A O Smith Corp (AOS) 2016 Q4 法說會逐字稿

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

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

Thank you, Bruce. Good morning, ladies and gentlemen, and thank you for joining us on our 2016 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, as a courtesy to 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. 2016 was another excellent year for A.O. Smith, setting records for sales and earnings. We continue to see healthy end markets for our consumer products in China and for boilers and commercial water heaters in the US.

Here are a few highlights. Sales grew 6% to a record of $2.7 billion. Excluding the impact from the strengthening US dollar against the Chinese currency, our sales grew 8% in 2016. China sales are up 19% in local currency.

Among several revenue growth drivers, A.O. Smith-branded water treatment sales grew over 40% in local currency. Our e-commerce sales in China reached nearly $200 million. Net earnings of $1.85 per share were 17% higher than our earnings per share in 2015.

We welcomed the Aquasana team to A.O. Smith through our acquisition of the US-based water treatment company in early August. A.O. Smith global sales of water treatment product totaled $194 million in 2016.

We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. During 2016, we repurchased approximately 3.3 million shares for $135 million. We announced a 17% increase to our dividend last month. The 5-year compound annual growth rate of our dividend is over 25%. We 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 year of nearly $2.7 billion were 6% higher than the previous year and 8% higher in local currency terms. Net earnings of $326.5 million improved 15% from 2015. Earnings per share of $1.85 improved 17% over last year.

Sales in our North America segment of $1.74 billion increased 2% compared with 2015. The segment benefited from a full year of pricing related to the US regulatory change in April of 2015 as well as a price increase related to steel and other cost inflation in August 2016.

Higher volumes of boilers and commercial water heaters in the US also contributed to higher sales. Lower volumes of US residential water heaters partially offset these benefits. The purchase of Aquasana in August added $18.4 million to our North America segment sales.

Rest-of-world segment sales of $966 million increased 11% compared with 2015. China sales increased 19% in local currency, driven by higher demand for water heaters, water treatment, and residential air purification products.

A.O. Smith-branded water treatment sales in China totaled nearly $148 million in 2016 compared with $110 million in 2015. Sales of in-home air purification systems almost tripled to $26 million in 2016 compared with $9 million in 2015.

On slide 6, North America operating earnings of $386 million were 14% higher than segment operating earnings in the previous year. And operating margin of 22% was 200 basis points higher than the 20% operating margin one year ago.

Pricing actions, lower material costs in the first half of the year, and higher boiler and commercial volumes in the US were partially offset by lower residential water heater volumes in the US. These factors were the primary drivers of the improved North America segment financial performance.

Rest-of-world operating earnings of $129 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 almost $8 million due to China currency translation.

Higher selling cost in China to support expansion in Tier 2 and Tier 3 cities and higher advertising costs to support brand building were the primary drivers of higher segment SG&A expenses. Segment operating margin of 13.4% was higher than one year ago.

Our corporate expenses were higher in 2016 compared with the year-ago period, primarily due to $1.2 million of Aquasana acquisition-related cost and higher expenses at our corporate technology center. Our effective income tax rate in 2016 was 29.4%, which was slightly lower than the rate of 29.7% recorded in 2015.

Sales for the fourth quarter of $698 million were 9% higher than the previous year. Net earnings in the fourth quarter of $83 million increased 4% from 2015. Fourth-quarter earnings per share of $0.47 increased $0.02 compared with 2015.

Sales in our North America segment of $436 million increased 5% compared with the fourth quarter of 2015. The increase in sales was primarily due to higher volumes of commercial water heaters and boilers in the US and pricing actions in August 2016 related to significant steel cost increases and inflationary pressure on other costs. Lower US residential volumes partially offset these factors. Aquasana added $12.2 million to our North American segment sales.

Rest-of-world segment sales of $268 million increased 15% compared with 2015. China sales increased 24% in local currency, driven by higher demand for our consumer products in the region, led by water treatment and air purification products.

On slide 9, North America operating earnings of $89 million were 3% lower than segment operating earnings in the year-ago quarter. And as expected, operating margin of 20.5% was lower than the 22.3% operating margin one year ago.

The favorable impact from the pricing action in the US and improved profitability of Lochinvar-branded products were more than offset by higher material costs and over $6 million of incremental ERP implementation expenses. These factors resulted in lower segment operating margins in the fourth quarter of 2016 when compared with 2015.

Rest-of-world operating earnings of $38 million improved 34% 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 $2.5 million due to China currency translation. Higher selling costs in China to support growth and higher advertising costs to promote our consumer products were the primary drivers of higher segment SG&A expenses.

Fourth-quarter segment operating margin of 14.2% was higher than one year ago, primarily due to higher gross margins as the result of a more profitable China mix and improved water treatment profitability in the 2016 quarter. Our corporate expenses were essentially the same in the fourth quarter compared with the year-ago period.

Our effective income tax rate in the fourth quarter of 2016 was 28.9%, which is higher than the 27% experienced during the fourth quarter last year. The fourth-quarter 2015 rate was lower than 2016, primarily due to the extension of the US research and development tax credit in late 2015 and additional R&D tax benefits in China.

We finished 2016 with a strong fourth quarter when adjusted for the $0.04 per share unfavorable impact from the expected incremental ERP expenses and the higher tax rate.

Cash provided by operations during 2016 was $447 million compared with $352 million for the prior year. Higher earnings and lower outlays for working capital, primarily in China, were the primary drivers of improved cash flow in 2016.

China experienced a series of favorable cash flow impacts in the fourth quarter. First, accounts receivable balances declined from the prior-year end, despite considerably higher fourth-quarter sales. We received a series of unexpected large customer payments late in the fourth quarter, and benefited from improved terms with a few customers, all resulting in lower AR balances.

Second, trade payable balances were higher, most notably due to higher inventory in advance of the Spring Festival occurring this week. And third, cash received in advance from distribution customers was higher than expected.

Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 18% at the end of 2016. We have cash balances totaling $755 million located offshore, and our net cash position was approximately $431 million at the end of December 2016. Our year-end 2016 net cash level was higher than we expected as a result of the working capital factors noted previously as well as lower capital spending than planned in 2016.

We completed the acquisition of Aquasana, a US residential water treatment company, in August 2016. Primarily as a result of continued strong cash flow and escalating TBGC premiums, we made a voluntary contribution to our pension plan of $30 million during 2016. The after-tax impact to our cash flow is approximately $18.5 million.

During 2016, we repurchased approximately 3.3 million shares of common stock for a total of $135 million. At its December 2016 meeting, our Board of Directors authorized the purchase of an additional 3 million shares. Approximately 4.9 million shares remained on our existing repurchase authority at the end of 2016.

This morning, we introduced our 2017 EPS guidance at a range of between $1.98 and $2.08 per share. The midpoint of our EPS guidance represents a 10% increase in EPS compared with our 2016 results. Please note that our first quarter historically has had the lowest EPS of our four quarters, resulting from softer sales in China during the New Year travel holiday and the seasonality of Lochinvar-branded products, which favor the second half of the year.

Please turn to slide 12 for several 2017 assumptions. We expect our cash flow from operations in 2017 to be approximately $350 million, which is lower than the $447 million generated in 2016. We expect higher earnings in 2017, but also larger outlays for working capital due to the higher-than-anticipated cash flows in the fourth quarter of 2016.

Over the 2-year period from 2016 to 2017, we expect to generate operating cash of approximately $800 million, which compares with $612 million during the 2 years 2014 to 2015.

We broke ground in 2016 on the construction of a new water treatment and air purification manufacturing facility in Nanjing to support the strong growth of these products in China. Our 2017 capital spending plans of $90 million to $100 million include approximately $40 million related to this plant.

Total cost for the facility, which is expected to be completed in early 2018, will be approximately $65 million. After this expansion, we expect capital spending in 2018 and beyond to be at levels approximately equal to our depreciation plus amortization. Our depreciation and amortization expense is expected to be approximately $70 million in 2017.

Expenses related to our ERP implementation were approximately $25 million in 2016 and are projected to decline to approximately $17.5 million in 2017. We expect to conclude our implementation efforts at a few of our small factories in North America this year. At this time, we do not expect to implement this system at our foreign operations.

Our corporate and other expenses are expected to be approximately $47 million in 2017, slightly higher than the $45 million in 2016, primarily due to higher expenses at our corporate technology center. Take note that our interest expense will be approximately $4 million higher in 2017 as a result of higher rates, share repurchase activity, and our acquisition last year.

Our effective tax rate is expected to be between 29.4% and 29.7% in 2017 and similar to the rate in 2016. This assumption is predicated on no change to the current US tax regime.

With regard to tax reform and border adjustment proposals, we have had several discussions with Big Four accounting firms. As you can appreciate, the proposals are fluid.

We believe A.O. Smith could benefit significantly from tax reform. Approximately 60% to 65% of our total profits are derived in the US. Our 35% Federal rate is reduced by approximately 2% for our manufacturing tax credit, which would likely be eliminated.

The savings on federal income taxes as a result of using the proposed House plan tax rate of 20% or the Trump plan tax rate of 15% would be a significant benefit compared with our current tax rates. With this reform, we expect our net effective state income tax rate would increase approximately 100 basis points.

As many of you know, we manufacture water heaters in the US and export a portion of them to Canada and elsewhere. Additionally, we have manufactured a minority of our water heaters sold in the US in our [Makelador] plant for almost three decades, and we import our tankless water heaters for sale in the US. If the net import concept is adopted, we believe we would experience an impact from border adjustments, as our net imports are estimated to be approximately $75 million.

Depending on the final tax reform, we could incur one-time income tax expense associated with repatriation and remeasurement of deferred taxes.

We expect to repurchase our shares in the amount of approximately $135 million in 2017 under a 10b5-1 plan. We may opportunistically repurchase additional shares up to $65 million. If $135 million of our stock is repurchased, we expect our average diluted outstanding shares in 2017 will be approximately $174 million.

I will now turn to call back to Ajita, who will summarize our guidance, the business assumptions for 2017, and our growth strategy, beginning on slide 13.

Thank you, John. We project revenue growth to be between 9.5% and 11% in local currency terms in 2017, and 8% to 9.5% in US dollar terms. We expect Aquasana sales to be almost $60 million this year, an incremental $40 million in sales over last year and slightly accretive to earnings.

With a full year of Aquasana sales as part of A.O. Smith, we expect our global water treatment product sales to be nearly $300 million in 2017. We predict that Chinese currency will remain at current levels against the US dollar, resulting in a 5% or $40 million sales headwind compared with the average rate in 2016.

We expect steel prices to continue to be volatile and decline slightly from current prices. This assumption is significantly higher than the average price in 2016 and results in the most difficult comparisons for the year in the first and second quarters.

Specific to our North America segment, we project US residential water heater volumes will increase approximately 200,000 units in 2017 due to new construction and expansion of replacement demand. We project US commercial volumes will be up modestly, with little growth in small electric units after the category grew significantly in 2016.

Fourth-quarter 2016 sales of US commercial boilers were strong, up double digits due to the introduction of new Lochinvar products and the continued transition to higher-efficiency boilers. We expect the total portfolio of Lochinvar-branded products to grow over 8% in 2017, which includes slower-growing Lochinvar-branded water heaters. These factors lead us to expect our North America segment operating margin to be between 21.5% and 22.25%, despite the headwind from lower Aquasana EBIT margin of almost 50 basis points.

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. We grew 19% in local currency last year after growing approximately 17% in each of the last 2 years.

With several growth drivers underpinning our China business, we are confident to project an annual growth rate of 15% in local currency in 2017. These drivers include: overall water heater market growth driven by household formation and an emerging replacement market; geographic expansion; market share gains; continued strong growth of water treatment products; and air purification product growth.

With benefits from China growth, smaller losses expected in India, and our air purification products approaching breakeven, we project rest-of-world segment operating margin to be at least 14% in 2017.

Please advance now to slide 14. Our 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 represent approximately 85% of North America water heater and boiler volume, positively differentiates 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 to 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.

The first question -- I think, John, Ajita, and Pat, could you just expand upon your comments around the steel pricing and the volatility and the compare for 1Q and 2Q in terms of how you are thinking about how that plays out in terms of growth and profitability for the Company in the first half as we get some texture around the first-half versus the second-half dynamic for your guidance?

Well, so I can tell you it began in 2015. Cold rolled steel was about $535 a ton or $550 a ton, I think. We are now at $830 a ton. And so the first 2 quarters are certainly -- as we talked about on the call, are going to have negative steel costs compared to the prior year. And as you move to the end of the year, you will be more equal to what we were paying in late 2016.

It has obviously been extremely volatile. We have talked to many experts. I think their forecast is for it to go down from here, but there's a lot of variables. Capacity is at 70%, but cold rolled is higher than that.

Some of the input costs have been coming down, but then you have some of the potential tariffs and duties that could take it the other way. But clearly, steel will be a negative comparison first half of the year of 2017 compared to 2016.

You have laid out a very impressive outlook for organic growth, as you always do. And obviously there's a lot of teeth and underlying assumptions that support the organic growth.

My question is you do have this outsized exposure to China sales, as everyone is well aware of. Is there anything -- and you talked about border adjustability as well, so you -- and the net export position and taxes. So you've given a lot of detail.

But in terms of the potential for trade war or tariff adventure in association with the Trump administration, how do you think about your headline risk there with respect to your business? Because you are well entrenched locally in China.

But is there anything on the fundamental basis you are concerned about? Certain policies or certain regulations, certain actions that could happen in global trade between China and the US that could really cause fundamental problems for you, aside from a headline risk?

I'll take a shot at it, and Ajita can add. The China entity is basically vertically integrated, and it sources and sells everything in China. From the US, we import very little from China. So from that standpoint, we shouldn't have too much impact.

And the other thing is both countries' trade is very intertwined. And our assumption is that ultimately it gets resolved reasonably. But with respect to China imports or exports, we really don't have much of either way going on.

And just to reinforce that, I think the key is -- because you are right that we do have a lot of revenue exposure there, which we like. The growth has been fantastic, and we have very strong fundamentals in China with a strong brand and strong distribution, a great team.

At the same time, we do worry about it, on nothing new now on an ongoing basis. And that's why we have, in fact, not just for the three of us and our team to be looking at it, but we hire outside experts to give us advice in terms of what's happening.

And we've talked about it before. We have the Eurasia group on retainer, and we work with them in terms of understanding the risk out there. They are experts at this. And we have consulted with them, and we are very comfortable in terms of where we are from a risk perspective, even in these economic times. And as John said, at the end of the day, the two economies are very intertwined, and we feel that cooler heads will prevail as time goes on, if there is anything.

Thanks, I'll get back in queue.

Jeff Hammond, KeyBanc Capital.

I really wanted to dig in on the res data. It looks like through November, it was up 7% if you adjust for some of the NAECA III shift from res to commercial, kind of up low-single digits.

Can you just talk about how you did relative to that? And what you see as kind of holding back the residential water heater business through 2016. And then how you are framing it for 2017, particularly where you can gain share or mix and price to grow that unit number.

Well, you are right. The industry was up the first 2 months of the year probably about 80,000 units. We were during that same time period down about 20,000 units.

And there's really two reasons for that. One is SAP went in at our wholesale plants, and our lead times extended a little bit there. So we didn't pick up as much on the wholesale side as we should have.

And then number two, our largest retail customer dropped their inventory from September to December to more normal levels, consistent with where they were at the end of last year. And so we didn't participate as much on the retail side, either. But those were, in our mind, two one-time events, if you will.

And they were approximately half-and-half in terms of their impact.

What we are looking at in 2017, and we've done a lot of modeling, obviously, trying to forecast the industry. It's been difficult over the last three years. Our forecast base level kind of assumes that the industry is going to go up about 200,000 units, and that's 100,000 in completions and 100,000 in replacements.

We think that's a reasonable assumption now that we think the inventory has cleaned out of the system from all the activity that happened with NAECA between the combination of price increases and the elimination of some products. So that's our base assumption going forward.

Okay. So it looks like -- so your guide, all in, is 8% to 9.5%, which it looks like FX offsets the Aquasana. Is that a fair --?

Right, right.

So the China one is easy. I'm just trying to bridge your 8% long-term target versus your 8% to 9%, like 9.5%. What's the upside scenario? Because it seems like China, you are saying plus 15%; Lochinvar plus 8%. And so --

Yes. I think what we have is a little bit of pricing carryover from 2016, so on the high end, that certainly helps us. If the industry is a little bit higher than we expected, that gets us to the high end. To get to the low end is the industry doesn't do as well is what we expect.

So that's kind of the bridge. You are correct that essentially Aquasana and what we are assuming for currency effect on China in 2017 pretty much offset each other.

Okay, helpful. Thanks, guys.

Bhupender Bohra, Jefferies.

John, on North America margins, you have the guidance out as 21.5% to 22.25%. And I believe in the prior calls, I think you had capped the high end at 22%. What makes you a little bit more comfortable extending that guide by 25 bps here at the high end, especially with the steel cost and some of the headwinds you have been talking about?

Sure. Well, as I had spoken, I had said our starting point was 21.5% to 22%, and we had not done our estimate. I think on the high end, if volumes come in at the 200,000 to 300,000 range, those come in at a very attractive incremental margin. If steel does recede more than kind of a little bit, that would obviously help our margins.

So it's a combination of those things. I think the high and low end of the margins will be driven primarily by the volumes in North America residential and commercial. I think we are pretty comfortable on the Lochinvar of 8% to 10%. And then where steel goes, plus or minus.

Okay. And any other -- we have been talking about SAP cost and some of the synergies, which we had not officially, but as we talked about you will be getting from the SAP implementation over the next two years. Is that built in the guidance, too, like the North America margin guidance?

No. I would tell you that the savings that I think we talked about on the last call, that we would expect to start generating savings in 2018. We are not completely installed yet. We will finish that in North America this year. We will make some improvements to the system.

And then I think our focus will be on things like shared services, looking at our supply chain and the benefits we can get from consolidated spend and some of those things. So we would start seeing that, we think, in the 2018 range. One of the benefits to margin is we've said we spent about $25 million in 2016, and we are forecasting $17.5 million in 2017. So that does help the margin some.

And this is very consistent with what we have said in the past, so it's not any change. It's that 2017 is going to be a year where we really stabilize the system, really get to understanding how we use it.

And then 2018 is when we really start -- and setting plans to reap benefits in 2018 is when we really think that's going to begin. And 2018 into 2019 onward -- which, again, from talking to other people who put in systems like SAP, it is pretty consistent.

Okay. And my last question, on Lochinvar China growth strategy. We have -- since your acquisition in 2011, I think the China strategy has been -- it seems like it's delayed by a couple of years over the last several years now.

Could you just update us like how big China is for Lochinvar in terms of potential? We saw -- I think you guys talked about some new product introduction in China in the third quarter last year. How the traction is coming along for that particular product --

Let me take a stab, and then you jump in. You are right. When we made the acquisition, we anticipated at the time that the Chinese market would become -- it would open up for -- that the timing would be that the Chinese market was opening up for these high-efficiency condensing products that Lochinvar makes. Obviously they have world-class products.

And we were wrong in the sense that that condensing market hasn't quite opened up at the speed that we anticipated. But in the meantime, we did see the opportunity for high-BTU-input noncondensing products. And Lochinvar developed some products which we started shipping to China end of last year. And we also manufacture that product in China.

So from a strategic viewpoint, we are doing what we said we would. It has been pushed out more, and it is a different type of product because the market for condensing product has not really developed at the speed we thought. We know it will. The indications are it's coming, but we just don't quite see it there yet.

However, the noncondensing part, the high-BTU noncondensing part, where the technology from Lochinvar really helps us, we have developed products. We are manufacturing some of them in China. We are exporting some of them. And the growth of that segment is going, actually, very well.

Anything to add, John?

No.

Okay. Thanks a lot then.

Matt Summerville, Alembic Global Advisors.

With respect to China, you sort of disclosed revenue numbers and year-over-year growth numbers for the treatment portion as well as purification on the air side. What did your legacy water heater business do in China in local currency in 2016?

And then moving to 2017, the bridge to that 15% number that you are calibrating everyone around and have -- you've obviously had that number for a long time. What growth expectations do you have for those three pieces in 2017 that gets you to that 15%?

When we look at the model compared to 2016, base water heater, which is about 70% of the business, grew at 6% or 7%. So a little bit more than -- contributed a little bit more growth than what we expected. Pricing was 4% to 5%, pricing market share was 4% to 5%, as we expected.

And then obviously, the ancillary product lines added about 8%. So that's kind of the math on how you get to the 19%, if you will. And obviously, 2 prior years we averaged about 17%. So from a growth standpoint, 2016 was a very good year.

Now, when we look into 2017, we are pretty much following our model, saying that we expect to get 5% from our legacy businesses, i.e., our electric and instantaneous gas. We expect to get 5% from either pricing, market share. And then we expect to get 5% from continued growth in water treatment, air purification, etc.

So the model is tracking very well for what we thought, a little bit better the last couple of years. And we are comfortable with the 15% growth.

And I think the individual pieces of the model -- long term, we are very comfortable. Short term, they are going to vary. But overall we are very comfortable with the average.

Got it. And then just as a follow-up, you talked about your ERP implementation costs and what they are doing from 2016 to 2017. Long term, what does that $17.5 million number go to? Does it eventually go to zero? Are you done? Is there a reason you are not migrating your SAP platform to your international operations? Can you give a picture on your ERP, please?

Sure. So as I said, we are about $17.5 million next year -- I'm sorry, this year, 2017. We would expect a run rate is probably about $15 million. And the pieces of that are the amortization of what we capitalized is almost $6 million. So that's going on for the next 10 years or so.

Then you have the services, the external services, the hosting services, the SAP support services, which are $3 million to $4 million. And then you have the license fees that you pay these guys going on, whether it's SAP, whether it's SuccessFactors.

So we think $15 million is probably a reasonable number. And then you have the COE, which is people that are supporting the system, etc. So we are saying $15 million is a reasonable number.

Now, Ajita and I have had a lot of discussions on taking it internationally. And we are not saying we're not going to at some point. But right now, China, when we sold EPC in 2011, we put QAD, a very good system, into China. And it can handle their growth for quite some time. India -- we think SAP at this time would be overkill for them.

So we will continue to evaluate. And again, our focus is, starting towards 2018, is starting to get savings in North America from the system. And that's where we are focusing on.

Yes. And just to reinforce, QAD is a very good system and is working extremely well for us. And also, we did do some -- maybe this is more detail than you want. But we did do some customization with QAD so that it handles not only the manufacturing, but also giving us really good data on the retail side of the business, which, as you know, is growing very well.

So that's working really well for us. And we don't think that putting SAP in there today is the right thing from a consolidation perspective because it's working for us.

Understood. Good color. Thank you, guys.

Charley Brady, SunTrust.

This is actually Patrick Wu standing in for Charley. Thanks for taking my question. I'm looking at China, up 24% excluding FX. What was the number including FX, all in?

And then how would you attribute or maybe parse out so as to build up normal seasonal demand leading up to the Chinese New Year versus the large customer orders that you talked about a little bit? Because I think, versus last year ex-currency, it was up 19%. There was a 5% delta there. Just wanted to bridge that gap.

Well, the first one -- so I think we said that currency affected 2016 by about $50 million. And that was all China, essentially.

What about at the fourth quarter? Sorry.

The fourth quarter, it took it from $19 million, it was $19 million, down to what?

The impact was about $17 million.

So we have -- I can tell you the fourth-quarter impact for sales was about $17 million. So in local currency, it was 24%, and in US dollars, it was about 16%. So that was the fourth-quarter impact. And we also talk about that it affected profits by about $2.5 million. Does that answer that question?

Yes, the first portion, definitely. But I was more looking at in terms of normal seasonality. You generally have a buildup leading up to Chinese New Year in the fourth quarter. I think last year, ex-currency, it was up 19%. And the fourth quarter of this year, it's up 24%. How would you parse out the seasonality versus maybe some of the larger orders that you mentioned during your prepared remarks?

Well, I wouldn't expect much change from the prior year. And what we were trying to allude to is that the first quarter is always their weakest of the four quarters, just because of the 10- to 12-day China holiday.

We did get some orders, but those came in late in the year versus -- and last year, they would have came in early in the year. So that was part of the timing, etc. But what we were trying to get across is first quarter is clearly China's weakest quarter. But we would still expect to see nice year-over-year growth.

Okay. When I'm looking at the water treatment sales for the year, I think if you X out Aquasana and then X out your China numbers, I think it leaves around $28 million in terms of water treatment. Is that mostly India?

And then also can you frame a little bit about how you guys view the losses in 2017? I think you guys said that there will be smaller losses in 2017 than 2016. But can you maybe give a little bit more granular color on that?

Sure. So in 2016, you are right. Branded was about $148 million. The legacy business we bought in China was about $18 million. Turkey was about $5 million. India was a couple million. Vietnam was about $4 million. And then you had Aquasana, the $18 million we talked about. So that's how you get to the $194 million for water treatment product sales.

So that's the first question. The second one was with respect to India?

Right. How should we think about the framework for losses in 2017 versus 2016?

You are fading. The last part of your question didn't come through.

I think he said losses.

Just thinking about how to frame the losses in terms -- in 2017 for India versus 2016 and how we think about that.

Sure. So in 2016, we lost almost $10 million. That was the high end of the range. And we would say that the fourth quarter was impacted by the demonetization, I think, the elimination of large bills, which you probably read about. So that had a negative effect.

So our loss was towards the high end of the range. Our forecast when we look into 2017 is that sales will grow, we think, over 30% and the losses will reduce to, let's say, around $8 million.

Great, thank you.

Scott Graham, BMO Capital Markets.

So really two questions. The one is the easier one. M&A -- any type of update you can give us, Ajita? Obviously, with the share repurchase upping in December, is that any type of a signal that you are maybe not seeing a lot in the M&A pipe? Or is that just sort of a just in case something doesn't happen?

No. There's no signal at all, no change in strategy. The market out there is active and we are looking with a wide net, as we have talked in the past.

Okay. I would attribute, certainly in part, the performance or lack thereof of the stock during this Trump rally on concerns over China backlash, China consumer backlash on the US. So if you could walk us through again why you think the fact that you are landlocked -- we all get that.

But why wouldn't a US brand as strong as A.O. Smith maybe not get any type of backlash? Certainly, we understand that you are kind of like the only game in town at your price point and what have you. But still, I think that there is still a concern out there about that. If you can maybe address that more fully?

I'll give it a shot. In terms of -- a lot of the rally has been around infrastructure-related types of stocks that have really done very well. But I can't judge what's happening in the market.

But from our perspective, like we said before, we are pretty much vertically integrated in China. We export a little bit from here to China: glass and a few components, very little. And we hardly -- I don't think we export anything from China -- we export very little, very little from China to the US. So we are pretty much self-contained in China. So that's number one.

And then also at the end of the day, the two economies are very intertwined. And what the experts are telling us, okay, because this is not something that Pat and John and I sit around the table and say here's what we think will happen, because we are certainly not the experts.

But what the experts are telling us is that as we look at all the pluses and minuses, that if there is anything, it will be short-lived and is going be impact more the cross-border type traffic and is not going to impact the companies that are self-contained in either place. Okay?

And we are comfortable with that. We don't see any evidence of anything happening. And so from a risk perspective, we are comfortable in terms of where we are.

So what I think I hear you saying is that ultimately cooler heads prevail. In other words, you have a powerful brand, everyone knows it's a US brand. You've talked ad nauseum over the years about how the power of a non-China brand works so well in the customer segment that you are targeting.

So it sounds to me like you are saying that if there is an impact, it will be short-lived because people will realize that everything you sell in China you make in China. But I guess -- and, look, it's impossible to handicap this at this point.

But I think the greater, larger concern is not about necessarily being landlocked, but just about US brands in China in general. And what the new President's -- with the potential for renegotiating trade agreements, what that could mean. And I'm sure your experts probably have an opinion on this, but that was really the nature of my --

So let me address that. There are two issues. Okay? One is in terms of renegotiating trade agreements, which is what will impact the cross-border type traffic, of which we have virtually none. Okay? So that's one.

The second is the secondary impact of what that would do in terms of the relationship and impact on US brands in China. I think that's what you are saying. Okay? In terms of the latter, like we said, from talking to the experts, we are not concerned.

And also, if you go back and look at what has been happening historically in China, not with the US, but very, very similar circumstances with a country that there has been constant ups and downs, and that's Japan. Japanese brands continue to do very well in China. We compete with Japanese brands in China, as you know.

And when these issues flare up -- and with Japan it flares up at least once a year with the visit to the shrine that happens in Japan every year -- things flare up for a short while and then it goes back down. This is in terms of the rhetoric in all the newspapers and all the rest of it. We see no impact in the marketplace. And it's business as usual.

So we put it all together and we say, you know, the best we know and the best we are hearing from the experts, we are not concerned.

Understood. That's a comprehensive answer, Ajita. Thank you. Here is just my last one, if I may. The transitory issues, or quote-unquote transitory issues you talked about, hitting the North American volumes. It sounds like from the guidance that you are assuming that that is, in fact, a transitory issue.

But I was wondering if you could bring to bear what you are seeing in January as proof that they are transitory issues. Are you seeing a return to normal trade volume in the -- did you see that in January?

Yes, yes.

Yes, we've seen -- but in the two areas, first of all, our lead times are coming down because -- there were -- John said, he used the word two one-time issues. Okay? Which explain about half-and-half, which explain the gap.

So our lead times are coming down. Is it down to where I want it to be right now? No, but it's coming down very nicely. That's number one. And number two, we see our customer building back inventories and the order rate is up. So we are comfortable as to where we are.

And we have lost no customers.

Right, yes. We haven't lost any customers. The lead time being down, but not a loss of customer. That's a good, important point.

Very good, thanks.

Alvaro Lacayo, Gabelli & Company.

My question is in regards with, I guess, the comments around the way volume went in the fourth quarter and tying it into the August price increase. Can you just maybe talk about market acceptance on that price increase versus what you've seen in the past?

And you mentioned those two one-time issues. Did rising price have anything to with the volume issues that you had in the fourth quarter?

Absolutely not, on the second one. No, no. The two reasons were we put SAP into our three major wholesale plants. Two of them are residential, and our lead times extended a little bit associated with SAP.

Number two is our largest retail customer from September 30 to December 31 adjusted their inventory levels down, putting them to more normal levels and very comparable to the prior year. So no, it had nothing to do in our mind associated with price.

Okay, great. And then I guess around just higher-level thinking on the M&A strategy, and with everything that we've been talking about in regards to trade tensions, repatriation, tax reform. In terms of how you are developing the pipeline and how you think about what the strategic pieces are going forward, how do you see any differences or potential opportunities, given all the changes that you are seeing in the market today?

I'll take a shot at it. I don't think our strategy has changed.

No, our strategy certainly hasn't changed.

It's consistent with what we've -- it's still the segment scenarios we've talked about for the last couple years on where we are focused.

Our strategy has not changed. Now, when -- and also in terms of there's a lot of speculation in terms of what's going to happen. We don't know what's going to happen. When things do happen, if that's going to impact our strategy or open up more opportunities because of repatriation, etc., then we ought -- or differences in the tax impact, then that would certainly go into impacting our strategy and tweaking our strategy or changing our strategy. But right now, we are very consistent with our strategy in terms of where the opportunities are and where we want to grow.

Okay, got it. And then in China, you talked about the better profitability. You mentioned better mix and better profitability in water treatment. If you could just provide more color on what the mix improvement drivers were, and then what was making water treatment more profitable? Was it just price increases or was something else going on?

It wasn't price increases. It was just kind of scale and much higher, so we are starting to get more contribution, etc. And they have very -- water treatment has very attractive gross margins.

Just to add a little more to what John said, we've always said when we get into a new business segment, obviously there's going to be an initial investment in terms of getting into the segment. We are going to lose money for a while until we build up to scale.

But also, remember, we are a consumer-products business in China. So in addition to building up scale like we would do with a normal manufacturing business, we are also investing in the brand and investing behind making sure the consumer knows that the A.O. Smith brand is in that category. And what our features and benefits are -- typical marketing. Okay? So it's that combination that makes that investment period and getting us to breakeven longer than a typical industrial-type business. Okay?

But at the same time, whenever we get into a category, we make sure that our gross margins are high and that we have a plan and a can-see path to get us to the right level of profitability. And we make sure that the teams are working towards getting up there. So we are along that path.

And as the volume grows and the scale grows and the contribution grows, and also we can appropriately scale our investment behind the brand in that category to make sure that we are reaching our profit targets at the right pace. So that's -- it's all up there. I know that's a mouth full, but that's all of that impacting us. And it's on track in terms of us getting to -- getting the water treatment profitability to the levels we want them to be at.

Okay, thank you very much.

Sam Eisner, Goldman Sachs.

I think actually most of my questions have been answered. Thanks.

David MacGregor, Longbow Research.

This is Brandon Rolle on for David MacGregor. I was going to ask you if you could talk quickly about your 2016 growth in commercial water heaters, and to the extent that you may have gained share. And then also if you could just talk about what might change competitively, if anything, in 2017 with a possibly stronger US dollar environment. Thank you.

I think share -- well, the whole industry grew about 20%. And I think we talked about the major reason for that being the 55-gallon and up electric, which was eliminated under NAECA from a residential standpoint.

So if you look at the 20% growth, I think about 17% of the growth was specific to that. And then small electrics under 55-gallon were the majority of the reminder, the 3%.

We really, from a share standpoint, it was pretty constant, except we did talk about the fact that we didn't have equivalent share in the 55-gallon and up electric. We brought out a product to compete in that late in the first quarter, and the product has been doing fairly nicely. But clearly, that had an impact on our overall share. So the industry, except for that specific, was pretty level for the year.

Does that answer your question?

Yes, that answers my question. And also I was going to see if you could just comment on if you think there will be a shift in competitive dynamics with a stronger US dollar in 2017.

Well, the good news for us is it's very hard to ship in water heaters from the outside. So the stronger dollar we are not concerned about. That's going to make imports better positioned.

So we are not concerned about what the effect is here. The stronger US dollar could have an impact on the Canada market a little bit.

I don't know if you (multiple speakers)

Yes, and we have some Canadian competitors in the US market, too. But they are seeing the advantage today. And we are not concerned about it.

Okay, thank you.

Robert McCarthy, Stifel.

Well, it looks like we are drawing to a close here, guys. But maybe you just -- have you provided any kind of implicit assumption for price in your outlook for 2017?

No. As you know, we can't speculate on price. And we talk about price only once something happens in the marketplace.

All right. And then just in terms of thinking about ERP spend, how do we think about it beyond this year in terms of incremental spend over the next two or three years from a long-term modeling standpoint? Are we done, or where are we in terms of a certain base level of spending?

Yes, I think what we tried to say is that was $25 million in 2016, about $17.5 million in 2017. And we would say that probably the run rate is $15 million going forward. And it's those components I talked about, which is the amortization of what we capitalized, the outside services, the license fees, etc. So I think the run rate after this, our best guess is $15 million going forward.

Thanks for your time.

Bhupender Bohra, Jefferies.

Just one more question here, which I forgot, was on the Aquasana. You have some cross-selling synergies over the next two years, which you gave last year. Could you just update us on that? And how the cross-selling between China and the US, keeping in mind the border adjustment tax, which we think will play or not play, I don't know, but has anything changed along with your strategy, keeping that in mind? Thank you.

I think at this time, nothing has changed. We expect their core business to grow over 20% this year, and then we will start to see some of the synergies associated with the cross-selling this year.

We said it would be backend loaded, but we would expect that to be in the area of $5 million of cross-selling this year, with the ultimate objective after a 3-year period to be in the $25 million to $30 million, I think is what we've talked about. So I would say Aquasana is on track, no surprises. And we are not going to change our strategy until there's something firm out there on --

On the cross-border [segment].

Yes.

And also I think the overall question, if I can take a step back on your question, in terms of -- and not to put words in your mouth, but how is Aquasana doing. I think from our perspective, it's right on track.

Strategically we are absolutely convinced it is the right thing to do, which is why we did the acquisition. And from a synergy perspective, one of the things we didn't talk about are the cost side of the synergies. It's going well; in fact, if anything, even a little better.

Okay, got it. Thank you.

(Operator Instructions) At this time, I'm showing no further questions. I would now like to turn the call back over to Ms. Patricia Ackerman for closing remarks.

Thank you all for joining us today. Please take note that we will participate in a couple conferences during the first quarter. The first is the Alembic conference in Salt Lake City on March 1, and the second is the Boenning & Scattergood conference in London on March 23. Have a great day.

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