Oct 17, 2012
Executives
Paul Jones -- Chairman and CEO John Kita -- CFO Ajita Rajendra -- President and COO Pat Ackerman -- VP, IR and Treasurer
Analysts
Matt Summerville -- KeyBanc Capital Markets Scott Graham -- Jefferies Mike Halloran -- Baird Sanjay Shrestha -- Lazard Capital Markets William Bremer -- Maxim Group Ryan Connors -- Janney Montgomery David Rose -- Wedbush Securities Samuel Eisner -- William Blair
Operator
Good day, ladies and gentlemen, and welcome to the A. O.
Smith Corporation Third Quarter 2012 Earnings Call. At this time, all lines are in a listen-only mode.
Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions).
As a reminder, today's conference call is being recorded. I would now like to turn the call over to your host, Pat Ackerman, Vice President, Investor Relations and Treasurer.
Please begin.
Pat Ackerman
Thanks, Shawn. Good morning ladies and gentlemen and thank you for joining us on our third quarter 2012 conference call.
With me participating in the call are Paul Jones, Chairman and Chief Executive Officer; Ajita Rajendra, President and Chief Operating Officer; and John Kita, Chief Financial Officer. Paul will begin with our presentation this morning with our third quarter highlights.
John will then elaborate on our financial results and Ajita will wrap up with our outlook and acquisition strategy update. Before we begin with Paul'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.
Paul, I will turn the call over to you.
Paul Jones
Okay. Thank you, Pat, and good morning ladies and gentlemen.
I'm going to start off with an apology. I've got a cold and my voice will probably come and go, but I'll try to do the best I can.
I feel like I got my head in a trashcan talking. But in the third quarter, we continued to see improvement in sales and earnings as a result of our acquisition strategy and global footprint.
Here are a few highlights. Our organic growth and acquisitions drove sales 12% higher to $462 million.
Lochinvar acquired in the third quarter of last year achieved $63 million in revenues. We are seeing normal seasonality in boiler volumes as our customers prepare for the hydronic heating season in the US.
In China, our sales of A. O.
Smith branded products grew 22%. Our earnings improved to $0.71 per share, which excludes a $0.08 gain related to an adjustment to Lochinvar earn-out.
Lochinvar continued to contribute significantly and meet the high end of our profit expectations. We met with many of you in late September at our Analyst Day in Nashville where we presented our 2015 growth aspirations as well as showcased our manufacturing excellence.
To those of you who attended, we thank you for spending the day with us. Our slide deck from the day is currently available on our website.
Last but not in any way least, I'm very pleased that our Board named Ajita Rajendra as my successor and the CEO role beginning January 2013. Ajita and I have worked together at A.
O. Smith and at prior companies and he is an outstanding leader and manager.
He and I developed the strategy we laid out at our Analyst Day last month together and Ajita is committed to it. I plan to serve the company and its shareholders in the role of Executive Chairman at least through 2013, and I have complete confidence in Ajita and our whole operating team.
This positive transition will be seamless and positive for our company and shareholders. John, I'll now turn the call over to you to elaborate on our third quarter results.
John Kita
Thank you, Paul. Sales in the third quarter of $462 million were 12% higher than the previous year.
Lochinvar, which we acquired in August last year, added $63 million in sales compared with 21 million last year. Sales of A.
O. Smith products in China grew 22% to $109 million.
Adjusted earnings of $0.71 per share were 82% higher than last year when the $0.08 per share Lochinvar earn-out adjustment 2012 and the $0.19 per share net gain for several one-time items in 2011, as excluded from the comparison. Third quarter earnings per share also benefit from a decline in the world wide effect of tax rate to 29%, primarily as a result of larger than anticipated deductions available for US domestic manufacturing activities.
Let me take a minute to explain the earn-out adjustment. We call that under the terms of the Lochinvar purchase agreement, Lochinvar shareholders than earn up to an additional $35 million that certain revenue objectives were achieved from December 1, 2011 to November 30, 2012.
At the time of the closing, the company projected the earn-out to be $16.8 million due to an estimated 16% increase in sales over the prior year. Based on the current estimate of a 12% increase in sales, the earn-out is projected to be $10.4 million resulting in a pre-tax gain of $6.4 million that was recorded in the third quarter.
Sales in our North America segment of $336 million increased 8% over last year. This segment includes our US and Canadian water heater and boiler businesses.
In addition to incremental sales of $39 million from Lochinvar in North America in the third quarter, we experienced higher volumes of commercial water heaters in the US. Lower sales of residential water heaters and tankless products in the US, more than offset higher US commercial volumes.
Based on our shipments, we estimate industry shipments of residential water heaters were down mid-single digits during the third quarter. The result of our China, India and Europe businesses are captured in our rest of world segment.
Segment sales of $134 million increased 21% compared with last year, due to a 22% increase in sales of A. O.
Smith branded products in China. Our growth in China is driven by several factors.
Our distribution channel continues to grow. Our premium brand continues to gain market share and our gas tankless and water treatment products are growing faster than out overall business.
North America adjusted operating earnings of $44 million was $13 million higher than last year. The adjusted result excludes the $6.4 million benefits from the adjustment to the Lochinvar earn-out.
The Lochinvar acquisition added $15 million to operating earnings in the quarter compared with $3 million last year. In addition, the segment benefited from higher commercial volumes and material costs which were lower than the relatively high levels last year.
These benefits more than offset the volume decline in residential water heaters. As a result, the segment's adjusted operating margin improved significantly to 13.2% in 2012.
Rest of world operating earnings of $13 million improved 41% compared with last year, driven by China, higher China sales and lower losses at our water treatment business. As a result, operating margin improved to 9.5%.
Our corporate and other expenses were $9.5 million, essentially the same as last year or adjusted for the benefit from the RBC share activity net of Lochinvar professional fees in 2011. Total operating profit, excluding these one-time items, improved 57% to $47.5 million.
Cash provided by continuing operations was $101 million at the end of the third quarter compared with cash used by operations of $68 million last year. 2011 cash flow through September included an approximately $140 million after-tax contribution to our pension plans.
Our liquidity position and balance sheet remains strong. Our debt to capital ratio declined to 19% compared with 30% at the end of 2011.
We have sizable cash balances located offshore, primarily related to the sale of electrical products and our net cash position was over $200 million at the end of September. We project our cash flow from operations for 2012 to be between $155 million and $165 million.
Our capital expenditures are expected to be $65 million to $75 million, which includes approximately $35 million for capacity expansion in China and India to meet growing demand for our water heaters. Our depreciation and amortization expense is expected to be $55 million this year.
I will now turn the call to Ajita who will summarize our outlook and acquisition strategy. Ajita?
Ajita Rajendra
Thank you, John. Given our strong performance in the third quarter, we raised our expected 2012 EPS guidance to be between $2.85 and $2.95 per share.
Our guidance does not include the impact from future acquisitions, again related to the sale of our RBC shares or the adjustments in the Lochinvar earn-out. Our outlook for 2012 includes the following assumptions.
First, we continue to remain positive on our growth in China. We expect our growth of A.
O. Smith branded products for the full year to be over 15%.
We expect China sales in the fourth quarter will be approximately 10% compared with 19% in the first nine months. The growth rate in the fourth quarter will be impacted by more difficult year-over-year comparisons as well as our belief that some of our distributors as carrying larger inventories than normal as a result of promotions related to our new product introductions and a weaker holiday season for water heaters in late September, early October of this year compared to a stronger season last year.
Second, we expect Lochinvar to continue to benefit from the transition from lower efficiency, non-condensing boilers to higher efficiency condensing boilers. Lochinvar's market leading condensing boilers continue to offer a compelling payback in the form of energy savings and the company has built a reputation for innovation and product quality.
The new line of Crest boilers launched last year exemplifies this reputation. This new line of condensing high efficiency boilers expands the Lochinvar portfolio to larger BTU input models and has gained excellent market acceptance.
As a result, we expect Lochinvar's growth rate in 2012 will be approximately 10% well ahead of GDP growth in the US. Third, our commercial volumes are higher than we expected so far this year and therefore we expect commercial water heater volumes in the US to remain at approximately 2011 levels.
We do not expect to see the benefit from new residential construction in our volumes this year as water heaters attract more closely with housing completions than starts. We estimate our residential industry shipments were down over 100,000 units in 2012 through September.
As a result of what we've seen so far this year, unit volumes for the full year could be 1% to 2% lower than last year. And forth, given the challenging macro environment in the eurozone, I want to remind you that we have minimal exposure in that region.
I want to now move from the outlook to our strategy. This is an exciting and transformative time for our company and the acquisition of Lochinvar represents a significant first step in building our global order platform.
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 solutions is very active. As we presented at our Analyst Day, we expect to grow organically over 7% per year which will result in $2.4 billion in sales by the end of 2015.
Adding our dry powder and making some assumptions about acquisitions, we expect to achieve revenues in excess of $3 billion, one-third of which will come from higher growth emerging regions of the world. Using these growth assumptions, we expect earnings to reach $5 per share in 2015.
Based on our core competencies, our strategic focus for growth is simple; hot water and clean water. We are pursuing actionable acquisitions to backfill these two areas around the world and particularly in developing and emerging geographies.
We are also pursuing acquisitions which expand our core product line. We are particularly keen on products and technologies that offer energy and water efficiency gains.
And finally, we are considering water-related adjacencies which can leverage our distribution and brand equity to provide value to our shareholders. Our integration of Lochinvar is essentially complete.
We have the human capital, financial resources and strategic focus to continue to add companies to our global platform which creates shareholder value and our business development teams are pursuing opportunities all over the world to do just that. One final point on geographic expansion, which I think is worth reiterating.
We are somewhat unique given our size to operate such a strong platform in China and a strengthening platform in India. These investments made over many years have proved to be very rewarding.
These two countries are by far the largest emerging and fastest growing regions in the world. We continue to look for opportunities in these markets to leverage our brand and distribution capabilities.
In addition, we are also exploring the suitability of these two platforms to serve as export basis to other smaller yet fast growing markets in Asia, Africa and the Middle East. And finally, we continue to pursue acquisition candidates which presently operate in other fast growing regions around the world to further compliment our platforms in China and India.
And finally our investment criteria, you've seen this before, we show this only as a reminder that we will be a financially disciplined acquirer. Our transactions will be focused on creating returns for our shareholders.
Those are the end of our prepared remarks and now we'll open the phone lines up for your questions.
Operator
Thank you. (Operator Instructions).
Our first question comes from Matt Summerville of KeyBanc. Please go ahead with your question.
Matt Summerville -- KeyBanc
Thank you. First, I want to talk about in North America how we should think about your product mix progressing through the fourth quarter with a couple of moving parts, Lochinvar benefits from favorable seasonality, in residential you have tough comps but in commercial you also have tough comps with last year's pre-buy.
So how should we think about mix in Q4 relative to what you saw in Q3?
Paul Jones
Well, Lochinvar traditionally third and fourth quarter are pretty comparable depending on the preseason buy in, et cetera. So we wouldn't expect a lot of difference between third and fourth quarter actually to be down a little bit in fourth quarter because we do think there was probably an early pre-buy.
So that will come into play. Certainly, we do have a tough comp because of the pre-buy in commercial and we would expect that to be lower than last year's commercial level by quite a bit as we talked about.
Residential, you can see by numbers we talked about the third quarter was down, somewhat unexpectedly. We expect the third – the fourth quarter to be fairly comparable to the prior year from a residential standpoint.
Matt Summerville -- KeyBanc
Okay. And then if we think about – you had very good incremental margins in North America in the quarter.
They've gotten better all year. In rest of world, they sort of fluctuated in that 10% to 20% range.
What needs to happen to get the incrementals in rest of world, maybe in more firmly into say a 20% to 30% range on a ongoing basis?
Paul Jones
I think on an ongoing if you recall, we said our objective for rest of world at our Analyst Day was to be at 13% level at 2015. We think we'll see improvement in India as we go forward, as we get some volume improvements there.
We've also talked about SWT reductions and the operating losses there. So I think those two will be the biggest components.
The China operating margins continue to be pretty steady. They were comparable to last year, a little bit down from the second quarter, but there were a couple of one-time items that affected them in the second quarter – in the third quarter, I'm sorry.
So I think it's the combination of all three business units continuing to progress.
Matt Summerville -- KeyBanc
And then just maybe two more questions on China and then I'll hop off. With regards to, I'd say it was 109 million you mentioned in China A.
O. Smith branded products sold in China, how does that breakdown between the water heater business and Shanghai water really trying to track the progress on the later?
And then with regards to same-store sales, can you comment on what your experience was tier 1 versus tier 2 and tier 3 and how's it deferred relative to the prior quarter or two? Thank you.
Paul Jones
On the water treatment we've talked about that the sales last year were about $8 million through A. O.
Smith branded. We expect those to be more than double in the 18 million to 20 million range.
So we've had pretty steady improvement on the water treatment and that's what it's benefiting. I'm not sure, what was the second question there?
Matt Summerville -- KeyBanc
Same-store sales…?
Paul Jones
Same-store sales are up slightly. I don't think the story has changed much.
Tier 1, there were up a little bit more than they were last year's numbers. So that's a little bit of improvement because we have been running flat.
Tier 2 cities are still running positive but as we talked about, they are running 20% plus last year and that number has been coming down. So we're still seeing some improvement in same-store sales.
Matt Summerville -- KeyBanc
Thanks, guys.
Operator
Our next question comes from Scott Graham of Jefferies. Please go ahead with your question.
Scott Graham – Jefferies
Good morning.
Paul Jones
Good morning.
John Kita
Good morning.
Scott Graham – Jefferies
So I was just wondering what your – maybe two housekeeping questions, what your full year tax rate is going to look like?
John Kita
Well, it's been running kind of year-to-date, we would expect the fourth quarter is going to be around 30%. We've had some variation in the tax weight rate without a doubt, I think it was 28% plus first quarter, 30%-some second quarter and now the average is 29% this year, so this quarter.
So we're expecting about 30% to be the best guess for the fourth quarter.
Scott Graham – Jefferies
Okay. And on the other income line, that is I assume interest income from the cash balance?
John Kita
Yes, that's primarily an interest income from the cash balance.
Scott Graham – Jefferies
Okay. But could you also tell us what kind of the first couple of weeks in October look like in resi water heaters in the US?
Paul Jones
Yeah, this is Paul. We're off to an okay start that's about all we'll say.
If I could, the industry data as you follow – sometimes it has some really wide fluctuations and so we tried to look at it on a rolling average basis, where one month can be off double digits and next month could be up double digits. We just keep operating business as usual through those cycles.
Scott Graham – Jefferies
Okay. Are you sensing a different tone in the channels with your customers, maybe a little bit more optimism in that these positive resi data points are maybe gaining momentum or no change in tone?
Ajita Rajendra
Scott, this is Ajita. We sense a little bit of positive.
There are the ups and downs, but overall people are feeling little more positive than they were feeling before.
Scott Graham – Jefferies
Very good. Our last question is on Suning and GOME to your knowledge, is there any even inflection in tone from the management teams of those companies about a change in store built plans?
Paul Jones
No. I mean they've announced earlier they've slowed down and that's to be expected and they're working on the quality which frankly we see as positive.
They're starting to actually close a couple of stores non-performing or poor-performing stores and which we think it means they're running their businesses very well. They're looking – making sure that where they had their capital investment, they're getting a return.
But they obviously are affected by the slowdown in China. You can see the data.
It's available out there and they're affected by that. The good news is the water heater business and some of their other appliance lines continue to do very well.
Scott Graham – Jefferies
Right. But they're not indicating to you anything incremental from that chain versus that change?
Paul Jones
No, they're sticking to the same thing they had before. Ajita, do you want to add to that?
Ajita Rajendra
No, that's essentially right. I was in China a few weeks ago and met with some of their top management and they see the slowdown and they're managing through it.
And as Paul said, shutting down some of the non-productive stores we see as very positive because it's volume that doesn't have a lot of profitability for us if we lose any volume and it's picked up by the other stores. So all that is very positive.
Scott Graham – Jefferies
Very good, thank you.
Operator
Our next question comes from Mike Halloran with Baird. Please go ahead with your question.
Mike Halloran – Baird
Good morning, everyone.
Paul Jones
Good morning.
John Kita
Good morning.
Mike Halloran – Baird
So can we talk about inventory levels, I know with the pre-buy the inventory levels spiked up and you were expecting a little bit longer tail and I'm assuming that was part of why the volumes were a little tough here in the quarter on the residential North America's side. Can you talk about how that trended through the quarter, if you've worked it off now and what the growth or the volume trends look like as you move through the quarter?
Ajita Rajendra
Yeah. We feel the inventories have worked themselves just out of the system.
We were a little surprised at the lower residential volumes that we saw in September. But as Paul said that sometimes with a one month, we don't really pay a lot of attention to it and on the other side we were frankly very positively surprised by the strength in the commercial side of the business.
So overall, things are moving along just as we have been seeing.
Mike Halloran – Baird
Are you seeing any differences in the wholesale versus retail channels at this point and talk a little bit about the competitive dynamic?
Ajita Rajendra
The wholesale is showing a little more strength than retail and retail inventories are a little bit on the lower side and they're managing them low. But we see that as a short-term type of cycle.
Mike Halloran – Baird
And then last question on India, could you just comment on how that's tracking relative to the expectation so far this year to the third quarter and what the profitability outlook looks like, as you move forward?
Ajita Rajendra
Yeah, the volumes are down and for a couple of reasons. One is that the rupee has devalued about 18% from when we planned this, so that's impacting us negatively.
And we ran into some issues in terms of our supply chain and installing some equipment as we were expanding our line and going into our good, better, best strategy. So that held us back a little bit.
But all those issues are behind us, not the currency issue but the operational and the supply chain issues are behind us. But the really good news is that the brand and the product continues to be very well accepted in the marketplace.
And so we'll be seeing 20% plus growth this year, not where we expected it to be because of the issues that I indicated to you. But the product is very well accepted and showing a lot of strength in the marketplace.
Mike Halloran – Baird
I appreciate the time.
Operator
Our next question comes from Charley Brady of BMO Capital Markets. Please go ahead with your question.
Unidentified Analyst
Good morning. This is Andrew (inaudible) for Charley Brady.
Paul Jones
Good morning, Andrew.
Unidentified Analyst
I had a question regarding the earn-out, just kind of what made up the difference between 15% expected when you closed and 12% now?
Paul Jones
When we closed they had a very aggressive internal plan and we said fine and we tracked our earn-out according to that. Internally, we – as you know, we're conservative.
So we took a little more conservative approach. We were hoping they would hit their plan because every dollar of revenue that they achieved in this earn-out was good for our shareholders and the shareholders win throughout the whole process but we're just adjusting to a little more realistic date.
We're not disappointed at all. The folks at Lochinvar have done a fantastic job and we're delighted with how well that business is doing.
It's just when you have a supper aggressive plan that there's about a 10% chance to hit, 90% of the time you don't hit it and that's – and with a bright light of hindsight that's the way we're seeing it right now.
Unidentified Analyst
Okay, great. Understandable.
The next question was just kind of Lochinvar's margins, I think in the past you've mentioned that prior margins before the acquisition were about like 20% EBIT. Do you guys seem like you will hit that kind of minus the earn- out this year (inaudible) this quarter?
John Kita
Actually their profit margin was up significantly this quarter, almost 25% -- I think 24.5%. So they had an excellent quarter.
And that's just a function of the higher volumes contribute very well.
Paul Jones
Mostly cost reductions…
John Kita
And the cost reductions as Paul said, the synergies we achieved that had pretty much all been in by the third quarter. So I think it's that combination but clearly the volumes helped them.
Unidentified Analyst
Okay, thank you.
Operator
Our next question comes from Sanjay Shrestha with Lazard. Please go ahead with your question.
Sanjay Shrestha -- Lazard Capital Markets
Great, thank you. Good morning, guys.
Ajita, first of all, congratulations on your new role for '013.
Ajita Rajendra
Thank you.
Sanjay Shrestha -- Lazard Capital Markets
My first question is on China since you just came back from there. So is there any incremental talk about introducing some type of a stimulus program and maybe actually impacting sort of your sales out for 2013?
Ajita Rajendra
They talk about it and the government has been talking about it and they have introduced some programs, but I think all of that is tied into their outlook and what's happening out there right now. They also feel very positive.
This is internally about the changes happening in the government and the leadership, and feel that the right programs will be put in place to get the economy back. They have been pushing that out because earlier on this year they said the second half will be stronger.
Now they're pushing it out to next year. But they overall feel that the government will have the right programs in place.
Sanjay Shrestha -- Lazard Capital Markets
Okay, got it. And now shifting gears back to North America, right, so when we really look at (inaudible), this is also a mixed issue in the quarter, even excluding Lochinvar margins for the traditional North American business look pretty good and how much of a benefit did you guys get from the lower input cost in the quarter, and can we expect that, this is the new level of the margins going forward, there was some raw material benefit that you saw in the quarter which actually ended up hurting the margin a bit in Q3?
Ajita Rajendra
Well, we definitely got some benefit from the raw material as we talked about that – the raw materials are down from very high levels last year, third quarter, but we also got some help from commercial. I mean commercial was much stronger this year than last year, so I think those were the two biggest contributors to the margin improvement, ex-Lochinvar obviously.
And the operations are running very well.
Sanjay Shrestha -- Lazard Capital Markets
Great. So on the commercial side, right, guys, it's done better than expectation given the sort of flattish on a year-over-year basis.
Is that a phenomenon that that segment of the market is relatively healthier, is it one of those dynamics as energy efficiency getting [good] attractions, so payback is better and interest is sort of embracing that and that's why this trend will continue and sort of get better if anything going forward. How should we think about that?
Ajita Rajendra
Yeah, I think that's exactly the way to think about it is the energy efficiency suddenly having an impact and especially on the commercial side where the payback is much more obvious. People are making the investment and we feel very positive about that because we have the products that can leverage that.
Sanjay Shrestha -- Lazard Capital Markets
Okay, great. Well, one final question I have to ask is I don't know how much color I'm going to get on it, but since the Analyst Day, you guys have been very disciplined about going out for the acquisition, but if you were to sort of think about what's in the pipeline from a size standpoint or the level of discussion where it is right now, can you give us any incremental color as to sort of what is the size like, what is the level of discussions or talking now, where are we, anything incremental you guys could share with us would be great?
Ajita Rajendra
Well, thanks for asking the question everybody else wanted to ask. But obviously we can't show our hand.
With regard to the acquisition pipeline, we continue to have active conversations with Japanese and both the US and in emerging economies that have a growing middle class. We've identified these regions in the past; Asia, Middle East and Sub-Saharan Africa and we have nothing else that we can add at this point.
Sanjay Shrestha -- Lazard Capital Markets
Okay, fair enough. Thank you so much guys.
Operator
The next question comes from William Bremer with the Maxim Group. Please go ahead with your question.
William Bremer -- Maxim Group
Good morning.
Paul Jones
Good morning.
William Bremer -- Maxim Group
Congratulations Ajita.
Ajita Rajendra
Thank you.
William Bremer -- Maxim Group
My first question let's go back to Lochinvar, North American sales were a little bit over 50 million, altogether 63 million. What is the strategy to roll this out globally and really leverage the AOS name in distribution?
Ajita Rajendra
One of the positives in terms of value creation with Lochinvar was the ability to take this product to other markets where we can leverage not only our brand but also distribution capability and service networks. So we are actively working on that.
It is something that this product – the Chinese market which is the first area we would be looking at is not quite ready for this product. This type of application is handled by Cast Iron Boilers and much more regional type players.
And what we're trying to do is to set up the distribution and the channels that can take this product to market. So there are teams from China who are – who have come here for training.
In fact they have a Lochinvar team as we speak in China, gone the other way in terms of looking at the market and looking at how best we can build this. So it's a definite opportunity.
It's not going to be something that's going to come right away. It's going to come in the next year or so and onwards from there.
William Bremer -- Maxim Group
Okay. And then on the water treatment, can you give us some – a little more color in terms of the underlying product that are now in China that you may be rolling out into all the geographic areas around the world?
Ajita Rajendra
Yeah, we've introduced some new products in China. One is the site stream which has much higher efficiency [RO] type of filter.
And this is unique to us, it's a patented product and we charge a higher price for it and it's doing very well in the market. We've just introduced it, lots of promotions, just introduced it.
And under the A. O.
Smith brand and that's one of the things that's driving the A. O.
Smith brand to be double what it was last year. So we see lots of positive things happening on the water treatment side.
On the SWT side of the business, obviously that sale we had the major issues in the past and that's making improvement, not as fast as we'd like, but making improvement. I anticipate this year that our sales will be up about $3 million and our pockets will be up about $3 million, still negative but it is an improvement from last year.
William Bremer -- Maxim Group
Okay, that's good to hear. And then Paul, maybe a little housekeeping, maybe this goes to John.
The corporate expense 9.5 million, is that a good run rate going forward, do you see things possibly tweaking up a little or there maybe some additional streamlining that can occur over the next couple of quarters?
John Kita
I think it was a little bit lower this quarter. We have a couple of accrual adjustments, et cetera.
I think we had been running the first half of the year at 10.5 million to 11 million a quarter and I think that's a reasonable run rate going forward.
William Bremer -- Maxim Group
10.5 million to 11 million, okay, versus the 9.5 million that we just came through right now, okay John. All right, great.
Thank you.
Operator
Our next question comes from Ryan Connors with Janney Montgomery. Please go ahead with your questions.
Ryan Connors -- Janney Montgomery
Thank you. Good morning.
Paul Jones
Good morning.
Ryan Connors -- Janney Montgomery
I had a question, it's a comprehensive call, so most of my questions have been answered at this point, but I did want to talk a little bit about the pricing environment in China. I know obviously from your comments you're comfortable on the volume outlook there, but I wondered if you could talk a little bit about the pricing side in the Chinese market?
And I guess a related question would be your strength on the higher end of that market, you talked about $400 plus being a sweet spot. Is that a segment of the markets that – does the outlook there differ from the lower end segments given the economic macro headwinds there?
John Kita
Our pricing in the past – let me go a little back in history. In the past before the last two years, we've never really raised prices.
We introduced new products with new features and benefits and drove our margins up through the new products and new features and benefits. The last two years, which is 2011 and 2012, we have increased prices on existing products and the price increases have stuck.
So that's the good news. And during that time we've also gained market share in that higher price segment.
So we've been able to drive that because – again, because of the strength of the brand and the new products and we continue during this time to introduce new products with new features and benefits. So all of that has helped to build the equity of the brand and for us to be able to sustain those prices, and the pricing is wholly.
Now I don't want to imply that increasing prices in China is easy and can be done at any time, but so far the prices are holding and our position in that higher end is very strong and we continue to slowly increase our market share.
Ryan Connors -- Janney Montgomery
Okay, (inaudible). And then also just you talked about the corporate line item in the previous question there, if you could kind of give us a similar analysis on SG&A, it's kind of being trending up sequentially.
Should we expect that to continue or do you think that that's kind of leveled out here and you'll be able to leverage that going forward?
John Kita
I think it was a little higher this quarter mainly because of the residential, et cetera. We still have most fixed SG&A costs and sales were down.
I think the year-to-date run rate is 23% and I think that's probably a reasonable percent as we look into the fourth quarter.
Ryan Connors -- Janney Montgomery
Okay, great. That's very helpful.
Thanks for your time.
Operator
Our next question comes from David Rose with Wedbush Securities. Please go ahead with your questions.
David Rose -- Wedbush Securities
Good morning. I think most of mine have been answered.
I did have one last on China. Can you provide a little bit more color, maybe some data points on the number of specialty store entrepreneurs that are [staying] open and if there has been any closures both in Tier 1, Tier 2 and Tier 3 for these?
Ajita Rajendra
Yeah, I think it's yes to all of them. I mean we are opening stores and we are also closing stores.
And that's been an ongoing process because we have very strong requirements and tight requirements in terms of the performance of those stores. And if the entrepreneurs are not performing, then we shut them down or bring in new people.
And that process is ongoing. I think with the turndown if anything, we are probably being a little more aggressive in shutting down the non-productive stores.
And that's a good thing because that ensures that the sales that we have continue to hold their profitability. And we are expanding into the second and third tier cities and that expansion is moving along.
And that's part of the reason that we've been able to show growth in our business beyond what's normally – what's happening in China and beyond what we see our traditional retailers experiencing. It's a combination of expanding into the second and third tier cities, expanding our stores with the new products, the pricing, putting all of that together is what's helping to drive our sales in China and we would certainly continue that formula.
David Rose -- Wedbush Securities
That's helpful, Ajita. And maybe a follow-up to that is on your – kind of on the look through and in terms of the pipeline of new entrepreneurs, do you see economic conditions changing the number of entrepreneurs that are willing to open or because there's lack of other opportunities for them, it's actually encouraging them?
Ajita Rajendra
No, the number of entrepreneurs, they are more than we can handle because the brand is so strong that there are lots of people who want it and we have not run into the issue where we see a reason and don't have people who want to come on board. It's the other way around.
David Rose -- Wedbush Securities
Okay, great. Thank you very much.
Ajita Rajendra
And we manage that because we don't want to have too many people too close to each other and so we want to manage the number that's out there.
David Rose -- Wedbush Securities
Okay, that's helpful.
Operator
Our next question comes from Samuel Eisner with William Blair. Please go ahead with your questions.
Samuel Eisner -- William Blair
Thanks very much. Good morning, everyone.
Paul Jones
Good morning, Sam.
Samuel Eisner -- William Blair
In terms of the commentary on the commercial business, obviously volumes are trending higher. Can you make any comments regarding if this is strictly retrofit or if there is any new that's actually embedded in that, I guess those higher volumes?
Ajita Rajendra
I think it's the normal combination. I don't know that I can't say that there's been a whole lot of new activity that's unusual.
It's a combination of both them and frankly we've been very presently surprised at the strength of the commercial market. It's stronger than what we anticipated it to be, especially given the buy-in at the end of last year.
Samuel Eisner -- William Blair
Great. And then moving over to China, obviously the commentary regarding same-store sales this quarter to be a little bit better than I was expecting given the fact that second quarter, I think you were flat in both tier 1 and tier 2 cities.
So I guess what is the – what is causing the increase I guess this quarter? And then maybe looking out to 2013 even if you're going to be only about 10% growth, how should I be thinking about looking out to 2013 when you're exiting '12 at about 10% levels?
Ajita Rajendra
John, you're going to help us out. We've been – we were pleasantly surprised at the 3% and the people have been saying things are going to be getting better, probably getting – this was getting a little better, a little faster than we thought.
But I don't want to spike the ball too early. I think things are getting better slowly and that's what we see in China.
Samuel Eisner -- William Blair
Okay. And then just last two questions here.
John, I think you mentioned there were some one-time items in China that affected the operating margins there this quarter. Can you call those out just so we can understand what…?
John Kita
Yeah, there were a couple of them. One is there was a new tax on a property tax like type tax that was put on multinationals and it was going back to the first part of the entire year, so we had to pick up the first three quarters.
So that probably affected it by 50 basis points. And then as Ajita said, we've come out with a couple of really new and exciting products; one was the [side screen] water treatment as well as the low noise instantaneous and so we have some pretty hefty incentive type programs during the quarter that probably affected margins, another 50 basis points.
So both of those I would view as somewhat one-time type items.
Samuel Eisner -- William Blair
So a clearer number would look close to 10.5%?
John Kita
Well, I remember that's the 9.5 is the entire rest of world, so it would be a little bit less than that, right?
Samuel Eisner -- William Blair
Okay, great. Thanks so much.
Operator
I'm not showing any other questions in the queue. I'd like to turn it back over for closing comments at this time.
Paul Jones
Okay, we appreciate everybody's interest and you know our phone number, so give us a call if you have any follow-ups. Thanks much.
Operator
Thank you. Ladies and gentlemen, thank you for your participation in today's conference.
This does conclude the conference. You may now disconnect.
Good day.