A.O. Smith Corporation

Good day, ladies and gentlemen, and welcome to A.O. Smith Corporation's fourth quarter 2018 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. If anyone should require assistance during the conference, you may press star then zero on your touchtone phone. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Patricia Ackerman, Senior Vice President of Investor Relations. Please begin.

Thank you, Norma. Good morning, ladies and gentlemen, and thank you for joining us on our 2018 results conference call. With me participating in the call are Ajita Rajendra, Executive Chairman, Kevin Wheeler, Chief Executive Officer, and John Keated, Chief Financial Officer. Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. In order to provide improved transparency into the operating results of our business, we provided non-GAAP measures, adjusted net earnings, adjusted earnings per share, and adjusted effective income tax rates for 2017 that exclude the estimate of our total that exclude the total tax expense related to U.S. tax reform. And for 2018, that excludes the restructuring and impairment costs associated with our plant closure in Renton, Washington. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. 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 Kevin, who will begin our prepared remarks on slide four.

Thank you, Pat, and good morning, ladies and gentlemen. Our mid-single-digit sales growth in 2018 was driven by positive end markets for our boilers, residential water heaters in the U.S., and continued demand for our water treatment products in China. Here are a few highlights. Record sales of $3.2 billion grew over 6%. Record adjusted earnings per share grew 20%. We are proud of the global water treatment platform we have built over the last seven years. Beginning in 2011, with about $35 million of water treatment sales in China, we significantly grew to approximately $400 million in 2018. As we experienced rapid organic water treatment growth in China, we added several bolt-on acquisitions in the U.S. and in Europe, launched water treatment products in India and Vietnam, and added water treatment engineers and technologists to our global engineering centers. We achieved exclusive supplier status for Lowe's water treatment business in the U.S. We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. In 2018, we repurchased nearly 4 million shares for approximately $200 million. We announced two dividend increases in 2018, and the five-year compound annual growth rate of our dividend is 30 percent. We repatriated over $300 million in overseas cash to the U.S., increasing the flexibility of our balance sheet. John will now describe our results in more detail, beginning with slide five.

Sales for the year of $3.2 billion grew over 6% compared with the prior year. Adjusted net earnings of $449 million increased 19% from 2017. Adjusted earnings per share of $2.61 increased 20% compared with 2017. Sales in our North America segment of $2 billion increased 7% compared with 2017. The increase in sales was primarily due to higher volumes of residential water heaters and boilers and pricing actions related to steel cost increases. North America water treatment sales, including the newly launched Lowe's business in the third quarter, incrementally added approximately $29 million to our North America segment sales. Rest of world segment sales of nearly $1.2 billion increased 5% compared with 2017. China sales increased nearly 2% on a local currency basis. The Chinese currency favorably impacted the translation of China sales by approximately $23 million. In China, higher water treatment sales, including consumables, were partially offset by lower sales of electric water heaters and air purifiers. Water heater and water treatment sales in India increased approximately $8 million, or over 40% in 2018, and local currency terms compared with 2017. On slide 8, North America adjusted segment earnings of $471 million were 10% higher than segment earnings in 2017. The favorable impact from higher sales of residential water heaters and boilers and the pricing actions in the U.S. were partially offset by higher steel costs and one-time costs associated with the launch of the water treatment products at Lowe's. As a result of these factors, 2018 segment margin of 23% was higher than the 22.5% generated in 2017. Rest of world earnings of $149 million were flat compared with 2017. The impact of profits from lower sales of electric water heaters and air purifiers, as well as higher SG&A expenses, were offset by the favorable impact of profits from higher water treatment product sales and improved performance in India. Higher advertising related to brand building and higher product development engineering costs were the primary drivers of higher SG&A in China. Segment margin in 2018 declined as a result of these factors. Our corporate expenses were essentially flat compared to 2017. Our adjusted effective income tax rate in 2018 was 20.4%. The rate was lower than the 27.4% experienced in 2017, primarily due to U.S. tax reform and benefited 2018 results by 2 cents per share compared with our October guidance. Sales for the fourth quarter of $813 million were 6% higher than the same quarter in 2017. Adjusted earnings in the fourth quarter of $126 million increased 21% from the fourth quarter in 2017. Fourth quarter adjusted earnings per share of 74 cents increased 23% compared with the same quarter in 2017. Sales in our North America segment of $522 million increased 13% compared with the fourth quarter of 2017. The increase in sales was primarily due to higher volumes of boilers and residential water heaters in the U.S. and pricing actions related to steel cost increases. Rest of world segment sales of 298 million declined 5% compared with the same quarter in 2017. China sales were down 3% in local currency as the China economy continued to weaken. Higher sales of water treatment products, including consumables, were more than offset by lower sales of water heaters and air purifiers. The weaker Chinese currency unfavorably impacted translated sales by approximately $12 million. India sales grew over 25% compared to the same period in 2017. On slide 12, North America segment earnings of $128 million were 22% higher than segment earnings in the same quarter in 2017. The favorable impact from higher sales of boilers and residential water heaters in the U.S. and pricing actions were partially offset by higher steel and other input costs. These factors drove fourth quarter 2017 segment margin higher to 24.4% compared with 22.8% last year. Rest of world earnings of $40 million declined 22% compared with the fourth quarter of 2017. The impact of profits from lower sales of water heaters and air purifiers and higher advertising costs in China related to online selling holidays more than offset the benefits to profits from higher sales of water treatment products and improved performance in India. China foreign currency foreign exchange negatively impacted earnings by approximately $2 million. As a result of these factors, segment margin declined significantly from the same quarter in 2017. Our corporate expenses were lower in the fourth quarter compared with the same period in 2017, primarily due to several miscellaneous items in the fourth quarter of 2017. The effective tax rate in the fourth quarter of 18.4% was lower than last year's rate due to tax reform. Cash provided by operations during 2018 was $449 million and compared with $326 million provided during 2017. Higher adjusted earnings and lower outlays for working capital were the primary reasons for the improved cash flow. Our liquidity position and balance sheet remained strong, Our debt-to-capital ratio was 11% at the end of 2018. We have cash balances totaling $645 million located offshore, and our net cash position was approximately $424 million at the end of 2018. During 2018, we repurchased approximately 4 million shares of common stock for a total of $203 million. Our board increased the number of shares eligible for repurchase by 5 million at its December meetings. Over 6 million shares remained on our existing repurchase authority at the end of December. This morning we announced our 2019 EPS guidance with a range of between $2.67 and $2.77 per share. The midpoint of our EPS guidance represents a 4% increase in EPS compared with our adjusted 2018 results. Please turn to slide 15 for several 2019 assumptions. We expect our cash flow from operations in 2019 to be between $500 and $525 million, which is higher than the $450 million generated in 2018. We expect higher earnings and lower outlays for working capital this year. Our 2019 capital spending plans are approximately $85 million, and our depreciation and amortization expense is estimated to be approximately $75 million in 2019. Our corporate and other expenses are expected to be approximately $50 million in 2019, higher than $47 million in 2018, primarily due to inflation. Our effective income tax rate is expected to be approximately 21.5% in 2019. We expect to repurchase our shares in the amount of approximately $200 million in 2019. We expect our average diluted outstanding shares in 2019 will be approximately 168.5 million. I will now turn the call back to Kevin who will summarize our guidance and business assumptions for 2019, beginning on slide 16.

Kevin O' Thank you, John. Our outlook for 2019 includes the following assumptions. We project U.S. residential water heater industry volumes will increase between 100,000 to 150,000 units in 2019 due to continued new construction and expansion of replacement demand, as well as continued growth in tankless units. Boiler revenues grew 9% in 2018, driven by solid demand for condensing boilers and new product-related market share gains. We expect our boiler sales to grow approximately 10% in 2019. We improved profitability in India in 2018 due to scale and our water heater and water treatment businesses from losing over $7 million in 2017 to under $5 million loss in 2018. We project India water heater EBIT will be positive in 2019 and improvements to continue for water treatment. And our total India business will be profitable in 2020. The overall loss in India is expected to be $2 to $3 million in 2019. Our forecast for the Chinese currency in 2019 is slightly weaker than it is today and over 4% weaker than last year. Almost all the FX impact is expected in the first half of 2019. As previously discussed, we believe customer inventory in China grew the first half of 2018 with the majority of the growth occurring in the first quarter. and was relatively flat the last half of the year after a decline in the fourth quarter. We estimate 2018 sales increased at least 5% due to the customer inventory build. We are assuming continued weakness in the China economy and relatively flat consumer demand for the full year in 2019. Without the impact of the 2018 China or channel inventory build, we are projecting full year sales to be down approximately 3% to 6% in local currency, all of which will occur in the first half of the year. Combined with a expected 4% unfavorable currency translation, our 2019 China sales projection is a decline of 7% to 10%. The first quarter of 2019 faces some significant headwinds. Due to our estimates that the majority of the China inventory, both in China occurred in the first quarter of 2018, creating a difficult comp. We project China's sales and local currency will decline approximately 20% or approximately $50 million for the first quarter of 2018. The earnings impact in the first quarter will be approximately 50% of the sales decline, as headcount and SG&A savings will unfold as the year progresses. In addition, China currency was at its strongest level for the year in the first quarter of 2018. As a result, we estimate currency translation will unfavorably impact first quarter sales by approximately 7%. In addition, steel costs will be significantly higher in the first quarter of 2019 compared with 2018. Please advance to slide 17. Continued momentum in North American water heaters, boilers, and water treatment collectively expected to grow up to 7% in 2019. Our business model in China is solid and continues to achieve low team margins. We have near-term challenges to navigate through as the China economy remains weak. We project revenue growth will be between 1% and 2.5% for the year in US dollars and 2.5% to 4% in local currency. EPS is projected to be between $2.67 and $2.77. We expect North America's segment margin to be between 23% and 23.5%, and rest of the world's segment margins to be between 12% to 12.5%. Especially in these uncertain economic times, we believe our stable defense replacement markets which we believe represent approximately 85% of North America water heater and boiler volumes, positively differentiates A.O. Smith from other industrial companies. 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 shareholders. That concludes our prepared remarks, and we are now available for your questions.

Thank you. Ladies and gentlemen, at this time, to ask a question, please press star, then 1 on your touch-tone phone. If your question has been answered or you would like to remove yourself from the queue, you may press the pound key. Please keep it to one question and one follow-up. We ask that to prevent any background noise to please mute your line once your question has been stated. Our first question comes from Scott Graham of BMO Capital Markets. Your line is open.

Yes, hi, good morning. Hey, Scott, good morning. Hi, so... China, the 2019 view that you have, I guess the simple 40,000-foot question is we've been kind of chasing what the declines or the deteriorating situation in China is with sales guidance for some time. And now we have a first quarter that looks very difficult. I guess the questions that come from there are, A, what gives you the confidence that you can eliminate the inventory in the channel mostly in the first half of the year? I guess because you thought you'd be able to do that by the year end. And secondly, it does appear as if your sales in China throughout 2018 were... I understand that housing's been weak, but retail sales, which is also an important number, weaker but still pretty decent. Do you think you're losing share? Away from the inventory bill, do you think you're losing share in China now?

There's a lot of questions there, Scott. So I'll start with the last one. From a share standpoint, when we look at the water heater market, What we're seeing for data, it was probably down 2% to 3% in 2018. And if we lost any share, it was minimal. So the water heater market was just very weak, and it's what you said. I mean, every housing metric we look at is weak and has gotten weaker. Water treatment, we had a good year, especially on consumables. but we'd also say we lost a few points of share there, and that was really driven by the fact that we didn't have those mid-price products that we had talked about on an earlier call, and we now have those late in the year. I mean, your real question is we were up, and we thought we'd be up for the year in October, and we're now down, and I think it's a variety of factors. One is we didn't take the inventory down in the fourth quarter as much as what we anticipated, and that's because the online holiday sales were not as good as what we thought. Number two, we had originally said that we thought that the second half of the year would be better in China. We are not forecasting that now. This is based on kind of a level the economy stays weak. Then when we look at next year now, the assumptions are that our sell out, if you will, is kind of level with 18, so we're not going to have much of a pickup. We're going to see some recovery in air purifier, water treatment because of the new products, et cetera. But you're right, the first quarter is difficult, and the first quarter is difficult because last year we picked up our inventory build occurred in the first quarter.

And we're saying that's not... Essentially, John, there's an opportunity here now in this first quarter for you to essentially flush this channel inventory out?

I wouldn't necessarily agree with that. What we're really saying is last year's first quarter probably had, let's say, $40 million to $50 million of inventory built in it, and we're saying that's not going to repeat itself. So, no, I don't think this flushes out the inventory. because we're having a weak quarter. It's just, I'll say, a very difficult comp because we built the inventory up last year and we're saying we're not going to build it up. We hope to take it down some in the first quarter. Now whether that'll happen will depend. But I will tell you every housing metric we look at is negative. We asked the same question about retail sales, that they're up 8%, and actually one of our advisors said, well, you know, retail sales also include some commercial spending, et cetera, not capital spending, so it's not a good number in our mind. All I can tell you is the market decline in water heaters was 2% to 3%, so it was very weak. Water treatment was up. And air purifier was down 30, 40%. So we say after the first quarter, we get to kind of a stable point. Again, some of the new products we have in place starts adding. Water treatment consumables had a very good year. We went from $20 million to $30 million, and we expect that to continue to increase. So it's just getting through the first quarter. I don't know if I answered all your questions.

Well, for the most part, John, and I very much appreciate the broadness of your answers. If I could just sneak this one in, within China, would the down 2% to 3% market estimate that you're suggesting here, was it weaker on the electric side than it was on the gas side, would you say?

Surprisingly, the gas was weaker. I mean, if you would have asked me, I would have thought that the electric would have been down. The numbers we saw for the year was gas was down 4%, electric was down about 1%. Thanks.

Thank you. Our next question comes from Matt Somerville of DA Davidson. Your line is open.

Thanks. Just to clarify, are you talking about the channel has 50 million, John, of excess inventory, and then AO Smith itself is sitting on some amount of excess inventory. Can you just sort of roll?

No, let me, I'll clarify that. So we're only talking about channel inventory, and that's why we can't be exact, right? I don't know exactly what's in my customer inventory levels. I have pretty good indications. We've done a lot of discussions with them. We've done some analysis. We've looked at what we think is sellout year over year, and that's why we've come to this 5%. Our inventory levels at A.L. Smith are really not up at all. They're no different than what they were. So we're only talking about channel inventories, and that's why we're estimating, because we don't have exact information.

Got it. And then for just sticking with China, for 2019, can you also clarify how much you expect water treatment to grow as well as air purification? And then what is A.L. Smith doing now? from a cost reduction standpoint in China and how much savings is baked into that 12 to 12.5% segment margin? Thank you.

Well, so air purifier we expect to be up. It was about 23, 24 million. It'll be in the low 30s. We think that's the new product that we're bringing into play. We think water treatment will be up low double digits. Again, led by the consumable piece, which is doing very well. In these numbers are baked headcount, ultimate headcount reduction of about 10%, and we're expecting to take advertising down 10% to 15%. And that will occur throughout the year. I will tell you certainly one of the factors we face is that a decent portion of our SG&A expenses is fixed because it's labor, and we can take some of it out, obviously, which we're doing. and also store-set kind of amortization. So we are certainly looking at every opportunity on SG&A that we can. Yeah, I would just like to add on to that.

I mean, those are the three areas that we've outlined over the last couple calls. Certainly headcount is going to be reviewed regularly so that we get the right size of the business. SG&A, constantly looking for ways to improve productivity and make those cuts that are appropriate for the business so the business continues to go forward. And then the store efficiencies remain high on our list as we continue to evaluate unproductive stores and take action with them over time. But all the SG&A and all the cost reductions that we've talked about, we've implemented those over the last six months or so and we'll continue to make progress on them, but they're going to come in time and we'll eventually get to that point where the business is right-sized to the amount of sales that we have into the market. So that's an ongoing priority for our businesses, along with increasing our sellout and driving new product sales.

Thank you. Our next question comes from Jeffrey Hammond of KeyBank. Your line is open.

Hey, good morning, guys. Good morning. So just back on the margin in China, so I think you said down $50 million in sales and kind of a 50% decremental on that. Does that incorporate any kind of one-timer structuring charges in there, or is that the true detrimental? And then, you know, I guess with that, you know, big dip, I'm just struggling on how you get back to kind of near-flat margins in the rest of the world.

Well, so, no, that's really kind of it. We've said kind of publicly in the past, you look at our gross margin of 41%. That's more than in China and our commercial markets. and Lock and Bar are higher than that Lock and Bar boiler. So you're looking at that sort of and then contribution margin would be a little bit higher. Now obviously we're going to have some benefit from reduction in headcount and reduction in some SG&A, but you also have significant plant efficiencies when you're taking out when you compare that to the prior year. So that is a significant decline over the first quarter. And then, you know, we are taking our margin assumptions down about at least on the low end a point. And, again, we expect India to improve. And so how we get there is the headcount reductions continue throughout the year. The SG&A, specifically advertising, continues. And then you start getting hopefully our estimate of the low end of three comes to play, and you'll have some volume benefit. So that's how we get there.

Okay, helpful. Just on North America, have you announced any or contemplated any additional price in North America?

Pricing is always a subject that comes up on these calls. What I would tell you is that, and what we've said in the past, that A.S. Smith has a history of dealing with costs and addressing those over time. And that's our position and will continue to be our position as we go forward.

Okay. And then just on, you know, there's been some deflation in steel. What's kind of the timing where you'd start to see some of the benefit from, you know, some of these lower inputs on cold roll?

It starts a little bit in the second quarter and certainly the last half of the year if it stays where it is. Now, we're assuming we've talked to our consultants, and I think that their feeling is, and I can't tell you necessarily why, but their feeling is we've kind of hit the bottom and that their expectation is that steel costs will increase from here. We'll continue to monitor that, et cetera. But we start getting the benefits starting in the second quarter.

Thank you. Our next question comes from Robert McCarthy of Stevens. Your line is open.

Good morning, everyone. How are you today?

Good morning.

All right, great. I guess the first question, you know, in terms of China and the 1Q compare, give us some sense of when do you think you're just going to have a better sense of the trajectory and visibility? I mean, do you think you'll have a comment sometime during 1Q in terms of how you're thinking about things shaking out? Because obviously your guidance is highly predicated on kind of how this all plays out in the near term and it's going to affect the various outcomes for the full year. And obviously bears are somewhat skeptical given the fact that you've had to take down numbers for China, you know, versus October. You know, what gives you any greater sense of visibility? So maybe you could just talk about what you're going to be looking for and what will that allow you to cast maybe a better view on China for the full year? When would we expect an incremental update? Because, you know, one cue is really the hinge.

Well, I'll start, and you can, Kevin. I'm not sure we'll have an incremental update. Obviously, we're going to continue as the quarter goes along, monitoring it very closely. I think what we have to kind of see is some of the statistics come out to play. So, again, housing has continued to be negative. There's no doubt about that. Certainly it would be positive, we think, from a consumer confidence standpoint if something got resolved with respect to the U.S.-China trade issues. So we certainly think that would be a positive. So those are kind of the things we're monitoring.

Okay. Just to add on to that, Q1 is normally one of our lower quarters. Some spring festivals coming up, and so – We'll get a better read as we continue to get through March and then obviously into the second quarter, which is a busier quarter for us. And again, as we're going to look at this, it'll be by product category, by channel, really looking closely at our sellout as an organization. And then also making sure that we've introduced a lot of mid-price point products in a lot of different channels, and we expect those to – to add incremental sales to our business. So as we get into the latter part of the second half of the year, we'll get a read on the China economy. As John said, we'll get a read on tariffs and where they're going. So there's a few things that have to kind of work themselves through for us to give you a better answer than we are today.

Okay. And then just switching gears over the longer term then, Obviously, you mentioned the strength in tankless, and I think in particular tankless gas in North America, that's a solid product category overall, and you do have a suite of products there and reasonable share, but that seems to be an area that seems to be gaining some strength, and anecdotally, it sounds like the cost of install is coming down. Are you concerned over the longer term that that product category could eat into kind of, you know, traditional tank and, you know, kind of what will be your response there and how will you manage that going forward? Because it seems to be a category that could be, you know, particularly attractive in the context of the replacement cycle.

And are you talking North America now or?

Talking North America tankless gas.

Yeah. You know, our view hasn't really changed. We're in the hot water business. As we go forward, we bring various solutions to consumers, whether that be tank, tankless. If you look at a very strong tank year just recently, we expect to be up into 350,000 units increased this year. Tankless, we expect, will probably decline a bit from 2017, a strong year, but still be in that low double digits growth. Overall, I would agree probably the installation would decline or the cost of it would become more affordable. Again, as we step back as an organization, we provide various solutions because not every solution is the right solution for every consumer. I think the broad breadth of our product line, both residential and commercial, provides those solutions. As we go forward, we're comfortable where the market is moving. I think we're in a position with products to capitalize on that. You look at our brand, our strength and distribution, our sales organization. So as a whole, the industry itself, we're comfortable where it's going, and we believe A.O. Smith will continue to be a major player and a market leader in those categories.

You know, it still is. Obviously, we are monetized very close, but it still is about 8% of the total market. So, I mean, it is a small part of the total market.

Thank you. Our next question comes from Ryan Connors of Bonning & Scattergood. Your line is open.

Great. Thank you. I just wanted to continue on the China topic for a minute. You know, on some of these past calls, you've talked about the issue of a consumer – trade down, I guess, and we've seen some of that all the way up to the apples of the world. And you mentioned, John, that you've got limited, if any, share loss. But can you just talk about the growth or lack thereof in the various strata of the market from the high end on down and how that's impacted you as a player, presumably on the high end?

Well, I would tell you, and there's no good data, but I would tell you we don't think the high end has been growing in this marketplace. You still have well-to-do people in China. There's still that group that is buying. But my guess is you're not seeing a lot of trading up going in this environment where the economy is not doing very well. But, again, the fact that we really haven't lost share in the water heater – I think kind of says that that's the place, that everything's kind of stable when you look at the different stratas, but that's an estimate. We just don't have good data on that.

And I would just echo that. That's kind of the feedback that we get back from our sales organization distributors and our store promoters, that the premium market is relatively stable, not a lot of trade down, but the trade-up has slowed or has is not where it has been in the past.

Got it. Okay. And then my other question is just, you know, can you discuss the relative impact and I guess the interplay between the deceleration and growth in China just on an organic basis versus the trade issues? I mean, you mentioned, Kevin, you know, potential trade resolution of some kind being a catalyst. And I think you'd be right in terms of the stock price certainly would probably trade that way. But what impact How do you divvy up what's happening to you in China from people were discussing a slowdown in China long before these trade issues. So how much of this is just a natural deceleration in the market versus really related to trade and therefore potentially that being a catalyst?

Yeah, I would tell you from a macro perspective, we don't know exactly how that would parcel out. One, there has been a slowing down in China. But certainly if you just take it back from a – from a consumer point of view and tariffs are in, your market starts to slow down and just simply, you know, the way we've described it is the Chinese consumer is no different than a U.S. or any other consumer when their job has slowed down, when they've seen maybe some layoffs in various parts of the industry and their friends that they simply just pull back and so We believe the tariff has had some impact on consumer competence, on their spending patterns, just for the fact that that's what we would do here in the U.S. And my comment is if the tariffs and when the tariffs get resolved, it will take some time, but that will remove that one uncertainty for the consumer, and that should free up. We know today, based on some of the information we get back, that the Chinese consumer is saving more and more. And that normally is an indication of their uncertainty. And again, once they feel things are settled down and there's more confidence in where the economy is going to go, we believe those resources and funds will free up. So that's where we're at. Certainly there has been a slowdown a bit from the housing side, but certainly on the other side, we really believe consumer confidence has been impacted by the tariffs and what's been going on in the recent months.

Thank you. Our next question comes from Mike Halloran of Baird. Your line is open.

Hey, morning, everyone. Morning. So, first, what's the best estimate now that you're exiting 2018 for the splits on replacement versus new build-oriented splits on China water heaters for your core business?

I mean, it's hard to say. I don't think we have any data. You're talking about the China business. I haven't seen any different data except that's 50%.

About 50% in Tier 1 and a little bit less.

And nothing that is necessarily increasing. I haven't gotten any updated data.

And what percentage is replacement on your water treatment side at this point?

What part is consumables? The consumable part this year was about $30 million, so it was up from $20 million last year. So the consumables are tracking very nicely, and we would expect that to, again, be over $40 million when we look at 2019. So that's progressing and tracking just the way we would have thought.

And then in North America, just from a cadence through the year, I suppose on China as well, it seems like China you're saying stable cadence from here if you can adjust for the inventory side. In other words, no improvement, no deterioration in market from current level. Maybe just give some thoughts in the U.S. as well on how you're viewing the cadence of underlying trends from here.

Well, from the U.S. side of business, I'll break that out, residential and commercial. We talked about our residential guidance, about 100,000, 150,000. Again, got to remember that's coming off, we believe, a pretty strong year of over 300,000 residential-type units. So modest growth, there's some talk about, you know, some housing slowdown, but still modest growth, and of course, 85% of that's going to be replacement. On the commercial front, As we talked to earlier, we just came back from a large industry expo, AHR, and the consensus from our customers, from our sales organization, is that there's about a 3% to 4% growth out there. Our order book is still pretty solid, and so we're optimistic in the first half of the year, and we're a bit more conservative in their comments in the second half, but overall, both sides of the of the channel residential commercial not, you know, growing, expanding rapidly, but solid growth in both sections.

Thank you. Our next question comes from David McGregor of Longbow Research. Your line is open.

Yes. Good morning, everyone. John, I just want to go back to China. And you talked earlier in the call about building representation in middle price points. So just, I guess, first of all, just some clarification, when you talk about stable 2019 in China, are you talking about still seeing maybe some weakness in the premium market, but that you're going to pick up share in the middle price points and as a consequence, all in that's going to provide you with your stability or just what are you expecting that would come incremental to your growth from participating in a segment of the market that I presume is doing a little bit better?

Well, we would hope, and that's what we hope the last three quarters of the year, that we will, you know, what I have said is that sellout we would expect for the year to be relatively stable. And if we can pick that up a little bit, we'll be able to do two things. One, either take inventories down a little bit or move from the, you know, to the 3% or whatever down for the year. We don't expect basically where we are that the premium market is going to change much. We'll maintain share there, and we hope that there is some growth in the midpoint area, and we have new products for that.

Can you give us any sense from a sizing standpoint of how much bigger the commercial opportunity is in midprice point versus kind of your legacy franchise in the premiums?

I won't say it's necessarily significantly bigger. It's just when we had price increases going back kind of into 17 and 18, we had moved out of that market. And so what we were trying to do, so we had been in that market. The price increases moved it out. What we call mid-price is 3,000 to 5,000 RMB. And so now we're putting products back into that, which will specifically help us, we think, on the online, which is growing. Okay.

Thank you. Our next question comes from Andrew Cohen of North Coast Research. Your line is open.

Thanks. Kind of staying with China, the Tier 2 and Tier 3 city footprint has how you roll out or how many places you roll out to changed at all? Are you guys approaching, I guess, expanding the locations differently, or how has that been impacted?

Well, certainly we're much more selective in not growing at the same rate that we've had in the past. So, yes, it's slowed a bit. Again, we're continuing to opening new stores and distribution points, but at the same time, to be candid, we're also making adjustments. So the net increase is fairly marginal over the year. So that's Where we're heading from a strategic standpoint, we still believe Tier 2, Tier 3, and Tier 4 cities have opportunity, particularly 3 and 4, and we'll continue to look for those right partners and expand it as appropriate.

And I think that's consistent with what the last couple years have been in that we've been adding, you know, 1 to 2 to 300 net, but it's a combination of some in the Tier 2, 3, 4, and then closing some of the non-productive stores. So we think that pattern will continue.

Okay. Thank you. And then on Lowe's, do you consider it to be fully rolled out? And if you could give any color on how you think it's, you know, tracking going into 2019.

Yeah, just some quick colors. Certainly we're – I don't know if anything's ever always rolled out because you're always making tweaks and improving your displays and working with your customer to improve sales. But overall, yes, it's been rolled out. And I would tell you the business is on track. We look forward to a terrific 2019 with Lowe's as a partner.

Thank you. Our next question comes from Charlie Brady of SunTrust. Your line is open. Thank you.

Yeah, thanks. Morning, guys. Morning, Pat.

Morning.

So I'm going to continue beating the dead horse of China here for a little longer. I just want to make sure I understand the commentary around Q1 in the rest of the world, particularly China. You're saying China down 50% local currency in sales year on year with a 50% technical margin.

No, I think we said 50 million, 20% in local currency, which is 20%, and that's about, equates to $50 million.

Okay, great. Thanks. That's helpful. That answers that question. I guess my bigger question maybe, though, is you look out to the back half of the year for the rest of the world and China, I mean, what gives you the – given the visibility you've got, what gives you the confidence that you are going to see, you know, maybe just a flat market and not a continuation of a down market in China?

Well, again, what we're assuming is some of our actually product lines like Air purification will improve a little bit. The commercial water treatment will improve. The commercial will improve. The new midpoint products we have will offset any further weakness in the market. But it's hard to say. I mean, what we are calling is for the market to really be stable to where it was or down a little bit, and we have some items that will offset that decline.

Thank you. I have a follow-up from Scott Graham of BMO Capital Markets. Your line is open.

Hi. Would you mind telling us specifically what the Lowe's number was in the quarter and how much is left to go on the fill? That was referred to a couple questions ago for 19.

Yeah, I would tell you that we hit the numbers that we talked about in the past and that there's, again, We prefer to not get into specifics about certain customers, particularly Lowe's and other public companies. So what I would tell you is that we launched, the fill is in, there's always going to be adjustments to additional areas of our product displays and product inventory, and that the overall outlook that we had with Lowe's is on track, and again, we look forward to continue in 2019.

Understood. And then just this last one from me. So at the Investor Day, you guys talked about a couple of different initiatives that you were going to pursue, and I was hoping you could kind of update us on them with respect to what the plans are for 2019, specifically tankless your desire to increase your penetration there, and also in digital?

Well, I'll take both of those. Tankless, I'm not specifically understanding exactly where it's going, but on the Tankless side of the business, we are going to continue to expand our product offering, bringing new products to market with features and benefits to be more competitive. We've talked about that. We look to be doing that in the second half of the year. And as far as digital, I think we're one of the premier companies, particularly in the water heater and the water treatment side, where digital has been an ongoing program for us for over a decade. We continue to enhance our websites, our e-commerce business, our ability to create demand through various digital media and marketing activities. And that's going to continue to move forward by both parts of our organization, whether we're in water heating boilers or, quite frankly, in water treatment. That was a very generic answer, but that's about, I think, where we're going to be at with any more specifics.

Thank you. I have a follow-up from Jeffrey Hammond of KeyBank. Your line is open.

Hi, yes. Just on North America, I just wanted to kind of unpack. I mean, it seems like you're implying kind of 5% to 10% growth in that business for the year. Is that the right way to think about it?

Yeah, I think our estimate is like close to, well, between 6% and 7%.

Okay, and then just what kind of growth rates are you expecting for water treatment all in?

Well, obviously we get the benefit of the full year of lows, and we're probably looking at an increase. Well, we are looking at an increase of the other businesses, so it'll be up 38%, you know, 40% or so from the prior year. So with the benefit of the full year of lows, obviously, and we're expecting the other businesses to grow nicely. And then Lock and Bar, again, we continue that to be, we're talking about the boilers growing at 10%. And we haven't mentioned it, Lock and Bar obviously had a great quarter. I mean, the boiler market was up 15% in the fourth quarter for us. So it was a very, very good quarter. So I think their backlog is in good position going forward as we look to the first half of the year, et cetera. Okay, thanks.

Thank you. Our next follow-up is from Robert McCarthy of Stevens. Your line is open.

Got a few follow-ups. You can hear me, right? Yes, we can. So China, can you talk about just kind of in terms of the organic growth rate for the fourth quarter and And for the first quarter, any directional view of kind of the pricing impact and how we should be thinking about it across your product portfolio?

I mean, I have not heard of a significant price adjustment at all. And I don't know, Kevin, if you have. No, I have not. But talking to our China people, I don't think there's been significant price adjustments by any means.

So if you dissembled organic growth, you wouldn't see a negative price variance in terms of – okay. And then, you know, two more questions. On the tankless gas side again, I think your share right now within that market is kind of high single digits, low double digits. within the category in the U.S. And you do have some products there, obviously, but I guess the question is, do you think at some point is it a make versus buy decision, whether you take a good technology or good adjacency and use your brand? Would that be a particular area of potential acquisition for you?

Well, we're always looking for potential acquisitions that add value. And, again, going back to the tankless part of the business, we do have terrific products. We're continuing to bring new products out with our partners. And so, again, I want to make sure we emphasize this is one of our solutions, not the solution. And, yes, we're at low double digits, but at the end of the day, that's not where it's going to stay, and we continue to move forward and gain share and and expand our products. So overall, you know, Tankless is, we're always looking for ways to improve our business, whether it be products, manufacturing, logistics, working with our customers. So I think our strategy is in place and we'll continue to execute it as we have in the past.

The last question is just in North America, kind of, I mean, one of your areas of potential capital deployment is around you know, or has been and will continue to be U.S. residential, you know, filtration or filtration products. I mean, can you talk about the TAM there, the total addressable market, and where you want to play in there? Because it seems to be, you know, a very difficult market that's highly unconsolidated, a lot of ready substitutes. I mean, do you see a future there for capital deployment, and do you see a future for a business there over the longer term?

Well, certainly long-term, North America water treatment, we see a significant business. We look at it somewhat as an opportunity when it's fragmented between somebody like us to be able to maybe do some consolidations and so forth in the right areas. I've said many times that this has opened the lens of our acquisitions possibilities, and we continue to go down that path, whether it be capabilities, products, distribution, dealers. And in our acquisition pipeline, certainly we're very active in that space. So, yes, 100% for sure do we believe there is a viable and growing market in North America water treatment, and we believe there's a lot of opportunities for A.O. Smith and our brand.

Okay. Thanks.

Thank you. As this concludes the Q&A portion, I'd like to turn the call back over to Patricia Ackerman for closing remarks.

Thank you for joining us on our call today. We have one conference in the first quarter. We will participate in the Benning and Scattergood Conference in London on March 14th. Have a great day.

Ladies and gentlemen, thank you for your participation in today's conference. You may disconnect. Have a wonderful day.