Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Second Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I'd now like to introduce your host for today's conference, Ms. Patricia Ackerman, Vice President of Investor Relations and Treasurer. You may begin, ma'am.

Thank you, Earl. Good morning, ladies and gentlemen, and thank you for joining us on our 2015 second 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. We set sales and earnings records again in the second quarter. Higher-than expected volumes of residential and commercial water heaters, earlier realization of higher pricing associated with NAECA III compliant water heaters, improved performance at Lochinvar, as well as lower than expected material costs resulted in stronger performance in the second quarter than we originally projected. Here are a few highlights. Organic growth in both of our segments drove sales 10% higher to a quarterly record of $654 million. China sales were up 15%. Net earnings of $0.79 per share were 20% higher than the adjusted earnings per share of $0.66 in 2014. We continued to review our capital allocation and dedicated a portion to return to shareholders. In addition to our regular dividend, we repurchased approximately 400,000 shares for $27 million during the second quarter. Our transition to NAECA III compliant products is complete. This is a very complex, complex project, impacting approximately 80% of our residential water heaters. I'm now going to hand it over to John, who will describe the results in more detail.

Thank you, Ajita. Sales in the second quarter of 654 million were 10% higher than the previous year. Net earnings of 71 million were 18% higher than second quarter adjusted earnings in 2014. Net earnings EPS of $0.79 per share improved 20% compared with adjusted earnings per share of $0.66 in 2014. Sales in our North America segment of 443 million increased 8% over 2014, driven by a price increase effective in April for both commercial and residential water heaters in the U.S. as well as higher sales of Lochinvar-branded products. Rest-of-world segment sales of 221 million increased 14% compared with 2014. China sales increased 15%, driven by higher demand for water heaters and the water treatment products. North America operating earnings of 86 million were 28% higher than adjusted segment operating earnings in the previous year, and the operating margin of 19.4% was significantly above the 16.4% adjusted operating margin one year ago. The favorable impact from higher water heater prices in the U.S. and Canada, higher boiler sales, and lower material costs was partially offset by approximately 4 million in expected incremental ERP implementation costs. Rest of world operating earnings of 31 million improved compared with 2014 due to higher profits in China. Operating margin of 14% fell from the previous year due to higher selling and advertising costs as a percentage of sales in China, including promotion related to the Company's new air purifier product and larger expenditures in India to support the launch of our water treatment products. Our corporate expenses declined modestly from the adjusted corporate expenses the prior year. Cash provided by continuing operations during the first half of 2015 was 59 million compared with 91 million provided in 2014. Higher earnings were more than offset by larger outlays for working capital in the…

Thank you, John. As John mentioned, the midpoint of our updated 2015 guidance implies growth of 26% over last year. Our 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, including an emerging replacement demand, which is most prominent in Tier 1 cities; market share gain; expanded distribution; 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. China inventory levels at our seven largest distributors are about the same as last March but up about $10 million from the end of last year and from a year ago. As we have expressed in the past, China inventories can rise as customers increase orders ahead of buying holidays or to ensure volume incentives. We are watching China inventories, as they are higher than normal. We do not expect the 30% decline in the Shanghai Stock Exchange Index to have a meaningful impact on the economy or our sales due to a number of factors. There is relatively low participation in the stock market by urban households. We estimate that to be around -- less than 10%. Stock holdings represent 10% to 15% of household wealth, and we have seen no historical evidence to support correlation between consumption and stock market level. Despite the recent decline, the stock market is up about 70% from last July. There was relatively low impact on retail appliance sales and our China sales when the China stock market corrected in 2008. And also, we do not view water heaters or water treatment systems to be discretionary purchases in China. Our second major assumption: we announced to our U.S. customers an average residential price…

Thank you. [Operator Instructions] Our first question comes from Robert McCarthy from Stifel. Your question please.

Hi. Good morning, everyone, and congratulations on an excellent quarter. I guess the first question would be, if you are thinking about 2016 in terms of anniversarying kind of the factors around the pre-buy and how we are thinking about it -- now, I know you are not initiating 2016 guidance here. But can we think of, qualitatively, about the factors that are going to impact kind of growth in North America in your business in 2016? Or how should we be thinking about it, because it's going to be difficult to model, because we just had such a strong year this year.

Well, you are right. We have not looked at the 2016 plan yet. We'll do that later in the third and fourth quarter. I think from a modeling standpoint, we are very comfortable still with that 8% to 9% organic growth that we have consistently talked about. So from a top line, we think that's very achievable. And from a margin standpoint, we've said we are going to try to continue to increase margins. Obviously there's factors that affect that, including steel costs, which are volatile, et cetera. But again, we haven't really done the modeling yet for 2016.

Yes. And I think, to add to what John said, the 8% to 9% is driven by a number of assumptions which we have talked about, which include North America, which we feel is going to be a little stronger because of the pricing action for NAECA III products and also China, driven by two times GDP and Chinese GDP. We are very comfortable with the overall guidance that we've been giving and that also includes the Lochinvar growing at 10%.

And just a follow-up on the comments -- which we appreciate, obviously, about the context around China and the inventory -- when do you think you are going to have a better sense of how you think the growth trajectory is going to play out kind of into 2016 from moderating the inventory levels? When do you think we will get a better sense from your customer distribution base in terms of how to -- thinking about planning for next year, given the inventory levels you cited?

As Ajita just said, I think we're comfortable with that two-times GDP. You have seen the model, Rob, on how we've grown water treatment from an ancillary product line -- continues to grow significantly. It was 75 million this year. It will be over 100 million next year. So that's certainly -- we expect that to continue as the market continues to grow. We've said consistently we think the water heater market in China will grow somewhere in that 7% range, helped by higher replacement, which we're certainly seeing in Tier 1 city. And you know, the third bucket we've talked about is gaining market share, which we're continuing to do on the GAF side. We're adding distribution; we're over 7,500 outlets. And we'll continue to have higher price increases at higher price as we bring products to market that have values and features the consumer wants. So the model we have to grow the business, we think, is intact. You're going to have some lumpiness on a quarterly basis, when you might have higher inventories because of VIP incentives that they are trying to get, etcetera. We don't necessarily look at a quarter-to-quarter. What we're looking at is full-year of that two-times GDP.

Thanks. I'll leave it there for now. Congratulations on an excellent quarter.

Thank you.

Thank you. Our next question comes from Scott Graham from Jefferies. Your question please.

Good morning, and nice quarter, you guys. I did also want to ask about China, because obviously the overriding driver to your sales there is GDP, but sort of de facto GDP. It's more, from what we've discussed, household formations. Like you, it doesn't seem as if household formations are going to slow a lot because the stock market slows. But there could be some temporary disruptions. And so I guess what I'm wondering is: is the combination of that -- if that's in your thinking, in fact -- plus the little bit of higher inventory could give us just some China sales numbers in the second half of the year that may be more toward, let's say, the 10% rather than the 15% growth?

I think, Scott, overall -- as John said -- we try not to react too much to the quarterly ups and downs. And we're very comfortable with the two-times GDP guidance for the year.

Yes.

And like I said, and you indicated, we are not concerned about the stock market and the impact, because I listed out the reasons we are not. And everything that we check on and the people we consult reconfirm to us that that's going to have little to no impact on, as you mentioned, household formation and the other drivers that really drive our volume.

Okay. Got you. Two other questions -- the price increase that you have the higher-priced versions of the water heater units that went out the door in the second quarter -- when did that actually start? Was that a middle-of-a-quarter phenomenon? You said it didn't really affect as much as you thought. My sense was that you guys were thinking sort of May. Did it actually happen in May, or was it -- you know, the higher-priced units start to go out the door earlier than that, in fact?

They actually went out earlier, Scott. We would've said -- we thought the industry would be down over 10% in the second quarter year-over-year for both residential and commercial. And we thought there would be a little bit of a lull after – you know, we could only manufacture the old one from April 2015, and the new one we started manufacturing on April 2016. We thought there would be a little bit of a lull, but we really did not see that. Essentially, the residential and commercial markets, we're thinking, are going to be about flat year-over-year for the quarter. And that surprised us. But the benefit of that is we have higher volumes than we thought. We also started selling the higher priced NAECA units earlier than what we thought. And so if you ask me when, I guess I would say kind of third – you know, third – certainly sometime last half of April, we started seeing the benefit of that. And that was earlier than we thought.

And last question is: you indicated the incremental upward change on North America water heater volumes within your view. Could you just remind me what your view is on North America residential water heater volumes for 2015?

So last year it was 9.2 million units. We said we thought there was some pre-buy in the last half of the year, and that it was going to be flat to up very slightly is what we said in the first quarter. Now, based on what we've seen in the first quarter and the second quarter, we would say industry units will be up 150,000 to 200,000 units, so somewhere in that 9.350 million to 9.4 million range.

Thank you.

Thank you. Our next question comes from Noah Kaye from Northland Capital. Your question please.

Thank you. Good morning, Ajita, John, and Pat. How are you?

Good morning.

First, maybe we could start on the gross margin line. At a 40%-plus gross margin, I would love to unpack that a little bit. You mentioned lower steel prices. You have also had the price increase. I know in the past you have said that you didn't think that gross margins would benefit necessarily from the price increases. And then, as you said, the volumes in some parts of the business have been stronger, leading to capacity utilization. So I would love to just kind of get a sense of what was the biggest driver among those three things in contributing to the higher margins? And how do you think about this? Is this a sustainable gross margin level over the next several quarters into 2016?

Well, so gross margins were up significantly. And it was primarily in North America, and it was a combination – Lochinvar and a very, very good quarter and year-to-date. So their margins were up several points. And on North America, margins were up. And as we had talked about, we had some price increases for commercial and non-NAECA III products due to wage and medical cost inflation. So that went in place during the quarter. We had two price increases in Canada during the first half of the year, and then we had higher-priced NAECA products, which had higher cost. But in addition, what you said is material costs did come down during the quarter and that benefited. So it was primarily in North America, and it was a combination of items. Now, to your next question, I think obviously there is – volume that can skew that. I think you are aware, when you look at the history of the water heater industry, the third quarter normally represents about 22% to 23% in the volumes, which -- so that can theoretically affect gross margins. But I mean, I think at current price and current material costs, those margins are reasonable on a several quarter basis.

Okay. Very helpful. Second question, we've been hearing even more recently a possibility by Congress to enact legislation that would include repatriation connected to the Highway Trust Fund. I'm sure you're watching that closely. You have talked about this in the past, but can you just remind us, first, if there were to be a repatriation, have you already assumed for income statement accounting purposes that the cash is coming home? And I guess the second there would be, if there were to be such a repatriation, how might that impact your views on doing foreign acquisitions? Thanks.

Well, a portion of it -- we do have accrual for a portion of it. It's approximately $200 million coming back home. So we do have an accrual on the books for that. Congress and the administration have talked about this probably four or five times over the last two years. So at this point we are not holding our breath on this happening. But we're happy to hear they are talking about it. And depending on what the cost is to bring it back, right now, in our mind, it's prohibitive to bring it back. So depending on what the cost is, we'll certainly consider that. But I think we've said all along -- and I don't think these changes it – that we're looking globally for acquisitions. And I think we'll continue to do that. So I wouldn't see us necessarily bringing back everything immediately, by any means. But we'll certainly evaluate it. We certainly do hope it goes through.

Okay. Great. Thanks so much. Congrats on the quarter.

Thanks.

Thank you.

Thank you. Our next question comes from Jeff Hammond from KeyBanc Capital. Your question, please.

Hi, good morning guys.

Good morning.

Hi, Jeff.

Can you just – so back to the North America margins, I mean, it seems like the big variable going forward is really input costs. And if those go back up, then maybe this margin is not sustainable. But it doesn't seem like there's any real aberrations in the margin.

No, nothing significant from an aberration standpoint. No unusual items in the quarter.

Okay. And then can you just talk about how ERP rolls off into 2016?

Well, we're looking at that as our planning process. We said this year we'll spend $19 million to $20 million in expense. Our best guess is that will be similar to maybe up a little bit next year, as we take more sites on in 2016. But we're evaluating that right now. We did our Johnson City plant, as we said, in August 2014. We did Lochinvar in May of this year. And given some of the NAECA items that have developed along the way, because it's been all-hands-on-deck from a NAECA standpoint – we probably will not do any more sites in 2015.

Okay. And just finally, on NAECA III, have you seen any dislocation from competitors, where you've been able to maybe perform better in the near-term or capture share? Or is everyone kind of transitioning well?

I mean, as I think we talked about last time, we weren't expecting anyone to really have any significant hiccups. So this has been in process for quite some time. From what we see, there really has not been much in the way of share changes during the first half of the year.

Yeah. We didn't model anything or expect anything. And it's kind of playing out.

Okay. Thanks, guys.

Thank you. Our next question comes from William Bremer from Maxim Group. Question please sir.

Good morning, Ajita, John, Pat. Outstanding quarter.

Thank you.

Hi, Bill.

Hey, good morning. My first question – and maybe you could just help me out on this – is on the China market: what is the breakdown of, say, replacement versus new? I know you emphasized Tier 1 replacement in your remarks, but can you give us a sense of what's currently the run rate there or the split there?

I can tell you, based on our survey data, there is no good data put out by the government on that, or at least we haven't found it. But when we look at our surveys that we have of people that bought, when I was over there two or three years ago and I ask every time I'm over there – they had talked about Tier 1 cities kind of being in the 35% range or whatever. And as we've been over there more recently, the talk is closer to 50% in Tier 1 cities. And that's logical, because you've now got pretty high penetration rates in Tier 1 cities for water heaters. So now we talk about our life being eight years. We're not going to comment on the life of what our competitors are, but at eight years you'll start having some replacement. So we think it's a bigger piece of the pot. And quite frankly, it will probably grow into bigger pieces of pot, especially in Tier 1 cities.

And also I think, Bill, anecdotally our brand is positioned at the high end. It's an aspirational brand. So as people's incomes get higher, and they replace, then if they decide on buying a better brand, then they gravitate more towards A. O. Smith. So it was a combination of all of that. But as John said, we don't really have any good quantitative data to back it up.

Right. Now, shifting to Lochinvar, seems as though it's been stellar, stellar performance. The market is starting to gravitate towards it. You are doing more and more fabrication for some top clients. And now we are starting to see it truly accelerate. Could you give us a sense of, first – not only the expansion, but give us a sense of the contribution to the quarter as well as the aftermarket?

Well, I'll start, and then Ajita can fill in. The aftermarket was up about 9%, which has been pretty consistent with what we had expected. Their commercial market has been very strong. We have talked about beginning of the year we thought the commercial industry for water heaters would be flat, and now we're talking it's going to be up 3%. They are continuing to see very strong commercial build. As I alluded to earlier, their margin points are up several points in the first half of the year. Their sales are up over 10% the first half of the year and their business continues to do very, very well. It's helped, obviously, by the new products that have come out. They expanded their line on the CREST down to 750,000 BTU. They bought out a fire tube boiler in the smaller range, and that's doing well. So all in all, Lochinvar had a great first half of the year. And they contributed to the performance in North America.

And you know, the only thing I would add to that is that the strategy behind Lochinvar is new products and coming out with new things. And we continue to invest in that area. As you saw during the Analyst Day, we are expanding our capacity in terms of engineering and testing capability and expanding the factory. And all of that is going well. And we will continue to invest in the key drivers, which is technology and being first to market with the best products in the marketplace.

Right.

And it's working.

I appreciate it. My last question is on the operating margins in North America. Very solid. The 19.4% -- that includes the 4 million of ERP systems, correct?

Right. Well, the incremental of ERP. So I mean you can kind of look at -- we're talking about $20 million of expenditures in 2015. And it's roughly flat lined, 5 million a quarter -- not quite, but about 5 million a quarter. What we're saying is last year in the quarter, it was about 1 million or so. And so there was an incremental four. So second quarter compared to third quarter ERP costs this year will be relatively similar.

Okay. Great. Thanks.

[Operator Instruction] Our next question comes from Todd Vencil from Sterne Agee. Your question please.

Thanks. Good morning, guys.

Hi, Todd.

Good morning.

I want to focus in on the margin in North America again I know you've had a few questions on it and given a few answers, but it was a big number, so I really want to make sure I understand it. John, you laid out the factors, and you kind of talked about them. Is there any way you can sort of size up how much was price and how much was sort of lower materials costs and things like that in terms of maybe the incremental operating profit in North America in the quarter? Or is that just kind of too hard to do?

Yes. We really are not going to break that out. And it's difficult to get your hands around it. But those -- the pieces I alluded to, the Canadian price increase, the price increase on non-NAECA, Lochinvar, the sale of higher-priced NAECA product, and lower material costs -- all of those where relatively significant factors in the improvement.

Got it. And can you maybe let me know how much those -- you know, I think you have talked about the NAECA -- the step-up on the NAECA-compliant product being about 20%. Can you remind me what the price increases were on the other products?

I think we said that they were -- commercial, we said there was a wide range depending on the geographic location and the type of product. I think you are probably somewhere in the high single digits on the other type products.

Got it. That's helpful. And on the lower raw materials, is that something that per your -- either your arrangements with distributors and customers or, given the competitive environment, that you are enjoying it for now but going to end up giving back? Or do you think you get to hold onto that raw material benefit?

Ajita, he was asking about raw material costs and pass-throughs etcetera. On wholesale, it's done traditionally through price adjustments, price increases or decreases, depending on the marketplace. But there is no direct pass-through on the wholesale side.

No. Yes.

Retail with some of our customers -- we do have some pass-through of steel, etcetera.

Would those be kind of yet to come? Or those have impacted?

I think they vary. They go in different cycles. And some of them are sooner than others. But they tend to be a little bit after.

Okay. And so if I kind of look at that 19.4% margin in North America, it feels like there's a whole lot that went right in the quarter. So would you think, like, a 19%-plus level is sustainable? Or just going to continue to kind of trend higher on a trailing four-quarter basis, or something like that?

Well, I think I alluded to it. I think the 19.4 -- what it was, based on current prices and current material costs and the continued strength in the commercial market -- which, remember, helps two of our operations; it helps our commercial water heater, and it helps our Lochinvar, which are higher-margin business. We are not uncomfortable with that range, given those factors.

Yes, and I think the key -- the wildcard is material costs. That can have an impact.

Well, I'll put steel on my screen, then, and keep an eye on that. Final question, kind of relatedly, kind of not: how does the inventory in the channel look? I know you were expecting some -- I guess a lot of guys were buying the non-NAECA III compliant. And I'm speaking -- I know you have talked about China, so I mean specifically about the U.S. now. But for you guys and for your customers, how do you feel like the inventory looks?

Maybe I'll take a stab, and John, you add to it. You know, unfortunately the visibility of inventory in most of our channels is very tough. Okay? In wholesale it's very difficult to take a look at. The retail side -- it's a little easier. And China, like I said, China is the one that -- again, it's an estimate. We feel it's a little on the high side, but not higher than last quarter. It's higher than the end of the year or from one year ago. But again, this tends to be lumpy sometimes when you look at it quarter-by-quarter because of the fact, as we have talked about in terms of people trying -- sometimes buying in to hit volume targets -- quarterly volume targets for VIPs; sometimes buying in for holidays, etcetera., that have high sales. So we're watching it. We are not concerned about it, but we are watching it.

When we look -- Todd, when we look at North America, as Ajita said, we don't have great visibility. But when we talk to our customers, our impression is that levels might be slightly elevated -- but not to any significant level, which is good. And that's why we felt comfortable increasing the full-year residential and commercial, because of our understanding of what's in the channel. Again, with the caveat we don't have great visibility. But certainly, we talk to our customers.

Right. So bottom line, we are comfortable with the annual guidance. And we are not overly -- we are watching, but not overly concerned about the inventory levels.

Great. Thanks a lot.

Thank you. Our next question comes from Ryan Connors from Boenning & Scattergood. Your question please.

Great. Thanks for taking my question. A couple of different type questions. First off, it was our understanding that there was an effort in the Senate to exempt certain water heaters used in electric utility demand/response programs from the NAECA III regulation. I wasn't ever sure what the outcome of that was. Do you know about that effort and whether that was successful?

It's still pending, but we don't expect a big impact on the market because of that for some time. It's a long period of time.

Okay. So that's not been finalized at this point?

Yes.

Okay.

And it's for really very, very large capacity type water heaters.

Yes. Now, do you manufacture any of those, to the extent that does go through? Or is that other players?

You know, we do manufacture some of them, but it's not a huge impact. But again, like I said, we don't see a huge impact of that legislation hitting this industry, if at all, for a long period of time.

Okay. Separately, a lot of news by one of the very large companies in the industry, General Electric, about some acquisitions they are planning, if they can get them through. Does that have any impact potentially on you all? What's your view there of how their recent strategic shifts impact their focus on this industry or not?

Not really. When you think of the water heater industry and General Electric, they are small player in one category which is heat pump water heaters. And that's part of their appliance business, which is pending sale to Electrolux. And so we expect that to continue. We don't know of any change in strategy by Electrolux, and so we have no idea – it's a very small impact on the industry.

Okay. And then finally, just the issue – I don't think you have addressed online sales at all in China, and how that's trending, and how all the noise in China that you have talked about a lot on the call here impacts the outlook for that piece of the business?

We haven't seen – so last year online sales were $55 million. Through the first six months they were about $50 million. We're still tracking towards the $90 million to $100 million that we have talked about on previous calls. So we haven't seen any impact whatsoever, and we are progressing as we expected.

Okay. And you envision that continuing – I mean, do you believe that's going to flatten out at some time? Or do you think that really will continue to grow at that kind of a trajectory and pretty quickly become the majority of the business?

No, I don't think it's going to grow at that trajectory. It's not going to go at 100% a year. There's still an – and again, we have different components of that. So water heaters probably represent about 75% of net sales. Water treatment represents 20% of net sales; and air purifiers, maybe 5% of net sales at most for the year is what we're expecting. So we think it will probably still continue to grow, but not at that trajectory.

Okay. Great. Thanks for your time.

Thank you. Our next question comes from David Rose from Wedbush Securities. Your question please.

Good morning. Thank you for taking my questions. Just a couple last ones. And not to go too much into the margin side, but just to clarify, as we look at the ERP comparison, it's easier in Q3 and Q4 than it was the prior year. Margins should be the same, all else being equal, but you get the benefit from the ERP. So am I missing something that would suggest that your margin in North America wouldn't be higher?

No, I guess what we're saying, David, is we were about – we'll be about 19 million or 20 million this year. And it was flat-lined -- somewhat flat-lined at 5 million a quarter, let's say. Last year, the first half of the year, it was 14 million. It was only about $4 million. Okay? So the 10 million versus 4 million is -- it affected us $6 million compared to the prior year. This year, the last half of the year, it's going to be roughly 10 million of ERP in 2015 compared to 10 million of ERP in 2014. So I don't know if that clarifies for your question, but it won't have an impact on margins over the prior year.

Okay. And so, then, there really shouldn't be any negative drag other than the possibility of kind of the pass-through costs for steel, if that happens?

And volumes. So when you look at volumes for the water heater industry, it's normally about 52% or so in the first half of the year, 48% the last half of the year. Commercial is very similar. So, volumes second half of the year will be a little bit less than the first half of the year, which has an impact.

Okay. That's helpful. And then, China, just lastly, you provided some good commentary about market sentiment. Maybe you can provide a little bit more commentary about your strategy in terms of pricing and promotion in light of what you may see a slightly weaker market or potentially a weaker market? Do you plan to be more aggressive? Do you plan to do more promotional work? Do you think you may limit your ability to increase prices?

There's a lot of questions there. So, promotion-wise, certainly we are spending more on promotion on air purifiers, water treatment, and also online. So that's a fact. We are spending more on those areas, as they are relatively new areas. So we are spending more promotion dollars there. As we have talked about in the past that SG&A spend can be very volatile. Last year it was very volatile. And we ended up at about 13.8% or so for rest-of-world, which was driven by China. But there was wide differences by quarter-to-quarter. This year we're thinking it's going to be more leveled out. And we have talked about being about 13.5% to 13.75%, let's say, for the full year. And that drop is driven by a couple things: it's driven by our investment in air purification. It's driven by our investment in water treatment in India. And also, we started selling water treatment in Vietnam, and that's having a negative effect on those margins. So we're very comfortable with where the margins are. They're pretty much what we had talked about. And again, what differentiates us from a lot of people in China is our growth model isn't dependent on only one item. We have those three buckets, and that gives us some comfort going forward. We will continue to build the brand and invest in the brand. I don't know if that answers your question.

Well, actually – I mean, the commentaries are pretty consistent, obviously, with what you've said in the past. I guess what I was really trying to get at was – and maybe you answered it earlier – you don't seem to be terribly concerned about the environment in China, the current stock market volatility in China, to make you change any of your pricing or promotional strategy or SG&A strategy. And that's really what I was getting at.

No, we don't. Like we've always said, we are always going to – there are going to be quarterly ups and downs in the marketplace in China. And we are very comfortable – or anywhere – and we are very comfortable with the longer-term guidance that we've given. And we manage the ups and downs as best we can, as we see them coming. Specifically in terms of the stock market, like I said, we are not concerned about the impact of it in terms of looking at the number of people it impacts, and all the reasons I gave -- and the fact that it's up 70% from last year, anyway, even with this recent drop. So we don't see that as having a long-term impact on our type of customer.

And I think as Ajita has alluded to, in 2008 the market dropped much more significantly than what it did. And it didn't have a significant effect on consumer spending. So we've looked at a lot of economists work, and there's no empirical evidence that ties to stock market move to consumer spending. And again, we also say – or household formation, so time will tell if this is something different, but there's nothing from a historical standpoint that supports that.

Okay. Thank you very much.

Thank you. Our next question comes from Robert McCarthy from Stifel. Question, please.

Yeah. Just a couple of follow-ups. You cited the strength in kind of your commercial-facing end markets. Clearly, you updated your guidance there. But any other additional color about how – you know, did you feel like this is real and sustainable? How do you think about where we could be? Could this be a multiyear thing in terms of the growth you are seeing?

I wish I could answer that. We haven't done a great job of estimating the commercial market. We continue – you know, we talk to our salespeople, and they are seeing it in a lot of different components. You know, gas, high-efficiency is becoming a bigger piece in the last three years. And that certainly is in one of our areas of strength. The hotel and the restaurant business is doing fairly well. So we are seeing construction there as well as retrofit work. We're also seeing for redundancy work being done. That's on kind of the commercial water heater. And then the verticals that Lochinvar works with are the educational side. And they are starting to see some potential in the healthcare side, et cetera. So there's been a lot of talk about commercial coming back, and it hasn't. But it has, for our businesses, come back pretty well. So we certainly cross our fingers and hope it will continue for the next several years.

And it sounds like you haven't seen material weakness in Canada. I think you alluded to some pricing as well. But I mean, could you comment there in terms of what you are seeing, and – just to give the macro outlook there?

Not much change in the industry. It's relatively flat year-over-year. But obviously, because of the currency, it's been affected. I mean three of the four players on manufacture in the U.S. So there's been impact there -- three of the four major players, I should say -- impacted there. We had some currency translation, adjustment of our top line, obviously, as the currency has devalued. But as I said, there's been price increases that have gone in there.

And then, finally, on China, just in terms of -- two questions. One, have you seen -- I mean, you are talking about the fact that you expect this replacement cycle to kind of manifest itself. Could you cite just specific -- just incremental or anecdotal -- data points that you are seeing that, number one? Obviously aside from the strong growth rate; I understand that. And then just number two, perhaps comment on how we should think about the long-term growth trajectory for water treatment vis-à-vis your core business?

Well, it's anecdotal replacement, and its anecdotal surveys that we do of people that buy water heaters. And it really is kind of the Tier 1 -- where I alluded to earlier. It's gone from 35% to 45% and 50%. So it truly is anecdotal. But it also makes sense, right, because of the high penetration rate for some time. Water heaters don't last forever, so they are going to be replaced. Water treatment Ajita alluded to: CMM has estimated a 35% to 40% growth rate over the next four or five years. We are comfortable with that growth rate. We have the right product in the right market with our reverse osmosis and our tankless product. We feel we have the best product on the marketplace. So we are comfortable with those types of growth rates as we look at it.

Thanks for your time.

And we have a follow-up question from William Bremer from Maxim Group. Your question please.

Follow-up -- maybe if you can just comment a little bit on the pricing environment in China. And given the $10 million inventory build there, what should we expect?

It's fairly flat, I think.

Yes. In terms of pricing in China as we go on – first of all, for obvious reasons we can't talk about pricing. But in China in the environment is – we rarely – our pricing comes from new products with new features, and benefits, and different value propositions that we are able to then get higher prices in the marketplace. Being a consumer appliance, that's essentially the way we improve unit price in the marketplace in China. The environment for pricing is – you know, it's a very tough environment. If you look at the CPI and PPI in China, they are actually headed downward. But in terms of tying to inventory levels, like I said, we are watching it. We are aware of it. But at this point we are comfortable with the guidance for the year.

Okay. Thank you.

Thank you. I'm not showing any other questions in the queue. I would like to hand the call back over to Patricia Ackerman for closing remarks.

Thank you all for joining us today. We have posted a slide deck from our Analyst Day in May and a new video showcasing our China business on our website, aosmith.com. We welcome your questions, and please do not hesitate to contact me. Have a wonderful day. Thank you.

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude our program. You may now disconnect. Everyone have a wonderful day.