Patricia K. Ackerman - A. O. Smith Corp. Ajita G. Rajendra - A. O. Smith Corp. John J. Kita - A. O. Smith Corp. Kevin J. Wheeler - A. O. Smith Corp..

R. Scott Graham - BMO Capital Markets (United States) Matt J. Summerville - D.A. Davidson & Co. Jeffrey D. Hammond - KeyBanc Capital Markets, Inc. Charles Brady - SunTrust Robinson Humphrey, Inc. Mike P. Halloran - Robert W. Baird & Co., Inc. Ryan Michael Connors - Boenning & Scattergood, Inc. David S.

MacGregor - Longbow Research LLC Alvaro Lacayo - Gabelli & Company Larry T. De Maria - William Blair & Co. LLC Andrew Cohen - Northcoast Research Partners LLC.

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Second Quarter 2018 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, today's conference is being recorded.

I would now like to turn the call over to Patricia Ackerman, Vice President-Investor Relations and Treasurer. Ma'am, you may begin..

Thank you, Mark. Good morning, ladies and gentlemen, and thank you for joining us on our 2018 second quarter results conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; Kevin Wheeler, President and Chief Operating 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 statement. 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 our prepared remarks on slide 3..

Thank you, Pat, and good morning, ladies and gentlemen. Our 13% sales growth in the second quarter was primarily driven by higher sales of water heaters and boilers in North America, and higher sales in China, including currency gains. Here are a few highlights. We achieved record sales of $833 million.

Net earnings of $0.66 per share were 25% higher than our earnings per share in 2017. We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. We repurchased 1.1 million shares for approximately $70 million through the first half of the year.

As a result of continued strong cash flow, our board approved an incremental 2.5 million shares to repurchase at its meeting earlier this month. We plan to continue buying back our shares at the previously stated $135 million annual pace using a 10b5-1 plan, and in addition, opportunistically buy back shares in the open market.

We announced the 29% increase to our dividend in January. The five-year compound annual growth rate of our dividend is over 25%. We repatriated nearly $240 million in the first half of 2018 using the proceeds to pay down floating-rate debt and improving the flexibility of our balance sheet.

John will now describe our results in more detail beginning with slide number 4..

Sales for the second quarter of $833 million were 13% higher than the same quarter in 2017. Net earnings in the second quarter of $115 million increased 24% from the second quarter in 2017. Second quarter earnings per share of $0.66 increased 25% compared with the same quarter in 2017.

Sales in our North America segment of $534 million increased nearly 14% compared with the second quarter of 2017, primarily due to higher volumes of water heaters and boilers in North America and pricing actions related to steel cost increases.

North America water treatment sales comprised of Aquasana and Hague, incrementally adding approximately $7 million to our North America segment sales. Rest of World segment sales of $308 million increased 13% compared with the same quarter in 2017. China sales growth was 12%, including a benefit from currency translation of approximately $19 million.

China sales grew 4% in local currency.

Pricing actions in mid-2017, primarily due to higher steel and installation costs, as well as higher sales of gas tankless water heaters and water treatment products, contributed to higher sales and were partially offset by the decline in air purification products and e-commerce sales compared with the prior year.

On slide 6, North America segment earnings of $125 million were nearly 15% higher than segment earnings in the same quarter in 2017. The favorable impact from higher sales of water heaters, boilers and pricing actions in the U.S. were partially offset by higher steel and other input costs.

North America segment margin was slightly higher than last year. Rest of World earnings of $35 million improved 7% compared with the second quarter of 2017. Higher China sales, including the price increase, were offset by higher engineering and advertising costs.

In addition, higher depreciation and utility costs and inefficiencies, all associated with the new water treatment plant negatively impacted earnings. Translation gains compared with last year added approximately $2 million to earnings. Second quarter segment margin of 11.3% was lower than one year ago due to these factors.

Our corporate expenses were similar to last year. Our effective income tax rate in the second quarter of 2018 was 21.7%. The rate was lower than the 27.8% experienced during the second quarter last year, primarily due to lower federal income taxes related to tax reform.

The lower effective income tax rate benefited second quarter 2018 earnings by $0.05 per share. Cash provided by operations during the second quarter of 2018 was $173 million compared with $73 million provided during the same period in 2017.

Higher earnings and a smaller investment in working capital were the primary drivers of higher cash flow compared with last year. Our liquidity position and balance sheet remains strong. Our debt to capital ratio was 12.5% at the end of the second quarter.

We have cash balances totaling $658 million located offshore and our net cash position was approximately $410 million at the end of June. During the first half of the year, we repurchased approximately 1.1 million shares of common stock for a total of $70 million.

Our board approved the repurchase of an additional 2.5 million shares at its meeting in July. The new authority is in addition to the authority to repurchase approximately 1.3 million shares, which remained at the end of June. This morning, we upgraded our 2018 EPS guidance with a range between $2.59 and $2.63 per share.

The midpoint of our adjusted EPS guidance represents a 20% increase in EPS compared with our adjusted 2017 results. Our EPS guidance excludes $0.03 per share of plant closing costs. Excluding the U.S. tax reform benefit, our operational performance is expected to improve by 12%. Please turn to slide 9 for several 2018 assumptions.

We expect our cash flow from operations in 2018 to be approximately $475 million, which is significantly higher than the $326 million generated in 2017. We expect higher earnings and lower outlays for working capital this year. Our 2018 capital spending plans are approximately $100 million.

Our depreciation and amortization expense is expected to be approximately $80 million in 2018. Our corporate and other expenses are expected to be approximately $48 million in 2018, slightly higher than the $47 million in 2017, partially due to higher projected spending at our Corporate Technology Center.

Our effective income tax rate is expected to be between 21.5% and 22% in 2018, lower than the previous year due to U.S. tax reform. We expect to repurchase our shares in the amount of approximately $135 million in 2018, under a 10b5-1 plan, similar to 2017. We may supplement our 10b5-1 plan with opportunistic share repurchase in 2018.

We expect our average diluted outstanding shares in 2018 will be approximately 173 million. Kevin will summarize our guidance, the business assumptions for the remainder of 2018 and our growth strategy beginning on slide 10.

Kevin?.

Thank you, John. Our outlook for 2018 includes several tailwinds and headwinds. First, our tailwinds. We project U.S. residential water heater industry volumes will increase approximately 350,000 to 400,000 units in 2018 due to continued new construction and expansion of replacement demand. This assumption includes tankless units.

Boiler revenues grew 10% in the first half of 2018, driven by solid demand for our commercial boilers and recently introduced products. We expect our boiler sales to grow approximately 10% in 2018.

As a result of significant higher steel prices and inflation in freight and other costs, we announced a price increase effective in early June, which will average approximately 10% on the majority of our U.S. water heater products.

Given significant depreciation of the China currency in the last month, we now project the full-year translation benefit of approximate $33 million compared with sales in 2017, which is $22 million smaller than our April forecast.

Our projection assumes the China currency will appreciate slightly from current levels during the second half of 2018, resulting in a small translation detriment of approximately $7 million to sales in the second half compared with rates in 2017. We expect the losses in India to decline from $7.5 million loss in 2017 to a $5 million loss in 2018.

The headwinds are higher steel prices and lower China sales growth. In the second half of 2018, we expect local currency sales in China to grow at a slightly higher rate than the first half or approximately 6%.

Sales are expected to be negatively impacted in the second half of the year by high channel inventory levels, which we believe to be the result of recently significant declines in the growth rate housing sales in China. For the full year, we project more than 8% growth and 5% in local currency terms.

We are confident the underlying fundamentals of our China business, including a well-known premium consumer brand and reputation for innovation, reliable products. In housing, sales recover before the end of the year, we project China's sales contribution of double-digit sales growth for the next year and beyond to remain intact.

New product introductions, fast-growing water treatment products, improvement in housing formation and growing replacement demand are expected to drive future growth. Lastly, we launch our A. O. Smith branded water treatment products at Lowe's next month.

The combination of our recent acquisitions of Aquasana and Hague, coupled with our globally accepted and innovative water treatment technologies and internally developed product selector tools and branded displays provide a compelling product proposition to customers interested in the quality and safety of their homes' water.

We expect $15 million of sales and a $1 million to $2 million loss this year due to startup and transition costs. Please advance to slide 11. Primarily as a result of strength in North America, we are optimistic about our growth in bottom-line performance for 2018. We project revenue growth will be between 9.5% and 10% for the year.

We raised our guidance for the full year to $2.59 to $2.63. As a reminder, our third quarter will be burdened by lighter water heater volume, driven by seasonality and a water heater price increase related to pre-buy, which benefited the second quarter, start-up costs for the new Lowe's water treatment business, and higher steel costs.

Despite subdued third quarter performance, we expect 2018 second half earnings will be stronger than the first half of the year.

We expect North America adjusted segment margin for the year to be between 22.25% and 22.5%, with the third quarter negatively impacted by the startup and transition costs of the new Lowe's water treatment business and lower water heater volumes.

We project weaker performance in the Rest of World segment in the third quarter, but recovery in the fourth quarter as normal seasonality is expected to favorably impact China and India volumes later this year. For the full year, we expect Rest of World margins to be flat to slightly down from last year. Please advance to slide 12.

Earlier this year, we updated the components of our growth model to be consistent with the new disclosure rules for disaggregation of segment revenues, as well as to incorporate recently acquired and organically fast-growing businesses.

We're comfortable with our 8% local currency growth model for 2019 and beyond predicated on housing recovery in China. That concludes our prepared remarks and we're now available for your questions..

Before we go on, I want to just kind of summarize and put it all together. This is Ajita. 2018 is turning out to be a very solid year for us, where it's almost 10% top-line growth, 20% EPS growth over last year. And we are achieving this without all of our units performing at top performance – at top levels.

And this shows the strength of the portfolio of businesses that we have. And as Kevin said, we're very comfortable with the longer-term 8% organic growth guidance that we've been giving you.

Pat, anything else you want to add?.

I'll wrap up at the end..

Okay. I guess we're done and open for questions..

Our first question comes from the line of Scott Graham from BMO Capital Markets. Sir, your line is open..

Good morning..

Hey, Scott..

And, Ajita, I know that you are not leaving us. But as this is, I'm assuming, your last conference call leading the call, I just want to say congratulations and good luck again, even though I know that you'll still be around..

Thank you. Yeah, I'll still be around quite a while (15:56)..

Sure. So, I guess, my question, of course, will be on China. And I guess the way I'm looking at this is that you have a CEO transition taking place. You've got an analyst meeting coming up in November. So, I'm assuming, internally, you've kind of flushed out what you're thinking on China, at least in large part, I'm guessing.

And so, I guess my questions are these. First of all, the slowdown in housing in China has kind of been with us for a while. The completions have been weak for a while. I guess I'm kind of wondering why all of a sudden is there an inventory channel build as opposed to not having occurred earlier.

And then, secondly, I guess my thinking here is that, obviously, water treatment is now kind of taking the lead there.

Would you expect the water heater market to revert back to that 7% growth next year and why?.

So, Scott, I'll start and they can fill in. I mean, it is kind of a first half/second half, there are different items that have come up. We had talked about the first half being up about 4%, and that's about where it came up. And it was due to two reasons.

The growth wasn't as much as we expected, but it was the 4% that we had talked about, and that was two reasons. One, air purifier's down about $18 million from last year's first half. And then the second piece is our online sales are down about 13% when you take out the air purifier portion of that.

Now, we had talked on the January conference call that there was a pre-buy and we had actually even said that some of that was for online. So, the decline in online was impacted by that as well as, quite frankly, we didn't come out with a water treatment product for online as quickly as we thought we were going to. So that impacted the first half.

Now, your question is what's changed with respect to the second half, and I would tell you it's a series of things. One is when we were talking in the first quarter, appliance sales were strong, consumer spending was strong, but you're right, it had started flattening.

Housing had started flattening, which was the first time it hadn't grown for a long period of time.

The inventory levels from the year-end to the first quarter grew exactly the same amount in units as the prior year December to the first quarter, okay? So when we look out at the second half, we were saying we think we can get back to more normal growth. Now, let's roll through the second quarter. What happened is inventories actually grew.

They grew about 15%. Historically, first quarter to second quarter, they would've been flat or down. Number two, we re-looked at what we're seeing in air purifier. We talked on the first call $40 million. We are coming out with new products, but we think more realistic is last half down a little bit from last year's last half.

So that's a $15 million decline from what we said about first quarter. And then as we talk to our distributors, I mean, there is concern, right? Consumer confidence, the economy is slowing down there. Housing hasn't turned. It's been flat now for two or three quarters. The currency has dropped dramatically in the last month. It's dropped 6%.

So it really had us step back and kind of take a look and say, we need to kind of get through the inventory, we need to get through this half of the year. And that was really the driver on saying our second half sales are going to be up from the first half, but not what we expected.

So, that's a long litany, but I mean that's how we looked at it internally recently. And again, our people have talked to distributors in July, and we just thought it prudent to take it down..

Well, that was very clear, John, as far as what's going on in this year. I very much appreciate that. I guess I'm hoping the part two of the question is, you guys have expressed – Ajita, your wrap-up comments as well expressed a lot of confidence in your business model in China, and it's understandable.

I guess the question would be, you're comfortable with the 8% organic long term, but is 2019 the year where that business is just so big now in China that maybe the target shouldn't be 15%, maybe it should be 12%? Is 2019 the year where maybe we have to pull that down a little bit and then maybe water treatment in the U.S., for example, fills the gap between that and the 8%?.

Yeah. Let me make some comments on what you said. First of all, the longer-term fundamental, I feel very comfortable with, as I said. What's going to happen in 2019? I don't know, because right now what's driving this slowdown in China is the economy in China and the slowdown in housing. Now, we know that that's going to improve at some point.

And in fact, you would have seen over the last few days, the Chinese government has started taking steps to increase liquidity and put more money into the economy. Okay? So when that comes back, we expect the economy to come back.

The fundamentals in China in terms of the massive movement of people into the middle class, the strength of our very strong consumer brand and our distribution, all those fundamentals are very solid.

And I think that as you look at this and you look at – put this, overlay this on our results so far this year and the guidance for the full year, which is almost 10% growth and the 20% EPS – 10% top-line growth and 20% EPS growth, it just shows the strength of the portfolio that we have, that even without all the businesses at top performance, we are still able to get this kind of performance.

So, we feel very comfortable going forward. The specific question you had in terms of what's 2019 going to be like, it really depends on how quickly the Chinese economy comes back..

The only other comment I'd give you, Scott, is you know our growth model now talks about 14% growth for those high growing, and you're right, we do expect India to grow above that. We do expect North America water treatment to do that – do above that.

We don't need China to grow at 14%, but we're not giving up by any means because of the issues that – I mean the macro factors that are there. But that's why we're comfortable in total with that 14% for 2019 for the high-growth piece (23:08)..

With the understanding that you might have to lean on that diversification that I alluded to and that you're alluding to now that China might actually be going forward not to 15% organic growth, but maybe something a couple of points less than that..

Yeah. Again, I'd say we're certainly not giving up on that. But in 2019, that's certainly the possibility, without a doubt..

Yeah. It depends on when it comes back, but we've always said, every portion of that equation is not going to be hitting every time. But in total, we are very comfortable. And again, I go back to 2018 as a great example that we're hitting our longer-term guidance, top and bottom line, without every unit performing at peak performance..

Right. And I appreciate that. If I can just sneak in a follow-up here on the Rest of World margin, because I know you guys have been frustrated at its level for some time. In fact, 2018's Rest of World margin, call it, 13-and-change, there was a lot of trials and tribulations within that number.

So, would that suggest that the setup here for after this year that you can actually start to push that margin up having, again, with the 2018 issues kind of doing a bit of a reset on purification, maybe even on water heaters, does that portend well for improvement in margin in the Rest of World after this year?.

I mean, I'll let Kevin answer the going forward. But I think this year, margins are certainly being impacted, and we've actually dropped them from our last call, because air purification, we had told you, was going to lose $5 million. It's now going to lose, we think, closer to $8 million. So, we certainly have an area there that we have to address.

Number two, what also is having a factor on margins this year, which we've also talked about, is we brought a new water treatment plant on board, and we had inefficiencies. As we talked about in the script, we had higher depreciation and utilities, which we knew and that was all built into the $5 million.

But you're right, going forward, we certainly expect efficiencies in that plant are going to help offset that. So, I'll let Kevin talk to going forward..

Well, going forward, we certainly will get efficiencies from our new water treatment plant. Some of the, I guess, headwinds behind us will be behind us. We'll improve our e-commerce sales. We'll have new products coming to market in number of categories, water treatment, tankless and in water heaters.

So going forward, we do see being able to leverage our operations and also increase those margins. Again, they'll be incrementally 0.25 points, 0.5 points moving forward, but we do believe, and we continue to put programs in place where we believe we can move the Rest of World margins forward. Again, John talked about India.

There's a number of other areas that are going to help us as we go forward to increase those incrementally over time..

Got it. Thank you..

Thank you. And our next question comes from the line of Matt Summerville from D.A. Davidson. Sir, your line is open..

Thank you. Couple of questions. Just again, sticking with the China business.

Can you give more specificity, you mentioned where you felt air purification would come in, where you feel the water heater business is going to come in, in 2018 versus 2017, as well as water treatment?.

Well, I'll start with water treatment. So, water treatment was up in local currency terms about 15% in the first half. But again, it's a tale of two cities. The offline was up significantly, over 25%. The online was down almost 25%. And again, the online being two factors.

One, there was an inventory build; and two, we didn't have the product that we wanted to bring to market. So, I would tell you, in general, we're very pleased with the first half of water treatment. When we look at the full year, we expect the second half growth to be more than the first half.

So, we're calling for air – water treatment to be in kind of the 18% to 19% type in local currency terms, and even more than that U.S. dollar terms. So, we're pleased. Again, we get that new product out. It's going to eliminate a lot of the connections. So, we're optimistic on that product. But again, it's complex and we had a big move go on.

So we're later than we expected. So, water treatment's doing very well. Water heater offline had a good first quarter, a good first half. But quite frankly, we're not expecting that in the second half as we work down the inventory. So, we'll say the second half is going to be somewhat flattish to up a little bit in RMB terms.

But we think it's important to reduce those inventory levels..

And then as my follow-up, with respect to the price increase you've put in place in early June, would you say the majority of that 10% or the full 10% is sticking at this point? And then, can you also just maybe put that in the context of you mentioned, I think it was maybe, Kevin, in his prepared remarks, that you felt that the pre-buy you saw in Q2 would impact volumes in Q3.

But I thought on your first quarter call, you'd felt that maybe that wasn't the factor. So, I guess, I'm trying to understand the change in stance on that issue. Thank you..

Let me take the – as far as the price increase that we announced in early June and the up to 12% with a 10% average across the board, that's been executed and implemented. With regards to the pre-buy, what we said is there would be a minimal to, we believe, no pre-buy just because of the timing of it, early June.

If you look at our AHRI data, we had a very strong April, had a very strong May. And I will tell you, we had a strong June. When you put them all together, we believe the industry is up about 300,000 units. And that would indicate there was some type of pre-buy.

The math that we've done, we figure somewhere in the neighborhood of 100,000 to 150,000 units were pulled forward. And I would tell you, that's about a week, maybe even a little bit less. So, it was minimal, but there was a pre-buy, and we felt that it was important for us to explain that to you on the call..

And we don't know for sure. But I think, as Kevin said, June being up was a surprise to us. And we talked to our customers, and I'd say inventory levels are a little bit heavy, not bad, but a little bit heavy. So, I think we just assume, for the most part, that the June excess was pre-buy. That's our caution (30:34)..

Thank you..

Thank you. And our next question comes from the line of Jeff Hammond from KeyBanc Capital Markets. Your line is open..

Hey. Good morning, guys..

Good morning, Jeff..

Good morning..

Good morning..

So just on North America, is there a way – if you look at the 12% growth, is there a way to break out units versus price, and then maybe just speak to what – I jumped on late. I don't know if you mentioned what boiler growth was in the quarter..

Well, I'll start. North America, we don't traditionally break out price and volume. But I will tell you, residential volumes were up significantly in the quarter. Commercial volumes were up in the quarter, not as much. Boiler sales were up 10%.

I will tell you, Lochinvar, as a whole, was up even more than that, because they were strong in their water heater and their custom commercial water heater. And then you throw in what we talked about North America water treatment of $7 million or so. It's all of those factors come into why volume was very strong in North America..

Okay. And then just it looks like the margins year-to-date are 23%. North America, you're guiding to a lower second half.

Can you just speak to why the margins stepped down just given that price seems to be running through?.

Yeah. And it's really the third quarter. I mean, we would expect fourth quarter margins to be fairly consistent with last year. It's really the third quarter and it's a few factors. One is, we talked about the loss we're going to experience on Lowe's as we buy back the inventory and the transition costs. Much of that hits in the third quarter.

Seasonally, third quarter residential volumes are lower than normal, than the other three, I'll say. And then we think that gets extended because of a little bit of pre-buy. So, I think those are probably the two biggest factors on why the third quarter margins, we would expect, would be down. But, again, fourth quarter back to normal..

Okay. And then D&A, it looks like you're running – you're saying $80 million and you're running, I think, $35 million through year-to-date.

What's the dynamic there that that steps up?.

I would have to look. I think we've obviously had some capital, but I would say that number might be a little bit high..

Okay. Thanks, guys..

Thank you. And our next question comes from Charlie Brady of SunTrust Robinson Humphrey..

Hi. Thanks. Good morning, guys. Good morning, Pat..

Good morning..

Good morning..

Good morning..

Hey.

Can you guys quantify the Lowe's impact that's going to hit in Q3, either dollars or margin wise?.

Yeah. Right now, we anticipate Lowe's to be on the sales side about plus $15 million. And then there'll be a loss of about $1 million to $2 million just due to the various transition costs, the displays and so forth that we'll need to do to convert the 1,700-plus stores..

In the third quarter, it costs us almost 1 point compared to – if you didn't have North America water treatment and just the other businesses, it costs us almost 1 point..

Okay. Got it. Got it. Makes sense. And then just in terms of the – talked about China advertising cost and I guess looking at the Rest of World margins, I mean, and you talked about getting that up.

I mean, can you just – is there something driving a short-term spike in some of that? Is it a function of you trying to get air purification sales up and doing more advertising in that area? Or what's really pushing some of that?.

Well, we have done some of that. We had run some promotions. If you're talking the second quarter, the second quarter is traditionally higher because we have some of the trade shows, et cetera. And so, we have Aquatech, et cetera, et cetera. So, those costs normally are more in the second quarter.

We would expect those to come down as we go into the third and fourth quarter..

Okay. Great.

And then just one more on the planned efficiency ramp, is that a one quarter kind of ramp or you think we're just going through 2018 and we get the full efficiencies starting in 2019?.

The inefficiencies will be second quarter, and then part of third. And we look to make up the balance of our deficit by the end of the year. So, it will be contained within the 2018 timeframe..

Great. Thank you..

Thank you. And our next question comes from Michael Halloran of Baird. Your line is now open..

Hey. Morning, everyone..

Good morning..

So, first, just following up on the Lowe's water treatment side. Obviously, you have probably a little bit of revenue on-boarding above trend and then, obviously, the profitability level pressures.

Could you help, on an annualized basis, once you get past the startup costs, talk a little bit about what that annual run rate for revenue looks like and then also how you're thinking about profitability on that business?.

Well, I think we talked a little bit about that on the last call, and we had said that next year – so Lowe's is adding about $15 million this year and we said it could be adding about $20 million incremental next year, so up to $37 million.

This year, North America water treatment, because of the one ramping up and then these transition costs are going to be in the high-single digit.

But, as we go into next year, I think our focus is – I think we even talked on the call, to get those to about 13% for the entire business, and then be able to continue to grow that as the Lowe's business continues to grow. So, as we go down the road, I think we're still focusing on trying to get to that 20%.

It's going to take us probably three years to get there, 2019, 2020, 2021, but we think those are achievable as volumes pick up and we get through this transition..

That makes sense relative to previous comments as well. So then the follow-up there from an earlier question.

Did I hear right that you said 300,000 units on-boarded for the front half of this year for residential water heaters? Is that accurate?.

Yeah. I would say we're up a little bit over 300,000, probably in tankless, you're close to 325,000 or so..

And then, full year expectations are in that, what was it, 350,000 to 400,000, kind of implying a slowdown in the back half of the year..

Well, so what you have is you have to move, right? If you say you're up a little over 300,000 and you expect that about 100,000 of it was maybe a pre-buy that would have had the first half be up closer to 200,000, right? So, I would tell you, the pre-buy is probably the biggest factor in that year-over-year..

All right. That's what I was looking for. And then, what you're essentially saying then is you normalize for pre-buy relatively smooth consistent underlying demand pattern..

Yeah. And I'll tell you, and Kevin can talk better than I can, but I talked to the salespeople couple days ago, and the industry is strong, there's no doubt about it, as they talk to their customers, et cetera, both commercial and residential..

I would say that it's across the board in our distribution contractors, both businesses, Lochinvar and our U.S. water heater business. There's just a solid trend and good growth rates across the board..

And we haven't talked enough about Lochinvar, probably. We talked about them being up 8% for the year. First half of the year, they're up over 10% and we expect them, for the year, to be up over 10%.

So, that's one of the pluses when we looked at the full year is we're taking Lochinvar up because not only has their first half been strong, their orders are strong, their backlog is strong. And as you look at some of the data, quotes are up. So, we're optimistic on it..

Great. Appreciate the time. Thank you..

Thank you. And our next question comes from the line of Ryan Connors of Boenning & Scattergood. Your line is now open..

Great. Thank you. Thanks for taking my question. Wanted to first talk about the China situation from a bit of a different angle. There has been a lot of talk in some of the popular financial press about branding impacts for American companies more – that talk's been more on the auto side and things like that.

But obviously, your brand is an American brand. It's English characters on the brand and all that, so it's clearly American. And you've got all the saber rattling and there's talk about that having a negative impact on American brands in China.

So, what's your take on that? Obviously, it's a tough issue to handicap it with any kind of granularity, but what's your take on that and what are you doing – you talked about advertising and so forth, what are you doing to kind of ensure that there is no negative impact on the brand with all this talk?.

Let me take a stab at that, and I was in China last week. So, this is pretty up to date. There's a lot of chatter in social media and stuff like that.

But we haven't seen any impact that we can directly point to it impacting our brand, and we don't really expect it, because compared to much more visible brands like Coca-Cola, or KFC, or Apple, we kind of fly under the radar. So, we don't really expect to have much. In terms of advertising, it's the normal game plan.

We're not doing anything too different. We are not pulling back. It's the normal game plan..

Yeah. And we probably stopped what, I think we pulled that two years ago focusing that it's an American company..

Right, in terms of our advertising..

Because we had so many different SBUs that we're working with that we had pulled back on that from an advertising two years ago..

Our advertising is much more focused on products, innovation, bringing benefits to the consumers and the markets, rather than what it has in the past..

Right. We started off way back as being U.S. water heater company was the focus of our advertising and our brand. But now our brand has evolved into water technology innovation brand. And so, our old advertising message has evolved with that..

Got it. Okay. And then, I guess, my second one just had to do with Lowe's. And my question is, is there a aftermarket service element to the arrangement with Lowe's? I assume Lowe's play some role in installation.

But then in terms of aftermarket servicing on the systems, is that something that's going to be taken care of for the customer through Lowe's or is that something that A. O.

Smith is involved directly and how does that work?.

Well, certainly there's an aftermarket with filters. And so, Lowe's will carry a full line of our filters as far as from a replacement standpoint. So yes, there is some installation which Lowe's will provide on some whole-house activity that we have in products.

But overall, the products will have a replacement market for many years as the filters – the various filters we have are used in and replaced..

Got it. Okay. But in terms of service, you're not involved directly in any kind of service work, not the resell, the filters or the replacement filters, but an actual system troubleshooting if there's a problem or something like that? It's not something that....

No, we're not involved in that at all..

Got it. Okay. Thanks for your time..

I'll just add to that, we'll have toll-free numbers and call centers and so forth to walk people through. So yes, we'll be involved in, if they need some questions, certainly, we'll have some items on the Internet to walk them through the process. But overall, to service them on an ongoing basis now..

Got it. Thanks again..

Thank you. And our next question comes from the line of David MacGregor of Longbow Research. Your line is now open..

Yes. Thanks. Good morning, everyone..

Good morning..

Just a question on China again. If you think about the situation there, you've got a slowing macro, you've got high channel inventories. In the Western world, this would be ripe for some very aggressive promotional sort of channel clearing. Maybe in China, business practices are a little bit different.

But given that you're up against Midea and Haier, which are both pretty aggressive players, it would seem to me that the promotional environment must be picking up here pretty aggressively. And I was just wondering if I can get you to comment, and maybe Ajita, you mentioned you just got back.

What are you seeing there in terms of inflection in promotional activity and how is that likely to impact the margin play here in the second half?.

Well, there has certainly been quite a bit of promotional activity by various competitors. We talked about that during the air purification. Our approach is we certainly have many programs to move our inventory and we'll do some promotions, some bundling. We'll do it in a systematic way.

We'll also do it looking at where our inventories are at, what categories do we have higher inventories, and we'll continue to move that forward. But our approach will be not – it will be, again, a thoughtful, a systematic approach to reducing inventories over time.

And we're going to be looking to reduce our inventory somewhere in the neighborhood about 30 days by the end of the year..

And it's the balance between how do we get the inventories down by – but still maintaining the type of price points that our brand calls for. So, it's that balance and our team is very good at doing that and has done it in the past, and we are very comfortable with the programs that we have.

And we tend to, as Kevin said, bundle with other products and promote in that manner. So in that sense, it is somewhat different in China than the U.S. market..

Do you sense that your channel inventory situation is unique to you and your competitors are not seeing a similar situation, or do you feel like maybe all the major players are dealing with this inventory surplus?.

We don't know. We don't really have any data that can say what the other competitors are like in terms of inventories. But the slowdown has to be hitting everybody..

I'm just wondering....

We don't see the numbers. From a share standpoint haven't moved much. So as Ajita said, we don't know, but you have to assume everybody's kind of in the same..

Sure, that would make sense. I guess that you've always demonstrated tremendous price discipline and you talked about your commitment to continuing to do that. I'm just wondering how you manage – maintain that first discipline dealing with this inventory and also maybe competitors that aren't quite as disciplined and historically haven't been.

How do you manage those potentially mutually exclusive goals?.

It's a tough balance, but it's a day-to-day management of it. And in fact, there is channel conflict and pricing conflict and things like that in the market. And we try to stay very disciplined.

And in fact, some of our customers, especially e-commerce customers, have come back to us and complimented us on managing that whole process as best we can, given the rules and the laws and what we can do and what's under our control..

Right. Well, you've got a history of doing well there, so good luck with that. Second question, if I could, is just on your raw material inflation.

What's your expected second half steel cost inflation versus the first half?.

Up significantly. It really started, as we said, there's a three, three-plus month delay depending on the situation. So, we've said that on the last call that first quarter – the second quarter was up, but the last half of the year was up significantly. And that's why we had this price increase, matches up with that pretty well..

Yeah.

Is there any chance of getting a little more granularity than up significantly?.

No. But I mean I can tell you these facts. I can tell you how much steel is up. Steel is up from the end of the year, it's up 20-some-percent. It's up 20% from the first of the year. Hot rolled is up 41%. When we talked in April, hot rolled is up even more from that, while cold rolled has steadied, which is good.

And again, a lot of that impact is coming in the second half of the year..

But those are spot price dynamics, I'm guessing through your contracts....

No, we end up getting price off of spot, to a degree. So, I mean, plus or minus. So....

Yeah. Because even though we have contracts, they're based off of pricing indices, the steel indices..

So, I guess, you can assume that the majority of that increase is in the second half..

And presumably, those contracts, there's some leakage of inflation coming through.

So, you're not getting perfectly fixed costs there? As the spot price is increasing, you're getting some – leakage of that inflation is coming through your contracts?.

I'm not sure what you mean, but I guess we're not going to get into details of the contract with our suppliers..

Okay. Well, thanks for the detail that you provided. Thank you..

Thank you. And our next question comes from Alvaro Lacayo of Gabelli. Your line is now open..

Good morning, everyone..

Good morning..

Good morning..

So I just wanted to start with the Rest of World. Two questions, one, for that 5% organic China growth number or if you want to just talk about the first half, the 4% organic number, how much of that was volume driven? And maybe comment just on water heater and water treatment products, separately.

And then, can you quantify the inefficiencies from the water treatment plant? And with regards to the delay of the product launch, if the inefficiencies had anything to do with that? And if not, what was the cause of the delay of the product launch?.

I'll start with the last. The cause was it's a complex product and that we were in the process of moving a major plant from one to another. So, those were the two factors that entered into where we thought we would have that product, which is going to help us on the online in the first half.

And now, it's going to be probably later third quarter, I think. But when you look at volumes, volumes in the first half of the year, water treatment was up significantly. I don't have the percentage in front of me, 10-plus percent. So, there was some price in there.

And I think water heater volumes were up a little bit, as the transition continues, where electric was down a little bit, but gas was up. And then we had some pricing in effect. So I don't know if that answers all your questions or not..

Yeah, it does. Thank you. And just the inefficiencies, is there a dollar amount with regards to how....

So, I mean, if you break out the efficiencies, so if I look at that $5 million we talked about hit this year, the efficiencies (sic) [inefficiencies] hit in the second quarter primarily. It's really three pieces. I'll tell you, the electricity, because of the size of the plant, is probably about $2 million of that increase.

The depreciation is about $ 1 million for the remainder of the year. So, you have that $3 million. And you had efficiencies (sic) [inefficiencies] running first half, first half and the first and third quarter, and what Kevin's saying, by the end of the year, we start offsetting those efficiencies..

Yeah..

So, that's how you end up in kind of the $5 million-ish..

Got it..

And I'll tell you, the plant – the feedback I received, the transition's going well. It's producing at the levels we thought or better. So, those numbers are well within line, what we told you..

But it was a major move..

Major move..

It's a major move..

Got you. Okay. And then in North America water treatment, if you can maybe update us on just the organic sort of industry growth that you're seeing.

And then just from a selling point expansion standpoint, what kind of opportunities you have, if you can quantify that in any way, that'll support that 14%-plus growth rates or even higher than that going forward..

Well, so I think we've talked about, and it depends if you're talking softening, you're talking about treating, et cetera, I think the numbers we've seen this year is kind of high-single digit kind of increases. I think what we confidently can do is leverage our distribution channel. So, we've talked about expanding it ultimately to plumbers.

We think we're the premier online seller of water treatment. Now as we get in Lowe's and we're able to leverage that role, I think as we look at those opportunities and bring new products, I think we're comfortable as we look out for that 14%-plus growth for North America water treatment for the next several years..

Yeah. And I would just add the dealer network that we have and continue to expand and grow that in the markets that we have some gaps in. So, overall, the wholesale business is still very early stages. Plumbers are very early stages. Dealers, we're continuing to expand; and Lowe's, we're just in the process of getting in the store.

So, you put that all together and you look forward, the water treatment business has a good runway heading into 2019 and beyond..

And also, when you look at the opportunity, I mean, the awareness of how good our water is in the country is getting more and more. And the whole water treatment category in North America, I think, has tremendous opportunity to grow very fast..

Great. Thank you very much and congratulations to Ajita and Kevin on the transitions..

Thanks..

Thank you..

Thank you. And our next question comes from Larry De Maria of William Blair. Your line is now open..

Okay. Thanks. Good morning, folks. Curious. I believe you guys said you want to reduce inventory by 30 days, I guess, by the end of the year, I think, is what you said. Just curious, what is the normal level of inventory? Obviously, it's at least a month different than that.

And would that be normalized? If you get it down 30 days, going into next year, if we have a similar rate of growth, call it, mid singles in local in China, would that be an adequate inventory reduction or would that require further inventory reduction next year?.

I would tell you that that is going to be a move in the right direction. If we're close to where we want to be, we'd probably like to drive it down just a little bit more over time. But, again, moving to 30 days would get us right into the level that we think is appropriate going forward..

Okay.

And you're moving it down to 30 days or you're moving it down by 30 days? I'm just trying to understand what's the normal level of inventory in the market?.

I'm sorry. Moving it down by 30 days..

Down by 30.

And what would that be then? That's like you end up with a quarter's worth of inventory? How big is the inventory normally?.

That would be a little bit less than a quarter..

Yeah, bit little less than a quarter..

(55:04) level..

Little less than a quarter. That's great. Thank you..

And that's kind of what we run. Days kind of in the 70, 80, 85 range..

Okay..

Given the complexity of the channels, that's about the level that's required to keep it efficiently moving..

(55:20)..

Okay. So, it can't go down much more than that.

And then, secondly, are you guys dramatically rethinking the China air purification strategy long term? And to also be clear, can we get that to breakeven next year if we have, obviously, continued volume headwinds there?.

My answer is no, we don't if we continue to have volume headwind. Kevin can talk about the new product we're bringing out and....

Yeah. At this time, we're certainly committed to the air purification market. Granted there has been some – the air and the things we've talked about in the past.

But you look at the products that we recently introduced that are going to address formaldehyde, and that's a year-around issue within most Chinese homes, that's still in the very early stages. As we have mentioned in past that we remain committed. Our engineering product development continues to move forward.

And it's early, but we still believe there is a place in air purification for A. O. Smith and the products that we can bring to market through our distribution..

I mean, it's like we talked about on the last call is what is – some of the stuff that the government's doing, is that sustainable from an air standpoint, and time will tell..

Right..

It's difficult to shut down plants and do some of the things they're doing and have that impact on business. So, we'll see if they continue to do that in the fourth quarter and first quarter of this coming year..

Right. And I think just to expand on that a little, when you look at the air quality in China, it's impacted by two things. One is what's outside in the environment, and that's what we kind of focus on and that's driven by pollution and coal-fired power plants and all of that stuff, cars and all that.

Then there's also the air quality that's impacted from the inside of the apartment or the home, which comes from furniture and the glues that are used in furniture, and things like that. And this is where the formaldehyde comes out.

And as we've talked before, if you recall, a few years back, we had the Lumber Liquidators issue, et cetera, which was the formaldehyde concerns in this country. And that was driven by the glues and the adhesive used in cheaper-quality furniture. Okay? So, that's another issue that's very prevalent in China.

We have the products that Kevin talked about that we just introduced. It's the only credible product in the market today that addresses that formaldehyde issue. Now, certainly, there'll be other products that follow. But we feel that with this and the initial – it's very early because we just introduced it.

But the initial reaction from the marketplace, especially our retailers, has been very positive. So, we feel there is going to be a market. We are going to be in the air purification market.

The size of the market we can't tell, which is why we are being conservative in pulling it down, because we don't know how sustainable the actions that the Chinese government has taken to clean up the outside air is going to be. But the inside part, the pollution caused by furniture, et cetera, that's going to be there for a while.

There's no indication there's anything happening to address that, and we have the products to address that..

To address your earnings question, I think everybody at this table and Chinese management realizes we can't lose $8 million on a $25 million business.

But I will tell you we spent a lot on engineering this year to bring the formaldehyde product, we'll bring a fresh-air product to market late in the year, but we all understand you can't lose $8 million on that size business. So, there will be an improvement. We just can't add $25 million sale be breakeven..

Yeah. We won't get to breakeven, but there will be....

But there'll be improvement..

...there'll be certainly improvement..

Okay. Thanks. That's really helpful. Thank you and good luck to you all..

Thanks..

Thank you. And our next question comes from the line of Andrew Cohen of Northcoast Research. Your line is now open..

Thanks. Very nice quarter. My question and I don't know how well you can quantify it, but you're talking about the Chinese housing market slowing or flattening. But one of the underlying things that's supposed to be supporting you is the growth in the upper middle class.

And I'm just wondering if that is also mitigated with the slowdown or if they're independent variables?.

I think they're independent. I think the growth in the middle class and the move in the middle class or the massive amount of people moving into the middle class is continuing. Those macro drivers in China, the indicators are very strong and continuing.

And in addition to that, the move made by the Chinese government to move their economy to be much more consumption-based and less dependent on exports, all that is happening. And all of those things and all of those drivers are very positive for our business long term.

We have the short-term impact of housing, and we expect that that's going to come back. It has to come back at some point. We just don't know when..

Thanks.

My other question, it's actually fairly simple, but this formaldehyde and the furniture issue that you brought up, does that exist in India as well?.

I don't know the answer to that question. There is certainly an air purification opportunity in India. We haven't fully investigated it yet. The issues in the Indian market are different. The homes are built differently. So, it's not a one-to-one match, but there certainly is an opportunity..

But the price point is....

The price point's high..

...is much different in India..

Right..

So, that's why we're not focusing on it at this point..

Right. Price points in, really, all appliances are different in India..

Okay. Got it. Thanks very much..

Thank you. And I'm showing no further questions at this time. I would now like to turn the call back to Patricia Ackerman for closing remarks..

Thank you for your participating in our call this morning. Please take note that we will participate in the D.A. Davidson Industrial Conference on September 20 in Chicago. And please also save the date for our 2018 Analyst Day to be held in Chicago on November 5.

The timing of our Analyst Day is intentionally set one day prior to and one block from the Baird Conference. To register to attend our 2018 Analyst Day, go to the Investor page of aosmith.com. Have a great day..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day..