A.O. Smith Corp (AOS) — Q4 2015 Earnings Call Transcript

Thank you, Eric. Good morning, ladies and gentlemen, and thank you for joining us on our 2015 fourth quarter and full year results conference call. With me, participating on the call, are Ajita Rajendra, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. Also, in respect of others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Ajita, who will begin his remarks on slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. 2015 was another excellent year for A.O. Smith, setting records for sales and earnings. We continued to see healthy end markets for U.S. commercial water heaters, our Lochinvar branded products, and our consumer products in China. We believe our organic growth outshines almost all other industrial companies. Here are a few highlights. Organic growth in both of our segments drove sales nearly 8% higher to a record $2.54 billion. Excluding the impact from the strengthening U.S. dollar against the Canadian and Chinese currencies, our sales grew over 9% in 2015. Despite being a sales record, this was lower than our previous estimate for the year as our year-over-year U.S. residential water heater volumes declined in the second half of the year, similar to the industry. China sales were up over 16% in local currency. Record net earnings of $3.16 per share were 30% higher than our adjusted earnings per share of $2.43 in 2014. We continue to review our capital allocation and dedicate a portion to return to shareholders. We repurchased approximately 1.9 million shares for $128 million during the year. We increased our dividend by 26% earlier this week, following a similar increase one year ago. And during 2015, we returned almost $200 million to our shareholders. John will now describe our results in more detail beginning with slide 4.

Thank you, Ajita. Sales for the full year of $2.54 billion were 7.7% higher than the previous year. Net earnings of $283 million improved 28% from 2014. As shown on slide 5, net earnings of $3.16 per share improved 30% compared with adjusted earnings per share of $2.43 in 2014. Sales in our North America segment of $1.7 billion increased 5% over 2014, driven by price increases in the U.S. and Canada for residential and commercial water heaters and higher volumes of commercial water heaters and condensing commercial boilers in the U.S. Based on our shipments, we expect residential water heater industry volumes in the U.S. to decline by approximately 300,000 units in 2015. Rest of world segment sales of $866 million increased 13% compared to 2014. China sales increased $95 million, driven by higher demand for water heaters and approximately $35 million of incremental sales of A.O. Smith branded water treatment products. Our newly launched in-home air purifier products added approximately $9 million to China sales. On slide 7, North America operating earnings of $340 million were 34% higher than adjusted segment operating earnings in the previous year, and an operating margin of 20% was significantly above the 15.6% adjusted operating margin one year ago. Pricing actions in the U.S. and Canada, higher sales of Lochinvar branded products and commercial water heaters in the U.S., and lower steel costs contributed to the significantly improved segment performance. The impact of profits from lower residential volumes in the U.S. partially offset these favorable factors. Rest of world operating earnings of $113 million improved 6% compared with 2014. Higher sales and lower steel costs were partially offset by lower sales of highly profitable commercial water heaters in China and increased selling, general, and administrative expenses. As a result of those factors, 2015 segment operating margin of 13% was lower than the 13.9% operating margin in 2014. Our corporate expenses declined from the adjusted corporate expenses the prior year, primarily as the result of higher interest income. Our effective income tax rate during 2015 of 29.7% was higher than the previous year due to a change in our geographic earnings mix. Sales in the fourth quarter of $639 million were 2% higher than the previous year and below our expectations. Lower U.S. residential water heater volumes and weaker U.S. boiler sales contributed to less organic growth than we expected. Excluding the unfavorable translation impact from the weaker Canadian and Chinese currencies of approximately $13 million, sales grew 4%. Net earnings of $80 million was 39% higher than fourth quarter adjusted earnings of 2014. As shown on slide 9, net earnings of $0.90 per share improved 41% compared to adjusted earnings per share of $0.64 in 2014. Sales in our North America segment of $414 million declined 4% over 2014. Price increases in the U.S. and Canada for residential and commercial water heaters and higher volumes of commercial water heaters were more than offset by lower volumes of U.S. residential water heaters and approximately $5 million unfavorable currency impact in Canada. Sales of Lochinvar branded products were flat in the quarter. Industry volumes of residential and commercial boilers declined in the fourth quarter of 2015 compared with the previous year. We believe warmer weather at the beginning of the heating season may have negatively impacted residential boiler volumes, and longer lead times for commercial projects may have negatively impacted the commercial boiler industry. Rest of world segment sales of $232 million increased 14% compared with 2014. China sales increased 19% in local currency, driven by higher demand for water heaters and water treatment products. Seasonally strong air purifier sales added over $5 million to China sales. Higher China sales were partially offset by unfavorable currency translation of approximately $8 million. On slide 11, North America operating earnings of $92 million were 30% higher than adjusted segment operating earnings in the previous year and an operating margin of 22.3% was significantly above the 16.4% adjusted operating margin one year ago. Pricing actions in the U.S. and Canada, higher sales of commercial water heaters, and lower steel contributed to the significantly improved segment performance. The impact to profits from lower residential volumes in the U.S. partially offset these favorable factors. Rest of world operating earnings of $29 million improved 27% compared with 2014. Higher sales and lower steel and advertising costs in China and smaller losses in India were partially offset by increased selling expenses in China. Segment operating earnings were reduced by over $1 million due to current China currency translation. Fourth quarter 2015 operating margin of 12.3% improved from the 11% operating margin in 2014. Our corporate expenses declined from the adjusted corporate expenses the prior year, primarily as a result of higher interest income. Fourth quarter results included approximately $3 million or $0.03 per share of income tax benefits primarily associated with the recently approved extension of the research and development tax credit in the U.S. and additional R&D tax benefits in China. Cash provided by operations during 2015 was $344 million, compared with $264 million provided in 2014, driven primarily by higher earnings and smaller outlays for working capital in the 2015 period. We exceeded our 2015 cash flow estimate by approximately $50 million as a result of lower capital spending as well as improvements in working capital. Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 15% at the end of 2015. We have cash balances totaling approximately $650 million located offshore and our net cash position was approximately $400 million at the end of December. During 2015, we repurchased approximately 1.9 million shares of common stock for a total of $128 million under a 10b5-1 automatic trading plan. At its December meeting, our Board increased its authorized share available for repurchase by 2 million shares. Considering this increase, we had approximately 2.6 million shares remaining on our existing repurchase authority at the end of December. This morning, we announced our 2016 EPS guidance to be between $3.40 and $3.55 per share. The midpoint of our EPS guidance represents a 10% increase in EPS compared with our 2015 results. Please turn to slide 14 for several 2016 assumptions. We expect our cash flow from operations in 2016 to be approximately $320 million, which is less than 2015, primarily related to expected higher outlays for working capital this year compared with 2015. We expect capital expenditures to be between $120 million and $130 million in 2016, and higher than the $73 million spent in 2015. Due to the strong growth of our water treatment business in China, we will reach the capacity of our existing lease facility in the next few years. Our 2016 capital spending plans include approximately $40 million related to the construction of a new water treatment manufacturing and air purification assembly facility in China. Total cost for the facility is expected to be approximately $65 million and it will be completed in early 2018. In addition, we expect to complete capacity expansion of two North America plants in 2016 at a cost of approximately $7 million. Our 2016 capital spending plan also includes approximately $8 million to support the ERP implementation. Our depreciation and amortization expense is expected to be approximately $70 million in 2016. We successfully completed our first two ERP go-live milestones in August 2014 and May 2015. We expect to convert the majority of our North American plant sites by the end of 2016. ERP implementation expenses were approximately $16.5 million in 2015 and are projected to be approximately $25 million in 2016, higher than the previous year due to a greater number of scheduled go-live events in 2016. Approximately $4 million of incremental ERP cost is expected to incur in the first quarter, with the remainder primarily in the fourth quarter of 2016. Our corporate and other expenses are expected to be approximately $48 million in 2016, higher than the $43 million in 2015, primarily due to expected lower interest rates than last year on cash deposits in China. Pension income is expected to be approximately $7 million in 2016 compared with zero in 2015. Costs associated with our replacement retirement plan are about $6 million in both years. Our effective tax rate is expected to be between 30.5% and 31%, higher than the 29.7% rate experienced in 2015 due to a change in our geographic earnings mix. We expect to continue to repurchase shares at a value equal to our free cash flow after dividends for approximately $150 million in 2016, which is consistent with our stated policy to maintain our net cash balance at approximately $350 million. As such, we expect our average diluted outstanding shares for the year will be between 87.5 million and 88 million shares. I will now turn the call back to Ajita, who will summarize the business assumptions in our 2016 outlook and our growth strategy, beginning on slide 15.

Thank you, John. We expect our businesses will collectively grow between 9% and 10% in local currency terms and between 7% and 8% in U.S. dollars in 2016. The assumptions for currency underlying our organic growth forecast are at current rates. We expect steel prices will remain at current levels, as global demand remains soft and capacity utilization remains slow. Some comments specific to our North American segment. We expect four months of pricing benefit in 2016 as the 2015 price increase in the U.S. will anniversary in late April. We expect U.S. residential water heater volumes will grow by 100,000 to 150,000 units in 2016, primarily as a result of new construction. We expect U.S. commercial water heater volumes will be modestly higher after strong growth in 2015. Due to the significant pre-buy which occurred in the first quarter of 2015, the first quarter of 2016 will be a difficult comparison for U.S. residential water heater volumes. After double-digit volume declines in the U.S. commercial condensing boiler industry in October and November, industry volumes grew 10% in December. We see this positive trend continuing in our business in January. The continuing transition to condensing boilers and new product introductions give us comfort to project Lochinvar branded sales growth of 10% in the first quarter of 2016, as well as for the full-year. Recall that our Lochinvar branded sales are seasonally skewed to the second half of the year which coincides with the heating season. The water heaters we sell in Canada are manufactured in the U.S. The Canadian dollar's weakness is expected to result in a significant product cost increase to our Canadian operations in 2016 which is only partially offset by announced price increases. The magnitude of this headwind is in excess of $5 million. These factors, in addition to the assumptions John discussed earlier, lead us to expect our North America segment operating margin will be between 20% and 21% in 2016. Now, some comments specific to the rest of world segment. We're committed to our business in India. We remain optimistic about the long-term opportunity in the country with the second-largest population and the second fastest growing economy in the world, and its developing middle class who desire quality-of-life products. India is an investment for the future and the $8 million to $9 million loss which we expect in 2016 is similar to 2015 and includes higher promotion and advertising costs related to brand building, as well as the expansion of our water treatment product distribution to six cities in 2016 from two cities in 2015. We expect combined sales of water heaters and water treatment products in India to be greater than $20 million in 2016, an increase from 2015 sales of nearly $16 million. We're a consumer products Company in China which distinguishes us from most industrial companies operating in China. The Chinese consumer demonstrated resilience in 2015. We have three growth drivers underpinning our China business which give us confidence to project an annual growth rate of approximately 15% in local currency for 2016. The first driver is overall market growth which we believe has impacted by household formation and a growing replacement market. A proxy we use to project their potential for water heater market growth is the growth in the consumption portion of GDP. We have seen independent forecasts, including one from the IMF which project China consumption growth between 7% and 8% in 2016. With continued urbanization, growth in the middle class, and a growing replacement and upgrade market, we expect supportive market growth to continue for quite some time. The second growth driver is market share gains and increases in average price. We have a strong market position by value in the electric wall-hung category. Our position in gas tankless, while a leader, is less than 20% by value and we see opportunity to gain more share with our well-respected and patented super quiet models and as our newly launched high-rise models gain acceptance. Our commitment to engineering resources will continue to result in new products with features and benefits in which consumers see value and for which they are willing to pay an incrementally higher price. This results in a favorable mix impact. The third growth driver is fast-growing ancillary product categories, the most significant example of which is water treatment. A.O. Smith branded water treatment products achieved sales of $110 million in 2015, up from $75 million in 2014, and added 5 percentage points of growth in each of the last three years. After successfully launching the A.O. Smith branded in-home air purifiers last year, we expect sales to more than double to approximately $20 million. The combination of A.O. Smith branded water treatment and air purifiers incremental sales is expected to add almost 5 percentage points of growth this year. The last two growth drivers are primarily in our control and as we continue to invest behind them. The first is a function of the growing replacement market and household formation. Combining these three growth drivers gives us confidence that we will grow approximately 15% in local currency in 2016. We expect rest of world segment operating margin in 2016 will be similar to last year's margin of 13%. One final comment on China, the recent declines in the China stock market and value of the Yuan are unprecedented and we acknowledge the concerns of the investment community surrounding our China business. While it is not our practice to discuss monthly results, recent trends might add some perspective, given that the latest macro events in China materialized in mid-December. In local currency, the average of our daily shipments in January increased over 15% year-over-year. Please also remember that the first quarter is typically our lightest China sales quarter, due to the New Year travel holiday in February. Especially in these volatile and uncertain economic times, we believe our long-term annual 8% organic growth potential and our stable defensive replacement markets, which we believe represent over 85% of North American water heater and boiler volumes, positively differentiate A.O. Smith among other industrial companies. Coupled with growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisitions that add shareholder value as well as allow us to return cash to shareholders. That concludes our prepared remarks and now we will take your questions. As Pat mentioned earlier, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. Please also note that John and I are in different locations and we will do our best to coordinate our answers to your questions.

I wanted to ask two different questions about China. One has to do with your cash position there, Ajita, and there has been some talk lately about, in light of all the issues, China reinstituting some of the capital controls, in particular clamping down on corporate profits leaving the country. How does that impact your view of your cash position there? Are there enough investment opportunities in China, given the environment, or should we look at that as kind of stranded cash?

Let me start with a general comment, and then I'll let John discuss the cash situation. I was in China last week, and I visit frequently. Interestingly, the discussions we hear about China pertaining to the stock market and various events are not topics of conversation among people on the street. They are focused on different drivers and issues. I met with customers and many members of our workforce, and I had dinner with the former dean of the business school at Nanjing University. The focus of our discussions was on different subjects altogether, so these issues aren't really part of their conversations. Regarding stranded cash, that topic didn’t come up, but we don’t have significant concerns about it. John, would you like to talk about it directly?

Ryan, one of the topics being discussed is capital controls. In the past, we withdrew about $100 million from China in 2014. We definitely have uses for cash in China. As mentioned, we will be adding a water treatment and air purification plant. We are always looking for opportunities to expand our product lines, similar to what we did with air purification and water treatment four or five years ago. We will continue to monitor the situation.

And then my follow-up was to do with China, also. I realize it's sensitive to comment on competitor moves, but it looked like General Electric's appliance business may end up in the hands of one of your notable competitors in China. Obviously, they've got a respected American brand like you do, so I wondered if you could just comment for us on how you view that potential development in the competitive landscape there, and whether that has a potential to disrupt anything competitively? Thank you.

Let me address that, John. I don't think there's a concern because GE has been established in this industry for a long time, and the GE brand is highly respected. They primarily produce heat pump water heaters, which is a small segment and hasn't significantly influenced the market. Haier is a competitor and a reputable company, particularly strong in China, where we've been gaining market share from them. They have the potential for extensive product development, but it's still early to assess the situation fully. Currently, we are not worried. At Haier, water heaters are not a core focus, and there is limited capacity available in the GE product line. We're keeping an eye on it, but it's not a pressing concern.

This is Patrick speaking on behalf of Charlie. Regarding U.S. residentials, you provided some insights, so thank you for that. Once you had clarity on the outlook for 2016, was the weakness you observed mainly due to macro factors, or was it influenced by the pricing increase in April? If it was the latter, can you provide any quantification or further details on that?

Our best estimate, if you look back to the end of 2014, shows that in the fourth quarter compared to 2013, there was an increase of about 180,000 units. We believe that a significant portion of this was due to pre-buying, as it was already known that NAECA was coming and some product lines would be discontinued, along with impacts on certain multi-family units. So, when we analyze this, we estimate that it could have been as high as 150,000 units of pre-buy last year. When you combine this with the fact that completions only increased by about 80,000 this year, you arrive at a difference of about 220,000, explaining the total of 300,000 units. We have also observed that some of our customers have reduced their safety stock since deliveries are now on time. Therefore, we think this combination is the reason for the decline. We will continue to monitor the situation as 2016 progresses.

I have a follow-up question regarding the steel costs. How much of the margin increase in both your reported segments can be attributed to the declining steel costs?

We haven't quantified that. As mentioned earlier, the improvements in margins stem from three key areas. Commercial performance was very strong. We implemented price increases earlier in the year on NAECA products, non-NAECA products, and commercial offerings. Additionally, we raised prices in Canada. The third factor contributing to this is the decline in steel costs. It's the combination of these three elements that has led to the enhanced margins.

Would you say that they are on the list then? In terms of the improvement, is that fairly high up there? I want to get a good gauge of what that number could be?

Pricing and steel were obviously the biggest ones.

Two questions for me. If I can go back and revisit this pre-buy in North American residential volumes. John, I thought I heard you say that 2015 finished down about 300,000 units. You see up about 100,000 to 150,000 units in 2016. So over that two-year period, we're net down. I guess my first question does that, again, all relate back to that pre-buy and that hard comp from Q4 2014? Or is there something else going on, maybe share-wise? Because it seems like, with the construction up cycle and so much of this replacement, that over a two-year period we would still be positive?

Well, it's not share. I would say our share was very consistent over the time period, so it was not share. Certainly, we're estimating some numbers. It's very possible this year, because of the downturn in 2015, could be closer to 200,000 up. We're just monitoring it. What we had, Kevin, is a significant increase in the industry from 2012, where it was 8.1 million units, up to 9.2 million units in 2014. Part of that was helped by new construction, but certainly part of it was helped by replacement. So it's really hard for us, quite frankly, to tell you within 100,000 or 200,000 units or within 2% of a 9.2 million units, what the exact number is.

Kevin, like you're saying, I hope we're being a little conservative.

Just to follow up on that, as we look into the first quarter and the first half, I know you don't typically comment on monthly trends, but we observed that industry figures fell by double digits in the fourth quarter. Is that what you expect again going into the first quarter? Or do you anticipate that will start to stabilize like it did with your China business?

I think it's clear that in the first quarter of 2015, due to the significant price increase, the industry saw an increase of around 300,000 units. We don't anticipate that happening again. Reflecting on the past couple of years, I believe we will more likely see a distribution similar to that of 2014 by quarter. This seems more reasonable to me, although we might see a slightly lighter fourth quarter due to the pre-buy. Overall, I think this represents a more normalized distribution compared to last year.

Could you comment first on the outlook for 2016? We have various issues at hand, including the carryover of pricing that you explained, some additional pricing, and the volumes. Is it possible to break down, on a consolidated basis, what you anticipate in terms of percentages from volume and price for 2016 or provide a range?

I believe the best estimate for volume comes from the residential side, which is our largest business. The distribution in 2014 likely serves as a reasonable reference. As for price, as mentioned during the call, we expect to see significant year-over-year price increases through the end of April. After that, we anticipate a leveling off since that's when the price increases were implemented. Looking back since we acquired Lochinvar in 2012, our earnings distribution has been 48% in the first half and 52% in the second half, and at a high level, that seems to be an unrealistic estimate.

Okay. And then, maybe you can just comment and just add to some of your comments around Lochinvar. Obviously, you saw a weakness in the fourth-quarter, but you saw some nice trajectory and exit rate. But just give some narrative around what undergirds your confidence there, given the change in regulatory standards? Or the progression that's going on there on the products that you think supports a 10% organic growth rate, there?

In October and November, the industry experienced a significant decline, but we were only affected by about half of that drop. We observed a notable recovery in the industry during December. Looking at Lochinvar for the entire year, sales increased approximately 7%. However, if we exclude China—where we faced challenges, particularly in the commercial sector, and our sales there were around $4 million—along with the shortfall in Canada due to competitive pressures and currency fluctuations, the growth would have been about 10%, even accounting for the fourth quarter. As we evaluate December and our projections for the first quarter, we anticipate growth of around 10%, and we are confident in achieving a full-year growth of 10% compared to last year.

And also comfortable with what we've always been saying in the longer-term conversion from non-condensing to condensing. You're going to have these short-term blips, but that longer-term trend and trajectory is solid.

Just a couple of things regarding North America. You mentioned that safety stocks are decreasing. Can you provide some insight into what your customers are saying about inventory levels and specifically about any pre-buy overhang? Additionally, in relation to the NAECA standard, have you observed any customers downgrading due to higher prices, especially for the 55-gallon-plus products?

We have recently completed our sales meetings, and the feedback from our sales team indicates that our customers' inventory levels are reasonable. However, as you may have observed in the broader industrial landscape during the fourth quarter, overall demand has been relatively weak. Nonetheless, we have noted some improvement in ordering patterns during December and January, though I would say that we are not fully back to normal yet. That said, I believe we are headed in the right direction. Regarding the trading down aspect, if you're referring to the discontinued electric units, it appears that the commercial business is performing well in the 55-gallon to 90-gallon range. This might suggest that either residential customers who previously purchased those sizes are now opting for commercial models, or that commercial customers are shifting from residential size options to commercial sizes. This could help explain the improved performance in the commercial sector. It's also possible that some customers might be opting for smaller sizes.

Okay. And just quickly on the Lochinvar comment about longer lead times. Is that a function of macro uncertainty? Some slowing in commercial construction? Or is it something different?

As we've spoken to various individuals, it seems likely that macro uncertainty is a factor, but we cannot be certain. Our customers are quite busy; however, the release of projects has not occurred as rapidly as usual. We are unsure if this is due to financing or other macroeconomic issues. Nevertheless, we believe this is likely just a temporary situation, as the good news is that the engineers seem to be very occupied.

Additionally, I want to share some observations from my experience at the ASHRAE show, where many of you were present as well. Conversations with customers indicate they have a positive outlook for 2016 and are optimistic about the direction of business.

Considering the foreign exchange commentary and how it varies by division, I believe there was around a $5 million headwind due to the impact of the Canadian dollar on North America. Is it reasonable to assume that North America faced about 1 point of headwind, while the rest of the world experienced around 4 points?

In the fourth quarter, it was $5 million for Canada and about $8 million for China. What we're estimating, based on current rates now, what 2016 headwinds could be is closer to $40 million for China over 2015. And maybe another $15 million or so for Canada for the year, top line.

Perfect. That's exactly what I was looking for. Could you discuss the new product developments in China for 2016? Is there anything notable coming in water filtration or air purification?

I feel very confident about the new products. As I mentioned earlier, I was in China last week and we have an exciting lineup of new products coming out. I won't go into specifics about things that haven't been introduced yet. However, the rate at which we are introducing new products and innovating to bring truly new items to market, as opposed to just making cosmetic changes, is significant. There's some intriguing new developments in water treatment. For air purification, we released two SKUs: one in April and a smaller version around October. These two SKUs generated $9 million in sales last year, demonstrating the strength of our brand in key categories with the right products, even with only two SKUs. We plan to expand that line in 2016 as well. Overall, I am very optimistic about the new products in our pipeline.

First question, can you clarify if air purification generated $5 million in revenue this quarter?

Yes, it was around $5 million in the fourth quarter, and $9 million for the year.

Okay. Second question, can you give us a little more granularity in terms of the replacement market in China and how large that is for you at this time?

Our analysis, based on survey data, indicates that we've observed an increase over the past two to three years. This trend makes sense, as we have been selling at a significant scale for about 10 to 12 years. Our products typically last around 8 to 9 years, and we believe they may outlast those of our competitors. Specifically in tier 1 cities, we've noticed a rise in replacement demand. We estimate that this could be nearing 50% based on our data. However, we don’t have as robust data as we do in the U.S., where all new construction can be clearly tracked against replacement figures. It stands to reason that this is on the rise, and we anticipate that it will continue to grow.

Very fine top line performance in China. No doubt. Just want to get a sense of your feeling of the inventory that's in the channel there, right now?

We're comfortable as we look compared to the year. I think the distribution by quarter was pretty reasonable, so I think we're comfortable where we're from an inventory standpoint. I don't know, Ajita, if you heard anything different when you were there last week?

No. I think that says it. It's about where we should be. In the past, we have expressed some concerns that it was a little high, as we did, I think, about one year ago. Right now, I would say we're where we should be. And like I mentioned, we don't normally talk about monthly results, but what we saw in January was the type of increase that we like to see for the year.

My question is regarding the margins for the rest of the world. We have been maintaining around 13% margins. What are your projections for the margins in China moving forward? If you look back to 2014, we reached a 15% margin. Can you provide some insights on this? What key changes would drive us from 13% to the next level of 14%, 15%, or mid-teens margins?

A significant portion of our growth is driven by China and the type of investments we are making. Currently, over the next 12 to 18 months, we are focusing on brand development in India. Our strategy in India mirrors what we implemented in China, involving substantial investment in the brand, followed by expanding into categories where we have strong presence. We are putting resources behind our brand in India. We've shared our expectations for the Indian market. In China, we are entering a new category—air purification—while continuing to heavily invest in water purification, where we already have a business exceeding $100 million. Recently, we have held a leading position in market share in that category and aim to reinforce our leadership as we transition from primarily being known for water heaters to water purification and now air purification. This expansion of our brand requires significant investment. We are also targeting investments in smaller, second and third tier cities, indicating a considerable amount of investment is currently underway.

You're right. In China, margins have decreased slightly, currently around 15%, which is down from 2014. There are a few factors contributing to this, as Ajita mentioned. The core businesses—electric, gas, and water treatment—are performing well, but we are investing in air purification, which will result in larger losses next year as we expand the distribution platform. The commercial sector has faced challenges this year, negatively impacting margins in China and elsewhere. Additionally, we are incubating other businesses, like combi boilers, which have incurred bigger losses, even though we believe this market is essential for the future, and we are committed to engineering in that area. We are confident about our prospects, but improvements in margins and profitability, particularly in India, will take time and is a goal we aim to achieve in the future.

I have a question about China, specifically regarding the margin side. What was the change in advertising spend year on year?

I think as we talked last year, the margins were negatively impacted because we were running a fair amount of CCTV advertising for water treatment. We did not have that this year. That was a pretty significant contributor to the improvement in the margins year over year in the fourth quarter. That was the major delta, is just we did not have that advertising on national television. And we kind of talked about in the past, these advertising spends can vary quarter to quarter and I think we outlined that last year in the fourth quarter. We did see better improvement in China margins this year than last.

The question on margins for China in 2017 is whether opening up the facilities leads to under-absorption in fixed costs, which could negatively impact margins. Should we consider it this way for 2017?

I don't think we would anticipate significant costs. We'll avoid some of the lease expenses, and we expect to maintain decent occupancy. To be honest, I haven't analyzed it much, but I wouldn't expect it to have a major impact.

I think it's fair to say that we are continuously expanding. We expanded our factory and opened a new facility last October. We are currently in the process of expanding that facility, even though we haven't moved into it yet. We generally have more capacity than we require in certain areas, and we are quickly filling that capacity while building new factories and moving in. Therefore, as John mentioned, I don’t anticipate seeing any unusual under-absorption levels in the next couple of years.

And then the follow-up question was a housekeeping one, the other income was up meaningfully from Q3. Can you just clarify what that was?

I need to check, but I know that interest income increased year over year. When we anticipated that China might lower rates, we protected against some volatility, but that will be ending towards the end of this year. That’s why we indicated that corporate expenses will rise next year; interest income is expected to decrease by about $4 million compared to last year.

Yes, one follow up. Just wanted to talk about the margin outlook for North America. What goes into that aside from just the anniversary of the price increase and how we see it playing out? Should we think about some core operating leverage on the basis of that? Obviously, if you look at the implied run rate, it's around the 21% range through 2Q through 4Q. Any kind of dynamics about how you're going to achieve that? And tentatively your confidence level in achieving that would be helpful?

I believe our performance over the last two quarters has exceeded expectations, primarily due to our product mix, particularly with commercial and Lochinvar being our highest margin lines, even though our residential segment has been weaker. There are various factors at play. For instance, we expect a favorable impact from steel prices this year. However, we also mentioned challenges related to the Canadian currency, which will negatively affect us. Additionally, we anticipate that SAP will increase by approximately $8.5 million to $9 million, making currency fluctuations and SAP the most significant factors contributing to the headwinds we are facing in North American margins.

Ajita, do you have any other thoughts on that or not?

No, I think that hits it. Because one of the things we didn't talk about a lot is the fact that the SAP, the ERP is going to be that much higher in 2016 over 2015.

This is actually Patrick again. Thanks for taking my follow-up. I wanted to touch a little bit on the online sales from China that you guys mentioned a little bit briefly. What was the level in 2015 versus 2014? And if I'm not mistaken, these higher-margin sales, right? And do you have any expectations for that number in terms of 2016?

It was about $140 million, which exceeded our projections. This is in contrast to approximately $55 million last year. It's difficult to categorize the margin as higher; we would say it's at least as good, but we are reinvesting a significant amount into advertising and the development of that channel. We anticipate that it will continue to grow, and right now, the estimate is around 20% to 25% growth from where it was. This channel is certainly becoming increasingly important for us.

I have a quick question about India. Is the expected loss for 2016 between $8 million and $9 million based on an expectation of $20 million?

Yes, we said over $20 million, and we had about $16 million. What's happening in India is, we're making improvements on the water heater side. We still have a ways to go. But as we talked in the release, here, we're expanding our water treatment. We think that's a potentially large market for us and to enter a market like that is going to take a decent amount of investment from an advertising, distribution, expansion, et cetera, standpoint. So water heaters are improving and we're spending more on water treatment, ending up about the same point.

Actually, my question was at what sales level will we be able to have a breakeven number?

On the water heater side, I think we've talked about in the past, it's about a $15 million business. Our expectation is to be a $30 million business. Somewhere around there would be a breakeven. I have the number for water treatment, but I can't recall it. It's probably a similar type of number. Maybe a little bit less.

Thank you all for joining us today. Please take note that we will be at the Wedbush Sustainability Conference on March 9 and the BB&T Industrials Conference on March 23. Have a wonderful day.