UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________________________________
FORM 10-Q
______________________________________________________
| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |||||
For the quarterly period ended March 31, 2023 .
or
| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |||||
For the transition period from __________ to __________
Commission File Number 1-475
________________________________
(Exact name of registrant as specified in its charter)
________________________________
(State of Incorporation)
(Address of Principal Executive Office)
(I.R.S. Employer
Identification No.)
(Zip Code)
(414 ) 359-4000
(Registrant’s telephone number, including area code)
_________________________________________________
Securities registered pursuant to Section 12(b) of the Act:
| Title of Each Class | Trading Symbol | Name of Each Exchange on Which Registered | ||||||||||||
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes o No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☒ Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
| ☒ | Accelerated Filer | ☐ | ||||||||||||
| Non-accelerated filer | ☐ | Smaller reporting company | ||||||||||||
| Emerging growth company | ||||||||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) ☐ Yes ☒ No
Class A Common Stock Outstanding as of April 26, 2023 - 25,903,736 shares
Common Stock Outstanding as of April 26, 2023 - 124,537,812 shares
Index
A. O. Smith Corporation
2
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(dollars in millions, except for per share data)
(unaudited)
| Three Months Ended March 31, | |||||||||||
| 2023 | 2022 | ||||||||||
| Net sales | $ | $ | |||||||||
| Cost of products sold | |||||||||||
| Gross profit | |||||||||||
| Selling, general and administrative expenses | |||||||||||
| Impairment expense | |||||||||||
| Interest expense | |||||||||||
| Other (income) expense, net | ( | ||||||||||
| Earnings before provision for income taxes | |||||||||||
| Provision for income taxes | |||||||||||
| Net Earnings | $ | $ | |||||||||
| Basic Net Earnings Per Share of Common Stock | $ | $ | |||||||||
| Diluted Net Earnings Per Share of Common Stock | $ | $ | |||||||||
| Dividends Per Share of Common Stock | $ | $ | |||||||||
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS
(dollars in millions)
(unaudited)
| Three Months Ended March 31, | |||||||||||
| 2023 | 2022 | ||||||||||
| Net earnings | $ | $ | |||||||||
| Other comprehensive earnings (loss) | |||||||||||
| Foreign currency translation adjustments | |||||||||||
Unrealized losses on cash flow derivative instruments, less related income tax benefit of $ | ( | ( | |||||||||
Adjustment to pension liability, less related income tax provision of | |||||||||||
| Comprehensive Earnings | $ | $ | |||||||||
See accompanying notes to unaudited condensed consolidated financial statements.
3
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in millions)
(unaudited) March 31, 2023 | December 31, 2022 | ||||||||||
| Assets | |||||||||||
| Current Assets | |||||||||||
| Cash and cash equivalents | $ | $ | |||||||||
| Marketable securities | |||||||||||
| Receivables | |||||||||||
| Inventories | |||||||||||
| Other current assets | |||||||||||
| Total Current Assets | |||||||||||
| Property, plant and equipment | |||||||||||
| Less accumulated depreciation | ( | ( | |||||||||
| Net property, plant and equipment | |||||||||||
| Goodwill | |||||||||||
| Other intangibles | |||||||||||
| Operating lease assets | |||||||||||
| Other assets | |||||||||||
| Total Assets | $ | $ | |||||||||
| Liabilities | |||||||||||
| Current Liabilities | |||||||||||
| Trade payables | $ | $ | |||||||||
| Accrued payroll and benefits | |||||||||||
| Accrued liabilities | |||||||||||
| Product warranties | |||||||||||
| Debt due within one year | |||||||||||
| Total Current Liabilities | |||||||||||
| Long-term debt | |||||||||||
| Product warranties | |||||||||||
| Long-term operating lease liabilities | |||||||||||
| Other liabilities | |||||||||||
| Total Liabilities | |||||||||||
| Stockholders’ Equity | |||||||||||
Class A Common Stock (shares issued, | |||||||||||
Common Stock (shares issued | |||||||||||
| Capital in excess of par value | |||||||||||
| Retained earnings | |||||||||||
| Accumulated other comprehensive loss | ( | ( | |||||||||
| Treasury stock at cost | ( | ( | |||||||||
| Total Stockholders’ Equity | |||||||||||
| Total Liabilities and Stockholders’ Equity | $ | $ | |||||||||
See accompanying notes to unaudited condensed consolidated financial statements.
4
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in millions)
(unaudited)
| Three Months Ended March 31, | |||||||||||
| 2023 | 2022 | ||||||||||
| Operating Activities | |||||||||||
| Net earnings | $ | $ | |||||||||
| Adjustments to reconcile net earnings to cash provided by (used in) operating activities: | |||||||||||
| Depreciation and amortization | |||||||||||
| Stock based compensation expense | |||||||||||
| Non-cash impairment | |||||||||||
| Net changes in operating assets and liabilities: | |||||||||||
| Current assets and liabilities | ( | ( | |||||||||
| Noncurrent assets and liabilities | |||||||||||
| Cash Provided by Operating Activities | |||||||||||
| Investing Activities | |||||||||||
| Capital expenditures | ( | ( | |||||||||
| Investments in marketable securities | ( | ( | |||||||||
| Net proceeds from sale of marketable securities | |||||||||||
| Cash (Used in) Provided by Investing Activities | ( | ||||||||||
| Financing Activities | |||||||||||
| Long-term debt (repaid) incurred | ( | ||||||||||
| Common stock repurchases | ( | ( | |||||||||
| Net proceeds (payments) from stock option activity | ( | ||||||||||
| Dividends paid | ( | ( | |||||||||
| Cash Used in Financing Activities | ( | ( | |||||||||
| Effect of exchange rate changes on cash and cash equivalents | |||||||||||
| Net increase (decrease) in cash and cash equivalents | ( | ||||||||||
| Cash and cash equivalents - beginning of period | |||||||||||
| Cash and Cash Equivalents - End of Period | $ | $ | |||||||||
See accompanying notes to unaudited condensed consolidated financial statements.
5
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(dollars in millions)
(unaudited)
| Three Months Ended March 31, | |||||||||||
| 2023 | 2022 | ||||||||||
| Class A Common Stock | |||||||||||
| Balance at the beginning of period | $ | $ | |||||||||
| Conversion of Class A Common Stock | |||||||||||
| Balance at end of period | $ | $ | |||||||||
| Common Stock | |||||||||||
| Balance at the beginning of period | $ | $ | |||||||||
| Conversion of Class A Common Stock | $ | ||||||||||
| Balance at end of period | $ | $ | |||||||||
| Capital in Excess of Par Value | |||||||||||
| Balance at the beginning of period | $ | $ | |||||||||
| Issuance of share units | ( | ( | |||||||||
| Vesting of share units | ( | ( | |||||||||
| Stock based compensation expense | |||||||||||
| Exercises of stock options | |||||||||||
| Issuance of share based compensation | |||||||||||
| Balance at end of period | $ | $ | |||||||||
| Retained Earnings | |||||||||||
| Balance at the beginning of period | $ | $ | |||||||||
| Net earnings | |||||||||||
| Dividends on stock | ( | ( | |||||||||
| Balance at end of period | $ | $ | |||||||||
| Accumulated Other Comprehensive Loss (see Note 16) | $ | ( | $ | ( | |||||||
| Treasury Stock | |||||||||||
| Balance at the beginning of period | $ | ( | $ | ( | |||||||
| Exercise of stock options | ( | ||||||||||
| Shares repurchased | ( | ( | |||||||||
| Vesting of share units | |||||||||||
| Balance at end of period | $ | ( | $ | ( | |||||||
| Total Stockholders’ Equity | $ | $ | |||||||||
See accompanying notes to unaudited condensed consolidated financial statements.
6
A. O. SMITH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2023
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2023 are not necessarily indicative of the results expected for the full year. It is suggested the accompanying condensed consolidated financial statements be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022 filed with the SEC on February 14, 2023.
Recent Accounting Pronouncements
No recent accounting pronouncements are expected to have an impact on our condensed consolidated financial statements.
2. Revenue Recognition
Substantially all of the Company’s sales are from contracts with customers for the purchase of its products. Contracts and customer purchase orders are used to determine the existence of a sales contract. Shipping documents are used to verify shipment. For substantially all of its products, the Company transfers control of products to the customer at the point in time when title and risk are passed to the customer, which generally occurs upon shipment of the product. Each unit sold is considered an independent, unbundled performance obligation. The Company’s sales arrangements do not include other performance obligations that are material in the context of the contract.
The nature, timing and amount of revenue for a respective performance obligation are consistent for each customer. The Company measures the sales transaction price based upon the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. Sales and value added taxes are excluded from the measurement of the transaction price. The Company’s payment terms for the majority of its customers are 30 to 90 days from shipment.
Additionally, certain customers in China pay the Company prior to the shipment of products resulting in a customer deposits liability of $70.3 million and $85.7 million at March 31, 2023 and December 31, 2022, respectively. Customer deposit liabilities are short term in nature, recognized into revenue within one year of receipt. The Company assesses the collectability of customer receivables based on the creditworthiness of a customer as determined by credit checks and analysis, as well as the customer’s payment history. In determining the allowance for credit losses, the Company also considers various factors including the aging of customer accounts and historical write-offs. In addition, the Company monitors other risk factors including forward-looking information when establishing adequate allowances for credit losses, which reflects the current estimate of credit losses expected to be incurred over the life of the receivables. The Company’s allowance for credit losses was $10.2 million at March 31, 2023 and $9.5 million at December 31, 2022.
Rebates and incentives are based on pricing agreements and are tied to sales volume. The amount of revenue is reduced for variable consideration related to customer rebates which are calculated using expected values and are based on program specific factors such as expected rebate percentages based on expected volumes. In situations where the customer has the right to return eligible products, the Company reduces revenue for its estimates of expected product returns, which are primarily based on an analysis of historical experience. Changes in such accruals may be required if actual sales volume differs from estimated sales volume or if future returns differ from historical experience. Shipping and handling costs billed to customers are included in net sales and the related costs are included in cost of products sold and are activities performed to fulfill the promise to transfer products.
Disaggregation of Net Sales
The Company is comprised of two reporting segments: North America and Rest of World. The 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 regions of the world.
7
2. Revenue Recognition (continued)
As each segment manufactures and markets products in its respective region of the world, the Company has determined that geography is the primary factor in reporting its sales. The Company further disaggregates its North America segment sales by major product line as each of North America’s major product lines is sold through distinct distribution channels and these product lines may be impacted differently by certain economic factors. Within the Rest of World segment, particularly in China and India, the Company’s major customers purchase across the Company’s product lines, utilizing the same distribution channels regardless of product type. In addition, the impact of economic factors is unlikely to be differentiated by product line in the Rest of World segment.
The North America segment's major product lines are defined as the following:
Water heaters The Company’s water heaters are open water heating systems that heat potable water. Typical applications for water heaters include residences, restaurants, hotels, office buildings, laundries, car washes and small businesses. The Company sells residential and commercial water heater products and related parts through its wholesale distribution channel, which includes more than 1,000 independent wholesale plumbing distributors. The Company also sells residential water heaters and related parts through retail and maintenance, repair and operations (MRO) channels. A significant portion of the Company’s water heater sales in the North America segment is derived from the replacement of existing products.
Boilers The Company’s boilers are closed loop water heating systems used primarily for space heating or hydronic heating. The Company’s boilers are primarily used in applications in commercial settings for hospitals, schools, hotels and other large commercial buildings while residential boilers are used in homes, apartments and condominiums. The Company’s boiler distribution channel is comprised primarily of manufacturer representative firms, with the remainder of its boilers distributed through wholesale channels. The Company’s boiler sales in the North America segment are derived from a combination of replacement of existing products and new construction.
Water treatment products The Company’s water treatment products range from point-of-entry water softeners, solutions for problem well water, and whole-home water filtration products to on-the-go filtration bottles and point-of-use carbon and reverse osmosis products. Typical applications for the Company’s water treatment products include residences, restaurants, hotels and offices. The Company sells water treatment products through its retail and wholesale distribution channels, similar to water heater products and related parts. The Company’s water treatment products are also sold through independent water quality dealers as well as directly to consumers including through e-commerce sales channels. A portion of the Company’s sales of water treatment products in the North America segment is comprised of replacement filters.
The following table disaggregates the Company’s net sales by segment. As described above, the Company’s North America segment sales are further disaggregated by major product line. In addition, the Company’s Rest of World segment sales are disaggregated by China and all other Rest of World:
| (dollars in millions) | Three Months Ended March 31, | ||||||||||
| 2023 | 2022 | ||||||||||
| North America | |||||||||||
| Water heaters and related parts | $ | $ | |||||||||
| Boilers and related parts | |||||||||||
| Water treatment products | |||||||||||
| Total North America | |||||||||||
| Rest of World | |||||||||||
| China | $ | $ | |||||||||
| All other Rest of World | |||||||||||
| Total Rest of World | |||||||||||
| Inter-segment sales | ( | ( | |||||||||
| Total Net Sales | $ | $ | |||||||||
8
3. Impairment Expense
In the first quarter of 2023, the Company entered into negotiations to sell its business in Turkey (disposal group), which is included in the Company's Rest of World segment. The Company determined that the fair value of the disposal group, less cost to sell, was lower than its carrying amount. As a result, in the first quarter of 2023, the Company recorded an impairment expense of $15.6 million of which $12.5 million was recorded in the Rest of World segment and $3.1 million was recorded in Corporate Expense. The impairment was recorded as a net reduction of $4.5 million to the assets and liabilities and $11.1 million for the anticipated liquidation of the cumulative foreign currency translation adjustment associated with the disposal group. The accrual for the impairment is recorded in Accrued liabilities in the condensed consolidated balance sheet.
As of March 31, 2023, the disposal group did not meet the requirements to be classified as discontinued operations as the sale will not have a material effect on the Company's operations and does not represent a shift in the Company's strategy. Accordingly, the remaining carrying value of the disposal group as of March 31, 2023, was $0.6 million and classified as held for sale. The sale of the disposal group was completed in April 2023.
4. Leases
The Company’s lease portfolio consists of operating leases for buildings and equipment, such as forklifts and copiers, primarily in the United States and China. The Company defines a lease as a contract that gives the Company the right to control the use of a physical asset for a stated term. The Company pays the lessor for that right, with a series of payments defined in the contract and a corresponding right of use operating lease asset and liability are recorded. The Company has elected not to record leases with an initial term of 12 months or less on its condensed consolidated balance sheet. To determine balance sheet amounts, required legal payments are discounted using the Company’s incremental borrowing rate as of the inception of the lease. The incremental borrowing rate is the rate of interest that the Company would incur if it were to borrow, on a collateralized basis, an amount equal to the value of the leased item over a similar term, in a similar economic environment. Variable lease components not based on an index or rate are excluded from the measurement of the lease asset and liability and expensed as incurred for all asset classes.
Certain leases include one or more options to renew or terminate. Renewal terms can extend the lease term from to five years and options to terminate can be effective within one year . The exercise of lease renewal or termination is at the Company’s discretion and when it is determined to be reasonably certain to renew or terminate, the option is reflected in the measurement of lease asset and liability. The Company’s lease agreements do not contain any arrangements related to material residual value guarantees, restrictive covenants or material subleases. Cash flows associated with leases are materially consistent with the expense recorded in the condensed consolidated statement of earnings.
Supplemental balance sheet information related to leases is as follows:
| (dollars in millions) | March 31, 2023 | December 31, 2022 | |||||||||
| Liabilities | |||||||||||
| $ | $ | ||||||||||
| Long term: Operating lease liabilities | |||||||||||
| Total operating lease liabilities | $ | $ | |||||||||
| Less: Rent incentives and deferrals | ( | ( | |||||||||
| Assets | |||||||||||
| Operating lease assets | $ | $ | |||||||||
| Lease Term and Discount Rate | March 31, 2023 | |||||||
| Weighted-average remaining lease term | ||||||||
| Weighted-average discount rate | % | |||||||
9
4. Leases (continued)
The components of lease expense were as follows:
| (dollars in millions) | Three months ended March 31, | |||||||||||||||||||
| Lease Expense | Classification | 2023(1) | 2022(2) | |||||||||||||||||
| Operating lease expense | Cost of products sold | $ | $ | |||||||||||||||||
| Selling, general and administrative expenses | ||||||||||||||||||||
(1)2023 includes short-term and variable lease expenses of $1.1 million and $1.2 million, respectively.
(2)2022 includes short-term and variable lease expenses of $0.5 million and $0.8 million, respectively.
Maturities of lease liabilities were as follows:
| (dollars in millions) | March 31, 2023 | ||||
| 2023 | $ | ||||
| 2024 | |||||
| 2025 | |||||
| 2026 | |||||
| 2027 | |||||
| After 2027 | |||||
| Total lease payments | |||||
| Less: Imputed interest | ( | ||||
| Present value of operating lease liabilities | $ | ||||
5. Inventories
The following table presents the components of the Company’s inventory balances:
| (dollars in millions) | March 31, 2023 | December 31, 2022 | |||||||||
| Finished products | $ | $ | |||||||||
| Work in process | |||||||||||
| Raw materials | |||||||||||
| Inventories, at FIFO cost | |||||||||||
| LIFO reserve | ( | ( | |||||||||
| Inventories, at LIFO cost | $ | $ | |||||||||
6. Product Warranties
The Company offers warranties on the sales of certain of its products with terms that are consistent with the market and records an accrual for the estimated future claims. The following table presents the Company’s warranty liability activity:
| (dollars in millions) | Three Months Ended March 31, | ||||||||||
| 2023 | 2022 | ||||||||||
| Balance at January 1, | $ | $ | |||||||||
| Expense | |||||||||||
| Claims settled | ( | ( | |||||||||
| Balance at March 31, | $ | $ | |||||||||
10
7. Debt
8. Earnings per Share of Common Stock
The numerator for the calculation of basic and diluted earnings per share is net earnings. The following table sets forth the computation of basic and diluted weighted-average shares used in the earnings per share calculations:
| Three Months Ended March 31, | |||||||||||
| 2023 | 2022 | ||||||||||
| Denominator for basic earnings per share - weighted average shares | |||||||||||
| Effect of dilutive stock options and share units | |||||||||||
| Denominator for diluted earnings per share | |||||||||||
9. Stock Based Compensation
The Company adopted the A. O. Smith Combined Incentive Compensation Plan (the Incentive Plan) effective January 1, 2007. The Incentive Plan was most recently reapproved by stockholders on April 15, 2020. The Incentive Plan is a continuation of the A. O. Smith Combined Executive Incentive Compensation Plan which was originally approved by stockholders in 2002. The number of shares available for granting of share units at March 31, 2023 was 2,491,654 . Upon stock option exercise or share unit vesting, shares are issued from treasury stock. Total stock based compensation expense recognized in the three months ended March 31, 2023 and 2022 was $7.0 million and $7.6 million, respectively.
Stock Options
The Company decided to no longer grant stock options beginning with fiscal year 2023. Stock options previously granted have a three year pro rata vesting from the date of grant. Stock options were issued at exercise prices equal to the fair value of the Company’s Common Stock on the date of grant. For active employees, all options granted expire ten years after the date of grant. The Company’s stock options are expensed ratably over the three year vesting period; however, included in the stock option expense for the three months ended March 31, 2022 was expense associated with the accelerated vesting of stock option awards for certain employees who either are retirement eligible or become retirement eligible during the vesting period. Stock based compensation expense attributable to stock options in the three months ended March 31, 2023 and 2022 was $0.3 million and $3.9 million, respectively.
Changes in options, all of which relate to the Company’s Common Stock, were as follows for the three months ended March 31, 2023:
| Weighted- Avg. Per Share Exercise Price | Number of Options | Average Remaining Contractual Life | Aggregate Intrinsic Value (dollars in millions) | ||||||||||||||||||||
| Outstanding at January 1, 2023 | $ | ||||||||||||||||||||||
| Exercised | ( | ||||||||||||||||||||||
| Forfeited | ( | ||||||||||||||||||||||
| Outstanding at March 31, 2023 | $ | ||||||||||||||||||||||
| Exercisable at March 31, 2023 | $ | ||||||||||||||||||||||
11
9. Stock Based Compensation (continued)
There were no stock options granted in 2023. The weighted-average fair value per option at the date of grant during the three months ended March 31, 2022 using the Black-Scholes option-pricing model was $17.59 . Assumptions were as follows:
| Three Months Ended March 31, | |||||
| 2022 | |||||
| Expected life (years) | |||||
| Risk-free interest rate | % | ||||
| Dividend yield | % | ||||
| Expected volatility | % | ||||
The expected lives of options for purposes of these models are based on historical exercise behavior. The risk-free interest rates for purposes of these models are based on the U.S. Treasury yield in effect on the date of grant for the respective expected lives of the option. The expected dividend yields for purposes of these models are based on the dividends paid in the preceding four quarters divided by the grant date market value of the Common Stock. The expected volatility for purposes of these models are based on the historical volatility of the Common Stock.
Share Units
Participants of the Incentive Plan may also be awarded share units. Share units vest three years after the date of grant. The Company granted 165,686 and 88,894 share units under the Incentive Plan in the three months ended March 31, 2023 and 2022, respectively.
The share units were valued at $11.1 million and $6.6 million at the date of issuance in 2023 and 2022, respectively, based on the price of the Company’s Common Stock at the date of grant. The share units are recognized as compensation expense ratably over the three-year vesting period; however, included in share unit expense in the three months ended March 31, 2023 and 2022 was expense associated with accelerated vesting of share unit awards for certain employees who are retirement eligible or will become retirement eligible during the vesting period. Stock based compensation expense attributable to share units of $6.6 million and $3.7 million was recognized in the three months ended March 31, 2023 and 2022, respectively. Certain non-U.S.-based employees receive the cash value of the share price at the vesting date in lieu of shares. Unvested cash-settled awards are remeasured at each reporting period.
A summary of share unit activity under the Incentive Plan is as follows for the three months ended March 31, 2023:
| Number of Units | Weighted-Average Grant Date Value | ||||||||||
| Issued and unvested at January 1, 2023 | $ | ||||||||||
| Granted | |||||||||||
| Vested | ( | ||||||||||
| Forfeited | ( | ||||||||||
| Issued and unvested at March 31, 2023 | |||||||||||
Performance Stock Units
Beginning in 2023, certain executives may also be awarded performance stock units under the Incentive Plan. Performance stock units vest over three years following the date of the grant. Performance stock units vest under a set of measurement criteria which are based upon achievement of certain Environmental, Social, and Governance targets. Potential payouts range from zero to 150 % of the target awards and changes from target amounts are reflected as performance adjustments. The Company granted 24,580 performance stock units under the Incentive Plan in the three months ended March 31, 2023.
The performance stock units were valued at $1.7 million at the date of issuance in 2023, based on the price of the Company’s Common Stock at the date of grant. The weighted average grant date value for the units granted was $67.14 . The performance stock units are recognized as compensation expense ratably over the three-year vesting period. Stock based compensation expense attributable to performance stock units of $0.1 million was recognized in the three months ended March 31, 2023. Certain non-U.S.-based executives receive the cash value of the share price at the vesting date in lieu of shares. Unvested cash-settled awards are remeasured at each reporting period.
12
10. Pensions
The following table presents the components of the Company’s net pension expense:
| (dollars in millions) | Three Months Ended March 31, | ||||||||||
| 2023 | 2022 | ||||||||||
| Service cost | $ | $ | |||||||||
| Interest cost | |||||||||||
| Expected return on plan assets | ( | ( | |||||||||
| Amortization of unrecognized loss | |||||||||||
| Amortization of prior service cost | ( | ||||||||||
| Defined benefit plan expense | $ | $ | |||||||||
The service cost component of net periodic benefit cost is presented within cost of products sold and selling, general and administrative expenses within the condensed consolidated statements of earnings while the other components of pension expense are reflected in other expense. The Company was not required to and did no t make a contribution to its U.S. pension plan in 2022. The Company is no t required to make a contribution in 2023.
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 from Mass Mutual Life Insurance Company (MML). As of March 1, 2023, MML assumed the future annuity payments for those eligible active and former employees and their beneficiaries. Remaining pension assets associated with the Plan at March 31, 2023 are $21.5 million. The Company intends to use the remaining assets to fund future non-elective contributions to the Company’s defined contribution plan. For additional information regarding the termination of the Plan and the Company’s defined contribution plan, refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2022 filed with the SEC on February 14, 2023.
13
11. Segment Results
The Company is comprised of two reporting segments: North America and Rest of World. The Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. The following table presents the Company’s segment results:
| (dollars in millions) | Three Months Ended March 31, | ||||||||||
| 2023 | 2022 | ||||||||||
| Net sales | |||||||||||
| North America | $ | $ | |||||||||
| Rest of World | |||||||||||
| Inter-segment | ( | ( | |||||||||
| $ | $ | ||||||||||
| Segment earnings | |||||||||||
North America(1) | $ | $ | |||||||||
Rest of World(2) | |||||||||||
| Inter-segment earnings elimination | ( | ||||||||||
Corporate expense(3) | ( | ( | |||||||||
| Interest expense | ( | ( | |||||||||
| Earnings before income taxes | |||||||||||
| Provision for income taxes | |||||||||||
| Net earnings | $ | $ | |||||||||
| Additional Information | |||||||||||
(1) Adjustments: North America | |||||||||||
| includes pension expense of: | $ | $ | |||||||||
(2) Adjustments: Rest of World | |||||||||||
| includes impairment expense of: | $ | $ | |||||||||
(3) Adjustments: Corporate expense | |||||||||||
| includes impairment expense of: | $ | $ | |||||||||
| includes pension expense of: | $ | $ | |||||||||
12. Fair Value Measurements
14
12. Fair Value Measurements (continued)
Assets (liabilities) measured at fair value on a recurring basis are as follows (dollars in millions):
| Fair Value Measurement Using | Balance Sheet Location | March 31, 2023 | December 31, 2022 | |||||||||||
| Quoted prices in active markets for identical assets (Level 1) | Marketable Securities | $ | $ | |||||||||||
| Significant other observable inputs (Level 2) | Other current assets | |||||||||||||
Items measured at fair value were comprised of the Company’s marketable securities (Level 1) and derivative instruments (Level 2). There were no changes in the Company's valuation techniques used to measure fair values on a recurring basis during the three months ended March 31, 2023.
13. Derivative Instruments
The Company utilizes certain derivative instruments to enhance its ability to manage currency exposure as well as raw materials price risk. Derivative instruments are entered into for periods consistent with the related underlying exposures and do not constitute positions independent of those exposures. The Company does not enter into contracts for speculative purposes. The contracts are executed with major financial institutions with no credit loss anticipated for failure of the counterparties to perform.
Cash Flow Hedges
With the exception of its net investment hedges, the Company designates all of its hedging instruments as cash flow hedges. For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), gains or losses on the derivative instrument are reported as a component of other comprehensive loss, net of tax, and are reclassified into earnings in the same line item associated with the forecasted transaction and in the same period or periods during which the hedged transaction affects earnings.
Foreign Currency Forward Contracts
The Company is exposed to foreign currency exchange risk as a result of transactions in currencies other than the functional currency of certain subsidiaries. The Company utilizes foreign currency forward purchase and sale contracts to manage the volatility associated with foreign currency purchases, sales and certain intercompany transactions in the normal course of business. Principal currencies for which the Company utilizes foreign currency forward contracts include the British pound, Canadian dollar, Euro and Mexican peso.
Gains and losses on these instruments are recorded in accumulated other comprehensive loss, net of tax, until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive loss to the consolidated statement of earnings. The assessment of effectiveness for forward contracts is based on changes in the forward rates. These hedges have been determined to be effective. The majority of the amounts in accumulated other comprehensive loss for cash flow hedges are expected to be reclassified into earnings within one year.
The following table summarizes, by currency, the contractual amounts of the Company’s foreign currency forward contracts that are designated as cash flow hedges:
| (dollars in millions) | March 31, 2023 | December 31, 2022 | |||||||||||||||||||||
| Buy | Sell | Buy | Sell | ||||||||||||||||||||
| British pound | $ | $ | $ | $ | |||||||||||||||||||
| Canadian dollar | |||||||||||||||||||||||
| Euro | |||||||||||||||||||||||
| Mexican peso | |||||||||||||||||||||||
| Total | $ | $ | $ | $ | |||||||||||||||||||
Net Investment Hedges
The Company enters into certain foreign currency forward contracts to hedge the exposure to a portion of the Company’s net investments in certain non-U.S. subsidiaries against the effect of exchange rate fluctuations on the translation of foreign currency balances to the U.S. dollar. For the derivative instruments that are designated and qualify as net investment hedges,
15
13. Derivative Instruments (continued)
gains and losses are reported in other comprehensive loss where they offset gains and losses recorded on the Company’s net investments in its non-U.S. subsidiaries. These hedges are determined to be effective. The Company recognized $0.5 million of after-tax gains associated with hedges of net investments in non-U.S. subsidiaries in currency translation adjustment in other comprehensive loss in the three months ended March 31, 2023. The Company recognized $0.3 million of after-tax losses associated with hedges of a net investment in non-U.S. subsidiaries in currency translation adjustment in other comprehensive loss in the three months ended March 31, 2022. The contractual amount of the Company's foreign currency forward contracts that are designated as net investment hedges was $25.0 million as of March 31, 2023.
The following tables present the impact of derivative contracts on the Company’s financial statements.
Fair value of derivatives designated as hedging instruments under ASC 815:
| (dollars in millions) | Balance Sheet Location | March 31, 2023 | December 31, 2022 | ||||||||||||||
| Foreign currency contracts | Other current assets | $ | $ | ||||||||||||||
| Accrued liabilities | |||||||||||||||||
| Total derivatives designated as hedging instruments | $ | $ | |||||||||||||||
The effect of cash flow hedges on the condensed consolidated statement of earnings:
Three Months Ended March 31 (dollars in millions):
| Derivatives in ASC 815 cash flow hedging relationships | Amount of gain (loss) recognized in other comprehensive loss on derivatives | Location of gain reclassified from accumulated other comprehensive loss into earnings | Amount of gain reclassified from accumulated other comprehensive loss into earnings | |||||||||||||||||||||||||||||
| 2023 | 2022 | 2023 | 2022 | |||||||||||||||||||||||||||||
| Foreign currency contracts | $ | $ | ( | Cost of products sold | $ | $ | ||||||||||||||||||||||||||
Balance Sheet Hedges
Foreign Exchange Contracts
The Company periodically enters into foreign exchange contracts to mitigate the foreign currency volatility relative to certain intercompany loans. These foreign exchange contracts did not qualify for hedge accounting in accordance with ASC 815 and as such were marked to market through earnings. The fair value of the foreign exchange contracts was zero as of March 31, 2023. The fair value of the foreign exchange contracts was an asset balance of $0.1 million as of December 31, 2022 and recorded in Other current assets within the consolidated balance sheet.
The following table summarizes the contractual amounts of the Company's foreign exchange contracts that are designated as balance sheet hedges:
| (dollars in millions) | March 31, 2023 | December 31, 2022 | |||||||||||||||||||||
| Buy | Sell | Buy | Sell | ||||||||||||||||||||
| Canadian dollar | $ | $ | $ | $ | |||||||||||||||||||
The amounts recognized within the consolidated statements of earnings related to the Company's foreign exchange contracts are set forth below.
Three Months Ended March 31 (dollars in millions):
| Derivatives not designated as hedging instruments: | Location of loss within the consolidated statements of earnings | 2023 | 2022 | ||||||||||||||
| Foreign exchange contracts | Other (income) expense - net | $ | ( | $ | |||||||||||||
16
14. Income Taxes
15. Commitments and Contingencies
The Company maintains a commercial relationship with a supply-chain service provider (the Provider) in connection with the Company’s business in China. In this capacity, the Provider offers order-entry, warehousing and logistics support. The Provider also offers asset-backed financing to certain of the Company’s distributors in China to facilitate their working capital needs. To facilitate its financing support business, the Provider has collateralized lending facilities in place with multiple Chinese banks under which the Company has agreed to repurchase inventory if both requested by the banks and certain defined conditions are met, primarily related to the aging of the distributors’ notes.
The Provider is required to indemnify the Company for any losses the Company would incur in the event of an inventory repurchase under these arrangements. Potential losses under the repurchase arrangements represent the difference between the repurchase price and net proceeds from the resale of product plus costs incurred in the process, less related distributor rebates.
Before considering any reduction of distributor rebate accruals of $1.2 million and $1.1 million as of March 31, 2023 and December 31, 2022, respectively, and from the resale of the related inventory, the gross amount the Company would be obligated to repurchase, which would be contingent on the default of all of the outstanding loans, was approximately $2.3 million as of March 31, 2023 and $2.4 million as of December 31, 2022. The Company’s reserves for estimated losses under repurchase arrangements were immaterial as of March 31, 2023 and December 31, 2022.
17
16. Changes in Accumulated Other Comprehensive Loss by Component
Changes to accumulated other comprehensive loss by component are as follows:
| (dollars in millions) | Three Months Ended March 31, | ||||||||||||||||
| 2023 | 2022 | ||||||||||||||||
| Cumulative foreign currency translation | |||||||||||||||||
| Balance at beginning of period | $ | ( | $ | ( | |||||||||||||
| Other comprehensive gain before reclassifications | |||||||||||||||||
| Balance at end of period | ( | ( | |||||||||||||||
| Unrealized net gain (loss) on cash flow derivatives | |||||||||||||||||
| Balance at beginning of period | |||||||||||||||||
| Other comprehensive gain (loss) before reclassifications | ( | ||||||||||||||||
Realized gains on derivatives reclassified to cost of products sold (net of income tax provision of $ | ( | ( | |||||||||||||||
| Balance at end of period | |||||||||||||||||
| Pension liability | |||||||||||||||||
| Balance at beginning of period | ( | ( | |||||||||||||||
Amounts reclassified from accumulated other comprehensive loss:(1) | |||||||||||||||||
| Balance at end of period | ( | ( | |||||||||||||||
| Accumulated other comprehensive loss, end of period | $ | ( | $ | ( | |||||||||||||
(1) Amortization of pension items: | |||||||||||||||||
| Actuarial losses | $ | $ | (2) | ||||||||||||||
| Prior year service cost | ( | (2) | |||||||||||||||
| Income tax benefit | ( | ||||||||||||||||
| Reclassification net of income tax benefit | $ | $ | |||||||||||||||
(2)These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. See Note 10 - Pensions for additional details.
18
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
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
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
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
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
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
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.
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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.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As is more fully described in our Annual Report on Form 10-K for the year ended December 31, 2022, we are exposed to various types of market risks, including currency and certain commodity risks. Our quantitative and qualitative disclosures about market risk have not materially changed since that report was filed. We monitor our currency and commodity risks on a continuous basis and generally enter into forward and futures contracts to minimize these exposures. The majority of the contracts are for periods of less than one year. Our Company does not engage in speculation in our derivative strategies. It is important to note that gains and losses from our forward and futures contract activities are offset by changes in the underlying costs of the transactions being hedged.
ITEM 4 - CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (Exchange Act). Based upon this evaluation of these disclosure controls and procedures, our principal executive officer and principal financial officer concluded that the disclosure controls and procedures were effective as of March 31, 2023 to ensure that information required to be
26
disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time period specified in the SEC rules and forms, and to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow timely decisions regarding disclosure.
Changes in internal control over financial reporting
There have been no changes in our internal control over financial reporting during the quarter ended March 31, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
There have been no material changes in the legal and environmental matters discussed in Part 1, Item 3 and Note 16 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2022.
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In the first quarter of 2023, our Board of Directors approved adding 7,500,000 shares of common stock to the existing discretionary share repurchase authority. Under the share repurchase program, the Common Stock may be purchased through a combination of Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The number of shares purchased and the timing of the purchases will depend on a number of factors, including share price, trading volume and general market conditions, as well as working capital requirements, general business conditions and other factors, including alternative investment opportunities. 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. In the first quarter of 2023, we repurchased 821,000 shares at an average price of $64.63 per share and at a total cost of $53.1 million. As of March 31, 2023, there were 7,057,462 shares remaining on the existing repurchase authorization.
| ISSUER PURCHASES OF EQUITY SECURITIES | |||||||||||||||||||||||
| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | Maximum Number of Shares that may yet be Purchased Under the Plans or Programs | |||||||||||||||||||
| January 1 - January 31, 2023 | 315,000 | $ | 60.14 | 315,000 | 7,563,462 | ||||||||||||||||||
| February 1 - February 28, 2023 | 230,000 | 67.29 | 230,000 | 7,333,462 | |||||||||||||||||||
| March 1 - March 31, 2023 | 276,000 | 67.52 | 276,000 | 7,057,462 | |||||||||||||||||||
ITEM 6 - EXHIBITS
Refer to the Exhibit Index on page 28 of this report.
27
INDEX TO EXHIBITS
Exhibit Number | Description | |||||||
| 31.1 | ||||||||
| 31.2 | ||||||||
| 32.1 | ||||||||
| 32.2 | ||||||||
| 101 | The following materials from A. O. Smith Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2023 are filed herewith, formatted in XBRL (Extensive Business Reporting Language): (i) the Condensed Consolidated Statement of Earnings for the three months ended March 31, 2023 and 2022, (ii) the Condensed Consolidated Statement of Comprehensive Earnings for the three months ended March 31, 2023 and 2022, (iii) the Condensed Consolidated Balance Sheets as of March 31, 2023, and December 31, 2022 (iv) the Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2023 and 2022 (v) the Condensed Consolidated Statement of Stockholders’ Equity for the three months ended March 31, 2023 and 2022 (vi) the Notes to Condensed Consolidated Financial Statements. | |||||||
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has authorized this report to be signed on its behalf by the undersigned.
| A. O. SMITH CORPORATION | |||||
| April 28, 2023 | /s/ Benjamin A. Otchere | ||||
| Benjamin A. Otchere | |||||
| Vice President and Controller | |||||
| /s/ Charles T. Lauber | |||||
| Charles T. Lauber | |||||
| Executive Vice President and Chief Financial Officer | |||||
29
Exhibit 31.1
CERTIFICATION
I, Kevin J. Wheeler, certify that:
1.I have reviewed this quarterly report on Form 10-Q of A. O. Smith Corporation;
2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.Based on my knowledge, the financial statements and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c)Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5.The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
April 28, 2023
| /s/ Kevin J. Wheeler | |||||
| Kevin J. Wheeler | |||||
| Chairman, President and Chief Executive Officer | |||||
Exhibit 31.2
CERTIFICATION
I, Charles T. Lauber, certify that;
1. I have reviewed this quarterly report on Form 10-Q of A. O. Smith Corporation;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's Board of Directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
April 28, 2023
| /s/ Charles T. Lauber | |||||
| Charles T. Lauber | |||||
| Executive Vice President and Chief Financial Officer | |||||
Exhibit 32.1
Written Statement of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, the undersigned certifies that to the best of my knowledge:
(1)the Quarterly Report on Form 10-Q of A. O. Smith Corporation for the quarter ended March 31, 2023 (the "Report") fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934; and
(2)the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of A. O. Smith Corporation.
April 28, 2023
| /s/ Kevin J. Wheeler | |||||
| Kevin J. Wheeler | |||||
| Chairman, President and Chief Executive Officer | |||||
Exhibit 32.2
Written Statement of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, the undersigned certifies that to the best of my knowledge:
(1)the Quarterly Report on Form 10-Q of A. O. Smith Corporation for the quarter ended March 31, 2023 (the "Report") fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934; and
(2)the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of A. O. Smith Corporation.
April 28, 2023
| /s/ Charles T. Lauber | |||||
| Charles T. Lauber | |||||
| Executive Vice President and Chief Financial Officer | |||||