A. O. Smith Corporation (AOS) Q1 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the A.O. Smith Corporation First Quarter 2015 Earnings Conference Call. All 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] I would now like to turn the conference call over to Ms. Pat Ackerman. You may begin.

Thank you, Kevin. Good morning, ladies and gentlemen and thank you for joining us on our 2015 first quarter results 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. Ajita, I will now turn the call over to you.

Thank you, Pat and good morning ladies and gentlemen. Our first quarter results set quarterly records. We continued to see the benefits in our performance from an improving economy in the U.S. and I expanding consumer business in China. Here are a few highlights. Our organic growth in both of our segments drove sales 12% higher to a record $619 million. China sales were up 15%. Our net earnings of $0.65 per share were 30% higher than the adjusted earnings per share of $0.54 recorded in 2014 primarily due to higher sales. We continue to review our capital allocation and dedicate a portion to return to shareholders. We repurchased approximately 333,000 shares for $21 million during the first quarter. We increased our dividend by 27% in January. Both of these actions are consistent with our stated capital deployment strategy. Our transition to NAECA III compliant products is on track. This is a very complex project impacting approximately 80% of our residential water heaters. Our team has done a tremendous job of navigating through this very challenging activity. John will now describe our results in more detail.

Thank you, Ajita. Sales in the first quarter of $619 million were 12% higher than the previous year driven by higher sales water heaters and commercial boilers in the U.S. and water heater and water treatment products in China. Net earnings of $58 million were 18% higher than first quarter adjusted earnings in 2014. Net earnings of $0.65 per share improved 20% compared with adjusted earnings per share of $0.54 in 2014. Sales in our North America segment of $429 million increased 10% over 2014 driven by higher volumes of U.S. water heaters and boilers. We believe a portion of the increase in water heater sales resulted from a pre-buy associated with our announced price increases for both commercial water heaters and NAECA III compliant residential water heaters. The price increases were effective in April. Lochinvar branded products grew over 10% during the quarter as new products, including our CREST boiler family continued to gain market acceptance. Rest of world segment sales of $196 million increased 13% compared with 2014. China sales increased 15% driven by higher demand for water heaters and water treatment products. North America operating earnings of $71 million were 20% higher than adjusted segment operating earnings in the previous year and operating margin of 16.6% was significantly above the 15.2% adjusted operating margin one year ago. The favorable impact from higher volumes for residential water heaters and higher margin commercial water heaters and boilers in the U.S. was partially offset by approximately 2.5 million in expected incremental ERP implementation costs. Rest of world operating earnings of $26 million improved 4% compared with 2014. Higher profits in China were partially offset by an approximately $1 million larger loss in India, which was expected due to the launch of water treatment products. Operating margin of 13.4% down from the previous year, primarily due to the larger loss in India and the launch of air purifiers in China. Our corporate expenses declined modestly from the prior year adjusted corporate expenses. We borrowed $75 million of 10-year average life fixed rate debt to achieve a better balance of fixed to floating rates in our debt portfolio. The higher rate on the term debt and the higher debt levels in the first quarter of 2015 account for the higher interest expense. Cash used by continuing operations during the first quarter 2015 of $3 million compares with $12 million provided in 2015. Higher earnings were more than offset by larger outlays for working capital in the 2015 period. Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 18% at the end of March 2015. We have cash balances totaling almost $575 million located offshore and our net cash position was approximately $270 million at the end of March. During the first quarter we repurchase approximately 333,000 shares of common stock for a total of $21 million under a 10b5-1 automatic trading plan. We had approximately 2.2 million shares remaining on our existing repurchase authority at the end of March. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we expect to spend approximately $100 million on share repurchase activity in 2015, resulting in net cash levels around $320 million at the end of 2015 similar to 2014 year-end levels. This is consistent with our stated capital allocation strategy. We expect our cash flow from operations in 2015 to be between $270 million and $280 million. We expect capital expenditures to between $100 million and a $110 million in 2015 which includes approximately $15 million to support the ERP implementation and approximately $30 million related to capacity expansion in China and in the U.S., to support Lochinvar branded sales. Our depreciation and amortization expense is expected to be approximately $66 million in 2015. We successfully completed our first ERP go-live milestone in August 2014. We expect the remainder of our North American planned sites to go-live in 2015 and 2016. ERP implementation expenses were $14 million in 2014 and are projected to be $20 million in 2015. We estimate the incremental ERP cost will occur in the first half of 2015. We estimate our effective tax rate to be between 29% and 30% in 2015. Our corporate and other expenses are expected to be approximately $48 million in 2015. This morning we increased our 2015 EPS guidance to between $2.72 to $2.82 per share. The midpoint of our upgraded EPS guidance represents a $0.05 per share increase over our previous guidance and a 14% increase in EPS compared with our 2014 adjusted results. We expect our earnings per share in the second quarter of 2015 to be above flat with 2014 adjusted second quarter earnings per share due to the following factors; we believe our second quarter residential and commercial water heater volumes will be impacted by the first quarter pre-buy. We expect ERP costs will be about $4 million higher in the second quarter 2015 as compared to the prior year and we expect the benefits of NAECA 3 pricing will be effective about mid-second quarter. I'll now turn the call back to Ajita, who will summarize the assumptions in our 2015 outlook and our growth strategy. Ajita?

Thank you, John. As John mentioned, the midpoint of our updated 2015 guidance implies growth of 14% over last year. The outlook for 2015 includes the following assumptions; first, we continue to expect strong profitable growth in China driven by expected and continued overall water heater market growth, market share gains, improved product mix and significant water treatment product growth. Collectively, we expect these drivers to deliver growth at two times China's GDP growth rate. Second, we forecast Lochinvar-branded product sales to continue to grow at least 10% keeping pace with the annual growth rates we have achieved since purchasing the business in 2011. This is well ahead of GDP growth in the U.S. as we believe our Lochinvar brand will continue to benefit from the expected transition from lower efficiency non-condensing boilers to high efficiency condensing boilers and new products driven by market leading innovation. We're starting to see strong acceptance from our newly introduced expansion of the CREST boiler family which targets the 750,000 to 2 million BTU per hour portion of the condensing boiler market segment. We launched this product earlier this year in advance of the 2015, 2016 heating season. Third, we announced to our US customers an average residential price increase of approximately 20% on NAECA 3 compliant products. We also announced a price increase on our US commercial water heaters, which became effective in April. Our US team has executed superbly through the NAECA 3 transition so far this year and we now expect the commercial water heater industry to modestly grow in 2015 after a strong first quarter. Fourth, we continue to seek ways to leverage our strong brand and distribution channel in China. Launching an A.O. Smith branded water treatment product line in 2010 was our first foray into a new product category in the region. Growing A.O. Smith-branded water treatment sales from $18 million to $75 million in the last two years continues to prove the power and the value of our A.O. Smith brand and infrastructure in China. Our experienced Chinese management team continues to leverage these assets to succeed in the very competitive and crowded Chinese marketplace. Total China water treatment sales in 2014 were $90 million, including $15 million of sales which are not branded A.O. Smith. China Market Monitor or CMM estimates that the point of use residential water treatment category in China will grow at over 40% per year over the next five years and we're excited about the opportunity and pleased with the market share gains that we have achieved through leveraging our brand, our engineering and our distribution strength. In China, our brand attributes include quality, reliability, safety and trust. These attributes translate well to air purifiers, which along with water treatment products, are among the fastest growing home appliance categories in China as measured by CMM. Partnering with a Japanese manufacturer, we launched the A.O. Smith brand air purifier in China late in the first quarter of 2015. An investment for the future, air purifier sales are expected to be less than $10 million in 2015 with losses of approximately $4 million primarily related to advertising and promotion costs. Fifth, we remain optimistic about the long-term opportunity in India and we're committed to the country with the second largest population and the second fastest growing economy in the world and its developing middle class who desire quality of life products. India is an investment for the future and the $7.5 million loss that we expect in India this year is similar to 2014 and includes higher product development and advertising costs related to the launch of water treatment products. We expect overall sales in India to be between $20 million and $25 million in 2015. We plan to hold an Analyst Day on May 21 at our Lochinvar plant near Nashville. The main focus will be presentations by our business leaders including Kevin Wheeler, Wei Ding, who will travel from China and Bill Vallett. Attendees will also have the option to tour the Lochinvar facility. This next graphic depicts the organic growth potential we see in our business going forward. In fact, we expect North America water heater sales will grow faster than 4% in 2015 as a result of the price increase on our NAECA 3 compliant products and commercial water heaters and result in total company sales growth of approximately 10%. Our lack of currency exposure to the volatile euro increases our comfort with our growth forecast. Our acquisition strategy has not changed. We remain focused on water heating and water treating companies around the world as well as leveraging our brand and distribution channel in China. The acquisition landscape continues to be expensive as sustained price appreciation in equity markets, lower financing costs and the lack of organic growth for many strategic buyers drive prices higher. Our teams are energetic, engaged and disciplined. Our capital deployment strategies continue to support a combination of investments for organic growth, acquisitions, share repurchase and dividends. You have seen this chart before and we show this only as a reminder that we will continue to be a financially disciplined acquirer of companies in our stated corporate strategy. This concludes our prepared remarks and now we're open for your questions.

[Operator Instructions] Our first question comes from Charley Brady with BMO Capital Markets.

Thanks, good morning.

Good morning.

I know it's difficult, but any sense as to the magnitude of the pre-buy impact on Q1 Rizzi water heater sales.

Well, as we look you've probably seen the AHRI data for January and February it was very strong, we think that continued at least for us it did in March so our estimate is the industry was probably up 250,000 to 300,000 units from the prior year, our guess would be a majority of that was pre-buy associated.

Okay, and you are seeing that trend kind of continue into this month?

I think orders are about where we expected. I mean as we said we expected to come down in the second quarter. So nothing surprising so far, but were only 20 days into the month.

Fair point. Just on China real quick then. I don't know if you called it up, but what was the margin impact on the air purification product launch costs in the quarter?

The air purification was a loss of about $500,000, so about 4/10 of a percent I guess.

That’s all I have. Thanks very much guys.

Our next question comes from Mike Halloran with Robert Baird.

So how much inventory do you think in the North American channel right now of the older model. We talking about a month and a half or so based on when you're, when you expect the pricing to start rolling through mid-2Q?

Yes. I think that's reasonable. You've almost got a break it down into pieces if you look at the discontinued product, which was over 55 gallon and some of the other products there's a pretty significant inventory build we think in those products. And that's going to kind of spread out over the probably the next nine months. We are not I would say I don't think we’re uncomfortable with the level of the old product out there I think as we talked about we put people on allocation and so I think we're relatively comfortable I think with the inventory levels except again for that discontinued product which we expected to be up and that started the pre-buy in the fourth quarter and it certainly has continued in the first quarter of those products.

That's good color there. And then any sense for how the industry from a ability to meet the new orders of the new standard water heaters. Any sense for how the industry itself is adapting any signs of any logistics as supply chain constraints are operational constraints right now?

We haven't seen anything that we really talked about ourselves I don't think - there's expectations everybody had a long time to prepare for this.

From an operational perspective I think we are right on track and where we expected to be at this point.

That makes sense. About what I would've thought and then lastly you know raise the commercial expectations a little bit here. What do you guys see on the underlying commercial water heater market and what were the factors that drove a price increase being put through for your perspective.

Well, we did see the commercial industry was strong. It was up where guessing 6,000 to 7,000 units and part of that we think was some pre-buy associated with the price increase. The rest of it is when we talk to our commercial salesman, the commercial market has been very strong. I mean Lochinvar for example had a great quarter their commercial water heaters and commercial boilers were very strong. They had lower engineering costs so when we look at the margin improvement in North America a good portion of that is due to just Lochinvar commercial mix. So it was very good quarter. So we have not done a good job of forecasting commercial as you know, but there are some times that a strong will see how it continues and that's really what drove us to raise commercial.

Good I appreciate the time is always. Thank you.

Our next question comes from William Bremer with Maxim Group.

Good morning gentlemen.

Good morning.

Let's go to Lochinvar. You just called out the commercial end of it was very strong. What types of like visibility do you have on Lochinvar and I also want you to comment a little bit on the manufacturing expansion plan for them as well?

Well, I mean the visibility we have is as I said the commercial continues to be very strong for them and it’s across the board and as you are aware we brought out some new products we extended the CREST product line we brought out new fire tube boiler for the 400 to 850 BTU area both those products have been well received and so we're optimistic and the capacity is for a good reason. I mean when they have been growing 10 plus percent we need to add capacity but also they built their business on innovation and we're adding several new labs et cetera. Engineering labs for them to continue that goal.

We are essentially doubling our testing capability. In Lochinvar as part of the expansion.

Okay. Great. And then let's go to the aftermarket there. We start to see aftermarket specifically for the highly condensing boilers pick up year-over-year.

Well actually was pretty flat in the first quarter and the reason for that as you may recall last year while we talked about the first quarter, that parts business was up quite a bit because of the weather et cetera. So that part of the business has been kind of in that 12% to 13% and it continues grow with the company. So we are very pleased with that part of the business.

And then finally on the air purification, how is that progressing and can you give us a little inside on are there any other avenues that will just slowly gravitate into maybe larger units and possibly commercial and are we to stay with the residential for the time being?

I think it’s very early in terms of air purifiers, but we see air purifier this is right on strategy from the point of you of leveraging infrastructure and brand in China and air purifiers along with water treatment products, residential water treatment products and residential air purifiers among the fastest growth categories of appliances - home appliances in China. So this is bright in line with our expansion and certainly what we see is that we will expanding that line as it goes. So we are very optimistic but it’s very early to tell we’ve just introduce the product.

Great. Nice quarter, Ajita thank you.

Thank you.

The next question comes from Scott Graham with Jefferies.

Hey, good morning all.

Good morning, Scott.

So could you tell us what the same-store sales growth was in Tier 1 and Tier 2?

Scott as we've talked about in the past and I think it's even become more complicated for us to try to measure that as we add stores and close stores. So our people over there are having some struggles calculating that. The bottom line is unit volume was up nicely. I could conjecture and say I think part of it is due to the new stores we’ve add it, but remember for the most part those are being added in Tier 3 and Tier 4 cities. And I think same stores were seeing nice improvements. So I think China had a very good first quarter up to 15% and water treatment continues to do very well.

Okay, fair enough. The price increase in North America is that I know it’s very early, but any signs of has your confidence increased, decreased are you good with this price increase is it holding so for.

Scott as I have said in the past, we can’t really comment on prices we could prices up and will have to see what happens.

Okay, last thing on - I am going to get one question answered here. Okay. On acquisitions and I'm not asking for anything that's overly sensitive for anything, but it sounds to me as if you know we were looking at one deal and that didn't work, and we were looking at maybe the purification and that may be didn't work and JVs. Is this going to be maybe something new? Because it seems like JVs are a very viable option for some capital deployment understanding of course there's going to be some losses in the early periods of the operations but can we see more of this from you guys in the rest of world.

I'll start and Ajita can finish. We really don't have a JV in the air purification you're right we looked for air purification acquisitions there have not come up with anything yet so the next step we took as we looked at companies that were there that had good product that didn't have what we have which is the brand and distribution so we under into buy/sell range but not really to JV buy/sell range with the manufacture will continue to look for opportunities because we certainly think our brand in our distribution, but we are also going to want to have best technology. So we will continue to do that. So I don’t think necessarily that JVs we are open to JV I mean it certainly something we are open to, but it’s not necessarily wave of the future for us.

Fair enough.

But if you look at JVs we’ve done eight years ago approximately which was with Takagi for our Tankless water heaters in North America, which is going very well. But as we look at capital allocation strategy have not changed it all.

Now understood.

We talked about Scott at the last call I believe that we were very close to couple opportunities, acquisition opportunities in the fourth quarter and because of price primarily we didn’t end up do in the deal so we will continue we are certainly seeing competition more from strategic now that we have probably in the past and that’s primarily do in our mind to the fact that they are not growing organically and we are not going to chase pricing because we are growing organically.

Understanding that you're looking everywhere, has the decline in the value of the euro say increased your figure on a potential European acquisition?

We are always looking. It's got to be strategic, okay so we continue to look like I said nothing has really changed. From a capital allocation strategy viewpoint. The fact that the euro is down makes potential acquisitions in Europe more attractive, but again it's got to meet our criteria.

Gotcha, thanks.

Our next question comes from Samuel Eisner with Goldman Sachs.

Good morning everyone.

Good morning.

Good morning.

On the pre-buy can you talk a bit about what your utilization rates were in the quarter and how you expect those to fair for the remainder of the year into the second quarter I just want to understand the impact on earnings from the pre-buy this quarter.

Well certainly absorption was very favorable in the first quarter because of the magnitude, and I can't give you a dollar number and what the effect will be in the second quarter, but certainly the run rates will be lower in the second order without a doubt and it will have an impact from and of absorption standpoint we were running full bar January, February, March without.

Got it. And then on the working capital build this quarter. Can you just talk a bit about what that’s actually going for what the plans are is that primarily for get new product out in China or just what specially that that’s targeted for?

Yes, I mean if you look back historically our first quarter normally have the little bit DSO. So when we look at DSO we are saying day sales and receivables plus days and inventory minus AP we are exactly where we were last year first quarter at about 37 days that’s up from the fourth quarter and traditionally is if you look at the pieces of it inventory we did built some finished goods inventory without a doubt so that was primarily North America. Receivables was kind of across the board when you look at the receivable belt from year-end it's a little deceiving because sales were up from November, December and the last two months of this quarter were up. So it really was reasonable that it's up. So nothing surprising whatsoever on the first quarter cash flow and we expect that we're staying with our same level for the year.

Got it. And then just lastly on the price increases in commercial are those are ready out in the market, and the reasoning behind the price increases is that just you feel better about the market so you can push a little bit of price or is that from material related on just want to understand the rationale behind it.

The price was put out I think late last year for effective for April 1. And there's a whole variety of reasons that go into it. There had been continual increasing costs previous price increases have not necessarily held so it's been out in the marketplace for quite some time and known. So that's why we think there was some pre-build - pre-buy.

And then just based on the last comment you anticipate that this price increase will hold if others have not held?

You know we're not going to conjecture our future effects of pluses or minuses on price increases.

Alright, thanks.

Our next question comes from Robert McCarthy with Stifel.

Good morning everyone.

Good morning.

First on water treatment I think did you suggest a long-term growth assumption in China collectively by 40% over the next five years is that correct?

That's based on CMM data which is a marketing group in China 40% we certainly saw that last year and we expect to see that this year and their forecast is for the next four or five years that to grow 40% and that's driven primarily because the penetration rate of water treatment products in China is very low. Compared to other Asian countries and obviously we know that there is some water issues et cetera.

In terms of I mean do you think of that execution happens over the next 18 to 24 months and would you expect it even perhaps think about your multiplier or [indiscernible] your shorthand for growth in China could be higher than specifically?

Well, I mean we are comfortable with the two times GDP and you know we broken that model out to three buckets and one of the buckets is for example on water treatment and when it grew last year, it grew about $30 million and we had about $600 million of sales that was above 5%. And we think that the reasonable level going forward and that certainly been important when you look at how other companies are doing in China. There is a slowing down, but we've got that growth through those three different buckets that makes us comfortable at two times GDP.

In terms of your growth drivers in China do you ever get nervous about potential with distribution if it could ever be like an inventory drawdown or any kind of volatility that you could anticipate that could kind of stunt your growth rate for a period of time?

Well, I mean when we talk about the growth rate we're really talking about on an annual basis. On quarter-to-quarter we can have some build for various reasons, holidays coming up, customers wanting to get their VIP allowance for the quarter et cetera so that can be a variety of reasons on a quarter-to-quarter basis, but I think we look at it on an annual basis and say that we think that's a reasonable estimate.

Switching gears with India, I mean a work flowing and by no means obviously its early days and you are getting lot of traction but what are kind of the qualitative factors you would decide whether maybe India is not a place you want to grow longer-term. What would be the basis for thinking for a retrenchment there?

I am going to let Ajita answer that but I'll say the first point I was here will we started China in 1995 and it was a painful seven or eight years, okay, really painful. Pretty heavy losses, but we were committed to the country because we started long-term growth. So I mean that’s the history of China from 1995 to 2003 that's when we broke even. And then I’ll turn it over to Ajita.

Yes, I think, first of all there's no - we don't have conversations frankly about retrenchment in India because like John said, we are looking at it long-term and really see the long-term potential in the country. I just in fact just got back earlier this week from a trip to India and the economy there is a lot of expectation and consumer confidence because of the new government. Although nothing has really happened yet, but from our perspective and looking at what we are doing in terms of building our brand and building our distribution points et cetera. You know things are going okay, given where we are in India. Obviously the economy were a little better last year actually the water heater market declined, housing starts have declined et cetera. But we expect that to come back because of fundamentals in India in terms of population and the drivers growing the middle class in India are pretty solid long-term we really have believe that this is a long-term tremendous opportunity and in fact in addition to water heating in this quarter, late in the quarter we introduced water treatment products also in India.

Okay, and then…

The only thing I’ll add Rob is neither one of us are obviously comfortable losing $7.5 million last year and what we talked about this year, so a similar amount now again we expect to see improvement in the water heater this year and we are making that investment in the water treatment which is making the loss for the whole India about the same, but it’s certainly not our intent to live with $7.5 million losses for a long period of time.

What do you think your reasonable cadence to breakeven then two to three years in India or what are we thinking?

I mean you've almost got a break it into the pieces and I think we talked about in the last call, if you think about water heating and that lost about $6.5 million last year we had about $15 million of sales, we expect those sales to move up about $5 million this year and that lost because of the higher sales and also more vertically integrating to go down a couple of million bucks. We look at a breakeven in the range of $30 million to $35 million or so for the water heater business. And we hope that certainly in the next two to three years.

Right. Switching gears to commercial. I mean obviously some clear signs of strength there do you think that speaks to kind of North American commercial construction markets picking up or how would you typify what you are seeing?

When I talked to our salesmen they would say yes, they are seeing compared to last year this time that there is more cranes, there is more building going on. I mean we had a strong commercial business because of the retrofit, because of the move to high efficiency, because of the move to building restaurants and small hotels, but I think you are starting to see more hospitals, education facilities et cetera. So I think we are cautiously optimistic that things are picking up.

And then finally in terms of your revenue growth for the year have you categorized how much you think I think is 10% core how much of that is price?

No, we haven't.

Okay, all right. Thanks very much for your time.

Our next question comes from Noah Kaye with Northland Capital.

Good morning and congrats on the quarter. $10 million for air purification for the first year seems like a very good start. Could you ballpark for us what you think the addressable market could be in China for air purification given your existing footprint.

So we've startled under $10 million in sales and the real key to remember on the air purification market is the highest sales level are in the third and fourth quarter primarily the fourth quarter, so that's still to come. When we look at the air purification market, our best estimate is about $2.5 billion last year and then if you look at our channel which is kind of retail stores and online, we're seeing it’s probably about half of that if you will is sold through that channel. And then this is where the guessing comes in. We are not going to play on the low-end. We are going to play on the high-end and our best guess is that's probably 40% to 50% of that number. So it's a long way to say and our best guess is probably $500 million maybe is the addressable market for us.

And how would you think about growth rate for that portion of that market, is it comparable to water treatment?

CMM I mean the good thing about the two areas we are in is those are the two fastest expected appliance growth markets for the next four to five years and both of them are kind of in that 40% range, so time will tell. Again part of the advantage why those are growing is the penetration rate is so low.

Sure. Part of the reason of course for your success with water treatment has been that you significantly reengineered and improve their product. You have to do that to kind of grow the sales the way that you want to? Are there other measures that you'll have to take can you talk about that a little bit.

We will certainly have to do that because our brand the equity of our brand is built around new products and being first to market on capabilities within categories that we're in. So we've entered the market with the [ME2] product and we will have to engineer it and come up with a value proposition that is at least somewhat unique to the market and different. So yes, we will have to - we are investing in engineering and figuring out how we do that.

And then so I guess the next question would be given that you have these high growth opportunities in water treatment in your purification. As you look at one, two years how much do your water heater sales in China actually have to grow on the percentage growth basis for you to continue to grow to X GDP, how would you think about that?

Well, I think probably the easiest way for me to answer that is kind of those buckets we’ve talked about and we’ve kind of laid it out that the first bucket is market growth and if you think of our water heater business right now it’s about 75% of our business over in China and CMM has estimated that’s going to grow at 7% and we think that’s reasonable going forward even as housing slows down we think replacement is increasing, we use to talk about 35% replacement above two to three years ago in Tier-1 cities we are now talking about 45% to 50% so that’s one bucket of approximately 5% and the other bucket is market share higher price as we bring out new products with values and features that consumer want has a higher price and then we grow our distribution. So where we hope to gain market share is in the water treatment and also in the instantaneous side of the market if you will, the gas instantaneous and then that third bucket is the ancillary product lines which is led by water treatment. So if those buckets that we have kind of stressed why we think we are different than other people who are in China.

Yes, and water treatment and now air purification which we hope will be another category that grows and also one more as we think of the long-term, the newer categories we are growing like water treatment and air purification has a replacement component that’s in a much shorter cycle than water heater, because not the whole thing but the filters. Okay now we haven’t seen the benefit of that yet, but we hope that benefit will also start growing as we go forward.

Terrific. Thank you for the answers and congrats again on the quarter.

Thank you.

Our next question comes from Jeff Hammett with KeyBanc Capital Markets.

Hey, good morning guys.

Good morning.

Good morning, Jeff.

Hey, one last one on price. What if you seen from your peers and competitors on pricing actions are they kind of aligning with what you've announced both in res and commercial?

We can talk about our pricing increase, which we have but really can't comment on the competition or looking forward and anticipate things happening on pricing.

And then just along those lines I mean you talked about your kind of readiness and everything is intact. How are you thinking about kind of profit flow through on those pricing increased based on your input costs and higher cost of manufacture et cetera.

I think we’ve kind of set our margins would stay similar on the new products and so that how we are kind of looking at it if you will.

Okay, great. And then finally, you guys in the last presentation looks like you gave some segment margin guidance 16% for North America 13.5% to 14% for rest of world. Are those still intact I didn't see anything in this presentation.

No. But as we raised our guidance I think you can look at probably the North America being a little bit higher than that and that's really driven by the commercial side of the market. You know now that we've raised our commercial estimates and we're a big player there and then we look at Lochinvar, and Lochinvar’s a big player in the commercial and that's stronger. I think it's that combination that allows us to say we think we can get a little bit higher in North America and that's why we raised our guidance.

Okay, perfect, thanks.

Our next question comes from Todd Vencil with Sterne, Agee.

Thanks, good morning, guys.

Good morning.

Covered a lot of good ground here bunch of my questions have been knocked out. I did want to ask about the ERP and just to make sure I am squared away on the number you said $20 million of spend this year coming entirely in the first half?

No. I'm sorry. So last year we spent $14 million and it was lower in the first half, higher in the second half last year. This year were saying it's going to be about $20 million spread relatively equally over the year which means the first half is about $6 million more than the first half last year. And then pretty flat year-over-year for the second half.

Got it, that makes sense. And that’s all - is that all P&L impact or…

Yes.

That includes. Okay, so that’s all P&L impacted in the $15 million of CapEx on top of that.

Right.

Okay, that was my question. Thanks a lot.

Okay, thank you.

Our next question comes from David Rose with Wedbush Securities.

Hi, thank you for taking my call. I have just a couple quick ones if we can bang them out. Following up on the debt. Just help me understand the reason behind increasing your debt at $80 million given the free cash flow you have the cash from the balance sheet are you thinking about much larger type acquisitions is this because you have something imminent?

No. So David when you look at we have cash overseas, we have debt here of about $250 million I suppose $270 million at the end of the quarter that was almost all floating rate. And so what we said given the attractiveness of long-term rates and just hedging that position we decided to draw down $75 million of long-term debt and pay down some of the short-term debt and it was kind of 35% to 40% fixed to floating and again we've talked about the fact that from a stock buyback standpoint if we buy back $100 million this year, probably about half of that will come from debt because we're obviously generating money in China and offshore. So that was the logic stream for doing it we think we got a very attractive rate of 3.5% tenure money so we're pleased with it.

Okay, thank you. And then just a couple of last ones with respect to which inventory and inventory now and just so we can have a better understanding the margin profile when that product flows through over the next couple of quarters, can you talk about scrap issues, quality maybe you made some reserves that you setup that’s on the balance sheet?

We took some in the first quarter some obsolescence as we evaluated the obsolescence and we talked about that, so we had some inefficiencies in the first quarter as well as obsolescence as we are running pilot runs and we had some weather et cetera. So we are not anticipated a significant amount of those issues at all in the second quarter, we hope that portion of it’s pretty much behind that.

Okay. And then on water treatment, what was the contribution from water treatment in China?

Water treatment was up about $10 million in sales. It was up over 80%. It's a little deceiving because last year's first quarter was an easy comp, so we think that 40% going forward for the next three quarters is a reasonable number. So if you look at when we talk about water treatment was $18 million two years ago, $43 million I’m sorry three years ago, $43 million, $75 million last year our forecast is in the low $100 million this year, so the growth is what we expect.

And what was the margin contribution?

I don’t know for the quarter, what we’ve talked about for the year last year that water treatment made about $2.5 million, we would think we would at least double that this year from a profitability standpoint.

Okay, great. That's it for me for now. Thank you very much.

Thanks.

Our next question comes from Jim Giannakouros with Oppenheimer.

Hi, good morning. Thanks for taking my question.

Good morning.

Lochinvar, just one follow-up there. Growing 10% plus can you give us more granular look into where you're seeing outside growth by geography you've given us the subcategories of non-res, but is there any particular areas of strength that you are seeing from a geographic perspective?

Well, the boiler business from a commercial standpoint is across the country so I don't think we're necessarily seeing any geographic. But the growth in Lochinvar is not only commercial boilers, they had a very good first quarter in commercial water heaters and we would say that's 500,000 BTU to say 2 million BTU and so that market also grew very well, so they saw their commercial market grow very nicely. And I haven't heard of any specific geographic region from a residential clearly the Northeast is that, but I think commercial it’s pretty much across the country. And again as I said earlier, education, hospitals et cetera those areas are certainly growing.

Got it, okay. And then just sticking to the boiler side I know we’ll take a closer look at next month at the facility, but are there any competitive advantages we should be mindful of that are potentially driving share gains among the competitors offering, similar energy efficiency upgrades and obviously the value proposition that comes with? Thanks.

I think the new products, we certainly feel the new products that have come out from Lochinvar have a clear advantage in the marketplace especially because they are fire-tube products as opposed to the water-tube products that are prevalent in the marketplace. So the new product the FTXL which we introduced early in the year and then subsequently the expansion of the Crestline, we feel have certainly are very attractive and been very well accepted in the marketplace and it’s early. We expect a lot of growth.

Yes, and you’ll see the controls I think are there in your lowest controls we think are also have a big competitive advantage.

Looking forward to it, thank you.

Our next question comes from William Bremer with Maxim Group.

Yes, a quick follow-up and hopefully you could clarify something that's puzzling me. The price increases. Both on the residential and the commercial, can you give us a sense of the magnitude of the price increase on the commercial end?

The price increase on the commercial and really varies by product et cetera in some product lines it low double-digits, but it really ranges byproduct so there's no one set amount.

Okay, and then on the water treatment I’m assuming that India would be an option, how much of a change or modification will be needed to what has been produced for the China market to then going to India?

We are manufacturing the water treatment products for India in India, so they are modified in the sense that the designs are different, China primarily they are hanging on the wall or under counter, India is primarily under counter top products. So the products are different, the technology is similar, but we are manufacturing for in India.

Ajita the $30 million to $35 million for the breakeven in India is that exclusively water heaters or does that also include the water treatment aspect of this.

That’s the water.

That’s water heater part of it. That’s the water heater part.

Okay thank you.

Our next question comes from Charley Brady with BMO Capital Markets.

Hey, thanks. Just a quick follow-up on the China air purification. Given that it's kind of a buying or selling you not manufacturing like you are in the water purification is there a meaningful margin differential so is that sort of a business starts really ripping up you know some small base, but just trying get us any meaningful margin back on the ROW margins.

Only from the standpoint, Charley, of the losses this year. Where we've said they could be up to $4 million. As we spend a lot of money on SG&A, but our philosophy, and I think you're aware of it but for the entire group, our philosophy is when we look at other alternatives. We're looking for product lines that have a premium product that can have relatively high gross margin. So that when we scale it up we can end up with the bottom line attractive margin. And we think air purification is one of those product lines. And certainly water treatment is.

Absolutely and you know what we’re looking at is when we get to longer-term steady state, that is not going to be a deterioration of our margins in China. And we feel pretty comfortable about that right now. It's very early, but we feel pretty comfortable that this is a category we can achieve that in the long term.

Great thanks guys. End of Q&A

And I am not showing any further question at this time. I would like to turn the call back over to management.

Thank you for joining us this morning. We hope to see many of you at our Analyst Day in May and registration information on our Analyst Day is available on the Investor page of our website aosmith.com. Have a great day.