A O Smith Corp (AOS) 2003 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the third-quarter earnings release conference call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will be given at that time. If you should require assistance during today's call, please press [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, 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 Ken Krueger, Chief Financial Officer, and John Kita, Treasurer and Controller. Before we begin with Ken's remarks, I'd like to remind you that some of the comments that will be made during this conference call - including the 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 described in this morning's press release. I'd also like to point out that this conference call is accompanied by slides on our website so please feel free to follow along while we conduct the call. Ken.

Third-quarter earnings were 20 cents per share or approximately $6 million, compared with 34 cents per share or $10 million earnings in last year's third quarter. Third-quarter sales were $356 million compared to a $352 million last year [indiscernible] comparisons last year later under business unit performance. From a forecast perspective, on September 24th, we announced an expected [indiscernible] in pretax earnings of approximately $11 million dollars compared with our prior forecast of approximately 20 million. This cost is related to timing disruptions caused by significant transitions in both businesses. These transitions included the repositioning of electric motors manufacturing to Mexico and China and the launch of [indiscernible] water heaters.

Due to the the lower third-quarter results as well as fourth-quarter inventory reduction initiatives in the motors business, we lowered the full year outlook for 2003 to a range of between $1.75 and $1.80 per share.

We are disappointed in this earnings reduction but expect to be back on track as we move forward. In the fourth quarter we believe our water heater business will be generating double-digit operating margins and though our motors business we'll experience some fixed cost [indiscernible] issues in the fourth quarter, we expect to see significant cost advantages in 2004.

As a result of the efforts to reposition manufacturing, we believe the motors business should generate incremental pretax earnings of at least $15 million in 2004. In water systems, the introduction of new regulations [indiscernible] as well as product standardization efforts and plant rationalization programs are expected to generate in excess of $20 million pretax.

Accordingly, we are projecting 2004 earnings to range between $2.40 and $2.60 per share compared with this year's estimate of $1.75 to $1.80.

Now I'd like to go through a more detailed review of the third quarter.

Third-quarter pretax earnings were approximately $11 million lower than our forecast at the end of the second quarter. As you'll recall in anticipation of the launch of the flammable vapor resistant products in the third quarter, customers purchased significant quantities of residential gas water heaters in the second quarter. The resulting sales reduction in the third quarter coupled with the disruption in manufacturing schedules caused by the (indiscernible) activity and the launch of the new product negatively impacted forecast in profit by approximately $6.5 million in the third quarter.

We believe this disruption has run its course and expect performance in the water heater business to be back on track in the fourth quarter.

In the electric motor business, profits fell about $4.5 million below forecast due to a combination of reasons. Sales volumes were below expectations, generating operating profit that was $3 million less than was forecasted. Previously announced efforts to reposition U.S. production to lower cost Mexican facilities were largely completed, although somewhat later in the quarter than we had forecasted.

As a result, savings from this transition came later than anticipated, generating a profit (indiscernible) of $1.5 million in the quarter. Manufacturing costs were higher than expected during the final stages of this transition, also negatively impacting third-quarter profitability by approximately $2.5 million.

As you may recall from last quarter, motor inventory levels have grown in order to assure customer delivery during this shift in production. Inventories are also higher due to manufacturing schedules that anticipated higher sales levels. Motor inventory levels increased during the quarter, causing an improvement in fixed cost absorption of approximately $2.5 million. As we reduced production and to rebalance inventory in the fourth quarter we will underabsorb fixed costs. This underabsorption will adversely affect fourth-quarter operating profits.

Operating cash flow for the first nine months of the year was $26 million. During the third quarter, the Company generated 32 million in operating cash flow. Cash flows typically waited until the second half of the year due to the seasonality of motor sales to the ACAC (ph) pump markets in the first half of the year, which tends to build up receivables at June 30th.

In addition to the seasonality, two other factors had pronounced impacts causing increases in receivables and inventory. 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 heaters on July 1st caused pressure on both receivables and inventories at water systems at the end of the second quarter.

During the third quarter, receivables declined $47 million while inventories increased $16 million.

For the full year, we are projecting operating cash flow of approximately $60 to $70 million as working capital returns to normalized levels coupled with specific efforts to reduce motor inventory.

Year-to-date, capital spending is $28 million compared to a depreciation of 39 million. For the full year, we are projecting capital spending of approximately 40 million to 45 million and depreciation of about $50 million.

As a result of the positive cash flow at third quarter, our debt to capital ratio declined to 33 percent from 34 percent at the end of June.

Now I'd like to move onto the discussion of the operating performance in our electrical products and water systems businesses compared to last year.

Sales of $201 million in our electrical products business were slightly higher compared with last year's third-quarter. Sales from last year's China acquisition and increased sales of air conditioning motors and motors sold through the distribution channel offset lower sales of motors for pumped, subfractional and general industry applications.

Operating profit electrical products declined to 9.6 million from 10.3 million last year. Third-quarter EBIT margin was 4.8 percent of sales. The decline in operating margin was due to the repositioning disruptions as well as last year's acquisitions whose sales do not yet contribute to profitability.

Though we are disappointed with the earnings [indiscernible] related to the repositioning activities of our electrical products we also believe we have achieved significant results, considering the number of simultaneous relocation activities. During 2003, three facilities were closed. Monticello, Indiana, Athens, Tennessee, and Ripley (ph), Tennessee.

Additionally we have moved significant amounts of production from four other U.S. facilities. In China, we are producing 25,000 motors a day at our Changheng (ph) facility and have begun to qualify [indiscernible] manufacturer in our newly acquired facilities outside Shanghai.

On a related note, we're happy to announce pending acquisition of Jiacheng (ph) Special Motor Co. Ltd. We have a letter of intent to place and expect to close this transaction in the next several weeks. This addition expands our manufacturing capabilities in China by adding hermetic motor manufacturing capacity.

Water systems' third-quarter sales of 155 million were flat compared with third-quarter of last year. Higher sales driven by the price increase introduced earlier in the year to offset higher steel costs as well as higher prices for flammable vapor product and the more than 40 percent increase in sales of our Chinese operation offset lower unit sales of both residential and commercial water heaters.

Operating profit of $7.98 million was $5.5 million lower than last year due to the disruptions related to the flammable vapor resistant product launch discussed earlier.

The wholesaler inventory levels related to the flammable vapor resistant private pre-buy have been [indiscernible] production and deliveries will return to normal in the fourth-quarter. Right now the flammable vapor resistant product line consists of all gas units in the 30, 40 and 50 gallon capacities. In 2004, the balance of the residential gas product line will be subject to the mandate.

NECA (ph), the National Appliance and Energy Conservation Act will require an efficiency improvement of 4 percentage points for electric water heaters and 5 percentage points for gas water heaters beginning in January 2004.

(indiscernible) Of the new products, we have launched a program to standardize and customize the water systems product line. This program will benefit our business in three ways.

First, standardizing the basic design will allow us to build product and plants closest to their end market maximizing the statistics and shipping efficiencies. Secondly, these products while having a standard chassis will allow for customized configuration further along the assembly process, minimizing the cost of product variation. And third this standardized and customized program allows us to streamline our manufacturing operation while enhancing customer service.

In connection with product standardization, we recently announced plans to consolidate the North American manufacturer of residential water heaters in our Ashland City (ph) , Tennessee and Juarez (ph), Mexico facilities. The initiative which will [indiscernible] residential production from the [indiscernible], South Carolina plant will be complete by the first quarter in 2004. At the same time we're consolidating most of our commercial manufacturing in our [indiscernible] facility which involves the transfer production from Ashland City, Tennessee, and El Paso, Texas. We expect the product standardization and plant rationalization programs to generate approximately $5 million in incremental savings in 2004.

Now I'd like to talk about the outlook. As I said earlier we're committed to inventory reduction in our motors business which will cause underabsorption of fixed cost and margin compression (ph) in the fourth-quarter. On the other hand, we expect strong margin performance in the water heater business. That's a cost and disruption to new product launch that are now behind us.

In summary, we expect full year earnings of between $1.75 and $1.80 per share. As we look ahead to 2004, we have a strong base for performance. The year 2003 has been one of both challenge and accomplishment. During the year, we have transferred half of our domestic motor manufacturing operations to lower cost facilities in Mexico and China.

In the water heater business, we've undergone the most significant product line transformation in our history. These transformations will be largely behind us by year end and we expect to be on track with our long-term strategic direction. Accordingly, we expect financial performance in 2004 to be in-line with our strategic plan in a range of $2.40 to $2.60 per share. This profit improvement will be driven largely by the efforts completed in 2003. In the motors business, we expect that a full year's impact of the transition to Mexico as well as the ramp up in China will generate pretax earnings of $15 million.

In the water heater business a full year's sale of flammable vapor resistant products as well as the introduction of NECA compliant product will generate $15 million pretax. The focusing of commercial water heater production in our [indiscernible] South Carolina plant [indiscernible] Ashland City, Tennessee is expected to provide $5 million in pretax impact.

These three items will generate a collective $35 million pretax improvement and service the underlying drivers for the projection of $2.40 to $2.60 per share earnings in 2004.

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 the opportunity to participate. Operator.

[Operator Instructions] Michael Schneider with Robert W. Baird.

First question - just on water heaters, could you give us an update on what the run rate and unit items are now that the flammable vapor presumably (ph) having passed and fully in place?

[indiscernible] on the residential -- I've got information on residential units which is about 120,000 a month. Now remember roughly a little more than half of those are gas and about two-thirds of the gas are flammable vapor resistant product.

So you are running at a full run rate, comparable, say, to what you did back in the first quarter in units?

We will be in the fourth-quarter. Yes.

But even exiting this quarter were you -- in September?

I honestly don't know the [indiscernible] unit count of September and I think basically as we enter the fourth-quarter we expect things to be pretty much on track with the history and the market both in terms of the unit sales as well as the mix of product on the residential side.

Your expectations for the NECA standard. Do you have any indications now as we proceed through the fourth-quarter that the prebuy, that there may be a prebuy as well this fourth quarter in the magnitude of that prebuy?

Yes there has been some efforts outline to sort of control any sort of prebuy activity and right now what we're estimating is the prebuy related to the NECA compliance at the end of the fourth-quarter here will approximate the prebuys we had last year in anticipation of the steel price increase.

You care to quantify that?

I think last year was about five percent of the residential sales went to prebuy.

And just a final question on pricing and water heaters and I know you guys are doing surveys and just checking data points with some of the different retailers. Have you seen any evidence that pricing has come under pressure or seen any bids from any of the OEMs -- that pricing has come under pressure?

We've not seen any indication that the pricing especially on -- the steel prices pretty well held throughout the year and final vapor price seems to be holding.

Matt Somerville (ph) for McDonald Investments.

Couple of questions. Can you -- first -- is there any more detail you can provide around that acquisition in terms of the size and what you paid and those sort of details. As well could you also comment within the framework of guidance that you've laid out here, what have you factored in in terms of contribution from the pension plan next year?

First of all, the acquisition of Taicang, they are a manufacturer of hermetic motors serving the ACAC industry. As we said before, we do need to sort of begin to fill out our line of motor manufacturing capability in China and this fits very nicely with that. We've mentioned before that these are relatively modest acquisitions. I think this one will be in the $5 million range.

Then on the pension?

What has been factored in, what we've said before the pension credit has been, they're stepping down over the last several years as we advertise out that performance from '99 and 2000 on the investment side. This year, the pension credit will approximate about $12 million. What we've factored in for next year is about a $6 million credit.

Then, lastly, as far as looking at the third quarter, can you tell me what the quarter growth rate was in your motor business?

Essentially, it broke down to -- most of the increase came from that China acquisition that we had in late last year - that was up by about $4 million, which accounted for virtually all the sales increase.

Scott Graham with Bear Stearns.

Could you -- I want to piggyback off that last question. The motors. You're saying $4 million year-over-year incremental sales in the motors business from the China acquisition of a year ago and I'm wondering if you could tell us, after that, what was our residential and what was commercial down and what was pumps down?

I don't have a breakdown between residential and commercial but the total sales to the ACAC industry was up in the 5 percent kind of range. Our sales to the distribution channels were up about 6 percent and the offset to that was the pump business that was down about 5 percent. We also had general industry down around 10 percent.

Generally -- at about what.

10 percent.

Okay. Could you can walk us through production moves motors into China going forward, what other mix -- what happens in the fourth-quarter? What happens in 2004 to get to that $15 million number?

First of all, a big portion of that $15 million number is just earning the benefits through the full year of the transition to Mexico we just completed. For China, what we will be looking for as I mentioned earlier we do about 25,000 motors in Changheng right now. Those are the C frame motors. That will go up substantially - that will go more into the 35 to 40,000 units per day. We are right now qualifying product in the pump motor and the fan motor for our Changzhou, those plants -- those ones near Shanghai and then this acquisition we just did on the hermetic side, we will begin to quantify (ph) some motors and serve customers with hermetic motors out of China as we get into the mid to later part of 2004.

So if we were to say of the $15 million maybe a little more than half is Mexico and that's done a little less than half is China and that is still to come?

I would put that Mexican impact more in the two-thirds to 75 percent range of that 15 million. China will really be in ramp up phase in 2004.

And back to an earlier question about the prebuy. This is a market, right now, that appears to be in something of a state of flux, given some pretty significant price increases in an important part of the category, overall, with more price increases coming. Understanding, of course, that these are 80 percent replacement-oriented products and essentially need to be bought, I guess I'm wondering why we would want to - within our fourth-quarter assumptions - assume any prebuy given not that there won't be one but how difficult it is to gauge what the profit impact from these price increases will be in a market that clearly does not seem to be taking them well?

I wouldn't necessarily disagree with characterization of being in a state of flux in the third-quarter. Clearly as we were talking about a very significant transition in the residential gas water heaters, the prebuy activities in second quarter and trying to gauge what impact that would have in the third-quarter. There was some disruption as we noted in the third [indiscernible] [technical difficulty] the inventories as the wholesalers seem to be in sort of the relatively historic proportion. I think we're looking forward to a more stable pattern of demand in the fourth-quarter. The question to the prebuy, we simply looked at last year where we had a 6 to 7 percent price increase related to steel and tried to estimate -- took a look at what impact that had on our total sales and simply projected that to the entire residential line because NECA does impact the entire residential line and just formed a judgment that since there was similar size of price increases there would be a similar impact on the prebuy.

And so we discounted this 5 percent increment into the fourth-quarter guidance, based on that?

(inaudible) percent that occurred in 2002 [indiscernible] price (indiscernible) increase.

I'm not [indiscernible], Scott, on your question.

I think you indicated, Ken, that you were looking in terms of how you were looking at the fourth-quarter that the prebuy had a 5 percent impact on residential business last year, therefore, we're going to get we are going to estimate that that will have -- this will have the same impact this year.

Yes, that is correct.

So it's really not necessarily data that you're seeing order rate you're seeing come across your desk right now that suggests that the prebuy will be that amount, you're just assuming that it is going to accelerate let's say, come December 1st kind of thing?

That is correct.

Okay. I guess the last question will be on the inventory side. Do you have a better handle, Ken, where you think inventories will come out at the end of the year?

We are targeting and we have reduced the line rates in our motors business to bring the inventory down to about $15 million. I would expect, potentially, a reduction in the range of $2 to $3 million on the water systems side so it's that kind of reduction we're looking for in the fourth-quarter.

$15 million from current levels?

Correct.

And would that possibly leave you still a little high, heading into next year?

That will leave us a little high. We're still working on bringing the Mexican [indiscernible] off the learning curve making them fully effective and efficient and we will need a little time to iron all the wrinkles out of all the production we shifted down there in the last three months and in the last year. So I expect that the inventory reduction will continue into the first quarter -- first half of next year.

Will that make earnings in 2004 back half loaded?

I really don't have a good view as to the balance of earnings next year. As we -- I would prefer not to comment, because I've really not looked into the details of that yet.

Michael Schneider with Robert W. Baird.

I am just trying to understand the motors impact this quarter. You mentioned $3 million lower -- $3 million of pretax impact due to lower than expected volumes, yet the motors revenue was essentially flat. And just if you follow my math, quickly, I must be missing something because $3 million of pretax impact and an average margin of 8 percent implies about $40 million in revenue. And I just -- I find it difficult to believe you guys were planning on $40 million of additional motor revenue this quarter. So I guess the question is, how do you come to the $3 million pretax impact due to lower than expected volumes?

Mike, you really have to look at the contribution rate, you are taking it all the way down to the bottom line but a lot of those costs are fixed down below. So you have to look at the contribution rate of say 25 to 30 percent which says volumes will be down kind of $10 to $50 million.

So, you're expecting growth -- you're presumably expecting a decline in pumps in general industry and that was probably the surprise this quarter?

We were forecasting our expected sales to be as John said, $10 to $10 million higher than they turned out.

Okay and on the pump side and the general industries markets, were there any particular distributors or OEMs that you lost or did not bid on?

No, there really wasn't any activity on that front. It was just a lower demand from some key customers.

And then similarly, Ken, you mentioned there is a $2.5 -million shift (ph) in higher manufacturing costs in the quarter related to these moves and these are distinct from the delay in closings. These are actually presumably manufacturing efficiencies that you experienced?

That is correct. We had forecast some cost for the transition - it turned out not to be a big enough forecast. Basically we had disruptions at both the [indiscernible] plants as they were going through the final transitions to a shift in manufacturer and, obviously, not having a high-efficiency level there as well as the ramp up in the learning curve in Mexico. The combination of those two things cost us about $2.5 million more than what we were anticipating.

The cost themselves - did they relate primarily to overtime so you could keep production at the rate it needed to be?

It was overtime but more of it was just having duplicate work forces. We had -- we didn't get everybody out on exactly the same ramp as we anticipated.

Where would you describe you are today in those duplicate work forces?

Clearly on the ascending side. We are -- we closed those plants and the workforces are gone. On the Mexican side, there is a learning scale that they're still coming up. We are not going to be [indiscernible] the efficiency rates we want to be until early next year. Whether that's the first or second quarter, I don't know.

Okay and then in '04 in the motors business, what type of topline growth have you assumed just roughly? I presume it is low single digits?

Yeah, if you called it about 5 percent you wouldn't be far off.

And then margins to hit the type guidance you are talking about, presumably you're talking 7.5 -- maybe 8 percent operating margins for that business?

Yes. It will be in that range.

Okay. And then, finally, just on the cash flow statement, you had a $3.1 million outflow related to acquisitions. Was that some type of prepayment for the China acquisition?

No, actually that was a clean up from the acquisition we did late last year that we talked about in our annual report. Those payments would be made in 2003.

Some type of balance sheet adjustment?

Balance sheet adjustment and then there was buildings etc. that we were getting liens [indiscernible], etc.

[Operator Instructions]. Roman Janovak (ph) from MFS.

Have a question - follow-up on the inventory. I think you mentioned that the inventory went by $16, $17 million from the last quarter. I was wondering if you could give the breakdown of what that number consists of?

Yes I was recall the $16 million increase was fairly evenly split between the two business units. Motors side [indiscernible] due to the disruption. We had to keep those inventories in place to serve the customers and we simply didn't get the plants shut down as quickly as we thought, so we didn't get the inventory out as quickly as we had anticipated. The water heater set -- there is really two factors going on there. One is [indiscernible] ramp up in inventory because of the flammable vapor launch and [indiscernible] higher cost now so the entire residential gas water heating inventory came up in value. And those were the two things driving increase in inventory on the water heater side.

There are no further questions at this time. Please continue.

If there are no further questions, we'd just like to say we are not happy about our financial results in the third-quarter but we are confident that the programs in place will significantly enhance our operating margins in the long run. We look forward to updating you again next quarter.

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.