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Edited Transcript of AOS earnings conference call or presentation 30-Apr-19 2:00pm GMT

Q1 2019 A. O. Smith Corp Earnings Call

MILWAUKEE May 3, 2019 (Thomson StreetEvents) -- Edited Transcript of A. O. Smith Corp earnings conference call or presentation Tuesday, April 30, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles Lauber

* John Kita

* Kevin J. Wheeler

A. O. Smith Corporation - CEO, President & Director

* Patricia K. Ackerman

A. O. Smith Corporation - Senior VP of IR, Corporate Responsibility & Sustainability and Treasurer

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Conference Call Participants

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* Alvaro Lacayo

G. Research, LLC - Research Analyst

* Andrew Loeb Cohen

Northcoast Research Partners, LLC - VP & Equity Research Analyst

* Andrew Sherman Haroldson

D.A. Davidson & Co., Research Division - Research Associate

* David Sutherland MacGregor

Longbow Research LLC - CEO and Senior Analyst

* Jeffrey David Hammond

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

* Robert Paul McCarthy

Stephens Inc., Research Division - MD & Analyst

* Robert Scott Graham

BMO Capital Markets Equity 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 first quarter 2019 earnings call. (Operator Instructions) As a reminder, this call is being recorded. I would now like to turn the call over to Patricia Ackerman. You may begin.

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Patricia K. Ackerman, A. O. Smith Corporation - Senior VP of IR, Corporate Responsibility & Sustainability and Treasurer [2]

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Thank you. Good morning, Ladies and gentlemen, and thank you for joining us on our first quarter 2019 earnings call. With me today are Kevin Wheeler, our Chief Executive Officer; John Kita, our retiring Chief Financial Officer; and Chuck Lauber, our incoming Chief Financial Officer.

Before we begin with Kevin'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.

In order to provide improved transparency into the operating results of our business, we provided non-GAAP measures, adjusted net earnings, and adjusted earnings per share for 2018 that exclude the restructuring and impairment costs associated with our plant closure in Renton, Washington.

Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. (Operator Instructions) I will now turn the call over to Kevin, who will begin our prepared remarks on Slide 4.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [3]

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Thank you, Pat. And good morning, ladies and gentlemen. Our first quarter results met our expectations and are aligned with our previously communicated projection for China of lower year-over-year sales as result of a channel inventory build in the first quarter of 2018. Company sales of $748 million declined 5% from the prior year.

Earnings per share of $0.53 declined 12% from the prior year. We repurchased approximately 900,000 of our shares for approximately $46 million. We are pleased to announce the acquisition of Water-Right, one of the strongest names in residential and commercial water treatment solutions, earlier this month. Please advance to Slide 5 for more details on this strategic acquisition.

Water treatment solution provider, Water-Right, squarely supports our growth trajectory in water treatment and enables us to expand beyond our strong presence in the direct-to-consumer and retail channels, with Water-Right's capabilities in the wholesale and water quality dealer channels.

The water treatment category in the U.S. is evolving from a taste and odor market to a health and safety market as families become more aware of contaminants in their drinking water.

Water-Right brings to us additional solution for residential and commercial applications.

Water-Right's product portfolio and channel access strengthens A.O. Smith's ability to serve customers seeking drinking water safety in any stage of their life, from school and college age, where portability and refillable bottles are prevalent, to first apartment to homeownership, when whole house products are desired. The purchase price of $107 million represents a trailing EBITDA multiple of approximately 9x, after the expected tax benefit related to a Section 338(h)(10) election. Water-Right meets our return on invested capital objective in the first full year.

We expect Water-Right to add approximately $45 million of revenue in 2019. The positive impact to earnings in 2019 is expected to be minimal due to the interest in purchase accounting and onetime cost. At this time, I would like to thank and acknowledge John Kita, who is on his last earnings call before retiring from A. O. Smith after over 30 years. We have transformed to a pure-play water company during his tenure as CFO, and John was integral in communicating the potential of A. O. Smith to investors. We wish John well in his retirement.

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John Kita, [4]

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Thank you, Kevin. We have been working diligently the last several months on my CFO transition to Chuck Lauber. Combining his background and 19 years of experience with A. O. Smith with a strong internal finance and accounting team, I'm confident the transition will be seamless. Chuck will now describe our results in more detail beginning on Slide 6.

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Charles Lauber, [5]

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Thank you, John. Sales for the first quarter of $748 million were 5% lower than the same quarter in 2018. Adjusted earnings in the first quarter of $89.3 million declined 14% from the first quarter in 2018.

On Slide 7, first quarter adjusted earnings per share of $0.53 were 12% lower than the same quarter in 2018. Sales in our North America segment of $522 million increased 4% compared with the first quarter of 2018.

The increase in sales was primarily due to higher volumes of boilers and water-treatment products and a mid-2018 water-heating price actions related to steel and freight cost increases, which were partially offset by lower residential water heater volumes. Rest of the World segment sales of $232 million declined 21% compared to the same quarter in 2018.

China sales were down 18% in local currency primarily related to channel inventory build, which occurred in the first quarter of 2018 and did not repeat in 2019.

Our China results essentially met the forecast we stated at our January earnings call. The weaker Chinese currency unfavorably impacted translated sales by approximately $13 million.

India sales grew approximately 30% in constant currency compared with the same period in 2018.

On Slide 9, North America segment earnings of $116 million were 3% higher than segment earnings in the same quarter in 2018.

Favorable impact from higher sales of boilers and the mid-2018 pricing actions were partially offset by higher steel and other input costs as well as the unfavorable impact from lower residential water heater volumes.

Weakness in the North America water treatment business as a result of tariff-related cost increases and lower-than-expected volumes drove first quarter 2019 segment margins slightly lower to 22.2% compared with the adjustment segment margin of 22.5% last year.

Rest of the World earnings of $12 million declined 66% compared with the first quarter of 2018. The impact to profits from lower China sales more than offset the benefits to profits from lower advertising.

First quarter headcount reduction programs were offset by severance costs. Our targeted 10% headcount reduction was largely completed at the end of March.

Weaker China currency translation negatively impacted earnings by approximately $1 million.

As a result of these factors, segment margin declined significantly from the same quarter in 2018.

Our corporate expenses were higher in the first quarter compared with the same period in 2018 primarily due to higher stock-based compensation. The effective tax rate in the first quarter of 20% was lower than last year's tax rate as a result of a onetime adjustment due to refinement and estimated tax due to U.S. tax reform.

Cash provided by operations during the first quarter of $22 million was lower than $43 million in the same period of 2018.

Lower earnings and lower accounts payable balances resulted in lower cash flow from operations. Our liquidity and balance sheet remains strong. Our debt-to-capital ratio was 14% at the end of the first quarter. We have cash balances totaling $633 million located offshore, and our net cash position was $349 million at the end of March.

During the quarter, we repurchased approximately 900,000 shares of common stock for a total of $46 million.

Approximately, 5.1 million shares remained on our existing repurchase authority at the end of March.

This morning, we updated our 2019 guidance to a range of between $2.69 and $2.75 per share with no change to the midpoint, which represents a 4% increase in EPS compared with our adjusted 2018 results.

We expect improved performance in China in the second quarter compared with the first quarter but project lower China sales than in the same period in 2018 due to the second quarter 2018 inventory build.

As a result, we expect our 2019 second quarter earnings per share will be slightly lower than the second quarter last year.

We forecast a stronger second half in 2019 compared with the first half due to: China performing better in the second half on constant currency basis impacted by normal seasonality and selling holidays; new product launches and cost benefits from lower advertising and headcount reductions; growth as well as typical seasonality of boilers, which are normally higher in the second half of the year; improvement in North America water treatment; and the India profitable in the second half due to volume growth, typical seasonality and improved operating performance.

We project significantly improved second half year-over-year performance as a result of: stronger water heater volumes as the third quarter of 2018 is an easy comparison due to the price increase put forward in Q2 2018; stronger boiler volumes due to tariff-related lost sales and supplier bottlenecks in the third quarter of 2018 also provides a favorable comparison; improved profitability in North America water treatment due to the absence of onetime product launch cost and softener production and efficiencies; and larger profits in India. We expect our cash flow from operations in 2019 to be between $500 million and $525 million, which is higher than the $450 million generated in 2018.

We expect higher earnings and lower outlays for working capital this year.

Our 2019 capital spending plans are approximately $85 million, and our depreciation and amortization expense is expected to be approximately $75 million in 2019. Our corporate and other expenses are expected be approximately $49 million in 2019, slightly higher than last year due to inflation.

Our effective tax rate is expected to be 21.5% in 2019. We expect to purchase our shares in an amount of $200 million -- approximately, $200 million in 2019. We expect our average diluted outstanding shares in 2019 will be approximately 168 million.

I will now turn the call back to Kevin who will summarize our guidance and business assumptions for 2019, beginning on Slide 13.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [6]

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Thanks, Chuck. Our outlook for 2019 includes the following assumptions: we project U.S. residential water heater industry volumes will increase between 100,000 and 150,000 units in 2019 due to continued new construction and expansion of replacement demand as well as continued growth in tankless units. Commercial industry water heater volumes are expected to be up 1%. Based on a strong first quarter, we expect our boilers sales to grow approximately 10% in 2019.

We improved profitability in India in 2018 due to scale in our water heater and water treatment businesses from losing over $7 million in 2017 to under a $5 million loss in 2018.

The overall loss in India is expected to be $2 million to $3 million in 2019. We project India water heater EBIT will be positive in 2019 and improvements to continue for our water treatment in 2019 and that overall in India, we will be profitable in 2020.

Our forecast for the Chinese currency in 2019 is essentially level with where it is today, weaker than last year. All the negative FX impact is expected in the first half of 2019. As previously discussed, we believe 2018 China sales increased at least 5% due to the customer inventory build in the first half of 2018. We are assuming continued weakness in the China economy and relatively flat consumer demand for the full year in 2019. Without the impact of the 2018 channel inventory build, we are projecting full year sales to be down approximately 6% to 8% in local currency terms, the majority of which will occur in the first half of this year. Combined with our expected 1 point of unfavorable currency translation, our 2019 China sales projection is a decline of 7% to 9%.

Please advance to Slide 14. We see continued momentum in North America with our water heater, boiler and water treatment products, collectively expected to grow up to 9% in 2019, including approximately $45 million in Water-Right sales. Our profitability improvement and sales growth in India is also encouraging. Our business model in China is solid for the long-term opportunity, and we continue to forecast low teen margins for the full year. We have near-term challenges to navigate through as the China economy remains weak.

We project revenue growth will be between 2.5% and 3.5% for the year in US dollars and 3% to 4% in local currency. EPS is projected to be between $2.69 and $2.75.

We expect North America segment margin to be between 23% and 23.25% and Rest of World segment margins to be between 11.75% to 12%.

Our stable defense replacement markets, which we believe represents 85% of North America water heater and boiler volumes, positively differentiates A. O. Smith from other industrial companies.

We have a strong balance sheet poised to take advantage of strategic acquisitions and add shareholder value as well as allow us to return cash to shareholders.

That concludes our prepared remarks, and we are now available 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 Alvaro Lacayo of G. Research.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [2]

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Congrats, John, on a very successful tenure as CFO.

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John Kita, [3]

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Thank you.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [4]

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I wanted -- my first question was around -- focused on North America, the volume in water heaters and the water treatment volumes that you called out as being -- I guess water treatment softened, and I believe residential water heater shipment was negative.

The shipment data shows that through February, it looked like shipments were a positive, I think about 3%. Maybe if you can just give me some color around what March would look like and maybe some commentary around what that means for your performance in the quarter. And then with water treatment, if you can provide some color on the magnitude of the price increases. And maybe just commentary around competitive response and how that -- and what was the delta between the volumes that you were expecting versus what you saw?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [5]

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Okay. This is Kevin. Let's talk about North America water heaters first. You are right. Through the first couple of months, the market was up about 50,000 units, and -- but as we saw in March, based on our March shipments, we are actually estimating that the industry will be marginally down to flat. And so we still feel the forecast of 100,000 to 150,000 is valid but we gave back, we believe, some of the units in March. Now what that does for us is we had a little bit of a share decline and that's mainly just due to order patterns with customers and how our distributors order. We don't see anything of material issue going forward. So we project our full year market share will remain flat, and we expect that the industry will grow as we have previously forecasted. Now with regards to -- you mentioned water treatment in pricing, I'm not sure -- if you could clarify that, that would be helpful.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [6]

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I think the comment was that volume was a little bit lower than anticipated due to cost base price increases from reacting to the tariffs. I was just wondering what kind of a price increase you implemented. And then how the volume is -- the delta between the expectation and the actual on the volumes for water treatment?

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Charles Lauber, [7]

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Yes. This is Chuck, Alvaro. Really not pricing, it's really just volume. So we're a little disappointed with our first quarter for water treatment. So our volumes are a little off. We started a little slow with one of our major customers, but we feel pretty good about the momentum that we have going into the rest of the year. The tariff-related costs are just -- we've recovered some of those, but we still have tariff-related costs in some of the filtration products that we have coming out of China. And on the water treatment side, we've got some of inefficiencies we had in Q1 that really, we believe, are beyond us. So as we look at the North America water treatment business, Q1 is really the low point for us for the year, and we just see that number improving throughout the year.

So we see increased volume as we go throughout the year, and we also see that the efficiencies in our softener production are overcome. And we see improvement in March, we see improvement in April. So the momentum is good on North America water treatment.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [8]

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And then just on Rest of World, are there any further actions from a cost-reduction standpoint? And I appreciate the comment around the severance offsetting some of the headcount benefits in Q1. But if you can tell me maybe from a magnitude perspective, how much fixed-cost reduction to expect from a year-on-year perspective going forward?

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Charles Lauber, [9]

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So if we look at -- and we're talking China, right? So China, so we did get the headcount reduction cost behind us. So we only see improvement on the headcount going forward. When we're looking at magnitude -- I mean, if you look at our percentage of SG&A and most of the savings are cost on the advertising side that really are more brand building than they are direct-promotion type costs. But I'll take it as a percentage of SG&A, and we're probably mid-single digits as a percentage of SG&A when you're looking at cost reduction year-over-year.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [10]

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Yes. I just want to add a little bit to that. Again, we've taken the steps, and we've talked about this on our call a few times that we want to right-size the business for the market that we're participating in today. We believe we've taken those steps but you should all know that we continue to monitor the market. And if additional actions are required from us, we'll be -- we will make those decisions as we go forward throughout the year.

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Operator [11]

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Our next question comes from Matt Summerville of D.A. Davidson.

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Andrew Sherman Haroldson, D.A. Davidson & Co., Research Division - Research Associate [12]

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This is Drew Haroldson on for Matt Summerville. I have just a couple of questions. First, do you believe that the inventory channel correction in China will be largely complete at the end of the second quarter? Or if not, when would you expect that pressure to alleviate?

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Charles Lauber, [13]

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Yes. This is Chuck, Drew. So we -- the inventory in China, it built last year, really. We saw that build in the first half of the year and larger percentage was in the first quarter than in the second quarter. For the last 3 or 4 quarters, it's been pretty stable. Our assumption when we kind of look at forward on the year is that it would be flat to down, but we don't see a lot of decrease in that in our forecast for the rest of the year.

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Andrew Sherman Haroldson, D.A. Davidson & Co., Research Division - Research Associate [14]

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Got it. And then just as a quick follow-up, can you talk about the cadence throughout the quarter in China? It seems as though some data points pointed to better overall sentiment in March versus January and February. Did you also see that in your business?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [15]

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Yes, we -- that's going up and down, quite frankly. If you look at just the macro environment, we would tell you it still remains a challenge. Consumer demand is weak, but we are seeing some stabilization and some, I don't want to say improvement, but certainly, just stable consumer demand. So we are seeing some of those signs, but I would tell you that we need to see more than just a few months. And so as we're looking at it going forward, that's why we projected relatively flat. And so we see more of a positive sign with some of the government possible stimulus packages and some of the other things that could help consumer demand if the tariff issue gets resolved. But we are seeing some, but I would tell you, we need to see a few more months before we're willing to say that there is a positive momentum in China.

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Charles Lauber, [16]

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Yes. I mean -- this is Chuck. So I mean, the first quarter is always difficult in China because of the Spring Festival, and it's a bit hard to get a handle on what the market is doing. So as we kind of got into the second quarter, hopefully, we'll see a little bit better view.

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Operator [17]

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Our next question comes from Jeff Hammond of KeyBanc Capital Markets.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [18]

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So just on China, I think first quarter you gave us some good color on kind of how first quarter was going to shape up, and I think you said you still expect decline. But can you just maybe give us a finer point on the magnitude of the year-on-year decline you expect in China in 2Q? And what kind of decremental margins you'd expect?

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Charles Lauber, [19]

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So yes, for Q1, we gave the guidance that Q1 would be down roughly $50 million. And last January, we talked a bit about the inventory build happening in 2018 predominantly in the first quarter but it did happen throughout the first half of the year. I mean, we don't know our channel inventory numbers precisely. But when we kind of take a step back and look at it, we would kind of gauge the Q2 impact to be roughly half of that of Q1. So the volume, we're saying $50 million in Q1, so we would peg that in Q2 as roughly half.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [20]

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Okay, then the decrementals tied to that? Because I think you have pretty high decremental...

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Charles Lauber, [21]

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No. It kind of would be similar to the first quarter. We have that as kind of a 50% to operating earning.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [22]

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Okay. And then how do you get to -- I mean, it just seems like a very back-end loaded year. How do you get to the margin assumptions for Rest of World? Like, what needs to happen in the second half to kind of get to that high 11% to 12% range?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [23]

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Yes, I mean, what really kicks in a bit is some of the cost-reduction programs that we talked about. We really don't see the headcount reductions until we start entering into the second quarter. So we see that -- we would see -- we're really being hurt by volume, obviously, in these first 2 quarters, and we're talking about the numbers in Q1 and Q2. And we expect that to flatten out, so the back half of China, from our sales perspective, we expect to be better.

And then India, so we've got improvement in India. When you look at kind of how India lays out for the year, it's very seasonal. They're clearly -- their strength is in the back half of the year. So really when you look at India, all of our losses accumulate in the first 2 quarters, and we're profitable in the back half the year, when we look at our projection, which is a pretty big swing quarter -- half-over-half.

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Operator [24]

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Our next question comes from David MacGregor of Longbow Research.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [25]

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Just first of all -- first question, really on China, and you had talked in the past about rolling out some mid-price-point water heaters in China. So I guess, I'd just start off by just asking if you could talk about the early experience with that rollout? And what did that represent as a positive offset within the Chinese growth compare? And what was the impact of cannibalization on the premium product?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [26]

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Well, let's just start out with the rollout. And we've been rolling out midpoint products now for the last several months, and we'll continue to roll them out into the remaining half of the second quarter and third quarter this year.

And I want to get specific because at the end, on the gas side, we are filling our line with the 0 cold water. We are in those mid-price-point products, which are important because we vacated those gaps on the offline but we also supports our online sales.

On the electric side, our wall-hung business, we'll introduce a mid-price steel jacket model. We're also going to upgrade one of our high-end models with several features, with regulators and displays and slimline-type tank design. Water treatment, we will introduce 2 new high-end products as well. One more of a DIY easy filter replacement. The other is boiling water with the tap -- luxury tap. So we have mid-price-point products, and we also have new high-end products that we are launching almost simultaneously, and they are -- right now, we're seeing improvement in our online sales. We are seeing some improvement in our mid-price-point range.

Now I'd tell you that this is early and each product takes some time to get out through certification. But the steps we're taking, we feel really good about our new product, we feel they're having the impact, and they will have the impact over the rest of this year. And as far as cannibalization, we have a high-end part of the market, which we continue to do well in on the water heater side of it, and that's tankless and electric wall hung.

I would tell you, people aren't probably trading up, but we don't see a lot of trading down. Water treatment's a little bit different story, but we do see some trading down going on there, so maybe a little bit of cannibalization. But overall, the product offering is meeting our expectations, and it's just a matter of getting them out into our distributors, into our distribution to have the full impact throughout 2019.

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Charles Lauber, [27]

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Yes. And this is Chuck, and I talked a little bit about cost reduction, but I just want to emphasize that we haven't cut back on R&D or our new product development or launching new products. So we're very upbeat and excited about the products that are coming out.

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Operator [28]

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Our next question comes from Scott Graham of BMO Capital Markets.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [29]

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John, I wanted to just extend congratulations to you. You had a terrific run here at the company.

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John Kita, [30]

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Thanks, Scott.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [31]

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I wanted to maybe first ask about the organic for the year or better yet, as you're calling it, sales in local currency, which I understand now means inclusive of Water-Right. It looks to me as if your organic expectation for the company is now 1.5% to 2.5%, is that -- am I calculating that right?

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Charles Lauber, [32]

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We're just taking a look at that, Scott.

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Patricia K. Ackerman, A. O. Smith Corporation - Senior VP of IR, Corporate Responsibility & Sustainability and Treasurer [33]

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So we said Water-Right sales would be $45 million this year.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [34]

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Which I think is about 1.5%?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [35]

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It's about 1.5%. Yes, that's correct.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [36]

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Okay. All right. The China water heater market, I know in the past you guys have had a pretty good bead on knowing what that market is running at, in total, not just your channel. Do you have an idea where that is right now? It was kind of -- I think you guys were kind of saying it was a little bit negative last quarter. Do you know where it is now?

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Charles Lauber, [37]

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What we look at from data, from our third-party -- this is Chuck, again. It's -- the ABC data that we use through the third-party, and it doesn't include our specialty stores, just the retail. What they're showing down for electric and gas is roughly in that 9% to 10% range for the first quarter. So they got the market down in that level with online that are performing a bit better, of course. Online is up a bit and offline down more than online's up.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [38]

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Got it. That's -- would you then say that's a deterioration from last quarter, right? From what you see?

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Charles Lauber, [39]

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Yes, we would say that. Last quarter was running less than that.

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Operator [40]

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(Operator Instructions) Our next question comes from Robert McCarthy of Stephens.

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Robert Paul McCarthy, Stephens Inc., Research Division - MD & Analyst [41]

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Congratulations, John, on a great career. What I would say is the following, I guess the first thing I'd like you to just go through. Could you -- could you all talk about, in the context of some of these acquisitions, kind of how you perceive the total addressable market for water treatment in North America? And where you want to play? Maybe if you could give us a sense of the total addressable market, some of the growth drivers and where you see the ability to create value for the company and where you want to play.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [42]

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It -- from -- let's just talk about Water-Right, and then I'll tag back into our other acquisitions. And we've talked about Water-Right fits squarely in our strategy, particularly from a residential and commercial point-of-view and some dealer network. But if you go back and you look at our strategy, Water-Right really complements our prior 2 acquisitions. Aquasana was our first acquisition and that provided carbon products and also provided a solid direct-to-consumer platform. That filled out 2 of our channels that we wanted to participate out of the 5. We also then acquired Hague, and there's a large water softening market out there, and Hague's innovative water softening products helped fill out that product portfolio for us. It also helped us enter into the water quality dealer network as well. And if you remember, we took those 2 acquisitions, we were able to put them together and offer a full package, which helped us in improving our big box retail position.

Now as you go forward here, where does Water-Right fit in? Water-Right fits in, in that residential and commercial problem water area. And they bring new products that help fill out that part of our business. They will -- they also brought a stronger dealer network, which now we've more than doubled our water quality dealer network, and by the way, that was with minimal overlap. And they also helped us enter into the wholesale side of the business, more of the specialty wholesale side of the business as well.

So when you put all 3 of these acquisitions together, they complement the 5 channels, which are residential and light commercial that we want to participate in. And as we go forward, our -- we firmly believe that the water quality in the United States, in North America will continue to deteriorate over time and that each one of these product or channel categories and the products that we offer will add value to those specific -- or customers that are purchasing through those channels. So going forward, we are very bullish on our water treatment business. We still believe that it's in its early stages as people become more aware of their -- the quality of the water throughout the United States and so forth.

So those all tied together and having a filtration carbon, having a water softening, having an RO system, now looking through -- now being able to leverage our commercial network that we have throughout the United States with water heaters and boilers, that's another key component. And we believe you wrap this up completely, this will provide a -- we had talked about at least high single-digits growth going forward and improved profitability, as we continue to build out and implement our strategy -- our water treatment strategy across North America.

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Charles Lauber, [43]

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This is Chuck. And just circling back to the total addressable market. I mean we estimate the North America market to be around $2 billion as a total addressable market. So we -- as Kevin said, we like the trends, and it's a large market that we think has a lot of potential as it evolves.

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Robert Paul McCarthy, Stephens Inc., Research Division - MD & Analyst [44]

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Great. And then maybe if you could expand your comments with respect to China and the water treatment trends you're seeing there in terms of growth? And then touch on air purification as well. Just give us the latest state-of-play of what you're seeing in terms of the market dynamics there in terms of growth.

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Charles Lauber, [45]

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Yes. Water treatment continues to be a bright spot for us in China. It didn't pop in the numbers this quarter, and the reason why is because we've talked about that inventory build last year. So if we look at kind of our water treatment business in China, we're looking at -- so for the quarter, we were down probably low single digits, just slightly down on our sales. Now the sellout was still kind of a bright spot when you look at what the sellout was and what we see in the marketplace. When we look at our year for water treatment, we see about 8% year-over-year growth, and we see consumables that are continuing to grow. So we're very happy with the consumable business. It's about a $30 million base last year, growing at about 30%. And it grew at 30% Q1, and we expect it to grow at 30% for the year. So water treatment continues to be a good product for us.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [46]

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And I would just add that this is not a -- water treatment is not a product that's tied to new construction, it's really tied to health and safety. And those are primary with the Chinese consumer, particularly with children. So we expect that to continue to grow and to have value for many, many years to come.

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Charles Lauber, [47]

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And I think you touched on -- you mentioned air purification. We really have moved into more of a formaldehyde product as we go into air purification. I think we're kind of really just entering into that time of the season. So the summertime is when you really see formaldehyde in China being more of an issue. So we're -- we've got some new products that we've launched into there. We've got fresh air product that is wall mounted that we're excited about coming into the market. Last year, our sales probably in the -- down a bit obviously, but probably in the $25 million range. And this year, we expect with our formaldehyde product to grow a bit, probably grow up to maybe $30 million is what our projection is. So we see a little bit of a positive there, but it really predicates a bit on what happens this summer in the formaldehyde.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [48]

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We still believe air purification, based on what we know today, has a place in our portfolio. And we're also adding a few new products there into more of the mid-price range to help the -- boost sales as well and address some of the consumers that we haven't been able to with our higher-end product. So overall, air purification remains part of our portfolio, and we believe it will -- may not be as we've talked in the past, may not be that 30% or 40% growth, but we still believe it's solid double digits going forward.

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Operator [49]

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Our next question is a follow-up from Jeff Hammond of KeyBanc Capital Markets.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [50]

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Just a follow-up on water treatment. I just want to level-set kind of how big do we think that business is in '19, now that you've included Water-Right? And what's kind of the core growth all-in for water treatment? And has that changed at all given the slow start?

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Charles Lauber, [51]

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So I -- Jeff, I think you're talking about just North America piece, right?

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [52]

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Yes, yes. North America.

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Charles Lauber, [53]

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Yes. So the Water-Right adds about $45 million. So we're looking at this year, the North America water treatment approaching $155 million of revenues and approaching a 10% operating margin return. And we would expect -- as we go forward, we would expect to have an expansion on the operating margin probably in the 200 to 300 basis points.

When we look at kind of the growth rate. We kind of -- you break it down, and you've got different growth rates probably for filtration products and get -- versus softeners. But overall, we would say, we'd be approaching high single-digit growth rates going forward. So when we kind of roll it all in and you look at 2020 and you've got a full year of Water-Right, we would be approaching $190 million, $200 million as we get into 2020. And we're looking at continuing to expand margins and a nice growth rate for the North America piece.

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Operator [54]

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Our next question comes from Scott Graham of BMO Capital Markets.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [55]

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I got cut off at the knees there. I'm not sure (inaudible) that question. So...

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [56]

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Scott, that was John.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [57]

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Yes. I actually thought it was you, Kevin. So help -- if you could help me understand the Lowe's. It looks to me like -- you tell me if I'm wrong on this, but you are maybe a little bit off track on where the Lowe's water treatment selling lands in 2019. Kind of what happened there? And maybe why?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [58]

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Well, I want to go back to we launched in August of last year, and we talked about it on a couple of calls. We started out a little bit slower than we expected. We had some capacity issues at our [ConXus] facility. And so we just got off to a slow start. But as Chuck mentioned early on in the call, we're seeing month-on-month growth in the space, and our capacity issues are clearly behind us right now, and our efficiencies continue to improve as we continue to build scale.

So are we behind a little bit? Yes, we are. Do we think we have the programs and the foundation set to go forward? And the answer is, yes. And like I said, we're starting to see that. We talked about having a good margin, we're off to a nice start in April. So it's -- moving forward, it's just going to be more timing, and we'll eventually get to the numbers that we thought. It would just be at a little bit slower rate.

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Robert Scott Graham, BMO Capital Markets Equity Research - Analyst [59]

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Got you. And before I get cut off, so I do have another question. Going back to China, I have not in a long time heard as many new product launches being teed up for the rest of the year, and it's definitely exciting. It does also, however, beg the question of mix. Historically, I think you have always hoped to get Rest of World margin into the 15% range. I -- just trying to understand kind of how -- what you're thinking now as longer term on Rest of World margin with a lot of new products coming in that are undoubtedly going to be lower margin in China than your core water heater offerings. Could you maybe talk around that a little bit?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [60]

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Well, we -- let's just start with that we have introduced a number of new products, particularly the midprice. And if you remember, we were just trying to fill some gaps that we created through a price increase. But also, online is becoming more prevalent, and that just doesn't have the same type of price point. So we need to make sure that we have the products to compete to garner the volume and the share that we have. Now our margins -- I would tell you, our -- by product are not going lower. Now our price points are, but we are -- the reason we are introducing new products, we're taking steps to drive cost out and diminish that price/cost ratio.

So margins are going to remain solid, as they have been. Our average selling price is going to drop a bit. But overall -- and by the way, just to go back, we may not have talked about all these new products that we've launched, but we've been very consistent over the last decade of introducing many, many products at a time. And of course, the number of products are going to get larger as you enter new categories. So this is not -- it's a little bit out of our behavior because of the mid-price-points, but the rest of them are just normal business -- being a consumer business, and appliance business, we're always introducing new products every 12 to 18 months.

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Operator [61]

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Our next question comes from Andrew Cohen of Northcoast Research.

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Andrew Loeb Cohen, Northcoast Research Partners, LLC - VP & Equity Research Analyst [62]

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You kind of touched on some of it, but I'm curious -- I mean, you seem to have gone in China into some tangential lines of business recently, and I'm wondering if this is a one-off? Or if you are trying to become more of a broad range scope of products in that market?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [63]

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I would tell you our strategy, let me just articulate that. We're always looking at new product categories to grow. In China is a growth market, has a lot of opportunity, but we have high criteria for our product launches. One, they have to be able to leverage our brand and our distribution, that's number one. And number 2, we don't enter any product category that we don't believe we can add significant value to the product category going forward. So if you look at air purification, we felt we could bring added value formaldehyde and so forth. But we're always going to continue. We're always incubating products. We're incubating combi boilers today. We're incubating air purification. We have a very nice growing commercial water treatment business that's moving towards profitability. So yes, we're going to enter new product categories but they're always going to be within our core and be able to leverage what we've been able to develop and build, which is our branded distribution over the last 20 years.

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Andrew Loeb Cohen, Northcoast Research Partners, LLC - VP & Equity Research Analyst [64]

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Does that include -- like you've got now Hague and Water-Right which are North American products. Are you looking for how those fit into the Rest of World market? Or kind of...

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [65]

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I would tell you right now, we already are selling the water softeners that are from Hague. We've been doing that over last couple of years, right? In fact, that's how we started our -- getting to know the Hague business as they were a customer -- or we were a customer of theirs from China. So yes, but that fits, again, squarely into being into the bathroom, being into the kitchen with our brand and our distribution. It's not a large part of the market but it's one that it's a natural synergy from the companies and the products we have, both in North America and it can go both ways back to China which it does in reverse osmosis.

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Operator [66]

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Our next question is a follow-up from David MacGregor of Longbow Research.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [67]

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I may get cut off again, so let me just give you 2 or 3 questions in a row here. First of all, I guess, pricing, you're anniversarying the second half or the midyear 2018 price increase, do you have additional pricing actions in place to carry the third quarter compare? And secondly, I guess replacement demand from 2007 to 2009, industry sales were down about 20%, as I recall. And so I'm interested in how you think about North American replacement demand against that historical pattern. How much of a drag, if any, is replacement demand on overall growth? And then if I could just through a third in. I guess just on boilers. Can you talk historically about how a severe weather-driven spike in sales has impacted subsequent quarters' growth? And do you feel you may have pulled forward some growth there?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [68]

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That was quite a list, thank you. I'm going to take the first one, it's pricing -- and we don't comment on pricing as we go forward. As we talked about that was implemented last year, you're right, it's anniversarying right now. We are constantly, always reviewing our cost positions and so forth, but we don't comment on future pricing actions.

And as far as the replacement demand, I'm glad you asked that because it's an important point that we get many times on the road with regards to -- I think you're going towards, "Hey, is there a cliff coming because of what happened in 2007, 2008?" And what we've articulated the last few years, so have done quite a bit of research and study. We went back to 1970 and really laid out our replacement market in a number of different ways, and what we have concluded, quite frankly, is yes, so we have a bell curve, but it's an elongated bell curve. It goes anywhere from 5 years to 20-plus years. And then if you look at the overall replacement market, our replacement market is really 14x what's the available housing out there, which is $120 million. When you put that all together and our assessment that we may have some blips here and there, but there is no cliff at all. In fact, it's going to just kind of level out over the years as it always has and continue, we believe, at a similar replacement pace that we've seen over the last 5 or 10 years. And as far as boilers...

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Charles Lauber, [69]

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Yes. And back to your question on boilers in Lochinvar and the -- or the seasonal weather, the cold weather I think was your question. I mean what we saw mostly was residential products, we don't believe that, that's going to impact kind of the normal seasonality of the boiler business for the back half of the year.

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Operator [70]

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Our next question is a follow-up from Alvaro Lacayo of G. Research.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [71]

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My follow-up is just the North American water treatment market. If you could break down the $2 billion or so in sales that you gave as an addressable market, if you could break it down by channel, and I think you've called out retail, direct-to-consumer, wholesale and water quality dealer. And then maybe if you can give some commentary around how many stores you're actually in at Lowe's or if you reach sort of the total amount of stores that you intend -- that you plan to reach? And then on the wholesale dealer channel, is that all incremental to you guys? And how big is that?

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [72]

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Okay, we'll give you some approximations here. When we talk about the overall water treatment market by channel, about 40% to 50% of it is dealers, about -- again 15% -- and these are approximate, 15% to 20% is on the wholesale side of the business. 15% is retail and 10% is basically other.

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Charles Lauber, [73]

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Yes. I mean, that's why we're really pleased to have Water-Right join because the largest part of the market is in that dealer wholesale piece, and they bring us a bit of a footprint there that's going to be very helpful to us.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [74]

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And going back to how much is that going to be incremental, it's surprisingly the number of dealers that we brought on with the Water-Right acquisition and we lay them on top of the dealers we have in Hague, there was very, very little overlap. so most of it's going to be incremental. And by the way, it's going to cover some areas that we were not in and give us a broader national footprint as we continue to grow that over the next few years.

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Alvaro Lacayo, G. Research, LLC - Research Analyst [75]

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And with Lowe's, are you fully launched there? Or is there more stores in the pipeline? And just to give us an idea how many stores you're in.

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Kevin J. Wheeler, A. O. Smith Corporation - CEO, President & Director [76]

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For the most part, yes. We are fully launched, and we are just moving forward with our store displays and generating consumer demand for our products. I would not expect any real meaningful loading, if you will, going forward. Just so we're clear, I mean, Lowe's has over 1,720-plus stores so it's taken us a while to get in there, but we're fully integrated there, displays and so forth and prepared to go forward with them.

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Operator [77]

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There are no further questions. I would turn the call back over to Patricia Ackerman for any closing remarks.

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Patricia K. Ackerman, A. O. Smith Corporation - Senior VP of IR, Corporate Responsibility & Sustainability and Treasurer [78]

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Thank you for joining us today on our first quarter results conference call. We will participate in the following conferences this quarter, Oppenheimer in New York on May 7; KeyBanc in Boston on May 29; and the William Blair Conference in Chicago on June 5. Have a great day.

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Operator [79]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.