A.O. Smith Corp (AOS) — Q2 2015 Earnings Call Transcript

Thank you, Earl. Good morning, ladies and gentlemen, and thank you for joining us on our 2015 second quarter results conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. Ajita, I will now turn the call over to you.

Thank you, Pat; and good morning, ladies and gentlemen. We set sales and earnings records again in the second quarter. Higher-than-expected volumes of residential and commercial water heaters, earlier realization of higher pricing associated with NAECA III compliant water heaters, improved performance at Lochinvar, as well as lower-than-expected material costs resulted in stronger performance in the second quarter than we originally projected. Here are a few highlights. Organic growth in both of our segments drove sales 10% higher to a quarterly record of $654 million. China sales were up 15%. Net earnings of $0.79 per share were 20% higher than the adjusted earnings per share of $0.66 in 2014. We continued to review our capital allocation and dedicated a portion to return to shareholders. In addition to our regular dividend, we repurchased approximately 400,000 shares for $27 million during the second quarter. Our transition to NAECA III compliant products is complete. This is a very complex project, impacting approximately 80% of our residential water heaters. I'm now going to hand it over to John, who will describe the results in more detail.

Thank you, Ajita. Sales in the second quarter of $654 million were 10% higher than the previous year. Net earnings of $71 million were 18% higher than second quarter adjusted earnings in 2014. Net earnings EPS of $0.79 per share improved 20% compared with adjusted earnings per share of $0.66 in 2014. Sales in our North America segment of $443 million increased 8% over 2014, driven by a price increase effective in April for both commercial and residential water heaters in the U.S. as well as higher sales of Lochinvar-branded products. Rest-of-world segment sales of $221 million increased 14% compared with 2014. China sales increased 15%, driven by higher demand for water heaters and the water treatment products. North America operating earnings of $86 million were 28% higher than adjusted segment operating earnings in the previous year, and the operating margin of 19.4% was significantly above the 16.4% adjusted operating margin one year ago. The favorable impact from higher water heater prices in the U.S. and Canada, higher boiler sales, and lower material costs was partially offset by approximately $4 million in expected incremental ERP implementation costs. Rest of world operating earnings of $31 million improved compared with 2014 due to higher profits in China. Operating margin of 14% fell from the previous year due to higher selling and advertising costs as a percentage of sales in China, including promotion related to the company's new air purifier product and larger expenditures in India to support the launch of our water treatment products. Our corporate expenses declined modestly from the adjusted corporate expenses the prior year. Cash provided by continuing operations during the first half of 2015 was $59 million compared with $91 million provided in 2014. Higher earnings were more than offset by larger outlays for working capital in the 2015 period. Increases in accounts receivable balances, primarily driven by higher sales, was a major driver of higher working capital requirements in 2015. Our liquidity position and balance sheet remained strong. Our debt-to-capital ratio was 16% at the end of June 2015. We have cash balances totaling $552 million located offshore, and our current net cash position was approximately $273 million at the end of June. During the first half of the year, we repurchased approximately 730,000 shares of common stock for a total of $47 million under a 10b5-1 automatic trading plan. We had approximately 1.8 million shares remaining on our existing repurchase authority at the end of June. Depending on factors such as stock price, working capital requirements, and alternative investment opportunities, we expect to spend approximately $125 million on share repurchase activity in 2015, resulting in net cash levels similar to 2014 year-end levels. This is a $25 million increase in our expected share repurchases due to projected improvement in earnings and cash flow. And it is consistent with our stated capital allocation strategy. We expect our cash flow from operations in 2015 to be approximately $300 million. We expect capital expenditures to be between $100 million and $110 million in 2015, which includes approximately $20 million to support the ERP implementation and approximately $30 million related to capacity expansions in China and in the U.S., with the U.S. portion in support of Lochinvar-branded sales. Our depreciation and amortization expense is expected to be approximately $65 million in 2015. We successfully completed our first two ERP go-live milestones in August 2014 and May 2015. We expect to convert all of our major North America plant sites by the end of 2016. ERP implementation expenses were $14 million in 2014 and are projected to be $19 million to $20 million in 2015. As we expected, the incremental ERP costs occurred in the first half of 2015. We estimate our effective tax rate to be approximately 30.5% in 2015, higher than earlier projections due to a change in our geographic earnings mix. Our corporate and other expenses are expected to be approximately $45 million in 2015. This morning we increased our 2015 EPS guidance to be between $3.04 and $3.09 per share. The midpoint of our upgraded EPS guidance represents a $0.30 per share increase over our previous guidance and a 26% increase in EPS compared with our 2014 adjusted results. I will now turn the call back to Ajita, who will summarize the assumptions in our 2015 outlook and our growth strategy. Ajita?

Thank you, John. As John mentioned, the midpoint of our updated 2015 guidance implies growth of 26% over last year. Our outlook for 2015 includes several assumptions. First, we expect strong, profitable growth in China, supported by overall water heater market growth, an emerging replacement demand particularly in Tier 1 cities, market share gain, expanded distribution, an improved product mix, and significant growth in water treatment products. Collectively, we anticipate these factors will drive growth at double the rate of China's GDP growth. Inventory levels in China at our seven largest distributors are similar to last March, though up by about $10 million from the end of last year and a year ago. We have noted that customer inventory levels can rise as they prepare for buying holidays or to secure volume incentives, so we are monitoring these levels, which are higher than usual. We do not foresee a significant impact on the economy or our sales from the 30% decline in the Shanghai Stock Exchange Index, as urban households have low participation in the stock market, estimated at less than 10%. Stock holdings constitute 10% to 15% of household wealth, and historically, we have not seen a correlation between stock market levels and consumer spending. Despite the recent downturn, the stock market is still up approximately 70% since last July. The impact on retail appliance sales and our sales in China was minimal during the 2008 stock market correction. Additionally, we do not consider water heaters or water treatment systems as discretionary purchases in China. Our second key assumption is that we notified our U.S. customers about an average residential price increase of around 20% on NAECA III compliant products, along with price hikes on our commercial water heaters in the U.S. and Canada as well as on non-NAECA III compliant residential heaters, effective in April. The magnitude of the NAECA pre-buy is now lower than we anticipated, leading us to raise our U.S. residential water heater industry volume forecast by an additional 150,000 units, or 1% to 2%, from last year. We have also revised our full-year outlook for the U.S. commercial water heater sector, expecting growth of 3% to 4% in 2015 following a robust first half. Our third assumption is that we project Lochinvar branded product sales to grow at 10%, keeping pace with the growth rates we have achieved annually since acquiring the business in 2011. This growth rate surpasses U.S. GDP growth rates, and we anticipate continued advantages for our Lochinvar brand due to the shift from lower-efficiency non-condensing boilers to high-efficiency condensing boilers, along with new products introduced through market-leading innovation. Our new expansion of the CREST boiler line, targeting the 750,000 to 2 million BTU segment, has seen strong acceptance since its launch earlier this year ahead of the 2015-2016 heating season. The fourth assumption involves leveraging our strong brand and distribution channels in China. We first entered the water treatment product category with the A. O. Smith brand in 2010. Our water treatment sales have grown from $18 million in 2012 to an anticipated $100 million in 2015, illustrating the strength of our brand and distribution infrastructure in China. Our adept Chinese management team is effectively utilizing these assets in a competitive market. The China Market Monitor estimates that the point-of-use residential water treatment segment will expand by 35% to 40% annually over the next five years. We are excited about the prospects and pleased with the market share gains we have made through our engineering, distribution, and brand strength. In China, our brand is recognized for quality, reliability, safety, and trust, which effectively translates to air purifiers. This category, alongside water treatment products, is among the fastest-growing home appliance sectors in China. We launched the A. O. Smith brand air purifier in China at the end of the first quarter of 2015. Our air purifier sales are projected to be around $8 million to $10 million in 2015, though we anticipate losses of approximately $4 million, mainly from advertising and promotion expenses. Fifth, we remain optimistic about the long-term opportunity in India, a country with the second largest population and the second fastest growing economy globally, characterized by a developing middle class seeking better quality of life products. India represents a future investment, and we expect a $7.5 million loss this year, consistent with 2014, which includes increased product development and marketing costs related to launching water treatment items. We project our overall sales in India to reach around $20 million in 2015. We believe our organic growth potential of 8% over the coming years sets A. O. Smith apart from other industrial companies. We anticipate North America water heater sales will exceed 4% growth in 2015, influenced by the pricing actions taken in April 2015, and contribute to total company sales growth of approximately 11%. Our historical organic growth rate and absence of currency exposure to the volatile Euro bolster our confidence in this growth forecast. Our acquisition strategy remains unchanged, focusing on water heating and treatment companies globally, while maximizing our brand and distribution channels in China. The acquisition environment remains costly, driven by sustained equity market appreciation, lower financing costs, and limited organic growth among many strategic buyers, which are inflating valuation multiples. Our teams are motivated, engaged, and disciplined. We continue to pursue capital deployment strategies that balance investments for organic growth, acquisitions, share repurchases, and dividends. You have previously seen our investment criteria, which serves as a reminder that we will maintain our commitment to being financially disciplined in acquiring companies that align with our corporate strategy. This concludes our prepared remarks, and we are now ready for your questions.

Hi. Good morning, everyone, and congratulations on an excellent quarter. My first question is whether you are considering 2016 in terms of the factors surrounding the pre-buy and how you are thinking about it. I understand you are not providing guidance for 2016 at this time, but could you share qualitatively the factors that might impact growth in North America for your business in 2016? It seems like it will be challenging to model since we just had such a strong year this year.

Well, you are right. We have not looked at the 2016 plan yet. We'll do that later in the third and fourth quarter. I think from a modeling standpoint, we are very comfortable still with that 8% to 9% organic growth that we have consistently talked about. So from a top line, we think that's very achievable. And from a margin standpoint, we've said we are going to try to continue to increase margins. Obviously there's factors that affect that, including steel costs, which are volatile, etc. But again, we haven't really done the modeling yet for 2016.

Yes. And I think, to add to what John said, the 8% to 9% is driven by a number of assumptions which we have talked about, which include North America, which we feel is going to be a little stronger because of the pricing action for NAECA III products and also China, driven by two times GDP and Chinese GDP. We are very comfortable with the overall guidance that we've been giving and that also includes the Lochinvar growing at 10%.

Can you provide an update on when you will have a clearer understanding of how the growth trajectory will develop through 2016 in relation to managing inventory levels? Additionally, when can we expect more insight from your customer distribution base regarding planning for next year, considering the inventory levels mentioned?

As Ajita just mentioned, we are comfortable with the two-times GDP projection. You have seen the model, Rob, regarding our growth in water treatment as it evolves from an ancillary product line and continues to expand significantly. This year, it reached $75 million, and we anticipate it will exceed $100 million next year. We expect this growth trend to persist as the market develops. We have consistently stated that the water heater market in China is likely to grow around 7%, supported by increasing replacements, especially in Tier 1 cities. Additionally, we are focused on gaining market share on the GAF side by enhancing our distribution, which now includes over 7,500 outlets. We will also implement further price increases as we introduce products with features and values that consumers desire. Our business growth model remains solid. Although there may be some fluctuations on a quarterly basis due to higher inventories influenced by VIP incentives, we do not focus on quarter-to-quarter performance. Our focus is on achieving the full-year projection of two-times GDP.

Thanks. I'll leave it there for now. Congratulations on an excellent quarter.

Thank you.

Good morning, and great job this quarter. I also wanted to ask about China, since the main factor driving your sales there is GDP, but effectively it's more about household formations. From what we've discussed, it seems that household formations are unlikely to slow significantly due to a downturn in the stock market, although there could be some temporary disruptions. So, I'm curious if you're considering the possibility that this, along with a slight increase in inventory, could result in China sales numbers for the second half of the year leaning more towards 10% growth instead of 15%.

I think overall, we try not to react too much to the quarterly ups and downs. We are very comfortable with the two-times GDP guidance for the year.

Yes.

And like I said, and you indicated, we are not concerned about the stock market and the impact, because I listed out the reasons we are not. And everything that we check on and the people we consult reconfirm to us that that's going to have little to no impact on, as you mentioned, household formation and the other drivers that really drive our volume.

Okay. I understand. I have two additional questions about the price increase for the higher-priced versions of the water heater units that were released in the second quarter. When did that actually begin? Was it something that started in the middle of the quarter? You mentioned it didn't have as much of an impact as you expected. I got the impression that you were thinking it might have started around May. Did it actually happen in May, or did the higher-priced units begin to go out earlier than that?

They actually went out earlier, Scott. We had initially estimated that the industry would decline over 10% in the second quarter compared to last year for both residential and commercial sectors. We anticipated a slight lull after we could only manufacture the previous model from April 2015, while the new model began production in April 2016. However, we did not observe that lull. We now believe that the residential and commercial markets will be roughly flat year-over-year for the quarter, which was surprising to us. The upside is that we are experiencing higher volumes than expected. Additionally, we started selling the higher-priced NAECA units sooner than anticipated. If you were to ask me when, I would guess sometime in the second half of April, as we began to see the benefits earlier than we expected.

And last question is: you indicated the incremental upward change on North America water heater volumes within your view. Could you just remind me what your view is on North America residential water heater volumes for 2015?

So last year it was 9.2 million units. We said we thought there was some pre-buy in the last half of the year, and that it was going to be flat to up very slightly is what we said in the first quarter. Now, based on what we've seen in the first quarter and the second quarter, we would say industry units will be up 150,000 to 200,000 units, so somewhere in that 9.350 million to 9.4 million range.

Thank you.

Thank you. Good morning, Ajita, John, and Pat. How are you?

Good morning.

First, maybe we could start on the gross margin line. At a 40%-plus gross margin, I would love to unpack that a little bit. You mentioned lower steel prices. You have also had the price increase. I know in the past you have said that you didn't think that gross margins would benefit necessarily from the price increases. And then, as you said, the volumes in some parts of the business have been stronger, leading to capacity utilization. So I would love to just kind of get a sense of what was the biggest driver among those three things in contributing to the higher margins? And how do you think about this? Is this a sustainable gross margin level over the next several quarters into 2016?

Gross margins have increased significantly, particularly in North America, thanks to a strong performance by Lochinvar and solid results year-to-date. Their margins rose several points. In North America, we implemented price increases for commercial and non-NAECA III products to address wage and medical cost inflation during the quarter. We raised prices twice in Canada during the first half of the year and had higher-priced NAECA products reflecting increased costs. Additionally, material costs decreased during the quarter, which contributed positively. Overall, this improvement was mainly in North America and resulted from multiple factors. Regarding your next question, it's important to note that volume can have an impact on margins. Historically, the third quarter accounts for about 22% to 23% of volumes, which could theoretically influence gross margins. However, considering the current pricing and material costs, those margins appear reasonable over several quarters.

Okay. Very helpful. Second question, we've been hearing even more recently a possibility by Congress to enact legislation that would include repatriation connected to the Highway Trust Fund. I'm sure you're watching that closely. You have talked about this in the past, but can you just remind us, first, if there were to be a repatriation, have you already assumed for income statement accounting purposes that the cash is coming home? And I guess the second there would be, if there were to be such a repatriation, how might that impact your views on doing foreign acquisitions? Thanks.

We do have an accrual of about $200 million anticipated to return. Congress and the administration have discussed this multiple times over the past two years, but we are not overly optimistic about it happening. We are pleased to see the discussions ongoing. Given the current costs associated with bringing the funds back, we find it prohibitive. We will consider the costs when evaluating this option. However, we have consistently stated that we are focused on global acquisitions, and that will continue to be our approach. Therefore, we do not expect to bring everything back immediately, but we will certainly assess the situation and hope for a positive outcome.

Okay. Great. Thanks so much. Congrats on the quarter.

Thanks.

Thank you.

Hi, good morning guys.

Good morning.

Hi, Jeff.

Can you just – so back to the North America margins, I mean, it seems like the big variable going forward is really input costs. And if those go back up, then maybe this margin is not sustainable. But it doesn't seem like there's any real aberrations in the margin.

No, nothing significant from an aberration standpoint. No unusual items in the quarter.

Okay. And then can you just talk about how ERP rolls off into 2016?

Well, we're looking at that as our planning process. We said this year we'll spend $19 million to $20 million in expense. Our best guess is that will be similar to maybe up a little bit next year, as we take more sites on in 2016. But we're evaluating that right now. We did our Johnson City plant, as we said, in August 2014. We did Lochinvar in May of this year. And given some of the NAECA items that have developed along the way, because it's been all-hands-on-deck from a NAECA standpoint – we probably will not do any more sites in 2015.

Okay. And just finally, on NAECA III, have you seen any dislocation from competitors, where you've been able to maybe perform better in the near-term or capture share? Or is everyone kind of transitioning well?

I mean, as I think we talked about last time, we weren't expecting anyone to really have any significant hiccups. So this has been in process for quite some time. From what we see, there really has not been much in the way of share changes during the first half of the year.

Yeah. We didn't model anything or expect anything. And it's kind of playing out.

Okay. Thanks, guys.

Good morning, Ajita, John, Pat. Outstanding quarter.

Thank you.

Hi, Bill.

Hey, good morning. My first question – and maybe you could just help me out on this – is on the China market: what is the breakdown of, say, replacement versus new? I know you emphasized Tier 1 replacement in your remarks, but can you give us a sense of what's currently the run rate there or the split there?

I can tell you, based on our survey data, there is no good data put out by the government on that, or at least we haven't found it. But when we look at our surveys that we have of people that bought, when I was over there two or three years ago and I ask every time I'm over there – they had talked about Tier 1 cities kind of being in the 35% range or whatever. And as we've been over there more recently, the talk is closer to 50% in Tier 1 cities. And that's logical, because you've now got pretty high penetration rates in Tier 1 cities for water heaters. So now we talk about our life being eight years. We're not going to comment on the life of what our competitors are, but at eight years you'll start having some replacement. So we think it's a bigger piece of the pot. And quite frankly, it will probably grow into bigger pieces of pot, especially in Tier 1 cities.

And also I think, Bill, anecdotally our brand is positioned at the high end. It's an aspirational brand. So as people's incomes get higher, and they replace, then if they decide on buying a better brand, then they gravitate more towards A. O. Smith. So it was a combination of all of that. But as John said, we don't really have any good quantitative data to back it up.

Right. Now, shifting to Lochinvar, seems as though it's been stellar, stellar performance. The market is starting to gravitate towards it. You are doing more and more fabrication for some top clients. And now we are starting to see it truly accelerate. Could you give us a sense of, first – not only the expansion, but give us a sense of the contribution to the quarter as well as the aftermarket?

Well, I'll start, and then Ajita can fill in. The aftermarket was up about 9%, which has been pretty consistent with what we had expected. Their commercial market has been very strong. We have talked about the beginning of the year we thought the commercial industry for water heaters would be flat, and now we're talking it's going to be up 3%. They are continuing to see very strong commercial build. As I alluded to earlier, their margin points are up several points in the first half of the year. Their sales are up over 10% the first half of the year and their business continues to do very, very well. It's helped, obviously, by the new products that have come out. They expanded their line on the CREST down to 750,000 BTU. They bought out a fire tube boiler in the smaller range, and that's doing well. So all in all, Lochinvar had a great first half of the year. And they contributed to the performance in North America.

And you know, the only thing I would add to that is that the strategy behind Lochinvar is new products and coming out with new things. And we continue to invest in that area. As you saw during the Analyst Day, we are expanding our capacity in terms of engineering and testing capability and expanding the factory. And all of that is going well. And we will continue to invest in the key drivers, which is technology and being first to market with the best products in the marketplace.

Right. I appreciate it. My last question is on the operating margins in North America. They are very solid at 19.4%, which includes the 4 million for ERP systems, correct?

The incremental ERP expenditures are around $20 million for 2015, averaging about 5 million per quarter. Last year, during the same quarter, expenditures were approximately 1 million, leading to an increase of about 4 million. Therefore, the ERP costs for the second quarter compared to the third quarter this year will be quite similar.

Okay. Great. Thanks.

Thanks. Good morning, guys.

Hi, Todd.

Good morning.

I want to focus in on the margin in North America again I know you've had a few questions on it and given a few answers, but it was a big number, so I really want to make sure I understand it. John, you laid out the factors, and you kind of talked about them. Is there any way you can sort of size up how much was price and how much was sort of lower materials costs and things like that in terms of maybe the incremental operating profit in North America in the quarter? Or is that just kind of too hard to do?

Yes. We are not going to break that out, and it’s difficult to quantify. However, the factors I mentioned, such as the Canadian price increase, the increase in non-NAECA prices, the sale of higher-priced NAECA products, and lower material costs, all contributed significantly to the improvement.

Got it. Can you let me know how much the price increases were on the other products, considering you mentioned the step-up on the NAECA-compliant product is about 20%?

I believe we mentioned that they were commercial, and there is a wide range depending on the geographic location and the type of product. You are likely looking at high single digits for the other types of products.

Got it. That's helpful. Regarding the lower raw materials, is this benefit something you anticipate maintaining due to your arrangements with distributors and customers, or do you think that, given the competitive environment, you might end up needing to give it back?

Ajita, he was asking about raw material costs and pass-throughs etc. on wholesale, it's done traditionally through price adjustments, price increases or decreases, depending on the marketplace. But there is no direct pass-through on the wholesale side.

No. Yes.

We do have some pass-through of steel with some of our customers.

Would those be kind of yet to come? Or those have impacted?

I think they vary. They go in different cycles. And some of them are sooner than others. But they tend to be a little bit after.

Okay. And so if I kind of look at that 19.4% margin in North America, it feels like there's a whole lot that went right in the quarter. So would you think, like, a 19%-plus level is sustainable? Or just going to continue to kind of trend higher on a trailing four-quarter basis, or something like that?

I believe I mentioned this earlier. The 19.4 percent margin is based on current prices, material costs, and the ongoing strength in the commercial market, which benefits two of our operations: the commercial water heater and Lochinvar, both of which are higher-margin businesses. We are comfortable with that margin range considering these factors.

Yes, I believe that material costs are a significant factor that could have an impact.

I'll monitor the steel market closely. For my final question, related but somewhat different: how does the inventory in the channel appear? I understand many were purchasing the non-NAECA III compliant products. While you've mentioned China, I'm specifically asking about the U.S. How do you perceive the inventory situation for you and your customers?

I can take a shot at this, and John can add on. Unfortunately, it's quite challenging to assess the visibility of inventory across most of our channels. In wholesale, it's particularly tough to gauge. Retail is somewhat easier, and regarding China, as I mentioned, we believe our estimates might be slightly high, though not above last quarter. It's higher compared to the end of last year or a year ago. However, inventory levels can fluctuate significantly from quarter to quarter because of factors like meeting quarterly volume targets for VIPs or seasonal purchases for holidays that see higher sales. We're keeping an eye on it. We're not worried, but we are monitoring the situation.

When we look at North America, we don't have great visibility. However, after speaking with our customers, our impression is that levels might be slightly elevated but not to a significant degree, which is a positive sign. This is why we felt comfortable increasing the full-year residential and commercial outlook, based on our understanding of what's in the channel. Again, we acknowledge the lack of visibility, but we do engage with our customers.

We are comfortable with the annual guidance and are monitoring the inventory levels, but we are not overly concerned about them.

Great. Thanks for taking my question. A couple of different type questions. First off, it was our understanding that there was an effort in the Senate to exempt certain water heaters used in electric utility demand/response programs from the NAECA III regulation. I wasn't ever sure what the outcome of that was. Do you know about that effort and whether that was successful?

It's still pending, but we don't expect a big impact on the market because of that for some time. It's a long period of time.

Okay. So that's not been finalized at this point?

Yes. And it's for really very, very large capacity type water heaters.

Yes. Now, do you manufacture any of those, to the extent that does go through? Or is that other players?

You know, we do manufacture some of them, but it's not a huge impact. But again, like I said, we don't see a huge impact of that legislation hitting this industry, if at all, for a long period of time.

Okay. And then finally, just the issue – I don't think you have addressed online sales at all in China, and how that's trending, and how all the noise in China that you have talked about a lot on the call here impacts the outlook for that piece of the business?

We haven't seen – so last year online sales were $55 million. Through the first six months they were about $50 million. We're still tracking towards the $90 million to $100 million that we have talked about on previous calls. So we haven't seen any impact whatsoever, and we are progressing as we expected.

Okay. And you envision that continuing – I mean, do you believe that's going to flatten out at some time? Or do you think that really will continue to grow at that kind of a trajectory and pretty quickly become the majority of the business?

No, I don't think it's going to grow at that trajectory. It's not going to go at 100% a year. There's still an – and again, we have different components of that. So water heaters probably represent about 75% of net sales. Water treatment represents 20% of net sales; and air purifiers, maybe 5% of net sales at most for the year is what we're expecting. So we think it will probably still continue to grow, but not at that trajectory.

Okay. Great. Thanks for your time.

Good morning. Thank you for taking my questions. Just a couple last ones. And not to go too much into the margin side, but just to clarify, as we look at the ERP comparison, it's easier in Q3 and Q4 than it was the prior year. Margins should be the same, all else being equal, but you get the benefit from the ERP. So am I missing something that would suggest that your margin in North America wouldn't be higher?

No, I guess what we're saying is we expect to reach about $19 million or $20 million this year, and it was somewhat consistent at $5 million a quarter. Last year, in the first half, it was $14 million, which was only about $4 million. So the difference of $10 million compared to $4 million affected us by $6 million compared to the previous year. This year, in the last half of the year, we anticipate around $10 million of ERP in 2015 compared to $10 million of ERP in 2014. I hope that clarifies your question, but it won't impact margins compared to the previous year.

Okay. And so, then, there really shouldn't be any negative drag other than the possibility of kind of the pass-through costs for steel, if that happens?

And volumes. So when you look at volumes for the water heater industry, it's normally about 52% or so in the first half of the year, 48% the last half of the year. Commercial is very similar. So, volumes second half of the year will be a little bit less than the first half of the year, which has an impact.

Okay. That's helpful. And then, China, just lastly, you provided some good commentary about market sentiment. Maybe you can provide a little bit more commentary about your strategy in terms of pricing and promotion in light of what you may see a slightly weaker market or potentially a weaker market? Do you plan to be more aggressive? Do you plan to do more promotional work? Do you think you may limit your ability to increase prices?

There's a lot of questions there. So, promotion-wise, certainly we are spending more on promotion on air purifiers, water treatment, and also online. So that's a fact. We are spending more on those areas, as they are relatively new areas. So we are spending more promotion dollars there. As we have talked about in the past that SG&A spend can be very volatile. Last year it was very volatile. And we ended up at about 13.8% or so for rest-of-world, which was driven by China. But there was wide differences by quarter-to-quarter. This year we're thinking it's going to be more leveled out. And we have talked about being about 13.5% to 13.75%, let's say, for the full year. And that drop is driven by a couple things: it's driven by our investment in air purification. It's driven by our investment in water treatment in India. And also, we started selling water treatment in Vietnam, and that's having a negative effect on those margins. So we're very comfortable with where the margins are. They're pretty much what we had talked about. And again, what differentiates us from a lot of people in China is our growth model isn't dependent on only one item. We have those three buckets, and that gives us some comfort going forward. We will continue to build the brand and invest in the brand. I don't know if that answers your question.

Well, actually – I mean, the commentaries are pretty consistent, obviously, with what you've said in the past. I guess what I was really trying to get at was – and maybe you answered it earlier – you don't seem to be terribly concerned about the environment in China, the current stock market volatility in China, to make you change any of your pricing or promotional strategy or SG&A strategy. And that's really what I was getting at.

No, we don't. As we've always stated, there will always be quarterly fluctuations in the marketplace in China, or anywhere for that matter. We remain confident in the long-term guidance we've provided and we manage these ups and downs as they arise. Regarding the stock market, as I mentioned, we aren't worried about its impact on our customer base due to the number it affects and the reasons I've previously outlined. The market is still up 70% from last year despite this recent decline, so we don't anticipate any long-term effects on our type of customer.

And I think as Ajita has alluded to, in 2008 the market dropped much more significantly than what it did. And it didn't have a significant effect on consumer spending. So we've looked at a lot of economists work, and there's no empirical evidence that ties to stock market move to consumer spending. And again, we also say – or household formation, so time will tell if this is something different, but there's nothing from a historical standpoint that supports that.

Okay. Thank you very much.

Yeah. Just a couple of follow-ups. You cited the strength in kind of your commercial-facing end markets. Clearly, you updated your guidance there. But any other additional color about how – you know, did you feel like this is real and sustainable? How do you think about where we could be? Could this be a multiyear thing in terms of the growth you are seeing?

I wish I could answer that. We haven't done a great job of estimating the commercial market. We continue – you know, we talk to our salespeople, and they are seeing it in a lot of different components. You know, gas, high-efficiency is becoming a bigger piece in the last three years. And that certainly is in one of our areas of strength. The hotel and the restaurant business is doing fairly well. So we are seeing construction there as well as retrofit work. We're also seeing for redundancy work being done. That's on kind of the commercial water heater. And then the verticals that Lochinvar works with are the educational side. And they are starting to see some potential in the healthcare side, et cetera. So there's been a lot of talk about commercial coming back, and it hasn't. But it has, for our businesses, come back pretty well. So we certainly cross our fingers and hope it will continue for the next several years.

And it sounds like you haven't seen material weakness in Canada. I think you alluded to some pricing as well. But I mean, could you comment there in terms of what you are seeing, and – just to give the macro outlook there?

There hasn't been much change in the industry; it's relatively flat compared to last year. However, currency fluctuations have had an impact. Three of the four major manufacturers are based in the U.S., so this has affected their performance. We experienced some adjustments in our top line due to currency devaluation, but as I mentioned, there have been price increases incorporated as well.

Regarding China, I have two questions. First, have you observed any specific or anecdotal data points that indicate the replacement cycle you mentioned is beginning? I understand the strong growth rate, but I’m looking for additional details. Second, could you provide insights on how we should view the long-term growth potential of water treatment in relation to your core business?

It's based on anecdotal evidence and surveys we conduct with water heater buyers. As I mentioned earlier, the tier one segment has increased from 35% to 45% and 50%. While this data is anecdotal, it aligns with expectations due to the long lifespan of water heaters, which eventually need to be replaced. Regarding water treatment, CMM has projected a growth rate of 35% to 40% over the next four to five years, and we feel confident about that. We have the right products for the right market, specifically our reverse osmosis and tankless options, which we believe are the best available. Thus, we are optimistic about these growth rates moving forward.

Thanks for your time.

Could you provide some insight on the pricing environment in China? Additionally, considering the $10 million inventory increase there, what should we anticipate?

It's fairly flat, I think.

Yes. In terms of pricing in China as we go on – first of all, for obvious reasons we can't talk about pricing. But in China in the environment is – we rarely – our pricing comes from new products with new features, and benefits, and different value propositions that we are able to then get higher prices in the marketplace. Being a consumer appliance, that's essentially the way we improve unit price in the marketplace in China. The environment for pricing is – you know, it's a very tough environment. If you look at the CPI and PPI in China, they are actually headed downward. But in terms of tying to inventory levels, like I said, we are watching it. We are aware of it. But at this point we are comfortable with the guidance for the year.

Okay. Thank you.

Thank you all for joining us today. We have posted a slide deck from our Analyst Day in May and a new video showcasing our China business on our website, aosmith.com. We welcome your questions, and please do not hesitate to contact me. Have a wonderful day. Thank you.