A. O. Smith (AOS) Q1 2018 Results - Earnings Call Transcript

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A. O. Smith Corp. (NYSE:AOS) Q1 2018 Earnings Call April 25, 2018 10:00 AM ET

Executives

Patricia K. Ackerman - A. O. Smith Corp.

Ajita G. Rajendra - A. O. Smith Corp.

John J. Kita - A. O. Smith Corp.

Kevin J. Wheeler - A. O. Smith Corp.

Analysts

R. Scott Graham - BMO Capital Markets (United States)

Jeffrey D. Hammond - KeyBanc Capital Markets, Inc.

Jim Giannakouros - Oppenheimer & Co., Inc.

Charles Brady - SunTrust Robinson Humphrey, Inc.

Matt J. Summerville - D.A. Davidson & Co.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Samuel H. Eisner - Goldman Sachs & Co. LLC

David S. MacGregor - Longbow Research LLC

Ryan Michael Connors - Boenning & Scattergood, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation First Quarter 2018 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. And as a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Ms. Patricia Ackerman, Vice President, Investor Relations, and Treasurer.

Patricia K. Ackerman - A. O. Smith Corp.

Thank you, Amanda. Good morning, ladies and gentlemen, and thank you for joining us on our 2018 first quarter results conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; Kevin Wheeler, President and Chief Operating 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 statement. 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.

In order to provide improved transparency into the operating results of our business, we provided non-GAAP measures, adjusted net earnings, adjusted earnings per share, and adjusted segment earnings, that excludes the restructuring and impairment costs associated with our plant closure in Renton, Washington. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. Also as a courtesy to 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 4.

Ajita G. Rajendra - A. O. Smith Corp.

Thank you, Pat, and good morning, ladies and gentlemen. A 6.5% sales growth in the first quarter was driven by continued demand for our consumer products in China and positive end market for our boilers in North America. Here are a few highlights.

Record sales of $788 million, adjusted net earnings of $0.60 per share were 20% higher than our earnings per share in 2017. We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. We repurchased over 500,000 shares for approximately $33 million. We announced a 29% increase to our dividend in January. The five-year compound annual growth rate of our dividend is over 25%. We repatriated over $210 million during the first quarter using the proceeds to pay down floating-rate debt and improving the flexibility of our balance sheet.

We announced earlier this month that A. O. Smith will be the primary water treatment brand at Lowe's beginning in August. The combination of our recent acquisitions of Aquasana and Hague, coupled with our globally accepted and innovative water treatment technologies, and internally developed products, selected tools and brand displays, delivered a compelling product and value proposition to the Lowe's merchandising team. We are very excited about the opportunity we earned because of our water treatment expertise and vision, and also to expand our relationship with our longstanding retail water heater partner.

We expect $15 million in sales and a $1 million to $2 million loss due to start-up and transition costs this year. John will now describe our results in more detail beginning with slide 5.

John J. Kita - A. O. Smith Corp.

Sales for the first quarter were $788 million or 6.5% higher than the same quarter of 2017. Adjusted net earnings in the first quarter of $104 million increased over 18% from the first quarter in 2017. First quarter adjusted earnings per share of $0.60 increased 20% compared with the same quarter in 2017.

Sales in our North America segment of $502 million increased 3% compared with the first quarter of 2017. Higher volumes of boilers and pricing actions in 2017 related to steel cost increases were partially offset by lower water heater volumes in Canada. North America water treatment sales comprised of Aquasana and recently acquired Hague incrementally added approximately $8 million to our North America segment sales.

Rest of World segment sales of $294 million increased 13% compared with the same quarter in 2017. In China, sales increased 13%, including a benefit from currency translation of approximately $21 million.

China sales in local currency terms were muted by the expected impact of a pre-buy in the fourth quarter of 2017. Pricing actions in mid-2017, primarily due to higher steel and installation costs as well as higher demand for the company's gas tankless water heaters and water treatment products, contributed to higher sales and were partially offset by a significant decline in air purification product sales, we believe, primarily due to improved air quality in China.

On slide 8, North America adjusted segment earnings of $113 million were 8% higher than segment earnings in the same quarter in 2017. The favorable impact from higher sales of boilers and pricing actions in the U.S. were partially offset by higher steel and other input costs.

Adjusted segment earnings exclude $6.7 million of pre-tax charges associated with the plant closing. These factors drove first quarter 2018 adjusted segment margin higher to 22.5% compared with 21.4% last year. Rest of World earnings of $36 million improved 11% compared with first quarter of 2017. Higher China sales, including the price increase, were partially offset by higher steel costs, selling and engineering costs associated with new products and the negative impact of earnings from lower air purification product sales. Translation gains compared with last year added approximately $3 million to earnings. First quarter segment margin of 12.3% was modestly lower than one year ago.

Our Corporate expenses were slightly higher in the first quarter compared with the same period in 2017, primarily due to higher spending at our Corporate Technology Center. Our effective income tax rate in the first quarter of 2018 was 21.4%. The rate was lower than the 27.2% experienced during the first quarter last year, primarily due to lower federal income taxes, related to tax reform, which was partially offset by lower stock-based compensation income tax benefits. The lower effective income tax rate benefited first quarter 2018 earnings by $0.04 per share.

Excluded from adjusted earnings was $5 million of after-tax restructuring and impairment costs associated with the closure of our Renton, Washington, specialty water heater plant. Efficiencies from manufacturing relocations will be offset by plant inefficiencies and move costs during the second and third quarter. We expect benefits from the relocation in 2019 to be approximately $3 million.

Cash provided by operations during the first quarter of 2018 was $43 million compared with $12 million used during the same period in 2017. Higher earnings and a smaller investment in working capital were the primary drivers of higher cash flow compared with last year. Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio was 15% at the end of the first quarter. We have cash balances totaling $680 million located offshore and our net cash position was approximately $387 million at the end of March.

During the first quarter, we repurchased approximately 500,000 shares of common stock for a total of $33 million. Approximately 1.9 million shares remained on our existing repurchase authority at the end of March. This morning, we upgraded our 2018 adjusted EPS guidance with a range of between $2.55 and $2.61 per share. The midpoint of our adjusted EPS guidance represents a 19% increase in EPS compared with our adjusted 2017 results. Our EPS guidance excludes $0.03 per share of plant closing costs.

Excluding the U.S. tax reform benefits, our operational performance is expected to improve by over 11%. We expect our cash flow from operations in 2018 to be approximately $475 million, which is higher than the $326 million generated in 2017. We expect higher earnings and lower outlays for working capital this year.

Our 2018 capital spending plans were approximately $100 million. Our depreciation and amortization expense is expected to be approximately $80 million in 2018.

Our corporate and other expenses are expected to be approximately $48 million in 2018, slightly higher than the $47 million in 2017, partially due to higher projected spending at our Corporate Technology Center.

Our effective income tax rate is expected to be approximately 22% in 2018, lower than the previous year due to U.S. tax reform. We expect to repurchase our shares in the amount of approximately $135 million in 2018 under a 10b5-1 plan, similar to 2017. We may supplement our 10b5-1 plan with opportunistic share repurchase in 2018. We expect our average diluted outstanding shares in 2018 will be approximately 173 million.

Kevin Wheeler will summarize our guidance, the business assumptions for the remainder of 2018, and our growth strategy beginning on slide 12. Kevin?

Kevin J. Wheeler - A. O. Smith Corp.

Thank you, John, and good morning, everyone. Our outlook for 2018 includes several tailwinds and headwinds. First, our tailwinds. We project U.S. residential water heater industry volumes will increase 250,000 to 300,000 units in 2018 due to continued new construction and expansion of replacement demand. This assumption includes tankless units. Boiler revenues grew 13% in the first quarter driven by solid demand for condensing boilers and recently introduced product. We expect our boiler business to grow approximately 10% in 2018. As a result of significantly higher steel prices and inflation in freight and other costs, we announced a price increase up to 12% on U.S. water heater products effective in early June. We expect the price increase to average 10% on majority of our water heater products.

While we previously expected a modest depreciation of the China currency during 2018, we now project a translation benefit of approximately $55 million to sales compared with the rates in 2017. Our projection is assuming modest appreciation of the China currency during the remainder of the year. The China currency is currently at an exchange rate which we experienced in 2015. And we expect the loss in India to decline from $7.5 million loss in 2017 to $5 million loss in 2018.

The headwinds include, our China sales grew 13% in first quarter, including currency gains. The air purifier industry demand declined over 50% in the first quarter, our business was down $11 million from the prior year. We have reassessed our original expectations for our air purifier business and now expect sales to be down from 2017 and to lose $5 million, similar to last year. We expect second quarter China sales growth to be similar to the first quarter due to the pre-buy and decline in air purification sales. We expect the impact of the pre-buy up and the lower air purification sales, and now forecast 9% to 10% growth in local currency and over 14% in U.S. dollars.

Our movement of water treatment and air purification manufacturing into our new plant in China will result in projected incremental costs of approximately $5 million, majority of which will occur in the second quarter of 2018.

I'm going to move to slide 13. Combined the impacts of the tailwinds and headwinds, we are optimistic about our growth and bottom-line performance for 2018. We project revenue growth will be between 10% to 10.75% for the year. This includes approximately $15 million of revenues in the recently announced water treatment business at Lowe's, and currency translation gains in China of approximately $55 million over the prior year and the 2018 U.S. price increase.

We expect U.S. segment margins to be between 21.75% and 22.25%, negatively impacted by the start-up and transition costs of the new Lowe's water treatment business. We project improved performance in China in the second half of the year as the China pre-buy and the plant move costs are behind us. As a result of China and India performance, we expect Rest of World margins to be at least 30 basis points to 40 basis points higher than last year.

I'm now moving to slide 14. Last quarter, we updated the components of our growth model to be consistent with the new disclosure rules for disaggregation of segment revenue as well as to incorporate recently acquired and organically fast-growing businesses. We combined North America water treatment and India with our consumer products business in China. This is our high growth category and it represents 36% of company sales. China is expected to continue its mid-teens growth rate due to its strength in water heaters and water treatment products.

We expect sales of North America water treatment, composed of Aquasana and Hague products, and the new Lowe's A. O. Smith branded business, will reach over $100 million of revenue this year. With the Lowe's business contributing $35 million to $40 million, we project North America water treatment sales to approach $140 million in 2019 and improve margins by 50% to 13%.

Global water treatment sales are forecasted to exceed $525 million in 2019. India grew over 40% last year and we are enthusiastic about our distribution now being pan-India for both water heaters, and water treatment. Based on the investments we have made and expect to make in the future, we project this high-growth portfolio to grow 14% per year.

As many of you know, sales of our Lochinvar-branded products are composed of approximately 60% boilers and 40% water heaters. Going forward, our growth model will separate the boiler piece of our company with assumed growth rate which matches its five-year revenue CAGR of 10%.

Sales of our North America water heater products remain the largest portion of our company's sales at 58%, including our Lochinvar-branded water heaters. Given the expected new construction needed to support household formation and expanded replacement demand, we project water heater growth at a rate of 4%. The weighted average of our growth model continues to be 8% for the medium-term timeframe.

Especially in these uncertain economic times, we believe our organic growth model potential and our stable defensive replacement market, which we believe that represents 85% of North America water heater and boiler volumes, positively differentiates A. O. Smith from other industrial companies. Couple that with our 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 our shareholders.

That concludes our prepared remarks, and we are now available for your questions.

Question-and-Answer Session

Operator

Thank you. Our first question comes from the line of Scott Graham of BMO Capital Markets. Your line is open.

R. Scott Graham - BMO Capital Markets (United States)

Hi. Good morning.

John J. Kita - A. O. Smith Corp.

Good morning.

R. Scott Graham - BMO Capital Markets (United States)

So, I have a number of questions, but I'll stay to your format of two and then get back in the queue. The first question that I think comes to mind for me is that the North American residential water heater market, which is your primary business, and it doesn't look like there has been a lot of growth there, frankly, for some time, in a market that has been growing sporadically. Could you talk a little bit about what's going on in that business, which is kind of your flagship?

John J. Kita - A. O. Smith Corp.

Well, Scott, we are forecasting, as we said, it to go up 250,000 to 300,000 units this year. And the first quarter was interesting. It was very strong, January-February, and then down in March. Our guess is the industry was up about 40,000 units total, including tankless. We were pretty flat and that's driven primarily by last year's first quarter for us was with Sears was our strongest quarter. So, we kind of performed as expected. The industry was up 40,000. We're calling for 250,000. When I talk to our salespeople, they're very optimistic. The biggest issue both on the residential and commercial is getting labor. But as they talk to people, they're optimistic. So if we do hit the 9.4 million industry that we talked about, that's a pretty significant growth. And now, obviously, that growth goes back. But if you look at the industry in 2009 to 2012, it was 8.1 million units. So now going to 9.4 million over this four or five-year stretch, we have seen decent growth.

R. Scott Graham - BMO Capital Markets (United States)

Yeah. I understand that. I guess, I was talking more about you relative to the market, and I know that that's sort of one or two months off because of sell-in versus sell-through and all this stuff. It just seemed to me as if – like the bottom line here is that, are your salespeople saying to you that you are comfortable in retaining share, but at the same time, everyone is kind of losing like a 0.5 point a year to tankless? Would that be a fair statement?

Kevin J. Wheeler - A. O. Smith Corp.

This is Kevin, and I'll address that. One that, when you compare Q1, that was the strongest quarter we had back in 2017, which add over 50% growth. And embedded in that, Canada had a price increase in Q1 of last year. So when you put it all together, we're very comfortable – to answer your share question, we're very comfortable where we're at and being able to compete in the market. And if you look forward, we're very comfortable with the $250,000 to $300,000 (sic) [250,000 to 300,000 units] forecast based on what we see in projects, in feedback that we're receiving from our sales organization. And as far as tankless, we have low-teens share or low-teen share and that is capturing some additional parts of the market. It grew 19% last year, it's growing about 10% this year. It's primarily in California, where it's new construction-oriented. And it continues to grow and we continue to bring products and capture additional customers and share. So overall, we are fairly comfortable with our residential business, its growth rate and its forecast for 2018.

R. Scott Graham - BMO Capital Markets (United States)

Kevin, thank you. That was very comprehensive answer. I appreciate it. The second question, even though that was kind of a triple-parter, is more about the statement that you make around air filtration, which the text in the press release was sort of around air quality improvement. And I'm sure you mean more than that, because China's air quality didn't suddenly improved in 90 days. Could you talk through what you mean by that and why sales on the market were down 50% in the first quarter? Is that potentially a secular thing?

John J. Kita - A. O. Smith Corp.

Well, as you alluded to, the industry was down over 55%. Talking to our people, there was a focus on improved air quality during the quarter, without a doubt. They closed coal plants and what we've heard, they closed them locally as well as much more control on automotive. Now, we will also say we've heard anecdotally that closing the coal plants to just get better air did create some disruptions for companies manufacturing, et cetera.

What we can't tell you, Scott, is this sustainable, that they can do it this way or not. But everything we've heard, talking to our people and talking to consultants, is the air quality was better in the quarter and that was the driver. Because otherwise there is no – the only other explanation that we've talked about in the past is that the consumer is not 100% sure these units are doing anything. Now, again, we told you we put sensors on there, we're doing a much better job of measuring PM2.5. But the only explanation we can come up with is better air quality.

R. Scott Graham - BMO Capital Markets (United States)

Got it. Thank you.

Operator

Thank you. Our next question comes from the line of Jeff Hammond of KeyBanc Capital Markets. Your line is open.

Jeffrey D. Hammond - KeyBanc Capital Markets, Inc.

Hey, good morning.

Ajita G. Rajendra - A. O. Smith Corp.

Good morning.

Patricia K. Ackerman - A. O. Smith Corp.

Hi, Jeff.

Jeffrey D. Hammond - KeyBanc Capital Markets, Inc.

Hey. So just on the revenue guidance increase, can you just kind of walk through that? Is that mostly FX, price and this incremental Lowe's, or are there some other moving pieces within that?

John J. Kita - A. O. Smith Corp.

I think you hit the majority of them. So when we estimated the year from a currency standpoint, we were expecting the RMB to appreciate a little less than 10 basis points. Last year, was about RMB 6.75 on average. We were expecting it to be a little above RMB 6.65. And now, we know rates are now RMB 6.30, we're expecting closer to RMB 6 – a little over RMB 6.40. So when you do that, that's about $40 million of incremental currency gain that we didn't have in our original estimate.

Now, as you know, we took China down. If you look at we were 12.5% to 13% – 12% to 13% when we talked in January, we're now saying 9% to 10%. That's about a 3 point difference, that's about $30 million, we're taking it down due to that. And again, we're saying that's basically all air purification. We expected – last year, air purification was $44 million, $45 million. We expect it to go to $65 million this year. Given the first quarter and given the second quarter, we're saying $40 million kind of at best. So that's the negative. And then, yeah, you add price and you add the Lowe's business. And that's why we're comfortable going from the 8.5% to 9.5% that we had in January to the 10% to 10.75% that we're forecasting now. So, there's a lot of puts and takes.

Jeffrey D. Hammond - KeyBanc Capital Markets, Inc.

Okay. That's very helpful. And then just on price, I know you guys don't like to talk too much about that, but have you seen similar size price increases from the other players in the water heater market at this point? And I guess just given the magnitude relative to kind of normal, what are you expecting in terms of any kind of pushback? Thanks.

Ajita G. Rajendra - A. O. Smith Corp.

Jeff, this is Ajita. As we've said before, we don't really comment on what anyone else is doing in terms of price. We put our pricing out there and we are very comfortable in terms of where we are.

Operator

Thank you. Our next question comes from the line of Jim Giannakouros of Oppenheimer. Your line is open.

Jim Giannakouros - Oppenheimer & Co., Inc.

Hi. Good morning, everyone.

John J. Kita - A. O. Smith Corp.

Good morning.

Patricia K. Ackerman - A. O. Smith Corp.

Hi.

Ajita G. Rajendra - A. O. Smith Corp.

Good morning.

Jim Giannakouros - Oppenheimer & Co., Inc.

Just to touch on Rest of World margin expectations. Obviously, lots of puts and takes there. But mix influences, leverage, marketing spend, obviously, FX clearly helping. Can you call out or at least rank-order the year-over-year impacts there and how you're kind of keeping your margin guidance for the year?

John J. Kita - A. O. Smith Corp.

Well, actually the currency doesn't really have an effect on the margin because sales are going up and, correspondingly, the EBIT. So we're not seeing any effect there. When we look at Rest of World, we talked about India. India, certainly, we expect to be a contributor. If you lost $7.5 million last year, you lose $5 million this year, that's $2.5 million on whatever, $1.1 billion. So, we pick up 20 basis points there. We expect China to be at least as good from a margin standpoint, even overcoming two things; the loss in air purification that we had in forecast and the $5 million of inefficiencies of the new plant. We expect China to be flattish to maybe up a little bit. So, I mean, I'd say, when you flush through everything, the biggest thing is India, and why we're comfortable raising 30 basis points to 40 basis points from last year.

Jim Giannakouros - Oppenheimer & Co., Inc.

Got it. Thanks. And maybe to tack on to Scott's original question, I mean, if you can give us an update on your sense of the state of the U.S. replacement cycle, just taking simple math on expected life of 10 years to 15 years for your water heaters here and the 2002 to 2008 swell on housing starts, should we think that that's going to taper in the next year or two? But if I recall, you still think that we have probably more runway there. So, I'd like to hear your updated thoughts there. Thanks.

John J. Kita - A. O. Smith Corp.

Yeah, I think all the studies we've seen, and they're done by independent third parties, say the average life of water heater is over 14 years, and that has increased. So if you look at the last figures of 2006-2007, that would take you out to the early 2020s. Now, we would also tell you that we don't think housing start of the 1.2 million are the right number, but we think that's going to continue to grow this year, housing starts and completions we're estimating up 100,000 units. So at some point, but I think it's in the future is when we'll have that, we'll have to evaluate that.

Jim Giannakouros - Oppenheimer & Co., Inc.

Thank you.

Operator

Thank you. Our next question is from the line of Charley Brady of SunTrust Robinson Humphrey. Your line is open.

Charles Brady - SunTrust Robinson Humphrey, Inc.

Thanks. Good morning, guys. Good morning, Pat.

Patricia K. Ackerman - A. O. Smith Corp.

Hi.

Ajita G. Rajendra - A. O. Smith Corp.

Good morning.

John J. Kita - A. O. Smith Corp.

Good morning.

Charles Brady - SunTrust Robinson Humphrey, Inc.

Just on the Lowe's deal, you talk – that's going to start in August. Are there costs that have to run ahead of that so that they slip into Q2 or should we expect those costs to all be mostly Q3 and into Q4?

Kevin J. Wheeler - A. O. Smith Corp.

This is Kevin. I'll take that. We expect most of it to be in around the timeframe that our implementation in August starts. As you know when you take on a significant amount of business, and certainly $35 million to $40 million of water treatment business from Lowe's is a significant win for our organization. But with that comes a inventory transition that we'll have to be working through. And again, that will happen about the same time as we're doing the transition in August. There'll be displays in point of purchase that we'll be resetting over 1,700 stores and the displays are going to be really focused on being consumer friendly and helping the consumer through the purchasing process of a very difficult purchase decision for them. And then there's just certification and packaging. Some of that will come maybe prior to August. But again if you look at it, most of it's going to be in that timeframe as we start to execute around August and get it fully implemented, hopefully, within 30 or so days.

John J. Kita - A. O. Smith Corp.

The only thing I'll add is we will have some costs in the second quarter, but Kevin's right, the majority will be in the third quarter. And then in fourth quarter, we start moving to profitability.

Charles Brady - SunTrust Robinson Humphrey, Inc.

Okay. That's very helpful on the timing. Thanks. And just on just North America, broadly speaking, on the margin there as it pertains to price increases, you're obviously capturing that from the 2017 price increase. You've got another one going in, I guess, in June. In between where we're at now and June, are we raw material cost neutral or we have to catch up until we get to the price increase coming up in the summer?

John J. Kita - A. O. Smith Corp.

Well, I'll answer it this way. Steel costs progressively increase throughout the year, but we really get affected in the second half of the year more materially than the second quarter. So, that will kind of be the transition, it will line up well with the price increase for the most part, which will be effective essentially in the – late in June.

Charles Brady - SunTrust Robinson Humphrey, Inc.

Yeah. Understood. Thank you.

Operator

Thank you. Our next question is from the line of Matt Summerville of D.A. Davidson. Your line is open.

Matt J. Summerville - D.A. Davidson & Co.

Thanks. Couple of questions. First, I don't recall you guys saying anything in your prepared remarks around the North American commercial water heater market. So maybe if you could speak to what you felt the industry did in Q1 and, specifically, what your outlook is for both the gas and electric side of the business for the full year?

Kevin J. Wheeler - A. O. Smith Corp.

This is Kevin. The first quarter was really flat year-over-year. And we were a bit surprised, because we did have a pre-buy in Q4. And we anticipated 5,000 being pulled in and that to have that impact in Q1. The pre-buy did not appear really to affect the commercial market. So, electric volumes were essentially flat. And so, as we go forward, we're going to change our forecasts. And given the neutral start of the commercial business and the industry, we revised our full-year forecast to be flat over last year, and that's both on gas and electric.

Matt J. Summerville - D.A. Davidson & Co.

Got it. And then just a follow-up on China. You mentioned air purification sort of down maybe 10%, I think, is what your new assumption is for the year. Can you also talk about what your assumption is for China water treatment? And then, what you're seeing in the water heater volume versus price, specifically, in China? And I'm curious as to whether or not you're seeing volume in the legacy sort of electric product continue to grow. Thank you.

John J. Kita - A. O. Smith Corp.

So, the water treatment had a good quarter. The industry, we think, was up about 11%. We were up 14% in RMB terms and up over 20% in U.S. dollar terms. We're expecting for the year that water treatment is going to be up probably about 18% to 19% in local currency terms and well over 20% in U.S. dollar terms. From a volume standpoint, I would tell you that the electric was somewhat flat from a volume standpoint, as this transition that we see from electric to gas continues, and our gas units were up. So, that's kind of the broad on the water heater side.

Matt J. Summerville - D.A. Davidson & Co.

Thanks, John.

Operator

Thank you. Our next question is from the line of Mike Halloran of Baird. Your line is open.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Hey. Good morning, everyone.

John J. Kita - A. O. Smith Corp.

Good morning.

Ajita G. Rajendra - A. O. Smith Corp.

Good morning.

Mike P. Halloran - Robert W. Baird & Co., Inc.

So on the air purification side in China, has this changed your long-term thought process in terms of investment or approach? In other words, do you think this is a blip, is it structural? Do you still see the same opportunity set? Any color around that would be great.

Ajita G. Rajendra - A. O. Smith Corp.

Mike, this is Ajita. We don't know what the impact is going to be in terms of the – as John said, in terms of what the government did whether it is sustainable. If you recall, they did something similar before the Olympics few years ago.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Yeah.

Ajita G. Rajendra - A. O. Smith Corp.

Cleaned up the air quality for a while and then things went back to normal. So here, what we did hear that there was significant disruption. People were not happy because it impacted their life, and because there was not enough capacity of other types of heating to compensate for the loss of the coal-fired plants. Okay? So, that's what happened in the past. How it's going to happen in the future? We don't know. However, from our perspective, we have some really exciting new products that are coming out and we are continuing like the market is going to be continuing to grow, but probably not at the pace that we've seen in the last couple of years. So, that's our approach. That's the best we know now.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Makes sense, and then...

Ajita G. Rajendra - A. O. Smith Corp.

But we're continuing to invest in the new products and new capabilities and the products that we're putting out.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Great. Thanks for that. And then another China question, obviously, North America, you're putting through the 10% price increase. Maybe just some thoughts on the price/cost in China. It doesn't sound like it's a big concern for you considering where the margin guidance is, but just some thoughts directionally and how you expect that to trend.

John J. Kita - A. O. Smith Corp.

Well, we did put price increases last year. I would tell you there is steel increase in China, but it's not to the extent we've seen in the U.S. So, I think at this point, we're comfortable with the cost/price relationship.

Mike P. Halloran - Robert W. Baird & Co., Inc.

Great. Thank you for the time.

Operator

Thank you. Our next question is from the line of Sam Eisner of Goldman Sachs. Your line is open.

Samuel H. Eisner - Goldman Sachs & Co. LLC

Hey. Good morning, everyone.

John J. Kita - A. O. Smith Corp.

Good morning.

Kevin J. Wheeler - A. O. Smith Corp.

Good morning.

Samuel H. Eisner - Goldman Sachs & Co. LLC

Just going to your North American margin guidance. So, midpoint of the guide is 22%. You guys last year did 22.5%. Obviously, doing much better here in the first quarter than we expected from a profitability standpoint. I guess, how do you guys think about the overall margin compression year-on-year? Recognized only 50 basis points, but John, your comments just before were indicating that you expect the inflation to be more 2H weighted, I guess that's when the pricing is heading. So I guess I'm failing to understand where the compression is going to come from or maybe I'm missing something in how you guys are thinking about it.

John J. Kita - A. O. Smith Corp.

Well, the Lowe's, right off the bat, takes about 30 basis points when you lose $1.5 million on $15 million of sales. So, that's probably the biggest impact going from the 22.5% down to 20%. Otherwise, I would tell you, it's primarily noise. But clearly, the Lowe's business is the biggest factor.

Samuel H. Eisner - Goldman Sachs & Co. LLC

Understood. That's helpful. And then maybe a question for the long term for Ajita. Just the balance sheet has gotten cleaned up. It looks like, you paid down some floating-rate debt. Obviously, your net cash balance is approaching $400 million. Your water treatment business is getting much larger. You called out the fact that it's now a global business. And so, maybe you can talk about just the long term. What's the right way to think about this business in the next two, three years? What's the overall outlook for water treatment for A. O. Smith?

Ajita G. Rajendra - A. O. Smith Corp.

So I think, from a capital allocation perspective, in terms of what we've done in the past, you see that our acquisition targets have been very strategic. And as you look at – when you think about water treatment, I'm going to say, three, four years back as we laid out our strategy globally, we said this is going to be a global business. We targeted India – outside of China, India and the U.S. And in the U.S., you can see that there were some very, very specific strategic moves that we made, taking our brand to Lowe's, making the acquisitions that we did in terms of Aquasana and Hague that then rounded out our line and gave us a broad line that we could then be a serious player and go compete for this business with, I would argue, the most competitive environment in certainly this country, which is trying to get big-box business, which we succeeded in doing, displacing brands that have been around for much longer than we have in the water treatment business.

So, we see water treatment as being a major growth driver for us in the future, both in China, in India and in the U.S. And us getting into Lowe's is the start of that with what we are hearing about in terms of – you have a number of – we've always said, there are a number of Flints (40:07) around the nation. The average municipal water infrastructure in major cities is over 75 years old. And as people start realizing what the quality of their water is, we see this business growing and we are investing behind it and counting on that growth.

Samuel H. Eisner - Goldman Sachs & Co. LLC

All right. That's helpful. Thanks so much.

Operator

Thank you. Our next question is from the line of David MacGregor of Longbow Research. Your line is open.

David S. MacGregor - Longbow Research LLC

Yes. Good morning, everyone. Can you just update us on Nanjing? I think you talked about the $5 million first quarter incremental costs. Can you provide some detail around how we should think about the impact for 2Q, 3Q, Q4 just over the next few quarters as we go forward?

John J. Kita - A. O. Smith Corp.

I think what we tried to say is for this year the impact will be about $5 million and we're expecting about $3 million of it – about $500,000 we experienced in the first quarter. We expect a little over $3 million in the second quarter. And that's really driven by – that's when the transition is going to be taking place. We'll be opening new plant. We're going to be operating two plants. We're going to have a move cost, just general inefficiencies, et cetera, depreciation and lease costs on both, if you will. And so then, as we get to the second half of the year, we'll start experiencing some Lowe's efficiencies that will offset the higher depreciation and utility costs. So I guess, I'd say, it's $500,000, $300,000 and probably, $750,000, $750,000, or what are the numbers in order to get to $5 million. And then next year, we're up and running and the plant is running efficiently, and we're offsetting some of those higher utilities and depreciation.

David S. MacGregor - Longbow Research LLC

Got it. Thanks for that. And secondly, just to follow up on a previous question with regard to Lowe's, notwithstanding, you've got sort of all the loading costs and everything is going on this year, but if you think on more of a normalized basis, so I guess 2019 and beyond, I guess, two questions. Number one, how should we think about the growth potential in North American market for that Lowe's business, how does that revenue grow? And then, secondly, is it accretive or dilutive to the North American margins?

John J. Kita - A. O. Smith Corp.

Well, I'll answer the last one. Ultimately, as we move up over the next couple of years, it's dilutive. But certainly, our objective is to get it up to North America margins in the next three years or so. But during this transition, and we grow sales, et cetera, it will be dilutive to the North America margins. Kevin, I don't know if you want to answer the...

Kevin J. Wheeler - A. O. Smith Corp.

Yeah. From a sales perspective, I mean, as we get through the transition and get into 2019, we'll have the full benefit, as I mentioned the $35 million to $40 million. We see long-term growth there. We believe that the consumer has not been – they've been confused about the product category, how to pick, how to choose their products. And the displays and things that we have in there are going to help that process. We're bringing a full line of products as well as our high-end RO, high performance, leading product there as well. So when you look at it as a whole, I'm going to go back to what Ajita said about the strategy, we look at it as a long-term growth component of our business and we will – as far as how it generates additional sales into the remaining years is going to be depended up on our effectiveness of our displays and how we go to market as well as the things that may happen, like another Flint (43:43) and other things like that. And as education goes up, we're very enthusiastic about the water treatment business in the U.S.

David S. MacGregor - Longbow Research LLC

How do you think about the longer-term category growth rate then, if we could ask it that way?

John J. Kita - A. O. Smith Corp.

I think mid-single...

Ajita G. Rajendra - A. O. Smith Corp.

Yeah.

John J. Kita - A. O. Smith Corp.

...mid- to high-single digits is what we've been talking about.

Ajita G. Rajendra - A. O. Smith Corp.

Yeah.

John J. Kita - A. O. Smith Corp.

And we hope we can, through education, even improve it higher than that.

Ajita G. Rajendra - A. O. Smith Corp.

Right. Because there isn't any – there isn't a lot of good data out there, especially on the filtration side. There is good data on the softening side. And what we believe and our research shows, we've done a significant amount of consumer research on this category, which is what helped us also develop our portfolio of products and value proposition for Lowe's. We feel that this category is going to continue to grow, especially on the filtration side.

David S. MacGregor - Longbow Research LLC

Thanks very much.

Operator

Thank you. Our next question comes from the line of Ryan Connors of Boenning & Scattergood. Your line is open.

Ryan Michael Connors - Boenning & Scattergood, Inc.

Great. Thank you. Did want to stick with the topic of Lowe's just for a minute, and congratulations on the deal, seems very exciting. But I want to understand better the interplay between the incremental business here and the existing water treatment business that you have, and whether this is entirely incremental or whether there's some degree of channel overlap and could there actually be some near-term cannibalization of your existing business there?

Kevin J. Wheeler - A. O. Smith Corp.

This is Kevin. As far as overlap, we see very little to none. This is a new channel, a new category for us and we had no presence until Lowe's. Yes, we have a e-commerce business and, of course, we had some business through Hague. But we look at this as primarily incremental business and with very, very little or no cannibalization.

Ryan Michael Connors - Boenning & Scattergood, Inc.

Okay. And then my follow-on to that is regarding Lowe's from a bigger picture strategic standpoint. Obviously, this deepens your relationship with them. You had the move last year of moving the flagship water heater brand into Lowe's. So, you've got a pretty significant presence now there for the brand and for the company. Obviously, they're known for being aggressive at times in line reviews and that sort of things. So, I guess, my question is two-fold. Number one, do you see further opportunities in the future to continue to build on that relationship and how do you look at Lowe's strategically for the company? And then relatedly, how do you protect yourself against some of the things that can happen, dealing with the big boxes, as you kind of alluded to, Ajita, and then being this tough customer at times?

Ajita G. Rajendra - A. O. Smith Corp.

We feel very good about the relationship. Certainly, we want to be able to leverage it going forward. In terms of dealing with big boxes and all of that, we know we've been a partner with Lowe's for – when you go back to before the American Water Heater acquisition, I think it's been (47:00) 30 years?

Kevin J. Wheeler - A. O. Smith Corp.

At least.

Ajita G. Rajendra - A. O. Smith Corp.

So 30 years plus, we have a very good partnership, I truly call it a partnership, and we're looking at any opportunity we can to grow the business there. The move of our flagship brand into Lowe's has – we are both very happy with the performance. I can't be specific about numbers, because Lowe's has not been public about the numbers. But I can say that we are both very happy with the performance of the brand at Lowe's.

Ryan Michael Connors - Boenning & Scattergood, Inc.

Great. Well, thanks for the color and congrats again. It's exciting.

Ajita G. Rajendra - A. O. Smith Corp.

Thanks.

Operator

Thank you. And our next question is from the line of Scott Graham with BMO Capital Markets. Your line is open.

R. Scott Graham - BMO Capital Markets (United States)

Yes. Hi. Thank you for allowing the follow-ups here. I don't remember when we had a 12% broad price increase like we're looking for next quarter. I'm just kind of wondering, have – other than that product line increases that are, whether NAECA or other trade driven, have you put out any price increase even close to this? And then the question by extension is kind of what's been the trade feedback in front of such an increase?

Ajita G. Rajendra - A. O. Smith Corp.

From a historic perspective, we have, and it's been driven by steel prices. I go back to the early 2000s, where we had significant steel price increases, and I'm going to say they were higher than this. They were high teens, from my recollection, high teens type price increases we had to put through. And in terms of the market, I'll have Kevin respond to that.

Kevin J. Wheeler - A. O. Smith Corp.

Over the years, on any price increase, particularly in water heaters, if there is a component out there that really drives that increase, and I would say steel has been the primary component, it's clear that there is a need out there. It's clear to our customers, distributors, retailers, to our contractors, and all the way down to builders and so forth. So, this is a need-based increase. And historically, those have been increases that have been put in the market, executed and implemented relatively without incident.

Ajita G. Rajendra - A. O. Smith Corp.

Yeah. And if you take a step back and look at the market in total, as Kevin said, the price increases are usually driven, the impetus for a price increase is a significant increase in some sort of cost, commodity cost or some sort of cost. This is not an industry that has an annual-type price increase. It's the impetus that drives it. And if you take a step back, with all of that, the price of a residential water heater with the warranties, about how long it lasts, et cetera, et cetera, is still very reasonable in the marketplace. So, I think those are the key drivers.

Kevin J. Wheeler - A. O. Smith Corp.

Yeah. I would tell you, just the reaction from our customer, based on our announcement, has been relatively similar to the past.

R. Scott Graham - BMO Capital Markets (United States)

And your escalator clauses with retailers versus your, let's say – and your newer pricing with distributors, that gap will be maintained?

Ajita G. Rajendra - A. O. Smith Corp.

Scott, this is Ajita. That's getting into the type of detail we're getting uncomfortable with. But what we see overall is that the implementation of this is – we don't see major change from history.

R. Scott Graham - BMO Capital Markets (United States)

Okay. So, you're not fearful of, let's say, a pre-buy in the second quarter and potential mix shifts to retail, which is lower margin?

Ajita G. Rajendra - A. O. Smith Corp.

I think – let me answer, first of all, we've never talked about a mix impact between channels. Okay? But in terms of pre-buy, I think it will be within the quarter. So, it's not going to be – if there is a pre-buy, you're going to get the plus and minus within the quarter. So, you're not going to see an impact in the quarter.

R. Scott Graham - BMO Capital Markets (United States)

Got it. Okay. Hey, thank you.

Operator

Thank you. And I'm showing no further questions at this time. I'd like to turn the conference back over to Ms. Patricia Ackerman for closing remarks.

Patricia K. Ackerman - A. O. Smith Corp.

Thank you all for joining us on our conference call today. Please take note that we will participate in several conferences during the second quarter. Oppenheimer in New York City on May 9, KeyBanc in Boston on May 30, Stifel in Boston on June 12, and William Blair in Chicago on June 14. Also, please save the date for our 2018 Analyst Day to be held in Chicago on November 5.

Have a great day.

Operator

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

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