Good day, ladies and gentlemen and welcome to the A. O. Smith Corporation Third Quarter 2014 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. (Operator Instructions). As a reminder, this conference call is being recorded. I now like to introduce your host for today’s conference, Patricia Ackerman, Vice President Investor Relations and Treasurer. Please go ahead.

Thank you, Kate. Good morning, ladies and gentlemen, and thank you for joining us on our third quarter 2014 conference call. With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Ajita’s remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include among others, matters that we have described in this morning’s press release. In order to provide improved transparency into the operating results of our business, we are providing non-GAAP measures, adjusted earnings, adjusted EPS and adjusted segment operating earnings that exclude certain items as well as non-operating pension costs consisting of interest costs, expected return on plan assets, amortization of actuarial gains and losses and curtailments. Prior year results are provided on a comparable basis. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. Ajita, I will now turn the call over to you.

Thank you, Pat. And good morning, ladies and gentlemen. Our strong performance in the third quarter was driven by solid growth and profitability across all our major businesses. Here are a few highlights. Our organic growth drove sales 8.5% higher to $582 million. China sales were up 16% with gas tankers and water treatment products growing faster than the business as a whole. Our adjusted earnings of $0.59 per share were 9% higher than the $0.54 per share recorded last year and were primarily driven by higher sales, which more offset $6 million in incremental ERP expenses. We continue to allocate a portion of our capital to returning cash to our shareholders. We repurchased approximately 1.8 million shares for $87 million this year through September 30th. We increased our dividend by 20% or more for the third consecutive year in early 2014. We are on track to return approximately $160 million to shareholders this year. In August, we successfully completed our first ERP go-live milestone. I commend our team for their laser focus on a successful outcome. The remaining go-live events are planned to occur in 2015. John will now describe our results in more detail.

Thank you, Ajita. Sales for the third quarter of $582 million were 8.5% higher than the previous year driven by higher sales of water heaters and boilers in the U.S. and water heaters and water treatment products in China. Adjusted earnings of $53.5 million improved 6% from 2013. Adjusted earnings in 2014 excluded after-tax non-operating pension costs of $2.9 million. Adjusted earnings in 2013 excluded after-tax non-operating pension costs of $3.2 million and after-tax restructuring and impairment expenses of $1 million. Adjusted earnings $0.59 per share improved 9% compared with $0.54 per share last year. The effective income tax rate associated with third quarter adjusted earnings in 2014 was 27.9% compared with 25.7% for the same period last year. The rate last year benefited from several non-recurring items. Consistent with previous disclosure, we expect the effective income tax rate for 2014 adjusted earnings will be between 28% and 29% with the GAAP effective income tax rate almost 1 percentage point lower. A reconciliation from GAAP EPS to adjusted EPS is included at the end of this presentation and covers the previously discussed adjustments. Sales in our North America segment of $392.4 million increased 6% over last year driven by higher volumes of U.S. residential water heaters and commercial boilers and a price increase in May. Rest of World segment sales of $198.5 million increased 13% compared with last year. Sales in China increased 16% driven by increased demand for water heaters and water treatment products and higher customer inventory levels in advance of the fall holiday. North America adjusted operating earnings of $56.3 million were 1% lower than last year and adjusted operating margins of 14.3% was lower as well. The favorable impact from higher volumes and prices in the U.S. were offset by higher steel costs and an incremental…

Thank you, John. As John mentioned, the midpoint of our updated 2014 guidance implies growth of 16% in adjusted earnings per share over last year. Our outlook for 2014 includes the following assumptions. First, we continue to see strong growth in China and we expect over 17% growth in the region in 2014. Second, we expect Lochinvar-branded sales to grow approximately 10% in 2014, well ahead of GDP growth in the U.S. as our Lochinvar brand is expected to continue to benefit from the transition from lower efficiency non-condensing boilers to high efficiency condensing boilers. We are encouraged by the acceptance in the market of the newer higher efficiency products in the Lochinvar portfolio. Specifically, we are seeing the CREST boiler being increasingly specified in projects. Additionally, we have received very positive feedback from the market associated with our recently announced FTXL boiler, which was launched late in the third quarter. Third, we are cautiously optimistic about the developing recovery in U.S. housing and the strengthening demand for commercial water heaters driven by replacement and retrofit activity. Fourth, we successfully implemented a mid-single-digit price increase for wholesale water heaters in May related to higher steel prices and inflation of other costs. Fifth, as we have discussed in the past, 2014 will be negatively impacted by approximately $10 million of incremental ERP implementation expense. The fourth quarter will be impacted by $3 million to $4 million of incremental cost and this is in line with our past guidance. I would like to dive into our growth model in a little more detail, first China. As many of you know, we are a consumer product business in China. We have three growth drivers underpinning this business which give us confidence to project an annual growth rate of two times GDP for the…

(Operator Instructions). Our first question comes from the line of Matt Summerville with KeyBanc. Your line is open.

Hi, just a couple of questions. First, can you talk a little bit about the inventory situation that you called out with respect to China, sounds like things maybe at a little built up here over the last couple of months. And is that more of a normal factor is this something unexpected I guess that’s what I’m trying to understand?

I think Matt as you go into the fall holiday; it’s not unusual for them -- for our customers to build up some inventory. I think it happened last year’s third quarter and this year it’s a little bit more of a pickup than last year’s third quarter. So, I don’t think it’s anything significantly out of the ordinary.

And can you just revisit -- and I apologize if you said this in your prepared remarks, it is my last question. In terms of commercial water heater market volume what you expect for 2014 was embedded in your guidance and then similarly for residential in North America?

Sure. When we look at 2014 commercial it’s been relatively strong year-to-date. The third quarter we’re thinking was pretty flat to up maybe a little bit. We’re estimating that fourth quarter will be flat with the prior year which gets you to 164,000 to 165,000 units. Last year is pretty much tracking where we sat, we said beginning of the year we were estimating 9 million units, we haven’t come off that. And as you know that’s up 4%, 5% from the prior year.

Great. Thank you.

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

Hey, good morning. I don’t want to read anything into it, because I don’t think that there needs to be right into it, but the China full year sales guide kind of suppose fourth quarter of up ‘12, just wondering off of -- particularly off of the previous question. Is there anything we should be reading into that or is that just some of that inventory order change or the change in dynamic of orders for the fourth quarter versus that third quarter build?

Yes. I think it could be impacted by a little bit of the inventory build. We would certainly expect the fourth quarter to be up double-digits. Quarterly growth can be lumpy due to variety of reasons including promotional activity inventory levels and previous year’s comparisons. So, we’re still very comfortable projecting two times GDP going forward and we think fourth quarter will be double-digit.

Okay. Thank you. John, I think it was you who said last quarter that the company was kind of looking to sort of freeze the cash balance and use the excess, the overage of free cash flow more for share repurchases. And certainly we have seen a pick-up in share purchases this year but now you’re talking about cash balance that has actually declined for the first time in a while in the third quarter and will decline again in the fourth quarter. Again, just trying to read tea leaves here, are we now…

Scott, what we said is we are going to try to keep our net cash balance for the year relatively constant with the prior year. Last year, it was $290 million. We would expect this year, it will be $275 million to $280 million. So I would read anything into it. That resulted though in us buying back $110 million or so of stock. And so that was really the focus as to keep the net cash balance relatively stable but we can only estimate it so close.

Right, and I get that. But I guess my question is my extension of that John is, are we seeing that the pace of 2014 share repurchases is kind of in the absence of acquisitions what we should see after 2014?

Well, we haven’t said what we’re going to do after 2014 but we did say, in 2014 we want to keep that net cash balance about constant and that we still think acquisitions are potentially the best value added opportunity for shareholders. But until we get that acquisition, we were comfortable proceeding in 2014 the way we did. So, as we look at our plan, and come out in the first quarter I mean in January of next year, we’ll evaluate where we are for 2015 at that time.

All right. Thank you. And last question, more for you Ajita. As you can see, I really have no questions operationally. The question I have is more about share -- I am sorry, acquisitions to finish off John’s point. Is there anything you could tell us to give us some type of temperature check on where this process is, it’s been a long time coming, we understand asset prices are higher, private equity a little bit looser with the cash but it’s been sometime and is there any way for -- is the temperature hotter now than it was in the second quarter or the first part of the year and if so why? Cold you give us some type of breadcrumb here on, where -- how hot the water is on the M&A side?

Like I said in the past, the activity level is high. If I look at last few months, it’s been as high as it has been in the past. And the timing of this is very difficult to judge obviously; companies come in the market and we don’t control that timing. We do also target companies and it depends on how those conversations go. So, it’s very difficult to predict that as you know. But from our perspective and our strategy, nothing has changed. We’re looking for the right type of acquisition and we’ve laid out the criteria that we have and we are being very disciplined about sticking to that criteria. And as John said, we believe long-term the best value that we could bring our shareholders is making the right acquisition.

Right. You have shared with us on that though that you have walked away from situations, be it price for or for extended due diligence reasons. So I guess my -- I am wondering again looking for these breadcrumbs again, Ajita, just wondering if we are closer to the altar on anything now than we were at the beginning of the year?

Scott you know I can’t comment on that.

Well, I was hoping you could, other companies do in fact. But if -- I know you guys do keep it a little bit closer to the best, but that’s all I had. I was just hoping for a little bit more on this because it’s been as you know more than three years running?

I understand.

Thank you.

Our next question comes from the line of Noah Kaye with Northland Capital. Your line is open.

Thank you, Ajita and John and congratulations on another strong quarter. If I could touch on China that 16% growth -- you’ve given some good granularity, let me put a little more detail on how to think about where the growth is taking place. Can you break it down a little bit in terms of the mix and water heaters the replacements versus new housing demand? And then also touch on as you have in the past the online versus the retail mix?

Well, I’ll say our online continues to be very strong. Last year it was $15 million for the full year. We originally estimated it would double, but by the end of the third quarter we were over $30 million. So we expect that to run pretty close to $40 million for the year. So that continues to do very well. The replacement versus new housing, I can only give you anecdotal kind of based on our survey. Our people would say the replacement is picking up, where they would have used a number of 35% or so of the market one or two years ago. They are now saying it’s approaching 50% specifically in the tier one steady. So, and I said anecdotal, that’s our survey data. As you know there isn’t good HRI and housing completion data like there is in the U.S. where we can be more specific and confident in that replacement new ratio, so that’s about the best I can do.

Sure. I understand. And margin in China were again very much lower, again really strong and you’ve guided I think previously to a much lower EBIT rate for the year. Is there a reason I think for the fourth quarter to expect some meaningful additional expenses in China and Rest of World that would kind of bring it back down or are we continuing to track above that as we look for the fourth quarter?

Well, the third quarter beyond us, the margins did surprise us a little bit. We have said SG&A would be up from the second quarter and it was, and it was up a couple of points we talked about. However gross margin because of some mix et cetera was also up. So we weren’t anticipating the gross margin mix positive that happened. When we look at the fourth quarter, SG&A will continue to be up, I mean it is traditional we talked about it last meeting about advertising being up in the second half of the year and we except that to continue. We do also as we look at India from a sales standpoint some things have come up. India was tracking a little bit behind last year and then we mutually agreed to wind down our crow banding relationship with our largest distributor in India in the third quarter due to some channel conflict issues. So absent those sales, we’re expected to be up 20 percentage here, but unfortunately we’re going to be down about $4 million with that customer mostly in the fourth quarter. So that will have some affect on margins, but again we still think we’ll be up, Rest of World year-over-year fourth quarter margins will be up. So, India has taken a little bit of a detour, we pass them long-term. We still think it’s a good place to be. We think we’ll be able to replace those sales as we go forward. And the core business is still seeing some growth.

Great. Thank you so much. I’ll jump back.

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

Good morning, good morning.

Good morning.

Nice quarter. Let’s go in for Lochinvar, can we get a sense on their revenue growth this quarter and I know you’re guiding for 10% for the year, but can you help us get a little more granular in terms of their operating margin and going into the winter season now more specifically on their aftermarket?

Well, as you know as we get in for the third and fourth quarter their aftermarket does pick up and we would expect that to be the case again. It might be monotonous, but they were up about 10% again this quarter and they continue to do everything that they said they will do. Their margins are very comparable to last year even when they have higher engineering and selling, so they continue to perform very well. For the year we expect them to be up about 10% with comparable margins again given that they’ve put a lot in engineering this year and a lot in selling, I think they’re doing extremely well.

Can you talk about specifically their expansion plans and not just here domestically, but potentially internationally?

Well, we’ve talked about the new products; the FT XL will come out late in the third quarter. We expect it to be well received. Good electronics and they will be more efficient than the competition in that space. They have some other product line expansion planned for next year that we think will also be beneficial. China I think we talked about in the last meeting, the condensing is moving slower maybe than what we’re anticipating. But we think there is some potential opportunities as we develop products for maybe the non-condensing in China that’s going to take most of next year to develop those products. But we’re still optimistic I would say on China long-term for the boiler business, but probably the condensing is going to take a little longer than we originally expected.

Okay. And then let’s go into India a little bit. Can we discuss what your strategy is now going forward and are you starting to think about bringing in the water treatment portion to this and I mean what’s the strategy going forward for India at this point?

I think the strategy has not changed at all. I think this relationship that we had with this customer, we expected at some point would that we’d go our different ways because of some of the channel contract that was built in. It came a little faster than we anticipated, but that’s kind of what built into our longer-term plan. Without that customer, we’ll still grow at 16% to 20% in India this year. The economy we feel is improving. The economy has been slow but it is improving. And the longer term strategy in terms of building our brand, building it with water heaters and then expanding it into water treatment has not changed.

Okay Ajita, thank you.

Our next question comes from the line of Samuel Eisner with Goldman Sachs. Your line is open.

Yes, thanks very much. And good morning everyone.

Good morning.

Just going back to some of the comments that John was making before on the rest of world profitability, it sounds as though that gross margin was a bit better than you expected, you said because of mix and then et cetera. I’m just wondering if you could expand on really what is driving the profitability in rest of world and if you could even call out what the profitability on water treatment was that’d be very helpful.

Well water treatment, I guess all I can really say about water treatment on an annual basis is last year we lost about $3 million in water treatment and we have talked about a $2 million or so profit this year. And everything we’re seeing that still on track. And I think that’s relatively equally spread across the four quarters. So, there is nothing unusual there. And I’m not sure the rest -- it truly was a mix in China. So, China had extremely good quarter, better than we would have said, we would have projected because of that gross margin improvement. And that was really mix, some of the customers carry higher margins and those had higher sales in the quarter.

And then if you look at your guidance for the year, I believe that implies around $0.60 in the fourth quarter. So, you just reported $0.59 quarter, should we be thinking about your business as essentially flat on a sequential basis, is it accelerating or was it slowing throughout the course of the quarter, just I want to help understand what that’s really implying for the fourth quarter.

Well, you’re right. The midpoint is $0.60 and that’s a 15% increase over last year. So, that’s a positive. As we look at the businesses, we look at as I mentioned that we expect commercial to be relatively flat year-over-year. So, we don’t expect to get benefit from that. We do expect Lochinvar to continue to be up, that will be beneficial. And then as I have said, China, we expect to be up double-digit, but we could have some margin changes there, because we’re not expecting the repeat of the gross margin improvement but we are committing to doing additional SG&A. And then as we talked about India’s profit will be down because of -- when I said we lost about $4 million with that customer, as you can understand since the fourth quarter is where 60% of our sales are much of that loss will be apples-and-apples to the fourth quarter of last year. We’ve said India is going to lose $5 million; it will probably lose a little bit over $5 million with this adjustment. But I think I go back to Ajita’s statement, when you look at our organic relative 8%, we’re comfortable with that going forward and on a quarter-to-quarter basis you can have some internals, but we’re certainly comfortable, we have a growing business which will add growing profitability.

And also when you compared to last year, it’s about a 50% improvement over last year’s fourth quarter.

I understood. And then if you just look over the course of the quarter if I just look at July, August and September, did you see any deviation in the rate of growth either in Rest of World or within the U.S. for your business? Just trying to understand if exactly are accelerating or decelerating or basically saying flat throughout the course of the current quarter that you just reported?

Well, it’s always dangerous to look month-to-month, but I’ll say that the resi and commercial are relatively strong in September. But again, I’d be careful taking going too much with that, because it’s in very month-to-month, but it was clearly stronger and China I think will just continue to be consistently that increase. So I wouldn’t to say I anything bowing down...

Yes. And I would just reinforce that it’s so difficult to see it month-by-month. I mean if you look at the AHRI data for August, I’m sorry July and August it was relatively flat to up a little bit. But based on our September, we expect September to be high. But again, overall the quarter is pretty good.

Great. Thanks so much. I’ll hop in queue.

Our next question comes from the line of Charley Brady with BMO Capital Markets. Your line is open.

Thanks. Good morning.

Good morning.

Just can we talk about on the price increase that you had in May. Are you now or did you -- are you recovering the steel costs now and have you seen any continued escalation in the material costs?

Well, as you’re aware, steel costs are up, as well as inflation was up for things like healthcare et cetera and that’s really what drove the price increase. And that was the factor for it. And steel prices as you know have stayed high and even increased over the year as things have gone on. So I mean it is what it is. Steel has stayed up there.

Right. So is it fair to say then it’s a little bit more of a margin headwind or does another price increase come through at some point this year?

We can’t talk about future price increases for sure. Clearly steel was up pretty dramatically especially when you look at last year to this year, it was up pretty dramatically. I mean the CRU numbers are out there that say it was up significantly.

Okay, thanks. And just on your -- I’m assuming there is no change to your expectation for how things starts in the U.S. given that your resi unit volumes about the same?

Right. We’re still at that million or so in completions, I think about 900,000 or so, so really no changes in our assumptions there. And as I said, the resi volumes are pretty much tracking where we thought they would be.

And we’ve been pretty consistent with that right from the beginning of the year.

Right. Just one more for me then on China, can you give us some granularity on the growth rate you’re seeing in the Tier 1, Tier 2 cities versus some other smaller Tier 3 Tier 4? Is there a large bifurcation for the growth rates between those tier cities?

Well, I guess I’d say Tier 2 continues to grow and become over 40% I think of our sales. We’re just right now I would say and Ajita you may know better than I do kind of looking at parallel trading Tier 3 and Tier 4 and then certainly as we go out into the future that’s an area we’re going to focus on. But I don’t think we’re significantly out there right now. We’re still in that 6,000 plus distribution outlets in total.

Right. And I think some of the smaller cities are also being penetrated by the online sales.

Right. But certainly as you look, we do look as part of our growth going forward. I think Tier 3 and Tier 4 cities will play a part in there without a go.

Thanks.

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

Good morning. Since most of my high level questions have been answered, I do have a couple of others. One is, if you could break out the inventory a little bit for us in terms of where you think it might be more concerning for you in China in terms of -- is it price point, is it Tier 1 or Tier 2 where do you think you maybe most inflated and why? And then if you could on that just also provide us a little bit more color on the consumable piece for the water treatment business, I know it’s relatively small, but maybe just a little bit of update on that? Thank you.

I’ll take the last one first. I don’t think there is anything really new in the consumable. We’re probably looking at $2 million to $3 million. I think I might have said 3 to 4 last quarter, but I had incorrect number, it’s probably closer to $2 million to $3 million. We do think as we’ve talked about we’ve tried to do some things. Our recent release in July makes all the filters proprietary now use that term a little bit loosely because you have to be able to enforce it, but we certainly think in the future that consumables will play a bigger part and we’re doing everything we can to try to maintain that proprietary filters in our systems. So that’s clearly something we look at. And as we go forward, we think it will become a bigger part of our business. And as we go through our planning phase, we might have a better feel for that. But as we talked about those four or five filters in each -- our old system and they have to be replaced at different time lines. Number two, the inventory, really not much and again, I don’t want to overemphasize the inventory. With the holidays, you would normally have a build up in the third quarter. It was a little bit more than last year, could have a minor effect on the fourth quarter. But again, we still expect growth in the fourth quarter to be up double-digit. And really nothing distinct about that inventory growth; it’s with our major customers which you would expect.

Okay. And then one more if I may, can India be breakeven next year? And what if so, what does it take for you to be breakeven?

I’ll take a shot at it. We said that it’ll lose $5 million this year, we certainly have every intention and we think we will improve the profitability of the water heater next year. We talked about last year, we were doing some vertical integration, bringing more of it in-house; we expect to have that done towards the end of this year. So, we will see some improvement. I’m not sure given the loss of this customer that we can get all the way to breakeven, but we certainly anticipate we’re going to have improvement in the water heater business next year. I think the wildcard will be water treatment for evaluating how we roll that out and clearly when you have a new role like that, that has some expenses associated with it. So, I think we’ll be in a better position to kind of talk about India when we do our year end review.

Okay, great. Thank you.

I’m not showing any further questions at this time. I’d like to turn the call back over to management for closing remarks.

Okay. Thank you very much for your attention to our company this morning. And you all have a great day. Thank you.