A O Smith Corp (AOS) 2006 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. We do appreciate your patience today while the conference assembled, and good morning. Welcome to the A.O. Smith first quarter 2006 earnings conference call. At this point, we do have all of your phone lines muted or in a listen-only mode. However, after the executive team's presentation today, there will be opportunities for your questions and those instructions will be given at that time. (Operator Instructions).

As a reminder, today's call is being recorded for replay purposes and we ask that you stay online at the conclusion of the call to receive that replay information.

With that being said, let's get right to this first-quarter agenda. Here with our opening remarks is Vice President 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 Paul Jones, Chairman and Chief Executive Officer; Terry Murphy, Chief Financial Officer and John Kita, Treasurer and Controller.

Before we begin with Paul's remarks, I'd like to remind you that some of the comments that will be made this morning during the 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've described in this morning's press release. We have a slide presentation on our web site to accompany this morning's remarks, so please feel free to follow along while we conduct the call. Paul?

Thank you, Craig. Good morning, ladies and gentlemen. This morning, we announced first quarter earnings of $15.5 million compared with $14.3 million last year. Earnings per share increased 5% to $0.50 per share compared with $0.48 per share earned last year. First quarter sales increased 12% to $459 million compared with the first quarter of 2005.

First quarter results included an after-tax loss of approximately $3.1 million, or $0.10 per share, from foreign currency contracts related to the GSW acquisition. Excluding the currency loss, first quarter earnings increased 30% to $18.6 million, or $0.60 per share, compared with the first quarter of 2005 net earnings of $14.3 million, or $0.48 per share. Additional currency transactions related to the completion of the acquisition subsequent to the close of the first quarter will result in an offsetting currency gain of approximately $3.2 million, or $0.10 per share in the second quarter.

Operating performance was strong in the first quarter. A 14% increase in sales at Water Products resulted from higher sales of residential product, a stronger market for commercial water heaters and continued strong growth in China. Sales of Electrical Products grew more than 10% in the quarter as a result of stronger HVAC sales, new programs and higher distribution sales.

Operating earnings increased 25% at Water Products, resulting in a margin of more than 11%. However, earnings improvement at Electrical Products was tempered by higher costs for freight and utilities.

Earlier this month, we completed the acquisition of GSW and have started the integration process. We are pleased to welcome the customers and employees of GSW and American Water Heater into the A.O. Smith family.

This morning, we confirmed our February forecast for 2006 earnings of between $2.30 and $2.50 per share, which includes earnings accretion from the acquisition of approximately $0.35 per share. Our strong first quarter results bolster our confidence in that forecast, and I will elaborate on that shortly. Terry will now discuss the financials, and I will come back to talk about GSW and the outlook for the balance of 2006. Terry?

Thank you, Paul. Net earnings for the first quarter were $15.5 million compared with $14.3 million last year. Excluding the currency loss for GSW, net earnings improved 30% to 18.6 million. Excluding the $0.10 per share charge related to the currency loss, earnings per share improved 25% to $0.60 a share compared with the $0.48 share earned last year. As Paul mentioned in his remarks, there will be a one-to-one offset for the currency losses recognized in the second quarter financials. In fact, had the events causing the gain and the loss all occurred in the same month rather than straggling the end of the quarter, we would not have ever needed to mention it here today.

First quarter sales at Water Products of 231 million were 14% higher than last year, reflecting gains in residential share, strength in the commercial market and significantly higher sales in China. First quarter sales in China increased 43% to $24 million.

At Electrical Products, sales increased 11% to $229 million on the strength of sales to the HVAC and distribution markets as well as the addition of new programs. Higher prices implemented to offset higher raw material costs also contributed to the sales improvement.

Turning to operating profit, the higher sales volume at Water Products and improved mix contributed to a 25% increase in operating profit that generated an operating margin of 11.2% compared with 10.3% last year. At Electrical Products, the earnings improvement from higher sales volume was tempered by higher peso costs and higher expenses for utilities and freight. As a result, our operating margin declined slightly to 5.9%.

As this earnings reconciliation chart -- slide demonstrates, the GSW currency hit of $4.2 million pretax offset a large portion of the $6 million improvement in operating profit. Corporate expense also increased $2.1 million compared with last year. On a positive note, our tax rate declined to 28% from 33% last year. The 28% rate resulted from proportionately higher income from foreign operations like China and Mexico where tax rates are significantly lower than in the Company's U.S. operations.

The tax rate for the year is expected to range between 29 and 29.5%, and in conjunction with the higher rate for the year, we're projecting a tax rate of between 30 and 31% in the second quarter before returning to between 29 and 29.5% during the second half. This rate increase will be because of the acquisition of GSW, whose U.S. operations will increase the proportion of U.S. income, and therefore, increase the overall tax rate.

Our gross profit margin of 21.5% was unchanged from the first quarter of 2005, while SG&A was 68.5 million in the quarter, compared with $62.4 million last year. The increase in SG&A was the result of higher SGA in China, higher selling expenses, pension cost and corporate expenses compared with the first quarter last year. As a percentage of sales, SG&A declined modestly to 14.9% from 15.3% last year.

Operating cash flow was negative $4.7 million in the first quarter and the debt to capital ratio increased modestly to just under 24% at the end of the first quarter. We're projecting full year operating cash flow of between $100 and $110 million for 2006. Cash cycle days of 63 were 24 days lower than last year and unchanged from the fourth-quarter rate of 63 days. Capital spending was $9 million for the quarter, compared with $7.4 million last year; depreciation and amortization was about $12.4 million for the quarter. Total year capital spending for 2006 excluding GSW will approximate 55 million compared to about $51 million last year, and about the same as depreciation.

We continue to enjoy strong growth in our Chinese Water Heater operation. Sales increased more than 40% to 24 million and are expected to exceed $100 million for the year. The expansion project that began in 2005 is on track and Phase I will be completed by the end of the second quarter. We expect the project to double annual capacity to more than 1 million units by the middle of next year.

Now Paul is going to talk more about the 2006 outlook and the GSW acquisition in a little bit more detail. Paul?

Thank you, Terry. In February, we achieved our forecast for 2006 of net earnings of between $2.30 and $2.50 per share. Here are the items that make up that forecast.

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. The Company expects pre-tax cost savings from the restructuring of approximately $8 million in 2006.

Electrical Products expects to report higher sales and profits in 2006 as a result of new program wins, the acquisition of Yueyang Zhongmin Commercial hermetic motors business in China and the benefits from the last year's restructuring initiatives. We are projecting sales of approximately $60 million from new business, including Yueyang, and Yueyang is expected to add 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 headwind in 2006, particularly for copper. Copper recently traded above $2.90 a pound on the spot market. Because of the dramatic year-over-year change in price, we are 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 in preparation for the switchover to the new 13 SEER product in January, 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 conditioner buying season.

In-market sales were 25% higher in the second half of last year compared with the five-year average for second half sales. Year-end inventories were 16% higher than average.

During the first two months of 2006, OEM shipments increased more than 40% compared with last year, while production has increased a more modest 11%. In fact, production declined almost 30% in February. Accordingly, inventories have started to come back in line. At the end of February, combined inventories were only 4% higher than the five-year average.

Additional headwind at Electrical Products are higher peso costs, increased freight expense and higher employee cost, particularly health care and pension expense.

Now onto Water Systems. Last year, our Water Systems business reported record sales and operating profit of $833 million and $79.5 million, respectively. Sales were $41 million, or 5% higher than 2005, due primarily to a $27 million, or a 45% sales increase, in China. Operating margin 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 wholesale water heater market penetration and growth in the market for commercial water heaters. In addition, sales in China are expected to exceed $100 million in 2006 compared with approximately $86 million in 2005.

Similar to Electrical Products, Water Systems is also facing the same headwinds of freight, health care and pension expense. In spite of this headwind, we believe Water Products will generate an operating margin in excess of 10% in 2006 before inclusion of the GSW operating results. Having said that, we remain concerned about potential cost volatility for raw materials and related pricing offsets as the year progresses.

On April 4, we completed the acquisition of GSW, so let's talk about our new Water Heater operation. As many of you know by now, GSW is a Canadian-based manufacturer of water heaters and building products that we acquired for approximately $340 million U.S. in cash. GSW's 2005 sales were approximately $520 million US. In addition -- the addition of GSW's and A.O. Smith's Water Heater operation expands the Company's position in both the growing retail channel of U.S. residential water heater market segment as well as in the commercial and residential segments of the Canadian water heater market.

We're projecting benefits from synergies of about $3 million in 2006 for the second through the fourth quarters of the year and accretion of approximately $0.35 a share, which includes estimated amortization costs related to purchase accounting. We expect accretion of between $0.60 and $0.70 per share in 2007, including synergy cost savings of between $11 and $15 million before taxes. Our accretion forecast assumes margins of approximately 8% in GSW's underlying Water Heater business.

Since 1997 when A.O. Smith Corporation focused on its Electric Motor and Water Heater businesses, the Company has significantly increased its size from just over $600 million in consolidated sales to almost $1.7 in 2005. In addition to the strategic acquisitions this growth has also been bolstered by growth in China. At the end of 2005, segment sales were fairly evenly split between Electrical Products and Water Systems.

A pro forma look at the two segments shows a $1.3 billion Water Heater business, making Water Products A.O. Smith's largest business with about 61% of consolidated sales. On a pro forma basis, 2005 consolidated sales would have totaled 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 a 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 offer will mirror the market, considering both the wholesale and retail market 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, U.S. 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, State and American are three of the leading brands in the wholesale plumbing channel and the A.O. Smith commercial has been chosen repeatedly as the preferred brand in surveys among plumbers and specifying engineers. The Whirlpool brand of 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 slightly 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 $490 million U.S. in 2005 in turn consists of two businesses -- American and GSW Water Heating. American serves the U.S. market and GSW serves Canada. 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. Last year, American supplied the U.S. residential market with approximately 2 million water heaters. Most of these heaters were manufactured at American's Johnson City, Tennessee facility.

GSW Water Heating is the legacy water heating business of GSW and is based and Fergus, Ontario, Canada. Last year, they marketed approximately 400,000 units in Canada under the John Wood, Space Saver and Superglue brand names.

GSW's Building Products business, located in Barrie, Ontario, Canada, had 2005 sales of approximately $30 million U.S. This business markets vinyl rainwear systems under the TuffFlo and Rain Master brands. The Building Products business is a relatively small part of GSW and is not really a strategic fit with A.O. Smith. Later this quarter, we will begin the process of finding a better strategic partner for this business and would hope to complete the process by the end of this year.

Now let's talk about strategic benefits. In addition to partnering up with Lowe's, A.O. Smith will be able to leverage its manufacturing operation 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 saving will be derived from material savings and the closure of the corporate headquarters operation, while next year, we expect additional savings from materials and the optimization of facilities and logistics. The acquisition also brings us a significant presence in the Canadian market.

So we're off to a very good start in 2006 and are enthused about our prospects. That completes my prepared remarks and we are now ready to take your questions.

(Operator Instructions). Mike Schneider, Robert W. Baird.

Good morning. Maybe we can first address just the water heater business. Paul, you made comments that you believe you're gaining share in the residential channel. I'm just curious what data you have behind that, maybe what your residential sales were up versus the market data you have seen?

Well, Mike, you've seen the same market data that we have and it's our belief and with some of the programs that we have had, and plus just looking at the year-over-year gain, that we have turned the corner. We've been declining market share for the last four or five years, but our data shows that we are now increasing. And some of the things that we have been doing in the marketing and sales arena in the areas of products, service and quality we think are starting to pay off.

Presumably those gains are occurring in the wholesale channel?

Primarily, yes.

Okay. And then, when you look at your forecast of the year, what have you assumed about residential housing? We got the latest update this morning for permits and construction, and they were both worse than expected. Despite the Q1 strength, just curious about what your segment leaders are saying about the segment and what's embedded in the forecast?

Well as you know, we do participate fairly heavily in the new housing side of the business because of our strength in wholesale. But, once again, we are at the tail end of the building cycle. They don't buy their water heater they day they get the permit, they buy it a few months later. And right now, we're just watching the up and downs, and frankly, we're just concentrating on getting some program wins in the marketplace. And so as of right now, we are forecasting as we start the year a slight decline, and we will be updating that as we go on. But my assumption is, when we meet with the folks later this week, that we'll be fairly close to where we have been.

Well, the [home builders], Paul, [has seemingly preannounced] across the board [in] the out quarters. Have you seen weakness in some of your major home building accounts?

No, we have not. We have not seen any weakness there. And just remind you that, even though we do participate in the new homes, still the vast majority of our Water Heater business is replacement.

Okay. And is it fair to say though, Paul, with the acquisition of GSW, given that you guys kind of represent the overall market, that your exposure to new housing would be as large or larger than just the new housing mix in the U.S. economy?

No, I don't think it would be larger. Again, the American product through Lowe's is almost exclusively a replacement business. So on a percentage basis, because of the large market share that we have in retail, I think on a percentage of the total, it would probably the smaller.

Again on your forecast, Paul, you said that you expect Water Systems to be up modestly in sales for the year, yet you were up 14% this quarter. And China is expected, at least by the numbers you gave, to be up over 25%. So how do we reconcile 14% for the first quarter, 25% plus growth in China, yet only modest gains for the year?

Well, we had a good quarter and we don't like to overpromise.

Was there any element of prebuying or anything that you sensed during the quarter?

For once I think in two years, I can say that we haven't seen any elements of prebuying. So maybe we are getting to what the market really is since we've had all these ups and downs the last couple of years.

Is it possible then, at least given your guidance forecast, that -- or I guess should we infer that you expect the business to possibly even be down in some of the coming quarters in Water Systems to make the math work?

Mike, I'm not going to do your model for you. We're just out there trying to get customers as fast as we can. We are being aggressive in the marketplace. We are doing some things on the product development, on service and quality, and it's our intention to be a strong participant in the water heater market and the motor markets.

Fair enough. And then the final question, just on the margin forecast there. Doing in excess of 10% operating margin in the core business. Again, the core A.O. Smith business alone in first quarter did 11 -- what was it?

11.2

11.2. Again -- well, copper is rising, steel has seemingly I guess reemerged on the positive side again, and inflation. Is that what you're trying to embed in the forecast, just higher costs going forward? Or, is there something about the mix that changes as the year progresses?

Well, third quarter is always a weak quarter. Other than that, you're right; we're putting in the things you just mentioned as increases for the year. I should point out that we're also having some pretty good productivity gains. We haven't talked about that. But our Ashland City facility continues to get significantly better on output per man-hour, and we have that factored in also.

Okay, thanks again and congratulations on the GSW deal.

Thank you.

Matt Summerville, KeyBanc.

Good morning. A couple questions. Paul, can you just remind us how much of your copper is locked in for 2006? Do you know the price you're paying for the remainder of the year?

Yes. It's all locked in through to 2006, and we know the price.

Okay. As you look out to 2007, historically, your strategy has been either pass-through arrangements with your customers, or you are buying the raw material forward. Are you doing that for 2007 given the recent spike we have seen at least year-to-date from close to $2 to the numbers you cited earlier? How are you thinking about that strategy, and does it make sense to buy forward, or are you looking at something else, and if so what?

Well, we continue to hedge and buy forward and we're continuing to do it with some of our customers. Obviously the things that have happened in the last week, we're not buying forward this week, for example. But we continue to watch it and monitor it and we have excellent people that work on this, both in our business as well as our customers' businesses and we consult with them on a regular basis and hedge when we think it's the right thing to do.

So you are, then, we can conclude, you are starting to lock in copper prices for 2007 at this point?

We have locked in some copper prices for 2007. We actually did it earlier in the quarter.

And would you anticipate having to buy any meaningful quantity on the spot market next year, or is your objective, as it has been in the past, again, to know as you enter that new year what you're paying for copper?

We have traditionally tried to make sure that we knew through the end of the year what we're paying for copper. And as of right now, I would say that's what we intend to do going into next year. But I will caution you, this is unprecedented prices on copper. If we see those prices tumbling, obviously, we're going to wait and we will make a judgment. We may be participating in the spot market next year if the copper market turns around as all the economists have been saying it's going to do. They've been saying that for two years and they have been wrong for two years, but one of these days they're going to be right.

If you look at -- is there any way for you to quantify or at least describe what your impact would have been in the first quarter had you not gone about and bought forward and hedged your exposure there? Would it be very significant? And then, how much pricing power do you think you still have left in this business if you are looking at $2.50 copper on a blended basis for next year, just throwing the number out?

We have not tried to normalize what it would have been. That's not something -- an exercise we do. But the whole market is going to see pricing pressures. And as we have demonstrated in the past, we're not going to be bashful about doing what we have to do to cover increased material costs.

Can you also just walk through the breakdown between motors and water heaters per-GSW, what the breakdown was between residential and nonresidential construction markets, as well as just your general thoughts on the growth rates that we're going to see this year?

In both businesses, we have been more heavily weighted to commercial products; that is both our HVAC on the Motor side and our Water Heater business in the past because we have had a fairly strong market share there both. In our Motor business, for example, in HVAC, about half, maybe a little more of that business is commercial and not residential.

On the Water Heater side, in the past, we have been a very strong commercial player, market shares approximating 50%. And as we go forward on the Water Heater side, we're still going to keep the same number of customers. And it's our intent to actually continue to try to grow that business. But as a percentage of the total with American coming into the fold, our commercial business is going to go down, I think we said around 11% from 19. It's not because of losing any business. We're still going to have probably a 50% market share of the commercial water heater business. It's just the very large retail component we get with American makes that to just be a smaller percentage of the pie.

Just back to the Motor business, you mentioned I think in your guidance for the year that you anticipate operating profit improvement. I was curious as to whether that means dollars or margin. And if you look at the revenue and the business in the quarter, you had a couple of million; 3, 4 million from Yueyang. Would that be accurate?

Yes, that is about right.

So you have a couple million dollars there, you have some new programs that you're ramping up. If you look at your base HVAC business, was it really up all that much? And then again, that begs the market share question in this business which you kind of hit on what you thought about market share in water heaters in the quarter?

Well, we think we're going to have -- we have the business growing on the Motor side, and that has been a stated strategy of ours to get back on the growth track there, and we're doing that. The HVAC piece, we happened to have a good quarter there as probably did our competition. It was a good market. But as we said, as we look forward, we can see inventories are back up. Inventories were way down last year. We had all the noise of 10 SEER product phasing out, 13 SEER coming in. I think we're getting to more of a normalized rate going into the year. And once again, most of our HVAC business is commercial, not residential.

So is there -- can you talk about how you think your market share trended in the motor business, similar to what you did in water heaters?

We think our market share is up a little bit because of the program wins. If we're projecting a revenue growth of around 60 million, we're not projecting the market to be up that much of our business. (MULTIPLE SPEAKERS) We're doing it with new customers, not with anything other than new customers.

And that would include the HVAC piece of the business, you think you're gaining sure there?

We're not going to break it down by segment; we're just talking in total.

Okay, thank you.

Scott Graham, Bear Stearns.

I have three questions. Paul, are you able to comment on the percent price realization you got company-wide in the quarter?

No.

Okay. With respect to the corporate expense number this quarter, was there anything in that number that was let's say management resources applied to closing the GSW acquisition? That number looked a little high.

I will let Terry answer that.

The answer is no. Most of that increase is due to two items. Once is the increase in pension expense and the other is that we had a $400,000 benefit last year for interest expense on a tax refund. So the combination of those two events I think make it look a little higher.

Very good. On the synergies, I was hoping that you might be able to go a little bit more in detail. Certainly corporate office closure is very straightforward, but could you talk specifically, Paul, to the materials, logistics and facilities synergies that you're referring to as part of the accretion estimate?

Well, just to remind you, we did not put, unlike a so-called normal merger integration, we just started putting our work teams together two weeks ago. We were doing very little work prior to the closing of the deal with the fine people at American and GSW. So we have been doing work independently, and by the way, so had the folks at American and GSW, and we've gotten those teams together. They are working actively right now, especially on the materials and purchasing side. And all I will say is that we are comfortable with what we've said to you before and those teams are working together very well. And we have the projects in place, we are assigning engineering resources where we need to have a change and we are comfortable with the synergies that we have indicated that we're going to be able to get over the next couple of years.

Scott, let me add one point to Paul's comments. Categorically, I can tell you that if the positives are material costs, kind of closing of the corporate office and reduced management incentives. Those are the positives that contribute to the $0.35. Those are offset by increases in depreciation as a result of the write-up of assets, increased amortization as a result of write-up and intangibles; profit and inventory, which will occur during the second quarter; and some loss of business. So categorically, those are the categories that we've looked at to some up to the $0.35. We're not going to break down the $0.35.

Right. I guess then two additional questions if I may. Again, I was looking for more than just what you said in the synergy number, Paul. I was looking for materials in particular. Are you just looking to consolidate purchasing and buy better, or is there some type of reengineering that goes on here, or is it both?

It's both. It's a combination of things. Some cases, it's just as simple as changing the heading on the purchase order, in some cases it requires an engineering change design. For example, we have three different combustion chambers for gas water heaters. We're going to have one at some point and it'll be a lower cost, better performing example. That is one of the longer-term improvements, and there's a lot of short-term. But there's things all over the mat, everything from pipe fittings and valves and controls, to the obvious ones of steel, copper and paint and things like that.

Okay, very good, thank you.

Ned Borland, Next Generation Equities.

Hi, guys. Just one quick question. Historically, you guys have had some cost savings based on moving production south of the border, into China. With GSW coming in, has that even been looked at as an option?

Yes, Ned. Lowe's is growing rather dramatically on the West Coast. That's part of their strategy, is to grow in that region. And it's very expensive to ship a water heater from Johnson City, Tennessee to the West Coast, which is happening today. One of the potential synergies that we're pursuing along with Lowe's and along with the folks at American, is using some of our available capacity in Juarez, Mexico to help with that growth. That's not going to be moving product lines, it's just going to be taking the growth that is occurring on the West Coast out of Juarez, which -- the main savings there, frankly, are in freight. It can cost over 20, $25 to ship a water heater from Johnson City to West Coast, and we can do it for far less than that out of Juarez. That's just an example.

Okay. Most of my other questions have been answered. Thanks.

Ted Wheeler, Buckingham Research.

In your guidance for the year, do you assume additional pricing to offset copper, or basically price -- I guess you mentioned, you know your copper costs. Are prices set for the year? Or, do you need to raise prices further to achieve your goals?

With the guidance we've given you right now, we are assuming fairly constant material costs as well as reasonably constant selling prices. We do have a few price initiatives that we're implementing, but they're market related and product related. And we're always going to have things like that.

Having said that, we do have some escalation clauses in some of our contracts, especially on the motor side for steel. And steel, frankly, is running higher right now than we thought it would. So there are a few things that will be happening there where we will invoke some of those escalation clauses where we are seeing increased raw material purchases, and we will pass that on. But more importantly, if copper continues to do what it has been doing and fuel costs keep going up, I think it would be realistic for us to look across the board at pricing in both businesses.

I guess that's what I was kind of coming to. It's hard to assume, but if we assume current conditions hold, what pricing needs do you -- do you envision in '07 to kind of hold even on raw materials, on copper particularly?

With the copper, if it holds steady through the rest of the year, we will be looking at some rather significant pricing actions on our motor business as we go into '07. I would really prefer not to announce price increases on an earnings call, but (MULTIPLE SPEAKERS) the things that will be studied and reviewed as any manufacturer would have to when they're seeing rapidly rising costs.

And certainly water heaters would face some requirement to raise prices as well, right?

To a lesser extent. We use -- a vast majority of our copper is used in the motor business. We do have a copper product line in the water heater business that would obviously be affected by copper prices. And there, we're not as contract-generated. It's more transactional, the water heater side. So price increases can typically occur a little quicker.

Terrific, thank you.

Mike Schneider, Robert W. Baird.

Hi, guys. Terry, maybe you could just address where you are on the copper recovery ratio right now. If you look at the sales of variance and then the cost variance, what percentage of the copper do you believe you are recovering today?

As we've kind of talked in the past, we have approximately half or so of escalator costs, et cetera, with our large customers, et cetera. And then there have been some price increases that have gone through the year. So again, as Paul has said, we are comfortable in 2006 based on the hedging that has been done and the current price situation. There may be some minor need to make some adjustments, but we felt we are in pretty good shape for '06 with respect to copper. But as we also mentioned, depending on where '07 copper ends up, it may require price increases and could be significant at this stage at this level.

Right, John, so are you recovering 80, 90% of the inflated copper price right now, and there's just a little bit to flow through, or are you even higher than that?

No, that's probably a reasonable type level.

Okay. And then just the '07 copper exposure, I guess obviously everybody is focused on this. How do you suggest we go about modeling this, or again, should we assume that the escalation clauses and pricing I guess and your customer base has been somewhat accustomed to your price increases, just more than overcome (indiscernible). I guess my question is -- at what point do you start to push on a [string], vis-a-vis copper and raw materials?

I will just say, it's our intent to cover those costs. As our costs go up and we're going to continue to do the productivity programs, continue to drive out costs. We have all of the corporate-wide purchasing initiative, the corporate-wide freight initiative that we started in 2004 and 2005. We're going to keep those things going. But, if our costs go up, it's our intent -- and whether you model it this way or not, is another matter -- but, it's our intent to cover those costs.

I think the other issue, Mike, is copper is obviously a global price. So I think everybody is in the same situation. It's not like a -- you know, a China Company is buying copper cheaper than a U.S. company. It is a global price. And so I think all suppliers are in the same position.

Paul, you've mentioned the 60 million in new wins on the Motor side. Is that a net number, or is that just a gross number?

It's a net number.

Okay. And where have you still suffered some losses? I guess maybe you could just speak to specific markets versus customers.

It's not surprising that we still lost some hermetic business, primarily from Bristol. And that's (technical difficulty) market share. And we're doing some things to offset that with some new global customers on the hermetic side where we started being aggressive two years ago and going out and getting product specified. Obviously, the Trane Cornerstone is a good example of where we picked up some additional business and we're actively working on some others right now that I cannot discuss. But we are an OEM supplier, so we have to get product on test, get samples being run and get those approved. And we have some exciting ones right now on test, had some customers, but nothing I can talk about yet, and there is no guarantee we will be successful. But we're sure going to try.

Okay. And as Bristol travails as of late with the sale of York and the potential divestiture of Bristol, has that impacted you directly or meaningfully at this point?

Well, we're still the 100% supplier and we continue to supply them with all their needs. They actually had a fair first quarter.

And when you mentioned in the press release and in your commentary, Paul, about new programs for the Motor business, aside from just the new wins, what are those new programs you're referring to?

It's the same thing -- new wins, new programs, it's the same thing. The program is when we get product -- get a customer, a potential customer, we get products that we design for their system, being an OEM supplier. [We buy them], we build samples, we put them on test. They're obviously very cautious, as are we, to make sure that we have a product that will stand the test that they need in their market (technical difficulty). And when we say we have -- two or three years ago, we had a lot of our engineers working on keeping the business we had as we were expanding our manufacturing footprint in Mexico and China. Now that we have all of those products specified out of Mexico and China, now we're on a growth track. We're out trying to pick up some new program wins, which is another way of saying new business.

Okay. And then final question just on second quarter. You've given this annual guidance, but maybe you could help us with some direction on how to model for GSW coming in. I presume there's a substantial inventory step-up that will depress margins for GSW just in the second quarter. Can you give us some indication as to what the pattern of earnings is as we head into the second quarter versus the first? Because, the second quarter historically has been your seasonal peak, but you have this significant offset now. Any range or bounds you can put around that for us?

I guess, Mike, I'd say the fourth quarter will be the biggest contributor. And as you said, the second quarter will be the least contributor. So it will be kind of a step-up function as you go up through the period. But, you are right -- obviously the second quarter, even though it's a relatively strong quarter for the water heater business, it's going to get hit by the step-up [in basis for] inventory.

Can quantify what that step-up is, John?

We have not finalized that at this point in time. I will say this --.

The process is still in place. We're still trying to work on the opening balance sheet, Mike. So I would prefer not give a number at this point.

And do you expect earnings to actually be sequentially down from the first quarter because of that step-up?

You're talking about --.

You mean GSW's earnings?

Well, no, total A.O. Smith. Now that you roll GSW in, do you expect earnings for A.O. Smith to be down sequentially from, say, the $0.62 you reported today?

We don't know, but we're not anticipating it.

Okay.

We're really not getting into quarterly projections. We will say this -- GSW we expect to be a positive contributor, even after --

The inventory write-off.

The inventory write-off.

They do not carry a lot of finished goods inventory. Again, their business with Lowe's -- they make it and it goes out the door. They are not like us that has the keep a substantial amount of finished goods inventory to support the wholesale market place.

Okay. So even with the upfront costs, you expect this deal to be accretive in the first quarter?

Yes.

Thanks again, guys.

Matt Summerville, KeyBanc.

Terry, can you just run through the tax rates again? I was not able to get all that down in terms of where you were with your previous guidance, where you are now, and then where the second quarter and full year is coming out, all of that stuff?

The second quarter -- of the first quarter tax rate is 28% versus 31 a year ago, and that's primarily attributable to higher earnings in China and Mexico relative to the U.S. operations. However, looking at the year, when we start consolidating GSW, GSW's earnings are predominantly U.S. earnings. So that is going to increase the tax rate for the year, up in the probably 29 to 29.5 for the year. But because we did not include GSW in the first quarter, FASB requires us to take into account just the tax rate for the first quarter. And so for the first quarter, it's 27 -- 27.5, I guess it is, as we rounded it to 28 for the first quarter. The next quarter, we'll have to raise it to between 30 and 31, but the tax rate for the year will be somewhere around 29 to 29.5% for the year.

And then before today, where were you with your tax rate guidance?

30.5.

For the year, we were at 30.5, and we're now at essentially about 29.5.

Okay, thanks.

Thank you very much Mr. Summerville. Well with that, Mr. Jones, and our host panel, I will turn the call back to you. There are no further questions.

Okay, thank you everybody. Craig has a few closing comments.

Thanks, everyone, for joining us this morning and we look forward to seeing many of you at our analyst meeting in New York on May 11. Thanks a lot.

Ladies and gentlemen, your host is making today's conference available for digitized replays for one full day starting at 12:30 PM Central daylight time, April 18, all the way through 11:59 PM, April 19. To access AT&T's executive replay service, please dial 800-475-6701. At the voice prompt, enter today's conference ID of 826-029.

And that does conclude our call for this first quarter. Thank you very much for your participation, as well as for using AT&T's executive teleconference service. You may now disconnect.