and that COVID-19 does not significantly impact our operations or our employees, customers or suppliers. Liquidity & Capital Resources Our working capital was $719.3 million at March 31, 2022 compared with $633.8 million at December 31, 2021. A majority of the increase in working capital was driven by lower accounts payable and payroll related accruals and higher inventory balances than at December 2021, which was partially offset by lower accounts receivables and cash balances. We expect to repatriate approximately $100 million in 2022 and use the proceeds to pay down debt balances and repurchase our common stock. (dollars in millions) Three Months Ended March 31, 2022 2021 Cash provided by operating activities $ 16.5 $ 104.4 Cash provided by investing activities 2.1 12.5 Cash used in financing activities (56.1) (111.5) Cash provided by operating activities in the first quarter of 2022 was $16.5 million compared with $104.4 million in the first quarter of 2021. Higher earnings in the first quarter of 2022 compared with the prior year was more than offset by higher incentive payments in 2022 due to record 2021 sales and earnings and working capital cash outlays for higher levels of safety stock on higher cost inventory, led to lower cash provided by operating activities. Our free cash flow in the first quarter of 2022 and 2021 was $3.6 million and $87.3 million, respectively. We expect free cash flow to be between $500 million to $525 million in 2022. Free cash flow is a non-GAAP measure and is described in more detail in the Non-GAAP Measures section below. Our capital expenditures were $12.9 million in the first quarter of 2022 and $17.1 million in the first quarter of 2021. We project our 2022 capital expenditures will be between $75 and $80 million and project depreciation and amortization will be approximately $80 million. In 2021, we renewed and amended our $500 million revolving credit facility, which now expires on April 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 of March 31, 2022 and expect to be in compliance for the foreseeable future. The facility backs up commercial paper and credit line borrowings. At March 31, 2022, we had $155.0 million outstanding under the facility and an available borrowing capacity of $345.0 million. 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 increased by $98.7 million from $196.7 million at December 31, 2021 to $295.4 million at March 31, 2022. The increase in debt balances was due to repurchases of our common stock. Our leverage, as measured by the ratio of total debt to total capitalization, calculated excluding operating lease liabilities, was 14.0 percent at March 31, 2022, compared with 9.7 percent at December 31, 2021. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2021. We forecast that we will not be required to make a contribution to the plan in 2022, and we do not plan to make any voluntary contributions in 2022. In the first quarter of 2022, our Board of Directors approved adding 3,500,000 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 quarter of 2022, we repurchased 1,486,500 shares of our stock at a total cost of $107.9 million. At March 31, 2022, we had 5,539,857 million shares remaining on the share repurchase authority. Depending on factors such as stock price, working capital 21 Table of Contents requirements and alternative investment opportunities, we expect to spend approximately $400 million on stock repurchases in 2022 through a combination of our Rule 10b5-1 automatic trading plan and open market repurchases. On April 11, 2022, our Board of Directors declared a regular quarterly cash dividend of $0.28 per share on our Common Stock and Class A common stock. The dividend is payable on May 16, 2022, to shareholders of record on April 29, 2022. Non-GAAP Financial Information We provide non-GAAP measures of free cash flow, adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense. We define free cash flow as cash provided by operating activities less capital expenditures. Our adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expenses excludes the impact of pension settlement expenses and non-operating pension income and expenses. We believe that free cash flow provides useful additional information concerning cash flow available to meet future debt service obligations and working capital requirements. We believe that the measure of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provides useful information to investors about our performance and allows management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance. 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 March 31, 2022 2021 Net Earnings (GAAP) $ 119.8 $ 97.7 Pension expense (income), before tax 2.9 (3.2) Tax effect of pension expense (income) (0.7) 0.8 Adjusted Earnings (non-GAAP) $ 122.0 $ 95.3 Diluted EPS (GAAP) $ 0.76 $ 0.60 Pension expense (income) per diluted share, before tax 0.01 (0.01) Tax effect of pension expense (income), per diluted share — — Adjusted EPS (non-GAAP) $ 0.77 $ 0.59 22 Table of Contents 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 March 31, 2022 2021 Segment Earnings (GAAP) North America $ 151.8 $ 130.4 Rest of World 24.8 11.8 Inter-segment earnings elimination (0.1) — Total Segment Earnings (GAAP) $ 176.5 $ 142.2 Adjustments: North America pension expense (income) $ 2.6 $ (2.6) Rest of World — — Inter-segment earnings elimination — — Total Adjustments $ 2.6 $ (2.6) Adjusted Segment Earnings (non-GAAP) North America $ 154.4 $ 127.8 Rest of World 24.8 11.8 Inter-segment earnings elimination (0.1) — Total Adjusted Segment Earnings (non-GAAP) $ 179.1 $ 139.6 A. O. SMITH CORPORATION Adjusted Corporate Expense (dollars in millions) (unaudited) The following is a reconciliation of reported Corporate Expense to adjusted Corporate Expense (non-GAAP): Three Months Ended March 31, 2022 2021 Corporate Expense (GAAP) $ (18.4) $ (15.1) Adjustments: Corporate pension expense (income) 0.3 (0.6) Corporate Expense (non-GAAP) $ (18.1) $ (15.7) 23 Table of Contents A. O. SMITH CORPORATION Free Cash Flow (dollars in millions) (unaudited) The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP): Three Months Ended, March 31, 2022 2021 Cash provided by operating activities (GAAP) $ 16.5 $ 104.4 Less: Capital expenditures (12.9) (17.1) Free cash flow (non-GAAP) $ 3.6 $ 87.3 A. O. SMITH CORPORATION 2022 Adjusted EPS Guidance and 2021 Adjusted EPS (unaudited) The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax): 2022 Guidance 2021 Diluted EPS (GAAP) $ 1.56 - 1.76 $ 3.02 Estimated pension settlement charge 1.73 (1) — Pension expense (income) 0.06 (2) (0.06) (3) Adjusted EPS (non-GAAP) $ 3.35 - 3.55 $ 2.96 (1) Includes pre-tax pension settlement charges of $378.3 million and $66.7 million, within the North America segment and Corporate expenses, respectively. (2) Includes pre-tax pension expense of $10.5 million and $1.3 million, within the North America segment and Corporate expenses, respectively. (3) Includes pre-tax pension income of $10.5 million and $2.6 million, within the North America segment and Corporate expenses, respectively. 24 Table of Contents 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, 2021. We believe that at March 31, 2022, there was 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”, “outlook” 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 demand for the Company’s products, particularly commercial products, and to its operations and workforce 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 in China; negative impact to the Company’s businesses from international tariffs, trade disputes and geopolitical differences, including the conflict in Ukraine; potential weakening in the high-efficiency boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; a 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.