SECURITIES AND EXCHANGE COMMISSION
| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended
June 30, 2019
.
| 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 or other jurisdiction of incorporation or organization) | | |
| | | |
11270 West Park Place, Milwaukee, Wisconsin | | |
(Address of principal executive office) | | |
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| | | | | |
| | | | |
Common Stock (par value $1.00 per share) | | | | |
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
☐
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
No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a
non-accelerated
filer, 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.
☐
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 July 31, 2019 - 26,052,985 shares
Common Stock Outstanding as of July 31, 2019 - 138,350,432 shares
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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 and six months ended June 30, 2019 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, 2018 filed with the SEC on February 15, 2019.
Recent Accounting Pronouncements
In January 2017, the Financial Accounting Standards Board (FASB) amended Accounting Standards Codification (ASC) 350,
Intangibles – Goodwill and Other
(issued under Accounting Standards Update (ASU)
2017-04,
“Simplifying the Test for Goodwill Impairment”). This amendment simplifies the test for goodwill impairment by only requiring an entity to perform an annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount that the carrying amount exceeds the reporting unit’s fair value. Any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The amendment requires adoption on January 1, 2020. The Company does not expect that the adoption of ASU
2017-04
will have a material impact on its consolidated balance sheets, statements of earnings or statements of cash flows.
In June 2016, the FASB issued ASC 326,
Financial Instruments – Credit Losses
(issued under ASU
2016-13)
which modifies the measurement of expected credit losses on certain financial instruments. ASU
2016-13
requires adoption on January 1, 2020. The Company does not expect that the adoption of ASU
2016-13
will have a material impact on its consolidated balance sheets, statements of earnings or statements of cash flows.
In February 2016, the FASB amended ASC 842,
(issued under ASU
2016-02).
This amendment requires the recognition of lease assets and lease liabilities on the balance sheet for most leasing arrangements classified as operating leases. The Company applied the modified retrospective transition method and elected the transition option to use the effective date of January 1, 2019, as the date of the initial application. The Company elected the package of practical expedients as well as a separate practical expedient not to separate lease and
non-lease
components. The Company did not elect the hindsight practical expedient. The adoption of ASU 2016-02 did not have a material impact on the Company’s consolidated balance sheets, statements of earnings or statements of cash flows. Refer to Note 4, Leases, for additional information.
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 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 $29.0 million and $47.0 million at June 30, 2019 and December 31, 2018, respectively. The Company assesses 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. The Company’s allowance for doubtful accounts was $6.4 million at both June 30, 2019 and December 31, 2018.
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 is 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 and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. The Rest of World segment also manufactures and markets
in-home
air purification products in China.
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 channel 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.
| Revenue Recognition (continued) |
The North America segment major product lines are defined as the following:
The Company’s water heaters are open water heating systems that heat potable water. Typical applications for water heaters include residences, restaurants, hotels and motels, 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 1,300 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.
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 our 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 and whole-home water filtration products to on-the-go filtration bottles and point-of-use carbon and reverse osmosis products, as well as solutions for problem well water. Typical applications for the Company’s water treatment products include residences, restaurants, hotels and offices. The Company sells water treatment products through its wholesale and retail distribution channels, similar to water heater products and related parts. The Company’s water treatment products are also sold through independent water quality distributors as well as directly to consumers including through internet 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.
| 2. | Revenue Recognition (continued) |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | |
| | | | | | |
| | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
Water heaters and related parts | | $ | | | | $ | | | | $ | | | | $ | | |
Boilers and related parts | | | | | | | | | | | | | | | | |
Water treatment products (1) | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | ) | | | | ) | | | | ) | | | | ) |
| | | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
| Includes the results of Water-Right, Inc. from April , the date of acquisition |
On
April 8, 2019
, the Company acquired 100 percent of the shares of Water-Right, Inc
. and its affiliated entities (Water-Right),
a Wisconsin-based water treatment company. With the addition of Water-Right, the Company grew its North America water treatment platform. Water-Right is included in the Company’s North America segment for reporting purposes.
The Company paid an aggregate cash purchase price of $107.0 million, net of cash acquired. In addition, the Company established a $4.0 million escrow to satisfy any potential obligations of the former owners of Water-Right, should they arise.
The following table summarizes the preliminary estimate of the fair value of the assets acquired and liabilities assumed at the date of acquisition of Water-Right for purposes of allocating the purchase price. The Company is in the process of finalizing the fair value estimates; therefore, the allocation of the purchase price is subject to refinement. The preliminary $57.6 million of acquired identifiable intangible assets was comprised of the following: $
million of customer relationships being amortized over 20 years, $18.2 million of trademarks not subject to amortization, and $1.1 million of non-compete agreements being amortized over 7.5 years.
| 3. | Acquisitions (continued) |
| | | | | |
April 8, 2019 (dollars in millions) | | | |
Current assets, net of cash acquired | | $ | | |
Property, plant and equipment | | | | |
| | | | |
| | | | |
| | | | | |
| | | | |
| | | | ) |
| | | | | |
Total liabilities assumed | | | | ) |
| | | | | |
| | $ | | |
| | | | | |
The acquisition was accounted for using the purchase method of accounting, and accordingly, the results of operations have been included in the Company’s consolidated financial statements from April 8, 2019, the date of acquisition. Revenues and
pre-tax
earnings associated with Water-Right included in the consolidated statement of earnings totaled $13.8 million and $2.0 million, respectively, which included $2.4 million of operating earnings less $0.4 million of acquisition-related costs incurred by the Company resulting from the acquisition.
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. The incremental borrowing rate is the rate of interest that the Company would have 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 one 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 material residual value guarantees or material restrictive covenants or material subleases. Cash flows associated with leases are consistent with the expense recorded in the condensed consolidated statement of earnings.
| 5. | Restructuring and Impairment Expenses |
In the first quarter of 2018, the Company announced a move of manufacturing operations from its Renton, Washington facility to other U.S. facilities. At that time, the Company recognized $
6.7
million of restructuring and impairment expenses, comprised of $
4.0
million of severance and compensation related costs, lease exit costs of $
2.1
million and impairment charges related to long-lived assets totaling $
0.6
million, as well as a corresponding $
1.7
million tax benefit related to the charges. The consolidation of the Renton facility to other U.S. facilities was completed in 2018.
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.
The Company has a $500 million multi-year multi-currency revolving credit agreement with a group of
nine
banks, which expires on
December 15, 2021
. The facility has an accordion provision which allows it to be increased up to $700 million if certain conditions (including lender approval) are satisfied.
Borrowings under bank credit lines and commercial paper borrowings are supported by the $500 million revolving credit agreement. As a result of the long-term nature of this facility, the Company’s commercial paper and credit line borrowings are classified as long-term debt at June 30, 2019. At its option, the Company either maintains cash balances or pays fees for bank credit and services.
| 9. | 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:
| | | | | | | | | | | | | | | | | |
| | | | | | |
| | | | | | | | | | | | |
Denominator for basic earnings per share—weighted average shares | | | | | | | | | | | | | | | | |
Effect of dilutive stock options and share units | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Denominator for diluted earnings per share | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| 10. | Stock Based Compensation |
The Company adopted the A. O. Smith Combined Incentive Compensation Plan (the Plan) effective January 1, 2007. The Plan was reapproved by stockholders on April 16, 2012. The 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 options or share units at June 30, 2019 was 1,870,386. 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 June 30, 2019 and 2018 was $2.1 million and $1.4 million, respectively. Total stock based compensation expense recognized in the six months ended June 30, 2019 and 2018 was $10.8 million and $7.9 million, respectively.
The stock options granted in the six months ended June 30, 2019 and 2018 have
three year
pro rata vesting from the date of grant. Stock options are 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 in 2019 and 2018 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 stock option expense for the three and six months ended June 30, 2019 and 2018 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 June 30, 2019 and 2018 was $0.9 million and $0.6 million, respectively. Stock based compensation expense attributable to stock options in the six months ended June 30, 2019 and 2018 was $5.2 million and $3.8 million, respectively.
Changes in options, all of which relate to the Company’s Common Stock, were as follows for the three months ended June 30, 2019:
| | | | | | | | | | | | | | | | | |
| | Weighted- Avg. Per
Share
Exercise
Price | | | | | | Average
Remaining
Contractual
Life | | | Aggregate
Intrinsic
Value
(dollars in
millions) | |
Outstanding at January 1, 2019 | | $ | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | ) | | | | | | | | |
| | | | | | | | ) | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Outstanding at June 30, 2019 | | | | | | | | | | | | | | $ | | |
| | | | | | | | | | | | | | | | | |
Exercisable at June 30, 2019 | | | | | | | | | | | | | | $ | | |
| | | | | | | | | | | | | | | | | |
| 10. | Stock Based Compensation (continued) |
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 curve 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.
Stock Appreciations Rights (SARs)
Certain
non-U.S.-based
employees were granted SARs. Each SAR award grants the employee the right to receive cash equal to the excess of the share price of the Company’s Common Stock on the date that a participant exercises such right over the grant date value of the SAR. SARs granted have
three year
pro rata vesting from the date of grant. SARs were issued at exercise prices equal to the fair value of the Company’s Common Stock on the date of grant and expire
ten years
from the date of grant. The fair value and compensation expense related to SARs are measured at each reporting period using the Black-Scholes option-pricing model, using assumptions similar to stock option awards.
No
SARs were granted in 2019 or 2018. As of June 30, 2019, there were 14,880 SARs outstanding and exercisable. In the six months ended June 30, 2019, 1,290 SARs were exercised. Stock based compensation expense attributable to SARs was minimal in the three and six months ended June 30, 2019 and 2018.
Restricted Stock and Share Units
Participants may also be awarded shares of restricted stock or share units under the Plan. The Company granted 139,892 and 102,666 share units under the plan in the six months ended June 30, 2019 and 2018, respectively. The share units were valued at $6.9 million and $6.4 million at the date of issuance in 2019 and 2018, 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 and six months ended June 30, 2019 and 2018 was expense associated with accelerated vesting of share unit awards for certain employees who either are retirement eligible or will become retirement eligible during the vesting period. Stock based compensation expense attributable to share units of $1.2 million and $0.8 million was recognized in the three months ended June 30, 2019 and 2018, respectively. Stock based compensation expense attributable to share units of $5.6 million and $4.1 million was recognized in the six months ended June 30, 2019 and 2018, 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 plan is as follows for the six months ended June 30, 2019:
| | | | | | | | |
| | Number of Units | | | Weighted-Average Grant Date Value | |
| Issued and unvested at January 1, 2019 | | | 379,601 | | | $ | 42.93 | |
| Granted | | | 139,892 | | | | 49.52 | |
| Vested | | | (147,642 | ) | | | 31.35 | |
| Forfeited | | | (2,405 | ) | | | 55.48 | |
| | | | | | | | | |
| Issued and unvested at June 30, 2019 | | | 369,446 | | | | 50.37 | |
| | | | | | | | | |
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 Rest of World segment also manufactures and markets
in-home
air purification products in China.
The following table presents the Company’s segment results:
| | | | | | | | | | | | | | | | | |
| | | | | | |
| | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | |
| | | | ) | | | | ) | | | | ) | | | | ) |
| | | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | |
| | | | ) | | | | | | | (0.1 | ) | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | ) | | | | ) | | | | ) | | | | ) |
| | | | ) | | | | ) | | | | ) | | | | ) |
| | | | | | | | | | | | | | | | | |
Earnings before income taxes | | | | | | | | | | | | | | | | |
Provision for income taxes | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
(1) includes restructuring and impairment expenses of: | | $ | | | | $ | | | | $ | | | | $ | | |
| 13. | Fair Value Measurements |
ASC 820,
, among other things, defines fair value, establishes a consistent framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring basis or nonrecurring basis. ASC 820 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. Assets and liabilities measured at fair value are based on the market approach which are prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.
The following table presents assets measured at fair value on a recurring basis.
| | | | | | | | | |
| | | | | | |
Fair Value Measurement Using | | | | | | |
Quoted prices in active markets for identical assets (Level 1) | | $ | | | | $ | | |
Significant other observable inputs (Level 2) | | | | | | | | |
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 six months ended June 30, 2019.
| 14. | 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.
With the exception of its net investment hedges, the Company designates that all of its hedging instruments are 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.
| 14. | Derivative Instruments (continued) |
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.
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, 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 $1.3 million of
after-tax
gains associated with hedges of a net investment in
non-U.S.
subsidiaries in currency translation adjustment in other comprehensive income in the six months ended June 30, 2019. The Company recognized $7.4 million and $3.2 million of after-tax gains associated with hedges of a net investment in non-U.S. subsidiaries in currency translation adjustment in other comprehensive income in the three and six months ended June 30, 2018, respectively. The contractual amount of the Company’s foreign currency forward contracts that are designated as net investment hedges is $100.0 million as of June 30, 2019.
| 14. | Derivative Instruments (continued) |
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:
| | | | | | | | | | | | | |
| | | | | | | | |
| | | | | | | | | | |
Foreign currency contracts | | | | | | $ | | | | $ | | |
| | | | | | | | | | | | |
| | | | | | | | ) | | | | ) |
| | | | | | | | | | | | ) |
| | | | | | | | | | | | | |
Total derivatives designated as hedging instruments | | | | | | $ | | | | $ | | |
| | | | | | | | | | | | | |
The effect of cash flow hedges on the condensed consolidated statement of earnings:
Three Months Ended June 30 (dollars in millions):
| | | | | | | | | | | | | | | | | | | |
| | | Amount of gain (loss)
recognized in other
comprehensive
loss on derivative | | | | | reclassified from
accumulated other
comprehensive loss
into earnings | |
| Derivatives in ASC 815 cash flow hedging relationships | | | | | | | | | | | | | | |
Foreign currency contracts | | $ | | | | $ | | ) | | | | $ | — | | | $ | | |
| | | | ) | | | | | | | | | | ) | | | | |
| | | | | | | | | | | | | | | | | | | |
| | $ | | | | $ | | ) | | | | $ | | ) | | $ | | |
| | | | | | | | | | | | | | | | | | | |
Six Months Ended June 30 (dollars in millions):
| | | | | | | | | | | | | | | | | | | |
| | | Amount of gain (loss)
recognized in other
comprehensive
loss on derivative | | | Location of gain (loss)
reclassified from accumulated other
comprehensive loss into
earnings | | | |
| Derivatives in ASC 815 cash flow hedging relationships | | | | | | | | | | | | | | |
Foreign currency contracts | | $ | | | | $ | | | | | | $ | | | | $ | | |
| | | | ) | | | | | | | | | | ) | | | | |
| | | | | | | | | | | | | | | | | | | |
| | $ | | | | $ | | | | | | $ | | ) | | $ | | |
| | | | | | | | | | | | | | | | | | | |
The Company’s effective income tax rates for the three and six months ended June 30, 2019 were
22.8 percent
and
21.5 percent
, respectively. The Company estimates that its annual effective income tax rate for the full year 2019 will be approximately
22.0 percent.
The effective income tax rates for the three and six months ended June 30, 2018 were
21.6
percent and
21.4
percent, respectively. The change in the effective income tax rate for the three and six months ended June 30, 2019 compared to the effective income tax rate for the three and six months ended June 30, 2018 was primarily due to earnings mix.
As of June 30, 2019, the Company had $8.3 million of unrecognized tax benefits of which $0.8 million would affect its effective income tax rate if recognized. The Company recognizes potential interest and penalties related to unrecognized tax benefits as a component of income tax expense.
The Company’s U.S. federal income tax returns for 2016-2019 are subject to audit. The Company is subject to state and local income tax audits for tax years 2002-2019. The Company is subject to
non-U.S.
income tax examinations for years 2013-2019.
| 16. | Commitments and Contingencies |
The Company maintains a long-standing 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 $21.1 and $25.1 million as of June 30, 2019 and December 31, 2018, 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 $72.5 million and $75.8 million as of June 30, 2019 and December 31, 2018, respectively. The Company’s reserves for estimated losses under repurchase arrangements were immaterial as of June 30, 2019 and December 31, 2018.
21
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, 2018, 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 Rule 13a-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 June 30, 2019 to ensure that information required to be 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 significant changes in our internal control over financial reporting during the quarter ended June 30, 2019 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
On May 28, 2019, a putative securities class action lawsuit was filed in the U.S. District Court for the Eastern District of Wisconsin against the Company and certain of its current or former officers. This action, captioned Henry Bleier v. A. O. Smith Corporation, et al., asserts securities fraud claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and seeks damages and other relief based upon the allegations in the complaint. Although the named plaintiff voluntarily dismissed his complaint on August 2, 2019, another putative class member filed a motion seeking to be named lead plaintiff in the case, and the Court has until August 26, 2019 to rule on that motion.
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In June 2019, our Board of Directors approved adding 3 million shares of common stock to an 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 second quarter of 2019, we repurchased 1,882,200 shares at an average price of $46.27 per share and at a total cost of $87.0 million. As of June 30, 2019, there were 6,281,253 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 | |
| April 1 – April 30, 2019 | | | 210,700 | | | $ | 55.01 | | | | 210,700 | | | | 4,952,753 | |
| May 1 – May 31, 2019 | | | 402,000 | | | | 48.33 | | | | 402,000 | | | | 4,550,753 | |
| June 1 – June 30, 2019 | | | 1,269,500 | | | | 44.16 | | | | 1,269,500 | | | | 6,281,253 | |
Refer to the Exhibit Index on page 33 of this report.
