LIQUIDITY AND CAPITAL RESOURCES

We achieved net earnings of $81.9 million or $2.70 per share in 2008, compared with $88.2 million or $2.85 per share in 2007 and $76.5 million or $2.47 per share in 2006. Net earnings recorded in 2008 were lower than 2007 due to lower sales of U. S. residential product, higher raw material costs only partially offset by price increases, higher product warranty costs at our Water Products segment primarily as a result of higher steel costs and a higher tax rate. These factors were partially offset by lower restructuring costs in our Electrical Products segment, another strong year for our China water heater business, and lower product liability costs in our water heater business. Net earnings recorded in 2007 were higher than 2006 due to a full year of the GSW business acquired in April 2006, higher sales of commercial product, solid growth at our China water heater operation and a lower effective tax rate. These improvements were partially offset by higher SG&A expenses and restructuring charges in 2007 compared with 2006. Our individual segment performance will be discussed later in this section.

Our working capital was $276.3 million at December 31, 2008 compared with $295.0 million and $322.7 million at December 31, 2007 and December 31, 2006, respectively. The $18.7 million reduction in our working capital in 2008 compared with 2007 resulted from the recognition of a non-cash $73.0 million liability for derivative contracts and lower accounts receivable balances at both businesses related to volume declines, which were partially offset by higher inventories and lower accounts payable balances at our Electrical Products segment and cash deposits of $22.5 million associated with derivative contracts. The $27.7 million reduction in our working capital in 2007 compared with 2006 was a result of lower inventories in our Electrical Products segment. Higher accounts payable balances in both businesses were offset by an increase in our Water Products segment's accounts receivable balances.

Cash provided by operating activities during 2008 was $106.6 million compared with $190.5 million during 2007 and $128.8 million during 2006. Lower net earnings in 2008 compared with 2007 and the changes in cash-related working capital accounts described above explain the majority of the decline. Higher net earnings in 2007 compared with 2006 combined with higher depreciation and amortization and the working capital decrease described above explain the $61.7 million year over year improvement in our cash flow. We expect cash provided by operating activities to be between $140 and $160 million in 2009.

Our capital expenditures were $66.1 million in 2008, lower than the $71.4 million spent in 2007. Our capital spending in 2006 was $68.2 million. We are projecting 2009 capital expenditures of between $75 and $85 million and 2009 depreciation and amortization of approximately $70 million. 2009 capital spending includes the construction of the water heater manufacturing plant near Bangalore, India and the completion of the expansion of our Nanjing, China water heater operations.

In February 2006, we completed a $425 million multi-currency five year revolving credit facility with a group of eight banks. The facility has an accordion provision which allows it to be increased up to $500 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants during all of calendar year 2008.

The facility backs up commercial paper and credit line borrowings, and it expires on February 17, 2011. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. At December 31, 2008, we had available borrowing capacity of $246.9 million under this facility. We believe that the combination of available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future.

At this point in time, our liquidity has not been materially impacted by the current credit environment, and we do not expect that it will be materially impacted in the near future. There can be no assurance however, that the cost of future borrowings on our credit facilities will not be impacted by the ongoing capital market disruptions.

Our total debt was $334.8 million at the end of December 2008 compared with $395.2 million at the end of 2007. Our leverage, as measured by the ratio of total debt to total capitalization, was 34 percent at the end of 2008 the same as at the end of 2007.

Aggregate Contractual Obligations

A summary of our contractual obligations as of December 31, 2008, is as follows:



(dollars in millions)                                             Payments due by period
                                                     Less Than       1 - 3      3 - 5       More than
Contractual Obligations                  Total        1 year         Years      Years        5 years
Long-term Debt                          $ 334.8     $      17.5     $ 217.8     $ 43.7     $      55.8
Fixed Rate Interest                        36.3             8.3        13.0        8.4             6.6
Operating Leases                           48.5            14.0        17.1        6.7            10.7
Purchase Obligations                       87.7            87.7           -          -               -
Other Liabilities:
Commodity futures contracts                52.1            48.9         3.2          -               -
Foreign currency forward contracts         19.1            18.8         0.3          -               -

Total                                   $ 578.5     $     195.2     $ 251.4     $ 58.8     $      73.1

As of December 31, 2008, the liability for uncertain income tax positions was $5.5 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid.

We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to the company's scheduled unit production. The purchase obligation amount presented above represents the value of commitments considered firm. The amounts in the table above for commodity and foreign currency contracts represent the costs to liquidate the contracts as of December 31, 2008.

GSW operated a captive insurance company to provide product liability and general liability insurance to its subsidiary, American Water Heater Company (American). We decided to cover American's liability exposures with our existing insurance programs and operate the captive in runoff effective July 1, 2006. The reinsurance company restricts the amount of capital which must be maintained by the captive. At December 31, 2008, the restricted amount was $26.3 million compared with $38.9 million at the end of 2007 and is included in other non-current assets. The restricted assets are invested in money market securities.

In February 2007, our board of directors approved a stock repurchase program in the amount of one million shares of our common stock. During 2007, we completed the repurchase of all one million shares at an average cost of $36.62 per share. Our board approved an additional one million shares to be repurchased under this program at its December 2007 meeting. As of December 31, 2008, we have not repurchased any shares under the authorization approved in December 2007.

Our pension plan continues to meet all funding requirements under ERISA regulations. While we were not required to make a contribution to the plan in 2008, we elected to make a contribution of $17.3 million. We are required to make a contribution of approximately $18 million in 2009. The company is forecasting contributions to the pension plan to be between $18 and $35 million in 2009 and between $40 and $50 million in 2010. For further information on our pension plan, see Note 11 of the Notes to Consolidated Financial Statements.

We have paid dividends for 69 consecutive years with payments increasing each of the last 17 years. We paid total dividends of $.74 per share in 2008 compared with $.70 per share in 2007.

RESULTS OF OPERATIONS

Our sales in 2008 were $2.3 billion, about equal to sales in 2007 as a $28.2 million increase in sales in our Water Products segment was more than offset by a $35.9 million decline in sales in our Electrical Products segment. The higher Water Products sales were due mostly to increased sales in China and material related price increases which were partially offset by significantly lower residential volume. The decline at Electrical Products resulted primarily from lower unit volumes associated with the weak housing market. Sales in 2007 were $2.31 billion, an increase of $150.8 million or 7.0 percent from sales of $2.16 billion in 2006. The sales increase occurred in our Water Products segment and was due to a full year of the GSW business acquired in April 2006, which added $128 million of sales in the first quarter of 2007 as well as increased sales

of commercial water heaters and higher sales in China. Sales for Electrical Products declined $11.9 million from $905.9 million in 2006 to $894.0 million in 2007 as improved pricing was more than offset by lower volume.

Our gross profit margin for 2008 was 21.6 percent compared to 22.2 percent in 2007 as increased margins at Electrical Products were more than offset by lower margins at Water Products. The higher margins at Electrical Products resulted from commercial contract improvements, including pricing, at targeted accounts and repositioning savings. The lower margins at Water Products were caused by higher raw material costs, primarily steel, and its related effect on warranty costs which were partially offset by improvements in pricing. Our gross profit margin for 2006 was 21.5 percent. The improved margins in 2007 were due mostly to sales of higher margin products in our Water Products segment.

Selling, general and administrative expense (SG&A) was $5.6 million lower in 2008 than in 2007 as lower product liability expense primarily associated with an adverse verdict in 2007 at Water Products and lower bad debt provisions at both our product operations more than offset higher SG&A in support of increased sales at our China water heater operation. The increase in SG&A of $39.0 million from 2006 to 2007 was due to higher selling and advertising costs to support increased sales at our water heater segment and included $15.2 million of first quarter SG&A attributable to the GSW acquisition.

Pension expense in 2008 was $4.0 million compared to $12.2 million in 2007 and $11.9 million in 2006. The decrease in pension expense from 2007 to 2008 was due to an increase in the discount rate, lower amortization of deferred asset losses, and the absence of curtailment and other charges of $1.1 million. The increase in pension expense from 2006 to 2007 was due to curtailment and other charges as partially offset by lower amortization of deferred asset losses.

Pretax restructuring charges were $9.2 million, $24.7 million and $9.6 million in 2008, 2007 and 2006, respectively. The majority of the charges incurred in 2008, consisting primarily of severance and asset impairment, were associated with the plant closures initiated by our Electrical Products segment in 2007 and completed in 2008. In 2007, $22.8 million of restructuring expense was recognized by Electrical Products with $12.0 million of the charge attributed to the closing of our operations in Scottsville, KY and Mebane, NC and the write down of other assets. The closing of these plants resulted in our hermetic motor assembly operations being consolidated in Acuna, Mexico and Suzhou, China. A pretax charge of $9.2 million associated with the closing of our motor facility in Budapest, Hungary was also included in the 2007 charge. A pretax charge of $1.6 million was also included in the 2007 Electrical Products charge for certain other domestic repositioning and asset write down expenses. In addition to the 2007 restructuring charges at Electrical Products we also recognized a $1.9 million corporate charge related to a previously owned business. In 2006, $8.9 million of the $9.6 million restructuring charge was recognized by Electrical Products, most of which was related to the closure of our McMinnville, TN motor fabrication plant completed in the first quarter of 2007 and the closure of our motor operation in Taizhou, China in the fourth quarter of 2006. We do not have any current restructuring plans.

Interest expense decreased from $26.7 million in 2007 to $19.2 million in 2008 as a result of lower interest rates and debt. Interest expense increased from $24.9 million in 2006 to $26.7 million in 2007 due to GSW acquisition related financing costs incurred for a full year in 2007 versus only nine months in 2006.

In 2008 net other expense of $1.6 million compared to net other income of $0.9 million. The $2.5 million differential is due to $1.0 million lower interest income on restricted marketable securities due to liquidation of $12.0 million of short-term securities in the second quarter of 2008 with the remainder due to exchange losses as foreign currencies strengthened against the U.S. dollar. In 2007 net other income of $0.9 million compared to net other expense of $0.6 million in 2006. The differential was due to $0.5 million of interest income on restricted marketable securities in the first quarter of 2007 with the remainder due to exchange gains associated with U.S. dollar purchases made by our Canadian operations.

Our effective tax rate was 25.4 percent in 2008, 11.7 percent in 2007 and 27.3 percent in 2006. The 2007 effective rate included a $3.7 million tax benefit upon completion of tax audits and lapse of statutes of limitations and a $1.1 million China investment incentive tax benefit. Also included in the 2007 rate is a $9.9 million tax benefit associated with the write-off of the investment in our Hungarian subsidiary.

Our 2008 net earnings were $81.9 million or $2.70 per share compared with $88.2 million or $2.85 per share in 2007 and $76.5 million or $2.47 per share in 2006.

Water Products

Sales for our Water Products segment were $1.45 billion in 2008, a modest increase over sales of $1.42 billion in 2007. Sales at our China water heater operation increased by $40.1 million in 2008. Despite price increases to compensate for higher material costs, sales for residential water heaters were significantly lower in 2008 and partially offset the growth in China. Sales in 2007 were $162.3 million higher than sales of $1.26 billion in 2006. The increase was due to a full year of the GSW business acquired in April 2006, which added $128.0 million of sales in the first quarter of 2007, a $30.1 million increase in sales at our China operation and increased sales of commercial water heaters.

Operating earnings for Water Products were $134.7 million in 2008 or 10.2 percent lower than earnings of $150.0 million in 2007. The impact of growth in China and lower SG&A was more than offset by lower residential volume and higher costs for raw materials and components which were not recovered with price increases. Operating earnings of $150.0 million in 2007 were 22.5 percent higher than earnings of $122.4 million in 2006. The increase in earnings was due to an additional three months of GSW earnings, higher earnings in China, and sales of higher margin products all of which offset lower residential water heater volume.

Electrical Products

Sales in our Electrical Products segment in 2008 were $858.1 million or 4.0 percent lower than 2007. Increased selling prices to offset higher costs for raw materials were more than offset by lower unit volume caused by the weak housing market as well as customer inventory reductions at the end of the year. Sales in 2007 of $894.0 million were 1.3 percent lower than 2006. Similar to 2008, the favorable impact of materials related pricing actions was more than offset by the negative impact of a weak housing market. Additionally, lower volume in the residential hermetic and pump motor markets more than offset improved sales in the commercial hermetic and distribution market segments.

Operating earnings at our Electrical Products segment were $39.1 million in 2008 compared with $23.1 million in 2007. The majority of the increase in earnings was due to a decrease in restructuring charges from $22.8 million in 2007 to $8.7 million in 2008. Operating earnings in 2007 were $25.0 million lower than earnings of $48.1 million in 2006 due to an increase in restructuring charges of $13.9 million and lower unit volumes. Please refer to the previous discussion on restructuring charges for additional details.

Critical Accounting Policies

Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability, and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We constantly reevaluate these significant factors and adjustments are made when facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Goodwill and Indefinite-lived Intangible Assets

In conformity with U.S. generally accepted accounting principles, goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management's judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct annual thorough and competent valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment.

Product warranty

Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed on a periodic basis. At times, warranty issues may arise which are beyond the scope of our historical experience. While our warranty costs have historically been within its calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. We provide for any such warranty issues as they become known and estimable. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates.

Product liability

Due to the nature of our products, we are subject to product liability claims in the normal course of business. A majority of these claims involve our Water Products business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. As of December 31, 2008, we maintained a self-insured retention of $5.0 million per occurrence with an aggregate insurance limit of $125.0 million per occurrence.

GSW insurance coverage included self-insurance retentions that varied by business segment and by year. Effective April 3, 2006 GSW maintained a $25.0 million aggregate loss retention through self-insurance and captive insurance company coverage. GSW claims occurring on or after July 1, 2006 are covered under the company's insurance program.

We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also use an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time.

Pensions

We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumptions for the expected rate of return on plan assets is 8.75 percent in 2008, unchanged from 2007. The discount rate used to determine net periodic pension costs increased from 5.90 percent in 2007 to 6.50 percent in 2008. In 2009, the rate of return on plan assets is 8.75 percent and the discount rate is 6.60 percent.

In developing our expected long-term rate of return assumption, we evaluate our pension plan's target asset allocation, the historical long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan's target allocation to equity managers is between 60 to 70 percent, with the remainder allocated primarily to bond managers and a small allocation to private equity managers. Due to market fluctuations, our actual asset allocation as of December 31, 2008, was 55 percent to equity managers, 36 percent to bond managers, six percent to private equity managers and the remainder in money market instruments. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan's historical 10-year and 25-year compounded annualized returns are 4.0 percent and 10.2 percent, respectively. We believe that with our target allocation and the historical long-term returns of equity and bond indices as well as our actual historical returns, our 8.75 percent expected return on assets for 2009 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2008, 2007 and 2006 were based on the Hewitt top quartile yield Curve (HTQ), which was designed by Hewitt Associates to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The HTQ is a hypothetical double A yield curve represented by a series of annualized individual discount rates. Each bond issue underlying the HTQ is required to have a rating of Aa or better by Moody's Investor Service, Inc. or a rating of AA or better by Standard & Poor's. Because of the volatile bond market, we adjusted our discount rate as of December 31, 2008 to take into account the effect of bonds that were on credit watch on December 31, 2008 and were subsequently downgraded below a AA rating before January 15, 2009. The discount rates

determined on the basis described above were 6.60 percent. 6.50 percent and 5.90 percent at December 31, 2008, 2007 and 2006, respectively. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary.

We estimate that we will recognize approximately $10.0 million of pension expense in 2009 compared to $4.0 million in 2008. Lowering the expected long-term rate of return on assets by 25 basis points would increase our net pension expense for 2009 by approximately $1.7 million. Lowering the discount rate by 25 basis points would increase our 2009 net pension expense by approximately $1.3 million.

Recent Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 161, "Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB No. 133," ("SFAS 161"). SFAS 161 is intended to improve transparency in financial reporting by requiring enhanced disclosures of an entity's derivative instruments and hedging activities and their effects on the entity's financial position, financial performance, and cash flows. SFAS 161 applies to all derivative instruments within the scope of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS 133"). SFAS 161 also applies to non-derivative hedging instruments and all hedged items designated and qualifying under SFAS 133. SFAS 161 is effective prospectively for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS 161 encourages, but does not require, comparative disclosures for periods prior to its initial adoption. We will adopt SFAS 161 on January 1, 2009 and are currently evaluating the potential impact on our financial statements when implemented.

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51", ("SFAS 160"). SFAS 160 changes the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. This new consolidation method changes the accounting for transactions with minority interest holders. SFAS 160 is effective beginning in 2009. Adoption of this statement will impact our accounting for any future transactions which include a noncontrolling interest.

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