A O Smith Corp (AOS) 2012 Q4 法說會逐字稿

Good day, Ladies and Gentlemen. Welcome to the A.O. Smith Corporation fourth quarter 2012 conference call.

(Operator Instructions)

I would now like to turn the conference over to your host for today, Miss Patricia Ackerman, Vice President Investor Relations and Treasurer. Ma'am, you may begin.

Thank you. Good morning, Ladies and Gentlemen, and thank you for joining us on our fourth quarter and full year 2012 conference call. With me participating in the call are Paul Jones, Executive Chairman; Ajita Rajendra, Chief Executive Officer; and John Kita, Chief Financial Officer. Paul will begin our presentation this morning, with our 2012 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 and good morning, Ladies and Gentlemen. In 2012, we achieved record sales and earnings as a result of our acquisitions strategy and global footprint. Here are a few highlights. Our organic growth and acquisition drove sales 13% higher, to $1.94 billion. Lochinvar, acquired in the third quarter of 2011, achieved $226 million in revenues. In China, our sales of A.O. Smith brand of products grew 20%.

Our earnings improved to $3.03 per share, which excludes a $0.46 per share in items unrelated to ongoing operations, including a gain on sale of the Regal Beloit shares, received with the divestiture of our motor business of $0.36 per share. A gain of $0.04 per share related to the revisions of our estimate of the Lochinvar earn-out. And $0.06 per share associated with the settlement with a component supplier in Canada. Lochinvar contributed at the high end of our profit expectations and we are extremely pleased with the team and the business. We met 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. Our slide deck from the day is currently available on our website.

Last, but not in anyway least, Ajita Rajendra has assumed the CEO role at the beginning of January. Ajita and I have worked together at A.O. Smith and a previous company, and he's an outstanding leader and manager. He and I worked on developing the strategy we laid out at our Analyst Day, and Ajita and the team are committed to it. I plan to serve the Company and its shareholders in the role of Executive Chairman, at least through 2013. John, I'll now turn the call over to you to elaborate on our fourth quarter and full year results.

Thank you, Paul. Sales for the full year of $1.9 billion were 13% higher than the previous year. Lochinvar, which we acquired in August 2011, incrementally added $150 million in sales, and A.O. Smith branded products in China grew 20% to almost $450 million. Adjusted earnings of $3.03 per share were 44% higher than in 2011, when the $0.46 per share gain in 2012, which was described by Paul, and the $0.28 per share net gain for several one-time items in 2011, are excluded from the comparisons. Sales in our North America segment, of $1.4 billion increased 11% compared with the prior year. This segment includes our US and Canadian water heater and boiler businesses.

In addition to incremental sales of approximately $140 million from Lochinvar's North American boiler business, we experienced higher volumes of US residential and commercial water heaters. These increases were partially offset by lower tankless and Canadian water heater volumes. The results of our China, India and European businesses are captured in our Rest of World segment. Segment sales of $542.5 million increased 19% compared with 2011. Increase in sales was due to a 20% increase in sales of A.O. Smith branded product in China, primarily driven by higher-priced product mix, continuing market share gains, particularly in our gas tankless and water treatment products, and pricing actions.

North America operating earnings of $193 million were $41 million higher than in 2011. The 2012 results exclude the $7.2 million combined benefit from the Canadian components supplier settlement, and the revision to the Lochinvar earn-out. And the 2011 results exclude the $3 million net gain from a similar component settlement and increase to the Canadian warranty reserve. Lochinvar acquisition incrementally added $38 million top rating earnings in 2012. In addition, the segment benefited from higher US residential and commercial volumes. As a result, the segment's operating margin excluding non-operating items, improved significantly to 13.5% in 2012.

Rest of World operating earnings of $60 million improved 40% compared with 2011, driven by higher China sales and smaller losses at our non-A.O. Smith branded water treatment business. Which were partially offset by larger losses in India due to a new product introduction cost and brand-building expenses. As a result, operating margin improved to 11%. Our corporate and other expenses were $44 million compared with $46 million the previous year, when the gain from the RBC share activities excluded in both years. Corporate expenses in 2012 benefited from higher interest income, which was partially offset by higher pension costs. Total operating profit, excluding one time items, improved 41% to $209 million.

The business performed extremely well in the fourth quarter. Sales of $524 million were 10% higher than the previous year. Sales of A.O. Smith branded products in China grew 24% to $129 million during the quarter, and demand for US residential water heaters increased, partially driven by the Super Sandy Storm. Earnings of $0.91 per share were 34% higher than in 2011, when the $0.06 per share gain from a settlement with the Canadian component supplier and the $0.04 per share expense associated with the final revision to the Lochinvar earn-out adjustments are excluded from the comparison.

Sales in our North American segment of $376 million increased 6% over the prior year. We experienced higher volume of residential water heaters in the US, partially due to the replacement demand from Super Storm Sandy. Which we estimate we have added $9 million to our fourth quarter sales. Increased demand for boilers, including high efficiency, condensing boilers, also drove segment sales higher. Rest of World segment sales of $157 million increased 21%, compared with 2011, primarily due to a 24% increase in sales of A.O. Smith branded products in China. Higher China sales were driven by a favorable mix in new products with more robust features and benefits, as well as a customer pre-buy in the quarter to achieve volume incentive rebates.

Higher water heater sales in India also contributed to the increase in year-over-year sales. North America operating earnings of $55 million were 18% higher than in 2011. The results exclude the $800,000 net benefit from the component supplier settlement, which was partially offset by the final revision to the Lochinvar earn-out. In addition to the profit from higher sales of residential replacement units associated with the hurricane, Lochinvar added $15 million top-rated earnings in the quarter compared to $10 million last year due to realization of cost synergies and higher volumes. As a result, the segment's operating margin, excluding non-operating items, improved significantly to 14.6% in 2012.

Rest of World operating earnings of $20 million improved 71% compared with the previous year, driven by higher China sales, and smaller losses on our non-A.O. Smith branded water treatment business. As a result, operating margin improved to 13%. Our corporate and other expenses were $13 million, significantly higher than 2011, primarily due to the absence of dividends from the now sold RBC shares, and higher pension costs. Total operating profit, excluding the non-operating items improved 25% to $63 million. Cash provided by continuing operations was $171 million for the full year 2012 compared with $61 million in 2011. 2011 cash flow was impacted by an after-tax contribution to our pension plan of approximately $125 million. An earn-out of $13.5 million was paid to the former owners of Lochinvar in December 2012.

Our liquidity position and cash balance sheet remain strong. Our debt-to-capital ratio declined to 17% compared with 19% 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 2012. We repurchased approximately 427,000 shares of our stock in 2012, at an average price of $51.60, for a total of $22 million. We have approximately 462,000 shares remaining on our existing repurchase program, previously approved by our Board.

We project our cash flow from operations for 2013 to be between $200 million and $220 million. Our capital expenditures are expected to be between $80 million and $90 million in 2013, which includes approximately $40 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 between $55 million and $60 million in 2013. We estimate our effective tax rate to be approximately 30% in 2013. Excluding the impact from non-operating pension costs, about which I will elaborate on the next slide, our corporate and other expenses are expected to increase in 2013 to $48 million, primarily due to lower investment income on our offshore cash. One final subject before I turn the call back to Ajita.

In our press release this mornings, we introduced new non-GAAP financial measures related to pension accounting. Significant declines in interest rates over the past several years have caused an extraordinary increase in certain components of pension expense that we consider to be unrelated to the underlying operating performance of our business. In addition, we have made changes to our pension plan, including closing the plan to new entrants effective January 1, 2010, and freezing the plan for the majority of existing participants effective January 1, 2015, which we believe will significantly decrease pension expense beginning in 2015.

In order to provide improved transparency into the operating results of our business, beginning in 2013, we will provide non-GAAP earnings measures, adjusted earnings and adjusted earnings per share, that exclude non-operating pension costs consisting of interest costs, expected return on plan assets, amortization of actuarial gains, losses, and curtailments and other one-time charges. In addition, our segment reporting will also present non-GAAP operating earnings which exclude non-operating pension costs, and be identified as adjusted segment operating earnings. 2013 guidance is being provided for GAAP, EPS, and adjusted EPS.

Consistent with other companies who have reported similar transparencies for pension costs, we have designated service costs and prior service costs as the components which are most relevant to the operating costs of our business. Operating pension costs were $7 million in 2012, and we project them to increase in 2013 to $8.5 million. Total estimated pension costs of $27.6 million for 2013 are significantly higher than the $13.8 million recorded in 2012 as a result of continued declines in interest rates, and a reduction in our expected rate of return on plan assets.

Adjusted earnings and adjusted EPS are reconciled to GAAP measures on this slide. We have also prepared quarterly and annual reconciliations of adjusted earnings, adjusted EPS, and adjusted segment operating earnings, and an annual schedule of components of pension expense for the years 2010 to 2012, which are provided in the supplemental financial data documents posted in the Investor Relations section on A.O. Smith's website. I will now turn the call the call over to Ajita, who will elaborate on our 2013 outlook and our acquisition strategy.

Thanks, John. This morning, we announced our non-GAAP 2013 adjusted earnings guidance of $3.25 to $3.45 per share, the definition of which John just described. We also provided GAAP earnings guidance of $3 to $3.20 per share. Our guidance does not include the impact from future acquisition. As shown on the previous slide, the mid-point of our 2013, adjusted earnings guidance represents approximately a 25%, five year earnings CAGR and an approximately 9% increase compared with our 2012 adjusted EPS, modified for the non-operating items including Hurricane Sandy.

Our outlook for 2013 includes the following assumptions. First, we continue to remain positive on our growth in China. We expect our sales of A.O. Smith branded products for the full year will grow at a rate of 15% in 2013. I would like to also elaborate on some recent activities associated with our distribution channel. We entered 2012 with 5,500 retail outlets in China, including specialty stores. This is lower than our original expectations, as we closed almost 500 underperforming stores last year.

Collectively the stores which were closed contributed annualized sales of approximately $5 million, or approximately 1% of our China revenue. The stores we closed had similar SG&A costs as our productive stores so the closures will be beneficial to our profitability going forward. We plan to open 350 net new stores in 2013, and continue our efforts to aggressively cull underperforming stores. We expect that continued expansion of our distribution channel, continued market share gains from our premium brand, including water treatment, and continued increasing in the average sales price per unit due to new products will drive growth in 2013.

Second, we expect to continue to benefit from the transition from lower efficiency non-condensing boilers to high efficiency condensing boilers. Our Lochinvar brand's market leading condensing boilers continue to offer a compelling payback in the form of energy savings, and our boiler operations have 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 our boiler portfolio with larger BTU input models, and has gained excellent market acceptance. We also expect to have the first A.O. Smith branded boilers approved in China and ready for sale in 2013. As a result, we expect our boiler business to grow approximately 10%, well ahead of GDP growth in the US.

Third, we expect US commercial water heater volumes to be similar to last year, about 147,000 units. The strength in 2012 commercial volumes, up 2% from the prior year, pleasantly surprised us. We are not expecting an additional increase in 2013, due to the lack of strong new commercial construction indicators at this time. We expect the new construction component of North American residential water heater volumes to be up slightly in 2012. The forecast we have seen indicate that the number of housing completions are expected to be about 150,000 higher in 2013, compared with 2012, resulting in a similar increase in residential water heater volumes.

Fourth, given the challenging macro environment in the euro zone, I want to remind you that we have minimal exposure in that region. This is an exciting and transformative time for our Company. 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 active.

As we presented at our Analyst Day, we expect to grow organically over 7% per year, which would result in $2.4 billion in sales in 2015. Adding our dry power and making some assumptions about acquisitions, we expect to achieve revenues in excess of $3 billion, with one-third from higher growth emerging regions of the world. Using these growth assumptions, we expect our existing businesses to deliver earnings of $4.30 per share in 2015. And $5 per share in 2015, when use of our cash and borrowing capacity are added to our organic growth.

Based on our core competencies, a 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 in emerging 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 to provide value to our shareholders.

Our integration of Lochinvar is 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. You have seen this slide before, and 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. We will now open the lines for your questions. Mary, we are ready to take questions now.

(Operator Instructions)

Scott Graham, Jefferies.

Good morning. Just really two questions for you, Ajita and Paul. I was hoping you can rank order for us when you have the sales growth that you did outside of China. Could you rank order us, North American resi-retail, versus resi-wholesale, versus commercial. I'm assuming commercial was down? I was wondering if you could answer how the other segments ranked for you?

We normally don't break it between wholesale and then retail, but the residential was definitely up as you said, partially due to over 50% that was due to the Super Storm Sandy. And commercial was down, which we expected because of the pre-buy that happened last year. It was probably down not as much as we originally forecast, but it was down.

Okay. The other question is kind of the elephant in the room question on acquisitions, because I know that you guys were signaling that, at your Analyst meeting, that you thought you had a line of sight on a couple, and then, I understand, as the second half progressed, that you needed to maybe walk away from those same couple. I was just wondering if you can give me where we are in the M&A process, because it's been about 1.5 years, and I know you have cash burning a hole in your pocket, particularly internationally. Have you, I'm not asking if you've relaxed your financial criteria, but have you maybe opened up some of the markets that you're looking at to try to get something done? Or is this just a matter of sifting through the current pipeline and finding something that ultimately works?

Scott, our pipeline for acquisitions is very active. It's been, like you said, it's been 1.5 years. I wish we could have had an acquisition behind us, but we've laid out very clear financial and strategic guidelines, in terms of what type of acquisitions we're going to be after, and we are going to be pretty disciplined in our process. We want to make sure that any acquisition we make is strategically relevant and creates value for our shareholders. We want to make sure we don't make the wrong acquisition. So it's been active. We have looked at a number of them. We've turned down a number of them, and we continue to look within the guidelines that we provided. I wish we could have had one under our belts, but we will do the right one.

All right. Fair enough. I guess maybe the question that stems from there is that, if things do not -- or you are unable to close maybe the goal that you have between now and 2015 on the capital deployment -- I think it was like $800 million or something like that, at what point do we start to accelerate share repurchases with that capital deployment? Is a mid-year '13 where we say, you know what, we're building enough cash, and we need to buy back some stock? Maybe you could give us a little color on that.

Yes, this is Paul. We look at that at every Board meeting, and we are constantly looking at it and evaluating what we do with the capital. We're not going to put deadlines or time limits on that.

Fair enough. All right. Thanks.

Sanjay Shrestha, Lazard Capital Markets.

Okay, thank you. Good morning, guys. A couple of questions. First, I just want to understand the guidance for 2013, and how much conservatism is there, because when you plug in all of things you guys talk about, in terms of Lochinvar, margins expanding in China, and things getting relatively better in the US residential market, and the contribution margin. I mean, it is difficult to see that low end of the range, so can you guys help us understand some of the puts and takes? And, by the way, appreciate the conservatism on your part all the time. What am I missing here?

Well, I mean, I won't say you're missing anything. I think you listed the major comments. We're not necessarily comfortable that the housing recovery is in existence. We have certainly started to see parts of it in the last half of the year, but we're kind of a wait-and-see on that. We're comfortable with our growth rate in China, but you always have exposures in China from the standpoint of their economy were to slow, but we're comfortable with our 15% grow rate. Lochinvar, we're comfortable with our 10%. We mentioned the fact we've had some headwind. One was the loss of interest income, and that was just a function of US dollar deposits in China earning quite a bit less in 2013 than 2012. As we've tried to be in the past, we are conservative in our estimates.

Okay, fair enough. Two more questions then for me, guys. Once you're done with this $80 million to $90 million in CapEx, your housekeeping one, so as you go into '14 and '15, that CapEx number really falls down to $40 million or $45 million in your maintenance CapEx number, right?

Yes, we would think $40 million to $50 million would be a reasonable assumption as we go forward, which is about our depreciation rate.

Got it. And one question again on the acquisition front, if I may. I know you guys don't want to get into too much detail, but two-part question. One, if there is any comment you guys could share with us about this [non-blue paper], commenting about today maybe close to closing a transaction there, some news media is printing that. And two, as we look at that pipeline for you guys right now, in terms of what you could buy, a mix of large, small, versus international opportunity. Can you give us any other granularity on that? Are there three large ones? Two large ones? How should we think about it? Thank you very much.

The acquisition in Turkey, that's a growing region of the world. It's a small acquisition, but we see that as a potential platform for bolt-on acquisitions on top of that, and we don't see it having big impact going forward. Sanjay, I didn't really hear the rest of your question.

I think he was asking about, can we give any color to the size of the, are we looking at two or three big ones or small ones or international. All we can really say, Sanjay, is it's all over the map. We have some of everything you mentioned, but we're not going to try to put any quantification on it. It just wouldn't be, frankly, we wouldn't be adding too much to the conversation if we tried to do that.

All right. I completely understand. Fair enough. Thanks, guys, and once again, congratulations on great execution.

Thank you.

Todd Vencil from Sterne Agee.

Good morning, guys.

Morning.

So I want to drill back in on the guidance just a little bit, and recognizing, John, what you said about the headwind from the loss of the interest income. It does look, and I just want to make sure I'm looking at this right, if I look at, and I'm looking at Slide 14 in the deck, if I look at 2012 versus 2013 guidance on both, a GAAP diluted EPS from continuing Ops line, and also on the adjusted EPS from continuing Ops, you're looking for a pretty significant decline, 2012 to 2013 in EPS on either of those measures, apples to apples.

And given that, as you mentioned, you're looking for generally higher revenues and volumes except in commercial, should we be looking for significant decline in the margin profile there, in addition to that loss of interest income you mentioned?

No, Todd, let me go through that example on Slide 14. What that implies, when you take out the one-time items, which we have this year, which was primarily the RBC stock. You take that $0.46 out, you take the benefit we feel we got from Hurricane Sandy, and you put pension on an apples and apples basis, i.e. service cost, you would be, 2012 would be $3.08. 2013 guidance, our midpoint would be $3.35 on an apples and apples basis, so that's taking out the one-time items of '12, getting '12 pension down to service cost. So, we are saying, and that's why Ajita said this speech, we see about a 9% increase in EPS year-over-year.

And all I was alluding to is that's a positive margin improvement. Lochinvar, China, all those improvements, and a little bit of help from residential, as we said, we see completions going up 150,000 units, and then one of the headwinds is about $5 million loss of interest income. But we're going up, in our mind, 9% on an apples and apples basis.

Got it. That makes more sense. Sorry for the confusion. Thanks a lot.

Matt Summerville, KeyBanc.

This is actually Joe Radigan on for Matt. Can you quantify the pre-buy in China, first of all? And then, as a follow-up question to that, how do you feel about inventory levels after that pre-buy in China, as well as inventory levels in North America?

I think that the China pre-buy, and we're estimating based on inventory levels, was probably about $5 million to $7 million. So even without that, they had a great quarter. And that's not unusual at the end of the year from trying to get V.I.P. incentives, so I think overall, we are comfortable with the China inventories. When you look at the residential, in the US, I think to the best of my knowledge, we are comfortable where the inventories levels are.

We've told you, some of our retail customers have actually taken their levels down this year, so we certainly think they are in decent shape, and everything we know about our wholesale customers, they are in decent shape. I think we're ending the year quite well from an inventory standpoint, with a little noise in China.

Okay. And then just a question on the commercial outlook. You guided to essentially flat industry shipments. It seems like it's surprised on the upside, at last several years, without much help from non-res construction. You guys appear to be taking share with the high efficiency, ROI-type upgrades. Why wouldn't that not continue? You've got, even without an uptick in non-res construction, why would that trend reverse itself?

Well, everything you said is right, we started the year thinking it was going to be in the high 130s, and it came. We think it's going to be even better than last year's 145, so you're exactly right there. You're right, we're gaining share there. What we just don't see a lot of, is the commercial construction benefit. If that happens, then it will turn out our numbers are probably too conservative, but we're not seeing that, and you're right. We were surprised by how strong it was this year.

Okay. And then just one last question, in terms of taking Lochinvar to China, what's the plan for distribution there? And then how should we think about how that business ramps, considering it's starting at zero? How should we think about the ramp there over the next several years?

Taking the product to China, we have to go through all of the import requirements, et cetera, in China, and making sure that we are complying with all of their requirements. That takes time, because the Chinese government is stringent about inspecting factories and doing all that type of stuff. It's going to be a slow ramp-up. It's not going to be a real fast ramp-up, but we continue to feel that the long-term potential for that product line in China is tremendous.

And then, Ajita, is that a direct sale, or do you go through a third party distributor there?

We will be going through third parties there. It's not a direct sale to the end user.

Okay. Thank you, guys.

Robert Kelly, Sidoti.

Hello, good morning. Thanks for taking my question. Just a point of clarification, the res industry shipments growth that you see in '13, that's coming all from the new side? You're not hearing anything positive on replacement?

I think replacement continues. Replacement has been steady and that part of it we can expect to continue to be steady, and the growth is going to come from the new construction coming back.

There's no chatter amongst your distributors about the warranties coming up, the pent-up demand?

I think there's probably a little bit. Because there is a certain amount of discretionary replacement which was stifled over the last few years. So we could have a little bit of that coming back also, but in the scheme of things, it's primarily going to be new construction that drives it.

We would also hope at some point the heavy construction improvement that happened in the late '90s, and early 2000s, with the average life being 12 years or whatever, would start helping replacement. We're just not building that really in.

Okay, fair enough. Apologize if you've covered this already. Could you give us a sense of where we are with the water filtration business in Asia? What your expectations are for 2013, and profitability in India? What the outlook is there for '13?

There's different components of that business, and let me start with the branded business in China. The branded water treatment business in China is doing extremely well. We just about doubled the business in 2012. And we expect continued strong growth and gain of market share in that segment of the business. In the non-branded -- non-A.O. Smith branded business, we again had very nice growth in the business, but in that segment of the business, we have been having some operational issues, et cetera, and we are putting those behind us and continuing to grow the business.

Overall, we had very good incremental growth in both top line and bottom line in that business in China. And we also expect that in the near future, sometime in 2014, we expect to be introducing that business, the water treatment business in India. So that's another growth opportunity going forward.

Okay, great. And then just as far as, you had a couple rounds of price increases during 2012. Seemingly, all your markets, but steel costs were down slightly. How much did that help you in 2012? And what's your expectation for raw materials trends in '13?

You know, overall, I think that as we look at pricing, what we try to do is balance, make sure that we are in balance in terms of our cost increases. With some of our customers, there are escalators, or indices for steel prices that are passed on, and some customers there are not. But overall, we feel pretty comfortable with where the balance is. And it's meeting our expectations. Steel prices are down, but again, a lot of that contractually go back to our customers also. Not all of them, but some of them. But overall, we feel comfortable with the balance.

No material benefit from weaker steel in 2012?

Yes, there was some benefit. When we looked at the price increase we have in 2012, and incorporated many different costs, healthcare, et cetera, but it also incorporated the steel increase that happened from 2010 to 2012. So there was some material cost benefit, but it was not significant in 2012.

Thanks.

David Rose from Wedbush Securities.

Good morning. I was hoping maybe we can dissect the margins a little bit more, if you can provide us a little bit more color and any of the effects on fixed cost absorption, the quarter pricing. And then, as we look into 2013, at least in the first quarter, what are your expectations from margins, and what would be the drivers for that going into the first quarter?

I think from a margin standpoint, you can see that Lochinvar did very well from the numbers we gave you, and part of that is driven by their fourth quarter is always going to be their strongest because their parts business is strongest and they have very good margins there. Their parts business is strongest in the fourth quarter, because people turn on their boilers, and all of a sudden it doesn't work sometimes, and instead of replacing the boiler, they replace parts. So that's very typical. You also see very strong margins on North America, and that was benefited by a pretty significant increase in residential volumes, which we've talked about. That was partly offset by commercial, which is one of our highest margin businesses, being down.

We have the same benefit in the fourth quarter for China. Their margins were very, very good, which you would expect, because that's starting to come in more at a contribution margin. So I think the fourth quarter margins were not necessarily indicative of a full year, because that was our highest volume quarter, significantly. As we get into the first quarter of next year, we wouldn't expect volumes to be quite as strong as what they are this quarter, obviously, because of some of the things we talked about, so I think it would be natural to think that margins would decline somewhat. Year-over-year, I don't think you'll see a significant difference in margins. You'll see some improvement, I think, continued improvement Rest of the World. North America, when you take out some of this pension noise, I think you'll see improvement also.

Can you talk about labor in China, and then raw material costs expectations? You mentioned the escalators, but at some point in time, does the price costs catch up to you in 2013?

I think China labor, everybody is seeing increases there, but fortunately, that's a relatively small cost of our total cost of our unit. So we have certainly seen that. From a cost price standpoint, as Ajita alluded to, we think we're at a fair point for A.O. Smith and our customers, and we'll evaluate as we go forward, depending on what some of our input costs adjust.

Okay. Great, thank you. And lastly, if I may, you historically talked about same-store sales trends in tier 1, tier 2 markets. I imagine the culling of stores helps improve the numbers a little bit, but can you provide us some color on what tier 1 and tier 2 same-store sales were like for the quarter?

Actually, fourth quarter same-store sales were strong. Some of the housing indicators in China have perked up a little bit. We're not sure if they're permanent or not. But clearly, we saw positive same-store sales both tier 1 and tier 2, in China, and we'll obviously watch that closely. Because, like I said, some of the housing indicators there, we just saw an article in the Wall Street Journal last week started to say new housing occupancy might be picking up. We'll wait and see.

Okay, great. Thanks, John.

Donald Bisson, Century Capital.

Thanks, I figured out the answer to my question. Thanks.

(Operator Instructions)

Ted Wheeler, Buckingham Research.

Good morning, everyone.

Morning, Ted.

Great, great job. On the China pricing, you alluded to, have you caught up there with where you want to be, or is there still room to have pricing action in China?

I think we are at a comfortable spot in China. We increased prices the last couple of years, which has been unusual for China, and we were able to pass them along because of the inflation that the market was seeing. But what we try to do in China is to increase the average cost of an item due to a better mix, because the new products that have better features and benefits. That's how we try to drive the average price of our units up. It's been a very successful strategy so far.

Yes. Lastly, any color on the retail big box negotiation this year versus where you've been in the last year or so? How does it feel? If you could give us color on that.

Obviously, we are always in negotiations with our customers, and I'd rather not comment at any particular time in terms of how they're going. They are normal, our relationships are very strong.

And the push on historic costs to catch up by, I think you alluded to, is pretty much stabilized? Is that a fair way to think about it?

Yes.

Good, thank you.

Thanks, Ted.

Thank you, I show no further questions at this time, and would like to turn the conference back to Ajita Rajendra for closing remarks.

Thanks very much, everybody. I really appreciate your attention and your interest in our Company. If you have any further questions, you know how to find us. Thanks very much.

Ladies and Gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect at this time.