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 and electric water heaters, boilers and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and markets water systems tanks. Our Rest of World segment also manufactures and markets in-home air purification products in China.

In our North America segment, we project our sales in the U.S. will grow in 2018 compared to 2017 due to higher residential water heater and boiler volumes resulting from expected industry-wide new construction growth and expansion of replacement demand. We expect the North America residential water heater industry to have three to 3.5 percent unit growth in 2018. Due to nearly 20 percent unit growth in 2017, partially driven by an anticipated 2018 regulatory change and resulting pre-buy, we expect the North America commercial water heater industry to have a three percent unit decline in 2018. Our sales of boilers grew 13 percent in 2017, and we expect ten percent sales growth in 2018, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. We continued to expand our North America water treatment platform with the acquisition of Hague on September 5, 2017. We expect sales of North America water treatment products to increase by approximately 50 percent in 2018, compared to 2017, primarily due to volume growth and a full year of Hague sales.

In our Rest of World segment, we expect China sales to grow in 2018 at a rate of approximately 13 percent, 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. In addition, we expect our sales in India to grow over 40 percent in 2018 from approximately $26 million in 2017.

Combining all of these factors, we expect total company sales growth of between 8.5 percent to 9.5 percent in 2018.

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 high growth regions demonstrated by our introduction in 2015 of air purification products in China and water treatment products in India and Vietnam.

RESULTS OF OPERATIONS

Our sales in 2017 were a company record $2,997 million surpassing 2016 sales of $2,686 million by 11.6 percent. The increase in sales in 2017 was primarily due to higher sales in China as well as higher sales of water heaters and boilers in North America. Sales in China grew 15.9 percent to over $1 billion in 2017, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 17.9 percent in 2017. Our sales in 2016 were higher than 2015 sales of $2,537 million by 5.9 percent. In 2016, excluding the impact from the appreciation of the U.S. dollar against the Chinese currency, our sales grew approximately eight percent. 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 by 18.9 percent in 2016.

Our gross profit margin in 2017 decreased to 41.3 percent from 41.7 percent in 2016. The slightly lower margin in 2017 was due to significantly higher steel costs that more than offset pricing actions taken in 2017 in North America and China. Our gross profit margin in 2016 increased from 39.8 percent in 2015 primarily 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. than in 2015.

Selling, general and administrative (SG&A) expenses were $59.3 million higher in 2017 than in 2016. The increase in SG&A expenses in 2017 to $718.2 million was primarily due to higher selling and advertising expenses to support increased volumes and brand building in our newer product categories. SG&A expenses were $48.2 million higher in 2016 than in 2015 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.

Pension income in 2017 was $9.1 million compared to $6.9 million in 2016 and $0.1 million of pension expense in 2015. As of December 31, 2015, we changed to what we believe is a more precise method to estimate the service cost and interest components of net periodic benefit cost for our pension and post-retirement plans. The change was the reason for $7.7 million and $7.1 million of decreases in 2017 and 2016, respectively, compared to 2015, in service and interest costs.

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Interest expense was $10.1 million in 2017 compared to $7.3 million in 2016 and $7.4 million in 2015. The higher interest expense in 2017 compared to 2016 was primarily related to higher interest rates as well as higher overall debt levels primarily due to increased share repurchases and acquisitions completed in 2016 and 2017.

Other income was $10.4 million in 2017 compared to $9.4 million in 2016 and $10.8 million in 2015. The increase in other income in 2017 compared to 2016 was primarily due to higher interest income. 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.

Our effective income tax rate was 43.1 percent in 2017, compared with 29.4 percent in 2016 and 29.7 percent in 2015. The significant increase in our effective income tax rate in 2017 compared to previous years was due to provisional one-time charges associated with the U.S. Tax Cuts & Jobs Act (U.S. Tax Reform) of $81.8 million, primarily related to the mandatory repatriation tax on undistributed foreign earnings that we are required to pay over eight years. Excluding the impact of the U.S. Tax Reform provisional one-time charges, our adjusted effective income tax rate was 27.4 percent in 2017. Our adjusted effective income tax rate in 2017 was lower than our effective income tax rate in 2016 primarily due to lower U.S. state income taxes and higher deductions for share-based compensation. Our lower effective income tax rate in 2016 compared to 2015 was primarily due to our adoption of an accounting standard for share-based compensation partially offset by a change in geographic earnings mix. We estimate our annual effective income tax rate for the full year 2018 will be approximately 22.0 to 22.5 percent, significantly lower than previous years due to U.S. Tax Reform.

North America

Sales in our North America segment were $1,905 million in 2017 or $162 million higher than sales of $1,743 million in 2016. The increase in sales in 2017 compared to 2016 was primarily due to higher volumes of water heaters and boilers, price increases in the U.S. for water heaters largely related to steel cost increases as well as our customer’s pre-buy of commercial water heaters in advance of an anticipated 2018 regulatory change. North America water treatment sales, comprised of Hague, acquired in September 2017 and Aquasana, acquired in August 2016, incrementally added approximately $40 million of sales in 2017. Sales in 2016 were $40 million higher than sales of $1,703 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 a 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 in 2016 compared to 2015 offset these benefits.

North America segment earnings were $428.6 million in 2017 compared to segment earnings of $385.9 million and $339.9 million in 2016 and 2015, respectively. Segment margins were 22.5 percent, 22.1 percent and 20.0 percent in 2017, 2016 and 2015, respectively. The higher segment earnings and segment margin in 2017 compared to 2016 were primarily due to higher water heater and boiler volumes and pricing actions which were partially offset by higher steel costs. Segment margin in 2017 also benefitted from lower SG&A expenses as a percent of sales. The higher segment earnings and segment 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., which were partially offset by lower U.S. residential water heater volumes. We estimate our 2018 North America segment margin will be between 22 and 22.5 percent primarily due to anticipated growth in boiler and residential water heater volumes offset by higher steel costs.

Rest of World

Sales in our Rest of World segment in 2017 were $1,116 million or $150 million higher than sales of $966 million in 2016. Sales in China grew 15.9 percent to over $1 billion in 2017 due to higher demand for our consumer products, led by water treatment and air purification products and pricing actions primarily due to higher steel and installation costs. Excluding the impact from the appreciation of the U.S. dollar in 2017, sales in China increased 17.9 percent. Water heater and water treatment sales in India increased $8 million, over 40 percent, in 2017 compared to 2016. Sales in our Rest of World segment in 2016 were $100 million higher than sales of $866 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. Water treatment sales in China totaled $177 million in 2016 compared to $130 million in 2015. Sales of air purification products were $26 million in 2016 compared to $9 million in 2015.

Rest of World segment earnings were $149.3 million in 2017 compared to segment earnings of $129.1 million and $113.0 million in 2016 and 2015, respectively. Segment margins were 13.4 percent in 2017 compared to 13.4 percent and 13.0 percent in 2016 and 2015, respectively. Higher segment earnings in 2017 compared to 2016 were primarily due to higher sales in China, which included a price increase, partially offset by higher steel costs, higher fees paid to installers and increased SG&A expenses. Higher SG&A expenses in China were primarily due to the expansion of water treatment and air purification product retail outlets in tier 2 and tier 3 cities, higher advertising expenses related to brand building in our newer product

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categories and higher water treatment product development engineering costs. Higher segment earnings and segment margin in 2016 compared to 2015 were primarily due to higher sales in China 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 in 2016. Operating earnings in 2016 were also negatively impacted by almost $8 million due to the appreciation of the U.S. dollar in 2016. We expect 2018 Rest of World segment margin to expand 30 to 40 basis points compared to 2017.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $978.3 million at December 31, 2017 compared with $796.4 million and $750.1 million at December 31, 2016 and December 31, 2015, respectively. Cash generation in China and sales-related increases in accounts receivable, and inventory levels explain the majority of the increase in 2017 and 2016. As of December 31, 2017, essentially all of our $820.0 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. In December 2017, we recorded provisional one-time charges of $81.8 million primarily associated with the mandatory repatriation tax of undistributed foreign earnings under U.S. Tax Reform. In addition, we had an existing accrual of $38.6 million associated with withholding taxes due upon issuance of foreign dividends. We expect to repatriate approximately $200 million in the first half of 2018 and use the proceeds to repay floating rate debt.

Cash provided by operating activities during 2017 was $326.4 million compared with $446.6 million during 2016 and $351.7 million during 2015. The decline in cash flows in 2017 compared to 2016 was primarily due to higher outlays for working capital than the below normal levels experienced in 2016, which more than offset the impact of higher earnings in 2017. The increase in cash flows in 2016 compared to 2015 was primarily due to higher earnings from operations and lower outlays for working capital. We experienced favorable cash flow impacts in China late in the fourth quarter of 2016 primarily from a series of unanticipated large customer payments including customer deposits.

Over the two-year period from 2016 to 2017, we generated operating cash of approximately $773 million, which compares with $616 million of operating cash flows during 2014 to 2015. We anticipate cash provided by operating activities to be $475 to $500 million in 2018, compared to $326 million in 2017, due to higher projected earnings and lower outlays for working capital, particularly inventory.

Our capital expenditures were $94.2 million in 2017, $80.7 million in 2016 and $72.7 million in 2015. 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 2017 capital expenditures were approximately $24 million related to capacity expansion 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 the continuation of 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. We project approximately $100 million of capital expenditures in 2018, which includes approximately $30 million related to the completion of capacity expansion in China. We project depreciation and amortization expense of approximately $80 million in 2018.

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.

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 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, 2017. 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.

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At December 31, 2017, we had available borrowing capacity of $217.1 million under this facility. We believe that our 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 $410.4 million at December 31, 2017 compared with $323.6 million at December 31, 2016, as our cash flows generated in the U.S were more than offset by our share repurchase activity and our acquisition of Hague. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 19.9 percent at the end of 2017 compared with 17.6 percent at the end of 2016.

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 2017 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 2018, and we do not plan to make any voluntary contributions in 2018. For further information on our pension plans, see Note 10 of the Notes to Consolidated Financial Statements.

In 2017, we repurchased 2,533,350 shares at an average price of $54.90 per share and a total cost of $139.1 million. A total of 2,373,053 shares remained on the existing repurchase authorization at December 31, 2017. 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 2018 using a 10b5-1 repurchase plan. In addition, we may opportunistically repurchase our shares in the open market in 2018.

We have paid dividends for 78 consecutive years with payments increasing each of the last 26 years. We paid dividends of $0.56 per share in 2017 compared with $0.48 per share in 2016. In January 2018, we increased our dividend by 29 percent and anticipate paying dividends of $0.72 per share in 2018.

Aggregate Contractual Obligations

A summary of our contractual obligations as of December 31, 2017, 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		$	410.4			$	7.5			$	6.8			$	296.5			$	99.6
Fixed rate interest			34.1				4.1				7.7				6.8				15.5
Operating leases			47.5				20.2				8.5				5.6				13.2
Purchase obligations			118.5				118.3				0.1				0.1				—
Pension and post-retirement obligations			57.2				0.8				17.0				2.0				37.4
Total		$	667.7			$	150.9			$	40.1			$	311.0			$	165.7

As of December 31, 2017, our liability for uncertain income tax positions was $6.2 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.

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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 (GAAP), 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 thorough and competent annual valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2017.

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, 2017 and 2016, our reserve for product warranties was $142.4 million and $140.9 million, respectively.

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 2017, 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, 2017 and 2016, our reserve for product liability was $40.1 million and $38.6 million, respectively.

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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 assumption for the expected return on plan assets was 7.50 percent in 2017 and 2016. The discount rate used to determine net periodic pension costs decreased to 4.15 percent in 2017 from 4.40 percent in 2016. For 2018, our expected return on plan assets is 7.15 percent and our discount rate is 3.65 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, 2017, was 45 percent to equity managers, 43 percent to bond managers, nine percent to real estate managers, two 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 6.3 percent and 9.2 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 7.15 percent expected return on plan assets for 2018 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2017 and 2016 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.

We recognized pension income of $9.1 million in 2017 compared to $6.9 million of pension income in 2016 and $0.1 million of pension expense in 2015. 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. Historically, we estimated the service and interest cost components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. We elected to utilize an approach that discounts the individual expected cash flows underlying the service cost and interest cost using the applicable spot rates derived from the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. This change was made to provide a more precise measurement of service and interest costs by improving the correlation between the projected benefit cash flows to the corresponding spot yield curve rates. The change was the reason for $7.7 million and $7.1 million decreases in 2017 and 2016, respectively, compared to 2015, in service and interest costs.

Costs associated with our replacement retirement plan in 2017 were approximately $6 million, consistent with 2016. 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 $2.0 million. Lowering the discount rate by 25 basis points would decrease our 2017 net pension expense by approximately $0.3 million.

Non-GAAP Measures

We provide non-GAAP measures (adjusted earnings and adjusted earnings per share) that exclude one-time expenses associated with U.S. Tax Reform. We believe that these non-GAAP measures better reflect our financial performance.

As such, we believe that the measures of adjusted earnings and adjusted earnings per share provide management and investors with a useful measure of our results. We have prepared annual reconciliations of adjusted earnings and adjusted earnings per share for 2017.

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A. O. SMITH CORPORATION

Adjusted Earnings and Adjusted EPS

(dollars in millions, except per share data)

(unaudited)

The following is a reconciliation of net earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP):

		Years ended December 31,
		2017				2016
Net Earnings (GAAP)		$	296.5			$	326.5
U.S. Tax Reform income tax expense			81.8				—
Adjusted Earnings		$	378.3			$	326.5
Diluted EPS (GAAP)		$	1.70			$	1.85
U.S. Tax Reform income tax expense per diluted share			0.47				—
Adjusted EPS		$	2.17			$	1.85

Excluding the impact of U.S. Tax Reform provisional one-time charges, our 2017 adjusted effective income tax rate was 27.4 percent as compared to our effective income tax rate of 43.1 percent in 2017.

Outlook

We expect our consolidated sales to grow 8.5 to 9.5 percent in 2018. With our organic growth potential and our stable replacement markets, we expect to achieve full-year earnings of between $2.50 and $2.58 per share, which excludes the potential impact from future acquisitions. Our guidance includes the estimated benefit related to our lower projected income tax rate under U.S. Tax Reform.

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 2017 and we do not expect them to be material in any single year. We have reserves and available insurance coverage 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.

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, 2017, we had net foreign currency contracts outstanding with notional values of $94.9 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 $9.5 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, 2017, we had $282.9 million in outstanding floating-rate debt with a weighted-average interest rate of 2.3 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 $0.6 million.

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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 slower rate of conversion in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; our inability to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in our replacement markets; foreign currency fluctuations; our inability to successfully integrate or achieve our strategic objectives resulting from acquisitions; competitive pressures on our businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; the impact of U.S. Tax Reform for effective income tax rates and one-time expenses under the new law 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.