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Edited Transcript of AOS earnings conference call or presentation 27-Apr-17 2:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 A. O. Smith Corp Earnings Call

MILWAUKEE May 2, 2017 (Thomson StreetEvents) -- Edited Transcript of A. O. Smith Corp earnings conference call or presentation Thursday, April 27, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ajita G. Rajendra

A. O. Smith Corporation - Executive Chairman, CEO and President

* John J. Kita

A. O. Smith Corporation - CFO and EVP

* Patricia K. Ackerman

A. O. Smith Corporation - VP of IR and Treasurer

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Conference Call Participants

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* Bhupender Singh Bohra

Jefferies LLC, Research Division - Equity Analyst

* Charles Damien Brady

SunTrust Robinson Humphrey, Inc., Research Division - MD

* James Giannakouros

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Jeffrey David Hammond

KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst

* Matt J. Summerville

Alembic Global Advisors - MD and Senior Analyst

* Robert P. McCarthy

Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst

* Robert Scott Graham

BMO Capital Markets Equity Research - Analyst

* Ryan Michael Connors

Boenning and Scattergood, Inc., Research Division - MD and Senior Analyst of Water and Environment

* David McGregor

Longbow Research - Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation First Quarter 2017 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Patricia Ackerman, Vice President, Investor Relations and Treasurer for A. O. Smith. Ma'am, you may begin.

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Patricia K. Ackerman, A. O. Smith Corporation - VP of IR and Treasurer [2]

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Thank you, James, and welcome, everyone, to our first quarter 2017 Earnings Call. Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. (Operator Instructions) I will now turn the call over to Ajita Rajendra, Chairman and Chief Executive Officer of A. O. Smith, who will begin with remarks on Slide 3.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [3]

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Thank you, Pat, and good morning, ladies and gentlemen.

A. O. Smith's solid performance in the first quarter set records for sales and earnings. We continue to see strong growth in our consumer products in China and our water heater end markets in the U.S. were very positive. Here are a few highlights.

Sales grew 16% to a record of $740 million. Excluding the impact from the strengthening U.S. dollar against the Chinese currency, our sales grew 18% in the quarter. China sales are up 27% in local currency. Among several revenue growth drivers, A. O. Smith branded water treatment sales grew over 50%, in local currency, and air purification products grew over 80%.

Net earnings of $0.50 per share were 22% higher than our earnings per share in 2016. We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. During the first quarter, we repurchased approximately 608,000 shares for $30 million.

We announced a 17% increase to our dividend earlier this year. The 5-year compound annual growth rate of our dividend is over 25%. John will now describe our results in more detail, beginning with Slide #4.

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John J. Kita, A. O. Smith Corporation - CFO and EVP [4]

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Sales for the first quarter of $740 million were 16% higher than the previous year. Net earnings in the first quarter of $88 million increased 19% from 2016, and first quarter earnings per share of $0.50 increased $0.09 compared to 2016.

Sales in our North America segment of $487 million, increased 15% compared with the first quarter of 2016. The increase in sales was primarily due to higher volumes of residential and commercial water heaters in the U.S. and Canada, and pricing actions in August 2016 related to significant steel cost increases and inflationary pressure on other costs. Aquasana, acquired in August of 2016, added $10 million to our North America segment sales.

Rest of World segment sales of $260 million increased 19% compared with 2016. China sales increased 27%, in local currency, driven by higher demand for our consumer products in the region, led by water treatment and air purification products, as well as a pre-buy in advance of a price increase related to steel and other cost inflation.

On Slide 6, North America operating earnings of $104 million were 13% higher than segment operating earnings in the year-ago quarter. The favorable impact from higher sales of water heaters in North America and the pricing action in the U.S., were partially offset by higher steel and other input costs.

The operating margin of the newly acquired Aquasana business is lower than the segment average and explain the overall margin decline for the segment in the first quarter. Rest of World operating earnings of $33 million improved 21% compared with 2016. Higher China sales were partially offset by increased selling, general and administrative expenses in China.

Higher selling cost and advertising costs to support growth were the primary drivers of higher segment SG&A expenses. Currency translations reduced China earnings by approximately $2 million compared with the prior year.

The China price increase had a minimal impact to earnings in the first quarter. First quarter segment operating margin was essentially the same as 1 year ago.

Our corporate expenses were higher in the first quarter compared with the year ago period, due to higher spending in our Corporate Technology Center.

Our effective income tax rate in the first quarter of 2017 was 27.2%, which was lower than the 29% experienced during the first quarter last year.

The first quarter 2017 rate was lower than 2016, primarily due to a larger benefit associated with stock-based compensation and a change in geographic earnings mix. The lower effective tax rate, compared with the effective rate a year ago, benefited 2017 results by $0.01 per share. Cash used by operations during the first quarter was $11 million compared with $27 million provided during the prior year. Higher earnings were more than offset by higher outlays for working capital. These factors resulted in lower cash flow in 2017.

Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio was 19% at the end of the first quarter. We have cash balances totaling $722 million located offshore, and our net cash position was approximately $353 million at the end of the quarter.

During the quarter, we repurchased approximately 607,000 shares of common stock for a total of $30 million. Approximately 4.3 million shares remained on our existing repurchase authorization at the end of March.

This morning, we increased the midpoint of our 2017 EPS guidance by $0.03 per share with the range of between $2.03 and $2.09 per share. The midpoint of our EPS guidance represents an 11% increase in EPS compared with our 2016 results. As a reminder, we do experience some seasonality in our business due to the boiler selling season, and China holidays, which benefit the second half of the year. Over the last 7 years our first half earnings have consistently represented slightly less than 50% of our total annual earnings.

Please turn to Slide 9 for several 2017 assumptions.

We expect our cash flow from operations in 2017 to be approximately $375 million, which is lower than the $447 million generated in 2016.

We expect higher earnings in 2017 but also larger outlays for working capital due to the higher than anticipated cash flows in the fourth quarter of 2016. Over the 2-year period,from 2016 to 2017, we expect to generate operating cash of approximately $825 million, which compares with $612 million during 2014 to 2015. We broke ground in 2016 on a construction of a new water treatment and air purification manufacturing facility in Nanjing to support the strong growth of these products in China.

Our 2017 capital spending plans of approximately $100 million include about $45 million related to this plant. Total cost for the facility, which is expected to begin production in the second quarter of 2018, will be approximately $65 million. After this expansion, we expect capital spending in 2018 and beyond to be at levels of approximately equal to our depreciation plus amortization.

Our depreciation and amortization expense is expected to be approximately $70 million in 2017. As previously discussed, expenses related to our ERP implementation were approximately $25 million in 2016, and are projected to decline to approximately $17.5 million in 2017.

Our corporate and other expenses are expected to be approximately $47 million in 2017, slightly higher than the $45 million in 2016, primarily due to higher expenses at our Corporate Technology Center and commissioned water treatment market studies.

Take note that our interest expense will be approximately $4 million higher in 2017, as a result of higher rates, share repurchase activities and our acquisition last year.

Our effective tax rate is expected to be between 28.75% and 29% in 2017, slightly lower than the rate in 2016. This assumption is predicated on no change to the current U.S. tax regime.

We expect to repurchase our shares in the amount of approximately $135 million in 2017, under a 10b5-1 plan. We may opportunistically repurchase additional shares up to $65 million. If $135 million of our stock is repurchased, we expect our average diluted outstanding shares in 2017 will be approximately $174.5 million. I will now turn the call back to Ajita who will summarize our guidance, the business assumptions for 2017, and our growth strategy beginning on Slide 10. Ajita?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [5]

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Thank you, John.

We project revenue growth to be between 10.5% and 11.5% in local currency terms in 2017, and between 9% and 10% in U.S. dollar terms. We expect Aquasana sales will be between $55 million and $60 million this year and slightly accretive to earnings.

With a full year of Aquasana sales as part A. O. Smith, we expect our global water treatment products sales will be nearly $300 million in 2017. We project the Chinese currency will depreciate slightly from current levels against the U.S. dollar, resulting in a 5% or $45 million sales headwind compared with the average rate in 2016.

Specific to our North America segment. We project U.S. residential water heater industry volumes will increase approximately 200,000 units in 2017, due to new construction and expansion of replacement demands. We project U.S. commercial water heater industry volumes to be up modestly with little growth in large electric units, after the category grew significantly in 2016. Lochinvar branded products grew 5% in the first quarter, driven by strong demand for water heater and modest growth in boilers.

We do expect double-digit full year boiler sales growth, driven by continued market share gain, new product introduction and energy-efficient product growth. We expect the total portfolio of Lochinvar branded products to grow over 8% in 2017.

Since our call in early February, steel prices have continued to move up, and not down, as we previously projected. We expect steel prices to continue to be elevated and volatile. This assumption is significantly higher than the average price in 2016, and results in the most difficult comparisons for the year in the second quarter.

These factors lead us to expect our North American segment operating margin will be between 21.5% and 22%, despite the headwind from lower Aquasana EBIT margin of almost 50 basis points.

Specific to our Rest of World segment. We are a consumer products company in China, which distinguishes us from most the industrial companies operating in China. We grew 27% in local currency in the first quarter, driven by continued strong demand for our high quality products and a pre-buy in advance of an announced price increase. We expect the pre-buy will negatively impact the next couple of quarters sales.

With several growth drivers underpinning our China business, we are confident to project an annual growth rate of at least 15% in local currency in 2017. These drivers include, overall water heater market growth driven by household formation and an emerging replacement market, geographic expansion, market share gain, continued strong growth of water treatment products and air purification product growth.

These benefits from China growth, smaller loss is expected in India and our air purification products approaching breakeven, we project Rest of World segment operating margin will be at least 14% in 2017.

I'm moving now to Slide #11. Our total company organic growth model continues to assume 8% growth for the foreseeable future. Especially in these volatile and uncertain economic times, we believe our organic growth potential and our stable defensive replacement markets, which we believe represent approximately 85% of North America water heater and boiler volumes, positively differentiate A. O. Smith from other industrial companies.

Coupled with strong growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisitions that add shareholder value, as well as allow us to return cash to shareholders.

That concludes our prepared remarks and now we are open for your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Charley Brady with SunTrust Robinson.

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Charles Damien Brady, SunTrust Robinson Humphrey, Inc., Research Division - MD [2]

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On the China pre-buy, I know you mentioned it's going to pull some stuff down from the upcoming quarters, but can you quantify any more on that as to how much you think you pulled forward? Particularly from Q2?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [3]

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That's pretty hard to calculate and actually determine what it is but we would say that we probably grew organically about 16%, which would result in approximately $15 million in pull forward.

And we think that will be over the next couple of quarters. There's some promotion being run in the second quarter so sales will definitely be down, affected by that, but it might leak into the third quarter also.

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Charles Damien Brady, SunTrust Robinson Humphrey, Inc., Research Division - MD [4]

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Sort of a follow-up, you talked about the pricing not having, I guess, a material impact on the first quarter. Do you expect an impact into second quarter and beyond?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [5]

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Yes, we think there will be some positive impact but clearly it was put in and it probably averaged about 3%, 3.5%, and it didn't cover all geographies but the major reason for it was to cover steel and also we increased what we're paying our installers, which we truly feel is a differentiator. Our service network in China is a differentiator. But there will be some net benefit coming in the last 3 quarters.

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Operator [6]

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Our next question comes from Jeff Hammond with KeyBanc.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [7]

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Just within the North America strength, which was a pretty big surprise. Can you give a little more granularity on what you saw out of Lochinvar and what you saw out of commercial and res, and maybe within that, talk about the issues that kind of hit you in the fourth quarter, in terms of cleaning those up, SAP and inventory destock?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [8]

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On the Lochinvar, we said it was up about 5% and that was primarily residential and commercial, and you probably saw the first 2 months of AHRI data, and they were very strong. The industry was up - 67,000 plus units in the first 2 months. And we think they're up even more given our March. So residential was quite strong, and when we look at commercial, it was up almost 4,000 units in the first 2 months and we think that trend continues. So the bottom line is, residential and commercial were quite strong for both Lochinvar and the base business. Water heaters.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [9]

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Just following to that, what's the quoting and order activity in Lochinvar that would support 8% plus growth, and then also how do you feel about how you've addressed the product category that you're underserved in that has seen more business as a result of NAECA III?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [10]

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We've made progress on the commercial, greater than 55 gallons, so we have made progress on that. We're not up to the share that our other business is -- our other commercial business is, but we definitely made progress on that.

Lochinvar, it's somewhat the same story. If you recall we had a strong commercial boiler market in the fourth quarter and it was pretty flat, up a little bit, in the first quarter.

Still a significant amount of quoting going on. We think projects are going to be released. We are coming out -- we've come out with a new product, the 6 million BTU condensing. We've come out with some noncondensing new products and we also have a Combi boiler coming out.

So I think when you add all that up and then you look at what the Dodge Momentum Index was talking about and the Architectural Builders Index, I mean, I think we're optimistic that we can get that 8% plus growth in Lochinvar for the year.

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Operator [11]

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Our next question comes from Scott Graham with BMO Capital market.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [12]

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I want to understand a little bit about, and you've certainly helped us with this little bit, John, price costs and kind of how it rolls through the rest of the year. My understanding, I think you guys talked about pricing up by 5% to 8% last summer to cover steel, and I think I heard you say that your realizations so far have been 3% to 3.5%. Am I comparing Apples-to-apples --

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John J. Kita, A. O. Smith Corporation - CFO and EVP [13]

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Say it again, I didn't hear the last part,Scott.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [14]

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It sounded to me like you just said that there was a price realization taking place of about 3% to 3.5%.

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John J. Kita, A. O. Smith Corporation - CFO and EVP [15]

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No, that's in China. That...

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [16]

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Fine. So then the 5% to 8% last summer, that is now in. And I guess I would've thought that given your sort of lag on how you pay for steel, I'm a little bit surprised that the margin guidance you're thinking for the second quarter is where it is.

So I guess what I'm asking here is that would you expect to have prices in place at today's steel prices, that you're pricing in place now. Should mean that your second-half margins are up in North America?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [17]

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First of all, steel. I'll tell you that we put in prices of approximately 5% of residential last year. Commercial might have been a little bit higher. Residential was about 5%, and we did get that 5%.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [18]

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And this is August of last year

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John J. Kita, A. O. Smith Corporation - CFO and EVP [19]

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Yes, this is August of last year. And so we also talked to you that we were about covering costs, we were not picking up margin and that's the case. So I would tell you, in the second quarter, for the most part, that they pretty much offset each other.

Price and cost. And that's what we've talked about in the past. Steel is much higher in the first quarter than the prior year. It's much higher in the second quarter than the prior year, and then it starts leveling off from a comparative standpoint compared to the prior year cost, if you will.

I don't know if that answers the question.

So I mean when you look at it in the first half of the year, we're going to have favorable price compared to the prior year. We're going to have favorable Aquasana compared to the prior year, from a revenue standpoint. The last half, not so much, kind of starting about August.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [20]

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And that's where the steel comps get easier?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [21]

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The steel comps get easier. You can conclude, we talked about 21.5% to 22% North America margins and we were at 21.30% or something in the first quarter so yes, we would expect margins -- when you add Lochinvar, remember Lochinvar is very seasonal. The second half of the year is significantly better sales and significantly better EBIT.

So that comes into play also.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [22]

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The other question I wanted to simply ask you guys is that when we look at where steel has sort of reinflated to after that downdraft in the second half of last year, and views that steel will edge down a little bit from here. But even notwithstanding that, your customers, from our conversations with them, pretty much expect you to increase prices each year and it does appear as if you with steel, having reflated again recently, that, that window is now open again. So what's the plan here? Are you looking to increase prices again in the second quarter?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [23]

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Scott, this is Ajita. As discussed many times in the past, we are not going to speculate on pricing in the future.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [24]

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That was direct.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [25]

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As it was meant to be.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [26]

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I do understand that. I guess my last question would be, where do you see your acquisition pipeline now versus, lets say, not even a year ago, maybe 6 months ago. I know there were some trade press that did some speculating that you were involved in one situation, sort of the bidding. Just sort of wondering where that process is now, in your eyes, versus 6, 9 months ago?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [27]

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I'm not sure, what you're referring to in particular, but in terms of total acquisition activity, it's very similar situation there. There is a lot of activity. There are opportunities out there. We are looking at opportunities. The prices are still high, and as we've always said, that we need to be able to see the value proposition. We need to be able to see returning costs across the capital to our shareholders in a reasonable period of time and we are running a very disciplined process.

And for obvious reasons, we are not going to be able to comment on something until it's a done deal. So we're not going to speculate on something that's in process. We can't.

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Operator [28]

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Our next question comes from Jim Ginnakouros with Oppenheimer.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [29]

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On U.S. residential, are you seeing any influences on volumes from retail storefront consolidation, and I guess an adjacent question there, are any sales, in a meaningful way, moving online in the U.S. specifically?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [30]

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I'm not aware of anything moving online, and from a retail storefront, I don't think its really affected our major customers except for obviously Sears. There is some impact from that as they the closed some stores.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [31]

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You get the occasional water heater online but its not anything big, but we do -- Rinnai is on Wayfair, I mean its a tankless product and that's the only thing I know of that's online. We know it's an online, we know it's a regular online retailer.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [32]

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And as a follow up, and I'm sorry if I missed it. Rest of word margins, I think you said you're confident in getting to over 14%. How should we be thinking about the mix influences, price cost and volume leverage, if you can't quantify it, I mean, just if you can rank order the influences there that would be helpful.

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John J. Kita, A. O. Smith Corporation - CFO and EVP [33]

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We were about very similar to the prior year, 12.4%, I think, compared to the prior year. And I will tell you first quarter margins that Rest of World were negatively impacted by some decisions we made in the air purification market.

That market has not been growing as fast as we expected. We want to position our brand strongly on that, so actually profitability was about $2 million worse than the first quarter of last year in air purification.

We think that's going to be a good investment as we talked about. We think by the end of the year, where air purification lost $5 million last year, we think we'll approach breakeven, we probably won't get there, but we'll approach it.

So we made that conscious decision to promote that product in the first quarter. So that's why you probably didn't see the contribution margin on that incremental sale to the level you would've expected.

But as we go forward, its a combination of volume, obviously. We talked about price increase is going to be affected by steel, and what we're doing from an installation standpoint. But we will get some of the benefit of that as we look at specifically in the second, third and fourth quarters. It's kind of a combination of things.

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Operator [34]

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Our next question comes from Bhupendra Bohra with Jeffries.

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Bhupender Singh Bohra, Jefferies LLC, Research Division - Equity Analyst [35]

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The question for Ajita here. I'm just trying to understand the China -- the Rest of World margins here. If you can explain how -- you know, you said there was pre-buy in the quarter and organically I think, John said I think you grew like 16%.

When you have organic growth, you definitely need to spend -- do more advertising and selling expenses but how does that work out when there is a pre-buy scenario? Shouldn't -- I believe there should be less, those sales should be less SG&A weighted sales than actually organic sales?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [36]

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So there are a couple of things that happened. The price increase, which was 3% to 3.5%, went in late in the quarter so we had, John estimated, about $15 million or so in sales. That was the pre-buy portion of it. Most of the pricing, they're not going to be seeing until the second quarter.

Also the cost increases we were talking about, really but they are the full quarter, the steel price, the steel cost, the increase that they gave to our installer et cetera was there for the whole quarter.

Also, as John explained, we did some very aggressive promoting of our air purification products because again, we see significant opportunity for that category to grow, and when we see the opportunities to drive those sales and make sure the consumer understands clearly, the value proposition of our product and the fact that we're in that market, which is a new market for us, we take the opportunity like we said, we saw about an 80% growth in air purification in the quarter.

So because of the opportunities to really drive home some very aggressive advertising too. So it's all of those things that come together that impacted. John, you want to?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [37]

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I think to just reinforce the point I tried to answer it but obviously I didn't. Yes, the incremental sales from the pre-buy were about $15 million. We did get, we think, contribution margin on that but that was offset by our additional investment in air purification where we lost an incremental $2 million over the prior year. So that's why you didn't see as much drop in to the bottom line.

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Bhupender Singh Bohra, Jefferies LLC, Research Division - Equity Analyst [38]

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The other thing was on the price increase, so that's basically broad-based on all the China products, not just water heaters which is the bulk of the business there?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [39]

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Yes, it covers most of the products and most of the geographies and we would guess it probably covers 85% to 90% of our business.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [40]

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There were some big markets there for example like Beijing, where we -- because of the competitive situation, we decided not to do things. So, just giving an example, it wasn't an across the board, all geographies type of price increase.

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Bhupender Singh Bohra, Jefferies LLC, Research Division - Equity Analyst [41]

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And my last question on the -- we have seen the water treatment business -- the market growth for that business has been 40% plus. I think that's what you said on the fourth quarter call and that saw prices much higher than that. Do you think the market growth itself has accelerated or was this just kind of -- the first quarter was like one-off?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [42]

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Some of that growth in water treatment was also associated with the pre-buy. We raised prices on water treatment. So there was a pre-buy in the water treatment segment. We grew 40%, but the industry, I think the last numbers we saw that the industry in 2016 grew about 30% to 31%.

And I think the forecast for this year is about 30% and we're certainly comfortable with that, but clearly water treatment had some pre-buy in the first quarter also.

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Operator [43]

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Our next question comes from Matt Summerville with Alembic Global Advisors.

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Matt J. Summerville, Alembic Global Advisors - MD and Senior Analyst [44]

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Couple of questions. First, have you been surprised by the continued strength we're seeing in the small commercial electric product in North America and I guess, what do you attribute that continued strength to at this point, relative to how fast the non-res market is growing more broadly speaking?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [45]

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When we saw the increase in the first quarter, it was a combination of 2 things. It was the greater than 55 electric and our guess is there's still some carryover associated with NAECA, where that product was eliminated. So you either have commercial customers that were buying residential are now buying commercial or you would have residential customers who were buying residential are now buying commercial. We think that's part of it and then yes, we saw pretty significant -- I mean a couple of thousand units increased in the lower electric too. The less than 55 and the only thing we can come up with is high-rises and those sorts of things as the utilization of that has improved.

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Matt J. Summerville, Alembic Global Advisors - MD and Senior Analyst [46]

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Now you've owned Aquasana for a couple of quarters, is the $10 million contribution you saw in Q1 consistent with your longer-term targets and how you built up the revenue synergy case around to making that acquisition? And have you started to shift product from China into the U.S. through that channel and vice versa? Aquasana into China through your established channels there?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [47]

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I would tell you, Aquasana was up about 11% or 12% compared to the prior year which is what the expectation was. And very little profit, which was what the expectation was similar to the prior year. Their fourth quarter is traditionally their strongest quarter as a primarily retail-type provider. And we never expected the revenue synergy out of the gate because there is government approvals. We certainly want to, as we've talked about, we are doing some market studies. We want to understand the market and then make the determination of which products go where and under which brand, et cetera. So we're in the process of that and we never expected that for the first couple of quarters. We should start seeing, we hope, some revenue synergies later in the second half. Not later in the year but second half of the year.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [48]

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And the cost synergies are on track. If anything maybe a little bit ahead of track. So I'd say that's good.

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Operator [49]

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Our next question comes from Robert McCarthy with Stifel.

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Robert P. McCarthy, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [50]

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I guess the first question. Aquasana I think contributed about $10.3 million in revenues for the first quarter. That's a little bit below its accrual rate. Can you talk a little bit about the seasonality of the business? How should we be thinking about modeling it?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [51]

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I think traditionally the fourth quarter is the strongest and the first quarter is the weakest. The other 2 quarters in between kind of continue to move up. So, again, it's very close to what we projected when we did our plan and no surprises, again with the fourth quarter being the strongest.

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Robert P. McCarthy, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [52]

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And obviously, I think you're going to brush this question back pretty quickly, but you're not going to share with us in the quarter of volume price acquisition on a percentage basis for North America and Rest of World?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [53]

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Well for North America we told you the $10 million for Aquasana, okay? We told you the price increase that went in place for residential in August, so you guys can do some math to come close to it, and residential was up and commercial was up. So I think you can do your calculations.

Rest of World, what we tried to say is that we think about $15 million of the increase was due to pre-buy in China. India was fairly close. Europe was a little bit less both on profit and sales. But again, we've given you the big piece which is $15 million of what we think is pre-buy.

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Robert P. McCarthy, Stifel, Nicolaus & Company, Incorporated, Research Division - Senior Analyst [54]

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The last question. Obviously, I think Scott Graham touched on acquisition opportunities as a whole, but can you review for us, in terms of balance sheet capacity and wherewithal or appetite -- not appetite, but wherewithal how big a deal you could do from your perspective?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [55]

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If you'll look at, we have, $720 million of cash. We are underlevered with 19%. We said we could go up to 35% to 40% debt-to-capital. So we have significant amount of room to obviously do acquisitions, to return cash to shareholders, et cetera.

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Operator [56]

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Our next question comes from David McGregor with Longbow Research.

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David McGregor, Longbow Research - Analyst [57]

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I guess the question is on China. It's kind of a bigger picture question, but a big part of the growth as I understand it is expanding geographically. I realize you started from Tier 1 markets, you've been moving out to Tier 2 and Tier 3 and so on. I guess the question is, are underlying margin realizations constant as you move out to those smaller markets? Or do fulfillment cost and other factors suggest that maybe that margin progression geographically is not constant?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [58]

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I would say they are fairly consistent, to my knowledge. As we move out into Tier 2 and Tier 3 cities, there are certainly middle class and upper-middle class people in the outlying cities.

Now I will tell you our store sales in Tier 2 and Tier 3 as not as high as they are in Tier 1, on a per store basis. But from a margin standpoint, I'd say it's not a significant delta.

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [59]

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And the other thing is that the cities in China are getting bigger also. Beijing is still growing. The whole drive to urbanization is driving people from the hinterland into the big cities, so it isn't just the second and third Tier cities that are growing. The big cities are also growing. So we see that growth happening all over.

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David McGregor, Longbow Research - Analyst [60]

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I guess as my follow up, the obligatory question on repatriation of cash and the proposed tax reform. What would be your thought in terms of the repatriation of cash and how would you put those proceeds to work?

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John J. Kita, A. O. Smith Corporation - CFO and EVP [61]

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It really depends on how they end up doing it. The initial talk was They'll tax cash that you have overseas at one level and the difference between cash and unremitted earnings at a different level.

I haven't heard much about a holiday so that won't happen; it doesn't appear. But the cash overseas, depending on how it all falls out, we may not bring it back immediately because we're looking, from an acquisition standpoint, globally. So obviously, if I did an acquisition in the U.S., I may bring it back. If I did an acquisition internationally, I'd rather have the money where it is now, in Europe and China, depending on where you do it. And then, there's also factors like do they eliminate interest expense. We have some interest expense in the U.S., we've evaluated.

So we're not going to pre-decide what we're going to do until we see the ultimate plan.

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Operator [62]

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Our next question comes from Ryan Connors with Boenning & Scattergood.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD and Senior Analyst of Water and Environment [63]

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My question was a little more strategic in nature. I want to get your take on kind of brand and channel management for the A. O. Smith brand in particular, which I understand has always been an exclusively wholesale brand.

So we were a little bit surprised to see the news, I guess a couple of weeks ago, that the A. O. Smith brand itself is now going to be available at Lowe's, and so -- and actually couldn't help but notice that they've already slapped the A. O. Smith brand on 1 of the NASCAR racecars, and so forth. so it seems like a bit of a shift there in terms of the branding and channel strategy for that particular brand. And I'm curious, how should we interpret that, whether that means going to try to leverage the broader brand, as you have in China, through Aquasana and so forth and whether that is or isn't the interpretation, and also just what are the risks and opportunities associated with going down that route?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [64]

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It's a great question. From our perspective, as we see the traditional channel boundaries blurring, the decisions being made more and more by the consumer because of online searches, and that's the first place people go look for products. We feel that having the A. O. Smith brand, both at wholesale and retail, it's just going to make it a stronger brand and help our growth across the board, in both wholesale and in retail. And the brand being at Lowes, gives it the opportunity to have 13 million viewings by consumers every week, and all of that will strengthen the brand which will make it a stronger brand at wholesale and at retail. So long-term, we think this is a great growth opportunity for the company.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD and Senior Analyst of Water and Environment [65]

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And then just a follow-up would be, managing the communication of what you've just communicated there with your wholesalers and also with the hardcore kind of contractor customers. Have you had any deliberate efforts to manage that communication to make sure there was no misinterpretation of what you're trying to do and that sort of thing?

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Ajita G. Rajendra, A. O. Smith Corporation - Executive Chairman, CEO and President [66]

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We have done that. We have talked to our major customers. I mean it's public information, it's out there. We met face-to-face with most of our major customers and explained it to them, and they understand what we're trying to do with the brand.

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Operator [67]

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I show no further questions at this time. I would now like to turn the call back over to Ms. Ackerman for closing remarks.

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Patricia K. Ackerman, A. O. Smith Corporation - VP of IR and Treasurer [68]

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Thank you, all for joining today. Please take note that we will participate in several conferences during the second quarter. We will be at Oppenheimer on May 10, in New York City. KeyBanc's conference on May 31, in Boston. William Blair's conference on June 13, in Chicago. Stifel's conference on June 16, in New York City and the (inaudible) conference on June 20, in Boston. Have a wonderful day.

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Operator [69]

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That does conclude this conference. Thank you very much for your participation. You may disconnect. Have a wonderful day.