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A.O. Smith Corporation

Q1 2008 Earnings Call

April 17, 2008 10:00 am ET

Executives

Craig Watson - Vice President of Investor Relations

Paul W. Jones - Chairman and Chief Executive Officer

Terry M. Murphy - Executive Vice President and Chief Financial Officer

Analysts

Paul Mammola - Sidoti & Company

Ned Borland - Next Generation Research

Mike Schneider - Robert W. Baird

Ted Wheeler - Buckingham Research

Matt Summerville - KeyBanc

Scott Graham - Bear Stearns

Operator

Welcome to the first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to our host Craig Watson, Vice President of Investor Relations.

Craig Watson

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 W. Jones

Welcome to this morning’s first quarter 2008 conference call. Total sales in the first quarter declined slightly to $571 million from $577 million last year. We reported higher earnings and continued strength in foreign operations, particularly China, as well as productivity and margin enhancement initiatives in spite of a tough economic environment, including sharply rising costs for steel and copper.

Net earnings increased 12% to $21.9 million and earnings per share of $0.72 per share were 14% higher than $0.63 per share in the first quarter of 2007, reflecting the additional benefit of our share repurchase program. Excluding restructuring expenses, primarily in our motors business, of $0.09 and $0.02 in 2008 and 2007 respectively, earnings increased 25% to $0.81 per share in the quarter just ended.

However, because we are concerned about the dramatic rise in raw material costs and the prospects that these elevated costs may persist for remainder of the year, as well as the construction market that has worsened since the forecast we gave last quarter, we are lowering our 2008 earnings forecast to $2.60 per share to $2.80 per share from the previous estimate of between $2.70 per share and $2.90 per share.

Terry will now discuss the financials in a little more depth and I’ll come back and talk about the outlook in a little more detail.

Terry M. Murphy

Sales about $352 million in the Water Products business were slightly lower than sales of $355.4 million in the first quarter of last year. Sales growth in China of more than 40% and increased pricing to cover high steel cost were more than offset by significantly lower residential unit volumes.

In Electrical Products, sales of $220 million were slightly lower than in the first quarter of 2007. Higher sales in China and increased pricing to cover raw material costs were more than offset by weaknesses in the residential market segment such as HVAC, swimming pool pumps and general residential applications.

Total operating profit excluding restructuring expense increased $4.5 million and operating performance improved in both businesses. The improvement in operating profit at Water Products was the result of the higher China sales and improved earnings in Canada. SG&A and the legacy business was also lower than in the prior year.

Margin was 10.2% in the first quarter compared with 9.6% last year. In Electrical Products, first quarter operating profit increased to $11.1 million compared with $10.2 million last year.

Excluding restructuring charges of $3.8 million in the quarter just ended and $1.2 million last year, operating profit increased 31% or $3.5 million. Improved pricing and benefits from product rationalization and repositioning savings more than offset lower unit volume and higher costs for raw materials. First quarter operating profit margin improved 5% from 4.6% last year. Adjusted for restructuring, operating margin increased 6.8%.

Operating cash flow was negative $15 million in the first quarter which was similar to a $17 million decline last year. The decline in cash flow was primarily the result of an increase in inventories in both businesses related to higher levels of raw materials. In addition, because of the seasonality of some of our businesses, working capital typically increases during the first quarter.

Notwithstanding the negative operating cash flow, cash cycle days declined to 65 days from 69 last year, primarily as a result of continued improvement in working capital in Electric Products. As a result of the negative operating cash flow, our debt-to-capital ratio increased modestly to 35.2% from 34.3% at the end of the year.

During the quarter, capital spending was approximately $10 million compared with depreciation and amortization of $17 million. Capital spending for the full year is still expected to range between $80 and $90 million, while depreciation and amortization is expected to total about $70 million. We’re projecting operating cash flow of approximately $125 to $135 million in 2008.

Paul will now discuss the outlook for 2008.

Paul W. Jones

In discussing the outlook, I wanted to touch on four items which include our cost reduction initiatives, the residential and commercial construction market, raw material cost increases particularly steel, and continued strong growth in China.

Let’s start with cost reduction. We have been working hard over the last several years to reduce costs, improve productivity and expand margins in both of our businesses. In Water Products, we’ve been combining our operations with GSW and generating significant synergies and savings. In our motors business, we’ve outlined our roadmap and have been making progress along that path.

Last year we announced the significant restructuring involving the closure of our operation in Hungary and two major U.S. facilities by the end of this year, which was expected to generate savings of $20 million per year, including $5 million in 2008.

In addition to these initiatives, we began voluntary salary workforce reduction program last month to our salaried employees throughout the organization. This is expected to begin contributing important savings later this year and into 2009.

Both of our businesses enjoy significant replacement demand in various markets, which in turn limits our exposure to downturns in the new housing construction market. In the motors business, new housing represents about 25% of total sales while the number is closer to 15% in Water Products.

Nonetheless, new housing is still pretty important and the outlook for that market deteriorating during the first quarter by approximately 200,000 units or nearly 20%. Where we were previously projecting approximately 1.1 million new starts in 2008, we are now expecting a level of around 900,000 starts. And we have heard numbers as low as 600,000 which would make this the worst housing market in the last 50 years.

Furthermore, we don’t believe it will bottom until some time next year. This additional weakening will adversely affect our residential water heating business as well as the motor markets for HVAC, pump, small appliance and general industry applications. The commercial market also turned negative during the quarter, a little earlier than expected, after some really solid performance over the last year-and-a-half.

We expect our commercial business, particularly our commercial water heating and air conditioning motor businesses to be challenged for the balance of 2008. But regarding our forecast, steel is probably our biggest concern for 2008. As this chart demonstrates, steel costs have risen dramatically and are expected to remain at record levels for the balance of the year.

Our ability to get paid for this higher-cost raw material will significantly influence our ability to make our forecasted earnings. And we will, of course, look to our customers to absorb the impact of these increases.

As I mentioned earlier, we are aggressively continuing the cost reduction programs but the rapid rise in raw material cost is more than productivity can offset. So most of our opening comments have been directed at how bad things are, I thought it’d be nice to finish with something positive.

Over the past couple of years we’ve attributed a lot of our growth from sales and earnings to our Water Products business in China. But our motors business also has a fast-growing business in China, particularly the commercial hermetic motors which we make in China for markets in China, Europe, the Middle East, as well as North America.

The combined Water Products and motor businesses have grown to almost $250 million in the China-Asia region at a compounded rate of more than 45% per year over the last five years, and now represent more than 10% of the total company sales. And looking globally, almost 25% of our total business is now outside the U.S. which I’m highlighting because this diversification should help temper the market adversity we have seen in the U.S. market.

Our China businesses grew more than 30% in the first quarter and continued strength in that market during the balance of 2008, should help us mitigate the cost headwinds I’ve outlined in the previous two slides. So let’s wrap things up. The additional headwinds and economic uncertainties I discussed will outweigh the strong first quarter performance and the positive outlook in China.

Accordingly, we have slightly lowered our forecast for 2008 by $0.10 a share to $2.60 to $2.80 per share compared with our previous earnings forecast of $2.70 to $2.90 per share. Adjusted for restructuring expense of $0.25 per share, the new forecast is $2.85 to $3.05 per share.

Before I conclude this call, I want to remind everyone that we will be hosting an analysts meeting next month at the Grand Hyatt in New York, on Wednesday morning of May 14. Please give Craig Watson a call if you’re interested in attending and we hope you all can make it.

With that we’re ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Paul Mammola - Sidoti & Company.

Paul Mammola - Sidoti & Company

I’m curious as to the breakdown in China in terms of growth in the water heater and motor business. Can you give more color as to what the specific breakdown is in percentage terms?

Paul W. Jones

Yes, the water heater business had a pretty strong first quarter, more than 40%. But most of the 250 million in sales that we had last year is coming from the water heater business. But the commercial hermetic, and this was an acquisition, Paul, that we have made, the Suzhou in December of ‘03 and then we added Yueyang in November of ‘05.

Those have been terrific acquisitions for us and they are growing at very strong 20% to 30% rates. And they’re also very, very good margin for us.

Paul Mammola - Sidoti & Company

So continuing on China, is there an update as far as the Nanjing addition and the doubling of the water heater capacity there?

Paul W. Jones

Yes, I was there last month and we have steel up. They were putting a roof on it, and they are pouring concrete floors. So we are still on track to have some production by the end of this year and have that done early part of next year.

Paul Mammola - Sidoti & Company

I read something that China could stop producing steel prior to the Olympics there. Have you heard anything like that?

Paul W. Jones

I’d say there are more things being done over there. They intend to do weather forecasts to see which way the winds are blowing and cut down power plants and turn off power to factories and shut people down, because this is a showcase for the world.

And they want to make sure that they don’t have marathon runners collapsing from the pollution while they’re running the marathon. I think they’re going to do anything they have to do to make that happen.

From our standpoint, our factories are all located south of Beijing and for the most part, we don’t anticipate any problems with having power cut off. That was my major concern. And we’re fairly confident we have steel supply locked in China to keep us supported through all this.

Paul Mammola - Sidoti & Company

Are we looking at still a $0.25 charge for restructuring in ‘08, or is that increasing, just because it was $0.09 this quarter?

Paul W. Jones

No, we’re right on track of $0.25.

Operator

We have a question from Ned Borland - Next Generation Research.

Ned Borland - Next Generation Research

On Electrical Products, the margin improvement, 6.8% this quarter ex restructuring, I was wondering if you could go back to the roadmap and just give us a sense for what were the contributors to the margin improvement via the roadmap after utilization.

Paul W. Jones

Yes, a little bit of it came from asset utilization from some of the things that we did last year. But we just got the Budapest operation closed. That’s the lowest cost. We’re still in the first quarter.

We’re getting some traction on the material takeout. That’s one of the three elements of the roadmap. This is a redesign effort, taking material out of the product. It takes, in some cases, 12 to 18 months. We started this a long time ago.

And it takes a long time to get the customer approvals. We’re starting to get customer approvals. It’s our intent to have 60% of the products done by the end of this year. And I’m very pleased with what that team has done and the fact that we’re getting some cost takeout there.

And the other element of the roadmap, if you remember, was the product and customer rationalization. We did eliminate those ugly pump motors that we had that had a minus 50% margin. Those products are gone. We’ve stopped producing them. That’s one of the reasons our revenue was lower but our margins went up.

And that’s the wound power while pump motors that I’ve been talking about for about a year, year-and-a-half. I had a little personal celebration December 31 when we stopped manufacturing those products and that contract ended.

Ned Borland - Next Generation Research

You have couple of facilities that are being transferred to Mexico with the production being transferred to Mexico later this year. Are you still on track with those production moves? And I imagine you’re going to get a bulk of savings from that later in the year.

Paul W. Jones

That’s a lot of savings. Those are going to take us the rest of the year to get done. We’re anticipating about $5 million in savings this year from these restructuring projects but those are on track. I’m very pleased with how we’re doing there and we’re on track to conclude those two closings by the end of the year.

Ned Borland - Next Generation Research

It looks like corporate expense may have been down when compared to last year. Is there anything in there that you can identify?

Paul W. Jones

I think our corporate expense was up. Our corporate expense was up for of a variety of reasons. Some of it from restructuring, we do have some more one-time expenses during the first quarter.

Operator

We have a question from Mike Schneider - Robert W. Baird.

Mike Schneider - Robert W. Baird

Maybe just starting on motors, could you maybe how much of this product pruning or product line pruning has impacted the top line. You mentioned some of the pump motors. But I think there is more than that hitting the revenue line. How much of this is intentional and how much is actually market-related?

Paul W. Jones

That pump contract was about $5 million a year and we actually got out of some of that last year. We were paring it down, but that is a pure elimination. Other than that we still have all the customers we have. We still have the same share of volume with them.

The rest of it is just related to share losses by our customers. And we’ve talked about that in every call. It’s relative to the markets, not necessarily share losses, just market decline. Let me rephrase that. We do have one customer that’s still experiencing share losses and they’ve been doing that for about four years. But the rest of it is just market decline in HVAC and pump markets. I think it’s pretty widely understood.

Mike Schneider - Robert W. Baird

Specific on the distribution side of your motor business, what are the trends in that business?

Paul W. Jones

We had an up quarter in distribution. It was not up the double-digits we’ve been experiencing last few years. But it was up and that business is still very good for us.

Mike Schneider - Robert W. Baird

The product redesign, can you give us a sense of where you are in that curve? You said you intend to have 60% of the lines done or SKUs done by year-end. But how much of that is actually benefiting you today? And where are you in that curve?

Paul W. Jones

We’re getting some traction there. We’re not going to quantify that yet because we’re still in discussions. You can understand how these discussions go with the customers. We were showing them a lower-cost design and they want some of that. That’s the reason it’s difficult for us to quantify it.

I’m very pleased to say that we’re seeing it on our income statement. They were giving savings from all the efforts that started about a year-and-half ago. And, we know we owe you some quantification on that.

We are most of the way towards the 60% that we’ve got done, but we don’t have all the customer approvals up to half yet. Those, as I said, there’s a lagging effect but those approval projects are under way and are going well and products are on tests, both in our labs, as well as our customers’.

Mike Schneider - Robert W. Baird

And then on the savings that are coming this year, the voluntary retirement program, was that built into the $20 million savings forecast or is that additive?

Paul W. Jones

That was additive, Mike. This steel spike is a relatively recent occurrence and it’s dramatic. Nucor put out on AMM Magazine put out a thing, Nucor going up over a $100. I was at a company yesterday that got hit with a 30% steel surcharge that morning from another steel company.

This is all happening literally in the last three or four weeks, huge, dramatic increases. So to that extent we were working on a voluntary reduction program and we accelerated that project. And we did do the voluntary reduction program. We had very good results from that.

It’s not going to regenerate a lot of savings this year because there are some costs that are associated with this. But it’ll be kicking in some savings late in the year and throughout all of ‘09 and beyond. We’ve had quite a few people, I’ll just say over 50 that have accepted this. So, we’re pleased with how the program is working.

Mike Schneider - Robert W. Baird

On the topic of steel, this is 2004 all over in a weaker market. Can you refresh us now because exiting ‘04 you restructured a lot of these customer contracts and then a much greater pass-through element. Can you give us a sense today now, maybe on each side of the business, how much is actually pass-through and that you don’t have to fight for increases? And how much you’re left to presumably fight with either your distributors or your OEMs?

Paul W. Jones

I’ll talk motors first. In 2004 almost all of our contracts were fixed price for the year, with no escalator clauses because for many, many years we had gotten fixed price contracts from the steel companies for the year.

We had fixed price agreements with our steel suppliers that they broke early in the year. They started dramatically increasing prices. We went to every customer we could. In many cases we were able to reopen the contracts because our customers buy steel and copper and aluminum also. And they saw what was happening. And in many cases we were able to get those reopened.

But in almost every case in motors we now have escalation clauses in our contracts. And most of our business is covered by contracts. We still have some customers that are not covered by contracts and those we will be, as I said in the press release, we want our customers to help seek some assistance with the increased costs we’ve had.

It’s just into the second quarter with the steel costs and the indices that we use, we have OEM seeing 8% to 11% increases in the second quarter over what they were paying for motors in the first quarter. That’s just how dramatic these things are. So those contractual agreements, we’ve been through all the conversations. Those people, some of those were pretty tough but, tough to swallow.

And you don’t want to get me on the soapbox on the steel companies. I haven’t seen them putting in a lot of capital investment and adding to their costs. So this thing is frankly unexpected and in many cases I think unwarranted, but the reality is that if they’re there, and if we want to keep serving customers, we’ve got to buy the steel.

Mike Schneider - Robert W. Baird

And what portion of the motors business is covered by contract and not covered by contract?

Paul W. Jones

The vast majority of it’s covered by contracts.

Mike Schneider - Robert W. Baird

Okay, and then the water heater business?

Paul W. Jones

On the water heater business, we have contracts only with our two large retailers, that’s Sears and Lowe’s. We do have agreements with the co-op buying groups. This is the Ace, True Value and Do It Best and the like. And those contracts and with our wholesalers for the most part as things change we go out and do what we have to do.

But although the contracts we have do have allowances for material cost increases of material nature of which we have right now. the whole point we’ve done, as we said repeatedly, within the water heaters, channel parity is important. We’re going to maintain it and we’re going to go to all of our customers to seek relief in this matter.

Mike Schneider - Robert W. Baird

As the year unfolds, it sounds like this is a fairly mechanical pass-through of steel. Is the second quarter just the biggest squeeze for you because of the lag in pricing and then really the second half looks a lot more balanced?

Paul W. Jones

Mike, there’s a lot of moving parts right now. And I would not characterize this as a relatively easy pass-through. There are some real tough discussions going on. We have some very large customers that we are in some incredibly tough discussions with.

All I can tell you is we’re going to hold firm. We have a major OEM customer that we stopped shipment on. I’m not going to name them, but we stopped shipping and they stepped in and decided to pay their invoices.

Mike Schneider - Robert W. Baird

Is it motors or heaters?

Paul W. Jones

It was motors.

Mike Schneider - Robert W. Baird

So the second quarter there in terms of steel squeeze, it sounds like the second quarter is most vulnerable but, by the time you get to the second half, most of this pricing should at least begin to flow in the third quarter?

I’m trying to identify. With the lag in pricing in these contracts, I presume the second quarter is where you’re going to get pinched the most on margins because of steel. But in the back half of the year, you’ll see the pricing begin to flow?

Paul W. Jones

Well that remains to be seen, but right now the last few weeks have just been incredible with what’s happening on steel. So the timing of this call is, we’ve just got a lot of moving parts right now that we’re trying to sort through.

Mike Schneider - Robert W. Baird

And are you actually having steel supply problems aside from price?

Paul W. Jones

No.

Operator

You have a question from Ted Wheeler - Buckingham Research.

Ted Wheeler - Buckingham Research

On the restructuring, what does it look like for next year? Do you think the restructuring expenses will be less or about the same?

Paul W. Jones

Now this is a pretty aggressive restructuring this year. Next year we intend to have this one done by the end of the year. As I’ve said before, I don’t like talking about restructuring but this one was so big we had to put it in. We’re going to continue to look for ways to get our margins up and then take costs out.

But I think as for as announcements and discussions in these calls, it’s my strong desire to not be talking about it next year and only be talking about the savings and quantifying how much we got versus the $20 million that we said we’d get, giving you an update on how we did on that project.

If I could look forward two or three years I think we’ll still see some reduction in facilities, continued consolidations as we can and moving some product lines around. But those are all just things that we would do in the normal course of business to try to make ourselves as competitive as we can and to return acceptable returns to our shareholders.

Ted Wheeler - Buckingham Research

On the new guidance and the raw materials issues, are the assumptions that you have today under the new guidance for recovery, are they the same assumptions or same degree of recovery as you had in your prior guidance? Are you factoring in a lesser recovery potential in your new business?

Paul W. Jones

They’re about the same. There are some minor changes that the commercial business is a little softer a little earlier. But when we talk about the commercial business declining, we’re not going to see commercial business declines to the extent of the residential.

Commercial doesn’t have a subprime problem and a mortgage default problem, and all the other things that they go along with residential. If we talk about the decline there, it will be down 3% or 4%, not 20%. So it’s happening a little earlier, but everything else is still on the same track and we’re anticipating the same recovery.

Ted Wheeler - Buckingham Research

So basically the guidance reduction is market-driven and predominantly the commercial market happening sooner. And residential, you lowered your depth of the decline as well?

Paul W. Jones

One clarifying point I need to make for everybody. I said that the EPC, I said vast majority of the business is under material clauses. That’s only the vast majority of the OEM contracts.

We do have a lot of business there that’s not OEM contract-related and frankly, those are the customers we’re going to right now to seek some release. I just want to make sure everybody understands. It’s the vast majority of our OEM contracts, essentially all. But we do in other business other than OEM contracts, particularly the export business out of China, distribution and things like that.

Ted Wheeler - Buckingham Research

So the guidance reduction in those, predominately your view of the unit situation in the various markets, residential use is down, commercial’s happening a little sooner and so you’ve got just more market headwind?

Paul W. Jones

I’m proud of the team. We obviously did some things like bring in some material early and a few other things, just one of the reasons our cash flow was just a little higher than you may have expected. But believe me, when costs are going up this much, the economics are pretty simple to bring the raw material in sooner.

Operator

We have a question from Matt Summerville - KeyBanc.

Matt Summerville - KeyBanc

Paul, can you review post-GSW, how much steel are you buying on an annual basis, as well as how much copper?

Paul W. Jones

Yes, we’re buying let’s say over 400,000 tons of steel. And we’re buying over 50 million pounds of copper.

Matt Summerville - KeyBanc

What copper assumption are you using for the year?

Paul W. Jones

I’m not going to go there. I have competitors listening to this call that would love to know that number. And I’m not going to disclose it.

Matt Summerville - KeyBanc

You mentioned that a company that you are, and this is a close-to or whatever, that’s received surcharge notices from the steel suppliers. Have you seen those yet?

Paul W. Jones

No. We think our contracts are fine and we won’t.

Matt Summerville - KeyBanc

I’m hearing out there, even companies with contracts in place are seeing these surcharges a lot like what happened in ‘04. But, it sounds to me like you feel like your contracts are firm enough that you’re not going to paying close to spot prices.

Paul W. Jones

That is correct.

Matt Summerville - KeyBanc

With the escalation that we’ve seen in both your key raw material inputs, when do these increases as of late start to impact the P&L? Is that second quarter? Are you fairly good on your raw material costs until around midyear? What’s the timing of how this stuff rolls through?

Paul W. Jones

Our contracts with our steel companies are determined off indices. And we use those same indices to put into our contracts with our OEMs where we have them. And, they are based on looking backwards and taking some points in time. So, we think we’re going to be, if we take a bit of nick in the second quarter, but maybe not a large one because we’ve got our steel costs and our selling prices.

Now I’m talking about motors now. For the ones we have contracts, we have those somewhat aligned. Where we don’t have contracts, we are in discussions as we speak and we will do what we can there and what we have to do in order to recover those costs and keep the margins where they should be.

On the water heater side, the steel increases we know what they’re going to be for the second quarter. More importantly, our main focus right now is the rest of the year and trying to make sure that we can get a reasonable estimate of what steel costs are going to be so that we can do the right thing with our customers.

Matt Summerville - KeyBanc

With respect to Lowe’s, it looked to me like you’re able to get a little bit of pricing out of that customer early on in the year. Have you been successful in going back for additional pricing? And if not, what has to happen for you to be able to do so?

Paul W. Jones

I don’t want to get into the discussion on pricing. Channel parity between wholesale and retail is something that we put a high priority on and we’re going to maintain that. And if our costs go up dramatically from things that we can’t control, obviously our first approach is to be as aggressive as we can on the cost reductions.

But, when we have steel going up $150 to $200 to $300 of ton, as it has being discussed right now, then we have to do what we have to do to go to our customer base and get some assistance from them with this matter. Again, the people we sell to are seeing this from everybody. We’re not the only customer they have that uses steel and copper.

Matt Summerville - KeyBanc

As far as the non-res business or the commercial business, you disclosed what you thought new residential was as a percent of segment sales for both motors and water heaters. Could you give that same disclosure for new commercial for both motors and water heaters?

Paul W. Jones

Commercial is a whole different animal. It’s primarily new. There is a replacement element to it but it’s primarily new. And we enjoy a pretty healthy market share there. It’s an area that we’ve focused on a couple of years ago on some new products that are hitting the market now and are really gaining some traction.

So it’s hard for me to quantify how big of a decline that we’ll see there. But, I think it will be minor. I don’t think we’re going to see a huge year-over-year decline on our commercial water heater business.

Matt Summerville - KeyBanc

I was looking more for how much of your motor revenue is commercial and then in the water heater business, how much is commercial?

Paul W. Jones

The commercial, we’re forecasting as being down 5% to 10% in unit sales this year. And again, this is off 90,000 units. We’re going to be down maybe 5,000 to 10,000 units from where we were. It’s not a huge decline.

Operator

We have a question from Scott Graham - Bear Stearns.

Scott Graham - Bear Stearns

I know that you are always loathe to put numbers for competitive reasons out there. I just wondering if there is any way you could tell us what the raw material situation is even if it’s at the margin, the incremental second half expectations versus first half. Again ex-ing out pricing because we’ll all make our assumptions there.

But what are you seeing? Is that like a 100 basis point to the margin change of second half versus first half or in dollars? Is there any way you can put some parameters around that for us?

Paul W. Jones

It’s difficult, Scott. We’ve obviously made some assumptions internally but they are really at this point, being blunt, just wild-eyed guesses. The industry for example, what we will use for our selling prices in the third quarter will be based on March, April and May indices of which we only have one of those three data points so far.

Scott Graham - Bear Stearns

I’m not talking about selling prices, I’m not asking for your dollar-per-pound copper or hundreds of dollars-per-ton steel assumptions. I’m not asking for that. I’m just asking for the cost, the incremental cost differential that you’re seeing in the second-half versus the first half if you straight-line current prices of those commodities?

Paul W. Jones

If we straight-line, I’m not going to give you a number. Sorry, I’m just being blunt. I’m sorry, Scott. I’m not going to do it. If we straight-lined our current prices, April prices, it would be up, not a lot. If we look at what the market is telling us and what’s happening relative to steel over the last three weeks, it would be up significantly.

And I’m not going to help the steel companies by telling them what we’re anticipating because they’ll be in here tomorrow with a new surcharge of some kind. We have made some estimates internally and it would be imprudent for me to share those with anybody.

Scott Graham - Bear Stearns

The whole water heaters market, obviously we’ve seen some weakness there. But in truth, I didn’t expect to see the seemingly domestic volume decline in water heaters. And could you maybe give us some color on that?

Paul W. Jones

Yes, there are a lot of things going on there. We’ve been doing some very aggressive service programs. We’ve got the lowest cycle time now and we’ve got the shortest delivery. That’s a good thing. That’s something we wanted to do and it gives our wholesalers, it helps them be a little more loyal to us because they can maintain lower inventory.

I don’t want to start getting onto trying to estimate what our wholesalers’ inventories are and how they changed during the first quarter. But I would expect and I believe that on an overall basis, there was a decline in the inventory of our wholesalers in the first quarter, but not a big measurable amount.

We did, as we’ve disclosed in our last call, have a slight pre-buy by the wholesalers at the end of the year, some of them, not as many as have participated in years past. But, there was a pre-buy by the wholesalers at the end of the year because we had a price increase effective January 1.

There’s a lot of thing is going on there but we’re delivering very quickly right now. We even have a commercial program where we can do a 24-hour shipment of some of our standard commercial units. And that’s unprecedented in the industry.

So, there’s a lot of things that we’re doing right there to maybe help us to have better volumes. But maybe over the short-term, it helps our customer maintain a little less capital invested in selling our products but enables them to be a lot more loyal and a lot more willing to work with us going forward.

Scott Graham - Bear Stearns

On share repurchases, could you tell us what’s left on the current authorization?

Paul W. Jones

We communicated an additional authorization from our Board of one million shares. And we’ve not done anything with that yet.

Operator

There are no additional questions.

Paul W. Jones

We appreciate everybody’s support, appreciate the questions, and appreciate your interest in the company. Hope to see all of you at the Grand Hyatt next month. We will have our operating group presidents there also. So, maybe you’ll have a little better luck getting straighter answers out of them than you get from me. So, I look forward to seeing you there. Thanks a lot.

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Source: A.O. Smith Corporation Q1 2008 Earnings Call Transcript
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