A.O. Smith Corp (AOS) — Q3 2017 Earnings Call Transcript

Thank you, James. Good morning, ladies and gentlemen, and thank you for joining us on our 2017 third results conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning’s press release. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Ajita, who will begin his remarks on Slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. A 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 on 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. So record-setting earnings at $0.54 per share were 15% higher than our third quarter earnings per share in 2016. We are delighted to work with the Hague team as part of 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 our cash to return to shareholders. Through the first nine 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 five-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. companies. 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 number 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 to 2016. Sales in our North America segment of $486 million increased 8% compared to 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 American water treatment sales comprised of weaker Hague, as well as a full quarter of Aquasana, which 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 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 operating earnings of $110 million were 10% higher than segment earnings in the prior year. This came from higher sales of boilers and residential water heaters, and the pricing action in the U.S. was partially offset by higher steel cost. 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 one 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. Costs associated with the expansion of retail outlets in tier two and tier three cities had sales of the company’s water treatment and air purification products, and higher water treatment product development engineering parts were the primary drivers of the higher SG&A in China. Third quarter segment margin was 4.5% compared to 4.9% last year due to these factors. Our corporate expenses were lower than one year ago. Our effective income tax rate in the third quarter of 2017 was 28.8%, which was more than the 20.7% 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 nine 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 remain strong. Our debt-to-capital ratio was 21% at the end of the third quarter. We have cash balances totaling $768 million located 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 a potential earn-out of up to $2 million. Primarily, as a result of continued strong cash flow and escalating PBGC premiums, we made a voluntary contribution to our pension plan of $30 million in the third quarter. The after-tax impact to our cash flow is approximately $18 million. During the first nine months of 2017, we repurchased approximately 1.9 million shares of common stock for a total of $103 million. Approximately 3 million shares remained on our existing repurchase authority at the end of September. This morning, we increased the mid-point of our 2017 EPS guidance by $0.04 per share with the range being between $2.12 and $2.14 per share. The mid-point 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 two-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 programmed in 2016 on a construction of a new water treatment and air purification manufacturing facility in Nanjing to support the strong growth of these products in China. Our 2017 capital spending plans of approximately $100 million include $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 in 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 acquisition 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 and the Tax Reform Act are 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 an 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 a one-time income tax expense associated with the repaid creation and measurement 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 to 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.

Thank you, John. We project revenue growth to be between 11% and 12% for the year. We expect Aquasana and Hague sales could be nearly $60 million this year and slightly accretive to earnings. Aquasana sales were up nearly 18% in the first nine months of this year compared to last year. Including North America water filter and softener sales, we expect global water treatment product 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 volume will increase over 300,000 units in 2017 due to new construction and expansion of replacement demand. This assumption includes tankless units. We project 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 regulatory change driven price increase effective January 1. Lochinvar branded products grew 17% in the third quarter and 9% in the first nine months of 2017, driven by solid demand for boilers and new product related market share gain. 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 a full year margin of approximately 15%, 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 represent approximately 85% of North America water heater and boiler volumes, positively differentiates A. O. Smith amongst 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 are available for your questions.

Thanks, good morning. I want 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? Thank you.

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 to be in that range of 30 or so in local currency. Air purification was up 75% in the quarter, more than double year-to-date and we would expect it to be more than double for the year. Didn’t touch, what was your last – was it something else?

Yeah, the performance system in the legacy water heater business in China in Q3.

In 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 distributions of that product, how many outlets you are in currently, how many you would anticipate and how that’s going to evolve over the next year or so. And then to 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 have been in the last couple of quarters in Rest of World?

Yeah, sure. For example, water treatment margins were down about 6 points in the third quarter and that accounted for almost all the decline in the margins for the quarter, and that was truly engineering and also investment in new retail outlets. We are at about 7,000 – we’re in 7,000 stores approximately, and then we have on-important some special zones, etc. I guess Ajita will 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 two years.

Yeah, I think if we went back two years ago, we would have said the rate of our build-out would have been slower and I think we’re just going to go faster because we see the opportunity long-term.

Yeah, we had about 1,500 stores, almost 2,000 outlets if you will over the last two years.

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

So when we look at the fourth quarter, that’s always our highest volume quarter. We would expect that to be the highest volume this year also. So we are going to get contributions. We would expect SG&A will be down a couple of 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 have talked over the years that those spends could be lumpy, and they clearly were in the second and third quarter, and we are comfortable they will be lower in the fourth quarter. So I think you are right. We have a fairly aggressive fourth quarter, but with higher volumes, we think we will get a little favorable mix from the introduction of a new electric unit and then lower SG&A, we are comfortable with the estimate.

Okay, and then just on North America, on the top line growth, is sort of I guess implied in the guidance. Did you – you mentioned a pre-buy that you expect that – that is why it’s kind of little bit maybe stronger growth in Q4 because you are pulling some stuff forward or is that just underlying stronger margin, obviously Lochinvar is doing pretty good?

Yeah, and we expect Lochinvar to be up. We expect residential to be up nicely in the fourth quarter. So those two, and then we do expect some pre-buy from the regulatory changes that are happening on the electric units on the commercial. So it’s a combination of all three zones, that’s why we think sales will be up nicely in the fourth quarter.

Hi, it’s Sam Eisner here, guys how are you?

Hi, Sam.

Just on the – just going back to my last question on the pre-buy, was there any pre-buy benefit this quarter that you guys saw that you can define them, and then also given the Lochinvar performance in the quarter, is there anything in particular going on there that you guys want to comment about?

Well, we don’t think there was any pre-buy. I mean I will tell you in September, residential was strong, but the price increase that had already been put in by August 1, so— I mean by I guess September 1. So any pre-buy would have happened in August if you will, so no. But September residential was strong, and Lochinvar had a greater quarter. I mean their boiler business was up 25%. You break that into three pieces, their residential was up over 30, their condensing, which is the big commercial boiler, was up high single digits, and then their non-condensing, which we have 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, about $3 million during the quarter, and so that clearly helped that to add 3 or 4 points of growth. And that’s from a distributor. We are also selling that product in China through our A.O. Smith operation. We expect that product will sell $15 million this year, 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 are very pleased year-to-date they are up about 9% and we are certainly comfortable with the 8% growth that we talked about earlier in the year portfolio.

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

Got it, that’s helpful, and maybe looking over on the Rest of World segment, the 13% growth that you guys are seeing 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, 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? Thanks.

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

Yeah, I think not much to add, am just reinforcing the fact that we are very comfortable with the 15% annual growth in China in local currency, which is what we’ve always said. And it is going 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 one quarter to another. 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 have given.

Hi, good morning, guys.

Good morning.

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, and the $40 million's the acquired growth or just help me there.

With what 60 is the full year Hague and Aquasana, and that’s about our incremental of about 40 over the prior year because we didn’t have Hague and we only had Aquasana, of course, from August of ‘16. So the incremental was 40, and the total water treatment in North America this year will be 60.

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 timing in Q4, but we would have known there’s anything you know working capital supply chain that’s driving that?

Well, the biggest issue is the pension contribution, so that’s $20 million plus, about $20 million of that. We did not have that in our estimate. Probably the other most significant item is we are probably building more inventory for our water treatment move that’s going to occur in the first quarter and late second quarter than what we had planned, and so that certainly benefits, but nothing out of the ordinary. We’re still very comfortable with our days' sales outstanding and etc. Yeah, and some of that build is demand-driven because, I mean, the business continues to grow very well, and so we’re anticipating that. In that transition, we want to make sure that we don’t lose out on any other revenue.

Yeah, hi. Good morning. 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, world-large number or want have you. Do you think we’re a year or two away for maybe kind of thinking that’s maybe a low teens growth business rather than 15%, which obviously there will be nothing wrong with that, but I’m just trying to gauge your thinking internally?

I am comfortable with where we are now and the outlook that we have. And what you say from a periodical perspective, we are going to be order of magnitude a billion dollar 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 as something that we say we’re going to have to turn that down a little, we will let you know. We will make sure that we communicate that to our investors.

Clear predict, Scott, continue growth on water treatment and air purification; those markets are expected to grow significantly. See I’m still talking about 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.

So that is kind of what I’m saying. Yes. Okay. That’s fine, but if you go for the intermediate term right?

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

Understood. I just – my second question is really about the U.S. business, both the results were pretty good. And as we look across the residential construction numbers over the last five months, which certainly is not a primary driver, but is a driver of the market. Those numbers have really been very strong, sort of 15% the last five or six months, and we also – it looks like the field might actually come down a little bit in the fourth quarter at least quarters you guys here, just sort of wondering how you’re 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 said we didn’t see strong; we’ve seen relatively strong growth in residential; it’s probably about 300,000 units. Now, again, that’s on a base of 8.7 million units. So that’s what 3% or 4%, and we have seen that the last three quarters with some of that in the fourth quarter. Commercial has been strong; it’ll be up – it was up by I think year-to-date probably about 7% or so. And that looks like that continuing. I would tell you it appears steel has leveled off, but we haven’t seen a decline; we say it’s leveled off, which would be a plus because it has gone up so much dramatically which benefits as it does kind of stabilize. You know, again, continuous growth margin, so yeah I think we’re optimistic as we look into the fourth quarter and next year from a North America standpoint. Ajita, if you have any?

No, I think that summarizes well.

Hi, thanks, good morning. I have two questions, but first, just to clarify, it looks like we needed $16 million, $17 million increase in EBIT sequentially to get the Rest of World record margins you’re projecting. Sounds like the bridge is a reduction engineering around $6 million, and then the rest is volume and slower growth in SG&A, is that right just to clarify, are we getting that right?

I won’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 pricing; again, even in China, last raw material costs have stabilized, so we think we will get some benefit net 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; then you throw in a little bit of favorable mix from the new electric units, those are the kind of the pieces that get us up there.

Okay. Thank you. And then secondly, staying in the rest of the world, how do you think about incremental margins going forward? Should we start to think about moving over 20% on an incremental annual basis now in rest of world, do you have scale there?

I am not sure, you said two different numbers; you said 20% and then you said 20% incremental.

Over 20% incremental on an annual basis going forward since you are leveraging infrastructure and getting scale in those businesses?

Well, I’ll take a shot at it. We clearly want our rest of world margins to grow; we think it’s a combination of India becoming more profitable, Turkey be capital, I should say, reducing the loss in India, and ultimately getting to a breakeven with the same statement for Turkey. And then, yeah, it’s our intention to leverage China’s SG&A and volume going forward. We have not put out any specific objective, but certainly it’s our objective to try to grow rest of the world margins.

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

Hi, thank you. Robert Aurand down for Dave McGregor today. Stock in China by your water heater business and what extent increased competition from the domestic manufacturers is impacting your results?

Look, you know it’s always been competitive as continually top; it’s always been competitive. We’ve seen in the market I’ll say the electric not growing as fast which we assumed would happen because there is more distribution of gas in the city. So if you would have asked us probably three years ago, we would have said electric was 55% in 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 happens. We don’t have a stronger position, but we’re – we have a good position in gas and we’re leading in electric. So I don’t think that there’s 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.

You know just to add a little more color to that, the changes John talked about have not happened overnight, evolutionary type changes that are happening. From going back to your question on the competitive environment, yeah I’ve always said China – the market in China is very, very competitive. You got all of 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. Thank you. And just one more question on China, I mean just new flow throughout the year that there are really trying to kind of cool down, the real estate market in the major cities there, aren’t get a property bubble, I mean what extent does that impact your results over there, do you guys think about that impacting 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 one or two month; we don’t know that’s a limp 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 outside for us going forward is we think replacement is becoming a bigger component, which just makes the sense the really good news about water heater in ultimately failed, and with that you have a replacement market. And as you know here in the States, the replacement market is you know that 9 million build about 7-8 million of this replacement. So we are nowhere near that in China, but it’s developing. So I think as we look forward, we still think we are going to be able to grow from the water heater segment and we have some of the best products in both electric and gas which differentiates us. Is that answer your question or not?

And I think if you look at it from a longer-term macro perspective, you know China has just completed or is completing this week the latest communist party congress, and you know you take headline coming out of that it’s a continuation of the policies which drives urbanization, drives more consumption-based growth and those things form a macro perspective also help us and really reinforce our strategy.

Hi, great quarter as always. Most of my questions have been answered, but just a couple of small ones on water treatment. When this plant comes online in the 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’ll certainly pass initially probably the first and second quarter. I mean, but we are moving a significant operation. The good news is we are not moving it far, but we’re going to have moving certainly in the first and second quarter. The new plans will offer higher depreciation for the year; we have – ultimately we’ll have some inefficiencies in the first half of the year. But the good news is ultimately we think it’s going to be a much more efficient plan. So there could be hiccups early in 2018, and we’ll talk about that when we get into through our planning process and possible talk more on year-end. But I think for the full year that we’ll have some marginal effect but not significant.

Yeah, we’ll be able to define it more three months from now. But just the team in China is very – they are used to doing this because they are constantly expanding and 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, you know we’ve designed this 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’s a real benefit.

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

Yeah, that was one of the things that attracted us to Hague as we have looked at water softener manufacturers; we’ve been OEM in over there and we look necessarily successful, and we looked for manufacturers of all the way. And quite frankly we feel agents for that. 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 you know it’s been nice sales; I think the sales probably in six months have been a million bucks sales over in China, and it’s of the Hague water heaters and in U.S. water softeners. So no, we are optimistic that they can really provide us the benefit in China.

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

Yeah. So it’s not something we are saying; we anticipate doing, it’s happening now.

Yeah, hi. 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 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 am asking?

I haven’t been, but again Scott just over, I understand better what you think. And it goes back to 9 million units, 7.8 of that is replacement. So completions you know are 1.2 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 that you have but I think that’s partly what’s driving that is you have that base of 7.8 million units, and that’s probably growing some this year because if you get 9 million units, you know, and completions are up of 100,000 to 150,000 and the rest is replacement. So that’s why I was trying to say.

And I guess I make another comment, Scott, which is, you know, not a quantifiable comment, obviously, but it may try and touch what you are saying. You know we just a couple of weeks ago faced an ASA meeting, which is the annual meeting where we have all of our distributors, and you know there was, you know, people were pretty optimistic. I can’t quantify that, but you know, people felt good about where things were.

Hi, thanks, good morning. I have two questions, but first, just to clarify, it looks like we needed $16 million, $17 million increase in EBIT sequentially to get the rest of world record margins you’re projecting. Sounds like the bridge is a reduction engineering around $6 million, and then the rest is volume and slower growth in SG&A, is that right just to clarify, are we getting that right?

I won’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 pricing; again, even in China, last raw material costs have stabilized, so we think we will get some benefit from net 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; then you throw in a little bit of favorable mix from the new electric units, those are the kind of the pieces that get us up there.

Okay. Thank you. And then secondly, staying in the rest of the world, how do you think about incremental margins going forward? Should we start to think about moving over 20% on an incremental annual basis now in the rest of world, do you have scale there?

I am not sure; you said two different numbers; you said 20% and then you said 20% incremental.

Over 20% incremental on an annual basis going forward since you’re leveraging infrastructure and getting scale in those businesses?

Well, I’ll take a shot at it. We clearly want our rest of world margins to grow; we think it’s a combination of India becoming more profitable, Turkey be capital, I should say, reducing the loss in India, and ultimately getting to a breakeven stating the same for Turkey. And then, yeah, it’s our intention to leverage China’s SG&A and volume going forward. We have not put out any specific objective, but certainly it’s our objective to try to grow rest of the world margins.

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

Hi, thank you. Robert Aurand down for Dave McGregor today. Stock in China by your water heater business and what extent increased competition from the domestic manufacturers is impacting your results?

Look, you know it’s always been competitive as continually top; it’s always been competitive. We’ve seen in the market, I’ll say the electric not growing as fast which we assumed would happen because there is more distribution of gas in the city. So if you would have asked us probably three years ago, we would have said electric was 55% in 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 happens. We don’t have a stronger position, but we’re – we have a good position in gas and we’re leading in electric. So I don’t think that there is much 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.

You know, just to add a little more color to that, the changes John talked about have not happened overnight; evolutionary type changes that are happening. From going back to your question on the competitive environment, yeah I’ve always said China – the market in China is very, very competitive. You got all of 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. Thank you. And just one more question on China, I mean, just new flow throughout the year that there are really trying to kind of cool down the real estate market in the major cities there, aren’t we getting a property bubble? I mean what extent does that impact your results over there, do you guys think about that impacting 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 one or two month; we don’t know if that’s a limp or not. We don’t – we’re not really tracking as closely on build; what we’re tracking is sales, because that’s what ultimately leads. The good news outside 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 ultimately it failed, and with that you have a replacement market. And as you know here in the States, the replacement market is, you know, that 9 million build about 7-8 million of this replacement. So we are nowhere near that in China, but it’s developing. So I think as we look forward, we still think we are going to be able to grow from the water heater segment, and we have some of the best products in both electric and gas, which differentiates us. Is that answer your question or not?

And I think if you look at it from a longer-term macro perspective, you know China is just completed or is completing this week the latest communist party congress, and you know you take headline coming out of that; it’s a continuation of the policies which drives urbanization, drives more consumption-based growth and those things form a macro perspective also help us and really reinforce our strategy.

Hi, great quarter as always. 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’s certainly will pass initially probably the first and second quarter. I mean, but we are moving a significant operation; the good news is we are not moving it far, but we’re going to have moving certainly in the first and second quarter. The new plans offering higher depreciation for the year; we have – ultimately we’ll have some inefficiencies in the first half of the year. But the good news is ultimately we think it’s going to be a much more efficient plan. So there could be hiccups early in 2018, and we’ll talk about that when we get into through our planning process and possibly talk more on year-end. But I think for the full year that we’ll have some marginal effect but not significant.

Yeah, we’ll be able to define it more three months from now. But just the team in China is very – they are used to doing this because they are constantly expanding and 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, you know we’ve designed this 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’s a real benefit.

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

Yeah, that was one of the things that attracted us to Hague as we have looked at water softener manufacturers, we’ve been OEM in over there and we look necessarily successful, and we looked for manufacturers of all the way. And quite frankly we feel agents for that. 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 you know it’s been a nice sales; I think the sales probably in six months have been a million bucks sales over in China, and it’s of the Hague water heaters and in U.S. water softeners. So no, we are optimistic that they can really provide us the benefit in China.

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

Yeah. So it’s not something we are saying; we anticipate doing, it’s happening now.

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