Patricia K. Ackerman - Vice President of Investor Relations and Treasurer Ajita G.

Rajendra - Chief Executive Officer, President, Director and Member of Investment Policy Committee John J. Kita - Chief Financial Officer and Executive Vice President

Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division William D.

Bremer - Maxim Group LLC, Research Division Charles D. Brady - BMO Capital Markets U.S.

Michael Halloran - Robert W. Baird & Co.

Incorporated, Research Division Sanjay Shrestha - Lazard Capital Markets LLC, Research Division Ryan M. Connors - Janney Montgomery Scott LLC, Research Division Samuel H.

Eisner - Goldman Sachs Group Inc., Research Division R. Scott Graham - Jefferies LLC, Research Division David L.

Rose - Wedbush Securities Inc., Research Division

Thank you. Good morning, ladies and gentlemen, and thank you for joining us on our third quarter 2013 conference call.

With me participating in the call are Ajita Rajendra, 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.

In order to provide improved transparency into the operating results of our business, we are providing non-GAAP measures, adjusted earnings, adjusted EPS and adjusted segment operating earnings that exclude certain items, as well as non-operating pension costs consisting of interest costs, expected return on planned assets, amortization of actuarial gains and losses and curtailments. Prior year results are provided on a comparable basis.

Ajita, I will now turn the call over to you.

Thank you, Pat, and good morning, ladies and gentlemen. We continue to see the benefits in our performance from the housing recovery in the U.S.

and our expanding consumer business in China. Here are a few highlights from our very strong quarter.

Our organic growth drove sales 16% higher to $536 million. Sales of A.

O. Smith-branded products in China grew 35%.

Our adjusted earnings of $0.54 per share were 46% higher than the $0.37 per share recorded last year. Incremental margins associated with higher volumes of water heaters and boilers drove earnings higher.

We celebrated the grand opening of our second water heater plant in China, which increases capacity in the region by 50% when the new plant is fully utilized. We also moved production of our fast-growing gas tankless products to the new plant during the quarter.

John will now describe our results in more detail.

Thank you, Ajita. Sales in the third quarter of $536 million were 16% higher than the previous year, driven by higher volumes of water heaters and boilers in the U.S.

and higher sales of A. O.

Smith-branded products in China. Adjusted earnings of $50 million improved 48% from our third quarter performance last year.

As previously announced, we transferred our residential water heater productions from our Fergus, Ontario plant to other North American facilities this year. As a result of the capacity rationalization, we incurred a pretax restructuring and impairment charge of $1.3 million in the third quarter and we expect a similar amount in the fourth quarter.

Adjusted earnings in 2013 excluded after-tax non-operating pension costs of $3.2 million and after-tax restructuring and impairment costs of $1 million. Adjusted earnings in 2012 excluded after-tax pension costs of $800,000 and an after-tax gain of approximately $3.7 million related to an estimate of an earn-out associated with an acquisition.

Third quarter earnings and adjusted earnings include approximately $3 million of higher income tax benefits than previously estimated, primarily related to manufacturing and research and development activities. Approximately $1.8 million of the tax benefit related to the 2012 tax year.

Adjusted earnings of $0.54 per share improved 46% compared with $0.37 per share last year. Adjusted EPS in the current period excluded non-operating pension costs of $0.03 per share and restructuring and impairment charges of $0.01 per share.

Adjusted EPS in 2012 excluded non-operating pension costs of $0.01 per share and the change to the earn-out estimate was a gain of $0.04 per share. Sales in our North America segment of $370 million increased 10% over last year, driven by higher sales of residential and commercial water heaters and commercial boilers in the U.S.

In addition, the third quarter last year was negatively impacted by a pull-forward of water heater volumes in advance of a June 2012 price increase. Rest of World segment sales of $175 million increased 31% compared with last year, driven by increased demand for water heaters and water treatment products in China and market acceptance of our newer, higher-value A.

O. Smith-branded products in China.

We continue to innovate our product lines with features and benefits which provide value to our customers and differentiate our brand. We introduced our eighth upgrade to our electric water heater offering in the second quarter and the products have been well received.

Other recent innovations include an ultra-quiet gas tankless water heater product line and water treatment products which have longer-lasting filters and waste less water. The return on investment in engineering and innovation is one of our key success factors in China.

We also believe our customers held higher inventory in advance of the autumn holiday in October, resulting in a benefit to sales of approximately $10 million. North America adjusted operating earnings of $57 million were 25% higher than last year, and adjusted operating margin of 15.3% improved almost 2 percentage points.

Higher incremental margins associated with increased volumes of water heaters and boilers in the U.S. were the primary drivers of the margin expansion.

Rest of World adjusted operating earnings of $27 million improved over 100% compared with last year. Higher sales and improved mix of A.

O. Smith-branded products in China and smaller losses in our non-A.

O. Smith-branded water treatment business drove operating earnings higher.

Segment operating margins of 15.4% improved significantly compared with last year as a result of higher volumes, better mix and lower selling and advertising expenses as a percentage of sales in China. Our adjusted corporate expenses were $14.3 million, an increase with the prior year primarily due to lower interest income, as well as higher expenses related to management incentive programs and higher stock-based compensation costs related to shorter amortization periods.

Cash provided by continuing operations was $190 million in the first 9 months of 2013 compared with $101 million last year, primarily driven by higher earnings from operations and a smaller investment in working capital. Our liquidity position and balance sheet remains strong.

Our debt-to-capital ratio was 15% at the end of September. We have sizable cash balances located offshore, and our net cash position was approximately $250 million at the end of the third quarter.

As mentioned last quarter, our free cash flow generation for the year is expected to be approximately $100 million, and our board increased our authorization to repurchase shares resulting an authority at that time to repurchase approximately 2.5 million shares. During the third quarter, we repurchased approximately 1,240,000 shares of common stock at an average cost of $42.48 per share under a 10b5-1 automatic trading plan.

The 10b5-1 plan remains in place. We expect our cash flow from continuing operations for the full year 2013 to be approximately $250 million.

Our capital expenditures are expected to be $90 million to $100 million, which includes approximately $40 million for capacity expansion in China and India to meet growing demand for our water heaters in those regions, as well as approximately $20 million related to our ERP implementation. Our depreciation and amortization expense is expected to be between $55 million and $60 million this year.

I will now turn the call back to Ajita, who will summarize our outlook and acquisition strategy.

Thank you, John. Our outlook for 2013 includes the following assumptions: first, we see strong growth in our A.

O. Smith-branded products in China, which are expected to add approximately $100 million to revenue this year.

The team continues to serve our customers and introduce new higher-value products with richer features and benefits that enhance our premium brand. Growth this year is expected to top 20%, which is well ahead of our original 2x GDP projection.

Second, we expect our Lochinvar brand to continue to benefit from the transition from lower efficiency, non-condensing boilers to higher efficiency, condensing boiler, as well as strong market acceptance of new products like our Lochinvar CREST condensing products, boiler -- condensing boiler product line. Lochinvar-branded condensing boilers continue to offer a compelling payback in the form of energy savings, and we have built a reputation for innovation and outstanding product quality.

As a result, we expect Lochinvar-branded sales to grow at least 10% in 2013, well ahead of GDP growth in the U.S. Third, we are cautiously optimistic about the developing recovery in U.S.

housing. We expect residential water heater volumes in the U.S.

to be 400,000 units higher than last year based on an increase in housing completion, as well as growth in replacement units. And we continue to be pleasantly surprised by the strength of the commercial water heater industry.

We now expect commercial industry units will approach 157,000 for 2013 or 6% higher than last year. Our performance in the third quarter and our outlook for the fourth quarter give us confidence to increase our 2013 adjusted EPS guidance to be between $2 and $2.04 per share.

The midpoint of our new range represents the nearly 30% increase over 2012 adjusted EPS of $1.56 per share. Our guidance implies a relatively strong fourth quarter as compared to the fourth quarter last year when the benefit from Superstorm Sandy is considered.

And our guidance is comparable to the third quarter we just completed when adjusted for income tax benefits, higher China volume and lower China advertising and selling costs. This guidance does not include the restructuring and impairment expenses associated with the planned rationalization, the settlement with a former supplier, non-operating pension costs or future acquisitions.

Our GAAP EPS guidance is now expected to be $1.78 to $1.82 per share due to the impact from the restructuring and impairment expenses, partially offset by the settlement income, neither of which were in our GAAP guidance at the beginning of the year. This continues to be an exciting and transformative time for our company.

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 solution is very active. You have seen this slide before, and we show it only as a reminder that we will be a financially disciplined acquirer of companies that fit our stated corporate strategy.

You should know that while we came close to completing a few acquisitions over the past 12 to 18 months, we walked away for various reasons. In the end, we held fast to our financial criteria and are focused on creating value and return for our shareholders.

That concludes our prepared remarks. And now, we are open for your questions.

A couple of questions. Ajita, as we think about product mix kind of going forward, how would you characterize this quarter?

Do you feel like your product mix is maxing out? Does it get -- is there room for it to get better from here?

Or is the next step sort of less favorable from a mix standpoint?

Let me ask -- answer that in a couple of different ways. I don't think they are maxed out on mix by any means, and that's because if you take -- let's look a different parts of the world.

If you look at China, we are constantly adding new products with features and benefits that command higher prices. And obviously, what we try to do is to improve our margins with those new products.

But that process will continue. We've been doing that in China for many years.

It's part of our growth strategy and it's been very successful. And we certainly invest behind the engineering and new product development capability to be able to continue to do that.

If we look at other parts of the world, as the housing recovery takes hold and our volumes go up, we've always said that the incremental margins come at pretty high -- the incremental margins are pretty good. So I think all of those circumstances are in play and we don't see that maxing out by any means.

Now one thing that John did mention that, as we look at our margins in China in the last quarter, SG&A expenses were a little lower than normal, and that's something we don't expect to continue.

And then you mentioned or one of you mentioned, you thought this kind of buy ahead of the October holiday in China was $10 million. Is this a period in 2013 different than any other year?

Would you normally see some sort of buy ahead relative to this holiday period? What's kind of "normal" for that business?

The way we looked at it, Matt, is we looked at the inventory levels of our major customers September 30 of this year compared to September 30 of last year, and they were higher by X number of units which equated to about $10 million. There is always probably some buy ahead when you're entering the October holidays, early October holidays.

But based on that is why we're saying we think it was $10 million more than the prior year.

And then where would you say the government -- the Chinese government position stands today with respect to trying to cool housing activities, speculation, household formation? What is their position, because that was something you guys were concerned about or at least cautious on -- at the beginning of the year?

Well, as we've talked about in the past, they're walking kind of a fine line. They're trying to move to a consumer economy which will certainly benefit us, as that's our place in the Chinese market.

They seem to have not necessarily implemented some of those taxes, et cetera, that we talked about early in the year with respect to capital gains, et cetera. So that did not take place.

So time will kind of tell, going forward, where they are. But again, they clearly have to move to a consumer economy which we think will be benefiting to us because it will generate helpful information.

And I think also, when you -- everyone saw the news last week, late last week, that their third quarter projection of GDP was a little higher than expected, and we hope that all of this leads to -- and as John mentioned, moving towards a more consumption-based economy, will be helpful to us in the future.

Ajita, John and Pat, very nice quarter. Given that, historically, this is one of your lighter quarters, if I recall, in terms of volume, very nicely done.

Let's go into Lochinvar. Can you give me an idea what the contribution was for the quarter?

More importantly, how was their operating margins? And I guess, lastly, their aftermarket exposure, how's that been growing?

We don't break them amount. But I can say, as we've said in there, that they grew over 10%.

They're running at close to a 12% year-to-date positive run rate compared to the prior year in volume. Their margins are growing, and so they continue to perform very well.

On the aftermarket side, we haven't seen any significant increase, it's been holding in at kind of the levels they've had in the past. So as we've talked about, they continue to do very well.

I think one...

Is it safe to say the margins were up year-over-year?

Yes.

Bill, one comment on the cyclicality. In the past, the third quarter used to be our slowest quarter.

But that has changed somewhat because the third quarter is Lochinvar's strongest quarter. So that's kind of impacted a little bit.

Okay, excellent. Can you give us a little sense on how the underlying steel prices have affected your COGs?

Steel has been down year-over-year, so it's had a positive effect. As you know, part of that is a direct pass-through.

As we go into the fourth quarter, our expectation is that will be the highest cost quarter of the year. As you know, steel has been going up, so it's been a marginal benefit for the year.

Do we still assume a tax rate in the range of a 30% to 32%?

Yes, I think a reasonable expectation for the fourth quarter would be around that 30% for adjusted.

Okay. And then finally, can you just give us an update?

I know that India is quite small right now, but just -- there's been a lot of volatility in that regions. Everyone salivates over the potential there.

Can you give us an update of what's occurring there for you guys?

Year-to-date sales are up 5%, and when you take into effect the currency has depreciated about 10%, your top line, apples-and-apples, would be up about 15%. As we've said at beginning of the year, we were hoping for them to break even.

They will not, and the biggest factor has been the currency. They still outsource a fair amount of their product from China, and that's had a negative impact.

Certainly, consumer confidence, given what's happened to the currency, has not been real strong in India, and that's a concern. But we expect, for the year, they're going to be up about 10%.

Again, when you incorporate the currency, that's closer to 20%. So it's progressing, probably not as quickly as what we had hoped.

But again, we can't do anything about the currency.

Just back on the China growth and then the -- kind of the pull forward from the holiday, I understand you look at inventory levels year-over-year and they are up $10 million or so. But I guess what I'm trying to say, if you look a year prior to that, were inventory running -- levels are running kind of flat going into the holiday season, and for some reason, this year, they kind of popped up?

Because I'm trying to understand, the holiday happens every year, unless for some reason, it's moving around one quarter to the next because of the calendar. Is there something that's different this year versus prior years?

Well, we didn't go back 2 years. We didn't have that data.

But again, last year, all we could calculate it on is, last year, the inventory level was X. This year, it was $10 million higher and it was specifically a couple of customers.

So that's how we came up with the number as an estimate of what the pre-buy, if you will, is compared to the prior year. So they're carrying higher inventory levels than last year by approximately $10 million.

And that all really occurred kind of in the third quarter, up until -- at the end of the second quarter, levels were pretty comparable. So that's how we backed into it.

And again, it's only an estimate.

And -- right. And you're saying, it's at a relatively limited number of customers.

So on an apples-to-apples -- so you obviously have greater distribution in China than you did 12, 18 months ago. It's like [ph] 4 months ago.

It's normalized for that as well?

Yes, it's just looking at really the top 5 or 6 customers.

Okay. And just looking on North America, you kind of alluded to the seasonality shift a little bit with Lochinvar now stronger in Q3.

But even that said, Q4 tends to be a pretty good quarter, and I guess given what you did in Q3 and the environment looking a little bit stronger, I guess I'm trying to -- it seems like the guidance might be looking a little lighter than what the environment might call for in terms of North America's strengths. So can you just kind of understand where your guidance is coming from?

What you're thinking about going into Q4 from North American outlook?

Yes, the real uncertainty is that we're estimating, again, based on our internal data that the industry's third quarter for residential and commercial will be the strongest third quarter in the last 5 or 6 years during the third quarter. So we had a very strong third quarter.

As you are aware, we increased our level saying that the industry -- our estimate will be 8.5% for residential versus 8.1%, so that's up 400,000. If you look at completions, they're are only up 200,000.

So that's coming from replacement. So our -- I won't say our concern, our unknown was the third quarter a lumpy plus that might not happen in the fourth quarter.

So you're right. Traditionally, the third quarter would be nowhere near as strong in the fourth quarter, but this year's third quarter was very, very strong.

So just kind of want to understand how we think about margin sequentially in Rest of World going from this quarter to next quarter. Obviously, you guys talked about some of the higher SG&A -- sorry, lower SG&A in the third quarter selling promotional stuff.

But when you think about some of the puts and takes here, I think you guys are expecting some lower volume because of the pre-buy. How does the factory moves impact that?

I know that's something we talked about. But the margins are really strong this quarter, but you're expecting some headwind from that.

And the reason I ask is, when you look at some of the guidance, the core guidance implies something potentially meaningfully lower than where you guys ended up in the third quarter here. Still to a very healthy level, but I just kind of want to understand the puts and takes sequentially and how you're getting to that.

Yes, the takes we look at it is, we have not changed our fourth quarter volume assumptions from what we said at the end of the second quarter. So the fourth quarter is what we originally thought.

We said it'd be a tough comparison because last year, there was a pre-buy, we think, to meet incentives, volume incentives. So at the end of last quarter, we said we'd be up 18% for the year.

Now we said we're going to be over 20%. But you're right, volume sequentially, we would expect to be down from the third to the fourth quarter.

That will have an impact. The SG&A, we would say, would also have an impact.

Third quarter is traditionally the lowest for advertising. Fourth quarter is higher.

We also changed our advertising agency, which might have helped us a little bit in the third quarter from a cost standpoint. And the third is, the plant really was just operating at the end of the quarter.

And we do expect that will have -- as we've talked about publicly, until we get to higher capacity levels, it's going to have a little bit of margin drag, just if nothing else, from the additional depreciation, et cetera. So I think you put all those together and you look at it for the whole year, we'll be up over 20%, and there will be a significant margin improvement in Rest of World year-over-year.

Absolutely. Just wanted to make sure I understood the sequentials there.

And then, how are you guys thinking about U.S. inventory levels at this point kind of broadly across the channels?

The U.S. inventory levels are okay.

I mean, no major positives or negatives.

That makes sense. And then on the buyback side, you have the 10b5-1 in place.

Any thoughts of being more aggressive from a buyback standpoint outside of offsetting dilution?

Well, we did more this quarter than offset dilution. We bought, as we said, 1.24 million shares, so that's much more than dilution, and it was $53 million worth or something.

We said, historically, we have 4 capital allocation options: grow organically, which we're doing this year by investing on our plants; acquisitions which we're actively looking at; dividends, which we raised last 2 quarters ago, 20%; and stock buyback. We bought over 3.7 million shares over the last 2 years.

We bought a fair amount, as I said, this last quarter, and it's clearly an option for us.

A couple of questions. So when we think about India, right, given the currency dynamics, so if you take the currency out, is India now running at breakeven, or India actually now taking money, or where are we?

Well, I guess I would say, if the currency was back when we started this whole thing in the 45-plus range, I would say, we would probably be operating pretty close to breakeven. It really is the currency has been the biggest impact.

When you look at what we said our volumes would be compared to when we started, I think we're pretty much on track. But the currency certainly has had a negative impact when you look at how much we're buying from China.

Sanjay, also, let me jump in on that. Because clearly, when we look -- if you look our -- at the results coming out of India, we are disappointed.

But the disappointment is driven entirely by the economy and what's happening with the economy. If you look at our own brand and our product, the volume is increasing, and more importantly, we are gaining market share.

So all of that is very positive. We still feel that India is a very, very good long-term bet.

And so we are continuing to invest. And even though the devaluation of the rupee is hurting us right now, it also is a great time to invest in the country in rupees in terms of advertising and brand building and things like that.

So we are continuing to do all of that because again, we feel that it's a terrific long-term bet.

I agree 100%. So few more questions for me.

So when I now, even taking out this whole pre-buy in China, right, so what is our sort of the same-store sales growth here in Tier 1 cities versus Tier 2 cities? And how many new stores did we add during the quarter?

And can you give us that breakdown for China?

Well we ended the year at about 5,200 stores, I think. Midyear, we were at about 5,400 stores.

And now, we're at close to 5,700 stores. So there has been a nice growth in distribution.

It's primarily in Tier 2 and Tier 3 cities. We did see sales increase in both Tier 1 and Tier 2 across the board.

So I mean, the bottom line is, China had a great quarter.

For sure. For sure.

So one last question then. Guys, I know you're not going to give me sort of the clear answer on this, but maybe more sort of philosophically now, right, is with your stock having done what it's done, cash generation potential of the company, but market is also getting better, right.

So are you now running into a bit more of a problem of finding things that are a better bargain buy out there and everybody is looking for a higher multiple? And has that changed your overall acquisition philosophy or for that matter, given the pipeline that might have been there 12 months ago and that it didn't cuts [ph] right now, can you talk about that a little bit, if there's any change in the philosophy of how you guys are looking at this?

Well, I'll start out from the financial side and Ajita can add. But we have not changed our discipline on what our requirements are.

And so yes, stuff has maybe gotten a little bit more expensive, but it all does come down to what sort of synergies, et cetera, we can provide, value added. And I would say the pipeline is relatively similar to what it's been a year ago.

Some came out, and some came in and some have come back. And so we're actively looking.

But again, we've said, we'll hold to our financial criteria, and we have.

Yes, I think that's well put, and I can't add much more to that other than, from a strategy viewpoint, there's been no change in our thinking in terms of -- in thinking vis-à-vis acquisitions. The 10b5-1 plan that we put in place is because of the cash generation that we're doing.

And it doesn't change our outlook and philosophy vis-à-vis growing by acquisition.

I had a couple of questions. First off, I wanted to revisit the topic from the prior quarter.

You had talked about a pre-buy in the first half at that time and that had impacted commercial volumes, but then you still expected kind of low- to mid-single digit growth in the commercial side talking U.S. here.

Obviously, you were able to deliver excellent results even with that sort of caution on commercial. Can you talk about that, how that played out, whether you still maintain the same kind of goals on the commercial side for the back half?

Well, we've continually raised our estimates on commercial, and we just have much more difficulty kind of estimating that. I think last quarter, we set 154,000 units compared to last year's, I think, 147,000.

And now, because of a very strong third quarter in commercial, we're going back to the drawing board and we've raised it to 157,000 units. So again, it's just very hard for us to estimate that.

There's -- obviously is some discretionary because, I mean, everybody you talk to, there's not a significant amount of commercial building going on. But we had -- it was a very strong third quarter.

Okay. Then also, just to talk about the components of your growth in China for a moment.

I mean, obviously, it's no secret that part of your growth has been driven by market share gain in addition to the growth of the underlying market. But yet, now you look and you're so dominant in that high-end $400-plus category.

How do you see those 2 factors contributing to your growth rate going forward, market share improvement versus underlying organic growth in the market itself?

Well, we certainly think we'll continue to gain market share. And specifically, as we've said in the instantaneous side of the market where we've come out with the super quiet product, that's been a big contributor to our market share going from the low 20s to the 25%.

Electric units all grew very nicely because of the series 8 we came out with, and so that had a very good quarter also. And then quite frankly, our water treatment, when we talked about it, was little less than $20 million last year.

We expect that to double on the A. O.

Smith brand this year. So that's doing extremely well.

And then you throw in some of the ancillary product lines, like heat pump is very doing well, commercial is doing very well. So as we've said, we've grown a lot of different ways in China.

It hasn't been dependent only on distribution. It's been growing distribution, growing market share, coming up with higher value products.

We think the replacement market is coming and will continue to come. So we've done it in a lot of different ways, and we think that will continue.

And also, just to add to that, John mentioned the replacement marker for water heaters. But also as we grow our water treatment business, the water treatment product has a replacement component to it in terms of filter.

So that's something. Now we are not going to see that for a couple of years, but that's something that also we hope will start building out in the future.

So as we look at China long term, we continue to be very bullish about the opportunities in China.

And why we said the consumerism is so important is the Chinese, based on all the surveys we see, provide premium brands that are providing value. And we think moving to the consumer economy, they're going to have to be able to increase income to make it affordable and then they'll prefer the premium brand.

So we think that will be a positive going forward for us.

Great, that's helpful. And then just one last one for me.

You alluded in the press release to, in the U.S., replacement demand being a driver. And kind of a big picture question, I know it's something difficult to quantify, but we're coming on about a decade now since the U.S.

went through its housing construction bubble, and presumably, some of those products are now reaching the end of their useful life. Do you see that replacement market as kind of evolving into a growth market over the next few years?

And is there any way you can kind of frame that, and if not, quantify it?

Well, we've looked back and looked at the data, and I think, the data I looked at was '96 to '98, the industry averaged X. '99 to 2001, it averaged 300,000 plus.

And then you go the next 3 years after that, that averaged another 300,000 plus. So you're right.

In the 12-year replacement, which again is on average, is right in that sweet spot. So it would be our hope that some of that replacement would start growing.

What we don't know is on the past, you had discretionary, and that's probably come down. Now we hope, given the economy coming back and the wealth factor, et cetera, for housing, maybe that'll get back to where it was before.

But yes, we've said there's some potential from the replacement side because it's right in that middle part. And this is probably the first year we've seen it because up until now, it's been -- replacement has been pretty flat, which is a positive, but we'd like to get some growth out of it also.

Had a few questions on China. I know that we're kind of talking about this pretty exclusively here.

But the pre-buy was about $10 million this quarter. That means you grew effectively organically about 23.5%.

I was just curious what the difference there is between price and mix and volume? Is there any way to kind of parse that out?

I don't have the specific detail, but it was all 3. I mean, units were up, i.e., volume was up and the average price per unit was up.

And so -- and we did grow our distribution, so it was all 3.

On the distribution this quarter, it seems like you added about 300 stores and those are about Tier 2 and Tier 3 cities. Are you gaining the same amount of sell-through in the Tier 2 and Tier 3 cities as the Tier 1?

And maybe just help us understand maybe how many stores you need to get the same amount of store growth out of a Tier 2 city versus the Tier 1 city?

In round numbers, 40% of our stores are in Tier 1 and about 60% of our sales. So no, we don't get the same sell-through that you would in a Tier 1 as you would a Tier 2 and 3.

Got you. That's helpful.

And then on the selling expense this quarter, is there any way to understand how much that was actually down in terms of actual dollars, or in terms of how much you've benefited the margin in terms of basis points?

Roughly a couple percent.

A couple percent.

It benefited the margin.

Couple of percentage points to the margin?

Right.

Got you. That's helpful.

And then lastly on, again, just sticking with the Rest of World segment. You called out the non-branded A.

O. Smith business was actually doing a little bit better.

Are we at breakeven in that business, or just maybe directionally, were [ph] just the losses there are [ph] declining? Just some greater clarity there would be better.

Yes, the loss are declining. When you take out the amortization we have associated with the acquisition, it would be breakeven to slightly positive.

So it's made good headway in 2013. More throughput, right?

I mean, it's making the products for the A. O.

Smith brand and you have much more throughput going through the plant, et cetera.

I really only have 2 questions for you. Number one is that, if steel is starting to rise, are there pricing plans for the first part of next year or even the fourth quarter of this?

Scott, we -- when it comes to looking out into the future, obviously, we don't talk about pricing at all.

Would you say, historically, that the incremental cost of steel where we are today versus earlier this year has prompted a price increase historically?

Let me put it -- let me answer the question a different way. In the past, over time, we've been able to pass cost increases out into the market, but it takes time and we do it over time.

In the past, we've been able to do that.

Okay. Along the same lines, this is the third part of question one, sorry, but did wholesale sales increase faster than retail sales this quarter?

Yes.

Okay. So the other question is simple.

On the Fergus benefits, how much have we seen and kind of how much is still to go through the P&L, even if you want to tell us on a percent basis?

John, do you want to...

I'm sorry, can you ask the question again? Fergus for this year?

Sure, sure. Just wanted to know how much of the Fergus operational benefits you've received so far in the third quarter, what you expect maybe in the second half of the year in total and what's still to come?

Well, what we've kind of said is that we had -- Fergus this year will benefit approximately $4 million. And we've said that our expectation is, next year, for a full year, that it'll be a $10 million, so about an incremental $6 million.

And we're kind of at that run rate now. We're running at, whatever that is, $750,000 a quarter.

So it's -- we're pretty well complete and it's gone about as well as we could've hoped.

Yes, the whole transition and the move from an operational execution perspective had gone very well according to plan. And from a customer perspective, it's gone very well.

There have been no issues in terms of deliveries or anything like that.

I think most of them has been answered. I can follow up on a couple.

First on the SG&A side, for China in particular. I think in the first quarter, if I'm not mistaken, SG&A was a little bit lower again, and then you ramped it up in Q2, you lowered in Q3.

I mean, how much abilities -- and I know -- I understand you want to really focus on growing the market share, but you're getting a lot of market share. You mentioned the change in the advertising agency.

I'm assuming you're getting some better pricing out of that. So can you reduce your SG&A?

Are you prepared to keep it lower on a longer-term rate as a percentage of sales instead of just ramping it up or maintaining it?

Well, I think what we've said is we could, but we probably won't, because what we have in our brand we feel is something special. And so we cannot re-create that brand position today, so we're going to make sure we can maintain it.

So we spend a fair amount in advertising, and I think we will continue to. Now a lot of the selling is somewhat variable because that's, as we open new distribution sites, et cetera, and new stores, we have to put in the displays and the employees, et cetera.

So a decent portion of the selling is somewhat variable there. So on the margin, yes, there's some room, but we're committed to continuing to invest in the brand.

And also, when you look at the growth in China, a lot of it is coming from new people coming into the market, okay, as people get into the demographic where they buy these type of products. And we have to constantly keep the advertising and promotion and programs communicating to them, the benefits of buying our product, why it's a premium brand and all the rest of it as you would with a typical consumer advertising strategy.

So we see that as continuing, and it's a major part of the growth plan for China.

Okay. Yes, that's helpful.

And you had called out Internet sales in the last quarter. Do you want to call them out now?

What were they, and how much did they grow in China?

We're very comfortable they'll more than double. In fact, they're close to almost doubling by the end of the third quarter going from 5 to, I think, the number was close to 9 or something, 9 or 10.

So they're on track and doing what we expected.

Okay. Is -- do you think that's part of the inventory increase from your customers, too?

No.

Or is it just so small?

Yes, I don't think we can tell.

No.

Okay. And then lastly, can you give us an update on the progress of the ERP?

ERP is progressing right on schedule. We have the team assembled, and we're very comfortable with the adviser we're working with and it's right on track.

Any small drag you saw on this quarter, and how should we think about the impact in Q4?

Well, I mean, what we've said is the impact will be about $5 million this year, and that is primarily in the second half of the year because that's when we started it. And we said next year that it'll grow to probably about $15 million as you end up expensing more, et cetera.

And so that will be primarily, I'll say, mostly the second half of next year because you're still capitalizing some stuff in the first half of the year. But right now, we're on track.

Yes, we are more than halfway through the blueprint stage and nothing has popped out that would make us change the forecast and the outlook that John just mentioned.

A couple of things. First, Ajita, is there any update on bringing Lochinvar's residential and commercial products into China?

What, ultimately, timing might look like, how that may or may not ramp up over the next year or so?

It's moving along on track. We -- in the next few months, we'll be introducing some products.

It's going on track. It's not -- as we always said, that is going to -- it's a longer-term program because the market for that product hasn't quite developed.

But we do see it developing. And so the more program is moving ahead.

What types of products will you be introducing? And is that a '13 or early '14 thing?

It's an early '14. I mean, it's an early '14 thing.

And initially, it'll be residential type combi boilers. Combi meaning it heats water and heat the environment.

And then as we think about just the U.S. commercial business, I mean, I know we're only a few weeks into October, but are you already seeing the implied slowdown in that business that your guidance or your 157,000 would have built in, assuming that the industry data is going to come through very nicely for August and September in Q3?

And I guess, you talk about not having all that great of visibility into, I guess, the out-the-door demand. I guess, Ajita, what are you watching for then in terms of warning signs that either this pent-up replacement demand or this drive towards energy efficiency, that that's closer to an end as opposed to a beginning?

Yes, we have not seen any slowdown, okay? The market has surprised us in its strength.

And like John mentioned earlier, we've increased our outlook in terms of the commercial market in total going up to 157,000 units.

And what do you think the market did in Q3?

Well, our GAAP says the market was probably up maybe 5% year-over-year. I mean, we're forecasting in our numbers that Q4 is going to be up slightly from Q3, and that's similar to what it was last year.

So that's kind of where we're forecasting it, and time will tell.

Hey John, can you actually give the same view on the residential market like you did commercial there?

Residential, we would expect, is going to be up from the third quarter to the fourth quarter. We do not think it'll be as strong as last year because last year was helped by Sandy.

But we do think sequentially, it'll be up. But again, I think we'd reiterated a couple of times, and this is typical, Lochinvar will be down sequentially from the third quarter to fourth quarter, exactly as they were last year.

Just wanted to get back on the M&A pipeline. You guys touched on it a little bit.

But can you give us a sense, in that pipeline size-wide, maybe kind of a range of what the deal pipeline looks like? Is there just -- is there one large, large deal?

Is there a lot of small, medium stuff?

Charley, we are -- like we've said in the past, we are looking at things that -- it's yes and yes, there are smaller programs -- there are smaller opportunities and larger opportunities. And it's really difficult to comment on it before it happens, because like we've said, these things can happen or not, and you don't really know until you've signed the deal.

Thank you very much for joining us today. And if you have follow-up questions, feel free to reach out to me.

Thank you.