10-Q
false SMITH A O CORP0000091142Q2--12-312020P1YIncludes the results of Water-Right, Inc. and its affiliated entities (Water-Right) from April 8, 2019, the date of acquisitionAmortization of pension items: These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. 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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 June 30, 2020.
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
 
 
A. O. Smith Corporation
(Exact name of registrant as specified in its charter)
 
 
 
Delaware
 
39-0619790
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
11270 West Park Place, Milwaukee, Wisconsin
 
53224-9508
(Address of principal executive office)
 
(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
Common Stock (par value $1.00 per share)
 
AOS
 
New York Stock Exchange
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.
 
Large accelerated filer      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, 2020 - 26,038,133 shares
Common Stock Outstanding as of July 31, 2020 - 135,375,099
 
shares
 
 
 

Index
A. O. Smith Corporation
 
 
  
 
 
Page
Part I.
  
 
 
     
 
  
 
3
     
 
  
 
3
     
 
  
 
4
     
 
  
 
5
     
 
  
 
6
     
 
  
 
7-24
     
Item 2.
  
 
25-33
     
Item 3.
  
 
33
     
Item 4.
  
 
33
     
Part II.    
  
 
 
     
Item 1.
  
 
34
     
Item 1A.
  
 
34-35
     
Item 2.
  
 
35
     
Item 6.
  
 
35
   
 
36
   
 
37
 
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
June 30,
    Six Months Ended
June 30,
 
     2020     2019     2020     2019  
Net sales
   $ 663.9     $ 765.4     $ 1,300.8     $ 1,513.6  
Cost of products sold
     416.4       456.7       813.8       912.1  
  
 
 
   
 
 
   
 
 
   
 
 
 
Gross profit
     247.5       308.7       487.0       601.5  
Selling, general and administrative expenses
     155.9       178.7       329.7       363.4  
Severance and restructuring expenses
     6.1                6.1           
Interest expense
     2.5       3.4       4.7       5.4  
Other income
     (4.0     (5.6     (8.2     (11.1
  
 
 
   
 
 
   
 
 
   
 
 
 
Earnings before provision for income taxes
     87.0       132.2       154.7       243.8  
Provision for income taxes
     19.2       30.1       35.2       52.4  
  
 
 
   
 
 
   
 
 
   
 
 
 
Net Earnings
   $ 67.8     $ 102.1     $ 119.5     $ 191.4  
  
 
 
   
 
 
   
 
 
   
 
 
 
Net Earnings Per Share of Common Stock
   $ 0.42     $ 0.61     $ 0.74     $ 1.14  
  
 
 
   
 
 
   
 
 
   
 
 
 
Diluted Net Earnings Per Share of Common Stock
   $ 0.42     $ 0.61     $ 0.74     $ 1.14  
  
 
 
   
 
 
   
 
 
   
 
 
 
Dividends Per Share of Common Stock
   $ 0.24     $ 0.22     $ 0.48     $ 0.44  
  
 
 
   
 
 
   
 
 
   
 
 
 
 
                                                                                   
A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS
(dollars in millions)
(unaudited)
 
     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2020     2019     2020     2019  
Net earnings
   $ 67.8     $ 102.1     $ 119.5     $ 191.4  
Other comprehensive earnings
 
(loss)
        
Foreign currency translation adjustments
     3.7       (10.1     (14.3     5.8  
Unrealized net (losses) gains on cash flow derivative instruments, less related income tax benefit (provision) of $0.3 and $0.2 in 2020, ($0.2) and ($0.1) in 2019
     (0.8     0.7       (0.5     0.6  
Adjustment to pension liability, less related income tax provision of ($1.2) and ($2.4) in 2020 and ($0.8) and ($1.8) in 2019
     3.7       3.1       7.3       6.0  
  
 
 
   
 
 
   
 
 
   
 
 
 
Comprehensive Earnings
   $ 74.4     $ 95.8     $ 112.0     $ 203.8  
  
 
 
   
 
 
   
 
 
   
 
 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
3

A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in millions)
 
     (unaudited)
June 30, 2020
    December 31,
2019
 
Assets
    
Current Assets
    
Cash and cash equivalents
   $ 442.7     $ 374.0  
Marketable securities
     126.0       177.4  
Receivables
     515.9       589.5  
Inventories
     306.0       303.0  
Other current assets
     53.8       56.5  
  
 
 
   
 
 
 
Total Current Assets
     1,444.4       1,500.4  
Property, plant and equipment
     1,170.5       1,156.9  
Less accumulated depreciation
     (636.7     (611.5
  
 
 
   
 
 
 
Net property, plant and equipment
     533.8       545.4  
Goodwill
     544.0       546.0  
Other intangibles
     329.5       338.4  
Operating lease assets
     45.2       46.9  
Other assets
     87.3       80.9  
  
 
 
   
 
 
 
Total Assets
   $ 2,984.2     $ 3,058.0  
Liabilities
    
Current Liabilities
    
Trade payables
   $ 435.7     $ 509.6  
Accrued payroll and benefits
     59.7       64.6  
Accrued liabilities
     188.4       143.7  
Product warranties
     44.8       41.8  
Debt due within one year
     6.8       6.8  
  
 
 
   
 
 
 
Total Current Liabilities
     735.4       766.5  
Long-term debt
     274.3       277.2  
Pension liabilities
     13.8       27.8  
Long-term operating lease liabilities
     37.5       38.7  
Other liabilities
     265.1       281.0  
  
 
 
   
 
 
 
Total Liabilities
     1,326.1       1,391.2  
Stockholders’ Equity
    
Class A Common Stock, $5 par value: authorized 27,000,000 shares; issued
,
26,172,713 and 26,180,885
     130.9       130.9  
Common Stock, $1 par value: authorized 240,000,000 shares; issued 164,534,881 and 164,526,709
     164.5       164.5  
Capital in excess of par value
     517.1       509.0  
Retained earnings
     2,365.1       2,323.4  
Accumulated other comprehensive loss
     (355.8     (348.3
Treasury stock at cost
     (1,163.7     (1,112.7
  
 
 
   
 
 
 
Total Stockholders’ Equity
     1,658.1       1,666.8  
  
 
 
   
 
 
 
Total Liabilities and Stockholders’ Equity
   $ 2,984.2     $ 3,058.0  
  
 
 
   
 
 
 
See accompanying notes to unaudited condensed consolidated financial statements
 
4

A. O. SMITH CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in millions)
(unaudited)
 
     Six Months Ended
June 30,
 
     2020     2019  
Operating Activities
    
Net earnings
   $ 119.5     $ 191.4  
Adjustments to reconcile net earnings to cash provided by (used in) operating activities:
    
Depreciation and amortization
     40.0       38.4  
Stock based compensation expense
     10.4       10.8  
Net changes in operating assets and liabilities:
    
Current assets and liabilities
     35.9       (75.9
Noncurrent assets and liabilities
     (26.5     (21.0
  
 
 
   
 
 
 
Cash Provided by Operating Activities
     179.3       143.7  
Investing Activities
    
Capital expenditures
     (24.8     (36.5
Acquisition
     —         (107.0
Investments in marketable securities
     (91.1     (202.3
Net proceeds from sale of marketable securities
     140.1       293.8  
  
 
 
   
 
 
 
Cash Provided by (Used in) Investing Activities
     24.2       (52.0
Financing Activities
    
Long-term debt (repaid) incurred
     (2.9     137.3  
Common stock repurchases
     (56.7     (132.6
Net payments from stock option activity
     2.6       (0.5
Dividends paid
     (77.8     (74.0
  
 
 
   
 
 
 
Cash Used in Financing Activities
     (134.8     (69.8
  
 
 
   
 
 
 
Net increase in cash and cash equivalents
     68.7       21.9  
Cash and cash equivalents - beginning of period
     374.0       259.7  
  
 
 
   
 
 
 
Cash and Cash Equivalents - End of Period
   $ 442.7     $ 281.6  
  
 
 
   
 
 
 
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
June 30,
    Six Months Ended
June 30,
 
     2020     2019     2020     2019  
Class A Common Stock
        
Balance at the beginning of period
   $ 130.9     $ 131.0     $ 130.9     $ 131.0  
Conversion of Class A Common Stock
              (0.1              (0.1
  
 
 
   
 
 
   
 
 
   
 
 
 
Balance at end of period
   $ 130.9     $ 130.9     $ 130.9     $ 130.9  
  
 
 
   
 
 
   
 
 
   
 
 
 
Common Stock
                
Balance at the beginning of period
   $ 164.5     $ 164.5     $ 164.5     $ 164.5  
  
 
 
   
 
 
   
 
 
   
 
 
 
Balance at end of period
   $ 164.5     $ 164.5     $ 164.5     $ 164.5  
  
 
 
   
 
 
   
 
 
   
 
 
 
Capital in Excess of Par Value
                
Balance at the beginning of period
   $ 516.1     $ 503.5     $ 509.0     $ 496.7  
Conversion of Class A Common Stock
              0.1                0.1  
Issuance of share units
              (0.1     (6.5     (6.2
Vesting of share units
              (0.1     (1.6     (2.0
Stock based compensation expense
     1.4       1.9       10.2       10.5  
Exercises of stock options
     (1.1     0.5       (1.2     0.6  
Stock incentives
     0.7       0.9       7.2       7.0  
  
 
 
   
 
 
   
 
 
   
 
 
 
Balance at end of period
   $ 517.1     $ 506.7     $ 517.1     $ 506.7  
  
 
 
   
 
 
   
 
 
   
 
 
 
Retained Earnings
                
Balance at the beginning of period
   $ 2,336.1     $ 2,155.0     $ 2,323.4     $ 2,102.8  
Net earnings
     67.8       102.1       119.5       191.4  
Cash dividends on stock
     (38.8     (36.9     (77.8     (74.0
  
 
 
   
 
 
   
 
 
   
 
 
 
Balance at end of period
   $ 2,365.1     $
 
2,220.2     $ 2,365.1     $
 
2,220.2  
  
 
 
   
 
 
   
 
 
   
 
 
 
Accumulated Other Comprehensive Loss (see Note 17)
   $ (355.8   $ (338.4   $ (355.8   $ (338.4
Treasury Stock
                
Balance at the beginning of period
   $ (1,168.9   $ (872.7   $ (1,112.7   $ (827.2
Exercise of stock options
     4.8       0.6       3.7       (1.3
Stock incentives and directors’ compensation
     0.4       0.2       0.4       0.2  
Shares repurchased
              (87.0     (56.7     (132.6
Vesting of share units
              0.1       1.6       2.1  
  
 
 
   
 
 
   
 
 
   
 
 
 
Balance at end of period
   $
 
(1,163.7   $ (958.8   $
 
(1,163.7   $ (958.8
  
 
 
   
 
 
   
 
 
   
 
 
 
Total Stockholders’ Equity
   $ 1,658.1     $ 1,725.1     $ 1,658.1     $ 1,725.1  
  
 
 
   
 
 
   
 
 
   
 
 
 
See accompanying notes which are an integral part of these statements.
 
6

A. O. SMITH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2020
(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 and six months ended June 30, 2020 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, 2019 filed with the SEC on February 24, 2020.
Recent Accounting Pronouncements
In December 2019, the Financial Accounting Standards Board (FASB) amended Accounting Standards Codification (ASC) 740,
Income Taxes
(issued under Accounting Standards Update (ASU)
2019-12,
“Simplifying the Accounting for Income Taxes”). This amendment removes certain exceptions to the general principles of ASC 740 and clarifies and amends existing guidance to improve consistent application. The amendment requires adoption on January 1, 2021, with early adoption permitted. The Company does not expect that the adoption of ASU
2019-12
will have a material impact on its consolidated balance sheets, statements of earnings or statements of cash flows.
In January 2017, the FASB amended ASC 350,
Intangibles –
Goodwill
and Other
(issued under 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 Company adopted the amendment on January 1, 2020 and the adoption of ASU
2017-04
did not have an 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. The Company adopted
 
ASU
 
2016-13
on January 1, 2020 and the adoption did not have a material impact on its consolidated balance sheets, statements of earnings or statements of cash flows.
 
7

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 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 $43.0 million and $49.6 million at June 30, 2020 and December 31, 2019, respectively. 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 doubtful accounts, 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 doubtful accounts, which reflects the current estimate of credit losses expected to be incurred over the life of the receivables. The Company’s allowance for doubtful accounts was $6.7 million at both June 30, 2020 and December 31, 2019.
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 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.
 
8

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 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.
The North America segment 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 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.
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 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.
 
9

2.
Revenue Recognition (continued)
 
(dollars in millions)
             
     Three Months
 
Ended
June 30,
     Six Months Ended
June 30,
 
     2020      2019      2020      2019  
North America
           
Water heaters and related parts
   $ 396.8      $ 438.9      $ 844.6      $ 894.6  
Boilers and related parts
     41.0        48.0        82.5        90.6  
Water treatment products
(1)
     42.7        37.1        86.3        60.6  
  
 
 
    
 
 
    
 
 
    
 
 
 
Total North America
     480.5        524.0        1,013.4        1,045.8  
Rest of World
           
China
   $ 172.7      $ 224.2      $ 263.7      $ 437.2  
All other Rest of World
     17.0        24.9        36.2        44.0  
  
 
 
    
 
 
    
 
 
    
 
 
 
Total Rest of World
     189.7        249.1        299.9        481.2  
Inter-segment sales
     (6.3      (7.7      (12.5      (13.4
  
 
 
    
 
 
    
 
 
    
 
 
 
Total Net Sales
   $
 
663.9      $
 
765.4      $ 1,300.8      $ 1,513.6  
  
 
 
    
 
 
    
 
 
    
 
 
 
 
(1)
 
Includes the results of Water-Right, Inc. and its affiliated entities (Water-Right) from April 8, 2019, the date of acquisition
 
3.
Acquisition
On April 8, 2019, the Company acquired 100 percent of the shares of 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. During the three months ended June 30, 2020 the
 
C
ompany
 
released $2.0 million of the escrow to the previous owners of Water-Right. The remaining balance of the escrow has scheduled disbursements of $1.9 million in the fourth quarter of 2020 and $0.1 million in the second quarter of 2021.
The following table summarizes the allocation 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. Significant assumptions used to estimate the fair value of intangible assets acquired include discount rates and certain assumptions that form the basis of the forecasted results, including revenue growth rates, attrition rates and royalty rates. The $60.4 million of acquired identifiable intangible assets was comprised of the following: $40.2 million of customer relationships being amortized over 20 years, $19.0 million of trademarks not subject to amortization, and $1.2 million of
non-compete
agreements being amortized over 7.5 years.
 
10

3.
Acquisition (continued)
 
April 8, 2019 (dollars in millions)
      
Current assets, net of cash acquired
   $ 9.7  
Property, plant and equipment
     8.6  
Intangible assets
     60.4  
Goodwill
     31.0  
  
 
 
 
Total assets acquired
     109.7  
Current liabilities
     (2.7
  
 
 
 
Net assets acquired
   $ 107.0  
  
 
 
 
As required under ASC 805 Business Combinations, Water-Right’s results of operations have been included in the Company’s consolidated financial statements from April 8, 2019, the date of acquisition.
 
4.
Severance and Restructuring Expenses
During the three months ended June 30, 2020, to align our business to current market conditions, the
C
ompany recognized $6.1 million of
 
pre-tax
 
severance and restructuring expenses, comprised of $5.2 million severance costs and $0.9 million of other restructuring expenses, as well as a corresponding $1.1 million tax benefit related to these charges. Of the $6.1
 
million
 
expen
s
e
 
recognized, $2.2 million was related to the North America segment and $3.9 million was related to the Rest of World segment.
 
The Company’s severance and restructuring actions were largely completed in the three months ended June 30, 2020.
The following table summarizes the activity in the Company’s accrual for severance and restructuring expenses incurred during the three months ended June 30, 2020:
 
(dollars in millions)
                    
     Severance
Expenses
     Restructuring
Expenses
     Total  
Accrued severance and restructuring expenses, March 31, 2020
   $ —        $ —        $ —    
Charges
     5.2        0.9        6.1  
Cash Payments
     (2.2      (0.3      (2.5
  
 
 
    
 
 
    
 
 
 
Accrued severance and restructuring expenses, June 30, 2020
   $ 3.0      $ 0.6      $ 3.6  
  
 
 
    
 
 
    
 
 
 
 
11

5.
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 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 materially consistent with the expense recorded in the condensed consolidated statement of earnings.
Supplemental balance sheet information related to leases was as follows:
 
(dollars in millions)
             
     June 30, 2020      December 31, 2019  
Liabilities
     
Short term: Accrued liabilities
   $ 11.5      $ 12.0  
Long term: Operating lease liabilities
     37.5        38.7  
  
 
 
    
 
 
 
Total operating lease liabilities
   $ 49.0      $ 50.7  
Less: Rent incentives and deferrals
     (3.8      (3.8
  
 
 
    
 
 
 
Assets
     
Operating lease assets
   $ 45.2      $ 46.9  
  
 
 
    
 
 
 
 
Lease Term and Discount Rate
   June 30, 2020  
Weighted-average remaining lease term
     9.8 years  
Weighted-average discount rate
     3.83
 
12

5.
Leases (continued)
 
The components of lease expense were as follows:
 
                                                              
(dollars in millions)
                  
         
Three months ended

June 30,
 
Lease Expense
  
Classification
  
2020
(1)
    
2019
(2)
 
Operating lease expense
   Cost of products sold    $ 0.8      $ 0.7  
  
Selling, general and administrative expenses
   $ 4.2      $ 4.1  
 
(1)
2020 includes short-term and variable lease expenses of $0.6 million and $0.5 million, respectively.
(2)
2019 includes short-term and variable lease expenses of $0.5 million and $0.2 million, respectively.
 
                                                              
(dollars in millions)
                  
         
Six months ended

June 30,
 
Lease Expense
  
Classification
  
2020
(1)
    
2019
(2)
 
Operating lease expense
   Cost of products sold    $ 1.5      $ 1.3  
  
Selling, general and administrative expenses
   $ 8.2      $ 9.0  
 
(1)
2020 includes short-term and variable lease expenses of $1.0 million and $0.9 million, respectively.
(2)
2019 includes short-term and variable lease expenses of $1.0 million and $1.0 million, respectively.
Maturities of lease liabilities were as follows:
 
(dollars in millions)
      
     June 30, 2020  
2020
   $ 7.0  
2021
     11.7  
2022
     9.9  
2023
     5.5  
2024
     4.4  
After 2024
     23.0  
  
 
 
 
Total lease payments
     61.5  
Less: imputed interest
     (12.5
  
 
 
 
Present value of operating lease liabilities
   $ 49.0  
  
 
 
 
 
6.
Inventories
The following table presents the components of the Company’s inventory balances:
 
(dollars in millions)
             
     June 30,
2020
     December 31,
2019
 
Finished products
   $ 134.3      $ 136.8  
Work in process
     22.7        21.7  
Raw materials
     172.8        168.3  
  
 
 
    
 
 
 
Inventories, at FIFO cost
     329.8        326.8  
LIFO reserve
     (23.8      (23.8
  
 
 
    
 
 
 
Net inventory
   $ 306.0      $ 303.0  
  
 
 
    
 
 
 
 
13

7.
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.
 
     Three Months Ended
June 30,
 
(dollars in millions)
      
     2020      2019  
Balance at April 1,
   $
 
135.3      $
 
136.2  
Expense
     12.3        11.4  
Claims settled
     (11.6      (13.6
  
 
 
    
 
 
 
Balance at June 30,
   $ 136.0      $ 134.0  
  
 
 
    
 
 
 
 
     Six Months Ended
June 30,
 
(dollars in millions)
      
     2020      2019  
Balance at January 1,
   $
 
134.3      $
 
139.4  
Expense
     25.8        20.8  
Claims settled
     (24.1      (26.2
  
 
 
    
 
 
 
Balance at June 30,
   $ 136.0      $ 134.0  
  
 
 
    
 
 
 
 
8.
Long-Term Debt
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, 2020. 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:
 
     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2020      2019      2020      2019  
Denominator for basic earnings per share - weighted average shares
     161,208,194        166,825,601        161,539,991        167,311,995  
Effect of dilutive stock options and share units
     965,648        1,260,667        995,675        1,276,451  
  
 
 
    
 
 
    
 
 
    
 
 
 
Denominator for diluted earnings per share
     162,173,842        168,086,268        162,535,666        168,588,446  
  
 
 
    
 
 
    
 
 
    
 
 
 
 
14

10.
Stock Based Compensation
The Company adopted the A. O. Smith Combined Incentive Compensation Plan (the Plan) effective January 1, 2007. The Plan was
 most recently
r
eapproved by stockholders on April 15, 2020. 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, 2020 was 3,410,323 which includes 2,400,000 additional shares that were authorized on April 15, 2020 at the Company’s annual meeting of stockholders. 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, 2020 and 2019 was $1.4 million and $2.1 million, respectively. Total stock based compensation expense recognized in the six months ended June 30, 2020 and 2019 was $10.4 million and $10.8 million, respectively.
Stock Options
The stock options granted in the six months ended June 30, 2020 and 2019 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 2020 and 2019 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, 2020 and 2019 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, 2020 and 2019 was $0.7 million and $0.9 million, respectively. Stock based compensation expense attributable to stock options in the six months ended June 30, 2020 and 2019 was $5.2 million, respectively. Changes in options, all of which
relate
to the Company’s Common Stock, were as follows for the six months ended June 30, 2020:
 
    
Weighted-

Avg. Per
Share
Exercise
Price
     Number of
Options
     Average
Remaining
Contractual
Life
     Aggregate
Intrinsic
Value
(dollars in
millions)
 
Outstanding at January 1, 2020
   $ 37.64        2,728,350        
Granted
     42.39        784,300        
Exercised
     14.79        (271,844      
Forfeited
     48.50        (68,654      
     
 
 
       
Outstanding at June 30, 2020
     40.54        3,172,152        7 years      $ 28.2  
     
 
 
       
 
 
 
Exercisable at June 30, 2020
     38.42        1,922,832        7 years      $ 28.2  
     
 
 
       
 
 
 
The weighted-average fair value per option at the date of grant during the six months ended June 30, 2020 and 2019 using the Black-Scholes option-pricing model was $8.15 and $10.83, respectively. Assumptions were as follows:
 
     Six Months Ended June 30,  
     2020     2019  
Expected life (years)
     5.7       5.5  
Risk-free interest rate
     1.6     2.7
Dividend yield
     2.1     1.6
Expected volatility
     23.6     22.8
 
15

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.
Restricted Stock and Share Units
Participants may also be awarded shares of restricted stock or share units under the Plan. Share units vest three years after the date of grant. The Company granted 169,539 and 139,892 share units under the plan in the six months ended June 30, 2020 and 2019, respectively. The share units were valued at $7.2 million and $6.9 million at the date of issuance in 2020 and 2019, 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, 2020 and 2019 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 $0.7 million and $1.2 million was recognized in the three months ended June 30, 2020 and 2019, respectively. Stock based compensation expense attributable to share units of $5.2 million and $5.6 million was recognized in the six months ended June 30, 2020 and 2019, 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, 2020:
 
     Number of Units     
Weighted-Average

Grant Date Value
 
Issued and unvested at January 1, 2020
     366,102      $ 49.92  
Granted
     169,539        42.39  
Vested
     (100,735      49.21  
Forfeited
     (10,656      52.48  
  
 
 
    
Issued and unvested at June 30, 2020
     424,250        46.93  
  
 
 
    
 
16

11.
Pensions
The following table presents the components of the Company’s net pension income.
 
     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2020      2019      2020      2019  
Service cost
   $ 0.3      $ 0.5      $ 0.7      $ 0.9  
Interest cost
     5.8        7.8        11.5        15.7  
Expected return on plan assets
     (13.0      (14.4      (26.0      (28.7
Amortization of unrecognized loss
     5.0        4.0        9.9        8.0  
Amortization of prior service cost
     (0.1      (0.1      (0.2      (0.2
  
 
 
    
 
 
    
 
 
    
 
 
 
Defined benefit plan income
   $ (2.0    $ (2.2    $ (4.1    $ (4.3
  
 
 
    
 
 
    
 
 
    
 
 
 
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 income are reflected in other income. The Company was not required to and did not make a contribution to its U.S. pension plan in 2019. The Company is not required to make a contribution in 2020.
 
12.
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 Rest of World segment also manufactures and markets
in-home
air purification products in China.
 
17

12.
Segment Results (continued)
 
The following table presents the Company’s segment results:
 
(dollars in millions)
                           
     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2020      2019      2020      2019  
Net sales
           
North America
   $ 480.5      $ 524.0      $ 1,013.4      $ 1,045.8  
Rest of World
     189.7        249.1        299.9        481.2  
Inter-segment
     (6.3      (7.7      (12.5      (13.4
  
 
 
    
 
 
    
 
 
    
 
 
 
   $ 663.9      $ 765.4      $ 1,300.8      $ 1,513.6  
  
 
 
    
 
 
    
 
 
    
 
 
 
Segment earnings
           
North America
(1)
   $ 105.4      $ 122.9      $ 232.5      $ 238.9  
Rest of World
(2)
     (5.8      22.4        (48.0      34.7  
Inter-segment
     (0.3      (0.1      (0.3      (0.1
  
 
 
    
 
 
    
 
 
    
 
 
 
     99.3        145.2        184.2        273.5  
Corporate expense
     (9.8      (9.6      (24.8      (24.3
Interest expense
     (2.5      (3.4      (4.7      (5.4
  
 
 
    
 
 
    
 
 
    
 
 
 
Earnings before income taxes
     87.0        132.2        154.7        243.8  
Provision for income taxes
     19.2        30.1        35.2        52.4  
  
 
 
    
 
 
    
 
 
    
 
 
 
Net earnings
   $ 67.8      $ 102.1      $ 119.5      $ 191.4  
  
 
 
    
 
 
    
 
 
    
 
 
 
(1)
includes severance and restructuring expenses of:
   $ 2.2      $         $ 2.2      $     
(2)
includes severance and restructuring expenses of:
   $ 3.9      $         $ 3.9      $     
 
13.
Fair Value Measurements
ASC 820,
Fair Value Measurements
, 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.
 
(dollars in millions)
             
Fair Value Measurement Using
   June 30, 2020      December 31, 2019  
Quoted prices in active markets for identical assets (Level 1)
   $ 126.0      $ 177.4  
Significant other observable inputs (Level 2)
     (0.4      6.9  
 
18

13.
Fair Value Measurements (continued)
 
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, 2020.
 
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.
Cash Flow Hedges
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.
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)
             
     June 30, 2020      December 31, 2019  
     Buy      Sell      Buy      Sell  
British pound
   $ —        $ 0.6      $ —        $ 1.3  
Canadian dollar
     —          39.6        —          49.7  
Euro
     24.6        —          36.0        —    
Mexican peso
     23.6        —          18.6        —    
  
 
 
    
 
 
    
 
 
    
 
 
 
Total
   $ 48.2      $ 40.2      $ 54.6      $ 51.0  
  
 
 
    
 
 
    
 
 
    
 
 
 
 
19

14.
Derivative Instruments (continued)
 
Commodity Futures Contracts
In addition to entering into supply arrangements in the normal course of business, the Company also enters into futures contracts to fix the cost of certain raw material purchases, principally steel, with the objective of minimizing changes in cost due to market price fluctuations. The hedging strategy for achieving this objective is to purchase steel futures contracts on the New York Metals Exchange (NYMEX) and copper futures contracts on the open market of the London Metals Exchange (LME) or over the counter contracts based on the LME.
With NYMEX, the Company is required to make cash deposits on unrealized losses on steel derivative contracts.
The
after-tax
gains and losses of the contracts as of June 30, 2020 were recorded in accumulated other comprehensive loss and will be reclassified into cost of products sold in the period in which the underlying transaction is recorded in earnings. The
after-tax
gains and losses on the contracts will be reclassified within one year.
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, 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 ($0.1) million and $0.7 million of
after-tax
(losses) 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, 2020, respectively. The Company recognized $- and $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 three and six months ended June 30, 2019, respectively. As of June 30, 2020, the Company had no foreign currency forward contracts designated as net investment hedges outstanding.
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
   June 30,
2020
     December 31,
2019
 
Foreign currency contracts
  
Other current assets
   $ 1.6      $ 8.4  
  
Accrued liabilities
     (1.9      (1.5
Commodities contracts
  
Accrued liabilities
     (0.1       
     
 
 
    
 
 
 
Total derivatives designated as hedging instruments
   $ (0.4    $ 6.9  
     
 
 
    
 
 
 
 
20

 
14.
Derivative Instruments (continued)
 
The effect of cash flow hedges on the condensed consolidated statement of earnings:
Three Months Ended June 30 (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 (loss)
reclassified from
accumulated other
comprehensive loss
into earnings
     Amount of gain (loss)
reclassified from
accumulated other
comprehensive
loss into earnings
 
     2020      2019             2020      2019  
Foreign currency contracts
   $ (0.6   $ 0.5       Cost of products sold      $ 0.5      $     
Commodities contracts
     0.1       (0.3     Cost of products sold                  (0.8
  
 
 
   
 
 
      
 
 
    
 
 
 
   $ (0.5   $ 0.2        $ 0.5      $ (0.8
  
 
 
   
 
 
      
 
 
    
 
 
 
Six Months Ended June 30 (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 (loss)
reclassified from
accumulated other
comprehensive loss
into earnings
     Amount of gain (loss)
reclassified from
accumulated other
comprehensive
loss into earnings
 
     2020      2019             2020      2019  
Foreign currency contracts
   $ 0.8     $ 0.6       Cost of products sold      $ 1.3      $     
Commodities contracts
     (0.1     (0.5     Cost of products sold                  (0.8
  
 
 
   
 
 
      
 
 
    
 
 
 
   $ 0.7     $ 0.1        $ 1.3      $ (0.8
  
 
 
   
 
 
      
 
 
    
 
 
 
 
15.
Income Taxes
The Company’s effective income tax rates for the three and six months ended June 30, 2020 were 22.1 percent and 22.8 percent, respectively. The Company estimates that its annual effective income tax rate for the full year 2020 will be between 23.0 and 23.5 percent. The effective income tax rates for the three and six months ended June 30, 2019 were 22.8 percent and 21.5 percent, respectively. The change in the effective income tax rate for the six months ended June 30, 2020 compared to the effective income tax rate for the six months ended June 30, 2019 was primarily due to a change in geographic earnings mix.
As of June 30, 2020, the Company had $9.7 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 2016-2020 are subject to audit. The Company is subject to state and local income tax audits for tax years 2002-2020. The Company is subject to
non-U.S.
income tax examinations for years 2014-2020.
 
21

16.
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 $7.2 and $14.1 million as of June 30, 2020 and December 31, 2019, 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 $10.8 million and $23.1 million as of June 30, 2020 and December 31, 2019, respectively. The Company’s reserves for estimated losses under repurchase arrangements were immaterial as of June 30, 2020 and December 31, 2019.
 
22

17.
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
June 30,
 
     2020     2019  
Cumulative foreign currency translation
    
Balance at beginning of period
   $ (84.2   $ (49.0
Other comprehensive
income
(loss) before reclassifications
     3.7       (10.1
  
 
 
   
 
 
 
Balance at end of period
     (80.5     (59.1
  
 
 
   
 
 
 
Unrealized net
gain
(loss) on cash flow derivatives
    
Balance at beginning of period
     0.5       (0.8
Other comprehensive (loss) gain before reclassifications
     (0.4     0.1  
Realized (gains) losses on derivatives reclassified to cost of products sold (net of income tax provision (benefit) of $0.1 and ($0.2) in 2020 and 2019, respectively)
     (0.4     0.6  
  
 
 
   
 
 
 
Balance at end of period
     (0.3     (0.1
  
 
 
   
 
 
 
Pension liability
    
Balance at beginning of period
     (278.7     (282.3
Amounts reclassified from accumulated other comprehensive loss:
(1)
     3.7       3.1  
  
 
 
   
 
 
 
Balance at end of period
     (275.0     (279.2
  
 
 
   
 
 
 
Accumulated other comprehensive loss, end of period
   $ (355.8   $ (338.4
  
 
 
   
 
 
 
(1)  
Amortization of pension items:
    
Actuarial losses
   $ 5.0
(2)
 
  $ 4.0
(2)
 
Prior year service cost
     (0.1 )
(2)
 
    (0.1 )
(2)
 
  
 
 
   
 
 
 
     4.9       3.9  
Income tax benefit
     (1.2     (0.8
  
 
 
   
 
 
 
Reclassification net of income tax benefit
   $ 3.7     $ 3.1  
  
 
 
   
 
 
 
 
(2)
These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. See Note 11 - Pensions for additional details
 
23

17.
Changes in Accumulated Other Comprehensive Loss by Component (continued)
Changes to accumulated other comprehensive loss by component are as follows:
 
(dollars in millions)
      
     Six Months Ended
June 30,
 
     2020     2019  
Cumulative foreign currency translation
    
Balance at beginning of period
   $ (66.2   $ (64.9
Other comprehensive
(loss)
income before reclassifications
     (14.3     5.8  
  
 
 
   
 
 
 
Balance at end of period
     (80.5     (59.1
  
 
 
   
 
 
 
Unrealized net gain on cash flow derivatives
    
Balance at beginning of period
     0.2       (0.7
Other comprehensive gain before reclassifications
     0.5           
Realized (gains) losses on derivatives reclassified to cost of products sold (net of income tax provision (benefit) of $0.3 and ($0.2) in 2020 and 2019, respectively)
     (1.0     0.6  
  
 
 
   
 
 
 
Balance at end of period
     (0.3     (0.1
  
 
 
   
 
 
 
Pension liability
    
Balance at beginning of period
     (282.3     (285.2
Amounts reclassified from accumulated other comprehensive loss:
(1)
     7.3       6.0  
  
 
 
   
 
 
 
Balance at end of period
     (275.0     (279.2
  
 
 
   
 
 
 
Accumulated other comprehensive loss, end of period
   $ (355.8   $ (338.4
  
 
 
   
 
 
 
(1)  
Amortization of pension items:
    
Actuarial losses
   $ 9.9
(2)
 
  $ 8.0
(2)
 
Prior year service cost
     (0.2 )
(2)
 
    (0.2 )
(2)
 
  
 
 
   
 
 
 
     9.7       7.8  
Income tax benefit
     (2.4     (1.8
  
 
 
   
 
 
 
Reclassification net of income tax benefit
   $ 7.3     $ 6.0  
  
 
 
   
 
 
 
 
(2)
These accumulated other comprehensive loss components are included in the computation of net periodic pension cost. See Note 11 - Pensions for additional details
 
24

PART I - FINANCIAL INFORMATION
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 and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world. Our Rest of World segment also manufactures and markets
in-home
air purifier products in China.
In January 2020, an outbreak of a novel coronavirus
(COVID-19)
surfaced in Wuhan, China. As a result of the outbreak, the Chinese government required businesses to close and restricted certain travel within the country. In cooperation with the government authorities, our operations in China closed for approximately four weeks before resuming production before the end of the first quarter. In March 2020,
COVID-19
was declared a global pandemic and we saw pressure in our other end markets worldwide. Through the date of this filing, our global manufacturing operations of essential water heating and water treatment products continue without material disruption to our operations. As a result of the
COVID-19
pandemic and in support of continuing our manufacturing efforts, we have undertaken numerous and meaningful steps to protect our employees, suppliers, and customers. These important steps, which in certain cases reduce efficiency, include continuous communication and training to our employees on living and working safely in a
COVID-19
environment, plant accommodations and reconfigurations to maintain social distancing, masks for all employees, implementation of sanitizing stations, temperature taking and regular, proactive deep cleaning and sanitization of our facilities, among others. As we receive guidance from governmental authorities, we adjust our safety measures to meet or exceed those guidelines. The majority of our customers in the U.S. are also deemed essential under Cybersecurity and Infrastructure Security Agency (CISA) guidance and are operating their businesses under varying state and local governmental guidance.
Our global supply chain management team continues to monitor and manage our ability to operate effectively as
COVID-19
cases in the U.S. and elsewhere periodically surge. To date, we have not seen any meaningful disruptions to our supply chain. Ongoing communications with our suppliers to identify and mitigate risk of potential disruptions and to manage inventory levels continue.
While we believe our balance sheet and capital position are strong, proactive management of discretionary spending and cost structure will continue. In addition, the members of our Board of Directors have voluntarily reduced the cash component of their board compensation by 25 percent and our chairman and chief executive officer (CEO) has voluntarily reduced his base salary by 25 percent. Our CEO’s staff, which includes our other named executive officers, have also volunteered a 15 percent reduction in base salary. We also continue to focus on aligning our cost structure in China through headcount reductions, store closures, cuts in advertising and other cost saving measures, as well as in North America through headcount reductions.
We estimate that between 80 to 85 percent of our water heater and boiler units sold in the U.S. relate to replacement business. While we expect that our replacement business in both water heating and boilers will provide a buffer in any economic downturn resulting from
COVID-19
in a similar manner to what we have seen historically, the impacts of the pandemic on consumer spending are difficult to predict.
 
25

We expect sales of North America water treatment products to increase by 20 to 22 percent in 2020, compared to 2019, primarily due to volume growth and a full year of sales from our Water-Right, Inc. (Water-Right) acquisition, which we completed in April 2019. We expect higher water treatment sales will be more than offset by expected declines in commercial water heaters and boilers volumes due to pandemic-related temporarily closed job sites and deferrals of discretionary replacement installations. We expect residential water heater demand will be flat in 2020 compared with 2019.
In our Rest of World segment, we expect 2020 China sales to decline between 18 and 20 percent in local currency compared with 2019, as pandemic-related closures in that region and further reductions in customer inventory levels negatively impacted the first half of 2020. In addition, we believe our mix of products sold in China is shifting to more
mid-price
range products from our historical mix of higher priced products.
Combining all of these factors, we expect our consolidated sales to decline approximately seven to eight percent in 2020. Our guidance assumes the conditions of our business environment and that of our suppliers and customers are similar for the remainder of the year to what we are experiencing currently and does not deteriorate as a result of further restrictions or shut downs due to the
COVID-19
pandemic.
RESULTS OF OPERATIONS
SECOND QUARTER AND FIRST SIX MONTHS OF 2020 COMPARED TO 2019
Sales in the second quarter of 2020 were $664 million or approximately 13 percent lower than sales of $765 million in the second quarter of 2019. Sales in the first six months of 2020 were $1,301 million or approximately 14 percent lower than $1,514 million in the same period last year. Our sales decline in the second quarter and first half of 2020 compared to the same periods last year was primarily driven by lower sales in China and lower commercial water heater and boiler volumes in North America. The decreased demand in both periods more than offset higher water treatment volumes in North America, which included incremental sales of $16 million in the first six months of 2020 from Water-Right, acquired on April 8, 2019.
Gross profit margin in the second quarter of 2020 of 37.3 percent was lower than the gross profit margin of 40.3 percent in the second quarter of 2019. Gross profit margin in the first six months of 2020 of 37.4 percent was lower than the gross profit margin of 39.7 percent in the first six months of 2019. The lower gross profit margin was primarily due to lower sales volumes.
Selling, general and administrative (SG&A) expenses in the second quarter and first six months of 2020 decreased by $22.8 million and $33.7 million, respectively, as compared to the prior year periods. The decrease in SG&A expenses in the second quarter and first six months of 2020 was primarily due to lower selling and advertising expenses.
During the second quarter of 2020, to align our business to current market conditions, we recognized $6.1 million of
pre-tax
severance and restructuring expenses, which were comprised of $5.2 million of severance costs and $0.9 million of other restructuring expenses. These activities are reflected in “severance and restructuring expenses” in the accompanying financial statements.
We are providing
non-GAAP
measures (adjusted earnings, adjusted earnings per share, and adjusted segment earnings) that exclude severance and restructuring expenses. Reconciliations to measures on a GAAP basis are provided later in this section. We believe that the measures of adjusted earnings, adjusted EPS and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better compare our performance period over period.
 
26

Interest expense in the second quarter of 2020 was $2.5 million compared to $3.4 million in the same period last year. Interest expense in the first half of 2020 was $4.7 million compared to $5.4 million in the same period last year. The decrease in interest expense in the second quarter of 2020 was primarily due to lower interest rates and lower average debt levels than the prior year period. The decrease in interest expense in the first half of 2020 was primarily due to lower interest rates, which was partially offset by higher average debt levels.
Other income was $4.0 million in the second quarter of 2020, compared to $5.6 million in the same period last year. Other income in the first six months of 2020 was $8.2 million compared to $11.1 million in the first half of 2019. The decrease in other income in the second quarter and first half of 2020 compared to the same periods last year was primarily due to lower interest income.
Our pension costs and credits are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. We consider current market conditions, including changes in interest rates, in making these assumptions. Our assumption for the expected rate of return on plan assets is 6.75 percent in 2020 compared to 7.15 percent in 2019. The discount rate used to determine net periodic pension costs decreased to 3.18 percent in 2020 from 4.32 percent in 2019. Pension income for the second quarter and first half of 2020 was $2.0 million and $4.1 million, respectively, compared to $2.2 million and $4.3 million in the second quarter and first half of 2019, respectively. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension income are reflected in other income.
Our effective income tax rates for the second quarter and first six months of 2020 were 22.1 percent and 22.8 percent, respectively. Our effective income tax rates for the second quarter and first six months of 2019 were 22.8 percent and 21.5 percent, respectively. Our effective income tax rate in the first half of 2020 was higher than the effective income tax rate in the same period of 2019 primarily due to a change in geographic earnings mix. We estimate that our annual effective income tax rate for the full year 2020 will be between 23.0 and 23.5 percent.
North America
Sales in the North America segment were $481 million in the second quarter of 2020 or $43 million lower than sales of $524 million in the second quarter of 2019. Sales for the first six months of 2020 were $1,013 million or $33 million lower than sales of $1,046 million in the same period last year. The decrease in sales in the second quarter and first six months of 2020 was primarily due to lower commercial water heater volumes, lower boiler volumes and a water heater sales mix composed of more electric models which have a lower selling price. The sales decline in both periods was partially offset by organic growth of approximately 19 percent and 17 percent in our North America water treatment products in the second quarter and first half of 2020, respectively. Water-Right added approximately $16 million of incremental sales to in the first half of 2020.
North America segment earnings were $105.4 million in the second quarter of 2020 or approximately 14 percent lower than segment earnings of $122.9 million in the same period of 2019. Segment earnings in the first six months of 2020 were $232.5 million or approximately three percent lower than segment earnings of $238.9 million in the first six months of 2019. Segment margin of 21.9 percent in the second quarter of 2020 was lower than 23.5 percent in the same period last year. Segment margin of 22.9 percent in the first six months of 2020 was essentially equal to the same period last year. Adjusted
 
27

segment earnings and adjusted segment margin in the second quarter of 2020 were $107.6 million and 22.4 percent, respectively. Adjusted segment earnings and adjusted segment margin in the first half of 2020 were $234.7 million and 23.2 percent, respectively. Lower segment earnings and segment margin in the second quarter were primarily driven by lower volumes of commercial water heaters and boilers and a mix skew to electric water heaters. Segment earnings and margin were also adversely impacted by certain costs related to the pandemic, including temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, proactively deep cleaning facilities, paying benefits during employee furloughs and other costs, which were approximately $5.5 million in the second quarter. These unfavorable factors more than offset lower steel costs in the quarter compared with last year. Lower segment earnings and segment margin in the first six months of 2020 were primarily driven by the factors identified above, partially offset by lower steel costs, and improvement in the profitability of water treatment sales, including incremental profit from Water-Right. We expect full year segment margin to be between 22.5 and 23.0 percent in 2020.
Adjusted segment earnings and adjusted segment margin in 2020 exclude $2.2 million of
pre-tax
severance and restructuring expenses associated with an initiative to align our business to current market conditions.
Rest of World
Sales in the Rest of World segment were $190 million in the second quarter of 2020 or $59 million lower than sales of $249 million in the second quarter of 2019. Sales in the first six months of 2020 were $300 million or $181 million lower than sales of $481 million in the first six months of 2019. Sales in China declined approximately 23 percent in U.S. dollar terms and 20 percent in local currency in the second quarter of 2020 and declined approximately 40 percent in U.S. dollar terms and 38 percent in local currency in the first six months of 2020 compared to the same period last year. The decrease in China sales in the second quarter of 2020 was primarily due to a higher sales mix of
mid-price
products and further reductions in customer inventory levels. Consumer demand for water heater and water treatment products in China was flat to slightly positive compared with the second quarter of 2019. India sales declined significantly as the economy was shut down during a majority of the second quarter to minimize the spread of the virus. The decrease in Rest of World sales in the first half of 2020 was primarily due to
COVID-19
pandemic-related weak consumer demand and the factors identified above. In addition, our sales in China were adversely impacted by currency translation of approximately $6 million and $9 million in the second quarter and first half of 2020, respectively, compared to the same periods last year, due to the depreciation of the Chinese currency compared to the U.S. dollar.
Rest of World segment losses were $5.8 million in the second quarter of 2020, compared to earnings of $22.4 million in the second quarter of 2019. Segment losses in the first six months of 2020 were $48.0 million, compared to earnings of $34.7 million in the first half of 2019. Adjusted segment losses in the second quarter and first half of 2020 were $1.9 million and $44.1 million, respectively. The unfavorable impact from lower China sales and a higher mix of
mid-price
products, which have lower margins compared to our historical mix of higher priced products, was partially offset by the benefits from lower SG&A expenses in that region. As a result of these factors, the segment margin and adjusted segment margin in the second quarter and first half of 2020 was negative compared with 9.0 percent and 7.2 percent in the same periods of 2019, respectively. We expect full year segment margin to be between (2.5) percent and (1.0) percent in 2020.
Adjusted segment earnings in 2020 exclude $3.9 million of
pre-tax
severance and restructuring expenses associated with an initiative to align our business to current market conditions.
 
28

Outlook
We project consolidated sales will decline by approximately seven to eight percent in 2020 compared to 2019 due to declines in sales in China as well as lower commercial water heater and boiler volumes in the U.S. which will more than offset an expected 20 to 22 percent sales growth in North America water treatment products. We believe we will achieve full-year earnings of between $1.69 and $1.83 per share, which excludes the potential impact from future acquisitions. We believe we will achieve full-year adjusted earnings of between $1.72 and $1.86 per share, which excludes severance and restructuring expenses and the potential impact from future acquisitions. Our guidance assumes the conditions of our business environment and that of our suppliers and customers are similar for the remainder of the year to what we are experiencing currently and does not deteriorate as a result of further restrictions or shut downs due to the
COVID-19
pandemic.
Liquidity & Capital Resources
Working capital of $709.0 million at June 30, 2020 was $24.9 million lower than at December 31, 2019, driven by lower sales-related accounts receivable and accounts payable balances and higher liabilities for income taxes, primarily due to the deferral of our April 2020 estimated federal income tax payment to July 2020. As of June 30, 2020, approximately $327 million of the $568.7 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We repatriated $178 million in cash to the U.S. in the first half of 2020.
Cash provided by operations in the first six months of 2020 was $179.3 million compared with $143.7 million provided during the same period last year. Lower investments in working capital compared with the same period in 2019, which were partially offset by lower earnings, resulted in higher cash provided by operations. We continue to monitor developments on an
on-going
basis and have taken proactive measures to focus on cash, manage working capital and reduce costs. For the full year 2020, we expect cash provided by operating activities will be approximately $350 million, compared with $456.2 million in 2019.
Capital expenditures totaled $24.8 million in the first six months of 2020, compared with $36.5 million in the year ago period. We project our 2020 capital expenditures to be between $60 and $70 million, lower than our approximately $80 million average annual spending in the last three years. We expect full year depreciation and amortization will be approximately $80 million.
We have a $500 million multi-currency credit facility with a group of nine banks, which expires in December 2021. The facility has an accordion provision, which allows us to increase it up to $700 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 June 30, 2020.
The facility backs up commercial paper and credit line borrowings. As a result of the long-term nature of this facility, our commercial paper and credit line borrowings, as well as drawings under the facility, are classified as long-term debt. At June 30, 2020, we had available borrowing capacity of $332 million under this facility. 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 declined slightly from $284.0 million at December 31, 2019 to $281.1 million at June 30, 2020. Our leverage, as measured by the ratio of total debt to total capitalization, calculated excluding operating lease liabilities, was 14.5 percent at the end of the second quarter in 2020, compared with 14.6 percent at the end of last year.
 
29

Our pension plan continues to meet all funding requirements under ERISA regulations. We are not required to make a contribution and we do not plan to make any voluntary contributions to the plan in 2020.
In the second quarter of 2019, our Board of Directors approved adding three million shares of Common Stock to an existing discretionary share repurchase authority. Under the share repurchase program, our common stock may be purchased 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 half of 2020, we repurchased 1,348,391 shares of our stock at a total cost of $56.7 million. At June 30, 2020, we had 1,613,824 million shares remaining on the board share repurchase authority. Due to the uncertainty surrounding the impact of the global
COVID-19
pandemic, we suspended our share repurchases on March 18, 2020.
On July 13, 2020, our Board of Directors declared a regular quarterly cash dividend of $0.24 per share on our Common Stock and Class A common stock. The five-year compound annual growth rate of our dividend is approximately 20 percent. The dividend is payable on August 17, 2020 to shareholders of record on July 31, 2020.
Non-GAAP
Financial Information
We provide
non-GAAP
measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment earnings) that exclude severance and restructuring expenses in 2020.
We believe that the measures of adjusted earnings, adjusted EPS and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better compare our performance period over period.
 
30

A. O. SMITH CORPORATION
Adjusted Earnings and Adjusted EPS
(dollars in millions, except per share data)
(unaudited)
The following is a reconciliation of net earnings and diluted EPS to adjusted earnings
(non-GAAP)
and adjusted EPS
(non-GAAP):
 
                                           
    
Three Months Ended

June 30,
    
Six Months Ended

June 30,
 
    
2020
    
2019
    
2020
    
2019
 
Net Earnings (GAAP)
  
$
67.8
 
  
$
102.1
 
  
$
119.5
 
  
$
191.4
 
Severance and restructuring expenses, before tax
  
 
6.1
 
  
 
—  
 
  
 
6.1
 
  
 
—  
 
Tax effect of severance and restructuring expenses
  
 
(1.1
  
 
—  
 
  
 
(1.1
  
 
—  
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Adjusted Earnings
  
$
72.8
 
  
$
102.1
 
  
$
124.5
 
  
$
191.4
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Diluted EPS (GAAP)
  
$
0.42
 
  
$
0.61
 
  
$
0.74
 
  
$
1.14
 
Severance and restructuring expenses, per diluted share
  
 
0.04
 
  
 
—  
 
  
 
0.04
 
  
 
—  
 
Tax effect of severance and restructuring expenses per diluted share
  
 
(0.01
  
 
—  
 
  
 
(0.01
  
 
—  
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Adjusted EPS
  
$
0.45
 
  
$
0.61
 
  
$
0.77
 
  
$
1.14
 
  
 
 
    
 
 
    
 
 
    
 
 
 
A. O. SMITH CORPORATION
Adjusted Segment Earnings
(dollars in millions)
(unaudited)
The following is a reconciliation of reported segment earnings to adjusted segment earnings
(non-GAAP):
 
                                           
    
Three Months Ended
June 30,
    
Six Months Ended
June 30,
 
    
2020
    
2019
    
2020
    
2019
 
Segment Earnings (GAAP)
           
North America
  
$
105.4
 
  
$
122.9
 
  
$
232.5
 
  
$
238.9
 
Rest of World
  
 
(5.8
  
 
22.4
 
  
 
(48.0
  
 
34.7
 
Inter-segment earnings elimination
  
 
(0.3
  
 
(0.1
  
 
(0.3
  
 
(0.1
  
 
 
    
 
 
    
 
 
    
 
 
 
Total Segment Earnings (GAAP)
  
$
99.3
 
  
$
145.2
 
  
$
184.2
 
  
$
273.5
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Adjustments
           
North America
(1)
  
$
2.2
 
  
$
—  
 
  
$
2.2
 
  
$
—  
 
Rest of World
(2)
  
 
3.9
 
  
 
—  
 
  
 
3.9
 
  
 
—  
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Total Adjustments
  
$
6.1
 
  
$
—  
 
  
$
6.1
 
  
$
—  
 
  
 
 
    
 
 
    
 
 
    
 
 
 
Adjusted Segment Earnings
           
North America
  
$
107.6
 
  
$
122.9
 
  
$
234.7
 
  
$
238.9
 
Rest of World
  
 
(1.9
  
 
22.4
 
  
 
(44.1
  
 
34.7
 
Inter-segment earnings elimination
  
 
(0.3
  
 
(0.1
  
 
(0.3
  
 
(0.1
  
 
 
    
 
 
    
 
 
    
 
 
 
Total Adjusted Segment Earnings
  
$
105.4
 
  
$
145.2
 
  
$
190.3
 
  
$
273.5
 
  
 
 
    
 
 
    
 
 
    
 
 
 
 
(1)
 
In the second quarter of 2020, the Company recognized $2.2 million of severance and restructuring expenses. For additional information, see Note 4 of the notes to the financial statements.
(2)
 
In the second quarter of 2020, the Company recognized $3.9 million of severance and restructuring expenses. For additional information, see Note 4 of the notes to the financial statements.
 
31

A. O. SMITH CORPORATION
Adjusted EPS and Adjusted 2020 Guidance
(unaudited)
The following is a reconciliation of diluted EPS to adjusted EPS
(non-GAAP):
 
     2020 Guidance      2019  
Diluted EPS (GAAP)
   $ 1.69 - 1.83      $ 2.22  
Severance and Restructuring expenses per diluted share, net of tax
     0.03        —    
  
 
 
    
 
 
 
Adjusted EPS
   $
1.72 - 1.86
     $ 2.22  
  
 
 
    
 
 
 
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, 2019. We believe that at June 30, 2020, there has been 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” 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: negative impacts to the Company’s business, including demand for its products, operations and work-force dislocation and disruption, supply chain disruption and liquidity as a result of the severity and duration of the
COVID-19
pandemic; a failure to recover or a further weakening of the Chinese economy and/ or a failure to recover or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to the Company’s businesses from international tariffs and trade disputes; potential further weakening in the high efficiency boiler segment in the U.S.; significant volatility in raw material availability and prices; inability of the Company to implement or maintain pricing actions; a failure to recover or further weakening in U.S. residential or commercial construction or instability in the Company’s replacement markets; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the Company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.
 
32

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, 2019, 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, 2020 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 changes in our internal control over financial reporting during the quarter ended June 30, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
33

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. Subsequently, on November 22, 2019, a consolidated amended complaint was filed by the lead plaintiff. This action, now captioned as City of Birmingham Retirement and Relief System 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 (“Exchange Act”), and seeks damages and other relief based upon the allegations in the complaint. On January 24, 2020, A. O. Smith and the other defendants moved to dismiss the consolidated amended complaint for failure to state a claim. On June 24, 2020, the U.S. District Court granted defendants’ motion to dismiss in its entirety. Based on its June 24 order, on August 3,2020, the District Court entered final judgement for the defendants and dismissed the lawsuit.
A shareholder derivative lawsuit, captioned as Pierce v. A. O. Smith Corporation, et al. and based on similar allegations as the putative class action, was filed on August 20, 2019, also in the U.S. District Court for the Eastern District of Wisconsin. On November 6, 2019, the plaintiff in the derivative action moved to dismiss his lawsuit,
and re-filed
it in the U.S. District Court for the District of Delaware on November 12, 2019. The derivative action asserts claims under Sections 14(a) and 20(a) of the Exchange Act, as well as for breach of fiduciary duty, unjust enrichment, and waste of corporate assets, and seeks damages and other relief based upon the allegations in the complaint. On February 12, 2020, the parties filed a stipulation seeking to stay the derivative lawsuit pending resolution of the City of Birmingham lawsuit. On February 13, 2020, a second shareholder derivative suit, captioned as Jarozewski v. A. O. Smith Corporation, et al., was filed in the U.S. District Court for the District of Delaware, asserting claims under Sections 10(b), 14(a) and 20(a) of the Exchange Act, as well as for breach of fiduciary duty, unjust enrichment, and insider trading, and seeks damages and other relief based upon the allegations in the complaint. On April 1, 2020, the U.S. District Court for the District of Delaware, upon a joint stipulation filed by the parties, consolidated both the Pierce and Jarozewski derivative lawsuits and stayed the consolidated actions pending resolution of the City of Birmingham lawsuit. Both lawsuits remain stayed.
ITEM 1A RISK FACTORS
There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form
10-K
for the year ended December 31, 2019, except for the addition of the risk factor set forth below:
The global coronavirus
(COVID-19)
pandemic, or other global public health pandemics, could have a material adverse effect on our business, results of operations and financial condition
Our business, results of operations and financial condition may be adversely affected if a global public health pandemic, including the current
COVID-19
pandemic, interferes with the ability of our employees, suppliers, and customers to perform our and their respective responsibilities and obligations relative to the conduct of our business and operations. The
COVID-19
pandemic has significantly impacted economic activity and markets around the world, and it could have a material negative impact on our business and operations in numerous ways, including but not limited to those outlined below:
 
   
The risk that we, or our employees, suppliers or customers may be prevented from conducting business activities for an indefinite period of time, including shutdowns that may be requested or mandated by governmental authorities.
 
34

   
Restrictions on shipping products from certain jurisdictions where they are produced or into certain jurisdictions where customers are located.
 
   
Inability to meet our customers’ needs and achieve cost targets due to disruptions in our manufacturing and supply arrangements caused by the loss or disruption of essential manufacturing and supply elements, such as raw materials or other finished product components, transportation, workforce or other manufacturing and distribution capability.
 
   
Failure of third parties on which we rely, including our suppliers, distributors, contractors and commercial banks, to meet their obligations to us, or significant disruptions in their ability to do so, which may be caused by their own financial or operational difficulties, or mandated shutdowns by governmental authorities, may adversely impact our operations.
 
   
Significant reductions in demand or significant volatility in demand and a global economic recession that could further reduce demand for our products, resulting from actions taken by governments, businesses, and/or the general public in an effort to limit exposure to and spreading of such infectious diseases, such as travel restrictions, quarantines, and business shutdowns or slowdowns.
 
   
Manufacturing plant inefficiencies due to safety and preventative health measures that we have implemented in our plants to prevent the spread of
COVID-19.
 
   
Deterioration of worldwide capital, credit, and financial markets that could limit our ability to obtain external financing to fund our operations and capital expenditures.
The extent to which the
COVID-19
pandemic, or other outbreaks of disease or similar public health threats, materially and adversely impacts our business, results of operations and financial condition is highly uncertain and will depend on future developments. Such developments may include the geographic spread and duration of the virus, the severity of the virus and the actions that may be taken by various governmental authorities and other third parties in response to the outbreak. In addition, we cannot predict how quickly, and to what extent, normal economic and operating conditions can resume cannot be predicted, and the resumption of normal business operations may be delayed or constrained by lingering effects of the
COVID-19
pandemic on our suppliers, third-party service providers, and/or customers.
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In the second quarter of 2019, our Board of Directors approved adding three 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. Due to the uncertainty surrounding the impact of the global
COVID-19
pandemic, we suspended our share repurchases on March 18, 2020. As of June 30, 2020, there were 1,613,824 shares remaining on the existing repurchase authorization.
ITEM 6 - EXHIBITS
Refer to the Exhibit Index on page 36 of this report.
 
35

INDEX TO EXHIBITS
 
Exhibit
Number
  
Description
31.1    Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
31.2    Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
32.1    Written Statement of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
32.2    Written Statement of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
101    The following materials from A. O. Smith Corporation’s Quarterly Report on Form
10-Q
for the quarter ended June 30, 2020 are filed herewith, formatted in XBRL (Extensive Business Reporting Language): (i) the Condensed Consolidated Statement of Earnings for the three and six months ended June 30, 2020 and 2019, (ii) the Condensed Consolidated Statement of Comprehensive Earnings for the three and six months ended June 30, 2020 and 2019, (iii) the Condensed Consolidated Balance Sheets as of June 30, 2020, and December 31, 2019 (iv) the Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 2020 and 2019 (v) the Condensed Consolidated Statement of Stockholders’ Equity for the three and six months ended June 30, 2020 and 2019 (vi) the Notes to Condensed Consolidated Financial Statements.
 
36

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
August 5, 2020      
/s/ Helen E. Gurholt
      Helen E. Gurholt
      Vice President and Controller
     
/s/ Charles T. Lauber
      Charles T. Lauber
      Executive Vice President and
      Chief Financial Officer
 
 
37
EX-31.1

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.

August 5, 2020

 

/s/ Kevin J. Wheeler

Kevin J. Wheeler
Chairman and Chief Executive Officer
EX-31.2

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.

August 5, 2020

 

/s/ Charles T. Lauber

Charles T. Lauber
Executive Vice President and Chief Financial Officer
EX-32.1

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 June 30, 2020 (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.

August 5, 2020

 

/s/ Kevin J. Wheeler

Kevin J. Wheeler
Chairman and Chief Executive Officer
EX-32.2

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 June 30, 2020 (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.

August 5, 2020

 

/s/ Charles T. Lauber

Charles T. Lauber
Executive Vice President and Chief Financial Officer