A. O. Smith Corporation (AOS) Q1 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you very much for standing by, and welcome to the First Quarter 2012 Earnings Conference Call. [Operator Instructions] Also as a reminder, today's conference is being recorded. I would now like to turn the conference over to Pat Ackerman. Please go ahead.

Good morning, ladies and gentlemen, and thank you for joining us on our first quarter 2012 conference call. With me participating in the call are Paul Jones, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Paul's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. Paul, I will now turn the call over to you.

Thank you, Pat, and Good morning, ladies and gentlemen. In the first quarter, we continued to see improvements in sales and earnings as a result of our acquisition strategy and global footprint. Here are a few highlights. Our organic growth and acquisitions drove sales 12% higher to $469 million. Lochinvar added $49 million and sales of A. O. Smith-branded products in China grew 18%. Our earnings, excluding the favorable impact from the sale of our Regal Beloit shares, were 22% higher than last year at $0.66 per share. Lochinvar continued to contribute significantly and meet expectations. We sold all of our shares of Regal Beloit stock during the first quarter for $188 million or an average of $66.19 per share. This result was almost $13 million higher than the price which was set at the time the deal was struck. John will now describe our results in more detail.

Thank you, Paul. Sales in the first quarter of 490 -- $469 million were 12% higher than the previous year. Lochinvar, which we acquired in August last year added $49 million, and sales of A. O. Smith-branded products in China grew 18%. Sales earnings of $47.5 million or $1.02 per share included the gain on the sale of our RBC shares of $16.7 million or $0.36 per share. Adjusting for the gain, our earnings of $0.66 per share improved 22% over last year's performance. Sales in our North America segment of $353 million increased 10% over last year. This segment includes our U.S. and Canadian Water Heater and Boiler businesses. The incremental sales from the Lochinvar acquisition were partially offset by lower sales of U.S. residential and commercial water heaters compared with last year. We believe our decline in volume is similar to the industry decline. Recall our customers added to their inventories in the first quarter last year in advance of an April 2011 price increase. Commercial gas water heater volumes were also lower in the quarter as an increase in air quality standards in Southern California prompted customers to pre-buy for this region in the fourth quarter last year in advance of the January 1, 2012, standard change. As previously discussed, the pre-buy will affect the second quarter as well. The results of our China, India and European Water Heating businesses and our Water Treatment business in China are captured in our Rest of World segment. Segment sales of $124 million increased 18% compared with last year due to the 18% increase in sales of A. O. Smith-branded products in China, which was driven by new distribution outlets, as well as a pre-buy in advance of a second quarter price increase. We expect growth in the second quarter…

Thanks, John. Given our strong performance in the first quarter but tempered by the pressure on the second quarter from the pre-buy in China and higher steel costs, we raised our expected 2012 earnings per share guidance to be between $2.75 a share to $2.90 per share. This range includes our recently-announced water heater price increase in the U.S. effective June 1. Our guidance also includes an incremental $0.40 to $0.50 per share from Lochinvar in addition to the $0.07 per share contributed by Lochinvar in 2011. Our guidance does not include the impact of future acquisitions and the gain related to the sale of the Regal Beloit shares. Our outlook for 2012 includes the following assumptions. First, our sales growth of A. O. Smith-branded products in China is slowing, but we expect continued share gains, new products and the addition of over 600 new retail outlets will drive our growth by approximately 2x China's GDP growth rate in 2012. Second, we expect Lochinvar to continue to benefit from the transition from lower-efficiency, non-condensing boilers to higher-efficiency, condensing boilers. Lochinvar's condensing boilers continue to offer a compelling payback in the form of energy savings, and the company has built a reputation for innovation and product quality. As a result, we expect Lochinvar's growth rate in 2012 will be over 10%, well ahead of GDP growth in the U.S. I should remind everyone that Lochinvar does have some seasonality to its business related to the products it sells for hydronic heating. Lochinvar's second half of the year typically has higher sales and profits than the first. Third, we expect water heater volumes in the U.S. to remain at 2011 levels due to the stable replacement and non-discretionary nature of our products. Fourth, get your calendars out, we are planning an Analyst…

[Operator Instructions] And the first question comes from the line of Mike Halloran with Robert Baird.

So first, on the China side, obviously really strong growth in the quarter. Now you've had 2 years in a row where you put -- had a first quarter that benefited from a pull-forward and then the second quarter of the year, where you're going to see maybe a little forward trend on an absolute basis. But when you think about the growth rate heading into 2Q, maybe down a little bit from the first quarter, but given that your comparison is relatively easy because you had the same dynamic last year, are you really expecting much different from that trend line in the second quarter in China?

No. Not really, Mike. I mean, as we're looking at the whole year, I mean, the quarter obviously is part of the -- of what we look at. But there is a slowing. You've seen -- everybody has seen the data. The government wants 7.5% GDP growth, which isn't bad, because it's not 10%. And we're continuing to open outlets, so we're still going to keep growing. We're still saying 2x GDP, and there could be some upside to that. So second quarter is going to be an interesting one when it's over, but we obviously feel pretty good about the rest of the year.

And now China has been very encouraging for you guys. And then in the U.S. side, it doesn't sound like, other than Lochinvar performing exceptionally well, that the trends had -- the outlook from your perspective on the commercial side or the residential U.S. side has really changed appreciably over the last quarter or so. Is that a fair way to characterize it?

No. The word we keep using is flat.

And then on the price increase that you guys talked about, just could you -- you said that in a quarter, are you expecting any real fluctuations between 2Q and 3Q on how that demand dynamic is going to play out?

Well, we've got to wait and see how it kind of goes. Sometimes price increases get announced and pulled back and sometimes they stick, and this one is effective June 1. There will probably be a little bit of volume come into May ahead of that. But it will still be within the quarter, and June will be weaker because of that. Typically, when our customers do a pre-buy ahead of a price increase, it's very rare they'll buy more in 3 or 4 weeks of additional product. So within the quarter, it will probably just be essentially a non-event.

And our next question comes from the line of William Bremer with Maxim Group.

Lochinvar, what are the plans strategically on a global basis for the company? Can you give us an idea of how you may proceed with Lochinvar internationally?

So that's an area of focus for us. They already have a toehold in Europe, which is more of a boiler-oriented market than the U.S. But we have said before that China is a strategic opportunity for us, and we are developing plans and moving forward with that as we speak. I don't think it will have a big impact on this year, what we're going to be able to do in China with that product. But we were excited about what it can do for us long-term.

Paul, the 457-square-foot facility in China, will there be a set area specifically for commercial at that plant?

You're talking about the new plant that we -- that's coming up over there in China. It's primarily to -- we've expanded our product line considerably there already. The main thing we need right now is tankless capacity. Our tankless business has been growing dramatically from a 0 starting point to we're now the leading tankless supplier in China. But that -- we need capacity for that. We have a commercial line right now that's in the existing Nanjing facility. That's being modified. We have a -- we have a heat pump. We have a solar. We have gas. We have electric, tank and tankless. We're moving that along. We don't have -- we're moving all those things along as we go forward. And the new plant is going to have more square footage then we need day one, and we'll just add equipment as necessary.

And Paul, any thoughts on in terms of servicing all the tankless, since they do need to be serviced almost annually?

Well, we have a service network throughout China right now that installs our product. This is not something that we own, but it's people that we essentially agree to work with to handle our product. But I don't think we're going to put in our own service network over there.

And our next question comes from the line of Matt Summerville with KeyBanc.

Couple of questions. First, with regards to China, in your comments on the large cities versus the small cities, I'm just trying to understand the magnitude in which your same-store sales has actually slowed or is it more of a continuation on what you saw in Q4? I guess, I'm trying to better understand what's going on there.

I think, Matt, what I would say is we've been talking about the Tier 1 cities kind of being level for quite some time, and that's still the case. We had been seeing the Tier 2 and Tier 3 cities approaching a 20% growth rate. I think it's what we talked about last year. And we've seen that kind of slow down to more like a 10%-type rate. So that's really what we're saying there.

Do you feel like that 10% is bottoming out? Or do you feel like it still has room to slide there? And then, how would you characterize your inventory levels in China versus -- as well as your customers?

I mean, I think we're comfortable with the inventory levels and our customers except for associated with the pre-buy that we just talked about. And so they've done that. As we've talked about quite a bit, we have better visibility as to inventory in China, quite frankly, than we do here. So we're comfortable with the inventory level. And the government started putting a squeeze on housing about a year ago. Our people said it was going to take 6 to 9 months to have an effect, and it is having an effect. The question is how long can they really put that squeeze on and I think they've even recently started loosening up a little bit so...

And if I could add a caution on inventory, it's a -- we're in a real short-cycle business. So from the time we complete a product until it get installed is not a lot of time. So that inventory buffer there is not very large and it may expand a little bit. But it goes back down pretty quickly.

Can you talk about 2 other business units within the Rest of World. I don't recall you mentioning anything about India, so can you update us on the trajectory in that business? I think last year it did $18 million, $20 million in revenue. What are you expecting this year? And then also, I think as you disclosed in your K, Shanghai Water lost $10 million or $12 million, something like that, last year. What do you expect that number to be this year? And what are you doing to diminish those losses?

Okay. India -- we're delighted with what's going on in India. That business could easily double this year over last year. When we first put that plant up, our internal plans were to expand it in 2014. We're now doing it this year. So we pulled those plans forward 2 years. So India is just doing great. We're spending a lot of money establishing the brand, taking the typical long-range approach. But India is going to be a contributor to the company this year and for many years to come, we believe. The Shanghai Water Treatment, last year was obviously a disruptive year. We unfortunately had to pick up and move in the first quarter of 2011 on very short notice in order to protect our employees. We did that, and we've been -- it's like a new plant startup with 750 people. And that plant is coming up. Our revenues are growing. The one piece that's doing great is the A. O. Smith branded, that is off to a terrific start. We're doing better than we expected there. But we have lost some volume on the traditional brands, the legacy brands there that we acquired. And we're building that back up. I'm hesitant to tell you what we think it'll be this year. It won't be bad as last year. Probably won't get to profit -- to break even this year. But we certainly expect that to happen. We're still committed to the strategy, matter of fact, we're expanding the product line to other countries. So it's one that we still believe in and are going forward with. But it's still an area that's a slight drag on earnings for the short term. But we're excited about it for the long term.

And then one final one, Paul. Can you just talk a little bit more, forgetting about the pre-buy dynamic in commercial, just what you're seeing from a market standpoint, how this year's replacement activity compares to last year's? And then also characterize new construction as well.

So if you're talking about commercial, it's flat. There is some replacement. There's a little bit for energy efficiency that's happening. Last year, I said our commercial did just a little better than we thought it would. It's going to be around -- it's going to be flattish this year as we look at it right now. New construction -- again, new construction that we look at is light commercial and light industrial for our product lines. It's -- you can see the Architectural Billing Index. That's the leading indicator that we look at. It's coming up a little bit, but we're expecting it to be flat.

Our next question comes from the line of Scott Graham with Jefferies.

So we on the outside have only this trade data to look at and when it comes to where your sales. You may refute it and that's fine, but that's what we have to go by. Over the last 5 months, North American water heater sales have risen each month, including January and February. So, I guess, I'm wondering, 1 or 2 quarters, I guess, could be refuted. But that type of a trend line would suggest that North American business should have been up since you're essentially half the market. Was it -- would you refute those data, again? Or would you say maybe March was weak? Or help me connect those dots if you could.

Scott, the real issue is March. Last year, there was a pre-buy. Last March was the largest month in a long time. And so we're projecting that March of this year could be down almost 20% year-over-year, and that's why we're saying that we believe the industry, because we are a big piece of it, is down in the first quarter. Even though the first -- January and February were both up about 6%. So it really is driven by the 875,000 units that were sold last year in the industry in March.

So it is a March issue, okay. Is it isolated to March? Or does this bleed over into April and May, do you think?

I think it's primarily a March issue. Again, it was just last year there was that significant pre-buy that we talked about.

It was probably a 4-week pre-buy last year.

So would it be fair to say then that you're more encouraged by your outlook in North American resi for the rest of the year?

Well, I think what we have said all along is that residential will be flattish to maybe up a little bit. And the real factor in that is that there's a long lead time between a housing start and when the water heater goes in. So we still think the replacement market is going to be what it's done for the last several years. We are not going to get help -- significant amount of help from new housing starts because we're late in the cycle.

Got you, okay. One sort of housekeeping point for you, John. The -- when you remove the gain from the other income line, there's still I think about $3 million, $4 million of income left, unless some tax is acting out [ph] wrong, but I don't think that's the case.

You mean compared to last year?

Yes. Well, no. In the quarter, there was other income switched -- other income expense swung to income. I was wondering what was in there.

Yes. What happened last year is we had a $2 million of an RBC loss. So that was the biggest factor compared to last year. So last year was really flat without that Regal Beloit collar loss of $2 million. So there's about a $2 million improvement over last year and a decent portion of that is the interest income.

That makes a lot of sense, okay. Okay, when you say that you're now in 600 more outlets in China, could you tell us kind of where they are? Does that include A. O. Smith stores? Could you give us a little more detail on that?

That's really both A. O. Smith stores and some of the big guys, as they're moving into the Tier 2 and Tier 3 cities. The majority of those are being added in those cities.

Is it a lot more? Because obviously when you say outlets, the A. O. Smith stores are much smaller. Is it 50-50? Is it more skewed to the AOS?

I think we said that the specialty stores will grow about 200 of the 600. I believe it's kind of the number, 200 to 300. So it's about 1/3 to 1/2 of the growth.

Got you, okay. I guess the last question would be maybe if you could just give us an update on what you're seeing out there in the pipeline. And I know that you're kind of chomping at the bit to do something else, but only if it makes sense. And just -- we haven't heard from you in 7 months on this. 7 months ago you had a good one. I'm just kind of wondering what you're seeing out there. And as an addition to that, I would say your decision to split your business, your segment reporting, North America to Rest of World, signals to me at least that it's going to that -- the acquisition focus will be Rest of World. Is that a fair statement? And maybe give us any type of update on the pipeline that you can.

We're looking for growth, and we've said that all along. And the U.S. market -- I think the housing situation is getting back to 1 million housing starts, could be 2 or 3 years away if not longer. So we're looking for markets where we can create more shareholder value than we could in the U.S. Obviously, as far as residential and commercial water heaters, we're not going to be able to do anything like that in the U.S., whereas we can go to other countries and get involved in residential and commercial water heaters. But we can do product line extensions in the U.S. like we did at Lochinvar, where we moved into product lines we didn't have. So as far as the pipeline, we have a lot of companies that are on the list. We have -- it's frankly my primarily focus going forward. But the discipline is still there. We're not going to get deal fever because we've got cash in our pocket. We're going to stick to a disciplined approach to make sure that when we do it, it meets the criteria that we've laid out, covering the cost to capital and meeting our internal rate of returns, as well as having a growth opportunity. There's a phrase I use all the time is, "Anybody can buy a company, but you make money for your shareholders with what you do with it afterwards." And in everything we're looking at, we have some downstream plans with those as to what we can do. When we find a good one that's actionable, we're going to go forward with it. But I can't give you any numbers or give you any indications, obviously, because of the legal restrictions.

Our next question comes from the line of Samuel Eisner with William Blair.

Most of my questions have been answered, but I just had -- basically concerning Lochinvar, it looks as though you had about a little bit over 20% EBIT margin in that business. I'm just curious kind of what are the levers that you pulled there in order to get the margins from around 18% last quarter to 20% this quarter? And where do you see other margin opportunities coming forward?

So we had -- as I just mentioned, we did have some plans there relative to cost improvements on the purchasing side, and those are being executed very well. And as you noticed, this was a growing very profitable business when we acquired it. And with becoming part of A. O. Smith, we had some synergies that we started working on immediately, and you're just seeing a little bit of benefit from those.

If I could then follow up to that, is there more room that you think that we can go higher on margins within Lochinvar?

Well, marginally. We have some other things we're working on. And we haven't even got into all the branded things that we can do and what we might be able to do internationally with their product line. So on an export basis, out of Southern [ph] Tennessee, but it's probably marginal at this point. But there's always a little bit more.

Very good. And then on the pre-buy for -- in China, at least this quarter and then the year-ago period, do you know how much of the 50% increase in the year-ago period and of the 18% this quarter, how much of that was from the pre-buy?

Well, let me try to answer it this way. We think that there's about an incremental $5 million more pre-buy this year than last year. It's what we've -- that's been able to tie [ph] that for me.

And then can I just have the year ago number, how much you thought the pre-buy was? I'm just trying to think of what the underlying growth rate is.

I think we'd have to go back. I think we were about $10 million-ish last year.

And our next question comes from the line of David Rose with Wedbush Securities.

This is David Rose at Wedbush. It's 3 quick questions. One is a follow-up to one of the previous questions on the other income line. Can you help me reconcile the difference between the gain, which was $27 million and the other income line that was $29 million? So was there another gain in the quarter? How much was interest income?

Yes, interest income incrementally I think was about $1.5 million over the prior year.

Well, just this year not versus last year.

It's close to $2 million.

Okay. So all of -- all that additional was as a result of interest income.

Well, offset somewhat by higher pension. Because, again, last year's corporate expense included $2 million associated with the Regal Beloit collar that we lost. So the real run rate number was 11.4 about, in the corporate expense line. Because we had a collar last year, we had the market-to-market. We marked it through that line.

Okay, that helps. And so your effective tax rate then is?

The effective tax rate we look going forward should be about 30%. Obviously, the share sale had an effect on the first quarter, but we think effective going forward will be about 30%.

So what was the tax rate if I exclude the shares? I came up with something below 30%.

It was kind of a little over 28%.

That's what I thought, okay. And then, can you provide a little bit more clarity on the pull-forward and the Southern California HUMD [ph]? I'm really -- we talked about this ad nauseam really but it looks like as though if I look at the AHRI [ph] numbers, gas heater sales were only down 0.5% in January. So if there was a pull-forward, a significant pull-forward, why didn't it happen in January? Is there something I'm missing?

Well, the pull-forward is just for that Southern California air quality district. So we're not talking about a huge part of the country. And the pull-forward was several months, unlike my earlier comment. This is not a case of them buying an extra month's worth. They bought at least 6 months extra. So there were a lot of moving parts going into that. But 6 to 8 months worth of extra inventory pull-forward in a small part of the country did have an effect.

Yes. I guess, John has really highlighted a big impact on the numbers. And -- but I'm only looking at the pull-forward. As I look at the pull-forward or potential pull-forward, I see January down a 0.5% on gas. I see February down 3.8%. And March, you obviously had really tough comparison. So I get that -- how do you reconcile the expected pull-forward to continue? And as you said, it's a small part of the market, the SQMB [ph].

Well, we're thinking that's going to be fairly consistent with the first and second quarter, mainly because it's our belief they bought about 6 months of inventory. So it will weave into that 6 months when you compare it to the prior years.

This is just pure -- this is about gas, right?

Oh, this is obviously about gas. But as you said, March was a difficult comparison, and we think the industry was down quite a bit compared to last year's March.

And then I look at April, and April starts to get better for you. I mean the comparisons from here on out start to get pretty good up until the third quarter -- at the end of the third quarter, I think the end of September. So you should see -- I would expect you'd feel a bit more comfortable.

Yes. I think we see the first, second quarter commercial being similar to the first quarter. That's our best guess. I mean, that's not a -- but it truly is a guess. And as Paul said, if you take away the pre-buy, we expect for the year, commercial is going to be flat. But the pre-buy, which we think is 6,000 units, we think commercial will be higher this year by close to 6,000 units. It would be our best guess, but it's truly is a guess. I'm sorry, this year will be lower by 6,000. But it's a best guess.

Okay, that's helpful. And then lastly on Lochinvar. When we had last spoken, we were on the road in March. We talked a lot about the opportunities to leverage the distribution, but you were concerned with Lochinvar that you were concerned about not as many opportunities to leverage the distribution as you had thought. You were still kind of working through the dealers. What's your sense now of the opportunities with Lochinvar to cross-sell? Has that -- is that getting any better or getting any more clarity?

We're still going through that process. It's almost a wholesaler-by-wholesaler discussion. And I don't think there's anything that we can add to that. It's an opportunity, and it's one that's being pursued. But we don't want to kill the goose that laid the golden egg here. So we're not going to go off and do something silly on it. And I mentioned earlier about branding discussion, that's what I was talking about. Not only what brands go to what wholesalers, but what products are included in those brands is another opportunity. And those are being pursued. We don't really have anything yet at this point that we can talk about.

And our next question comes from the line of Todd Vencil with Sterne Agee.

Maybe I missed it, did you guys quantify the price increase in June?

No.

Can you?

No. Sorry, we can't.

That's okay. You can't blame a guy for trying. Most of my questions had been knocked out. I had one question. You talked about the fact that China slowed down but you still think you can do 2x China GDP growth rate for this year. I mean, how do you feel about next year and going forward? Is that kind of a good thought for the next few years?

It's a guess at this point. But my gut -- I was just there last month. I don't think the government can hold the rate, the 7.5%, for very long. I think the GDP will probably start inching up in spite of the government's attempts to put the brakes on it. That's my guess, personal guess. We're conservative in our outlook, conservative in our forecast. Obviously, we're building a new plant over there, and we're keeping a lot of dry powder to respond in case the market takes off.

And we've talked about the demographics are certainly moving our way and that there's a big move into the upper middle class as they define it, as that's our sweet spot.

So you still think, for the next few years, 2x whatever China GDP ends up that being.

Oh, yes.

And our next question comes from the line of Robert Kelly with Sidoti.

Just a little bit more on Lochinvar. The double-digit growth you saw 1Q, that's totally standalone growth? That's no synergistic benefits from being part of A. O. Smith?

Yes, that's correct.

And the opportunity -- with the opportunities you see out there, could that at one point be a mid-teen growth business, once they're totally layered into your operation?

Well, we're not ready to say that at this point, but it's our objective obviously to keep that business growing as much as possible. We have a capacity there to expand, and we hope you can come see it in September, if not before. And we're going to -- the first opportunity -- the only opportunity we're really talking about is China because that's an obvious one, where they have very, very low sales of Lochinvar products so far. And we think there is possibly an opportunity there to sell more of their product and maybe take the growth rate up a little bit. But we're not ready to quantify that.

Fair enough. I believe the number you put out for the EBIT contribution for Lochinvar was about $10 million in the quarter just ended.

That's correct.

So you talked a lot about in prior quarters the seasonal swing of their revenue. I mean, we're in a low seasonal quarter contributing $10 million -- almost $10 million in EBIT, 20% plus EBIT margins. Do the margins also have a seasonal component to them? Or are there -- am I missing something that you're adding significant cost quarter-to-quarter in the higher seasonal quarters?

No. I think the margins were about the same over the year. I can't remember seeing anything of any significance. We got a little bit of a bump because of the cost improvement.

Yes. And I think that the synergies certainly were helpful in the first quarter, and we've talked about some other synergies that we put in place. So as Paul said, their margins were about 20%, and we would think that would grow a little bit as the year goes on.

Just correct me if I'm wrong, the seasonally strong quarters are 2Q and 3Q for Lochinvar.

No, it's 3 and 4. And we also did have some purchase accounting still lingering from the fourth quarter that we talked about also, which also affected margins.

I'm just trying to line up the $0.40 to $0.50 and then just what you did in 1Q.

Q2 is usually the weakest quarter for what it's worth. So we're going into the heating season -- for the warm season, warm weather, so not many people buying boilers in the second quarter.

And remember, the $0.40 to $0.50 is incremental over last year's $0.07. So we're really saying Lochinvar is going to add $0.47 to $0.57.

Okay, great. And then just one final one with the new facility being built in China. Do you expect to absorb significant drag there in Rest of World during 2012?

Well, not 2012, we won't have. Basically, 2013 such as going on halfway through the year and as Paul talked about, we're going to kind of sequence the things we absolutely need which are instantaneous. Solar and a waste facility, moving that in there. So we're not expecting 2013 to have a significant drag either.

Next question comes from the line of Sanjay Shrestha with Lazard Capital.

I got in a little bit late so I apologize if you guys already touched on this, but I kind of want to come back to this China question. This is a pretty impressive growth for you guys in the face of sort of slowing residential market and obviously, there's the price increase there. But can you guys talk about -- are you seeing an incremental benefit from maybe some of this residential construction apartment buildings that happen, but people weren't moving in. And now finally, with the prices falling, people are starting to move in and that's kind of creating a pent-up demand for you. So it's not just about new stores being added in Tier 2 and Tier 3, but that's also a factor that's kind of contributing and that's why China ends up being better than your prior expectation for '12?

Yes, that's correct. The household formation is still occurring, and we're still benefiting from that. And that's why we keep saying we're going to be at 2x GDP. But yes, that is still occurring, and the sales expansion is contributing also.

Okay. Have you guys sort of tracked as to what is that potential number or what is that opportunity as it relates to all these apartment buildings that remains vacant, that kind of creates a bit of a pent-up demand for you guys. Do you guys have a number on that? How big that is and what could that mean?

It's probably millions of empty apartments over there, and I was there last month and had a lot of windshield time from Shanghai to both of our operations in Nanjing and everything. You just see -- you still see a lot of construction going up. You see a lot of apartments and see a lot of fancy new apartment buildings finished with -- and that are empty. And those were all opportunities for us. As prices have come down, it's a little bit of an incentive for people to go ahead and form the household earlier, and I think we're benefiting from that. And I think we will. But we haven't -- have no way of quantifying that. We have tried. I asked exactly the same question of our people over there as recently as Monday of this week. And essentially, we are getting a benefit of that right now, but it's hard to quantify. Is the dam going to break and us suddenly get a huge slug of business. We're not planning on it. But if it happens, we can handle it.

And our next question comes from the line of Scott Graham with Jefferies.

Just one quick follow-up and it's another housekeeper for John. The SG&A rate was up year-over-year in the quarter, whereas I think we've seen some pretty good management there. Was there something that going on this quarter in SG&A?

Lochinvar is a big piece of it. That's $11 million to $12 million of the increase. And then China SG&A continues to grow, as we've talked about and the advertising sells the brand and the selling cost of their sales increase. So the increase is strictly China and Lochinvar.

Right. But it was still on a percent of sales basis with Lochinvar and China still being active. The last couple of quarters, of course, you're still down in those quarters, but up in this quarter. Was there anything at A. O. Smith North America? Is that...

No, I don't -- not that I'm aware of. I mean, I thought the rate was fairly similar for the fourth quarter. I guess, I'd have to look at what the fourth quarter rate is.

Is it pension?

Pension is certainly adding something. There's no doubt about that, year-over-year. We can look at it and talk about it ...

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