A.O. Smith Corp (AOS) — Q2 2019 Earnings Call Transcript

Good morning, ladies and gentlemen, and thank you for joining us on our second quarter 2019 results conference call. With me participating in the call are Kevin Wheeler, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. As a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Kevin, who will begin our prepared remarks on slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. Chuck will elaborate on our financial performance in a moment. And while China continues to be particularly challenging, I am pleased to highlight several items and actions which help position us for future success. Number one, our solid operating margin performance in North America remained steady despite expected lower water heater volumes compared with last year. We announced a price increase of up to 4% on our North America wholesale water heater portfolio, effective August 1st. We joined our Hague and Water-Right water quality dealer sales organization together, so as to represent one customer-facing organization in that channel, and the transition has gone well. Continuing our strategy to leverage our distribution channel, we launched our A. O. Smith branded water treatment portfolio in the U.S. wholesale channel. We revised our China sales expectations as we moved into the back half of the year, with a path towards more normalized channel inventory levels, which, as previously discussed, has been elevated for over the past 15 months. Chuck will now describe our results in more detail, beginning on slide 4.

Thank you, Kevin. Sales for the second quarter of $765 million were 8% lower than the same quarter in 2018. Earnings in the second quarter of $102 million declined 11% compared to the second quarter in 2018. And second quarter earnings per share declined 8% to $0.61. Sales in our North America segment of $524 million declined 2% compared with the second quarter of 2018. Lower residential water heater volumes due to a tough second quarter 2018 comparison driven by pre-buying in advance of the price increase were partially offset by the mid-2018 pricing actions. In addition, our recently acquired Water-Right business added approximately $14 million to sales. Rest of the World sales of $249 million declined 19% compared with the same quarter of 2018. China sales were down 16% in local currency, primarily related to previously disclosed channel inventory buildup, which occurred in the first half of 2018 and did not repeat in 2019. The weaker Chinese currency unfavorably impacted translated sales by approximately $16 million. India sales grew over 30% in constant currency compared with the same period in 2018. In North America, segment earnings of $123 million were 2% lower than segment earnings in the same quarter in 2018. The favorable impact from mid-2018 pricing actions were more than offset by the unfavorable impact from the lower water heater volumes and higher steel costs and other costs. As a result, second quarter 2019 segment margin of 23.5% was essentially the same as last year. Rest of the World earnings of $22 million declined 35% compared with the second quarter of 2018. The impact to profits from lower sales more than offset the benefit to profits from lower SG&A expenses. Weaker China currency translation negatively impacted earnings by approximately $2 million. Our corporate expenses of $9.6 million were lower in the quarter compared with the second quarter last year, primarily due to lower incentive-based compensation. Interest costs were higher in the second quarter than a year ago due to the acquisition of Water-Right in early April. For the year, we expect interest expense to be approximately $11 million. Cash provided by operations of $144 million during the first half of 2019 was lower than $173 million in the same period of 2018, with lower earnings and higher working capital investment resulting in lower cash flow from operations. Our liquidity and balance sheet remain strong. Our debt-to-capital ratio was 17% at the end of the second quarter. We have cash balances totaling $578 million located offshore. Our net cash position was $219 million at the end of June. During the first half of 2019, we repurchased approximately 2.8 million shares of common stock for a total of $133 million. Through yesterday, we have purchased approximately 4 million shares at a cost of approximately $185 million, accelerating the pace of our repurchase due to valuation. Approximately 6.3 million shares remained on our existing repurchase authority at the end of June. We continue to see prolonged headwinds in the appliance market in China. Recent indications from our customers in China inform us that they will reduce orders for the third quarter. As a result, we have revised our 2019 EPS guidance to a range of between $2.35 and $2.41 per share, a 9% decline at the midpoint compared to last year. We expect our cash flow from operations in 2019 to be approximately $400 million compared with $450 million in 2018, primarily due to lower earnings. Our 2019 capital spending plans are approximately $85 million, and our depreciation and amortization expense is expected to be approximately $75 million in 2019. Our corporate and other expenses are expected to be approximately $49 million in 2019, slightly higher than last year due to inflation. Our expected effective tax rate is approximately 22%. We expect to repurchase our shares in the amount of $300 million in 2019. We expect our diluted outstanding shares in 2019 will be approximately $167 million. I will now turn the call back to Kevin, who will summarize our guidance and business assumptions for 2019, beginning on slide 10.

Okay, great. Thank you, Chuck. Our outlook for 2019 includes the following assumptions. We project U.S. residential water heater industry volumes will be down 50,000 to 100,000 units in 2019 as replacement remains stable, but new home construction appears to be lackluster due to labor shortages and weather delays. Commercial industry water heater volumes are expected to be up 1%. Based on boiler sales growth of 7% in the first half, we expect our North America boiler sales to grow approximately 7% for the full year. We project India water heater EBIT will be positive in 2019 and improvements to continue for water treatment in 2019. Overall in India, we will be profitable in 2020. Our forecast for the Chinese currency in 2019 is essentially level with where it is today and weaker than last year. Essentially all of the negative FX impact occurred in the first half of 2019. We see continued and prolonged headwinds in the appliance channel in China. Our third-party analysis of overall market performance in the second quarter showed the electric water heater market was down 8% to 9%, gas tankless water heaters down 2% to 3%, and water treatment systems down 1% to 2%. As previously discussed, we estimated 2018 China sales increased due to distributor inventory buildup, primarily in the first half of 2018. We are assuming continued weakness in the China consumer demand for the full year in 2019. We continue to improve our process to quantify inventories, while we experienced seasonality, a normal inventory level would be two to three months. Our current view is that the channel inventory is approximately four months. Based on our recent conversations with key customers, we expect channel inventory levels to decline over the back half of the year to approach normal channel inventory levels by the end of 2019. Due to the 2018 channel inventory buildup and with the impact of the expected 2019 channel inventory decline, we are projecting full-year sales to be down approximately 16% to 17% in local currency terms. Combined with our expected three points of unfavorable currency translation, our 2019 sales projection is a decline of approximately 19% to 20%. We expect third quarter 2019 channel China sales to be down 20% compared to the third quarter of 2018. Due to the decline in sales, we expect plant inefficiencies, reductions in headcount, and a higher mix of mid-priced products will have a slightly lower contribution margin weighing on margins. We forecast China third quarter 2019 operating margin will essentially breakeven. We expect fourth quarter performance to be similar to the second quarter as the fourth quarter is typically the strongest quarter of the year, offset by expected continued channel inventory declines. We see continued momentum in North America with our water heater, boiler, and water treatment products collectively expected to grow up to 6% in 2019, including approximately $40 million in Water-Right sales. Our profitability improvements and sales growth in India is also encouraging. Our business model in China is solid, and we are committed to the region for the long-term. We have near-term challenges to navigate through in China as the economy remains weak. We continue to stay close to our distribution customers as they work down channel inventory, and we continue to review our cost structure to right-size the business. We project revenue will decline by 2% to 2.5% for the year in U.S. dollars and 1% to 1.5% in local currency. EPS is projected to be between $2.35 and $2.41. We expect North America's segment margins to be between 23.50% and 23.75% and Rest of World segment margins to be approximately 6%. Our stable replacement markets, which we believe represent approximately 85% of North America water heater and boiler volumes, the long-term growth drivers in water treatment solutions and boilers across North America, coupled with our strong balance sheet, position us well to enhance shareholder value. That concludes our prepared remarks. We are now available for your questions.

Good morning. Could you update us on how you're thinking about price cost in North America in the second half of the year and maybe into 2020 given your price increase announced today and then lower steel costs?

We've typically not discussed pricing. I can say historically; we've been able to offset increased costs with pricing action. Our forecast and assumptions on steel are that currently we expect it will remain at this level for the rest of the year. Recently, we've seen some increases in steel prices or indications that steel prices may be going up.

Okay. And then, I believe you have previously done headcount reductions in China, but given the lower outlook would you reduce this more or do you believe you have already right-sized the business for current market conditions?

No, we're going to continue to review the business, as we always have, and we'll be aggressive. The first headcount reduction was about 10%. We completed that in the first quarter of last year. We are planning an additional 5% reduction in Q3. Additionally, we continue to scrutinize SG&A to ensure we are spending our money appropriately. We will continue to close on productive stores. As the market evolves, we'll aggressively adjust our business and right-size it to current conditions.

I appreciate that. That was helpful. Thank you.

Thank you for taking my questions. I wanted to start with Rest of World and maybe if you could try to categorize for us the visibility that you see. I know you mentioned that you believe that the inventories may normalize toward the end of the year. But given the big step change from last quarter to this quarter, could you talk about visibility and what you can see going forward? In terms of the numbers you highlighted about the volume declines, has that stabilized or do you believe they have not found a bottom in terms of year-on-year declines?

This is Chuck. Let me just talk a little bit about China. What we've talked about in the past is the weak economy and that continues. We have continued to see a weak economy that really has not changed. The elevated inventory remains roughly where it has been since we started discussing it in June of 2018. We've also talked about assuming our outlook last call. If channel inventory remained flat, we would be down 6% to 8%. What's changed in our visibility is that recently, as we came out of June and had conversations with customers, they indicated they will order less in the third quarter. Typically, in the third quarter, we would expect that inventories would go up. However, our visibility shows that we expect those inventories would start to come down in the third quarter and by year-end we'd have inventory levels similar to those at the end of 2017. So we believe we can reverse out some of the inventory that went into the channel last year and normalize to typical two to three month inventory levels by the end of this year.

Got it, thank you.

To add to that, we hope we have hit the bottom. We will monitor the situation closely, and if any adjustments are needed, we'll aggressively pursue them to right-size the business. But we believe we have offered the best outlook based on Chuck's insights into inventory visibility.

And in terms of the cost reduction initiatives that you mentioned previously, can you quantify for us how much savings you expect from the initiatives you've already taken?

Yes. For the year, the savings from the SG&A category are approximately $24 million to $25 million year-over-year. Think of that split roughly evenly between the first half and the back half of the year. However, the back half is slightly less due to some planned advertising investments for the fourth quarter, but that's roughly the amount. There is some headwind in the back half as we do have some severance costs associated with the headcount reductions.

Good morning, everyone. How are you doing?

Good morning.

So I guess the first question is thinking through the guidance you've provided regarding flat margins in China in the third quarter and a projected 6% for the full year. Could you walk us through a bridge of where you think, because I believe your initial guide was around the 11% range? Could you break down what's leading to the decline from 11% to 6% in terms of deleverage, restructuring, and sales volume?

Yes, I'll kind of take it in broad strokes. We discussed the inventory coming down, which is significant. The third quarter is expected to resemble the first quarter where sales are projected to be down about 20% compared to last year. The significant decline in sales results in plant inefficiencies that we hadn't previously anticipated, which negatively impacts margins in the third quarter. The fourth quarter should reflect similar performance to the second quarter, as it usually is our strongest period of the year, but we still expect some headwinds from channel inventory.

Okay. And then, as a follow-up, can you share your thoughts on the current state of your balance sheet in terms of M&A, especially considering the recent anticipation of the cut given how your stock has traded intraday? If there’s a significant market dip that places your stock at a substantial discount, would you consider being more aggressive with your share buyback program to capitalize on that opportunity?

Regarding China, we believe we'll be able to work through the inventories by the end of the year. Once we clear those hurdles, we expect more normalized operating performance. We plan to repurchase $300 million worth of shares this year and intend to stay on track with that.

To add, while we are encountering challenges in China, I wouldn’t classify it as a fight of a lifetime. We have a strong management team capable of navigating through tough periods, and we will emerge as a stronger organization. We've seen some mid-price point products gaining share, and our market share in Q2 was higher than Q1, showing encouraging trends.

There has been no meaningful trading down in our brand, and we feel confident about the long-term growth potential in China due to urbanization and the move towards the middle class.

Last question. In light of slight negative organic growth in the U.S. and the underlying fundamentals, do you have any concerns about potential changes in the organic growth rate moving forward?

We still believe there is stable organic growth in North America. We believe the slowdown seen in residential water heaters is due to external factors such as labor shortages limiting new construction, but we expect replacement markets to remain stable.

Well gentlemen, good luck. The market seems to be believing in you today.

Thanks. A couple of questions. Why do you think it's taking either the channel or A. O. Smith so long to react to the inventory situation in China?

We've had a prolonged slowdown in China that has persisted over multiple quarters, and discussions with customers indicate a decision to reduce orders in the third quarter was recently made. Expectations for June were likely not met, which has led to this adjustment.

So possibly could you elaborate on Q2 performance and what your expectations are for the year concerning the water heater business, water treatment business, and air purification in China?

In water treatment, we experienced a 12% decline largely due to channel inventory reduction impacts. For the full year, we expect sales to be down about that same percentage. The consumer demand is reported to be up about 8% to 10%. For water heating, we have introduced mid-range priced products and do have some headwinds, looking for demand to track similarly to the first half of this year.

Hey, good morning, everyone. On the performance of your core product categories in China, how do you think that's been tracking lately? What are the assumptions going forward?

Our best indicator is market share. At the start of the year, we saw a slight decline overall, but in Q2, our market share exceeded Q1. Acceptance of our new mid-price products has been encouraging, and we believe we're retrieving ample market share in the various categories.

Was that commentary exclusive to the water heater business or did that include treatment as well?

It includes both our water heaters and water treatment business. We have numerous categories, but overall we believe we're gaining fair share across all categories.

Can you talk about market share, how your market share is holding in North America on the residential and commercial water heater side? And then what's the progress on the water treatment side relative to your plans?

We had very good Q2 performance, and our market share in key categories, especially residential and commercial, returned to 2018 levels, showing slight improvement.

We expected incremental improvement in Q2 versus Q1, and that is indeed happening. We've had strong Q2 performance in water treatment. Our sales were about $37 million, with $14 million attributed to Water-Right, which is integrating well and on track.

On the topic of China, can you give us an early impression of the new price point product and when it might start to gain traction?

The mid-price point products have been introduced in phases. These are designed to have a suitable cost structure for the relevant category. Acceptance has been good, and we expect to introduce a few more products to fill gaps in offerings over the second half of the year.

Can you give us an idea of the current mix between premium and mid-price point products and your expectations for this mix one year from now?

Currently, we have a heavier mix of mid-price products, as we continue to work through the back half of the year. As we grow e-commerce and mid-to-mid-price products, we expect this mix to further normalize, although we will monitor margins closely.

Thanks for your response. I guess there's been earlier discussions about raw materials and pricing, and while spot market prices have been declining, your contract prices have remained high. When do you expect to see a benefit from lower steel prices, if any?

We expect to see benefits from lower prices within a 90 to 120-day lag once market prices adjust.

Is there a way to quantify those benefits?

We will look at quarter-over-quarter improvements but do not have a specific figure to disclose at this time.

Can you discuss what you are doing regarding the wholesale channel with respect to water treatment? Do you have a revenue target for this wholesale initiative?

We have just launched into that channel and are looking at growing our water treatment business year-over-year in the 10% to 15% range. However, the specific revenue target for the wholesale rollout isn't something we are sharing yet.

As for your global water treatment business, what's your revenue objective for 2019?

The objective is approximately $440 million to $450 million.

Can you discuss Lochinvar on the boiler side and how it performed in Q2 in contrast to your 7% growth target?

The backlog remains strong, but wet weather and labor shortages have hindered both our water heater and boiler sides. We expect a 7% growth rate due to these external factors affecting production.

Thank you for joining us on our call today. We will participate in several conferences in the third quarter. We will attend the Oppenheimer Conference in Chicago on August 15th, the Longbow Conference in New York on August 21st, and the Davidson Conference in Chicago on September 18th. Enjoy your day.