SMITH A O CORP - Quarter Report: 2014 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2014.

or

For the transition period from                      to                     

Commission File Number 1-475

A. O. Smith Corporation

(Exact name of registrant as specified in its charter)

(414) 359-4000

(Registrant’s telephone number, including area code)

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.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 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    x  No

Class A Common Stock Outstanding as of October 28, 2014 — 13,163,850 shares

Common Stock Outstanding as of October 28, 2014 — 76,382,084 shares

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Index

A. O. Smith Corporation

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS

A. O. SMITH CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(dollars in millions, except per share data)

(unaudited)

A. O. SMITH CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS

(dollars in millions)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS

A. O. SMITH CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in millions, except share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS

A. O. SMITH CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in millions)

(unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS

A. O. SMITH CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2014

(unaudited)

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 nine months ended September 30, 2014 are not necessarily indicative of the results expected for the full year. It is suggested that 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 latest Annual Report on Form 10-K filed with the SEC on February 20, 2014.

On April 15, 2013, the company’s stockholders approved a proposal to increase the company’s authorized shares of Common Stock and the company’s board of directors declared a two-for-one stock split of the company’s Class A Common Stock and Common Stock (including treasury shares) in the form of a 100 percent stock dividend to stockholders of record on April 30, 2013 and payable on May 15, 2013. All references in the financial statements and footnotes to the number of shares outstanding, price per share, per share amounts and stock based compensation data have been recast to reflect the split for all periods presented.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Codification (ASC) 606-10, Revenue from Contracts with Customers (issued under Accounting Standards Update No. 2014-09).

ASC 606-10 will replace all existing revenue recognition guidance when effective. ASC 606-10 is effective for the year beginning January 1, 2017. Either full retrospective adoption or modified retrospective adoption is allowed under ASC 606-10. The company is in the process of determining whether the adoption of ASC 606-10 will have an impact on the company’s consolidated financial condition, results of operations or cash flows.

On February 14, 2013, the company acquired 100 percent of the shares of MiM Isitma Sogutma Havalandirma ve Aritma Sistemleri San. Tic. A.S. (MiM), a privately-held Turkish water treatment company. The addition of MiM expanded the company’s product offerings and gave the company access to Eastern Europe and Black Sea region water treatment markets. MiM is included in the Rest of World segment.

The company paid an aggregate cash purchase price of $4.0 million, net of cash received of $1.9 million. In addition the company assumed debt of $1.7 million and recorded contingent consideration of $1.1 million, the fair value of the contingent payment due to the former owners of MiM if certain targets are met for growth in sales, gross profits and operating profits through 2017.

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The fair value of the purchase price resulted in an allocation to acquired intangible assets totaling $4.3 million of which $2.4 million has been assigned to customer lists which are being amortized over ten years.

MiM’s results of operations have been included in the company’s financial statements from February 14, 2013, the date of acquisition. Revenues and pre-tax results associated with MiM included in results of operations for the three and nine months ended September 30, 2013 were not material to the company’s net sales or pre-tax earnings.

In the first quarter of 2013, the company announced the move of manufacturing operations from its Fergus, Ontario facility to other North American facilities. During the three months ended September 30, 2013, the company recognized $1.3 million of pre-tax restructuring and impairment expenses, comprised of $1.3 million of equipment relocation costs and $0.3 million of inventory obsolescence reserves and a reduction in severance costs of $0.3 million, as well as a corresponding $0.3 million tax benefit related to the expenses. For the nine months ended September 30, 2013, the company recognized $18.2 million of pre-tax restructuring and impairment expenses, comprised of $7.5 million of severance costs, $1.9 million of inventory obsolescence reserves, impairment charges related to long-lived assets totaling $7.5 million and $1.3 million for equipment relocation costs, as well as a corresponding $4.6 million tax benefit related to the expenses. The majority of the consolidation of operations occurred in the second quarter of 2013.

In the first quarter of 2013, the company entered into a settlement agreement with a former supplier of a North American subsidiary regarding previous overcharges and warranty costs. The terms of the settlement agreement resulted in an $11.0 million cash payment to the company, a pre-tax gain of $11.0 million and a related $4.2 million income tax expense.

The following table presents an analysis of the company’s restructuring and impairment reserves:

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The following table presents the components of the company’s inventory balances:

The company has a $400 million multi-currency revolving credit agreement with eight banks, which expires on December 12, 2017. The facility has an accordion provision which allows it to be increased up to $500 million if certain conditions (including lender approval) are satisfied. Borrowings under bank credit lines and commercial paper borrowings are supported by the $400 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 September 30, 2014.

The company offers warranties on the sales of certain of its products and records an accrual for the estimated future claims. The following table presents the company’s warranty liability activity.

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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:

The company adopted the A. O. Smith Combined Incentive Compensation Plan (the “plan”) effective January 1, 2007. Stockholders reapproved the plan on April 16, 2012. The plan is a continuation of the A. O. Smith Combined Executive Incentive Compensation Plan which was originally approved by stockholders in 2002. The number of shares available for granting of options, restricted stock or share units under the plan at September 30, 2014 was 2,321,641. Upon stock option exercise or share unit vesting, shares are issued from treasury stock.

Total stock based compensation cost recognized in the three months ended September 30, 2014 and 2013 was $1.8 million and $2.3 million, respectively. Total stock based compensation cost recognized in the nine months ended September 30, 2014 and 2013 was $9.6 million and $8.8 million, respectively.

Stock Options

The stock options granted in the nine months ended September 30, 2014 and 2013 have three year pro-rata vesting from the date of grant. Stock options are issued at exercise prices equal to the fair value of Common Stock on the date of grant. For active employees, all options granted in 2014 and 2013 expire ten years after date of grant. Options are expensed ratably over the three-year vesting period; however, included in the stock option expense for the three and nine months ended September 30, 2014 and 2013 is 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 cost attributable to stock options in the three months ended September 30, 2014 and 2013 was $0.8 million and $1.1 million, respectively. Stock based compensation expense attributable to stock options in the nine months ended September 30, 2014 and 2013 was $4.5 million and $4.1 million, respectively.

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Changes in option awards, all of which relate to Common Stock, were as follows for the nine months ended September 30, 2014:

The weighted-average fair value per option at the date of grant during the nine months ended September 30, 2014 and 2013 using the Black-Scholes option-pricing model was $16.55 and $12.48, respectively. Assumptions were as follows:

The expected life is based on historical exercise behavior and the projected exercise of unexercised stock options. The risk free interest rate is based on the U.S. Treasury yield curve in effect on the date of grant for the expected life of the option. The actual dividend yield is based on the actual annual dividends divided by the grant date market value of the company’s common stock. The expected volatility is based on the historical volatility of the company’s common stock.

Restricted Stock and Share Units

Participants may also be awarded shares of restricted stock or share units under the plan. The company granted 110,605 and 142,900 share units under the plan in the nine months ended September 30, 2014 and 2013, respectively. The share units were valued at $5.1 million and $4.9 million at the dates of issuance in 2014 and 2013, respectively, based on the company’s stock price at the dates of grant. The company’s share units are recognized as compensation expense ratably over the three year vesting period; however, included in share unit expense in the three and nine months ended September 30, 2014 and 2013 is 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. Share based compensation expense attributable to share units of $1.0 million and $1.2 million was recognized in the three months ended September 30, 2014 and 2013, respectively. Share based compensation expense attributable to share units of $5.1 million and $4.7 million was recognized in the nine months ended September 30, 2014 and 2013, respectively.

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A summary of share unit activity under the plan is as follows:

The following table presents the components of the company’s net pension expense:

The company did not make a contribution to its U.S. pension plan in 2013. The company is not required to make a contribution and does not intend to make a voluntary contribution in 2014.

The company is comprised of two reporting segments: North America and Rest of World. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective regions of the world. The Rest of World segment is primarily comprised of China, Europe and India. The North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water system tanks. The Rest of World segment also manufactures and markets water treatment products, primarily in Asia.

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The company’s operations by segment are as follows:

ASC 820, Fair Value Measures and Disclosures, 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.

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Assets and liabilities measured at fair value on a recurring basis are as follows:

There were no changes in the company’s valuation techniques used to measure fair values on a recurring basis during the nine months ended September 30, 2014.

ASC 815 Derivatives and Hedging as amended, requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of the hedging relationships. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as a part of a hedging relationship and, further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, the company must designate the hedging instrument, based upon the exposure hedged, as a fair value hedge, cash flow hedge, or a hedge of a net investment in a foreign operation.

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), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive loss, net of tax, and is 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. The amount by which the cumulative change in the value of the hedge more than offsets the cumulative change in the value of the hedged item (i.e., the ineffective portion) is recorded in earnings, net of tax, in the period the ineffectiveness occurs.

The company utilizes certain derivative instruments to enhance its ability to manage currency 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.

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. Currencies for which the company utilizes foreign currency forward contracts include the British pound, Canadian dollar, Euro, Indian rupee and Mexican peso.

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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 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 is expected to be reclassified into earnings within one year and all of the hedges will be reclassified into earnings no later than December 31, 2015.

The following table summarizes, by currency, the contractual amounts of the company’s foreign currency forward contracts:

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 copper, with the objective of minimizing changes in cost due to market price fluctuations. The hedging strategy for achieving this objective is to purchase commodity futures contracts on the open market of the London Metals Exchange (LME) or over the counter contracts based on the LME.

The minimal after-tax gain on the effective portion of the contracts as of September 30, 2014 was 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 effective portion of the contracts will be reclassified within one year. Commodity hedges outstanding at September 30, 2014 involve a total of approximately 1.0 million pounds of copper.

The impact of derivative contracts on the company’s financial statements is as follows:

Fair value of derivatives designated as hedging instruments under:

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The effect of derivatives designated as hedging instruments on the statement of earnings is as follows:

The effective tax rate for the three and nine months ended September 30, 2014 was 27.0 percent and 27.3 percent, respectively. The company estimates that its annual effective tax rate for the full year of 2014 will be between 27.0 and 28.0 percent. The full year effective tax rate in 2013 was 28.2 percent.

As of September 30, 2014, the company had $1.3 million of unrecognized tax benefits of which $0.9 million would affect its effective tax rate if recognized. The company recognizes potential interest and penalties related to unrecognized tax benefits as a component of tax expense.

The U.S. federal tax returns for 2011—2013 are subject to audit. The company is subject to state and local audits for tax years 2000—2013. The company is also subject to non-U.S. income tax examinations for years 2006—2013.

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Changes to accumulated other comprehensive loss by component are as follows:

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Changes to accumulated other comprehensive loss by component are as follows:

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PART I—FINANCIAL INFORMATION

ITEM 2— MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a leading manufacturer of water heaters and boilers, serving a diverse mix of residential and commercial end markets principally in the U.S. with a strong and growing international presence. Our company is comprised of two reporting segments: North America and Rest of World. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our Rest of World segment is primarily comprised of China, Europe and India. The North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. The Rest of World segment also manufactures and markets water treatment products, primarily for Asia.

Sales in our North America segment grew approximately six percent in the third quarter of 2014 due to higher sales of U.S. residential water heaters and Lochinvar branded products. As a result of new home construction and expansion of the replacement market, we expect the residential water heater industry’s unit shipments to grow approximately four percent in 2014. We expect the commercial water heater industry’s growth in units shipped to be approximately five percent in 2014. Driven by a continued transition in the boiler industry from non-condensing boilers to condensing boilers, we expect sales of Lochinvar branded products to grow approximately ten percent in 2014.

Sales in our Rest of World segment grew approximately 13 percent in the third quarter of 2014, primarily as a result of a 16 percent growth in sales in China. We expect 2014 sales in China to grow over 17 percent as consumer demand for water heaters and water treatment products contribute to our growth.

RESULTS OF OPERATIONS

THIRD QUARTER AND FIRST NINE MONTHS OF 2014 COMPARED TO 2013

Sales in the third quarter of 2014 were $581.6 million or 8.5 percent higher than sales of $536.2 million in the third quarter of 2013. Sales in the first nine months of 2014 were $1,729.2 million or 8.4 percent higher than sales of $1,594.9 million in the same period last year. The increase in sales in both the third quarter and first nine months of the year is primarily due to higher sales in China as well as higher sales of water heaters and boilers in the U.S. Sales in China grew 16 percent and 19 percent in the third quarter and first nine months of 2014, respectively, compared to the same periods of 2013.

Gross profit margin increased slightly in the third quarter of 2014 to 37.0 percent from 36.7 percent in the third quarter of 2013. Gross profit margin in the first nine months of 2014 also increased slightly to 36.3 percent from 36.0 percent in the first nine months of 2013.

Selling, general and administrative (SG&A) expenses in the third quarter and first nine months of 2014 increased by $11.8 million and $28.5 million, respectively, as compared to the same periods last year. The increases in SG&A expenses in both periods in 2014 were primarily due to higher selling and advertising costs in support of increased volumes in China. The increased costs in third quarter of 2014 also included $6 million of planned incremental costs associated with the implementation of our enterprise resource planning system (ERP).

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On March 28, 2013, our board of directors approved a plan to transfer residential water heater production from our Fergus, Ontario plant to our other North American facilities. The majority of our production was consolidated in the second quarter of 2013. As a result of the capacity reduction, we incurred pre-tax restructuring and impairment expenses of $1.3 million and $18.2 million in the third quarter and first nine months of 2013, respectively, related to employee severance costs, impairment of assets and equipment move costs.

In addition, included in operating earnings in the first nine months of 2013 is a pre-tax gain of $11.0 million from a first quarter settlement with a former supplier related to previous overcharges and warranty costs.

Interest expense in the third quarter of 2014 was $1.5 million compared to $1.4 million in the same period last year. Interest expense in the first nine months of 2014 was $4.3 million compared to $4.5 million in the same period last year.

Other income was $1.0 million in the third quarter of 2014, essentially unchanged from $1.1 million in the same period last year. Other income in the first nine months of 2014 was $3.5 million, up from $2.8 million in the first nine months of 2013. The increase in other income in the first nine months of 2014 was primarily due to increased interest income as compared to the same period last year.

Our effective tax rates for the third quarter and first nine months of 2014 were 27.0 percent and 27.3 percent, respectively. Our effective tax rates for the third quarter and first nine months of 2013 were 24.6 percent and 29.2 percent, respectively. The effective tax rate for the first nine months of 2014 benefitted from a revised domestic manufacturers’ deduction related to a prior year resulting in an increased income tax benefit on an amended prior year tax return filed in the second quarter of 2014. The lower effective tax rate in the third quarter of 2013 was primarily due to the recognition of higher income tax benefits related to U.S. manufacturing and research and development activities.

Our pension costs and credits are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on assets, retirement ages, and years of service. 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 7.75 percent in 2014 compared to 8.00 percent in 2013. The discount rate used to determine net periodic pension costs increased from 4.05 percent in 2013 to 4.90 percent in 2014. Pension expense for the first nine months of 2014 was $19.8 million compared to $20.9 million in the first nine months of 2013. Total pension expense for 2014 is expected to be $28.6 million. Our pension costs are reflected in cost of products sold and SG&A expense.

We are providing non-generally accepted accounting principles (GAAP) measures (adjusted earnings, adjusted earnings per share, adjusted segment operating earnings and adjusted segment operating margins) that exclude certain items as well as non-operating pension costs consisting of interest cost, expected return on plan assets, amortization of actuarial gains (losses) and curtailments. Prior year results are provided on a comparable basis. Reconciliations to measures on a GAAP basis are provided later in this section.

North America

Sales in our North America segment were $392.4 million in the third quarter of 2014 or $22.3 million higher than sales of $370.1 million in the third quarter of 2013. Sales for the first nine months of 2014 were $1,191.0 million or $53.2 million higher than sales of $1,137.8 million in the same period last year. The increased sales in the third quarter and first nine months of 2014 were primarily due to higher sales of residential water heaters in the U.S., higher sales of commercial boilers and a price increase effective on May 1, 2014. The first nine months of 2014 also benefitted from higher sales of commercial water heaters in the U.S.

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North America operating earnings were $53.0 million in the third quarter of 2014 or approximately three percent higher than operating earnings of $51.5 million in the same period of 2013. Operating earnings in the first nine months of 2014 were $171.5 million or approximately seven percent higher than operating earnings of $160.6 million in the first nine months of 2013. Adjusted segment operating earnings were $56.3 million in the third quarter of 2014 compared to $56.7 million in the third quarter of 2013. Adjusted segment operating earnings were $182.5 million in the first nine months of 2014 compared to $178.9 million in the first nine months of last year. Adjusted operating margin of 14.3 percent in the third quarter of 2014 was lower than 15.3 percent in the same period last year. Adjusted operating margin of 15.3 percent in the first nine months of 2014 percent was lower than 15.7 percent in the same period in 2013. Operating earnings in the third quarter and first nine months of 2014 benefitted from increased sales of water heaters and boilers in the U.S. and a May 1, 2014 price increase. The favorable impact of increased sales was more than offset by higher steel prices and planned costs associated with our ERP implementation, contributing to lower adjusted operating earnings in the third quarter of 2014 and lower adjusted operating margins in the third quarter and first nine months of 2014.

Adjusted segment operating earnings exclude non-operating pension costs in all periods presented. Adjusted segment operating earnings in the third quarter of 2013 also exclude $1.3 million of pre-tax restructuring and impairment charges associated with the transfer of production from Fergus, Ontario. Adjusted segment operating earnings in the first nine months of 2013 also exclude $18.2 million of pre-tax restructuring and impairment charges associated with the transfer of production from Fergus, Ontario and an $11.0 million pre-tax gain on the settlement with a former supplier.

Rest of World

Sales in the Rest of World segment were $198.5 million in the third quarter of 2014 or $23.3 million higher than sales of $175.2 million in the third quarter of 2013. Sales in the first nine months of 2014 were $564.9 million or $81.9 million higher than sales of $483.0 million in the first nine months of 2013. Sales of water heaters and water treatment products in China grew 16 percent and 19 percent in the third quarter and first nine months of 2014, respectively, as compared to the same periods in 2013. The increases in sales in the third quarter and first nine months of 2014 were primarily due to greater demand for our water heating and water treatment products in China. Sales in China in the third quarter of 2014 also benefitted from higher customer inventory levels in advance of the fall holiday.

Rest of World operating earnings were $30.0 million in the third quarter of 2014 or approximately 12 percent higher than operating earnings of $26.9 million in the third quarter of 2013. Operating earnings in the first nine months of 2014 were $84.3 million or approximately 25 percent higher than operating earnings of $67.6 million in the first nine months of 2013. Operating margin in the third quarter of 2014 of 15.1 percent declined slightly from operating margin of 15.4 percent in the same period last year. Operating margin of 14.9 percent in the first nine months of 2014 was higher than operating margin of 14.0 percent in the same period last year. The third quarter year over year decline in operating margin was a result of higher sales in China offset by higher selling and advertising costs as percentage of sales in China in 2014. The improved operating earnings and operating margin in the first nine months of 2014 were due to higher sales in China and improvements in profitability associated with water treatment products in China.

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Outlook

We continue to expect strong, profitable growth in China, and we expect over 17 percent revenue growth in the country in 2014. We expect Lochinvar branded sales to grow approximately ten percent in 2014, well ahead of GDP growth in the U.S., as we expect the Lochinvar brand to continue to benefit from the transition from lower efficiency, non-condensing boilers to high efficiency, condensing boilers. We are cautiously optimistic about the developing recovery in U.S. housing and the strength in demand for commercial water heaters driven by replacement and retrofit activity. Given these factors, we have increased our guidance for 2014. We believe A. O. Smith Corporation will achieve full-year GAAP earnings of between $2.23 and $2.27 per share with adjusted earnings of between $2.37 and $2.41 per share. These estimates do not include the potential impact from future acquisitions.

Liquidity & Capital Resources

Working capital of $707.5 million at September 30, 2014 was $92.8 million higher than at December 31, 2013. Higher cash balances in China, higher inventory balances in North America and lower accounts payable balances in China account for the majority of the increase. As of September 30, 2014, almost all of the $523.7 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have accrued $54.8 million for the repatriation of a portion of these funds.

Cash provided by continuing operating activities in the first nine months of 2014 was $165.3 million compared with $189.8 million during the same period last year. The reduced operating cash flows were primarily related to larger working capital requirements, which were partially offset by higher earnings. For the full year 2014, we expect total cash provided by continuing operating activities to be $225 to $235 million.

Capital expenditures totaled $66.0 million in the first nine months of 2014, compared with $65.7 million spent in the year ago period. We are projecting 2014 capital expenditures to be $80 million to $90 million, including approximately $30 million to support our ERP system implementation. We expect full year depreciation and amortization to be approximately $65 million.

In December 2012, we completed a $400 million multi-currency credit facility with a group of eight banks which expires in December 2017. The facility has an accordion provision which allows it to be increased up to $500 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 September 30, 2014.

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 September 30, 2014, we had available borrowing capacity of $189.5 million under this facility. We believe the combination of available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt increased $62.6 million from $191.9 million at December 31, 2013 to $254.5 million at September 30, 2014, primarily due to costs incurred in the share repurchase program in 2014. Our leverage, as measured by the ratio of total debt to total capitalization, was 15.6 percent at September 30, 2014, compared with 12.6 percent at December 31, 2013.

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Our pension plan continues to meet all funding requirements under ERISA regulations. We are not required to make contributions and do not intend to make a voluntary contribution to the plan in 2014.

In July 2013, our board of directors approved a stock repurchase program authorizing the purchase of 2,000,000 shares of our common stock. On April 7, 2014 our board of directors approved adding an additional 1,500,000 shares of common stock to the existing discretionary share repurchase authority. During the first nine months of 2014, we repurchased approximately 1,811,000 shares at a total cost of $86.6 million. A total of approximately 840,000 shares remained of the existing repurchase authority at September 30, 2014. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we expect to repurchase approximately 490,000 of the remainder of the authorized shares in 2014 and spend an aggregate of approximately $110 million in 2014 for share repurchases.

On October 13, 2014, our board of directors declared a regular cash dividend of $.15 per share on our common stock and Class A common stock. The dividend is payable on November 17, 2014 to shareholders of record on October 31, 2014.

Non-GAAP Financial Information

We provide non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment operating earnings) that exclude certain items as well as non-operating pension costs consisting of interest cost, expected returns on assets, amortization of actuarial gains (losses) and curtailments.

We believe that the measures of adjusted earnings, adjusted EPS and adjusted segment operating earnings provide useful information to investors about our operating performance and allow management and our investors to compare our performance period over period.

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Adjusted Earnings and Adjusted EPS

(dollars in millions, except per share data)

(unaudited)

The following is a reconciliation of net earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP):

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Adjusted Segment Operating Earnings

(dollars in millions)

(unaudited)

The following is a reconciliation of segment operating earnings to adjusted segment operating earnings (non-GAAP):

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Adjusted 2014 EPS Guidance and Adjusted 2013 EPS

(unaudited)

The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax):