A O Smith Corp (AOS) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Third Quarter 2017 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, Patricia Ackerman, Vice President, Investor Relations and Treasurer. Please proceed.

Thank you, Terrence. Good morning, ladies and gentlemen, and thank you for joining us on our 2017 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. (Operator Instructions) 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. Our double-digit sales growth in the third quarter was driven by continued strong demand for our consumer products in China and positive end markets for our boilers and residential water heaters in North America.

Here are a few highlights: sales grew 10% to $750 million. Currency fluctuations had a negligible impact to sales in the third quarter. China sales were up nearly 13%. A. O. Smith branded water treatment sales grew 31% year-to-date, and air purification product revenue doubled. Record-setting earnings at $0.54 per share were 15% higher than our third quarter earnings per share in 2016. We are delighted to welcome the Hague team to the A. O. Smith family through our acquisition of the U.S.-based water softener company in early September. Hague fits squarely in our acquisition strategy to grow our global water treatment platform. We are excited about the global opportunities, Hague's innovative and high-quality products bring us as well as Hague's experienced water quality dealer network.

We continue to review our capital allocation and dedicate a portion of cash to return to shareholders. Through the first 9 months of 2017, we repurchased approximately 1.9 million shares for $103 million. We announced a 17% increase to our dividend earlier this year. The 5-year compound annual growth rate of our dividend is over 25%. A. O. Smith joined the S&P 500 index in July. We are honored to join this prestigious group of U.S. company. Our inclusion is a significant milestone in our company's rich 143-year history.

John will now describe our results in more detail, beginning with Slide #4.

Sales for the third quarter of $750 million were 10% higher than the previous year. Net earnings in the third quarter of $94 million increased 13% from 2016. Third quarter earnings per share of $0.54 increased 15% compared with 2016.

Sales in our North America segment of $486 million increased 8% compared with the third quarter of 2016. The increase in sales was primarily due to increased sales of boilers, higher volumes of residential water heaters and pricing actions related to steel cost increases. North America water treatment sales comprised of (inaudible) as well as a full quarter of Aquasana incrementally added approximately $8 million to our North America segment sales.

Rest of World segment sales of $270 million increased 12% compared with 2016. China sales increased 13%, driven by higher demand and for our consumer products in the region led by water treatment and air purification products and pricing actions primarily due to higher steel and installation costs.

On Slide 6, North America segment earnings of $110 million were 10% higher than segment earnings in the prior year. The favorable impact from higher sales of boilers and residential water heaters and the pricing actions in the U.S. were partially offset by higher steel costs. These factors drove third quarter 2017 segment margins higher to 22.7% compared with 22.3% last year.

Rest of World earnings of $34 million improved 9% compared with 1 year ago. Higher China sales, including pricing actions, were partially offset by higher steel costs, higher fees paid to installers and increased selling, general and administrative expenses. Cost associated with the expansion of retail outlets in Tier 2 and Tier 3 cities that sell the company's water treatment and air purification products and higher water treatment products development engineering cost were the primary drivers of higher SG&A in China. Third quarter segment margin was 12.5% compared with 12.9% last year due to these factors. Our corporate expenses were lower than 1 year ago. Our effective income tax rate in the third quarter of 2017 was 28.8%. The rate was lower than the 29.7% experienced during the third quarter last year, primarily due to lower state income taxes. The lower effective tax rate compared with the effective rate a year ago benefited 2017 results by $0.01 per share.

Cash provided by operations during the first 9 months of 2017 was $150 million compared with $264 million provided during the prior year. Higher earnings were more than offset by higher outlays for working capital. Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio was 21% at the end of the third quarter. We have cash balances totaling $768 million located on offshore and our net cash position was approximately $318 million at the end of the quarter.

We completed the acquisition of Hague, a U.S.-based water softener company, during the third quarter for $44.5 million plus the potential earn-out of $2 million. Primarily, as a result of continued strong cash flow and escalating PBGC premium, we made a voluntary contribution to our pension plan of $30 million in the third quarter. The after-tax impact to our cash flow was approximately $18 million.

During the first 9 months of 2017, we repurchased approximately 1.9 million shares of common stock for a total of $103 million. Approximately 3 million shares remain on our existing repurchase authority at the end of September. This morning, we increased the midpoint of our 2017 EPS guidance by $0.04 per share for the range between $2.12 and $2.14 per share. The midpoint of our EPS guidance represents a 15% increase in EPS compared with our 2016 results.

Please turn to Slide 9 for several 2017 options. We expect our cash flow from operations in 2017 to be approximately $325 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 flow of approximately $775 million, which compares with $612 million during 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 were approximately $100 million, includes $38 million related to this plant. Total cost for the facility, which is expected to begin production in the second quarter of 2018, will be about $67 million.

Our depreciation and amortization expense is expected to be approximately $70 million in 2017. As previously discussed, expenses related to our ERP implementation were $25 million in 2016 and are projected to decline to approximately $18 million in 2017.

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 and commissioned water treatment market studies. Take note that our interest expense will be approximately $3 million higher in 2017 as a result of higher rates, share repurchase activities and our acquisitions of Aquasana and Hague. Our effective income tax rate is expected to be approximately 28% in 2017, lower than the 29.4% rate in 2016, primarily due to lower state income taxes. The President's recently proposed tax plan has brought tax reform back to top of mind. We believe A. O. Smith could benefit significantly from tax reform. Approximately 60% to 65% of our total profits are derived in the U.S. We estimate the net impact from the combination of the proposed lower federal tax rate of 20%, the elimination of the manufacturers' tax credit and the smaller federal benefit from our state tax deduction would result in approximately $40 million less federal income tax, or over $0.20 per share based on 2017 earnings. Depending on the final tax reform plan, we could incur onetime income tax expense associated with the 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 expect our average diluted outstanding shares in 2017 will be approximately $174.6 million.

I will now turn the call back to Ajita, who will summarize our guidance, the business assumptions for 2017, and our growth strategy, beginning on Slide 10. Ajita?

Thank you, John. We project revenue growth to be between -- to be 11% to 12% for the year. We expect Aquasana and Hague sales to be nearly $60 million this year and slightly accretive to earnings. Aquasana sales were up nearly 18% in the first 9 months of this year compared with last year. Including North America water filter and softener sales, we expect our global water treatment products sales will be approximately $300 million in 2017. We project full year depreciation of the Chinese currency will be 2% from 2016, resulting in a $20 million headwind to sales.

Specific to our North America segment. We project U.S. residential water heater industry volumes will increase over 300,000 units in 2017 due to new construction and expansion of replacement demand. This assumption includes tankless units. We expect U.S. commercial water heater industry volumes will be approximately 10% higher this year, primarily due to strong demand for electric units as well as an anticipated pre-buy in advance of a regulatory change driven price increase effective January 1.

Lochinvar branded products grew 17% in the third quarter and 9% in the first 9 months of 2017, driven by solid demand for boilers and new product related market share gains. We expect the total portfolio of Lochinvar branded products to grow over 8% in 2017. As a result of rising steel costs, we increased prices by approximately 4% on the majority of our U.S. water heater products effective in late August. These factors lead us to expect our North American segment operating margin to be similar to 2016 margin of 22.1% despite a 40 basis point headwind to operating margin from North America water treatment.

Specific to our Rest of World segment. Our China sales grew 13% in the third quarter and we expect over 15% growth in local currency for the full year. We expect improved profitability in India due to scale in our water heater business. We expect improvement in China margins in the fourth quarter, resulting in full year margins of approximately 15% and flat to last year. As a result, we now expect Rest of World segment operating margins will be similar to last year.

Our total company organic growth model continues to assume 8% growth for the foreseeable future. Especially in these uncertain economic times, we believe our organic growth potential and our stable defensive replacement markets, which we believe represents approximately 85% of North America water heater and boiler volumes, positively differentiates A. O. Smith from other industrial companies. Coupled with growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisitions that adds shareholder value as well as allow us to return cash to shareholders.

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

(Operator Instructions) And our first question comes from Matt Summerville from Alembic Global Advisors.

I wanted to ask you a couple of questions on China. You mentioned some year-to-date numbers in treatment and purification. I was wondering if you could give a little more detail specific to the third quarter. How those products performed and then what your outlook is for the full year, while also commenting on the performance in the legacy water heater business in China during Q3?

So water treatment was up about 13% in the quarter, and it's up in local currency year-to-date about 35%. And we would expect, for the year, it's going to be up in that range of 30%-or-so in local currency. Air purification was up 75% in the quarter, it's more than double year-to-date and we would expect it'd be more than double for the year. Didn't catch -- what was your last? Was there something else?

The remaining...

Yes. The performance just in the legacy water heater business in China in Q3.

Q3, when I look at electric and gas, it was probably up about 7% or 8%.

Got it. And then just one final question. You mentioned added spend in China associated with bringing water treatment, air purification in the Tier 2, Tier 3. Can you maybe talk about where you're at with the distribution of that product. How many outlets you're in currently? How many you would anticipate? How that's going to evolve over the next year or so and then -- just some less spend back off a bit in Q4, is that why we should see margins snap back pretty meaningfully at least relative to where they've been in the last couple of quarters in Rest of World?

Sure. For example, water treatment margins were down about 6 points in the third quarter and that explains almost all the decline in the margins for the quarter and that was truly engineering and also investment in new retail outlets. We're at about 7,000 stores approximately and then we have -- we're in some special zones, et cetera. I guess, Ajita, I would comment, we think that growth will slow as we look to the next couple of years because we have been building it all pretty aggressively over the last 2 years.

Yes, I think if you went back 2 years ago, we would have said the rate of our build-out would have been slower, and I think we just gone faster because we see the opportunity longer term.

Yes. We had about 1,500 stores, almost 2,000 outlets, if you will, over the last 2 years.

And our next question comes from Charley Brady from SunTrust Robinson Humphrey.

I just want to drill down a little bit on Rest of World margin because the guidance clearly implies a pretty big step up in the Q4 margin, and I get that with the overall guidance is what's coming out of China. But is that just a function of this engineering cost? Is it going into water treatment? Or essentially you took a big hit and that's kind of largely done or certainly declining a lot? Or...

No, it's a seriously -- sorry?

Yes, go ahead.

So when we look at the fourth quarter, that's always our highest volume quarter. We would expect it to be the highest volume this year also. So we're going to get contribution. We would expect SG&A will be down a couple points and that is a combination of the engineering cost not being high -- as high, and the SG&A not being as high as a percent with advertising being lower. We've talked over the years that those spends can be lumpy and they clearly were in the second and third quarter and we're comfortable they'll be lower in the fourth quarter. So I think, you're right, we have a fairly aggressive fourth quarter, but with the higher volumes, we think we'll get a little favorable mix from new -- introduction of a new electric unit and then a lower SG&A, we're comfortable with the estimate.

Okay. And then just on North America, on the top line growth, it sort of, I guess, implied in the guidance. You mentioned, I thought, a pre-buy, you expect that -- is that why it's kind of a little bit maybe stronger growth in Q4 because you're pulling some stuff forward? Or is there just an underlying stronger market, obviously, Lochinvar is going pretty good.

Yes. I mean, we expect Lochinvar to be up. We expect residential to be up nicely in the fourth quarter. So those 2, and then we do expect some pre-buy from the regulatory change that's happening on the electric unit on the commercial. So it's a combination of all 3 of those is why we're -- we think sales will be up nicely in the fourth quarter.

And our next question comes from Sam Eisner from Goldman Sachs.

It's Sam Eisner here, guys. So just going back to that last question on the pre-buy, was there any pre-buy benefit this quarter that you guys saw that you can discern? And then also, given the Lochinvar performance in the quarter, is there anything in particular going on there, do you guys want to comment about that?

Well, we don't think there was any pre-buy. I mean, I'll tell you September residential was strong, but I mean, the price increase had already been put in by August 1, so -- I mean by, I guess, September 1. So any pre-buy we think would have happened in August, if you will. So no, but September residential was strong. And Lochinvar had a great quarter. I mean, their boiler business was up 25%, you break that into 3 pieces, their residential was up over 30%. They're condensing, which is their big commercial boiler was up high single digit, and then their noncondensing, which we've talked about historically, is their smaller business, but that was almost double and that's the reflection of a new product that they brought out 2.5 million to 5 million BTU. They did have a large order in China of about $3 million during the quarter and so that clearly helped that add a 3 or 4 points of growth. From a distributor, we're also selling that product in China through our A. O. Smith operation. We expect that product will sell $15 million this year and with 12 or 13 of it in China. So Lochinvar just had a very good quarter. They grew margins, they grew sales significantly and we're very pleased year-to-date. They're up about 9% and we're certainly comfortable with the 8% growth that we talked about earlier in the year for the year.

And also, Sam, I think that the results, especially this quarter, but it's been building, just reinforces the global demand for that Lochinvar product and the global opportunity that we have in leveraging the product and capability with our existing distribution and presence in various countries.

Got it. That's helpful there. And maybe looking over on the Rest of World segment, the 13% growth that you guys have seen is certainly a little bit below the kind of 15% rate that you guys have called out in your kind of long-term view. Is that something that we should be nervous about? Do you think that's kind of transitory? And then maybe a second part of that on the Tier 2 and Tier 3 spending, should that continue into fourth quarter and 2018?

Well, I guess, I'll say, and Ajita, you can add, I mean, we've never said that we're going to have quarterly growth of right at 15%. And what we've talked about with our model as we think on an annual basis, they can grow 15%. As a matter of fact, in year-to-date, in U.S. dollars, they're up about 15%. So we're comfortable they're going to achieve that 15%-plus in local currency for the year and it is going to be lumpy. I mean, it is not going to be 15% every quarter. We're looking at an annual basis. So we're very comfortable. With respect to the spend, yes, we did have some higher spend, specifically water treatment and even some of the air purification in the third quarter. We think that will be less in the fourth quarter and we're looking at our plan right now. I mean, as Ajita said, I think the rollout of stores will slow as we look into '18 and '19. And so, we'll be looking hard at SG&A.

Yes, I think, not much to add, other than just reinforcing the fact that we're very comfortable with the 15% annual growth in China in local currency, which is what we've always said. And it is going to be lumpy. Especially, China is driven a lot by different selling holidays and things like that, that make the spending and the sales from year-to-year can vary from 1 quarter to the other. So from that perspective, each quarter may seem lumpy but for the year -- on an annual basis, we are very comfortable with the guidance that we've given.

And our next question comes from Jeff Hammond from KeyBanc Capital Markets.

Just to be clear, Ajita, on the acquisitions. I think the presentation has $40 million of incremental growth, you said $60 million. Is that all-in in the 40s, the acquired growth? Or just help me there.

Well, $60 million is the full year of Hague and Aquasana, and that's about an incremental of about $40 million over the prior year because we didn't have Hague and we only had Aquasana from August '16. So the incremental was $40 million and the total water treatment in North America this year will be $60 million.

Okay. And then on cash flow, looks like you took cash flow from ops down $50 million, anything going on there? I think you cited kind of timing in 4Q, but we would've known that. Anything working capital, supply-chain that's driving that?

Well, the biggest issue is just the pension contribution, so that's 20-plus -- about $20 million of that, we did not have that in our estimate. Probably the other most significant item is we're probably building more inventory for our water treatment move that's going to occur in the first quarter, late second quarter than what we had planned. And so that certainly been a factor. But nothing out of the ordinary. We're still very comfortable with our day sales outstanding and et cetera.

And some of that build is demand driven because, I mean, the business continues to grow very well. And so we are anticipating that. In that transition, we want to make sure and that we don't lose out in any of the revenue.

And our next question comes from Scott Graham from BMO Capital Markets.

Last question on -- only one question on Rest of World, I promise. At some point, the 15% number is going to be difficult to reach given essentially the size of the business or large numbers and what have you. Ajita, do you think we're a year or 2 away from maybe kind of thinking that that's maybe a low-teens growth business rather than 15%, which obviously, there would be nothing wrong with that, but I'm just trying to gauge your thinking internally?

I'm comfortable with where we are now and the outlook that we have. And what you've said from theoretical perspective, it's true, in a way we're going to be order of magnitude a $1 billion business, which says it's $150 million of new revenue every year, okay? So for the foreseeable future, we are comfortable. As soon as we see that, that is something that we say, "We're going to have to tamp it down a little," we will let you know. We will make sure that we communicate that to our investors.

It's clearly predicated, Scott, on the continued growth on water treatment and air purification. Those markets are expected to grow significantly. CMI still talks about a 30% growth in water treatment. I mean, we have a pretty significant franchise. Now when you add the consumables and you add our businesses in China, it's over $200 million.

That is kind of what I'm saying, yes, okay, that's fine. But you feel good for the intermediate term, right?

And also, part of our strategy as we have talked about is to get into new categories. To leverage our brand and distribution getting into new categories. So we're not counting on just the same portfolio of businesses to bring us that incremental growth every year, okay? So we balance that in terms of the right time to get into it then -- and to leverage the infrastructure that we have in China.

Understood. And I just -- my second question is really about the U.S. business where the results were pretty good, and as we look across the residential construction numbers over the last 5 months, which certainly is not a primary driver, but it is a driver of the market. Those numbers have really been very strong, sort of 15%, last 5 or 6 months. And we also -- it looks like steel might actually come down a little bit in the fourth quarter, at least the quarter, at least the [quarters our guys] here. I was just sort of wondering how you were looking at the North American sales and operating margin sort of trajectory. And I know that you're going to probably not go far past, if any, the fourth quarter, but it just looks like that the backdrop for North America sales and operating margin looks pretty good the next couple of quarters. Would you agree with that? Can you comment on that?

Well, I guess, I'd say we did see strong -- we have seen relatively strong growth in residential. It's up probably about 300,000 units. Now, again, that's on the base of 8.7 million units, so that's what, 3% or 4%. And we have seen that in the last 3 quarters. We expect some of that in the fourth quarter. Commercial has been strong. It'll be up. It was up, I think, year-to-date probably about 7% or so, and that looks like that's continuing. I would tell you it appears steel has leveled off, we haven't seen it decline, we'd say it's leveled off, which would be a plus, because it's gone up so much dramatically, which is a benefit if it does kind of stabilize. And Lochinvar, again, continues to grow margin. So, yes, I think we're optimistic as we look to the fourth quarter and next year from a North America standpoint. I don't know, Ajita, if you have any...

No, I think that summarizes it well.

And our next question comes from Larry De Maria from William Blair.

I have 2 questions, but first, just to clarify. Looks like we need a $16 million, $17 million increase in EBIT sequentially to get to the Rest of World record margins you're projecting. Sounds like the bridge is reduction engineering around $6 million, and then the rest is volume and slower growth in SG&A, is that right? Just to clarify? Or -- are we getting that right?

I wouldn't say engineering going down $6 million is right. We think that SG&A will be down a couple of points. We will get the benefit of price, again, even in China, at last, raw material costs have stabilized. So we think we'll get some benefit in that price compared to material, and then we're going to have some volume that's also going to contribute. So those are the major pieces, and then you throw in a little bit of favorable mix from the new electric unit, those are kind of the pieces that get up there.

Okay. And secondly staying at the Rest of World, how do you think about incremental margins going forward? Should we start to think about moving over 20% with obviously the exception of the fourth quarter, which would be good? As these smaller businesses get scale and you're leveraging infrastructure out of your reference, can we look at over 20% incrementals on an annual basis now in Rest of World? Do we have enough scale there?

Well, I'm not sure. You said 2 different numbers. You said a 20% and then you said 20% incremental...

Yes. Over 20% incremental on an annual basis going forward since you're leveraging the infrastructure and getting scale on those businesses.

Well, I'll take a shot at it. We clearly want to grow Rest of World margins. We think that's a combination of India becoming more profitable, Turkey, the capital, I should say, reducing the loss in India and ultimately get into a breakeven, with the same statement for Turkey. And then, yes, it's our intention to leverage China's SG&A and volume as we go forward. We have not put out any specific objective, but certainly, it's our objective to try to grow the Rest of World margins.

And so incremental margins will be better than the average, certainly, but we had not put out a number.

And our next question comes from Robert Aurand from Longbow Research.

Robert Aurand on for David MacGregor today. Can you just talk in China about your water heater business? And what extent increased competition from the domestic manufacturers is impacting your results?

It's always been competitive, as Ajita continuously talks, it's always been competitive. We've seen in the market, I'll say, electric not growing as fast, which we assumed would happen because there's more distribution of gas in the city. So if you would have asked us probably 3 years ago, we would've said electric was 55% of the market and gas was 45%. It's probably close to a flip now. Not sure if it's going to go much further but that's happened. We don't have as strong a position, but we have a good position in gas and we're leading in electric. So I don't think that's as much the competition as the dynamics in the marketplace, but all that being said, water heater growth this year is going to be nice for us and it's led by gas.

And just to add a little more color to that, the changes John talked about have not happened overnight. The evolutionary type changes that are happening. From -- going back to your question on the competitive environment. I have always said China, the market in China is very, very competitive. You got all the major players in the world there and they're all bringing in new products and being in a very competitive branded consumer appliance business. So none of that has changed. It's always been very competitive.

Okay. And then just one more question on China. I mean, just news flows throughout the year that they're really trying to kind of cool down the real estate market in the major cities there. May not get a property bubble. I mean, to what extent does that impact your results over there? Do you guys think about that impact and you moving forward?

Well, real estate is still the primary investment for the Chinese. The recent data does show that sales of property have slowed. It's kind of a 1 or 2 month, we don't know if that's a blimp (sic) [blip] or not. We don't -- we're not really tracking as closely build, what we're tracking is sales, because that's what ultimately leads. The good news, I'll say, for us, going forward, is we think replacement is becoming a bigger component, which just makes sense. The really good news about water heater is, it ultimately fails and with that, you have a replacement market and as you know here in the states, the replacement market is -- on that $9 million build, about $7 or $8 million of it is replacement. Now we are nowhere near that in China but it's developing. So I think as we look forward, we still think we're going to be able to get growth from the water heaters segment and we have some of the best products in both the electric and gas, which differentiates us. So I don't know that answers your question or not.

And I think if you look at it also from a longer-term macro perspective, China is just completed or completing this week the latest Communist Party Congress. And if there's a headline coming out of that, it's a continuation of the policies which drives urbanization, drives more consumption-based growth, and all those things from a macro perspective also help us and really reinforce our strategy.

And our next question comes from Andy Cohen from Northcoast Research.

Most of my questions have been answered but just a couple of small ones on water treatment. When this plant comes online in second quarter, is that going to materially affect margins? Or is it going to be roughly the same cost basis?

Well, I mean, we will -- we're going through our planning process right now. It certainly we'll affect initially probably the first and second quarter. I mean, we're moving significant operation. The good news is we're not moving it far but we're going to have moving costs certainly in the first and second quarter. The new plant will bring higher depreciation for the year. We have -- ultimately, we'll have some inefficiencies the first probably half of the year, but the good news is, ultimately, we think it's going to be a much more efficient plant. So there could be some hiccup early in 2018 and we'll talk about that when we get into -- we're through our planning process and then talk about that more on the year end. But I think for the full year, it will have some marginal effect but not significant.

Yes. And we'll be able to define it more 3 months from now. But also, the team in China is very used to doing this because we are constantly expanding, building new factories and moving operations into new factories. And as John said, that entails, obviously in the new factory, potentially higher depreciation which we will see in this factory. But at the same time, we've designed these to have fairly significant operational benefits in terms of productivity. So we see both.

And we'll expect to see that later in 2018 and certainly when we get into 2019, that being a real benefit.

Second question, probably fairly small, but the Hague acquisition. Is this portfolio also going to be sold over in Rest of the World or is it pretty much just a U.S.-based set of products?

Yes. That was one of the things that attracted us to Hague as we have looked at water softener manufacturers with an OEM over there and we weren't necessarily successful. And we looked for manufacturers globally and quite frankly, we feel Hague is the best and they can make a compact unit which is important for the China market and they started selling those in, I guess, about March, April. And it's been a nice sales. I think the sales probably, in 6 months, has done $7 million or $8 million sales over in China and it’s of the Hague water heaters, I mean, water softeners. So no, we're optimistic that they can really provide us the benefit in China.

And these are Hague -- water softeners made by Hague, branded A. O. Smith selling in China?

Yes.

So it's not something we're saying we anticipate doing, it's happening now.

And our next question comes from Scott Graham from BMO Capital Markets.

I just -- John, I was cut off before but the overriding point that I was making was that residential construction has been very strong and residential water heater shipments have been just sort of okay. Is -- that gap seems to be pretty wide right now, suggesting that the next couple of quarters could be fairly strong. Are you hearing that from your guys is what I'm asking.

I haven't been. But again, Scott, just so we understand better what you're saying, and it goes back to 9 million units, 7.8 million of that is replacement. So completions are 1.2 million, and maybe up a little bit. But on the margin, that might add 50,000 to 100,000 units. You know what I mean? So -- but I have not -- I don't know, Ajita, if you have, but I think that's partly what's driving it is you have that base of 7.8 million units and that's probably grown some this year, because if you get 9 million units and completions are up 100,000, 150,000, then the rest is replacement. So that's what I'm trying to say.

I guess, I'll make another comment, Scott, which is not a quantifiable comment, obviously, but it may try and touch on what you're saying. We, just a couple of weeks ago, finished the ASA meeting, which is the annual meeting where we have all of our distributors. And there was -- people were pretty optimistic. Now I can't quantify that, but people felt good about where things were.

I guess, my final question would be -- I'm sorry, for the Rest of World double up here, but the weakness in the margin off of the spending, I mean, I don't remember the last time you called out the need to increase your Tier 2 and Tier 3 spending. So I guess, my question is kind of twofold: number 1, I understand the markets are competitive but has there been some competitive uptick in either water treatment or air purification that's required this additional spending? Number 2, the dynamic of the water heater distribution points versus treatment and purification is different, which is requiring an incremental investment. Can you talk about that a little bit?

Well, I guess I'll take the first one. We're the market share leader in water treatment and we have the best products and we're going to continue to invest in R&D to support that position. And I wouldn't say the competitive environment of the water treatment has changed. We want to build out our distribution. We talk about Tier 2 and Tier 3 cities, not only do we want to be there, that helps us from a online position because somebody got to fulfill that and it's these distribution locations we talk about. So when we're growing the retail, it's primarily, I'll say, our specialty stores in water treatment. Air purification, we are not the market share leader. We think we have some new products that we're going to be bringing out next year that we think will be beneficial and so we're investing in R&D and also growing out that portfolio. I think one thing I want to mention is, yes, Rest of World, China, did not meet the margins that we talked about beginning of the year, but when we're done with the year, we expect them to grow 15% organically and have about 15% EBIT return. So I don't want to give the impression they're not having a good year. They're having a good year. Maybe not what we expected and we're spending more than what we thought and then raw material costs have hurt us. So as we look at the year, they are having a good year and I don't think there's anything unique from a competitive or strategic standpoint that's really changing how we're doing things.

I think that summarized it well. And as we -- the advertising and things like that in a branded consumer plants business that's -- those are things we need to do, especially when we get into new category reason. We just had some research come back that said that our brand is getting better and better known and very well known in these new categories. And as John said, when it comes to water treatment which we feel has a huge, huge long-term potential in China, we are the market share leader. So we feel pretty good about that. From a competitive situation, it's like I said earlier, to a question earlier in the presentation, it's a very competitive market and it continues to be that and I don't see any material change either up or down from a competitive perspective.

And our next question comes from Jeff Hammond from KeyBanc Capital Markets.

Just a quick recall, Ajita, you mentioned some inflection in Lochinvar international in China. That seems to be an area that was taking a while in a struggle. So what's really changed there? Are you starting to see an inflection where you can start to penetrate Lochinvar internationally?

I think the key difference then, Jeff, you've got a good memory, we're going back to the acquisition, but we felt that the time that we did the acquisition, was that there would be a market for the condensing boilers in China, that there was a market that was growing. What's taken time is that we didn't see that condensing boiler demand grow in China. But what we did see is continued demand for the lower efficiency noncondensing type products in China. Lots of reasons for that, low energy costs, I mean, lots of reasons for that. So we literally designed some products, which were very conducive for the Chinese market and fit the market needs within China and we are actually selling those products 2 different ways in China: We are selling them Lochinvar manufactured products, branded Lochinvar in China through one set of distribution. And then we are also manufacturing those products in China and selling them under the A. O. Smith brand name. So we are -- and both those are being very successful. So if there's a change, it's that we recognized that there was market for the noncondensing products, designed some products for the Chinese market and we brought them out there in the last 12, 15 months, and they have been very successful. So we're very happy about that.

And at this time, I'm showing no further questions.

Thank you for joining us today. Please take note that we will participate in several conferences in the fourth quarter. Baird Industrial Conference on November 8 in Chicago; The North Coast Conference on November 9 in New York City; and the Goldman Sachs Conference on November 14 in Boston. Have a wonderful day.

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