AO Smith Corp. Q2 2009 Earnings Call Transcript

Jul.22.09 | About: A. O. (AOS)

AO Smith Corp. (NYSE:AOS)

Q2 2009 Earnings Call

July 17, 2009 10:00 am ET

Executives

Patricia Ackerman - Vice President of Investor Relations and Treasurer

Paul Jones - Chairman and Chief Executive Officer

Terry Murphy - President, Chief Financial Officer and Executive Vice President

John Kita - Senior Vice President of Finance

Analysts

Mike Schneider - Robert W. Baird

Ned Borland - Next Generation Equity Research

Scott Graham - Ladenburg Thalmann

Ted Wheeler - Buckingham Research

Matt Summerville - KeyBanc Capital Markets

Chip Rewey - CRM

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the A.O. Smith Corporation Second Quarter 2009 Earnings Call. For the conference all the participants are in a listen-only mode. However there will be an opportunity for your questions and instructions will be given at that time. (Operator Instructions). As a reminder today's call is being recorded. With that been said, I'll turn the conference now to Ms. Patricia Ackerman, Vice President, Investor Relations and Treasurer. Please go ahead.

Patricia Ackerman

Thank you John. Good morning ladies and gentlemen and thank you for joining us on this conference call. With me this morning participating in the call are Paul Jones, Chairman and Chief Executive Officer, Terry Murphy, Chief Financial Officer and John Kita, Senior Vice President of Finance.

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 mornings press release. Paul I'll turn the call over to you.

Paul Jones

Thank you Pat and good morning ladies and gentlemen. Before we get into the highlights, let me say that we are encouraged by our second quarter results. The challenges of the global recession are still present, but our focus on cash management and cost reduction, have really paid off for our shareholders. A few highlights to consider.

First, while earnings were down from last year due to lower volumes, the improvement from the first quarter is considerable. Our Water Products Company logged in operating margins at 10.8%, up from 9.5% last year and 8.6% last quarter.

Sales at our Electrical Products Company increased 13% from the previous quarter.

Secondly, our operations generated almost $94 million in cash in the first-half of the year. Our inventory reduction programs delivered some great results as levels declined by 20%, from the end of last year.

Additionally, improved terms with our vendors have now resulted in negative working capital levels in China. Third, our water heater operations in China grew 16% over last year. The Chinese Governments stimulus program is definitely working.

Fourth, our motor operations started to see an uptake in orders from its HVAC customers in the second quarter, related to seasonal summer sales. In fact, due in large part to the success of our cost management efforts and sequential improvement in second quarter earnings, we increased our dividend by 3%, and we increased and narrowed our 2009 earnings guidance. The earnings scale.

Patricia Ackerman

The audio dropped.

Unidentified Company Representative

John, is the audio still on, we just got information that the audio was dropped further on.

Operator

You were still connected.

Unidentified Company Representative

Okay. We'll go on then.

Paul Jones

Earnings guidance for the full year is now at a range of $2.05, and $2.25 per share on a non-GAAP basis, an increase from $1.80 to $2.10 per share range that we gave during our first quarter call in April. The forecast on a GAAP basis is $2.15 to $2.35 per share. Terry Murphy, will now elaborate on our GAAP and non-GAAP reporting and our second quarter financial results. Terry.

Terry Murphy

Thank you, Paul. Before I get in to the financials, I'd like to briefly explain what caused us to now be reporting GAAP and non-GAAP financial measures. On 4/22/'09 Seiko is emerged in to A.O. Smith Corporation as a subsidiary. That transaction resulted in Seiko shareholders maintaining a similar, but direct ownership in A.O. Smith stock. Transaction is accounted for as a reverse acquisition under SFAS 141(NYSE:R), with no purchase accounting required and for accounting purposes, Seiko is the acquirer and AOS is the acquiree well for legal purposes Seiko is the acquiree and A.O. Smith is the acquirer.

To review briefly what happened from an accounting perspective, let's look at the six months ended 6/30/2008, sales in gross profit were the same for GAAP and historical reporting.

GAAP earnings are less, because of Seiko expenses during the first six months, that wouldn't have been shown in the historical statement. The discontinued operations are the results of the two small Seiko subsidiaries. Since, Seiko has about 9.5 of the 30 million shares outstanding or about one-third, on a consolidated Seiko financial statement it has to eliminate two-thirds of the earning.

Non-controlling interest, and then divide by the Seiko shares outstanding net result is the GAAP is a $1.67 versus our reported number of a $1.78 last year.

Now, let's look at 2009. Gross profit is the same again. Net earnings are slightly less for GAAP, again because of Seiko expenses. However, rather than eliminating two-thirds of the earnings for the entire period, two-thirds of the earnings are eliminated only up through 4/22/'09. And then a 100% of the earnings are accounted from 4/23/'09 through 6/30/'09. Same kind of calculation for the shares 9.5 million shares up to 4/22/09, 30 million shares thereafter. All in, it produces earnings-per share of a $1.19 on a GAAP basis which is higher than what we would've reported historically at $1.07.

We've included a reconciliation in our press release today, which should be helpful in understanding the complicated GAAP accounting required for this transaction. We believe the non-GAAP presentation of the historical information provides investors with a better understanding of what's happening in our business because it's comparable to our historical information as well as our earnings guidance for next year. We'll continue to provide information in the non-GAAP format for the next three quarters.

The remainder of the presentation we'll provide information that is non-GAAP. Total sales in the second quarter declined to $499 million from $622 million last year. Due to the declines in volumes we experienced in all and other North American end market, we've reported lower earnings of $23.7 million or $0.79 of share compared with $32 million or $1.06 per share last year. The 2009 earnings per share included $0.06 per share in positive after-tax benefits related to our Chinese water heater business.

The 2008 earnings per share included $0.03 per share of net benefit from a cumulative currency translation gain related to the closing of our operation into the past.

Sales of $337 million in our Water Products business were up 11% from last year and mask sales increases in China were about 16%. Commercial volumes were down more than residential volumes, but both lost double-digit amounts.

We estimate that the industries residential replacement volumes in North America are now about 92% reflecting housing starts of historically low levels of below 600,000 new homes.

Electrical product sales declined by one third to a $162.4 million driven by declining end market demand and customer inventory reductions, despite continuing to add business with some of our large distribution account, volumes in all our strategic business units or SBU's experienced double-digit decline. Year-over-year volume declines in our pump, motor and general industry SBU's are the largest. Before we leave this slide, a comment on our HVAC businesses in order.

As Paul mentioned we have seen a progressive increase in volumes in the second quarter, April better than March, May better than April and so on. We expect volumes to level up in the third quarter and then fall off some as the summer season line is down.

Total operating profit declined $33 million from $47 million last year. Operating profit with Water Products was $36.5 million essentially the same as last year. Operating margins improved to 10.8% from 9.5% last year as a result of aggressive cost reduction programs and higher pricing.

Electrical products posted a second quarter operating profit of $7.6 million compared with operating profit of $22.5 million last year. The earnings impact from the significant drop in volumes more than offset over 5 million in savings associated with product repositioning and plant consolidation.

Operating cash flow was almost $94 million in the first six months which was considerably better than the operating cash flow of $20 million last year, a 20% reduction in inventory levels from the end of last year contributed over $50 million to this years operating cash flow.

During the second quarter, capital spending was approximately $22 million compared with depreciation and amortization of $34 million. Capital spending for the year is expected to be around $60 million which is trimmed about $20 million as a result of our efforts to conserve cash. Depreciation and amortization is expected to total approximately $70 million. We are still projecting operating cash flow between $140 million and $150 million for 2009.

Our liquidity position and balance sheet remains strong. Our debt total cap declined to 29% from 34% at the end of the year. We had limited amortization of our long-term debt portfolio in the coming years. Our $425 million credit facility doesn’t expire until February 2011 and we had over 268 million of available capacity under the facility at the end of the quarter. Paul will provide details on some exciting new product introductions and then we will open up or questions. Paul.

Paul Jones

Thanks Terry, as we have been saying for some time we are continuing to invest in new products and technologies to ensure that we are well positioned when the global economy recovers. And then we are going to start talking about those a little more. We are excited about the new products we have introduced in the second quarter as well as the products in our pipeline and here is just a few examples. Our latest new product in china represents a real game changing application. Solar water heating is a huge market in China. If you have been there you’d see solar collectors or panels literally covering the roof tops of homes and apartment buildings. But problem is less and less roof tops space is available. In addition in high-rise buildings apartments, on the lower floors are difficult to serve with solar panels on the roof. Our award winning product which consists of about balcony mounted solar panel and a pressurized water heater addresses the problem wonderfully. We have plans to introduce other pressurized solar water heating products in China before the end of the year.

In April, we acquired a small heat pump commercial water heater company. The U.S. heat pump water heater market is its infancy, so the government has incentives and the push for green buildings we believe the market will become as large as China the next several years. China put a 160,000 units in service by next year. The acquisition not only provides a new technology for us, but for our engineering expertise which we will use in our global heat pump product development as well as U.S. residential applications.

We recently installed 14 commercial heat pump water heaters at the Fort Knox army base, which added to the roughly 50 units that were installed prior to our acquisition of the Company.

In electrical products, we’ve been working on variable speed motors for many applications. Taking advantage of our leadership position of the pool and spa pump motor segment, we have two new products and production this quarter, including a premium efficiency two speed motor and a full variable speed motor or ECM for pool pump manufacturer, Jandy. These new pool pumps comply with new energy efficiency regulations, put in to effect late last year in California, and we expect more space to implement similar legislation in the very near future.

In discussing the outlook, I want to touch on four items. One: the strong water heater replacement demand, two: our China volumes, three: the volume declines in our motor business and four: our cash conservation coupled with cost reduction activities.

Let's start with replacement demand. As you know the North American Water Heater market is largely a replacement market. Historically, the replacement volumes for the industry range from seven million to 7.5 million units per year. We now expect new construction to incrementally add only 550,000 units in 2009. With the replacement market now expected to be 92% of the volume, this year. These volumes are much more predictable than for our motor business. Second, we are expecting our China business to grow modestly in 2009.

Our China Water Heater sales were up 16% in the second quarter, after being down 10% in the first quarter of the year. It's clear that the China's stimulus package is helping our customers buy homes and are still confident.

Third, as I mentioned earlier, our OEM motor customers have indicated that their 2009 volumes will be substantially below last years volumes.

Most are forecasting 20% to 30% declines. We have had individual conversations with all of our largest customers and as is no different than what we hear in the general economy. As a result of the lower volumes, we have eliminated over a 1000 jobs, since the beginning of the year.

Finally, we will continue our focus on conserving cash. These programs have already generated great results as evidenced by our strong cash flow. But the programs will remain in place for the foreseeable future.

To wrap-up then, our 2009 earnings guidance is now $2.05 per share to $2.25 per share, on a non-GAAP basis, an increase from the $1.80 to 2.10 range that we gave during the first quarter call in April. The forecast on a GAAP basis is $2.15 to $2.35 per share.

This concludes our prepared remarks. We'll now open up the lines for questions. John.

Question-and-Answer Session

Operator

(Operator Instructions). And first from the line of Mike Schneider with Robert W. Baird. Please go ahead.

Mike Schneider - Robert W. Baird

Congratulations, and obviously a very nice performance in a tough market. Maybe, we can just focus on margins for a minute. The cost savings are coming through. Maybe Terry, you could just give us some more detail on how cost of good sold is down sequentially while sales are up, 17 million or so. If you could just dwell into what the (dwelt) is on materials and labor or anything like that. Any color would be helpful just to give us a sense of how sustainable these margins are going forward?

John Kita

Certainly materials are a big impact on that. We've said that we trail (inaudible) mechanism we have we trail in steel and some of those things. So we are favorable to steel quarter-over-quarter and some of the labor enhancements we've done are also helping the gross margin line.

Mike Schneider - Robert W. Baird

Could you give us an order of magnitude? Is it, you know are you lower by 10 million even sequentially in materials?

Paul Jones

Mike its Paul. I don’t think we can give that out. I think we'll be giving little bit too much information. I will say that when we look at our bridges from year-over-year and quarter-over-quarter, I've never seen such big numbers on these bridge territorial pick to volume and mix and material costs and labor costs and everything else. It's become part of the reason for our conserving, being conservative with our guidance last quarter was the fact that, that we were seeing some really big swings in some of the potential variations coming up on cost.

So we are being a little conservative. We are tracking it obviously minute-by-minute in every element of the income statements and try to make sure that we stay on top of it. And as John just mentioned, steel was very good cost position and indices in the first quarter and that’s what we are paying in the second quarter. In the third quarter we'll be paying what it was in the second quarter. So we now have nine months visibility on to the majority of our material cost. So feeling, it's a little bit better handle on how things are going to be through rest of the year.

Mike Schneider - Robert W. Baird

Okay. And production levels, can you give us a sense of where you are right now. And will absorption be as good in the second half as it was in the second quarter or will it be even better as you stopped depleting inventory.

Paul Jones

Yeah it will be better in the first half because we've been taking some absorption hits in the first half as we've been taking finished goods inventory down. I want to stress we are not impacting service. As we've talked about and I know a lot of people yawn when they hear it. Well we put a lot of capital investment in to information systems over the last several years and they are truly paying off.

We have a much better visibility on to what we need and when we need it. And we've been aggressive I've told the whole team, we'll take all the absorption hits we can get to get our balance sheet in line. And get our service levels where they need to be. So we have taken some absorption hits in the first half. We may just take a few more in the second half as we continue to assist to generate cash. But that's all in my opinion money well spent to get the new business position properly.

Mike Schneider - Robert W. Baird

But the absorption hit will be lesser in the second half at least if volume stays at current levels?

Paul Jones

Yeah I think so and to help answer your question we have taken some line rates up. Things like hermetic have really taken off, residential hermetic we've had to take those lines rates up significantly. We are not sure its sustainable that's why we are being conservative but we've had to do a few things because there was just not a lot of inventory in the pipeline as you know you reported that in your own reports.

Mike Schneider - Robert W. Baird

Yes. And then in water heaters if China was up 16 or it's like domestically you were down by the comparable amount 15%. Can you give us a just some commentary on the mix there residential versus commercial and I guess just have you seen the full mix hit from commercial or indeed with the second half if commercial continues its trend actually suffer in a more margin pressure than we have seen in the second quarter?

Paul Jones

I think it is tough to tell that we think that residential seems to have leveled off. Notice a lot of replacements now at 92% of the business so that one has leveled off. Commercial it’s been a little bit erratic once we think it’s the leveling off it will drop a little bit and then we will think well that’s it and then it’ll start going up. It's still below last year, we are running a neighborhood of 20% or so below last year on a volume basis on the incoming order rate. It is hard to say where that is going to be. We have some things that we are doing on the commercial side to help our business and to help our mix but I personally think that we are going to see the light commercial construction decline for at least another 3 to 6 months before it will start going up.

Mike Schneider - Robert W. Baird

So residential was still down double digits though?

Paul Jones

Small double digits yeah it is not going to be and whether that will pick up as the year goes on because there has been some inventory decline in the channel that we may see a little pick up from that but I am not sure how much.

Mike Schneider - Robert W. Baird

Okay and then just high efficiency water heaters I believe it is the vortex line is that available at retail yet or will that.

Paul Jones

Yeah it is vertex, but no that is not available at retail yet but retail like a lows or a true value or seers which you can certainly give them from your local plumbing wholesaler.

Mike Schneider - Robert W. Baird

Okay and is there plans to put that in retail?

Paul Jones

Can't talk about our product introduction plans. One thing I’ll say from our philosophy standpoint is we are going to announce some when we implemental.

Mike Schneider - Robert W. Baird

Okay.

Paul Jones

Now I am going talk about what we were going to do in 2011 like some competitors.

Operator

Next questions from Ned Borland with Next Generation. Please go ahead.

Ned Borland - Next Generation Equity Research

Just on the electrical products segment, the margins, I know that the second quarter is sort of a high water mark seasonally. But backing in to what I am up with basically 2% operating margins for the rest of the year. I mean, what I guess in terms of the initiatives you’ve put in I mean, is there any offset are missing there.

Paul Jones

Well, the addition is that we did, we were pretty vocal about those. And I think the electrical products has taken some, obviously some severance cost hits this year that has hit in the first-half. We don’t think we are going to have that level of it in the second-half and we get the benefit from the nine plants that we closed over the last five years. And all the repositioning we’ve done there. We are still doing some tweaking to some of the repositioning, but as I mentioned in the last call, we just might not talk about it any more. Its going to be sort of thing, where we will take a severance hit and we’ll get the benefit back in four or five months. And so, we are just going to keep doing what's right so far as the management business to get our margins up.

Ned Borland - Next Generation Equity Research

Okay and your comments about the water heater demand. Usually you see kind of the seasonal build in the second quarter of revenue didn’t look like that was the case, this time. Are we at something kind of a flattish revenue line and then from these levels throughout the rest of the year.

Paul Jones

Yeah, for the most part, the reason being that we are down to almost replacement business. So the replacement business is pretty on a straight line. We don’t have the seasonal home building piece of it in extent and how with housing starts down to one-fourth or what they were three years ago, so it’s essentially replacement and thank goodness people still take one cold shower. And they find room on a credit card replace that water heater before the next morning.

Ned Borland - Next Generation Equity Research

Okay, so the Chinese growth basically offsets much of the decline you are seeing here is the (most).

Paul Jones

Yeah, China, we were obviously concerned in the first quarter, as China was down 10% in the first quarter, now that bounced back very nicely in the second quarter and I don’t think we’re going to see the 35% growth we've seen last three or four years, but we want to have good growth in China this year.

Ned Borland - Next Generation Equity Research

Okay, and then on the cash, very impressive cash generation, just wonder discuss your cash priorities at the moment?

Paul Jones

Well it's been a priority for sometime, but obviously when you go into a recession as we are in, we have several programs underway. Primarily focusing on the operations side receivables, payables, inventory, lots of things on the cost reduction side that we’ve been doing for sometime. Trying to get, best cash flow as earnings. So, this is not a new program or a fad program, fad of the month it's just taking the efforts we’ve had to another level and it's paying off and we are giving the results.

Ned Borland - Next Generation Equity Research

Are you starting to look at maybe an acquisition pipeline or anything of that nature?

Paul Jones

We are always looking for opportunities to generate increased returns for shareholders. And acquisitions are certainly on the agenda there.

Operator

And next from the line of Scott Graham with Ladenburg Thalmann. Please go ahead.

Scott Graham - Ladenburg Thalmann

I have a couple of questions for you, on revenues and really, Paul if would characterize the business trends, order trends, frankly in both businesses if you would. As you enter the quarter versus as you exited the quarter. What did that feel like?

Paul Jones

Well I think water products are pretty well as flat, maybe a little bit of a decline on the commercial side towards the end of the quarter very, very slight. Electrical products actually heading month-over-month improvements, since second quarter.

April was better than March, May was better than April and June was better than May a little bit. Moving up, I think we are not may be we are being conservative I hope we are. I hope that trend continues, but we think we are just essentially responding on electrical products through the short term replacement needs that people have (electric) pumps, swimming pool pumps and they are like as low as HVAC.

And we are thinking without any improvement in the economy, that we may see a fall off on motors as the cooler weather arrives in the fall and winter. But water products, residential has been essentially flat for the last several months.

We think that'll continue maybe it'll pick up and commercial has been erratic. It's may be its down definitely more was a year ago, but it has been erratic it's over the last three months.

Scott Graham - Ladenburg Thalmann

Not to be a kill joy here but, wouldn’t that pick up on the electrical products in seasonal for the HVAC season or are you saying that that’s not what it is?

Paul Jones

Well it is seasonal because the HVAC season, but what happens is normally that an inventory bill will occur in the first quarter and first part of the second quarter and all of our OEM customers have been saying we are just going to disappoint customers. We are not going to have everything in inventory this year. We are conserving cash, so we saw a huge fall off in our order rate in the first quarter. And the reason it's picking up in the second quarter as there is no inventory in the pipeline. So, when somebody needs a, the air conditioner goes down. They call and the product may or may not be available off the shelf, it may have to be something gets manufactured. And so we've seen may be a slippage in the inventory bill. Or we normally be building inventory, let's say we are in March, April time period, we are essentially supplying needs in the April, May and June time periods.

Scott Graham - Ladenburg Thalmann

Got you. Okay that makes sense. So essentially you are confirming that there is an HVAC season not what we've seen in past years, but there is still a season. So…

Paul Jones

That's correct people will still from the air conditioners come on, not all of them work I mean you have just sitting all winter and they fail. And people, if we've seen any little trend may be they are not replacing the whole outside condenser unit, but are just replacing the component that fail. But either way we get the motor, so it works.

Scott Graham - Ladenburg Thalmann

I got you. And yeah that is what the industry numbers are showing. Underneath there is some 12% decline in water products. I want to may be look at this may be cut it in a different way and try to understand it, if we are now really, frankly for all of 2009 so far, we are at this 90% plus replacement rate. Why do think the year-over-year in the second quarter immediately verses a more difficult comparison. But why are these year-over-year still declining as much as they are, you think?

Paul Jones

Well I think, our customer has spent a lot of time with customers over the last few weeks. And they've taken their inventories down by 50% - 60% these are the wholesalers because year ago they didn't see the recession that we are looking at right now, nobody did. Second quarter of last year it still a pretty good time in the economy, few things happening on Wall Street but not everybody was focused on that. Now we are definitely in a recession. Our customer base, we have been very fortunate. Now we don’t have any receivables issues there and we were doing everything to watch that but our customer base is conserving cash they have take their inventories down I think that has a definite impact on our second quarter. This year versus second quarter last year incoming order rate. And that was believed that may be there would be a pick up as their inventories get to a stable point as we go in the rest of the year and there is a lot of people in the business think that will happen we are just not counting on it. If it does we would ready for it and we can respond.

Scott Graham - Ladenburg Thalmann

Actually that is where exactly where I was going with that question Paul so thank you. I guess the other question would be on pricing I mean you guys have benefited pricing wise a lot in the last couple of years obviously you know kind of just trying to catch up with the raw material situation I know that you have pricing Paul this is a big initiative that you are pumping and make sure you keep what you have gotten so far. How is that going in each business right now Paul?

Paul Jones

The major priority of our is to make sure that we maintain the margins necessary to continue to invest in the business and we are good at that all the elements that they go into margin and I really cant comment further than that Scott and you know why so every competitor we have is listening to this call.

Scott Graham - Ladenburg Thalmann

I get it no problem. Last question is this everything in the restructuring I know all the heavy lifting is behind you we now should pretty much see some pretty good roll through of the road man on the electrical product side and kind of a similar type although not exactly quantified on the water heater side, type of roll through in cost savings going forward, yes.

Paul Jones

That’s correct, if we get a normal economy right now. We’ve done a little bit of work on that but we are very proud of where the margins would be. But that’s all just paper taking any number you want to put on it. We haven’t demonstrated it because we haven’t been in a normal economy. Yes, that’s right. The savings are there, we are actually exceeding and we track that as you know very routinely with in the company and frankly very proud of what's happening.

All the heavy lifting is done but there are still some pretty nice projects out there to improve our margins of from just a day-to-day operation standpoint. As well as some design elements and as I mentioned we are still doing some factory repositioning, still looking at a few things there. But they are not going to be the kind of things we been taking about over the last five years. That will be just more or less, quick hits. We can do them fairly quickly, get the savings coming in with in a week, few weeks of having gotten that project done.

Scott Graham - Ladenburg Thalmann

Okay. And here is I promise my last question. Your inventory, you guys have done a fantastic job pushing that number way down. Now, if there is any type of a pick-up in the second-half of the year, that’s not going to be a problem for you to capture those sales, is it?

Paul Jones

Absolutely not, because among other things we’ve been doing with all of this repositioning, we have significantly tightened our cycle time. From start to finish we have a very short cycle time across the business and we have kept the capabilities in place to respond to pick-up and in a matter of few days or some times less than that we can have our output up double-digits out of every factory.

Operator

Our next question is from the line of Ted Wheeler with Buckingham Research. Please go ahead.

Ted Wheeler - Buckingham Research

I echo the comments on performance, nice job. A couple, this (metrics) I guess, one just to start in your prepared remarks in discussing China, you talked about modest growth and then I think a few moments ago you talked about good growth. In your guidance I know there its not picking but what is your guidance assume good or modest for China.

Paul Jones

Our guidance is assuming modest in China, if we talking, do it in six months, but right now we are assuming modest.

Ted Wheeler - Buckingham Research

Okay. And just another one that cost program in the electrical products, there was a headline sort of the number you wrapped up late last year and there was some benefits I guess 5 million last year and then some carryover this year and the significant carryover this year, but then I think in the quarter, you talked about more than 5 million of benefit, does that change the, it just seems like that’s a little larger run-rate than the sort of a larger picture or number you've hold out last year?

Paul Jones

That’s a good catch Ted you’re absolutely right. We said last year 5 million in '08 and additional 15 million in '09 and we are running ahead of the 15 million in '09.

Ted Wheeler - Buckingham Research

And if I look, there was the 1000 people that you talked about, being equivalent to that run rate of the quarter of 5 million or is there more cost cuts from the 1000 people takeout, going forward?

Paul Jones

There has been 1000 people plus takeout this year, we took out quite a few people last year and we are only talking about the year-to-date when we say a 1000 just due to the declines we've seen this year.

Terry Murphy

Ted, there is another factor and there are two of that factors that we had restructuring expenses in the second quarter of last year that we didn’t have this year. So you’ve got on an incremental basis, you’ve not only got the savings from what you did last year you have also got the lack of an expense that occurred last year that didn’t occur this year.

Ted Wheeler - Buckingham Research

Okay. Right and on the HVAC seasonal question, I can't recall but I think last year maybe there wasn’t much of a seasonal pick up during the second quarter. Is that a fair statement?

Paul Jones

No, it was last year.

Ted Wheeler - Buckingham Research

Okay.

Paul Jones

It was business as usual last year and the pick up was in late first quarter and into the second quarter and all of our OEMs are building the normal inventory that they’ve done for years as they go into the summer season. That did not happen this year. They did not lay in the inventory.

Ted Wheeler - Buckingham Research

And it's been pushed to the right?

Paul Jones

Yeah, pushed to the right and then down.

Ted Wheeler - Buckingham Research

Yeah. And then kind of on the same subject, you highlighted the inventory levels that electrical in most of the remarks and then just in a question recently you talked about wholesale water heater inventories seem to be you are employing there very, very well as well. Is that true?

Paul Jones

They are lower than they’ve historically been and at the wholesalers, and that’s due to the recession and everybody trying to hang on to cash.

Ted Wheeler - Buckingham Research

So there is presumably a little bit of a spring loading up-turn if confidence improves in these two I would think?

Paul Jones

I would think so. It could happen. We have not put that into our estimates yet.

Ted Wheeler - Buckingham Research

And then I guess maybe the last one. You highlighted some new products, I think in the May meeting you spend some time talking about the instant hot water, on instant hot water product that would be a bit of a change from the ones that you are offering now and what the industry seems to be offering and we didn’t discuss that today. Is there any reason why that wouldn't be talked about today is that been pushed out?

Paul Jones

No it's a instantaneous, the on-demand water heaters that are out year and if you want to buy an A. O. Smith one you can they are out there.

Ted Wheeler - Buckingham Research

I thought you had a next generation product that you were going to introduced since in the fall?

Paul Jones

Yes we have a next generation product. And we'll be talking about it in the future call. That is not later that project is ongoing.

Ted Wheeler - Buckingham Research

The reason I brought up, because you did mention it May and you didn't today I wondered if that it slipped?

Paul Jones

No we will have that product to the market by the end of the year.

Operator

Next question is from the line of Matt Summerville with KeyBanc. Please go ahead.

Matt Summerville - KeyBanc Capital Markets

Good morning couple of questions. If I look at the motor business on a sequential basis just using around numbers your revenue was up about $20 million, operating profit up about $10 million, that’s pretty high in terms of incremental margins. I guess I am trying to get a sense of how much of that was driven by the incremental headcount you've taken out versus other factors. And then can you remind me in the first and second quarter whether or not you had gains or losses in terms of your forward or hedging contracts.

Terry Murphy

Let me try to address part of that. In the first quarter if you recall we had about $2 million hit from what we called excess hedging contracts or we've hedged volumes greater than volumes that we were manufacturing. So we had to take that so about $2 million of that loss was I think it was a $3 million loss in the first quarter was associated with that. So you don't have those in the second quarter. Also in the second quarter, and a question was asked earlier about cost of good sold and raw materials. If you look at, we've got lower steel prices, you've got which will translate in to lower product warranty prices. You've got lower freight costs associated with diesel fuel going down you've got lower volumes so you got lower freight costs all of those things will factor in, plus the fact that we had the severance payments and some of the severance payments associated for the first quarter expenses will get the benefit of those headcounts not being in on the second quarter, so it is a combination of things that cause the operating profit to go up sequentially more than the revenues.

Matt Summerville - KeyBanc Capital Markets

Based on how your input costs have (tried) obviously very high coming down pretty dramatically beginning to take up a little bit in some instances would you think the second quarter one of the most favorable quarter for A.O. Smith in terms of input costs or had we, are there still more favorable periods yet to be seen, I think you mentioned that earlier in the call that you have about nine months worth of visibility on that equation?

Terry Murphy

Yeah I think its true that all of our raw material costs as its been true I think with most companies have gone down slightly, we are not in the business of predicting what they are going to be as we look out ahead, but from a steel standpoint as Paul mentioned we do buy our steel on a quarterly basis and we do have visibility for steel. We don’t know what's going to happen to diesel costs we don’t know what's going to happen to a lot of the other input costs moving forward, but generally speaking our second, third quarters are our best quarters. We have demonstrated that or you have seen that over the last few years.

Paul Jones

Just to give you an example of some of the things that we deal with the steel companies as you know are struggling, because of lower volumes, so they are currently running at a 50% capacity utilization rate. The steel CRU index last week went up $89. Is there anybody on this call that can explain why that happened to us? That's a sort of thing that happens and we don't think that will be sustainable. But if it is, it will impact our fourth quarter cost. But that’s the sort of thing that we are facing right now as I mentioned on the first questions. Some really big numbers been used in some other swings that we’re seeing year-over-year on quarter-to-quarter. Makes it may be a little more difficult to predict.

Matt Summerville - KeyBanc Capital Markets

Thanks for that added color, it's helpful. As far as the commercial business, I think Paul, you mentioned response to a question that incoming orders were down, trending down roughly 20%. Is that true for both the water heater and motor business and then I guess if I recall correctly, so correct me if I am wrong. In the third quarter of '08, in the third quarter of '09, excuse me; you will face the toughest commercial comp of the year. I guess why wouldn’t that go down to 20 get incrementally worse in the back half of the year.

Paul Jones

Well those apply in both the businesses because we are not billing little strip malls and the restaurants, we are not putting in the HVAC system or the water heater. So answer that question? As far as what it’ll be in the third quarter, I think its going to be about flat to what we've seen in the second quarter, I am not real sure what, it will be relative to the comparable but, I think it will be about in the same ball park.

Terry Murphy

The strongest quarter in '08 for commercial -- was the second quarter last year.

Matt Summerville - KeyBanc Capital Markets

The second quarter, okay.

Paul Jones

That was the strongest quarter in last year.

Matt Summerville - KeyBanc Capital Markets

Okay. And then as far as the water heater margins, almost 11% in the second quarter, I guess, how should we think about sustainability there through the back half of the year. And then Terry, can you just comment based on the strong cash flow generation you have which has obviously been very good. Do you anticipate pretty more in the pension this year then you’ve indicated previously.

Paul Jones

I’ll answer the margin; I’ll let Terry talk about the pension. Obviously, you know our objective is to be above 12% operating margin in the water heater business. That has not changed. We're not there yet. And we think that will give us the cash flow to continue to invest. Obviously, there is so much coming down the pipe on regulations, on energy efficiency, rebate programs, tax credit programs, not just in U.S. but around the world. We’ve seen that coming and we’ve been putting a tremendous amount of effort into our R&D and our product development. We talk of all the things we’ve done to reduce cost. We have added several dozen electronics engineers across the company, I don’t want to give the exact number, but we're putting up tremendous amount of money and effort into some new products and we need those margins enable us to keep doing that so we can keep our customers at the forefront of what the market wants and we expect to do that for many more years. We’re working on products if I want to introduce for three or four years we are doing the efforts right now. So, that’s why giving -- to pay for all that, to fund all that, we need to get our margins even higher than what you're seeing now. I would not like to think that today's margins are normal; I would like to think that we can improve on considerably from where they are right now.

Terry Murphy

Relative to pension from an expense standpoint, pension expense will go from 4 million in '08 to about 10 million in '09. Relative to pension contributions we've made about a $15 million contribution last year, we've made a $15 million contribution so far this year, but we expect to make contributions of about 35 million this year to the pension plan.

Matt Summerville - KeyBanc Capital Markets

That’s 35 million for the total year

Terry Murphy

So the total year…

Matt Summerville - KeyBanc Capital Markets

(Inaudible).

Terry Murphy

It would be another additional 20.

Operator

Next in line is Chip Rewey with CRM. Please go ahead.

Chip Rewey - CRM

Thanks guys. A lot is being covered. I just wanted to ask a little bit of a big picture question on the Smith Investment Company. Along the lines of why now is a motivation to do the transaction if you could shed some color on it? I know it wasn’t really your decision but if you could discuss the timing?

Also can you discuss what it means from a governance point of view as far as will it change any of the board structure, any seats there that could change and will it also change the way you set your strategy as far as maybe free you up to make some more acquisitions or anything along those lines? And lastly would it change the response of the company to perhaps a bid by a larger player? Thanks.

Paul Jones

Okay. I will try to answer those. The timing had nothing to do with recession or anything else. This is a subject that’s been discussed for sometime. Smith Investment Company, owned shares in AO Smith. The 48 trusts are sold and owned in shares of Smith Investment Company did not own those shares directly. This is a structure put in place in the 50s.

It doesn’t work because of the tax policy of this country. Those dividends that we paid to Smith Investment Company were taxed, and then when they were distributed to the family members they were taxed. That’s one of the motivators behind doing the deals that we did. We had special committees of Smith Investment Company and special independent committee of AO Smith and negotiated that. It was done strictly on arms length and why now it was, we finally came up with a structure that at the Smith Investment Company could do and our role was facilitators to help get that transaction done.

We have presented it to you as a non-event in AO Smith slide and I still do. We have the same Board we had before. Its just the shares that were owned by Smith Investment Company are now owned by the members of the Smith Family. The Board is the same as it was, the emphasis on it with the corporation and what we do as always been what's best for the shareholders, what's best for the Company in long-term.

We've been operating that way before, we are doing that now and we will in the future. The only minor thing that I think happened is that the independent directors went from three to four. And the Smith elected directors went from seven to six, but I may not only know whose who on the Board that’s not something I pay attention to and it's essentially a non-event.

And what would happen if we get a phone call, same thing I would hope would happen with any Public Company in America. We would respond and look what's best for the shareholders.

Operator

And we do have a follow up from Ted Wheeler, Please go ahead.

Ted Wheeler - Buckingham Research

Yeah thanks. Hi if I look at the restructuring and cost initiatives you've put in. I am wondering if there is also measures such as salary freezes and short weeks or short time and may be deferrals as a benefit plans matching and that sort of thing. And if so what kind of clause will be coming back in to the Company when the sky is clear and the revenue outlook looks better and you know we are in to recovery.

Paul Jones

We have not done any, we've done some short weeks in our factories, we've had a lot of factories running four days not five. That's back to the being having the capability to respond quickly. We started that a year ago, that's nothing new, on the salary raise we have, we have done some pretty substantial salary reductions. But we have not done any furloughs of salaried people unpaid time off and we have not done anything relative to benefit to any benefit changes, we have not done salary freezes we have certainly not may be not have the salary increases we have had in years passed, the bonus programs obviously are going to be lower than what has happened in the past because the earnings this year are going to be down. All of our bonus programs are based on returns, share holder returns turn on invested capital. But no, our intent is you know if we have too many people we take care of that problem and reduce the total count. I am not a big fan of salaried people time off without pay. If you don’t need the people then go ahead and cut the costs and keep the people that you want to keep and keep them focused on the business.

Ted Wheeler – Buckingham Research

Thank you for the color. Again nice quarter.

Operator

(Operator Instructions). And to the presenters, there are no further questions in queue.

Paul Jones

Okay thanks everybody for being on the call.

Operator

Ladies and Gentlemen this conference is available for replay it starts today at 11 A.M. central and will last until tomorrow at mid night. You may access the replay at any time by dialing 1-800-475-6701 and entering the access code 106884 that number again 800-475-6701 and entering the access code 106884. That does conclude your conference for today thank you for your participation you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!