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A. O. Smith Corporation (NYSE:AOS)

Q4 2012 Earnings Call

January 24, 2013 10:00 a.m. ET

Executives

Ajita G. Rajendra – President and CEO

John J. Kita – CFO

Paul W. Jones– Executive Chairman

Pat Ackerman – VP, IR and Treasurer

Analysts

Scott Graham – Jefferies

Sanjay Shrestha – Lazard Capital Markets

Todd Vencil – Sterne, Agee & Leach

Joe Radigan – KeyBanc Capital Markets

Robert Kelly – Sidoti & Company

David Rose – Wedbush Securities

Donald Bisson – Century Capital

Ted Wheeler – Buckingham Research Group. Inc.  

Operator

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Fourth Quarter 2012 Earnings Call. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, today's conference call is being recorded.

I would now like to turn the call over to your host, Pat Ackerman, Vice President, Investor Relations and Treasurer. Please begin.

Pat Ackerman

Thank you. Good morning ladies and gentlemen and thank you for joining us on our fourth quarter and full year 2012 conference call. With me participating in the call are Paul Jones, Executive Chairman; Ajita Rajendra, Chief Executive Officer; and John Kita, Chief Financial Officer.

Paul will begin our presentation this morning with our 2012 highlights. John will then elaborate on our financial results and Ajita will wrap up with our outlook and acquisition strategy update.

Before we begin with Paul'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.

Paul, I will turn the call over to you.

Paul Jones

Okay. Thank you, Pat, and good morning ladies and gentlemen. In 2012, we achieved record sales in earnings as a result of our acquisition strategy and global footprint. Here are a few highlights. Our organic growth and acquisition drove sales 13% higher to $1.94 billion. Lochinvar, acquired in the third quarter of 2011, achieved $226 million in revenues. In China, our sales of A. O. Smith branded products grew 20%.

Our earnings improved to $3.03 per share which excludes $0.46 per share in items unrelated to ongoing operations, including a gain on sale of the Regal Beloit shares received with the divestiture of our motor business of $0.36 per share, a gain of $0.04 per share related to the revisions to our estimate of the Lochinvar earn-out and $0.06 per share associated with the settlement with the component supplier in Canada.

Lochinvar contributed at the high end of our profit expectations and we are extremely pleased with the team and the business. We met many of you in late September at our Analyst Day in Nashville where we presented our 2015 growth aspirations as well as showcased our manufacturing excellence. Our slide deck from the day is currently available on our website.

Last but not in any way least, Ajita Rajendra has assumed the CEO role at the beginning of January. Ajita and I have worked together at A.O Smith and a previous company and he’s an outstanding leader and manager. He and I worked on developing the strategy we laid out at our Analyst Day and Ajita and the team are committed to it. I plan to serve the company and its shareholders in the role of Executive Chairman at least through 2013.

John, I’ll now turn the call over to you to elaborate on our fourth quarter and full year results.

John Kita

Thank you, Paul. Sales for the full year of $1.9 billion were 13% higher than the previous year. Lochinvar, which we acquired in August 2011, incrementally added $150 million in sales and A.O Smith branded products in China grew 20% to almost $450 million.

Adjusted earnings at $3.03 per share were 44% higher than in 2011, when the $0.46 per share gain in 2012 which was described by Paul and the $0.28 per share net gain for several onetime items in 2011 are excluded from the comparison.

Sales in our North America segment, $1.4 billion, increased 11% compared with the prior year. This segment includes our U.S and Canadian water heater and boiler businesses. In addition to incremental sales of approximately $140 million from Lochinvar’s North American boiler business, we experienced higher volumes of U.S residential and commercial water heaters. These increases were partially offset by lower tanklets and Canadian water heater volumes.

The results of our China, India and European businesses are captured in our rest of world segment. Segment sales of $542.5 million increased 19% compared with 2011. The increase in sales was due to a 20% increase in sales of A.O Smith branded products in China, primarily driven by higher price product mix, continuing market share gains particularly in our gas tankless and water treatment products and pricing actions.

North America operating earnings of $193 million were $41 million higher than in 2011. The 2012 results exclude the $7.2 million combined benefits from the Canadian component supplier settlement and the revision to the Lochinvar earn-out and the 2011 results exclude the $3 million net gain from a similar component settlement and increase to the Canadian warranty reserve.

Lochinvar acquisition incrementally added $38 million top rating earnings in 2012. In addition, the segment benefited from higher U.S residential and commercial volumes. As a result, the segment’s operating margin, excluding non-operating items improved significantly to 13.5% in 2012.

Rest of world operating earnings of $60 million improved 40% compared with 2011, driven by higher China sales and smaller losses at our non A.O Smith branded water treatment business, which were partially offset by larger losses in India due to new product introduction costs and brand building expenses. As a result, operating margin improved to 11%. Our corporate and other expenses were $44 million compared with $46 million the previous year when the gain from the RBC share activity is excluded in both years. Corporate expenses in 2012 benefit from higher interest income which was partially offset by higher pension costs.

Total operating profit excluding onetime items, improved 41% to $209 million. The business performed extremely well in the fourth quarter. Sales of $524 million were 10% higher than the previous year. Sales of A.O Smith branded products in China grew 24% to $129 million during the quarter and demand for U.S residential water heaters increased partially driven by super Sandy storm.

Earnings of $0.91 per share were 34% higher than in 2011 when the $0.06 per share gain from the settlement with a Canadian component supplier and the $0.04 per share expense associated with the final revision to the Lochinvar earn-out adjustment are excluded from the comparisons.

Sales in our North American segment of $376 million increased 6% over the prior year. We experienced higher volume of residential water heaters in the U.S partially due to the replacement demand from superstorm Sandy which we estimate we have added $9 million to our fourth quarter sales. Increased demand for boilers, including high efficiency condensing boilers also drove segment sales higher.

Rest of world segment sales of $157 million increased 21% compared with 2011, primarily due to a 24% increase in sales of A.O Smith branded products in China. Higher China sales were driven by a favorable mix in new products with more robust features and benefits as well as a customer pre-buy in the quarter to achieve volume incentive rebates. Higher water heater sales in India also contributed to the increase in year-over-year sales.

North America operating earnings of $55 million were 18% higher than in 2011. The results exclude the $800,000 net benefit from the component supplier settlement which was partially offset by the final revision to the Lochinvar earn-out. In addition to the profit from higher sales of residential replacement units associated with the hurricane, Lochinvar added $15 million to operating earnings in the quarter compared with $10 million last year due to realization of cost synergies and higher volumes. As a result the segment’s operating margin, excluding non-operating items, improved significantly to 14.6% in 2012.

Rest of world operating earnings of $20 million improved 71% compared with the previous year, driven by higher China sales and smaller losses on our non A.O Smith branded product treatment business. As a result, operating margin improved to 13%.

Our corporate and other expenses were $13 million, significantly higher than 2011, primarily due to the absence of dividends from the now sold RBC shares and higher pension costs. Total operating profit, excluding the non-operating items, improved 25% to $63 million.

Cash provided by continuing operations was $171 million for the full year of 2012 compared with $61 million in 2011. 2011 cash flow was impacted by an after-tax contribution to our pension plan of approximately $125 million. An earn-out of $13.5 million paid to the former owners of Lochinvar in December 2012.

Our liquidity position and cash balance sheet remain strong. Our debt to capital ratio declined to 17% compared with 19% at the end of 2011. We have sizeable cash balances located offshore primarily related to the sale of electrical products and our net cash position was over $200 million at the end of 2012. We repurchased approximately 427,000 shares of our stock in 2012 at an average price of $51.60 for a total of $22 million. We have approximately 462,000 shares remaining on our existing repurchase program previously approved by our board.

We project our cash flow from operations for 2013 to be between $200 million and $220 million. Our capital expenditures are expected to be between $80 million to $90 million in 2013 which includes approximately $40 million for capacity expansion in China and India to meet growing demand for our water heaters. Our depreciation and amortization expense is expected to be between $55 million and $60 million in 2013. We estimate our effective tax rate to be approximately 30% in 2013.

Excluding the impact from non-operating pension costs about which I will elaborate on the next slide, our corporate and other expenses are expected to increase in 2013 to $48 million, primarily due to lower investment income on our offshore cash.

One final subject before I turn the call back to Ajita. In our press release this morning, we introduced new non-GAAP financial measures related to pension accounting. Significant declines in interest rates over the past several years have caused an extraordinary increase in certain components of pension expense that we considered to be unrelated to the underlying operating performance of our business. In addition, we have made changes to our pension plan, including closing the plants and new entrants effective January 1, 2010 and freezing the plant for the majority of existing participants effective January 1, 2015, which we believe will significantly decrease pension expense beginning in 2015.

In order to provide improved transparency into the operating results of our business, beginning in 2013 we will provide non-GAAP earnings measures, adjusted earnings and adjusted earnings per share that exclude non-operating pension costs consisting of interest costs, expected return on plan assets, amortization of actuarial gains, losses, and curtailments and other onetime charges. In addition, our segment reporting will also present non-GAAP operating earnings which exclude non-operating pension costs and be identified as adjusted segment operating earnings. 2013 guidance has been provided for GAAP EPS and adjusted EPS.

Consistent with other companies who have reported similar transparency for pension costs, we have designated service costs and prior service costs as the components which are most relevant to the operating cost of our business. Operating pension costs were $7 million in 2012 and we project them to increase in 2013 to $8.5 million. Total estimated pension costs of $27.6 million for 2013 are significantly higher than the $13.8 million recorded in 2012 as a result of continued declines in interest rates and a reduction in our expected rate of return on plan assets.

Adjusted Earnings and Adjusted EPS are reconciled GAAP measures on this slide. We have also prepared quarterly and annual reconciliations of Adjusted Earnings, Adjusted EPS and Adjusted Segment Operating Earnings and an annual schedule of components of pension expense for the years 2010 to 2012 which are provided in the Supplemental Financial Data document posted in the Investor Relation section on A. O. Smith's website.

I will now turn the call over to Ajita who will elaborate on our 2013 outlook and our acquisition strategy.

Ajita Rajendra

Thanks John. This morning, we announced non-GAAP 2013 adjusted earnings guidance of $3.25 to $3.45 per share, the definition of which John just described. We also provided GAAP earnings guidance of $3 to $3.20 per share. Our guidance does not include the impact from future acquisitions.

As shown on the previous slide, the midpoint of our 2013 adjusted earnings guidance represents approximately a 35% five year earnings CAGR and an approximately 9% increase compared with our 2012 adjusted EPS, modified for the non-operating items, including hurricane Sandy.

Our outlook for 2013 includes the following assumptions. First, we continue to remain positive on our growth in China. We expect our sales of A. O. Smith branded products for the full year will grow at a rate of 15% in 2013.

I would like to also elaborate on some recent activities associated with our distribution channel. We ended 2012 with 5,500 retail outlets in China, including specialty stores. This is lower than our original expectations as we closed almost 500 underperforming stores last year. Collectively, the stores which were closed contributed analyzed sales of approximately $5 million or approximately 1% of our China revenue. The stores we closed had similar SG&A costs as our productive stores so the closures will be beneficial to our profitability going forward. We plan to open 350 net new stores in 2013 and continue our efforts to aggressively cull underperforming stores.

We expect that continued expansion of our distribution channel, continued market share gains from our premium brand, including water treatment and continued increases in the average sales price per unit due to new products will drive growth in 2013.

Second, we expect to continue to benefit from the transition from lower efficiency, non-condensing boilers to high efficiency condensing boilers. Our Lochinvar brands market leading condensing boilers continue to offer a compelling payback in the form of energy savings and our boiler operations have built a reputation for innovation and product quality. The new line of CREST boilers launched last year exemplifies this reputation. This new line of condensing high efficiency boilers expands our boiler portfolio with larger Btu input models and have gained excellent market acceptance.

We also expect to have the first A. O. Smith branded boilers approved in China and ready for sale in 2013. As a result, we expect our boiler business to grow approximately 10%, well ahead of GDP growth in the U.S.

Third, we expect the U.S commercial water heater volumes to be similar to last year of about 147,00o units. The strength in 2012 commercial volumes, up 2% from the prior year, pleasantly surprised us. We are not expecting an additional increase in 2013 due to the lack of strong new commercial construction indicators at this time. We expect the new construction component of North American residential water heater volumes to be up slightly in 2012. The forecast we’ve seen indicate that the number of housing completions are expected to be about 150,000 higher in 2013 compared with 2012, resulting in a similar increase in residential water heater volumes.

Fourth, given the challenging macro environment in the Euro zone, I want to remind you that we have minimal exposure in that region. This is an exciting and transformative time for our company. We have cash and borrowing capacity for additional acquisitions and our pipeline of acquisitions supporting our stated growth strategy to expand our global footprint in water heating and water treatment solutions is active.

As we presented at our Analyst Day, we expect to grow organically over 7% per year which would result in $2.4 billion in sales in 2015. Adding our dry powder and making some assumptions about acquisitions, we expect to achieve revenues in excess of $3 billion, with one third from higher growth emerging regions of the world. Using these growth assumptions, we expect our existing businesses to deliver earnings of $4.30 per share in 2015 and $5 per share in 2015 when use of our cash and borrowing capacity are added to our organic growth.

Based on our core competencies, our strategic focus for growth is simple, hot water and clean water. We are pursuing actionable acquisitions to backfill these two areas around the world and particularly in developing and emerging geographies. We’re also pursuing acquisitions which expand our core product line. We are particularly keen on products and technologies that offer energy and water efficiency gains. And finally, we are considering water related adjacencies which can leverage our distribution and brand to provide value to our shareholders.

Our integration of Lochinvar is complete. We have the human capital, financial resources and strategic focus to continue to add companies to our global platform which creates shareholder value and our business development teams are pursuing opportunities all over the world to do just that.

You have seen this slide before and we show this only as a reminder that we will be a financially disciplined acquirer. Our transactions will be focused on creating returns for our shareholders.

We will now open the line for your questions. Mary, we are ready to take questions now..

Question-and-Answer

Operator

(Operator instructions). Our first question comes from Scott Graham from Jefferies. Your line is open.

Scott Graham – Jefferies

Good morning. Just really two questions for you Ajita and Paul. Was hoping you could rank order for us when you have the sales growth that you did outside of China. Could you rank order for us North American resi retail versus resi wholesale versus commercial? I’m assuming commercial was down. I was wondering if you could answer maybe how the other segments ranked for you?

John Kita

We normally don’t break between wholesale and retail, but the residential was definitely up as you said, partially due to – over half was due to the superstorm Sandy and commercial was down which we expected because of the pre-buy that happened last year. It was probably down not as much as we would originally forecast, but it was down.

Scott Graham – Jefferies

Okay. The other question is I guess the elephant in the room question on acquisitions because I know you guys were signaling at your Analyst meeting that you thought you had line of sight on a couple and then I understand as the second half progressed that you needed to maybe walk away from those same couple. I was just wondering if you can give me where we are in the M&A process because it’s been about a year and a half and I know you’ve got cash burning a hole in your pocket, particularly internationally. Have you – I’m not asking if you’ve relaxed your financial criteria, but have you maybe opened up some of the markets that you’re looking at to try to get something done? Or is this just a matter of sifting through the current pipeline and finding something that ultimately works?

Ajita Rajendra

Scott, our pipeline for acquisitions is very active and like you said, it’s been a year and a half. I wish we could have had acquisitions behind us. But we’ve laid out various clear financial and strategic guidelines in terms of what type of acquisitions we’re going to be after and we’re going to be pretty disciplined in our process and we want to make sure that any acquisition we make is strategically relevant and creates value for our shareholders. So and we want to make sure we don’t make the wrong acquisition. So it’s been active. We’ve looked at a number of them. We’ve turned down a number of them and we continue to look within the guidelines that we’ve provided. I wish we could have had one under our belts, but we’ll do the right one at the right time.

Scott Graham – Jefferies

Fair enough. I guess just maybe the question that stems from there is that if thing do not or you are unable to close maybe the goal that you have between now and 2015 on the capital deployment, I think it was like $800 million or something like that, at what point do we start to accelerate share repurchases with that capital deployment. Is midyear ’13 where we say you know what, we’re building enough cash, now we need to buy back some stock or maybe you can give us a little color on that.

Paul Jones

This is Paul. We look at that at every board meeting and we’re constantly looking at it and evaluating what we do with the capital and we’re not going to put deadlines or time limits on that.

Operator

Our next question comes from Sanjay Shrestha from Lazard Capital Markets. Your line is open.

Sanjay Shrestha – Lazard Capital Markets

Good morning guys. A couple of questions. First, just want to understand the guidance for 2013 and how much conservatism is there. When we plug in all the things you guys talk about in terms of Lochinvar margin expanding in China, things getting relatively better in the U.S residential market and therefore the contribution margin, it is a bit difficult to see (inaudible) at the low end of the range. So can you guys help us understand some of the process taken? By the way appreciate the conservatism on your part all the time. So what am I missing here?

John Kita

Well, I won’t say you’re missing anything. I think you’ve listed the major comments. We’re not necessarily comfortable that the housing recovery is in existence. We’ve certainly started to see parts of it in the last half of the year, but we’re kind of wait and see on that. We’re comfortable with our growth rate in China but you always have exposures in China from the standpoint if their economy were to slow. But we’re comfortable with our 15% growth rate. Lochinvar we’re comfortable with our 10%. We mentioned the fact that we have some headwind. One was the loss of interest income and that was just a function of U.S dollar deposits in China earning quite a bit less in 2013 than 2012 and as we’ve tried to be in the past, we are conservative in our estimates.

Sanjay Shrestha – Lazard Capital Markets

Fair enough. Two more questions then for you guys. So once you’re done with the $80 million to $90 million from CapEx, your housekeeping one, so as you go into ’14 and ’15, that CapEx number really falls down to 40 or 45, your maintenance CapEx number, right?

John Kita

Yeah. We would think $40 million to $50 million would be a reasonable assumption as we go forward which is about our deprecation rate.

Sanjay Shrestha – Lazard Capital Markets

Got it. And one question again on the acquisition front if I may. So I know you guys don’t want to get into too much detail, but two part question. One, if there is any comment you guys could share with us about this sort of (inaudible) for commenting about today’s maybe close to again closing that transaction there, some news media expressing that. And two, as we look at that pipeline for you guys right now in terms of what you could borrow, some mix of large, small versus international opportunity. Can you give us any of the granularity on (inaudible) three large one or two large one as you’re evaluating or how should we think about it? Thank you very much.

Ajita Rajendra

The acquisition in Turkey, that’s a growing region of the world. It’s a small acquisition, but we see that as a potential platform for bolt-on acquisitions on top of that and we don’t see it having a big impact going forward. Sanjay, I didn’t really hear the rest of your question.

Paul Jones

I think he was asking about can we give any color to the size of the – are we looking at two or three big ones or small ones or international and all we can really say Sanjay is it’s all over the map. We have some of everything you mentioned, but we’re not going to try to put any quantification on it. It just wouldn’t be, frankly we wouldn’t be adding too much to the conversation if we tried to do that.

Sanjay Shrestha – Lazard Capital Markets

I completely understand. Fair enough. Thanks guys and once again congratulations on a great execution.

Operator

Our next question comes from Todd Vencil from Sterne, Agee & Leach. Your line is open.

Todd Vencil – Sterne, Agee & Leach

Good morning guys. So I want to draw back in on the guidance just a little bit and recognizing, John, what you said about the headwind from loss of the interest income. It does look and I just want to make sure I’m looking at this right. If I look at – and I’m looking at slide 14 in the deck, if I look at 2012 versus 2013 guidance on both, GAAP diluted EPS from continuing ops line and also on the adjusted EPS from continuing ops, you’re looking for a pretty significant decline 2012 to 2013 in EPS on either of those measures apples to apples. And given that as you mentioned, you’re looking for generally higher revenues and volumes except in commercial. Should we be looking for significant I guess decline in the margin profile there in addition to that loss of interest income you mentioned?

John Kita

Todd, let me go through that example on slide 14. What that implies when you take out the one-time items which we have this year which was primarily the RBC stock, you take that $0.46 out, you take the benefit we feel we got from hurricane Sandy and you put pension on apples and apples basis i.e. service cost, you would be – 2012 would be $3.08. 2013 guidance, our midpoint would be $3.35 on an apples and apples basis. So that’s taking out the onetime items the ’12, getting ’12 pension down to service cost. So we are saying and that’s why Ajita said in his speech, we see about a 9% increase in EPS year-over-year and all I was alluding to is that’s a positive margin improvement. Lochinvar, China, all of those improvements and a little bit of help from residential. As we said we see completions going up 150,000 units and one of the headwinds is about $5 million worth of interest income. But we’re going up in our mind 9% on an apples and apples basis.

Todd Vencil – Sterne, Agee & Leach

Got it. That makes more sense. Sorry for the confusion. Thanks a lot.

Operator

Our next question comes from Matt Summerville from KeyBanc. Your line is open.

Joe Radigan – KeyBanc Capital Markets

Morning. This is actually Joe Radigan on for Matt. Can you quantify the pre-buy in China first of all? And then I guess as a follow up question to that, how do you feel about inventory levels after that pre-buy in China as well as inventory levels in North America?

John Kita

So I think that the China pre-buy and we’re estimating based on inventory levels, was probably about $5 million to $7 million. So even without that they had a great quarter. So we don’t – and that’s not unusual at the end of the year from trying to get the IP incentives. So I think overall we’re comfortable with the China inventories and when you look at the residential in the U.S, I think to the best of my knowledge we’re comfortable with the inventory levels. We’ve told you some of our retail customers have actually taken their levels down this year. So we certainly think they’re in decent shape and everything we know about our wholesale customers, they’re in decent shape. So I think we’re ending the year quite well from an inventory standpoint with a little noise in China.

Joe Radigan – KeyBanc Capital Markets

Okay. And then just a question on the commercial outlook, you’ve guided to essentially flat industry shipments. It seems like it surprise on the upside at least the last several years without much help from non-res construction. You guys appear to be taking share with the high efficiency ROI type upgrades. Why would that not continue? You’ve got – even without an uptick in non-res construction, why would that trend reverse itself?

John Kita

Everything we said is right. We started the year thinking it was going to be in the high 130s and it came – we think it’s going to be even better than last year’s 145. So you’re exactly right there. You’re right, we’re gaining share there. What we just don’t see a lot of is the commercial construction benefit. And so if that happens, then it will turn out our numbers are probably too conservative, but we’re just not seeing that and you’re right, we were surprised by how strong it was this year.

Joe Radigan – KeyBanc Capital Markets

Okay. And then just one last question. In terms of taking Lochinvar to China, what’s the plan for distribution there? And then how should we think about how that business ramps considering it’s basically starting at zero? How should we think about the ramp there over the next several years?

Ajita Rajendra

Taking the product to China we have to go through all of the import requirement, et cetera in China and making sure that they’re complying with all of their requirements and that takes time because the Chinese government is very stringent about inspecting factories and doing all that type of stuff. It’s going to be a slow ramp up. It’s not going to be a real fast ramp up, but we continue to feel that the long term potential for that product line in China is tremendous.

Joe Radigan – KeyBanc Capital Markets

And then Ajita, is that a direct sale or do you go through like a third party distributor there?

Ajita Rajendra

We’ll be going through third parties there. It’s not a direct sale to the end user.

Operator

Our next question comes from Robert Kelly from Sidoti & Company. Your line is open.

Robert Kelly – Sidoti & Company

Good morning. Thanks for taking my questions. Just a point of clarification. The res industry shipments growth that you see in ’13, that’s all coming from the new site? You’re not hearing anything positive on replacement?

Ajita Rajendra

I think replacement continues. Replacement has been steady and that part of it we expect to continue to be steady and the growth is going to come from the new construction coming back.

Robert Kelly – Sidoti & Company

There’s no chatter amongst your distributors about the warranties coming up and the pent up demand for it?

Ajita Rajendra

I think there’s probably a little bit because there is a certain amount of discretionary replacement which was stifled over the last few years. So we could have a little bit of that coming back also. But in the scheme of things it’s primarily going to be new construction that drives it.

Paul Jones

We would also hope at some point the heavy construction improvement that happened in the late 90s and early 2000s with the average life being 12 years or whatever would start helping replacement. We’re just not building that really in.

Robert Kelly – Sidoti & Company

Okay, fair enough. Apologize if you’ve covered this already. Could you just give us a sense of where we are with the water filtration business in Asia, what your expectations are for 2013 and profitability in India, what the outlook is there for ’13?

Ajita Rajendra

There’s different components to that outside business and let me start with the branded business in China. The branded water treatment business in China is doing extremely well. We just about doubled the business in 2012 and we expect continued strong growth and gain of market share in that segment of the business. And in the non-branded or the non A.O Smith branded business, we again had very nice growth in the business, but in that segment of the business we’ve been having some operational issues, et cetera and we are putting those behind us and continue to grow the business. Overall we had very good incremental growth in both topline and bottom line in that business in China and we also expect that in the near future, sometime in 2014, we expect to be introducing that business, the water treatment business in India. So that’s another growth opportunity going forward.

Robert Kelly – Sidoti & Company

Okay, great. And then just as far as – you had a couple of rounds of price increases during 2012 in seemingly all your markets, but still costs were down slightly. How much did that help you in 2012 and what’s your expectation for raw material trends in 2013?

Ajita Rajendra

Overall I think that as we look at pricing, what we try to do is balance, make sure that we’re in balance in terms of our cost increases. We have even some of our customers there are escalators or indices for steel prices that are passed on and some customers they’re not. But overall we feel pretty comfortable with where the balance is and it’s meeting our expectations. Steel prices are down, but again a lot of that contractually go back to our customers also. Not all of them, but some of them. But overall we feel comfortable with the balance.

Robert Kelly – Sidoti & Company

No material benefit from weaker steel in 2012?

John Kita

Well, there were some benefits. When we looked at the price increase we had in 2012, it incorporated many different costs, healthcare, et cetera, but it also incorporated the steel increase that happened from 2010 to 2012. So there was some material cost benefit, but it was not significant in 2012.

Operator

Our next question comes from David Rose from Wedbush Securities. Your line is open.

David Rose – Wedbush Securities

Good morning. I was hoping maybe we can dissect the margins a little bit more. If you can provide a little bit more color on any of the effects on fixed cost absorption in the quarter pricing. And then as we look into 2013, at least in the first quarter, what are your expectations for margins and what would be the drivers for that going into the first quarter?

John Kita

Well, I think from a margin standpoint you can see that Lochinvar did very well from the numbers we gave you and part of that is driven by their fourth quarter is always going to be their strongest because their parts business is strongest and they have very good margins there. Their parts business is strongest in the fourth quarter because people turn on their boilers and all of a sudden it doesn’t work sometimes and instead of replacing the boiler they replace parts. So that’s very typical. You also see very strong margins on North America and that was benefited by a pretty significant increase in residential volumes which we’ve talked about that was partially offset by commercial which is one of our highest margin businesses being down. And we have the same benefit in the fourth quarter from China. Their margins were very, very good which you would expect because that’s start to come in more the contribution margin.

So I think fourth quarter margins were not necessarily indicative of full year because that was our highest volume quarter significantly. So as we get into the first quarter of next year, we won’t expect volumes to be quite as strong as what they are this quarter obviously because of some of the things we talked about. So I think it would be natural to think that margins would decline somewhat. Year-over-year I don’t think you’ll see a significant difference in margins. You’ll see some improvement I think, continued improvement rest of the world. North America when you take out some of this pension noise I think you’ll see improvement also.

David Rose – Wedbush Securities

And can you talk about labor in China and then raw material cost expectations? You mentioned the escalators, but at some point in time does the price costs catch up to you in 2013?

John Kita

I think China labor everybody has seen increases there, but fortunately that’s a relatively small cost of our total cost per unit. So we’ve certainly seen that. From a cost price standpoint as Ajita alluded to, we think we’re at a fair point right now for A.O Smith and our customers and we’ll evaluate as we go forward depending on what some of our input costs are.

David Rose – Wedbush Securities

Lastly if I may, you’ve historically talked about change for sales trends in tier 1, tier 2 markets. I imagine the culling of stores helps improve those numbers a little bit. But can you provide us some color on what tier 1 and tier 2 same store sales were like for the quarter?

John Kita

Actually fourth quarter same store sales were strong. Some of the housing indicators in China have perked up a little bit. We’re not sure if they’re permanent or not, but clearly we saw positive same store sales, both tier 1 and tier 2 in China and we’ll obviously watch that closely because like I said, some of the housing indicators there – you saw a couple of Wall Street Journal last week started to say new housing occupancy might be picking up. We’ll wait and see.

Operator

Our next question comes from Donald Bisson from Century Capital. Your line is open.

Donald Bisson – Century Capital

Thanks. I figured out the answer to my question. Thank you.

Operator

(Operator instructions). Our next question comes from Ted Wheeler from Buckingham Research. Your line is open.

Ted Wheeler – Buckingham Research Group. Inc.  

Good morning everyone. Great job. On the tier pricing you alluded to, have you caught up there with where you want to be or is there still room to have pricing action in China?

Ajita Rajendra

I think we had a comfortable spot in China. We increased prices the last couple of years which has been unusual for China and we were able to pass them along because of the inflation that the market was seeing. But what we try to do in China is to increase the average cost of our items due to a better mix because of new products that have better features and benefits. And that’s how we try to drive the average price of our units up and it’s been a very successful strategy so far.

Ted Wheeler – Buckingham Research Group. Inc.  

Lastly, any color on the retail big box negotiation this year versus where you’ve been the last year or so and how does it feel? If you could give some color on that.

Ajita Rajendra

Obviously we’re always in negotiations with our customers and I’d rather not comment at any particular time in terms of how they’re going. They’re normal. Our relationships are very strong.

Ted Wheeler – Buckingham Research Group. Inc.  

And the push on historic costs to catch up I think you alluded to has pretty much stabilized now. Is that a fair way to think about it?

Ajita Rajendra

Yeah.

Operator

I show no further questions at this time and would like to turn the conference back to Ajita Rajendra for closing remarks.

Ajita Rajendra

Thanks very much everybody. We really appreciate your attention and your interest in our company and if you have any further questions you know how to find us. Thanks very much.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect at this time

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