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Executives

Patricia Ackerman - Vice President, Investor Relations and Treasurer

Paul Jones - Chairman and CEO

Terry Murphy - CFO

Analysts

Ned Borland - Next Generation

Michael Schneider - Robert W. Baird

Scott Graham - Ladenburg Thalmann

Ted Wheeler - Buckingham Research

Presentation

AO Smith Corp (AOS) Q4 2009 Earnings Call January 26, 2010 10:00 AM ET

Operator

Ladies and gentlemen, welcome to the AO Smith Corporation fourth quarter 2009 earnings conference call. At this time all lines are in a listen-only mode. Later there will be a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder today’s call is being recorded. At this time, then I would like to turn the conference over to the Vice President, Investor Relations and Treasurer, Patricia Ackerman. Please go ahead.

Patricia Ackerman

Thank you Kent. 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 will now 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 couldn’t be happier with our 2009 result. We set all time earnings per share and operating cash flow records. 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.

A few highlights to consider. While sales were down nearly 14% from 2008, our earnings of $90 million were up 10%. Growth and higher margin China sales, a vast array of cost control programs and lower raw material and restructuring costs contributed to the improvement. Our operations generated almost $270 million in cash.

Our inventory reduction programs delivered some great results as levels declined by almost 25% or $70 million from the end 2008. As a result of the strong cash flow, we have paid down almost $100 million in debt since the beginning of 2009. And we paid for the Water Treatment acquisition with cash.

Our water heater operations in China grew 19% over 2008, higher consumer confidence in China as well as achieving the number 1 market share position, expansion into new geographies and new residential and commercial product launches, all contributed to the strong growth. Before I turn this call over to Terry to go through the 2009 details, let me share with you our thoughts underlying 2010.

First, the good news. We expect our Chine growth rate to be higher than China’s GDP as our customers continue to open new stores and new geographies and as our 2009 new product introductions like the solar water heater gained traction.

In 2010, we also benefit from the full year results of the China water treatment business which is expected to add between $0.10 and $0.15 per share. Additionally, the overall improvements made to our cost structure in 2009 will in general carry over into 2010.

What we learned going through the recession is that we now have a different definition of discretionary spending and is much broader and deeper than in the past. As a company we've also demonstrated to ourselves that we can remain focused on our customers and increase our own productivity. This is a great combination for our shareholders.

Finally we've seen some stabilization in the U.S. residential housing market and we expect a small increase in new home construction in 2010. We are forecasting housing starts to be around 850,000 in 2010, which is above the current run rate so there must be a pick-up during the year to achieve that number.

The caution in our guidance stems from the declines in our commercial volumes due to the global recession. In spite of the fact that about 75% of our commercial business is replacement, it's still the highest margin piece of both businesses and we expect the 10% decline in 2010, a smaller decline than we experienced in 2009.

In addition, while we enjoyed softness in commodity costs in the second half of 2009, the trajectory on steel and copper is marching north putting pressures on margins and the increases ultimately raise the pricing question.

Finally, in spite of closing our pension plan to new participants at the beginning of the year, we expect our pension cost to increase in 2010 by about $5 million. As a result of all these factors we've established full year guidance of $2.95 per share to $3.25 per share for 2010.

Terry will now talk about our financial results in more detail. Terry?

Terry Murphy

Thank you, Paul. Before I go through the financial results, I'd like to remind you that the required GAAP accounting for the Smith Investment Company transaction which posed in the second quarter of 2009 distorts our results on a historical basis. For that reason, we will provide non-GAAP information in this presentation. The reconciliation from GAAP to non-GAAP is provided in the press release that we issued this morning.

Total sales for the year declined to $2 billion from $2.3 billion last year. Despite the declines in volumes that we experienced in all of our North American end markets, we reported a 10% increase in earnings to $89.7 million or $2.96 a share compared with $81.9 million or $2.70 a share last year.

Total sales in the fourth quarter of $509.6 million were essentially unchanged from last year. However, earnings markedly improved to $20.7 million to $0.24 per share from $6.7 million or $0.22 per share last year. Taking a closer look at the individual segments, Water Products recorded sales of $1.38 billion, a 5% decline from 2008 sales of $1.45 billion. This segment benefited from a 19% increase in China sales that finished the year $219 million.

However, lower residential and commercial water heater volumes in North America overshadowed the strong progress in China. Electrical Product sales declined by 28% to $620.4 million driven by declining end market demand. Volumes in all of our strategic business units except distribution, experienced declines ranging from 25% to 40%. Distribution volumes were of high single digits as overall market declines were tempered by new business wins at our largest distribution customers.

Fourth quarter sales of $362.2 million of water products, were up 5% compared with fourth quarter of 2008, as the 32% increase in China sales more than offset residential and commercial water heater volumes in the US.

At Electrical products, fourth quarter sales of $148.4 million, declined 9% compared with the same period in 2008. Fourth quarter is typically the highest production quarter for our OEM customers and we were encouraged to see some evidence of improved demand in some of our global motor markets. Total operating profit increased 5% to $131 million from $125 million last year. At water products, 2009 operating profit of $148.9 million represented an 11% increase over 2008. Earnings were favorably impacted by higher margin China sales, aggressive cost reduction programs and lower raw material costs.

Operating margins grew to 10.8% in 2009, from 9.3% in 2008. Electrical products posted 2009 operating profit of $32.5 million compared with operating profit of $39.1 million last year. Significant volume declines were partially offset by repositioning savings, aggressive cost reduction activities and lower raw material and restructuring costs.

In addition, electrical products operating profit included an incremental $6.6 million favorable LIFO adjustment, net of lower absorption of fixed cost as a result of significant reductions in the inventory levels when compared with 2008; add $1.6 million of restructuring income, primarily associated with the sale of a plant in China also improved the 2009 operating profit. 2008 earnings included $8.7 million in restructuring expense and operating margins improved to 5.2% from 4.6% last year.

At Water Products, fourth quarter operating profit increased significantly to $44.5 million from $29.6 million in the fourth quarter of 2008. 32% growth in China water heater sales, aggressive cost reduction and lower raw material costs contributed to the higher profit. As a result, operating margins expanded nearly 400 basis points. Electrical Products are at $5.1 million in the fourth quarter, a significant improvement from the prior year.

Cost reduction programs implemented earlier this year, lower raw material costs and a $6.4 million net-favorable LIFO adjustment contributed to the improved performance. Fourth quarter 2008 earnings included restructuring charges of $2.9 million, Electrical Products operating margins improved to 3.4%.

Operating cash flow was almost $268 million in 2009, more than twice the operating cash flow of $98 million last year. A 25% reduction in inventory levels from the end of the year contributed over $70 million to this year’s operating cash flow. Cash cycle days of 42 were almost 25 days better than the year ago, primarily from the inventory reductions and improved vendor terms in China.

It should be noted that this cash flow result is after a $50 million contribution to our pension plans, which was made in the second and third quarters of 2009. We are projecting cash flow in 2010 to be considerably lower than 2009 due to the expectation that working capital will not shrink any further. We expect to generate $115 million to $125 million in 2010.

Capital spending was approximately $57 million, compared with depreciation and amortization of $68 million. Capital spending is expected to be between $75 million and $85 million in 2010 and the increase is due to the completion of the India water heater production facility and the construction of a new water treatment facility in China.

Depreciation and amortization is expected to total about $75 million. Our liquidity position and balance sheet remains strong. We paid down almost a $100 million in debt during 2009 and this was after purchasing the Water Treatment Company for $77 million. Our debt-to-capital to total capital ratio declined to 24% from 34% at the end of 2008.

We have limited amortization of our long-term debt portfolio in the coming years. Our $425 million credit facility does not expire until February 2011 and we had over $300 million of available capacity under the facility at the end of 2009. We expect to begin working on the renewal of that credit facility in the upcoming months. I’ll now present a few more details about our outlook and then we will open up the call for your questions. Paul?

Paul Jones

Thanks, Terry. Going into 2010, our largest concern would have to be the continued decline of new commercial construction. Despite the fact that about 75% of our commercial products are for replacement and as a result, our volume declines are somewhat insulated from the overall drop in commercial construction activity, these products represent the highest margins in both businesses. We expect commercial construction activity will experience a typical 18 to 24 month lag from new home construction and therefore we do not expect to see an end to the declines until 2011.

However, we do have some bright spots in this category, which should help mitigate the declines. We continue to gain market share in the commercial water heater segment as a result of our energy efficient Cyclone product line and we have seen evidence of some increases in orders in our commercial Motor segment in China from the depressed 2009 levels.

Revenue growth in 2010 will come from one, increases in new home construction; two, increases in consumer confidence which prompts home owners to replace failing systems and sort of fixing them; number three, increases in our customer's confidence prompts restocking inventories along the channel ahead of end market demand; and four, increases from our businesses operating in Asia; and number five, don’t want to under estimate this is new products. We have an exciting stream of new primarily energy efficient products being introduced as this year goes along.

Most forecasters expect housing starts to rebound in 2010. We are carefully watching for signs of increases in demand for our products. We will not add to our production resources until the demand is real and sustainable. We are determined to maintain our low cost structure and the benefits to arrive from our aggressive cost reduction and cash generation activities implemented in 2009. This will provide some margin leverage when demand does pickup.

We will finish our 2010 outlook commentary with Asia. Our 2009 sales in China inched over the $300 million mark in 2009. In 2010, we expect the total to be close to $400 million, coupled with the fact that our margins in Asia are better than in North America, this region plays a vital role in our gross strategy.

Many of you are familiar with our China Water heater story. Last year, our largest retail customers opened 100 new stores in tier two cities. This represents new retail footprint for us in addition to the 2000 stores already selling our products. In 2010, these customers are expected to add another 200 stores. In 2009, our water heater group initiated a new distribution channel for us in China by establishing about 300 independently owned stores. These stores sell water related products exclusively and some carry only A.O. Smith branded products. We expect to add another 200 or so such stores in 2010.

We launched several new products in China last year and 2010 will represent the first full year of sales for these products. Many have started to gain traction including the balcony mounted solar water heater and our tankless water heaters. We ended 2009 in the number one market share position in China residential water heaters. We go back and forth between first and second place with our largest competitor higher, a local China white goods manufacturer. All of these factors combine to back up our [GD plus] growth rate assumptions for our China water heater business.

Our foray into water related products started late last year when we purchased 80% of the leading residential reverse osmosis water treatment system manufacturer in China for $77 million. We closed in late November and therefore water treatment sales and earnings were not significant for us in 2009. We expect 2010 accretion to be between $0.10 and $0.15 per share from this acquisition. We will also introduce A.O. Smith branded water treatment systems in to our existing China retail distribution channel later this year. Expect meaning contribution from the branded product introduction in years to come.

We will leave the 2010 outlook discussion with a quick update on India. The production facility is progressing on our expected time table with a production launch in a few months. We're now selling AO Smith water heaters in 40 cities in India. Sales in 2009 were over $6 million and we expect 2010 to almost double 2009 results.

Profitability was negatively impacted by import tariffs in 2009, and again by fixed manufacturing costs in 2010, but India should be profitable for us in early 2011. So while we set an earnings record in 2009, and had some great momentum in Asia, we are cautious about 2010. Earnings guidance for the full year is projected to be between $2.95 to $3.25 per share. We welcome your questions and ask the operator to open the phone lines at this time. Kent?

Question-and-Answer Session

Operator

Great, thank you very much. (Operator Instructions). And our first question comes from the line of Ned Borland with Next Generation. Please go ahead.

Ned Borland - Next Generation

If we could talk margins and raw materials for a second here, in the water segment you saw unbelievable margins of north of 12%. As you have expectations of raw materials getting higher here, the increase in raw materials, how much do you think that’s going to impact your margins in that segment?

Paul Jones

Well, it’s tough to say, there’s a lot going on. We just got a new steel index this morning. Steel is now up almost 50% from where it was six months ago and it’s been moving up over the last few months. So, with our water heater business that’s half our cost of steel, over half. So it’s certainly putting some pressure on us right now. As far as the margins, it’s our objective to be above 12% in the water heater business.

We think that’s a good healthy business model to have. We have been continuing to reinvest back into the business, even as margins are well below that because we do take a long-term outlook with the business. This certainly is our long-term intent to have margins above 12% there continuously and that would easily allow us to continue to be the leader in new product introductions in the water heater market. [Technical Difficulty]

Ned Borland - Next Generation

Okay and conversely on the electrical side of the business, 4% operating margins. With all the costs tick off that you have had there and was this mostly a story of copper or volumes pulled through in the earlier quarters, from tax incentives and HVAC can you help us out with that?

Paul Jones

Yeah, that’s primarily volume and our volume was off significantly in the motor side and the fact that we still have operating margins at the considerably lower levels, I think is attributed to what that management team has done over the last several years and all the restructuring we’ve been doing, which every one of the restructuring projects has generated, the savings that they projected it would.

So while we are certainly not happy, our objective there is 10%, but the fact that we actually grew the margins last year with such a large fall-off in volume and is encouraging for what the future that business could hold. But we need to have the top line start to grow and we’ve got some new products coming out, we have got some new wins on our variable speed motors and we’ve got some other products in the pipeline, that’s got some encouraging feelings here about how that business will do long term.

Back to your other comments, copper is twice what it was a year ago right now. It’s certainly throwing a damper on things.

Ned Borland - Next Generation

Right and circling back on your comments on motor demand improving. I mean is that really underlying housing start data, what you expect or is that more about the new products?

Paul Jones

It’s a combination of things, I mean how these starts will certainly help, it’s primary reason for the big decline of adding some inventory reductions in the channel that we’ve already talked about many times, but we are excited about the new products coming on and what benefit those will give us going forward.

Ned Borland - Next Generation

Okay and then finally on cash, pretty impressive year for cash generation. Do you think on the horizon and the acquisition line, maybe something else in China?

Paul Jones

We are looking all the time as we reported before. We have on a long-term basis increased our corporate development staff and we have a lot more going on throughout Asia as well as other parts of the world looking for the right acquisition. I hope we developed a reputation for being good stewards of the cash and how we are very diligent about the acquisitions we make and make sure that we generate returns for the shareholders. But it is our intent to continue to grow the business and grow it with acquisition that not only are accretive, but cover the cost of capital very quickly after us making the acquisitions.

Operator

Thanks and our next question comes from the line of Mike Schneider with Robert W. Baird. Please go ahead.

Michael Schneider - Robert W. Baird

The electrical products division, the operating income this quarter was largely if not even more so entirely due to the LIFO benefit, so as you look forward now into 2010, can you just kind of give us the ups and downs of presumably higher production, higher raw material costs, just what your outlook is for pricing and electrical and I guess as that all rolls up, is it realistic to assume that margins rise much if at all in 2010 within electrical, again given the LIFO headwind hat you start with?

Paul Jones

Yes, Mike, we think they will grow because as we have mentioned, a lot of our pricing most of the pricing in this business segment is tied to contracts, so contractually as steel and copper move up, we are able to pass those costs through because of the agreements we have with our customers. The whole strategy with our motor business, it’s been a drag on our stock price; it’s been to finish the rationalization of the acquisitions that were made and optimize the business that we had and then start growing it.

We’ve got it optimized, not perfectly. We still have lots of things on our cost reduction list, but it’s now time to start growing the business and time will tell we will have to see how that plays out as the year and the subsequent years rollout, but it’s our belief that we’ve got the right products coming out. The marketplace is embracing, us bringing these products out and we'll see how successful we're going to be. We're always optimistic. We'll see how it goes.

Michael Schneider - Robert W. Baird

And distribution has been the channel you've grown most. I guess as you look forward this year, what channel would you expect to see electrical make the greatest strides?

Paul Jones

I think distribution will continue to grow. We've got a very good position in hermetic and I think that looks pretty good too. And we're focusing on all of them. In pump, we've got a huge market share; they are relying on the market to come back, primarily swimming pools. Whether that happens or not, we'll see.

Michael Schneider - Robert W. Baird

I presume within electrical, production rates will at least be equal to the sell-through this year. So that will be a tailwind for absorption. Currency with the moves in the [pacil], can you just give us a view on where you are on the hedging and what that looks like as a tailwind in 2010?

Paul Jones

Well the [pacil] is helping right now given that we've got such a large amount of production there. Yes, we will be, I should point out that with the inventory reductions, we increased service levels across the company. I've mentioned this before and people usually eyes glaze over, but we made it a pretty significant investment in our information systems in the company and we now have much better information and visibility to what's going forward.

So we've been able to reduce our inventories and increase our service levels. So, production ought to be at the sales rate which it wasn’t last year and we think that ought to help us also as we go forward. We won’t have the under absorption costs that we had last year, which obviously cut into the LIFO but the LIFO ended up being the number last year.

Michael Schneider - Robert W. Baird

Okay and then just one question on water. Within residential water in the U.S., typically the December quarter is a quarter in which your customers pre buy the price increases for the following year. At least my contacts suggest there's been no such price increases issued. So, does that mean that at least as best you can tell, there really wasn’t any pre buy activity in the December quarter within U.S. residential and presumably you benefit from that as we start 2010?

Paul Jones

Yes, there was no pre buy Mike, you're right.

Michael Schneider - Robert W. Baird

And remind me, what went on in Q4 of 2008. I presume there was little or no pre buying then?

Paul Jones

Q4 2008, we thought the world was coming to an end.

Michael Schneider - Robert W. Baird

Right.

Paul Jones

We were seeing and we were on this call last January. We had very little to say about how the future was going because we're watching the order rates fall precipitously but yeah there was no pre buy a year ago until our fleet people were, and our customer base was assured that their lines credit were going to be maintained. Customers tell us that they were afraid they'd get cancel even though they had excellent credit. So, there was a lot going. There were so many moving parts from September 15 of '08 through the first quarter of '09. So it’s hard to do any correlation between those two. I’m glad that period is over.

Michael Schneider - Robert W. Baird

Because if I am correct, you have not issued any price increases thus far for 2010 and Water?

Paul Jones

We don’t talk about pricing on this. So we are always looking, what we need to make sure that we're covering our cost and material and as I mentioned, our material costs are going up. So, I can't make any comments here Mike.

Michael Schneider - Robert W. Baird

But there is pressure then and for doing mid-year price increases within by U.S. Water?

Paul Jones

Yeah, there have been years, we did three in one year.

Operator

Great, thanks and our next question comes from the line of Scott Graham with Ladenburg Thalmann. Please go ahead.

Scott Graham - Ladenburg Thalmann

Very nice quarter. In the past call you have helped us in unbundling some of the segment sales in Electrical for example, you've talked about the sales numbers for these trends better or worse, what have you even, HVAC versus pumps versus general industrial and where in the past you've done sort of your retail, wholesale commercial thing. Would you be able to at least tell us which were the worst markets, which were the better markets in each segment this quarter?

Paul Jones

You know I would love to do that, but our competitors are listening to this call, and we found out that they were getting a lot more information out of that than we wanted them to get. So we have purposely stopped giving out segment information, and when our competitors give it out, we'll go back to doing it.

Scott Graham - Ladenburg Thalmann

Well, fair enough. Two other questions, back on the Electrical Products, I think because obviously, I don't think anyone has, I don't have any questions about the word in your business right now, but the Electrical Products margin obviously without the benefit of the LIFO is as was previously pointed out, operative at a loss in the last quarter, and I'm just wondering if we look at the month of December, did you see customers closing a week or two early? Does that impact the business?

Paul Jones

Yeah. We saw that all year last year. We had a lot of customers; where we were running four day weeks, a good part of the year of trying to maintain the flexibility to go back up in the market that continues. But our OEM customers did significant reductions in their production rates throughout the whole year.

Scott Graham - Ladenburg Thalmann

I guess then the follow-up question then Paul would be that, it then looks like the electrical products business from maybe more normalize standpoint than based on what you just answered there, is really running almost at breakeven level in the fourth quarter. And I guess I know the level of cost reductions that you've put through there and I know the realizations have all come through for you. But is there a next step here given what has happened. I know you are looking at to grow the business, I heard that. But operating that business at kind of a breakeven level in the fourth quarter I assume you're not satisfied with that.

Paul Jones

No but fourth quarter's always our worst quarter. It was a whole lot better in the fourth quarter a year ago and we were not upset with how the fourth quarter came out. It actually came out a little bit better and we thought it would as we went into the quarter and I was down at our operations last week reminding when the last year is over and we start over zero again. They are all focused on 2010 and we expect to be off to decent start this year.

Scott Graham - Ladenburg Thalmann

Okay, last question is about your balance sheet which obviously is in great shape and even post the acquisition which is as you pointed out you paid oft in cash. Are acquisitions the number one priority for uses of cash or could we see some a share repurchase authorization not that you would forecast that but is that on the priority list share repurchases?

Paul Jones

We have a share repurchasing authorization already that we have in place right now and we're always looking what we need to do. Our job is to increase shareholder returns. We increased our dividend last July. A lot of industrial companies did that last year. We evaluate that all the time both as a management team and with our board of directors. So it's our objective to increase returns to shareholders. If we can get a bigger return with an acquisition we'll do that but we're currently recognized that we are under levered as a corporation and we're well aware of that.

Scott Graham - Ladenburg Thalmann

Okay. I actually did have one other question. It was about SG&A which I'm throwing out the percentage of sales because of the decline in sales but on a grossed up basis, on a whole dollar basis, SG&A for the year was up and what I'm wondering is that in light of the fact that sales were down and part of SG&A of course is variable and some of the cost reductions did impact the SG&A, what would you say would be some of the increments of why SG&A actually went up because if we look at the 360-667 number there, cost reductions impacted that and as I said the variable cost nature of them. So it looks to me like you had I don’t know, somewhere between $15 and $20 million increase in SG&A x those items. Could you talk about that a little bit?

Paul Jones

Let me make a quick comment and then Terry is going to finish it. We have said that we are continuing to put resources in to electronics and product development and we've done that throughout even when as I joked earlier we thought the world was ending, we still went ahead with increases. We also did SG&A reductions last year. We had layoffs, two of them across the company that we're painful to do but necessary to do. It's not going to be flat across the board declines or flat across the board increases. We're managing the business the way we feel it should be managed both for the short term and the long term and with that being said, I will let Terry add a few more a little bit more color to what I just said.

Terry Murphy

Yes, Scott, when you look at that number, the $ 17 million increase, I am not going to go through each and every item, but I would say that there is a couple of million there relative to some legal issues, to some legal cases, there’s a little bit of pension increase in there. There is about $4 million in there increase as a result of China, increased SG&A in China, there is increased product liability cost in there of a $2 million, there is costs associated with the purchase of Tianlong.

So there is a combination of a number of things that make up that, some of which would not occur next year, but all in as Paul indicated we actually had made a lot of SG&A reductions. These kinds of things that I’ve pointed out with the exception of China, China and pension are kind of one-time increased accruals resulting from events that wouldn’t reoccur.

Operator

Thank you and our next question comes from the line of Matt Summerville with KeyBanc. Please go ahead.

Unidentified Analyst

Hi this is actually [Joe Riddick] on for Matt. You touched briefly on the variable speed and I was wondering if you could just give us an update on the development cycle there. Are there still field tests in place and how are those progressing and has there been any change in when you think that could be a meaningful contributor?

Paul Jones

There is a lot of field tests going on. We have had field tests going on for years with some of the customer base. I was just at the ASHRAE show yesterday in Orlando and saw four products of our customers that had our variable speed motors in them. So we haven’t had the huge wins there, but we're getting wins as we go forward, both variable speed in the pump market as well as HVAC. So it’s still starting.

We've gotten some very positive feedback on the test results we have so far and it’s one of those stay tuned, till we can talk about that piece of the business growing. I know our customer base wants it. We've developed the products. We feel good about the products we have. But when you’re an OEM supplier, there's a pretty lengthy approval process as there should be and right now we feel real good about where we stand with those.

Unidentified Analyst

Okay and then sticking with electrical products, I think you said you've seen improved demand from the OEM customers. Was that commentary based on what you're seeing in January so far or did you see that towards the end of the fourth quarter and are you seeing a more normalized seasonal bill heading into the kind of spring season.

Paul Jones

Compared to it, last year first thing that happens is stock getting worse and that was a positive sign. And then it leveled off and we're now seeing a little bit of an increase. This time last year, our customer base was telling us they were not going to do the seasonal build. We're not hearing that this year. So, we think we'll be in a more normal year and frankly comparisons to last year aren’t going to mean much as we go into this year.

Unidentified Analyst

Okay and then on the water side, kind of similar inventory question, there obviously was no pre-buy ahead of a price increase, but are you starting to get the sense that customer inventory, that customers are going to start building inventories in the channel. I know you mentioned that as kind of upside to the number, customer confidence restocking ahead of demand. Are you starting to see that yet or is that are we still kind of just-in-time delivery mode because the turnaround times are so short?

Paul Jones

I am going to say we are seeing a little bit of that, but I am going to also say that it couldn’t get any worse. We couldn’t get any lower channel inventory than we had last year. So, it’s expected that we will start seeing some and we are pursuing some, not a lot just once again, the first thing it happens is stock getting worse, then it leveled off, now we are seeing a little bit of an uptick in demand.

Operator

(Operator Instructions). And we are going to go to the line of Ted Wheeler with Buckingham Research. Please go ahead.

Ted Wheeler - Buckingham Research

You mentioned a bit of an uptick, I guess you said it was faint I guess on commercial hermetic in China. And I wondered if you could just refresh me as to where you are, say now on orders from where they were when before the downturn came, just try and get an idea about how far down that business is?

Paul Jones

From China or?

Ted Wheeler - Buckingham Research

Commercial hermetic in China?

Paul Jones

Commercial hermetic in China, it was down. I’m not going to talk about a specific, but our customer base is OEM, so we sell the product to and that’s a very much of a global product. We ship it all over the world with that product and it was all good double digits last year.

We are starting to see a little bit of an indication that they are going to have a better year this year than last year, whether it will be back to 2008 levels or 2007, I don’t know. I am always an optimist, I think we will go past those numbers, but for right now we haven’t seen the orders to do that. We have one fairly large customer that actually bought nothing for nine months last year. This is the customer that makes the hermetic for the shipping containers, refrigerator shipping containers and their back orderings, so that's a good positive signs.

Ted Wheeler - Buckingham Research

I guess by what you call in the peak might have been '07 and that…

Paul Jones

Well, it was early on, first half of '08 was pretty good, but, September 15th, I think when Lehman collapsed and everything else happened that our world changed at that point as everybody else's.

Ted Wheeler - Buckingham Research

Okay. And another one on the acquisition, the Water treatment business. What is your revenue expectation for that business? I guess as I recall, revenue is about comparable to the acquisition price on a run rate.

Paul Jones

No, revenue was below that, but the joke internally right now is we're taking revenue down on purpose. There were some export customers that they shipped to that we eliminated as a potential actually before we closed the business they stopped exporting. They export to you, if they did export to 30 countries, it's now 28 because we are at another back complying with all the laws and they were shipping to countries that we don't ship to, but time will tell. We're not giving out any revenue number on that at this point.

Ted Wheeler - Buckingham Research

Well, do you expect growth in revenues from the base after this discontinuance?

Paul Jones

Yeah. Yes, yes. We expect that to continue to grow.

Ted Wheeler - Buckingham Research

I mean you are exploring.

Paul Jones

I think market penetration is very slight there. We estimate 10% market penetration. We think there is a lot of demand for the product. We have a lot of plans in place relative to increasing the sales and distribution network especially taking it through the existing A. O. Smith one and we haven’t implemented any of that yet so while we’ve seen the plans and looked at the numbers and challenged some exercise the people putting the numbers together, we're not ready to go public of what we think that will be.

Ted Wheeler - Buckingham Research

Will it go into the A. O. Smith distribution channels with the A. O. Smith branded products I think you said will happen this year? Is that correct?

Paul Jones

Yes, that will happen this year.

Ted Wheeler - Buckingham Research

And will it get to a small fraction of those outlets starting out or will you go throughout the entire…

Paul Jones

We want to go across the board and the good news is, so do our customers. The OEM is just a little history. Our OEM customers, the [Sunnings and Gomez] have been pushing us to expand the A. O. Smith brand product line. We sell water softeners now that we're private label. We do a couple of things. We’ve spent a lot of money over the years establishing a very strong brand image in China and their whole point is take advantage of it and expand your product offerings and that’s what this is doing for us.

Operator

Operator Instructions). And at this time I am showing no further questions in queue.

Paul Jones

Okay. We thank everybody once again. We're very pleased with 2009 but its over and its time to get to work on 2010. Thanks for your interest in the company.

Operator

Great and thank you. And ladies and gentlemen this conference will be available for replay starting today Tuesday, January 26 at 11:00 a.m. Central Time and it will be available through Wednesday January 27 at midnight Central Time. And you may access the AT&T executive playback service by dialing 1800-475-6701 and then enter the access code of 142898. Now that is a domestic number or domestic within the U.S. or Canada. From outside the U.S. or Canada, please dial 320-365-3844 and again with the access code of 142898. So, those numbers once again 1800-475-6701 within the U.S. or Canada or 320-365-3844 from outside the U.S. or Canada. And again, enter the access code of 142898. And that does conclude our conference for today. Thanks for your participation and for using the AT&T's executive teleconference. You may now disconnect.

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Source: AO Smith Corp. Q4 2009 Earnings Call Transcript
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