A. O. Smith's (AOS) CEO Ajita Rajendra on Q4 2015 Results - Earnings Call Transcript

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A. O. Smith Corp (NYSE:AOS)

Q4 2015 Earnings Conference Call

January 29, 2016, 10:00 AM ET

Executives

Patricia Ackerman - VP, IR & Treasurer

Ajita Rajendra - Chairman & CEO

John Kita - CFO

Analysts

Ryan Connors - Boenning & Scattergood

Kevin Maczka - BB&T Capital Markets

Robert McCarthy - Stifel Nicolaus

Jeff Hammond - KeyBanc Capital Markets

Mike Halloran - Robert W. Baird

William Bremer - Maxim Group

Bhupender Bohra - Jefferies

David Rose - Wedbush Securities

Operator

Welcome to the A.O. Smith Fourth Quarter 2015 Earnings Call. [Operator Instructions]. I would not like to introduce your host for today's conference, Mrs. Patricia Ackerman, Vice President of Investor Relations and Treasurer. Ma'am, you may begin.

Patricia Ackerman

Thank you Eric. Good morning, ladies and gentlemen and thank you for joining us on our 2015 fourth quarter and full year results conference call. With me, participating on the call, are Ajita Rajendra, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer.

Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking 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.

Also, in respect of others in the question queue, please limit yourself to one question and one follow up per turn. If you have multiple questions, please rejoin the queue.

I will now turn the call over to Ajita, who will begin his remarks on slide 3.

Ajita Rajendra

Thank you, Pat and good morning, ladies and gentlemen. 2015 was another excellent year for A.O. Smith, setting records for sales and earnings. We continued to see healthy end markets for U.S. commercial water heaters, our Lochinvar branded products, and our consumer products in China. We believe our organic growth outshines almost all other industrial companies.

Here are a few highlights. Organic growth in both of our segments drove sales nearly 8% higher to a record $2.54 billion. Excluding the impact from the strengthening U.S. dollar against the Canadian and Chinese currencies, our sales grew over 9% in 2015. Despite being a sales record, this was lower than our previous estimate for the year as our year-over-year U.S. residential water heater volumes declined in the second half of the year, similar to the industry. China sales were up over 16% in local currency. Record net earnings of $3.16 per share were 30% higher than our adjusted earnings per share of $2.43 in 2014.

We continue to review our capital allocation and dedicate a portion to return to shareholders. We repurchased approximately 1.9 million shares for $128 million during the year. We increased our dividend by 26% earlier this week, following the similar increase one year ago. And during 2015, we returned almost $200 million to our shareholders.

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

John Kita

Thank you, Ajita. Sales for the full year of $2.54 billion were 7.7% higher than the previous year. Net earnings of $283 million improved 28% from 2014. As shown on slide 5, net earnings of $3.16 per share improved 30% compared with adjusted earnings per share of $2.43 in 2014. Sales in our North America segment of $1.7 billion increased 5% over 2014, driven by price increases in the U.S. and Canada for residential and commercial water heaters and higher volumes of commercial water heaters and condensing commercial boilers in the U.S.. Based on our shipments, we expect residential water heater industry volumes in the U.S. to decline by approximately 300,000 units in 2015.

Rest of world segment sales of $866 million increased 13% compared to 2014. China sales increased $95 million, driven by higher demand for water heaters and approximately $35 million of incremental sales of A.O. Smith branded water treatment products. Our newly launched in-home air purifier products added approximately $9 million to China sales.

On slide 7, North America operating earnings of $340 million were 34% higher than adjusted segment operating earnings in the previous year, and operating margin of 20% was significantly above the 15.6% adjusted operating margin one year ago. Pricing actions in the U.S. and Canada, higher sales of Lochinvar branded products and commercial water heaters in the U.S. and lower steel costs contributed to the significantly improved segment performance. The impact of profits from lower residential volumes in the U.S. partially offset these favorable factors.

Rest of world operating earnings of $113 million improved 6% compared with 2014. Higher sales and lower steel costs were partially offset by lower sales of highly profitable commercial water heaters in China and increased selling, general, and administrative expenses. Segment operating earnings were reduced by approximately $2.5 million due to China currency translation.

Higher selling and promotion cost to support expansion in tier 2 and tier 3 cities and our e-commerce platform in China as well as higher development and advertising costs associated with the 2015 launch of air purification in China were the primary drivers of higher segment SG&A expenses. As a result of those factors, 2015 segment operating margin of 13% was lower than the 13.9% operating margin in 2014.

Our corporate expenses declined from the adjusted corporate expenses the prior year, primarily as the result of higher interest income. Our effective income tax rate during 2015 of 29.7% was higher than the previous year due to a change in our geographic earnings mix. Sales in the fourth quarter of $639 million were 2% higher than the previous year and below our expectations. Lower U.S. residential water heater volumes and weaker U.S. boiler sales contributed to less organic growth than we expected.

Excluding the unfavorable translation impact from the weaker Canadian and China currencies of approximately $13 million, sales grew 4%. Net earnings of $80 million was 39% higher than fourth quarter adjusted earnings of 2014. As shown on slide 9, net earnings of $0.90 per share improved 41% compared to adjusted earnings per share of $0.64 in 2014. Sales in our North America segment of $414 million declined 4% over 2014. Price increases in the U.S. and Canada for residential and commercial water heaters and higher volumes of commercial water heaters were more than offset by lower volumes of U.S. residential water heaters and approximately $5 million unfavorable currency impact in Canada.

Sales of Lochinvar branded products were flat in the quarter. Industry volumes of residential and commercial boilers declined in the fourth quarter of 2015 compared with the previous year. We believe warmer weather at the beginning of the heating season may have negatively impacted residential boiler volumes and longer lead times for commercial projects may have negatively impacted the commercial boiler industry.

Rest of world segment sales of $232 million increased 14% compared with 2014. China sales increased 19% in local currency, driven by higher demand for water heaters and water treatment products. Seasonally strong air purifier sales added over $5 million to China sales. Higher China sales were partially offset by unfavorable currency translation of approximately $8 million.

On slide 11, North America operating earnings of $92 million were 30% higher than adjusted segment operating earnings in the previous year and operating margin of 22.3% was significantly above the 16.4% adjusted operating margin one year ago. Pricing actions in the U.S. and Canada, higher sales of commercial water heaters, and lower steel contributed to the significantly improved segment performance. The impact to profits from lower residential volumes in the U.S. partially offset these favorable factors.

Rest of world operating earnings of $29 million improved 27% compared with 2014. Higher sales and lower steel and advertising costs, all in China and smaller losses in India were partially offset by increased selling expenses in China. Segment operating earnings were reduced by over $1 million due to current China currency translation.

Fourth quarter 2015 operating margin of 12.3% improved from the 11% operating margin in 2014. Our corporate expenses declined from the adjusted corporate expenses the prior year, primarily as a result of higher interest income. Fourth quarter results included approximately $3 million or $0.03 per share of income tax benefits primarily associated with the recently approved extension of the research and development tax credit in the U.S. and additional R&D tax benefits in China.

Cash provided by operations during 2015 was $344 million, compared with $264 million provided in 2014, driven primarily by higher earnings and smaller outlays for working capital in the 2015 period. We exceeded our 2015 cash flow estimate by approximately $50 million, as a result of lower capital spending as well as improvements in working capital.

Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 15% at the end of 2015. We have cash balances totaling approximately $650 million located offshore and our net cash position was approximately $400 million at the end of December.

During 2015, we repurchased approximately 1.9 million shares of common stock for a total of $128 million under a 10b5-1 automatic trading plan. At it's December meeting, our Board increased its authorized share available for repurchase by 2 million shares. Considering this increase, we had approximately 2.6 million shares remaining on our existing repurchase authority at the end of December.

This morning, we announced our 2016 EPS guidance to be between $3.40 and $3.55 per share. The midpoint of our EPS guidance represents a 10% increase in EPS compared with our 2015 results. Please turn to slide 14 for several 2016 assumptions.

We expect our cash flow from operations in 2016 to be approximately $320 million which is less than 2015, primarily related to expected higher outlays for working capital this year compared with 2015. We expect capital expenditures to be between $120 million and $130 million in 2016 and higher than the $73 million spent in 2015. Due to the strong growth of our water treatment business in China, we will reach the capacity of our existing lease facility in the next few years.

Our 2016 capital spending plans include approximately $40 million related to construction of a new water treatment manufacturing and air purification assembly facility in China. Total cost for the facility are expected to be approximately $65 million and it will be completed in early 2018. In addition, we expect to complete capacity expansion of two North America plants in 2016 at a cost of approximately $7 million.

Our 2016 capital spending plan also includes approximately $8 million to support the ERP implementation. Our depreciation and amortization expense is expected to be approximately $70 million in 2016.

We successfully completed our first two ERP go-live milestones in August 2014 and May 2015. We expect to convert the majority of our North American plan sites by the end of 2016. ERP implementation expenses were approximately $16.5 million in 2015 and are projected to be approximately $25 million in 2016. Higher than the previous year due to larger number of scheduled go-live events in 2016. Approximately $4 million of incremental ERP cost is expected to incur in the first quarter, with the remainder primarily in the fourth quarter of 2016.

Our corporate and other expenses are expected to be approximately $48 million in 2016, higher than the $43 million in 2015, primarily due to expected lower interest rates than last year on cash deposits in China. Pension income is expected to be approximately $7 million in 2016 compared with zero in 2015. Costs associated with our replacement retirement plan are about $6 million in both years.

Our effective tax rate is expected to be between 30.5% and 31%, higher than the 29.7% rate experienced in 2015 due to a change in our geographic earnings mix. We expect to continue to repurchase shares at a value equal to our free cash flow after dividends for approximately $150 million in 2016 which is consistent with our stated policy to maintain our net cash balance at approximately $350 million. As such, we expect our average diluted outstanding shares for the year will be between 87.5 million and 88 million shares.

I will now turn the call back to Ajita, who will summarize the business assumptions in our 2016 outlook and our growth strategy, beginning on slide 15. Ajita?

Ajita Rajendra

Thank you, John. We expect our businesses will collectively grow between 9% and 10% in local currency terms and between 7% and 8% in U.S. dollars in 2016. The assumptions for currency underlying our organic growth forecast are at current rates. We expect steel prices will remain at current levels, as global demand remains soft and capacity utilization remains slow.

Some comments specific to our North American segment. We expect four months of pricing benefit in 2016 as the 2015 price increase in the U.S. will anniversary in late April. We expect U.S. residential water heater volumes will grow by 100,000 to 150,000 units in 2016, primarily as a result of new construction. We expect U.S. commercial water heater volumes will be modestly higher after strong growth in 2015.

Due to the significant pre-buy which occurred in the first quarter of 2015, the first quarter of 2016 will be a difficult comparison for U.S. residential water heater volumes. After double-digit volume declines in the U.S. commercial condensing boiler industry in October and November, industry volumes grew 10% in December. We see this positive trend continuing in our business in January.

The continuing transition to condensing boilers and new product introductions give us comfort to project Lochinvar branded sales growth of 10% in the first quarter of 2016, as well as for the full-year. Recall that our Lochinvar branded sales are seasonally skewed to the second half of the year which coincides with the heating season.

The water heaters we sell in Canada are manufactured in the U.S.. The Canadian dollar weakness is expected to result in a significant product cost increase to our Canadian operations in 2016 which is only partially offset by announced price increases. The magnitude of this headwind is in excess of $5 million. These factors, in addition to the assumptions John discussed earlier, lead us to expect our North America segment operating margin will be between 20% and 21% in 2016.

Now, some comments specific to the rest of world segment. We're committed to our business in India. We remain optimistic about the long term opportunity in the country with the second-largest population and the second fastest growing economy in the world and its developing middle class who desire quality-of-life products.

India is an investment for the future and the $8 million to $9 million loss which we expect in 2016 is similar to 2015 and includes higher promotion and advertising costs related to brand building, as well as the expansion of our water treatment product distribution to six cities in 2016 from two cities in 2015. We expect to combined sales of water heaters and water treatment products in India to be greater than $20 million in 2016, an increase from 2015 sales of nearly $16 million.

We're a consumer products Company in China which distinguishes us from most industrial companies operating in China. The Chinese consumer demonstrated resilience in 2015. We have three growth drivers underpinning our China business which give us confidence to project an annual growth rate of approximately 15% in local currency for 2016.

The first driver is overall market growth which we believe has impacted by household formation and a growing replacement market. A proxy we use to project their potential for water heater market growth is the growth in the consumption portion of GDP. We have seen independent forecasts, including one from the IMF which project China consumption growth between 7% and 8% in 2016. With continued urbanization, growth in the middle class and a growing replacement and upgrade market, we expect supportive market growth to continue for quite some time.

The second growth driver is market share gains and increases in average price. We have a strong market position by value in the electric wall-hung category. Our position in gas tankless, while a leader, is less than 20% by value and we see opportunity to gain more share with our well-respected and patented super quiet models and as our newly launched high-rise models gain acceptance. Our commitment to engineering resources will continue to result in new products with features and benefits in which consumers see value and for which they are willing to pay an incrementally higher price. This results in a favorable mix impact.

The third growth driver is fast-growing ancillary product categories, the most significant example of which is water treatment. A.O. Smith branded water treatment products achieved sales of $110 million in 2015, up from $75 million in 2014, an added 5 percentage points of growth in each of the last three years. After successfully launching the A.O. Smith branded in-home air purifiers last year, we expect sales to more than double to approximately $20 million. The combination of A.O. Smith branded water treatment and air purifiers incremental sales is expected to add almost 5 percentage points of growth this year.

The last two growth drivers are primarily in our control and as we continue to invest behind them. The first is a function of the growing replacement market and household formation. Combining these three growth drivers give us confidence that we will grow approximately 15% in local currency in 2016. We expect rest of world segment operating margin in 2016 will be similar to last year's margin of 13%.

One final comment on China, the recent declines in the China stock market and value of the Yuan are unprecedented and we acknowledge the concerns of the investment community surrounding our China business. While it is not our practice to discuss monthly results, recent trends might add some perspective, given that the latest macro events in China materialized in mid-December.

In local currency, the average of our daily shipments in January increased over 15% year-over-year. Please also remember that the first quarter is typically our lightest China sales quarter, due to the New Year travel holiday in February. The Spring Festival in February.

Please move on to slide 16. Especially in these volatile and uncertain economic times, we believe our long term annual 8% organic growth potential and our stable defensive replacement markets which we believe represent over 85% of North American water heater and boiler volumes, positively differentiates A.O. Smith among other industrial companies. Coupled with growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisitions that add shareholder value as well as allow us to return cash to shareholders.

That concludes our prepared remarks and now we will take your questions. As Pat mentioned earlier, please limit yourself to one question and one follow up per turn. If you have multiple questions, please rejoin the queue. Please also note that John and I are in different locations and we will do our best to coordinate our answers to your questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question comes from the line of Ryan Connors from Boenning & Scattergood. Your line is now open.

Ryan Connors

I wanted to ask two different questions about China. One has to do with your cash position there, Ajita, and there has been some talk lately about, in light of all the issues, China reinstituting some of the capital controls, in particular clamping down on corporate profits leaving the country. How does that impact your view of your cash position there? Are there enough investment opportunities in China, given the environment, or should we look at that as kind of stranded cash?

Ajita Rajendra

Why don't I give a general comment and then let John talk specifically about the cash. I was in China last week, and as you know, I go there very often. It's interesting that all of the talk that we hear about China in terms of the stock market and all of the things happening -- the people on the street, that is not even a topic of conversation. They are looking at different drivers and different things.

I met with customers, I met with obviously a lot of people in our workforce. I had dinner with the ex-dean of the business school at Nanjing University. The focus and discussion are on very different topics. So things like this, they are not really -- it's not a topic of conversation within China. Specifically on stranded cash, obviously that topic wouldn't come up, but we don't have too many concerns about that. John, maybe you want to address it directly.

John Kita

Ryan, it's clearly one of the things they are talking about is capital controls. We have in the past -- we took out about $100 million out of China in 2014. We certainly have uses of cash in China. As we talked about, we’re going to be adding the water treatment and air purification plant. We're looking at opportunities, always, to expand our product lines, as we did with air purification and water treatment both four or five years ago. So we will obviously continue to monitor the situation.

Ryan Connors

And then my follow-up was to do with China, also. I realize it's sensitive to comment on competitor moves, but it looked like General Electric's appliance business may end up in the hands of one of your notable competitors in China. Obviously, they've got a respected American brand like you do, so I wondered if you could just comment for us on how you view that potential development in the competitive landscape there, and whether that has a potential to disrupt anything competitively? Thank you.

Ajita Rajendra

Let me take that, John. I don't think so, because first of all, GE has been in the business for a while and obviously the GE brand name is very, very well-respected here. They have -- they essentially make heat pump water heaters. It's a very limited line and haven't had a huge impact on the marketplace.

Now Haier is a competitor; they are a very good company, also. They are a strong competitor in China. We have been gaining share from them in China. They have the capability of much broader product development. But again, it's early to tell. But it's not something at this point we're concerned about. Haier has -- when you look at the hierarchy of products at Haier, water heaters comes very low, and there is limited capacity that is available right now with the GE product line. We're not concerned about it, but it's something we're watching.

Operator

Our next question comes from the line of Charlie Brady from SunTrust. Your line is now open.

Unidentified Analyst

This is actually Patrick standing in for Charlie. Just looking at U.S. residentials -- obviously you added some color there, so thanks a lot for that. Once you knew what the outlook was for 2016, was any of the weakness that you saw -- obviously, you said back-half was weak. Was that mostly macro-related or was there any due to the pull-forward of the pricing increase in April? And if so, is there a quantification of that or just any color on that would be great.

John Kita

Our best estimate, if you go back to the end of 2014, the fourth quarter compared to 2013, that was up about 180,000 units, fourth-quarter 2014 versus 2013. Our guess -- and it is a guess -- is that a healthy portion of that was pre-buy, because it was already out that NAECA was coming and there was going to be some discontinued lines. There was going to be some effect on some of the multi-family units, et cetera.

So when we look back at it, we estimate it could have been as high as 150,000 units of pre-buy last year. When you incorporate that with the fact that completions were only up about 80,000 this year, you come up with the delta of about 220,000, explanation [ph] of the 300,000 units. We certainly have seen some of our customers reduce their safety stock because everybody now is delivering on time. So we think the combination of those two is the reason that it's down. We will obviously continue to monitor 2016 as it goes forward.

Unidentified Analyst

And just one question, I guess my follow-up is on the steel costs. How much of the margin increase in both your reported segments were attributable to these improvements -- declining steel costs for you guys?

John Kita

We haven't quantified that. As we said earlier, it's really -- the margin improvements really came from three different areas. Commercial was very strong. We put price increases in earlier in the year on NAECA product, on non-NAECA product, and on commercial. We also put price increases in, in Canada. The third component, if you will, is lower steel costs. It's a combination of all three of those that are contributing to the improved margins.

Unidentified Analyst

Would you say that they are on the list then? Or -- in terms of the improvement or is that fairly high up there? I want to get a good gauge of what that number could be?

John Kita

Pricing and steel were obviously the biggest ones.

Operator

Our next question comes from the line of Kevin Maczka from BB&T Capital Markets. Your line is now open.

Kevin Maczka

Two questions for me. If I can go back and revisit this pre-buy in North American resi volumes. John, I thought I heard you say that 2015 finished down about 300,000 units. You see up about 100,000 to 150,000 units in 2016. So over that two-year period, we're net down. I guess my first question does that, again, all relate back to that pre-buy and that hard comp from Q4 2014? Or is there something else going on, maybe share-wise? Because it seems like, with the construction up cycle and so much of this replacement, that over a two-year period we would still be positive?

John Kita

Well, it's not share. I would say our share was very consistent over the time period, so it was not share. Certainly, we're estimating some numbers. It's very possible this year, because of the downturn in 2015, could be closer to 200,000 up. We're just monitoring it. What we had, Kevin, is a significant increase in the industry from 2012, where it was 8.1 million units, up to 9.2 million units in 2014. Part of that was helped by new construction, but certainly part of it was helped by replacement. So it's really hard for us, quite frankly, to tell you within 100,000 or 200,000 units or within 2% of a 9.2 million units, what the exact number is.

Ajita Rajendra

Kevin, like you are saying, I hope we're being a little conservative.

Kevin Maczka

Right. Just to follow up on that, as we look out into Q1 in the first half -- I know you are not usually commenting on monthly progression here, but we saw industry numbers down double digits in Q4. Is that your expectation again going into Q1? Or should that start to normalize like your China business had?

John Kita

I think, clearly -- and we said it on the call last year -- 2015 first quarter, because of the significant price increase, the industry was up 300,000 units or so. And we certainly don't expect that to happen. I think -- as I looked at the history, the last couple of years, I would think we're going to approach more like the 2014 distribution by quarter. That would seem to be more sense for me -- maybe a little lighter in the fourth quarter because of the pre-buy. But otherwise, I think that's the more normalized distribution than what we had last year.

Operator

Our next question comes from the line of Robert McCarthy from Stifel. Your line is now open.

Robert McCarthy

So maybe you can just comment first on -- boiling down for 2016 -- because we have a lot of issues going around, obviously the carryover of pricing which you elucidated and then obviously some incremental pricing and then the volumes. But is there a way to break down, basically on a consolidated basis, what you expect on a percentage basis from volume and from price in 2016 or a range?

John Kita

Again, I think the best estimate for volume would be what I just said from the standpoint of residentials, our biggest business. I think that, that distribution in 2014 is probably reasonably representative. From a price standpoint, as we said in the call, we're about -- certainly through the end of April, we would certainly think we're going to see significant price, year over year. And then it starts leveling off after that, because that's when the price increases went in. If you look at our ownership since we've had Lochinvar, 2012, the distribution of our earnings has been 48%, 52%, first half, second half; and I guess as a high level, that is not in an reasonable estimate.

Robert McCarthy

Okay. And then, maybe you can just comment and just add to some of your comments around Lochinvar. Obviously, you saw a weakness in the fourth-quarter, but you saw some nice trajectory and exit rate. But just give some narrative around what undergirds your confidence there, given the change in regulatory standards? Or the progression that's going on there on the products that you think supports a 10% organic growth rate, there?

John Kita

A couple things. October and November were double -- the industry was down double digits; we were down about half that. And then we did see a decent recovery in the industry in December. As for us, if you look at the entire Lochinvar for the year, they were up about 7%. But when you take out China -- and the sales to China were about $4 million and we've talked about not only our China business struggling, commercial in China, but also Lochinvar.

You take out the Canada shortfall and quite frankly, from a competitive standpoint, because we're competing against some competitors in Canada and the currency has moved so much, it's more difficult. You take those two out and they were up about 10%, even with the fourth quarter. So when we looked at December and we look at where we're projecting for the first quarter -- up about 10% -- we're comfortable with the full-year growth of 10%, year over year.

Ajita Rajendra

And also comfortable with what we've always been saying in the longer-term conversion from non-condensing to condensing. You're going to have these short-term blips, but that longer-term trend and trajectory is solid.

Operator

Our next question comes from the line of Jeff Hammond from KeyBanc. Your line is now open.

Jeff Hammond

Just a couple things back on North America. So you mentioned safety stocks coming down. Just maybe assess what your customers are telling you in general about inventory levels and specific to pre-buy overhang? And then, just on mix around the NAECA standard -- have you seen people trading down as a result of the higher pricing, particularly at the 55 gallon-plus level?

John Kita

Safety stock, we've just finished sales meetings and the input we got from the salespeople is, the inventory levels of our customers are reasonable, but as you've seen in the whole industrial landscape in the fourth quarter, the demand has been relatively weak. We have seen an improvement in our normal ordering patterns in December and January, but I'd say we're not quite normal yet. But I think we're on the right trajectory.

I was just going to answer the second one. The trading down -- Jeff, I don't know. If you're talking about the discontinued electrics, in effect what we've probably seen happen there is, the commercial business has been strong in the 55-gallon to 90-gallon range. So one of two things probably happened either residential customers -- that were buying those residential units in that size now are buying commercial; or commercial customers that were buying the residential in that size are now buying commercial. That's one of the explanations on why commercial has been better. And could they be trading down? Certainly, it's a possibility to a smaller size, if you will.

Jeff Hammond

Okay. And just quickly on the Lochinvar comment about longer lead times. Is that a function of macro uncertainty? Some slowing in commercial construction? Or is it something different?

John Kita

As we've talked to people, you would say it probably is due to macro uncertainty, but we don't know. The engineers are -- our customers are very busy; it's just the release of the projects weren't happening as quickly as they normally do. I don't know if that's financing; I don't know -- other macro issues. But again, we view it as probably only a temporary blip, because the good news is the engineers appear very busy.

Ajita Rajendra

Also, just to add some color to that -- this is more anecdotal than quantitative -- but I was at ASHRAE and I know many of you were at the ASHRAE show. Talking to customers, they feel pretty good about 2016 and where business is going to be.

Operator

Our next question comes from the line of Mike Halloran from Robert Baird. Your line is now open.

Mike Halloran

Just thinking about the FX commentary and splits by division -- I think it was $5 million or so headwind, I think you said for the Canadian dollar impact to North America. So is it fair to think about 1 point of headwind in North America and then more like 4-ish for the rest of the world?

John Kita

In the fourth quarter, it was $5 million for Canada and about $8 million for China. What we're estimating, based on current rates now, what 2016 headwinds could be, is closer to $40 million for China over 2015. And maybe another $15 million or so for Canada for the year, top line.

Mike Halloran

Perfect. That's exactly what I was looking for. And then, on the China side, maybe you could just talk about the new product curve, as you see it through 2016, here? Anything interesting coming on the water purification -- I'm sorry, water filtration or the air purification side?

Ajita Rajendra

Yes. I feel very good about the new products. Like I said at the early part of the call, I was in China last week. We have an interesting slate of new products coming out. I don't want to be specific in terms of either new stuff that they haven't introduced yet. But the pace of new product introduction, the pace of innovation in bringing truly new things to the market as opposed to cosmetic changes -- because we do both -- There is some interesting new stuff that's coming out In water treatment.

In air purification, we had essentially two SKUs. We had one SKU that we came out with in April; and another one, a smaller size which we introduced around October. Those two SKUs had $9 million of sales last year which again shows the power of the brand in the right categories with the right products, even though they were only two SKUs. We will be expanding that line also in 2016. I feel very good about the new products that are in the pipeline.

Operator

Our next question comes from the line of William Bremer from Maxim Group. Your line is now open.

William Bremer

First question I just want to get a clarity on -- did you mention earlier that air purification contributed $5 million in revenue this quarter?

John Kita

Yes, it was around $5 million in the fourth quarter, $9 million for the year.

William Bremer

Okay. Second question, can you give us a little more granularity in terms of the replacement market in China and how large that is for you at this time?

John Kita

All we can look at is based on our surveying data, et cetera. We have seen, in our estimation, that increase over the last two to three years -- which is logical, right? We have been selling in some sort of magnitude for the last 10, 12 years. Our units last on average about 8 or 9 years and we think it is probably longer than our competitors. So in tier 1 cities specifically, we have seen an increase in replacement. Our estimate would be, it would be approaching 50% or so, based on our data. But we don't quite have the data we do in the U.S., where you can -- everybody is reporting and you can take new construction and subtract it to get replacement. It's logical it's increasing. We would expect it is.

William Bremer

Very fine top line performance in China. No doubt. Just want to get a sense of your feeling of the inventory that's in the channel there, right now?

John Kita

We're comfortable as we look compared to the year. I think the distribution by quarter was pretty reasonable, so I think we're comfortable where we're from an inventory standpoint. I don't know, Ajita, if you heard anything different when you were there last week?

Ajita Rajendra

No. I think says it. It's about where we should be. In the past we have expressed some concerns that it was a little high, as we did, I think, about one year ago. Right now, I would say we're where we should be. And like I mentioned, we don't normally talk about monthly results, but what we saw in January was the type of increase that we like to see for the year.

Operator

Our next question comes from the line of Bhupender Bohra from Jefferies. Your line is now open.

Bhupender Bohra

My question is around rest of the world margins, here, like we have spoken -- Ajita, we've spoken about. We have seen -- we have been hovering around 13% margins. Where do we see the rest of world? The China margins go forward, here? I think if you'll go back in 2014, we have hit 15% number here. If you can just give some color on that? And what would be the inflection point where we see from 13% to go to that next level of 14%, 15%, mid-teens margins, here?

Ajita Rajendra

If you look at -- a lot of it is driven by China. A lot of it is driven by what type of investments we also are making. At this point in time -- and when I say point in time I am taking a fairly -- you know, 12 to 18 month time frame -- we're investing in India, in terms of brand building. Again, in India we're following the same type of similar playbook as we did in China which is heavy investment in the brand and then following it up with categories in which we're strong -- products and categories in which we have strength. So we're investing behind the brand in India. We talked about what we expect in India.

In China, we're investing in a new category that we're getting into which is air purification. We're continuing to invest heavily behind water purification even though we have a $100 million-plus business. Again -- and for the last few months in China, we have been the leaders in that category, in terms of market share. But, we continue to invest heavily behind it to really solidify our position as being the leaders in that category, because for 20 years we were a water heater guy and now we're a water guy and now we're getting into air purification.

So we're expanding that brand and that takes heavy investment. Also, we're investing in terms of getting into those second and third tier cities. The smaller cities. So there is a heavy amount of investment going on right now. There has always been a question of, can we see more leverage in China for the increased volume? Yes, at this point in time we're investing a lot of that back into new products and new distribution and new categories.

John, you want to add any color to that?

John Kita

You are right. From the standpoint of China, margins have come down a little bit. They were about mid-teens this year, about 15%, down a little bit from 2014. I think there are a couple things driving that, that Ajita talked about. I think the core businesses -- electric, gas, water treatment -- doing very well. But we're investing in air purification and will have a larger loss next year than this year as we grow the distribution platform. Commercial -- we've talked about, had a difficult year this year. That had a negative effect on China's margins and rest of world. And quite frankly, there's other businesses we're incubating that had larger losses, like combi boilers, where we think that's an important market in the future and we're committing to engineering.

We're very comfortable, but the anticipation is down the road. Certainly it's to grow these margins and also to improve our profitability in India. So it's not going to happen overnight, but that is certainly an objective down the road.

Operator

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

David Rose

I just wanted to have a question on China and there is an embedded question within that and then I have a follow-up. On China, just on the margin side -- to be clear, what was the change in the advertising spend year on year?

John Kita

I think as we talked last year, the margins were negatively impacted because we were running a fair amount of CCTV advertising for water treatment. We did not have that this year. That was a pretty significant contributor to the improvement in the margins year over year in the fourth quarter. That was the major delta, is just we did not have that advertising on national television. And we kind of talked about in the past, these advertising spends can vary quarter to quarter and I think we outlined that last year in the fourth quarter. We did see better improvement in China margins this year than last.

David Rose

Okay; and then the question on margins for China for 2017 is -- if you open up the facilities, do you have under-absorption in factory in your fixed costs, depressing margins? Should we think about it that way in 2017?

John Kita

I don't think we would expect significant -- obviously we'll avoid some of the lease costs we have, et cetera and we're going to be able to be at a decent occupancy. To be honest, I have not -- it's really 2018 that -- it's going to open early 2018. I have not done a lot of analysis of that. But I wouldn't expect it is going to have a huge effect.

Ajita Rajendra

Also, I think it's fair to say that we have ongoing -- because we always have been expanding. We expanded our factory, opened the new factory, October -- year ago October. We've expanded that facility right now; we haven't moved into it yet. We always have more capacity than we need in some areas and we're filling it up very quickly and building new factories and moving in. So I don't think -- as John said, I don't think you're going to see an unusual under-absorption level in the next couple of years.

David Rose

And then the follow-up question was a housekeeping one, the other income was up meaningfully from Q3. Can you just clarify what that was?

John Kita

I would have to look, but I know year over year it was interest income. When we saw that China could potentially lower rates, we laddered some volatile while away, but that will be expiring towards the end of this year -- towards the end of 2015. And that's why we said corporate expense goes up next year; interest income will be down, I think, $4 million or something from year over year.

Operator

And our next question comes from the line of Robert McCarthy from Stifel. Your line is now open.

Robert McCarthy

Yes, one follow up. Just wanted to talk about the margin outlook for North America. What goes into that aside from just the anniversarying of the price increase and how we see it playing out? Should we think about some core operating leverage on the basis of that? Obviously, if you look at the implied run rate, it's around the 21% range through 2Q through 4Q. Any kind of dynamics about how you're going to achieve that? And tentatively your confidence level in achieving that, would be helpful?

John Kita

I think what we've done the last two quarters is above that, but that's been driven by mix as much as anything -- commercial and Lochinvar which is our highest margin product lines, certainly contribute to that; and resi being weaker. But I think there is puts and takes. Obviously, steel will probably be a benefit this year. On the other hand, we talked about the Canadian currency issues. That is going to be a negative. And then the other thing that ends up in the play in North American margins is, SAP is going to be up about $8.5 million to $9 million. That and the currency are probably the biggest factors on why there is a little bit of headwind from that standpoint.

Robert McCarthy

Ajita, do you have any other thoughts on that or not?

Ajita Rajendra

No, I think that hits it. Because one of the things we didn't talk about a lot is the fact that the SAP, the ERP is going to be that much higher in 2016 over 2015.

Operator

Our next question comes from the line of Charlie Brady from SunTrust. Your line is now open.

Unidentified Analyst

This is actually Patrick again. Thanks for taking my follow-up. I wanted to touch a little bit on the online sales from China that you guys mentioned a little bit briefly. What was the level in 2015 versus 2014? And if I'm not mistaken, these higher-margin sales, right? And do you have any expectations for that number, in terms of 2016?

John Kita

It was about $140 million. It was higher than what we thought it would be when we put out our projections. That compares to what -- $55 million or something last year. It's hard to say a higher margin. We would say at least as good a margin, but we're putting a fair amount back into advertising, et cetera, in development of that channel. So that is certainly the case. We would expect that's going to grow. I think right now their estimate is about 20% to 25% growth over where it was. But that is certainly becoming an important channel for us.

Unidentified Analyst

And one very quick question about India. The $8 million to $9 million loss expected for 2016 on -- I think you said $20 million of it expected?

John Kita

Yes, we said over $20 million and we had about $16 million. What's happening in India is, we're making improvements on the water heater side. We still have a ways to go. But as we talked in the release, here, we're expanding our water treatment. We think that's a potentially large market for us and to enter a market like that is going to take a decent amount of investment from an advertising, distribution, expansion, et cetera, standpoint. So water heaters is improving and we're spending more on water treatment, ending up about the same point.

Unidentified Analyst

Actually, my question was at what sales level will we be able to have a breakeven number?

John Kita

On the water heater side, I think we've talked about in the past, it's about a $15 million business. Our expectation is to be a $30 million business. Somewhere around there would be a breakeven. I have the number for water treatment, but I can't recall it. It's probably a similar type of number. Maybe a little bit less.

Operator

Ms. Ackerman, I'm showing no further questions at this time. Please proceed with any further remarks you may have.

Patricia Ackerman

Thank you all for joining us today. Please take note that we will be at the Wedbush Sustainability Conference on March 9 and the BB&T Industrials Conference on March 23. Have a wonderful day.

Operator

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

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