Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters, as well as water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets in-home air purification products in China.

In 2016, our North America segment sales were $1,743.2 million and our Rest of World segment sales were $965.6 million. Sales of our products in China grew significantly in 2016, increasing 12.5 percent over 2015. Excluding the impact from the strengthening U.S. dollar, sales in China increased 18.9 percent in 2016. We expect sales in 2017 in China to grow at a rate of approximately 15 percent in local currency, as we believe overall water heater market growth, geographic expansion, market share gains, and growth in water treatment and air purification products will contribute to our growth. Price increases for residential and commercial water heaters and higher volumes of commercial water heaters and boilers contributed to 2016 sales increases in our North America segment. Partially offsetting these factors was a decline in residential water heater volumes in the U.S. We expect our North America residential and commercial water heater industry unit to show modest growth in 2017. Lochinvar-branded products contributed $300.6 million to our net sales in 2016, and we expect over eight percent sales growth of Lochinvar-branded products in 2017, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. Approximately 40 percent of Lochinvar-branded product sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvar-branded product sales consist primarily of boilers and related parts.

Our stated acquisition strategy includes 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 throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions demonstrated by our introduction of air purification products in China and water treatment products in India and Vietnam in 2015.

Consistent with our stated strategy to expand our core product offering, we acquired Aquasana, Inc. (Aquasana) in August 2016. Aquasana designs, assembles and markets premium performance water treatment products, including whole-house treatment systems, drinking water solutions for at home and on-the-go, and shower filters. Aquasana sells products primarily directly to U.S. consumers through e-commerce, as well as through retail outlets and distributors. With a three year compound annual revenue growth rate of 17 percent as of December 31, 2016, Aqausana fits squarely within our stated strategy to expand our core product offerings to new geographies that present growth opportunities.

RESULTS OF OPERATIONS

Our sales in 2016 were a record $2,685.9 million surpassing 2015 sales of $2,536.5 million by 5.9 percent. Excluding the impact from the appreciation of the U.S. dollar against the Chinese currency that occurred in 2016, our sales grew approximately eight percent in 2016. The increase in sales in 2016 was primarily due to higher sales in China of water heaters, residential air purification products, as well as 35 percent sales growth of A. O. Smith-branded water treatment products. Sales in China grew 12.5 percent in 2016, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 18.9 percent in 2016. Our sales in 2016 also benefitted from price increases in the U.S., higher volumes of U.S. boilers and commercial water heaters as well as $18.4 million of sales of Aquasana-branded water treatment products resulting from our acquisition of Aquasana in August 2016. These items more than offset lower volumes of U.S. residential water heaters. Our sales in 2015 were higher than 2014 sales of $2,356.0 million by 7.7 percent. The increase in sales in 2015 was attributable to higher prices in North America, higher sales of Lochinvar-branded products and commercial water heaters in the U.S. as well as strong demand for our water heating and water treatment products in China. Sales of water heaters and water treatment products in China grew 13.7 percent in 2015 compared to 2014. Sales of water heaters and water treatment products in China grew 16.1 percent in 2015 compared to 2014, excluding impact of the appreciation of the U.S. dollar in 2015.

Our gross profit margin in 2016 increased to 41.7 percent from 39.8 percent in 2015. The higher margin in 2016 was due to price increases in the U.S., lower material costs in the first half of 2016 and higher sales of boilers and commercial water heaters in the U.S. Our gross profit margin in 2015 increased from 36.5 percent in 2014 primarily due to price increases in the U.S. and Canada, higher U.S. sales of commercial water heaters and boilers, lower steel costs and a reduction in pension-related costs.

Table of Contents

Selling, general and administrative (SG&A) expenses were $48.2 million higher in 2016 than in 2015. The increase in SG&A expenses in 2016 to $658.9 million was primarily due to higher selling costs supporting our sales efforts in tier 2 and tier 3 cities in China as well as higher advertising costs to support brand building in China. SG&A expenses were $38.6 million higher in 2015 than in 2014 primarily due to higher selling and engineering costs supporting increased volumes in China as well as higher costs associated with the 2015 launch of air purification products in China which more than offset lower pension costs in the U.S.

Pension income in 2016 was $6.9 million compared to pension expense of $0.1 million in 2015 and $28.6 million in 2014. As of December 31, 2015, we changed to a more precise method to estimate the service cost and interest components of net periodic benefit cost for our pension and post-retirement plan. The change is the primary reason for the $7.1 million decrease in service and interest costs in 2016 compared to 2015. The significant decrease in pension expense in 2015 compared to 2014 was due to the sunset of our pension plan for the majority of our employees on December 31, 2014. In 2015, we began making additional Company contributions to a defined contribution plan in lieu of benefits earned in our pension plan.

Interest expense was $7.3 million in 2016 compared to $7.4 million in 2015 and $5.7 million in 2014. The higher interest expense in 2015 compared to 2014 was primarily related to interest rates on term notes in the amount of $75 million issued in January 2015 that were higher than the interest rate on the revolving credit facility that it replaced as well as higher overall debt levels related to share repurchases.

Other income was $9.4 million in 2016 compared to $10.8 million in 2015 and $5.2 million in 2014. The decrease in other income in 2016 compared to 2015 was primarily due to a decrease in interest income caused by lower interest rates in China in 2016. The increase in other income in 2015 compared to 2014 was primarily due to higher interest income resulting from a higher level of marketable securities during the year.

Our effective tax rate was 29.4 percent in 2016, compared with 29.7 percent in 2015 and 27.5 percent in 2014. Our lower effective tax rate in 2016 compared to 2015 was primarily due to our adoption of a new accounting standard for share-based compensation that was partially offset by a change in geographic earnings mix. The higher effective tax rate in 2015 compared to 2014 was primarily due to a change in geographic earnings mix.

North America

Sales in our North America segment sales were $1,743.2 million in 2016 or $40.2 million higher than sales of $1,703.0 million in 2015. The sales increase in 2016 resulted from a full year of U.S. price increases for residential water heaters related to a regulatory change in April 2015, and an August 2016 price increase in the U.S. related to higher steel prices and other cost inflation. Sales in 2016 also benefitted from higher volumes of boilers and commercial water heaters in the U.S. as well as the addition of $18.4 million of sales of water treatment products resulting from our Aquasana acquisition. Lower volumes of U.S. residential water heaters partially offset these benefits. Sales in 2015 were $81.3 million higher than sales of $1,621.7 million in 2014. The sales increase in 2015 resulted from a price increase for residential water heaters in the U.S. due to a regulatory change in April 2015 and higher volumes of commercial water heaters and condensing commercial boilers in the U.S., partially offset by lower residential volumes in the U.S. and a decrease in the translated value of the Canadian dollar during 2015.

North America operating earnings were $385.9 million in 2016 compared to operating earnings of $339.9 million and $238.7 million in 2015 and 2014, respectively. Operating margins were 22.1 percent, 20.0 percent and 14.7 percent in 2016, 2015 and 2014, respectively. The higher operating earnings and operating margin in 2016 compared to 2015 were primarily due to pricing actions in the U.S., lower material costs in the first half of 2016 and higher boiler and commercial water heater volumes in the U.S. that were partially offset by lower U.S. residential water heater volumes. The significantly higher operating earnings and operating margin in 2015 compared to 2014 were primarily due to higher prices in the U.S. and Canada, higher sales of Lochinvar-branded products and commercial water heaters in the U.S., lower steel costs and lower pension costs which more than offset lower residential water heater volumes in the U.S. We expect North America operating margin to be between 21.5 and 22.25 percent in 2017, despite the headwind from lower Aquasana margins of almost 50 basis points.

Rest of World

Sales in our Rest of World segment in 2016 were $965.6 million or $99.5 million higher than sales of $866.1 million in 2015. Sales in China grew 12.5 percent in 2016. Excluding the impact from the appreciation of the U.S. dollar in 2016, sales in China increased 18.9 percent in 2016 driven by higher demand for water heaters, water treatment products and residential air purification products. A. O. Smith-branded water treatment sales in China totaled $148 million in 2016 compared to $110 million in 2015. Sales of in-home air purification products were $26 million in 2016 compared to $9 million in 2015. Sales in 2015 were $97.8 million higher than sales of $768.3 million in 2014 due to higher demand for water heaters, approximately $35 million of incremental sales of water treatment products and approximately $9 million in sales of our newly launched in-home air purification products. Sales in China grew 13.7 percent in 2015. Excluding the impact from the appreciation of the U.S. dollar in 2015, sales in China increased 16.1 percent in 2015.

Table of Contents

Rest of World operating earnings were $129.1 million in 2016 compared to operating earnings of $113.0 million and $106.7 million in 2015 and 2014, respectively. Segment operating margins were 13.4 percent in 2016 compared to 13.0 percent and 13.9 percent in 2015 and 2014, respectively. Higher operating earnings and operating margin in 2016 compared to 2015 were primarily due to higher sales in China that were partially offset by increased SG&A expenses in China. Higher selling costs in China to support our sales efforts in tier 2 and tier 3 cities and higher advertising costs to support brand building were the primary drivers of higher SG&A expenses. Operating earnings in 2016 were also negatively impacted by almost $8 million due to the appreciation of the U.S. dollar in 2016. Higher operating earnings in 2015 were primarily due to higher sales in China and lower steel costs that were partially offset by lower sales of highly profitable commercial water heaters in China, increased SG&A expenses and approximately $1.5 million of higher losses in India compared to 2014. Earnings in China were reduced by approximately $2.5 million due to the appreciation of the U.S. dollar in 2015. Higher selling and engineering costs in China as well as higher SG&A costs associated with the 2015 launch of air purification products were the primary drivers for decreased operating margins in 2015 as compared to 2014. We expect 2017 operating margin to exceed 14 percent.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $796.4 million at December 31, 2016 compared with $750.1 million and $713.8 million at December 31, 2015 and December 31, 2014, respectively. Cash generated in China and sales-related increases in accounts receivable, inventory and accounts payable levels explain the majority of the increase in 2016 and 2015. As of December 31, 2016, essentially all of our $754.6 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have an accrual of $42.3 million for the repatriation of a portion of these funds.

Cash provided by operating activities during 2016 was $446.6 million compared with $351.7 million during 2015 and $264.0 million during 2014. The increase in cash flows in 2016 was primarily due to higher earnings from operations and lower outlays for working capital. We experienced a series of favorable cash flow impacts in China in the fourth quarter of 2016, including:

	•		A decline in accounts receivable balances from the prior year-end, despite higher fourth quarter sales in 2016. We received a series of unanticipated large customer payments late in the fourth quarter of 2016 and benefitted from improved terms with a few customers, all resulting in lower accounts receivable balances;

	•		An increase in trade payable balances most notably due to higher inventory in advance of the spring festival occurring in China in the last week in January; and

	•		Higher receipts of cash in advance of sales from distribution customers.

The improvement in cash flows in 2015 was primarily due to higher earnings from operations and lower outlays for working capital driven primarily by increases in accounts payable balances in China. We expect cash provided by operating activities in 2017 to be approximately $350 million. We expect higher earnings in 2017 to be more than offset by larger outlays for working capital due to the higher than anticipated cash flows in the fourth quarter of 2016. Over the two-year period from 2016 to 2017, we expect to generate operating cash of approximately $800 million, which compares with $616 million of operating cash flows during 2014 to 2015.

Our capital expenditures were $80.7 million in 2016, $72.7 million in 2015 and $86.1 million in 2014. We broke ground in 2016 on the construction of a new water treatment and air purification products manufacturing facility in Nanjing, China, to support the expected growth of these products in China. Included in 2016 capital expenditures were approximately $13 million related to capacity expansion in China as well as approximately $11 million related to our enterprise resource planning (ERP) system implementation. Included in 2015 capital expenditures were approximately $16 million related to our ERP implementation and approximately $19 million related to capacity expansion in China and the U.S. to support growth. Included in 2014 capital expenditures was approximately $31 million related to our ERP implementation. We project between $90 and $100 million of capital expenditures in 2017 and depreciation and amortization expense of approximately $70 million. We expect our spending on the manufacturing facility in Nanjing will be approximately $40 million in 2017.

In December 2016, we completed a $500 million multi-currency five year revolving credit facility with a group of nine banks. The facility has an accordion provision which allows it to be increased up to $700 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, 2016. The facility backs up commercial paper and credit line borrowings, and it expires on December 15, 2021. 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.

Table of Contents

In November 2016, we issued $45 million of fixed rate term notes in two tranches to two insurance companies. Principal payments commence in 2023 and 2028 and the notes mature in 2029 and 2034, respectively. The notes carry interest rates of 2.87 and 3.10, respectively. We used proceeds of the notes to pay down borrowings under our revolving credit facility.

In January 2015, we issued $75 million of fixed rate term notes to an insurance company. Principal payments commence in 2020 and the notes mature in 2030. The notes carry an interest rate of 3.52 percent. We used proceeds of the notes to pay down borrowings under our revolving credit facility.

At December 31, 2016, we had available borrowing capacity of $310.8 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 increased to $323.6 million at December 31, 2016 compared with $249.0 million at December 31, 2015, as our cash flows generated in the U.S were more than offset by our share repurchase activity and our purchase of Aquasana. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 17.6 percent at the end of 2016 compared with 14.7 percent at the end of 2015.

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 2016 but made a voluntary $30 million contribution due to escalating Pension Benefit Guaranty Corporation insurance premiums. We forecast that we will not be required to make a contribution to the plan in 2017 and we do not plan to make any voluntary contributions in 2017. For further information on our pension plans, see Note 10 of the Notes to Consolidated Financial Statements.

During 2016, our Board of Directors authorized the purchase of an additional 3,000,000 shares of our Common Stock. In 2016, we repurchased 3,273,109 shares at an average price of $41.30 per share and a total cost of $135.2 million. A total of 4,906,403 shares remained on the existing repurchase authorization at December 31, 2016. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, such as acquisitions, we expect to spend approximately $135 million on share repurchase activity in 2017 using a 10b5-1 repurchase plan. In addition, we may opportunistically repurchase an additional $65 million of our shares in 2017.

We have paid dividends for 77 consecutive years with payments increasing each of the last 25 years. We paid dividends of $0.48 per share in 2016 compared with $0.38 per share in 2015. In January 2017, we increased our dividend by 17 percent and anticipate paying dividends of $0.56 per share in 2017.

Aggregate Contractual Obligations

A summary of our contractual obligations as of December 31, 2016, is as follows:

(dollars in millions)						Payments due by period
Contractual Obligations		Total				Less Than 1 year				1 - 2 Years				3 - 5 Years				More than 5 years
Long-term debt		$	323.6			$	7.2			$	7.2			$	202.9			$	106.3
Fixed rate interest			38.6				4.6				8.1				7.2				18.7
Operating leases			37.4				19.5				7.9				4.2				5.8
Purchase obligations			150.8				141.4				5.8				3.6				—
Pension and post-retirement obligations			66.0				0.9				9.5				8.6				47.0
Total		$	616.4			$	173.6			$	38.5			$	226.5			$	177.8

As of December 31, 2016, our liability for uncertain income tax positions was $4.2 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

Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements.

Table of Contents

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 U.S. 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 monitor these significant factors and adjustments are made as 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 arm’s-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 in goodwill or indefinite-lived assets in 2016.

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 at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. 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. At December 31, 2016, our reserve for product warranties was $140.9 million.

Product liability

Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2016, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million.

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 utilize 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. At December 31, 2016, our reserve for product liability was $38.6 million.

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 plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our

Table of Contents

assumption for the expected return on plan assets was 7.50 percent in 2016 compared to 7.75 percent in 2015. The discount rate used to determine net periodic pension costs increased to 4.40 percent in 2016 from 4.05 percent in 2015. For 2017, our expected return on plan assets is 7.50 percent and our discount rate is 4.15 percent.

In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected 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 approximately 45 to 55 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2016, was 48 percent to equity managers, 37 percent to bond managers, ten percent to real estate managers, four percent to private equity managers and one percent to others. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 5.7 percent and 9.0 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.50 percent expected return on plan assets for 2017 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2016 and 2015 were based on the AonHewitt AA Only Above Median yield curve, which was designed by AonHewitt to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard &Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary.

As of December 31, 2015, we changed the method we used to estimate the service and interest components of net periodic pension benefit cost for our pension plan and post-retirement benefit plan. The change was the primary reason for the $7.1 million decrease in the service and interest components of pension costs in 2016.

As a result, we recognized pension income of $6.9 million in 2016 compared to $0.1 million of pension expense in 2015. Costs associated with our replacement retirement plan in 2016 were approximately $6 million, consistent with 2015. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014 which significantly decreased pension expense beginning in 2015. Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2017 by approximately $1.9 million. Lowering the discount rate by 25 basis points would decrease our 2017 net pension expense by approximately $0.3 million.

Outlook

We expect our sales in China will continue to grow at a rate of approximately 15 percent in local currency terms in 2017 led by continued strong sales growth of water heaters, water treatment and air purification products. We project continued declines in the Chinese currency compared to the U.S. dollar resulting in a five percent, or $40 million, headwind in 2017 sales, compared with the average rate in 2016. We expect our sales in the U.S. to grow due to residential water heater industry growth, driven by new construction and expansion of replacement demand, as well as continued growth in sales of our boilers and water treatment products. We expect sales of Lochinvar-branded products to grow over eight percent. We expect sales of Aquasana-branded water treatment products will add an incremental $40 million of sales in 2017. We expect steel prices to continue to be volatile and to be significantly higher than our average cost in 2016. We expect our effective tax rate to be between 29.4 percent and 29.7 percent assuming the current U.S. tax system remains in place.

Combining all these factors, we expect sales growth of between eight and 9.5 percent in 2017 and sales growth of between 9.5 and 11 percent measured in local currency in 2017 and earnings to be in the range of $1.98 to $2.08 per share for 2017. This does not include the potential impact of future acquisitions.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2016 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

Table of Contents

Market Risk

We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements.

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2016, we had net foreign currency contracts outstanding of $102.2 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $10.2 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2016, we had $189.2 million in outstanding floating-rate debt with a weighted-average interest rate of 1.5 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.3 million.

Forward-Looking Statements

This filing contains statements that the company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further slowdown in the growth rate of the Chinese economy and/or a decline in the growth rate of consumer spending in China; potential weakening in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; inability of the Company to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in the Company’s replacement markets; uncertain costs, savings and timeframes associated with the Company’s new enterprises resources planning system; foreign currency fluctuations; the Company’s ability to execute its acquisition strategy; competitive pressures on the company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this release, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.