Jan 23, 2008
Executives
Craig Watson - Vice President of Investor Relations Paul Jones - Chairman and Chief Executive Officer Terry Murphy - Chief Financial Officer John Kita - Controller and Senior Vice President of Finance
Analysts
Andy Teller – Teller Research Ted Wheeler - Buckingham Research Scott Graham - Bear Stearns Mike Schneider - Robert W. Baird Matt Summerville - KeyBanc Jeffrey Matthews - RAM Partners
Operator
Welcome to the fourth quarter 2007 earnings call. (Operator Instructions) I would now like to turn the conference over to our first speaker, Mr.
Craig Watson, Vice President of Investor Relations. Please go ahead sir.
Craig Watson
Good morning, ladies and gentlemen and thank you for joining us on this conference call. Joining me this morning participating in the call are Paul Jones, Chairman and Chief Executive Officer; Terry Murphy, Chief Financial Officer; and John Kita, Controller and Senior Vice President of Finance.
Before we begin with Paul’s remarks, I would like to remind you that some of the comments that will be made during this 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. With that, Paul.
Paul Jones
Thank you, Craig and good morning, ladies and gentlemen. Our operating units performed well in 2007 given the difficult conditions in the housing market.
In spite of those difficulties, we generated record sales of $2.3 billion and earnings growth of 15% to $2.85 per share. Adjusted for $0.33 in non-recurring charges and $0.16 in tax benefits, we earned $3.02 per share above our forecast range of $2.95 issued at the beginning of the year.
As a result of the strong focus on working capital, we generated operating cash flow of $191 million or $119 million of free cash flow after capital spending. Sales at our water products operation in China grew 25% to $150 million, and along with strong sales of commercial water heating products, contributed to an operating margin of 10.5% in our water products business.
It was 11.9% in the fourth quarter alone. We also continued our margin enhancement initiative in our motors business with the 2008 plant repositioning actions announced at the end of the third quarter.
This morning, we established a 2008 earnings forecast of $2.70 to $2.90 per share which includes estimated restructuring expense of $0.25 per share. Adjusted for the charge, we are forecasting earnings of between $2.95 and $3.15 per share before restructuring.
Regarding the outlook for 2008, we believe the soft housing market will continue throughout the year and may be accompanied by a slowdown in the commercial construction market. In addition, stubbornly high prices for steel and copper continued to pressure our business.
All of these factors, including the restructuring in our motors business, will make 2008 another challenging year for A. O.
Smith, and thus our forecast of earnings similar to those generated in 2007. Terry will now talk about financial results in more detail.
Terry Murphy
Thank you, Paul. Good morning, ladies and gentlemen.
Sales increased 7% to $2.3 billion in 2007 and reported net earnings and earnings per share both increased 15%. Adjusted for $0.33 in restructuring charges and a $0.16 per share tax benefit, earnings were $3.02 per share, up 13% compared with an adjusted $2.68 a share in 2006.
I will discuss the unusual tax benefits for both the year and the quarter later in the presentation. Fourth quarter sales increased 5% to $570 million while net earnings declined 10% to $17 million or $0.55 a share.
Fourth quarter earnings included $8.2 million or $0.26 per share of restructuring charges and $0.06 per share in tax benefits. Adjusted for the restructuring charge and the tax benefits, earnings per share actually increased 7% to $0.75 a share compared with adjusted earnings of $0.70 a share in the fourth quarter of last year.
Looking at the segments, water products achieved record sales of $1.42 billion, a 13% increase over 2006 sales of $1.26 billion. The segment benefited from a full year of sales from GSW, increased sales of commercial water heaters and a 25% increase in sales in China.
In spite of selling price improvements to offset higher cost for raw materials in growth in the global market, sales in the electrical product segment declined modestly in 2007 to $894 million. Unit sales were negatively impacted by the weak housing market, most notably in the residential hermetic and pump motor segment, which more than offset improved sales in the commercial hermetic and distribution market segments.
Fourth quarter sales of $379 million of water products increased nearly 11% compared with the fourth quarter of 2006 due to strong sales of commercial and residential wholesale products and sales growth of 40% in China. Sales in the wholesale channel benefited from a pre-buy related to a January 2008 price increase.
At electrical products, fourth quarter sales of $192.4 million were 5% lower than the same period in 2006 due to weakness in its residential market segments, which more than offset growth in global markets. As we look at operating profits, water products recorded record 2007 profits of $150 million, representing a 23% increase over 2006.
A full year of sales from the GSW acquisition, sales of higher margin products and growth in China more than offset lower residential water heater volume and higher costs for raw materials and components. Operating profit margin increased to 10.5% in 2007 from 9.7% last year.
At electrical products, operating profits for 2007 declined to $23.1 million and included a restructuring charge before taxes of $22.8 million primarily associated with the planned 2008 closings of three manufacturing facilities. Operating profit was $48.1 million in 2006 and included pre-tax restructuring expense of $8.9 million.
Excluding restructuring expenses, the operating margin for 2007 was 5.1% compared with 6.3% last year. The lower operating profit and margin were primarily the result of a decline in unit volumes.
Corporate expense increased $5.6 million as a result of an increase in expense for discontinued operations, dispute with a software vendor and for pension adjustment and miscellaneous other increases. At water products, the strong fourth quarter sales of commercial product and growth in China generated a 33% increase in operating profit to $45.1 million compared to the fourth quarter of 2006.
Fourth quarter operating margins grew to 11.9% compared with 9.9% in the fourth quarter of 2006. Electrical products recorded an $18 million loss in the fourth quarter which included a $21.2 million pre-tax charge for restructuring.
Fourth quarter operating profit in 2006 was $9.3 million and included $3.1 million for restructuring. Excluding restructuring charges, operating profit at electrical products was $3.2 million in the fourth quarter of 2007 compared with adjusted profit of $12.4 million last year.
Operating margin at electrical products was 1.7% in the fourth quarter of 2007 compared with 6.2% in 2006. The lower operating profit and margin resulted from higher raw material costs and a decline in unit volumes that more than offset improved pricing.
Fourth quarter of 2007 also included a $4 million LIFO benefit related to lower inventory levels, which was mostly offset by an increase in the company’s bad debt reserve of approximately $3 million. Excluding one-time benefits, our normalized tax rate was 24.7% for 2007.
The one time benefits totaled approximately $5 million, equivalent to $0.16 a share, for the year and $0.06 a share for the fourth quarter. About $0.12 of the benefit related to the expiration of statutes to limitations on prior filing as well as completed tax audits.
The other $0.04 cents related to China investment incentive. In addition to the $0.06 benefit, the fourth quarter also benefited from lower taxes resulting from higher income in the lower tax jurisdictions of China and Mexico.
The effect of this benefit was approximately $0.03 a share. The favorable tax treatment in China and Mexico that we have enjoyed over the last few years will begin to expire in 2008.
We expect our tax rate to increase to approximately 26.5% in 2008. Operating cash flow of $191 million in 2007 surpassed expectations.
After capital spending of $71 million, free cash flow totaled $119 million. In addition to strong earnings, a sharp focus on working capital management at electrical products made a strong contribution to the record cash flow.
Total cash cycle days declined significantly to 57 days from 65 last year. Sharp reduction in inventory and improved accounts payable days more than offset an increase in day sales outstanding.
Depreciation and amortization totaled approximately $68 million in 2007 compared to $71 million in capital spending. Capital spending is expected to range between $85 million and $90 million for 2008 and the increase is primarily due to the water heater capacity expansion projects in China and the new facility for the Yueyang motor operation.
As a result of the excellent cash flow, our debt-to-capital ratio decreased to 34.3% from 39.1% at the end of 2006. We also purchased a total of 1 million shares in 2007 at an average price of $36.60 a share for $36.6 million.
This completed the million share authorization granted last February. In December, the Board granted an authorization for another million shares.
For 2008, we are expecting full year operating cash flow of approximately $150 million. As we announced at the end of the third quarter, we will close our operations in Scottsville, Kentucky and Mebane, North Carolina and consolidate our North American hermetic motor manufacturing operations in Juarez and Lacuna, Mexico.
We expect the transfer of work at both hermetic facilities to be completed by the fourth quarter of 2008. We will also close our motor facility in Budapest, Hungary by the end of the first quarter and transfer the remaining production to China.
We expect to generate savings of approximately $5 million in the later part of this year and annual savings of $20 million beginning in 2009 from these repositioning actions. The full year impact on operating profit is expected to add at least 200 basis points to the 2009 operating margin at electrical products.
Now, a little more detail on the costs for the restructuring initiative at electrical products. During the first nine months of 2007, electrical products recorded pre-tax restructuring charges of $1.6 million or $1 million after-taxes equivalent to $0.03 a share.
During the fourth quarter of 2007, we recorded $12 million of pre-tax charge or $8.7 million after taxes associated with the closing of the North American facilities and a writedown in the value of other assets. We also recorded a pre-tax charge of $9.2 million to close the Budapest operation and a $9.9 million benefit associated with the write-off of investment in that operation.
In the fourth quarter, the combined pre-tax charge was $21.2 million or $7.9 million after-taxes equivalent to $0.25 a share. For the full year, the restructuring expense at electrical products totaled $22.8 million before taxes or $8.9 million after taxes, equivalent to $0.28 a share.
In 2008, we expect to record an additional pre-tax restructuring charge of approximately $13.2 million associated with the above-mentioned facilities, equivalent to $7.9 million after taxes or approximately $0.25 a share. The expense is expected to be incurred relatively evenly throughout 2008.
In addition to the restructuring charges at electrical products, we also recorded a pre-tax charge at corporate of $2 million, or $1.2 million after-tax, equivalent to $0.04 a share in charges primarily related to discontinued operations. Now, Paul is going to talk about the outlook for 2008, and then we’ll open up the call for questions.
Paul Jones
Thanks, Terry. Throughout 2007, the impact of housing-related weakness was more than offset by strength in our commercial, Asian and Middle East businesses, and the positive impact of our ongoing cost reduction initiatives.
We are again forecasting lower unit sales in our residential businesses in 2008. Furthermore, we believe the weakness in construction could broaden and negatively affect our commercial businesses later in the year.
Accordingly, we are projecting commercial sales in the North American market to be no better than equal to sales in 2007. On a more positive note, we expect our businesses in Asia and the Middle East to continue to generate favorable results in the coming year.
The China water heater operation continues to post impressive results with sales growth of 25% to $150 million in 2007, and it continues to return double-digit operating margins. We expect that momentum to continue in 2008 with expected sales growth of 20% to 25%.
Last year we launched the next phase in their expansion. When this phase is completed by the end of 2009, we expect once again to have doubled capacity to more than 2 million units.
Our commercial hermetic motor operating in Yueyang and Suzhou are also making good traction and grew more than 20% in 2007. In Yueyang, we broke ground on a new facility that we expect to be up to speed by the middle of next year.
However, notwithstanding the bright prospects in China, we remain concerned with the outlook for 2008. The persistence of the soft housing market, the slowdown in commercial construction, stubbornly high prices for steel and copper will all continue to pressure our business in 2008.
All of these factors, including the restructuring of our motors business, will make 2008 another challenging year for A. O.
Smith. Accordingly, we expect earnings, including an expected $0.25 per share in restructuring for the motor business, to range between $2.70 and $2.90 per share.
Excluding the restructuring charge, earnings are expected to range between $2.95 and $3.15 per share compared with an adjusted earnings per share of $3.02 in 2007. With that, we are ready to take your questions.
Operator
Your first question comes from Andy Teller – Teller Research.
Andy Teller – Teller Research
As we go into a very challenging economy for the remainder of the year, Paul, what would you say are going to be your operational improvement initiatives regarding lean manufacturing, SixSigma and so forth?
Paul Jones
Well, I think we’ve got a pretty good record there of operational improvements. We are looking at not only efficiencies in the businesses, but also using our capital primarily for productivity projects and we have a lot of design initiatives.
So pretty much the things that we’ve been doing, maybe enhancing them a little bit, given the concerns about the economy.
Operator
Your next question comes from Ted Wheeler - Buckingham Research.
Ted Wheeler - Buckingham Research
Could you quantify or add some color to the impact of the pre-buy wholesale issue in the water products business in the fourth quarter?
Paul Jones
Well, we had a stronger-than-expected December and we think a lot of that was the pre-buy. We are also very pleased with what our sales group is doing there, not only on commercial, but the residential wholesale.
We are pleased with what Sears and Lowe’s have been doing in water heaters. We had a pretty good quarter even without affecting the pre-buy.
I would characterize the pre-buy as minor. We are actually off to a pretty good start this year so I don’t think it’s going to have a huge effect on our first quarter.
Ted Wheeler - Buckingham Research
I guess the third quarter sales were down, the fourth quarter sales were up nicely. If you look into the first quarter, would you think sales would be up or down in water products?
Paul Jones
Well, it’s too early to say. I would predict again, 80% of that business is replacement and that hangs in there fairly well for us.
As a matter of fact, given what’s going on in housing, the replacement market is probably more than 80% now for the water products business. But, my best guess as to first quarter would be flat volume.
Commercial is holding up very well so far. We are only three weeks into the year.
Ted Wheeler - Buckingham Research
On pricing, where are costs and where are prices? I know you don’t want to be specific, but if you could add some color on how that sits as you look at ‘08, the interplay between raw materials and product pricing?
Paul Jones
We’ve got a pretty good track record there. We are the only public company that reports on the water heater side, it’s a concentrated industry and I’m just not going to make any comments other than that.
We had 11.9% operating profit in the fourth quarter in our water heater business. We are not happy with that, we think it ought to be higher.
Ted Wheeler - Buckingham Research
Do you think that issue will be materially different from the good management job you did in ‘07?
Paul Jones
We have the same team working on it and they are always coming up with new ideas. I’m proud of what’s going on in both of our operations right now.
We have to take a little more longer-term approach at electrical products, but we are taking a long-term approach to water products too, it’s just that we’ve got some traction there that’s visible to the marketplace and the things going on in electrical products won’t be visible to the marketplace for several months yet, but they will be visible also.
Operator
Your next question comes from Scott Graham - Bear Stearns.
Scott Graham - Bear Stearns
I have questions about pricing. Recognizing, Paul, that you don’t give those numbers out any more, would you expect to increase prices in either or both divisions after this price increase that you are referring to in water heaters, that’s the recent one?
After this one, are you expecting more price increases from your businesses going out to the market?
Paul Jones
It’ll be driven primarily by what happens with steel, copper and other commodities -- maybe even freight -- and those will be the things that drive our decisions.
Scott Graham - Bear Stearns
Could you give us an idea of the receptivity of customers of this latest price increase beyond the pre-buy? Was this maybe the first time in a while you saw some pushback?
Paul Jones
I think we see pushback every time we try to raise prices, we do that with our suppliers.
Scott Graham - Bear Stearns
Recognizing that Paul, I think you know where I’m coming. You have a weaker market climate than we have had in some time and I’m wondering if the pushback intensity is higher now?
Paul Jones
I am not going to try to characterize that. I will say if you look the steel indices, the CRU index went up $149 a ton which is in my opinion unconscionable, but I guess greed is out there alive and well in the steel industry, because I don’t see any economic reason to have that big of an increase.
But like we have been doing all along -- us and our competitors -- we know how to deal with these things. We’ve had to learn in the last four plus years how to put these indices into our contracts so that we get automatic pricing on our motor side when things like this happen with copper and steel and other commodity indices when they move up.
Scott Graham - Bear Stearns
Are you changing the way you are buying or contracting to buy raw materials in 2008?
Paul Jones
No.
Scott Graham - Bear Stearns
The GSW acquisition, in hindsight, was a nice one from an earnings accretion standpoint and even though it has the preponderance of your sales in this market that has probably got some limitations on growth, nevertheless it seems to be a really good fit for you guys after all. You went out initially with this 60% to 70% accretion estimate.
Could you gauge where you are relative to that estimate? I know that you loathe to talk about specifics Paul, but whatever you can give us, bigger than a bread box type of stuff would be helpful, and where you see that number going over the next two years?
Paul Jones
Well, we are very pleased with the GSW acquisition and we got a lot more than a good solid business. We got a terrific management team.
We got some engineering talent that is paying off across our whole water heating operation. We have stopped keeping track of the synergies internally.
As synergies, we still have specific projects that are cost improvement related, new product performance, energy efficiency related. As a matter of fact, in our water heater operation we have the best stream of new products coming to market that we have had in a long-long time, because we’ve had the time to work on them, instead of working on all the regulatory compliance designs.
I am excited about the new products that we have coming to market. I think they are going to help us pickup some share as we go forward because we are going to have a value proposition for the customer base.
As far as the GSW, when you look at things like we have a new combustion chamber coming to market next quarter that’s going to go across to all the lines. We get a benefit from GSW because we have more volume because of GSW.
So when we have a certain amount of savings per water heater, we have more water heaters take that across. Is that a synergy?
Well, you probably could say it is, but in our opinion we have a solid water heater operation with good market shares, with a good set of customers and we are working with those customers to try to make our business and theirs to even stronger.
Scott Graham - Bear Stearns
The two other questions I would have is one on water heaters and one on motors. When you look at Lowe’s and the display at Lowe’s of the water heaters, it’s really very attractive and for you guys that’s obviously a winning strategy for both of you.
Whereas you go to Home Depot, truthfully it’s a nightmare with dust on the boxes, very little product shown and what have you. I am wondering, have you discussed anything cooperatively with Lowe’s to try to get people to see not only the number of SKUs and how they are described in what is a very high replacement market?
Have you discussed anything cooperatively with Lowe’s to sort of out this for you?
Paul Jones
Every day. We are in constant cooperation with Lowe’s.
We love them. They are doing a terrific job in the marketplace.
They are very focused on gaining share versus their largest competitor and they are doing a good job of it. We are in there working with them day-in and day-out on a whole array of things to try to help make sure that Lowe’s continues to be successful with their water heater business.
Scott Graham - Bear Stearns
Whereas the execution in water heaters continues to look quite good for you guys, the motors number, the margin was kind of an eyesore and I noted that the factors that you discussed related to that number, but it just doesn’t seem to explain the entirety of what I think was a 1.7% operating margin in the business. Which other than that period two or three years ago when you actually had losses in the business in the second half, I mean that was as bad as it gets.
I am wondering what gives you guys the confidence that the motors group is going to be able to pull off the restructuring seamlessly? What are you guys doing to monitor that and is there any way to do this thing faster than over a year’s time?
Paul Jones
Well, there are several questions there. I’ll only just talk in general.
The motors business is doing a lot of heavy lifting now. By the end of this year we will have redesigned over 60% of the product.
This is our lean initiative. It is one of those things you are not seeing but I see it every month or twice a month.
We typically visit that operation a couple of times a month. I am very pleased with the management team.
It has not shown up, but this group has done a phenomenal job. We will now have closed, I think by the time this was done 15 plants, within 12 to 15, I have lost track, within the last four-and-a-half years in that business and they have nailed the numbers.
They know how to move product, know how to get a move to lower cost manufacturing and I have tremendous confidence in that management team. It’s going to be clean in a year.
If we can do it faster, we are going to try to do it faster and we have a couple of ideas and a couple of initiatives maybe that could cause some of this to happen a little faster but right now we are just letting you know what we see and we are being our typical slightly conservative selves and we are going to keep encouraging and helping that management team do what they already know how to do. Our focus is on 2009 when we expect to have a significantly improved margin in the motors business, which is what we communicated to you three months ago.
We are still on track to achieve that.
Operator
Next we have the line of Mike Schneider - Robert W. Baird.
Mike Schneider - Robert W. Baird
Starting on water heaters, it was my understanding going back a couple of years that the steel issue and to some extent copper was resolved by negotiating or altering the contracts to be much more passthrough oriented. Can you discuss if that’s changed and why we are still talking about raw materials at this point in water heaters, given those contract changes?
The same question on the motors side of the business.
Paul Jones
Well, it really applies more to motors, Mike. We don’t have contracts with our wholesalers, so I don’t know where that impression came out.
We have sales agreements with them, but the water heater business when we have an announced increase, we announce an increase and it is across the board and that’s the way they get sold into the market. We do have something a little more definitive with our large retail customers, as you might expect, but the contracts and the indices changes are on the motor side and essentially with every one of our OEMs; from us and our competition, in 2004 we all learned how to do this.
We have all the pricing almost all set up on an index relative so that whatever our raw material costs are, we are able to recover that on the sell side.
Mike Schneider - Robert W. Baird
The commentary around the motor operating margin of 1.7%, some of the explanation was blamed on higher raw material costs and also lower volumes, the lower volumes are clear. But again, given your comments, why is it that raw materials are still hitting the motors business?
Paul Jones
Well, it hits distribution, we don’t have contracts there. Distribution is now $150 million of the business.
We have been consciously trying to grow that as much as we can. Again, we are constantly looking for ways to improve the margins there.
I can’t remember how many price increases we’ve implemented at both motors and water heaters, it’s been a lot. Some of them been design related, regulatory related, but the majority of them in the last four years have been relative to raw material prices, which have shot up dramatically.
We are going to continue to do what we’ve been doing.
Mike Schneider - Robert W. Baird
Sticking with motors, could you give us some commentary on the specific market slices within motors? What is running below or above expectations?
I presume distribution is still one of the principal areas of growth and then maybe the other segments if you could comment?
Paul Jones
I am going to be real general Mike because as you know, when we used to be more specific, our competitors loved it. So, I don’t want to give them any more help than they are already getting.
The things that are performing well are commercial hermetic. I think it was up over 20% in the quarter.
We are doing very well in the Middle East with that product as well as in Asia as well as in the US. Distribution has had a real good year and we’ve picked up another couple of pieces of business that we are going to fold in this year.
It will not surprise you that the disappointments would be residential hermetic -- again that’s a [inaudible] comment -- and the HAC was off in the fourth quarter significantly, not because we lost any customers, but our customers were taking some time off. The majority of HAC factories took a lot of time off over the holidays.
I think all but one that we serve didn’t start production till January 7, they even took the first three days of January off. So, little bit of an effect on the fourth quarter and a little bit in the first quarter.
Mike Schneider - Robert W. Baird
Is the change in mix in that it’s greater distribution each quarter, is that also laying on the margins for the overall segment?
Paul Jones
What do you mean Mike? I didn’t understand that.
Mike Schneider - Robert W. Baird
Is the growth in the distribution piece of the business actually laying on the margins or depressing margins for the segment?
Paul Jones
It helps the margins.
Mike Schneider - Robert W. Baird
It helps the margins?
Paul Jones
Yes, pretty much.
Mike Schneider - Robert W. Baird
Inventory, cash flow was strong. Is part of the explanation inventory reduction efforts as far as the margins go in the motors business as well during Q4?
Paul Jones
Yes, it is. Once again the motors business generated over $80 million in cash flow and when you figure only $20 million out of that was related to operating earnings that says what they have done.
We have been putting in a new operating system there and one thing you get with a new operating system is you learn some things you didn’t know before and we have got some real good data. We are using that data to help schedule and run our factories better and they are taking a lot of inventory out.
Did we take some absorption hits because of that? Sure.
Gladly by the way. We are delighted to have the cash flow and they understand that anytime they can take inventories down, we will take the absorption hit to do that.
So, there are a lot of moving parts there Mike, a lot of things lying there. I think your question was whether we have some increased cost of absorption that has lowered the operating margin and the answer is yes, we did.
Mike Schneider - Robert W. Baird
Do you believe you are complete with that process or is Q1 another quarter that suffers under absorption?
Paul Jones
I think we always have opportunities on working capital and we are going to keep looking at it. Granted the last three years have been pretty good years for working capital for us and at some point we are not going to be able to keep getting our cash cycle down to 57; 65 to 57 was a terrific accomplishment.
I think I would be way out there if I thought we could do that again, because essentially low-hanging fruit, a good portion of that is already done. But we are still focused on working capital.
We still believe, last year we started the year saying $150 million was our internal plan, we are saying that again this year. If we can do better than that, I assure you we will.
Mike Schneider - Robert W. Baird
Looking into ‘08 now for the motors division, can you give us a sense, knowing that there are some very easy comparisons because of housing in ‘07, I guess what segments you would actually expect maybe the greatest growth in units and then what segments of the motors business you would expect probably to be most challenged in unit growth in 2008?
Paul Jones
Asia is going to be very strong we believe. US commercial is still going very strong so far this year.
Our order rate is essentially the same as it was at the end of last year or all of last year, which was a strong year. I think HAC will be challenged simply due to the new construction.
The replacement piece is an area we are focusing on. We expect that will continue to go well.
We think probably pump will be challenged and of course residential hermetic will be challenged. On the other side of it, I talked about the new products coming online at water products.
We have some pretty exciting motor products coming online. We do have an initiative going on on ECM, it will announce a few units in late ‘08, but it could be a significant portion of our business in ‘09 and beyond.
We have some high efficiency products coming to market that we think can command some premiums and time will tell whether we can achieve that, but I’m frankly excited about some of the new products we have coming along.
Mike Schneider - Robert W. Baird
Terry, sticking with motors, the LIFO benefit I presume was because of the delayering in the inventory reduction efforts?
Terry Murphy
Yes.
Mike Schneider - Robert W. Baird
The bad debt reserve, can you explain now what that relates to?
Terry Murphy
There were two small customers, both had some economic problems and the total accrual was somewhere in the $3 million neighborhood for these two customers, neither of which were real large customers.
Mike Schneider - Robert W. Baird
Just looking at both businesses, do you guys have an implicit housing assumption or housing starts assumption for 2008?
Paul Jones
Our assumption on housing starts is around 1.1 million. I actually have challenged the businesses to putting contingency plans at a lower number.
I think when we put our budget together in November that’s what we targeted on, but I think we are already possibly expecting -- maybe we are reading too much of the press, I don’t know – but we are expecting a lower number than that.
Mike Schneider - Robert W. Baird
China, just to finish on a positive note, great growth, I presume still one of your most profitable businesses. Looking into ‘08 now as the growth continues, can you talk about margins looking forward for that specific segment/ What I’d like you to specifically address is the cost now going from tier 1 cities to tier 2 cities and then maybe just the additional capacity and overhead burden that you have got, I presume as you doubled, and are in the process of doubling capacity again?
Paul Jones
I will make an announcement during this, we actually built over 1 million water heaters last year. We crossed the million mark right at the end of December.
Very good growth in that business, it’s going to continue to grow. The capacity we are bringing online is to take us over 2 million units in ‘09.
We will have some of that capacity online late this year. It looks like we are going to need it, which is good.
Margins continue to be in the teens. That’s all I’ll say about it.
I think the management team there is managing the cost side of that very well. Again, lots of new products, we are constantly bringing on new products, which gives us an opportunity to put a new margin point out there, a new price point on these new products and that business is going well.
I will also point out that our motors business is growing significantly in Asia, a lot of it is exports out of China to the Middle East and some to Europe and that business has very good margins. The Yueyang operation, which is growing dramatically, but it’s just small proportionately, but our water heater business used to be small too and it’s got higher margins than the water heater business.
I hope that’s enough color because that’s all I’m going to give you Mike.
Operator
Our next question comes from the line of Matt Summerville - KeyBanc.
Matt Summerville - KeyBanc
Paul, I’ve listened to all of your comments on pricing, raw material costs and I have to be honest; it’s still unclear to me if you believe you are in parity right now in the water heater business with the increase you’ve gone out with and maybe you can talk about wholesale versus retail? And then in the motor business, with copper where it is right now, do you believe you are in price parity here in early 2008?
Paul Jones
Operating margins in our water heater business went up about a point last year and we are expecting those margins to continue to expand. On the motor side, we buy about half our copper along with our customers, specific customers.
So obviously we are in parity there when we do that. The other half of our copper we typically hedge as do all of our competitors and I think we, like them, they have done a pretty good job there.
Matt Summerville - KeyBanc
Did you go out with the price increase in your motor business? You mentioned one in water heaters?
Paul Jones
Yes.
Operator
Your next question comes from Jeffrey Matthews - RAM Partners.
Jeffrey Matthews - RAM Partners
I am not asking for names, I am just trying to understand the type of company that you had said they were small but that you have bad debt reserves on?
Paul Jones
They are both on the motor side of the business, both small companies on the motor side of the business. They are OEM customers of ours, so we supply a motor that goes into a system and it’s probably not companies you would even recognize and know of; very small.
Terry Murphy
And each of the companies made up about half of the bad debt accrual.
Jeffrey Matthews - RAM Partners
International, U.S. or no geographic issue?
Terry Murphy
U.S.
Operator
Mr. Jones, there are no further questions.
Please go ahead with any closing remarks.
Paul Jones
We appreciate everybody’s interest in the company. As always, give us a call with questions, but thanks for your time today.
We appreciate it.