A O Smith Corp (AOS) 2005 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the A.O. Smith conference 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). I would now like to turn the conference over to Director of Investor Relations, Mr. 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 Paul Jones, Chairman and Chief Executive Officer; Terry Murphy, Chief Financial Officer; and Jack Kita, Treasurer and Controller.

Before we begin with Paul'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 as well as in our Form 10-K.

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. Paul?

Thank you, Craig. Good morning, everyone. This morning I'm going to make a few comments about the forecast we issued this morning and I will touch on GSW a little more than I have in the past. However, we're still limited with respect to what we can and cannot say regarding GSW, so please bear that in mind as we work through the Q&A.

We thought as late as Friday when we issued our press release that we would be able to share in some detail the specifics surrounding some of the numbers in our press release. As you well know, this is customary at this point for a transaction headed for the goal line. Unfortunately, counsel for GSW, a Canadian company, has indicated that doing so would violate our confidentiality agreement with them. As a result, we have decided to share a limited amount of information at this time.

I will commit to you, however, that when we close the deal and complete the tender around the end of the first quarter that we will provide you with much more substance when we release our results for the first quarter, which will be a couple of weeks after closing of the deal. With that, let's get started.

Today we issued a forecast for 2006 net earnings of between $2.30 and $2.50 per share. This forecast includes expected nine months earnings accretion of $0.35 per share from the GSW acquisition after taking into account the effect of purchase accounting, transaction costs and expected synergies available to our water systems unit and GSW. In 2007, we expect that number to substantially improve as synergies are implemented and completed. This compares with net earnings in 2005 of $46.5 million or $1.54 per share after restructuring and other charges of approximately $12.9 million or $0.42 per share. Adjusted for the restructuring, net earnings were approximately $59.4 million or $1.96 per share.

In 2005, our electrical products business reported full-year sales of approximately $861 million and operating profit of $42.3 million after restructuring costs of $12.6 million before tax. The Company expects pretax cost savings from the restructuring of approximately $8 million in 2006.

The electrical products expects to report higher sales and profits in 2006 as a result of new program wins, the acquisition of the Yueyang Zhongmin commercial hermetic motors business in China and the benefits from last year's restructuring initiatives. We are projecting sales of approximately $60 million from new business, including Yueyang. And Yueyang is expected to have sales of between 15 and $20 million and generate incremental earnings of as much as $0.05 per share.

However, I think this slide says a lot. We're facing some headwinds in 2006, particularly for copper. Copper recently traded for more than $2.25 a pound on the spot market. Because of the dramatic year-over-year change in price, we're facing some cost adversity in 2006, notwithstanding our active program to hedge costs. Additionally, because of the record-breaking performance in the air-conditioning market in 2005, driven both by 10 SEER inventory replenishment and preparation for the switchover to the new 13 SEER product last month, we believe that the HVAC marketplace could prove difficult in the second half of the year, especially, if extended cool spring weather tempers the normal air-conditioning buying season. In market sales were 25% higher in the second half of the year than the five-year average for second-half sales. Year-end inventories were 16% higher than average.

Additional headwinds are higher peso costs, increased freight expense and higher employee costs, particularly healthcare, and pension expense.

Now on to water systems. Last year, our water systems business reported record sales and operating profit in 2005 of $833 million and $79.5 million, respectively. Sales were $41 million or 5% higher than 2004, due primarily to a $27 million or 45% sales increase in China. Operating margin for water systems rose to 9.5% in 2005.

Water systems is also projecting higher sales and income in 2006. Sales are expected to increase modestly as a result of improved residential water heater market penetration and growth in the market for commercial water heaters. Additionally, China is expected to grow at least 20% in 2006 to more than $100 million from 86 million in 2005.

Similar to electrical products, water systems is also facing some of the same headwinds of freight, healthcare and pension expense. In spite of this headwind, believe they could generate an operating margin of approximately 10% of sales in 2006 before inclusion of the GSW operating results. However, we remain cautious about potential cost volatility for raw materials and related pricing offsets as the year progresses.

Now let's talk about GSW and the new combined water heater operation. GSW reported sales of approximately $500 million in 2004 and enjoyed decent growth through at least the first nine months of 2005. We are acquiring GSW for approximately $334 million U.S. and as stated last Friday, we have completed a deposit agreement with the two majority shareholders and will begin a tender offer for the balance of the shares later this month. The price we are paying is equivalent to 67% of 2004 sales. We are not in a position to talk about other valuation metrics such as EBITDA at this point in time.

We are projecting earnings accretion of $0.35 a share in 2006 after taking into account the effect of purchase accounting, transaction costs and expected synergies available to both the Company's existing water systems unit and GSW.

Since 1997, when A.O. Smith Corporation focused on its electrical motor and water heater businesses, the Company has significantly increased its size from just over $600 million in consolidated sales to almost $1.7 billion this year. In addition to the strategic acquisitions, this growth has also been bolstered by our growth in China. At the end of 2005, segment sales were fairly evenly split between electrical products and water systems.

Our pro forma look at the two segments shows a 1.3 billion water heater business, making water systems A.O. Smith's largest business with about 61% of consolidated sales. On a pro forma basis, consolidated sales now total approximately $2.2 billion.

Under the new combination, approximately two-thirds of the water heater business will serve the U.S. residential marketplace, similar to today. 11% of the business will serve the commercial market compared with 19% before the acquisition because the American commercial business is relatively modest compared with this residential offering. The 19% international is the combination of our Chinese, Europe and Middle Eastern operations and the Canadian water heater business of GSW. When you put both businesses together, our residential offering will mirror the market, considering both the wholesale and retail channels. Another advantage is that the combination positions us to stay on top of the increasingly important retail channel in the plumbing marketplace.

The addition of the GSW brands American, American PROLine, Whirlpool, US Craftsmaster, GSW, and John Wood to our already hearty stable of A.O. Smith and State brands, represents a significant competitive advantage. A.O. Smith and State are two of the leading brands in the wholesale plumbing channel and A.O. Smith has been chosen repeatedly as the preferred brand in surveys among plumbers and specifying engineers. The Whirlpool branded American product, marketed through Lowe's, significantly enhances our retail offering. A.O. Smith's current retail offering includes the Kenmore brand through Sears and the Reliance brand, well-known and widely respected in the hardware co-op channel, where we are an exclusive supplier to the Ace, True Value and Do It Best chains.

Now a little background on the GSW business. GSW consists of two business segments, Water Heaters and Building Products. The water heater segment, with sales of approximately $500 million U.S. in 2004, in turn consists of two businesses, American and GSW Water Heating. American serves the U.S. market and GSW serves Canada.

In 2002, GSW acquired American Water Heater from its then Australian parent, Southcorp. American primarily serves the retail channel and Lowe's is far and away its biggest customer. As I mentioned, GSW also has a modest commercial offering marketed under the PROLine brand.

GSW's Building Products Business, located in Barrie, Ontario, had 2004 sales of approximately $35 million U.S. This business markets vinyl rainwear systems under the TuffFlo and Rain Master brands.

Now let's talk about strategic benefits. In addition to partnering us with Lowe's, A.O. Smith will be able to leverage its robust manufacturing operations in Juarez, Mexico to better serve GSW's growing needs in the western part of the country. In addition, there are numerous synergy opportunities. In 2006, the primary cost savings will be derived from the closure of the corporate headquarters operation while next year, we expect additional savings from materials and the optimization of facilities and logistics. This acquisition also brings us a significant presence in the Canadian residential market.

Finally, regarding the completion of the acquisition. Now that the deposit agreement has been attained and the GSW board has recommended the offer to the rest of its shareholders, we're now positioned to launch the tender offer for the balance of the shares later this month. We expect to be able to close the transaction by the end of the first quarter.

So in conclusion, we think that 2006 holds great promise and we look forward to discussing our opportunities in great depth as the year proceeds.

We're now ready to take your questions. Cynthia?

(OPERATOR INSTRUCTIONS). Scott Graham, Bear Stearns.

Good morning. In the past, A.O. Smith has really made a nice living from moving production around the world to lower-cost areas and obviously you have a great footprint in Mexico and an increasing one in China. I guess my simple question is, is this a situation where GSW will enable you to at some point in the next couple of years close another or more than one additional facility in favor of building out in Juarez? In particular I guess it would be a GSW facility. Are there any plans in the next couple of years where you would do that? And I have two other questions.

Okay, Scott. The short answer is there are absolutely no plans to close any of the facilities at this time and I really can't envision that happening. The GSW plant, the American plant in Johnson City, Tennessee is running very, very well. Probably it will be probably our most efficient operation.

It's running -- getting close to capacity, that's my understanding. And probably what we will be doing is picking up some Lowe's growth out of Juarez but it will not mean even a downsizing, maybe a reduction in overtime but not a downsizing of Johnson City. So probably the only thing you'll see in the next couple of years is handling some of the Lowe's growth, particularly on the West Coast out of our Juarez facility. But there just would not be enough capacity at two of the three facilities no matter which two of the three you pick to cover the marketplace and be able to handle the growth we expect. You said you had some other questions?

I did, but if I may also, Paul, so it sounds to me as if rather than rationalizing capacity, you would be rather in this integration it would be sort of light lifting not heavy lifting and synergies based over a several-year period of time rather than one or two major thump type of plant closures, yes?

That's correct. And the synergies would be in the area of some material purchasing, putting the -- which would serve the entire, our whole water systems business, by putting together the purchasing power of both groups. But that's probably the number one synergy that we see on the future.

Very good. Second question relates to your customers, you being a primary source of Sears in the category and they being a primary source of Lowe's in the category. What has been the feedback from these two very important, very large customers? Is there a problem there or is that something that they really don't even mind?

That's really a question you will have to address to them. We have got a good relationship with Sears. It's been a long-term relationship, we value it very much and we expect to continue to be an excellent supplier to them. American has got a great relationship with Lowe's and after this transaction, we expect to be a great supplier to them.

Okay. Last question relates to back on the motors business. Obviously, you have done a great job in signing on new business that seems to -- reversing a trend of certainly 2005 possibly even getting back to 2004 in that business. My simple question is of the $60 million that you guys talk about in new business, could you guys give us an idea of what the margins on that business are and where you're getting it from?

Margins are along the normal lines for the different markets that they are in. They are acceptable margins. What we're doing is we are on offense. We were doing for the last several years, we have been getting our manufacturing footprint in place and we have had to devote our resources towards getting the products specified and approved. Once again, I remind you the majority of our motors business we are an OEM supplier and our product goes into somebody else's product that is designed for a specific purpose. So our engineering group has worked with their engineering group to make sure that the system they are building, be it a garage door opener or a furnace or an air-conditioning system that the motor or motors fit the rest of the system. So when we move from one manufacturing location to another, that's a pretty big project, 12 to 18 months sometimes.

Well we got all of that out of the way now or most of it out of the way. We're always going to have some of it going on. So now we are unleashing our sales force to go knock on doors and unleashing our engineers to go work on new applications and new applications of existing products, and it is our intent to grow market share in the motors business as we go forward.

Ted Wheeler, Buckingham Research.

Good morning, all. I wonder if you could just give a little bit of color or detail on the inventory write-up costs and transaction costs that you expect will accompany the deal?

Nothing yet; that's still being evaluated. We're going to use the tender offer process as an opportunity to work on some of that.

Okay, but the technical, I guess, issue would be what you write up inventory so the first turn is at no margin; is that how that works?

Yes, we will have some costs associated with the current profited inventory. We will likely have some write-up of property, plant and equipment and we expect that there will be a write-up in intangibles. So we did factor in some expenses or some increased costs associated with increased amortization and depreciation expenses and coming up with the $0.35 a share.

Okay, but you can't sort of give us any clues as to what all that might --?

We're not even there yet. We're in the process of sending out a request for quotes for someone to do that valuation for us so we have some idea -- not ideas that we're ready to share with anybody.

One other question just on the copper issue, where are you in your hedging and just sort of how far in advance are you hedged and to what degree? I guess I'm thinking most of your pricing opportunities are early in the year and did we capture, I don't know, January pricing in your attempts to price for the product line today?

Obviously, there's a strong need in the motors business to get some price. We're in the middle of that process as the whole industry and the copper just happens to be a glaring element of our cost. The pricing actions that we're doing are a cost base. And we typically on the hedging, we and pretty much most of our competitors, do some hedging. Some a little more than others, some a little less. We typically hedge about a year in advance and that is the program we are under right now. So we have pretty much got most of our copper for this year accounted for.

Once again, most of what we get or about half of what we buy, we buy in partnership with our customers. So we will go collectively at a point in time and at a price to get the copper and then it's factored into our price to them; it's just a pass-through of that cost.

And on the part that's not a pass-through, the pricing is being -- I guess you're negotiating now? The prices are not really set then for '06?

Well, I mean we have a lot of customers that are not part of contract pricing agreements, like distribution for example, things like that.

So you can move those around --?

Aftermarket. So we're in discussions as probably is everybody else that's looking at this unprecedented increase in material costs. It's not just copper. Aluminum is going up also dramatically right now. Among other things, we're doing some conversions of products, especially in motors from copper wire to aluminum wire, to all the cost saving opportunities we see.

If I thought about your profit outlook, would we think in terms of electrical products margin as being similar to '05 and then add the restructuring benefits? Would that be a proper way to approach your --?

That's probably a good, appropriate way of looking at it on a conservative basis.

On a conservative basis, terrific, thank you.

Brian Rayle, FTN Midwest.

The question -- most of them have been answered -- but the question about the HVAC on the back half of '06, I am assuming that commentary is basically generated from a tough comp. You're not really saying that -- basically what you are saying is that '06 may be a normalized year versus that tough comp? Or is there something else in that guidance that may not have come through?

No, there's nothing else to read. Just to point out that about half of our HVAC business is commercial, which was not affected by the HVAC inventories in the chart that I showed a little bit earlier. We are really compared to others, we are a smaller player in the residential side, but we get the same data everybody else does and there was a very, very strong third and fourth quarter. We had a longer, hotter summer that went a little longer into August, September and that depleted inventories and we all saw a little more business the third and fourth quarter. And we just don't quite know how that's going to play out as we play out '06. So it's just a little bit of caution there as to how we're looking at what that market might be this year. I think most people would expect that the residential HVAC market in '06 will be smaller than it was in '05.

(OPERATOR INSTRUCTIONS). Matt Summerville, KeyBanc.

Good morning, couple of questions. First in the motor business, Paul, can you talk a little bit about like you did in water heaters -- I mean you threw out a 10% target -- kind of what your margin target for that business is this year? Because you have obviously some new business that's ramping up; you also have pension point against it, you have copper point against it, and then the savings from the Ireland closure, obviously, on the positive side. I mean when we net all that out, should we be looking for 100, 200 basis points of expansion or is that too aggressive?

I'd rather not try to get into anything that specific, Matt, at this point. Let's just say it's our intent to grow the margins and the margin percent, margin dollars and margin cents in the electrical products business. And don't leave out productivity. We're still getting productivity gains in that business too, to help offset the things you correctly pointed out, like pension costs and healthcare and copper and freight and all those things that are hitting a lot of businesses these days.

The motor business is a little different point in the cycle than the water products business and we still have some more work to do on the internals relative to productivity and getting our costs in line and some -- possibly some additional restructuring although it will be nothing along the lines of what you saw last year. But it's our intent to grow margins there, dollars and percent, but I'd rather not give you a target right now.

As far as the 60 million in new revenue, 20 of it we'll say is the acquisition that you made, so that's 40. Is that net of any pieces of business that maybe you didn't recapture or are rolling off?

For the most part, yes. I mean, we've got a few things. As everybody knows, we have a fairly large customer that has lost some market share over the last couple of years and we've obviously been impacted by that. But yes, that's pretty much net of everything. We expect we will be able to hold our own except for the new business.

I got on the call a few minutes late so if you already answered this, my apologies. Did you in any way relative to that $0.35 of accretion you expect for GSW, how much of that is synergies in 2006?

No, we didn't give you any of that specifics and we will wait and do that in our first-quarter call in April.

Scott Graham, Bear Stearns.

Paul, are there any different types of accounting rules? I'm not familiar with Canadian GAAP. So are there any adjustments that have to be put through GSW's margins, costs, what have you, that would change what they publicly report as operating margin as expenses? Could you give us a quick sum up of that?

Well the accounting folks in the room with me are shaking their head no, that there's nothing unusual that would impact this.

So the operating margin in Canada, converted, should be essentially the operating -- well other than changes in fixed asset and inventory valuations for currency, that would be it, in other words. Just those are the only differences, the changes based on the currency, the translation, yes?

The answer is yes. Let me just point out, I assume everybody knows that GSW has not to date made public its total-year 2005 financial results. And that will be coming up at some time in the future. So I really can't comment beyond that.

Mike Schneider, Robert B. Baird. Mike, your line is open. Please go ahead.

Mike, are you there? Why don't we go to the next one?

(OPERATOR INSTRUCTIONS). I am showing no one in queue at this time.

That's fine. We just want to thank everyone for being on the call today. As always, you know our phone numbers, so we stand ready to discuss the business any time. And I think, Cynthia, you're going to explain the replay information, please.

Yes, ladies and gentlemen, today's call will be available for replay after 12.30 PM today until midnight, February 9. You may access the AT&T Teleconference Replay System at any time by dialing 1-800-475-6701 and entering the access code of 818367. International participants dial 320-365-3844. Once again, those numbers are 1-800-475-6701 or 320-365-3844, entering the access code of 818367. That does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.