A. O. Smith Corporation (AOS) Q4 2011 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Fourth Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I'd now like to turn the conference over to our host, Vice President of Investor Relations and Treasurer, Pat Ackerman. Please go ahead.

Thank you, Paul. Good morning, ladies and gentlemen, and thank you for joining us on our fourth quarter 2011 conference call. With me participating in the call are Paul Jones, Chairman and Chief Executive Officer; and John Kita, Chief Financial Officer. Before we begin with Paul's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. Paul, I will now turn the call over to you.

Thank you, Pat, and good morning, ladies and gentlemen. 2011 was a record-setting year of financial performance and an extraordinary year of change. Here are a few highlights. Organic growth in acquisitions drove sales from continuing operations 15% higher to a record $1.7 billion. Lochinvar added $76 million and sales of A. O. Smith branded products in China grew 29% to $370 million. Our growth in China continues from a number of drivers, including growth in same-store sales of almost 15%, expansion of our distribution with the addition of over 600 retail and specialty stores selling the premium brand of A. O. Smith products, primarily in Tier 2 and Tier 3 cities. We now have 5,400 outlets in China selling our products and gains in our water heater share from 20% to 22%. We also set an earnings record for the fifth time in 6 years. Earnings from continuing operations, excluding the favorable impact from non-comparable items, were 23% higher than last year at $2.11 per share. Lochinvar added $0.07, including interest expense and a $0.10 cent per share charge related to acquisition fees and purchase accounting charges. We sold our electrical products company for $700 million in cash and 2.83 million shares of Regal Beloit stock. Our gain on the sale was over $150 million. Remarkably, in the same week, we sold EPC, we purchased Lochinvar, a manufacturer of some of the most sought-after, energy-efficient boilers in the U.S. I will now turn the call over to John to go through our financial results in more detail.

Thanks, Paul. I will start with details on our fourth quarter performance and then follow with our full year results. Total sales in the fourth quarter of $476 million increased 29% from the previous year. Lochinvar added $55 million to sales in the quarter, and our A. O. Smith branded products in China grew over 30%. Higher sales of commercial water heaters in advance of a regulatory change in Southern California, as well as higher residential volumes as customers recalibrated their inventory level following a drawdown in the previous quarter, added to our sales in the U.S. Earnings of $31.5 million or $0.68 increased over 50% from last year, with Lochinvar contributing to $0.11 per share in the fourth quarter. Fourth quarter operating profit increased 30% to $58.4 million from $44.8 million in the fourth quarter of 2010, largely due to Lochinvar's operating profit of $10.2 million. Contributions from higher sales in China and in the U.S. were partially offset by higher steel costs and lower volumes in Canada. As a result, adjusted operating margins edged upward in the quarter to 12.3%. Our corporate and other expenses were $8.5 million, a decline of 35% from 1 year ago. Interest income on our offshore cash, dividends from our RBC shares and lower pension costs contributed to the improvement from last year. Total operating profit excluding the flood impact in 2010 improved 57% to $50 million. Total sales in 2011 of $1.7 billion were 15% higher than the previous year. Lochinvar, which we acquired in late August, added $76 million and sales of A. O. Smith branded products in China grew almost 30%. Sales of water heaters in India doubled to $19 million, and we experienced a full year of sales of gas tankless products in North America. Our commercial water heater volumes in the U.S. were higher in advance of an anticipated regulatory change in Southern California and a global, commodity-related price increase effective last April also contributed to higher sales in 2011. Earnings of $111.2 million, or $2.39 per share, included a few non-comparable items, which collectively added $0.28 per share for the year. I will elaborate on these items more specifically on the next slide. Adjusting for the non-comparable items, our earnings of $2.11 per share improved 23% over last year's performance, excluding the impact from the flood. Operating profit increased 15% to $193.5 million from $168.3 million last year, excluding the impact from the net settlement gain in 2011 and the flood in 2010. Lochinvar's operating profit was $13.2 million, including purchase accounting charges. Organic growth in our China and U.S. commercial businesses was partially offset by a decline in volumes in Canada and losses at our water treatment business. As a result, adjusted operating margins at 11.3% were the same as last year. Our corporate and other expenses were $45.5 million excluding the net gain and value of our hedged RBC shares and improved 12% from last year's primarily due to interest income on our cash, lower expense from incentive compensation programs and lower pension cost. Total operating profit excluding non-comparable items improved 27% to $148 million. Cash provided by operations was $57.3 million in 2011, which included the impact of pension contributions. Higher earnings and working capital improvements were more than offset by the $107 million after-tax impact from the pension contribution, resulting in lower cash flow than the previous year. Our liquidity position and balance sheet remains strong. Our debt-to-capital ratio increased to 30% compared to 23% at the end of 2010, as we borrowed on our credit facility to purchase Lochinvar. Our funding sources are solid and stable. We have sizable cash balances located offshore, primarily related to the sale of electrical products, limited amortization of our long-term debt portfolio in the coming years and a $425 million credit facility, which does not expire until November 2013. In addition to $463 million in cash at the end of December, we have $61 million of capacity unused on our credit facility and unsold RBC shares valued at approximately $160 million. Capital spending for the year was $53.5 million, and depreciation and amortization expense was $47 million. We purchased 611,000 shares in 2011 at an average cost of $38.69 per share or $23.5 million as we recognize that our market valuation on our shares dipped significantly below our historical long-term average enterprise value to EBITDA multiple. Paul will introduce our thoughts on 2012 guidance in a few minutes, but as we finish our recap of 2011 performance, I thought it would be helpful to show you some of our assumptions for 2012 alongside our 2011 data. We expect operating cash flow to be significantly higher in 2012 and to range from $145 million to $155 million, primarily because we do not expect to make a pension contribution. In 2012, we project our capital spending will be between $80 million and $90 million, with over half of this expected to be in Asia. 2012 capital spending includes approximately $40 million to begin construction of a second water heater manufacturing plant in Nanjing, China, to meet local demand. When complete, the new plant is expected to add 50% more capacity to our China water heater operations. We also plan to begin expanding our plant in India to accommodate production of more water heater models and to in-source some component manufacturing as we build scale to meet local demand. Depreciation and amortization expense was $47 million in 2011. It will be higher in 2012, primarily as a result of higher depreciation and also amortization of intangible assets related to Lochinvar. Our effective tax rate was 31.1% in 2011, and we estimate the rate to be between 30% and 31% in 2012. I mentioned that we do not expect to make a contribution to our pension plan, which is underfunded by about $150 million at the end of 2011. Lower investment returns, a reduction in the discount rate and the amortization of investment losses experienced in 2008 will result in significantly higher pension expense in 2012 as compared with 2011. We project 2012 pension expense to be $13 million to $14 million. The incremental impact to 2012 earnings from higher expense will be approximately $0.13 per share. Our corporate and other expenses excluding the gain in value of our hedged RBC shares were $45.5 million in 2011, and we project those will be similar amounts in 2012. One final comment before I turn the call back to Paul. We evaluated our segment reporting after the sale of EPC and the purchase of Lochinvar and determined that reporting 2 geographic segments would more closely align our reporting with how we manage our business. We will report the results of our North American legacy water heater business and Lochinvar in our North American segment and our China, India and Europe results in our rest of world segment. We will introduce our new segment reporting on our 10-K, which we expect to file on or about the end of February. Paul will now discuss our guidance for 2012 and provide an update on our growth strategy.

Thanks, John. In our press release this morning, we announced our expected 2012 EPS guidance to be between $2.65 to $2.85 per share. The compounded annual growth rate of our adjusted earnings from continuing operations over the last 4 years to the midpoint of our guidance is 25%. Our guidance includes an incremental $0.40 to $0.50 per share from Lochinvar in addition to the $0.07 per share contributed by Lochinvar in 2011. Of particular note, our guidance does not include the impact from future acquisitions and activity related to the Regal Beloit shares. Our outlook for 2012 includes the following assumptions. First, our sales of A. O. Smith branded products in China continue to experience strong growth. We expect continued share gains, new products and the addition of over 600 new retail outlets will drive our growth by approximately 2x China's GDP growth rate in 2012. Second, the transition in the U.S. boiler industry from lower efficiency non-condensing boilers to higher efficiency condensing boilers is expected to continue in 2012. Lochinvar's condensing boilers continue to offer a compelling payback in the form of energy savings. The company has built a reputation for innovation and product quality. As a result, we expect Lochinvar's growth rate in 2012 to be over 10%, well ahead of the GDP growth in the U.S. I should remind everyone that Lochinvar does have some seasonality to its business related to the products it sells for hydronic heating. Lochinvar's second half of the year typically has higher sales and profits than the first half. Third, we expect water heater volumes in the U.S. to remain at 2011 levels due to the stable replacement and nondiscretionary nature of the products. However, we do expect to experience a sizable reduction in our gas commercial water heater volumes in the first quarter, as some customers added to their inventories ahead of an air quality standard change in Southern California. This is an exciting and transformative time for our company, and the acquisition of Lochinvar represents a significant first step in building our global water platform. We have cash and borrowing capacity for additional acquisitions, and our pipeline of acquisitions supporting our stated growth strategy to expand our global footprint in water heating and water treatment solutions is active. Products that supply clean water for drinking and hot water for hygiene are taken for granted in the developed world but are sought after by people entering the middle and upper middle classes in the developing world. Our products improve standards of living, which is one of the reasons why we've been successful in China and India and why we believe developing countries have higher growth potential for us. Our integration of Lochinvar is progressing very well. We have both human and financial resources to continue to add companies to our global platform, which create shareholder value, and our business development teams are pursuing opportunities all over the world to do just that. We are now finished with our prepared remarks, and we'll now open up the lines for your questions. So, Paul, if you'll manage the questions, please go ahead.

[Operator Instructions] And we do have a question from the line of Sanjay Shrestha.

So my first question is, given the way you guys are kind of adding capacity in China, can you sort of update us on how are you seeing sort of the same-store sales and the store addition? And is there a potential for a softer first half and a meaningful uptick in the second half? And with this 50% capacity addition in China, how should we think about sort of your anticipated growth rate and when does that kind of comeback in? Is it second half contribution or into 2013?

Well, our estimates, Sanjay, are that we will see probably a little bit weaker first half than second half, as you look at China overall, because there is -- they are in a recovery mode. Their downturn was very minor, in our opinion. And I think our best estimate is that we might see a little bit weaker first half. And I'm hearing all sorts of bullish comments from people over there about how the second half will occur. It wouldn't surprise me if we got off to a little slower start in China, but we are still committed to the investment and [ workers underway ] on the factory to make sure that we stay ahead of the demand. And we're also, as we've mentioned before, actively pursuing sales in other parts of Asia where we can use the capacity in China and ship to other places like Vietnam, Malaysia and places like that.

Got it. Now one quick follow-up, if I may. So when we sort of hear your comment on -- it does not include acquisition, right, in this guidance? So what sort of a pipeline are you looking at? Is there a potential for a meaningful enough of a deal to close in 2012?

It's hard to say. I mean, we will only do good deals. We're only going to do deals that follow the criteria that we've established, which is obviously accretive, but more importantly, return the cost to capital by at least year 3, preferably in year 1 or 2. Lochinvar did it in year 1. But we have 3 people internally as well as a lot of external resources working on with it with us. And we just don't predict when we'll do an acquisition. When we have one with a contract, we will make an announcement at that time.

Great. One final question from [ me for ] the guidance. So X the pension expense for 2012, your numbers is really more like $2.80 to $3 in guidance. So what are sort of the puts and the take in terms of that low-end of expectation for you versus the high-end of expectation?

Well, I think we've established a reputation for being a little bit conservative. We want to make sure that we deliver what predict we're going to do. But we do see a weak U.S. economy. I think we'd be kidding ourselves if we said it was going to pick up, but maybe in our growth rate in China, we're seeing 2x GDP; we've been seeing 2 to 3. But where -- we will be running at an annualized rate of over $400 million there sometime this year, and that's going to be a pretty big number to keep adding 2 to 3x 20% to 30% growth on. So we're being maybe being a little conservative in saying we feel things will be up 20% there. And India, we're predicting it's going to have a strong growth again, it's doubled, more than doubled last year, and I don't know when it'll double this year, but it might be close to doubling again this year as it continues to grow.

And our next question comes from Mike Halloran.

So first, on the commercial side, could you maybe just talk about trends that you're seeing there outside of the California pre-buy? In other words, are you still seeing the modestly positive trends based on the switchover to energy efficiency oriented commercial water heaters?

Yes, that's correct, Mike. We're seeing a little bit of, I think the phrase I've been using is we're doing better than we should be, and it is essentially the only way to say that we're doing better is the energy efficiency and people buying the Cyclone product or some of our newer energy-efficient products because they get a payback on it, and it's worth their time and effort to -- and cash to make that investment. So it continues, as you know, light commercial construction is significantly down in this country. But we're doing well on the share equation, and we're continuing to promote the energy efficiency. So I think overall, we will continue to see that going this year, but obviously the big win for both residential and commercial is when the economy does pick up and new construction starts again. And we've got the capacity and capability to ride that, and our gross margins are good enough that a good portion of that, almost all of it, will fall through. But I'm not ready to predict when that's going to happen.

That makes sense. And then in India, it sounds like the revenue levels have been tracking a bit above expectations. Maybe a comment on how the profitability is trending there as well.

Well, operating profit is positive now within 2 years of opening the plant. We've got a terrific leadership team there, just like we do in China. And I can't say enough for the job that we're doing. We're well over 1,000 outlets there and growing every day, and we're still investing a lot of money in the brand identity. We did over, I think, it was over 12,000 ads, TV ads, last year to get our brand name out across India. So we're continuing to invest there; that's a lesson we learn from China that's paying big dividends in China to this day. So I'm bullish on India. It's, I think, by 2013, it will be up to where China was about 7 or 8 years ago. We certainly like the trend we've had there.

Mike, just to add on to that. To Paul's point from an operating standpoint, it was slightly profitable, but we did have some translation loss because we're buying the product from China, et cetera. And that's one of the reasons why you're seeing the addition to India capital structures, not only demand but we're going to bring some of that components in products that we're buying from China in because I think you know the rupee significantly declined, et cetera.

Yes, that makes sense as well. And then last one on the Lochinvar side, could you provide an update on a couple of the synergy items, including what the plans look like from here to bring Lochinvar internationally, as well as sourcing, using A. O. Smith water heaters for Lochinvar products? And could you also maybe put that in the context of the $0.40 to $0.50 guidance and what's assumed in there versus, qualitatively, obviously, what's assumed in that $0.40 to $0.50? And then if you can accelerate some of those plans, if that would be upside or not.

The bringing in sourcing of the A. O. Smith water heaters is well underway. We've been -- we're ramping up and starting to supply more and more products every week. We're on track, actually a little bit ahead of our internal plans on that, and we are -- we have a team from China, I think they're making their second trip over, I think week after next, to get the training on the product line. So we can start rolling out the product in China. We've been conservative on our estimates and the guidance we've given you on how well that will do in China. I'm personally more bullish than what we have in our plans, but we've got a lot of work to do yet to get the people trained and make sure that we can modify the products such that they can fit not only on the electrical system but all the systems and the infrastructure in China.

I think, Mike, when we had talked last quarter, we had said $10 million to $15 million of synergies over the next several years, with a good portion of the $10 million coming in relatively early. And we think we are seeing that. And then the other $5 million to $7 million, if you will, is going to come as we kind of expand in China, et cetera. To continue what Paul said, when we went out with our earnings initially on Lochinvar, we said it would be flat in 2011 and add about $0.40 to $0.50. We were very pleased with their performance in 2011 and added a net $0.07, and we're seeing next year, it will be an incremental $0.40 to $0.50 on that. So Lochinvar is doing everything we thought plus.

And next, from Jefferies, we'll go to the line of Scott Graham.

I wanted to ask you about the North American resi because you indicated, I think, that volumes were up in the quarter and the color that John gave was rebalancing inventory. Does that suggest that you're not seeing volumes up so far in January?

Well, so far in January, volumes are okay. They're actually maybe a little better than we originally expected, but not much. The North American market is a replacement market right now, and we're replacing water heaters that fail; it's not a discretionary expenditure; it's about 93% of our revenue right now are units that we sell are replacement. It used to be 80%, but it's going to have little bitty, time to time, little fluctuations on inventory that as our wholesalers adjust their inventories to manage the business they see in their trading territories. But on a macro basis, looking to whole year, it's going to be about flat with last year, I think, when the year is over.

All right. Two others. The Sears situation with historic closures, how much have you factored into your sales on that? Would you be willing to share that?

Well, we do have an estimate for all of our customers, and Sears being one, and an important one. And that's within our guidance and, of course, Lowe's is continuing to grow, and that's factored in also.

And as we looked at the individual stores, we did not see a significant impact from the stores that are closing.

Okay. Last question. Steel is starting to creep up a little bit, looks like price increases are sticking. Is there any plan in the first quarter to increase prices to the trade?

We don't discuss pricing on our call because our competitors are nonpublic, and we don't want to do that. But I think our history has shown that we will recover our costs if they go up. We have our first quarter costs already established. We have our -- our contract allows that, and like everybody, we saw the CRU index pop up, and we will do whatever is necessary to make sure that we continue to generate returns for our shareholders.

And next, we'll move to the line of Matt Summerville of KeyBanc.

A couple of questions. First, can you comment a little more on China in terms of what you're seeing in same-store sales within the bigger Tier 1 cities like Beijing and Shanghai versus what you're seeing in maybe same-store sales from some of the smaller Tier 2 and 3 cities?

Yes. We're trying to refine that data, but all indications we're seeing is kind of same thing we said in the third quarter is Tier 1 cities, there is not much growth year-over-year in same-store sales. In Tier 2 and Tier 3, we're still seeing double-digit growth in same-store sales, as well as a good portion when we're adding 600 retail outlets. Probably a disproportion of those are going to the Tier 2 cities. So on top of favorable same-store sales, we're getting more growth because of more distribution. But I don't think it's really changed much from the third quarter, Matt, is what we said.

Got it. And then I want to make sure I'm kind of clear on Lochinvar; you talked about the first half being a little seasonally stronger. Is that business, even though volumes sound like they're very strong, north of 10% or whatever you guys said there, has that business though been maybe impacted a little bit with a somewhat mild winter thus far, and will that push out some of that seasonality? I guess I'm trying to understand as we look at 2012, which quarter you would expect to be kind of the peak quarter for A. O. Smith. Is it still kind of Q2 would be the right way to think about that?

No, I need to correct you, Matt. What Paul said is because of the heating season and the distributors buying, the second half of the year is stronger than the first half of the year. So I don't know exactly the distribution, but a 60%, 40%, 60% second half, 40% first half would be reasonable because the distributors have bought for the heating season. Now carryover to the first quarter, yes, I mean, it has some potential impact that the price of natural gas has come down significantly and also the warmer winter season than you would expect. So again, we're still expect very good growth for the year. But those things are having a little -- will probably have a little impact in the first quarter.

Okay. That helps clear that up. And then I guess is there a way, given how you bring your commercial product to market in the U.S., is there a way to quantify the magnitude of impact of that pre-buy in the fourth quarter and what you think the overhang or the pull-forward would have been out of Q1?

John, you want to do that?

Yes, what we can say, and these are estimates because the final numbers aren't out, is that year-over-year, commercial was up almost 20% from quarter-to-quarter -- I'm sorry, quarter-to-quarter, was up almost 20%. And sequentially, from the third quarter to the fourth quarter was up almost 20%. So clearly, that will have an impact on the first quarter. What Paul had said earlier when somebody asked about the industry, we expected the industry to be about flat year-over-year. But because of the pull-in, it was almost 5%. So that certainly will have an effect on 2012 and much of it in the first half of the year.

Okay. And then just lastly, can you maybe talk about how you're thinking about monetizing the Regal stock over the coming year?

Well, yes, we've said that we're not a long-term shareholder. And we're right now, under a 144A registration, and that expires February 22, at which time our shares are really [ clearly tradable ] after that. Before February 22, it's pretty difficult to tell because it's much less flexible. So what we have is, as you know, we'll be monetizing 1/2 of that at the end of the first quarter some time as we get out of the collar, which we have said expired at the end of March. And then the other half, really after February 22, we're in a position to do what we want with it, if you will. And we'll make that determination kind of based on price, et cetera. But clearly, we are not a long-term shareholder of Regal in our mind.

And next, we'll go to Maxim Group with William Bremer's line.

First question is just real broad. What's the mix right now overall for the company, residential versus commercial embedding Lochinvar?

I don't think it changes a lot because a lot -- well, it changes a little bit, but Lochinvar was probably a little more commercial than residential.

2/3, correct?

Yes, about 2/3. So at $200 million on 1.6 is kind of noise. I mean, it was moving a little bit obviously more commercial than residential, but not significantly.

Okay. And you sort of called that out a lighter first half here overall. If I remember correctly, Lochinvar's strongest quarter was the fourth followed by a weaker third and then the first and second quarter, pretty much maybe the first a little lighter than the second. Is that still the way to think about it as we go into '12 here?

Yes. The way I think we're thinking about it is the first and second will be fairly comparable and then the third and fourth, the fourth being the strongest, and the third being the second strongest, if you will. So that's where you get to that kind of 40%, 60% I should say.

Right. And, Paul, right now, overall, for the company, what type of capacity are you running at right now as a percentage of what you can do?

As far as manufacturing capacity?

That's correct.

We're around 60%, 65%, that's based on a normalized, no overtime, 2 shift operation, but we can always ramp that up with more overtime. We had, like residential water heater market now is a little over 7 million units a year in the U.S. It's been as high as 9 million, 9.5 million units a year. So we're ready for a pickup in housing construction, but as we've said, we don't see it coming this year at all.

Okay. And just one for you, John. In terms of the corporate expense line, $8.5 million this quarter. Is that sort of a good run rate going forward? I know that in the PowerPoint, you sort of provided sort of a corporate and other expense, I just really want to focus on the corporate side of it.

Yes, I think what you can look at is the fourth quarter was $8.5 million, and that has about $1 million related to Regal Beloit dividends that, on an ongoing basis, will not be there. And so as I had said on the last call, we felt the fourth quarter would be a run rate of about $10 million. And when you look into next year, you add about $3 million of the $10 million, pension expense will be at corporate, and then some inflation. That's how -- the midpoint of the range we gave you is 44, and that ends up being about $11 million a quarter.

The next from JMP Securities, Shawn Severson.

I know it's difficult to talk about acquisition pipelines and such, but if you were to kind of handicap it by region, if we look at China versus other emerging markets, including India versus North America, where would you say you're most likely to be active? And then within those regions, are there different things you're looking to accomplish in terms of the acquisition strategy relative to the geography?

Well, we're looking for places where we can create value for our shareholders. And we're looking in Asia, we're looking in Latin America, we're looking in sub-Saharan Africa. There's a lot of places around the world where we're seeing some opportunities in developing markets and emerging markets. That doesn't mean we're not still looking in North America too. There's still some potential opportunities there, and we're not losing sight of that, but we have an effort underway in all of the regions that I just mentioned. And as I've said, there's no way to handicap whether we will do 0 this year or 5 this year. We're just not ready to say until we get something to -- ready to sign a contract at that point, we'll make an announcement.

So I guess maybe in pursuing China a little bit further, I mean, there you already have such a strong beachhead; is that more likely to be that type of a technology tuck-in type acquisition or are there still things there that are kind of [ upsides for ] lack of a better term?

There's some technology tuck-in's that we could do; we're not as strong commercially there as we'd like to. We still have a lot of opportunity on the water treatment there; same thing in India. So those are all things that we have on our radar screen.

And just to clarify, you guys exports to some of the other countries in Asia and Southeast Asia; are you following your existing retail channels that you have in China that it moving over there or you are you developing new distribution relationships in those countries?

Every country is a little different. The retail program in China is a fairly new event. And 8 years ago, Suning had 20 stores, and they now have well over 1,000. So that is something that just emerged in China that has really taken off like a rocket. Vietnam, Malaysia, they all have different distribution networks, and we will be bringing products appropriate for those networks that we're able to go in and sign up customers for.

And next, we'll move to the line of Todd Vencil of Sterne Agee.

I guess all my -- most of my questions have been answered. But I did want to ask about the buybacks; I saw you did some of that in the quarter. Can you just talk about what sort of the parameters there are on what you think about that as a use of cash and how you're thinking about when you would come in?

Well, we had talked at the last call that one of the measures we use to evaluate the attractiveness of the share repurchase was the enterprise value to EBITDA, and what we said in the third quarter we felt our shares were significantly undervalued, and when you looked at our actual enterprise value to EBITDA multiple, it was much below our historical average, especially given our growth profile, et cetera, et cetera. So we purchased shares in the fourth quarter. We had good appreciation in the fourth quarter. We, like every other management team, see our stock as still undervalued. However, we think there's some acquisition opportunities that have the potential to bring better shareholder return. So I'd say right now at this price, we're not actively buying at this time.

And next from William Blair, we'll go to the line of Samuel Eisner.

So I had some questions regarding Lochinvar. You mentioned that you expect to grow about 10% in 2012. Can you talk about any share gains that you might be experiencing on either the commercial or the residential side there?

Well, they have a -- they've really got, we think, the best product out there in the industry. Obviously there's competitors that will probably argue with that. But they are growing their business certainly well above what one would expect given the U.S. commercial construction. And the reason is, the high-efficiency condensing stainless steel boilers, they've really got a product that's a category leader, and they're becoming the -- have become and are continuing to expand their reputation in that area. And as I've said before, I could not be more proud of the people and the facilities and all the design team and manufacturing team at Lochinvar, sales team, marketing team, they're just terrific, and they're continuing to put up impressive numbers.

And then to that point, I mean, it seems as though on the operating margins on Lochinvar, you've gone from about 14.5% now up to [eighteen].5%, I mean, should we continue to see operating margin expansion on Lochinvar into 2012?

We're still implementing the synergies, as John mentioned earlier, and we're not done with that. So I would be surprised if we didn't continue to see expansion in the margins there.

And then you mentioned twice now water treatment, can we maybe just get an update on what Shanghai Water Treatment and how that's performing, maybe the size of the business, profitability? And then could you potentially rank in terms of either water treatment or water heating products your preference for acquisitions going forward?

I'll talk in general, John. We're still losing money there, we did last year on Shanghai Water Treatment. Part of it is we're investing in the A. O. Smith brand; we're doing better than we thought we would with the A. O. Smith branded product. But we've relocated the plant on very short notice because of some problems with our former partner. We're still committed to it strategically, and we're still committed to it from an acquisition standpoint. And in other regions, not just China, in other areas of India and other parts of the world where people need clean water just to make sure that they survive. So we're committed to it. It was a loser for us last year. We covered it with other parts of the operation doing better than we originally thought. That's how we beat our guidance that we gave last January for 2011 was we overcame some of those. You have ups and downs in every piece of the business, and it's our job to continue to get shareholder returns by managing through those. John, you want to add a comment on that?

No. I think to Paul's point, we certainly lost some volume. Volume last year was $30 million, and we were closer to $20 million this year, and that was a function of moving the plant. We lost some salespeople to our previous owner, and the big export business we had, much of it went to India, where you had a weakening currency in India. So that was difficult on us. So we also had some moving costs, and we also, as Paul said, had some significant inefficiencies. When you move a complete plant and you hire 500 to 600 new employees, that's going to have an effect -- a significant effect on profitability. We have, we think, a plan in place to over the next couple of years return to profitability. It's going to be dependent on getting some of those sales back. And again, I'm talking about the one side of the business. The other side of the business, we are very pleased with what's going through the A. O. Smith retail outlet. Profitability is slightly less there than we thought, but that's just a function of advertising costs. Sales are actually better. So that's kind of where water treatment stands.

Great. And then just one last question with the new, I guess, segment breakout. Can we get an indication maybe of what margins will be for the 2 segments, or are we going to have to wait until the 10-K...

You're going to wait as we're kind of refining those numbers now, and we'll put it -- that's why we just wanted to kind of give a forewarning that we are going to be putting it in the K, so you'll have that, and we can certainly -- we'll attempt to discuss those margins in the MD&A and give you an understanding of where they're coming from.

And next, from the line of David Rose with Wedbush.

A couple of last follow-up questions. If we can go back to China and discuss a little bit about what you see is the market size or the market opportunity in the Tier 2 and Tier 3 markets, if you can quantify that a little bit. And then secondly, on the China front, if we can get a better idea of what sort of leverage that you might to see in China; clearly you folks have discussed, we've discussed it with you, about putting more money into SG&A. When do we start to see that leverage? Is it 2013? Is it 2014? And how much leverage can we see there? And then on the water treatment side, just to expand on that, what can we expect in terms of expanding that business in India and the timeframe for that?

Well, let me start out with the comments on China. Tier 2, the stores that are opening up in Tier 2 and Tier 3 cities are smaller than the stores that you have in a Beijing, Shanghai, Nanjing, the large cities. So the sales through those per week are going to be a lower number. But that doesn't mean that it's not a compelling thing for us to do. We're expecting let's say 20% growth this year. Well, that's another $75 million to $80 million of revenue, which is pretty significant for a business that was only doing $45 million [indiscernible] years ago. So we still are committed, still it's a different business model than the U.S. There is a heavier percentage SG&A, but the operating profit is higher in that business than -- still by some amount than our current North American business. So we're still committed to it, and matter of fact, delighted to have the market leadership position in China. And we're even expanding that leadership position. We're now #1, and we're distancing ourselves from #2, and that's going to continue. As far as water treatment, the largest export market for water treatment products is India. And we are doing a capacity expansion there, and we're evaluating the water treatment piece of that, and we'll probably talk about that in some future conference call.

If we can follow-up on the investment in the Tier 2 and Tier 3. Is the margin profile the same, or is it less? I mean, you have lower volumes. Do you have a lower margin profile?

No. The margins will be the same too out [ there ]. We'll put the promoters in the stores, but there won't be as many in Tier 2 and Tier 3 as we have in the Tier 1. So these, and we expect to maintain the margins. Of course we have the manufacturing capacity and the manufacturing efficiency. I haven't talked about it, but we're doing some pretty interesting things within the existing Nanjing facility to improve productivity. We're actually handling growth right now without adding people due to some productivity improvements, little simple automation things, or some of them not so simple, but where we're able to eliminate positions; we don't exactly lay people off because we're still getting growth, but we don't have to hire as many people going forward. So I'm pleased with the margins there, and we're still doing all the things that we know how to do all over the world relative to improving margins on an ongoing basis.

That leads to my last question is can you talk about any specific initiatives? You mentioned out [ one ], Nanjing to some degree. But in terms of something, somewhere to lean or is there any new ERP that you plan to roll out, is there something additional that we can expect?

Well, if you get a chance to go visit the plant in Nanjing, go do so. They'll be happy to show you. We put in -- I was there in November and saw some pretty impressive automation in the stamping area that is eliminating I think over 30 positions. That's pretty impressive to look at. And things like that, it's not going to be where we're going to take out several hundred people, positions. But I think 50 to 80 a year with the lean programs they have going on there is an appropriate number. The wage rates in China continue to go up. It's a double-digit increase, so that's becoming more and more compelling. We're just trying to get ahead of the curve and make sure we have a very efficient plant. If you tour our plant in Ashland City or Johnson City or any of them and then go to Nanjing, you won't see a lot of differences. It's a very modern, efficient facility, and we're just going to continue to improve it.

And our last question in the queue at this time, from KeyBanc, Matt Summerville.

Just a couple of follow-ups. John, I want to make sure I'm clear on the operating cash flow guidance. Does that include the cash tax payments you'll be making? I think you mentioned $30 million early on in the year. And then what's the assumption there relative to the earn-out mentioned in the original press release when you bought Lochinvar? Is that assumed is paid or not paid?

Well, the first question is, no, the tax payment would not be there; that will show up next year as a discontinued operating cash flow because it's a payment of taxes associated with EPC. The second one, I believe that number is in that cash flow number. The earn-out, the earn-out.

I'm sorry, can you say that one more time?

Yes. I believe the earn-out is in that number.

Okay. And then with regards to some of these currency dynamics, you have the Chinese currency, Indian currency, pesos, Canadian dollars. What was the aggregate FX impact on A. O. Smith in 2011? And what sort of placeholder are you using for 2012 per your P&L?

Yes. I do not have that. I mean, I can tell you translation wise for the year, we probably had a hit of $1 million to $1.5 million. And a big piece of that was India, which is buying from China, okay? And so that payable until it's settled gets marked to market, and you had a declining currency there. So that was a good portion, that was probably almost $1 million, [ $1.5 million ]. You also had a little bit on the Canadian because they're purchasing some products from the U.S., and again that would go through the translation. When you translate the earnings of Nanjing, the RMB probably appreciated 2%, 3%, that would have been a benefit that I'm not including in what I'm giving you. So yes, you're right, we have a lot of things going every which way, and some of it just ends up in comprehensive income and some of it ends up in the P&L.

But the point is, it's less than $0.02 a share for last year.

Yes. Right, yes. I just wanted to make sure that, at the end of the day, when you sum it all up, it's not that meaningful. And then just lastly, I want to make sure I'm clear on Shanghai Water. So when you bought this thing, you thought it had about $75 million in revenue. It's bottoming now. Is it indeed bottoming, I guess is part of my question, at about $20 million. And I guess can you help fill in that blank a little bit, that big gap down, what exactly drove all of that, and if -- your level of confidence that, that has bottomed out, and I guess when does it start contributing positively to your P&L?

It was never a $75 million business. We were -- we found 2 sets of books, there was a third set that was -- that, well, unfortunately didn't come to light until after we had closed, and it has bottomed. We're actually seeing increases right now. We're seeing increases in productivity, increases in revenue from the $20 million bottom that John mentioned. And we're not ready to tell when we think we'll be into the positive margin, but we're going to see significant improvements this year from the losses we incurred last year. And we're still as determined as ever and as committed to the strategy. It's the right strategy. We just started at the wrong place, and then we had to quickly move the facility and hire almost all new people and start from scratch. We did a new plant start-up starting last January. And it's been progressively getting better month after month.

And with that, there are no further questioners in the queue. Please continue.

Okay, Paul, why don't you just go ahead and give them the dial-in information, and we'll just go ahead and conclude this call for anybody who wants to get a playback.

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