A O Smith Corp (AOS) 2007 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the A.O. Smith Corporation first-quarter 2007 earnings conference. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for questions and instructions will be given at that time. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded. I will now turn the conference over to Craig Watson, Vice President of Investor Relations. 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, Controller and Senior 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 do be materially different. Those risks include, among others, matters that we have described in this morning's press release. Paul?

Thank you, Craig. Good morning, ladies and gentlemen. This morning, we are pleased to release our results for the first quarter of 2007. Sales in the first quarter increased to $577 million, including $128 million from the GSW acquisition, which was closed about a year ago. This compares with $459 million in the first quarter of 2006.

Net earnings increased to $19.5 million or $0.63 per share and that compares with $15.5 million or $0.50 per share last year. I will remind you net earnings in the first quarter of 2006 include a $3.1 million after taxes or a $0.10 per share expense for a currency hedge related to the acquisition of GSW.

We are also confirming our 2007 earnings forecast this morning of $2.75 to $2.95 per share. I will come back to talk about the forecast later, but, first, Terry Murphy will talk about financial results in a little more depth. Terry?

Thank you, Paul. First-quarter sales of water products increased $124 million as the addition of GSW's $128 million in sales more than offset a decline in the legacy water heater business resulting from weakness in the residential housing market. Commercial sales were flat while sales in China increased approximately 35%.

At electrical products, sales declined a modest 3%, primarily as a result of a sharp drop in sales to a major HVAC customer, as well as weakness in the residential new construction market. The decline in domestic sales was mitigated by improved pricing and a more than 20% increase in sales in the Company's Asian operations.

Operating profit in the first quarter increased $4.3 million or 15% as a result of the more than $8 million increase at water products, which more than offset a $3 million decline in electrical products. The improvement in operating profit at water products was the result of the incremental GSW earnings. Margin was 9.6% in the first quarter compared to 11.2% last year. The lower margin is primarily the result of the inclusion of GSW's proportionally higher, but lower margin, residential sales. Having said that, we are pleased with the progress we are making with respect to synergies from the combined businesses.

At electrical products, first-quarter operating profit declined to $10.2 million from $13.6 million last year. Improved pricing and repositioning savings were more than offset by the lower volume and higher costs for raw materials. First-quarter operating profit margin was 4.6% compared to 5.9% last year.

Our tax rate declined in the first quarter to 25.8% from our forecasted rate of 28%. The lower rate resulted from proportionately higher income from foreign operations in China and Mexico where tax rates are significantly lower than in the Company's U.S. operations. The lower rate contributed approximately $0.02 per share compared with the 28% rate in the first quarter of last year. The tax rate for the entire year is also expected to be around 25.8%.

Operating cash flow was -$17 million in the first quarter. The decline in cash flow was primarily the result of an increase in receivables. Days sales outstanding increased to 66 days from 62 days while inventory and accounts payable were basically flat compared with last year. Cash cycle days increased to 69 from 63 in last year's first quarter. As a result of the negative cash flow, our debt to capital ratio increased to 39.8% from 39.1% at the end of the year.

During the first quarter, capital spending totaled $11 million while depreciation and amortization was $16 million. Capital spending for the full year is expected to range between $75 million and $80 million while depreciation and amortization is expected to total about $70 million.

For 2007, we're projecting operating cash flow of approximately $150 million as a result of higher projected earnings and an emphasis on improved working capital management. Now Paul is going to talk about the outlook for the balance of 2007 and then we will open up the call for questions. Paul?

Thanks, Terry. As I mentioned at the outset, we are still projecting a full-year earnings range of between $2.75 and $2.95 per share in 2007. For the full year, we are projecting flattish sales in our legacy North American water heater business. The current outlook for the legacy business will continue to be challenged by the slowdown in new housing and potentially tough comparisons for the commercial water heating segment as the year continues. Sales growth will result from the additional quarter of GSW and a projected 25% improvement in China where China will be approximately $150 million this year in revenues.

Since 2002, the Company's water heater operation in Nanjing, China has seen its sales multiply fivefold from approximately $30 million in 2002 to the expected $150 million this year. The Company expects to complete the second phase of its current capacity expansion by the end of May, bringing annual capacity to 1.1 million units, more than double the capacity at the inception of the project in 2005. The operation is expected to double again as productive capacity by the end of 2008.

Sales at electrical products are also projected to be similar to last year as the slowdown in new housing construction is expected to offset the benefit of improved pricing. And as Terry mentioned earlier, the revised tax rate will add about $0.10 to earnings in 2007 compared with our estimate at the beginning of the year.

So with respect to the forecast, we do still have some concerns about sales and cost headwinds related to the housing market and potentially softening economy, but expect the outlook to improve as the year progresses. Accordingly and notwithstanding the $0.10 pickup from the tax rate, we are leaving our forecast range unchanged at $2.75 to $2.95 per share.

That completes our opening comments and we are ready for your questions. Kathy, can you open the lines please?

(OPERATOR INSTRUCTIONS). Scott Graham, Bear Stearns.

Yes, good morning, everybody. Wanted to try to -- I know that you guys are always loath to talk about pricing for competitive reasons and I understand that. But I was wondering if you can answer maybe one or both of the following questions.

In each business, would it be fair to say that pricing was somewhere between zero and plus 5%? The second question would be -- hopefully you can answer this one also -- what are you right now seeing in terms of the price gap -- price increases versus raw materials in each business?

Well, Scott, again, we are the only one that seems to talk about pricing and it is frankly putting us at a competitive disadvantage. We achieved price increases going into this year higher than the range you put out and I am really not going to comment any further than that. We, like all the hundreds of other motor companies and the several water heater companies, when we see significant material increases as we have seen over the last three years, we have to have significant price increases to offset that and hopefully grow our margins. That's to operate our business day in and day out. I apologize. I wish I could give you more, but when you get specifics from Emerson or Regal Beloit and Ream and Bradford White, then I will be happy to weigh in.

Would you be able to answer the second part of that question, the gap between pricing and raw materials even if it is in millions of dollars?

It varies by [SBU] and productline and customer across the map and we are just going to let our first-quarter results speak for themselves and hopefully, we are building credibility on our forecasting ability for the year.

I think you are doing that, indeed. Let me ask this follow-up question. The streamlining of GSW looks like it is tracking as you intended and I am wondering versus the conference call of I guess it was January and then even the one before that, but January in particular is the one you put out I think your 2007 guidance and since that time, a couple of things have happened.

Raw materials prices have become more of a headwind and the housing market has declined probably more rapidly than I am guessing that you were expecting. You have kept the guidance. You are going to be aided by the tax rate, but what I am wondering here is how much can you pull this lever on GSW with respect to the accretion guidance that you have given, I think $0.60, $0.70 a share, something like that. Where can that number go and are you doing anything now that you are seeing these additional headwinds to either expedite or exceed that accretion?

Well, we said the $0.65 to $0.70 was something we said a year ago and I think we have communicated that we are actually finding more synergies than we saw a year ago and we are on track to get those. Some of them (technical difficulty) some of them will go out into next year as we've said. They will take a little longer than this year, but the synergies with GSW, we are delighted with what the team is doing. We are on track. We review it and stay on top of the projects as a management team of water products and those are moving along well.

Right now, running on an annualized basis above the $0.70 a share number, is that fair to say?

No, we said that we will achieve the $0.70 this year and you are probably right. We have probably got a few material headwinds knocking that down from maybe a number that could have been higher. All I am saying is that we will be getting some synergies from the GSW acquisition into 2008 and we are excited about that. We're going to meet what we said in '07 and we are going to have a few more coming our way in '08.

There is nothing, however, that you are seeing out there that will stop you from achieving that essentially?

Not right now and I will remind you that the majority of that business is replacement business and a consequence of it is tied to housing. With anything, there is a lot of moving parts, Scott. We have material price increases. There has been a huge increase in gas valves from one of the two suppliers that affects us a little bit; it affects our competitors in some cases a little more. There is a lot of moving parts there. We look at all of it when we come out here ready to talk to you. Right now, we are still comfortable with our guidance.

Thanks, very much.

Thank you.

Matt Summerville, KeyBanc.

A couple questions. First, with respect to the guidance, Paul, I just want to be clear. The $2.75 to $2.95 includes the 26% tax rate?

Yes, that is factored into it.

Okay. And then typically you give a little bit of color around volume in the motor business across the different verticals. I think you highlighted HVAC being down double digit. Maybe can you give a little more color on residential versus commercial, if there is a customer-specific issue, if you can give any more detail around that and then how volumes fared in the other kind of divisions that you have in your motor business?

We try not to talk about specific customers. We do have a very large hermetic customer that I am assuming everybody knows. They had a very, very weak first quarter with us primarily because they were involved in being acquired by a private equity group. I've probably given you enough hints to figure out who it is. They had a very weak quarter, but their volumes are now back up, their order rate is back up.

The other moving parts that we had within HAC were not only weaker housing that started last fall, but also there was an excess of inventory of HVAC products in the whole supply chain from our customers through the wholesalers getting ready to go to the users.

We think that inventory has worked its way down to a more normalized level and that is frankly good because we were getting lower volume for two reasons; weak (inaudible) market and large inventories. We've now eliminated one of those reasons and are pretty much faced with the weaker market.

But the market is still weaker. I mean you can pick up -- you can read anything on what is going to happen to housing. There was a good report yesterday, housing starts were up. We are just preparing ourselves for any eventuality, be it a pickup in the second quarter as some people have predicted and some people have said it is going to be a weak market all year and we have got our business position to go either direction.

Okay. And then can either you or Terry comment on the restructuring? What do you anticipate in the motor business in terms of savings in 2007 and then what do you anticipate in terms of cost? I think you incurred a little over $1 million in the first quarter. How should we be thinking about that as we go throughout the year?

The majority of the projects that we are doing relative to restructuring are right now are about pay within a year of what the costs are. That is a bit of an overgeneralization, but as we incur $1 million over the next 12 months, we will get $1 million of savings is a real rough estimate and we are continuing to look at restructurings there as we have been talking about for the last three or four years. And that is a generalization, a little bit of an overgeneralization and if there is something that is material different from that, we will communicate it.

I guess more what I was asking, Paul, based on what you did last year, how much in savings you anticipate generating in electrical products and then based on your ongoing restructuring plans, do you anticipate having these $1 million or so charges as we go throughout 2007?

We have had a couple of pretty significant restructurings over the last three years that we have washed all the way through the system. I think as a generalization this year, we will probably have a little more savings than costs for the calendar year of 2007. Last year, I think we had about the same cost versus savings. Is that about right, John? I'm looking for a little help here.

Last year, we had pretty significant costs -- multiple speakers -- some of the savings, but we will certainly get more savings than costs this year. We have $1 million -- $1 million plus of costs in the first quarter. Some of the announced closings will incur some costs in the second and third quarter associated with that. So you might be talking about $2 million to $3 million total restructuring costs on the year.

Okay, great. That's all for now. Thanks.

Okay. Thank you.

Ned Borland, Next Generation Equity.

Good morning, guys.

Good morning, Ned.

A couple of small ones here. The press release made some reference to an increase in SG&A in water. I guess what was the impact of that?

GSW.

Okay.

And, Ned, a little bit of China.

Okay. And then also the expansion in the Yueyang operation for the commercial hermetic, can you just give us a sense for what the margins are like over there versus the legacy business here?

They are very good, Ned. That is why we are doing an investment there. We are not going to quantify it, but it is strong double-digit operating margins there and strong double-digit growth.

Okay. And then the shutdowns that you announced last year, I mean how far along are -- are those completed or are those -- you still have more room to go on those?

The McMinnville plant was shut down I think early February. That one is completely behind us now. The Tipp City one will happen in the second quarter. And that is all we have announced so far.

Okay. All right. That's all I had. Thanks.

Thank you.

Andrea Sharkey, Sidoti & Co.

Good morning.

Hi, Andrea.

Hi, Andrea.

A question on China. You are talking about expanding -- the expansion being complete by May for 1.1 million units. I think in the past, you have said that is about $150 million in revenue. Is that still the case or is that, you know, just that you are talking about it differently or has that number changed somehow?

The $150 million in revenue is what we are expecting for '07. We would have capacity above that in '08 after this capacity expansion is done. We are starting to push the envelope again, so that is why we have announced another doubling. It is our intent to have over 2 million units in capacity by the end of '08.

Okay. And that is in the same -- just expanding the same plant that you have; that is not a new geographic region?

Yes, that is -- we have decided -- there's been a big study on that. We have the land available there and we have got a pretty good transportation infrastructure and we are still right where the market is, which is on the East Coast. So we have decided to expand that facility rather than going to a second site. I think it is safe to say the next expansion that we will be looking at will probably be an additional site and we are already checking around about possible locations for that.

And then just one more question is kind of on the margin side of the business. You know, it seems to me from your guidance that you would be expecting to see, for the full year, margin improvement and based on this quarter, we didn't see really that in either segment. So I was just wondering if maybe you could talk a little bit more about the improvements that you think you can get in the next three quarters in each business and how you get there and maybe give us a little bit of a sense of quantifying the magnitude.

I will talk in generalities, Andrea. The majority of the increase in margins is going to come from cost reductions, cost efforts. We're doing a lot of standardization progress -- programs, a lot of material production programs, our motor business -- 60%, 70% of our costs are material and we have a lot of projects to get material out, substitute other materials and other things to get the margins up there. So I would say it is heavily weighted towards margin reduction with some weighting on volume in certain areas where we have some opportunities to pick up some additional volume. But that is the real short answer on the thing. There is always -- if you want to really get out there, material prices keep going up. Obviously, price will play a part in that as we go through the year if that gets to the point where we have to do that.

Sure. And then I guess based on all these things that you are doing, could you give me a sense maybe of timing? Is this going to be something that is going to be a lot more heavily weighted towards, say, the fourth quarter, maybe see some in the third quarter, second quarter still see some pressure? Any sense on timing?

Well, it is one of the elements of the whole equation. We are doing a lot more on material cost reductions now then say we were a year ago and we are ramping that up as we go through the year, but it is only one element of the whole equation.

The biggest issue relative to our earnings right now is probably the market more so than what we are going to be able to do on the cost side. We can't do anything about the market, but we can do a heck of a lot on the cost side and every time we look at potential opportunities -- another way of saying it is we are applying resources, in some cases, significant resources, to the cost reduction efforts, which is frankly what you would expect us to do when you are looking at a little weaker market. Let's put those talents of the engineering group on getting some costs out of the product for the volumes that we have.

Sure. And then just a final question. Terry mentioned that the DSOs were up. Is there some kind of problem maybe with some of your customers or is it just -- I guess what was driving the receivables going up in the quarter?

Well, part of it is increase in sales; part of it is we give longer terms in the first quarter in Asia. There isn't really any problem associated with it; it's just that they happen to be up a little bit more this quarter.

And we typically -- our customers will load up on pumps to some extent. It is actually less this year than it has been in the past. I think we had a fairly sizable check that arrived on April 2 instead of March 30.

Yes, (inaudible) March. Right.

But there is no problem is the short answer.

Okay. Great. Thanks so much.

We are still projecting around $150 million of cash flow this year before CapEx.

Michael Schneider, Robert W. Baird & Co.

Good morning, guys.

Good morning, Mike.

Good morning, Mike.

Maybe we could stick with that pool business and then circle back to HVAC. Could you give us a sense, guys, we're heading into the strong seasonal period for both HVAC and pool and spa. What is your read on those markets now as we head into March and we are almost complete now in April? Have you -- obviously we have seen a seasonal bounce, but has it been of the magnitude as it has been in past years or are you concerned about those trends most recently?

It has not been to the extent of past years, Mike, for, again, a couple of reasons. The housing is only part of it. And you can check in with what our customers have to say. I think they have covered this pretty clearly, but they have taken their inventories down. They had bumped up inventories 15, 18 months ago. Those inventories have now been worked down. I think we are seeing more of a normalized seasonality rather than, frankly, was more than normal seasonality in the last couple of years.

But, yes, the market is a little weaker and we are not mentioning customers, but you know who we are talking about. They have done a pretty good job I think of getting communication out as to what they are seeing in the market and since we have such a strong share in the inground swimming pool, we track right along with the market there.

Okay. And have you seen in the HVAC space again the seasonal bounce? Has it been -- we know housing is weaker than even we expected. Is there anything else occurring there?

Well, we are seeing a little bounce due to the fact that the inventories are down, but we are also seeing, as you mentioned, a weaker housing market than we were probably expecting three months ago.

Okay. And the progress of the eMod or the ECM motor, just some update there.

Well, we are making some progress. It is still a fairly small piece of both cases on the total, but it is something that we are excited about long term.

And did you win platforms for the 2007 summer season?

Yes, but small ones.

Okay. And sticking with motors, last time we talked and since then obviously copper has surged quite a bit, you were -- last time we talked, you mentioned that you were not in a mindset to raise prices at least at 250 copper. 350 copper, 360 copper now, have you issued price increases during the last 60 days or are you on the cusp of doing so?

No. We have not issued any price increases in the last 60 days and we are not going to talk about what we may or may not do in the future.

Okay. And Paul, in this strategy shift from growing to religious fixing what you own, especially in motors, can you update us on -- we've talked a lot about the savings you expect, but can you give us some specific examples of what has gone on in the first 100 days of the year and what will go on in the next 100 days?

I think we have publicly announced that, at least we have announced it internally, maybe not publicly, but we have put an engineering team in China on one of our SBUs. This is the V&R, ventilation and refrigeration. We are essentially going to be a China motor manufacturing company for that productline. They are solely focused on getting cost out of the current product. When we do a comparison between our product and other China motor manufacturers that are shipping products into the U.S., we see some opportunities. We are doing that. We made that switch I think in late February, early March, about six weeks ago.

Other than that, it is just -- as the market is weaker, instead of having let's say 20 design engineers working on samples and new products, we have taken 20 of the ones that were doing that and we have put them over on material cost reduction. So we still have people working on samples. We are not out of the growth business. We still have some pretty significant opportunities we are looking at. We have grown our distribution business double-digits the last three years. We just picked up another piece of business from Granger, so there are some things going on on the growth side.

And to say it is a major strategy shift, I would disagree with that. It is just on what you normally do. If you are seeing a little weaker market, you maybe redouble your efforts on cost reductions and that is what we are doing.

Okay. And then switching to -- well, sticking there then in the restructuring. Did I hear John correctly that there is probably another $1 million to $2 million coming for the balance of the year on restructuring expenses?

No, I would say, Mike, probably a little less than $1 million. We will probably end up around $2 million with the announced projects we have that Paul talked about. We still have some coming in in the second quarter, a little more maybe (inaudible) the third quarter. But we're probably for the year going to be around $2 million-ish or so total.

Total. Okay. And then in water heaters, the volumes we have talked about, I am curious though. There has been a long-held belief that this is primarily a replacement market. Have you seen any impact on what you can identify as replacement-oriented sales? Has that slowed down at all or is it indeed all new construction?

The replacement part is continuing as it always has and this is the same old story. When people take a cold shower, within four hours, they make a decision. Now there is a very small element occasionally where there are people that, every six or eight years, they just change out their water heater automatically, but that is a very small portion of the population and there is a couple of little vignettes about a couple of areas where people are seeing a little weakness there from discretionary purchases in water heaters, but that is under a 1% effect on the whole market and so it is not anything to look at.

One thing that we do with looking at housing, you know, housing completions were up last year. Even though housing starts were down, housing completions were up and the water heaters typically install towards the end of the housing construction process. So we are tracking ourselves versus the completions and that, frankly, gives us the explanation as to why the water heater piece for the new construction is where it is.

Okay. But if volumes have been affected by a slower economy, has the mix changed such that -- I don't know -- your average gallon size has fallen over the last three, four months as the economy has slowed?

We have seen no effect there at all.

Okay. And I guess final question just specifically on CapEx. You didn't spend much in the first quarter; yet the guidance is still $75 million to $80 million. Where is the money going and I guess when does the surge occur?

It is going primarily to China with the Yueyang expansion facility and we will be doing some initial stages of the water heater expansion over there. If there is anything we are doing a little differently relative to CapEx is we are doing a lot of tooling expenditures, smaller type CapEx related to some of the material design changes, taking material costs out of the product. Some of those projects are four or five-month paybacks, so we will be doing a few more of those, but it is not going to show up -- in total, we are still where we said we would be.

Okay. Thank you.

Ted Wheeler, Buckingham Research.

Good morning.

Good morning, Ted.

I wonder if you could just add a little color on the weakness in the commercial water heater market. What do you see behind that? Are there some marketshare issues?

No, no marketshare issues and weakness is probably too strong a word. We had a very strong year last year and we are probably going to have a year just about equal with that this year. So we just got a strong comparable. It's just that we are not going to be able to grow it and see the increases over the previous year. We are frankly delighted with the light commercial construction and what that is helping us with, both with water heaters and motors.

Does that I guess imply the strength last year included some inventory building that is being worked through? I mean the markets will be up, so I would think you would be up in the commercial.

Well, light commercial. You have to break the commercial down to where we will be putting a water heater in. You know, they go into laundromats and car washes and small office buildings. That is primarily the light commercial that we are talking about and we see that as essentially flat this year, but flat to probably the strongest year in many years, last year. So we are not exactly unhappy about that.

Also, just on a raw materials, I would think maybe by this point in the year you would have your copper costs pretty well known for this year. Is that a fair assumption?

Well, again, we'd like to tell you more about what is going on with copper, but since nobody else does, we can't either. Like everybody else, we hedge copper to various levels depending on what is going on at the time and I remain convinced that all of us do it at about the same time at about the same level, so it is really pretty much something that the whole market does at the same time year after year and whether we hedge for more than a year at certain times or less than a year at certain times, we are all kind of using the same people to do the transactions and talking to the same consultants. So I don't see that being a competitive advantage or disadvantage.

I was just trying to figure out where that stands. I guess in the past, in history, you would have been more or less visible on costs by this time in a year I mean if you go back over --

We used to talk about them more than we do now, but we found out that our competitors were loving our conversations, so we don't want to do anything to comfort them.

And I think you have mentioned along the last few quarters that some of the contracts do have some flexibility on copper adjustments. Is that correct?

Yes. I mean we learned that in '04. Copper, steel, aluminum, freight, we have escalators in almost all of our contracts now relative to different material prices and once again, the other thing, Ted, is copper, about half of our volume -- the customers buy copper forward with us, so we actually do that in a partnership with them for about half of the copper buy. So I hope that answers your question. (multiple speakers)

That's very helpful, yes. That's fine.

Three or four years ago, we used to have fixed-price contracts with a customer and then all of a sudden, the steel took off in '04 and we really got burned on that as did everybody else in the industry. So we all learned how to put those clauses in the new contracts.

Right. You know, thanks for that. That's helpful. One last question on the myriad of actions you are taking in the electrical products business, standardizing and taking raw material substitution and that sort of thing. Is that going to be a very gradual process or will there be a point out in the future where we will see some meaningful impact from what you are doing? I mean we are not seeing it now it seems.

Yes, we have so many different products in our motor business that, as we take these things on from your standpoint, it is probably going to look as steady incremental improvements as compared to like the water heater side where we are working on our new combustion chamber for gas water heaters. That is an event and that will be a significant event when we get that one done and it will have, at that time, to us a significant improvement.

But I would say on the motor side, from your standpoint, it is going to be more incremental a little bit every quarter. So many new products -- so many products eliminated, consolidated into one design or one platform from three or four, material substitutions. But for any one motor design, we don't have a tremendous amount of volume of any one thing that we can call it an event.

Well, it may look gradual to us now, but at some point if you are target is still -- what is it? 10% margin -- I think it is a three-year goal that we are in -- we are in the window of three years. At some point, if you get there, there will be a jump. I mean the math would just indicate that. Isn't that right or --

That's the plan. Our target is to be double-digit in '09.

Well, okay.

I am not into a travel log, but I was with the team yesterday and they are still (multiple speakers) signing up for it.

I guess -- okay. So you are reiterating that that is still an achievable goal as you see it today.

We believe that is an achievable goal as we sit here today.

Great, thanks.

Mike Marburg, Ramsey Asset Management.

Hi, guys. I just wanted to follow up the flow on water systems as it related to new housing construction. In the past, I think you've said that exposure to new construction was up 15%. Is that right?

Yes.

So in the first quarter, completions were down 19% or 20% let's say. So, you know, that is about -- would account for about -3% of what looks like -6%. So when you back out GSW and you back out china, the first quarter's sales for the pure legacy business is down 6%. What is the balance there between the -3% that would be from new residential construction and the -6%? Is it still the pre-buy from the third quarter?

It is a little bit of the pre-buys. It is a little bit of us getting our service levels up to record levels and our wholesalers taking their inventories down. It is just a few things. It is nothing other than that.

And then -- so when I look at starts in the third quarter of last year -- starts now, not completions -- starts were down 19%. So it looks like there's about a six-month lag. Starts in the fourth quarter were down 25%. Starts in the first quarter, down 30%. So I would expect then if I apply that to the 15% number that we are starting off with roughly -- roughly down 6%. Just from new residential construction, maybe 5%. So what -- you say flat for the year. How are you going to make up that 5%? Is that based on commercial business or what?

Well, as I have said, we were expecting commercial business to be good, but not great. One statistic that I just had handed to me is the industry market in the first quarter was down 10%.

Right.

We were down 6%.

Yes.

I don't think the market is going to be off 10% all year. I don't think anybody else does. So we still feel that we are going to be flattish with that business for the rest of the year when the year is totaled.

But I guess what you're saying to us by focusing on completions is the next two quarters get harder from a -- from the exposure to residential construction and you have got to make it up in either commercial or by gaining a lot of share?

Well, we like our customer base right now. We really are glad that we -- Lowe's is growing faster than anybody else in retail. We're certainly happy to be the exclusive supplier there and we are delighted with the wholesalers that we have representing us in the marketplace.

Okay. Thanks, guys.

Thank you.

(OPERATOR INSTRUCTIONS). Alan Mitrani, Sylvan Lake Asset Management.

Hi, thank you. You had changed the compensation structure this coming year for management if I am correct, right, from -- towards return on invested capital versus weighted after cost of capital, is that correct?

Yes, that's correct and that is over a three-year period, but it is for a significant portion of the long-term compensation. It can be zero or up to 150% of a target number based on how we do on return on invested capital over the next three years.

Can you give us a sense of where you are now or -- I haven't just calculated it yet this morning, but where you are now versus -- what do you believe your weighted average cost of capital is now and what is your return on invested capital now and what are your targets and how do you specifically get there with some of the things you are targeting?

John is going to give you a little further answer, but this is the change for our Company. Last year, we exceeded the cost of capital. Our returns were above the cost of capital for the first time in quite a while. We are currently projecting this year will be an even bigger spread between our returns and our cost of capital as the current projection for the year. Do you have any --?

Well, I think our -- just want -- I think that we earned about, what, 8.4% last year?

Right.

8.4% on return on invested capital last year and our cost of capital as we calculated it was somewhere in the 8% or 8.2% range, so we were a little bit above cost of capital last year. We set an objective that is higher than that 8.4% for this year. And that objective will be the basis on which the long-term incentive bonuses will be paid. So it is higher than the 8.4%. Our cost of capital is going to vary year to year based upon obviously upon our debt to equity relationship and the cost of debt. So it might go up a little bit, but right now it is somewhere in the 8% neighborhood.

Okay. And do you have a share buyback in place?

Yes, we do.

And has it been active at all?

No. Our Board approved it at our February board meeting. They approved a share buyback. That was the one thing we had missing from our whole shareholder tied-in dividends looking at everything. We did not have a share buyback program. We now have one.

Can you remind us just what that is?

It is a million shares.

1 million? Over a period of time or --

Yes, our objective is frankly to at least cover every year the number of shares and stock options that are given out as management incentives, so that means that we need to acquire around 300,000 shares. That is not a guarantee that we will do that every year. Like anybody, we are going to be a little opportunistic about when and how we do this, but it is our objective to do at least that every year barring something significant that could cause us to change that.

And you haven't bought any yet this year, right?

We have not bought any yet.

Okay. And then lastly, just a reminder, you said CapEx was $75 million to $80 million and D&A was going to be $75 million, is that correct?

Yes, $70 million.

$70 million. Okay, excuse me. And then of the CapEx, how much of that is what you'd call one-time CapEx? Remind us what the maintenance CapEx is on both businesses?

Well, I will [back] that differently. As Paul said, in this year's numbers, a couple unique things. We are going to be expanding Yueyang. We are going to be starting rather significantly the expansion in China for water heaters. So I think actually a little bit, but probably core would probably be about $55 million, $60 million-ish range total.

But core is probably more than maintenance. Maintenance is probably a number that's less than that.

I think maintenance is around 30 million, 35 million.

That's right. I would use about 30 million to 35 million

$30 million or so of maintenance and about $25 million or so of cost reduction related to CapEx and then the one-time facility and equipment piece would be another whatever it is depending on what we are expanding at that one point in time.

So next year could be a year where CapEx is less than D&A.

Could be.

CapEx could be more.

He said next year.

No, next year, next year, not this year -- (multiple speakers)

(multiple speakers) We have some China carryover among that project into next year, but I think right now, we haven't done the projections obviously. We think it would be similar or less.

And then finally if I can, you mentioned at the Gabelli conference earlier this year and you mentioned how you were sick of having the margins in motors and the electrical side basically being 5% for a while for a long time and your goal was to get into double-digits. Do you feel that you are taking -- that you have to correct two or three-year plan to get it there I guess regardless of where commodities go or do you really need a commodity pullback in order to hit double-digit margins with what your plans are for the next couple of years in terms of shutdowns and cost reductions?

We have a steadily improving plan to do that in my mind. We have had -- it has been a 5% business for seven or eight years and it is our objective to get that up. Our assumptions right now is that the cost and price equation will be flat as I said repeatedly if material costs go up. Prices will go up. So our objective is to do the things that we can control, which is get the costs out and we know we can get cost out of the whole equation.

We have done a terrific job at moving most of our labor to low-cost countries. We only have 8% of our direct labor on motors now in the United States. That is largely done. There is still a little bit more to be done there and I think it is just natural that you would expect us to take a hard look at material costs, which is a bigger cost than labor and that is what we are doing and yes, we think we can get there. If raw material prices pull back and we don't have to reduce prices, that is even better. If they go up, we will increase prices and keep that spread.

Do you typically lose prices if raw materials pull back or is there a lag -- I mean could you just tell us -- obviously there is a lag if commodity prices go up on the way up, but you manage to recapture most of that over time with your eight or nine price increases you have had, but on the way down, can you just remind us how that works?

Well, it's typically a quarter lag. So, yes, there is a little bit of an advantage there if we can get it. Commodity prices haven't exactly been pulling back, so we haven't had to experience that side of it very much.

Excellent. Okay, thank you.

Matt Summerville, KeyBanc.

All the industry data that you shared I think two or three callers ago, was that residential unit shipments or was that -- or did that include commercial? You said it was like down 10%.

That was residential.

Okay and then --

A little over 10% from last year's first quarter.

Okay. Then you mentioned kind of -- or it was discussed. I don't know if you used the number or not, but the one guy discussed your residential business kind of being down 6%, but wouldn't it have been down more like the 10% if you exclude pricing? I mean you indicated you got five points of price or better in each business. I am just trying to understand.

Well, what you had is the GSW business was not down as much as the market. In fact, it was down less than half the market. The legacy business was down pretty close to the market, so you pick something up there.

Okay. Okay. And then I just -- as you call it, Paul, the cost and price equation and I think that gets back to one of the first questions asked and I want to make sure that I am accurate on this. Do you believe in the first quarter (inaudible) cost and price parity? If not, do you believe you'll be there in the second quarter and can you talk -- delineate between the two businesses?

Well, again, as so many -- we can look at segments of it where we are ahead, segments where we are a little behind. It is not an across-the-board percentage of material costs. We are always looking for an opportunity to expand our margins any way we can. Either reducing our material costs, changing the mix or doing anything we can relative to what prices we can get in the marketplace. And to try to say we are at parity, I don't think we are ever happy with where we are. We are always trying to improve from where we are.

Okay. Thanks.

And our margins are what they are. We report them every quarter.

Gentlemen, we have no further questions.

Well, we appreciate everybody's interest. Thanks very much and we are going to go back to work.

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