A O Smith Corp (AOS) 2002 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the A.O. Smith corporation second quarter earnings release conference call. At this time, all participants are in a listen-only mode. However, later in the conference call we will be conducting a question and answer session. With instructions to be given to you at that time. If you should require distance from an operator during the conference call, please press the zero and the star and you will be assisted offline. As a reminder, today's conference is being recorded. I would now like to turn the conference over to Director of Investor Relations, Mr. Craig Watson. Please go ahead.

Good morning, ladies and gentlemen. And thank you for joining us on this conference call. With me this morning participating in the call are Bob O'Toole, Chairman and Chief Executive Officer, Ken Krueger, Chief Financial Officer, and John Kita, Treasurer and Controller. Before we begin with Bob's remarks, I would like to remind you that some of the comments that will be made this morning, 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. Bob will now make a few opening comments and Ken will discuss results in more detail.

Thank you, Craig. This morning, we were pleased to report earnings of 66 cents per share. Compared to 45 cents in the year earlier period. Net income of $18 million from continuing operations set a record for the second quarter. These results solidly beat our forecast and were the results of stronger operating performance and synergies related to the state industries acquisition. As well as product repositioning and other cost reduction programs and electrical products. Consolidated sales, excluding state, were slightly higher than in the second quarter of 2001. Reflecting a slight decline in motors offset by a modest increase at Water Products. Year-to-date our motor business is 7% lower than it was last year, primarily reflecting the sharp decline in the first quarter. Our flat second quarter motor sales signaled an improvement in the trend, and we're cautiously optimistic that our motor markets, particularly air-conditioning, will show positive comparisons from here. Given our strong first half performance, profitability expectations have improved for the full year. Not with standing earnings dilution of approximately 17 cents a share, resulting from our recently completed stock offering. We are improving our earnings per share forecast range for 2002 to between $1.70 and $1.80 per share. Ken will now take you through a review of the second quarter in a more in-depth discussion of the outlook.

Thank you, Bob. Sales in the second quarter of 2002 were $386 million. An increase of $78 million, compared with the second quarter of 2001. Motor sales declined $2 million to $219 million, while water systems sales increased $81 million to $167 million. The state acquisition represented 78 million of the increase in the water systems sales.

Second quarter net earnings were $18 million, or 68% higher than the earnings of $10.7 million in the second quarter of 2001. On a per share basis, net earnings were 66 cents, compared to 45 cents in the second quarter of 2001. The higher earnings were attributable to lower manufacturing costs and the elimination of goodwill amortization and electrical products. Synergies from the state acquisition and higher sales volumes in the base water systems business. It should be noted that earning per share were diluted by approximately 6 cents a share, as a result of the May 10th stock offering, which resulted in 4.8 million more shares outstanding. Gross margin was 21.2%, compared with 19% in the second quarter of 2001. This increase is the result of materially cost savings at both businesses, better sales mix at water systems, and product repositioning at electrical products. SG&A increased to 50.2 million from 36.3 million, as a result of the incremental SG&A of state. As percent of sales, SG&A increase from 11.8% to 13%, in 2002 as a result of our water systems business, which has higher SG&A levels. Water systems has grown from 28% of sales in the second quarter of last year, to 43% of sales in the quarter just ended, thus the higher company wide rate of SG&A.

Interest expense declined to $3.7 million, compared with $3.9 million in the second quarter of 2001. As a result of lower debt due to the stock offering.

At electrical products, sales to the HVAC market were approximately 5% lower than the second quarter of 2001. While sales and motors for pump and general industry applications both improved more than 10%, compared with last year.

Earnings in the motors operation increased to $20.5 million, from $15.4 million in 2001. The current quarter excluded $1.7 million in goodwill amortization recorded in the second quarter of 2001. Adjusted for this goodwill, the segments operating margin improved to 9.4% from 7.7%. This favorable trend in operating margin reflects cost reduction activities, including those announced in the fourth quarter of 2001.

At water systems, sales Rose to $167 million, up from $87 million last year. The majority of the increase was due to the acquisition of state industries. The base business grew 3%, with residential sales increasing 2%, and commercial sales up 5%, compared to last year. Water systems earnings improved to $16.6 million, from $9.9 million last year. Operating margin was 9.9% in the quarter, compared with 11.4% last year. The 9.9% margin compares favorably with the 8.7 generated in the first quarter of the year, and reflects the continued success of the integration of state.

Cash flow, before financing for the first six months of the year, was $32 million. An increase of 30 million dollars over the same period in 2001. The improvement was driven by higher earnings of $11 million, and accelerated tax filing process that resulted in the $12 million tax refund in first quarter and continued diligence managing our working capital investment. As a result of the strong cash flow and the stock offering completed in early May, debt declined during the first six months of the year and our debt to capital ratio now stands at approximately 27%. Compared to 46% at the end of last year. Based upon the strong first half performance, we have improved our projected operating cash flow forecast for the full year to a range of $80 to $85 million.

I would now like to provide a brief update on the cost reduction programs. In addition to our ongoing cost improvement practices, the plant repositioning, and other elements of the business improvement program announced during the fourth quarter of 2001 are on track. The consolidation of warehouse and logistic operations, and the salaried workforce reductions are complete. The biggest remaining piece of the improvement program involves the repositioning of six product lines. During the second quarter, we announced our plans to close the Monticello, Indiana subfractional horsepower motor plant, and relocate that business to existing motor plants in Mexico and China. All product repositionings, will be complete by the end of the first quarter of next year. We continue to project that the combination of these actions will generate cost savings of more than $16 million this year, and between 20 and 25 million annually in 2003 and beyond.

The state integration continues to progress smoothly and we completed the relocation of our water systems headquarters to Ashland City, Tennessee, in June. The purchasing synergies are coming in ahead of schedule and a longer term tactical improvements have begun to take shape. We're quite pleased with the early results of this acquisition. On the gross side of the equation, we completed the purchase of the hermetic motor assets of the athens products division of Electrolux group on July 1 for approximately $11 million. This purchase is expected to add at least $30 million in annual sales and generate modest incremental earnings in 2003.

As we look to the rest of the year, seasonal trends and general economic softness will cause sales to be lower in the second half of the year. Relative to the first half. Compared to last year, second half motor sales to the HVAC market should be up due to the dismal market in 2001. We're more cautious about the other markets served by the electric motor business, which are more dependent on consumer spending and general economic conditions. Water systems sales should be modestly higher in the second half compared to last year. While sales volumes could be retarded by soft economic conditions, we remain enthusiastic about our continued progress in reducing costs. Accordingly, we are improving our EPS forecast for 2002, to between $1.70 and $1.80 per share. Our prior forecast was for earnings between a $1.60 and $1.70 per share. Before the 17 cent full year dilution resulting from the stock offering.

In conclusion, A.O. Smith is on track in attaining a world-class cost structure and is enjoying a good year in tough market conditions. We continue to identify opportunities and make investments to profitably grow the business. We look forward to continuing to share the story with you in future quarters.

That completes our opening remarks and we're ready for your questions. Please limit your inquiries to one or two questions at a time so everyone interested has an opportunity to participate. Operator.

Thank you. Ladies and gentlemen, if you wish to ask a question, please press one on your phone. You'll hear a tone indicating you've be placed in cue and you may remove yourself from cue at any time by pressing the pound key. If you are on a speaker phone we ask that you please pick up your handset. Our first question will be from the line of Michael Schneider from Robert W. Baird

Good morning.

Good morning, Mike.

Excellent quarter, as like last quarter. I guess you've answered my question as to if the guidance was conservative, that you would be flat sequentially from first quarter to second quarter. On the water systems side, maybe you can spend a minute on the margins the numbers are coming in seemingly well ahead of schedule. You mentioned you're early, or you are ahead of schedule on the purchasing synergies. In the second half, the third quarter is generally the seasonally weakest, but how should we view margins going forward in the water systems group? Is 9.9 kind of the [INAUDIBLE], or would you expect a seasonal down take in the third quarter even with staying ahead of schedule?

Yeah, thanks, Mike. As you mentioned there, we are ahead of schedule on the synergies. And a lot of that came about as a result of the jump-start we got on the purchasing side as we worked out the final details of the transaction and got through Hart Scott [RADENO] filing the last quarter of last year. As a result, rather than a ramp up, our purchase savings were in place immediately and that's really been a key factor in getting ahead of game early with the synergies. The other thing that we implemented was a reduction in the overall administration costs. There's some savings there just from combining the two companies. The last piece of that is to better align our production capabilities with our customer location and that really won't have any meaningful impact on the bottom line until, you know, either very late in this year or starting in next year. So as a result with those lower sales volumes in the third quarter and synergies being pretty stable, I would expect we'd see the operating margins come down a little bit on the water systems in the third quarter.

Okay. And sticking to that side of the business, could you give us an update on China and what the sales amounts were there this quarter and where you are in capacity utilization?

Yeah, thank you. The sales in China were up from last year. They were $7.3 million, which was looks like about a 5 to 6% improvement over last year. And we did achieve profitability in China. We clearly have enough capacity there to serve a much broader business. The business continues to grow. Obviously, as you get bigger, it's harder to maintain a 20% growth rate, but we still anticipate a healthy double digit kind of increase, and we don't anticipate any capacity additions that we would need to make in order to meet those kind of growth rates.

Okay. And final question, waterside again, in terms of pricing, couple things have gone on. Rheem put through a nice price increase, starting in March. Wondering if you've seen the price increases that you and others have put in stick for the year and then secondly, maybe give us an idea of your optimism for price increases that could be put through as a result of the flammable vapor rollouts.

Yeah, a couple things there. As you alluded to, typically there are price increases put in place earlier in the year in the water heater industry, and then everybody works to make sure they stick or hold during the course of the year. I think on the commercial side, we've had a little more success in seeing some price improvement during the year, not a lot. And on the residential side a little, very little of that, perhaps has stuck to the bones after the implementation. You had talked about the flammable vapor implementation, that's of course scheduled for March of 2003. And again, that will be fundamentally a new water heater brought to the market and will establish new price points in the industry. for the full range of the water heaters eventually.

Okay. Can you quantify what you think the margin capability or the pricing increase could be on those new products?

Well, clearly, we would like to at least maintain our margin, and cover all of that in price for the final vapor improvement. Whether or not there's any opportunity beyond that, I truly don't know at this point in time.

Okay. Thank you.

Thank you. Our next question will be from the line of Martin Sanky from Goldman Sachs. Please go ahead.

Okay. Hi, everybody. You mentioned during the call that you bought some assets out of Electrolux. Could you elaborate on that? What you bought? How does it fit? And would you be relocating the machinery down to Mexico?

Yes. We bought the fixed assets of the plant in Athens. We will be operating it for up to a year in total. But we will be moving those assets down to our plant in Mexico. And we already negotiated a contract with the union. It was a unionized facility, so we already have a closing contract with that union. So a year from now, I would expect -- or so that all of that production would be in Mexico.

Okay. And you said it's about 30?

It's at least 30 million or more or sales volume.

Okay.

Martin, it integrates very tightly with the rest of the business. Its manufacturers, motors for air conditioner compressors, very similar to the ones we manufacture, and has a customer base that is very similar to our own.

Okay. How much of the production was dedicated to Electrolux? And do you have a supply agreement?

None of it. This plant used to make motors, Martin, for the refrigeration compressors for Electrolux, which Electrolux shut that operation, and therefore had to shut the motor operation. So what we're buying is product that goes into residential air-conditioning compressors.

Uh-huh. Okay. And when you complete the move, how much savings would you expect?

Well, as we said in the earnings release, when we get all said and done, we expect it will add a few cents a share to next year. Modestly, accretive and be worth a few more cents in that in the following year.

Okay, thanks.

Thank you. Our next question will be from the line of Bill Gibson from Bank of America. Please go ahead.

I wanted to follow up on the margin issue. Just -- and let's look it at on a combined operating margin for the company. It sounds like it probably dips a little in the third quarter, but are we going to be near these levels on a go-forward basis?

Yes, thank you, Bill. As we said earlier and typically as is the case for us. Seasonally we have more sales in the first half of the year than in the second half of the year, and that's really a portion of the reason as we partically look to the third quarter that I think the operating margins could be down. If's simply the loss of the contribution margin on the relatively lower sales in the third quarter. There's also typically a little less sales in the fourth quarter than there is in the first half of the year, that's the primary reason we're looking at the kind of numbers we're talking about before.

And looking out three years, as we get near the end of that phase, are 12% operating margins achievable?

Yeah, I think as we've talked in the past, if you take a look at the culmination of the activities that have occurred at the electrical products business with the Magnatech integration. Certainly they've had great success in the business improvement program they announced in the fourth quarter, and that they're working at implementing this year. And as we continue our migration of our capability to manufacture, bolstering our presence in Mexico, establishing it in China, operating margins in the 12% and maybe even a little, a tad better than that are certainly possible out that kind of time frame.

Good. Thank you. And just one last question: Any change on your pension fund return assumptions?

Yes, as a result of our annual review, comparing ourselves to other companies' expectations, taking a look at our returns historically, we moved the pension return assumption from 10% to 9 and three-quarters.

Okay good, thank you.

You're welcome.

Ladies and gentlemen, if you wish to ask a question, please press the 1. And our next question will be from the line of Scott Graham from Bear Stearns.

Good morning. Just a couple questions. First of all, the HVAC unitary market has shown some upticks from a shipment standpoint, yet distributors continue to liquidate inventories. Just wondering if you guys were hearing, if your business unions were hearing, at the distributor level, if that phase of inventory reduction, which has lasted for well over a year now, has maybe run its course?

At this time, quite frankly, it's still a little confusing out there. The conditions -- you know, externally when you look at the conditions, the warm weather in the northern half of the U.S., the inventories at the end of May substantially below where they were at the end of May last year, you would think that we should really have a rebuild of inventory and some of that going on. Our customers continue to be extremely cautious, and the earnings estimate that we've given you here for the year is under the assumption that they neither take inventory down significantly, nor do they take inventory up significantly in the back half of the year. Right at this point in time, that really is our best estimate of what's going on. And you know, they really don't have had rebuild it until the first quarter next year, Scott.

Right. Right. And I'm sure you would agree that even the rebuild will probably be with some caution as well, moreover given logistics improvements within their operations, they probably have to rebuild less going forward.

Well, I think quite frankly, March of last year was too high. You know. And they built it higher than they should have in the first quarter. So I don't expect to get back up to those kind of levels. But certainly, there's two or three hundred thousand units that you probably would expect to rebuild. From the data that I am seeing, they have not rebuilt. But, you know, you can't overstress the fact that with everything that's going on, people continue to run their business very cautiously.

Yes. Separate and apart from that, with the Electrolux acquisition now in the fold, has that at all dampened your appetite for additional acquisitions in '02, if something were to come to the fore for you?

No, this is a very modest one. It fits -- it fits in beautifully. It's incremental, it fits right into our current production lines. We don't have anything that we are close to closing or talking about at this point in time. But our appetite remains about the same.

Terrific. Thank you very much for your time.

Thank you. Once again ladies and gentlemen, if you have a question, please depress the 1. We have a follow-up from a line of Michael Schneider from Robert W. Baird.

Could you talk about the motor market as it progressed through the quarter and maybe the July results as you've seen them preliminarily? I realize the seasonality causes the numbers to ramp through the quarter, but if you look at kind of a year over year or, on a weekly basis, are things actually getting stronger this summer? And how did July look?

Well, July is still going on. Mike. I would tell you right now that we're not seeing great signs of strength. This is usually a period where we begin to get in shutdowns of our customers and that as we hit July and July-August. And what, Mike, what we see is continued caution by our customers out there.

So if we look at the margins of the second half of the motor segment, the second half of last year was obviously unusual with not only the slower market but a massive inventory liquidation at your OEM customers and distributors. Maybe Ken you shed some light, if we see flat sales in the second half, what would that mean given a more normalized production from margins in the second half?

Thanks, Mike. Yeah, we won't be atypical for to see flat sales in the second half to the first half year, by think it would also be atypical -- I think the third quarter of last year was difficult, the fourth quarter, knock on wood, is not going to be replicated because of the inventory reduction. Typically, as you know, we see 52 to 53% of our sales in the first half of the year, with the inverse in the second half, which implies kind of a first half to second half overall 5 to 10% drop in the sales. And I think the contribution margin, as you know, on that side is in that 25 to 30% range. So it's very likely as a result that we won't be able to hold the kind of operating margins we had here in the second quarter, and in fact typically we don't hold them as we move from the second to third quarter. So I'm not certain I know exactly the magnitude of it, but you're going to see I would suspect some shortfall, some drop, modest in the operating margins of the motors business in the second half of the year, compared to the first half.

But again, the more appropriate comparison is looking at margins this year second half versus first year, rather than the second half of this year versus the second half of last year, just because production was so slow on your part and for the industry's part in the latter half of last year, that it's almost an inappropriate comparison.

I would agree with?

Okay. And you believe that the 20 to 25% incremental margin in the motor business still holds? You did like 22 this quarter, anything different about that in the second half?

No, there's really -- I mean, we always and continue to face some pretty difficult competitive situations. But having said that, there's nothing of any magnitude that should take us off that sort of historical 25% contribution range.

Okay. And the Monticello move, later this year, some of other product line moves, those presumably don't benefit this year yet?

Some of them will begin to benefit us in the fourth quarter and will be complete by the end of the first quarter of next year.

Okay, thanks.

Thank you. We have no further questions in the cue. Please continue.

Okay. Thank you very much for dialing in this morning and we look forward to talking to you next quarter.

Thank you. Ladies and gentlemen, today's conference call will be available starting at 12:15 central time today and running through Saturday, July 13th at midnight. During that time you may access the AT&T executive playback service by dialing 1-800-475-6701 and enter the access code as 643952. Once again, the dial in number is 1-800-475-6701, access code is 643952. That's concludes your conference for today. We thank you for your participation and for using AT&T executive teleconference services. You may now disconnect.