A O Smith Corp (AOS) 2010 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the third quarter 2010 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.

Now I'd like to turn the conference over to your host, Vice President of Investor Relations and Treasurer, Ms. Pat Ackerman. Please go ahead.

Thank you, Hope. 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, 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 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. We are pleased to report that we continue to achieve strong operating performance in 2010. Here are a few highlights from this quarter.

Sales of $559 million, up almost 12% from last year, generated earnings of $1.04 per share for the quarter. Our electric motor business experienced increased demand globally and operating margins were almost 12%. The higher volumes contributed a great deal to the segment's performance, but the excellent execution of our strategy to lower our cost structure over the years, including plant closings, product rationalization, and manufacturing process streamlining, is contributing to margin improvement as well. It is exciting to share the transformation of this business with you.

Our water heater operations in China grew significantly over the third quarter of 2009; marketshare gains and new product introductions are driving our growth in this important geography. We expect our water heater sales growth in China this year to continue to be two to three times the country's GDP.

As a result of the strength in our underlying business, specifically the high replacement component of our North American business and the growth that we continue to see in Asia, we increased our guidance, which includes one-time flood expenses, to $3.25 to $3.35 per share. This guidance does not take into effect the impact from the 3-for-2 stock split which was announced last week.

I will now pass the call over to Terry Murphy, who will provide more details on the financials.

Thank you, Paul. Total sales for the quarter increased to $559.4 million from $501.5 million last year as a result of higher water heater motor sales in China, replacement demand from our US customers, and pricing actions in both businesses effective earlier this year.

Earnings of $32 million or $1.04 a share were lower than the $34.6 million or $1.14 per share last year, primarily due to higher material costs and the absence of $4.5 million, or $0.15 a share, in one-time gains recorded last year related to a manufacturing plant sale in China and the closure of 2005 and 2006 income tax returns.

At Water Products, third quarter sales of $377.5 million were up 12% compared with third quarter of 2009. A 30% increase in China water heaters sales, pricing actions related to higher raw material costs, and higher residential and commercial sales in the US drove the increase in overall sales.

At Electrical Products, third quarter sales of $183.3 million increased 10% compared with the same period in 2009. Hermetic motor sales in China were significantly higher than last year as a result of new products and a stronger overall market, and many of our North American OEM customers restocked inventories early in the quarter.

At Water Products, third quarter operating profit was off 3% to $37.6 million from the $38.7 million reported in third quarter of 2009. Higher steel costs, which were partially offset by a price increase effective in August and inefficiencies caused by the flood in May, negatively impacted profits. As a result, operating margins edged lower to 10%.

Electrical products earned almost $22 million in the third quarter, 5% less than last year. Earnings associated with higher volumes and pricing actions were partially offset by higher material costs. In addition, last year, this segment reported a $3 million gain from the sale of the manufacturing plant in Shenzhen, China and a $2.2 million LIFO benefit in the third quarter. Despite the absence of these favorable 2009 items, Electrical Products again achieved operating margins in the quarter in excess of its 10% goal.

Higher working capital needed to support higher sales in both businesses reduced operating cash flow during the first nine months of 2010 as compared to 2009. That being said, maintaining cash cycle days near last year's level was essentially achieved with cash cycle days of 53 days. We are projecting operating cash flow in 2010 to be between $150 million and $160 million, and we normally generate more than 50% of our cash in the second half of the year as our seasonal working capital levels come down. This projection is after the $30 million contribution to our pension plan made earlier this year.

Capital spending during the first half of the year was $48 million and it is expected that total year expenditures will range between $80 million and $90 million in 2010. The capital expenditure projection includes flood-related capital of approximately $20 million. Depreciation and amortization is expected to total $70 million this year. Our debt to capital ratio is holding at 24%, the same level as a year ago. At this leverage level, our balance sheet provides ample support for acquisitions, which can add to shareholder value.

Paul will present a few more details about our outlook and then we'll open up the call for your questions. Paul?

Thanks, Terry. Our performance this year has been bolstered by strong replacement demand in North America for both residential and commercial products in both of our businesses. Despite new commercial construction activity still down compared to last year and construction of new homes being flat, our volumes have increased across the board.

In addition, our China water heater business continues to experience strong growth, with sales for the first nine months up 37% over last year. The growth in the China economy, coupled with our leading market share, as well as the strong acceptance of our instantaneous gas water heating products, are propelling [growth] at this exceptional level.

Also, I'm happy to report to you that we introduced the A. O. Smith branded line of water treatment products into our retail channel in the last quarter. Finally, our China hermetic motor sales continue to grow over last year, with sales up significantly in the quarter.

As many of you know, our motor business is impacted by seasonality in North America. Historically, Electrical Products experienced its lower revenue quarter of the calendar year in the fourth quarter. We expect that will be the case this year as well.

Finally, our stock has appreciated 37% so far this year and we announced a 3-for-2 stock split to increase the liquidity and affordability of our shares. Shares outstanding are expected to be a little over $45 million after the affect of the split on November 15. And as I mentioned earlier, as a result of our success so far this year, we are raising and narrowing our full-year guidance to between $3.25 a share and $3.35 per share, including the $0.68 per share charge from the flood. And once again, I'll remind all of you that the guidance is before the impact of the stock split.

Now I'll open up the telephone lines for your questions. Hope, could you set up the first caller, please?

Sure, not a problem. (Operator Instructions). Mike Halloran, Robert W. Baird.

So a few questions on the margin side in particular. When you look at the water sales, they were roughly comparable to last quarter, I would say margins were down about 120 basis points on an adjusted basis sequentially. You probably had a modest headwind from the Ashland City disruptions. Is it fair to characterize the remaining headwind on a sequential basis as more related to steel prices going up? Or is there something else going on there?

Well, there's a lot going on there, Mike. Steel prices being up about $250 a ton over where they were this time last year is certainly a headwind. Ashland City -- we still don't have all the high efficiency equipment back online, so our man hours per unit is running about 30% above what it was before the flood.

So we still have a little bit of headwind there, but that is coming down. That plant is -- I'm really proud of what that team has done; not only to get it online and take care of the customer, which has been our big theme and our single message to the people in Ashland City -- we brought the plant back. We are taking care of the customer, not as efficiently as we will, and that the efficiency is coming up every week. Every week when we look at it, it's a little better.

And we're getting the new automated equipment in for the second time that got destroyed in the flood and we've had to replace. And as that comes online, you'll see that extra 30% of labor go away over the next few months.

So is it fair to characterize this as a pretty equal split of the rising steel prices and then continued headwinds in Ashland City?

It's hard to say. There's a lot of things going on, but yes, that's probably a real rough estimate of what's going on.

Yes, rough. Okay. That's fair. And then on the pricing side in your wholesale water heater channel, could you maybe talk about the effectiveness of price increases on that side?

Well, we had a price increase during the quarter and it was driven by the higher material costs. And so far, that's going just fine.

On the EPG side, the margin levels, now, you've got a couple of quarters in a row here where you're significantly ahead of that 9% to 10% target range. Could you maybe talk about the factors that have led to such strong performance there? And then what the sustainability of that performance looks like, particularly in the face of the commodity inflation on the copper side for next year?

Well, we started several years ago with a roadmap to profitability that we heavily communicated. I know there was a lot of skepticism, but since we've delivered on that road map, I hope that skepticism has gone away.

We are above 10% now and we're still -- frankly, everything is clicking. We are picking up a little bit of volume. All the cost reductions we've put in place are working. All the redesigns, the plant closings, the moving of equipment around -- that has been done as well as I've ever seen a company restructure itself in my life. So I'm really proud of what's going on at Electrical Products.

The reason we're probably a little conservative in our guidance, I hope that's not a shock to anybody, Q4, as I mentioned during my opening remarks, is seasonably about the lowest. It's a couple of points below 25% typically in the fourth quarter.

One thing I can add, other than steel being up $250 a ton, copper is up 20% over the last two months -- we have a lot of customers taking days off out of their schedule. That has happened typically in the fourth quarter. It appears to be just a little higher now. So maybe our customer base is being a little more cautious as they are going into the end of the year and getting their inventories down. And we're just being conservative as we look at the fourth quarter.

I will point out we had a very healthy cash flow in '09. And part of that was the LIFO that -- we had a new operating system that was part of our roadmap to profitability, a new IT system put in at Electrical Products. And we had a lot of LIFO income in the fourth quarter last year and that's not going to recur this year.

Okay. That makes a lot of sense. And so, do you still feel comfortable with that 9% to 10% range on EPG margins, recognizing that as volumes come back, it's probably going to end up being a little bit conservative? Is that a fair way to think about it?

That's a fair way to think about it.

Alright. And then last one, just making sure I'm thinking about the rising copper prices appropriately, what's the lag between when you guys hedge and/or make your purchase agreements and when that actually flows to your P&L? So, over the last two months, you've seen the copper go up, as you said, when would you expect that to start rolling through your P&L?

Mike, we use a consulting firm that does our trading for us and we work with them on the hedging. Everybody that hedged copper got burned last year and we had higher copper prices rolling through the P&L than the spot market. So there's been a significant reduction by our customers on hedging.

We still do some hedging and we pretty well follow the same format. We'll have the majority of the next quarters copper hedged and then a lessening percentage as you go out for about 12 to 18 months in front of us. We don't give out that data. One thing we've learned looking at it is just about all of us do it about the same way, as we look back at how we did it. But that's about all I can really say about our copper hedging.

Makes sense. I appreciate the time. Enjoy the day.

Sure, Mike.

Ted Borland, Hudson Securities.

Ned Borland, Hudson Securities.

(laughter) Hi, Ned. I wondered if you'd a name change there.

Not lately. Anyway, just to take a look at motors for a second, the volumes -- it seems like you've had some share gains and commercial and hermetic strength is -- I mean, is that sustainable? And is there more opportunity for you guys to pick up some share, given what's happened in your industry there over the past couple months?

Well, we'd always like to think so. I just was at a planning conference the last two days with the Electrical Products [people]. We've got some exciting products coming out, energy efficiency products. We've had a lot of products on test around the circuit with all of our major customers. And some of those are being accelerated and we are seeing some new business come in.

In the commercial hermetic, out of Yueyang, you folks probably get tired of me talking about it, but that is just a fantastic operation that we've got over in China that serves customers around the world. And they're just doing a great job. We've got a new facility there last year. That thing has come online and is really humming. And it's a wonderful operation that's generating some pretty significant sales growth for us this year.

Okay. And then I guess if you could sort of elaborate on what's going on with your Tianlong operation and the rollout there. And then also the partnership you've got with Takagi.

Okay, I'll talk about the Shanghai Water Treatment, which is what we are calling it now that we've acquired it. It is -- the roll-out, as I mentioned, we rolled it out to the retail channels last quarter. We are actually putting a bigger investment into that because our initial entrance to the retail was so strong that we have added people, added resources.

We need to get on our website a picture of what that display looks like. It's a phenomenal display. If you've ever been to China and go through the retail outlets, the water filtration is off in a corner and it's hard to find. Well, not the A. O. Smith water filtration offering. It's out front, a very large, probably 18-foot-long display.

And the sales have been remarkable since we rolled that out. They have far exceeded our expectations as to what we're getting in the retail stores we put that display into. So we're pleased with how that's going. We've got the quality levels up to a level where we're comfortable putting the A. O. Smith brand name on. Obviously, we think that's a gold standard in China and we weren't going to do anything that would lessen the strength of that. So we only have a first-class product there and it's going very well.

On the tankless side, the Takagi is going very well in this country, even though sales are not that strong on the tankless. I was just in China less than three weeks ago and we're now the largest tankless manufacturer in China. We don't bring that product back to the US yet that we make in China; we're actually just -- we started making our own design tankless product there three years ago, and we're going to have to do a significant capital investment to keep that going.

It's a space-saving, very good product. It's fairly low flow rates, a little too low for the US, but fits the sweet spot of the China market.

Okay. Thanks for the color. And then on the Chinese central bank just raised rates, it looks like today. Does the tightening cycle -- does that dampen your enthusiasm at all for the strength you've seen in basically all your Chinese businesses over there?

Not really. When they do that, what they're really trying to get a handle on is the construction side of it. Now, they've cut down on the amount of homes. People can own one home and they have to get government approval to own a second. They're not allowed to own a third. Before all this started, there were some entrepreneurs, which the Chinese are famous for being, that were buying 20 and 30 homes and flipping them. And the government is trying to slow that down.

That doesn't drive water heater and HVAC equipment sales. That gets driven by household formation. And if there's a couple of extra million empty apartments or condos around China, that actually helps us a little bit because the owners of those are motivated to get people in them either paying rent or buying the condo. And when they do whatever promotion they have, that's what actually drives our business.

We've modeled it looking forward. We think there will be some moderation in the growth, but there will still be growth as we go forward. Whether we're going to always have 20% or 30% or more growth every year, I don't know. We've been doing it for several years in a row now.

We have an excellent stream of new products coming out. We introduced the solar balcony-mounted product a year and a half ago. We now have a pressurized roof-mounted unit that we just brought to market. It's getting great acceptance. And we have quite a few more things coming downstream -- a little miniature hybrid, a smaller sized one that would fit very well in the Chinese apartments, so it takes the efficiency level way up.

We have a small heat pump product that we're introducing to the China market. A lot of things going on now that I think are going to stimulate growth. So whatever the central bank is doing, frankly, I'm not that concerned about at this time. They've tried before to slow down the growth. When they tried to slow down, they never hit their target on lowering it and I don't think they're going to now. I think they're starting to realize what a free enterprise system can really do.

Okay, great. Thank you.

Matt Summerville, KeyBanc.

A couple of questions. First, just to stick with the China water heater business, Paul, do you have any detail? Can you talk to or speak to what you think your same store sales are kind of trending around? If you grew the business 25%, 30% this quarter year-over-year, what do same store sales look like versus the growth there being driven by your key customers opening new locations?

The only information -- we don't have that data like we do in the US, so the only thing we have is just opinions and people -- offhand comments. So we're really better off not talking about it.

The store growth is still occurring at Suning; GOME is still growing stores but at a lower level, but GOME is working on the quality of their existing stores. For example, our same store sales out of GOME this year are very good, because they've been doing a better job managing the stores they already have, and that's driving some volume from us there.

And the other is the storefronts. The storefront thing that we only started talking about a few months ago is really taking off. We'll have over 1,000 of those next year. And it's like a little mini plumbing wholesaler. And that is definitely a contributor to our growth this year.

So if I looked at it, I'd say the majority of our growth is still from either new retail stores or the phenomenal growth from these storefronts, but secondarily, we are continuing to get growth at what we in the US call same store sales.

Paul, as we move into 2011, have you spoken with your key customers or have they given you any sort of inclination as to what their capital spending plans are looking like, as far as new store openings next year?

In China?

Yes.

Yes, the Suning is still go-go. They've got numbers that are in the stratosphere of what they want to open. We tend to temper that a little bit and the number ends up being between our number and theirs. But it's always good.

GOME is talking about maybe cranking up their store openings. We haven't got final numbers yet from them on that. But I think we'll probably -- looking at China, I think we'll probably see more new stores in 2011 than we saw in 2010.

That's helpful. Sticking with Tianlong or Shanghai Water Treatment, when you bought that business, you had to go in there and -- it underperformed your original expectations, is what I'm trying to get at.

I guess, Paul, I'm curious as to outside of launching products in your core retail channel, how is that base business performing? What did it contribute to your top-line here in Q3? And what's the base run rate that we should be thinking about as we build our models for that piece of the -- good piece of the pie going forward?

Well, it is underperforming what we originally said it would do and that's obviously a disappointment to us. It's primarily the top-line. We're actually getting the margins up faster than we thought we would. We've got the quality up. I love the way the production operation is going.

We have had to do a lot of work on the sales and distribution and the branding of that business. I like where we are now. I love the strategy. This is going to be a super success for us. This is probably going to be a year later than we originally said.

As far as revenues, it's a small piece right now. During the holiday in China, we sold about three times as many of the product that we thought we would during that holiday period. So it's really taking off and people are buying the product. It's just with the A. O. Smith brand name on it. And that's where, as we've always said, where we expect to get the significant growth.

A few things going on on the export arena. We're taking exports to India up where we have a sales and distribution network that we've established there now and a few other things.

Long-term, delighted with the leadership, delighted with the team that's in place there. We still have a lot of work to do on the marketing and sales side, and still have some work to do on the manufacturing, both capacity and capability. But the products that we're putting out right now is a gold-plated product at a reasonable cost to the consumer and it's starting to take off.

Again, it's small. This is less than 10% -- it's -- assume 10%, 12% of our China water heater business is sales; but it will grow as we go forward.

Okay. And then just sticking with the growth initiatives in the water heater business outside North America, can you provide an update on where you are with your facility in India? How do you think about revenue ramping up there over the next one year and maybe three to five-year period, compared to your experience curve in China over the last 10 or 15?

So maybe speak about India for a moment. And then, what are your capital plans with regards to China? I would think you're at least approaching, to some extent, capacity out of your existing infrastructure.

Yes. India, first of all. Well, first of all, we learned a lot from China and we kept our lessons-learned book and we read it before we went to India. So we have a product the consumer wants right off the bat and we're doing quite well.

The growth is going to be phenomenal percentages, strong double digits, because we started at 0 three years ago. But that, we still expect that business to be at breakeven or above next year. And since two years after the plant was opened, that's in a brand-new market, we think that's a pretty good performance. And it's going to continue to grow. Our partner there is opening new stores and we're looking at other channels of the market now where we can branch out and have other ways to sell the product.

And you're spot-on on China. We are doing another capacity expansion on the existing site. But when I was there three weeks ago, I put on some boots and walked around some land that's in another area.

And we'll probably be doing something relative to additional capacity in China, to not only handle the market demand, but we need to have a facility more oriented towards the tankless product, which is, I've already mentioned, is taking off, as well as the heat pumps and solar products. They're taking up a lot of floorspace right now to build those in our existing facility. And we're looking at all the ways we can make sure that we handle all the different breadths of products that we have there and make sure that we've got capacity in place before the demand requires.

Thanks, Paul.

So no announcement yet, but we will be -- probably when we talk in January, we may be able to add a little bit more detail to that.

Appreciate the color. Thank you.

William Bremer, Maxim Group.

Many of my questions have been answered already, so let's go to the balance sheet -- cash on-hand extremely strong. What's the key here? I'm sure you'll be refinancing or rolling that short-term piece, but what's the game plan for the balance sheet?

Part of the reason the balance sheet looks so strong is we have a lot of cash in China at this point. I think we've got over $90 million of cash in China.

Also, as it relates to the refinancing of the bank agreement, we're in the midst of doing that as we talk. We haven't had any problems at all in refinancing the level of -- or the $425 million level, commitment level that we had in the past. In fact, at least early indications are that we would be over-subscribed. The cost, obviously, of the facility will be much more expensive than it is, given today's facility, but it's still, at least right now, it will be priced at investment-grade level, at BBB level.

So, use of cash is the same as we've always kind of talked about -- first, to meet internal requirements; second, looking for growth acquisitions returning greater than their cost of capital; third, paying down debt, which right now we're probably a little under-levered; fourth, buying back shares; and fifth, increasing the dividend.

Okay. Second half, the CapEx ramps and I guess Paul alluded to the fact that increased investments in China. How much of what I'm seeing in the CapEx increases will be going into India?

Not much. India is pretty -- well, I can't say India is done, but the facility has been built; the big expenditures associated with India were in 2008 and 2009 -- or 2009 and 2010, but there is not going to be much more looking forward into India.

Great. Thank you.

(Operator Instructions). We have no more further questions. Please continue.

Okay. Well, thanks, everybody, for your continued interest in the Company. We're going to go back to work. Have a great day.

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