A. O. Smith Corporation Q3 2009 Earnings Call Transcript

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A. O. Smith Corporation (NYSE:AOS)

Q3 2009 Earnings Call

October 16, 2009 10:00 am ET

Executives

Patricia Ackerman – Vice President of Investor Relations and Treasurer

Paul W. Jones – Chairman and Chief Executive Officer

Terry M. Murphy – Chief Financial Officer

John J. Kita – Senior Vice President of Finance

Analysts

Michael Schneider - Robert W. Baird & Co., Inc.

Ned Borland - Next Generation Equity Research

Scott Graham - Ladenburg Thalmann & Co.

Paul Mammola - Sidoti & Company

Matt Summerville - Keybanc Capital Markets

Ted Wheeler - Buckingham Research Group Inc.

Operator

Ladies and gentlemen, thank you for standing by and welcome to the A. O. Smith Corporation’s third quarter 2009 earnings call. (Operator Instructions) As a reminder, today’s conference is being recorded and I would now like to turn the conference to your host, Miss Patricia Ackerman, Vice President of Investor Relations and Treasurer. Please go ahead.

Patricia Ackerman

Thank you, [Kaylee]. 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 morning’s press release.

Paul, I’ll turn the call over to you.

Paul W. Jones

Thank you Pat and good morning, ladies and gentlemen. Before we get into the highlights let me say that we couldn’t be happier with our third quarter results. We set an all time quarterly earnings record. The challenges of the global recession are still present, but our focus on cash generation and cost reduction have really paid off for our shareholders.

Let me cover a few highlights to consider. First, while sales were down nearly 17% from last year, our third quarter earnings were up 62%. A vast array of cost control activities and temporary softness in raw material prices benefited both businesses. Second, our water heater operation in China grew 35% over last year. Higher consumer confidence in China as well as expansion into new geographies and new residential and commercial products all contributed to the strong growth year-over-year. Third, our operations generated almost $198 million in cash during the first nine months of this year. Our inventory reduction programs delivered some great results as levels declined by over 20% or $63 million from the end of last year. Additionally, improved terms with our vendors have now resulted in negative working capital levels in China. As a result of the strong cash flow, we have paid down over $100 million in debt since the beginning of this year.

And fourth, due in large part to the success of our cost management efforts, we increased our 2009 earnings guidance. Our non-GAAP earnings guidance for the full year is now a range of $2.60 to $2.75 per share, an increase from the $2.05 to $2.25 range that we gave during our second quarter conference call in July. Our forecast on a GAAP basis is $2.95 to $3.10 per share.

Terry Murphy will now elaborate on our third quarter financial results. Terry?

Terry M. Murphy

Thank you Paul. Before I go through the third quarter financial results, I’d like to remind you that the required GAAP accounting for the Smith Investment Company transaction is different than the accounting we show here on a historical basis. For that reason, we will provide a reconciliation from GAAP to non-GAAP in the press release that we issued this morning.

Total sales in the third quarter declined to $501.5 million from $602.7 million last year. Despite the declines in volumes that we experienced in all of our North American end market, we reported higher earnings of $34.6 million or $1.14 a share compared with $21.4 million or $0.70 a share last year. Our 2009 results benefited from two favorable items, the sale of our Shenzhen China facility which generated a net gain of about $3 million and a $1.5 million tax benefit from the closure of our 2005 and 2006 federal income tax returns. Collectively these items added $0.15 a share to our third quarter earnings. The 2008 earnings per share included restructuring charges at Electrical Products Company amounting to $0.05 a share.

Sales of $336.7 million in our Water Products business were off 10% from last year and masked sales increases in China of about 35%. Commercial volumes were down more than residential volumes, but both were off by more than 15%. We estimate that the industry’s residential replacement volumes in North America are now about 93%, reflecting housing starts of historically low levels of below 600,000 new homes.

Electrical Products sales declined by 28% to $165.9 million, driven by declining end market demand. Despite continuing to add business at some of our large distribution accounts, volume in all of our strategic business units except distribution experienced double-digit declines. Distribution volumes were off high single digits. The largest volume declines were in our heating and air conditioning, pump and general industries strategic business units.

Total operating profit increased by 46% to $48.5 million from $33.2 million last year. Operating profit at Water Products was $38.7 million, up 18% from last year. Operating margins improved to 11.5% from 8.8% last year as a result of increases in higher margin China sales, aggressive cost reduction programs and lower raw material costs.

Electrical Products boasted a third quarter operating profit of $22.8 million compared with operating profit of $10.6 million last year. The profit improvement was the result of saving from its 2007-2008 repositioning activities, lower raw material costs, a $3 million net benefit from the sale of the Shenzhen plant and a year-over-year $2.2 million favorable LIFO adjustment. Operating margins improved to 13.7% from 4.6% last year. One further comment on the plant sale in China, as we relocate production out of Shenzhen over the next six months we expect to incur moving and severance costs which will partially offset the net gain recorded in the third quarter of this year.

Operating cash flow was almost $198 million in the first nine months, which was considerably better than the operating cash flow of $75 million last year. In fact, after CapEx and dividends, free cash flow was over $100 million. A 22% reduction in inventory levels from the end of last year contributed over $60 million to this year’s operating cash flow. Cash cycle days of 49 were almost 15 days better than a year ago, primarily from improved vendor terms in China. It should also be noted that this cash flow result is after a $50 million contribution to our pension plan, which was made in the second and third quarters of this year.

Through the third quarter, capital spending was approximately $38 million compared with depreciation and amortization of $51 million. Capital spending for the full year is expected to range between $55 and $60 million. Depreciation and amortization is expected to total $70 million.

We’re projecting operating cash flow of $190 to $200 million in 2009, about where we ended the third quarter as we expect that our China operations will use working capital between now and the end of the year and our electric motor division may build some inventory ahead of the spring selling season.

Our liquidity position and balance sheet remain strong. Our debt to total cap ratio declined at 24% from 34% at the end of the year. We have limited amortization of our long term debt portfolio in the coming years. Our $425 million credit facility does not expire until February of 2011 and we had over $325 million of available capacity under the facility at the end of the quarter.

Paul will provide some details on the acquisition which we announced last month and talk about our outlook and then we’ll open up the call for your questions. Paul?

Paul W. Jones

Thanks Terry. Last month we announced our intentions to purchase 80% of the assets of Tianlong Holding Company for $77 million. We are excited about the growth opportunity that water treatment represents.

Several factors make China a particularly rich environment for growth in water treatment. First, the economy has been growing at about 8% per year and is expected to continue to grow at at least that rate. Second, our research indicates that the market for water purification equipment is expected to grow annually more than 30% over the next three to five years. Several factors will drive this greater than GDP growth.

The Chinese government has done a great job of bringing water to the cities. However, after years of industrial waste, the majority of the water is polluted. Second, as living standards have improved and the economy opens up, the population has become more educated about the poor quality of its water. The Internet has been a large part of this education. The most popular solution in China at this time is to buy a dispenser for your home and haul large jugs of water back to your apartment or home, or to purchase single-serving bottles of water. The quality of this purchased water, however, is starting to become suspect. Consumers are looking for alternatives and the in-home, point of use appliances that Tianlong makes are attractive solutions.

Tianlong is the market leader and what comes with that is a quality product line, manufacturing and product development expertise, and well developed customer and supply chain relationships. The current owner who will remain in the business is well regarded in the industry and a passionate advocate for the health benefits of Tianlong’s water purification technology.

One of the strengths we bring to the acquisition is our retail distribution, now over 2,000 stores and our strong brand in China. We expect to have an A. O. Smith branded system in the retail channel next year. We expect to maintain the existing distribution channel and continue its growth. Finally, our existing customer service and marketing investment and our manufacturing expertise will provide synergies over time.

The majority of Tianlong’s current business is domestic sales in China, primarily through distributors. However, about 30% is exported to other developing countries where water purification is a real need. We expect the acquisition will be accretive to earnings from the start, as the profit margins are similar to those which we currently are experiencing in our China water heater operation. We expect that the acquisition of Tianlong will earn more than its cost to capital by the end of next year and we anticipate closing the transaction in the fourth quarter.

In discussing the outlook for the fourth quarter I want to touch on four items; the stabilization of our residential end markets, our China volumes, raw material costs and our cash conservation coupled with cost reduction activities. Let’s start with the residential markets. We are starting to see signs that declines in new residential construction have leveled off. We don’t know how they could have gotten any lower. In the last couple of months, annualized new housing starts have bottomed out in the 500,000 to 550,000 annual range, although we don’t expect to see that number increase much anytime soon as the supply of foreclosed homes needs to be worked down. In addition, our commercial end markets are still seeing new construction spending declines and we expect that our commercial volumes will continue to decline into 2010 as well. Finally, the fourth quarter is typically one of the lowest volume quarters in our more seasonal segments such as air conditioning and pool pump. So we expect softness in our Q4 sales compared with the third quarter.

Second, we are expecting our China water heater business to grow about 10% in 2009. Our China water heater sales were up 35% in the third quarter after being down 10% in the first quarter and up 16% in the second quarter. We’ve said it before. The China stimulus package is bolstering consumer confidence and ending up in consumer’s wallets and they are opening those wallets and buying goods.

Third, raw material costs especially steel have marched upward 30 to 40% after reaching their lows in the second quarter. Because our costs are indexed, they lag the market by about 90 days. Therefore we have good visibility into what our costs will be in the fourth quarter. This will pressure margins when compared to the third quarter.

Finally, we continue to focus on conserving cash. These programs have already generated great results as evidenced by our strong cash flow, and the programs will remain in place for the foreseeable future. We expect to be well positioned with a lean cost structure that will allow us to leverage our position as the economy improves. So while we set an earnings record in the third quarter, we remain cautious about the fourth.

Our earnings guidance for the full year is now a range of $2.60 to $2.75 per share on a non-GAAP basis, an increase from the $2.05 to $2.25 range that we gave during our second quarter call in July. And on the GAAP basis which we don’t think is a relevant way to look at the company, it’s $2.95 to $3.10.

We now welcome your questions and we ask Kaylee to open up the phone lines at this time.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Michael Schneider - Robert W. Baird & Co., Inc.

Michael Schneider - Robert W. Baird & Co., Inc.

First I guess on motors, the margins and actually revenue were both impressive. Can you just address on revenue? It’s unusual that motor sales would be sequentially and just given the seasonality of HVAC could you just give us some color on what actually improved sequentially and why?

Paul W. Jones

Sure Mike. We’ll remind you on this year we did not get the normal inventory build that we’d normally get in the March, April, May time period. Consequently in June when people start turning on their air conditioners and their swimming pool pumps they were having failures and they had to wait for the product, but we did see a bump up in business in pool pumps and hermetic especially. And the encouraging thing to us is you know three years ago we laid out our roadmap to profitability for the motors business of a couple of points each in three different categories, managing assets better and getting our cost structure in line and managing the products we offered and the customers we served. Those things are working. Unfortunately the great recession has hit us and it wasn’t visible.

But we got some visibility into that in the third quarter with really not a large jump up in volume but a very, very encouraging that when the volume jumped up, the margins fell through. So when the economy comes back and we get back to normal levels we’re quite excited. We believe the motor business will be achieving the 10% operating profit that we laid out three years ago. You know without the Shenzhen sale and the LIFO benefit we were about 10% last quarter.

Michael Schneider - Robert W. Baird & Co., Inc.

And just the distribution business, did you see a similar pickup in that business? Because it seems to me to be probably a better barometer of just GDP.

Paul W. Jones

Yes. Distribution business was very strong in the third quarter, relative to where we are in the marketplace. And we picked up a little bit more business in distribution that kicked in a little bit of volume, too, during the quarter.

Michael Schneider - Robert W. Baird & Co., Inc.

And then just on margins, so if we do kind of the elevator ride and we scrub motor margins and the one time benefits and the LIFO adjustment, operating income was up about $10 million sequentially and $3.5 million more in sales sequentially, so obviously a huge flow through there. Of that $9 million that I would estimate is probably outside of volume increases, how would you bucket the $9 million between materials and what I would call more structural savings as a result of the cost reduction activity?

Paul W. Jones

That’s hard to say, Mike. I mean material cost was a large part of it because we did hit a bottom on steel in the second quarter. The one thing you didn’t mention, we do have lower cost products, lower cost designs in the marketplace than we had a year ago. We’re continuing to roll those out every month. We did have some mix benefit. We are having some success with our energy efficient products, which come with higher margins. You know we have a variable speed pump program that’s working very well. So there’s a lot of moving parts in this thing and I think it would not be telling the whole story if you say boy, I got a really big benefit from material costs, even though that did have some tailwind in the quarter. A lot of other things are really clicking in the motor business.

Terry M. Murphy

We also had some one time in the second quarter, Mike, where we had those excess copper contracts of $2 million that hurt us in the second quarter that we talked about. We also had some negative absorption in the second quarter. The CPC took their inventory down quite a bit in the second quarter and that did not repeat itself. So as Paul said it was clearly not only raw materials.

Operator

Your next question comes from Ned Borland - Next Generation Equity Research.

Ned Borland - Next Generation Equity Research

Let’s go with China here. You know a significant acceleration sequentially it looks like. I mean last quarter you were talking about it was going to be up single digits for the year and now you come in with a 35% increase. Is this just all China stimulus or what’s going on here?

Paul W. Jones

The China stimulus is a lot of it. And the stimulus is oriented towards a lot of second and third tier cities. And our partners there, the retail customers especially Suning have really been accelerating their growth into that area.

I’ll give you one little statistic. This is a company that five years ago had 30 stores. They added 50 stores on October 1. On the one day. They were doing it ahead of the Chinese holiday. So we had to have product available in those stores, but the sales will come in the fourth quarter. Remember we put the product into those stores on a consignment basis and so we expect to get some continued volume growth in China. That 10% for the year might be conservative now because we had a $24 million water heater month in September and our folks over there tell us that that’s incremental to the year. That was not stealing from the fourth quarter. So the China economy is really coming back quickly. They’re offering incentives, especially in the rural areas for people to buy appliances. And some of these stores may be selling only two or three a day but still it’s all incremental to us and we’re delighted with what’s going on there.

Ned Borland - Next Generation Equity Research

And then sticking with China for a second, the filtration business, you know what, it’s the market leader Tianlong is but how fragmented of a market are we talking about? And is there potential for a further consolidation of that market?

Paul W. Jones

It’s a very fragmented market in China at this point. We’ve been looking at it for about a year and a half. We had about 40 companies that we started out and we pared it down to three and then went ahead with negotiations with those three. Tianlong is the market leader. They have number one share and are experiencing the fastest growth rate. So that obviously was our primary target and we’re delighted to have gotten to a deal with them.

And you know the market’s still way under penetrated. We believe the penetration rate in China is below 10% so we think there’s a long runway ahead of us. And we think the best way to win is to pick up the market leader and ride with them. And as to further consolidations, absolutely. Those are certainly a potential.

Ned Borland - Next Generation Equity Research

And then circling back to the motors margins you know I noticed that last year you had a decent second quarter of ’08 you know, coming in about 9% or so, 9.3%, you know but it was unable to be sustained. I’m just wondering you know what are you seeing now that gives you confidence that these are more sustainable going forward?

Paul W. Jones

Well we’ve been continuing the cost reduction activity. You know what happened last year was the third quarter the world came to an end. We saw our order rates plunge in the third quarter. While we work with a small backlog, it’s not a large one. So essentially what’s happened, you know the second quarter of last year probably compares better with the third quarter of this year than those four quarters in between that we’ve had to get through. So that’s probably one way to look at it.

And we have not let up on the massive redesign efforts and standardization efforts as well as the manufacturing footprint consolidations to continue to get our costs down. The real short plan is still the same thing. Get to a profitable base and then grow from there. We’re to the profitable base and now we’re focusing on the growth.

Ned Borland - Next Generation Equity Research

And then finally on steel overall, I mean you’ve noted that the steel index has moved up. How does your inventory cost of steel look right now? I mean are you still working through some of that low cost steel from the second quarter?

Paul W. Jones

It’s gone. We tried to buy more but the mills were just not shipping. You know, why should they ship it to us at one price when they can get $150 or $200 a ton more for it a week later, two weeks later? So we’re working off of essentially the third quarter. I think we saw the CRU Index go up $197 over the last three months and that’s indicative of what we’re paying this quarter. And we just got the October numbers and they were about $40 a ton more than we thought they would. They moved up even more than they thought we would and that’s giving us an indication of first quarter next year.

Operator

Your next question comes from Scott Graham - Ladenburg Thalmann & Co.

Scott Graham - Ladenburg Thalmann & Co.

I do want to kind of split Mike’s question maybe a little bit of a different way. I’m trying to as I think many of us are triangulate to what was raw materials, what was restructuring and what was let’s say beyond restructuring. So were the restructuring savings in the quarter in line or above your expectations?

Paul W. Jones

In line because we said $20 million this year and its $5 million in the quarter. That’s just one of those three steps on our roadmap that was optimizing our assets. But that’s permanent. We’re going to keep that savings forever.

Scott Graham - Ladenburg Thalmann & Co.

So there were actually some blocking and tackling improvements here, over and above restructuring. I’m wondering if you could tell us kind of where that’s coming from. And I’m specifically talking about in Electrical Products first.

Paul W. Jones

Okay. Well both of our operations are doing a terrific job on productivity. The plant operations, the way we measure them continued to improve month after month after month. We of course do all the forecasting and the plant operations, even with the lower volumes, have been coming in with better than forecasted results. And it’s a combination of everything, you know labor productivity, efficiencies in the factories. We do a, we call them [Kizan] events every week in every plant. We’ve freed up a lot of floor space in every plant. That’s allowing us to do some consolidations in Mexico that we’re not even talking about. You’re not going to hear us say eating a restructuring charge, but if we can empty a building in Mexico and consolidate into another, we get some fixed factory overhead goes away as well as some SG&A and some indirect factory costs.

It’s a lot of things like that that I want to make sure that the company is getting credit for doing. Because that’s going to be with us month after month as we go forward. We’re going to continue to ride this elevator ride of material costs, you know copper, aluminum, steel, etc. and all we can do there is try to buffer it with maintaining margins by making sure that we have the right price-cost relationship. But on top of that, standardizing product, redesigning products such as that takes less steel and the factory productivity programs are a major focus of our company.

Scott Graham - Ladenburg Thalmann & Co.

So would you care to say that some of the things that you’re doing in the restructuring, for example the standardizing of the products that you just mentioned is maybe having more benefit than you expected because its kind of got long arms, it effects other areas of the factory and other operations. Would that be fair?

Paul W. Jones

Well, all these things are interrelated. By the way, don’t rule out mix. One of the three elements we focused on three or four years ago was product optimization and customer optimization. And that’s paying off for us. We don’t have any blow water deals with customers anymore. And in both businesses now we’re up to a margin level that we can continue to work on some new products. I’m looking forward to having that conversation with you in the near future as we start to rollout some of the products we’ve been working on the last two or three years that we think are going to make a pretty significant impact on the marketplace.

Scott Graham - Ladenburg Thalmann & Co.

Kind of the same question on Water Products and I know that some of your comments are going to be repeat comments in terms of the factory improvements. But I guess where I’m going with this is if we look at mix, so China was strong so that aids, but then commercial was weaker than construction so that tracks, would you say that those are kind of offsetting? And then if we unbundled the rest of the incremental, we kind of arrive at raw materials plus operating improvements? Do you know what I’m saying?

Paul W. Jones

Yes. I think that’s probably a fair way to do it. You know commercial is declining. We think it’s going to continue to decline, based on our forecast. But it’s not going to have the decline residential had. We don’t have a sub-prime problem with commercial, the new commercial construction. And we still enjoy a very healthy replacement business in commercial. So we’re not going to see that market dropping you know by the 75% level or so over the last three years that new housing construction did.

But it’s still declining, but yes its as everybody knows a good margin business for us. But the strength in China has certainly offset that and the residential is essentially a flat line. Our replacement business on residential now is over 92% of our sales. That’s down only 8% new construction it was 20% a couple of years ago.

Scott Graham - Ladenburg Thalmann & Co.

This is on the water heater business so in res we obviously this spiked north of 90% is kind of difficult to explain if you don’t assume that maybe some people are somehow repairing units, which is you know kind of odd for the market. But I’m wondering on the commercial side that trend I think is potentially more real on the repair. So I’m wondering, are you doing anything with your business to position yourself for commercial parts pickup going forward?

Paul W. Jones

Yes. That’s a real good question, a real good observation. We are seeing two things. One is that when there is a repair that can be done, more and more people are doing it. The other thing is we’ve come to understand there’s a discretionary replacement. There are people that you know have three teenagers at home and a 40 gallon water heater. They’re delaying putting that 80 gallon in or putting another 40 gallon in. So both of those things are happening.

But to your specific point, do we supply the parts. You know we supply parts for our own product and we supply the parts to many of our competitors and our parts business is up this year.

Operator

Your next question comes from Paul Mammola - Sidoti & Company.

Paul Mammola - Sidoti & Company

On the cost savings, Paul, would you say its fair that this is all permanent and you could realize its all through 2010? Or do you expect some variable costs to come back in terms of shifts? I guess what are your thoughts on that?

Paul W. Jones

Well you know I think it is going to stick. We still have some of our factories we’re running a four day week. That’s not real efficient, but we can get a 25% bump in output just by adding the fifth day. You know we save a little bit on the labor but we still have the full benefits costs of those employees. So I think there’s some pluses and minuses that will come in as we ramp up. But you know everything other than material we feel pretty good about our handle on that going forward. Our plants are productive, continue to be more productive.

You know Terry talked about capital spending and we do have that pretty healthy fourth quarter capital spend ahead of us compared to what we’ve done the last three quarters. One of those projects is a significant productivity improvement that has a very nice internal rate of return on it that we’re doing in one of the water heater factories, for example. And we’re also finishing the factory in India. We’ll have that up and running early next year.

Paul Mammola - Sidoti & Company

So I would assume that you’ll stay on a four day week at most of those plants in the fourth quarter. Correct?

Paul W. Jones

Probably. Yes. And we may take an extended Christmas shutdown and things like that.

Paul Mammola - Sidoti & Company

And then on new products, you talked about China and what was driving that but I think we had talked about a solar water heater on the balcony mounted and I was wondering if that was a part of the growth and maybe some of the other new products that were launched there. And what the penetration rate is for that stuff right now.

Paul W. Jones

Yes. The solar product has gotten off to a terrific start and that is part of what we had in the quarter. I actually got to see some of those units last month. And you know people are delighted with them. They cut the electricity cost use by 75% in the Shanghai area and the Nanjing area. Nanjing was where I actually saw them. So you know as they go further south they actually cut even more. That’s a great product. We’re expanding our commercial offering in China and that’s got a nice upward growth to it. And we have some more things coming out very soon.

Paul Mammola - Sidoti & Company

Paul, what do you think the penetration rate is on that solar water heater?

Paul W. Jones

Very, very small. You know if you’ve been to China and seen all the high rise buildings, some of these can only get sun three or four hours a day on the balcony. And that’s still enough in the Nanjing area to get enough water in the storage tank, which is very well insulated and holds the hot water and keeps it hot that these things are selling. People are excited about them and they’re buying the product.

Operator

Your next question comes from Matt Summerville - Keybanc Capital Markets.

Matt Summerville - Keybanc Capital Markets

Paul, you kind of walked through where you were from an inventory standpoint with regards to steel on the raw materials side. Can you sort of walk through where you are with copper as well? If you still have any lower cost copper that’s flowing through the P&L?

Paul W. Jones

Yes we’ve got some but we’re essentially at our normal hedge rate where we don’t have any underwater contracts anymore like we had earlier in the year when copper got down to $1.75. But its been moving up you know pretty regularly since then, since the spring, just like a lot of other things. But we were hedging obviously a little heavier when copper was at $1.75 to $2.00 range, along with our customers. Again we do most of our copper hedging alongside customers that we’ll get together with them and decide to hedge a certain percent of their volume at some determined level into the future.

Matt Summerville - Keybanc Capital Markets

If we look at the fourth quarter, obviously you give annual guidance, but if you kind of go through the math it looks like your earnings guidance would fall in the range of $0.35 to kind of $0.50. If we assume you did about $1 in the third quarter excluding the $0.15 worth of good guys one time that you pointed out, I guess help me bridge that sequential decline. I guess what kind of sequential volume decline are you looking for in your overall business relative to the third quarter that would underpin that kind of sequential decline in EPS?

Paul W. Jones

Well if you look at our company historically, fourth quarter is the low volume quarter. So volume is the first thing I’m going to mention. You know we have the holidays and everything else. Shenzhen, yes.

Terry M. Murphy

The benefit this quarter in Shenzhen, we’ll have expense in the next quarter in Shenzhen.

Paul W. Jones

Yes, the Shenzhen $3 million or so benefit we’re actually going to use a lot of that up over the next several quarters. The accounting rules don’t let us take all of those expenses until we actually incur them. So that will be a part of the fourth quarter. And material costs is going to be part of the fourth quarter, primarily steel. But the first thing I’d mention is volume. Probably the second element would be material. And the third would be there’s some Shenzhen expenses that come into play that eat into the one time gain that we had this quarter.

Matt Summerville - Keybanc Capital Markets

Terry, how much of that $3 or thereabouts would you anticipate in Q4? And then what’s left over for 2010? And then I think in your prepared remarks, Terry, you mentioned what your year-to-date pension contribution has been. I missed that unfortunately. Can you give that again?

Terry M. Murphy

Okay, relative to the Shenzhen expenses there’ll probably be about $0.5 million in the fourth quarter and then maybe another $1 million in 2010. And relative pension contribution, we made a pension contribution of $50 million this year, cash contribution.

Matt Summerville - Keybanc Capital Markets

And that’s included in the $190 to $200 operating cash flow guidance, correct?

Terry M. Murphy

Yes. That is.

Matt Summerville - Keybanc Capital Markets

And then what are your thoughts on cash contributions next year based on kind of where you’re at today?

Terry M. Murphy

We actually made a higher contribution this year for tax purposes than we had really thought about at the beginning of the year. I expect that contributions will be high but less than $50 million next year. Probably in the $35 to $40 million range next year. And maybe at that level for a couple of years. Then it will shoot up, all the things being equal after we’ve amortized the past gains, the pension contribution would shoot up quite dramatically unless the markets improve.

Matt Summerville - Keybanc Capital Markets

And then just one final question on pricing. Can you kind of update us what you’re seeing in terms of pricing right now in both of your businesses? And given your comments on raw material and inflation kind of ticking up, do you think that gives you any incremental pricing power in 2010?

Paul W. Jones

Well, once again we cannot be very open about that because our competitors are on this call. And obviously if material costs keep going up, there’s going to be some upward pressure. But we’re not going to talk about anything relative to pricing in either business.

Operator

Your next question comes from Ted Wheeler - Buckingham Research Group Inc.

Ted Wheeler - Buckingham Research Group Inc.

I just wanted to hone in on maybe one comment you made. That was that the steel indices this month look like they’re $40 a ton, a little ahead of your plan. And it might impact the first quarter as it flows through. Now can you change and will you change pricing to basically offset that?

Paul W. Jones

Well the steel index, we thought it’d go up about $30 and it went up about $70, the October CRUN Index. So that’s really what we’re talking about. And that’ll impact our costs in the first quarter. You know obviously we have a very strong priority to maintain margins.

Ted Wheeler - Buckingham Research Group Inc.

Well, just as a practical matter, excepting for competition which I guess is a big concern, too, but from a timing point of view there’s no barrier to you adjusting prices and capturing that.

Paul W. Jones

No. You know one exception is our motor business. We have a lot of our OEMs are on a contract. So it’s got an escalation or de-escalation clause and those kick in every quarter as we incur the higher costs, we’re then able to pass that along to our OEM customers. But on the water heater side we have limited contracts and yes we can do anything at any time there, you know given the competitive situations.

Ted Wheeler - Buckingham Research Group Inc.

If the timing is such that everyone’s got this issue and presumably pricing will adjust to keep that cost from being a hit for anybody.

Paul W. Jones

We’ll see. We’re not going to make a price announcement in our earnings call. We’ll do that separate.

Ted Wheeler - Buckingham Research Group Inc.

But you have the wherewithal and the timing is such that you could do it if you wanted.

Paul W. Jones

The industry has a long history of end of the year price increases. We’ll see.

Operator

And speakers, there are no further questions in queue at this time.

Paul W. Jones

Okay. Well thanks Kaylee. Thanks everybody for being on the call. We’re going to go back to work on the fourth quarter. Any other questions, give us a call.

Operator

Thank you. And ladies and gentlemen this conference will be available for replay after 11:00 AM Central Time today until October 17 at midnight. You may access the AT&T Executive Playback Service at any time by dialing 1-800-475-6701 and entering the access code of 118098. International participants may dial 1-320-365-3844 again with the access code of 118098. That does conclude our conference for today. Thank you for your participation and for using the AT&T Executive Teleconference Service. You may now disconnect.

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