A. O. Smith Corporation (AOS) Q3 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Third Quarter 2017 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 is being recorded. I would like to introduce your host for today's conference, Patricia Ackerman, Vice President, Investor Relations and Treasurer. Please proceed.

Thank you, James. Good morning, ladies and gentlemen and thank you for joining us on our 2017 third 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. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Ajita, who will begin his remarks on Slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. A double digit sales growth in the third quarter was driven by continued strong demand for our consumer products in China and positive end markets for our boilers and residential water heaters in North America. Here are few highlights. Sales grew 10% to $750 million. Currency fluctuations had a negligible impact to sales in the third quarter. China sales were up nearly 13%. A. O. Smith branded water treatment sales grew 31% year-to-date and air purification product revenue doubled. So record setting earnings at $0.54 per share were 15% higher than our third quarter earnings per share in 2016. We are delighted to work on the Hague team to the A. O. Smith family, through our acquisition of the U.S. based water softener company in early September. Hague fits squarely in our acquisition strategy to grow our global water treatment platform. We are excited about the global opportunities, Hague's innovative and high quality products bring us as well as Hague’s experience water quality dealer network. We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. Through the first nine months of 2017, we repurchased approximately 1.9 million shares for $103 million. We announced a 17% increase to our dividend earlier this year. The five year compound annual growth rate of our dividend is over 25%. A. O. Smith joined the S&P 500 Index in July. We are honored to join this prestigious group of U.S. Company. Our inclusion is a significant milestone in our company’s rich 143 year history. John will now describe our results in more details beginning with Slide number 4.

Sales for the third quarter of $750 million were 10% higher than the previous year. Net earnings in the third quarter of $94 million increased 13% from 2016. Third quarter earnings per share of $0.54 increased 15% compared to 2016. Sales in our North America segment of $486 million increased 8% compared to the third quarter of 2016. The increase in sales was primarily due to increase sales of boilers, higher volumes of residential water heaters and pricing actions related to steel cost increases. North American water treatment sales comprised with weaker Hague as well as full quarter of Aquasana incrementally added approximately 8 million to our North America segment sales. Rest of world segment sales of $270 million increased 12% compared with 2016. China sales increased 13%, driven by higher demand for our consumer products in the region, led by water treatment and air purification products, and pricing actions primarily due to higher steel and installation cost. On Slide 6, North America operating earnings of $110 million were 10% higher than segment earnings in the prior year. The same from higher sales of boilers and residential water heaters and the pricing action in the U.S. were partially offset by higher steel cost. These factors drove third quarter 2017 segment margins higher to 22.7% compared with 22.3% last year. Rest of world earnings of $34 million improved 9% compared with one year ago. Higher China sales including pricing action were partially offset by higher steel cost, higher fees paid to installers and increased selling, general and administrative expenses. Cost associated with the expansion of retail outlets in tier two and tier three cities had sell the company’s water treatment and air purification products and higher water treatment product development engineering parts was primary dives the higher SG&A in China. Third quarter segment margin was 4.5% compared to 4.9% last year due to these factors. Our corporate expenses were lower than one year ago. Our effected income tax rate in the third quarter 2017 was 28.8%, the rate was more than the 20.7% experienced during the third quarter last year, primarily due to lower state income taxes. The lower effective tax rate compared with the effective rate a year ago benefited 2017 results by $0.01 per share. Cash provided by operations during the first nine months of 2017 was $150 million compared with $264 million provided during the prior year. Higher earnings were more than offset by higher outlays for working capital. Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 21% at the end of the third quarter. We have cash balances totaling $768 million located offshore, and our net cash position was approximately $318 million at the end of the quarter. We completed the acquisition of Hague, a U.S. based water softener company during third quarter for $44.5 million plus a potential earn out of up to $2 million. Primarily, as a result of continued strong cash flow and escalating PBGC premiums, we made a voluntary contribution to our pension plan of $30 million in the third quarter. The after-tax impact to our cash flow is approximately $18 million. During the first nine months of 2017, we repurchased approximately 1.9 million shares of common stock for total of $103 million. Approximately 3 million shares remained on our existing repurchase authority at the end of September. This morning, we increased the mid-point of our 2017 EPS guidance by $0.04 per share with the range of between $2.12 and $2.14 per share. The mid-point of our EPS guidance represents at 15% increase in EPS compared with our 2016 results. Please turn to Slide 9 for several 2017 options. We expect our cash flow from operations in 2017 to be approximately $325 million, which is lower than the $447 million generated in 2016. We expect higher earnings in 2017 but also larger outlays for working capital due to the higher than anticipated cash flows in the fourth quarter of 2016. Over the two-year period from 2016 to 2017, we expect to generate operating cash flow of approximately $775 million, which compares with $612 million during 2014 to 2015. We programmed in 2016 on a construction of a new water treatment and air purification manufacturing facility in Nanjing to support the strong growth of these products in China. Our 2017 capital spending plans of approximately $100 million include $38 million related to this plant. Total cost for the facility, which is expected to begin production in the second quarter of 2018 will be about $67 million. Our depreciation and amortization expense is expected to be approximately $70 million in 2017. As previously discussed, expenses related to our ERP implementation were $25 million in 2016, and are projected to decline to approximately $18 million in 2017. Our corporate and other expenses are expected to be approximately $47 million in 2017, slightly higher than the $45 million in 2016, primarily due to higher expenses that our Corporate Technology Center and commissioned water treatment market studies. Take note that our interest expense will be approximately $3 million higher in 2017 as a result of higher rates, share repurchase activities and our acquisition of Aquasana and Hague. Our effective income tax rate is expected to be approximately 28% in 2017, lower than the 29.4% rate in 2016, primarily due to lower state income taxes. The President’s recently proposed tax plan and by Tax Reform Act to top of mind. We believe A. O. Smith could benefit significantly from cash reform. Approximately 60% to 65% of our total profits are derived in the U.S. We estimate the net impact form the combination of the proposed lower federal tax rate of 20%, the elimination of the manufactures tax credit and the smaller federal benefit from our state tax deduction would result in an approximately 40 million less federal income tax or over $0.20 per share based on 2017 earnings. Depending on the final tax reform plan, we couldn’t hear one-time income tax expense associated with the repaid creation and measurement of differed taxes. We expect to repurchase our shares in the amount of approximately 135 million in 2017, under a 10b5-1 plan. We expect our average diluted outstanding shares in 2017 will be approximately $174.6 million. I will now turn the call back to Ajita who will summarize our guidance, the business assumptions for 2017, and our growth strategy beginning on Slide 10. Ajita?

Thank you, John. We project revenue growth to be between 11% to 12% for the year. We expect Aquasana and Hague sales could be nearly $60 million this year and slightly accretive to earnings. Aquasana sales were up nearly 18% in the first nine months of this year compared to last year. Including North America water filter and softener sales, we expected on global, water treatment product sales will be approximately $300 million in 2017. We project full year depreciation of the Chinese currency will be 2% from 2016, resulting in a $20 million headwind to sales. Specific to our North America segment, we project U.S. residential water heater industry volume will increase over 300,000 units in 2017 due to new construction and expansion of replacement demand. This assumption includes tankless units. We project U.S. commercial water heater industry volumes will be approximately 10% higher this year, primarily due to strong demand for electric units as well as an anticipated pre-buy in advance of regulatory change driven price increase effective January 1. Lochinvar branded products grew 17% in the third quarter and 9% in the first nine months of 2017, driven by solid demand for boilers and new product related market share gain. We expect the total portfolio of Lochinvar branded products to grow over 8% in 2017. As a result of rising steel costs, we increased prices by approximately 4% on the majority of our U.S. water heater products effective in late August. These factors lead us to expect our North American segment operating margin to be similar to 2016 margin of 22.1%, despite a 40 basis point headwind to operating margin from North America water treatment. Specific to our rest of world segment, our China sales grew 13% in the third quarter and we expect over 15% growth in local currency for the full year. We expect improved profitability in India due to scale in our water heater business. We expect improvement in China margins in the fourth quarter resulting in full year margin of approximately 15% and flat to last year. As a result, we now expect rest of world segment operating margins will be similar to last year. Our total company organic growth model continues to assume 8% growth for the foreseeable future. Especially in these uncertain economic times, we believe our organic growth potential and our stable defensive replacement markets which we believe represent approximately 85% of North America water heater and boiler volumes positively differentiates A. O. Smith amongst other industrial companies. Coupled with growth and stability, we have a strong balance sheet poised to take advantage of strategic acquisition that adds shareholder value, as well as allow us to return cash to shareholder. That concludes our prepared remarks and now we are available for your questions.

Thank you. [Operator Instructions] And our first question comes from Matt Summerville from Alembic Global Advisors. Your line is open.

Thanks, good morning. I want to ask you a couple questions on China. You mentioned some year-to-date numbers in treatment and purification, I was wondering if you could give a little more detail specific to the third quarter how those products performed and then what your outlook is for the full year while also commenting on the performance in the legacy water heater business in China during Q3? Thank you.

So, water treatment was up about 13% in the quarter and it’s up in local currency year-to-date about 35%. And we would expect for the year is going to be after that range of 30 or so in local currency. Air purification was up 75% in the quarter is more than double year-to-date and we would expect it to be more than double for the year. Didn’t touch, what was your last – was it something else.

Yeah, the performance system in the legacy water heater business in China in Q3.

Q3, when I look at electric and gas, it was probably up about 7% or 8%.

Got it and then just one final question, you mentioned added spend in China associated with bringing water treatment, air purification in the Tier 2, Tier 3, can you may be talk about where you’re at with the distributions of that product, how many outlets you are in currently, how many you would anticipate and how that’s going to evolve over the next year or so. And then to some less spend back off a bit in Q4 is that why we should see margins snap back pretty meaningfully at least relative to where they have been in the last couple of quarters in Rest of World?

Yeah, sure. For example, yeah, water treatment margins were down about 6 points in the third quarter and that acquainted almost all the decline in the margins for the quarter and that was truly engineering and also investment in new retail outlets. We are at about 7000 – we’re in 7000 stores approximately and then we have on important some special zones et cetera. I guess Ajita will comment, we think that growth will slow as we look to the next couple of years because we have been building it all pretty aggressively over the last two years.

Yeah, I think if we went back two years ago, we would have said the rate of our build out would have been slower and I think we’re just going to faster because we see the opportunity longer term.

Yeah, we had about 1,500 stores, almost 2000 outlets if you will over the last two years.

And our next question comes from Charley Brady from SunTrust Robinson Humphrey. Your line is open.

Hi, thanks. I just want to jump down a little bit on Rest of World margins because the guidance clearly implies a pretty big step up in the Q4 margin and I get them with the overall guidance it’s what coming out of China, but is that just a function of this engineering cost that is going into water treatment or essentially you took a big hit and that’s kind of largely done or certainly declining a lot or

So when we look at the fourth quarter, that’s always our highest volume quarter. We would expect that to be the highest volume this year also. So we are going to get contributions. We would expect SG&A will be down a couple of points and that is the combination of the engineering cost not being high, as high and the SG&A not being as high as a percent with advertising being lower. We have talked over the years that those spends could be lumpy and they clearly were in the second and third quarter and we are comfortable they will be lower in the fourth quarter. So I think you are right. We have a fairly aggressive fourth quarter but with the higher volumes, we think we will get a little favorable mix from new – introduction of a new electric unit and then lower SG&A, we are comfortable with the estimate.

Oaky and then just on North America, on the top line growth is sort of I guess implied in the guidance. Did you – you mentioned a pre-buy that you expect that – that is why it’s kind of little bit maybe stronger growth in Q4 because you are pulling some stuff forward or is that just underlying stronger margin obviously Lochinvar is doing pretty good?

Yeah, and we expect Lochinvar to be up. We expect residential to be up nicely in the fourth quarter. So those two and then we do expect some pre buy from the regulatory changes that’s happening on the electric units on the commercial. So it’s a combination of all three zones that’s why we think sales will be up nicely in the fourth quarter.

And our next question comes from Samuel Eisner from Goldman Sachs. Your line is open.

Hi, it’s Sam Eisner here, guys how are you?

Hi, Sam.

Just on the – just going back by the last question on the pre-buy, was there any pre-buy benefit this quarter that you guys saw that you can define them and then also given the Lochinvar performance in the quarter, is there anything in particular going on there that you guys want to comment about?

Well, we don’t think there was any pre-buy, I mean I will tell you in September residential was strong, but I mean the price increase that already been put in by August 1, so – I mean by I guess September 1. So any pre-buy we think would have happened in August if you will, so no. But September residential was strong and Lochinvar had a greater quarter, I mean their boiler business was up 25%. You break that into three pieces, their residential was up over 30, their condensing which is the big commercial boiler was up high single digit and then their non-condensing which we have talked about historically is their smaller business, but that was almost double and that’s the reflection of a new product that they brought out, 2.5.million to 5 million BTU. They did have a large order in China well about $3 million during the quarter and so that clearly helped that to add a 3 or 4 points of growth. And that’s from a distributor. We are also selling that product in China through our A.O. Smith operation. We expect that product will sell $15 million this year and with 12 or 13 of it in China. So Lochinvar just had a very good quarter, they grew margins, they grew sales significantly and we are very pleased year-to-date they are up about 9% and we are certainly comfortable with the 8% growth that we talked about earlier in the year portfolio.

And also Sam I think that the results, especially this quarter, but it’s being building, as reinforced us the global demand for that Lochinvar product and the global opportunity that we have in leveraging the product and capability with our existing distribution and presence in various country.

Got it, that’s helpful and maybe looking over on the Rest of World segment, the 13% growth that you guys are seeing is certainly a little bit below the kind of 15% rate that you guys have called out in your kind of long term, long term view. Is that something that we should be nervous about, you think that’s kind of transitory and then maybe a second part of that on the Tier 2 and Tier 3 spending. Should that continue into fourth quarter and 2018? Thanks.

Well, I guess I will say and Ajita you can add, I mean we have never said that we are going to have quarterly growth of right up 15% and what we have talked about with our model, as we think on an annual basis they can grow 15%, as the matter of fact and year-to-date, I mean U.S. dollars they are up about 15%. So we are comfortable they are going to achieve that 15 plus percent in local currency for the year and it’s going to be lumpy I mean it’s not going to be 15% every quarter. We are looking at annual basis. So we are very comfortable. With respect to the spend, yeah, we did have some higher spend, specifically in water treatment and even some in the air purification in the third quarter. We think that will be less in the fourth quarter and that we are looking at our plan right now, I mean as Ajita said I think the role out of stores will slow as we look into ’18 and ’19 I mean so we will be looking hard at SG&A.

Yeah, I think not much to add, am just reinforcing the fact that we are very comfortable with the 15% annual growth in China in local currency which is what we’ve always said. And it is going lumpy especially China is driven a lot by different selling holidays and things like that, that make the spending and the sales from year-to-year can vary from one quarter to the other. So from that perspective, each quarter may seem lumpy, but for the year on an annual basis we are very comfortable with the guidance that we have given.

And our next question comes from Jeff Hammond from KeyBanc Capital Markets. Your line is open

Hi, good morning guys.

Good morning.

Just to be clear Ajita, on the acquisitions, I think the presentation has 40 million of incremental growth, you said 60, is that all in and the 40s the acquired growth or just help me there.

With what 60 is the full year Hague and Aquasana and that’s about our incremental of about 40 over the prior year because we didn’t have Hague and we only had Aquasana of course from August of ’16. So the incremental was 40 and the total water treatment in North America this year will 60.

Okay. And then on cash flow, looks like you took cash flow from ups down 50 million, anything going on there? I think you cited kind of timing in 4Q, but we would have known there anything you know working capital supply chain that’s driving that?

Well, the biggest issue is the pension contribution, so that’s 20 plus, about $20 million of that. We did not have that in our estimate. Probably the other most significant item is, we are probably building more inventory for our water treatment move that’s going to occur in the first quarter and late second quarter then what we had planned and so that certainly benefactor but nothing out of the ordinary. We’re still very comfortable with our days’ sales outstanding and et cetera.

Yeah, and some of that build is demand driven because I mean the business is continues to grow very well and so we’re anticipating that. In that transition we want to make sure that we don’t lose out in any other revenue.

And our next question comes from Scott Graham from BMO Capital Markets. Your line is open.

Yeah, hi. Good morning. Last question on – only one question on rest of world I promise. At some point, the 15% number is going be difficult to reach given essentially the size of the business, world large number or want have you. Do you think we’re a year or two away for maybe kind of thinking that’s maybe a low teens growth business rather than 15% which obviously there will be nothing wrong with that but I’m just trying to gauge your thinking internally?

I am comfortable with were we are now and the outlook that we have. And what you say from periodical perspective, we are going to be order of magnitude a billion dollar business which says it $150 million of new revenue every year, okay. So for the foreseeable future, we are comfortable. As soon as we see that is something that we say what we’re going to have to turn that down a little, we will let you know. We will make sure that we communicate that to our investors.

Okay. Thanks.

Clear predict Scott, continue growth on water treatment and air purification, those markets are expected to grow significantly. See I am still toss about 30% growth in water treatment, I mean we have a pretty significant franchise now when you add the consumables, and you add our businesses in China, it’s over $200 million.

So that is kind of what I’m saying. Yes. Okay. That’s fine, but if you go for the intermediate term right?

Yeah and also it is part of the strategy as we’ve talked about is to get into new categories, to leverage our brand and distribution getting into new categories. So we’re not counting on just the same portfolio businesses to bring us that incremental growth every year, okay. So we balance that in terms of the right time to get into it and to leverage the infrastructure that we have in China.

Understood. I just – my second question is really about the U.S. business, both the results were pretty good. And as we look across the residential construction numbers over the last five months, which certainly is not a primary driver, but is a driver of the market. Those numbers have really been very strong sort of 15% last five or six months and we also – it looks like field might actually come down a little bit in the fourth quarter at least quarters you guys here, just sort of wondering how you are looking at the North American sales and operating margin sort of trajectory. And I know that you are going to probably not go far past, if any the fourth quarter, but it just looks like that the backdrop for North America sales and operating margin looks pretty good the next couple of quarters, would you agree with that, can you comment on that?

Well I guess I said we didn’t see strong, we’ve seen relatively strong growth in residential, it’s probably about 300,000 units. Now, again that’s on base of 8.7 million units. So that’s what 3% or 4% and we have seen that the last three quarters with that some of that in the fourth quarter. Commercial been strong, it’ll be up – it was up by I think year-to-date probably about 7% or so. And that looks like that continuing. I would tell you it appears steel has leveled off but we haven’t seen a decline, we say it’s leveled off which would be a plus because it gone up so much dramatically which is the benefit as it does kind of stabilize.You know again continuous go margin, so yeah I think we’re optimistic as we look in the fourth quarter in next year from a North America standpoint. Ajita if you have any?

No, I think that summarizes well.

And our next question comes from Lawrence DeMaria from William Blair. Your line is open.

Hi, thanks, good morning. I have two questions, but first, just to clarify, it looks like we needed $16 million, $17 million increase in EBIT sequentially to get the rest of world record margins you’re projecting. Sounds like the bridge is a reduction engineering around 6 million and then the rest is volume and slower growth in SG&A, is that right just to clarify, are we getting that right?

I won’t say engineering going down $6 million is right. We think that SG&A will be down at couple of points. We will get the benefit of price again even in China last raw material costs have stabilized, so we think we will get some benefit net price compared to material. And then we’re going to have some volume that’s also going to contribute. So those are the major pieces then you throw in a little bit of favorable mix from the new electric units. Those are the kind of the pieces that get up there.

Okay. Thank you. And then secondly, staying in the rest of the world, how do you think about incremental margins going forward? Should we start to think about moving over 20% without any exception of the fourth quarter which would be good as the smaller businesses get scale and you are leverage infrastructure you referenced, can we look at over 20% incremental annual base now in rest of world, do have not scale there?

I am not sure, you said two different numbers, you said a 20% and then you said 20% incremental.

Over 20% incremental on an annual basis going forward since you are leveraging infrastructure and getting scale in those businesses?

Well, I’ll take a shot at it. We clearly want our rest of world margins, we think it’s a combination of India becoming more profitable, Turkey be capital I should say, reducing the loss in India and ultimately getting to a breakeven with the same statement for Turkey. And then yeah it’s our intention to leverage China’s SG&A and volume as we going forward. We have not put out any specific objective but certainly it’s our objective to try to go rest of the world margins.

And so incremental margins will be better than the average certainly but we have not put out the number.

And our next question comes from Robert Aurand from Longbow Research. Your line is open.

Hi, thank you. Robert Aurand downfor Dave McGregor, today. Stock in China by your water heater business and what extent increased competition from the domestic manufacturers is impacting your results?

Look, you know it’s always been competitive as continually top, it’s always been competitive. We’ve seen in the market I’ll say the electric not growing as fast which we assumed would happened because there is more distribution of gas in the city. So if you would asked us probably three years ago, we would have said electric was 55% in the market and gas was 45%, it’s probably close to a flip now. Not sure if it’s going to go much further but that happens. We don’t have a stronger position but we’re – we have a good position in gas and we’re leading in electric. So I don’t think that there’s much the competition as the dynamics in the marketplace, but all that being said, water heater growth this year is going to be nice for us and it’s led by gas.

You know just to add a little more color to that, the changes John talked about have not happened overnight evolutionary type changes that are happening. From going back to your question on the competitive environment, yeah I’ve always said China – the market in China is very, very competitive. You got all of the major players in the world there and they’re all bringing in new products and being in a very competitive branded consumer appliance business. So none of that has changed, it’s always been very competitive.

Okay. Thank you. And just one more question on China, I mean just new flow throughout the year that there are really trying to kind of cool down, the real stay market in the major cities there, aren’t get a property bubble, I mean what extent does that impact your results over there, do you guys think about that impacting you moving forward?

Well real estate is still the primary investment for the Chinese. The recent data does show that sales of property have slowed. It’s kind of a one or two month, we don’t that’s a limp or not. We don’t – we’re not really tracking as closely build, what we’re tracking is sales, because that’s what ultimately leads. The good news outside for us going forward is we think replacement is becoming a bigger component which just makes the sense the really good news about water heater in ultimately failed and with that you have a replacement market. And as you know here in the States, the replacement market is you know that 9 million build about 7-8 of this replacement. So we are nowhere near that in China but it’s developing. So I think as we look forward, we still think we are going to be able to growth from the water heater segment and we have some of the best products in both electric and gas which differentiates us. Is that answers your question or not.

And I think if you look at it from a longer term macro perspective, you know China is just completed or completing this week the latest communist party congress and you know you take headline coming out of that it’s a continuation of the policies which drives urbanization, drives more consumption based growth and those things form a macro perspective also help us and really reinforce our strategy.

And our next question comes from Andrew Cohen from Northcoast Research. Your line is open.

Hi, great quarter as always. Most of my questions have been answered but just a couple of small ones on water treatment. When this plans comes online in second quarter, is that going to materially affect margins or is it going to be roughly the same cost basis?

Well, I mean, we will, we’re going through our planning process right now. It’s certainly will pass initially probably the first and second quarter. I mean but we are moving a significant operation, the good news is we are not moving it far but we’re going to have moving certainly in the first and second quarter. The new plans offering higher depreciation for the year, we have – ultimately we’ll have some inefficiencies the first half of the year. But the good news is ultimately we think it’s going to be a much more efficient plan. So there could there could hiccups early in 2018 and we’ll talk about that when we get into through our planning process and possible talk more on year end. But I think for the full year that we’ll have some marginal effect but not significant.

Yeah, we’ll be able to define it more three months from now. But just the team in China is very – they are used to doing this because they are constantly expanding building new factories and moving operations into new factories. And as John said that entails obviously in the new factory potentially higher depreciation which we will see in this factory. But at the same time, you know we’ve designed this to have fairly significant operational benefits in terms of productivity. So we see both.

And we’ll expect to see that later in 2018 and certainly when we get into 2019 that’s you know real benefit.

Great. Second question it’s probably fairly small but the Hague acquisition, is this portfolio also going to be sold over in rest of world or is it pretty much just a U.S. based set of products.

Yeah, that was one of the things that attracted us to Hague as we have looked at water softer manufactures, we’ve been OEM in over there and we look necessarily successful and we looked for manufacturers and of all the way. And quite frankly we feel agents for that. And they can make a compact unit which is important for the China market and they started selling those in I guess about March, April. And you know it’s been a nice sales, I think the sales probably in six months have been a million bucks sales over in China and it’s of the Hague water heaters and in U.S. water softener. So new we are optimistic that they can really provide us the benefit in China.

And these are Hague, you know water softener is made by Hague, branded A. O. Smith selling in China.

Yeah. So it’s not something we are saying, we anticipate doing, it’s happening now.

And our next question comes from Scott Graham from BMO Capital Markets. Your line is open.

Yeah, hi. I just – John, I was cut off before but the overwriting point that I was making was that residential construction has been very strong and residential water heater shipments have been just sort of okay. Is that gap seems to be pretty wide right now suggesting that the next couple of quarters could be fairly strong, are you hearing that from your guys is what I am asking?

I haven’t been but again Scott just over, I understand better what you think. And it goes back to 9 million units, 7.8 of that is replacement. So completions you know are 1.2 and maybe up a little bit, but on the margin that might add 50,000 to 100,000 units. You know what I mean? So but I have not, I don’t know that you have but I think that’s partly what’s driving that is you have that base of 7.8 million units and that’s probably growing some this year because if you get 9 million units, you know and completions are up of 100,000 to 150,000 and the rest is replacement. So that’s why I was trying to say.

And I guess I make another comment Scott, which is you know not a quantifiable comment obviously but it may try and touch what you are saying. You know we just couple of weeks ago faced a ASA meeting which is the annual meeting where we have all of our distributors and you know there was you know people were pretty optimistic. I can’t quantify that but you know people felt good about where things where.

Okay, well thanks on that. So I guess my other question would be, you know I am sorry for the rest of word double up here but you know the weakness in the margin off of the spending I mean I don’t remember the last time you called out and need to increase your tier two and tier three spending. So I guess my question is kind of twofold, number one, I understand the markets are completive, but has there been some competitive uptick in either water treatment or air purification that’s required this additional spending? Number two, the dynamic of you know the water heater distribution points versus treatment and purification is different which is requiring an incremental investment, can you talk about that a little bit?

Well, I guess I’ll take the first one is where the market share lead the water treatment. And we have the best products and we’re going to continue to invest in R&D to support that position. And I won’t say that competitive environment for water treatment has changed, we want to build out our distribution. You know we talk about tier two and tier three cities not only do we want to see there that helps us from online position because somebody got to fulfill that and it’s distribution locations we talk about. So when we’re growing the retail, it’s primarily I’ll say our specialty stores and water treatment. Air purification, we are not the market share leader, we think we have some new products that we’re going to be bringing out next year that we think will be beneficial. And so we’re investing in R&D and also going out that portfolio. I think one think I want to mention is yes, rest of world, China did not meet the margins that we talked about beginning of the year, but when we are done with the year, we expect them to growth 15% organically and there is about 15% EBIT return. So I don’t want to give the impression, they are not having a good year, they are having a good year maybe not what we expected and where the spend being more than what we thought and then raw material cost have hurt us. So as we look at the year, I having a good year and I don’t think there is anything you need from a competitive or strategic standpoint that’s really changing our things.

And I think that summarized it well. And you know as we – you know the advertising and things like that in a branded consumer clients business that’s a – those are things we need to do especially when we get into new categories and we just had some research come back that our brand is getting better and better known and very well known in these new categories. And as John said when it comes to water treatment which we feel has a huge, huge long term potential in China, we’re the market share leader. So we feel pretty good about that. From a competitive situation, it’s like I said earlier to a question earlier in the presentation, it’s a very competitive market and it continuous to be that. And I don’t see any material change either up or down from a competitive perspective.

And our next question comes from Jeffrey Hammond from KeyBanc Capital Markets. Your line is open.

Hey, just a quick call. Actually you mentioned some inflection in international in China, and that seems to be an area that was taken along when a struggle. So what’s really change there, are you starting to see an inflection where you can start to penetrate internationally? Thanks.

Yeah, I think the key difference then Jeff you got a good memory, we are going back to the activation but we felt that’s the time we did the acquisition. But that there would be a market for the condensing boilers in China that there was a market that is growing. What’s taken time is that we didn’t see that condensing boiler demand grow in China but what we did is continued demand for the lower efficiency non-condensing type products in China. Lots of reasons for that, low energy cost, I mean lots of reason for that. So we literally designed some products which are very conducive for the Chinese market and fit the market needs in China and we are actually selling those products two different ways in China. We are selling them a blocking wall manufactured products, branded blocking wall in China through one set of distribution. And then we also manufacturing those products in China and selling them under the A. O. Smith brand name. So – and both those are being very successful. So it is a change it’s that we’ve recognized that there was market for the non-condensing products, design some products for the Chinese market and we brought them out saying the last 12-15 months and they have been very successful. So we are very happy about that.

Okay, thanks Ajita.

And at this time, I am showing no further questions.

Thank you for joining us today. Please take note that we will participate in several conferences in the fourth quarter. The Baird Industrial Conference on November 8th in Chicago, the North Coast Conference on November 9th in New York City, and the Goldman Sachs Conference on November 14th in Boston. Have a wonderful day.

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