A O Smith Corp (AOS) 2012 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation third-quarter 2012 earnings call. At this time, all lines are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, today's conference call is being recorded.

I would now like to turn the call over to your host, Pat Ackerman, Vice President Investor Relations and Treasurer. Please begin.

Thanks, Sean. Good morning, ladies and gentlemen, and thank you for joining us on our third-quarter 2012 conference call. With me participating in the call are Paul Jones, Chairman and Chief Executive Officer; Ajita Rajendra, President and Chief Operating Officer; and John Kita, Chief Financial Officer.

Paul will begin with our presentation this morning with our third-quarter highlights. John will then elaborate on our financial results and Ajita will wrap up with our outlook and acquisition strategy update.

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.

Okay. Thank you, Pat. Good morning, ladies and gentlemen. I'm going to start off with an apology. I've got a cold and my voice will probably come and go but I'll try to do the best I can. I feel like I've got my head in the trash can talking.

But in the third 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 $462 million. Lochinvar, acquired in third quarter of last year, achieved $63 million in revenues. We are seeing normal seasonality in boiler volumes as our customers prepare for the hydronic heating season in the US. In China, our sales of A. O. Smith-branded products grew 22%.

Our earnings improved to $0.71 per share, which excludes an $0.08 gain related to an adjustment to Lochinvar's earn-out. Lochinvar continued to contribute significantly and meet the high end of our profit expectations.

We met with many of you in late September at our Analyst Day in Nashville, where we presented our 2015 growth aspirations as well as showcased our manufacturing excellence. To those of you who attended, we thank you for spending the day with us. Our slide deck from the day is currently available on our website.

Last but not in any way least, I am very pleased that our Board named Ajita Rajendra as my successor in the CEO role beginning January 2013. Ajita and I have worked together at A. O. Smith and at prior companies and he is an outstanding leader and manager. He and I developed the strategy we laid out at our Analyst Day last month together and Ajita is committed to it.

I plan to serve the Company and its shareholders in the role of Executive Chairman at least through 2013 and I have complete confidence in Ajita and our whole operating team. This positive transition will be seamless and positive for our Company and shareholders.

John, I will now turn the call over to you to elaborate on our third-quarter results.

Thank you, Paul. Sales in the third quarter of $462 million were 12% higher than the previous year. Lochinvar, which we acquired in August last year, added $63 million in sales compared with $21 million last year. Sales of A. O. Smith-branded products in China grew 22% to $109 million.

Adjusted earnings of $0.71 per share were 82% higher than last year when the $0.08 per share Lochinvar earn-out adjustment in 2012 and the $0.19 per-share net gain for several one-time items in 2011 are excluded from the comparison.

Third-quarter earnings per share also benefitted from a decline in the worldwide effective tax rate to 29% primarily as a result of larger than anticipated deductions available for US domestic manufacturing activities.

Let me take a minute to explain the earn-out adjustment. Recall that under the terms of the Lochinvar purchase agreement, Lochinvar shareholders could earn up to an additional $35 million if certain revenue objectives were achieved from December 1, 2011 to November 30, 2012. At the time of the closing, the Company projected the earn-out to be $16.8 million due to an estimated 16% increase in sales over the prior year. Based on the current estimate of a 12% increase in sales, the earn-out is projected to be $10.4 million resulting in a pretax gain of $6.4 million that was recorded in the third quarter.

Sales in our North America segment of $336 million increased 8% over last year. This segment includes our US and Canadian water heater and boiler businesses. In addition to incremental sales of $39 million from Lochinvar in North America in the third quarter, we experienced higher volumes of commercial water heaters in the US.

Lower sales of residential water heaters and tankless products in the US more than offset higher US commercial volumes. Based on our shipments, we estimate industry shipments of residential water heaters were down mid single digits during the third quarter.

The results of our China, India, and Europe businesses are captured in our Rest of World segment. Segment sales of $134 million increased 21% compared with last year due to a 22% increase in sales of A. O. Smith-branded products in China.

Our growth in China is driven by several factors. Our distribution channel continues to grow. Our premium brand continues to gain market share, and our gas tankless and water treatment products are growing faster than our overall business.

North America adjusted operating earnings of $44 million were $13 million higher than last year. The adjusted results exclude the $6.4 million benefit from the adjustment to the Lochinvar earn-out.

The Lochinvar acquisition added $15 million to operating earnings in the quarter compared with $3 million last year. In addition, the segment benefited from higher commercial volumes and material costs which were lower than their relatively high levels last year. These benefits more than offset the volume decline in residential water heaters. As a result, the segment's adjusted operating margin improved significantly to 13.2% in 2012.

Rest of World operating earnings of $13 million improved 41% compared with last year driven by China, higher China sales and lower losses at our water treatment business. As a result, operating margin improved to 9.5%.

Our corporate and other expenses were $9.5 million, essentially the same as last year but adjusted for the benefit from the RBC share activity net of Lochinvar professional fees in 2011. Total operating profit excluding these one-time items improved 57% to $47.5 million.

Cash provided by continuing operations was $101 million at the end of the third quarter compared with cash used by operations of $68 million last year. 2011 cash flow through September included an approximately $140 million after-tax contribution to our pension plan.

Our liquidity position and balance sheet remains strong. Our debt to capital ratio declined to 19% compared with 30% at the end of 2011. We have sizable cash balances located offshore primarily related to the sale of electrical products and our net cash position was over $200 million at the end of September.

We project our cash flow from operations for 2012 to be between a $155 million and $165 million. Our capital expenditures are expected to be $65 million to $75 million, which includes approximately $35 million for capacity expansion in China and India 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 to Ajita, who will summarize our outlook and acquisition strategy. Ajita?

Thank you, John. Given our strong performance in the third quarter, we raised our expected 2012 EPS guidance to be between $2.85 and $2.95 per share. Our guidance does not include the impact from future acquisitions, the gain related to the sale of our RBC shares, or the adjustment to the Lochinvar earn-out.

Our outlook for 2012 includes the following assumptions. First, we continue to remain positive on our growth in China. We expect our growth of A. O. Smith branded products for the full year to be over 15%. We expect China sales in the fourth quarter will be approximately 10% compared with 19% in the first nine months. The growth rate in the fourth quarter will be impacted by more difficult year-over-year comparisons as well as our belief that some of our distributors are carrying larger inventories than normal as a result of promotions related to our new product introductions and a weaker holiday season for water heaters in late September, early October of this year compared to a stronger season last year.

Second, we expect Lochinvar to continue to benefit from the transition from lower efficiency non-condensing boilers to higher efficiency condensing boilers. Lochinvar's market-leading condensing boilers continue to offer compelling pay back in the form of energy savings and the company has built a reputation for innovation and product quality. The new line of CREST boilers launched last year exemplifies this reputation.

This new line of condensing high-efficiency boilers expands the Lochinvar portfolio to larger BTU input models and has gained excellent market acceptance. As a result, we expect Lochinvar's growth rate in 2012 will be approximately 10%, well ahead of GDP growth in the US.

Third, our commercial volumes are higher than we expected so far this year and therefore we expect commercial water heater volumes in the US to remain at approximately 2011 levels. We do not expect to see the benefit from new residential construction in our volumes this year as water heaters track more closely with housing completions than starts.

We estimate our residential industry shipments were down over 100,000 units in 2012 through September. As a result of what we have seen so far this year, unit volumes for the full year could be 1% to 2% lower than last year.

Fourth, given the challenging macro environment in the Eurozone, I want to remind you that we have minimal exposures in that region.

I want to now move from the outlook to our strategy. 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.

As we presented at our Analyst Day, we expect to grow organically over 7% per year, which will result in $2.4 billion in sales by the end of 2015.

Adding our dry powder and making some assumptions about acquisitions, we expect to achieve revenues in excess of $3 billion, one-third of which will come from higher growth emerging regions of the world. Using these growth assumptions, we expect earnings to reach $5 per share in 2015.

Based on our core competencies, our strategic focus for growth is simple -- hot water and clean water. We are pursuing actionable acquisitions to backfill these two areas around the world and particularly in developing and merging geographies. We are also pursuing acquisitions which expand our core product line. We are particularly keen on products and technologies that offer energy and water efficiency gains.

And finally, we are considering water-related adjacencies which can leverage our distribution and brand equity to provide value to our shareholders.

Our integration of Lochinvar is essentially complete. We have the human capital, financial resources, and strategic focus to continue to add companies to our global platform, which creates shareholder value and our business development teams are pursuing opportunities all over the world to do just that.

One final point on geographic expansion, which I think is worth reiterating. We are somewhat unique given our size to operate such a strong platform in China and a strengthening platform in India. These investments made over many years have proved to be very rewarding. These two countries are by far the largest emerging and fastest growing regions in the world. We continue to look for opportunities in these markets to leverage our brand and distribution capabilities.

In addition, we are also exploring the suitability of these two platforms to serve as export bases to other smaller yet fast-growing markets in Asia, Africa, and the Middle East. Finally, we continue to pursue acquisition candidates which presently operate in other fast-growing regions around the world to further complement our platforms in China and India.

Finally, our investment criteria, you've seen this before. We show this only as a reminder that we will be a financially disciplined acquirer. Our transactions will be focused on creating returns for our shareholders.

Those are the end of our prepared remarks and now we will open the phone lines up for your questions.

(Operator Instructions). Matt Summerville, KeyBanc.

First, I want to talk about in North America how we should think about your product mix progressing through the fourth quarter with a couple of moving parts. Lochinvar benefits from favorable seasonality. In residential, you have tough comps but in commercial, you also have tough comps with last year's pre-buy. So how should we think about mix in Q4 relative to what you saw in Q3?

Lochinvar, traditionally their third and fourth quarter are pretty comparable depending on the preseason buy-in, etc., so we wouldn't expect a lot of difference between third and fourth quarter. Actually it could be down a little bit in the fourth quarter because we do think there was probably an early pre-buy, so that will come into play.

Certainly we do have a tough comp because of the pre-buy in commercial and we would expect that to be lower than last year's commercial level by quite a bit as we've talked about.

Residential, you can see by the numbers we talked about, the third quarter was down somewhat unexpectedly. We expect the fourth quarter to be fairly comparable to the prior year from a residential standpoint.

Okay, and then if we think about -- you had very good incremental margins in North America in the quarter. They have gotten better all year. In Rest of World they have sort of fluctuated in that 10% to 20% range. What needs to happen to get the incrementals in Rest of World maybe in more firmly into, say, a 20% to 30% range on an ongoing basis?

I think on an ongoing if you recall, we said our objective for Rest of World at our Analyst Day was to be a 13% level by 2015. We think we will see improvement in India as we go forward, as we get some volume improvements there. We have also talked about SWT reductions and the operating losses there, so I think those two will be the biggest components.

The China operating margins continue to be pretty steady. They were comparable to last year, a little bit down from the second quarter but there are a couple one-time items that affected them in the second quarter -- in the third quarter, I'm sorry. So I think it's the combination of all three business units continuing to progress.

Then just maybe two more questions on China and then I will hop off. With regards to I think it was $109 million you mentioned in China, A. O. Smith-branded products sold in China, how does that break down between the water heater business and Shanghai Water really trying to track the progress on the latter?

And then with regards to same-store sales, can you comment on what your experience was Tier 1 versus Tear 2 and 3 and has it differed relative to the prior quarter or two? Thank you.

On the water treatment, we have talked about it. The sales last year were about $8 million through the A. O. Smith branded. We expect those to be more than double in the $18 million to $20 million range, so we've had pretty steady improvement on the water treatment and that's what it's benefiting. I'm not sure I -- what was the second question, Matt?

Same-store sales.

Same-store sales are up slightly. I don't think that story has changed much. Tier 1, they were up a little bit more than they were last year's numbers so that's a little bit of an improvement because we had been running flat. Tier 2 cities are still running positive but as we talked about, they were running 20% plus last year and that number has been coming down. So we are still seeing some improvement in same-store sales.

Thanks, guys.

Scott Graham, Jefferies.

Good morning, so I was just wondering what your -- maybe two housekeeping questions -- what your full-year tax rate is going to look like?

Well, it has been running kind of year to date, we would expect the fourth quarter is going to be around 30%. We have had some variation in the tax rate without a doubt. I think it was 28-plus% first quarter, 30-some% second quarter and now the average was 29% this year -- this quarter. So we are expecting about 30% would be the best guess for the fourth quarter.

Okay, on the other income line, that is I assume interest income from the cash balance?

Yes, that's primarily interest income from the cash balance.

Okay, could you also tell us what kind of the first couple of weeks in October look like in resi water heaters in the US?

Yes, this is Paul. We are off to an okay start. That's about all we will say. In fact, the industry data as you follow it sometimes has some really wild fluctuations and so we try to look at it on a rolling average basis, so where one month can be off double digits and next month could be up double digits. We just keep operating business as usual through those cycles.

Okay, are you sensing a different tone in the channels with your customers maybe a little bit more optimism that these positive resi data points are maybe gaining momentum or no change in tone?

Scott, this is Ajita. We sense a little bit of positive. There are the ups and downs but overall people are feeling a little more positive than they were feeling before.

Very good. Last question is on Suning and Guomei. To your knowledge, is there any even inflection in tone from the management teams of those companies about a change in store build plans?

No, they've announced earlier that they have slowed down and that is to be expected and they are working on the quality, which frankly we see as positive. They're starting to actually close a couple of stores, nonperforming or poor performing stores which we think means they are running their businesses very well. They are looking, making sure that where they have their capital invested, they are getting a return.

But they obviously are affected by the slowdown in China. You can see the data. It's available out there and they are affected by it but the good news is the water heater business and some of their other appliance lines continue to do very well.

Right. But they're not indicating to you anything incremental from that change -- versus that change?

No, they are sticking to the same thing they had before. Ajita, do you want to add to that?

That's essentially right. I was in China a few weeks ago and met with some of their top management. They see the slowdown and they are managing through it. As Paul said, shutting down some of the nonproductive stores we see as very positive because it's volume that doesn't have a lot of profitability for us if we lose any volume and it's picked up by the other stores. So all that is very positive.

Very good, thank you.

Mike Halloran, Baird.

Good morning, everyone. Can we talk about inventory levels? I know with the pre-buy, the inventory levels spiked up and you were expecting a little bit longer tail and I'm assuming that was part of why the volumes were a little tougher in the quarter on the residential North America side. Can you talk about how that trended through the quarter if you've worked it off now and what the growth or the volume trends look like as you move through the quarter?

Yes, we feel the inventories have worked themselves out of the system. We were a little surprised at the lower residential volumes that we saw in September, but as Paul said, that sometimes one month we don't really pay a lot of attention to it and on the other side, we were frankly very positively surprised by the strength in the commercial side of the business. So overall things are moving along just as we have been seeing.

Seeing any differences in the wholesale versus retail channels at this point and talk a little bit about the competitive dynamics?

The wholesale is showing a little more strength than retail and retail inventory is a little bit on the low side and they are managing them low but we see that as a short-term type of cycle.

Then last question on India, could you just comment on how that's tracking relative to the expectations so far this year through the third quarter and what the profitability outlook looks like as you move forward?

The volumes are down and for a couple of reasons. One is that the rupee has devalued about 18% from when we planned this so that is impacting us negatively. And we ran into some issues in terms of our supply chain and installing some equipment as we were expanding our line and going into a good better best strategy, so that held us back a little bit.

But all those issues are behind us, not the currency issue but the operational and the supply chain issues are behind us. But the really good news is that the brand and the product continues to be very well accepted in the marketplace and so we will be seeing 20% plus growth this year not where we expected it to be because of the issues that I indicated to you, but the product is very well accepted and showing a lot of strength in the marketplace.

I appreciate the time.

Charlie Brady, BMO Capital Markets.

Good morning, this is Andrew Dunham on for Charlie Brady. I had a question regarding the earn-out, just kind of what made up the difference between 16 expected when you closed and 12% kind of now?

When we closed, they had a very aggressive internal plan and we said fine and we tracked our earn-out according to that. Internally, as you know, we are conservative so we took a little more conservative approach. We were hoping they would hit their plan because every dollar of revenue that they achieved in this earn-out was good for our shareholders. The shareholders win throughout the whole process but we're just adjusting to a little more realistic date.

We are not disappointed at all. The folks at Lochinvar have done a fantastic job and we are delighted with how well that business is doing. It's just when you have a super aggressive plan that there's about a 10% chance to hit, 90% of the time you don't hit it and that's in the -- with the bright light of hindsight, that's the way we are seeing it right now.

Okay, great. Understandable. Next question was just kind of Lochinvar's margins. I think in the past you have mentioned that prior margins before the acquisition were about like 20% EBIT. Do you guys seem like you will hit that kind of minus the earn-out this year? It seemed like it may have dipped a little this quarter.

Actually their profit margin was up significantly this quarter almost 25%, I think 24.5%, so they had an excellent quarter and that's just a function of the higher volumes contribute very well.

Plus the cost reductions we implemented.

And the cost reductions, as Paul said, the synergies we achieved have pretty much all been in by the third quarter so I think it's that combination but clearly the volumes helped them.

Okay, thank you.

Sanjay Shrestha, Lazard.

Thank you. Good morning, guys. Ajita, first of all, congratulations on your new role for 2013. My first question is on China since you just came back from there. So is there any incremental talk about introducing some type of a stimulus program and maybe potentially impacting sort of your sales outlook for 2013?

They talk about it and the government has been talking about and they have introduced some programs, but I think all of that is tied into their outlook and what's happening out there right now. They also feel very positive. This is internally about the changes happening in the government and the leadership and feel that the right programs will be put in place to get the economy back.

They have been pushing that out because earlier on this year they said second-half will be stronger. Now they are pushing it out to next year but the overall feel that the government will have the right programs in place.

Okay, got it. Now shifting gear back to North America, when we really look at -- obviously there was a mix issue in the quarter but even excluding Lochinvar, the margins of your traditionally North American business looked pretty good. How much of a benefit did you guys get from the lower input costs in the quarter and can we expect that this is the new level of the margins going forward or there was some raw material benefit as you saw it in the quarter which actually ended up helping the margin a bit in Q3?

We definitely got some benefit from the raw material, as we talked about, and raw materials are down from very high levels last year third quarter. But we also got some help from commercial. Commercial was much stronger this year than last year, so I think those were the two biggest contributors to the margin improvement, ex Lochinvar, obviously.

And the operations are running very well.

Great. So on the commercial side, it's done better than expectation even though it's sort of flattish on a year-over-year basis. It is a phenomenon that that segment of the market is relatively healthier? Is it one of those dynamics have energy efficiency getting better traction so payback is better and industry is sort of embracing that and that's why this trend will continue and sort of get better if anything going forward? How should we think about that?

I think that's exactly the way to think about it. It's the energy efficiency certainly having an impact and especially on the commercial side, where the payback is much more obvious, people are making the investment and we feel very positive about that because we have the products that can leverage that.

Okay, great. One final question. I have to ask this, don't know how much color I'm going to get on it, but since the Analyst Day, sort of you guys have been very disciplined about going after the acquisition but if you were to sort of think about what's in the pipelines from a size standpoint or the level of discussion, where it is right now, can you give us any incremental color as to what is the size like? What is the level of discussion sort of talking now? Where are we, anything incrementally you guys could share with us would be great.

Thanks for asking the question everybody else wanted to ask. But obviously we can't show our hand with regard to the acquisition pipeline but we continue to have active conversations with companies in both the US and in emerging economies that have a growing middle class. We have identified these regions in the past -- Asia, Middle East, and sub-Saharan Africa and we have nothing else that we can add at this point.

Okay, fair enough. Thank you so much, guys.

William Bremer, the Maxim Group.

Good morning. Congratulations, Ajita.

Thank you.

My first question, let's go back to Lochinvar. North America sales were a little bit over $60 million, altogether $63 million. What is the strategy to roll this out globally and really leverage the AOS name and distribution?

One of the positives in terms of value creation with Lochinvar was the ability to take this product to other markets where we can leverage not only our brand but also distribution capability and service networks. So we are actively working on that. It is something that this product -- the Chinese market which is the first area we would be looking at is not quite ready for this product. This type of application is handled by cast iron boilers and much more regional type players. And what we are trying to do is to set up the distribution and the channels that can take this product to market.

So there are teams from China who are -- who have come here for training. In fact the Lochinvar team as we speak in China gone the other way in terms of looking at the market and looking at how best we can build this. So it's a definite opportunity. It's not going to be something that's going to come right away. It's going to come in the next year or so and onwards from there.

Okay, and then on the water treatment, can you give us some a little more color in terms of the underlying products are now in China that you may be rolling out into other geographic areas around the world?

Yes, we have introduced some new products in China. One is the side stream, which has much higher efficiency RO type of filter and this is unique to us. It is a patented product and we charge a higher price for it and it's doing very well in the market. We just introduced it, a promotion, just introduced it under the A. O. Smith brand and that's one of the things that's driving the A. O. Smith brand to be double what it was last year.

So we see lots of positive things happening on the water treatment side.

On the SWT side of the business, obviously that's where we had the major issues in the past and that's making improvement, not as fast as we would like but making improvement. I anticipate this year that our sales will be up about $3 million and our profits will be up about $3 million, still negative but an improvement from last year.

Okay, that's good to hear. Finally, a little housekeeping, maybe this goes to John. The corporate expense, $9.5 million, is that a good run rate going forward? Do you see things possibly tweaking up a little or is there maybe some additional streamlining that can occur over the next couple of quarters?

I think it was a little bit lower this quarter. We had a couple of accrual adjustments etc. I think we had been running the first half of the year at $10.5 million to $11 million a quarter and I think that's a reasonable run rate going forward.

$10.5 million to $11 million versus the $9.5 million that we just came through right now? Okay, John. All right. Great, thank you.

Ryan Connors, Janney Montgomery.

Thank you, good morning. I had a question. It's a comprehensive call, so most of my questions have been answered at this point. But I did want to talk a little bit about the pricing environment in China. I know obviously from your comments you are comfortable on the volume outlook there but I wondered if you could talk a little bit about the pricing side in the Chinese market?

And I guess related question would be your strength on the higher end of that market. You talked about $400 plus being a sweet spot. Is that a segment of the market that -- does the outlook there differ from the lower end segments given the economic macro headwinds there?

Our pricing -- in the past -- let me go a little back in history. In the past before the last two years, we'd never really raised prices. We introduced new products with new features and benefits and drove our margins up through the new products and new features and benefits. The last two years, which is 2011 and 2012, we have increased prices on existing products and the price increases have stuck. So that's the good news.

And during that time, we have also gained market share in that higher price segment so we have been able to drive that because again because of the strength of the brand and the new products and we continued during this time to introduce new products with new features and benefits.

So all of that has helped to build the equity of the brand and for us to be able to sustain those prices and the pricing is holding.

Now I don't want to imply that increasing prices in China is easy and can be done at any time but so far the prices are holding and our position in that higher end is very strong. We continue to slowly increase our market share.

Okay, that's good to hear. And then also just you talked about the corporate line item in the previous question there. If you could kind of give us a similar analysis on SG&A, it's kind of been trending up sequentially. Should we expect that to continue or do you think that that is kind of leveled out here and you will be able to leverage that going forward?

I think it was a little higher this quarter mainly because of the residential, etc. We still have those fixed SG&A costs and sales were down. I think the year-to-date run rate is 23% and I think that's probably a reasonable percent as we look into the fourth quarter.

Okay, great. That's very helpful. Thanks for your time.

David Rose, Wedbush Securities.

Good morning, I think most of mine have been answered. I do have one left on China. Can you provide a little bit more color, maybe some data points on the number of specialty store entrepreneurs that are planning to open and if there'd been any closures both in Tier 1, Tier 2, and Tier 3 cities?

I think it is yes to all of them. We are opening stores and we are also closing stores and that has been an ongoing process because we have very strong requirements and tight requirements in terms of the performance of those stores. And if the entrepreneurs are not performing then we shut them down or bring in new people. That process is ongoing.

I think with the turn down if anything, we are probably being a little more aggressive in shutting down the nonproductive stores and that is a good thing because that ensures that the sales that we have continue to hold their profitability and we are expanding into today into the second and third tier cities and that expansion is moving along.

That is part of the reason that we have been able to show growth in our business beyond what is normally -- what's happening in China and beyond what we see our traditional retailers experiencing. It's a combination of expanding into the second and third tier cities, expanding our stores, the new products, the pricing, putting all of that together is what is helping to drive our sales in China and we would certainly continue that formula.

That's helpful, Ajita. Maybe a follow-up to that is kind of on the look through in terms of the pipeline of new entrepreneurs, do you see economic conditions changing the number of entrepreneurs that are willing to open or because there is lack of other opportunities for them it's actually encouraging them?

No, the number of entrepreneurs, they are more than we can handle because the brand is so strong that there are lots of people who wanted and we have not run into the issue where we see a region and don't have people who want to come on board. It's the other way around.

Okay, great. Thank you very much.

We manage that because we don't want to have too many people too close to each other and so we want to manage the number that's out there.

Okay, that's helpful.

Samuel Eisner, William Blair.

Thanks very much. Good morning, everyone. In terms of the commentary on the commercial business, obviously volumes are trending higher. Can you make any comments regarding if this is strictly retrofit or if there's any new that's actually embedded in that -- those higher volumes?

I think it's the normal combination. I don't know that I can say that there's been a whole lot of new activity that's unusual. It's a combination of both, Sam, and frankly we've been very pleasantly surprised at the strength of the commercial market. It's stronger than what we anticipated it to be especially given the buy-in at the end of last year.

Great. And then moving over to China, obviously the commentary regarding same-store sales this quarter seemed to be a little better than I was expecting given the fact that second quarter I think you were flat in both Tier 1 and Tier 2 cities. So I guess what is the causing the increase I guess this quarter?

Then maybe looking out to 2013 even, if you're going to be only about 10% growth, how should I be thinking about looking out to 2013 when you are exiting 2012 at about 10% levels?

You know, we were pleasantly surprised at the 3%. People have been saying things are going to be getting better, probably this was getting a little better a little faster than we thought. But I don't want to spike the ball too early. I think things are getting better slowly and that's what we see in China.

Okay, then last question here, John, I think you mentioned there were some one-time items in China that affected the operating margins there this quarter. Can you call those out just so we can understand (multiple speakers)?

There was a couple of them. One is there was a new tax on -- a property tax like type tax that was put on multinationals and it goes back to the first part of the entire year, so we had to pick up the first three quarters. So that probably affected it by 50 basis points.

And then as Ajita has said, we've come out with a couple of really new and exciting products. One was the side stream water treatment as well as the low noise instantaneous and so we had some pretty hefty incentive type programs during the quarter that probably affected margins another 50 basis points. So both of those I would view as somewhat one time type items.

So a cleaner number would look closer to 10.5%?

Well, remember the 9.5 is entire Rest of World, so it would be a little bit less than that, right?

Okay, great. Thanks so much.

I'm not showing any other questions in the queue. I would like turn it back over for closing comments at this time.

Okay, we appreciate everybody's interest and you know our phone number, so give us a call if you have any follow-ups. Thanks much.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day.