A O Smith Corp (AOS) 2005 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the A.O. Smith third-quarter earnings call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. I would now like to turn the conference over to your 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 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.

Our opening remarks will refer to a slide presentation which is available on our investor Web page, so please feel free to follow along while we conduct the call. Bob.

Thank you, Craig. This morning we were pleased to report earnings of $0.32 per share compared with $0.10 a share last year. Net income of $9.7 million easily exceeded last year's net income of $3 million. Excluding an after-tax restructuring charge of approximately $2 million or $0.07 per share, net earnings were 11.7 million or $0.39 per share. The improvement in earnings was primarily driven by higher sales and earnings in the water heater business, which benefited from a return to more normal profit margins, reduced manufacturing inefficiencies, and continued strong growth in China.

Excluding a $3 million pretax restructuring charge, operating income at electrical products increased 16%, as better contribution margins and product mix more than offset higher costs from raw materials and freight. Consolidated sales increased 5% to $408 million compared to 390 million last year. Higher sales at water products more than offset lower sales at electrical products.

This morning we refined our 2005 earnings forecast to between $1.70 and $1.80 per share before restructuring and other charges of $0.35 per share. This new forecast excludes the potential effect of a prebuy related to the upcoming 13 SEER energy efficiency mandate taking effect on January 23rd. As you know, in June we 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 heaters and building products, and is a major player on the retail side of the water heater market as the 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 retail and wholesale channels in Canada.

We believe the synergies in materials, logistics and manufacturing resulting from the combination of these two operations will generate significant benefits for A.O. Smith and its customers. As you also know, this agreement is subject to the normal regulatory review, and we expect a decision by the middle of December. Should we receive a favorable decision, we would expect to close this transaction in the first quarter of next year. Needless to say we are very excited about this opportunity. We made good progress in both businesses during the third quarter, and John will now give you some more depth in regarding these results.

Thank you, Bob, and good morning, ladies and gentlemen. Third-quarter net income before restructuring and other charges was 9.7 million compared with 3 million last year. These earnings include an after-tax charge of $2 million, primarily related to previously announced repositioning activities in the motor business. Last year's weak third-quarter earnings were primarily the result of high raw material and freight costs and manufacturing inefficiencies at water products. Earnings were $0.32 per share and included $0.07 a share for restructuring in the motor business. Excluding the charge, earnings were $0.39 per share compared with $0.10 a share last year. Third-quarter sales of 408 million were 5% higher than last year. A 14% increase at water products more than offset a 2% decline at electrical products.

Our gross profit margin increased to 19.8% from 15.9% last year, as a result of the improved performance at both businesses. SG&A was 59.7 million in the quarter compared with 57.4 million last year. As a percentage of sales, SG&A was 14.6% similar to the third quarter of last year. We are projecting a full-year tax rate of approximately 31% on prerestructuring earnings. We had a very good quarter for cash flow, bringing year-to-date operating cash flow to 139 million compared with 27 million last year. Significant improvements in working capital were responsible for the strong cash flow.

Cap cycle days declined to 70 days from 94 days in the year-ago period. We expect operating cash flow to be fairly neutral in the fourth quarter. Year-to-date capital spending was $31 million compared to depreciation and amortization of 39 million. Total 2005 capital spending is projected to be approximately 50 to 55 million, about the same as depreciation. The largest single component of fourth-quarter capital spending will be for the previously announced expansion of the water heater operation in China. Capital spending was 48 million in 2004. As a result of the strong cash flow, our debt to capital ratio declined to 25% from 32% at the end of last year.

Net debt to capital after considering cash was approximately 20%. As we stated earlier, we recorded an after-tax charge in the third quarter of $2 million or $0.07 per share for previously announced repositioning activities in our electrical products business. We have generated total after-tax restructuring costs of 10.5 million through the nine months ending September 30th. As you will recall, the biggest piece of the restructuring activity relates primarily to the closing of the Company's Bray, Ireland motor facility during the second quarter.

In 2006, we believe these restructuring actions will generate annual pretax savings of approximately $8 million or 6 million after taxes. Now Paul will discuss the operating performance in our water systems and electrical products businesses.

Thank you, John, and good morning, ladies and gentlemen. Water products sales increased 14% or $25 million in the third quarter. Higher residential sales and a 50% increase in sales at our Chinese water heater business more than offset a modest year-over-year decline in sales of commercial products. Importantly, we believe the improvement and residential unit volume reflects a diminishing problem with respect to the unusually high wholesale inventories we discussed last quarter. Operating earnings of $14.5 million represented significant improvement over the third quarter of 2004. Last year's third quarter, which ended in a pretax loss of $2.1 million, was challenged by the high and mostly uncovered costs of raw materials and freight, as well as some fairly significant manufacturing inefficiencies.

Results for the quarter just ended reflect a return to more normal gross profit margins, sales growth in China, and an improvement in plant operating efficiency. Our Chinese water heater operation again delivered outstanding results in the third quarter with sales of $21 million or an increase of 50% over last year. As many of you know, this operation has grown 35% annually for the last five years. It 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, primarily during the second half of this year.

Now, on to electrical products. Sales of $211 million at electrical products were 2% lower than last year, as improved pricing and higher sales of pump motors and products through distribution were more than offset by weaker sales to HVAC customers and the closure of the Bray, Ireland motor operation. Operating profit at electrical products was $11.6 million, which includes a pretax restructuring charge of approximately $3 million compared with $12.6 million last year. Excluding the charge, operating profit was $14.6 million, and despite the decline in sales increased 16% as a result of better mix and an improvement in gross profit margin. Operating margin excluding the restructuring charge was 6.9% compared with the 5.9% earned last year.

Now I would like to spend a little time talking about the HVAC market and the impending introduction of the higher energy efficient 13 SEER air-conditioning standard. First some background. The Energy Department's 13 SEER mandate raises the minimum energy efficiency standards from 10 to 13. SEER is an acronym for seasonal energy efficiency ratio, and is a function of energy consumed to generate refrigerated air under specific seasonal conditions.

The mandate applies to all products manufactured as of January 23rd, 2006, and by products we're talking about the air-conditioning system which includes compressor motors, fan motors, coils, valves, controls and fan blades. So 13 SEER represents a higher-end lower-volume product relative to the broader market for 10 SEER. That will all change when the low end of the efficiency standard rises to 13 in January. Bottom line, there is nothing revolutionary about manufacturing motors for 13 SEER products. We have been manufacturing motors for systems from 13 SEER to 18 SEER for a long time.

There has been much speculation regarding a fourth-quarter prebuy of old standard product; basically artificial fourth-quarter demand at the expense of first quarter of 2006. Due to unseasonably extended cooling system season, the strong air-conditioning demand seen in July and August has driven industry inventory levels below 1.3 million units compared with more than 1.5 million units at the end of August of last year. This represents a decline of 15%. This reduction should serve to reduce the magnitude and distortion that might be caused by a prebuy relative to the January 23, 2006 mandate.

However, having said that, our customers are beginning to indicate there may be heavier demand in the fourth quarter than normal. It just isn't measurable at this time. As Bob indicated at the beginning of this call, we have narrowed our forecast for 2005 earnings to between $1.70 and 1.80 per share, excluding full-year restructuring charges of $0.35 per share. Including the charges, earnings per share are expected to range between $1.35 and $1.45 per share. Our 2005 forecast does not include the benefit of any significant fourth-quarter prebuys that may occur because of the January 2006 mandate to meet 13 SEER energy efficiency requirements.

And finally, as we consistently indicated, being one of the few public companies in our industry, 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 complete 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.

(OPERATOR INSTRUCTIONS). Your first question comes from the line of Andy Keller from Churchill Investment.

Thank you very much. First of all, I want to wish Robert congratulations on a well-deserved retirement coming up.

Thank you, Andy.

A couple of things, there are still a few concerns I have. Over the last three years, your stock hasn't really done much. It's been up-and-down, but it is still at the levels it was three years ago. Back on your last call in July, you had mentioned that Ron Massa is now handling a lot of your global sourcing and started it back in early January with some new initiatives. What are some of the quantifiable results? What are some of the good things he has done over the years that you could tell us on this call to help really improve sourcing in terms of quantifiable results?

Well, Ron is doing at terrific job for us in that area. We have opened some doors around the world to raw material. I am not going to get into any real specifics relative to any particular commodity or -- I think this might be Paul Jones -- or any particular company that we might be acquiring things from. But let's just say we have opened up our power supply chain on the purchasing side to a lot of new areas of the world and some new companies, and we -- for example, we have opened a purchasing office, sourcing office now in China, as well as a few other things. So we're very pleased with what is going on and frankly excited about the future with all the things that Ron and a lot of other people supporting him are doing for the Company.

Michael Schneider from Robert W. Baird.

Maybe first you can give us some commentary on the mix in motors, and we are obviously all trying to sort out the HVAC thing. When you say there was a better mix, Paul, I presume that it's more industrial, less HVAC.

Yes, it was more industrial in distribution and less HVAC in the quarter.

And then looking at the segment being down 2%, we know there has been significant price increases that have gone through earlier in the year, so presumably units are down more than that. Do you sense given what the ARI data shows for shipment in inventories that you guys have lost share in the year-to-date period, or do you believe you have kept pace with what has gone on, at least vis-a-vis the ARI data?

Well, Michael, I think we're probably lost a little -- I know we have lost some share through the year, especially relative to ARI data. That is due to a lot of things and a lot of factors. But I can tell you as we sit here today that we think we have turned the corner, and there is not any specifics that I can mention right now, but I am quite pleased with the efforts out of electrical products on the sales and marketing side.

And again on the HVAC business, a lot of that again is our customer mix and how they are performing in that marketplace. For example, our largest customer in the hermetic side sells a lot of product internationally, which has been a particularly weak market for them, and then, of course, that translates to us.

Right. And then looking into '06 now as 13 SEER unfolds, describe from a manufacturing standpoint how this actually changes your operations? Are you changing over lines? Must you change over entire facilities? Or is it only trimming or modifying things around the margin?

It is just taking the volume of some of our products we already have up and taking the volume of other products down. There is absolutely no change in our manufacturing. As I said previously we have been making motors -- compressors as well as air moving. The compressor is about 80% of the energy consumed. Air moving is about 20%, and we have been making motors for our customer base for all the way up to 18 SEER for years. So it is just a matter of the mix of the product going through our factories that will change slightly.

Well, given this choice of trying to improve compressor efficiency and motor efficiency, what is your sense now as you look across the different OEMs how the platform changes and the model changes actually shook out? Do you believe you actually gained some content per item if you want to put it that way, or indeed has all the emphasis been on the compressor?

The emphasis has not all been on the compressor. People are using a lot of different methods to get there. We are seeing the coils as being a big piece, but even fan blades, controls and valves are part of it. There has been a lot of noise, Mike, relative to ECM motors for fans. We are participating in that. We're quite proud of the product we have out there, and we will pick up a little market share on the air moving side simply because we are just now introducing the product and it is going to go from zero to something. And the compressor motor is still a piece of it, and we make the majority of our hermetics for reciprocating compressors, but we also make them for Scroll. And a lot of the manufacturers are using -- there has been a lot of misinformation here. Early in the year we were hearing people say you couldn't get to 13 SEER with the reciprocating compressor, and now all of our customers are going to be using them for some of their product, if not all.

So a lot of noise. This thing is going to shake out, but we are participating in the market with our customer base and it is right now at this point it's difficult to see what that is going to mean relative to the fourth quarter as well as for all of 2006.

We'll talk about Scrolltech specifically, because that will indicate to what extent you're participating on the scroll side. What has growth been this year; what do you expect growth to be next year from at least vis-a-vis A.O. Smith shipments to that joint venture?

We are not going to speculate on units relative to different customers, Mike. That is just not appropriate for us to get into that. That's a morass that we would have trouble getting all the way through, so we're not going to do that.

Okay. And then the idea of a prebuy in the fourth quarter, it's both in the press release and in your prepared comments, you seem to be signaling at least some expectation of a prebuy. Are you able to decipher, though, how much of this is restoring inventory in the channel versus actually prebuying ahead of whatever is coming in '06?

No, we are not able to decipher that part. We will say that there is some prebuy. We are seeing an increase in the orders now, as well as obviously we are having those discussions with our customer base. We just don't know yet at this point to what extent that will be, and how much of that will be restoring inventories and how much of it will be for people voting up inventory ahead of January 23rd.

I guess as a motor manufacturer, both standard and now these higher energy efficiency motors, why would anybody be prebuying I guess is the question as it relates to A.O. Smith specifically? If you're going to be making these products after January 20th and you're making them today, why does someone need to prebuy?

Well, you need to really be asking that question to the HVAC people who are our customers who will be buying it. But as we have said before, they are all saying they won't, hoping they will be the only one that does because after January 23rd if they've already manufactured the system, they can go out and sell that as a lower price than the guy down the street that's got only 13 SEER in inventory. But you really need to ask that question of them.

Fair enough. Thanks again, guys. And Bob, congratulations. I wish you the best.

Thanks, Mike.

Scott Graham from Bear Stearns.

I have three questions. First of all, on the water system side Paul, could you give us a bit of flavor to the extent that you are willing to? It seems to me like pricing held up in a way that you were hoping it would, and with the volume in the channel looking like they are a lot better on a year-over-year basis the last couple of months, is it fair to say that somewhere between maybe plus 3 and minus 3, plus 5 and minus 5, was the truth on volumes in the water systems business?

I don't think I understand your question completely, but let me try to answer the question I think you were asking. Essentially, we are pleased with the volumes on the water heater side, and we are pleased with the relationship between cost and price relative to productivity and everything else, and all the -- the three price increases we have had. We had a good quarter there and there is a little bit of mix. Our commercial where we have a very strong market share, as you know, has been weaker all year, and it was weaker in the quarter. But our residential has picked up steadily throughout the quarter, and we think that the order rates are now back to more normal levels.

Would you say that residential is better in retail, wholesale or both?

During the quarter, it was better in wholesale because the retail did not do a prebuy late last year like the wholesalers did. So the more normalized level is on the wholesale side.

Very good. Second question relates to your cash flow. You guys have done a great job this year in really bouncing back on the cash flow side. Could you talk about some of the inventory initiatives that you guys have been pursuing that are starting to drive that number down consistently?

Thanks for the question. We are delighted with cash flow. It is not a one-year event. This is an ongoing thing that we have been doing for some time, but we obviously have a lot of things working in the right way. The important thing is that we have taken our service levels up through this whole time. We had a lot of finished goods inventory relative to all the repositioning we were doing, especially on the motor side, and we have been working that down. But what I am probably more proud of is the fact that work in process raw materials is getting under better control. We have focus programs relative to supply chain, relative to production planning and inventory planning in all of our operations, and it is visible. We can go see our factories and see wide-open spaces there. And that is around the world.

So it is an ongoing program, a lot of people doing a lot of hard work, taking down a lot of work in process and raw, which will stay down. This is permanent inventory reductions. We're doing a good job on the accounts receivable. We're taken down our disputed claims quite a bit. We're doing a good job on accounts payable negotiating new terms. It's been an across-the-board program that has really clicked into place, and we're proud of those results.

Very good. You're not going to thank me for the third question though, Paul.

Oh, you never know, but give it a try.

The HVAC motors business, Michael started to head down this path, and if you know at the HVAC unitary numbers this quarter they were up about 30%, actually a little north of that to date. And if you bake in the information that you have said, pricing being positive, your pumps business being positive in motors, it does suggest that your HVAC volumes were -- volumes only -- were perhaps down double-digit in an environment that was as strong as that. Could you help us understand that disconnect?

Well, you are taking one quarter of data. You know, this thing is very fluid and you almost need to look at it over a longer period of time to get a full understanding of what is going on there. We're just telling you what happened. This is a third-quarter call, and we're talking with you about what happened in the third quarter. You're comparing our customers' finished product and finished production to one of their suppliers, and right now we are going into -- we will be going into the buildup by them of inventories for the season next spring, and we are participating with the customers we have been participating with.

Do you believe that this participation that you're calling it is a better level of volume presently than it was last year at this time? I'm trying to get a little sense for -- you made a comment that you said you feel that you're turning the quarter, but then didn't say why you felt that way, probably for competitive reasons. Could you give us maybe something on this front why in over the next three to six months you're feeling better about the motors business than what we have seen in the results of the last three quarters?

I will give you a little bit. We have closed some new agreements going into next year that will put some business and some customer on our order sheets that we don't have at this point. But I am not ready to discuss any of them because in many cases, we're going through the transition and in some cases their current supplier has not been notified, and I probably already said more than I should. But we have picked up some new contracts for next year.

I'm really proud of what is going on with the sales and marketing people. It is a long gestation period in this business to go out and get a product approved and go through all the testing and like testing and everything else for an OEM to then put it into their product. And we have been working on that for some time. All I am saying is that some of those things are starting to come to fruition and we have others going on all the time.

Bob, congratulations. Best of luck.

Thank you.

Matt Summerville from KeyBanc.

A couple of questions. First on the water heater business, can you help me understand on a sequential basis why revenues were down 5 million, your operating profit was almost down 5 million? That leverage isn't all that great in that business, it looks like. Can you help me rectify that?

Well, I think the biggest factor we talked about by far as almost the entire decline in sales was in the commercial market side, which is our high-margin business. And I think as Paul has alluded to and you've probably seen some of the write-ups, the commercial industry, both HVAC and the water heater industry, remains weak. And it continued in the third quarter, and that was by far the biggest factor.

All right, that makes sense. Next question, I want to talk about copper. Copper prices continue to go up. They have never really looked back. We are getting close to $2 a pound. I know you guys are good to go for this year. As I recall, you hedge about 50% of your exposure with your customers. The rest you use various derivative contracts. What is your strategy going to look like for 2006? And as I recall, you buy roughly 60 million pounds of copper a year. Even your hedged cost is going to be up significantly, I would think. How are you going to deal with that?

Well, you are right. Copper has been behaving counter to what the experts have been telling us all year. We typically hedge about a year in advance, so we are pretty far along on our '06. We also, in many cases, buy copper along with our customers either as an agreement between the two of us at a price for all of next year, and we're in some of those discussions now, or we have an escalation/de-escalation clause in their agreement where we take prices up-and-down relative to what is happening to copper throughout the year. So we are pretty well -- have ourselves covered there on copper as far as the pricing going into next year, into any additional year.

But that being said, I should also mention that there are some customers that we will be going out with price increases, and as the copper is just such a big piece of what we do, that we and everybody else in the market I'm sure will be doing some things on price.

How much do you think your average cost of copper will be up in '06 versus '05, based on what you know today?

We know that number, but we're not going to divulge it.

Okay. All right. A couple more questions. First, just in terms of HVAC volumes, your thoughts around this. As all these changes occur heading into 2006, do you feel -- I know you have kind of alluded to some things that look like they might ramp up for you. If that non-HVAC related stuff; is it HVAC? I would think by now you know exactly what platforms you're going to be on in '06 in the HVAC business versus '05, and where your customers are going to be. Net-net, do you think you will gain on HVAC or lose on HVAC next year?

We still have some discussions going on that could cause that to be one or the other. Let me just say that we have picked up some business in a lot of our different markets that we participate in, and we will be able to talk more about that next year as that information becomes public.

Okay. I guess -- I mean is there any other color, though, that you can provide about -- with just respect to HVAC how significant these things can be one way or the other?

Not at this time.

And then last, I guess, I would love to hear any of your comments -- well, second to last; I have one more. What are your thoughts on the JCI York transaction and what that is going to mean for A.O. Smith?

Well, we are obviously very proud of our relationship with York, and we are 100% behind what they're doing, and we don't think it is going to have much of an effect on us. We're still going to be a supplier as we go forward.

And then lastly, maybe John, can you talk about what your thoughts are for pension expense in '06 based on what we know today?

Based on what we know today, our pension expense this year is about $5 million. Right now, excluding the discount rate adjustment which is significant, but is dependent on what it is at the end of the year, we would probably be looking at about a 9 to $10 million number.

So a $5 million roughly increase year-over-year, '06 versus '05, before we even take into account a discount rate change; is that right?

Yes.

And then if your discount rate goes down 25 basis points, what does that do to that number?

That is about a -- a little less than $2 million, about $1.5 million.

Michael Schneider with Robert W. Baird.

Guys, just continuing on this discussion of just the pluses and minuses for 2006. Can you talk about the water heater margin? I guess I am surprised at the deleveraging this quarter with commercial being down. If you finish the year, let's call it, at a 9% margin and presumably commercial has been lighter than normal in this business, where do you go in 2006 if you assume you get mid single-digit volume increase? I think what we're all trying to put some bounds around, and we're not asking for specific guidance, but I think we're all wrestling with what to do with the 2006 trajectory, given what raw materials have done, given what is going on in the HVAC business, and then presumably in water systems now as you guys are wrestling with the commercial business as well.

Well, I don't agree we are wrestling with the commercial business. We are holding our market share there. We have a very good market share, a very good distribution base. It is just the commercial market itself is down. As you know, that has traditionally been a very high-margin business for us. The residential within the quarter, remember when we started the quarter we were still working down some inventory in the wholesale channel. We think that has normalized now, and again, we are not ready at this point -- there's too many moving parts to give you much help on the guidance for '06. We will be able to do more on that at our end-of-the-year call in January.

Well, Paul, back at the turn of the year when there was a big prebuy going on ahead of the big steel price increase for water systems, the comment was that the price increases of midteens would do enough for the residential business to put this segment back into call it the 12 to 14% target range. That was the hope; that was the goal. Now if you look at the third quarter and fourth quarter, if inventory and demand is back to equilibrium in residential, do you still believe that the price increases of the past three quarters, even four quarters, have indeed accomplished that goal, or because of raw material inflation we are back to below watermark?

We are pleased at this point with the relationship between our costs and our selling prices in the water products business.

Does that mean you're on target with reaching low double-digit margins in this segment with the price increases that are in?

Yes.

Does that then depend in '06 that the commercial market strengthens, or is it kind of status quo you can reach that level?

We are not going to project on '06 at this point. But obviously, it would be helpful if the commercial volumes increase. Right now, they have been weak all year long, as lots and lots of people have weighed in on.

That's it. Thank you.

Sanjay Sen (ph) from Auknowgin (ph) Investment Management.

I know that you had said that you would not comment specifically on unit volumes and stuff like that, but I had a couple of questions on the water heater side which I wanted to run by you. Year-to-date, your revenues are up 5%, which includes the price increase. Would it be fair to say that water heater volumes overall are down in the $0.07 to $0.10 range?

We are not going to put a number on that, but yes, our volumes have been down the early part of this year. And as I indicated earlier, we think we have turned the corner and we're very pleased with the incoming order rate now.

And I know the industry has been weak up to June, and then it seemed to get a little better as July and August went by. How did September compare to July and August, if you look at it that way?

We have not yet seen the industry numbers for September, but what I can say is right now we are projecting the industry for the year to be down 6% on the residential side. As a matter-of-fact, the commercial side we are saying is probably going to be at the lowest level it has been for seven years. So I mean it just represents how weak the industry has been.

How much was the industry up last year with this prebuy on the unresidential side if you look at it that way then, if it is down 6%?

The last two years, 2003 and 2004, have been pretty strong years, but last year the industry was up -- if you bear with me for one second.

Sure.

Not that much. I think about 1% last year, and the year before that it was up a couple of percent. So we are calling, though, for a significant decline on the residential side and commercial side this year.

So is this in your mind an issue of pent-up demand which should come through then in a strong '06 for the industry, or is it just stuff which you think is going away for good? Are heaters lasting longer, for example?

It is a combination of a lot of things. A lot of it is the things that happened over the last two years with all of the prebuys, prebuys ahead of flammable paper implementation, ahead of NECA, ahead of steel price increases. There has been a lot going on in this market in the water products business over the last couple of years that has really thrown a lot of noise and has really skewed a lot of the market shares from quarter-to-quarter and year-to-year. What we're saying now is that we're at a more normalized rate as far as what is going on in those markets, and we shouldn't be seeing the level of peaks and valleys that we have seen in the past.

And that activity as we saw in the last couple of years as you said, that didn't manifest in particularly big sales increases in the past, so -- but this normalized out, so you wouldn't expect this stuff to come back necessarily. This is more of a normalized level for the industry?

When you go back and average everything out, it has been a normalized volume. This is a fairly predictable market over a long period of time relative to the growth. There were a lot of peaks and valleys over the last couple of years that maybe didn't manifest themselves in total year numbers, but they were sure jumping up and down from quarter-to-quarter. And all we are saying is right now, it is a more normalized level. We have seen normalized levels over the last two years from time to time. We are expecting a more normalized level through at least the next year or so.

I think the other thing that has probably happened this year which we have talked about earlier is some dollarization of inventory as some of our wholesale customers in effect have tried to reduce inventories, and we would view that as a onetime kind of adjustment in our mind because they can only take their inventory levels down so far. So we really believe we have seen some of that happening this year, also. So I would not say that this year's levels are normal levels.

What would you say -- like you have consolidated the residential production in McBee, I believe, and the commercial in another facility. What would be plant utilization for you guys in the water heater business? How would you characterize that at this stage after all that work and factoring in also the demand-side that you are seeing?

First of all, we consolidate all the residential into Ashland City, Tennessee, as well as Juarez where we have a facility there, too. And our commercial was moved into McBee, so it's a little bit different from what you had said. We are not going to discuss the capacity utilization of the two facilities.

Would you be happy with the levels, I guess, then?

Sure, yes. We are happy with the efficiencies, especially the Ashland City improvements and how well that factory is going, and we are also pleased with some of the plans we're seeing for the future.

Final thing, is there anything else you can tell us with regard to the GSW thing? I know that people probably ask, but how the process is going and what you see there?

There is nothing else we can say about it at this time.

I appreciate it. Thank you.

Adam Fullen (ph) from Excalibur Research.

I have a follow-up to an earlier question regarding Ron Massa. How has he helped actually improve margins, and what concerns do you still have regarding sourcing and purchasing going forward?

I think I answered that question. Ron has opened some doors at some potential suppliers and people that we have not bought from in the past. We are doing a lot of things, not just knocking on doors and going to see other people and bringing in raw material from new customers. We have started reverse auction processes that are starting to pay some benefits. There is a lot going on on the supply side, and Ron is leading that effort. And that is not unlike what a lot of other companies are doing, but we are quite pleased with the results and the impact that that is giving to help us this year, and probably more excited about what the future will hold.

So he is looking at all areas to improve shareholder value regarding sourcing?

That is correct.

Matt Summerville, KeyBanc.

Just a couple quick follow-up questions. You have a very tough comp in your water heater business in the fourth quarter this year, and I was wondering if you could talk about what order trends look like thus far, and remind us what drove the very strong comp that you had in the fourth quarter. And then I guess as we are tidying up our models, whether or not you think that business is going to grow on a year-over-year basis?

Well, I think we've already answered that, that the order rate is very good right now. Once again last year in the fourth quarter, we had a double-digit price increase starting January 1st, and that obviously drove some volume into the fourth quarter.

Right. And then lastly with respect to China, what was the timing again on the startup there, and do you have an estimate on what startup costs are going to look like or what that curve will look like as you ramp that to capacity?

We're adding capacity to an existing facility. We are actually doubling it in Phase I, and that will be coming online in the first half of next year, and none too soon with the order rate there. We need that capacity -- we will need that capacity when it is ready.

Scott Graham from Bear Stearns.

Paul, I want to ask a question that I previously asked that I guess you didn't necessarily follow me on. Probably it was my fault. When we consider the volumes in China, we consider your comment that water heater volumes have essentially been down all year. It does suggest that you are doing quite well on the pricing side, certainly it would seem, in and around double-digit, maybe north of that. And I am wondering what is the reason why more of that is not translating down to the margin line in your opinion?

Well, we are pleased with what has happened there. Did we walk away from maybe some contractor business early in the year? Yes, we did, because we had a very high priority on getting the margins to the level they needed to be at. Residential margins have not been good and you know that, and we set an objective to get them there, and we have. Now we are on offense on the revenue side, and we are having some success.

If I may, Paul, that didn't really answer my question, though. I was asking about the margin in water heaters and why more of the pricing is not making it down to the bottom line in water heaters. I understand that mix is part of it with commercial. I also understand that this is not the in-season; this is actually the off-season for water heaters. But is there something else going on there that is stopping that full drop-down or even three-quarters of the drop-down of that pricing?

I think you're underestimating the effect of mix. You mentioned mix, and mix is a big, big portion of what happened in this last quarter. And as we go forward, time will tell whether the commercial returns or not. We are anticipating there will be a pickup in commercial, and we will see whether that happens or not. But mix is a big piece of what is going on, of what went on in the third quarter on the -- as far as the margins on water products. I can't stress enough, we are pleased with the relationship we have and the margins we have in that business now.

Okay, that is helpful. Second question relates to not necessarily GSW, because I know that you're not talking about that, but will GSW preclude you from doing other acquisitions for a while?

No, it won't, but it will probably preclude us from -- it will probably limit the scope of the acquisitions we will have to do, but we are still active on the acquisition part of growth. It is interesting to note, I am sure you realize that the strong cash flow we have had this year is going to help that situation going forward. I think it -- I probably shouldn't say anything else relative to GSW, but we are still active, but probably if we have additional acquisitions, they will be a little smaller. Maybe they are not going to be anything the size of GSW for the next couple of years.

On this point though, Paul, I know you have been around for two or three years now, and I guess I am just wondering did we exhaust all other possibilities for going into other businesses? I know that GSW has definite benefits for you guys, both in the retail channel as well as on the cost side. I don't think any of us doubt that. But what I am wondering is you guys have an extremely liquid balance sheet right now, and it is only getting better with your cash improvement. And I am just wondering if there was any thought given to adding a third leg to A.O. Smith rather than just buying GSW?

That is the world we live in. We are looking at that all the time trying to find any avenue to enhance returns to shareholders. Right now, the biggest opportunity we see for the shareholders is GSW, and we are going to pursue that and we are pursuing it, as you know, and we are awaiting regulatory -- it is in the process of regulatory review right now. But we look not only at products, but at market conditions. We look at geographies. We look at what is going on in other parts of the world where we could participate. Our approach is looking first at close adjacencies, things that are fairly close to what we do, but we are also open to other ideas and suggestions where we can take the strengths and maybe the sales and distribution networks or some technology that we have or something else to the marketplace and get returns for our shareholders.

So to answer your question, we're not just shutting down and looking opportunistically at one thing. We are reviewing on an ongoing basis, on a weekly basis, opportunities around the world. We are going to continue to do that.

Is there a breakup fee involved if this doesn't happen?

We're not going to discuss any of the details of GSW. Sorry.

That's okay.

Can't right now.

Michael Schneider from Robert W. Baird.

Just one follow-up on residential water heaters. There was the recall of a valve used by almost every one of your competitive brands. You guys use White-Rodgers, and I understand which did not have a problem. Was there a material benefit in the quarter or in the second half as a result?

Yes, Mike, we got a few more orders, but that problem got rectified fairly quickly. It was maybe a 10 or 15 -- maybe 20,000 additional units. It was not -- it gets lost in the rounding. It certainly helped our reputation relative to quality in the marketplace, but it was just a short blip there in August because the valves were -- the problem was fixed very quickly and our competitors very quickly took out the bad valves and started supplying products with the good valves very quickly.

And then on water systems as well. The idea that the Juarez plant now should be servicing and better balancing and minimizing freight across the U.S. map, where are you in that process and have you really realized the savings you were hoping for 18 to 24 months ago when we started talking about this?

Yes, we have taken our freight costs down year-over-year this year, and we are quite proud of that. And a lot of things have helped that, not just the increased utilization of Juarez. We have obviously and are absorbing a lot of fuel surcharges and everything else, but all the initiatives that we started a year-and-a-half ago or two years ago on freight have certainly paid off with better routings and better load factors and things like that that have helped us take our freight costs down. And those are permanent improvements that will be with us as we go forward, but it is obviously -- we're not able to show you as much of an improvement there because we have been paying, along with everybody else, these fuel surcharges.

And then just final focus is on the industrial motors division, which we haven't spent any time on. Presumably, was that actually up in the quarter, given your comments about HVAC?

It was a mixed bag through there. Again, one quarter when you're an OEM supplier, you can get a lot of ups and downs. But it was good in a couple of the markets and flat in some others.

And do you sense that you are holding or gaining share I guess in your ex HVAC businesses, pool and spa, and industrial in particular?

Yes.

Can you talk about any of the OEM wins that you have had? In past calls you have mentioned optimism about some of the wins and the momentum heading into '06. Any update you can give us on OEM wins, contract wins, whatever it may be?

Not at this time.

At this time, we have no further questions. Please continue.

This is Bob O'Toole again. You know, I have been doing these calls now for 20 years, and it just dawned on me this actually will be my last call. And I would like to thank all of you for your participation and your interest in A.O. Smith. If we didn't have your interest and support, we wouldn't be able to do what we're doing. So I truly appreciate it.

I feel very good about the transfer of the Company to Paul. Paul has been with us now for 21 months, and it really has been a seamless handoff. So I look forward to a really good future for A.O. Smith, and I don't know what -- I guess I will listen in on the conference calls in the future. Thank you very much.

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