Commission File Number 1-475
P.O. Box 245008, Milwaukee, Wisconsin 53224-9508 Telephone: (414) 359-4000
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 and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes X No ___
Class A Common Stock Outstanding as of June 30, 2004 — 8,495,906 shares
Common Stock Outstanding as of June 30, 2004 — 20,937,631 shares
Exhibit Index Page 18
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A.O. SMITH CORPORATIONCONDENSED CONSOLIDATED STATEMENT OF EARNINGSThree and Six Months ended June 30, 2004 and 2003(dollars in millions, except for per share data)(unaudited)
See accompanying notes to unaudited condensed consolidated financial statements.
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A.O. SMITH CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETSJune 30, 2004 and December 31, 2003(dollars in millions)
See accompanying notes to unaudited condensed consolidated financial statements
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A.O. SMITH CORPORATIONCONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS Six Months Ended June 30, 2004 and 2003 (dollars in millions)(unaudited)
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PART I — FINANCIAL INFORMATION ITEM 2 —MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS
Sales were $437.3 million in the second quarter of 2004, approximately five percent higher than sales of $417.6 million in the second quarter of 2003. Sales for the first half of 2004 were $853.8 million or six percent higher than sales of $805.5 million in the same period last year. The increase in second quarter and first half sales was due primarily to price increases associated with the introduction of flammable vapor ignition resistant and National Appliance Energy Conservation Act (NAECA) compliant product at Water Systems as well as growth in our China operations.
Our gross margin in the second quarter of 2004 of 20.2 percent, reflects higher contribution margin from new product offset by higher steel and freight costs and is similar to the 20.1 percent gross margin in the second quarter of 2003. The gross profit margin for the first half of 2004 was 19.5 percent compared with 20.1 percent in the same period last year. The decrease in margin was the result of disruptions in our Water Systems segment due to several conversion projects as well as increased freight and material costs.
Selling, general and administrative expenses in the second quarter and first half of 2004 were higher than the same periods in 2003 by $7.2 million and $11.9 million, respectively. The increases resulted primarily from higher selling and advertising costs at Water Systems, higher corporate expense and lower pension income.
Interest expense for the second quarter and first half of 2004 was higher than the comparable periods in 2003 by $.2 million and $.5 million, respectively, due mostly to incremental interest on $50.0 million of senior notes issued in June 2003 to repay commercial paper.
We have significant pension benefit costs and credits that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumptions for the expected rate of return on pension plan assets is 9.0 percent in 2004, unchanged from 2003. The discount rate used to determine net periodic pension costs and credits decreased from 6.75 percent in 2003 to 6.25 percent in 2004. Pension income recognized in the second quarter and first half of 2004 was $1.2 million and $3.0 million, respectively, and compared with $3.3 million and $5.8 million in the comparable periods of 2003. Total pension income for 2004 is projected to be $6.0 million. Our pension income is reflected as reductions to cost of products sold and selling, general, and administrative expense.
The difference in other income/expense in the second quarter of 2004 compared to 2003 is due to $.4 million of interest income on a tax refund in 2003.
Our effective tax rate for both the second quarter and first half of 2004 was 33.5 percent and compares to 32.1 percent and 33.1 percent in the second quarter and first half of 2003, respectively. The rates in the second quarter and first half of 2003 were both favorably impacted by the release of a $.7 million reserve upon resolution of a federal tax audit in May 2003.
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Net earnings in the second quarter declined from $19.8 million in 2003 to $17.3 million in 2004. Net earnings of $28.0 million for the first half of 2004 were $5.5 million lower than net earnings of $33.5 million in the first half of 2003. The second quarter and first half of 2004 benefited from $2.5 million of non-recurring pre-tax gain associated with favorable resolution of litigation related to a discontinued product line of our State Industries acquisition, partially offset by a write-off of capitalized software at Electrical Products. The decline in earnings for both the second quarter and first half was attributable to increased costs for steel, freight and manufacturing disruptions associated with multiple conversion programs in our Water Systems segment. On a per share basis, second quarter earnings declined from $.67 in 2003 to $.58 in 2004. First half diluted earnings per share declined from $1.13 in 2003 to $.94 in 2004. The per share impact of the non-recurring gain in 2004 was $.06.
Electrical Products
Second quarter sales for our Electrical Products segment were $227.7 million, similar to the same quarter in 2003. Second quarter sales to the pump and ventilation markets increased by over 15 percent but were offset by lower sales to the heating and air conditioning market, which declined about ten percent due primarily to the loss of a sales contract by an OEM customer. Year-to-date sales for this segment were $451.3 million, an increase of $10.6 million from 2003 first half sales of $440.7 million.
Operating earnings for our Electrical Products segment in the second quarter were $17.4 million, or $1.2 million lower than operating earnings of $18.6 million in the second quarter of 2003. First half operating earnings in 2004 were lower than the same period in 2003 by $1.7 million. The lower earnings in both the second quarter and first half were due to higher steel and freight costs which were partially offset by steel related price increases and the benefits of this segment’s repositioning program. A $.8 million write-off of capitalized software was also recognized in the second quarter.
Water Systems
Second quarter sales for our Water Systems segment increased by more than ten percent from $190.0 million in 2003 to $209.6 million in 2004. First half sales were also up by more than ten percent from $364.8 million in 2003 to $402.5 million in 2004. The sales increase in both the second quarter and first half was due mostly to the introduction of new flammable vapor ignition resistant water heaters and initial shipments of water heaters meeting the new NAECA mandate for improved energy efficiency. Significant growth in sales in China also impacted the first half. Price increases implemented to cover higher steel costs provided some of the second quarter increase. Residential volume was about ten percent lower in the second quarter of 2004 due to the significant customer pre-buy that occurred in the second quarter of 2003 related to the July 2003 introduction of flammable vapor ignition resistant product. Offsetting this decline, sales to the commercial market began to show some strength in the quarter as volume improved more than ten percent from the second quarter of 2003.
Operating earnings for our Water Systems segment were $18.7 million in the second quarter of 2004 including a $3.3 million non-recurring favorable adjustment resulting from the reversal of a reserve established at the time of the State Industries acquisition. The reserve was established to cover alleged damages associated with lawsuits related to the Duron product line which had been discontinued prior to the acquisition. The last of the lawsuits were dismissed in the second quarter. The reserve was therefore eliminated. Operating earnings in the quarter, excluding the aforementioned adjustment were $15.4 million or $2.4 million less than the second quarter of 2003. First half operating earnings decreased $5.7 million from 2003 when excluding the non-recurring adjustment in 2004. The operating earnings decline in the second quarter and first half resulted from increased steel and freight costs, as well as manufacturing inefficiencies caused by the conversion of residential water heaters to meet new efficiency standards, standardization of the A. O. Smith and State residential product lines, relocation of production between Ashland City, TN, and McBee, S.C. plants and an information systems conversion.
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We are forecasting that earnings will be in a range of $.42 to $.46 per share for the third quarter. While this is significantly better than last year’s difficult third quarter, which yielded $.20 per share, it is lower than we had anticipated due to the slower than expected progress in improving manufacturing performance at the Ashland City plant.
We believe efficiency levels at the Ashland City plant will improve as the year proceeds. Additionally, price increases are now beginning to offset higher steel and freight costs at both Electrical Products and Water Systems.
Accordingly, we are maintaining our full-year projection of $1.90 to $2.00 per share.
Our working capital, excluding short-term debt, was $346.7 million at June 30, 2004, $40.8 million higher than at December 31, 2003. Increases in accounts receivable of $69.6 million, primarily as a result of increases in sales, were partially offset by increases in accounts payable of $30.5 million. Cash provided by operating activities during the first half of 2004 was $11.1 million compared with the $6.1 million of cash used in operating activities during the first half of 2003. The majority of the $17.2 million difference in cash flow is explained by a smaller investment in working capital in 2004 of $43.8 million as compared with a $62.4 million investment during the same period in 2003. We expect cash provided by operating activities for the year to be between $110 and $120 million due to improved working capital levels and second half earnings.
Our capital expenditures during the first half of 2004 totaled $19.0 million, which was $4.2 million higher than the capital expenditures in the first half of 2003. Capital expenditures increased at both of our business segments. We are projecting 2004 capital expenditures to be between $45 and $50 million. We expect that cash flow during 2004 will adequately cover planned capital expenditures. We believe that our present facilities and planned capital expenditures are sufficient to provide adequate capacity for our operations in 2004.
On June 10, 2004, we entered into a new $265 million, five year revolving credit facility with a group of eight banks. The new facility expires on June 10, 2009, and it replaces a $250 million credit facility, which was terminated on June 10, 2004 prior to its scheduled expiration on August 2, 2004. The new facility backs up commercial paper and credit line borrowings. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings are now classified as long-term debt.
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Our total debt increased by $13.8 million from $275.5 million at December 31, 2003 to $289.3 million at June 30, 2004. Our leverage as measured by the ratio of total debt to total capitalization was 33%, up slightly from the 32% at the end of 2003. We did not enter into any significant operating leases during the first half of 2004. At June 30, 2004, our company had available borrowing capacity of $152.2 million under our credit facility. We believe that the combination of available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future.
On July 13, 2004, our board of directors declared a $.01 increase in our regular quarterly cash dividend to a rate of $.16 per share on our Common stock and Class A common stock, which is payable on August 16, 2004 to stockholders of record on July 30, 2004.
Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements as disclosed in the Form 10-K for the fiscal year ended December 31, 2003. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill, as well as the recoverability of receivables resulting from the payment of claims associated with the dip tube class action lawsuit (see Part II, Item I of this report). There are also significant estimates used in the determination of liabilities related to warranty activity, litigation, product liability, environmental matters and pensions and other post-retirement benefits. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We constantly reevaluate these significant factors and adjustments are made when facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.
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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
As is more fully described in our annual report on Form 10-K for the year ended December 31, 2003, we are exposed to various types of market risks, primarily currency and certain commodities. We monitor our risks in these areas on a continuous basis and generally enter into forward and futures contracts to minimize these exposures 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
The chief executive officer and chief financial officer have evaluated the effectiveness of the company’s disclosure controls and procedures as of June 30, 2004 and have concluded that these disclosure controls and procedures were adequate and effective to ensure that material information relating to the company and its consolidated subsidiaries would be made known to them by others within those entities.
There were no significant changes in our internal controls over financial reporting or in other factors that could significantly affect our disclosure controls and procedures nor were there any significant deficiencies or material weaknesses in our internal controls. As a result, no corrective actions were required or undertaken.
This filing contains statements that we believe 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,” “continue,” or words of similar meaning. These 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 release. Factors that could cause such a variance include the following: instability in our electric motor and water products markets; the inability to generate the synergistic cost savings from the acquisition of State Industries; the inability to implement cost-reduction programs; adverse changes in general economic conditions; significant increases in raw material prices; competitive pressures on our company’s businesses; and the potential that assumptions on which we based our expectations are inaccurate or will prove to be incorrect.
Forward-looking statements included in this filing are made only as of the date of this filing, and our 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 A. O. Smith, or persons acting on its behalf, are qualified entirely by these cautionary statements.
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PART II — OTHER INFORMATION ITEM 1 — LEGAL PROCEEDINGS
In the legal matters discussed in Part 1, Item 3 and Note 14 of the Notes to Consolidated Financial Statements in the company’s Form 10-K Report for the year ended December 31, 2003, and Part 2, Item 1 in the quarterly report on Form 10-Q for the quarter ended March 31, 2004 which are incorporated herein by reference, the company reported on the status of the direct action lawsuit that was brought in the Civil District Court for the Parish of Orleans, State of Louisiana by A. O. Smith Corporation, Bradford White Company, American Water Heater Company, Lochinvar Corporation and State Industries, Inc. (the “water heater manufacturers”) against Perfection Corporation and American Meter Company, the parent company of Perfection, and their insurers to recover various damages caused by deteriorating dip tubes that were manufactured by Perfection Corporation. The trial was completed, the jury finished its deliberations and returned a verdict to the presiding judge in mid May 2004. The jurors were able to reach a verdict on some, but not all, of the claims presented at trial. On July 8, 2004 the Judge entered an order of partial judgment finding Perfection liable to the water heater manufacturers, with the exception of Lochinvar Corporation which was denied a recovery, for breach of express warranty and for contribution and awarded $19.3 million with judicial interest from the filing of the lawsuit. The judgment also rejected all of Perfection’s claims against the water heater manufacturers and the water heater manufacturers’ claim for breach of contract against Perfection. The Judge ordered a new trial on the water heater manufacturers’ other claims against Perfection and the claim against American Meter Company asserting that it is liable for the acts of Perfection. The water heater manufacturers are seeking to recover approximately $77 million in additional damages at the new trial, being the amount the jurors in the first trial assigned to the claims for which they were not able to reach a verdict and which are the subject of the new trial. The date of that trial has not been established. The judgment entered on July 8 cannot be appealed until the new trial has been completed and a judgment entered. It is likely that all or part of the judgments will be appealed by one or more parties adversely affected by the judgments. The appeals process could take from one to three years to complete. The company continues to expect that all or a substantial portion of its costs will be recovered from Perfection Corporation, American Meter Company, the funds held in escrow resulting from the settlements with the insurers of Perfection Corporation and American Meter Company, and from the company’s insurers.
The company also reported that it is currently involved as a potentially responsible party (PRP) in judicial and administrative proceedings initiated on behalf of various state and federal regulatory agencies seeking to clean up 11 sites which have been environmentally impacted and to recover costs they have incurred or will incur as to those sites. In June, 2004 the company fulfilled all of its obligations under a de minimis settlement agreement with the United States Environmental Protection Agency with respect to one of the sites and will have no further liability at the site.
ITEM 4 — SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On March 3, 2004, the company mailed a proxy statement to its stockholders relating to the annual meeting of stockholders on April 5, 2004. The annual meeting included the election of directors and the ratification of Ernst & Young LLP as the independent auditors of the company for 2004.
Directors are elected by a plurality of votes cast, by proxy or in person, with the holders voting as separate classes. A plurality of votes means that the nominees who receive the greatest number of votes cast are elected as directors. Consequently, any shares which are not voted, whether by abstention, broker nonvotes or otherwise, will have no effect on the election of directors.
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For all other matters considered at the meeting, both classes of stock vote together as a single class, with the Class A Common Stock entitled to one vote per share and the Common Stock entitled to 1/10th vote per share. All such other matters are decided by a majority of the votes cast. On such other matters, an abstention will have the same effect as a “no” vote but, because shares held by brokers will not be considered to vote on matters as to which the brokers withhold authority, a broker nonvote will have no effect on the vote.
ITEM 5 — OTHER INFORMATION
None
ITEM 6 — EXHIBITS AND REPORTS ON FORM 8-K
On April 2, 2004, the Company filed a Current Report on Form 8-K, reporting under Items 5 and 7, announcing the reduction of the Company’s first quarter earnings estimate.
On April 15, 2004, the Company filed a Current Report on Form 8-K, reporting under Items 7 and 12, announcing the Company’s results for the quarter ended March 31, 2004.
On May 12, 2004 the Company filed a Current Report on Form 8-K, reporting under Item 5, announcing Donald M. Heinrich’s resignation.
On July 13, 2004, the Company filed a Current Report on Form 8-K, reporting under Item 5, announcing an increased quarterly dividend and announcing judgment in the dip tube trial.
On July 15, 2004, the Company filed a Current Report on Form 8-K, reporting under Items 7 and 12, announcing the Company’s results for the quarter ended June 30, 2004.
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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.
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