A O Smith Corp (AOS) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A.O. Smith Corp. third-quarter 2015 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Ms. Patricia Ackerman. Ma'am, you may begin.

Thank you, Shanelle. Good morning, ladies and gentlemen, and thank you for joining us on our 2015 third-quarter results conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer, and John Kita, Chief Financial Officer.

Before we begin with Ajita'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.

I will now turn the call over to Ajita, who will begin with remarks on slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. We set earnings records again in the third quarter, and sales were the second highest in Company history.

Here are a few highlights. Organic growth in both our segments drove sales 7.5% higher to a third-quarter record of $625 million. Despite being a record, this was lower than our previous estimate for the third quarter, as we believe a pre-buy of residential water heaters in the first quarter ultimately negatively impacted third-quarter volume. In addition, the decline in the value of the Chinese currency negatively impacted sales by $5 million. China sales were up over 13% in local currency. Net earnings of $0.82 per share were 39% higher than the adjusted earnings per share of $0.59 in 2014.

We continue to review our capital allocation, and dedicate a portion to return to shareholders. In addition to our regular dividend, we repurchased approximately 850,000 shares for $57 million during the third quarter. Our transition to NAECA III compliance products is complete. This was a complex project impacting approximately 80% of our US residential water heaters.

John will now describe our sales in more detail, beginning with slide 4.

Thank you, Ajita. Sales in the third quarter of $625 million were 7.5% higher than the previous year. Net earnings of $74 million were 38% higher than third-quarter adjusted earnings in 2014. As shown on slide 5, net earnings of $0.82 per share improved 39% compared with adjusted earnings per share of $0.59 in 2014.

Sales in our North America segment of $417 million increased 6% over 2014, driven by price increases in the US and Canada for residential and commercial water heaters, and higher volumes of commercial water heaters and commercial boilers. Residential volumes declined, as we believe channel inventory continues to adjust to the pre-buy in the first quarter.

Rest of world segment sales of $217 million increased over 9% compared with 2014. China sales increased over 13% in local currency, driven by higher demand for water heaters and water treatment products. Higher China sales were partially offset by currency translation, and lower sales in India and Europe. Consistent with prior years, we believe inventory levels at some of our customers in China were elevated in advance of the one-week holiday in October.

On slide 7, North America operating earnings of $91 million were 61% higher than adjusted segment operating earnings in the previous year, and operating margin of 21.7% was significantly above the 14.4% adjusted operating margin one year ago. Pricing actions in the US and Canada, higher sales of Lochinvar-branded products and commercial water heaters, and lower steel and ERP implementation costs, contributed to the significantly improved segment performance. The impact to profits from lower residential volumes in the US partially offset these favorable factors.

Rest of world operating earnings of $27 million declined compared with 2014. Higher sales and lower steel costs were more than offset by lower sales of highly profitable commercial water heaters in China, and increased selling, general and administrative expenses. Higher promotion costs in advance of China's one-week holiday in October, as well as higher development and advertising costs associated with the 2015 launch of air purification in China, and water treatment products in India, were the primary drivers of higher segment SG&A expenses.

Segment operating earnings were reduced by almost $1 million due to currency translation. As a result of those factors, third-quarter 2015 operating margin of 12.6% was lower than the 15.1% operating margin in 2014. Our corporate expenses declined from the adjusted corporate expenses the prior year, primarily as a result of higher interest income.

Our effective income tax rate during the first nine months of 2015 of 30.7% was higher than the previous year, primarily due to the change in our geographic earning mix. We anticipate our effective income tax rate for the full year will be similar to earlier projections of approximately 30.5%.

Cash provided by continuing operations during the first nine months of 2015 was $232 million compared with $165 million provided in 2014, driven primarily by higher earnings and smaller outlays for working capital in the 2015 period. Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 15% at the end of September 2015. We have cash balances totaling more than $600 million located offshore, and our net cash position was approximately $345 million at the end of September.

During the first nine months of the year, we repurchased approximately 1.6 million shares of common stock for a total of $104 million under a 10b5-1 automatic trading plan and in the open market. We had approximately 900,000 shares remaining on our existing authorization authority at the end of September. Depending on factors such as stock price, working capital requirements, and alternative investment opportunities, we expect to spend approximately $128 million on share repurchase activity in 2015, resulting in net cash levels similar to 2014 year-end levels. This is consistent with our stated capital allocation strategy.

Please turn to slide 9 for several full-year assumptions. We expect our cash flow from operations in 2015 to be approximately $300 million. We expect capital expenditures to be between $85 million and $90 million in 2015, which includes approximately $17 million to support the ERP implementation, and approximately $30 million related to capacity expansions in China and in the US, with the US portion in support of Lochinvar-branded sales. Our depreciation and amortization expense is expected to be approximately $65 million in 2015.

We successfully completed our first two ERP go-live milestones in August 2014 and May 2015. We expect to convert the majority of our North America plant sites by the end of 2016. ERP implementation expenses were $14 million in 2014, and are projected to be about $17 million in 2015. Our corporate and other expenses are expected to be approximately $43 million in 2015.

This morning, we increased our 2015 EPS guidance to be between $3.08 and $3.12 per share. The mid-point of our upgraded EPS guidance represents a 28% increase in EPS compared with our 2014 adjusted results.

I will now turn the call back to Ajita, who will summarize the assumptions in our 2015 outlook and our growth strategy, beginning on slide 11. Ajita?

Thank you, John. Our China business grew 15% in local currency through the first nine months of 2015. Many of you have seen our China growth model. In the past, we have used a multiple of China GDP as a simple proxy for our China growth. We do not believe that China GDP is the only driver of our growth, nor does it adequately reflect our potential in China. We are a consumer products Company in China, which distinguishes us from most industrial companies operating in China today.

We have three growth drivers underpinning our China business, which gives us the confidence to continue to project an annual growth rate of approximately 15% in local currency for the foreseeable future. The first driver is overall market growth, which we believe is impacted by household formation and a growing replacement market. One factor that might not be obvious when looking at our China business for the first time is that a developer is very unlikely to install water heater or water purification products in apartments offered for sale. In fact, about 80% of high-rise apartments in China are sold without water heaters or other appliances. The newly formed household essentially buys an apartment with four walls, and decorates it or finishes it after purchase.

We view the unsold apartment as a major opportunity in China, which is very different than in the US. Our focus, therefore, is not on new apartments that have been built, but on the sales of apartments to individual homeowners, which, by the way, is increasing. The three-month moving average year-over-year growth rate of new apartment square footage sold was in the mid-teens in July and in August.

The other proxies we use to track water heater and water treatment appliance sales growth are retail sales, as well as growth in the consumption portion of GDP. The IMF forecast for China consumption growth, which was published in August, is 7% this year, and almost 8% next year. With continued urbanization, growth in the middle class, and a replacement and upgrade market of 50% in the largest cities, this is based on our surveys, we expect strong market growth to continue in China for quite some time into the foreseeable future.

The second growth driver is market share gains, and increases in average price. We have a strong market position by valuing the electric wall-hung category, our position in gas tankless, while a leader, is less than 20% by value. We see opportunity to gain more share in our well-accepted and patented super-quiet model. Our commitment to engineering resources will continue to result in new products with features and benefits in which consumers see value, and for which they are willing to pay an incrementally higher price. This results in a favorable mix impact, and increases the average price per unit sold.

The third growth driver is fast-growing ancillary product categories, the most significant example of which is water treatment. The A.O. Smith branded water treatment added 5 percentage points of growth to our total China volume in each of the last two years, and is expected to grow from $75 million last year to over $105 million this year. In addition, we expect to sell approximately $8 million in air purifiers in 2015, after launching the A.O. Smith branded category in March of this year. The combination of A.O. Smith branded water treatment and air purifiers will add over 5 percentage points of growth this year.

The last two drivers I mentioned are primarily in our control as we continue to invest behind them. The first is a function of the growing replacement market and urban household formation, especially at the income level which consumers typically buy our products, and which is forecasted to increase significantly over the next few years. Combining these three growth drivers gives us the confidence that we will continue to grow at approximately 15% annually in local currency for a number of years into the future.

On the next slide, I will describe our portfolio growth model. We believe our 8% organic growth potential for the next several years differentiates A.O. Smith among other industrial companies. We are comfortable with our projected China growth rate of approximately 15% in local currency, as I have explained.

Sales of Lochinvar-branded products grew over 9% during the first nine months of 2015, which included commercial boilers growing at a faster rate. Given the strength in our end markets, we continue to believe sales of Lochinvar-branded products will grow approximately 10% per year.

The residential water heater industry continues to transition through the NAECA III regulatory change, as channel inventories built in the first half of the year continue to run out. Based on our volumes through the first nine months of the year, we believe the industry volume will be flat for the year, slightly less than the pace year to date. Our estimate for industry volumes of commercial water heaters is 178,000, or a 6% increase over last year, and also slightly less than the pace year to date.

We expect sales in India will be approximately $15 million, down from our earlier projection of $20 million due to a decline in new-home sales that is a result of lower-than-expected sales of water heater and water treatment products. Losses are expected to be slightly higher than the prior year.

Slide 13, the next slide, outlines our four options for capital allocation. One, we continue to invest in ourselves. As John mentioned earlier, we expect to spend approximately $85 million to $90 million this year on capital projects. Two, we have borrowing capacity and cash to support over $1 billion worth of acquisitions, and our strategy has not changed. We remain focused on water heating and water treating companies around the world, as well as business which will leverage our brand and distribution channels in China.

Three, we will deliver a growing, sustainable and competitive dividend. We have increased our dividend by 20% or more in each of the last four years. And four, we are satisfied with the cash and borrowing capacity we have for acquisitions, therefore, we are comfortable repurchasing shares in 2015 in an amount slightly less than the free cash flow after dividends, or approximately $130 million.

This concludes our prepared remarks, and now we are open for questions.

(Operator Instructions)

Jeff Hammond, KeyBanc Capital Markets.

Can you hear me?

Can now.

Okay. The margin's exceptional in North America. Can you talk about any aberrations to the good? And talk about sustainability of those margins.

Well as we'd talked in the past, it is several significant items. We've have had price increases that we've talked about in commercial and residential and also in Canada. Lochinvar sales were up in the third quarter, and their historically back half of the year is much stronger than the first half of the year. So that significantly helps margins.

Commercial volumes were also up and material costs were down. So it's a series of many items. Now, the current margins, they were over 21% in North America, again, are helped by Lochinvar in the second half of the year. We talked last quarter and said that on an ongoing annual basis, that 19% to 20% is reasonable at current commercial levels, pricing and material levels.

Okay. And then real quick on residential, what is your assessment of inventory that was pre-bought being run out? And then along those same lines, any feedback from distributors or the channel that consumers are reacting negatively to the higher price point products around the NAECA increase?

The first one is inventory levels. We said at the end of June they were slightly elevated. I guess now in hindsight, they were probably a little more elevated than what we thought.

If you look at what happened, the trend during the quarter, in July and August residentials were down about 5%, 4% to 5%. We are expecting in September they were down closer to 20%. Now part of that is a very difficult comp with the prior year, but the other part we are assuming is an adjustment of inventory levels.

I think, when you go back on what we said, when we started the year we said that we thought there was a pre-buy of 100,000 units in 2014. Then we rolled forward to the first quarter and the first quarter volumes were up 300,000. In the second quarter we said we assumed residential was going to be down about 10% and it was flat. We were surprised by that. And we, I will say prematurely, took our estimate for the industry up by about 150,000 units.

I think we are right back to where we started with our original projection, saying we think the industry is going to be flat for the year. And part of that's going to come out of September and October. So that would be our best guess.

I will comment on consumer pricing. I haven't heard anything. I'll make the comment that from a end-consumer product the price is very reasonable. You get a six-year warranty, you get a very energy efficient product, and it's going to last 12 to 14 years. In the appliance world is it a very reasonably priced end product. I have not heard any pushback, if you will. Ajita --

Yes, I think that is very accurate. There has been no pushback we're hearing in the marketplace in terms of from the end user.

Okay, thanks, guys.

Todd Vencil, Sterne, Agee & Leach, Inc.

Hey, good morning, guys.

Morning.

Sticking with North American residential for a second. If we look at the margin, is there any way to -- I think the three big categories you cited there were -- or that we would think about were the mix, resi down and the higher-margin commercial and Lochinvar up. There has got to be some production incrementals going on there.

And then price cost. On that price cost, obviously you had the price increase but the new units were more expensive. Have you actually seen an improvement in your price cost spread there, that you can tell?

Well, the only comment I will make is still costs have come down somewhat. Otherwise, I think you summarized it pretty well. It's a combination of price increases and non-NAECA and commercial, both in the USA and Canada.

We have higher-margin dollars associated with the NAECA product. We had a very strong, again, commercial, which helps both our Lochinvar and our commercial water heaters. And we had lower material costs. So it is the variety.

And then on top of it, compared to the prior year we had about $5 million less ERP costs. It is a variety of several items.

Got it, thanks. I think you just said this, but I will ask it a slightly different way to make sure. The 20% increase you guys put in on the NAECA products, that hold up even in the face of the decline in volumes that you have seen in the third quarter?

In the declines in volumes in the third quarter, as we've stated in the past, we did increase prices for the new NAECA III products on average 20%. And we have been very transparent with what the NAECA pricing increase is. We really can't comment any further on pricing, as we are the only public company in our industry.

Got, fair enough. Switching to China, just to make sure, you said, Ajita, I think that in the first nine months of the year China growth, ex currency, was about 15%.

Yes.

Okay. And then the inventory issues that you've mentioned heading into the holiday, are we through those at this point, do you think?

I don't think we necessarily said we had inventory issues. We said that inventory levels in the third quarter were up consistent with the prior year. And we think that was driven primarily by the holiday that comes in late September and goes through October. At this point I don't think we are uncomfortable with the inventory levels.

As John said, the increase we saw was in line with the increase we had last year.

Got it, understood. Thanks for that. Then, final one for me. If we think about the China business, and I want to make sure I am thinking about the math the right way, you mentioned that water treatment and air filtration added, I think you said, more than 5 percentage points to the growth rate? Should we take from that, that the growth rate on water heaters is around 10%?

When we break it into the three buckets, we really say that the first bucket is the water heater market and our expectation is it's going to grow about 7%. I'd say that is about what we are seeing and that was the formal number for last year and as we look at numbers. And then we are saying that is about 70% of our business, so that ends up about being 5 points.

The third bucket is the one you are alluding to. When you look at our water treatment for the last two years it went from 18 to 43 to 75. That added 5 points by itself. This year 73 to over 105 is going to add 4.5 points or whatever, and with the air purifier it will take us over about 5 points of growth. That is how we break it up. And then there is the second bucket, which you'd alluded to.

Got it, okay. Thanks for that.

Just another point to add to that is that we hear lots of, obviously, news about GDP dropping. The forecast has gone from 7% to 6.9%. But what impacts us more is consumption. Because unlike a lot of companies, we are manufacturing in China for the Chinese market and the Chinese consumer.

The consumption portion of GDP is what impacts us more. And the forecast, IMF forecast, for that component is growth of 7% to 8% in the next couple of years. It is very consistent with what we are seeing and what you are hearing from us.

Got it, thank you very much.

William Bremer, Maxim Group.

Good morning, Ajita, John and Pat.

Hey, Bill, good morning.

My first question is where steel prices are currently, does now the time that the Board thinks about locking in for the foreseeable future? How do you look at that given the balance sheet's growth?

And secondly, China, can you give us a sense on how much more investment is needed, specifically on the air purification? Is that basically being targeted for your stores? And then just an update on the store locations in terms of tier 1 through tier 3, please.

I will start with the last one. Store locations were about 8,000 stores, so that is up. I think the distribution of 40% in tier 1 and 60% in tier 2 and 3 is still pretty close. That hasn't changed.

Your first one is hedging. We continue to look at hedging. It is not a terribly liquid market, on the LME and on the exchanges. But we continue to look at it and we have made no formal decisions.

The second one was air purifiers. I think the one comment we have made is that given the significant growth in water treatment, and we think the potential for air purification, we are going to have to put some brick and mortar in China for those two businesses. We're evaluating the options right now on what to do there.

And I think, Bill, if your question was around the investment in terms of SG&A and advertising, et cetera, we have been saying that we lose about $4 million in the category, air purification category, and we are comfortable with that. It would be in line with what we have been saying.

And then one for you, John, on the ERP implementation. You mentioned $17 million. How much has been spent year to date there? Am I under the correct assumption of $5 million to hit in the fourth quarter?

Yes, I think the fourth quarter is about $4 million or $5 million hit, somewhere in that range is reasonable. We spent about $13 million year to date. We have been running at that $4 million to $5 million range, if you will.

That is exclusively in North America, correct?

That's exclusively in North America.

Great, thank you.

Kevin Maczka, BB&T Capital Markets.

Thanks, good morning.

Good morning.

First question, to make sure I am clear on the North American water heater forecast that the volumes will be flat this year. We had a big pre-buy in late 2014, the price increases hit in early 2015, why is it, again, that is starting to materialize in the form of 20% volume declines in September and October? Is that primarily a comp issue? I am wondering why are we seeing such a severe decline now?

It is a great question and obviously we did not necessarily anticipate it when we took volumes out. The best -- I will use the word -- guess is lead times -- if you go back to the first quarter, they certainly wanted -- our partners wanted some of the old product and we put them on allocation, but they got some. The new product came out and they certainly wanted some of that product.

And the lead times, I think for the industry, extended some, because we were changing 80% of our SKUs. It was a significant undertaking. I think there was safety stock built up, et cetera, et cetera, that's again, our estimate.

And that now lead times are back to more normal levels for us, and we would guess, for all of our competition. Now there is some excess inventory in the channel. That is the best, for lack of better word, that we can come up with.

I think a lot of just-in-time systems, they adjust outputs when lead times go out adjust downward when lead times shorten. I think it is an impact of that. As John said, it surprised us too. It was higher than we anticipated, but we don't see any major market impact that is causing that, other than inventory.

And so we are right back, as I said earlier, to our original estimate where we thought there was about 100,000 of pre-buy, 100,00 to 150,000 of pre-buy in the fourth quarter. And we said completions were going to be up 100,000 to 150, 000 and so those would wash. And we said the industry would be flat.

The thing to remember is the industry has grown pretty nicely over the last two years as replacement has become a bigger piece. So I think right now we are saying flat is a reasonable expectation.

Got it, it all makes sense. To get to flat, what does that imply for the remaining months of the year?

The remaining months of the year, the fourth quarter we would expect is going to be down. Again, part of that is a reflection of that pre-buy that happened last year, that 100,000, 150,000 units. So it ends up with the industry being down, I guess a couple hundred thousand units or something.

Okay. If I could just ask one more on China, and I appreciate all the comments and the nuance on the resi side with the purchasing the heaters after the apartment purchase. I am wondering if you can say a little bit more about what you are seeing on the commercial side? It sounds like that was a little bit softer. Is there some macro pressure on that side of the business there?

It did have an effect on margins in the third quarter. We have about a $30 million business last year. So it's not a huge business, but it is a very profitable business. Year to date we saw that it is down over 30%. And it specifically affected the third quarter by about $3 million, sales being down $3 million and profits being down $2 million.

The bad news is it had a significant effect. The good news is the business is only a $30 million business. And we have seen that in a couple of different parts. We saw that in our Lochinvar business, who sells boilers through a distributor. Those sales were down in the third quarter also relatively significantly.

The bad news is, yes, the commercial market is weak. The good news for us is it is not a huge component of our sales by any means.

This is in line with, again, things we have been reading about China where infrastructure spending has come down. And this is, again as John said, a small part of our business, but it is being impacted by that.

Okay, I will jump off after this. That's likely to continue, it sounds like, if in fact that China big picture macro pressure.

In theory. But again, if we are down to $20 million-some, we would think at some level that is the baseline. We are down from $30 million to probably a little over $20 million this year. I am not sure it will go much lower.

And again, it really does mask how well China really did in the quarter, because water heaters and water treatment were up very nicely. You take out that $3 million decline in sales, they were up 15% in all of their other businesses. So they had a very good quarter.

Margins were good, again, except for this effect of the commercial business as well as the translation of their margins -- the margin dollars, if you will. All in all, I think China had a very good quarter.

Okay, great, thank you.

Mike Halloran, Robert W. Baird.

Good morning, everyone.

Hi, Mike.

Staying on the China side and staying on the margins of specifically, you had the promotion costs that extended into the third quarter of this year. I think last year or maybe even the year before, they were flipped around, with very minimal promotion-oriented costs in the third quarter, more aggressively in the fourth quarter. Maybe you could talk about how that tracks as we move into the fourth quarter here, and if you expect some reversion.

I think we would expect that, and I think we have talked about that a little bit in previous calls, that last year we had higher margins in the first three quarters and then lower margins in the fourth quarter. And it was really partly what you said, a distribution of some of the SG&A costs. I think we've said that we expect this year it's going to be more of a level type margins for China, if you will.

Okay, that makes sense there. North America, not to beat a dead horse, but another question on the residential side. Is the implication then that once you work through September-October time period that the inventory levels are then about right-sized, and you see some more normalized trends? Or do you think that the inventory build stretches a little bit longer than the next couple of months, or the months we just had?

As we've talked to our partners, we would say it probably stretches through October, and then the anticipation is it's going to level off.

That make sense. Thanks, guys.

Samuel Eisner, Goldman Sachs.

Thanks very much and good morning, everyone.

Good morning.

Going back to the North American resi comments, I want to understand. You mentioned destocking. Is there a way to parse out, is there a difference in the channel between your wholesale customers as well as your retail customers?

In what sense, Sam?

I guess we know who your largest customer is on the retail side, or the home center side, but curious if there is a -- this destocking, is it across the board destocking? Is it more pronounced in one of those main channels) I want to understand it on a more granular level.

It is more pronounced in wholesale. I understand your question now. It is more pronounced in wholesale.

Got it, that is helpful there. On the margins, I'm going to try to ask it again, 700 basis points on a year-on-year basis is pretty phenomenal. You mentioned mix, at least for Lochinvar, it's always in the back half of the year, so that would not necessarily be a tailwind. Perhaps you can talk about mix on commercial as well as Lochinvar, absent of the normal 2H ramp that you would see from Lochinvar.

I am not exactly sure of the question, but I guess what I was implying is that we've said in the past that Lochinvar is about 60% of their earnings come in the last half of the year, 40% in the first half of the year. We are certainly seeing that in their commercial business; it's very strong, which has even better margins for them. So that is a contributor.

We have also seen our commercial business up year to date and in the third quarter, relatively significantly. And again, that is a big contributor because those two businesses are our highest margin businesses.

All right, I guess my point is though, Lochinvar is always going to be stronger in the back half of the year. So on a year-on-year basis there should not be a change in the profitability, unless you are mix is dramatically improved on the other, within commercial water heaters. So that's what I'm trying to understand.

Within them, their margin percentages were up very nicely for the quarter and year to date. And part of that is what you alluded to, commercial was up more, and so that is a contributor to that. I hope that answers the question, but yes, their margin percentage points was up very nicely year to date.

Understood. Sorry, don't mean to interrupt. Lastly on the rest of world growth rate, the roughly 9.5% that you guys grew, I recognize there is some FX headwinds there. Wondering if you can put that growth rate that you saw in the quarter into the three main buckets that, Ajita, you guys referred to as your overall rest of world growth. Thanks.

First of all, remember, rest of China was up about 13.5% not 9%. They were up about 13.5% in the quarter in local currency terms. I guess if you asked me, and I have not done it, but I would say it was 5% or so for water treatment/air purification. We think the market was probably up 4% to 5% when you adjust for -- I should say 6% and then you adjust for our 70% of the business.

And we continue to gain share in water the instantaneous side of the market and some price. I think it was reasonably split between those three buckets, for us to get the 13.5% in local currency terms.

I do want to caution that quarter by quarter that mix will change. And frankly, we are not really good at forecasting quarter by quarter. But from a longer-term or a annual perspective, we are very comfortable with those three buckets.

And it so happens that this quarter they are about a third each. There are times when one will be growing faster than the other and compensating. I just want to caution that it is not always a third, a third, a third for the three buckets.

Got it, that is very helpful. I'll get back in queue. Thanks.

Robert McCarthy, Stifel Nicolaus.

Good morning, everyone.

Good morning.

In terms of 2016, getting back to the sustainability of the North American margins given the very impressive performance, I think you alluded earlier on the call that given the factors that were set, you would have expected a more normalized level margin, in the 2016 timeframe could be 19% to 20%. What is the implication for pricing with respect to your North American product? Is it disciplined pricing? Or would you expect tougher pricing incrementally, particularly if volumes continue to be weak going into 2016?

One thing is, we cant and don't speculate on what is going to happen to price going forward. Again, we are the only public company and we are the only ones out here talking about our plan. Speculating on price is something we just don't do.

Okay, fair enough. Doubling down on the question, thinking about the de-val in China, do you think that's hurt any of the movement secularly to the high end of the market, your bread and butter in terms of -- or has it hurt pricing in any large degree? How do you think about the de-val in terms of the competitive dynamics for you in China?

We have not seen any movement away from our products, being on the high end. In fact, if you look at our short-term market shares in China, again from a value perspective, we have been inching up. So we have not seen any movement away from the higher-end products.

And I don't think we would expect, given the de-val, that we would.

Okay. And moving on, you talked about disconnecting from the China GDP multiplier, which I think makes some sense, and focusing on consumption trends. But looking at China overall, obviously the commercial business was an area of weakness. Are there any other parts of the business that you are watching in the context of -- it looks like air purification was a little light versus your expectation.

Obviously most of these are small numbers, but I think you got initially about $10 million in revs. This year it looks like it's going to be $8 million. Can you speak to -- are you seeing any areas of incremental weakness aside from the commercial side?

No, not really. Overall I think, like we said during my comments, we are comfortable with the 15% annual growth that we have been talking about. And to your point, we've used GDP as a convenient benchmark or reference point in the past. But as GDP becomes more volatile, I think that is why we are trying to explain more in terms of what really drives our business. And we get down to the three buckets that are impacted really by different components of GDP, by consumption as opposed to the whole GDP measured by itself.

As I said, air purification I think we've said in the past, under $10 million and we were always in that $8 million to $9 million range. We really have not adjusted that down. I will say that the air purification in the first half of the year, the market did not grow as expected. It really did not have much of an effect on us since we are just bringing our products into the marketplace at this point in time.

The category grew phenomenally fast last year, and for the first half of this year has been relatively flat, if not down a little. This is the total category in the market. But we are still comfortable that it is a great place to go into, because we think over time we will be able to bring some innovation and new things to that market.

Thank you for that. Looking across the other parts of the portfolio, ERP expense next year, what is your expectation initially in terms of incremental expense or tailwind or the expense coming down into 2016?

It won't come down. We are going through the planning process right now. It will go up, mainly because you end up expensing more during go-lives and we will have more go-lives next year.

We are looking at that right now, and it is probably -- it could approach $25 million, I guess, next year. But we are in the process of doing that. When we get into the first-quarter call, we will have finalized that.

$25 million in total, not incremental.

Yes, $25 million in total.

Right, okay, to be clear.

So no gain, or whatever.

Right, okay.

And that is very much a guess at this point in time.

Right, that will be refined down the road. Okay, on the M&A front. Obviously you've spoken in the past you're focused on a value-focused idea or deal in certain regions or geographies. I think you've spoken to the limited opportunity set of properties.

Has anything changed, given the macro, given the bid asked, in terms of expectations? And has it changed your view of capital redeployment here in terms of perhaps doing other things, given that the M&A environment may be particularly murky or volatile?

No. First of all, the answer is our strategy has not changed. We've been very consistent with our strategy. There are opportunities out there, no question about it. The market is very expensive. People are paying -- companies who don't have the organic growth, we see are paying very high prices for growth. So it makes it a little more challenging type of market, but we are sticking to our strategy and our stated objectives in terms of return to shareholders.

Okay. The last question is, without going into 2016 too much because I know you're going to do that later on. Looking at the performance you have had year to date, how do we think about, in terms of the relative compares next year, is first half tougher next year? Or is second half tougher next year? Thinking about the walk.

Again, I will give you some macro comments and, John, you may want to add to it. We don't expect there to be too much difference in the cycle and the cyclicality of the business. We're just going through our plans, so our plans are putting them together so they're by no means definite.

But again, longer-term we are very comfortable with the 8%-plus growth portfolio that we have talked about, organic growth portfolio that we have talked about. Very comfortable with that.

John, do you have anything to add?

No. You obviously should incorporate the price increases, et cetera, went in April. So that (multiple speakers) but otherwise I agree completely.

I will leave it there. Thanks for your time.

Ryan Connors, Boenning & Scattergood, Inc.

Great, thanks for the time this morning. I had a question. You've talked a lot about the NAECA III situation in terms of pricing and the tactical impact on channel inventories. But I wondered if you could comment on that from the angle of competitive offerings and market share.

As the relative merits of everyone's compliant offerings become better understood in the marketplace, is that a situation where you and others will pretty cleanly map over your respective customer bases to your new offerings? Or are there opportunities here to either pick up, or I guess lose, market share based on the relative merits of the different compliant offerings? Without getting too technical, obviously.

I think everybody, it appears, have approached it pretty much the same way. So the offerings that have come out are relatively consistent. So we would not, I don't think, expect much movement from a market share standpoint either way.

Okay. Is that the way it is being marketed in the channel? I would imagine the products are being sold on some kind of a relative superiority. There's some competitive dynamics at play there. But you are saying that the reality is, it is more or less commoditized, which means it would default back to more or less a pricing game to some extent then.

I guess what I was saying is I don't think it's really changed the dynamics change before or after NAECA from a product standpoint. But you still have all of the things of your distribution channels, who has better distribution channels. You have all of those things still come into play, and it is not by any means only a price game.

I think just to reinforce that is, the competitive dynamics have not changed vis-a-vis NAECA coming in. But your point in terms of if you segment the business into commercial and residential, clearly the residential business is much more commoditized and the commercial business sells much more in value. And that is where, frankly, we come out on top.

Okay, that's helpful. Thanks so much.

Larry De Maria, William Blair.

Okay, thank you. This is first capital allocation, you noted the strategy has not changed, so therefore should we assume the share repo policy would continue next year and be reauthorized when you complete the remaining 900,000 shares?

Yes. From the point of view of saying we are not going to be adding to our cash reserves, we are going to be buying back shares, yes.

Okay, great, thanks. China sales, obviously strong but below the 15% in the quarter. What do you see that gives you the confidence that it will accelerate in the fourth quarter? And are you already seeing that? Maybe the market has responded to promotions and the holiday you referenced. And are there any new products in the fourth quarter that are worth talking about?

Year to date we were at about 15% and we would expect the fourth quarter will be about 15% increase, and that is why we are comfortable with that. Nothing out of the ordinary, as I mentioned earlier, we had all of our SBUs did extremely well except the commercial side. And the commercial side is, it is only a $30 million business in 2014 numbers. It did have an effect, but the business is doing very well and we are comfortable with the 15% in the fourth quarter, which would give us about 15% for the year.

Okay. But has the market responded to the promotions that you reference that cost similarly in October?

I think the sell-through was decent in the holiday, certainly.

Okay. One last question. Correct me if I am wrong, but you are looking for deceleration in margins in the fourth quarter after obviously posting really good results this quarter. Is there any reason for this besides the India headwind? I don't know if there's factory shutdowns for seasonal reasons. Or is there any reason for the deceleration, aside it's not normal?

I would not say we are forecasting much in the way of deceleration of margins in the fourth quarter. We earned $0.82 in the third quarter. The midpoint of our range in the fourth quarter is about $0.84. So I don't think we're expecting much in the way of deceleration in margins by, overall.

Okay.

There will be some on the margin because commercial and Lochinvar is a little bit lighter in the fourth quarter than the third quarter, which is traditional. They have been every year we owned them. And the commercial market we would expect will be down a little bit, but again, nothing significant.

Got it, thanks very much.

Bhupendar Bohra, Jefferies.

Hey, good morning, guys.

Good morning.

Most of the questions have been answered. I just wanted to get a sense of how we have been talking about your previous presentations and China, water treatment market, the size of it. I believe John actually mentioned something about the water treatment in India. Can you talk about that, like the size of the market, like what growth rates we see for that category and how it builds over the next few years?

CMM has estimated that the water treatment in China is going to grow 35% to 40% over the next three or four years. We are seeing this year we would expect probably about 40% growth in that category, and that is what we will have. So we are very comfortable with that, mainly because the penetration rate of water treatment equipment in China is very low compared to other developed countries.

So I think that is the basis why CMM is saying that it's going to continue to grow, and grow dramatically, over the next several years. We are comfortable that the size of the market it is always hard to get your hands around, but we would say that without the VAT, et cetera, it is probably a $2 billion market. Half of it is distributed through our channels and half of it would be on the high end, so our guess is it is probably a $500 million to $600 million market at this time, but growing dramatically.

Okay. Do you have the same study on the India water treatment?

We do not have the same study in water treatment in India. We just brought that product to market late in the first quarter of 2015. We are really doing it in two cities in India, as it is a heavily advertised product and we wanted to make sure that we were focused on a couple of cities. That's what we're looking at right now.

Okay. I believe, Ajita, you mentioned something like a number you are comfortable investing in China air purifier. I believe it was $4 million next year on advertising and marketing. Is there a similar number for the other markets like India? And if you are doing the same thing for southeast Asia?

No. Just to clarify, what I mentioned was that we expect the air purification number to be negative $4 million in 2015, this year. We have not said anything about next year.

Okay.

Again, these are new businesses that we're getting into and we expect that we will have to invest behind them. Which is, by the way again, part of our strategy which we have been doing right through, that as different categories grow and they are in their growth stage, we have always been investing in what is coming down the road and what is going to be our growth engines in the future. So this is a continuation of that strategy that has been very successful for us in China, and we hope in India going forward.

Okay, that's all I have. Thank you.

David Rose, Wedbush Securities

Good morning, thank you for sneaking me in this morning. I was wondering if we can clarify something on North American margins first and then go into China. Help me remember the impact of NAECA, you had the price increase so generally you have escalators or adjustments built-0in when steel prices move. But because of NAECA you did not do that necessarily.

Does that mean now going forward, that we would see adjustments because of steel prices? And that they could go down, your pricing could go down theoretically? Help me understand that, if you don't mind.

We have no price adjusters on the wholesale side of the business and we have a few on the retail side of the business. I don't think necessarily it would automatically you can assume that.

Okay. On the DIY side I just thought we might see something. So we should not assume that at all?

We're not going to comment on future price. There is nothing set up, if you will.

Okay, that is helpful. And then on China. You called out the contribution to growth of water treatment business of being 4.5 points, that business grew 40%. That contribution was less than the growth rate last year, so I am assuming roughly 3 points of growth.

If I strip that out of your growth rate, that implies that your water heater business last year grew roughly 12%, if I am not mistaken, 12% to 13%. So this step-down in growth rate in the water heater business, was there a particular market that was weaker for you? Did you see that step-down in growth in tier 1 or tier 1 markets? Maybe you can break that out for us.

From a China perspective water treatment growth last year I think was about 5 points, not 8 points for the total. This year it will probably be about 4.5 points, so it is very close for the same segment. So there is not much of a difference there.

As Ajita alluded to, there's different buckets and different moving on the three buckets year over year, but nothing specific from a water heater standpoint. We continue to do very, very well on the instantaneous gas with our new product. And again, the thing you have to build in there is commercial is down, and that is on the periphery is affecting some of the noise.

Okay. And then you did -- the DSOs declined nicely in the quarter. And I am assuming most of that was -- was that in China? Was that North America?

It was really in both. We had some inventory build for a variety of reasons, but our DSOs were down and our accounts payable days were up. So I think year over year our total days and cash cycle were down.

Okay, so then on the China front can you provide a little bit more clarity in terms of how you are monitoring the financial strength of the distributors in China, particularly the independents?

A lot of the independents and distributors that we have, we get our cash up front. The really is not a whole bunch of AR-type risk that we run in China.

Okay. There's strength in terms of being able to support the channel going forward? Are you getting any sort of color?

I think we have strong distribution partners because they are selling our product, which is selling very well. So we are comfortable with the strength of our distribution partners. We have a lot of specialty stores.

We have, what, I think 1,800 or so, specialty stores. But those are concentrated; it's not that we are dealing with 1,800 different distributors. Those are concentrated in a group of distributors, if you will. We continue to do well and our partners continue to do well.

But also, I think to answer your question, is there concern about their financial strength and their ability to fund the growth that we expect going forward? No. We do monitor that; we work with them. And if we find that there are concerns about that, we have a plan to switch them out. And that, by the way, is not anything new. That's something that has been in place for some time in the way we manage the business in China.

Okay, that's helpful. Thank you, Ajita, thank you, John.

William Bremer, Maxim Group.

Thank you for taking it. I was wondering if you could give us a little granularity on Lochinvar, their commercial side. Is it just fabrication orders versus more standard? And I hate to say standard off-the-shelf product that they serve, but can you give us a sense of are you starting to see more specific fabricated orders there? And then just a quick update on Canada.

Not much different in terms of the dynamics with Lochinvar. The condensing boiler segment is very strong. Like John mentioned, there was some weakness in the product, the non-condensing products that are sold in China through a distributor through the Lochinvar brand. But other than that, the dynamics are not very different. Does that answer your question, Bill?

Well, I think the Canada piece.

Oh, I didn't talk about Canada.

Since the volumes are relatively flat, obviously there is effect on the translation back to the US. Also much of the product is purchased from the US by three of the four competitors there. That is really what generated the price increases to maintain reasonable levels of profitability.

Thank you. On Lochinvar, I was really going to the fact that when we did visit the plant down in Tennessee, we definitely saw the expansion occurring and anticipating more specific fabrication for corporate clients. I was wondering if that is what is powering these margins a little bit more at this time.

No. As you saw and when we had our Analyst Day there, the expansion is happening and it is going very well. That is the combination of expanding manufacturing capacity and also expanding engineering and testing and lab capacity. And that is all looking at the long-term.

As we have indicated, we think that the long runway for this business to continue to grow at 10%. And so what we are doing is just planning for that and it is going well. From a longer-term perspective, the dynamics are in place and we are very comfortable with that and what is built into our guidance.

Great, thank you, Ajita.

I am showing no further questions at this time. I would now like to turn the call over to Ms. Patricia Ackerman for closing remarks.

Thank you for joining us today. Please take note that we will be at the Goldman Sachs conference in Boston on November 3 and the Baird conference in Chicago on November 9. A short video showcasing our China products and distribution can be found on our website, aosmith.com. Have a wonderful day.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may now all disconnect. Everyone have a great day.