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 saw improvement in our supply chain during 2022, particularly in the second half of the year and remained relatively stable through the first quarter of 2023. We remain in close contact with our suppliers and logistics providers to resolve supply chain constraints as they arise. We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. 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. In the first quarter of 2023, we committed to a plan to sell our business in Turkey. We recognized a non-cash impairment charge in the first quarter of $15.6 million, primarily in anticipation of the liquidation of the cumulative foreign currency translation adjustment. While the more project based business model in Turkey did not fit well in our strategy, we remain committed to our global water treatment business and will continue to invest in other regions. In our North America segment, we saw resilient demand in the residential water heater industry in the first quarter. We continue to monitor proactive replacement and new home completions. We project 2023 industry residential unit volumes will be approximately flat to 2022. Demand for commercial electric water heaters was strong in the first quarter of 2023 compared to the first quarter of 2022 and our orders remain strong in April. Therefore, we expect that commercial water heater industry volumes will increase mid-single digits compared to 2022. We expect to see a mid-single digit increase in our sales of boilers in 2023 compared to 2022, driven by pricing and demand for our high efficiency commercial boilers. We anticipate sales of our North America water treatment products will increase approximately five to seven percent in 2023, compared to 2022, primarily driven by pricing and consumer demand. In our Rest of World segment, our China business performed as we expected in the first quarter and we saw sequential month over month improvement in sales. We believe it will take time for consumer confidence to strengthen and for the economy to improve. We project our sales in China will grow three to five percent in 2023 in local currency compared to 2022. Our guidance assumes volume will improve sequentially throughout the year. We assume that currency translation will negatively impact sales by approximately two percent. Combining all of these factors, we expect our 2023 consolidated sales to be approximately flat to 2022 with a range of plus or minus two percent. Our guidance excludes the impacts from potential future acquisitions. 19 Table of Contents Results of Operations (dollars in millions) Three Months Ended March 31, 2023 2022 Net sales $ 966.4 $ 977.7 Cost of products sold 592.3 636.1 Gross profit 374.1 341.6 Gross profit margin % 38.7 % 34.9 % Selling, general and administrative expenses 187.2 179.8 Impairment expense 15.6 — Interest expense 4.0 1.5 Other (income) expense - net (4.0) 3.7 Earnings before provision for income taxes 171.3 156.6 Provision for income taxes 44.4 36.8 Net Earnings $ 126.9 $ 119.8 Our sales in the first quarter of 2023 were $966.4 million, or 1.2 percent lower than first quarter 2022 sales of $977.7 million. Compared to the prior year quarter, our change in sales was primarily driven by higher water heater volumes in North America, partially offset by lower sales in China. In addition, our sales in our Rest of World segment were unfavorably impacted by approximately $17 million in the first quarter of 2023 due to the deprecation of foreign currencies compared to the U.S. dollar. Our gross profit margin in the first quarter of 2023 was 38.7 percent and increased compared to 34.9 percent in the first quarter of 2022. The higher gross profit margin in the first quarter of 2023 was primarily due to lower steel and other material costs. Selling, general, and administrative (SG&A) expenses were $187.2 million in the first quarter of 2023 or $7.4 million higher than the first quarter of 2022. Higher selling expenses were primarily driven by higher selling expenses in North America on higher volumes, partially offset by lower selling expenses in China on lower sales. Impairment expense in the first quarter of 2023 was $15.6 million which is related to our commitment to sell our business in Turkey. Of the $15.6 million impairment, $12.5 million was recorded in the Rest of World segment and $3.1 million was recorded in Corporate Expense. Interest expense in the first quarter of 2023 was $4.0 million and higher compared to $1.5 million in the first quarter of 2022 primarily due to higher debt levels and interest rates. Other (income) expense-net was ($4.0) million in the first quarter of 2023 compared to expense of $3.7 million in the first quarter of 2022. Pension expense in the first quarter of 2023 was $0.3 million compared to $3.6 million in the first quarter of 2022. In 2021, the Company's Board of Directors approved the termination of the Company's largest defined benefit pension plan (the Plan) with a termination date of December 31, 2021. The Plan represented over 95 percent of the Company's pension plan liability. In the fourth quarter of 2022, the Company settled Plan liabilities through lump-sum payments from existing plan assets to eligible participants who elected to receive them and through the purchase of annuities. Our effective income tax rate was 25.9 percent in the first quarter of 2023, compared with 23.5 percent in the first quarter of 2022. The change in the effective income tax rate for the three months ended March 31, 2023 compared to the effective income tax rate for the three months ended March 31, 2022 was primarily due to a change in geographical earnings mix as well as the $15.6 million impairment expense recorded with no associated tax benefit. We estimate that our annual effective income tax rate for the full year of 2023 will be 24.0 percent. We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of the 2023 impairment expense and 2022 non-operating pension expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the Non-GAAP Measures section below. 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. 20 Table of Contents North America Segment (dollars in millions) Three Months Ended March 31, 2023 2022 Net Sales $ 752.7 $ 730.1 Segment Earnings 188.6 151.8 Segment margin 25.1 % 20.8 % Sales in our North America segment were $752.7 million in the first quarter of 2023 or $22.6 million higher than sales of $730.1 million in the first quarter of 2022. Higher sales in the first quarter of 2023 were primarily driven by higher residential and commercial water heater volumes, partially offset by lower pricing. North America segment earnings were $188.6 million in the first quarter of 2023, an increase of approximately 24.2 percent compared to segment earnings of $151.8 million in the first quarter of 2022. Segment margins were 25.1 percent and 20.8 percent in the first quarter of 2023 and 2022, respectively. Higher segment earnings and margins in the first quarter of 2023 compared to the first quarter of 2022 were primarily due to higher volumes of commercial and residential water heaters and lower steel costs. We estimate our 2023 North America segment margin will be approximately between 23 and 23.5 percent. 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 2022 exclude $2.6 million of pension expense. Rest of World Segment (dollars in millions) Three Months Ended March 31, 2023 2022 Net Sales $ 219.1 $ 256.0 Segment Earnings 5.3 24.8 Segment margin 2.4 % 9.7 % Rest of World sales of $219.1 million in the first quarter of 2023 decreased 14 percent compared to the first quarter of 2022, including an unfavorable currency translation impact of $17 million. In local currency, segment sales decreased by approximately eight percent compared to last year. The decrease in sales in the first quarter of 2023 was driven primarily by lower consumer demand in China due to COVID-19. Sales in India increased 28% in local currency in the first quarter of 2023 on strong demand for our water heater and water treatment products compared to the prior year quarter. Rest of World segment earnings were $5.3 million in the first quarter of 2023, compared to $24.8 million in the first quarter of 2022. Segment margins were 2.4 percent and 9.7 percent in the first quarter of 2023 and 2022, respectively. Lower segment earnings and segment margin in the first quarter of 2023, were primarily driven by the impairment expense of $12.5 million associated with our commitment to sell our business in Turkey and lower sales in China. Adjusted segment earnings and adjusted segment margin in the first quarter of 2023 were $17.8 million and 8.1 percent, respectively. Adjusted segment earnings and adjusted segment margin in the first quarter of 2023 exclude the $12.5 million of impairment expense. We estimate our 2023 Rest of World adjusted segment margin will be approximately 10 percent, excluding the impairment expense. Outlook We expect our consolidated sales in 2023 to be flat to 2022 with a range of plus or minus two percent. Our sales projection is driven by expected flat industry residential unit volumes in North America, increased commercial water heater volumes, higher boiler and water treatment sales in North America, and higher sales in China. We assume that currency translation will negatively impact sales by approximately two percent. As a result, we expect to achieve full-year earnings of between $3.20 and $3.40 per share and adjusted earnings of between $3.30 and $3.50 per share. Our guidance excludes the impacts from potential future acquisitions. 21 Table of Contents Liquidity & Capital Resources Our working capital was $748.1 million at March 31, 2023, and higher compared with $699.5 million at December 31, 2022. The increase in working capital was primarily driven by lower accounts payable, payroll-related accruals and inventory balances than at December 31, 2022, which were partially offset by higher accrued liabilities. In addition, cash balances as of March 31, 2023 were positively impacted by $2.4 million due to the effects of changes in foreign currency during the year. (dollars in millions) Three Months Ended March 31, 2023 2022 Cash provided by operating activities $ 119.9 $ 16.5 Cash (used in) provided by investing activities (9.8) 2.1 Cash used in financing activities (97.5) (56.1) Cash provided by operating activities in the first three months of 2023 was $119.9 million compared with $16.5 million in the same period last year. Cash provided by higher earnings in the first three months of 2023 compared with the prior year was also positively impacted by lower incentive payments in 2023 and lower inventory levels. Our free cash flow in the first three months of 2023 and 2022 was $109.2 million and $3.6 million, respectively. We expect cash provided by operating activities to be between $650 million and $700 million in 2023. We expect free cash flow to be between $575 million and $625 million in 2023. Free cash flow is a non-GAAP measure and is described in more detail in the Non-GAAP Measures section below. Capital expenditures totaled $10.7 million in the first three months of 2023 compared with $12.9 million in the same period last year. We project 2023 capital expenditures will be between $70 and $75 million and full-year depreciation and amortization expense will be approximately $70 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, 2023, and expect to be in compliance for the foreseeable future. The facility backs up commercial paper and credit line borrowings. At March 31, 2023, we had $211.1 million outstanding under the facility and an available borrowing capacity of $288.9 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 decreased by $3.7 million in the first three months of 2023 which was primarily due to the payment of debt. Our leverage, as measured by the ratio of total debt to total capitalization, was 16.0 percent at March 31, 2023, compared with 16.5 percent at December 31, 2022. In the first quarter of 2023, our Board of Directors approved adding 7,500,000 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 three months of 2023, we repurchased 821,000 shares of our stock at a total cost of $53.1 million. At March 31, 2023, we had 7,057,462 shares remaining on the share repurchase authority. Depending on factors such as stock price, working capital requirements, and alternative investment opportunities, we expect to spend approximately $300 million on stock repurchases in 2023 through a combination of our Rule 10b5-1 automatic trading plan and open market repurchases. On April 10, 2023, our Board of Directors declared a regular quarterly cash dividend of $0.30 per share on our Common Stock and Class A common stock. The dividend is payable on May 15, 2023, to shareholders of record on April 28, 2023. 22 Table of Contents Non-GAAP Financial Information We provide non-GAAP measures of free cash flow, adjusted earnings, adjusted EPS, total segment earnings, 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 exclude the impact of the 2023 impairment expense and 2022 non-operating pension 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 Earnings Per Share (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted earnings per share to adjusted earnings (non-GAAP) and adjusted earnings per share (non-GAAP): Three Months Ended March 31, 2023 2022 Net Earnings (GAAP) $ 126.9 $ 119.8 Impairment expense, before tax 15.6 — Pension expense, before tax — 2.9 Tax effect on above items — (0.7) Adjusted Earnings (non-GAAP) $ 142.5 $ 122.0 Diluted Earnings Per Share (GAAP) $ 0.84 $ 0.76 Impairment expense per diluted share, before tax 0.10 — Pension expense per diluted share, before tax — 0.01 Tax effect on above items per diluted share — — Adjusted Earnings Per Share (non-GAAP) $ 0.94 $ 0.77 23 Table of Contents A. O. SMITH CORPORATION Adjusted Segment Earnings (dollars in millions) (unaudited) The following is a reconciliation of reported earnings before provision for income taxes to total segment earnings (non-GAAP) and adjusted segment earnings (non-GAAP): Three Months Ended March 31, 2023 2022 Earnings Before Provision for Income Taxes (GAAP) $ 171.3 $ 156.6 Add: Corporate expense (1) 18.6 18.4 Add: Interest expense 4.0 1.5 Total Segment Earnings (non-GAAP) $ 193.9 $ 176.5 North America (2) $ 188.6 $ 151.8 Rest of World (3) 5.3 24.8 Inter-segment earnings elimination — (0.1) Total Segment Earnings (non-GAAP) $ 193.9 $ 176.5 Additional Information (1) Corporate expense $ (18.6) $ (18.4) Impairment expense, before tax 3.1 — Pension expense, before tax — 0.3 Adjusted Corporate expense (non-GAAP) $ (15.5) $ (18.1) (2) North America $ 188.6 $ 151.8 Pension expense, before tax — 2.6 Adjusted North America (non-GAAP) $ 188.6 $ 154.4 (3) Rest of World $ 5.3 $ 24.8 Impairment expense, before tax 12.5 — Adjusted Rest of World (non-GAAP) $ 17.8 $ 24.8 24 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, 2023 2022 Cash provided by operating activities (GAAP) $ 119.9 $ 16.5 Less: Capital expenditures (10.7) (12.9) Free cash flow (non-GAAP) $ 109.2 $ 3.6 A. O. SMITH CORPORATION 2023 Adjusted EPS Guidance and 2022 Adjusted EPS (unaudited) The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax): 2023 Guidance 2022 Diluted EPS (GAAP) $ 3.20 - 3.40 $ 1.51 Impairment expense 0.10 (1) — Pension settlement charges — 1.60 (2) Pension expense — 0.06 (3) Legal judgment income — (0.05) Terminated acquisition-related expenses — 0.02 Adjusted EPS (non-GAAP) $ 3.30 - 3.50 $ 3.14 (1) Includes pre-tax impairment expense of $12.5 million and $3.1 million, within the Rest of World segment and Corporate expenses, respectively. (2) Includes pre-tax pension settlement charges of $346.8 million and $70.5 million, within the North America segment and Corporate expenses, respectively. (3) Includes pre-tax pension expense of $9.7 million and $2.0 million, within the North America segment and Corporate expenses, respectively. 25 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, 2022. We believe that at March 31, 2023, there was 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”, “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: further softening in U.S. residential water heater demand; negative impacts to the Company, particularly the demand for its products, resulting from global inflationary pressures or a potential recession in one or more of the markets in which the Company participates; 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, as a result of the severity and duration of the lingering effects of the COVID-19 pandemic; further weakening in U.S. residential or commercial construction or instability in the Company's replacement markets; inability of the Company to implement or maintain pricing actions; inconsistent 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 business in China as a result of future COVID-19 related disruptions there; 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; 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; the inability to respond to secular trends toward decarbonization and energy efficiency 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.