A O Smith Corp (AOS) 2009 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the A. O. Smith Corporation second-quarter 2009 earnings conference call.

For the conference, all the participants are in a listen-only mode. However, there will be an opportunity for your questions and instructions will be given at that time. (Operator Instructions). As a reminder, today's call is being recorded.

With that being said, I will turn the conference now to Ms. Patricia Ackerman, Vice President-Investor Relations and Treasurer. Please go ahead.

Thank you, John. Good morning, ladies and gentlemen, and thank you for joining us on this conference call. With me this morning participating on the call are Paul Jones, Chairman and Chief Executive Officer; Terry Murphy, Chief Financial Officer; and John Kita, 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 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, I will turn the call over to you.

Thank you, Pat, and good morning, ladies and gentlemen.

Before we get into the highlights, let me say that we are encouraged by our second-quarter results. The challenges of the global recession are still present, but our focus on cash management and cost reduction have really paid off for our shareholders.

A few highlights to consider -- first, while earnings were down from last year due to lower volumes, the improvement from the first quarter is considerable. Our Water Products company logged in operating margins at 10.8%, up from 9.5% last year and 8.6% last quarter.

Sales at our Electrical Products company increased 13% from the previous quarter.

Secondly, our operations generated almost $94 million in cash in the first half of the year. Our inventory reduction programs delivered some great results, as levels declined by 20% from the end of last year. Additionally, improved terms with our vendors have now resulted in negative working capital levels in China.

Third, our water heater operations in China grew 16% over last year. The Chinese government stimulus program is definitely working.

Fourth, our Motor Operations started to see an uptick in orders from its HVAC customers in the second quarter, related to seasonal summer sales.

In fifth, due in large part to the success of our cost-management efforts and sequential improvement in second-quarter earnings, we increased our dividend by 3% and we increased and narrowed our 2009 earnings guidance. (technical difficulty)

Earnings guidance for the full year is now a range of $2.05 to $2.25 per share, on a non-GAAP basis, an increase from the $1.80 to $2.10 per share range that we gave during our first-quarter call in April.

The forecast on a GAAP basis is $2.15 to $2.35 per share.

Terry Murphy will now elaborate on our GAAP and non-GAAP reporting and our second-quarter financial results. Terry?

Thank you, Paul. Before I get into the financials, I would like to briefly explain what caused us to now be reporting GAAP and non-GAAP financial measures. On 4-22-09, SICO was merged into A. O. Smith Corporation as a subsidiary. That transaction resulted in SICO shareholders maintaining a similar but direct ownership in AOS Smith stock. The transaction was accounted for as a reverse acquisition under SFAS 141-R with no purchase accounting required. For accounting purposes, SICO was the acquirer and AOS was the acquiree, while for legal purposes SICO is the acquireee and A. O. Smith is the acquirer.

To review briefly what happened from an accounting perspective, let's look at the six months ended 6-30-2008. Sales and gross profit are the same for GAAP and historical reporting. GAAP earnings are less because of SICO expenses during the first six months that wouldn't have been shown on the historical statements.

The discontinued operations are the result of those two small SICO subsidiaries. Since SICO held about 9.5 million of the 30 million shares outstanding, or about one-third, on a consolidated SICO financial statement, you would have to eliminate two-thirds of the earnings, non-controlling interest, and then divide by the SICO shares outstanding. The net result is that GAAP is $1.67 versus hour reported number of $1.78 last year.

Now, let's look at 2009. Gross profit is the same again. Net earnings are slightly less for GAAP, again because of SICO expenses. However, rather than eliminating two-thirds of the earnings for the entire period, two-thirds of the earnings are eliminated only up through 4-22-09, and then 100% of the earnings are calculated from 4-23-09 through 06-30-09. The same kind of calculation for the shares -- 9.5 million shares up to 4-22-09, 30 million shares thereafter. All-in, it produces earnings per share of $1.19 on a GAAP basis, which is higher than what we would have reported historically at $1.07.

We've included a reconciliation in our press release today which it should be helpful in understanding the complicated GAAP accounting required for this transaction. We believe the non-GAAP presentation of the historical information provides investors with a better understanding of what's happening in our business because it is comparable to our historical information as well as our earnings guidance for next year.

We will continue to provide information in a non-GAAP format for the next three quarters. The remainder of the presentation will provide information that is non-GAAP.

Total sales in the second quarter declined to $499 million from $622 million last year. Due to the declines in volumes we experienced in all of our North American end markets, we recorded lower earnings of $23.7 million, or $0.79 a share, compared with $32 million or $1.06 a share last year. The 2009 earnings per share included $0.06 per share in positive after-tax benefits related to our Chinese water heater business.

The 2008 earnings per share included $0.03 per share net benefit from a cumulative currency translation gain related to the closure -- closing of our operation in Budapest.

Sales of $337 million in our water products business were off 11% from last year and masked sales increases in China of about 16%. Commercial volumes were down more than residential volumes but both were off double-digit amounts. We estimate the industry's residential replacement volumes in North America are now about 92%, reflecting housing starts at historically low levels of below 600,000 new homes.

Electrical Products sales declined by one-third to $162.4 million, driven by declining end market demand and customer inventory reductions. Despite continuing to add business with some of our large distribution accounts, volumes in all of our strategic business units, or SBUs, experienced double-digit declines. Year-over-year volume declines in our pump motor and general industry SBU were the largest.

Before we leave this slide, a comment on our HVAC business is in order. As Paul mentioned, we've seen in a progressive increase in volumes in the second quarter -- April better than March, May better than April, and so on. We expect volumes to level off in the third quarter and then fall off some as the summer season winds down.

Total operating profit declined to $33 million from $47 million last year. Operating profit at Water Products was $36.5 million, essentially the same as last year. Operating margins improved to 10.8% from 9.5% last year as a result of aggressive cost reduction programs and higher pricing.

Electrical Products posted a second-quarter operating profit of $7.6 million compared with operating profit of $22.5 million last year. The earnings impact from the significant drop in volumes more than offset over $5 million in savings associated with product repositioning and plant consolidation.

Operating cash flow was almost $94 million in the first six months, which was considerably better than the operating cash flow of $20 million last year. A 20% reduction in inventory levels from the end of last year contributed over $50 million to this year's operating cash flow.

During the second quarter, capital spending was approximately $22 million compared with depreciation and amortization of $34 million. Capital spending for the year is expected to be around $60 million, which is trimmed about $20 million as a result of our efforts to conserve cash.

Depreciation and amortizaton is expected to total approximately $70 million.

We are still projecting operating cash flow of between $140 million and $150 million for 2009.

Our liquidity position and balance sheet remain strong. Our debt to total capital declined to 29% from 34% at the end of the year. We have limited amortization of our long-term debt portfolio in the coming years. Our $425 million credit facility doesn't expire until February of 2011, and we had over $268 million of available capacity under the facility at the end of the quarter.

Paul will provide details on some exciting new product introductions, and then we will open up for questions. Paul?

Thanks, Terry. As we've been saying for some time, we are continuing to invest in new products and technologies to ensure that we are well-positioned when the global economy recovers. Now we're going to start talking about those a little more.

We are excited about the new products we've introduced in the second quarter, as well as the products in our pipeline. Here are just a few examples.

Our latest new product in China represents a real game-changing application. Solar water heating is a huge market in China. If you've been there, you see solar collectors or panels literally covering rooftops of homes and apartment buildings.

The problem is less and less rooftop space is available. In addition, in high-rise buildings apartments on the lower floors are difficult to serve with solar panels on the roof. Our award-winning product, which consists of a balcony-mounted solar panel and a pressurized water heater, addresses the problem wonderfully. We have plans to introduce other pressurized solar water heating products in China before the end of the year.

In April, we acquired a small heat pump commercial water heater company. The US heat pump water heater market is in its infancy, but with government incentives and the push for green buildings, we believe the market will become as large as China in the next several years. China put 160,000 units in service last year. The acquisition not only provides a new technology for us, but it provides engineering expertise which we will use in our global heat pump development as well as US residential applications.

We recently installed 14 commercial heat pump water heaters at the Fort Knox Army base, which added to the roughly 50 units that were installed prior to our acquisition of the company.

In Electrical Products, we've been working on variable speed motors for many applications. Taking advantage of our leadership position in the Pool and Spa Pump Motor segment, we have two new products in production this quarter, including a premium-efficiency two-speed motor and a full variable-speed motor or ECM for pool pump manufacturer [Gandy]. These new pool pumps comply with new energy efficiency regulations put into effect late last year in California. We expect more states to implement similar legislation in the very near future.

In discussing the outlook, I want to touch on four items -- one, the strong water heater replacement demand; two, our China volumes; three, the volume declines in our motor business; and four, our cash conservation coupled with cost-reduction activities.

Let's start with replacement demand. As you know, the North American water heater market is largely a replacement market. Historically, the replacement volumes for the industry ranged from 7 million to 7.5 million units per year. We now expect new construction to incrementally add only 550,000 units in 2009. With a replacement market now expected to be 92% of the volume this year, these volumes are much more predictable than for our motor business.

Second, we are expecting our China business to grow modestly in 2009. Our China water heater sales were up 16% in the second quarter after being down 10% in the first quarter of the year. It's clear that the China stimulus package is helping our customers buy homes and instill confidence.

Third, as I mentioned earlier, our OEM motor customers have indicated that their 2009 volumes will be substantially below last year's volumes. Most are forecasting 20% to 30% declines. We have had individual conversations with all of our largest customers, and this is no different than what we hear in the general economy. As a result of the lower volumes, we have eliminated over 1000 jobs since the beginning of the year.

Finally, we will continue our focus on conserving cash. These programs have already generated great results, as evidenced by our strong cash flow. But the programs will remain in place for the foreseeable future.

To wrap up then, our 2009 earnings guidance is now $2.05 per share to $2.25 per share on a non-GAAP basis, an increase from the $1.80 to $2.10 range that we gave during the first-quarter call in April. The forecast on a GAAP basis is $2.15 to $2.35 per share.

This concludes our prepared remarks. We will now open up the lines for questions. John?

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

Good morning, guys. Congratulations -- obviously a very nice performance in a tough market.

Maybe we can just focus on margins for a minute. The cost savings are coming through. Maybe Terry, you could just give us some more details on how cost of goods sold is down sequentially while sales are up $17 million or so? If you could just delve into what the delta is on material and labor, anything like that. Any color would be helpful just to give us a sense of how sustainable these margins are going forward.

Mike, this is (technical difficulty). Certainly materials are a big impact on that. We've said that (technical difficulty) mechanism we have, we trail in steel and some of those things. So we are favorable to steel quarter over quarter (technical difficulty) labor enhancements we've done are also helping the gross margin line.

Can you give us an order of magnitude? Is it -- are you lower by $10 million, even sequentially, in materials?

Yes, Mike, this is Paul. I don't think we can give that out. I think we would be giving a little bit too much information.

I will say that, when we look at our bridges from year-over-year and quarter-over-quarter, I've never seen such big numbers on these bridge charts, relative to volume and mix and material cost and labor costs and everything else. It has become -- part of the reason for our conserving or being conservative with our guidance last quarter was the fact that we were seeing some really big swings in some of the potential variations coming up on costs. So we are being a little conservative. We are tracking it obviously minute-by-minute in every element of the income statement to try to make sure that we stay on top of it.

As John just mentioned, you know steel was very good cost position indices in the first quarter, and that's what we are paying in the second quarter. In the third quarter, we will be paying what it was in the second quarter. So we now have nine months' visibility onto the majority of our material costs. So it's giving us a little bit better handle on how things are going to be for the rest of the year.

Okay. And production levels, can you give us a sense of where you are right now? Will absorption be as good in the second half as it was in the second quarter, or will it be even better as you stop depleting inventory?

Yes, it will be better in the first half because we've been taking some absorption hits in the first half as we have been taking finished goods inventory down.

I want to stress we are not impacting service. As we've talked about -- and I know a lot of people yawn when they hear it -- but we put a lot of capital investment into information systems over the last several years, and it is really paying off. We have a much better visibility onto what we need and when we need it, and we have been aggressive. I've told the whole team, we will take all the absorption hits we can get to get our balance sheet in line and get our service levels where they need to be.

So we have taken some absorption hits in the first half. We may take a few more in the second half as we continue the emphasis to generate cash, but that's all, in my opinion, money well spent to get the business positioned properly.

But the absorption hit will be lesser in the second half, at least if volumes stay at current levels?

Yes, I think so. To help answer your question, we have taken some line rates up. You know, things like hermetic have really taken off. residential and hermetic; we have had to take those line rates up significantly. We are not sure it's sustainable, and that's why we are being conservative, but we've had to do a few things because there was just not a lot of inventory in the pipeline, as you know; you reported that in your own reports.

Yes. And then, in water heaters, if China was up 16%, it looks like domestically you were down about a comparable amount, 16%. Can you give us just some commentary on the mix there, residential versus commercial? I guess just have you seen the full mix hit from commercial, or indeed will the second half, if commercial continues its trend, actually suffer more margin pressure than we've seen in the second quarter?

I think it is tough to tell. We think the residential seems to have leveled off. (inaudible) replacement is now 92% of the business, so that one has leveled off.

Commercial, it has been a little bit erratic. Once we think it is leveling off, it will drop a little bit, and then we will think "Well, that's it." And then it will start going up. It's still below last year. We are running in the neighborhood of 20% or so below last year on a volume basis on the incoming order rate. It's hard to say where that's going to be. We have some things we are doing on the commercial side to help our business and to help our mix, but I personally think that we are going to see the commercial -- light commercial construction decline for least another three to six months before it will start going up.

So residential was still down double digits though?

Small double digits, yes. It's not going to be -- and whether that will pick up as the year goes on, because there has been some inventory decline in the channel, and we may see a little pickup from that but I'm not sure how much.

Okay. Then just high-efficiency water heaters, I believe it's the Vertex line. Is that available at retail yet or will it be?

Yes, it is for Vertex. But no, that is not available at retail yet, at retail like a Lowe's or a True Value or Sears. But you can certainly get them from your local plumbing wholesaler.

Okay, is there plans to put that at retail?

We can't talk about our product introduction plans.

One thing I will say from a philosophy standpoint is we are going to announce them when we implement them. We are not going to talk about what we're going to do in 2011, like some competitors.

Ned Borland, Next Generation.

Good morning, guys. Great quarter.

Just on the Electrical Products segment, the margins -- I know that the second quarter is sort of a high water mark seasonally, but backing into it, I am coming up with basically 2% operating margins for the rest of the year. I mean, what I guess in terms of the initiatives you've put in, is there anything else that I am missing there, or --?

Well, the initiatives that we did, we were pretty vocal about those. I think the Electrical Products has taken some, obviously some severance costs hit this year that have hit in the first half. We don't think we're going to have that level of it in the second half, and we get to benefit from the nine plants that we've closed over the last five years and all the repositioning we've done there.

We are still doing some tweaking to some of the repositioning, but as I mentioned at the last call, we are just not going to talk about it any more. It's going to be the sort of thing where we will take the severance hit and we will get the benefit back in four or five months, so we're just going to keep doing what's right as far as to manage the business to get our margins up.

Okay, and your comments about the water heater demand -- usually you see kind of a seasonal build in the second quarter of revenue. It didn't look like that was the case this time. Are we assuming kind of a flattish revenue line from these levels throughout the rest of the year?

Yes, for the most part, the reason being that we are down to almost replacement business, so the replacement business is pretty well a straight line. We don't have the seasonal homebuilding piece of it to an extent now with housing starts down to one-fourth of what they were three years ago. So it is essentially replacement. Thank good people still take one cold shower and they find room on a credit card to replace that water heater before the next morning.

Okay, so the Chinese growth basically offsets much of the decline you're seeing here, is the message?

Yes, yes. China, we were obviously concerned in the first quarter, because China was down 10% in the first quarter. It bounced back very nicely in the second quarter. I don't think we are going to see the 35% growth we've seen the last three or four years, but we ought to have good growth in China this year.

Okay. Then on the cash, very impressive cash generation. I just wanted to discuss your cash priorities at the moment.

Well, it's been a priority for some time, but obviously. when you go into a recession as we are in, we have several programs underway primarily focusing on the operations side -- receivables, payables, inventory, lots of things on the cost-reduction side that we've been doing for some time, trying to get best cash flows, earnings. So this is not a new program or a fad program, fad of the month. It is just taking the efforts we've had to another level, and it's paying off and we are getting the results.

Are you starting to look at maybe an acquisition pipeline or anything of that nature?

We are always looking for opportunities to generate increased returns for shareholders. Acquisitions are certainly on the agenda there.

Scott Graham, Ladenburg Thalmann.

Good morning. I have a couple of questions for you on revenues. Really, Paul, if you were to characterize the business trends, order trends, frankly in both businesses if you would, as you entered the quarter versus as you exited the quarter, what did that feel like?

Well, I think water products pretty well was flat, maybe a little bit of a decline on the commercial side towards the end of the quarter, very, very slight.

Electrical Products actually had a month-over-month improvement in the second quarter. You know, April was better than March, May was better than April, and June was better than May a little bit, moving up. We are not -- maybe we are being conservative. I hope we are. I hope that trend continues. But we think we are just essentially responding on Electrical Products to the short-term replacement needs that people have relative to pumps, swimming pool pumps and the like, as well as HVAC. We are thinking, without any improvement in the economy, that we may see a falloff on motors as the cooler weather arrives in the fall and winter.

But water products, residential has been essentially flat for the last several months. We think that will continue. Maybe it will pick up.

Commercial has been erratic. It's down definitely more than it was a year ago, but it has been erratic the last three months.

Not to be a killjoy here, but wouldn't that pick up on the Electrical Products in seasonal for the HVAC season, or are you saying that that's not what it is?

Well, it is seasonal because of the HVAC season, but what happens is normally that inventory build would occur in the first quarter and first part of the second quarter, and all of our OEM customers have been saying we are just going to disappoint customers. We are not going to have everything in inventory this year. We are conserving cash.

So we saw a huge falloff in our order rate in the first quarter. The reason it is picking up in the second quarter is there is no inventory in the pipeline. So when somebody needs -- their air conditioner goes down, they call and the product may or may not be available off the shelf. It may have to be something that gets manufactured. So we've seen maybe a slippage in the inventory build. Where we'd normally be building inventory in the February-March-April time period, we are essentially supplying needs in the April-May and June time periods.

I got you, okay. That makes sense. So essentially you are confirming that there is an HVAC season, not what we have seen in past years but there is still a season, so --.

That's correct. People still -- when the air-conditioners come on, not all of them work after sitting all winter and they fail. If we have seen any little trend -- maybe they are not replacing the whole outside condenser unit, they are just replacing the component that failed. But either way, we get the motor, so it works.

I got you. Yes, that is what the industry numbers are showing.

Underneath this 12% decline in Water Products, I want to maybe look at this, maybe cut it in a different way and try to understand it. If we are now really, frankly, for all of 2009 so far, we are at this 90%-plus replacement rate, why do you think the year-over-year in the second quarter, admittedly versus a more difficult comparison, but why are these year-over-year still declining as much as they are do you think?

Well, I think our customers -- and I've spent a lot of time with customers over the last few weeks. And they've taken their inventories down by 50%-60%, and these are the wholesalers, because a year ago, they didn't see the recession that we are looking at right now. Nobody did. The second quarter of last year, it was still a pretty good time in the economy, a few things happening on Wall Street but not everybody was focused on that.

Now, we are definitely in a recession.

Our customer base, we've been very fortunate, we don't have any receivables issues there and we were doing everything to watch that. But our customer base is conserving cash. They've taken their inventories down. I think that had a definite impact on our second quarter this year versus second quarter last year incoming order rate.

Now that would mean that maybe there would be a pickup as their inventories get to a stable point as we go into the rest of the year. There's a lot of people in the business that think that will happen. We are just not counting on it. If it does, we will be ready for it and we can respond.

Yes. Actually, that's exactly where I was going with that question, Paul, so thank you.

I guess the other question would be on pricing. You know, you guys have benefited pricing-wise a lot in the last couple of years, obviously kind of just trying to catch up with the raw material situation. I know that you have pricing policies. This is a big initiative at your company, and you make sure it you keep what you've got and so far. How is that going in each business right now, Paul?

The major priority of ours -- to make sure that we maintain the margins necessary to continue to invest in the business, and we are good at that, all the elements that go into the margin. And I really can't comment any further than that, Scott, and you know why. So every competitor we have is listening to this call.

I get it, no problem.

This last question is this. Everything in the restructuring, I know all of the heavy lifting is behind you. We now should pretty much see some pretty good roll-through of the roadmap on the Electrical Products side, and kind of a similar type although not exactly quantified on the water heater side, type of roll-through in cost savings going forward, yes?

That's correct. If we had a normal economy right now -- we've done a little bit of work on that but we are very proud of where the margins would be. But that's all just paper taking any number you want to put on it. We haven't demonstrated it because we haven't been in a normal economy. But yes, that's right.

The savings are there. We are actually exceeding them. We track that as you know very, very routinely within the company, and frankly are very proud of what's happening. All the heavy lifting is done, but there are still some pretty nice projects out there to improve our margins up from just a day-to-day operations standpoint, as well as some design elements. As I mentioned, we are still doing some factory repositioning, still looking at a few things there. But they are not going to be the kind of things we've been talking about over the last five years. They will be just more or less quick hits. We can do them fairly quickly, get the savings coming in within a few weeks of having gotten that project done.

Okay, and here is, I promise, my last question. Your inventory, you guys have done a fantastic job pushing that number way down. Now, if there is any type of a pickup in the second half of the year, that's not going to be a problem for you to capture those sales, is it?

Absolutely not because, among other things we've been doing with all of this repositioning, we have significantly tightened our cycling time. From start to finish, we have a very short cycle time across the business, and we have kept the capabilities in place to respond to pick up. In a matter of a few days or sometimes less than that, we can have our output up double digits out of every factory.

Very good. Thanks for your time.

Ted Wheeler, Buckingham Research.

Good morning and I echo the comments on performance; nice job.

A cut a couple of knit picks, I guess. One just to start, in your prepared remarks in discussing China, you talked about modest growth and then I think, a few moments ago, you talked about good growth. In your guidance, I know that it's nitpicking, but what does your guidance assume -- good or modest for China?

Our guidance is assuming modest in China. We may be talking good in six months but right now we are assuming modest.

Okay. Just another one -- the cost program at the, in Electrical Products, there was a headline sort of number you wrapped up late last year and there was some benefits, I guess $5 million last year and then some carryover this year and significant carryover this year. But then I think, in the quarter, you talked about more than $5 million of benefit.

Yes.

Now, does that change the -- it just seems like that's a little larger run rate than the sort of larger picture number you rolled out last year. In other words, the delta (multiple speakers) --

That's a good catch, Ted; you are absolutely right. We said last year $5 million in '08 and an additional $15 million in '09, and we are running ahead of the $15 million in '09.

And if I look at -- with the 1000 people that you talked about, the equivalent to that run rate of the quarter of $5 million, or is there more cost cut from the 1000 people take-out going forward?

The 1000 people-plus take out is this year. We took out quite a few people last year. We are only talking about the year to date when we say 1000, just due to the declines we've seen this year.

Ted, there is another factor in there, too, and that factor is that we had restructuring expenses in the second quarter of last year that we didn't have this year, so you've got -- on an incremental basis, you've not only got the savings from what you did last year, but you've also got the lack of an expense that occurred last year that didn't occur this year.

Okay, right. On the HVAC seasonal question, I can't recall but I think last year maybe there wasn't much of a seasonal pickup during the second quarter. Is that a fair statement?

No, there was last year, because it was business as usual last year and the pickup was in late first quarter and into the second quarter. All of our OEMs were building their normal inventory that they've done for years as they go into the summer season. That did not happen this year. They (multiple speakers) (technical difficulty) lay in the inventory.

And it's been pushed to the right?

Yes, pushed to the right and down.

Then kind of on the same subject, you highlighted the inventory levels at Electrical in most of the remarks, and then just in a question recently, you talked about wholesale water heater inventories. It seemed to be implying they are very low as well. Is that true?

They are lower than they've historically been at the wholesalers, and that's due to the recession and everybody trying to hang onto cash.

So there's presumably a little bit of a spring loading upturn if confidence improves in that piece, too, I would think.

I would think so. It could happen. We have not put that into our estimates yet.

I guess maybe the last one, you highlighted some new products. I think in the main meeting, you spent some time talking about the instant hot water -- an instant hot water product that would be a bit of a change from the ones that you are offering now and what the industry seems to be offering. We didn't discuss that today. Is there any reason why that wouldn't be talked about today? Has that been pushed out?

No, it's instantaneous. The on demand water heaters are out there, and if you want to buy an A. O. Smith one, you can; they are out there.

I thought you had a next-generation product that you were going to introduce in the fall.

Yes, we have a next-generation product and we will be talking about it in a future call. That is not later; that project is ongoing.

Well, the reason I brought it up is because you did mention it in May and you didn't today. I wondered if that had slipped.

No, we will have that product to the market by the end of the year.

Terrific. Thank you for your help.

Matt Summerville, KeyBanc.

Good morning. A couple of questions -- if I look at the Motor business a sequential basis just using round numbers, your revenue was up about $20 million, operating profit up about $10 million. That's pretty high in terms of incremental margins. I guess I'm trying to get a sense of how much of that was driven by the incremental headcount you have taken out versus other factors? Then can you remind me, in the first and second quarter, whether or not you had gains or losses in terms of your forward or hedging contracts?

Let me try to address part of that. In the first quarter, if you recall, we had about a $2 million hit from the what we called "excess hedging contracts" where we had hedged volumes greater than volumes we were manufacturing. So we had to take -- so about $2 million of that loss was, I think of the $3 million loss in the first quarter, was associated with that. So you don't have those in the second quarter.

Also in the second quarter -- and the question was asked earlier about cost of goods sold and raw materials. If you look at -- we've got lower steel prices, you've got -- which will translate into lower product warranty prices. You've got lower freight costs associated with diesel fuel going down. You've got lower volumes, so you've got lower freight costs. All of those things will factor in, plus the fact that we had the severance payments and some severance payments associated for the first-quarter expenses. We will get the benefit of those headcounts not being in, in the second quarter. So it's a combination of things that caused the operating profit to go up sequentially more than the revenues.

Based on how your input costs have trended obviously very high, coming down pretty dramatically, beginning to tick up a little bit in some instances, would you think the second quarter was the most favorable quarter for A. O. Smith in terms of input costs, or are there still more favorable periods yet to be seen? I think you mentioned earlier in the call that you have about nine months' worth of visibility on that equation?

I think it's true that all of our raw material costs, as has been true I think with most companies, have gone down slightly. We are not in the business of predicting what they are going to be as we look out ahead. But from a steel standpoint and as Paul mentioned, we do buy our steel on a quarterly basis and we do have visibility into steel. We don't know what's going to happen to diesel costs. We don't know what's going to happen to a lot of the other input costs moving forward. But generally speaking, our second and third quarters are our best quarters. We've demonstrated that and you've seen that over the last few years.

Just to give you an example of a set of some of the things that we deal with, the steel companies as you know are struggling because of the lower volumes. They are currently running at a 50% capacity utilization rate.

The steel CRU index last week went up $89. Is there anybody on this call that can explain why that happened to us? That's the sort of thing that happens. We don't think that will be sustainable but if it is, it will impact our fourth-quarter costs. But that's the sort of thing that we are facing right now, as I mentioned in one of the first questions, some really big numbers being used in some of the swings that we are seeing year-over-year and quarter-to-quarter. It makes it maybe a little more difficult to predict.

Thanks, Paul. That added color is helpful.

As far as the commercial business, I think, Paul, you mentioned in response to a question, that incoming orders were trending down roughly 20%. Is that true for both the water heater and motor business?

Then I guess, if I recall correctly, so correct me if I'm wrong, in the third quarter of '09, you will face the toughest commercial comp of the year. I guess why wouldn't that down 20% get incrementally worse in the back half of the year?

Well, it does apply to both businesses, because we are not building the little strip malls and the restaurants and are not putting in the HVAC system or the water heaters. So that's the answer to that question.

As far as what it will be in the third quarter, I think it's going to be about flat to what we've seen in the second quarter. I'm not real sure what it will be relative to a comparable, but I think it will be about in the same ballpark.

The strongest quarter in '08 for commercial was the second quarter last year.

Paul Jones; Oh, the second quarter, okay.

That was the strongest quarter last year.

Okay. Then as far as the water heater margins at almost 11% in the second quarter, I guess how should we think about sustainability there through the back half of the year? Then, Terry, can you just comment? Based on the strong cash flow generation you've had, which has obviously been very good, do you anticipate putting more in the attention this year than you've indicated previously?

I will answer the margin and I will let Terry talk about the pension.

Obviously, you know, our objective is to be above 12% operating margin in the water heater business. That has not changed. We are not there yet, and we think that will give us the cash flow to continue to invest.

Obviously, there is so much coming down the pike on regulations on energy efficiency, rebate programs, tax credit programs, not just in the US but around the world. We've seen that coming and we've been putting a tremendous amount of effort into our R&D and our product development.

We have talked about all of the things we've done to reduce costs. We have added several dozen electronics engineers across the company. I don't want to give the exact number, but we are putting a tremendous amount of money and effort into some new products. We need those margins to enable us to keep doing that, so we can keep our customers at the forefront of what the market wants. We expect to do that for many more years.

So we are working on products we probably won't introduce for three or four years, but we are doing the efforts right now. So that's why, to pay for all that and to fund all of that, we need to get our margins even higher than what you're seeing now. I would not like to think that today's margins are normal. I would like to think that we can improve them considerably from where they are right now.

Relative to pension, from an expense standpoint, pension expense will go from $4 million in '08 to about $10 million in '09. Relative to pension contributions, and we made about a $15 million contribution last year. We've made a $15 million contribution so far this year but we expect to make contributions of about $35 million this year to the pension plan.

That's $35 million for the total year, so an additional $20 million.

Right, so it would be another additional 420 million.

Great, thanks a lot, guys.

[Trip Ruery], CRM.

A lot has been covered. I just wanted to ask a little bit of a big picture question on the Smith Investment Company, along the lines of why now is the motivation to do the transaction, if you could shed some color on it. I know it wasn't really your decision, but if you could discuss the timing.

Also, can you discuss what it means from a governance point of view as far as will it change any of the Board structure, any seats there that could change? Would it also change the way you set your strategy as far as maybe freeing you up to make some more acquisitions, or anything along those lines?

Lastly, would it change the response of the company to perhaps a bid by a larger player?

Okay, I will try to answer those. The timing had nothing to do with the recession or anything else. This is a subject that has been discussed for some time.

Smith Investment Company owned shares in A. O. Smith. The 48 trusts or so that owned shares of Smith Investment Company did not own those shares directly. This is a structure put in place in the '50s. It doesn't work because of the tax policy of this country. Those dividends that we paid to Smith Investment Company were taxed, and then when they were distributed to the family members, they were taxed. That's one of the motivators behind doing the deal that we did.

We had special committees of Smith Investment Company and a special independent committee of A. O. Smith that negotiated that. It was done strictly arm's length.

And, why now? We finally came up with a structure that we could -- that the Smith Investment Company could do, and our role was facilitators to help get that transaction done.

We have presented it to you as a nonevent in A. O. Smith's life. I still do. We have the same board we had before. It's just the shares that were owned by Smith Investment Company are now owned by members of the Smith family. The Board is the same as it was. The emphasis on it with incorporation on what we do is, as has always been, what is best for the shareholders, what's best for the company long-term. We've been operating that way before. We are doing that now and we will in the future.

The only minor thing that I think happened is that the independent directors went from three to for, and the Smith-elected directors went from seven to six. I don't even know who's who on the Board. That's not something I pay attention to, and it's essentially a nonevent.

What would happen if we get a phone call? The same thing I would hope would happen with any public company in America. We would respond and look at what's best for the shareholders.

All right, great. Thanks for the color.

Ted Wheeler.

If I look at the restructuring and cost initiatives you've put in, I'm wondering if there's also measures such as salary freezes and short weeks or short time, and maybe deferrals of benefit plans matching and that sort of thing. If so, what kind of costs will be coming back into the company when the skies clear and the revenue outlook looks better and we are in a recovery?

We have done any -- we have done some short weeks in our factories. We've had a lot of factories running for days, not five. That is back to having the capability to respond quickly. We started that a year ago; that's nothing new.

On the salaried range, we have done some pretty substantial salary reductions, but we have not done any furloughs of salaried people, unpaid time off. We've not done anything relative to benefits, or to any benefit changes. We have not been salary freezes. We have certainly not -- maybe not had the salary increases we've had in years past. The bonus programs obviously are going to be lower than what have happened in the past because the earnings this year are going to be down. All of our bonus programs are based on returns, shareholder returns, return on invested capital.

No, our intent is, if we have too many people, we take care of that problem and reduce the total count. I am not a big fan of salaried people time off without pay. If you don't need the people, then go ahead and cut the costs and keep the people that you want to keep, and keep them focused on the business.

Thank you for the color. Again, nice quarter.

Thank you.

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