A O Smith Corp (AOS) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the second quarter 2006 earnings conference call. At this time all participants are in a listen only mode. Later we will conduct a question-and-answer session with instructions given at that time. (OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded. I would now like to turn the call over to Vice President 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 on the call are Paul Jones, Chairman and Chief Executive Officer; Terry Murphy, Chief Financial Officer; and John Kita, Controller and Vice President of Finance.

Before we begin with Paul's remarks, I'd like to remind you that some of the comments that will be made during this call - including answers to your questions - will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include among others matters that we have described in this morning's press release.

I'd also like to direct you to a PowerPoint presentation on our website that accompanies this morning's conference call. Please feel free to follow along while we conduct the call. Paul.

Thank you, Craig. Good morning, ladies and gentlemen.

This morning, we are pleased to announce solid second quarter performance. Total sales increased to a record $595 million compared with $438 million in the second quarter of 2005. Net earnings increased to $25.1 million or $0.81 per share; and this compares with $6.5 million or $0.22 per share last year.

Second quarter of 2006, net earnings included $3.2 million after taxes or $0.10 per share related to a currency gain from the GSW acquisition, while the second quarter of 2005 included $7.9 million after taxes or $0.26 per share, related primarily to the closure of the Company's Bray, Ireland motor manufacturing facility.

Adjusted for these unusual items, net earnings increased approximately 50% to $21.9 million or $0.71 per share compared with $14.4 million or $0.48 per share last year. Net earnings included a penny a share for the discontinued building products business of GSW.

Operating performance was strong in the second quarter. Excluding GSW, sales at the Legacy Water Products business increased 10% as a result of stronger markets for both residential and commercial water heaters and continued strength in China. We're now projecting full-year sales for the China water heater operation to exceed $110 million.

Sales increased 8% at Electrical Products to $254 million. Sales for the quarter represented records for both business segments, even without including the GSW acquisition. Given our concerns over raw material and energy costs, we are maintaining our 2006 forecast for full-year earnings of between $2.30 and $2.50 per share.

Terry will now discuss results in a little more detail and I will come back to talk about the outlook for the balance of 2006. Terry.

Thank you Paul. Before going into the formal remarks, I just want to clarify and expand upon something that Paul had said in his last slide; and that is, that wasn't necessarily clear in the press release, but the $0.10 positive impact that we had from the GSW currency impact that we had in the second quarter offset a $0.10 hit that we had in the first quarter that we announced in first-quarter earnings.

So year-to-date that $0.10 a share is a wash. There was a $0.10 hit in the first quarter and a $0.10 benefit in the second quarter.

Now going more specifically to the business segments. Second-quarter quarter sales of Water Products were 343 million and that was $139 million higher than last year. Excluding 118 million from the additions of the American and GSW water heating business, sales grew 10%, reflecting strength in the residential and commercial markets and significantly higher sales in China. Second-quarter sales in China increased 60% to $32 million.

At Electrical Products, sales increased 8% to a record 254 million as a result of new programs, the Yueyang acquisition and sales to the HVAC and distribution markets. Price increases implemented to offset higher raw material costs also contributed to the sales improvement.

Turning to operating profits, the higher sales volume and stronger commercial business at Water Products contributed to a nearly $14 million increase in operating profit, which represents an operating margin of 9.7% compared with 9.2% last year.

We are particularly pleased with the increase in margin, considering the inclusion of the predominantly residential business of GSW and its generally lower margins. Operating earnings at Electrical Products were $16.6 million compared with $6 million in the second quarter of last year. Earnings in the second quarter of 2005 included a pretax charge of $7.4 million, primarily related to the closure of the Company's Bray, Ireland manufacturing facility.

Adjusted for the restructuring, the $3.1 million improvement in operating earnings was attributable to the higher sales as well as cost savings from repositioning activities, which more than offset higher costs for raw material, utilities, and increased employee expenses for health care and pensions, the Company's operating profit margin of 6.5% compared with 5.8% last year - an almost 1% year-over-year improvement.

Our gross profit margin of 21.3% improved over last year's margin of 19.2%. SG&A was 86 million in the quarter compared with 60 million last year. The increase in SG&A was a result of the addition of GSW, higher SG&A in China, higher selling expenses, pension costs, and corporate expenses compared with last year. As a percentage of sales, SG&A increased to 14.5% from 13.8% last year.

Year-to-date operating cash flow was $31 million and the debt-to-capital ratio increased 43.6% compared with approximately 24% at the end of the first quarter as a result of the GSW acquisition. Cash cycle days of 61 were 17 days lower than last year and similar to the first quarter rate of 63 days.

Capital spending spinning for the first six months ended June 30 with $25 million compared with $16 million last year. Year-to-date depreciation and amortization was about $31 million. Capital spending for 2006 - including GSW - will total approximately $65 million compared to $51 million last year. Depreciation is also expected to total approximately $65 million. We're projecting full-year operating cash flow and approximately $100 million for 2006.

We continue to enjoy strong growth in our Chinese water heater operation. Sales are more than 50% higher year-to-date and increased 60% to $32 million in the second quarter. For the year, China water sales are expected to exceed $110 million.

In addition, the first phase of the expansion project begun in 2005 was completed during the (technical difficulty), increasing capacity by more than 60%. We are on track to complete the final phase of this project by the middle of next year, which will effectively double the capacity that existed when the project commenced in the second quarter of 2005.

Now Paul is going to talk more about the 2006 outlook in a little more detail and then we will open the call for questions. Paul.

Thanks Terry. As we mentioned earlier, rather than increase our forecast in connection with the stronger-than-expected results of the second quarter we have decided to stick with our previous range of full year 2006 earnings of between $2.30 and $2.50 per share - which includes expected nine-month earnings accretion of $0.35 per share from the GSW acquisition.

As I will demonstrate shortly, this conservatism is primarily out of concern of our raw material cost volatility. The legacy water heater business continues to benefit from stronger residential and commercial markets and continued strong performance in China.

At Electrical Products, higher sales and profits in 2006 are expected to result from improved pricing, new volume programs, and a fourth quarter 2005 acquisition of the Yueyang Zhongmin commercial hermetic motors business in China. In addition to the higher volume earnings will also benefit from last year's restructuring initiatives, which included the one major restructuring - the closure of the Company's Bray, Ireland operation.

In our last conference call, we discussed some of the headwinds our business is facing as the year progresses. And this slide looks like a good place to begin the recap. Raw material costs have been rising during the last quarter. During our road trips over the last couple months we talked a lot about copper in the neighborhood of $4.00 a pound.

In addition to copper, rising steel costs have also been a concern. The already high price for steel as reflected in these second-quarter numbers are increasing again early in the third quarter; and historically the third quarter sees lower steel costs, but not this year. Suffice it to say, we are concerned about raw material price volatility; and this will continue to be an issue for the foreseeable future in both of our businesses.

High-energy prices as they affect freight costs and utility expenses as well as higher cost for health care and pension are other areas of concern. As a result of all that, we have chosen to stick with the existing forecast for earnings of between $2.30 and $2.50 per share.

Notwithstanding this caution. I am quite pleased with how our people are executing their plans and the way the year 2006 is progressing. Craig.

That completes our opening remarks and we're 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) Michael Schneider with Robert W. Baird.

Wonder first if I could focus on water heaters? The margin at 9, 7 this quarter was impressive especially rolling in GSW. Can you talk about what the core profitability ex GSW looks like in the U.S. and the water heater business and maybe what efforts - or I should say what initiatives are actually driving that margin?

As always, it is a lot of things. I'm particularly pleased with the productivity that we are getting out of Ashland City Operation, which is the largest water heater operation in the world. It is of course the one that produces the -- at present, the legacy A. O. Smith. It's A. O. Smith and State and Kenmore and the other brands.

But that productivity is certainly contributing. We have on a concerned side its contracts, especially in retail, are typically set from February throughout the year. Steel is running a little higher. It is running right now quite a bit higher and we expect it, as the year began and it will be another six months before we will be able to do anything about those prices. And just in conversations with the steel companies recently, we are just a little cautious as to what they might be doing.

But on the water heater side we are picking up volume. We are being aggressive in some areas where we think we can do it and get a good return for our shareholders and where we find a customer that matches up with our capabilities; and we have some pretty exciting new products coming to market that are appearing to get a little bit of traction.

I'm not going to give you a specific number at this point as to trying to break out how everything is doing. We are just going to look at our total water products business; and right now we are very pleased with how they are performing.

On the volume topic in water heaters if I back out China and I back out GSW, it looks like the U.S. operations and revenue were up about 4.5%. Yet the [gamma] data - at least year-to-date through May - shows shipments are up 10 to 11%.

Can you reconcile those numbers? And then maybe talk about what your expectations are for the new volume wins and what they drive that growth to

Sure. A little bit of that is recognizing that we have had market share declines for the last several years for a variety of reasons. Mainly because a lot of the things we were doing internally to get the business in the position and shape it is in right now which is pretty good. Secondarily to that we feel and we have said this now for about three months that we have arrested the market share decline; and in fact we think that we are out picking up a little bit of share at present.

Now, if you look at six-month year-to-date data we may be running a little behind.

And the other piece is obviously the age-old question of breaking out the commercial and the residential. We are a very strong commercial player and as of the last three months now, we have been a very strong residential player with market shares in the 45 to 50% range.

So that being said we are pleased with the business. We are pleased with some of the new customers we picked up; and it looks like we are hanging on to essentially all, maybe a couple of small defections from people moving away from American since the acquisition.

But for the most part we are doing better than expected on hanging on to volumes. All I can say is stay tuned. I'm pleased and I think the outlook for the rest of the year is that we will be at around what the market is doing. And maybe next year we can talk about being a little bit above it.

So is it just the case some of these new wins have not hit the books yet?

That's part of it. Like I say there's a lot of moving parts in the equation.

In GSW it looks like the revenue year-over-year, excluding building products, was down about 10 million. Is that some of the customer defections going on there or are you pruning the business? Can you just talk about that?

There's nothing we can comment there. We are not losing any customers. That's just quarter-over-quarter things jumping around. So Lowes has done some things to take some inventory down. That's probably as much a piece of it as anything.

Matt Summerville with KeyBanc.

Couple of questions. First, Paul, can you talk about what you're seeing in terms of pricing in the motor business? I think sometime in the second quarter you put in place a 9% price increase. First how much of that is sticking and then how much of your product mix has that impacted?

That only impacts a percentage of our product mix. We -- or at least, the price increase that we put in place in the second quarter, but we have -- the majority of our business there does have some indices tied to the contracts so in some of those cases we are getting index-driven price increases simply because of what is happening with steel, copper, aluminum freight and everything else over the last quarter. They have all moved up.

Part of -- the short answer is, we are pleased with the way that price has held and I think that's reflected in the second-quarter results from our Electrical Products business. The price increase was cost-driven, purely cost-driven and as always when commodity prices are moving up up like this it is affecting the whole industry, not just A. O. Smith. And there certainly seems in this case to be an industrywide -- at about the same time I'm not sure who was first and what market -- but at about the same time, there was a pretty much across the board price increases in the -- early in the second quarter.

And it was all driven by what we all saw as a spike in steel. Of course copper, just going through the roof during the quarter.

While we are on the copper topic, can you just talk about where you are at with any hedges you have put in place for 2007? Along those same lines. if copper stays in the neighborhood of $3.50, $4.00 a pound how much of a price increase are you going to need next year to cover that?

As I said in our last call, if copper stays at this price we are going to need a very large price increase in the motor business going into the next year. I am not going quantify how much that will be. We have some rough numbers that we are working on. And as always we look at this all the time.

We do have a portion of '07 hedged. We are very pleased with the way that has worked out and the timing that we have and this is something that we constantly look at.

Every economist is telling us that copper will come back down. There are a few of us that maybe don't think that will happen. We are going to make sure that we do we have to do to try to have surety, as well as low as possible costs we can have going into next year.

Another thing is it affects everybody. I think anybody in the industry right now looking at copper, we are all struggling with, do we hedge at $3.00? We can buy an '07 contract now at something around $3.20, $3.30 a pound. Do we do that or not? And or do we do some at that level?

Those are the sort of decisions that we are faced with and I'll just ask you to look at our history. I think we do a pretty good job at it. And once we get the surety and what our costs are going to be, I think we've proven over the last 2 1/2 years we know how to go past those on the price increases.

So I think our motor business is going to maintain margins and continue to expand margins going forward.

Do you think for the full year '06, you'll get margin expansion in motors or are you looking relatively flat based on what you know today?

I think we will see some margin improvement this year.

Thanks.

Andrea Sharkey with Sidoti & Co.

A couple of my questions were already answered. I don't know if you already covered this, but can you break out -- electric motor revenue was a 8% this quarter. How much of that was from price increases? And how much versus unit volume?

It was - I will say that the majority of it was from unit volume but some of it was from price increases obviously. We expect that maybe a little more of it will be from price increase in the second quarter that was implemented going forward. I'd rather not break out the percentages; but obviously, in the first quarter -- we publicly disclosed that we picked up $[60] million of additional volume for this year. So you can run the numbers on that. That is probably 7% gain are so. Any addition to that you can probably say that was due to price.

You did implement that 9% price increase, I believe it was last quarter and I guess my question with that is, is that covering higher costs you have this year or was that more in anticipation of maybe some of the higher costs that you are going to have next year? I guess just trying to get a sense of how large a price increase you may need to take next year if copper stays where it is.

The customers that we implemented the price increase to, it was strictly to cover the costs that we were seeing as we go through this year. We sat down with each one of them and justified it, based on the cost that we were incurring.

Obviously a little bit of it's conditioning for the people that we will be talking to in the third and fourth quarter as to what they might want, be expecting to see as we go into next year.

Rough numbers and a couple of your colleagues and probably you, too, have run some numbers relative to what if copper stays at $3.20 to $3.50 range in to next year. On a year-over-year basis we are looking at a price increase in the low teens to cover those costs. Those are the sort of numbers that we are batting around internally, as well as discussing with our major customers.

To switch over to the water products. Can you talk about the GSW integration? Things that are going on and how far into that process you are? And are things going on schedule or ahead of schedule, behind schedule? Where you stand with that?

The short answer is I'm very pleased with how that is going. We have the teams working, the integration teams working in a lot of different areas. The majority of the synergies that we expect to see are in the materials area. This is in a lot of cases requiring engineering changes. But I think it is safe to say that we see larger synergies than maybe we originally expected.

We have not seen any negative surprises. If anything, maybe as a word of caution, a lot of the synergies we are seeing are going to take some time to implement. So we are talking about over a couple years for some of these things.

Give you examples. We have one particular product that we have and America has and GSW has. You add them up there are 22 similar versions of that product and we think we can get that to five or six. Matter of fact the engineering team has already you decided that they can get it to five or six but it takes about nine months to get that completely done with all the designs and some retooling changes.

The savings for projects like that are significant. So bottom-line, I'm delighted with how the cultures are meshing. I'm delighted all the way across the board with how the people are working together. The ideal generation and sitting in on some of these meetings where we are talking in great detail about very specific items, very specific purchase items, very specific manufactured items, and what our current situation is and what it can be.

I couldn't be more pleased with the energy and the drive that we are getting out of the business. And I think, ultimately, a couple of years from now when we look back and look at the factual history on this is going to turn out to be a wonderful acquisition for our Company.

Thank you very much.

Ned Borland with Next Generation Equity Research.

Quick question on the water products. Just looking for some color on the mix here. Commercial sales versus residential sales for the quarter.

You have that, John? We are looking for it right now. Go ahead with another question and we'll we find that one.

Yes. Also, just on the steel question. Maybe going about this a different way. I mean, what are your steel assumptions trending like for this year versus last year?

We began the year, we had an assumption for steel price and they were all over the map, obviously, because we use different grades of steel. We have hot rolled, cold rolled as well as electrical grade. Those are the three principal steels that we buy. One of those, I'm not going to tell you which one, we had an anticipated price for the year of around $620 and that is now up about $50 and we are seeing some projections that it might go up another $30 before the end of the year.

That is just one steel grade and one type of steel and just some really rough numbers that we are seeing.

The steel companies are feeling their oats again. They are back to mid '04 sort of things and they are going up.

On the residential commercial of the second quarter they were both up about the same percentage. So it was about an equal percentage on those two as far as the increase year-over-year.

One last quick one. Have you seen any weather-related effects in your Electrical Products business so far here in the third quarter?

Not that we can quantify but, obviously, if it stays as hot as it has been the last couple, the last week or so and Milwaukee has been pretty brutal -- if it continues like that, that will obviously be a positive effect on our business.

Nice quarter. Thanks.

George Nissan with Merrill Lynch.

Congratulations on a great quarter. How do you streamline the selling process now to reduce ordering accuracies to make it a better buying experience for your customers?

You are talking about a pretty broad area. We have a major initiative internally to be -- to provide better service. That is in capital letters. That includes not only delivery but also product development, product design, as well as the whole selling relationship.

I am not going to go into great detail but we have put in some internal measurements related to telephone calls, length of time to answer, calls abandoned, all the normal customer service stuff.

I'm reviewing that on a regular basis and it is getting dramatically better. It was obviously an area that needed some attention and so there are other things we are doing that we have plans for as we move forward. I'm not going to tell you where we should be, relative to the overall buying experience. My belief is you never get there. That is a journey that never has an end. And we were maybe playing catch-up.

I think now we're maybe in the middle of the pack and within a year I think we are going to be out front in that area.

So that is very important to you?

Yes it is.

I guess what my question was, how are you better communicating with your dealer channel to be responsive to the challenging market and in customer needs that you are experiencing everyday?

Again, I am assuming you have probably talked to some of our dealers and we are in communication with them on a regular basis. We have got a very solid sales organization out there. We are maintaining some brand differentiation, which is giving us some -- I think some opportunities on the market share game as we go forward.

We have dealer councils. We have dealer meetings. We have regular meetings with them as we go forward.

So you are constantly meeting with your dealers to understand what is going on in the market. What are they telling you that they are seeing in the marketplace that they are experiencing that they are letting you know? Just as a concern we need to address?

George, we have dealers in various channels and we are talking to all those dealers and all those channels all the time. And I'm not going to make any further comments about our dealer arrangements.

(technical difficulty) --.

[Andy Keller] with J.P. Morgan.

And the are you there? Did we lose Andy?

Michael Schneider with Robert W. Baird.

Paul, maybe you could just spend a minute on the HVAC slice in the motors business. What have you seen year-to-date and have you raised your expectations at all? Obviously people have been looking for a down year, given the channel fill, but with the weather have you seen better-than-expected volumes in HVAC?

Yes we have. We have seen better-than-expected volumes in HVAC. I think it's fair to say. It's been something we have had a little bit of concern about as we go into the year but our business is up. And it continues to be up as we go forward.

So I don't want to get into any great detail on the different business segments. I will point out that we did have a couple of program wins there. These are the ones we started a couple of years ago. Most notable being the train cornerstone (indiscernible) running ahead of expectations.

So, overall, we had a little bit of a fall back relative to some business we lost because of the break in closure but that turned out to be less than $1 million.

So, overall, we feel pretty good. Don't forget [Yueyang] which we continue to be very pleased with. It was a small acquisition but it is performing ahead of expectations.

So on an overall basis looking at our HVAC business just in the quarter we were up high single digits; and right now, we are starting to rethink whether this is going to decline as the year goes on. And we are a little surprised at how strong the market has been.

I think that is probably true across the board. We got rid of all of the 10 SEER to 13 SEER noise that was out there. And all the things that were making it a multiple variable equation for all of us to try to figure out and we are getting down to a little more simplified relative to the heat, the replacement market, and as well as housing starts being the drivers to market.

And your ECM or variable speed technology, I know you have some on test. Do you have any firm orders for the upcoming season?

Yes, we have orders. So that's good. We've got a start. We've got an order and we have a lot more on test but we do have a firm order. More than one. Firm order for ECEMs for the upcoming season and we also got our first orders for the EMOD. The pump motor that goes into swimming applications that gives backup protection for entrapments. So that is also starting to get some traction.

That's end of the pool and a slice of the motors business. Is that keeping pace or are you beginning to see the impact of slower U.S. housing?

It is keeping pace. It's up with us essentially equivalent to what the market is doing.

What is the laggard? If HVAC is up, pool is strong, what is the laggard within the motors business, what application? Is it the distribution slice of it or others?

No distribution has been good for us because we picked up a couple of programs there. That is up in the single digits. We've got a few things on the short-term basis that, frankly, are not really worth commenting on.

General industries was down a little bit. We saw a little bit of seasonal reduction in BNR. We are talking about minor things that could be attributed to pricing action last year. It could be as much as (indiscernible) year over year but --.

Maybe you could just trend -- comment on trends during the quarter. We have heard [Fastow and Granger] and a couple of the other earlier reporters here to discuss weakness in late June and they've probably come in just a bit light on revenue and obviously spooked people into thinking we are in a real-time slowdown here.

What did you see during that quarter and what does your gut tell you and the field tell you about trends as of very late?

We don't see it yet. We've talked -- we obviously talk to the same customers. Granger is becoming as of -- we keep winning programs there. They are becoming a bigger and bigger customer for us and all I can say is that as we get into the third quarter, things are going pretty well there right now. Maybe it is the hot weather.

Thanks again.

At this time we will turn it back to our host. Please go ahead.

Okay. This is Paul. Again we want to thank everyone for participating today. As always we are ready at any time, if we can help answer any questions. This replay will be available. Operator, do you want to give them the replay information? We appreciate everybody's support.

Ladies and gentlemen, the conference is available for replay after 12:30 PM Central time today through midnight, July 20th, 2006. You make access the AT&T Teleconference Replay system at anytime by dialing 1 800-475-6701 and entering the access code 836308.

International participants dial 320-365-3844. That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.