A O Smith Corp (AOS) 2003 Q2 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by and welcome to the second quarter earnings release conference call. (CALLER INSTRUCTIONS) As a reminder, today's conference call is being recorded. I would now like to turn the conference call over to our host, Investor Relations Director, 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 during this conference call, including answers to your questions, could 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. I would also like to point out that we have posted slide on our website, so please feel free to follow along while we conduct the call. Bob will now make a few opening comments and Ken will discuss results in more detail.

Robert O’toole: Thank you, Craig. Second quarter earnings were $19.8 million, representing a 10 percent improvement compared with the $18 million earned in last year's second quarter. Earnings were 67 cents per share compared with prior year earnings of 66 cents per share. EPS only increased 1 cent as the result of the dilutive effect of the secondary stock offering in May of '02. Second quarter sales were $418 million, compared with $386 million in the second quarter of last year. The increase in sales was due to the July 2002, acquisition of Athens Products, sales from recently acquired Chinese Motor Operation, and higher volume at Water Products.

We had an unusually large number of the dynamics impacting second quarter financial performance. As I said, sales were up about 32 million for the quarter. Sales increases were due to the July 2002 acquisition of Athens Products, our recently acquired Chinese Motor Operations, and accelerated buying of residential gas water heaters ahead of the July 1st launch of the flammable vapor resistant products. These sales increases more than offset weakness in the commercial construction market for both commercial water heaters and air conditioners, as well as softness in the residential air-conditioned markets. The resulting mix of these sales negatively impacted operating margins. The decline in operating margins however was overcome by one time positive items including an insurance settlement and a favorable resolution of a R&D credit for tax purposes. All of these dynamics resulted in improved performance relative to last year.

On the operating front, our repositioning activities continue in 2003 as we move products out of higher cost facilities in the U.S. into Mexico, and manufacture an increasing number of motors in our new facilities in China. Earlier this month we began manufacturing the flammable vapor resistant gas water heater in 30, 40 and 50-gallon sizes. In addition to incremental sales and margins, the introduction of these new products will allow us to accelerate the standardization of the combined water heater product line, which is expected to generate significant cost savings as we streamline manufacturing and ship products from plants that are better aligned with our customer locations.

Last year -- last week we announced the rationalization of our major U.S. residential and commercial water heating operations in our Ashland City, Tennessee and McBee, South Carolina facilities, respectively. And Ken well elaborate on those actions shortly. The Company's overall cost structure has improved significantly over the last 18 months and our operating units will continue to aggressively improve costs in both the third and fourth quarters. This morning we announced a projection of 42 to 46 cents for the third quarter and reaffirmed our 2003 outlook and narrowed our guidance for the full year 2003 earnings of between $2.10 and $2.25 a share.

As we have previously stated, operating improvements will materialize and accelerate during the second half of the year. These improvements include the continued success of the motor repositioning programs and the ongoing integration of the State Industries' acquisition. In addition to these operating improvements, the introduction of new water heater products during the second half of the year is projected to generate additional sales and earnings. As a consequence, earnings per share comparisons are expected to improve summarily in the third and fourth quarters of this year.

Ken well now take you through a more detailed discussion of the quarter and the outlook for the balance of 2003.

Thanks, Bob. During the second quarter sales were $418 million, up 8 percent from the second quarter of 2002. As Bob said, sales increases came from acquisitions in the motors business and residential gas water heater sales, which more than offset declines in sales of commercial water heaters and air conditioners, as well as residential electric water heaters.

Net earnings for the quarter increased to $19.8 million compared to 18 million last year. Business segment earnings were down 700,000 due to the mix of product sales. This shortfall was more than offset by an insurance recovery from a bankrupt carrier and the favorable resolution of a R&D tax credit. Earnings per share improved modestly to 67 cents from 66 cents last year as improved earnings more than overcame the 5 cent dilutive impact of the May 2002 stock offering. On a year-to-date basis, earnings are $1.13 per share compared to last year's $1.17 per share. The stock offering had a 13 cent dilutive impact on a six month comparison.

Operating cash flow for the first six months of the year was an outflow of $6.1 million. Operating cash flow is typically weighted to the second half of the year. This is due to the seasonality of motor sales to the HVAC and pump markets in the first half of the year, which tends to build receivables at June 30th. In addition to this seasonality, two other items caused increases in receivables and inventory this year. Electrical Products repositioning to Mexico and China required increased inventory levels to minimize customer service disruption through the transition. The launch of flammable vapor resistant water heaters on July 1st caused pressure in both receivables and inventories at Water Systems. For the full year, but we're projecting operating cash flow of 80 to $90 million as working capital returns to normalized levels, coupled with specific efforts to reduce inventory at Electrical Products.

One encouraging area was accounts payable, which improved 31.3 million from year end. Capital spending totaled $15 million compared with depreciation of $26 million. For the full year, we're projecting capital spending of approximately 45 million and depreciation of $50 million. As a result of the native cash flow year-to-date, our debt to capital ratio of 34 percent is slightly higher than the 33 percent recorded at year end. During the second quarter, we took advantage of the favorable interest rate market and secured approximately $50 million in new long-term debt at a fixed rate of just under 4.5 percent.

Now I would like to move on to discussion of the operating performance in our Electrical Products and Water Systems businesses. Sales in our Electrical Products business increased $8 million to 228 million in the second quarter, primarily as a result of the Athens Products and Chinese Motor acquisitions. Excluding these acquisition related sales of approximately $19 million, sales were modestly lower as a result of continued weakness in commercial markets and weather-related softness in both HVAC and leisure pump markets. HVAC sales declined approximately 5 percent. Electric Products recorded a 9 percent decline in operating income to 18.6 million, compared with 20.5 million last year. Second quarter EBIT margin was 8.2 percent of sales. The decline in operating margin was due primarily to the acquisitions whose sales do not yet contribute to profitability.

EPC repositioning activities continue. During the first quarter of 2003, we closed our Monticello operation. And during the second quarter we completed the transfer of production from our Athens facility. We also announced that our Ripley operation will close this month. In combination with a 10 percent reduction in salaried workforce in 2002, and the consolidation of logistics operations, these actions generated $19 million in savings in 2002 and are expected to generate more than 25 million in 2003 and beyond.

While we suffered a brief delay due to the SARS situation, transition of motor manufacturing to China continues. Our Shenzhen facility is producing a significant volume of C frame motors. We're in the final stages of customer approval for pump and fan motors at both Shenzhen and our motor operations in Changzhou. We're also continuing our evaluation and expect to expand our Chinese manufacturing capabilities to include hermetic motors.

As I mentioned HVAC sales, excluding the sales of the Athens Products acquisition, declined in the quarter consistent with industry trends. Total air-conditioning inventory of 1.7 million units at the end of May was 8 percent higher than last year. Year-to-date, distributors sales are down 10 percent while OEM sales have declined 4. Water Systems second quarter sales of $190 million were 23 million higher than in the second quarter of last year. The higher sales were driven by the price increase introduced earlier in the year to offset higher steel costs, expanded sales of residential gas water heaters in anticipation of the new flammable vapor resistant product, and a more than 40 percent increase in sales at our Chinese operation. Commercial sales declined less than 5 percent reflecting the soft commercial construction market.

Operating profit of 17.8 million was 7 percent higher than last year. The slower growth in operating income compared to sales is the result of higher steel costs and the adverse product mix.

Manufacturing of the flammable vapor resistant product has begun through all gas units in the 30, 40 and 50 gallon capacity as mandated by American national and Canadian standards associations. Any inventory of existing preregulation product, regardless of its location in the channel, will continue to be salable until all inventories are liquidated. In the second quarter, customers purchased approximately one month extra volume of 30, 40 and 50 gallon gas water heaters.

Unit volume in Electric Product was depressed during the quarter and so replenishment of that product should mitigate the expected softness in the residential gas market during the first half of the third quarter. Sales of the flammable vapor product should positively impacted both sales and margin later in the third quarter and all in the fourth quarter.

In connection with the introduction of the new flammable vapor resistant product, we have launched a program to standardize and customize the Water Systems product line. This program will benefit our business in two ways. First, standardizing the basic design will allow us to build product in plants closest to their end market, maximizing logistics and shipping efficiencies.

Secondly, these products, while having a standard chassis, will allow for customized configuration further along in the assembly process. This standardize in customized program allows us to streamline our manufacturing operation while enhancing customer service, and maintains the most up-to-date products for all brands.

The Company recently announced plans to consolidate the North American manufacturer of residential water heaters at its to Ashland City, Tennessee and Juarez, Mexico facilities. The initiative which will involve transferring residential production from the McBee South Carolina plant will be complete by the first quarter of 2004. At the same time, we're consolidating most of our commercial manufacturing in our McBee facility, which involves the transfer of production from Ashland City, Tennessee and the El Paso, Texas boiler plant.

As Bob mentioned at the beginning of this call, our cost structure has improved significantly over the last 18 months. And this morning we projected third quarter earnings of 42 cents to 46 cents and reaffirmed our full year 2003 earnings estimate of between $2.10 and $2.25 per share. Significant operating improvements will begin to materialize in the third quarter and accelerate in the fourth quarter. These improvements include completing the motor repositioning program with the closure of the Athens and the Ripley plants, ramping up the Chinese operations, and the integration of the State Industries' acquisition. In addition to these operating improvements, the introduction of new flammable vapor resistant water heaters beginning this quarter should generate additional sales and earnings during the second half. From this point forward our comparable year-over-year share base will include the last year's 5 million shares stock offerings. And we will no longer need to overcome the dilutive impact of the additional shares. As a consequence of all these items, earnings per share comparisons are expected to improve significantly in the third quarter with even further improvement in the fourth quarter.

In conclusion, our cost saving and new product initiatives are on track. And we are financially well positioned to take advantage of growth opportunities as they materialize. We look forward to reporting on our continued progress again next quarter.

That completes our opening remarks and we are now ready for your questions. As a reminder, please limit your inquiries to one or two questions at a time so that everyone interested has an opportunity to participate. Operator?

(CALLER INSTRUCTIONS) Michael Schneider with Robert W. Baird & Company.

Just focusing on the motor business first, the savings estimate of 25 million this year, that is up from 16 million. Did that include originally Ripley, or have you not yet reflected or changed your guidance on the savings to include Ripley?

Hi, Mike. Actually the number was 19 million last year. We originally targeted 16. We hit 19. Included in that forecast of a little more than 25 million for this year and beyond is the Ripley operation, or the transition out of the Ripley operation.

How much in expenses related to those moves is buried in the third quarter guidance? I presume it will be run through for severance and stuff?

Actually, for the Ripley operation, again, that was part of that restructuring program back in the fourth quarter of 2001, so much of the expense was carried back there. There will be some expense in the third quarter, not related to the motors operations, but due to those transitions we talked about in the water heater operations. It is included in the guidance and it is all told for the year probably less than $1 million from a P&L perspective.

The reason I asked the cost questions is just trying to get a handle on your expectations for motor margins in the second half. Clearly inventories have somewhat suffered from the cool weather here. Do you intend to take production off-line during the third quarter to drawdown some of the motor inventories?

Yes. As I mentioned earlier, obviously our inventories are not in the position we want them and that was a driver behind the cash flow which we need to get moved up. And part of that is going to be in inventory reduction at Electrical Products. That's when to put pressure on the schedules. It is going to put pressure on absorption of the fixed costs. So that will have an impact on the margins.

Do you expect margin in the second half of the motor business to be comparable to or above last year's operating margins? Basically in the second half you did 6 7, 6 8 in the motor business.

I would expect -- hang on one second, Mike -- Yes, they're going to be comparable. We're going to have the positive impact, obviously, from getting rid of the fixed costs of the plants we talked about earlier. That is going to, however, be offset by the fact that we are trying to bring inventory significantly. We've got the July plant shutdowns and we have got, as always, relatively low volumes in the fourth quarter. So you will have upward momentum on an ongoing basis from the fixed cost reductions, but during the second half of the year we are going to have lower production levels, and that is going to put downward pressure on the margins.

Scott Graham with Bear Stearns.

I have several questions. I think you said, Ken, you're looking for 80 to $90 million in operating cash flow in 2003. That is a big number versus the year-to-date minus 6. And while I certainly understand where you are coming from in inventory, a lower run rate production level in the second half of the year, obviously a big piece of that is going to have to come out of accounts receivable as well. At the same time, you're expecting a fair amount of offset in the early part of the third quarter from the purchases of electric water heaters and then a pickup in the higher priced piece for the rest of the second half of the year. Give us an idea of what piece of that 80 to 90 ultimately which implies of that 100 million in the second half of the year will be inventory, and what piece will be AR, if you could?

Sure. Again, anticipation will just be from the seasonality of sales that our AR would fall by 20 to 25 million relative to where we are right now. And that has just about everything to do with just the seasonality of sales, Scott. The inventory we would expect would be reduced in the range of about $15 million. So those two elements, coupled with the earnings we are going to have in the second half of the year, are really what drive the cash flow.

That is about call it $40 million at the midpoints in the second half of the year. And as I look back at your history you have never done that before. And just wondering if maybe the 80 to 90 might be a bit aggressive or do you have specific programs, specific SKUs targeted to get there on the inventory side?

Yes, Scott, there are specific programs in place. The other piece of that is, you're right, historically we haven't had that big of a mismatch between the first and the second half. But we have also never had quite a tough a first half. We've had some relatively unique situations here with the ramp up in sales right towards the end of the second half here with the gas water heaters and with the need to put inventory in place to cover some pretty significant production transitions. Obviously we're not proud of that number we put up in the first half of the year, but that also is somewhat of an historical aberration and that should also reversed itself as we move toward the end of year.

Just two other questions. Could you give us an idea of -- you've got a lot of production moves behind you. It looks like things in front of you. You have got a couple of closings. Really two things, number one, is there anything in the couple of facility closings that are going to take place in the second half of the year that gives you any type of pause. Number two, how is warrant expense running?

You always have a little bit of a pause when you go through the magnitude of movement of the production that we have. However, and you know our story very well Scott, we have been transitioning production from the U.S. to Mexico for the better part of almost 20 years now and had become quite skilled at it. So what you worry about is making sure that you maintain customer service, and we have been able to do that. I think we are far enough along in all of the items that we have -- there's always risk, but we're feeling pretty good that we have planned and managed around most of it.

Still ongoing, obviously, even after those plant movements is our buildup and our capability of producing our product in China. That is all going very well. We had a little bit of a delay there because it was difficult to transit people back and forth. But the startup of those plants thus far is pretty well on schedule, given that we had a four to six week chink in our schedule there because of the SARS situation.

And warranty is not the worse for any of this?

No. I have not noted any significant change in our warranty class.

Last question. On the HVAC side, have you detected any -- I know that channel inventories were running down for a long time and they kind of finally hit the bottom it seemed at the end of last year, early this year. Did you detect any excessive channel inventory build only to be met by the poor weather? Is that a potential problem or are you okay with where you see the channels?

As we look at the inventories at the end of May, they look like they are okay. They're not way out of whack. If you notice, production was actually down in both April and May. So I think our customers are trying to make sure inventory doesn't get out of whack. So we're not really expecting any abnormal reduction of inventory across the back half of the year.

(CALLER INSTRUCTIONS) Michael Schneider with Robert W. Baird.

Could you give me a sense of how the ramp in flammable vapor production went? I guess when you actually ceased production of the old line -- when you commenced production of the new line, any disruptions you had or difficulties you had?

We started a rolling change during June just to get started with it. As of July 1st all manufacturing of gas in those models has to be the new. And you know, we are almost at the pace that we have set for ourselves. There is a little bit nits and gnats there, but we're not looking at any significant problems at all, Mike.

To date you have not standardized the standard chassis for these things? Oh, sure. You have?

Oh, yes, absolutely. The new 30, 40, 50 gallon are the same sizes for both State and for Smith. If you remember, you know we had a half-inch difference in the diameters of the product, which meant to the height of the products were different, the tooling was different. But the new product, the 30, 40, 50 flammable vapor is all the same diameter and height, etc.

The costs of that transition during the quarter, have you been able to pinpoint what it actually cost tangibly and intangibly?

No, no we really haven't, Michael.

But presumably there were disruptions during the month of June?

Some, but quite frankly, it is a move that we have been doing -- we have been planning it for some time. We've been making some adjustments to the assembly line as we have been going to make space for this. We have been changing some other processes right along with it to give it the ability to do it. So I think our guys have done a good job of both planning and execution on it. So it is not a dramatic thing. It is not something of significant impact here.

Can you update us on your thoughts on pricing of the new standard models?

The pricing, Mike, as we talked about, the list price of it has basically gone up $60. It is still too early to see how it all shakes out. Right at this point in time, you know, it looks like the marketplace is accepting it. This is one of the most significant changes in a gas water heater in 20 or 30 years. And so right now we're expecting that it is going to go through.

So that is $60 on a rough base of $160?

No, Mike, that is not the list price. Like all industries there is a suggested list price and then there is all kinds of discounts that kind of come off of that. So it is in line, Mike, with the expectations about we have been telling you all along.

Switching gears, just some numbers. Can the capex forecast for '04, now that you've got all these moves either completed or to be completed in '03, what is the number in '04?

Obviously, it is too early to nail down a number, Mike. But as we said before, the majority of our capital spending is maintenance capital. We have not had a significant amount of bricks and mortar, very little to do this transition. I'm not expecting a big change one way or the other as we go forward here.

Along those lines of '04, I know it is early, but the savings estimate for this year, 25 million, doesn't reflect a full rate of savings for the closings that have gone on midyear and presumably in the second half. Do you have a number ballpark of what that run rate annualized in '04 means?

You know I really don't. I just haven't done the arithmetic. But you're right, obviously because we got absence (ph) closing here and Ripley more or less at the midpoint, because Monticello's only going to have three quarters of a year, we would expect some acceleration from the 25 million next year. But I have not done the arithmetic to figure out what that number might be.

The tax rate benefited from the R&D ruling what does that mean for '04 tax rate, anything?

It doesn't mean anything for '04's tax rate. As we have said before, we continue to put efforts in place to plan a more efficient international tax structure to make sure that we're doing all compliance efforts we can to minimize the tax rates. We have been successful in getting the tax rate down by about a half a point a year for the last couple of years. And I would anticipate we would be able to continue that effort.

Scott Graham with Bear Stearns.

This is like tag team. I will go a little easier than Michael did. The second half of the year talk about if you would, how you foresee the water heater sales rolling in? You talked about the channel fill need early in the quarter on electric, but I'm wondering with the new energy efficiency changes coming in six months from now, how do you see that playing out? Is that something that can potentially hurt the flammable vapor resistant?

No. Scott, let me give you an insight. The third quarter is somewhat confusing because to the best of our knowledge there is probably a month prebuy of the old-style of flammable vapor. So in a way the third quarter at best -- and we will see maybe two months of flammable vapor on average. And who knows whether we are accurate on the -- whether it is one month prebuy or 1.5. That will just sort itself out.

From the channels?

From the channels. Because they can continue to sell the old-style until they run out of inventory. So fourth quarter should be should be a normalized fourth quarter and have the full impact of flammable vapor. Now, you are correct that there is new energy efficiency going in of January of '04 that will cause some prebuy in the fourth quarter. If you recall, we had a prebuy in the fourth quarter of '02 because of the price increase for steel. So, and it is not uncommon for us to have some prebuy in the fourth quarter. So we're anticipating that we will have some prebuy in the fourth quarter. It will cover both products, both electric and gas. It doesn't have any negative impacts on flammable vapor. It will probably be somewhat along the lines of what last year's was. And we kind of have all of that, as best we can identify it, baked into our estimates for the year.

So it is a little murkier than normal in the third quarter just because of all these product changes and what is really sitting there distributor's hands and how it will flow through. But the fourth quarter ought to get relatively normalized.

If you would, Bob, and/or Ken, talk if you would about the -- you've got a range of guidance out there which is suggested at least the high-end of some fairly extraordinary things occurring in the fourth quarter. Could you tell us how you get to the high-end of the range?

Well, as you said, Scott, it is a pretty narrow range given the magnitude of the numbers. I think the higher end of the range occurs if we get stability, maybe a little bit of an up tick in the commercial markets. It is more volume driven than it is anything else.

The real underlying fundamental power of that fourth quarter is primarily cost driven. As you know, we will have all of our U.S. plants activities pretty much culminated. We always have ramped continues activity in transitioning production to Mexico and China. But we will pick up certainly the fixed cost as I said before from those three plans we talked about earlier.

We'll have a full quarter of the flammable vapor introduction, as well as potentially a little bit of prebuy on ANECA (ph). So all of those add up to some pretty powerful cost reductions in full bloom in the fourth quarter.

I think just to summarize what Ken said, I think maybe a little better market than what we're anticipating would drive the top number, just a little more prebuy, if the commercial market stabilized and maybe come back a little bit. You know, there's been a lot of talk with all the rain in the northeast construction is way behind in the Northeast and some of that will come back. Well, maybe it will, maybe it won't. We have been around long enough to see that there's always a lot of excuses why things don't happen. So I would say the biggest swing for the top line is probably a little bit of volume.

(CALLER INSTRUCTIONS). There are no further questions, sir. Please continue.

Okay. Well, once again, thank you for joining us. We feel that in the second quarter we really accomplished a lot of the activities that are a part of our long-term strategic program. We've gotten through the introduction of brand new product in the water heater business, which is very significant. We continued on the execution of our plans of moving production to Mexico and some of it ultimately to China. We have announced the rationalization of our residential and commercial production in the water heater business. So all in all, we think it was a very good quarter despite some softness in some of our marketplaces.

Thank you once again for joining us. And we look forward to this conversation at the end of next quarter. Thank you.

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