Oct 16, 2007
Operator
Good morning, ladies andgentlemen. Thank you for standing by.
Welcome to the third quarter 2007 earningsconference call. (Operator Instructions) I would now like to turn theconference over to our host, Mr.
Craig Watson, Vice-President of InvestorRelations. Please go ahead.
Craig Watson
Thank you. Good morning,ladies and gentlemen, and thank you for joining us on this conference call.With me this morning participating in the call are Paul Jones, Chairman andChief Executive Officer, Terry Murphy, Chief Financial Officer, and John Kita,Controller and Senior Vice President of Finance.
Before we begin withPaul’s remarks, I would like to remind you that some of the comments that willbe made during this conference call, including answers to your questions,constitute forward looking statements. Forward looking statements are subjectto risks that could cause actual results being materially different.
Thoserisks include, among others, matters that we have described in this morning’spress release. Paul.
Paul Jones
Thank you, Craig. Goodmorning, ladies and gentlemen.
This morning we released our results for thethird quarter of 2007. Sales in the quarter decreased slightly to $554 million,while net earnings increased to $24.7 million, or 79 cents per share.
This compareswith $17 million, or 55 cents per share, last year. The earnings in the currentquarter included a 10-cent-per-share tax benefit that Terry will describe lateron.
In addition to earningswe announced the closing of three of our motor operations. The weaker thanexpected housing market has negatively impacted existing plant utilizationrates in our residential hermetic motor business.
Therefore, we’ve decided toaccelerate the closing of our operations in Scottsville, Kentucky, Mebane, North Carolina, and are relocating theproduction to Mexico.In addition, we will be closing a much smaller operation in Hungaryand will be writing down the value of certain real estate and other assets.These decisions are consistent with our road map to substantially increasemargins and returns in our motors business. We will close ouroperation in Scottsville, Kentucky,and transfer its production to our facilities in Juarez and Acuna, Mexico.
The residentialhermetic motor manufacturing facility in Scottsville was acquired in 1998. Overthe last five years, the market share of one of our larger customers hasdeclined significantly and, as a result, plant utilization rates have declinedin both Scottsville and Acuna, Mexico.These actions will appropriately resize this business segment for this market.
Consistent with ourobjective to consolidate our hermetic motor manufacturing and more fullyutilize our Acuna operation, we will also close our commercial compressor motoroperation in Mebane, North Carolina.The transfer of work at both hermetic motor facilities will be completed by thefourth quarter of 2008. We will also close our motor facility in Budapestand we will complete that closing early in the first quarter of 2008.
Terrywill cover the financial details of the restructuring shortly. As we announced thismorning in our press release, we’ve narrowed our earnings forecast again for2007 to $2.85 to $2.95 per share.
This is before the estimated 25-cent fourthquarter charge, or to $2.60 to $2.70 per share including the charge. But we arestill within the previous range prior to the restructuring charge.
We havebecome more cautious about the general economic outlook. I’ll come back to talkabout the forecast later, but first Terry will talk about the financial resultsin a little more depth.
Terry.
Terry Murphy
Thank you, Paul. Thirdquarter sales of water products were $334.5 million, a 3% decline compared withthe third quarter of 2006.
The primary reason for the decline was lower salesin the residential market, particularly on the wholesale side, which is moreheavily impacted by the new housing market. The decline was partially offset byincreases in commercial and other market segments, including a nearly 20%increase in China.
Third quarter sales of$220.1 million were essentially flat compared with the same period last yearfor EPC. Higher pricing related to raw material increases and modest increasesin the distribution and commercial hermetic motor market segments offset lowervolumes in the pump, residential hermetic, and general industry marketsegments.
Operating profit of$39.5 million increased 22%, or $6.5 million compared with the third quarter in2006. For WPC, despite thelower residential volumes in our water products business and higher costs forraw materials and components, an operating profit of $33.6 million increased$4.4 million, or 15% compared with the third quarter of 2006.
The increasedresulted from acquisition synergies, higher profits in China,and lower SG&A expenses. Operating profit margin was 10% compared with 8.5%last year.
In the motors business,operating profit of $12.7 million was $4 million higher than the third quarterof 2006, which included $2.5 million of higher restructuring expenses. Thirdquarter operating profit margin improved 5.8% from 3.9% last year.
Our tax rate was 15.1%in the third quarter as a result of a $3 million tax benefit worth 10 cents ashare from the reversal of tax reserves associated with closed tax years andaudit settlement. The tax rate for the fourth quarter and the full year,excluding the fourth quarter restructuring charge, will be 25.8%.
Operating cash flow as$95 million for the first nine months, reflecting $57 million of positive cashflow in the third quarter. Cash cycle days increased slightly to 67 days from65.
Lower receivable and inventory days were offset by an increased basepayable. We were particularly pleased with the 13-day reduction in inventorydays at EPC.
Capital spending totaled$42 million for the first nine months of the year, similar to last year. Wecontinue to project approximately $75 million for the full year.
Depreciation andamortization were $50 million through September and should total approximately$70 million for the full year. As a result of theexcellent cash flow, our debt to capital ratio decreased to 36.6%, 38.5% at theend of the second quarter, and 39.1% at the end of 2006.
Since the sharerepurchase authorization last spring, we’ve repurchased 189,000 shares at anaverage price of under $41.50 per share. For 2007, we’re projecting full yearoperating cash flow of $150 million.
In addition to fourth quarter earnings, weexpect cash flow to benefit from continued working capital improvement, as wellas the tax benefit from restructuring. Now more onrestructuring.
We anticipating recording a fourth quarter pre-tax charge ofapproximately $13 million, or $9 million after taxes, to close the NorthAmerican facilities and write down the value of other assets. We will alsorecord an estimated charge of approximately $9 million to close the Budapestoperation and will receive an estimated $10 million tax benefit associated withthe write-off of our investment in this operation.
The combined after-taxcharge is estimated to total approximately $8 million, or 25 cents a share. In 2008, we anticipatereporting an additional pre-tax charge of approximately $12 million to completethe closure of the North America facilities, equivalentto approximately $7 million after taxes, or 24 cents a share.
The expense forthe North American facilities is expected to be incurred relatively evenlythroughout the year. The company alsoanticipates reporting an additional after tax charge of $2 million, or 6 centsa share, on the first quarter of 2008 to complete the closure of the Budapestfacility.
Approximately $12million of the total costs are expected to be future cash payments, while a taxsavings associated with the repositioning are expected to be approximately $19million for a net favorable cash impact of $7 million. As many of you know,we’re working hard to expand the margins in our motors business and areformalizing a road map to get us there by the end of 2009.
Big pieces of thatroad map are captured on this slide. Our lean products initiative is intendedto reduce product SKUs and components and simplify product offerings.
This isintended to address opportunities related to the integration of some of theacquisitions we have made. Our product and customer rationalization initiativeis intended to address the weaknesses in some of the lower margin products weoffer in the markets we serve.
The third initiative is asset optimization,significantly addressed this morning. The closures we announced this morningrepresent an important part of the asset optimization initiative.
We expect togenerate savings of approximately $5 million in 2008, and annual savings of $20million beginning in 2009 from these repositioning actions. The full yearimpact on operating profit is expected to add at least 200 basis points to the2009 operating margin in electrical products.
As we work our way through asofter economic environment, we’ll continue to work diligently to enhance motormargins through our product standardization, rationalization, and asset optimizationprograms. Paul will now finish upwith the outlook, and then we’ll take your questions.
Paul.
Paul Jones
Thank you, Terry. Thoughwe are still within the range before the restructuring charge that we issued atthe end of the second quarter, we have lowered the top end because of theweaker than expected residential end markets, particularly with respect to thebalance of this year.
Also, like most economists, we now believe this housingweakness will continue for the foreseeable future. Throughout the year, theimpact of housing related weakness has been more than offset by strength in ourcommercial and Chinese businesses, and the positive impact of our aggressivecost reduction activities.
For the balance of the year we expect to continue tobe challenged in the residential market segment. And as we move into 2008, webelieve the weakness in the housing market will persist and may be accompaniedby a slowdown in our other market segments, including commercial.
Ironically,though we would expect these softer markets to provide relief from high rawmaterial costs, we expect to continue to face historically high prices forsteel and copper as we move forward. So in front of these headwinds, we aremore cautious about the outlook for our business for the foreseeable future.
Operator, we’re nowready to take questions.
Operator
(OperatorInstructions) We’ll take the first question from Ned Borland with NextGeneration Equity. Please go ahead.
Ned Borland
Good morning, guys.
Paul Jones
Good morning, Ned.
Ned Borland
Just a quickclarification on the guidance. Does that include the tax benefit at 10 cents inthere?
The $2.85 to $2.95?
Paul Jones
Yeah, it’s everything inthere.
NedBorland
Okay. All right.
And ifwe could go to water heaters, first, what did you see in terms of unit declinein the quarter in North American residential?
Paul Jones
Well, we’re not givingout that much information because we’re the only public water heater company,so we don’t want to give our competitors that information. But there wasdefinitely a decline.
If you remember in the quarter, the first couple weeks inAugust when the credit dried up and that was when everybody decided that weweren’t at the bottom on the housing. But we saw a couple weeks practically noorders in both businesses, and I think that was across the industry.
Thingshave picked up and we actually ended up with, you know, within the quarter,given the volumes, we think a pretty good quarter because really, really doinga good job in the operations and controlling costs and productivity. The plantmanagers have done a real good job on scalability to enable us to not incurhuge costs as we do things to keep our inventories in line, keep our servicelevels up, and the like.
But there was, without a doubt, obviously we have someprice in the quarter, then we show essentially flat to down revenues. There wasdefinitely a decline in volume in the quarter.
Ned Borland
Okay. And then thecommercial water heaters, is that market still strong or is it consistent withwhat you’ve seen here today?
Paul Jones
Yeah, it’s held upstrong and it continues to be strong. We’ve got a couple of new products thatwe’ve brought out there that are just booming, that we’re really proud of inthe commercial segment that we have a small commercial boiler that’s selling attwice the rate we anticipated when we first brought it out a few months ago.
Acouple of others. So we’re very pleased with what’s going on in commercial.
Wehave not seen anything that would indicate there would be a slow down goinginto next year, but history tells us that after a housing decline there will besome decline in commercial. It won’t be near as significant as housing becausewe don’t have a sub-prime problem with commercial, but if subdivisions don’tget built some of the commercial restaurants and strip malls and the like willbe delayed a few months or a year.
So we’re anticipating, as we go into nextyear, that there might be a decline, but we haven’t seen it yet.
Ned Borland
Okay. And then on Chinaare you still sticking with the 25% growth this year?
Paul Jones
Yeah, 25% is still doingwell. It’s going to be as large of a volume growth year as we’ve had.
Ourretail partners are opening stores at a record pace, but we have to remind youthat they’re doing it in second-tier cities now. So they’re not opening thesehuge mega stores.
They’re more sized for the local market and the volumes outof those stores will be a little less than what we’ve been getting in the majormarkets. But the expansion rate continues and we’re very proud of theproductivity and the margins out of that business.
Ned Borland
Okay. And then thesemoves that you’ve announced today on electrical products, does this sort ofaccelerate the margin improvement in that segment or does it just sort ofmakes, does it offer you some cushion to get it there to double digits by 2009?
Paul Jones
It’s an acceleration,Ned. When we go back, four years ago, when we first started on this plantrationalization – by the way, we’ll have closed nine plants when we completewith these three from that project.
This is primarily the rationalization offacilities from all the acquisitions we’ve made over the last decade. This hasbeen on the list, towards the end of the list, on getting the operations into Acuna.We have freed up, there are two facilities in Acuna, we have freed one of thoseup over the last couple of years so it can now take the commercial out of Mebaneand we’re able to take the residential into the other plant, Acuna 1, out ofScottsville and some of Scottsville will go to Juarez.This was part of the plan that we had around four years ago that we’ve beenfollowing.
It’s just that, as you know, we have one very large residentialhermetic customer and their volume is off somewhere in the neighborhood of 75to 80% from where it was five years ago. So we’re just right-sizing the assetsto serve the market that we have there.
We still have enough capacity in place,as well as enough idle equipment to put in place in case the market takes off,but for right now we’re just making sure we have the right size for the marketsthat we’re in.
Ned Borland
Okay. I’ll let somebodyelse ask questions here.
Operator
We’ll take the nextquestion from Scott Graham with Bear Stearns. Please go ahead.
Scott Graham
Hey, good morning. I’vegot several questions.
Your new guidance indicates a pretty troubling fourthquarter and I was just kind of wondering why the fourth quarter thinking,particularly given that you’ve seen the residential order rights bounce back,albeit modestly. Commercial continues strong.
It looks like you still have GSWsynergies that are reading through. You’ve got pricing in your favor.
Maybe getto what are the two or three critical factors that are, you know, having youguys really communicate a very weak fourth quarter.
Paul Jones
Our cautions are relatedto one thing and that’s top line volume. We’re pleased with how the operationsare performing.
We still got 5.8% operating margin out of EPC. That’s above thehistorical 5% average.
It follows the 7% we got out in the second quarter.We’re still getting traction on the margin improvement projects there. I knowthey’re taking longer than some people think they should.
And by the way, we’repushing as hard through those as fast as we can, but some of the OEM customersrequire 10, 12, 18 months of testing and we just gotta go through that. But toanswer your question as we look at the fourth quarter, it’s just the top linerelated.
It’s not share related. We are still picking up a little share in themarket segments where we want to, where the margins are good.
We’re doing somevery, very surgical things there that are helping us in both businesses movethe returns up. It’s just the overall softness.
We’re one of the first to comeout and report. It’ll be interesting what others related that have operationsin housing have to say, but I don’t think they’ll see anything too muchdifferent than we do.
Scott Graham
Paul, are you suggestingthat after you saw the pick up later in the quarter in your residentialvolumes, I’m assuming that means both motors and water heaters that maybe yousaw renewed weakness in the month of October?
Paul Jones
Well, Scott, we saw a small pick up from practicallynothing the first couple weeks in August. It’s still weak.
We’re still havingrevenues below what our plans were for the year because the market is a lotsofter. Our original plan was for 1.7 million housing starts.
And you know,it’s now going to be 1.4 to 1.3 and we have 50% share of residential waterheaters. So you can tell right there that there’s a couple hundred thousandwater heaters that we’re not going to sell this year that when we began theyear we thought we would sell.
That’s just one example. And of course the motorbusiness is a little more complex, but it has essentially the same thing.
Sowe’re not predicting a disaster by any means. We’re just cautious folks.
Welike to tell you what we’re going to do and then meet it.
Scott Graham
Okay. The GSW acquisition,obviously the synergy’s there and maybe taking a little bit longer based onwhat you’re talking about with the product testing.
I assume that you meantthat for the water heater business. But the similarity in the manufacturing, Imean, it’s almost perfect similarity between you and GSW, what is still infront of us on the improvement with the synergy realizations in this business?
Paul Jones
I’m going to disagree with you.We’re not behind there, we’re actually ahead on our internal projects. We aregetting everything blended together.
We did not mention GSW in the pressrelease today on purpose. It’s essentially getting hard to delineate whetherthis is a GSW synergy or whether it’s just ongoing efficiency improvements inthe businesses.
We still have quite a few projects that we’re pretty excitedabout across the whole water heater business for cost reductions. One that’sunder test right now that I think I’ve talked about publicly is a new combustionchamber where we will standardize on one from three.
That’s one that we’ll beimplementing early next year and it has a pretty significant savings. There areseveral others that we’re working on that are pretty good sized for both waterheaters and motors relative to cost reductions.
We frankly are very pleasedwith what’s happening there and think that it’s going to show up in theoperations of the businesses as we go forward.
Scott Graham
So your reference to some peoplebelieve that we’re behind on, your reference wasn’t clear. You were talkingabout the motors business then?
Paul Jones
Yes.
Scott Graham
Okay. Okay.
Fine. So you’re aheadof plan on GSW.
Paul Jones
We are ahead of plan on the GSWintegrations. We’re actually stopping talking about it internally.
Scott Graham
Understood.
Paul Jones
We’re not tracking GSW. Becauseit’s all meshed together with everything else.
Scott Graham
And there’s nothing that you now,over a year, well over a year past this thing almost –
Paul Jones
Year and a half.
Scott Graham
Yeah. Nothing that suggests thatthis still can’t be a 12% margin business?
Paul Jones
Absolutely not. We still believeit’s 12% plus.
We grew margins last month, last quarters with a sales miss. Ithink that says it all there.
If we had a stronger market right now I’d reallybe crowing about the numbers right now. But we’re just facing the reality ofwhat we have.
Scott Graham
Okay. A couple of others.
Curiousabout the Budapest closing, becauseit would seem to me that that would be a lower cost facility. I’m just, whythat facility and what area does that facility serve whereby Chinacan serve that same group of customers?
Paul Jones
That’s exactly what’s happening.The customer base that we have there is being transitioned to China.We started this project a couple years ago. That’s what’s happening.
The Budapestoperation is an old, large, inefficient manufacturing operation that has beencosting us operating income year after year and that will go away within thenext few months.
Scott Graham
What area does that serve?
Paul Jones
It served some customers in Europewith some hermetic, as well as some industrial, business.
Scott Graham
Okay. Two final questions.
Are youcontemplating additional pricing actions in either business in the quartersahead?
Paul Jones
Our costs are going up and we’retaking the appropriate actions relative to that.
Scott Graham
Gotcha. And lastly, you had aterrific quarter of free cash flow.
What did you do with an inventory andaccounts receivable that was really the contributor there?
Paul Jones
Well, we’ve been working, it’sbeen a major effort for the last three years to get our cash flow up. We didover $300 million over ’05 and ’06 together.
I’m adding both years together.And we’re continuing to do that. We’re just right sizing the inventory.
We’retaking our service levels up, getting our inventories down. We’ve taken over$20 million out of one water heater facility and process inventory simply byusing modern manufacturing techniques, point of use inventory, things likethat.
I’m particularly please, I think Terry mentioned it in his comments, withwhat the electrical products group is doing. We’re not talking about theabsorption hit that we’re taking there.
We still grew our earnings $4 millionover third quarter last year and we’re obviously getting some absorption, butit’s the right thing to do. It’s getting the inventories in line and gettingour inventory terms up, and I still think we have a lot of runway for thatproject.
I know that we’ve done quite a bit to get our terms up, but I thinkthere’s even more on the horizon as we go forward.
Operator
We’ll take the next question fromAndrea Wirth with Robert Baird. Please go ahead.
Andrea Wirth
Morning.
Paul Jones
Morning, Andrea.
Andrea Wirth
Just a question on the residential outlook.You had mentioned now you’re looking for about 1.4, 1.3 million units for ’07.Just curious what your initial thoughts are on ’08. It kind of seems like sincethis is more like 1.2 million units that your current thoughts, well, are you alittle bit more pessimistic than that.
Paul Jones
No, we’re currently in the throesof putting together an operating plan for next year and we are in the 1.15 to1.2 range right now in our thinking and we’re still gathering data.
Andrea Wirth
And then, I guess, just a question of what weshould maybe expect next year. I know you’re still doing your initial planning,but just kind of given that obviously you’re going to probably another downwardstake in the housing market next year and all the moves that you have going on.Should we still expect margins to expand in ’08 in the motors business or is itjust a little bit, maybe it costs a little bit too much to overcome with thevolumes and also the moves going on.
Paul Jones
It is our expectation that themargins will expand before the additional restructuring charges. We do have,you know, because of the way we have to do accounting now we will have some ofthe restructuring charges for next year will be coming pretty well evenlythroughout the year.
So before the restructuring charges, I’m quite confidentwe’ll see the margins improve and then you’ve probably already done thearithmetic on the turnaround from ’08 to ’09, from the results of therestructuring charges. So that’s the roadmap that we’re on and we’re stickingwith it.
Andrea Wirth
And then, just a question to follow up onpricing. It sounds like your competitors, Ream and Bradford-White, have bothraised pricing in the wholesale channel about 4 to 6% for next year.
Did youalso follow that price increase?
Paul Jones
Everybody has announced a priceincrease and I really can’t talk about pricing in the water heater business.Our costs are going up and relative to that we’re taking the appropriateactions that a prudent company would do.
Andrea Wirth
Just a final question, for the guidance,what’s the tax rate we should assume for the fourth quarter?
Terry Murphy
Twenty-five-point-eight%.
Andrea Wirth
Great. Thanks, guys.
Paul Jones
Thank you.
Operator
The next question is from JohnEmerich with Ironworks Capital. Please, go ahead.
John Emerich
Thanks. Just a couple questions ofclarification.
What is the percentage of total company revenue that is newresidential construction?
Paul Jones
New residential constructionaffects about 20% of the water heater residential market. About 80% ofresidential water heaters is replacement.
And roughly, on the motor side,roughly about 70% of our product line is affected, but a whole lot of that isreplacement. Our distribution business has been growing double digits everyyear and has continued to do so.
The new housing part for motors is tough toget a handle on, but it’s probably in the 15 to 20% of revenues are affected bynew housing.
John Emerich
So 15 to 20% of total company revenue.
Paul Jones
Approximately, yes. M-hm.
John Emerich
Right. And, I’m sorry, could you repeat yourstatement about housing, your housing starts expectations for ’08 as they’reobviously in the early stages of being developed?
Paul Jones
Yeah, it’s about 1.2 million rightnow. Maybe slightly before.
I saw a forecast from somebody that has beenaccurate more often than most and his was 1.16. We’re still finalizing thenumbers and we’ll, as always, in January when we come out with our guidance for’08 we will reference what we believe the number will be at that point.
John Emerich
Right. I guess with orders the last threemonths that have been coming in from the public home builders being downanother 25%, ’08 could easily be down another 10 to 20% in starts from this ’07number, I’m guessing.
Correct?
Paul Jones
I think that would be a worsescenario than what we’re forecasting.
John Emerich
Okay. Fair enough.
Thank you.
Paul Jones
The other part that I haven’ttalked about is, when I said we had very few orders, obviously the people thatserve, you know, we don’t sell directly to the home builders, we sell throughwholesalers that go to the homebuilders, and we sell to OEMs. They all tooktheir inventories down because they’re right sizing it, so we saw a little bitmore of a downward blip simply due to our customers reducing their inventoriesto serve a weaker end market.
It’s hard to say, but we think that part’s prettymuch behind us. Next question.
Operator
Next question is from Ted Wheelerwith Buckingham Research. Please go ahead.
Ted Wheeler
Yeah, hi, good morning.
Paul Jones
Good morning, Ted.
Ted Wheeler
You started to answer this. Maybeyou could just add a little color on channel inventory.
I guess they took itdown and could you kind of go through some of the pieces, if you would,wholesale and retail and both electric and water heater?
Paul Jones
It’s a little bit, it’s nothinglike what we’ve seen in the past relative to inventories ahead of pre-buys andenergy mandated energy or redesigned changes. But it was tweaking down.
I thinkwe saw the wholesalers in water heater and the retail have taken theirinventories down slightly and that’s been reflected in a decline in our orderrate for a short period of time. And I think our OEM partners, you know, thelarge HVAC companies have all taken their inventories down somewhat.
They’retaking days of production out of their facilities. We have no, when you’re anOEM supplier you have very tight lines of communication with your customerbase, so if they’re taking an extra few days off in December we already know itand it’s factored into our plans.
Ted Wheeler
Okay. That was kind of myquestion.
So as far you can see through the rest of this year, you feel thatthe information on inventory change with customers is pretty solid?
Paul Jones
Yeah. It’s minor.
It’s nothinglike we’ve talked about in the past. They probably affected a couple of percentagepoints of revenue in the quarter.
Ted Wheeler
And for the fourth quarter aswell, I presume.
Paul Jones
Well, it’s, we’re not as bad as wewere in August on an order rate, right now, but we’re being cautious about thefourth quarter. Maybe we’ll be surprised on the up side.
Ted Wheeler
And when your customers come toyear end will those inventory levels be normal? Of course, it’s a movingtarget, of course, is the sales levels, but would you think they’ll be atnormal levels or below or still above?
Paul Jones
If there is a normal level, that’swhere they’ll be. I’m not being flip.
All of us thought, I mean, we had ourcall in July we really thought that we were level at a lower housing rate, thatit would stay at that rate. Nobody was anticipating a significant drop againthat happened in the August-September time period.
But to answer your question,yes, they will be at the appropriate level they feel they need to be for themarket they’re serving.
Ted Wheeler
Just lastly, I guess, back onpricing. If steel and copper prices were to stay where they are today would youneed to increase prices similar to the pricing you got in ’07 or do you thinkyou need to raise prices more or less?
Paul Jones
Well, we have a lot of contractson the motor side that have escalation clauses in them and those contracts arebeing renewed all the time and being modified all the time. We have a couple ofcontracts, long-term contracts, that thankfully run out at the end of this yearand we have put new contracts in place for those that will give us betterrecovery as we go forward.
So we’re not going to have, we have one contractthat was for a fixed price from four years ago. We’re wrapping very large billsaround that one.
Currency around those, we ship them. That contract goes awayin another 10 weeks.
And we have a couple of others where we had a 50% sharingon steel that has turned sour on us, obviously, so we’re not going to haveagreements like that. Other than that, all of our contracts have these clausesin them and our non-contract business like district distribution and motors, aswell as the water heater side, we do what we need to do as our costs go up.
Andwe do it across the whole customer base. Residential, commercial, residentialwholesaler, residential retail.
Ted Wheeler
Yes, that’s very helpful. Itsounds like maybe you’re slightly more optimistic on recovery next year thanyou have been.
Paul Jones
I think our margins are going tocontinue to move up. I’m really pleased with what’s happening in the operationsand getting traction on the improvement program.
We’re just suffering with aweak market right now.
Ted Wheeler
No, no, I –
Paul Jones
That gives us a chance tore-arrange the jungle and be more aggressive on some things so that when thingsdo pick up we’ll have a step function movement in our margins.
Ted Wheeler
I agree, your margins, I think,all things considered, are doing fairly well. Just kind of go forward and get asense of your feel.
That’s very helpful. Thank you.
Paul Jones
Okay. Thank you.
Operator
Our next question is a follow upfrom Scott Graham with Bear Stearns. Please go ahead.
Scott Graham
Yeah, just one follow up, Paul. Onyour roadmap to improvement in the motors business, could you talk about, youknow, maybe two things, two sub-parts to this question.
First, the anticipatedSKU reduction in terms of sales, what should we sort of be modeling in? Even ifyou could give us a reasonable parameter for that for next year and 2009.
Andthen, additionally, you know, the lean initiatives that you’re talking aboutcertainly now could be applied to a much smaller base of manufacturing. I guessmy question would be that, why weren’t some of these things being donepreviously?
I mean, that business’ margins frankly exchanges has been a flatline at about 6% for probably five years. You guys are looking at the samenumbers I’m looking at and I’m sure equally frustrated.
Why wasn’t thishappening beforehand?
Paul Jones
Well, I’m not going to comment onthe history. Today is October 17th and we look at the situation wehave.
About a year ago we elected to tweak or change the strategy. We were onmore of a growth track.
But as we looked at the growth opportunities we had onthe motor side we decided that we really had better returns to shareholders byfocusing more on getting our margins up. And the roadmap that we communicatedat that time was lean products, which is a standardization, optimization, takeall the acquisitions we’ve made and all the 20- and 30-year old motor designsthat came with those, and optimize them to one motor design with a reducedmaterial and a cost-reduced parts list to serve that particular application.
Onthat track we are getting some traction. We’re still in a lot of discussionswith a lot of our OEMs relative to getting trials scheduled.
Some of thesetrials take 12 to 18 months because obviously they’ve designed an airconditioning unit around their OEM parts or a furnace in a home and they want,rightfully, to make sure it works properly. So the OEM part of that is taking,it takes a while to get that sold in.
The second element that we’ve also saidis one to two points is a product and customer rationalization. We are gettingsome benefit there.
We have had some very tough discussions with somecustomers. It’s either raised the price or the business goes away, but we’renot going to sell it below cost anymore.
And we’re getting a little bit oftraction on that, but because of the sensitivity of some of those conversationswe’re not yet ready to come out and say what the ultimate benefit would be fromthat element. The third element, the asset optimization, capacity utilizationwe have said will give us one to two points of margin in the motor business andwe just announced today that it’s going to be in excess of two points when thatproject gets completed by the end of ’08.
So that’s about as much guidance aswe can give you right now. You run the numbers, it gets us to 10, a little bit above that.
By the endof, as we get into ’09, and that’s the game plan we’re on. If anything, atleast one of the three we’re reporting today has a little bit of upside to itfrom what we told you before.
Scott Graham
Okay. Thanks.
Paul Jones
Sure.
Operator
We have no questions at this time.Please continue.
Paul Jones
Okay. We appreciate everybody’sattention today.
As always, we’re available to help answer your questions whenwe can. But thanks for your interest in our company.
Operator
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