A O Smith Corp (AOS) 2016 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A.O. Smith corporation second-quarter 2016 earnings conference call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Ms. Patricia Ackerman, Vice President Investor Relations and Treasurer. Ms. Ackerman, you may begin.

Thank you, Danielle. Good morning, ladies and gentlemen, and thank you for joining us on our 2016 second-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.

Also in respect of others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue.

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

Thank you, Pat, and good morning, ladies and gentlemen. The second quarter of 2016 was another excellent quarter for A.O. Smith, setting second-quarter records for sales and earnings. We continue to see healthy end-markets for our consumer products in China and commercial water heaters and boilers in the US. Here are a few highlights.

Sales grew 2% to a record $667 million. Excluding the impact from the strengthening US dollar against the Chinese and Canadian currencies, our sales grew 4% in the second quarter. China sales were up 16% in local currency. Record second-quarter net earnings of $0.98 per share was 24% higher than our earnings per share during the same period last year.

We continue to review our capital allocation and dedicate a portion to return to shareholders. During the first half of the year, we repurchased approximately 1.1 million shares for $82 million. We increased our dividend by 26% six months ago.

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

Thank you, Ajita. Sales for the second quarter of $667 million were 2% higher than the previous year. Net earnings of $87.1 million improved 23% from 2015. Earnings per share of $0.98 improved 24% over last year. Sales in our North America segment of $433 million declined 2% compared with the second quarter of 2015. A decline in sales was primarily due to lower volume of residential water heaters in the US. This was partially offset by price increases implemented in 2015 in the US related to a regulatory change, and in Canada throughout 2015 related to Canadian dollar weakness, as well as higher volumes of boilers and commercial water heaters in the US.

Rest-of-world segment sales of $240 million increased 8% compared with 2015. China sales increased 16% in local currency, driven by higher demand for water heaters and A.O. Smith branded water treatment products.

On slide 6, North America operating earnings of $104 million were 21% higher than segment operating earnings in the previous year, and operating margin of 24.1% was significantly above the 19.4% operating margin one year ago.

Higher prices in the US and Canada and significantly lower material cost contributed to the improved segment financial performance. The positive impact of profits from higher US commercial volumes essentially offset lower US residential water heater volumes.

Rest-of-world operating earnings of $33 million improved 7% compared with 2015. Higher China sales were partially offset by increased selling, general and administrative expenses in China and larger losses in India. Segment operating earnings were negatively impacted by approximately $2 million due to China currency translation. Higher selling costs in China to support expansion in tier 2 and tier 3 cities, and our e-commerce platform, as well as higher advertising costs to promote our water treatment and air purification products in China were the primary drivers of higher segment SG&A expenses.

Second-quarter segment operating margin of 13.8% was slightly lower than one year ago.

Our corporate expenses were flat in the second quarter compared with the year-ago period. Our effective income tax rate in the second quarter of 2016 was 29.8%, lower than the 31.1% reported in the prior-year quarter, and benefited from the early adoption of a new accounting standard for share-based compensation.

Cash provided by operations during the first half of the year were $155 million, compared with $61 million during the same period last year, driven primarily by higher earnings and lower outlays for working capital in the 2016 period.

Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio was 16% at the end of the second quarter. We have cash balances totaling over $665 million located offshore, and our net cash position was approximately $385 million at the end of June.

During the first half of the year we repurchased approximately 1.1 million shares of common stock for a total of $82 million. We had approximately 1.5 million shares remaining on our existing repurchase authority at the end of the second quarter.

This morning, we announced an increase in the midpoint of our 2016 EPS guidance in a range between $3.58 and $3.64 per share. The midpoint of our EPS guidance represents a 14% increase in EPS, compared with our 2015 results.

Please turn to slide 9 for several 2016 assumptions.

We expect our cash flow from operations in 2016 to be approximately $340 million, which is similar to 2015. We expect higher earnings will be offset by higher outlays for working capital this year compared with 2015.

Due to the strong growth of our water treatment business in China, we will reach the capacity of our existing leased facility in the next few years. Our 2016 capital spending plans of $105 million to $115 million for the total year include approximately $20 million related to construction of a new water treatment manufacturing and air purification assembly facility in China. Total cost for the facility, which is expected to be completed in 2018, will be approximately $65 million.

In addition, we will complete capacity expansion at two North America plants in 2016 at a cost of approximately $7 million. Our 2016 capital spending plan also includes approximately $10 million to support the ERP implementation.

Our depreciation and amortization expense is expected to be approximately $70 million in 2016.

We successfully completed three ERP go-live milestones since 2014. We expect to have converted the vast majority of our North America plant sites by the end of 2016. Expenses related to our ERP implementation were about $16 million in 2015 and are projected to be approximately $25 million in 2016. Higher than the previous year due to the large number of the large number of scheduled go-live events for 2016.

We had expenses of approximately $9.5 million in the first half of 2016, which was comparable to 2015. Our corporate and other expenses are expected to be approximately $47 million in 2016, higher than the $43 million in 2015, primarily due to higher expenses at our corporate technology center and expected lower interest rates than last year on cash deposits in China. Our effective tax rate is expected to be approximately 30% in 2016, slightly higher than the 2015 rate.

We expect to continue to repurchase shares at a value equal to our free cash flow after dividends, or approximately $175 million in 2016. This is consistent with our stated policy to maintain our net cash balance at approximately $350 million. As a result, we expect our average diluted outstanding shares for the year will be slightly greater than $88 million.

Primarily as a result of continued strong cash flow and escalating PBGC premiums, we expect to make a voluntary contribution to our pension plan of $30 million in the third quarter. The after-tax impact to our cash flow is approximately $18.5 million.

I will now turn the call back to Ajita, who will summarize the business assumptions and our 2016 outlook and our growth strategy beginning on slide 10. Ajita?

Thank you, John. We expect that our businesses will collectively grow approximately 8% to 8.5% in local currency and approximately 6% to 6.5% in US dollars in 2016. The assumptions for currency underlying our organic growth forecast are at current rates. With the exception of continued depreciation in the China currency rate to CNY6.8 RMB per dollar in the fourth quarter.

Specific to our North America segment, our announced 5% to 8% price increase on wholesale US water heaters will take effect on August 1. We expect steel prices to remain firm, as they are up over $250 a ton since the beginning of the year. Partially offset by the August 1 price increase, steel will have a progressively negative impact on North America margins in the second half of the year.

We expect US residential water heater industry volumes will remain constant in 2016 at 2015 levels of 8.9 million units, including tankless. This forecast is lower than our earlier projections, as industry volumes in the first half of the year were lower than we expected.

We continue to see a noteworthy trend emerge in the commercial water heater industry. The majority of the growth in commercial industry units so far in 2016 has been in the 55- to 90-gallon electric category. You may recall similarly sized electric residential units were discontinued by NAECA III.

Driven by continued growth in the small electric category, we expect US commercial water heater industry volume will grow 35,000 to 40,000 units in 2016 after strong growth in 2015.

Lochinvar boiler sales increased 10% in the first half of the year and were partially offset by lower residential water heater volumes, which experienced difficult comps to 2015. The net result was an increase in Lochinvar branded product sales in the first half of the year of 2%. Based on the first half of the year, we expect Lochinvar branded sales will grow approximately 6% for the total year, implying that we expect sales in the second half of the year for Lochinvar will grow about 10%.

We expect the historical transition from lower-efficiency, non-condensing boilers to high-efficiency condensing boilers to continue. This long-term trend, coupled with new product introductions and normalization of residential water heater volumes, gives us confidence to project a 10% growth rate for Lochinvar branded sales in 2017 and beyond.

As John previously noted, our ERP implementation costs are expected to be $9 million higher than in 2015. The additional cost in the second half of 2016 will negatively impact North American margins by more than 50 basis points, compared with the first half of 2016. These factors, in addition to the assumptions John discussed earlier, lead to our expectation that our North America segment operating margin will be between 21.5% and 22% in 2016.

Some assumptions specific to our rest-of-world segment. We are a consumer products Company in China, which distinguishes us from most industrial companies operating in China. In local currency, our sales in China have grown by 18% in 2014, 16% in 2015 and 16% in the first half of this year despite a softer China economy. We have various growth drivers underpinning our China business, which give us confidence to project an annual growth rate of approximately 15% in local currency for 2016. These drivers include overall water heater market growth driven by household formation and an emerging replacement market, geographic expansion, market share gains, growth in water treatment and air purification products, and improved product mix. We expect rest of world segment operating margin in 2016 to be similar to last year's margin of 13%.

I'm moving on to slide 11 now. Especially in these volatile and uncertain economic times, we believe our long-term annual 8% organic growth potential and our stable defensive replacement market, which we believe represent approximately 85% of North America water heater and boiler volumes, positively differentiate AOS among other industrial companies.

Coupled with growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisitions that add shareholder value as well as allow us to return cash to shareholders.

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

(Operator Instructions) Robert McCarthy, Stifel.

Good morning, everyone. I guess the first question I would have is, maybe you could just amplify your comments around the price increases that you were going to be pushing through in August and your thoughts about the cadence of volumes for the back half of the year in the North American business, how we should be thinking about that.

North America volumes, I guess, first half of the year to second half of the year we would actually expect to be relatively similar. The third quarter is traditionally quite a bit lighter than the third -- fourth quarter. But this year we will think it will only be slightly less because of the price increases, et cetera. So that's how we would view the North America volumes. Obviously very favorable comps compared to the last half of the year 2015, the opposite of what we had in the first half.

So, that certainly will result in an increase year over year.

With respect to the price increase, we talked about -- I think we put out an 8-K, and we said it's effective August 1. Obviously, there can be some pre-buys, so it might be -- ultimately be a little later in the quarter. But that's effective August 1.

You would expect some kind of modest pre-by in association with that?

Yes, I think that's what typically happens.

Okay. And then my follow-up question I think would be -- just stepping back obviously -- continued commitment to share repurchase. Stock continues to work. You guys continue to perform. But I guess the -- not the concern, but I guess the -- what was out there remains capital allocation for doing just kind of a very high-potential deal in M&A. And could you talk about the opportunity set there? Because it seems like it's perpetually very challenged. I mean, Lochinvar was obviously admittedly a home run. But you've got a strong balance sheet. You've got a very high stock price. You've got opportunities to redeploy the capital aside from share repurchase. Could you talk about the capital allocation front? And are we getting closer to something a little more dynamic in terms of strategic deal right now?

I'll start, and then Ajita you can kind of fill in. We've taken the position that with our current balance sheet we have enough in our war chest to do transactions. So we've said we are going to leave our net cash position about $350 million, and we'll split that up between dividends and stock repurchase. And we've also said that we are going to be disciplined. We've said all along our preference would be to do a deal. We think that's the best value we can provide shareholders if we do the right deal. And we've said we will be disciplined. And, quite frankly, there are opportunities out there. And as long as you can get synergies -- and we are holding steadfast that we need to get proper returns to return our cost of capital. So, you know, both Ajita and I want to do deals, but we want to do the right deal.

What's your theoretical constraint on a deal? Sorry. I didn't mean to interrupt you, Ajita.

No, go ahead.

What's your theoretical -- how much could you deploy on a deal, given -- what's your walk-and-chew-gum number in terms of being able to deploy and then with your existing cash generation and your comfortable leverage ratio?

Well, we have said we'd be comfortable getting up to 35% debt to capital. So that leaves you quite a bit of room there. You'd have a $600 million-some offshore that we could also do. So I think realistically we certainly have over $1 billion of available capacity.

So, just to add onto a little bit of what John said, we are very comfortable with the having the ability to do a large or a number of acquisitions up to about $1 billion. And what we've also said in terms of our capital allocation strategy is that we are not going to add to our cash reserves. And as we generate cash, we are going to be buying back stock approximately equal to our cash flow, so -- to our free cash flow.

So, I think we are very comfortable with that position. And, again, as John said, there are opportunities out there, but we are going to be strategic and disciplined in terms of our approach.

Thanks. I'll get back in queue.

Charley Brady, SunTrust Robinson Humphrey.

Just on the North America margin outlook, second half over first half, I guess it looks like to get you to the high end of that range you laid out for North America, it's about 160, 170 basis points year over year, second-half versus first-half decline. Is that entirely due to your commentary about steel pricing or steel cost rather being a greater headwind as you go through the year? Or are there some other factors going on in there?

Well, I think there's a couple of things going on. Number one is ERP spending is higher the last half of the year than the first half. So we've said that will affect margins by over 50 basis points compared to the first half of the year. And I think the other biggest factor is what you alluded to. Steel is going to be effective July 1. The price increase will be effective some time probably mid-quarter. And then also, anytime you put a price increase like this, it is customary for our industry to commit pricing to some projects. So the entire pricing might not get in until later this year, early next year. So I think steel certainly is the biggest factor.

So you've got a lag on the pricing versus steel costs going up, and you've probably got some pre-buy, which skews the volume a little earlier price hit.

Yes.

Got it. Okay. That's all for me. Thanks.

David MacGregor, Longbow Research.

Can you just -- with respect to the residential water heater business, can you just discuss any differences you are seeing in growth patterns between wholesale and retail?

I'll start. Wholesale has grown a little bit better than retail. There might have been some -- and I'd say the opposite happened last year. I think retail probably grew a little bit more than said wholesale, so I think you have that slip-back going on. But, I don't think it's dramatic either way, if you will.

Yes. The ratios really haven't changed.

Yes, that's right. (inaudible)

And just further to that point, are you seeing disparity within your retailer mix that would raise concerns, or is it pretty even?

No, not really. I talked to our salespeople last couple of days. And where there is disparity is there's some geographic mix. I mean, the Southeast is very strong. The Midwest isn't as strong. So I mean, you have some of those things going on.

I think that the comments they made to me as much were the market is steady. I'm not going to tell you it's robust, but they also said it's not weak. And our forecast of flat to last year results in us taking down our unit volumes by about 100,000 to 150,000. But in total, that's less than 2% of the market. So, it kind of is what it is.

Right. Second question. Just on China, your best assessment of China's market to unit growth rate in the second quarter, and what are you assuming for the second half in your EPS guidance?

Unit growth. I don't have -- oh, yes. I mean, it depends which sector you are talking about. The water treatment was up 30%, very strong. Our instantaneous gas, very strong. We are still a little bit on the combi boiler, and the commercial are a little bit behind. And the electric is up. So it (multiple speakers) --

The mix in the first half is really in local currency about a 16% increase. And there is some pricing in there because average unit prices have gone up, as we've talked about. Because with the new products we tried to make sure that with enhanced features and benefits we are driving unit prices up. So, the 16% is a combination of a little bit of pricing and unit volumes going up.

And, I mean, I think if you look at the last half we are probably -- given our 15% and we were up 16%, we're a little bit lower the last half of the year, but that's just difficult comps quarter to quarter. So we kind of look at it on an annual basis.

Yes, I guess just to that point within that 15% second half, are you expecting slightly better category and maybe just changes in terms of share and pricing? Or just if you could deconstruct that for us.

No. I think it's pretty much the same thing as water treatment continues to do very well. We would hope commercial will come back a little bit more in the second half of the year. We are introducing a new product there. But all in all, I don't see anything dramatically moving (multiple speakers).

Yes. We have new products. We have Series 10 coming out in the electric. We have an enhanced portfolio of air purification products. And you know, that's a seasonal product so that when it gets to the fourth quarter, December, January is where you see the high volumes there.

So overall, pretty much continuation of the same.

One thing I want to add in terms of -- just to add some color to your question. When it comes to water treatment, which is probably the business segment that is growing the fastest, the penetration of that product in households in China is very low; it's single-digit. And that's part of what's driving this 30%-plus growth rate in the marketplace. And we have a high share position and we continue to grow. So we are very bullish about the opportunities in that segment also.

And I guess if you look at the first-half margins for rest of world, it was about 13% and we are expecting the last half of the full year to be 13%. So we'll come in relatively similar.

Right. Okay. Thanks very much. I appreciate it.

William Bremer, Maxim Group.

Could we touch base a little bit on Lochinvar here? In your slide deck you said that the product sales growth of about 6%, but yet your commentary was voicing first half of this year 10% and second half 10%. This is predominantly a North American play. I'm just trying to get a sense on how is it progressing. And have we started to consider bringing this internationally?

I'll kind of clarify the numbers maybe. We didn't clarify them quite correctly. We really split it into, I'll say, two segments. One is I call their core business, which is the boiler business, residential, commercial boilers. And we said year-to-date that was up about 10%. Okay? But they do have, as you know, a standard commercial and a residential business, and that residential business in the first half of the year was down 18%.

Residential water heaters.

Residential water heaters. So what we said is for the first half of the year, it was -- the total Lochinvar was up 2%. Then we went to the second half of the year, and we said the run rate, we think, will be at about a 10% run rate for the second half of the year, again led by boilers which will be up double digits. And residential will again have some drag, but not as much.

So what we've said is that gets us to kind of that 6% for the year, less than we expected. And, quite frankly, we just didn't build in the residential volatility that we saw. We had a very strong residential last year, and we are seeing it come back this year.

Yes, and that's a key point there, too, because the residential water heater business for Lochinvar was very strong in the first half of last year, so they had tough comp. And so we see it getting back on track in the second half.

The other thing I'll say is as we look at our boiler business, we appear to be gaining market share. So we are very pleased with that.

Okay. The aftermarket there, has that been picking up as well?

Up 5%, 6%. Up a little bit. Not dramatic.

Okay. And finally, steel prices. The 10-Q is not out yet. Just wondering, do you take this opportunity? Or where are you in terms of positioning yourself -- I know about the price increase, but more an instance on hedging tactics going forward.

You know, we've talked about it. We've done some hedges on steel. It's not a very liquid market. And we have put some hedges in place that really didn't have much effect at all on the second quarter. And it's just difficult given the liquidity to do much. You have to have a -- to be a buyer, you have to have a seller. And it's not a liquid market; it's developing. But we have put some hedges in place.

Great. Thank you.

Alvaro Lacayo, Gabelli & Company.

Just a quick -- just some more clarity around sort of the flat volume for residential water heater expectation. If you could just comment on sort of the clarity you have and for the market and maybe some commentary around sell-in versus sell-out. And you mentioned there is some pre-buy; you've already seen some evidence of that.

I guess what I would say -- and we haven't been very clairvoyant on that. But I would say that when I talk to our salespeople, they think that inventory levels are reasonable. And they will actually be a little elevated obviously at the end of July because of the pre-buy, which we expected. But all in all, inventory levels are reasonable.

I think the myth was probably that the inventory levels were just much higher last year than we expected. I mean, Ajita talked on the first conference call that contractors pre-bought. That normally doesn't happen. We've actually seen some NAECA II products sold online recently. So there's still some out there. But as our people look and talk to their customers, I think I'd be repeating myself, but it's steady. They -- completions are kind of moving the way that was expected. And it's -- I think we are relatively comfortable with flat second half of the year compared to first half of the year. And we'll see.

Okay. And then secondly, just the organic growth assumption on Q2 versus Q1, it's down a little bit. Is that just a reflection of maybe a little bit lower volume on the residential water heater? Or are there other elements at play here?

I think it's two things. We've changed our assumptions for currency from the first quarter, and that probably cost us $10 million, $12 million. The RMB has moved faster than what we thought. And so, we are assuming right now 6.7 kind of in the third quarter, 6.8 in the fourth quarter and that's up from our original assumption. And I think the other adjustment would be the residential volumes.

Got it. And the acceleration in the back half of Lochinvar is just purely comps-related from the residential water heater portion of it?

Well, not purely. But I guess I'd say what happens is we don't have as much drag from residential, but the boiler business continues to do what it's been doing. Like I said, in the first half of the year up [10%], and we expect the second half of the year to be up more than [10%]. Then you throw in, yes, it does have favorable comps, just like our North American water heater business does. So, yes.

Okay. Thank you.

Scott Graham, BMO Capital Markets.

The expectation that you guys have for the full-year residential water heater business, I'm not privy; I don't have it in my hands, the tankless side. But it would suggest that the water heater side residential, your expectation for the second half of the year and volumes are up more than 10%, which seems reasonable given the comparisons and what have you.

I guess my question is that we are kind of -- this has been a pretty long destock following the pre-buy, looking in your earlier comments. And what I'm wondering here is we are at, like, 7.8 million units trailing 12 months. That's a number we haven't seen since, well, three years ago. So I'm wondering if there is anything else that you think is going on in the channels that might have gotten us to this level. They seem to be leaner than lean, but is there more going on in your view?

I guess what I would say is, repeating myself, we just -- it turned out that the volumes were much higher in the pre-buy starting in 2014 and 2015. I think when we step back, Scott, we still look that we had a run rate in this industry in 2010 to 2012 about 8.1 million units. We are up to this year, and last year we are saying about 8.9 units when you include tankless in there. And completions have probably added probably 400,000. So we've had some replacement growth in there. And I think our people are comfortable with the estimates we have in the last half of the year, but --

Yes. I think the pre-buy -- as John said, the pre-buy was greater than we thought. And the feedback we are getting from the marketplace is there are no distributors. Their run rates are -- they are saying, hey, things are okay.

Okay. That's fine. So there's really no change in your view that there is this still large amount of pent-up demand because the residential water heater volumes have still a ways to go catch-up-wise from how wicked bad it was last cycle. So you are still thinking that the under-build on starts in particular still suggests that there is a significant amount of units of pent-up demand. Would you -- are you holding to that?

Long-term, yes.

Yes, yes, agreed, long-term.

Long-term, yes. In terms of current run rate, things are okay. But long-term, the fact is if you go do the math in terms of the over-build before the recession and housing starts since then, there's a deficit in housing. And like I've spoken before, we don't think it's going to come back quickly, but it will come back in terms of steady growth over the long haul. And frankly we prefer that.

Yes, yes. Got it. My second question is very simple. It's on the rest-of-world margins, which have been kind of like -- you know, you get volume leverage and then you spend it. And I'm -- this is my phrase, not yours. You kind of manage the earnings about business really well. I guess the question is, at what point does rest-of-world spending start to comp a little bit more easily and rest-of-world margin actually starts to benefit from the volume leverage that you are generating?

You know, I think you are right. We have been investing. And the level of investment in new businesses in the last few months has been a little higher than what we've done in the past. We had -- we still have air purification, which is an investment. We have -- we've gotten into commercial water treatment, which is an investment. We are investing in e-commerce business, which is growing at warp speed. It's just growing very fast. So -- and we are also investing in terms of going into second- and third-tier cities, the smaller cities. So we do have a lot going on right now.

But longer-term, you should see an increasing leverage and increasing profitability coming out of the China business as we continue to grow. And what we are doing now are investments to make sure that we are feeling that growth out into the future. Because we continue to believe that our brand and distribution in China and our footprint in China has significant upside potential as we expand our categories and continue to grow in the categories we are in.

Yes. I'd just emphasize I think China is having a great year. So, one, it doesn't affect their margins, but their currency has affected their absolute profits by $6 million or $7 million. And we've chosen to invest in two businesses specifically that Ajita talked about: air purification, which will probably lose an additional $3 million over last year; and commercial water heating, which will probably lose $3 million over last year because we weren't in it. But we think long-term both those businesses can be very attractive.

You meant commercial water treatment.

Yes, commercial water treatment.

Thank you. That's all I had.

Sam Eisner, Goldman Sachs.

If I look at your trailing 12-months operating profits in North America and the margins there, you are at roughly 22.5%. That's up from this time last year on an LTM basis, up 17%. So, this is now four quarters in a row where we've generated north of 20%, even margins within North America. I was wondering if you could parse out how much -- if you isolated just the raw material tailwind, how much that really has been to you guys. Because obviously now we are starting to lap some of the savings. So I was wondering if you could just isolate how big the steel tailwind has been for you guys on an LTM basis.

I don't have that data. You've got things going on commercial up and down during that time period. Clearly, steel was beneficial for us over the last three quarters, I'd say. But I don't have any data that would parse that out. You have Symphony costs going plus and minus during -- I mean, not Symphony -- SAP costs going plus and minus. So there's a lot of variables. But certainly steel was beneficial to us over the last three quarters.

And there were timing differences, too.

Yes, got it.

And you had pricing changes in there (multiple speakers) --

Pricing changes, timing differences. So there are lots of puts and takes in that.

Okay. And maybe to ask a forward-looking question, you've given some margin targets for the remainder of 2016. You give us kind of the organic growth medium-term algorithm. But is there a way to think about what the medium-term algorithm would be for margin profiles for North America and rest of world going back to the last question? Should we expect some type of harvest mode for rest of world at some point in the future? Is a 22% trailing 12-month operating margin in North America the right way that we should think about the long-term profitability of that segment? Perhaps you could just put some parameters around the way that we should think about kind of the medium-term algorithm for you guys.

Well, I guess I'll say it this way: we haven't done our 2017 plan yet. I think the full year of 21.5% to 22% is a reasonable starting point to look at. Again, by that time, the entire price increase will be in et cetera. Symphony, we get some -- I'm sorry, SAP we get some benefit. By the way, internally we call SAP Symphony; that's why I keep using that word.

We'll get some benefits from that next year. So, again, we really haven't done our plan to really determine, but I don't think that's an unreasonable starting-off point.

Rest of world, it just depends on some of these businesses that we've talked about that have had some issues, if you will, partly because they are starting out. But just commercial water treatment, I won't call it an issue. We are getting into new business, and we've got to make an investment. Air purifiers, we are getting into a new business; we've got to make the investment.

Actually, when it comes to volume and when it comes to the growth of both of those businesses, I'm very pleased about how it's going.

But we haven't put out any long-term aspirations for rest of world, except Ajita and I are both in agreement that we ultimately have to grow those margins. And we do that by leveraging SG&A. We do that by improving performance in India. And we do that in performing some of these businesses that we are investing in.

Got it. And then I realize that your price increase is just about to take effect in a few days here. But I was curious, with your wholesale customers, what the conversations have been up until this point. Is anybody pushing back on that? Are you seeing that they are willing to accept 5% to 8%? Maybe you can give us some kind of clarity on what expected realization of that 5% to 8% would ultimately be. Thanks.

I don't know about you, Ajita. I have not heard any negative feedback. Obviously, steel is up. Cold-rolled is up $300 a ton from the beginning of the year. Hot-rolled is up $200 a ton from the end of the year. So it's been significant increases in steel.

Yes. I think our distributors expected it, and it's a very little conversation.

Got it. Thanks.

Kevin Maczka, BB&T Capital Markets.

Can we just do a clarification on the ERP spend expectations for the year? We're -- on a full-year basis, we'll be $9 million higher this year than last year. Is Q4 a very heavy-spend quarter in the back half, the heavier-spend quarter? And any sense yet on how much that declines into next year?

Yes, I will try to clarify. First half of the year, we spent about $9.5 million. That was very similar to last year's first half of the year. Okay? The second half of the year, then, we'll spend a delta of $15 million, $15.5 million. That's going to be about $9 million more than the prior year. And I would tell you, we will be spending that $15 million or $16 million a little bit heavier in the fourth quarter than the third quarter. So does that clarify this year?

Sure does.

Okay. So then, when you go into 2017, our expectation -- and, again, we haven't done our planning process, but I would think a reasonable run rate is going to be closer to $15 million versus the $25 million. Now, with one caveat, we have not made a decision on what we are doing internationally. I think we've talked on this call that China has a good ERP system. So at this point we will see where we go. It probably is not necessary to put SAP into China. And with that caveat, I would say we think a reasonable run rate would be $15 million, and that kind of covers the amortization, that covers the hosting cost, that covers the service and those sorts of things.

Okay. John. Very helpful. Thank you.

Bhupender Bohra, Jefferies.

First question on China here. We have seen like year to date now the organic sales growth about like 16%. Could you give us like a second quarter -- you know, the core water heater sales as well as the water treatment and air purifier?

Air purifier was not much. It was up probably $1 million, but that's off a very low base. Because I think the two big quarters for air purifiers are the third quarter -- I'm sorry, the fourth quarter and first quarter. So it was up. It's doing well. Ajita talked about a new product we've introduced. We'll see how successful it is in the -- but the first point it's going to be significant is in the fourth quarter. I would say in local currency, electric was up, gas was up more than that and water treatment was up 30%.

Okay. Do you have numbers for water heater, like electric and gas, on an organic basis?

Combination, we think, Pat, is probably 5%, 6%, 7%, I guess the two combined.

Yes.

Okay. So, somewhat in line with the market growth, right? What your (multiple speakers) --

Yes, I think we are very consistent. When we look at our market share -- and if you are getting at our first growth situation where we talked about the market growing at 7%, the data we've got in our appliances, of which water heaters are a part of that, grew a little bit more than 7%. And certainly, all the share data we see, we are maintaining share in electric and gaining share in gas.

And other indicators we look at, right, residential square footage of residential sales home sales is up nicely -- 20%-plus. There's no direct correlation we see, but we track those numbers because all of those impact what our demand is going to be.

Okay.

You know, everything we see in China -- the move to the consumer-driven economy, retail sales numbers, consumption -- all seem in place. And we've said many times on this call, we are a consumer products Company in China.

Okay, okay. And the other question was around North America commercial products. You have commercial water heaters. Ajita, you talked about the shift, and we have seen that in the AHRI numbers here from the residential electric to the commercial electric here. How should we think about from volume perspective and when does that anniversary? Because we are seeing growth rates of like 70% or 60% month over month here over the last at least last two or three months here.

I think anniversary is probably at the end of the quarter. But I should emphasize there are two things that could be happening. One is residential clients could be buying commercial units. But there were also smaller commercial customers who -- gas stations, et cetera -- that very easily could have been buying residential products and can't now. So -- but you are right. Almost all of the growth has been in that 55 to less than 90 gallons, and that probably continues through the first quarter of next year.

Okay, okay. And I believe your -- you know, you guys actually introduced a new product in that particular channel here on the commercial side. I think Pat was talking about it earlier this year. How is that doing? And from a market share perspective especially on the commercial side?

Yes, you know, we were late getting into that segment on the commercial side, and we have products in there now and they are doing well.

Okay, okay. And lastly on the North America residential here, I've done some channel checks here -- like you know people, some of the wholesalers have been talking about some good traction in the tankless water heater because of the NAECA III regulation kind of made, as you said, like 80% changes to your SKUs. So have you heard anything on that? It's a pretty small category, about 0.5 million in North America. Have you seen some more traction in that category? Any thinking about the medium-term growth in that particular category?

It's grown 500,000 last year. It will probably be 550,000 or so this year. It's -- as we've talked about in the past, it's more new rather than retrofit because it's more expensive. I will also tell you the tankless unit is more expensive than our tank units. And so there is some growth in it. We don't expect it to be enormous. We have a product in that category, so we are covered if that category (multiple speakers).

Either way.

Either way.

This year, if you look at the first part of this year, tankless has gained market share faster -- tankless has gained. It's growing faster than the tank type. From our perspective, we are actually gaining market share in the tankless. So either way, from our perspective, you've got both categories. We are covered in both categories and somewhat indifferent as to which grows faster.

Okay, okay. And any reason behind why, year-to-date, it has grown a little bit faster than the tank?

I think a lot of it is driven by NAECA III and the fact that you had that significant buy-in last year of the tank type.

Okay, okay. Got it. That's all I have. Thank you.

Jeff Hammond, KeyBanc.

Just on China, a couple of questions. One, can you just talk a little bit more about your investment in commercial water treatment, what you think the opportunity is, growth rates long-term? And then also Ajita, you mentioned e-commerce growing dramatically. What's driving that market? How big is that business for you? What do you see as the growth rates?

I'll answer the last one. You can get the first one. The last year, we saw -- sold about $140 million in e-commerce. We are up year to date very nicely. Our expectation is we will be over $180 million this year.

I can't say what's driving it as much as obviously the Chinese consumer is very willing to buy online. And all the statistics show that that they are more willing to do that than the US consumer, et cetera. And it's an opportunity for us because we have good distribution. So when they buy online, we have the capability to install the product and we are doing that. So we -- our management team saw this in China, saw this about four or five years ago and started putting in the infrastructure. And we are doing advertising on the net, et cetera, so we think we are in very good position with respect to that category.

Yes, and we've added a significant amount of people and skill sets in terms of being able to, you know, sell our products online. Merchandise our products online, do the search engine optimization so that our products pop up when people do the searches. And there are interesting statistics. More than 75% of online sales are done through your smart phone in China. So that takes another skill set in terms of how you market and merchandise your products on a smart phone because obviously the amount of information you can put on a screen is so much less.

So but we are building all those skill sets and this channel is growing very fast. It's another channel that allows us to reach new customers and especially customers in smaller cities. So, the fast growth is really something that we like. And we are leveraging it as quickly as we can.

The answer to your first question on water treatment, we entered that market -- commercial water treatment, we entered that market this year. It's a little bit different model. It's a lease model, and typically it's a five-year type lease. So, unfortunately, you don't get the benefit of the sales upfront. You obviously don't -- you only have 1/5 of the cost, but you do have all the SG&A, et cetera, to get in there. So that's going to be a little bit of a drag, but we think it's a natural extension of our water treatment business.

And it's an annuity (multiple speakers) once you are in --

Capabilities (multiple speakers) yes, (multiple speakers).

The lease goes on into an annuity, and the products will last longer than what our amortization is.

So, we think it's just a natural extension of our residential water treatment business.

Great. Thanks, guys.

Robert McCarthy, Stifel.

Just a couple more in the interest of time. Have you sized just in terms of annual numbers for 2016 for your water treatment business, your air purification business? You've given us some numbers in the past. I didn't know given the growth rates we've seen whether you could give us those updated numbers. And then I have a follow-up on India.

Last year in our branded business, we sold about $110 million. We would expect to be close to 30%, although again you have currency playing issues there. But we are certainly expecting to be in that $135 million to $140 million range, I would say, for a business for water treatment, and that is after a fair amount of currency drag. You throw in in Vietnam we will sell 3 million or so this year. India will probably sell about 3 million this year. And Turkey we will sell 5 million to 6 million this year. And then our base legacy business that we bought will sell about 15 million. So, water treatment is starting to get to a reasonable scale, and we think there is very, very good potential in that area.

And air purification is still like $10 million to $15 million? What are we talking about?

Well, air purification last year was $10 million, and we said we expect it to double this year.

Okay. In the $20 million range. And then, just in terms -- you did cite the losses in India. Could you speak to them? And is there any kind of gut check there around levels of investment, the market, et cetera? Or maybe you can just give us some metrics around the growth opportunity there or an update.

I think our costs have been a little bit higher because we are expanding into more cities in water treatment. And that's costing us more. And also one of the things that's happened in India is that it's been a very, very hot summer. And so the water heater sales volume, the whole market is lower than we anticipated when we went into the year. So it's a combination of those two that where expenses have been a little higher than we anticipated.

We have put in a new management team, and I think we are impressed internally in the last six months or year. And there's certainly a marketing focus. And we're making the investment in the water treatment because, as we have talked about in the past, that's a, we think, a larger category than water heaters.

And can you size what you think the revenues will be this year and what the loss will be? Or have you publicly (multiple speakers)?

I think we have.

We've said that. We've said that last year revenues were about $15 million to $16 million. This year, it will be about $20 million. We said last year we lost $9 million, and we will probably lose a little bit more than that this year.

So there's no major change to those assumptions?

No.

No. Nothing from what we said earlier in the year.

Okay. Well, we are up against the hour. We will leave it there.

(Operator Instructions) This concludes today's Q&A session. I would now like to turn the call back over to Patricia Ackerman for closing remarks.

Thank you all for joining us today. Please take note that we will participate in several conferences during the third quarter: Jefferies conference in New York City on August 10; Oppenheimer corporate access day in Chicago on August 18; and the CFA Society conference in Minneapolis on August 23. Have a wonderful day.

Ladies and gentlemen. Thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.