A O Smith Corp (AOS) 2012 Q1 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by. Welcome to the First Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and answer sessions.

(Operator Instructions)

Also, as a reminder, today's conference is being recorded. I would now like to turn the conference over to Pat Ackerman. Please go ahead.

Good morning, ladies and gentlemen. And thank you for joining us on our First Quarter 2012 Conference Call. With me participating in this 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 that 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. In the first quarter, we continued to see improvements in sales and earnings as a result of our acquisition strategy and global footprint. Here are a few highlights. Our organic growth and acquisitions drove sales 12% higher to $469 million. Lochinvar added $49 million, and sales of A.O. Smith branded products in China grew 18%. Our earnings, excluding the favorable impact from the sale of our Regal Beloit shares, were 22% higher than last year, at $0.66 per share. Lochinvar continued to contribute significantly and meet expectations. We sold all of our shares of Regal Beloit stock during the first quarter for $188 million, for an average of $66.19 per share. This result was almost $13 million higher than the price, which was set at the time the deal was struck. John will now describe our results in more detail.

Thank you, Paul. Sales in the first quarter of $469 million were 12% higher than the previous year. Lochinvar, which we acquired in August last year added $49 million, and sales of A.O. Smith branded products in China grew 18%. Earnings of $47.5 million or $1.02 per share included the gain on the sale of our RBC shares of $16.7 million, or $0.36 per share. Adjusting for the gain, our earnings of $0.66 per share improved 22% over last year's performance.

Sales in our North America segment of $353 million increased 10% over last year. This segment includes our US and Canadian water heater and boiler businesses. The incremental sales from the Lochinvar acquisition were partially offset by lower sales of US residential and commercial water heaters compared with last year. We believe our decline in volume is similar to the industry decline. Recall our customers added to their inventories in the first quarter last year in advance of an April 2011 price increase.

Commercial gas water heater volumes were also lower in the quarter, as an increase in air quality standards in Southern California prompted customers to pre-buy for this region in the fourth quarter last year, in advance of the January 1, 2012, standard change. As previously discussed, the pre-buy will affect the second quarter as well.

The results of our China, India, and European water heating businesses, and our water treatment business in China, are captured in our rest-of-world segment. Segment sales of $124 million increased 18% compared with last year, due to the 18% increase in sales of A.O. Smith-branded products in China, which was driven by new distribution outlets, as well as a pre-buy in advance of a second-quarter price increase. We expect growth in the second quarter will be negatively impacted by the pre-buy, and we are experiencing slower growth in China overall. Our sales in the larger cities are flat, and we now see a slower pace in our growth in the smaller tier two cities. However, we still believe our China-branded sales will grow at two times the China GDP rate in 2012.

North America operating earnings of $42 million were 11% higher than last year, and operating margin was slightly higher at 11.9%. The Lochinvar acquisition added almost $10 million to operating earnings, and the effect of lower US volumes and higher steel costs partially offset the contribution from Lochinvar. Rest-of- world operating earnings of $14 million improved over 30% compared with last year, driven by higher China sales and a smaller loss at Shanghai Water Treatment. As a result, operating margin gained more than one percentage point.

Our corporate and other expenses were $10.7 million, excluding the gain from the sale of our RBC shares, and improved 9% from last year, primarily due to interest income on our cache, which was partially offset by higher pension costs. Total operating profit, excluding the RBC share gain, improved 23% to $46 million. Please note that we have included the supplemental schedule in our 8-K this morning,, which provides our historical 2011 and 2010 segment sales and operating earnings by quarter. This schedule is also available on our website.

Cash provided by continuing operations was $15 million in the first quarter, compared with cash used by operations of $52 million last year. 2011 cache flow included a $45 million contribution to our pension plan. We sold all of our shares of RBC stock during the first quarter for $188 million, or $66.19 per share, and received $123 million from the shares which settled in the first quarter. We received the remaining $65 million of proceeds in the first week of April. The proceeds from the sale were used to pay down borrowings on our credit facility.

Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio declined to 22%, compared with 30% at the end of 2011. We have sizable cache balances located offshore, primarily related to the sale of electrical products, and our net cash position was over $150 million, after all the proceeds were received, and the share sale and taxes were paid on the gain. We project our cash flow from operations for 2012 to be between $145 million and $155 million.

Our capital expenditures are expected to be $80 million to $90 million, which includes approximately $40 million for capacity expansion in China to meet growing demand for our water heaters. Our depreciation and amortization expense is expected to be $55 million this year. I will now turn the call back to Paul, who will summarize our outlook and acquisition strategy. Paul?

Thanks, John. Given our strong performance in the first quarter, but tempered by the pressure on the second quarter from the pre-buy in China and higher steel costs, we raised our expected 2012 earnings per share guidance to be between $2.75 a share to $2.90 per share. This range includes our recently announced water heater price increase in the US, effective June 1. Our guidance also includes an incremental $0.40 to $0.50 per share from Lochinvar, in addition to the $0.07 per share contributed by Lochinvar in 2011. Our guidance does not include the impact of future acquisitions and the gain related to the sale of the Regal Beloit shares.

Our outlook for 2012 includes the following assumptions. First, our sales growth of A.O. Smith-branded products in China is slowing, but we expect continued share gains, new products, and addition of over 600 new retail outlets will drive our growth by approximately two times China's GDP growth rate in 2012. Second, we expect Lochinvar to continue to benefit from the transition from lower efficiency non-condensing boilers to higher-efficiency condensing boilers. Lochinvar's condensing boilers continue to offer a compelling pay-back in the form of energy savings and the Company has built a reputation for innovation and product quality. As a result, we expect Lochinvar's growth rate in 2012 will be over 10%, well ahead of GDP growth in the US.

I should remind everyone that Lochinvar does have some seasonality to its business related to the products it sells for hydronic heating. Lochinvar's second half of the year typically has higher sales and profits than the first. Third, we expect water heater volumes in the US to remain at 2011 levels, due to the stable replacement and non-discretionary nature of our products. Fourth, get your calendars out. We are planning an analyst day on September 26 in Nashville, to showcase both our water heater plant and our new boiler plant. Watch for details from Pat, and we look forward to seeing you in September.

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 supporting our stated growth strategy to expand our global footprint in water heating and water treatment solutions is very active. Our integration of Lochinvar is on track. We have the human capital, financial resources, and strategic focus to continue to add companies to our global platform which create shareholder value, and our business development teams are pursuing opportunities all over the world to do just that.

As has always been the case, all of our teams, regardless of focus area, are preparing recommendations for investments which meet the following criteria. First, we expect each investment to bring value-creating opportunities. Second and third, the investment return must be in excess of our cost of capital, at the latest by the end of the second or third calendar year, and meet its risk-adjusted hurdle rate. Fourth, we are especially interested in opportunities which expand our existing operating margins and bring higher growth. Fifth, and given the investments must be accretive to earnings in the first year.

Finally, it's important to note that we have not set maximum or minimum transaction sizes or time frames, nor have we prioritized the four focus areas. We will consider acquisitions, joint ventures for other business relationships to maximize the given opportunity and maximize the returns available to our shareholders. With that, we're now ready for your questions. We'll turn it back to the operator.

(Operator Instructions)

Mike Halloran, Robert W. Baird & Company

First, on the China side, obviously really strong growth in the quarter. Now you've had two years in a row where you've put -- had a first quarter that benefited from a pull-forward, and then the second quarter of the year where you're going to see maybe a little slower trends on an absolute basis, but when you think about the growth rate heading into Q2, maybe down a little bit from the first quarter, but given that you're comparison is relatively easy because you had the same dynamic last year, are you really expecting much different from that trend line in the second quarter in China?

No. Not really, Mike. As we're looking at the whole year, I mean, the quarter obviously is part of what we look at. But there is a slowing. You've seen -- everybody's seen the data the government wants 7.5% GDP growth, which isn't bad, but it's not 10%. We're continuing to open outlets, so we're still going to keep going. We're still saying two times GDP, and there could be some upside to that. Second quarter is going to be an interesting one when it's over, but we obviously feel pretty good about the rest of the year.

No, China's been very encouraging for you guys. On the US side, it doesn't sound like other than Lochinvar performing exceptionally well, that the trends -- the outlook from your perspective on the commercial side or the residential US side has really changed appreciably over the last quarter or so. Is that a fair way to characterize it?

The word we keep using is flat.

Yes. Then on the price increase that you guys talked about, just could you -- since that's inter-quarter, are you expecting any real fluctuations between 2Q and 3Q on how that demand dynamic is going to play out? Well, we've got to wait and see how it goes. Sometimes price increases get announced and pulled back, and sometimes they stick. This one is effective June 1. There will probably be a little bit of volume come in to May ahead of that. But it'll still be within the quarter and June will be weaker because of that. Typically, when our customers do a pre-buy ahead of a price increase, it's very rare that they'll buy more than three or four weeks of additional product. That's about what I was --

Within the quarter it will probably just be essentially a non-event.

Yes, that's what I would have thought. Appreciate the time. Thank you.

William Bremer, Maxim Group.

Nice quarter. Lochinvar -- what are the plans strategically on a global basis for the company? Can you give us an idea of how you may proceed with Lochinvar internationally?

Well, that's an area of focus for us. They already have a toehold in Europe, which has more of a boiler-oriented market than the US. We have said before that China is a strategic opportunity for us, and we are developing plans and moving forward with that as we speak. I don't think it will have a big impact on this year, what we're going to be able to do in China with that product, but we were excited about what it can do for us long-term.

Paul, the 457-square-foot facility in China, will there be a set area specifically for commercial at that plant?

You're talking about the new plant that's coming up over there in China? It's primarily to -- we've expanded our product line considerably there already. The main thing we need right now is tankless capacity. Our tank less business has been growing dramatically, from a zero starting point to we're now the leading tankless supplier in China. But that -- we need capacity for that. We have a commercial line right now that's in the existing managing facility -- that's been modified. We have a heat pump, we have a solar, we have gas, we have electric, tank and thankless. We're moving that along. We don't have -- we're moving all those things along as we go forward. The new plant, it's going to have more square footage than we need day one, and we'll just add equipment as necessary.

Paul, any thoughts in terms of servicing of the tankless, since they do need to be serviced almost annually?

Well, we have a service network throughout China right now that installs our product. This is not something that we own, but it's people that we essentially agree to work with to handle our product.

Right.

I don't think we're going to put in our own service network over there.

Okay. Thanks again.

Matt Summerville, KeyBanc Capital Markets.

Couple questions. First, with regards to China, in your comments on the large cities versus the small cities, I'm just trying to understand the magnitude in which your same-store sales is actually slowed, or is it more of a continuation on what you saw in Q4? I guess I'm trying to better understand what's going on there.

I think, Matt, what I would say is we've been talking about the tier one cities kind of being level for quite some time, and that's still the case. We had been seeing tier two and tier three cities approaching a 20% growth rate, I think is what we talked about last year. We've seen that kind of slow down to more like a 10% type rate. That's really what we're saying there.

Do you feel like that 10% is bottoming out or do you feel like it still has room to slide there? How would you characterize your inventory levels in China versus -- as well as your customers?

I think we're comfortable with the inventory levels, ours and our customers, except for associated with the pre-buy that we just talked about. So they've done, and as we've talked about quite a bit, we have better visibility into inventory in China, quite frankly, than we do here. We're comfortable with the inventory levels, and the government started putting the squeeze on housing about a year ago. Our people said it was going to take six to nine months to have an effect, and it is having an effect. The question is, how long can they really put that squeeze on? I think they've even recently started loosening up a little bit.

If I can add a caution on inventory, it's a -- we're in a real short-cycle business. From time we complete a product until it gets installed is not a lot of time. That inventory buffer that's there is not very large, and it may expand a little bit, but it goes back down pretty quickly.

Can you talk about two other business units within rest of world? I don't recall you mentioning anything about India, so can you update us on the trajectory in that business? I think last year did $18 million, $20 million in revenue. What are you expecting this year? Also, I think as you disclosed in your K, Shanghai Water lost $10 million or $12 million, something like that, last year. What do you expect that number to be this year, and what are you doing to diminish those losses?

Okay. India, we're delighted with what's going on in India. That business could easily double this year over last year. We first put that plant up, our internal plans were to expand it in 2014, we're now doing it this year, so we pulled those plans forward two years. India's just doing great. We're spending a lot of money establishing the brand, taking the typical long-range approach, but India's going to be a contributor to the Company this year, and for many years to come, we believe.

Shanghai water treatment, last year was obviously a disruptive year. We unfortunately had to pick up and move in the first quarter of 2011 on very short notice in order to protect our employees. We did that, and we've been -- it's like a new plant start-up, with 750 people. That plant is coming up, our revenues are growing, the one piece that's doing great is the A.O. Smith-branded. That is off to a terrific start. We're doing better than we expected there, but we have lost some volume on the traditional brands, the legacy brands there that we acquired, and we're building that back up.

I'm hesitant to tell you what we think it will be this year, won't be as bad as last year. Probably won't get to break-even this year, but we certainly expect that to happen. We're still committed to the strategy. Matter of fact, we're expanding the product line to other countries, so it's one that we still believe in and are going forward with. It's still an area that's a slight drag on earnings for the short-term, but we're excited about it for the long-term.

Then one final one, Paul. Can you just talk a little bit more, forgetting about the pre-buy dynamic in commercial, just what you're seeing from a market standpoint, how this year's replacement activity compares to last year's? Also, characterize new construction as well?

If you're talking about commercial, it's flat. There is some replacement. There's a little bit for energy efficiency that's happening. Last year I said our commercial did just a little better than we thought it would. It's going to be around -- it's going to be flattish this year as we look at it right now. New construction, we look at is like commercial and light industrial for our product lines. It's -- you can see the architectural building index. The leading indicator we look at, it's coming up a little bit, but we're expecting it to be flat.

Great, thank you.

Scott Graham, Jefferies & Company.

We on the outside have only this trade data to look at, and when it comes to water heater sales, you may refute it and that's fine, but that's all we have to go by. Over the last five months, North American water heater sales have risen each month, including January and February. I guess I'm wondering, one or two quarters I guess could be refuted, but that type of a trend line would suggest that your North American business should have been up since you're essentially half the market. Was it -- would you refute those data again, or would you say maybe March was weak or help me connect those dots, if you could?

Scott, the real issue is March. Last year there was a pre-buy. Last March was the largest month in a long time. We're projecting that March of this year could be down almost 20% year-over-year, and that's why we're saying that the -- we believe the industry, because we are a big piece of it, is down in the first quarter, even though the first January and February we were both up about 6%. It really is driven by the 875,000 units that were sold last year in the industry in March.

So it is a March issue, okay. Is it isolated to March, or does this bleed over into April and May, do you think?

I think it's primarily a March issue. Again, it was just last year that there was that significant pre-buy that we talked about.

It was probably a four-week pre-buy last year.

Would it be fair to say then that you're more encouraged by your outlook in North American resi for the rest of the year?

I think what we've said all along is that residential will be flattish to maybe up a little bit. The real factor in that is that there's a long lead time between a housing start and when the water heater goes in. We still think the replacement market is going to be what it's been for the last several years, and we're not going to get help -- significant amount of help from new housing starts because we're late in the cycle.

Got you, okay. One sort of housekeeping point for you, John. When you remove the gain from the other income line, there is still I think about $3 million, $4 million of income left, unless I'm tax-effecting it wrong, but I don't think that's a case.

You mean compared to last year?

Yes. Well no, in the quarter. There was an other income switched -- other income expense swung to income. I was wondering what was in there?

What happened last year is we had $2 million of an RBC loss, so that was the biggest factor compared to last year. Last year was really flat without that Regal Beloit collar loss of $2 million. There's about a $2 million improvement over last year, and a decent portion of that is the interest income.

That makes a lot of sense, okay. When you say that you're now in 600 more outlets in China, could you tell us kind of where they are? Does that include A.O. Smith stores? Could you give us a little bit more detail on that?

That's really both A.O. Smith stores and some of the big guys as they're moving into tier two and tier three cities. The majority of those are being added in those cities.

Is it a lot more -- because obviously when you say outlets, the A.O. Smith stores are much smaller. Is it 50-50, is it more skewed toward the --?

I think we've said the specialty stores will grow about 200 of the 600, I believe is kind of the number, 200 to 300. It's about a third to a half of the growth.

Got you, okay. I guess the last question would be maybe if you could just give us an update on what you're seeing out there in the pipeline. I know that you're kind of chomping at the bit to do something else, but only if it makes sense. We haven't heard from you in seven months on this, seven months ago you had a good one. Just kind of wondering what you are seeing out there. As an addition to that, I would say your decision to split your business, your segment reporting, North America to rest of the world, signals to me, at least, that the acquisition focus will be rest of world. Is that a fair statement? Maybe give us any type of update on the pipeline that you can?

Yes. Well, we're looking for growth, and we've said that all along. In the US market -- I think the housing situation, getting back to 1 million housing starts could be two or three years away, if not longer. So we're looking for markets where we can create more shareholder value than we could in the US. Obviously as far as residential and commercial water heaters, we're not going to be able to do anything like that in the US, whereas we can go to other countries and get involved in residential and commercial water heaters. But we can do product line extensions in the US, like we did with Lochinvar, where we moved into product lines we didn't have.

As far as the pipeline, we have a lot of companies that are on the list. We have -- it's frankly my primary focus going forward, but the discipline is still there. We're not going to get deal fever because we've got cash in our pocket. We're going to stick to a disciplined approach to make sure that when we do it, it meets the criteria that we've laid out of covering the cost of capital, and meeting our internal rate of returns, as well as having a growth opportunity. The phrase I use all the time is, anybody can buy a Company, but you make money for your shareholders with what you do with it afterwards. Everything we're looking at, we have some downstream plans with those, at what we can do. When we find a good one that's actionable, we're going to go forward with it. I can't give you any numbers or give you any indications, obviously, because of the legal restrictions.

That's fine. That's all I had, thank you.

Samuel Eisner, William Blair & Company.

Most of my questions have been answered, but I just had basically concerning Lochinvar, looks as though you had about a little bit over a 20% EBIT margin in that business. I'm just curious what are the levers that you pulled there in order to get the margins from around 18% last quarter to 20% this quarter, and where do you see other margin opportunities coming forward?

Well we had, as I just mentioned, we did have some plans there relative to cost improvements on the purchasing side, and those are being executed very well. As you noted, this was a growing, very profitable business when we acquired it. With becoming part of A.O. Smith, we had some synergies that we started working on immediately, and you're just seeing a little bit of benefit from those.

A follow-up to that, is there more room that you think that we can go higher on margins within Lochinvar?

Well, marginally. We have some other things we're working on, and we haven't even gotten into all the branded things we can do, and what we might be able to do internationally with their product lines on an export basis out of Lebanon, Tennessee. It's probably marginal at this point, but there's always a little bit more.

Very good. On the pre-buy in China, at least this quarter and in the year-ago period, do you know how much of the 50% increase in the year-ago period and of the 18% this quarter, how much of that was from the pre-buy?

Let me try to answer it this way. We think that there's about an incremental $5 million more pre-buy this year than last year, is what we've best been able to kind of estimate.

Then, to kind of just have the year-ago number, how much you thought the pre-buy was? I'm just trying to think of what the underlying growth rate is ex the pre-buy?

I think we'd have to go back -- I think we were about $10 million-ish last year.

Very good. Thank you very much.

David Ross, Wedbush Securities.

This is David Rose at Wed bush. Three quick questions. One is a follow-up to one of the previous questions on the other income line. Can you help me reconcile the difference between the gain, which was $27 million, and the other income line which was $29 million. So was there another gain in the quarter? How much was interest income?

Interest income incrementally, I think, was about $1.5 million over the prior year.

Just this year, not versus last year.

It's close to $2 million.

Okay. So all of that additional is a result of interest income?

Well, offset somewhat by higher pension, because again, last year's corporate expense included $2 million associated with the Regal Beloit collar that we lost, so the real run rate number was $11.4 million, about, in the corporate expense line.

Okay.

Because we have a collar last year, we had the marked-to-market, we marked it through that line.

Okay, that helps. So you're effective tax rate then is --

The effective tax rate we looked going forward should be about 30%. Obviously, the share sale had an effect on the first quarter, but we think effective going forward will be about 30%.

What was the tax rate if I exclude the shares? I came up with something below 30%.

It was kind of a little over 28%.

That's what I thought, okay. Can you provide a little bit more clarity on the pull forward in the Southern California QMD? Number one, I'm really -- we talked about this ad nauseum, really, but it looks as if I look at the AHRI numbers, gas heater sales were only down 0.5% in January. If there was a pull forward, a significant pull forward, why didn't it happen in January? Is there something I'm missing?

Well, the full pull forward is just for that Southern California air quality district.

Sure.

We're not talking about a huge part of the country. The pull forward was several months. Unlike my earlier comment, this is not a case of them buying an extra month's worth. They bought at least six months extra, so there were a lot of moving parts going into that, but --

I'm still confused --

Six to eight months worth of extra inventory pull forward in a small part of the country did have an effect.

John's really highlighted it as a big impact on the numbers, and -- but I'm only looking at the pull-forward. As I look at the pull-forward, or potential pull-forward, I see January down 0.5% on gas, I see February down 3.8%, and March, you obviously had really tough comparisons, so I get that. How do you reconcile the expected pull-forward to continue? As you said, it's a small part of the market, the SQMD.

We're thinking it's going to be fairly consistent in the first and second quarter, mainly because it's our belief they bought about six months of inventory. It will weed in through that six months when you compare to the prior year.

This is just pure -- this is a best guess, right?

This is obviously a best guess. But as you said, March was a difficult comparison, and we think the industry was down quite a bit compared to last year's March.

Then I look at April, and April starts to get better for you, and any comparisons from here on out start to get pretty good up until the third quarter. At the end of the third quarter, I think you get September. You should see, I would expect you'd feel a little bit more comfortable?

Yes, I think we see the first -- second quarter commercial being similar to the first quarter. That's our best guess. But it's really is a guess, and as Paul said, if you take away the pre-buy, we expect for the year commercial's going to be flat, but the pre-buy, which we think is 6,000 units, we think commercial will be higher this year by close to 6,000 units, would be our best guess. But it truly is a guess. I'm sorry, this year will be lower by 6,000, but it's a best guess.

Okay, that's helpful Then lastly on Lochinvar, when we had last spoken, and we were on the road in March, we had talked a lot about the opportunities to leverage the distribution, but you are concerned with Lochinvar. You were concerned about not as many opportunities to leverage the distribution as you had thought. You were still kind of working through the dealers. What's your sense now of the opportunities with Lochinvar to cross sell? Has that -- is that getting any better? Are you getting any more clarity?

We're still going through that process. It's almost a wholesaler-by-wholesaler discussion, and I don't think there's anything that we can add to that. It's an opportunity, and it's one that's being pursued, but we don't want to kill the goose that laid the golden egg here. We're not going to go off and do something silly on a -- when I mentioned earlier about branding discussions, that's what I was talking about, about not only what brands go to what wholesalers, but what products are included in those brands is another opportunity. Those are being pursued, but we don't really have anything yet at this point that we can talk about.

Okay, that's helpful. Thank you, Paul. I'm finished, thank you very much.

Todd Vencil, Sterne, Agee & Leach.

Maybe I missed it. Did you guys quantify the price increase in June?

No.

Can you?

No.

Okay.

Sorry, we can't.

That's okay. Can't blame a guy for trying.

Yes.

Most of my questions have been knocked out. I did have one question, though. You talked about the fact that China slowed down, but you still think you can do two times China GDP growth rate for this year. How do you feel about next year and going forward? Is that kind of a good thought for the next few years?

It's a guess at this point, but my gut -- I was just there last month -- I don't think the government can hold the rate to 7.5% for very long.

Right.

I think the GDP will probably start inching up in spite of the government's attempts to put the brakes on it. That's my guess, personal guess. We are conservative in our outlooks, conservative in our forecast. Obviously we're building a new plant over there, and we're keeping a lot of dry powder to respond in case the market takes off.

We've talked about the demographics are certainly moving our way and that there's a big move into the upper middle class as they define it, and that's our sweet spot.

So you still think for the next few years two times whatever China GDP ends up being?

Oh, yes.

Okay, thank you.

Thank you.

Robert Kelly, Sidoti.

Sidoti. Thanks for taking my questions. Just a little bit more on Lochinvar. The double-digit growth you saw 1Q, that's totally stand-alone growth? That's no synergistic benefits for being part of A.O. Smith?

That's correct.

The opportunity -- with the opportunities you see out there, could that at one point be a mid-teen growth business once they're totally layered into your operations?

We're not ready to say that at this point, but it's our objective, obviously to keep that business growing as much as possible. We have the capacity there to expand, and we hope you can come see it in September, if not before. We're going to -- the first opportunity, only opportunity we're really talking about is China, because that's an obvious one, where they have very low sales of Lochinvar products so far. We think there is possibly an opportunity there to sell more of their product and maybe take the growth rate up a little bit, but we're not ready to quantify that.

Fair enough. I believe the number you put out for the EBIT contribution for Lochinvar was about $10 million in the quarter just ended?

That's correct.

You talk a lot about in prior quarters the seasonal swing of their revenue. We're in a low seasonal quarter, contributing $10 million and almost $10 million in EBIT, 20% plus EBIT margins. Do the margins also have a seasonal component to them, or am I missing something? Are you adding significant cost quarter to quarter in the higher seasonal quarters?

No. I think the margins are about the same over the year. I can't remember seeing anything of any significance. We got a little bit of a bump because of the cost improvements, synergies.

Yes. I think the synergies certainly were helpful in the first quarter, and we've talked about some other synergies that we've put in place. As Paul said, their margins were about 20%, and we would think that would grow a little bit as the year goes on.

Just correct me if I'm wrong, the seasonally strong quarters are 2Q and 3Q for Lochinvar?

Three and four.

Three and four, okay.

We also did have some purchase accounting still lingering from the fourth quarter that we talked about also --

Right.

Which affected margins.

I'm just trying to line up the $0.40 to $0.50, and then just what you did in 1Q. It seems like there's an opportunity there?

Q2 is usually the weakest quarter, for what it's worth. We're going into the waiting season, to the warm season, warm weather. Not many people buying boilers in second quarter.

Remember, the $0.40 to $0.50 is incremental over last year's $0.07, so we're really saying Lochinvar is going to add $0.47 to $0.57.

Okay, great. Just one final one with the new facility being built in China. Do you expect to absorb a significant drag there in rest of the world during 2012?

Well, 2012 we won't have basically any. 2013, since it's going on halfway through the year, and as Paul talked about, we're going to kind of sequence the things we absolutely need, which are instantaneous, solars, and a lease facility, moving that in there. We're not expecting 2013 to have a significant drag either.

Okay, great. That's all I got, thanks a lot.

Sanjay Shrestha, Lazard Capital Markets.

Great, thank you. Good morning guys, and first of all, congratulations on a great quarter and execution. I got on a little bit late, so I apologize if you guys already touched on this, but I kind of want to come back to this China question. This is a pretty impressive growth for you guys in the face of sort of slowing resident residential market. I'm thinking obviously there's a price increase there, but can you guys talk about -- are you seeing an incremental benefit from maybe some of this residential construction apartment buildings that happened, but people weren't moving in, and now finally with the prices falling, people are starting to move in and that's kind of creating a pent-up demand for you. It's not just about new stores being added in tier two and tier three, but that's also a factor that's kind of contributing and that's why China ends up being better than your prior expectations over 2012?

Yes, that's correct. The household formation is still occurring, and we're still benefiting from that, and that's why we keep saying we're going to be at two times GDP. Yes, that is still occurring, and the sales expansion is contributing also for outlets.

Okay. Now have you guys sort of tracked as to what is that potential number, or what is that opportunity as it relates to all the apartment buildings that remains. They can kind of create a bit of a pent-up demand for you guys. Do you guys have a number on that, how big that is, and what could that mean?

It's probably millions of empty apartments over there, and I was there last month, and had a lot of windshield time from Shanghai to both of our operations in Nanjing and everything. You still see a lot of construction going up, see a lot of apartments and see a lot of them -- apartment buildings finished with them that are empty, and those are all opportunities for us. As prices have come down, there's a little bit of an incentive for people to go ahead and form the household earlier, and I think we're benefiting from that, and I think we will.

But we have no way of quantifying that. We have tried. I asked exactly the same question of our people over there as recently as Monday of this week. Essentially, we are getting a benefit of that right now, but it's hard to quantify. Is the damn going to break and us suddenly get a huge slug of business? We're not planning on it, but if it happens, we can handle it.

Okay. That's great. That's all I had, guys. Once again, congratulations.

Scott Graham, Jefferies & Company.

Just one quick follow-up, and it's another housekeeper for John. The SG&A rate was up year-over-year in the quarter, whereas I think we've seen some pretty good management there. Is there something that was going on this quarter in SG&A?

Lochinvar is a big piece of it, that's $11 million to $12 million of the increase, and then China SG&A continues to grow, as we've talked about the need to advertise, build the brand, and the selling costs of the sales increase. The increase is strictly China and Lochinvar.

Right, but it was still on a percent of sales basis with Lochinvar in China still being active the last couple quarters, of course. Still down in those quarters, but up in this quarter. Was there anything at A.O. Smith North America that --

No, I don't -- not that I'm aware of. I thought the rate was fairly similar to the fourth quarter. I guess I'd have to look at what the fourth-quarter rate is.

Is it pension?

Pension is certainly adding something, there's no doubt about that, year-over-year.

All right. I'll figure it out, thank you.

Yes. We can look at it and talk about it.

Thanks, Scott.

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