A O Smith Corp (AOS) 2006 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the A. O. Smith Corporation third-quarter 2006 earnings conference call. At this time all lines are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded.

I would now like to turn the conference over to Vice President of Investor Relations, 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 John Kita, Controller and Vice President of Finance.

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.

I would 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 record third-quarter performance. Total sales increased to $564 million including $118 million from GSW, compared with $408 million in the third quarter of 2005. Net earnings increased to $17.2 million or $0.55 per share, compared with $9.7 million or $0.32 per share last year. These earnings included a tax rate benefit of approximately $0.05 a share that will be discussed in more detail later. GSW contributed approximately $0.10 in the quarter.

Operating performance in the water heater business was strong in the third quarter. Excluding sales of $118 million from GSW, sales at the legacy Water Products business increased 14% as a result of commercial market strength, pre buys in residential wholesale business, and continued strength in China. We are now projecting full year sales for the China water heater operation to exceed $110 million. Sales increased 5% at Electrical Products to $221 million as a result of improved pricing and last year's acquisition of the Yueyang commercial motor operation.

Finally, despite the strong performance in the third quarter and expected continued strength in commercial markets and China, we see concerns on the [softer] residential market and continued raw material cost increases that affect both of our businesses for the balance of the year. Accordingly, we are still within the range we have given all year long and are narrowing our 2006 total year forecast to a range of between $2.30 and $2.40 per share.

Terry will now discuss the financial results in more detail and I will come back with some closing comments. Terry?

Thank you, Paul. Third-quarter sales of Water Products were $344 million, $145 million higher than last year. Excluding $118 million from the additions of American and GSW water heating businesses, sales grew 14%, reflecting strength in the residential and commercial markets, the residential wholesale pre-buy, and significantly higher sales in China. Third-quarter China sales increased 48% to $31 million.

At Electrical Products, sales increased 5% to $221 million as a result of improved pricing to offset raw material inflation and the Yueyang acquisition. Excluding the acquisition and the improved pricing, unit sales were lower. Industry sales of HVAC products were particularly strong in the year ago quarter as the industry began to ramp up its transition to the 13 SEER product. We expect fourth-quarter comparisons to be similarly challenged.

Turning to operating profits, the higher sales volume, stronger commercial business, and GSW contributed to a $15 million increase in operating profits representing an operating margin of 8.5% compared with 7.3% a year ago. Operating earnings at Electrical Products declined to $8.6 million from $11.7 million last year. Improved pricing was offset by increased raw material costs particularly copper and steel. Lower unit volumes and higher costs for freight, the Mexican peso, and utilities contributed to the decline.

Our gross profit margin of 20.5% improved over last year's margin of 19.8% primarily due to stronger commercial water heating sales. SG&A was $83 million in the quarter compared with $60 million last year and the increase reflects the inclusion of GSW. Compared with the second quarter this year, SG&A declined from $86 million. As a percentage of sales, SG&A was basically flat at 14.7 compared to 14.6 in the second quarter.

Paul said we'd talk about the taxes later and this slide represents the year-over-year reduction in tax rate from 32.6% to 25% for the third quarter. There are two reasons for the reduction. First, a higher R&D tax credit combined with an increase in the U.S. manufacturer's deduction; and secondly, a higher proportion of earnings from lower tax jurisdictions. The annual tax rate for 2006 will be about 29.25% versus 30% for the entire year last year.

Year-to-date operating cash flow is $64 million, up $33 million from the end of the second quarter and the debt-to-cap ratio decreased slightly to 42.8%.

Cash cycle days of 65 increased four days from the second quarter primarily as a result of a build in inventory. Capital spending for the nine months ending September 30 was $41 million compared with $31 million last year and essentially reflects the addition of GSW. Year-to-date depreciation and amortization was $44 million. Capital spending for 2006 including GSW will total approximately $65 million compared to $51 million last year and depreciation is also expected to approach $60 million. We project full year operating cash flow to be approximately $100 million for 2006.

We continue to enjoy strong growth in our Chinese water heater operation. Sales are 50% higher year-to-date and increased 39% to $29 million in the third quarter. For the year, China water heater sales are expected to exceed $110 million. In addition, the expansion project is on track to double capacity from 2005 levels by the end of the first quarter of next year.

Now Paul is going to talk about the outlook for the balance of the year and we'll open the call for questions. Paul?

Thank you, Terry. Last quarter we confirmed our year-long forecast of $2.30 to $2.50 a share. This morning we trimmed the high-end of that forecast back to $2.40. All year long there has been some pressure to raise guidance because we've had good quarters. We have not done that as we've seen opportunities to accelerate some initiatives to build a stronger business for the long term and we have been implementing some of those and that is some of what we saw in the third quarter.

With that, let me go ahead. The legacy water heater business continues to benefit from stronger residential and commercial markets and continued strong performance in China, but in the quarter just ended we also benefited from a price increase related to pre-buy in the wholesale marketplace. As a consequence, we are projecting slower water heater sales performance in the fourth quarter.

At Electrical Products, sales have benefited from improved pricing and new programs, but Electrical Products will continue to face raw material headwinds and, like Water Products, will face softer residential markets as we finish out the year. And though energy costs have been moderating lately, they are still a factor in both businesses as are health costs and pension expense.

So I am pleased with the performance we just closed out in the third quarter but we've got some headwinds and some work to do as we finish out the year and get ready for 2007.

With that, we will open this up for your questions.

(OPERATOR INSTRUCTIONS) Andrea Wirth, Robert W. Baird.

I wonder if I could just start with the water heater business. Could you maybe quantify how much you think the pre-buy benefited results in the quarter?

I don't think I can, Andrea. We've got a couple of moving parts there as we're looking into the quarter and as you know we have been conservative all along and continue to be so. We had a price increase in the third quarter related to frankly steel and transportation are running higher than we expected as the year began. So we raised prices effective the middle of September and our wholesale customers always pre-buy ahead of that. It was up for a single digit price increase.

The other thing is if you'll remember going into last year at the end of the year we had a mid-single digit price increase effective 1/1/'06 and there was a little bit of a pre-buy in the fourth quarter last year. So with those sort of moving parts we're just being a little conservative as to how we expect the fourth quarter to play out.

But I guess another way to answer your question is it is nothing like the sort of pre-buys we saw ahead of flammable vapor, a couple of other things for those of you that have been following the company for the last several years, but there was definitely -- the wholesalers take advantage of any opportunity to lay in inventory that automatically gets 9% more valuable a couple of weeks later and they've done that again.

Just a little bit to dig into your guidance a little bit and what you're looking for the fourth quarter. On the water heater side -- your expectation for softer sales, is that just a function of overhang from the pre-buy or heavier market expectations actually changed in regards to the slowdown in housing? So meaning, have you essentially changed your forecast for the market overall ex the pre-buy?

It is primarily, the most of it is due to the pre-buy, Andrea, although we have adjusted our own thoughts on housing. It frankly dropped a little faster. I was -- one of the economists that predicts this, I was actually chatting with him over the weekend and he said it is going to be a soft landing on housing but it is going to be bumpy. I thought that was an interesting choice of words. He said it would be a little bumpier landing and a couple of other people were commenting that they have seen a rather significant fall off. We have not quite seen much of it yet on the water heater side as far as related to housing. And I believe the majority of what we've seen on the motor side has really been inventory adjustments rather then market weakness, although we are seeing some market weakness there too.

And then just a little bit on GSW. The revenue came in a little bit light of what we were looking for again and I know last quarter Lowe's had some inventory destocking going on. Is that still occurring and is there some hangover there or I guess maybe what is going on in that business?

First of all, GSW is going great. It is actually doing better than on an overall basis than we originally expected. And being so strongly tied into Lowe's, how Lowe's does is how we do. If they decide to adjust inventories, by the way, part of the reason they're doing that is because of our service levels and that is really healthy long-term. The fact that we can be counted on to deliver in shorter cycle times allows them to have lower inventory and improve their earns and turns. That is something that Lowe's is very keen to do.

So the short answer is everything is going very well with Lowe's. They continue to grow. They are the fastest-growing water heater retailer in North America. We are certainly very pleased to be aligned with them.

Do you think that the inventory correction is pretty well complete now or do you think that there will still be some more destocking just given all the negative outlook on the residential market?

I think it is pretty well done but I would never tell you it's fully done because if they find an opportunity to take another day out of inventory, we're going to work hard with them to help implement it.

Okay, and then just on moving over to the motors business, I was wondering if you could give us a little bit of clarity. I know you guys don't like to give actual movements in the different pieces of your business but could you give us an idea of where the weakness was in the quarter, was HVAC -- obviously residential HVAC was going to be down, but what did you see in the commercial business? I'm expecting you had some issues in the pool business or your pool related business as well.

I think you just answered the question for me. Yes, the commercial business is doing fine. As I have said before, we're not going to go through each of the SBUs because we were providing a gold mine of information to our competitors that don't break into those. So all I'll do is talk about the markets.

Last year there was a 13 SEER build-up going on and as we look at that, we're not going to have that this year even though it didn't affect us as much last year on the upside. So we don't think it will affect us as much on the downside. There was a pump build-up that your firm has been very consistent in reporting and that is not going to happen this year. I think the inventory adjustments for some of our major customers. We know for a fact that a lot of them are taking them down primarily because this long predicted housing slowdown appears to be with us right now.

Just a quick question on the margins even aside from the restructuring charges you had in there. It seemed like margins were squeezed even more than we would've thought. I am just curious what is really causing that. Is there something with the timing of the price increase that you've put in place that's maybe part of the reason you're not fully benefiting yet? Or I guess really what is going on there?

It is the timing of the price increase. That is just now coming into effect on our motor business and we're starting to get the benefit of that now. It is commodity prices, freight, the Mexican peso has been moving in the wrong direction this year, and as you know we have 16 plants in Mexico, so that has been a pretty significant hit. The plant operations are doing very well. They continue to hit their productivity targets. We don't have quality problems or cost problems in any of the operations. We haven't lost any customers. We are just seeing some market weakness and maybe a little slowness in the industry to move on the material price increases that we are seeing.

Thank you.

Matt Summerville, KeyBanc.

Paul, you commented a little bit on the inventory situation in both of your businesses. I guess do you have a good amount of confidence that any pre-buy hangover will just be relegated to the fourth quarter and won't slip into '07? And then with respect to your motor business, how would you describe channel inventories kind of now versus entering Q3?

Okay, it all depends on what we -- anybody does relative to price. If -- we are in the process of talking to the steel companies right now and those conversations are tough. If we do another price increase the first of the year, there will be another pre-buy ahead of that. There almost always is. And as far as the channel inventories, I think they're getting in line. We've actually got a little too much inventory ourselves. We are going to be trimming that in the fourth quarter as we try -- we probably have an extra $3 million or $4 million in our motor business that because of the decline in orders that we mainly saw in September. We have a little bit more and we will be trimming that down.

The channel inventories frankly I'm not upset about what's happened there. I think they're getting them in line on a pretty good timing ahead of what we hope will be a shallow and a short downturn in the housing market. We don't see it continue to go down. We think it will plateau in the fourth quarter and then start picking up again next year. But we are going to be cautious about how we manage the business to that end.

You mentioned, on the water heater business the price increase you put through in the wholesale channel, assuming it sticks, are you covered based on where spot prices are today with respect to next year or in fact do you still need another price increase? What is your strategy going to be in the retail channel along those lines as well?

I think the jury is out. I think we're covered on where we are right now, but as I mentioned a minute ago, we are in discussions. We just met with one of our major steel suppliers yesterday afternoon and we are by nowhere to a deal yet on what our steel pricing and arrangements will be for next year, so I am going to keep the option open if necessary. As we have shown I think eight times now when commodity prices go up, we will be very quick to go to the marketplace to recover our costs.

As far as retail, there was not price increase on retail this year. If steel comes out where I think it will be, there will be a need for a price increase in retail in order to get the margins back up to acceptable levels. We are actually squeezed a bit there because steel has been running a little higher this year than we began the year. It has crept up as the year has gone on and is putting us in a little bit of a squeeze right now, not a major one but we were not surprised that that happened but we would certainly like to see little higher margins on the retail side.

Can you talk in the motor business, the anticipated cost and then the anticipated savings associated with the plant closure that you mentioned?

Yes, you're talking about McMinnville. That's one of the things that we saw an opportunity to do quicker. We actually started working on that earlier in the year to do it sooner than our original plan relative to fabrication consolidation. And we took it. And the charges this quarter I think were a little close to $3 million on restructuring.

As a general rule, Matt, you can go out with these restructurings that we are announcing and others that will be calming. Essentially on average the savings per year will be about equal to the charge. There might be an occasional exception. As a matter-of-fact there is one that will be even higher savings than the closing charge that is being worked on. But for the most part a good general rule going forward is the annual savings will be about equal to the charge. But as you know, you don't get the savings at the same time you get the charge. So there is a little bit of a lag, but that is probably a rule of thumb that won't have you too far off base.

Okay. And then just in terms of pricing in the motor business, you mentioned you are just now starting to benefit from that. When was the increase announced and can you quantify like you did on the water heater side? And then how much of the business does it impact?

Some of our business there is covered by contracts where we have a pass-through on the cost and we adjust quarterly relative to changes in commodity prices. But it affects -- the one that we did is effective in October and it affects us somewhere around half of our motor business and that's the increase that we put out. By the way, we are still watching to see if that one sticks, but it is out there right now and we are benefiting right now from it.

Then the pricing benefit you got in Q3, was that related to an action that you took in July?

Yes, we've had two motor increases this year.

Okay. Would that have affected a similar amount of your business?

Yes.

Then just your thoughts on copper for next year. Are you any more hedged at this point than you were on your last conference call?

Yes, a little more.

So is it safe to assume then you've bought forward at kind of where -- above $3 a pound kind of prices?

It looks like, Matt, the reality is that $3 a pound copper is going to be with us for a while.

Okay, thank you.

Ned Borland, Next Generation Equity.

A couple of housekeeping items here. What was Yueyang's contribution in the quarter?

Sales were about (multiple speakers)

About $7 million in sales was the answer.

$7 million, okay. On this charge, is that all related to the facility shutdown?

Almost all.

Almost all to the McMinnville shutdown.

Okay, was there any other in there?

There is still some carryover from some other facilities we have announced, but again, the majority of it was clearly McMinnville.

Oak. Let's see. I guess that is all I have. Thanks.

At this time we have no further questions.

Well, we appreciate everyone's interest in the Company and appreciate your faith and confidence in us. We are going to go back to work. Thanks a lot, everybody.

Ladies and gentlemen, if you wish to access the replay of today's call, it will be available after 12:30 today Central through tomorrow, October 18, 2006 at midnight. You may access the replay system at any time by dialing 1-800-475-6701 and entering the access code 844752. (OPERATOR INSTRUCTIONS). That does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.