OVERVIEW

We are a leading manufacturer of water heaters and boilers, serving a diverse mix of residential and commercial end markets principally in the U.S. with a strong and growing international presence. During the fourth quarter of 2011, we reorganized our management reporting structure to reflect our current business activities. Historical information has been revised to reflect our new structure. Our company is comprised of two reporting segments: North America and Rest of World. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our Rest of World segment is primarily comprised of China, India and Europe. The North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. The Rest of World segment also manufactures and markets water treatment products, primarily for Asia. On August 22, 2011, we sold EPC to RBC for approximately $760 million in cash and approximately 2.83 million shares of RBC common stock valued at $140.6 million as of that date. Due to the sale, EPC has been reflected as discontinued operations in the accompanying financial statements for all periods presented. In 2012, sales for our North America segment were $1,430.8 million and sales for our Rest of World segment were $542.5 million.

Sales of our Rest of World A. O. Smith branded products in China grew significantly in 2012. We expect sales of A. O. Smith branded products in China to grow approximately 15 percent in 2013, as geographic expansion, market share gains, growth in water treatment and improved product mix due to new product introductions contribute to our growth. Although the residential and commercial replacement market contributed significantly to 2012 sales for our North America segment, residential and commercial new construction remains fragile due to the relatively low number of housing starts and slight recovery of commercial construction activity. Our 2012 North America residential unit sales were essentially flat compared to the prior year and commercial unit sales showed mid-single digit growth. We expect the North America residential water heater industry unit growth to be one to two percent for 2013, and we expect commercial industry units to be flat. Lochinvar branded products contributed approximately $226 million to our net sales in 2012, and we expect further sales growth of Lochinvar branded products of approximately ten percent in 2013, driven by sales of energy efficient products.

We recognized a pre-tax charge of $35.4 million in 2010 for expenses related to damages to our water heater manufacturing facility located in Ashland City, TN caused by flooding of the Cumberland River. This facility was temporarily shut down and production of water heaters was temporarily transferred to our other water heater manufacturing facilities in the U.S., Canada and Mexico. Our recovery from the impact of the flood was essentially completed by year end 2010. We lost some sales orders in 2010 due to the flood, however, we retained all customers from which we lost orders.

We purchased the remaining 20 percent interest in SWT from the former owner in the fourth quarter of 2010. The progress of our water treatment business has been slower than anticipated due to a number of unforeseen challenges. We incurred losses in 2012, 2011 and 2010. We continue to expect strong long term sales growth opportunities in the water treatment market in China. We introduced
A. O. Smith branded water treatment products into our China distribution network during 2010, and the products have been well received with sales more than doubling to greater than $20 million in 2012.

During 2010, we began production of residential water heaters for the Indian market at our new plant located near Bangalore, India. Our sales in India increased 10.5 percent to $20.0 million dollars in 2012.

In 2010, we acquired the rights from Takagi to market gas tankless water heaters in North America and entered into a long-term agreement with Takagi to supply gas tankless water heaters. As part of the venture, we took over the management of Takagi's North American sales and distribution organization. Through this venture, we offer a full line of gas tankless water heaters under our own brands in association with the Takagi brand. In 2012, we estimate the industry sold approximately 360,000 gas tankless water heaters in North America, down from approximately 420,000 units in the prior year.

On October 11, 2010, our board of directors declared a three-for-two stock split of our Class A Common Stock and Common Stock in the form of a 50 percent stock dividend to stockholders of record on October 29, 2010 and payable on November 15, 2010.

We intend to take advantage of our strong balance sheet to execute on a number of our water-related strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses in our existing operations in the high growth regions of China and India. We will look to expand into additional fast growing

Consistent with our stated strategy to expand our core product offering with new technologies, on August 26, 2011, we acquired Lochinvar for a base price of approximately $421 million, and we agreed to pay an earn-out that resulted in a payment of $13.5 million to the former owners of Lochinvar in December 2012. Lochinvar, one of the leading manufacturers of residential and commercial boilers in the U.S., fit squarely within our stated strategic growth initiative to expand our core water heating business. Sales of Lochinvar branded products in 2012 were approximately $226 million and have grown at a nine percent compound annual growth rate over the last five years. The boiler market in the U.S. has been transitioning to higher efficiency, condensing boilers for the last several years. In 2011, approximately 30 percent of boilers sold in the U.S. were condensing boilers, compared with five percent eight years ago. Our Lochinvar brand is a leading brand of higher efficiency, condensing boilers. We expect the transition in the U.S. to higher efficiency boilers will continue into the foreseeable future and, as a result, we expect sales of Lochinvar branded products will likely continue to grow approximately ten percent in 2013. We paid for Lochinvar using a combination of cash on hand and amounts that we borrowed under our credit facility.

RESULTS OF OPERATIONS

Our sales in 2012 were a record $1,939.3 million surpassing 2011 sales from continuing operations of $1,710.5 million by 13.4 percent. The increase in sales was attributable mostly to sales of our Lochinvar branded products. We acquired Lochinvar in August 2011, and sales of Lochinvar branded products totaled $225.7 million compared with $75.9 million in 2011. In addition higher sales of A. O. Smith branded products in China grew 20.5 percent to $448.3 million for the year. Our sales from continuing operations were $1,489.3 million in 2010. The $221.2 million increase in sales from 2010 to 2011 was due to the $75.9 million of sales added from our Lochinvar acquisition and increased sales of A. O. Smith branded products in China which grew by 29.0 percent or $83.8 million. Pricing actions related to higher material costs, higher commercial water heater volumes and a full year of gas tankless products in North America also contributed to the increased sales in 2011.

Our gross profit margin in 2012 increased to 33.6 percent from 30.0 percent for continuing operations in 2011. The impact of the addition of relatively higher margin sales of Lochinvar branded products, increased sales of A. O. Smith branded products in China and lower manufacturing and warranty costs contributed to the higher margin in 2012. Our gross profit margin in 2010 was 29.9 percent, about equal to 2011. The impact of relatively higher margin sales of Lochinvar branded products and increased sales of A. O. Smith branded products in China in 2011 was offset by a decline in margin for water treatment products and higher material costs.

Selling, general and administrative expense (SG&A) was $77.7 million higher in 2012 than in 2011. The increase in SG&A was due to higher selling and advertising costs in support of increased volumes in China, additional expenses from a full year of Lochinvar operations and increased pension expense. SG&A increased by $44.1 million from 2010 to 2011 resulting mostly from incremental selling costs to support higher volumes in China and $15.9 million of additional expenses from operations supporting Lochinvar brands.

Pension expense in 2012 was $13.8 million compared to $3.3 million and $10.5 million for continuing operations in 2011 and 2010, respectively. The increase in pension expense in 2012 from 2011 was due to decreases in the discount rate and expected rate of return on plan assets. The decrease in pension expense in 2011 from 2010 was due to earnings derived from $175 million of contributions made during 2011.

We purchased the remaining 20 percent interest in SWT from the former owner in the fourth quarter of 2010. At the same time, we also settled certain disputes with the former owner relative to the condition of SWT on the date of purchase. The settlement resulted in a $5.0 million non-taxable gain in 2010. Additionally, we incurred an impairment charge of $3.3 million related to the value of trademarks we received as part of the SWT acquisition in 2010. We moved the water treatment operations to Nanjing, China to recognize synergies associated with our strong management team and the engineering center in place at our water heater operations in that city. As a result of the move announced in 2010, we recorded $1.8 million in moving costs during the fourth quarter of 2010. The net impact of these transactions associated with our SWT operation was $0.1 million of pre-tax expense for restructuring, impairment and settlement income in 2010.

Interest expense in 2012 was $9.2 million, compared to interest expense for continuing operations of $9.3 million in 2011. Interest expense in 2011 and 2010 is net of the amount allocated to discontinued operations. Interest expense that could not be attributed to specific entities within the company was allocated to EPC based on the ratio of net assets to be sold to the sum of the consolidated net assets and debt exclusive of debt attributable to specific entities of the company. The $2.4 million increase in continuing interest expense from 2010 to 2011 included $1.9 million associated with the debt incurred relative to the Lochinvar acquisition with the remainder of the increase being attributable to higher interest rates.

Our effective tax rate was 30.4 percent in 2012, compared with 31.1 percent and 23.3 percent for continuing operations in 2011 and 2010, respectively. The rate decline in 2012 from 2011 was due to larger than anticipated tax deductions resulting from our domestic production activities deduction. The relatively low effective tax rate in 2010 was due to lower domestic earnings as a result of $35.4 million pre-tax flood related expense as well as higher 2010 foreign earnings which were in lower tax jurisdictions.

We achieved net earnings inclusive of discontinued operations and non-controlling interest of $158.7 million or $3.41 per diluted share in 2012 compared with $305.7 million or $6.57 per diluted share in 2011 and $111.7 million or $2.42 per diluted share in 2010. Our 2012 earnings include discontinued operations after-tax losses of $3.9 million, or $.08 per diluted share, related to the sale of EPC which occurred in 2011. Included in discontinued operations was $6.4 million of expense representing the correction of an error primarily due to our calculation of taxes due upon repatriation of undistributed foreign earnings. Additionally in continuing operations we recorded after-tax gains totaling $21.7 million, or $.46 per diluted share, associated with the sale of our shares of RBC common stock, a legal settlement with a component supplier for our Canadian operations and the revisions to our estimate of the Lochinvar earn-out obligation. Our 2011 earnings include $194.5 million, or $4.18 per diluted share, related to EPC, as well as an after-tax gain of $12.9 million, or $.28 per diluted share, associated with our shares of RBC common stock, a legal settlement with a component supplier for our U.S. operations and an increase to a warranty reserve associated with the Canadian component supplier. Our 2010 earnings include an after-tax $21.6 million or $0.47 per diluted share charge for the flood of our Ashland City, TN water heater plant in May 2010 as well as $54.4 million or $1.18 per diluted share from EPC.

North America

Sales for our North America segment were $1,430.8 million in 2012 or $141.3 million higher than sales of $1,289.5 million in 2011. The sales increase in 2012 included $142.9 million of incremental sales from Lochinvar branded products resulting from our acquisition of Lochinvar completed on August 26, 2011. We also experienced higher volumes of U.S. residential and commercial water heaters which were offset by lower gas tankless and Canadian water heater volumes. Our North America sales of $1,289.5 million in 2011 were $134.1 million higher than sales of $1,155.4 million in 2010. The sales increase in 2011 included $75.9 million of sales of Lochinvar branded products. Our commercial water heater volumes were also higher in 2011 in advance of a regulatory change in Southern California. A material related price increase effective in April 2011 and a full year of sales of gas tankless products also contributed to increased sales in 2011.

Operating earnings for North America were $199.8 million in 2012 or $45.8 million higher than operating earnings of $154.0 million in 2011. Our Lochinvar acquisition added $37.1 million of incremental operating earnings in 2012. Higher U.S, residential and commercial volumes also contributed to the increase in 2012 earnings. Also included in 2012 is a $3.9 million pre-tax gain from a settlement with a component supplier for our Canadian operations which is reflected in the "Restructuring, impairment and settlement (income) expense-net" line in the accompanying financial statements. This segment's 2012 operating earnings also include a net $3.3 million favorable pre-tax adjustment to the estimate of contingent consideration due to the former owners of Lochinvar. The acquisition agreement contemplated contingent consideration based on achieving a specified level of sales of Lochinvar branded products from December 1, 2011 through November 30, 2012 and the fair value of the contingent payment was estimated to be $16.8 million at the closing of the acquisition based on a forecasted 16 percent increase in sales. The actual 15 percent sales increase resulted in a net $3.3 million pre-tax gain in 2012 from the decrease in the contingent payment. This earn-out adjustment is reflected as "Contingent consideration adjustment" in the accompanying financial statements.

Rest of World

Sales for our Rest of World segment in 2012 were $542.5 million or $86.9 million higher than sales of $455.6 million in 2011 due to a higher priced product mix in the region as a result of product innovations with more robust features and benefits, as well as pricing actions. Market share gains derived from sales of
A. O. Smith branded products in China grew by $76.6 million and sales for our non-A. O. Smith branded water treatment business increased by $3.8 million in 2012. Rest of World sales in 2011 were $86.7 million higher than sales of $368.9 million in 2010. A. O. Smith branded products sales in China grew by $83.8 million and sales in India more than doubled to $18.1 million in 2011. Sales for our water treatment business were $13.0 million lower in 2011 than 2010 primarily due to inefficiencies as a result of moving our SWT manufacturing facility.

Rest of World operating earnings were $59.6 million in 2012 compared to 2011 earnings of $42.7 million. The $16.9 million increase in earnings in 2012 was driven by higher volumes of A. O. Smith branded products in China and reduced losses of $3.2 million for the non-A. O. Smith branded water treatment business which was partially offset by larger losses in India due to new product introduction costs and brand building expenses in the region. Rest of World operating earnings were $42.4 million in 2010. Increased earnings in 2011 for our A. O. Smith branded products in China were offset by losses at SWT of $10.6 million in 2011 compared to losses of $3.2 million in 2010.

The operating margins for our Rest of World segment were 11.0 percent, 9.4 percent and 11.5 percent in 2012, 2011 and 2010, respectively. The increased margin in 2012 was favorably impacted by increased volumes of A. O. Smith branded products in China. The 2011 margin was impacted by losses at SWT resulting from lower sales and costs associated with moving to a new manufacturing facility in 2011.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $611.3 million at December 31, 2012 compared with $727.9 million and $209.5 million at December 31, 2011 and December 31, 2010 respectively. The $116.6 million decline in working capital in 2012 was primarily due to the sale of our shares of RBC common stock which were received as a result of our divestiture of EPC. The proceeds from the sale were used to repay debt. The sale of the shares more than offset a $57.0 million sales-related increase in accounts receivable. The majority of the $518.4 million increase in working capital in 2011 was due to the receipt of cash and shares of RBC common stock from the sale of EPC, which closed in the third quarter, less the cash used in the acquisition of Lochinvar, and, to a lesser extent, the increase in working capital related to the purchase of Lochinvar. As of December 31, 2012, $457.1 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. The company would incur a cost to repatriate these funds to the U.S. and has accrued $65.1 million for the repatriation of these funds.

Operating cash provided by continuing operations during 2012 was $171.2 million compared with $61.0 million during 2011 and $63.3 million during 2010. The improvement in cash flow in 2012 was primarily related to higher earnings and the impact in 2011 of pre-tax pension contributions of approximately $175 million partially offset by higher working capital requirements. Higher earnings in 2011 and improved working capital were more than offset by $175 million of pre-tax pension contributions, resulting in lower operating cash flows in 2011 than in 2010. We expect cash provided by operating activities in 2013 to be between $200 and $220 million.

Our capital expenditures for continuing operations were $69.9 million in 2012, $53.5 million in 2011 and $53.5 million in 2010. Capital expenditures in 2012 were higher than in 2011 as a result of construction activity for a second water heater manufacturing plant in Nanjing, China to meet local demand. The new plant is expected to add 50 percent more capacity to our China water heater operations and to come on line in mid-2013. In 2012, we also began construction to expand our India plant to accommodate more water heater models, in-source some component manufacturing and meet local demand. We are

In December 2012, we completed a $400 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 as of December 31, 2012.

The facility backs up commercial paper and credit line borrowings, and it expires on December 12, 2017. 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, 2012, we had available borrowing capacity of $236.3 million under this facility. We believe that the combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt declined to $243.7 million at December 31, 2012 compared with $461.6 million at December 31, 2011, due to the sale of our shares of RBC common stock and cash flow generated in the U.S. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 16.9 percent at the end of 2012 compared with 29.8 percent at the end of 2011.

Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2012, and we did not make any voluntary contributions. We are forecasting that there will be no required contributions to the plan in 2013, and we do not plan to make any voluntary contributions. For further information on our pension plans, see Note 12 of the Notes to Consolidated Financial Statements.

In December 2010, our board of directors ratified its authorization of a stock repurchase program in the amount of 1.5 million shares of our common stock. During 2012, we repurchased 426,490 shares at an average price of $51.60 per share for a total amount of $22.0 million. As of December 31, 2012, a total of 461,921 shares remained in the existing repurchase authority.

We have paid dividends for 73 consecutive years with payments increasing each of the last 21 years. We paid total dividends of $.72 per share in 2012 compared with $.60 per share in 2011.

Discontinued operations financial information is provided in Note 2 of the Notes to Consolidated Financial Statements.

Aggregate Contractual Obligations

A summary of our contractual obligations as of December 31, 2012, is as follows:



(dollars in millions)                                                   Payments due by period
                                                           Less Than      1 - 2       3 - 5       More than
Contractual Obligations                        Total        1 year        Years       Years        5 years
Long-term debt                                $ 243.7     $      18.6     $ 29.2     $ 187.1     $       8.8
Fixed rate interest                              11.1             3.9        5.0         2.0             0.2
Operating leases                                 45.1            10.4       16.5         7.9            10.3
Purchase obligations                            100.4           100.0        0.4          -               -
Pension and post-retirement obligations         172.5             1.5        8.5        74.4            88.1

Total                                         $ 572.8     $     134.4     $ 59.6     $ 271.4     $     107.4

As of December 31, 2012, our liability for uncertain income tax positions was $1.3 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 our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm.

Recent Accounting Pronouncements

In September 2011, the FASB issued ASU No. 2011-08, "Testing of Goodwill for Impairment (Topic 350)". ASU No. 2011-08 allows companies to assess qualitative . . .