A O Smith Corp (AOS) 2011 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the AO Smith third quarter 2011 earnings call. For the conference all the participants will be in a listen-only mode. There will be an opportunity for your questions. Instructions will be given at that time.

(Operator Instructions)

As a reminder, today's call is being recorded. Now with that being said, I'll turn the conference over to the Vice President Investor Relations, and Treasurer, Ms. Pat Ackerman. Please go ahead.

Thanks, John. Good morning, ladies and gentlemen, and thank you for joining us on our Third Quarter 2011 Conference Call. With me participating in the call are Paul Jones, Chairman and Chief Executive Officer, and John Kita, Chief Financial Officer. 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 we have described in this morning's press release. Paul, I will now turn the call over to you.

Thank you, Pat, and good morning ladies and gentlemen. Our third quarter was noteworthy, as we closed on two transformational transactions, and achieved increases in sales and earnings. A few of the highlights -- our earnings from continuing operations, excluding the $0.19 per share favorable impact from the hedged Regal Beloit shares and the Lochinvar-related items, were 11% higher than last year, at $0.39 per share. Sales grew 9% in the quarter, to $412 million, as sales of Lochinvar added $21 million. Additionally, sales for our water heater operations in China grew 17%, largely as a result of an increase in the number of retail and specialty stores selling the premium branded AO Smith products in Tier 1 and Tier 2 cities.

We closed on the sale of our Electrical Products Company, receiving approximately $730 million in cash and 2.83 million shares of Regal Beloit stock. Our gain on the sale was $150 million. Remarkably in the same week we sold EPC, we closed on our purchase of Lochinvar for $418 million in cash, and John and Pat were quite happy that we closed them in the right order. I'll now turn the call over to John to go through our third-quarter results in more detail.

Thank you, Paul. Total sales in the third quarter of $412 million were 9% higher than the previous year. The newly acquired Lochinvar business added $21 million to sales in the quarter. Higher China and India sales, coupled with higher sales of gas instantaneous products in North America, and a global commodity-related price increase more than offset a fall-off in residential and commercial water heater volumes in the US.

Industry residential and commercial water heater volumes in the US were down in the third quarter, as we believe customers drew down inventories over the summer as fears of a double-dip recession escalated across the country. In addition, the third quarter is historically the lightest quarter in the year from a volume standpoint. We believe our volume declines were in line with the volume declines of the industry.

Earnings of $26.9 million, or $0.58 per share, include several one-items which collectively added $0.19 per share in the quarter. I will elaborate on these items more specifically on the next slide. Adjusting for the one-time items, our earnings in the quarter of $0.39 per share improved 11% over last year. At Water Products, third quarter operating profit increased 6% to $39.9 million, from $37.6 million in the third quarter of 2010 due to Lochinvar's operating profit of $3 million. Contributions from higher sales in Asia and of gas instantaneous water heaters in North America were more than offset by lower residential and commercial volumes in the US. As a result, operating margins were down from last year.

Our corporate expenses were $9.6 million, excluding the net gain in value of our hedged RBC shares and the professional fees relating to buying Lochinvar. Excluding the impact from these items, corporate expenses were down 24% compared with last year, due to lower expense for incentive compensation programs and pension costs. You will recall that the value of the equity collar and the hedged RBC shares will be re-measured every quarter, as required by accounting rules, until the collar settles and the shares are sold in March 2012. Our tax rate for the quarter was 32%, compared to 30.5% last year. Total operating profit excluding one-time items improved 21% to $30.3 million.

We had a few unusual items over the past 2 years which we have excluded from our guidance. This schedule should help to calibrate everyone. In this morning's press release, we stated our full-year EPC, EPS guidance for 2011 is expected to be in the range of $2 to $2.10, excluding the impact from future acquisitions, the settlement, and additional warranty reserve announced in the second quarter, and the impact from the marked-to-market of our hedged RBC shares.

Our earnings performance to date has been $1.43 per share exclusive of these items and represents a 15% increase over our performance last year. Included in our 2011 guidance is an expected $0.04 per share contribution from Lochinvar. Through September 30, the net impact from Lochinvar, including earnings and professional fees related to the acquisition, was a negative $0.04 per share, $0.02 in each of the last 2 quarters, which will be more than offset by earnings in the fourth quarter of $0.08 per share.

Cash used by operations during the quarter was $76 million in 2011, compared with $37 million provided last year as a result of contributions totaling $175 million to the pension plan. We project our cash flow for the full year to be between $10 million and $15 million, as a result of a sizable tax benefit associated with the pension contribution, which will be realized when we pay our taxes associated with the sale of ETC. We are expecting tax payments of approximately $105 million in December.

Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio was 26% compared to 23% at the end of 2010. The increase was related to borrowing for Lochinvar. Our funding sources are solid and stable, as we have sizable cash balances located offshore, primarily related to the sale of Electrical Products, limited amortization of our long-term debt portfolio in the coming years, and a $425 million credit facility which does not expire until November 2013. At the end of September we had $130 million of capacity unused on our credit facility.

Capital spending for the year through September was $37 million. We expect capital spending for the full year to be approximately $60 million, about 1/3 of which will support capacity expansion in China. I will now turn it back to Paul.

Thanks, John. Before answering your questions, I'll mention a few highlights for the remainder of the year. First, we have started the process of integrating Lochinvar and we very much like what we see. Lochinvar's strong operating team and well-connected technically savvy group of independent sales representatives are a great addition to the AO Smith family. We expect earnings accretion of $0.14 per share from Lochinvar in 2011, which we expect to be partially offset by the $0.10 per share from purchase accounting and professional fees related to the acquisition. Second, we expect volumes in the US to recover in the fourth quarter, as our customers evaluate their progress towards annual volume incentives. We also expect a pre-buy of our gas commercial water heaters ahead of an air quality standards change in Southern California in the beginning of 2012.

This is an exciting and transformative time for our Company, and the acquisition of Lochinvar represents a significant first step in building our global water platform. We have cash and borrowing capacity for additional acquisitions, and our pipeline of acquisitions is active. We continue to look for opportunities to expand our global footprint. In addition, the recent decline in our stock price has prompted us to re-evaluate the 1.4 million shares remaining on our stock buy-back authorization from our Board. Based on valuation metrics, we feel our stock is under-valued and we may buy back shares if the price remains at these low levels.

Now that we've closed our acquisition, we have increased our full-year EPS guidance for continuing operations, and I expect it to be $2 to $2.10 per share for 2011, to incorporate a net benefit of $0.04 from Lochinvar. Our guidance does not include the impact from future acquisitions, the second quarter one-time settlement, our increase to the warranty reserve, nor the quarterly change in the value of our hedged RBC shares.

We are now finished with our prepared remarks and we will now open up the lines for your questions. John, if you will take over and handle the questions, please.

Certainly.

(Operator Instructions)

First go to the line of William Bremer with Maxim Group. Please go ahead.

Good morning.

Good morning.

Very nice quarter.

Thank you.

I was hoping you would give a little color. You mentioned your CapEx, $60 million, a third of it in China, what about utilizing some of this for Lochinvar? I mean, are you seeing based upon what we see -- I know it's a short period of time, but how much CapEx is needed there, and potentially where could Lochinvar take you in terms of what you're looking to do a few years out?

Well, Lochinvar was extremely well-capitalized and is right now. They have a -- it's a state-of-the-art facility with absolutely the latest and greatest in capital equipment. They did have 1 substantial piece of capital equipment on order that obviously will be going into our CapEx as part of what we did for the year.

But it's very well capitalized. They do have available capacity within their current building and with their equipment to continue to grow. They're going to be up double-digits this year over last year, and not necessarily in a good market environment.

But, they've got terrific products, we think the best in the industry, and we expect them to continue to grow. From a capital standpoint, obviously we'll do what we need to do, like we're doing in China. If we need to put capital into Lochinvar, we will do it very willingly.

Great. And Paul, could you give us a little color on India, how that's progressing?

Yes. The fourth quarter's going to be pretty strong there. It typically is. There're not a lot of water heaters sold in the summer because the water's already hot.

But we have rolled out our distribution. We're now in over 1,000 locations in India. We're expecting a pretty strong fourth quarter. We believe revenue there, which was about $8 million last year, will be around $20 million the end of this year. So, nice 150% growth in the second year ahead in the factory there.

Okay, and that's where I was going next was the factory. How many lines, or what's your capacity there, and potentially can you give us an idea of how quickly you will be expanding that?

Well, because of the growth that we're having, we're already in discussions about expanding it. So, we will probably be kicking something off early next year.

Okay, great. And a quick 1 for John regarding the tax rate. What should we be using going forward here, John? It did tweak up a little bit here.

I think 30.5% or so is a reasonable estimate for the full year.

Fantastic, thank you.

Next go to Matt Summerville with KeyBanc. Please go ahead.

Good morning. Several questions. First, can you just give us a little more detailed assessment of the channel here in North America? It sounded like July was obviously not that great.

August was still soft. It sounds like things got better in September. How do you feel with regards to the sell-in and sell-through you're seeing with your customers now, and do you expect inventories to get a little bloated again in Q4, if customers are trying to buy up to hit rebates?

Matt, it's on a customer-by-customer standpoint on what they'll do. Yes, September was better. We are expecting for the quarter for residential to be down low-single digits when the final quarter results are in, and commercial will probably be down mid- to high-single digits as for the quarter.

As far as what happens in the fourth quarter, we are already seeing the orders out of Southern California, Pacific Gas commercial units, as people are doing a pre-buy to get ahead of a standards change there. And we do in conversations with all of our wholesalers, we've got a pretty good idea that some of them are going to be doing a little bit of a buy-ahead to hit certain volume targets.

Can you give us some color, Paul, since you mentioned the fourth quarter, how volumes in residential and commercial would have looked, then, on an actual basis for AOS in Q3?

As far as what we would estimate for the fourth quarter without any sort of a pre-buy, it would probably be flat.

Okay. So I guess I just want to clarify something you said. Res was down low-single, commercial down mid to high. Was that in reference to Q3 or Q4?

Q3. Industry estimates for Q3.

That's our industry estimates for the Q3. We don't have the September results yet. We already have July and August that you've seen if you look at that, but we expect -- September did come back stronger. They couldn't run their inventories below zero. So they are -- or the order rate did pick up September and we expect it will for the rest of the year.

Okay, and then similarly, how are you feeling about the channel in China in terms of what you're seeing from a sell-in, sell-through standpoint? Obviously the growth rate in that business has come down. There's a huge first quarter.

The growth rate I think year-over-year pretty similar to what you saw in Q2, but I guess how are you thinking about China going forward, and I guess what are your customers there telling you is the consumer mentality right now? Can you just dig into that a little more?

We were up 17% in the quarter, and that's not -- we've typically said, we'll be 2 to 3 times GDP. As you're hearing, in the large Tier 1 cities, we're not seeing increases in revenue there from the existing stores, but every 1 of our customers is expanding stores, and putting new stores into Tier 1, Tier 2 cities, and that's where we're getting our growth.

So yes, there is some -- in Shanghai and Beijing, the stores that have been there for a while are essentially not increasing anywhere near the rate that we're getting other places. But we're still growing. We were very pleased with the 17% in the third quarter.

So, Paul, does that mean that in the quarter overall your same store sales, if you will, were flat or just in -- well, I guess can you clarify that? Is that what you're saying? I don't want to put words in your mouth.

Well, the same store sales, if we could really get a good handle on that data, did not show a large increase, not anywhere near the 17%, and it depends on the city. The main place we're seeing the weakness is the very large cities -- I'm talking the Shanghai, Beijing-type cities. But you get out to the other cities, many of which have over 10 million people in them, and we're still getting very nice growth there and still expanding our base because our customers are adding stores.

Got it. 1 final 1, and I'll get back in queue. If you back out kind of the noise around the Lochinvar costs and you back out the noise around the gain from the equity collar, your operating margins were the lowest they've been in a couple of quarters, I guess. Is that purely volume related in North America on res and commercial?

Is there something else going on there from a mix standpoint? Then, how should we think about margins maybe bouncing off of that third quarter level, as you indicated volumes being healthier in Q4?

You're right, it was volume related, primarily tied to North America. And we're seeing residential and commercial coming back, so it's our expectation that our margins will go back up.

Profitability in China's still pretty solid?

Yes.

Okay, thank you.

Next the line of Sanjay Shrestha with Lazard Capital. Please go ahead.

Great, thank you. Good morning, guys. Couple of quick questions here. On the Lochinvar side, now, you guys have had a chance to sort of take a look at it. I know you don't give your 2012 guidance until Q4, but that $0.14 number that you guys expect in Q4 of 2011, can you help us understand the seasonality with that business and should 1 be analyzing that for 2012, and how should we really think about potential contribution from that for 2012?

Well, there is some seasonality to boilers because a lot of the boilers that they make are for home heating, and so they would be some seasonality coming in the latter part of the year. But, we're very happy with how that business is performing. We were expecting a lower number than $0.14 on the day we closed. So, we're actually moving our own number up as we get more comfortable with the business and how they're going.

And I think the $0.40 to $0.50 estimate that we gave last quarter for next year, we're very comfortable with.

Okay, terrific. So 1 follow-up. You talk about active pipeline of acquisitions as well as share buyback plans. Can you give us any more detail on that active pipeline, any timing on it, any geography, any product line, can you share with us anything incremental there.

The short answer is no, we can't share anything. We do have a lot of things going on. We're talking to a lot of companies. We've had people traveling all over the world, looking at different markets and talking to folks.

As with anything, we're not going to announce it until we sign something. I've learned over the years, it's very dangerous to predict, because I've had deals fall apart in the last minute for good reasons, when we've walked away because we found out something, or whatever.

We're going to be judicious with your money. We're not going to go and let it burn a hole in our pocket. We're going to find deals like Lochinvar which will be, as we've always said, obviously accretive.

But, more important in my mind, covering the cost of capital very quickly. Lochinvar will cover the cost of capital the first year. We'd like to see it do it in the first or second year. If it's a terrific strategic opportunity, we'll cover the cost of capital in the third year and still do it, but that's as far out as we would go.

Okay. That's fair enough. Thank you so much, guys.

Sure, thank you.

Our next question's in Mike Halloran with Robert W. Baird. Please go ahead.

Good morning, everyone.

Good morning.

Hey, so a couple questions. Just first a clarification. The $0.02 that you referenced in the press release, that's the Lochinvar-related items, is that a net $0.02, i.e., net the professional fees and expenses of $4.4 million?

Yes, it is, it's the $4.4 million and the $3 million of income, and the interest associated with it gets you to the loss of $0.02.

Okay, so then realistically in the quarter Lochinvar was -- call it a $0.04 to $0.05 of accretion in the quarter and then the $0.02 probably --

Was about $0.03 for the quarter, yes.

Okay. So the $0.02 undersells things. Okay, that makes sense. Then could you just give a little more nuance on the regulation that's going in Southern California, and then to the extent that you guys have visibility into it, maybe a little bit more color on the kind of benefit you expect that to be in the fourth quarter?

Yes. It's a low nox regulation that's going in Southern California, nitrous oxide. We are allowed to make and ship products to that market up until December 31, and after that we'll be shipping products to Southern California, we will have to comply with the new regulation. And not surprisingly, the newer products are going to be much more expensive.

They're going to cost the customers more. So our wholesalers there are -- can, within the regulation, buy up until December 31st, and that's what they're going to do, and we've already seen some of those orders coming in. We're just now getting a handle on how much we think that will contribute and we felt obligated to let you know.

No, fair enough. Then 1 last question from me on the commercial side of things. Could you talk a little bit about the customer buying decision when it comes to trading out for higher-efficiency items? If you're still seeing that pretty -- what's been a pretty positive trend for you guys play out, or if there's been any hesitancy in your customer base?

Yes, it's still playing out, Mike. The same thing -- you can put in 1 of our high-efficiency commercial units into a restaurant and you get their money back in 2 years or less. I've heard stories of 7 months getting their money back when it's a high-volume, glass-plate restaurant, and that's still the -- the math still works for them.

They're still doing it. In July and August, we saw everybody holding onto cash. There was so many crazy things going on. I hope this doesn't come across as an editorial, but all the silliness in Washington, and everything else going on, people held onto cash. Our order rates really plummeted.

They couldn't do it forever. We have primarily a replacement market. We're not relying on new construction. But we are still seeing, and have seen all year long, frankly, more replacement on the commercial than 1 would have thought, and the only reason for it is the payback they're getting on the energy-efficient products.

We're still seeing quotes, large restaurant chains wanting to change out. Their water heater tends to need to be replaced in a light commercial, especially, restaurants, where they're getting exercised pretty heavily, a lot more so than residential water heaters. Still working.

I figured that was the case. Just wanted to see what your thoughts were. But, as always, I appreciate the time.

Thanks.

Our next question's from Scott Graham with Jefferies. Please go ahead.

Good morning.

Good morning, Scott.

So, the comment that you made, Paul, on the third quarter resi, down low-single, and commercial down mid- to high-single for the industry, that's a dollar comment?

Yes.

That's what I thought. And so you're --

That's unit.

No, that's a unit. My mistake. I was trying relate back the AHRI. That's a unit.

Even if September was pretty decent. I thought July was bad enough where resi low single, that looks a little -- it looks to me from the average numbers that I've seen so far, that resi low single would mean quite a September. Is that what you're implying, or maybe --?

Yes.

Yes?

We had a very strong September.

The industry?

We believe it did, yes. We haven't seen the data either, but I guess that's 1 way of telling you that we had a strong September.

But then that would probably be -- fair. That would probably also mean that maybe we took the inventories in the industry down a little bit too much, because if you're implying that fourth quarter without the pre-buy will be flat, with pricing up, I'm assuming that your fourth quarter without the pre-buy comment is dollars, right?

Yes.

So, if pricing's up, are you still expecting volumes to decline in the fourth quarter?

Well, I'm being conservative when I say flat. I think maybe units will be flat and dollars will be up a little bit.

Okay. So, then it would look like September's kind of like a short-lived situation.

Well, it certainly was strong, as the customers needed to get their inventories back up, they started placing orders again, actually started in August. But we're seeing good order flow rate so far this quarter. We expect it to continue.

Okay. Can you talk about as much as you can, because I know that you're not a fan of this question, Paul, but kind of price/cost --

You want me to answer it before you ask it?

I guess that was a stupid way to present it, but I would say if pricing is positive, are we at kind of that price/cost parity that we were all on Wall Street love to use that phrase? Are we there?

Same answer, just keep looking at our margins. We know how to manage that. We do have all sorts of escalation clauses now that give us a lot more protection from the wild swings we're seeing in commodities and just look at our margin performance over the years and we know how to manage that piece of it.

That's fair. This question relates more to what if. I know you've talked about potential acceleration of the share re-purchasing, and I know that you can pull forward some of these synergies on Lochinvar to boost the accretion if you need to. Could you talk about some other strategic sort of states of readiness, if you will. If in fact the economy does not behave, what are you guys -- what's in the CEO's top right-hand drawer, so-to-speak, as far as what you can do to protect your earnings, if there is a double dip?

Well, we're doing everything in every piece of the business to maximize earnings and returns to shareholders. I'm never going to be in a position to having something held back that we can do. We're going to do everything we can every day.

That's what's gets us in here and gets us driving forward. Volumes were off in the third quarter and we cut costs. We ran factories 4-day weeks. Then we got back to 5-day weeks in late August because we felt fairly confident that we would need those people.

If there is a double-dip, we will be reducing staffing. We'll be doing all the normal things we've done in the past, like what we did in 2009 when we had -- and we had record earnings in 2009. So, we're going to maximize returns for shareholders every way we possibly can in every corner of the Earth and every piece of the business.

Great. Here's my last question, and this is kind of back on the water heater market overall. I took some time the other day to look at the historical data. And even when you x out the housing bubble type of activity, let's not go there type of thing, because that's maybe an unreasonable way to look at the market, but you go back to the late 1990s, the volumes in the industry right now on the resi side are more than 20% below where they were in the late 1990s, data which I'm sure you're familiar with, suggesting that -- it doesn't seem like there could be much more down side.

But, it also suggests that the units out there are better and that potentially there's some people repairing units. Can you kind of characterize kind of where we were versus where we are, because you seem to be a little bit more optimistic about the business on a go-forward basis. Is that the reason, because we're at such a low level?

There's really 2 answers in my mind, Scott. 1 is that we have -- I don't think it can go any lower. That's why I'm a little more optimistic. I don't see how it can go lower. But you are right, the quality of the products out there, they are lasting longer.

Ten years ago we introduced a new glass coating formulation called Blue Diamond, and it works. It is a better coating. We use it, as do some others in the industry who buy it from us, and we think that's probably adding a year or 2 of life to the water heaters.

That's not all bad. There's still going to be the same -- right now, I think 93% of our residential volume is replacement, only 7% is new construction. That's normally, on a long-term normalized basis, it's been 80/20. It's now 93/7.

I don't think it can go any lower, and I think there is some good data. We're actually seeing it in our own warranty claims and everything, that units we're making and probably the units the industry's making are better than they were in the late '90s.

Which seems to be why the market has not really resuscitated yet?

In the US, that's right.

In the US. But it seems that with a 6-year warranty rolling off from the last peak of the cycle, would you say that the residential replacement market could potentially have a pretty good year next year?

Well, the units are lasting 10 years. That's a good average, 10 to 12 is what is happening in the industry. It depends on the geography and the quality of the water as to how long they last. I do think we'll see a pick-up in replacement units next year.

On a global basis, because the replacement side of China is really starting to take off. We've had units that have been out in the field for 10 years there now. Not very many, but we're starting to get some replacement volume out of China.

So I think overall, we'll probably see it pick up as the year goes on. There's still a little bit of the replacement that's discretionary, a part that I call the teenager effect. People have a 40-gallon gas water heater and they've got 3 teenagers and they get tired of taking a cold shower, so they replace it before it fails by putting a bigger 1 in.

I think there's been a slowdown in that piece this year, but I think that will also pick up sometime. It can't get any worse. It can't get any lower than it has been this year, in my opinion.

That's all very helpful. Thanks very much.

Thanks.

Our next question's from David Rose with Wedbush Securities. Please go ahead.

Good morning. Couple questions. On the margin side, I'd like to get a little bit more clarity on -- you had commented on the third-quarter margin is largely impacted, if you take out the Lochinvar side of it, which seemed to be close to 17% margins. If you look at the -- your traditional business, the margins were down significantly as commented earlier.

You mentioned it's primarily volume. Can you talk about -- to provide a little bit more comfort in the actions you might be taking to ensure that the fourth quarter margins in your traditional business will be back to where they were pre-Lochinvar, or can we get back to those levels in the near term?

Yes. What we did in July and the first 3 weeks of August, we knew the in-coming order rate was not going to stay that low. So, we went to a 4-day week in several of our factories. That hits your margin pretty hard when you do that, because we still have the people on the payroll.

They're still getting benefits. They're still getting all those other things. We just didn't have the volume to cover our variable costs to the level that we had in the past. We're now back to 5 weeks. We're back running the plants and staffs at the appropriate level and I think it's a reasonable expectation that the margins will return.

Yes, I think David, the other issue is when you have a volume decline like we saw in commercial for the quarter, and we've talked about that, that's a very good margin business, that that has a major factor effect during the quarter. We're expecting some recovery in commercial in the fourth quarter, getting back to more normalized levels, and that will be a big factor in the margin going back up.

So, and I really don't want to talk about 2012. I mean, I do, but I don't think you can as much. But at least if you start to think about it, you're probably going to have a pull-forward in the first quarter of 2012 based on the pre-buy. Do you have some sort of expectations for the market for 2012? You have some tough comps, as well, for part of the period, at least the first half. Maybe you can provide a little bit more color on what you would expect?

Well, I think it's a little too early, frankly. January, we'll have our earnings call. We will have the actual fourth-quarter data.

We'll have a little more information on what's happening. We could have an acquisition. There could be a lot of moving parts as we go forward. We'll give you our best estimate of the guidance in January. We've been doing a pretty good job of that.

Even this year, where the volumes are less than what we expected in January. It still looks like we're going to come in maybe be a little bit above the guidance that we gave you in January, and that's the way to run a business. We intend to do what we say we're going to do.

But we'll tell you in January. I'm not ready to put out a number now. We're right in the middle of our budgeting cycle and I want to get a little more data before we do that.

No, Paul, I appreciate that. I was really trying to get a better idea of your margin expectations, as well, because it does seem like the first half is going to be challenging. Maybe on that note, you can comment on the upside surprise in margins on Lochinvar, because it seems like the sales side were in line with your expectations, but the margins were better than expected.

What sort of came out of the Lochinvar acquisition that surprised you on the upside? Is there anything that provides you confidence that those margins will continue going forward?

Well, we're very happy with that acquisition, very happy with that team that's there and the job they're doing. We were a little conservative -- we gave, because you always -- are we going to find anything after we own the Company?

There's always a little bit of a concern that we would find a negative somewhere. Many times we do. In this case, we didn't. It's a good solid business with as you've already noted, very good margins and it's growing double digits, and it's performing well, and we expect it to continue to perform well.

As far as the first part of your question, right now the thing we're trying to figure out is where steel is going. It's dropped significantly. The steel companies are all whining. They're shutting down capacity.

Every time they do that, the prices start going up, so we're trying to figure out what that's going to do, because that will then drive our decisions relative to pricing, and that will drive what happens to our margins next year. Those are all things that we're watching very closely right now and putting together our plans and contingency plans and all the what-ifs that could possibly happen now to commodity prices.

Okay, and the last question, if I may, is on the tax rate. Again, we're going into next year, but John had made the comment earlier in previous meetings about Lochinvar, obviously shifts a little bit more weight back to the US side. So, is there an expectation for tax rate to bump up for 2012, above the 30.5%?

It's still a little early, David. But, if you ask me to guess, I'd say the 31% to 32% would be kind of a reasonable estimate at this point in time, but we'll have a better look at that as we go through the budgeting process, et cetera.

Okay, great, well thank you very much.

Our next question's from Samuel Eisner with William Blair & Company. Please go ahead.

Good morning, everyone.

Good morning.

Just had some questions regarding the growth of stores over in China. I know that you mentioned that your same-store sales were relatively flat in basically Shanghai and Beijing. What are the plans going forward for the Soonings and the Gomays and even your specialty stores, has there been any deviation from the plans that you guys have put forward I guess into 2013?

No. They're going to grow for the next 20 or 30 years, at least. There is so much of that country that's still not covered, and so much of their population that we see a significant growth as all the stores, we only started talking about the specialty stores about a year, year and a half ago. Those are growing dramatically, and that's going to continue to grow.

So it's -- we don't see any slowdown there. Everybody reads about the China slowdown in housing that the government is trying to orchestrate. It's obviously having an effect in some of the bigger cities.

But we're offsetting that lack of growth by continuing to grow in areas where we've not covered before. Our customers are going, not us. We just go with them.

Sounds good. I know there wasn't any comments in the release, but just any quick update on the water treatment business that you guys acquired? Are you reaching profitable levels there? Are you reaching breakeven? Just any color that you might be able to provide.

Well, we did -- we took a big hit with that 1, with just abruptly pulling out of Shanghai and going to a more friendly environment in Nanjing. So, we had to bring on about 700 -- we've got 700 employees there, and we had to bring -- retrain a whole lot of them. Some did move with us, but we had to re-train a lot of people. But it's -- we're coming up the learning curve.

The highlight is the AO Smith brand, which was the main reason we acquired them. The AO Smith brand is doing better than we expected, being sold through Soonings and Gomays of the world, as well as a lot of the specialty stores, and that 1 is performing well. But we're still in a turnaround, still need to get that business up to breakeven. It's not there yet.

Do you think it would be by the end of this year or is that more of a 2012 story?

No it will not be break-even by the end of this year. Among other things, we're investing a lot of money in advertising and getting the brand out and getting the product out.

Okay, then regarding the fourth quarter guidance you mentioned regarding the pre-buy in California, was there any pre-buy that occurred in the third quarter? Have you seen that in the third quarter? Is that strictly all fourth quarter?

No, there were no pre-buys in third quarter. I think overall our customers took inventories down in the third quarter.

Okay, lastly, on the corporate line, the $3 million year-on-year decrease, can you just -- I know you mentioned there are a couple items in there. Can you just recap those and talk about if that's going to continue to decline going forward, or has that already reached a sustainable level at this kind of $9 million or so?

Yes, I would think at this point the $9 million to $10 million, somewhere in that range, is a reasonable estimate, probably $10 million on average. There were certainly some higher incentives we booked last year in the third quarter that we didn't have this year, pension was down.

We had some additional legal expenses last year that we didn't have this year so it's kind of a variety of items. There was no big 1-time benefits this year, so I think that $10 million range is a reasonable estimate.

Okay, great. And then just 1 last question, if I may. The new products that you're introducing in California, this newer kind of low nox products, you mentioned they're a higher ASP, higher cost. Are the margins materially different from that of your existing commercial business?

We expect the move to be comparable to the existing commercial margins.

Great. Thank you very much.

We'll go to Matt Summerville with KeyBanc. Please go ahead.

Just a couple quick follow-up questions. You mentioned how you're thinking about Shanghai water from a profitability standpoint. Paul, I think the thought on India as well was that maybe in the second half of 2011 you approach a run rate that business becomes accretive to AO Smith's earnings. Is that outlook still intact?

How fast do you think after growing 150% or so, plus or minus, in 2011, what is the ultimate growth trajectory look like of India? Can you double it again next year before that growth rate maybe starts to slow down to something more normalized?

Well, first of all, I'll tell you that it is going to be profitable this year. We are going to -- it is going to be contributing to the earnings this year, which was a very nice thing I found out about a month ago in an operating review. Volumes are going to be strong enough.

We're still -- how many are we doing, 11,000 advertising spots on TV and Internet over the next few months that we've already paid for, but yet we're still going to be profitable. As far as what the future growth rate will be, I don't expect it to be 150%, maybe not even 100% next year. We're still putting that together. But it's going to have substantial growth.

And then John, you mentioned pension expense. Can we just get a quick review what your pension expense is in 2011 versus 2010? Then, what the funded status should look like at the end of 2011 based on kind of the push and pull here in the markets, and then the big contribution you made earlier?

Sure. This year pension expense is about $3.5 million, roughly. Last year it was about $10 million. If you look at the balance sheet, you can see we're under-funded by about I believe it was $50 million.

The discount rate, I think as everybody knows, it's probably come down another 40 or 50 basis points since year end, so that could add another $40 million to $50 million, if that were to stay. That gets done at 1 point in time. So, it will be dependent what interest rates are, and the discount rate at December 31 is, but right now, best guess would be maybe $100 million under-funded.

And then what would happen to pension expense then in 2012?

Pension expense in 2012 we would expect would go up. It's going to be again a function of the discount rate. It's going to be a function of the returns this year. We would have expected it to go up anyways, because you're still amortizing some of those losses from 2008. It will definitely be a headwind next year, again we'll have a better estimate when we get to the end of the year.

Just lastly, you guys had talked about before -- and I think this would have been excluding any noise around inventory step-up transaction costs, Lochinvar being roughly $0.10 accretive to AO Smith in 2011, $0.40 to $0.50 in total in 2012. Again, moving the noise to the side, has that 2012 view changed at all, based on what you've experienced thus far in owning the business for a short time?

No. I mean, the $0.10 that we mentioned is now $0.14, for this year. So, that's certainly a positive move. I'd like to think the $0.40 to $0.50 is conservative, but we'll have a little better view on that in January after we get a little -- we've had the business now for 2 months almost, not quite 2 months, so we're very happy with what we're seeing. We're putting together the budget for next year.

They're going to have above 10% top-line growth, and are already contributing to our earnings. So, we're -- as I keep saying, we're delighted with that business and a terrific group of people that came with it.

Paul, if you kind of look at what -- I apologize if you answered this earlier and I missed it but if you look at what's in your pipeline from an M&A standpoint, would you expect future deals to be similar size to Lochinvar or was this an unusually large transaction, opportunistic? I guess, what do you consider the average size from a revenue standpoint of the companies maybe you're looking at right now?

We have a pretty strong pipeline right now of things we're looking at, and they range from revenue of $10 million or $15 million to several hundred. There's no way I'm going to try to predict what the average is going to be. It will be a good deal for the shareholders or we won't do it. We're looking at all the things, sticking to the strategy that we laid out, I guess about a year ago, on geographic expansion, product line extensions, primarily, accretive the first year, cover the cost of capital at worst case by the third year. That's the criteria and we're going to stick to it.

Thanks, guys.

We have a follow-up from William Bremer with Maxim Group. Please go ahead.

Hi, Paul. Just a quick follow-up. Can you comment a little bit on your tankless water heater sales in North America, and where else in the world are you selling them?

Well, we're the largest tankless supplier in China now. We introduced the product 3 years ago there. Our own design, building it, and we're now the largest China manufacturer of tankless, and it's selling well in the US. It's showing some top-line growth.

Even with nat gas and LP prices where they are, still selling quite well?

Yes, you still run into people that they just think they're getting the latest and greatest when they get a tankless. You need to read Consumer Reports and get a little bit more objective view, but if somebody wants to buy a tankless, we'll sell them 1.

Okay, great. Thank you.

We have a follow-up from Scott Graham with Jefferies. Please go ahead.

Hi. A little bit more on the accretion for the fourth quarter for Lochinvar. You gave us a number of $0.10 a share back when we did the deal, and for the fourth quarter. I just want to make sure I understand the numbers correctly. That $0.10 is now $0.14?

No, it's $0.14 from the time we closed the deal.

I would say we closed the deal a little bit earlier than what we originally projected, so that helped contribute, as well as their sales came in a little bit better.

Okay. But the follow-up to that is that the $0.10 was not inclusive of purchase accounting?

Correct. And the $0.08 that we're talking about does have purchase accounting in there for the fourth quarter.

The $0.08 does have purchase accounting.

Right.

Right, okay. Got you. All right, that was it. Thanks.

Thank you.

(Operator Instructions)

Okay. Thanks, everybody.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.