A O Smith Corp (AOS) 2008 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the third quarter 2008 earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Vice President, Investor Relations, Ms. Patricia Ackerman. Please go ahead.

Good morning, ladies and gentlemen. 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; John Kita, Senior Vice President of Finance; and Craig Watson, now Vice President in our Business Development Group. 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. Paul.

Thank you, Pat, and we want to welcome you to your new responsibilities in investor relations. Have to say you have a knack for timing. Good morning, ladies and gentlemen, and welcome to this morning's third quarter 2008 conference call. We are pleased to report our third quarter results this morning. Total sales in the third quarter increased 9% to $603 million from $554 million last year. Net earnings of $21 million were $3 million lower than last year's third quarter, while earnings per share were $0.70 per share compared with $0.79 per share last year. Adjusting for two things, last year's nonrecurring tax gain of $0.10 and pre-tax restructuring expense of $2.1 million equivalent to $0.05 per share in our motors business, earnings per share on an adjusted basis increased 10% to $0.75. Our operating units are performing well in the most difficult economy in recent memory. We remain confident in our ability to manage the challenges associated with the weak housing market and relentlessly high raw material and energy prices. Because of the strong performance in the third quarter, we have increased and narrowed our 2008 earnings guidance to $2.80 to $2.90 per share from the previous estimate of $2.70 to $2.85 per share. Obviously, we remain cautious regarding the balance of the year. Terry will now discuss the financials in a little more depth, and I will come back and talk about the outlook. Terry.

Thank you, Paul. Sales of $372 million in the water products business were 11% higher than the $335 million reported in the third quarter of last year. Strong commercial sales, and growth in China of more than 25% as well as pricing actions related to higher costs for steel were partially offset by lower residential unit volumes. Third quarter sales of $232 million in electrical products rose 5% compared with the same period last year. A double-digit decline in unit volumes related to the soft U.S. housing market was more than offset by sales growth in China and improved pricing related to higher costs for steel and copper. Total operating profit was $3 million lower than last year, primarily the result of higher restructuring costs in electrical products this year versus last year. Third quarter operating earnings for the water products business of $32.8 million were similar to the third quarter of last year. Lower residential volumes and higher steel costs more than offset the benefits from higher sales of commercial product and China and the impact of pricing actions. Operating profit margin declined to 8.8% from 10% last year. Third quarter operating earnings in electrical products were $10.7 million and included $2.1 million in charges for restructuring activities. Operating earnings were $12.7 million in the third quarter of 2007. Operating margin was 4.6% compared with 5.8% last year as a result of lower volumes. Adjusted for restructuring, operating margin was 5.5% in the third quarter of 2008 compared with 5.9% last year.

Operating cash flow was a real highlight during the quarter. Generated $56 million of operating cash, bringing year-to-date cash flow to $79 million. Compared with the same period in 2007, cash cycle days declined to 63 days from 67 days in the third quarter as a result of better receivables collections and lower inventory days primarily at water products. As a result of the positive operating cash flow, our debt-to-capital ratio declined to 29.7% from 34.3% at the end of the last year. Year-to-date capital spending totaled $44 million compared with $42 million last year. Capital spending for the full year is expected to range between $70 million and $80 million, down from the $85 million we previously forecasted. Depreciation and amortization for the first nine months totaled $50 million and is expected to total about $67 million for the year. Projecting total operating cash flow of approximately $150 million for 2008, up from our forecast of approximately $120 million at the end of the second quarter. I will now turn the call back to Paul for some comments on the outlook. Paul.

Thanks, Terry. I would like to spend a few moments discussing the market and our operating environment. As you know, our biggest end markets are residential and commercial construction. The protracted slowdown in the residential market is old news at this point, while we believe the slowdown in the commercial market segments we serve is beginning to pick up some steam. As you also know, for both our businesses we sell products into fairly mature segments of both residential and commercial market segments, allowing us to benefit from the lower volatility associated with high replacement demand. As you can see, for water products we estimate that it is over 70% replacement, while for motors it is approximately 60%. We estimate that housing completions will decline more than 30% this year and will decline meaningfully again in 2009. Nonetheless, for 2008 the decline in residential water heater shipments is projected to be a more modest 5% to 8.5 million units from 9 million units in 2007, the slower pace reflecting the high replacement nature of the market. We do expect a similar change in 2009. With respect to channels, the decline is more pronounced in the wholesale business, which is more closely tied to new housing construction.

A couple of slides back I mentioned that the light commercial market segment that we sell our commercial product into is beginning to decline at a quickening pace. This slide depicting retail construction spending makes that point. We believe this is a good barometer for our commercial business because it captures the strip mall construction that usually accompanies growth in residential construction. As new subdivisions go up, strip malls usually accompany them. Conversely as residential construction declines, eventually (inaudible - background noise) commercial. Although we have enjoyed good commercial sales growth during most of this year, we believe the declines in spending will catch up with with us beginning in the fourth quarter of this year and will last through most of 2009. Steel costs are dramatically up in 2008, more than 80% from the beginning of the year, now to over $1,000 a ton. Because of the lagging effect of our contracted steel costs, we will continue to fully experience the steel cost inflation seen in the last three months during the fourth quarter of this year. In segments that our current pricing does not cover the cost of steel, we are evaluating a full range of options to improve our profitability.

Now switching to Asia. China now represents more than 10% of our business and is a key ingredient of both our sales and earnings growth initiatives. We expect that region of the world to account for almost $300 million in sales in 2008 and makes a proportionately higher contribution to operating profit. But economists have been reducing their 2009 growth contrast for China from over 10% maybe two months ago to under 8% last month and around 4% earlier this week. It is only logical that as the world's developed economies slow in the wake of this financial crisis that China will slow as well, so those more conservative forecasts are not surprising. Our sales in China grew more than 30% a year from 2003 to 2007, well above the GDP growth in that country. This year the combined China business will reflect slower growth of approximately 20% with some of that reflecting the appreciation of the RMB. So we are beginning to see the slowdown in the markets and are making the appropriate adjustments. And where our Chinese businesses have helped mitigate some of our U.S. based headwinds, the last few years, we're growing more cautious of our prospects for the next twelve to eighteen months. Having said all that, we're still very excited about our momentum and long-term opportunity in Asia as we leverage our brand and expand our product offerings.

So where does that leave us? Well, as I stated at the beginning, as a result of our strong performance in the third quarter, and despite the difficult economic environment we're facing in the fourth quarter, we have increased and narrowed our 2008 earnings guidance to between $2.80 to $2.90 per share from our previous estimate of $2.70 to $2.85 per share. However, we face headwinds going forward, including lower commercial volumes and higher raw material costs that will only be partially recovered. Furthermore, the uncertainty with regard to the economy's stability continues to cloud our visibility, thus the cloud you see on this slide. Regarding our longer term prospects, again, we see lots of moving parts, some things good and some things not. For instance, we do see the housing market stabilizing, which is very positive. On the other hand, we see is bottoming later than we previously thought. We see a declining commercial market, which carries important mix implications. We see a slowing economy in China, which will adversely affect unit demand. But a slowdown will allow us and a larger economy to catch our breath while helping to cool global commodity inflation. It all adds up to a lot of moving parts, challenges and opportunities that we intend to provide further insight to when we meet with you again in January to discuss total year 2008 results. With that, we're ready to take your questions. Ruth, I will turn it over to you.

Thank you. (OPERATOR INSTRUCTIONS) The first question does come from Mike Schneider with Robert W Baird. Please go ahead.

Good morning, everyone.

Good morning, Mike.

Maybe first we can start with the water products division. Can you remind us now as we exit 2008 after all of the prebuys and other dynamics, what the commercial and residential split is in revenue and then operating income as well, so we can get a sense of what the mix implications are for 2009?

Mike, for competitive reasons we would rather not talk about what those are. The unit volumes are out there. I think you can get that, and we have about a 50% share on the residential side, and we've been able to move up to north of that on the standard and commercial side. But we're not going to talk about the margin splits, and I am sure you understand why.

And we have to make an assumption about average price points. Can you give us a sense of what your average price point is or revenue per unit is in residential versus commercial so we can make those assumptions?

I really can't, Mike. It is all over the map. We make some commercial water heaters that are five gallons, and we have shipped a couple of huge 6,000-gallon commercial stainless steel units to Dubai a couple of weeks ago, so it is all over the map, everything in between. We have cranked up our export business there, and that is doing quite well for us. I know we're hitting you with some caution, just remind you we are conservative folks. It is very difficult right now to forecast, given all the volatility and all the different mixed signals that are coming at us, so we tend to go, as you know, with a rather cautious or conservative approach.

Well, in fact, that brings the next question on the commercial water heater side. If you look at light commercial construction including the chart you laid out in your presentation, it has been down and deteriorating really for two years and has been negative this year, yet your commercial products, I would guess, are probably having record quarters right now. Is it exports? Is it market share gains? Is it just the price increases that are distorting the actual negative volume shipments? Just any color to explain why we haven't seen it yet in your commercial business.

It is a lot of things, Mike. I am really proud of the leadership team we have there. We are doing a lot more on export. We have been able to bring out a lot of new products. I won't go into great detail, but we have got a cyclone water heater, which is moving up to about -- I think we're getting close to 20% of commercial sales. It is a brand new high efficiency commercial water heater. We have a variable flame boiler, a light small boiler doing well. It is a lot of things. We're selling products all over the world. We are expanding our commercial business in China. We're putting a commercial production line in there. As a matter of fact, we're already making some units there. There is a lot of things going on. We're probably anticipating some things that are going to happen. I think you would expect us to constantly look at what -- not only what the most likely is, but make sure we're protecting against the worst case.

And are unit volumes actually down this quarter in commercial or are they up, just in addition to positive pricing?

We had a good quarter last quarter in commercial.

And then on pricing, you and your two major competitors went out with 10 points of pricing on commercial alone. Do you think that drove any prebuying this quarter in the commercial slice?

Yes, it did. That increase was in September, so that prebuy came into August. There might still be a little bit of an overhang of that, Mike. It is hard to tell.

Okay. And on the residential portion, did I hear you right, Terry, there were double-digit volume declines in residential or was that revenue?

Motors.

It was in motors, Mike.

Yes. Double-digit declines in motors.

We are seeing unit declines in residential water heaters, down about 5%, I think.

And with the pricing, though, is residential still up in dollars?

Yes.

Okay. I will get back in line. Thank you, guys.

Thanks.

The next question comes from Ned Borland with Next Generation Equity. Please go ahead.

Good morning, guys.

Good morning, Ned.

Just want to talk about the electrical side for a minute. Even ex the restructuring, if units are down that much, I mean is there something going on there with regard to the road map initiatives? Are there some unfavorable copper hedges or what's going on with the margin there?

It is a tough economy. The volumes are down due to -- look at the customer base we have and check out what they're saying about looking at the HVAC businesses right now, but we're still on track with road map. We're still committed and have detailed plans to achieve the anticipated results that we've given you. That's coming. Have we lost some business, yes, we have. When we were that aggressive at getting the -- our objective is to get our margins everywhere across the Company above the cost of capital, and we've got detailed plans in every little market segment and product line and customer, and where we're not able to do that, we're taking pretty aggressive actions to get it up, either with a significant price increase, a redesign, a product substitution, maybe we do a product downgrading that better fits what they need, any number of things. And also, as you well know, we've exited some business there and we've had some customers exit business with us and we were pretty aggressive on the pricing. But sometimes they come back as we just had one make an inquiry the other day that exited several months ago and they're not getting the quality of service so they're now initiating discussions with us again. A lot of things going on. We're still committed to the road map, and we're still convinced that that's going to lead to significant profitability improvement in electrical products and get that business up to covering cost of capital.

Okay. And then on the road map initiatives, I guess the big savings come next year, but can you give us a sense of how that kind of lays out for next year?

We said we're going to get $5 million this year. We've already gotten most of that, so we're very comfortable that will happen, and that will increase the $20 million next year or $15 million over this year from the restructuring road map activities. We're still on track. That's baked into our budget for next year, the budget prep we're doing, and there -- as always we're not satisfied with that. We're looking at other opportunities. We're starting to do a little bit more on the motor side on some growth initiatives, both new products and some new customers, some geographic things going on there that we're pretty excited about. Some of these take a year to get online, but where we have successfully taken a product line up to a margin level that's acceptable for the long-term, it would make sense that we would then go out and start trying to grow that, and that's what we're doing. We've been in a shrinking fix-it mode there for four years, and I think you as an investor would expect us at some point to turn that around.

Right. Right. Okay. And then my last question is in regard to the operating cash flow, looks like you saw good improvement there. I know you're still kind of in a holding pattern with regard to share repurchase, but are we just looking at debt reduction going forward with the free cash flow?

No. I mean, we're very pleased to do drop below the 30% debt-to-capitalization. We had originally said that would happen at the end of the year, and we got there in the third quarter, so I am really proud of the team for what they're doing. Like every other manufacturing company out there right now, cash is king is the motto we're using right now. We still have some ample room in our debt agreement, and it has got some -- a few more years of life left in it. The reason we have the no-trade window is the pending deal with SICO, Smith Investment Company, that is still being worked on by special committees, but we're looking at acquisitions. There might be some private equity firms out there that maybe have some troubled assets and they're looking for cash, and we are out doing a lot of prospecting right now as well as looking geographically as well as some product expansions. We've got a couple of technology moves that we're looking at. So we think we've got some dry powder right now. We know we have some dry powder, and if we can find a real bargain out there that would immediately return cost to capital and be accretive to earnings, we're going to be after it.

Okay. Great. Thanks.

The next question comes from Paul Mammola with Sidoti & Company. Please go ahead.

Good morning, guys.

Good morning, Paul.

Given what you said about prebuying steel and how you've lagged the price of steel and copper over the past six months, would it be fair to say that going forward you could see further margin pressure from where we are here?

Well, yes, a little bit. I mean, it is going to be about the same as where we were in the third quarter. Our steel agreements, I think we've discussed this in the past, is we will take last quarter a 3-point average, and that determines the price for the next quarter. We've done that so we could have some surety of what our costs are going into the next quarter, and then we use that as an index depending on the material content of the products we sell to put into the contract. Now, this is primarily on the motor side. So that as we go into a new quarter, if our steel costs are going up, the majority of our contracts will have an automatic escalation clause so we get that cost recovered. We don't quite have the same situation on the water heater side, but, yes, the rapid increase again we saw one in the second quarter and then lately there was another spike towards the end of the quarter, third quarter. It is now falling back a little bit, and that's certainly -- maybe will give us a little bit of relief going into the first quarter, but right now we're not anywhere close. Well, we're close, but we're not where we were at the beginning of the year relative to steel and we're taking some actions to make sure we rectify that.

Okay, that's very helpful. And then on India, obviously that could be a big market for you guys. Would you expect the ramp up there to be similar to China, or in other words, maybe a ten-year timeline to get a sizable chunk of that market?

We think it will be faster than that. We learned a lot of lessons and we still have the same people that did the China expansion. We have gone into India with products specific for that market. We had a lot of same sort of things we do here. We get focus groups together and find out what the ultimate consumer wants to have in a water heater, and we designed that in. We have a very special product for the market there, and we're off to a much better start, much more sales than we initially thought we would get. We're still making the product in China and shipping it to India, which for a whole lot of reasons is not helping out short-term on the profitability. But once we get the factory up and running there and making the product in India, we think we're going to have a pretty solid business there in a very short period of time.

Okay. You spoke and gave some good color on China. Is it fair to say that through the first few weeks of the fourth quarter that China is slowing or has that -- is that about to come about? What do you think?

I think we're seeing China slowing, but remember we're now down to only about a 20 or 25% growth rate. That's not something I am going to be too upset about. It has been above 30% for the last several years, so we're still doing much better in GDP for two reasons. Our water heater business is targeted a still-growing segment of the market, that's the upper middle class. And our motors business we're doing much more exporting out of China now all around the world with our commercial hermetic, which is becoming a pretty good size piece of the company now and a profitable piece.

Okay. Thank you.

(OPERATOR INSTRUCTIONS) The next question comes from Matt Summerville with KeyBanc. Please go ahead.

Terry, I was wondering if you can quantify what your pension expense is in 2008 versus 2007 running through the P&L and if today was 12-31, assuming that is your measurement date, what would pension expense look like next year?

For '07 it was $11 million. For '08 it was about $4 million, and at this point '09 is really up in the air, given current market performance, but my best guess is that it would be a little -- it would be a little bit higher than it was in '08, but probably it won't be as high as it was in '07.

Okay. That's helpful. Thank you. Could you guys also talk about how you're perceiving channel inventories in both water heater and electrical products business? In motors maybe compare your OEM guys versus distributors and then in the water heater side what you're seeing channel inventories at the retail level as well as at the wholesale level?

Okay. The OEM side I think they've pretty well got the inventories in line. We don't see an excess or shortage there on the motor side. Distributors in some cases are seeing an opportunity on the replacement side, and we've got a couple of distributors that are actually tweaking up their inventories a little bit. We have a very short production cycle from order to shipment, so we're doing everything we can to help make sure when they do have an opportunity for business we can support it. On the water heater side, I think the inventories are down from where they were a year ago at our wholesalers. That's good. I think they're down at our retail partners. That's good. The reason for that is we've shortened our cycle time from order to delivery and significantly increased our service levels. We've pretty well absorbed those things this year, and I think the inventories are pretty much in line. We may be still, as I mentioned earlier at Mike Snyder's question, we may still have a little bit of overhang on commercial water heaters, because it was a pretty sizable price increase in September. And we did see a few customers lay in some standard commercial product and maybe they're still holding onto that for another few weeks, and then that will be out of the system. And of course things are still -- we're still evaluating what we're going to need to do January 1 relative to price, and we'll be coming out with those announcements during this quarter.

How should we be thinking about copper as far as how that's impacting the motor business in the third quarter and kind of on a go-forward basis since the commodity price is well off its high and at the same time does then that mean that your average selling prices, everything else held equal, so steel held equal, would actually come down then?

Well, copper is -- we hedge copper as does everybody else in the industry. We do about half, maybe a little over half of our hedging alongside our customer. In other words, the customer makes a decision to lock in some copper at this -- at a particular price, and we go lock it in, and that determines the selling price to them for that period of time. For competitive reasons I don't want to talk too much about hedging, but I think it would be safe to say that everybody in the industry is doing a lot less hedging than maybe they were a couple of years ago simply simply because of the volatility and the prices have been coming down. Copper got down to $2.05 last Friday. It then went up to about $2.50, and I think it is $2.20 today. It is pretty volatile. So we along with our customers -- we have some customers, one in particular with pretty sophisticated forecasting models. Overall the way we do it, we have a copper hedge committee. They meet on a regular basis. We have smart people in there. We have some outside forecasters giving us what they think will happen. Like all forecasts, they're almost always wrong, but they've been less wrong lately than they were before, so we're just -- we just watch it, and I think I would be surprised if any of our competitors would give you any different answer than that.

Great. Thanks a lot.

And the next question comes from Mike Schneider with Robert W. Baird. Please go ahead.

Wonder if we could just talk about the implied guidance for Q4 and the sequential decline in earnings that's implied. If you look at the annual guidance backout, it seems to imply that Q4 earnings on a GAAP basis are going to be at the midpoint $0.37, which is almost half of what you reported this quarter. And I suspect there is about $0.05 more restructuring in Q4, at least based on the annual guidance. But even scrubbing that additional $0.05, I struggle to understand why earnings are effectively going to be down 40% sequentially when seasonally that's normally not the case.

Mike, I am going to tell you that I don't feel good about how well we can forecast right now. I hope you don't take that as a negative comment. I hope you take it as a cautious comment. There is just a lot going on out there right now. We're monitoring very closely our customer base, their liquidity. A lot of money dried up over the last two or three weeks, and we're making some assumptions. Obviously we are going to work 24/7 to make sure we beat the heck out of this forecast, but right now we've got to look at what -- we don't want to give you a number and miss it, and I think we've proven that, and it is just a tough time right now to sit down and put a forecast together.

Understood. Have you, as a consequence, taken significant production days out of the forecast for Q4 to reduce your own inventories? Or what do you expect based on your plans for Q4 internally that would impact margins so dramatically, because a decline like that I have only seen in my history but you guys over the last ten years that it is associated with huge inventory and production cuts in Q4?

We have taken some days out of the production schedule. We actually had one day this month that we did not run a water heater plant in the U.S. That's the first time that's happened since I have been here. It is just one day, but again where cash is king we're monitoring the cash. We made a lot of internal improvements and operating systems where we're able to give better service with lower inventories, so we're now to the case where we can keep our inventories in line, keep our service levels up. We're monitoring our customers. We have -- one of the reasons for conservative forecast, we have a motor OEM customer right now talking about taking -- possibly taking several weeks out in the fourth quarter. If they take several weeks of production out, that's several weeks of our sales to them that won't occur, so we don't know for sure what is going to happen. Our folks are in daily contact, as you would expect us to be, with the OEMs where our product is designed into their product. And we're do I kind of taking a worst case scenario and trying to make sure we still have positive cash flow and hit our earnings estimates.

Okay. Understood. And just a couple surgical questions, in the retail water heater space we've been talking about potential price increases finally being realized. Do you have any update there?

Can't talk about pricing there, Mike. I am sure you understand.

And in motors, the distribution slice of that business, can you just describe the trends there, not only during the quarter but maybe even as of late as an indication of your industrial exposure?

It's -- our distribution side, first of all, our industrial exposure in distribution continues to decline. That's the interval horsepower. We -- that is just not a business that we can compete with the Baldors and Regals and we're deemphasizing that. But on the replacement side, it is still growing. We're still picking up some business. We're still picking up additional pages in the catalog for lack of a better word, and we have programs going into next year that will help us continue to do that. Obviously the pieces of the business that go to -- some of these people sell to the pool, swimming pool installers, that's down so that piece of it, but the replacement market there, people still replace their swimming pool pumps, so that part is still going okay. We're pleased. Our distribution, as you know, we started an emphasis on that a few years ago, and we've grown it every year, and it is my expectation we'll continue to do that this year and beyond.

Okay. And just in water heaters again, did you see quarter end or even in October now any trends that signal a significant change in direction?

No. We're actually forecasting the incoming order rate is -- it is okay. It is not great. It is okay. As the joke we always have, the good news and bad news about water heaters, the bad news is it is the replacement part's a GDP business. The good news is it is always there. We continue to see -- thank goodness for the strength. We say 70% of water product sincerely replacement. If you look at U.S. residential it is north of that, probably as much as 85% now, and that is as steady a business as you could ever have.

A more strategic question, Paul, I know you're always evaluating business lines, business portfolios. Do you have an update on your view of the portfolio at this point and/or when we might get one?

We'll try to give a little bit more information on that in January. Right now we're still continuing to evaluate. We have cranked up our new product introduction in the market segments, new product programs in the market segments that look attractive to us. Our ECM motor is finally is getting some traction. We have a major program that will be kicking off next year that's coming to fruition. We love our commercial hermetic. We have a few other market segments, even one in water products, that we're continuing to look at and looking at alternatives. And as we can give you an update, I want to. Let me put it that way. If we can say something that won't put us at a disadvantage on a competitive basis, we'll tell you.

Okay. Thank you.

At this time there are to further questions in queue. Please continue.

Thanks, everyone, for joining with us. It is a pretty volatile time out there right now, and I don't have to tell you that. And we appreciate your continued interest in our company, and we're going to continue to do the best job we can for you. And with that, operator, if you will give them the call-in numbers and we'll all go back to work.

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