A O Smith Corp (AOS) 2005 Q2 法說會逐字稿

Welcome to the A.O. Smith second-quarter earnings call. [OPERATOR INSTRUCTIONS] As a reminder, this teleconference is being recorded. I would now like to turn your conference 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; 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, 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 please feel free to follow along while we conduct the call. Bob.

Thank you, Craig. Good morning, ladies and gentlemen. Before we get into more detail regarding our second-quarter results, I'd like to make a few general comments. As you know, a little less than a month ago we made two significant announcements. The first was to adjust our forecast and indicate that our second quarter and full-year earnings would come in at a level lower than expected at the end of the first quarter. The cause of this change was primarily an inventory buildup in the wholesale side of the water heater market. Additional inventory will be taken out of the wholesale channel during the second half of the year. We have reduced our estimate for the full year to between $1.60 and $1.80 per share from $1.80 to $2 per share. These estimates exclude $0.35 a share for restructuring charges with the most-significant piece related to the closing of the Bray, Ireland motor facility.

Secondly, we have signed a letter of intent with GSW of Canada, the parent company of American Water heater to acquire that business. GSW is a $470 million business that manufactures and markets water heater and building products and is a major player on the retail side of the water heater market as a sole supplier to Lowe's. This acquisition will enable us to be a more significant player in the retail channel of the water heater market in the United States as well as in both the retail and wholesale channels in Canada. We believe the synergies and materials, logistics, and manufacturing resulting from the combination of these two operations will generate significant benefits for A.O. Smith and its customers. We have begun the customary regulatory review process and are optimistic that this acquisition will be completed by the end of the year. We are very excited about this opportunity.

At the end of June Ken Krueger resigned as CFO so that he could more freely pursue other opportunities, including positions in operating management. Ken has been a friend and valued member of our team and we wish him all the success.

Finally, regarding our forecast adjustment. I share your frustrations that we are not more able to accurately assess the inventory buildup in the wholesale water heater channel and the eventual impact on demand in the quarter and for the year. Unfortunately, the truth is there just isn't very timely data regarding inventory levels in the wholesale channel. Over the last two years, we have experienced significant challenges related to new-product introductions, raw-material cost, and pricing. In July of 2003 the regulatory agencies required the industry to introduce the flammable vapor ignition prevention residential gas water heater. That introduction was preceded by dramatic prebuys of gas water heaters in May and June of 2003. The balance of the year was characterized by erratic swings between electric and gas water heater production rates.

In January of 2004, regulatory changes again required the industry to introduce higher efficiency water heaters. That introduction was also greeted with significant prebuys. Then throughout 2004 steel prices increased dramatically and continually and the industry struggled all year to keep up. And the first efforts to address the steel cost issues in March of 2004 through the initiatives in January of this year, customers prebought large quantities of water heaters. All of those prebuys added up to a lot of inventory in the wholesale channel and working it off is where we are today.

Considering all that turbulence, I am pleased with the progress we are making. We believe the inventory problem will correct itself in the second half of the year and that the industry volatility will abate. And for both businesses we are optimistic that improved pricing related to raw materials and operating efficiencies related to restructuring and repositioning will begin to yield positive results in the future. John will now review the quarter in more detail. John.

Thank you, Bob. And good morning, ladies and gentlemen. Net earnings for the second quarter before restructuring and other charges were 14.4 million compared with 17.3 million last year. These earnings exclude an after-tax charge of 7.9 million primarily related to closing the Bray, Ireland motor facility, which we announced in April. Earnings excluding $0.26 for the restructuring charge were $0.48 per share compared with $0.58 last year. Second-quarter sales of 438 million were unchanged from the second quarter last year, slightly higher sales at Motors offset a modest decline in Water Systems. Our gross profit margin decreased to 19.2% from 20.2% last year and was the result of lower margins at Electrical Products. Margins were negatively impacted by absorption associated with inventory reduction initiatives.

SG&A was 60.4 million in the quarter, compared with 58.9 million last year. Last year's second-quarter SG&A included a nonrecurring pre-tax gain of approximately 3.3 million from the favorable resolution of litigation related to State Industries' Duron product. As a percent of sales, SG&A was 13.8% this year compared to 14.2% last year excluding the Duron gain. Corporate SG&A increased $3 million primarily as a result of higher pension expense and a charge related to a contingent leasing liability at our discontinued automotive operation. As a result of our reduced earnings projection, we are now forecasting an annual effective tax rate on pre-restructuring earnings of 30%. The tax rate has been revised due to the change in the geographic composition of this year's earnings.

We had a very good quarter for cash flow, bringing total year operating cash flow to 51 million compared with 12 million last year. Improved working capital performance was the primary driver. We are still projecting a full-year operating cash flow of 120 to $130 million. Year-to-date capital spending was $16 million compared to depreciation of 26 million. Total 2005 capital spending is projected to be approximately 50 to 55 million, about the same as depreciation. Capital spending was 48 million in 2004.

During the quarter, we received a $28 million payment against our dip tube receivable, which left a balance of approximately $6 million that we will collect in the second half of this year. These payments will result in the complete recovery of receivables associated with this dispute. All litigation associated with this issue has been concluded. Concurrent with this receipt, we elected to make a voluntary contribution of $30 million to our pension plan during the quarter. As a result of the strong cash flow, our debt-to-capital ratio declined to 28% from 31% at the end of the first quarter.

In the second quarter we recorded a pre-tax charge of 8.6 million for restructuring and other costs. In addition to the 7.4 million charge at Electrical Products, primarily related to the closure of our Bray, Ireland facility, there was also a 1.2 million expense related to a contingent leasing liability at our discontinued automotive operation, which was recorded as a corporate expense, as I had mentioned earlier. Beginning in 2006, we believe these restructuring actions will generate annual pre-tax savings of approximately $8 million or $6 million after taxes. Now Paul will discuss the operating performance of our Water System and Electrical Products businesses.

Thank you, John, and good morning ladies and gentlemen. Although we saw higher sales at Water Products resulting from improved pricing and a 35% sales increase in the China Water Heater business, second-quarter sales declined $6 million to $204 million because of softer customer demand in the North American market. As we mentioned earlier in this call, sales from the wholesale side of the business were particularly weak as a result of more significant prebuying and inventory buildup late in 2004 and extending into early 2005. There has been much consternation both internally and externally regarding the lack of good industry data and related forecasting problems. As Bob mentioned, timely data in the wholesale market is hard to come by.

But looking back, we now know that the residential industry was particularly strong in the fourth quarter of 2004 and in the early part of 2005. Wholesale customers were aggressively stocking up on product in front of industry price increases related to higher steel costs. In fact, we have recently read analyst reports where sample distributors are commenting that they haven't bought any meaningful quantities of water heaters since January. Industry sales of 660,000 units of residential product in May were the lowest for May in 12 years. For the three months of March through May, industry sales were down 375,000 units or 15%. And after declining 9% in the first quarter, commercial units decreased 25% in both April and May. We believe industry commercial comparisons were more benign in June but we won't know that for another few weeks.

Having said all of that, having the significant new-product introductions behind us and more stability regarding raw materials and other costs, we have a very positive influence on industry performance in the future. In spite of all the wholesale channel volatility, we believe our solid wholesale distributor/customer base remains intact. Our China Water Heater operation again delivered outstanding results in the second quarter with sales of $20 million or an increase of 35% over last year, similar to the increase it generated in the first quarter. As many of you know, this operation has been growing 35% annually for the last five years and is now expected to generate sales of $75 million in 2005.

As a consequence of this growth, we announced an expansion program at the end of the first quarter. 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. We will spend approximately $9 million in capital on this project in 2005.

Operating earnings of $18.8 million were similar to the second quarter of 2004 as improved pricing offset the impact of lower unit volumes. Last year's second quarter included a nonrecurring pre-tax gain of approximately $3.3 million from the favorable resolution of litigation related to the State Industries' Duron product. Operating margin improved to 9.2% of sales compared with 7.4% last year, excluding the Duron gain, and notwithstanding the unit volume challenge, this operation has come a very long way over the last year. Considering the strength of their performance under these trying circumstances, we are very enthused about Water Products' prospects as their operating environment becomes less volatile in the future.

And now on to Electrical Products. Sales of $234 million at Electrical Products were 3% higher as improved pricing more than offset weaker demand, primarily in markets adversely affected by cooler weather. Examples of affected markets include HVAC, air-conditioning, and swimming pool pumps and the related sales through distribution.

Let me talk a little bit more about the HVAC industry. After increasing 5% in the first quarter, both OEM and distributor air-conditioning shipments declined 15% in April and May. OEM inventories increased 22% in May and are at their highest level in the last 10 years. They are 25% higher than the average levels for the month of May for the five years ending 2004. Fortunately, distributor inventories are still at favorable levels. The recent weakness in the air-conditioning market is similar in both residential and commercial segments.

Operating profit at Electrical Products was $6 million, or $13.4 million excluding a $7.4 million restructuring charge. This compares with $17.4 million last year. Though improved pricing offset higher material costs, reduced contribution on lower margin and negative absorption of fixed manufacturing expense related to inventory initiatives resulted in a decline in operating profit. Days on hand of inventory declined 10 full days, which represents a $20 million reduction in inventory. We incurred a $2 million of the costs in absorption in the quarter related to the inventory reduction. We were very, very pleased with that progress. Operating margin, excluding the restructuring charge, was 5.7% compared with 7.6% last year.

Now let's talk a little bit about the outlook. Last month we issued guidance for 2005 of earnings ranging between $1.25 and $1.45 per share, or $1.60 to $1.80 before special charges. Our 2005 forecast does not include any fourth-quarter prebuys of motors that may occur because of the January 2006 mandate to meet 13 SEER, energy efficiency requirements. And on an overall observation of our company, price and material cost relationships are in reasonable shape. Working capital is improving and it will continue throughout the year. Our manufacturing operations are running well and we are located in low-cost areas around the world. So we're now down to a major focus of revenue growth in both of our businesses.

And, finally, being one of the few public companies in each of our industries for competitive reasons we will avoid commenting specifically about units and prices in both of our businesses. So please keep that in mind as you pose your questions. Craig?

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.

Thank you. [OPERATOR INSTRUCTIONS] The first line will open to Stephen Weiss with Mindflow Capital Investment. Please go ahead.

Thank you very much. Robert, obviously you guys had a very challenging quarter and face some uncertainties down the road, but seems like you guys have some initiatives in place. Regarding raw materials, a lot of your competitors over the last year have really been implementing some new strategic initiatives to reduce their raw material costs at a very challenging environment by establishing a better line of communication with their suppliers and opening up better collaboration as well. I'm interested if you can provide some color of what you plan to do from now on to reduce your raw material costs by opening up a better line of collaboration with the supplier base to improve your cost of goods sold and therefore your bottom line?

Okay. Stephen, this is Paul Jones, I'll answer that question.

All right, Paul.

We have done a reorganization that if you look back -- I think it was back in the January time period, and Ron Massa, who has had experience of running several of the A.O. Smith businesses over the years has moved in as Senior Vice President into world headquarters and his job, among other things, primary responsibility, is to open up lines of communication, open up relationships and start doing business around the world. We have also recently opened an office in China. We have been doing a lot of sourcing out of Asia from our operations here in the U.S. We've been having some significant results in doing that over the last couple of years. But we need to kick that into a higher gear. And the new office that we have in -- that's located in Nanjing, China will have sourcing as part of the responsibilities of people there. So there's quite a few things going to open up relationships and it's not just steel, it's a little bit of everything.

I should also mention that our AT COM operation that supplies parts to the water heater industry, ourselves and our competitors, has recently opened up a manufacturing operation in China so we're now supplying a lot of those components to the industry and we're also in the process of expanding that between now and this time next year. So there's a lot of initiatives going on. I could talk about more of them if you're interested just call back and we can talk further.

One other thing, for following A.O. Smith the last couple of years, quality's always been a top priority of your company that's how you guys have always enabled to achieve fairly record levels of growth. Regarding your suppliers, how are you always making sure the right suppliers are providing the right quality components each time? Are you meeting with them on a quarterly basis through supplier forums, are you doing types of supplier scorecarding to make sure their level of quality's meeting up to A.O. Smith's standards and then how are you justifying for particular demand any allocations to your supply base?

We have a very strong -- let me answer. We have a very strong supplier qualification program. We believe in it. We're constantly strengthening it and that is not something anybody should be concerned about. We're going to -- we bring on additional suppliers that are going to be fully qualified and we're going to maintain our quality levels or take them up.

Have you been looking to reuse your supplier base or are you pretty happy with the level of the number of suppliers you have right now?

We're always reviewing the supplier base.

Thank you very much. Congratulations.

Thank you.

The next line we'll open is Matt Summerville with Keybanc. Please go ahead.

Morning. A couple questions. First, if I recall back to late 2004, as we were moving into the new year, I think you guys had a feel that at least in the wholesale side of water heaters that there would be at least an attempt at a prebuy and you felt very comfortable given the experience curve you'd had with prebuys in the past, you highlighted several of them in your prepared remarks that you would be -- you were better equipped and would be able to deal with this situation limiting quantities and so on and so forth and I guess, Paul or Bob, maybe you can comment on what went wrong?

Okay, Matt. Obviously as we mentioned, there wasn't a lot of visibility in what was going on. We found a lot of the prebuy occurred in October and we are making those comments in October, November. That was when we were putting things in place relative to -- we would ship at price and effective time of shipment and we were trying as best we could to -- to supply our customer base with what they needed in the November, December time frame. But in many cases the channel was already stuffed more than we knew at that time and that's just -- now looking back and in enhanced conversations with our customer base, we see that the channel had more in it than we thought and as we got into January for some competitive reasons, we had to do some things to keep our market share with certain customers, as did our competition.

So the short answer is there were a lot of moving parts, a lot of things going on at the time that was what we thought, we put some provision in place and limited it, but in now looking back, there was a lot more channel stuffing going on than we were aware of at that time.

Matt, just to add some color to what Paul is saying. When we look -- we did control how much our customers could order in the fourth quarter and it was basically -- they could order a normal fourth-quarter worth of volume. And we -- we did hold that and we held that pretty well. Not all of our competitors were as good at -- on that and so there was a little more got in I think from that point of view. But looking back at it, if you remember last year, the industry was running behind the year before through the third quarter of the year. And I think what would have happened is in the fourth quarter of last year we would have gotten the rest of the inventory liquidation going on that would have gone on if there hadn't been the big price increase.

So some of this, as we look back at it, goes all the way back to the volatility that was brought in when the flammable vapor product got introduced at all the prebuys and there's been just a whole series of prebuys just begin to get the inventory down, prebuy again because of new efficiency standards, start to drive it down again, prebuys because of a price increase, drive it down again. So it was a series of those things. So the truth is we should have held not to normal volumes in the fourth quarter of last year but a lower volume in order to get the inventory up. But we can't control all of that. So we thought we were controlling our sales level to them, which we did reasonably well in the fourth quarter, but it would have been softer.

Okay. And then just two quick follow-up questions. First, can you comment, then, on how -- I mean you mentioned that this inventory drawdown situation is extending into the back half of the year. I mean, do you have any good feel in talking to your customers what sort of duration we're talking about? Are we talking two months, three months? The remaining five and a half months of the year? And then also if you can comment on your inventory levels at the factory if you will in your Water Heater business.

This is Paul again. The -- we've talked to a lot of our customer base and I'll just give you one vignette. I met with one of our major wholesalers recently and they commented that they had taken over several million dollars out of inventory, Water Heater inventory the preceding month. There's two things significant about that. There's several million dollars equated to a little over two weeks of their normal sales. And the other interesting thing is they were talking dollars not units. As the water heater has more value in inventory than it did a couple years ago, because of the price increases relative to flammable vapor, industry -- the efficiency standards compliance as well as three price increases due to steel. So they're looking at their balance sheet and looking at the dollars of inventory and distributors work off urns and turns as you well know. So their amount of water heater inventory's getting more scrutiny.

But all that being said, we believe that the excess inventory was about a month's supply, a couple of months ago. We think that's working down. It would be a little more speculation on our part than we're willing to do at this point to say when that will go away. Obviously the -- some of the customers we've met with have given us very clear schedules. But that's only a part of the whole answer so we really shouldn't be trying to guess. But we think within the next few months this issue will get behind us and we don't see anything else coming at us at this point so we ought to be a lot more normalized as this year unfolds.

So it sounds like it's more of a third quarter than a fourth quarter event based on your last comment there, Paul?

That's probably a fair assumption.

Okay. Thanks. I'll get back in queue.

The next line we'll open is Scott Graham with Bear Stearns. Please go ahead.

Yes, good morning.

Good morning.

I have several questions and I hope you'll bear with me. On the motors side. Could you tell us what this -- this charge -- this leasing charge was specifically? Dollars.

That was really -- hi, Scott. That was on the -- actually on the corporate side. What that related to is we had subleased a facility to Teller Automotive when we sold the automotive operation. They are currently in bankruptcy and they have notified us that in October of this year they are going to reject the sublease arrangement, i.e. walk away from it. So we've now estimated our loss to be at this point in time $1.2 million associated with the transaction.

Okay. So 1.2 million. So that's in corporate.

Yes.

Okay. So I apologize. That wasn't in motors. But I guess that maybe brings me to my next point. If we look back at really the last -- what I'd call normal year in the motors business, where your in-season HVAC 2Q and 3Q, you really kind of have to look back to the second and third quarters of 2002 where you earned in total operating income about $30 million. Now, if we were to look at the current number that you reported even when you add back the restructuring charge this quarter, it was about $13 million. And let's assume a couple million dollar impact from the -- from the inventory reduction and even a couple million dollar impact from the -- from the HVAC weather conditions. Still really only gets you to about a sort of a $17 million number in a quarter that in 2Q was a $20 million operating income number.

Suggesting that there is still a fairly sizeable gap between raw materials and volume. I'm sorry, raw materials and pricing right now. I understand you are reluctant to talk about the water heaters price versus volume relationship, but -- because of competitive reasons. That's actually completely understandable. But you're really not a significant player in motors overall, maybe third in HVAC, but still there isn't enough data to kind of trace down what you say and understand what you mean. So if you could help us understand the price versus raw materials relation in motors because it does seem to be a much larger gap than I would have thought at this point.

Scott, this is Paul. I'll take the first stab at that and let anybody else chime in that wants. We think the price versus cost relationship is in reasonably good shape on motors. Obviously depending on the product line and the market that we sell into, there's varying margins related to those. But I think your premise is off a little bit. I think another -- a good piece of this has been what's happened on the volume side. And if you will remember, especially in the hermetic side, our customer lost a major customer a year and a half ago, that just flushed its way through the channel last year. Several people in the hermetic industry, and I'm talking about our customers, have been struggling over the last few -- couple of years for various reasons and you can go look up their data and look up their press releases and get quite a bit more information.

What we're trying to do is go after volume and we want to turn that -- that top line towards an upward slope. We like our manufacturing costs, we think we've got a very good situation right now with our material costs, although we're always looking to improve it. Our manufacturing footprint is in terrific shape compared to other people in the industry and we're down to a situation of turning our sales force away from getting current products qualified so we can move them to a low-cost country, our sales force is now getting products qualified so we can grow our top line.

Okay. Maybe we can move on. For -- actually, a final question, Electrical Products, is the inventory reduction there now done?

No.

Okay. So we'll have another quarter of that, or is that a full second half?

We're always going to look to improve our -- part of the reason our inventory's got high was due to all the repositioning we were doing. We were moving products from North American locations to Mexico and China, working very closely with our customer base, our OEMs. We didn't want to have a hiccup on supply to them, so in conjunction with them we put in some inventories and we're now working those down as the plants in China and Mexico have continued to ramp up. So you will see continued inventory reductions. The $2 million of absorption, frankly, I was delighted with because we've got $20 million of inventory reduction and we are expecting both of our businesses, it's a major focus this year, to get our working capital in line. We're not pleased with our days of working capital. We're not pleased with our inventory turns and are looking to, frankly, generate a little more cash out of operations as this year unfolds.

Okay. Good enough there. GSW. I guess at this point where you're talking about the signing of a definitive agreement and just pending new by government authorities, I guess I would have hoped that we would have had more financial details on this transaction, purchase price, your thinking when you -- when Bob said at the top that you expect significant benefits to you and your customers, maybe some quantifications, some parameters around those numbers. What else can you tell us about GSW since it's such a significant acquisition and there's really only one small paragraph in the entire press release on this?

Well, we told you everything that we can tell you at this point. It is significant, it is something that we are excited about, but at this point there's nothing more we can say about it.

Okay. Thank you.

The next line we'll open is Brian Rayle at Midwest Research. Please go ahead.

Good morning.

Good morning Brian.

Building on the inventory question, the Electrical Products business. Obviously you guys are not exactly where you want to be in terms of moving your cost base into the lower cost areas. Do we expect that to sort of ramp up every time you make a major move and then continue to pull down? I mean, is it downward sloping trend or is it more of just a vacillation around those moves?

Brian, it's -- it's still going to be a downward sloping trend on inventory but it's going to be probably less of a slope. I want to comment, I think we are -- we have gotten the majority of those moves behind us. So the significant amount of repositioning has already taken place. We are always going to be continuing to -- maybe right now we're putting a few stamping machines into Mexico and moving some stamping operations out of some U.S. plants. And doing things like that are just part of our ongoing productivity improvement programs that we have. But as far as the inventory reduction, we will continue to get -- generate cash flow out of inventory reductions through the rest of the year. I don't see any more $20 million quarters. I don't think that we're going to see something to that level. But I think you're going to see -- we expect that both of our businesses will generate some working capital through the combination of managing receivables, payables, and inventory as this year unfolds.

Great. And then a follow-up question on the GSW. I know you can't obviously just from the last question give us more information on the purchase price and the synergies. Could you give us a little bit of thought process on how you would finance a transaction from your side?

Our intention right now would be to finance it with debt. As we talked about earlier, our debt-to-capital ratio is at 28% and we feel we certainly have plenty of room there to finance that and so that would be the intent.

Okay. So an all-debt transaction.

Yes.

Thank you very much.

[OPERATOR INSTRUCTIONS] The next line we'll open is Mike Schneider with Robert Baird, please go ahead.

Good morning guys.

Good morning, Mike. We wondered where you went.

I was just sitting back listening in. I guess I'll follow up on some of Scott's questions about motors and volumes, et cetera. While you don't want to dissect price and volume, can you at least give us the revenue growth by subsegment within motors to give us a sense of what HVAC did, pumps did, distribution, et cetera?

Mike, if we got into that for competitive reasons, and you are well aware of this, it's not just investors that listen to this call. And there's some people out there that would love to know what our units and revenue are doing in each of the segments. In some cases they may have a general idea of the units and if we give you the revenue, then they're going to back into that piece of the equation and for competitive reasons we just rather not give out. So from a general standpoint, we can tell you that the things like pump and distribution and general industries were up and as we've already talked the HVAC was down, including the hermetic and that's about as far as I think we want to go at this point. I understand why you want to know it and believe me I'd love to give it to you. If Emerson took their motor business public and GE took their motor business public we could be a lot more open about this.

Okay. And then I guess just looking forward, then. Where do you expect the growth to come? The HVAC season aside, is there further growth to come in pump and distribution? You obviously won the Grainger business, which is driving distribution right now, but where do you expect growth and I've learned you've won a couple meaningful contracts here for the coming 12, 18 months, I guess in what subsegments are they?

Well, we have picked up some business in HVAC that we cannot announce at this point. We picked up some in another industry that we can't even mention the industry at this point because it would be too transparent. We also see some opportunities on distribution and are going to continue to do that. And I wouldn't rule out geographic. With our -- we've just doubled the size of our Jiangsu facility, which is a hermetic facility in China and we are seeing some opportunities around the globe for products -- for products out of that facility. So we're knocking on a lot of doors, making a lot of calls, trying to put together a lot of deals.

As I've said earlier, we have secured some '06 business, we're excited about it. We don't know what else is going to happen between now and the end of the year and I would hope that that would be higher. When we can in these calls, we will tell you about business we've secured. But with some of these agreements, the current supplier doesn't know it and our customer has requested that we keep it confidential and we're always going to follow the wishes of our customers on matters like this.

Within HVAC now you've got 13 SEER looming in '06, in talking to Emerson, talking to the GE HVAC guys, et cetera, they know what specific platforms and SKUs they are on. Do you know with your ECM motor and your standard motor what type of growth you expect in HVAC related to 13 SEER or what SKUs you've lost as a result of 13 SEER.

Well, I'll say there's lot of planning coming together right now with our customer base. A lot of it is completed. We have quite a bit of definitive info, information but there's still some unknowns and there's still a few more moving parts out there based on our observations of what's going on. And anything I would say today would have a bit more speculation in it than I'm willing to say at this point. We obviously will give you some indications of this when we can but there's a lot of products on task, there's a lot of people talking right now. There's a lot of very clear plans already in place. But there's a lot of options that our customer base still has.

Given that your ECM motor is new to the market and GE has been doing this for over a decade, let's just assume for a minute that you don't gain traction in your ECM motor. Does that mean 13 SEER for you is a net negative in volume?

Not necessarily. Again, our existing product the customer can get to 13 SEER and we have some that are trying to do it. We also have some modified products that we are working with customers on. So I think that would be a stretch to say that.

Okay.

By the way, we will also say that the ECM is something we're very excited about. It is better than anything else in the industry. And we're excited about the opportunities out there today. I'm talking like a salesman.

Right.

But we've had some very, very good meetings with a lot of customers right now relative to our ECM product and stay tuned, we'll see how it works in the marketplace.

Okay. And I might have missed this comment, but switching to water heaters. Your inventory efforts there to reduce your inventory, not channel inventory, where are you in that process? Because presumably the channel has backed up on you.

Well, you're talking finished goods inventory. Our finished goods inventory is in good shape there. We have shortened our cycle time in the factory. The Ashland City facility is something that I know it was an issue a year ago. The team there has done an outstanding job of streamlining that operation. They've taken over $10 million out of the raw and work in process in that plant alone this year. They are just running the business better, shortening cycle times. We now have -- for those of you that have visited the plant, we have lots of wide-open spaces where material used to be stored, that we're working that inventory down and that plant's running well.

Finished goods inventory on water heaters is at an appropriate level and we can keep it there. We have the capability. It's not the shortest lead time I've ever seen but it's pretty short. Within a shorter period of time we can take our inventories up to any level and we're also talking, as I mentioned earlier, a lot more with our distributors, working with them on forecasts. We have a supply-chain fellow in Ashland City that's staying in contact with people in our marketplace, so we're making sure that we're ready to respond and we're ready to react to whatever our customers need.

So there's no extraordinary inventory reduction that comes in the second half within water heaters.

No, we're just going to keep tweaking it down as we take our -- primarily it's going to come out of work in process I think and maybe a little bit on raw material the rest of the year.

Okay. And if you take a step back, I guess given Bob's comments about -- you were disciplined in trying to limit the prebuy in water heaters back in the fourth quarter, others may not have been. I guess that to me smells like you probably voluntarily -- well, I guess unwittingly surrendered some market share.

I think voluntarily would be a better word.

Okay. Voluntarily surrendered some market share back in the fourth quarter and presumably in the distribution channel or wholesale market. What's your confidence level you get that back? Because as you've read in my notes, one of my big concerns is that you've been losing shares steadily in the wholesale market, actually to your newest counterpart which is GSW. Can you give us some sense of your outlook for that market or doesn't it matter if indeed the GSW contract or transaction goes through?

Well, our -- what happened is a lot of people price protected into the year. We didn't. So they would take an order in November and price protect it and still ship product in January at the old prices. We elected not to do that. And we did our restrictions that Bob mentioned in December. But a lot of people had prebought in October and that's another piece. There's a lot of moving pieces in this thing. The -- we have held on to our wholesaler base. In some cases where they share some business, where they share suppliers, maybe there's been -- there has been admittedly some -- some market-share movement. And I'll just repeat what I've said before, that with what we have in place now with manufacturing costs, with a very short lead time, we can use our technology, quality, and service to grow the top line and that's the focus we have at this point. And we'll just have to see how the future unwinds as we pursue that.

Okay. Final question, John. Just on the transaction again. Avoiding any specifics on GSW itself. But if indeed you finance this with all debt, what is a rough range of debt to cap that investors can expect post the transaction?

Mike, I really can't discuss that at this point in time because then you can back into kind of the sales price and all sorts of things. So we're just not comfortable as Paul and Bob said in their comments of saying any more about the transaction at this point in time.

Okay. Thanks, guys.

The next line we'll open is Matt Summerville. Please go ahead.

John, I have a question on the voluntary pension contribution. First, is this -- do you see any more subsequent voluntary contributions like you made this time? And then, also, with the contribution, kind of -- as of the end of June plus a contribution, what is the funded status of the plan and then does this contribution do anything to the pension expense number for the year?

Sure, Matt. First question is we -- when we looked at mandatory contributions, we really didn't have to make any until two or three years down the road. However -- and it was about 30, $35 million. However, from a tax efficiency standpoint, it made sense for us to take -- make that now. So it's a long way of saying at this point in time we don't anticipate any future contributions for the immediate future for sure. With respect to pension expense, last year we had pension income of $6 million. We're now projecting it to be about $5 million expense this year. We went through the census data, the valuation, it incorporates this contribution and we're sitting at about a $5 million expense number this year.

What would your original guidance have been on the expense number for this year?

The original number would have been about $4 million.

Okay. --lower to buy a million bucks.

No, we've actually increased it $1 million.

Increased, that's right.

When we incorporate the valuation and the contribution.

And then I didn't hear you guys talk much about the retail channel in the water heater business, just -- can you talk about in general what you saw during the quarter, what sell-through looks like there and maybe comment somewhat on volumes to the extent you can?

Yes. The retail has just been normal operations throughout. There have not been prebuys there. Any of the volatility we see in the wholesale side.

Okay. And then also if you -- as you look at the Water Heater business as you progress through the second quarter, did overall volumes pick up, tail off? I mean, was June better than May and April in terms of volumes? As we enter July, can you give us some sort of sense on whether you've seen sequential improvement?

April and May were awful and June was a little better.

Okay. And then lastly, steel costs have obviously come down a lot. What -- at what point do you start passing -- what point do you start seeing those lower prices in terms of your costs of goods sold, at what point do you start passing those on to your customers and then what does that do to pricing in the back half of the year?

Well, the short answer is we don't know what that's going to do to pricing and we don't know what it's going to do to our costs as we go along. One of the indices is some of our agreements we're tied to went up this morning by $20. So this thing's still got some moving parts in it. We contracted at the end of the year -- last year for steel this year as we've mentioned to you we had some variability built in to our purchase. And we have some selling agreements that have some variability in them in order for us to maintain acceptable margins. Also mention that we buy a lot of specialty steels that maybe don't get the same sort of treatment as some of the general comments that you see in the industry.

But as far as we can see right now and we're making no prediction on the future, but on total material costs, steel, copper, aluminum, resins and of course what's happening with the fuel and the freight charges, in total there's only been a modest change. And as we look forward, I'm always hesitant to predict what may or may not happen. So right now we've got the relationship where we think it ought to be and we just are intent to keep it that way. As the year goes on we'll make adjustments as necessary.

And then one last question, Paul -- or Bob. Can you just talk about, where you're at if anywhere with the CFO search, if this is likely going to be an outside candidate as opposed to internal? And then, sort of qualitatively, what kind of individual are you looking for?

It'll be a well-qualified person, Matt, and that's as far as -- on the conference call we don't want to talk about people.

Okay. Thanks, guys.

The next line we'll open is Scott Graham. Please go ahead.

Let me -- if I can, ask Matt's question a different way because I thought it was a good one. What if steel prices and all the components of it stayed where they are today, have you done any modeling on what that means for pricing in the second half of the year?

Yes. It's built in to our forecast and we've given you an earnings range for the year.

Can you tell me what the 2004 pension expense was?

The 2004 pension income was $6 million.

Income.

Income. And this year we're expecting it to be about $5 million expense. So that's a change of $11 million.

All right. I remember that now. The last question is could you give me an idea when the restructuring benefits start to bake into the numbers? When do you start to see them?

We'll see -- and I think as we said in the last conference call, we'll see some minor improvements the last half of the year. And by the end of the year, we expect to have everything pretty much in place. So that number that was thrown out on the -- earlier in the call of 8 million pre-tax and 6 million after tax, we expect to see that in 2006.

Very good. Thanks.

The next line we'll open is Mike Schneider. Please go ahead.

Guys, maybe you can just talk about this concept of a prebuy in the fourth quarter for Electric Motors related to 13 SEER. I guess I'm confused. If the ECM portion does or doesn't take off and you're selling existing motors for inclusion in the 13 SEER, why would you guys see a prebuy unless you're actually raising prices on existing motors?

Well, our customer base has indicated there's not going to be a prebuy and once again 13 SEER is a lot more things than an ECM motor. The compressor, the hermetic piece is a piece of how they can get their, too. So we're just -- we're just repeating what our customers have said, is that there's not going to be a prebuy. We joke among ourselves that maybe they're all saying that hoping they're the only one that does do a prebuy but we're ready if they want additional product this year we're just letting you know that we don't have it in our forecast as we go through the rest of the year.

Mike, it's not a prebuy on motors. It's whether or not they do a build of inventory, of the total air-conditioning unit.

Got it. Okay. That's what I was--.

When we're talking a prebuy. That's really what we're talking about.

Okay. And then I guess just more generally, Bob. You're obviously in the meat of the State acquisition when it occurred and we're on the cusp here of the GSW acquisition. What do you look at as the chief differences between the business? Because State was predominantly retail as well, GSW is predominantly retail although they're riding the coattails of--.

Mike, I would say that the big difference is that State had a broader product line -- a much more broader product line than American has. I mean American really is dominated by their sales by the one large account, Lowe's. And so their business to some extent is a simpler business. The other big difference was that State had a lot more free capacity than what American has. Besides that, they're pretty much the same.

Okay. And I guess that is -- that is a big point about basically their Lowe's dependents in the fact if you boil it down they probably make 5 SKUs and run those things hard versus you guys running hundreds if not a thousand SKUs. So if GSW is tapped out on capacity, is there anything different about the five SKUs that you would run in excess through your facilities that requires modification or reconstruction of your existing lines?

No. Mike, when the time comes, we'll have to take a look at how we do it. But it's not anything major in any of our plants. It's a matter of fine-tuning the products, where we might have a little more insulation or they might have something slightly different. So I don't see that as being a big deal.

Okay. Thanks again.

We have no additional questions queued up at this time. Please continue with your presentation.

Paul.

Well, that pretty well wraps up today's call and we appreciate everybody's participation. And you know where to find us if any further questions come up. Thank you.

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