A O Smith Corp (AOS) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation third-quarter 2016 earnings conference call. (Operator Instructions). As a reminder, this call may be recorded.

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

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

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 his remarks on slide 3.

Thank you, Pat, and good morning, ladies and gentlemen.

The third quarter of 2016 was another excellent quarter for A. O. Smith, setting a record for sales. We continued to see healthy end markets for our consumer products in China and commercial water heaters in the US.

Here are a few highlights. Sales grew 9% to a record $684 million. Excluding the impact from the strengthening US dollar against the Chinese and Canadian currencies, our sales grew 11% in the third quarter. China sales were up 17% in local currency.

Third-quarter net earnings of $0.47 per share were 15% higher than our earnings per share during the same period last year.

We are delighted to welcome the Aquasana team to the A. O. Smith family, through our acquisition of the US water treatment company in early August. Aquasana fits squarely in our acquisition strategy to grow our core and expand into new geographies. In this case, we are expanding our Asia-based reverse osmosis water treatment platform into the US. We're also excited about the opportunities Aquasana's carbon-based products bring us to cross-sell water treatment products in China.

We continue to review our capital allocation and dedicate a portion to return to shareholders. During the first three months of the year, we repurchased approximately 1.3 million shares for $100 million. We increased our dividend by 26% six months ago. We also announced a 2-for-1 stock split, which became effective on October 6.

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

Thank you, Ajita.

Sales for the third quarter of $684 million were 9% higher than the previous year. Net earnings of $83 million improved 13% from 2015. Earnings per share of $0.47 improved 15% over last year.

Sales in our North America segment of $451 million increased 8% compared with the third quarter of 2015. The increase in sales was primarily due to higher volumes of residential and commercial water heaters in the US.

The purchase of Aquasana in August added $6.2 million to our North America segment sales. Rest-of-world segment sales of $240 million increased 11% compared with 2015. China sales increased 17% in local currency, driven by higher demand for water heaters and water treatment products.

On slide 6, North America operating earnings of $101 million were 11% higher than segment operating earnings in the previous year, and operating margin of 22.3% was higher than the 21.7% operating margin one year ago. Higher volumes in the US were the primary driver of the improved North America segment financial performance. Rest-of-world operating earnings of $31 million improved 14% compared with 2015.

Higher China sales were partially offset by increased selling, general, and administrative expenses in China. Segment operating earnings were negatively impacted by approximately $2 million, due to currency translation. Higher selling cost in China to support expansion in Tier 2 and Tier 3 cities and higher advertising costs to promote our products in China during the summer Olympic Games and the European Football Championship were the primary drivers of higher segment SG&A expenses.

Third-quarter segment operating margin of 12.9% was slightly higher than one year ago, primarily due to smaller losses in India.

Our corporate expenses were higher in the third quarter compared with the year-ago period, primarily due to $1.2 million of Aquasana acquisition-related costs and higher expenses at our corporate technology center.

Our effective income tax rate in the third quarter of 2016 was 29.8%, which is lower than the 31.3% experienced during the third quarter last year and similar to our 2016 guidance.

Cash provided by operations during the first nine months of 2016 was $264 million, compared with $237 million during the same period last year. Higher earnings in 2016 were partially offset by higher outlays for working capital in the 2016 period.

Our liquidity position and balance sheet remains strong. Our debt to capital ratio was 18% at the end of the third quarter. We have cash balances totaling nearly $680 million, located offshore, and our net cash position was approximately $343 million at the end of September.

During the quarter, we completed the acquisition of Aquasana, as we previously discussed.

Primarily as a result of continued strong cash flow and escalating PBGC premiums, we made 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.

During the first nine months of the year, we repurchased approximately 1.3 million shares of common stock for a total of $100 million. We completed a 2-for-1 stock split in early October 2016. Adjusting for the split, approximately 2.6 million shares remained on our existing repurchase authority at the end of the third quarter.

This morning, we announced an increase to the midpoint of our 2016 EPS guidance in a range of between $1.81 and $1.83 per share. The midpoint of our EPS guidance represents a 15% 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 $325 million, which is lower than the $344 million generated in 2015. We expect higher earnings will be more than offset by higher outlays for working capital this year, compared with 2015, and the voluntary $30 million pension contribution made earlier this year.

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 $95 million to $100 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 early 2018, will be approximately $65 million.

In addition, we completed 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 $66 million in 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 larger number of scheduled go-live events in 2016. We recognized expenses of approximately $15 million during the first nine months of 2016 and we expect approximately $7 million of incremental expenses in the fourth quarter, compared with the prior year. This, in combination with a significantly lower tax rate in 2015, will result in fourth-quarter 2016 earnings per share being approximately flat compared with the prior year.

We started the final phase of our ERP system implementation on October 1, which consists of three major manufacturing sites. We expect to conclude our implementation efforts at a few of our small factories next year. At this time, we do not expect to implement the system at our foreign operations.

Our corporate and other expenses are expected to be approximately $46 million in 2016, higher than the $43 million in 2015 primarily due to higher expenses at our corporate technology center and acquisition-related costs.

Our effective tax rate is expected to be approximately 29.7% in 2016, similar to 2015. We expect to repurchase shares in the amount of approximately $135 million in 2016. As a result, we expect our average diluted outstanding shares for the year will be approximately 176.8 million shares.

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

Thank you, John.

We expect our businesses will collectively grow approximately 8% to 8.25% in local currency and approximately 6% to 6.25% 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 average RMB6.8 per $1 in the fourth quarter.

Specific to our North America segment, we will experience the full impact of higher steel costs in the fourth quarter, due to the timing of steel cost realization in our P&L. We expect slower growth in our Lochinvar-branded sales than we originally projected. Our Lochinvar-branded products have historically grown as a result of the transition from lower-efficiency boilers to higher-efficiency boilers, new product introductions, and market-share gain.

In 2016, we expect our condensing boiler business to grow at 10%, which will be essentially offset by a decline in water heater and non-condensing boiler volume, resulting in minimal growth this year.

These factors, in addition to the assumptions John discussed earlier, lead to our expectation that our North America segment operating margin will be between 21.75% and 22% in 2016. This implies North America margins will be down sequentially in the fourth quarter as a result of several unusual events.

First, the incremental ERP spend will impact margins negatively by over 100 basis points. Second, we expect lower commercial volumes in the fourth quarter than in the third quarter, as we encouraged our distribution partners to hold more inventory in advance of our October 1 SAP implementation, which included our commercial water heater plant. And, third, we will experience the full impact from higher steel costs in the fourth quarter.

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 17% in the first nine months 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 over 16% 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 gain; growth in water treatment and air purification products; and improved product mix. The rest-of-world segment operating margin in 2016 will be slightly higher than 13%.

Now moving now onto slide number 11. We have refined our growth model to reflect the growth in our China business, which is now 32% of sales. Additionally, we modified our Lochinvar-brand growth rate. During our ownership, our Lochinvar-branded condensing boilers have grown at a double-digit pace, driven by the continued transition to higher-efficiency boilers, market-share gain, and new product introductions.

We think this is a reasonable assumption going forward. Assuming 4% growth for Lochinvar-branded water heater sales, our projected growth rate for total Lochinvar-branded sales is 8%. Our refined total Company organic growth model continues to assume 8% growth for the foreseeable future.

Especially in these volatile and uncertain economic times, we believe our organic growth potential and our stable, defensive replacement market, which we believe represents approximately 85% of North America water heater and boiler volume, positively differentiates A. O. Smith 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). Scott Graham, BMO Capital Markets.

Just wondering if we could -- on the third-quarter margin, it looks like steel impacted less in the third quarter than it will in the fourth quarter. Could you give us -- I know you said, John, and certainly in the text you said, it was volume. So was there anything else impacting the North American margin in the quarter? Was there an increment there from Aquasana that helped?

No, Aquasana has very little impact in the quarter. In fact, it is at a negative of about $700,000 or $800,000, but that's in corporate expense because those were the expenses we talked about regarding the acquisition related.

So, no, it was primarily the residential and commercial volumes that dropped to the bottom line, if you will. We did have higher steel costs. That was partially offset by price, et cetera. But that's the magnitude of it.

Got you. Two other questions. Does the yuan's weakness, if we use the year-end -- the quarter-end rate, does that go from [$]0.01 to [$]0.02 in the fourth quarter and then stay there?

I am not sure your question, if you use the fourth-quarter EPS or the fourth-quarter operating margin or what?

So from your press release, you indicated there was about a $2 million segment income hit, which translates to just a little bit below $0.01, and I was just wondering. That's an average for the quarter rate, so based on the end of the quarter 3Q rate, is that now $0.02 going forward?

$2 million [currency] rate you're talking about? Yes. No, I think in the fourth quarter it will be similar to maybe a little bit higher, because we are using a 6.8 rate, so it will be slightly higher than $0.01. Yes, a little bit higher than $0.01.

Okay, last question. The last couple of conference calls you guys have said that you are looking at more deals this year than you have in some time, both from a change in some of your external resources, but also from internal resources. Could you give us an idea of what the pipeline looks like? I know good, but is this something that we can expect six months some type of monetization? I know Aquasana is done. I get that, but just looking for more, size wise, just some type of thumbnail sketch on what you think maybe the next six months looks like.

Scott, this is Ajita. The pipeline is active, as it has been, but for obvious reasons I can't comment on something that could happen in the future vis-a-vis acquisition. We are active, the pipeline is interesting, and that's about all I can say at this time.

All right. Let me ask the question a different way. Are you looking at a lot of Aquasana-sized acquisitions? Are you looking at some larger deals? And regionally, could you give us an idea of where it is more active, US or (multiple speakers)

There is a wide range of deals. There are little ones and there are larger ones, and that has been -- that's about what it has been in the past.

And all geographies.

Yes (multiple speakers)

All geographies.

[Underway].

Got you. Okay, thanks.

Alvaro Lacayo, Gabelli & Co.

I just wanted some commentary about your expectations for both residential and commercial water heater shipments and how they have changed, and if Q3 had any sort of unique choppiness to it? And then, how all that translates to the updated Lochinvar guidance with respect to the water heater piece and the noncondensing piece?

I will take a shot at it, Ajita, and then you can. I would say that the residential volumes we saw in July, which is public, for the industry was up 9% or so, and as we looked at August and September, we think it was up more than that. So I think we are tracking pretty well to where we thought. I would tell you in the last call we said 8.9 million for the year. We would probably say 8.8 million to 8.9 million now, so we are tracking pretty well where we thought.

And on the commercial side, same sort of thing. I think we talked about a 225 to 230 level. We saw the second quarter up 30%, which we know is being driven by that 55- to 90-gallon electric. We saw July up about 28%, so it is tracking at that level, so I don't think any surprises.

Now to answer your question on Lochinvar, it is really two things. They had a very strong residential market last year and that has come back to bite us this year. They are going to be down probably 15%. And the noncondensing, which, quite frankly, we think is probably a shrinking market because of the move to condensing, has got quite competitive and will be down 15% to 20% in that part of the market. Now it is a relatively small part. It is just over 5%, but it hurts the growth rate.

The way we are going to remedy that is we're coming out with some new noncondensing products late this year that we think will help us in that category, as well as other products that -- two other categories that Lochinvar is coming out at the end of the year.

So they are having a difficult year from a growth standpoint. Their margins and margin dollars are growing, so that's very positive, and we think with the new product introductions that are going to happen next year, as well as some help from some of their key verticals -- education has been weak, and their multi-family, those categories have been flat, we would hope they would grow a little bit.

So going forward, we are comfortable with that 8%. We've modified it a little bit to really just reflect the growth that we have seen historically and modeled that going forward.

Just to clarify, when John talked about the verticals, he was talking about the full market verticals have been stopped. Those verticals have been stopped.

The only thing that I would add from a Lochinvar perspective is to just reinforce that the condensing boiler part is still growing double digit, which is what we expect, and the other is that in going back to residential water heaters, from what we are hearing anecdotally from our distributors, the inventories in the channel seem to be in good shape. And again, I want to remind you we don't have real good information about that, but we do get anecdotal feedback that is usually pretty good. And the inventories seem to be in reasonable shape.

It seems like a lot of these moving pieces are related to these one-time items and things that happened last year, so I was surprised to see the long-term growth rate come down versus just maybe -- just the Q3 and Q4.

You mean with Lochinvar?

Yes, correct.

Yes, what happened with Lochinvar last year, and we talked about that at length, is China hurt them because they were down significantly in China last year, as well as the Canadian market last year hurt them.

So, again, we just relooked at where they are this year, the new product introductions. Historically when we have owned them, the condensing has grown 10% and we think we are very much in a position to grow it at 10% going forward, and that's about 60% of the business.

And the water heater part is -- our guidance really gets in line with the rest of our North American water heater business at around 4% also.

Got it, okay.

So it is just a logical shifting.

Okay.

But there is still -- when you look at our total portfolio, it is still at the 8% type of growth rate that we've been talking about.

Okay, and then I guess with regards to the Aquasana acquisition, maybe if you could just go over some of the synergies and how you will be able to leverage the platform that you built out in China to support Aquasana in the US, and vice versa.

Yes, what we have said is it is a very complementary acquisition. So we are very, very strong in China in the reverse osmosis market. We do not have much in the way of carbon product. In the US, Aquasana is very strong in the carbon related product. They have some RO, but it's minimal, so we think there is truly some sales cross-selling opportunities.

One of their important products is a whole-house filter and that is installed by plumbers. We think we have some potential capability there to expand that. So, much of the opportunities are revenue synergies that we are very comfortable that we can end up getting, and then on top of that they have direct marketing capability that we think in the long run will be beneficial to us.

I think, just to add to that, from an acquisition and integration perspective it is just about two months under the belt and things are on track, no surprises. And things are as we expected.

What I didn't say is it obviously gets us into the North America market, which is a $2 billion market.

For water treatment?

Yes, for water treatment, which is a large market.

Okay, thank you very much.

Matt Summerville, Alembic Global Advisors.

I think, Ajita, it was in your closing remarks you made a comment that you were encouraging some of your distributors to sort of, I guess, for lack of a better term, pre-buy, stock up, buy more than would normally be necessary ahead of, I believe you said, an SAP implementation.

Can you talk a little bit more about that, if that event has already transpired, how that progressed, how the systems are functioning, and how much pull forward, if you will, was there into Q3, if I understood your comments correctly?

Sure, we had three major factories and a distribution center go on live on SAP, and that's a fairly large portfolio of factories going live at the same time. The date was -- October 1 was the go-live date and all these things are fairly long transition.

Things are on track. I wouldn't say it is completely error free. When someone is doing an SAP transition and they say it is error free, I don't know how to say this nicely, but there is probably more behind the curtain, okay?

But things are on track. They are where we expect. The teams are -- when issues come up, we have been addressing them very quickly, and so far the customer has not been impacted any more than we expected. And we encourage some of our customers to buy ahead just because it is a prudent thing to do, and we have done that with every one of our other SAP implementations with other factories. And there was some amount of buy-in -- I don't have an exact number -- in commercial. In residential, there was hardly any.

Yes, that's what we would have concluded from the numbers is commercial, there was some buy-in, but very little on the residential side.

But the gist of your question in terms of how the transition is going and things like that, it is on track.

Got it. And then, just as a follow-up with respect to China, what is your expectation for the full year for water treatment and air purification revenue? And then, just moving over to India, can you talk about at what point -- if you have a vision to breakeven, when you think that business starts to break even? Thank you.

I will start. Water treatment had a very, very strong quarter in the third quarter. It was up over 40%. Year to date, that's up approaching 40% in local currency terms, so about 30% in US dollars, and we expect -- that's what we expect for the year. So the water treatment business is doing very, very well.

Air purification is on track. I think at the beginning of the year we said that we would be double sales, from about $10 million to $20 million. We are on track to do that. We think we could be a little bit higher than that. So I would say both those businesses are doing as good or better than what we expected.

With respect to India, you really got to break it into two categories. We have a water heater business there, which I think we have said publicly if sales are about $15 million to $16 million now, let's say, this year, then we need a breakeven of probably $30 million to $35 million to get that to breakeven. What we need is we need some help from the economy, growth in housing, which hasn't taken place for the last two years. And then we have a water treatment business, which we have said is in its infancy and this year we'll sell a couple million dollars of it. We're in about six cities, and that is going to take -- we haven't really done the breakeven analysis yet on that business.

Yes, just to add a little bit of color to both those. In terms of India, the economy is doing well in many sectors, but not in housing, and that's what impacts us. So it is disappointing from that perspective, but we continue to add distribution and gain market share, which has been our game plan.

In China, as we look at the growth that we have seen in water treatment and air purification, the really exciting part of this is the fact that in China what we have is a very strong consumer brand and very strong distribution. And about four years ago or five years ago, we said -- we looked at how do we translate that brand into new categories beyond water heating, and obviously we have been very successful as we move into water treatment, and we think it's a little too early to spike the ball, but we have been on track or ahead when it comes to air purification. And that just tells us and gives us the confidence that there are a number of other categories and segments that we can get into, new segments, where we can leverage our brand and our distribution to continue this type of growth in China.

And when it comes to India, it is the same type of game plan. It is going much slower, but building the brand, building distribution, and then seeing how do we expand in terms of our categories to be able to access those hundreds of millions of people getting into the middle class.

Got it. Thank you, guys.

Bhupender Bohra, Jefferies.

So, just a broad question here. When I look at A. O. Smith, if you look at the gross margins over the last five years, you have done an excellent job. It used to be a 30% gross margin business. We are inching or have been consistently above 40% over the last four, five quarters here, since the second quarter last year.

How should we think about -- this is a light manufacturing company. How should we think about going forward over the next two years? And in the previous calls, John had mentioned about think about North America margins starting point to be like 21.5% to 22%. Can you comment on that going forward? Should we think about A. O. Smith has to be a 40%-plus gross margin business, with North America to be around that 20%-plus EBIT margin?

Yes, we are running about 40%, and we have said that historically there is three businesses above that, our commercial, our Lochinvar, and our China. And our residential is below that.

So we certainly think those margins, those gross margin levels, are sustainable going forward. You could have some volatility, depending on steel and pricing, et cetera, but we certainly think that's a realistic starting point.

I was asked on the last call regarding margins, and I guess my comment was we have not done the plan yet. We're in the process of doing it right now, but I certainly think that 21.5% to 22% is a good starting point. Now we've got to incorporate things like Aquasana into that plan, which has a little lower margin, but we certainly think that's a realistic starting point, and now it is our objective to obviously continue to grow margins.

We have said that once we get SAP in, the objective is to optimize it next year, but certainly we need to start getting some benefit from SAP as we look into the 2018 period, et cetera. Also, we think our spend on SAP next year is less; that hits the expense. We don't have that finalized. It's probably $5 million to $10 million less, so we have some positive things helping us with margins, et cetera, and certainly it's our objective to continue to grow margins.

And also, just to add a little bit, Bhupender, when you look at -- we have capacity. Our most challenged margin business, as John mentioned, is our residential water heater business, and, as you know, we have a deficit in housing that is not going to come back real fast, but it will come back. And our incremental margins in our residential segment are in the 30% type of level.

So there is leverage opportunity also as the volume grows, and at this stage, again, John mentioned SAP and our ERP system cost, but we also have a number of businesses where we are in the investment stage, probably more so as a portfolio than we would on a longer-term basis. But all of those are investments for growth.

So as those markets get traction and continue to grow, there certainly is leverage opportunities in every one of those -- the segments that you talk about. Lochinvar, we have consistently increased our margin. North America, we have talked about, and China, because it is a consumer business, will be a little slower, but the opportunity to leverage is certainly there.

Okay, thanks a lot. Just a second question, price increases. I know, Ajita, you had mentioned that price increases went pretty well. Can you give us what would be the impact? Or have they been realized, like most of it, or are we going to see that realization happen in fourth quarter on both residential -- and was it also applied towards commercial?

We had a price increase effective August 1, and we are comfortable with what our guidance is in terms of how the pricing is impacting us. In terms of the marketplace and competitively and things like that, again, for obvious reasons, I am just not going to comment on what is happening from a competitive perspective. But we are comfortable with the guidance that we have and the pricing that is built in there.

I think we said in the last call that it ranged from 5 to 8, and to answer your question (multiple speakers) apply to residential and commercial.

Yes, that's right. I missed that. It did apply to both.

Okay, got it. Thank you so much.

David MacGregor, Longbow Research.

Just a few quick questions here. You have taken your cash flow from operations guidance down from $340 million to $325 million. Was that just the greater working capital that you referenced in your remarks?

It was primarily the pension contribution. We decided in August to make a voluntary pension contribution, and that was the primary reason.

About $30 million.

Yes, about $30 million, $20 million or so after tax (multiple speakers)

Got it, thanks. And then, secondly, when you are talking about your North American margins and the fact that you expect them to be down sequentially in 4Q, you talked about the ERP being negative, greater than 100 bps. You talked about the reduced commercial volumes and then you talked about higher steel price. Is there any chance you could quantify for us just what you are expecting in the way of cost inflation pressure on North American margins there?

We really haven't disclosed that, but I think we said in the last call that sequentially steel prices were going to go up because we have a delay, if you will, on what the impact is, and I can tell you the fourth quarter will be the largest hit compared to third quarter.

4Q will be the largest?

Yes, Q4 will be the largest.

And then, have you -- I realize you're not going to provide a lot of detail on this at this point, but can you say whether you have settled on your 2017 steel agreements yet or is that still in negotiation?

Both are still in negotiations, I believe.

Okay, thanks (multiple speakers)

(multiple speakers)

Great, and then last question is just on China. And I was wondering if you could talk about any change in your share in the Tier 1 markets, and the extent to which you are seeing certain local brands trying to reposition to play more in the higher price points?

I will take a stab, and you were just there, Ajita, so you can probably say. I don't think we have seen -- the data we look at where units sold over $400, we are still maintaining our share there. I think it is certainly very competitive in the lower end, and I will say the middle tier, but I think we still have very, very large market share in the high end and we haven't really seen any change in that.

No, and John is right. I was there last week, in both Vietnam and in China, and the teams are excited and very upbeat about next year and where we are headed, the new products that are coming out. And so, we feel pretty good about what our guidance for China.

Great, thank you very much.

Jeffrey Hammond, KeyBanc.

I just wanted to come back to price and the margin. So your fourth-quarter guidance, does that reflect that you're getting those price increases you put through?

Yes, I think it assumes the price increases we talked about.

Now, a couple things. We also said on the last call that because of some project work, et cetera, you don't necessarily get all the pricing at that time and we said some of that would carry over into the first quarter, if you will. But, yes, for the most part, that does assume that.

The biggest impact, as we talked about earlier, is SAP is going to add $5 million to $6 million in the fourth quarter compared to the third quarter and $7 million compared to the prior year. So that is certainly having an effect on fourth-quarter margins that we don't think going forward we have that impact. And then the stronger commercial, which was unusual for the third quarter, has -- stronger commercial is what it did. But again, that was due to the pre-buy.

Okay, because your implied margin is right around 20% or sub-20% for the fourth quarter versus 23% in the first three quarters, so it seems like, I guess, as you look into 2017, SAP costs roll off and the commercial issue goes away, but the steel dynamics stays with us? Is that the way to think about the moving pieces?

Yes, that's one way to look at it. But I guess if you talk about a 20% as your starting point and you adjust for SAP, you are over 21%, and then you adjust for a leveling off of that -- of commercial, you get back to that starting-point range that I talked about earlier, that 21.5% to 22%.

Okay (multiple speakers) very very helpful.

Clearly, steel is having an impact on the margins, without a doubt. We did have a price increase, but we didn't necessarily cover margin with that.

Okay, that's helpful. And then, the -- so you mentioned the res industry numbers. How did your growth line up with that in the third quarter? And then, along those lines, I think you had a product hole in that small commercial category. How are you performing there as you have filled that product hole?

I think the quarterly market share was pretty similar, up a little bit from the previous quarter, so, again, we are forecasting what the industry is going to be. So residential is holding pretty well for us. We did introduce that product in the 55 to 90. We have gained some share in that, but I'll also tell you we are not back to where our overall commercial margin -- I mean, market share is, but we have made progress on that.

Okay, great. Thanks, guys.

Ryan Connors, Boenning & Scattergood.

I wanted to discuss a little bit of Aquasana and specifically the recent news in Milwaukee that the Company is in talks with the city about rolling that product out in certain homes where there are lead service lines remaining in operation. Recognizing that you can't necessarily disclose too much on that specific deal, other than what's in the press, but obviously that issue is not unique to Milwaukee, and there's a lot more attention to this lead issue post Flint, Michigan.

So my question is, how significant a growth opportunity do you think that is for Aquasana, that type of sell-in through a partnership with a municipality? And is that a transformational opportunity for Aquasana or is that just incremental? And then, also, was that a specific element of the rationale for that acquisition or is that something that you're just learning now more about as you get involved with the business?

I will try to answer all of those. The specific issue in Milwaukee was not a driver for the acquisition, but clearly the fact that there are lead issues around the country, like Flint and many other cities, was clearly an indicator for us, among a lot of other things, that there is a water treatment opportunity in the US.

And we have world-leading products that take care of all of these types of pollutants, especially world-leading reverse osmosis products. So we clearly see the opportunity to bring that technology to the US.

Aquasana was a great acquisition and a vehicle to get those products into consumers' hands, and using a channel that we really don't have a lot of expertise in, which we expect to grow in the future, obviously in terms of digital reach into every home.

The specific instance in Milwaukee, we are working with the local government and the United Way and other agencies, especially since we live here, to get the product out and help as much as possible. That's not going to be necessarily transformational for Aquasana, but it really has a terrific impact in promoting the name and getting the name out there as being a leader in the solutions for some of the problems that we have in many of our cities. So long term, that's absolutely going to help.

Yes, and just following up on the topic, I guess one of the things that really jumped out at me reading what the city had said was that it was going to cost them something like $800 million if they wanted to replace all these service lines, but yet they could buy every single affected home -- the city could buy each home a water filter and it would cost less than $10 million. So to the extent those are the two options for dealing with this issue, it seems like a no-brainer.

Is there a model here where the cities actually get involved via some kind of a rebate or something like that and actually fund some of this, or do you still think most of the sales will be funded by the homeowner?

I think it is going to be a combination. I think cities will get involved and fund some of this. It is hard to tell, but the city of Milwaukee is getting involved. Again, I think the big opportunity is not only getting the product out there, but getting our brand name out there in terms of being a leader in this category.

Got it. And then just one final question on that, so following up on the acquisition discussion earlier, do you feel that with Aquasana you have now got the platform you need in water treatment in the US or do you feel like there could be a further rollup on your part, that you would still be interested in adding to that platform via acquisition?

Aquasana is a start. We would certainly be interested in appropriately adding to that platform. And that's an ongoing -- and that's clearly on strategy, the way we have described our strategy.

Got it. That's very helpful. Thank you.

Charley Brady, SunTrust Robinson.

I want to just drill down on the rest-of-world op margin assumption. So you are saying it is over 13%, slightly over 13% for the year, implies a pretty strong Q4. Call it 13.5%. Is that a function of just some of the promo advertising spending dropping off from the level it was in Q3? And I know you're not giving 2017 guidance, but would you expect that number flat with where you are in 2016 or do you see it ramping up again?

I think it's combination of two things. Traditionally, our fourth quarter in China is our strongest quarter from a sales standpoint. We think that will continue.

And, yes, I would think that our advertising as a percent of sales will probably be a lower percentage than what it was in the third quarter because of those two events we talked about. So I think both of those help in effect get the margin -- having a relatively strong margin in the fourth quarter.

We have not talked about or -- we're in our planning phase. Ajita and I have talked at length. Certainly, it is our objective to grow north -- rest-of-world margins, and you do that with a combination of things. You leverage the advertising spend and the SG&A in China. Number two, you turn a couple of the businesses that right now we are incubating, like air purification. That is going to lose probably $5 million this year. We move that towards breakeven as we get higher sales levels.

We're also incubating the commercial water treatment business, where we will lose $3 million or $4 million this year. So I think those are ways to grow margin, and then we talked about we need to get India on a path of improved earnings. So, we haven't come out with an estimate, but certainly those are some of the things we are looking at.

And also, just add to that, when you talk about these incubating businesses in China, like air purification and commercial water treatment, et cetera, we usually have what I call a can-see plan, which is a multiyear plan that says here is how we're going to get -- here are the specific projects and here is how we're going to get our gross margins to the level that then we need for it to start contributing to the bottom line.

So it isn't -- it is more than we hope it will get there. There is very specific things we know we have to do and are executing to get those margins up there, just like we did in water purification.

Yes, that's helpful. Thanks. And just on the Chinese water heater market, I know it's tough to even gauge this, but can you talk a little bit about what you're seeing in terms of the replacement market there -- we're getting to the lifetime expectancy of some of these water heaters, and what that might add to growth going forward? Are you seeing much of it today?

We are. I will take a shot, and, John, you can jump in. Again, there isn't any real good data, but we have reasonable data in terms of our own warranty cards and things being returned, where people tell us where we ask the question as to was this a replacement or not. And in the largest cities, we think the replacement is around 50%, and in the smaller cities, probably 30% to 35%. That's the kind of range that we are seeing, from the somewhat limited data set that we have.

(multiple speakers) about comfort level from the standpoint, Charley, that when we talk about the market, the water heater market growing at 7%, we think that's going to contribute to that.

And also, what we also see is that since A. O. Smith is at the top of the food chain as a high-end brand, it is an aspirational brand. So when people replace lower-end product, very often they upgrade to the higher-end brands, which is our brand.

Got it. Thank you.

David MacGregor, Longbow Research.

Thanks for taking the follow-up. Just quickly, the 17% organic growth in China, how much of that was from expanded distribution versus same-store sales?

We did expand our distribution, but I really -- we don't have a good way of really measuring that. We've tried to do same-store sales, but we have had difficulty because we are continually opening stores and we are continually closing stores that are inefficient, et cetera. I would tell you the majority of it is the growth in the market and that that certainly has been a contributor.

Thank you very much.

That does conclude our question-and-answer session. I would now like to turn the call back to management for any further remarks.

Thank you for joining us today. Please take note that we will participate in several conferences during the fourth quarter -- Goldman Sachs in Boston on November 2; Baird in Chicago on November 8; and Northcoast in New York City on November 10. Have a wonderful day.

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