A O Smith Corp (AOS) 2005 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the A.O. Smith first quarter earnings teleconference. (OPERATOR INSTRUCTIONS). As a reminder, this teleconference is being recorded. I would now like to turn the teleconference over to the Director of Investor Relations, Mr. Craig Watson. Please go ahead, sir.

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; Paul Jones, President and Chief Operating Officer; Ken Krueger, Chief Financial Officer; and John Kita, Treasurer and Controller.

Before we begin with Bob's remarks, I would like 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. I would also like to point out that we have a slide presentation on our website, so feel free to follow along while we conduct the call. Bob.

Thank you, Craig. Good morning, ladies and gentlemen. Before Paul and Ken get into more detail regarding the first quarter results, I would like to make just a few general comments.

I'm pleased with the progress we're making in establishing prices to offset the cost increases that we received last year. The progress is evident in this morning's report. Gross margins improved in both businesses relative to the last quarter of 2004.

Throughout the year we announced a series of pricing initiatives, and with the first quarter implementations feel confident we have restored the proper relationship between pricing and material cost, and that the new pricing levels have begun to restore gross margins to their historical levels.

Early in the first quarter, though, new prices reflecting the higher raw material costs were not uniformly implemented across the industry, and have therefore given rise to some of the noise that we are seeing in softer first quarter unit volumes. We're confident that business activity will improve as we progress through the year.

There have been a lot of moving parts in the first quarter, such as customer negotiations, prebuys and inventory liquidations. Because of all this noise, I think we'll see stronger business levels through the remainder of the year. With that, I would like to turn the microphone over to Paul.

Good morning, ladies and gentlemen. This morning we announced first quarter earnings of $14.3 million, compared with $10.8 million in last year's first quarter. Earnings per share increased 32% to $0.48 per share, compared with $0.36 earned last year. The impact of improved pricing at both businesses, and operating performance in our Water Systems business, more than offset the effect of lower sales volumes.

First quarter sales were $409 million, compared with $417 million in the first quarter. Price increases were effectively implemented in both businesses to offset the impact of higher steel, freight and other material costs.

These price increases have largely brought our gross margins back to historical levels. Lower unit volumes more than offset the pricing impact, resulting in a net 2% decline in sales.

We also issued a forecast for 2005 of earnings of between $1.45 and $1.65 per share, which includes an after-tax charge of $10.5 million or 37 cents per share for restructuring at Electrical Products. Excluding the restructuring expense, our forecast is $1.80 to $2 per share compared with $1.18 last year.

This restructuring involves the closure of our manufacturing facility in Ireland and the acceleration of additional repositioning activities in the motor business.

Notwithstanding a soft start at motors, we are generally pleased with our performance during the quarter. Pricing has improved in both of our operations, and the operating disruptions of water products are now firmly behind us, as is evidenced by a (technical difficulty) operating margin of 10.3%.

Having said that, volumes were down in the motor business as a result of fourth quarter prebuys, last year's loss of a contract by one of our large OEM customers, and softer customer demand.

Ken will now expand on this morning's earnings announcement. Ken.

Net earnings for the first quarter were $14.3 million, compared with 10.8 million last year. Pretax earnings increased $5 million as a result of a $12 million increase in operating earnings at Water Systems, offset by a $5 million decline at motors and a $2 million increase in corporate expense.

Earnings per share increased to $0.48 per share compared with $0.36 last year.

First quarter sales were $409 million, compared with 417 million in the first quarter of last year.

Sales of 207 million Electrical Products were 7% lower than last year, while sales of 203 million at Water Systems improved 5%.

Our gross profit margin increased to 21.5% from 18.8 last year, as a result of the improved performance at Water Systems as well as price increases implemented in both businesses to address material and freight cost increases.

SG&A increased primarily because of higher selling and advertising costs in China, higher pension and corporate expenses. SG&A amounted to 15.3% of sales compared with 14.1 last year.

Cash flow from operations was $13 million in the quarter, representing a $24 million improvement over the first quarter of last year. The increase was the result of higher income and improved first quarter working capital management.

Capital spending was $7 million, compared with depreciation of 13 million. 2005 capital spending will approximate $55 million, about the same as depreciation. Capital spending was 48 million in 2004.

The incremental spending is related to the expansion of our Chinese water heater facility. As many of you know, this operation has been growing more than 30% annually, and is expected to exceed $70 million in sales in 2005. This expansion project, the first phase of which will be completed by the end of the first half of 2006, will more than double the capacity of our Nanjing manufacturing facility.

As a result of the favorable cash flow, our debt to capital ratio declined slightly to 31% during the quarter, compared with the year-end ratio of 32%.

Now I would like to talk about the operating performance in our Water Systems and Electrical Products businesses. First quarter sales of 203 million at Water Systems were 5% higher than the first quarter of last year. The sales increase resulted from improved pricing and higher unit sales at our Chinese operation.

Unit sales of residential and commercial water heaters were lower than in the first quarter of 2004. Some of the softer residential business was due to a fourth quarter prebuy related to the January 2005 price increase.

Water Systems' operating profit increased significantly in the first quarter to 20.8 million, compared with 8.8 million last year. The $12 million increase was driven by a significant improvement in operating efficiency, a more normalized relationship between product price and material cost, and a positive $3 million adjustment to the warranty reserve. The warranty reserve adjustment was due to a change in customer return policies, offset by steel cost increases.

Operating margin improved to 10.3% compared with 4.5% last year.

Sales of 207 million in Electrical Products were 8% lower than in the first quarter of 2004. The decline in sales resulted from fourth quarter prebuys in front of the January price increase, the loss of a significant contract by a major OEM customer late in the first quarter of last year, and softer customer demand, in some cases due to the higher prices.

Operating earnings declined to 12.5 million from 17.1 million last year, as the positive pricing impact was more than offset by increased steel and material costs and reduced unit volumes. Operating margin was 6% compared with 7.7 last year.

As Bob mentioned, we also announced our intention to close our motor operation in Bray, Ireland, which we expect to complete by the end of the second quarter.

Historically, this operation supplied large commercial hermetic motors to European air-conditioning and refrigeration customers. We have determined that it is no longer economical to supply this product from Ireland. Accordingly, will begin to serve this market from our other hermetic motor operations in China and North America.

We expect 2005 sales volume to be adversely affected by approximately $10 million, but we expect to recoup our lost sales in 2006.

As a result of the Bray closure, where -- we record an $8.5 million after-tax charge in the second quarter with no tax deduction available for the charge. The charge primarily coverers employee severance, lease costs, and relocation of machinery. The closure is expected to generate annual savings of more than $3 million.

In addition, we will take an after-tax charge of approximately $2 million for the acceleration of planned repositioning programs at other U.S. motor plants. Approximately $600,000 of the charge fell in the first corner, with 800,000 in the second quarter and remainder in the last half of the year. Annual after-tax improvement related to these actions is expected to be about $2.5 million.

This morning we issued a forecast for 2005 of earnings between $1.45 and $1.65 per share, which includes the after-tax charge of 10.5 million for restructuring at Electrical Products. Excluding the restructuring expense, our forecast is $1.80 to $2 per share compared with $1.18 last year.

The increase in earnings will be driven by improved operating performance at Water Systems and pricing levels that will help restore gross margins to their historic levels.

Offsetting these improvements is potential volume softness in our motor operation. Our '05 forecast does not include any fourth quarter prebuy of motors that may occur because of the January 2006 mandate to meet 13 SEER energy efficiency requirements.

As Bob mentioned at the outset, we're encouraged by our start in 2005 and believe we are the right track in both of our businesses. We look forward to reporting our continued progress throughout the year.

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

(OPERATOR INSTRUCTIONS). Mike Schneider, Robert Baird.

First, very nice quarter. It's great to see the pricing coming through. And on that topic can you give us a sense, on the water side, where we are in this pricing flowthrough, if we have seen the bulk of it already this quarter? Or what is left to really transpire during the second quarter?

I think as Bob alluded to in his comments, the pricing that didn't necessarily come in uniformly across the industry in the first quarter now is largely in.

Is largely in as of quarter end, and I presume then we would see an increase in margins in the second quarter as result?

It is going to be small. When I say didn't come in uniformly across the industry, I think we're probably one of the earlier people in the quarter to get the price increase implemented. So we'll have a little bit of tailwind, but not a lot in the second quarter.

Now that -- the fact that steel has basically come off now for roughly four to five months in a row, how does that play out in your new pricing terms with your suppliers and your customers?

Let me back up little bit, because not unlike all the other contract buyers, there really was an adjustment or a reestablishment of pricing on January 1. So what happened in the industry in the back half of last year, really wasn't -- didn't impact our costs that much. We had fundamentals -- the new pricing coming in on January 1.

As you alluded to, it is tied to indices. We have seen some very modest changes in those indices in the first quarter, so there might be a little bit of a downtick on the steel cost, but nothing of any magnitude at all.

Do you consider most of your steel costs on the -- or in the water heater business now to be passed through?

As a result -- as you know, the fundamental reason, what drove the pricing in the industry and for us was the recovery of those costs, and as I said earlier, the pricing is largely in by the end of the quarter. I guess the long answer to the short question is yes.

I guess what I'm asking is as we proceed through '05 now, do you consider almost steel as a pass-through cost plus and minus, such that revenue will be variable but the margins will show the commensurate impact as well?

I would say that is generally true. None of us can forecast whether there is going to be any dramatic increase or decrease in the cost. Obviously if it is sort of -- if there is a dramatic move in either direction, it would probably need to get reflected in pricing.

Okay. And then final question, can you just tell us what units did for both residential and commercial during the quarter?

They went down in both cases as we said before. As far as specifics, we're opting to not get into the specifics of either the magnitude of the price increase or the units, just because I think -- if anything, then probably too open in the discussion of the percentage of the price increase. We're going to, in order to protect ourselves a little bit competitively, we will talk about the direction, and the direction was down, but not the magnitude of the change this quarter.

Put a different way, if you blend the fourth quarter and first quarter as a 6-month period are your units still down?

Compared to --?

Say the prior 6-month period? I'm trying to smooth out the effect of the price increases and determine if your unit count adjusted for the prebuy, by combining fourth quarter and first quarter, are still down?

There was so much noise in the fourth and first quarter, because not everybody in the industry handled the volumes and the price cut the same way -- or price change the same way we did. And so there is just an awful lot of noise throughout this entire period.

I think by the time we get to the end of the quarter, the industry is going back to a more normal balance. And that was our comment relative to -- we expect to see higher volumes in the rest of the year. But there was just a tremendous amount of noise out there.

I will get back in line. Thanks guys.

Matt Summerville, McDonald Investments.

A couple of questions. First, with respect to Electrical Products, Ken, historically you provided a little bit more granularity in terms of -- and you might be opting the same thing in this business, volume trends in residential HVAC, commercial HVAC, pumps in general industrial.

First, are there specific numbers you can cite? And if not, can you at least give us a little bit more color directionally as residential down 5 to 10, or commercial down 10, or done double digits or something like that? Is there a way you can quantify that?

Yes, as I said part of our difficulty is we have been very descriptive on both the denomination of the price increase and the volumes. Being less descriptive is, I think, helpful to us right now, again, just from the competitive environment.

Having said that, we did say that the unit volumes were down in the first quarter. I won't give any specific magnitude. I will tell you that relative to each other, we probably did a little better than the average on the pump and distribution side.

And in conjunction with some of the activity, particularly the loss of OEM customer, we probably didn't do as well on the hermetic side.

Outside of that OEM loss that you were just referring to -- well, actually first of all, can you quantify that in the first quarter in terms of dollars, how much roll off you think you saw there? Because now we have fully anniversaried that, so we shouldn't see that again, and then how you feel your overall marketshare is holding up in the HVAC business?

First question first. We have said before that that was near the 25 to 30 million range, and obviously the first quarter is a heavy season for the hermetic industries. So it is probably more than 25% of that, to give you an idea.

And again, I do not want to comment on unit volumes beyond that.

What about marketshare? That is really more my question. If you exclude this OEM loss you had talked about on (ph) any number of occasions, how do you feel overall marketshares trending in your HVAC business?

This is Paul. As Bob has said, there is some noise and there is in discussions going on, and this is not something that we want to discuss right now.

Scott Graham, Bear Stearns.

I'm going to ask the easier one first. What happened in the corporate expense account that drove up that number so substantially?

First of all, good morning. Second of all, there was a lot of little things there. Probably the only things that even approached the kind of $0.5 million mark was the impact of the pension expense. The other is not unlike a lot of other companies. Because of the change in the accounting rules, we moved some of our compensation from options to restricted stock, which have an impact on the P&L. And that probably -- those are probably two of the bigger ones, but again neither one of those exceeded $0.5 million. The rest was just a lot of little things.

Here is the harder one I guess. Considering that price realizations are such a significant portion of the earnings delta in 2005, I guess I share my colleague's frustration that you have decided to kind of pull back on that information, just when we need it the most.

It is hard to make an investment decision for people that own the stock, that are on this call, without something more than what you have given. Perhaps in the next quarter or sometime in the interim, I guess I would ask for you to reconsider that because of the magnitude of the price as it relates to operating income this year.

I understand and I'd appreciate that. I guess some of the evidence that would support our assertion that we have largely got the price levels in place to be -- to offset the cost increases that we suffered is the operating margins, particularly in the Water Systems business.

I'm not precluding as we get into I'll call a more normalized situation, where there aren't consistent pricing activities, that we may not go back to specific discussion of unit volumes and percentages, and even talk about it in terms of the application served.

It is just that we are in environment right now when -- some of the pricing from a timing standpoint, and to a lesser degree a magnitude standpoint, did not go in uniformly across the industry. And is not to our advantage to talk in detail about specifics of the price increase.

I understand that and I appreciate your reconsideration of that in the future periods. Suffice to say then, Ken, that based on what you have said, it sounds to me like unit volumes were in fact down obviously in Electrical Products, but also in water heaters as well?

Yes.

Mike Schneider, Robert Baird.

After the events of the last 6 months in pricing, could you give us your updated thoughts on where you believe margins can go in each business? Because like Scott, I think most of the investors in this call are trying to figure out what the earnings power of this business is, based on unit growth.

What are your targets for each of the businesses, given that today's pricing? And does the variable pricing model related to raw materials impact that at all?

Thanks, Mike. And we have talked before to a number of the people on this call and others that our targets for both of these businesses are in that 12% EBIT margin range. Those are targets that represent performance levels we have had historically before we built up both of these platforms through acquisition. They represent things, as we look in the marketplace, that we believe are achievable.

We have also said that coming off of where we were at the fourth quarter of last year, that the rebalancing of our pricing with the cost levels would get us back in that 8% to 10% range for both businesses, and that there were further actions that we needed to take over time to get to the 12 level.

On the motor business, that comprised of continuing to take advantage of our established footprint in lower-cost arenas like Mexico and China, and a gradual transition from U.S. operations there. As we said this morning, we have accelerated some of that.

On the water heaters side, it was taking advantage of the standardization of the product so that we could serve customers from the nearest manufacturing location. It was taking advantage of the consolidation of our commercial production in our McBee plant, and it was our residential production in Ashland City.

All of that goes largely unchanged. We are tracking long-term. Our target, our goal is to have both of these businesses in that 12% EBIT margin kind of range.

Then drilling down on water, if you scrub (ph) of the $3 million warranty reversal, you basically did 8.5% operating margin in water this quarter. It sounds like with more normal volumes, based on moving beyond the prebuy, you probably get about 100 basis points just in the volume leverage. So now you're approaching 10.

So what has to go on in the water business to take it from 10 to 12? Because the market grows, as you know, call it 3% plus whatever China contributes. Is that it? Are there still relocations, and geographic shifts and shipping shifts and stuff like that that drive you to 12?

As I said, the primary things are taking advantage of the fact that we standardized that product so that we can manufacture it at the plant closest to the customer. We have not earned all the benefit from that action that we completed last year, as well as the consolidation of the manufacturing in McBee in Ashland City. So there will be some leverage, some push from that.

I will also, as we said, we didn't -- there will be -- still be a little bit of tailwind from the pricing, because it didn't all go into effect immediately on January 1.

Final question on water, have you heard at all plans to put water heaters on the floors of Kmarts?

Not yet.

Is that a realistic possibility?

Yes, they have announced that they're going to take 400 of the Kmart stores and convert those to Sears stores, but we have not heard any details of what sort of products will be in those.

I will jump back in line. Thanks guys.

Matt Summerville, McDonald Investments.

A follow up on your guidance that one -- let's just look at the $1.80 to $2. Does that include the $0.7 or so worth of help on the warranty side, Ken?

Yes, it does.

How much of a benefit from the restructuring actions that sound like are going to be predominately relegated to the first half of the year? How much restructuring benefit is included in that 1.80 to 2?

That is going to be relatively modest, because obviously we're announcing the restructuring activities today. They will be -- as we said, the Ireland will be closed by the end of the second quarter, so that is going to be the biggest piece of it. The rest of it, those other restructuring actions are really going to happen, be completed in the latter portion of the year. I would say someplace in the 2 to 3 million kind of range for the year would be about the magnitude of it.

And then order of magnitude compared to the other things you have talked about impacting volumes in the two businesses, where would you put the prebuy in there? As I recall back to the fourth quarter call, I thought you guys had indicated that if there was a prebuy, it probably wasn't all that significant.

Order of magnitude, first of all, there is a couple of prebuys to be considering here. We did have a prebuy in the first quarter of '04, and a lot of these comparisons are being done to there. And that was as a result of what had been substantially the first price increases put in place in both businesses.

So -- I don't recall the magnitude of that, but it was not insubstantial. So that is a factor, as we said, that on the motor side that OEM customers have factored. And we have said the unit volumes is the other factor.

All right. And then can you talk about what your cash flow expectations are for the year?

Yes. As we showed, we had a good performance on cash flow in the first quarter. And we expect that we will have cash flow from -- on an operating standpoint, before CapEx, someplace in the $120 to $130 million range for the year.

And how much of that will be driven by the 120 to 130 working capital improvement?

As we have said before, we've got a target of $10 to $15 million out of working capital. That is a relatively high bar because remember, and I know you know this, but the price increase and the cost increase stick in receivables and inventory as well. So it is going to take more reduction in days than usual to get that kind of improvement out of working capital.

Let's exclude the noise, if you will, on the volume side. Maybe you guys can spend a minute talking about what you're seeing from a macro standpoint in the various business lines in which you compete, you know to help give us some flavor for what we should think about with respect to volume going forward.

As a general trend, late in the first quarter, and we're seeing it carry over into April, we are seeing it pick up in the volume rates as some of the inventory in the channel gets worked down and things appear to be returning to a more normalized level.

So it is only a small amount of data right now, the last four or five weeks, but we have seen indications across both businesses of a volume pick up from what we were seeing early in the first quarter.

Are we talking residential HVAC motors, commercial HVAC motors, residential water heaters, commercial water heaters? Are we talking about all that?

We're talking generally across the board.

Godfrey Birckhead, SBK Brooks.

Two questions. The first question has to do with inventory. You haven't talked about that so far. Where do they (ph) stand? And then the second question is, when you talk about getting to 12% EBIT overall in both segments, how should we think about this in terms -- are we talking 2 to 3 years, or are we talking 5 years or what?

Good morning. On the inventory question, we did have inventory increases in both businesses, basically. Simply, we produced a little more than we sold in the quarter.

As far as the timing of the 12%, we said before, again, as we talked in the end of 2004, we needed to get that balance back between pricing and material costs, and that would get us into the 8 to 10 range.

And as we implemented and took advantage of the things that we put in place in both the motors and the water business, over the course of a year and a half, two years, we ought to be able to get into that 12% kind of range.

Inventory is satisfactory now, unsatisfactory, or about where you want them?

They're too high right now, and we're going to be working those down and the year goes on.

Can you quantify that at all or not?

It is a general matter. We did, as Ken indicated, we had production above what we needed in the first quarter pretty much in both businesses. That's good because the plants are really running very well right now. But we've got to do some things, primarily in the work in process, reducing cycle times. And that in turn will allow us to start lowering our finished goods inventory, yet still keep the service levels up.

Scott Graham, Bear Stearns.

My question was just answered. Thank you.

Mike Schneider, Robert Baird.

Ken, given the corporate expense run rate right now, should we annualize that and assume 8.5 million is a good number for each quarter? Or is there anything that fades from here?

Just thinking about it, I think if you annualize, that would be as good an estimate as any.

We have no additional questions at this time. Please continue.

Thank you for joining us and we look forward to speaking with you in July as we report second quarter results.

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