A.O. Smith Corp (AOS) — Q3 2019 Earnings Call Transcript

Thank you, Victor. Good morning, everyone, and thank you for joining us for our third quarter 2019 results conference call. With me today are Kevin Wheeler, Chief Executive Officer, and Chuck Lauber, Chief Financial Officer. Before we start, I want to remind you that some of the comments made during this call, including responses to your questions, will contain forward-looking statements. These statements are subject to risks that may cause actual results to differ materially. Those risks include, among others, details we have outlined in this morning's press release. I will now hand the call over to Kevin, who will begin our prepared remarks on Slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. I'm pleased to review several items regarding our third quarter performance. Sales in our North America segment increased 6%, and operating margin performance in North America improved approximately 200 basis points over last year. Our North America water heater and boiler operations continue to perform well. I'm particularly pleased with our commercial water heater performance, where we continue to outperform the market. Productivity within North America water treatment, manufacturing, and the effectiveness of our direct-to-consumer channel continued to improve, and Water-Right's performance is right on track with our expectations. We announced a 9% increase to our quarterly dividend rate in early October to $0.24 per share, which represents a five-year CAGR of 24%. In China, while the third quarter came in where we expected, we are disappointed to see further weakness in demand and expect that to continue in Q4. Moving to Slide 4, please. As weakness in our end markets in China persist, we have implemented further cost reduction actions. Over the course of the last 10 months into Q1 2020, we are targeting a 20% reduction in headcount from December 2018 levels. We continue to review and rationalize brand building and advertising spend, selling expenses, travel costs, and other SG&A spend. By the end of the year, on a net basis, we will close over 700 in non-productive stores. We are continuing our aggressive cost reduction programs in both manufacturing processes and product costs, and we'll continue to work with our distribution customers on programs to reduce their inventory. Total annualized savings as a result of these actions is estimated to be $38 million to $40 million, of which approximately $28 million will be realized in 2019. I will now turn over the call to Chuck, who will review our third quarter results in more detail. Chuck?

Thank you, Kevin. Sales for the third quarter of $728 million were 3% lower than the same quarter in 2018. Earnings in the third quarter of $87 million declined 17% from the third quarter in 2018, and third quarter earnings per share declined 13% to $0.53. Sales in our North America segment of $515 million increased 6% compared with the third quarter of 2018. Higher water heating, heating, heater and boiler volumes in the U.S. were supplemented by $16 million in sales in our recently acquired Water-Right business. Rest of the world segment sales of $220 million declined 20% compared with the same quarter in 2018. China sales declined 20% in local currency, primarily related to weak consumer demand and previously disclosed channel inventory levels. The weaker Chinese currency unfavorably impacted translated sales by approximately $6 million. India sales grew at 9% in local currency compared with the same period in 2018. On Slide 6, North America segment earnings of $122 million were 15% higher than segment earnings in the same quarter in 2018, driven by the favorable impact on profits from higher U.S. water heater and boiler volumes as well as lower steel costs, improvement in the profitability of Water-Right sales without Water-Right and incremental profit from Water-Right. As a result, third quarter 2019 segment margin of 23.6% improved from 21.7% achieved in the same period last year. Rest of the world earnings of $4 million declined significantly compared to the third quarter of 2018. The unfavorable impact on profits from lower China sales and a higher mix of mid-price products, which have lower margins, more than offset the benefit to profits from lower SG&A expenses in that region. As a result of these factors, segment margins declined to 1.9% compared with 14.3% in the same quarter of 2018. Our corporate expenses of $10 million were lower in the current quarter compared to the third quarter last year, primarily due to incentive-based compensation. Interest costs were higher in the third quarter than a year ago due to higher debt levels associated with the acquisition of Water-Right in April. For the year, we expect interest expense to be approximately $11 million. Cash provided by operations of $280 million during the first 9 months of 2019 was lower than $289 million in the same period of 2018 as a result of lower earnings, which were partially offset by a lower investment in working capital compared to a year ago. Our liquidity and balance sheet remain strong. Our debt-to-capital ratio was 16% at the end of the third quarter. We have cash balances totaling $514 million located offshore, and our net cash position is $195 million at the end of September. During the first 9 months of 2019, we repurchased approximately 4.9 million shares of common stock for a total of $230 million. Approximately 4.1 million shares remained on our existing repurchase authority at the end of September. On Slide 9, 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 $80 million, and depreciation and amortization expense is expected to be approximately $75 million in 2019. Our corporate and other expenses are expected to be approximately $46 million in 2019, essentially the same as last year. Our effective tax rate is expected to be approximately 22% in 2019. We expect to purchase our shares in the amount of approximately $300 million in 2019, and we expect average diluted outstanding shares in 2019 to be approximately 167 million. On Slide 10, we continue to see headwinds in our markets in China. The fourth quarter is typically the strongest consumer demand quarter of the year. However, with continued weak year-over-year consumer demand and persistently high channel inventory levels, we are forecasting the fourth quarter in China to be similar on the top line and operating profit line to the third quarter of 2019. As a result, we revised our 2019 EPS guidance to a range of between $2.25 and $2.28 per share, a 13% decline at the midpoint compared with last year. I will now turn the call to Kevin, who will summarize our guidance and business assumptions for 2019, beginning on Slide 11.

Okay. Thank you, Chuck. Our outlook for 2019 includes the following assumptions. First, let me start with China. We saw year-over-year consumer demand in the third quarter decline compared with the first half of the year and project full year sales to be down approximately 19% in local currency terms. Combined with our expected 4 points of unfavorable currency translation, our 2019 China sales projection is a decline of approximately 23%. Our forecast for the Chinese currency in Q4 substantially levels with where it is today. The sales decline of 19% in local currency is roughly equally attributable to weaker consumer demand and the change in China inventory year-over-year based on our projections of year-end channel inventories. Total channel inventory remained relatively unchanged from the second quarter at approximately four months. Historically, channel inventory increases in Q3 as it did in 2018 as the market prepares for the higher fourth quarter sales. This year, the channel did not experience a third quarter inventory increase. While we expect that consumer demand will be higher than other quarters of the year as the fourth quarter is typically a period of high promotion and buying in China, our assumption is the fourth quarter demand will run at a year-over-year decline similar to what we saw in the third quarter. We project that the channel inventory will be reduced nearly 1 month. We expect that we would exit the year with channel inventory levels remaining above normal. Normal is in the 2- to 3-month range. In the U.S., we project residential water heater industry volumes will be down 100,000 to 150,000 units in 2019. Commercial industry water heater volumes are expected to be up 4% to 5%, primarily driven by growth in the light-service electric models. Based on boiler sales growth of 5% year-to-date, we expect our North America boiler sales to grow approximately 5% for the full year. We project India water heater EBIT will be positive in 2019, and we expect India will achieve breakeven in 2020. Please advance to Slide 12. We project revenue will decline by approximately 5% for the year in U.S. dollars and 3.5% in local currency. We see sales growth in North America with our water heater, boiler and water treatment products collectively expected to grow approximately 4% in 2019, including $40 million to $45 million in Water-Right sales. EPS is projected to be $2.25 and $2.28. We expect North America segment margin to be between 23.5% to 23.75% and Rest of World segment margins to be approximately 4.25%. We are pleased with how our North America segment is performing, particularly on the water heater side on lower industry volumes. We see long-term growth drivers in water treatment solutions and boilers across North America. In the near term, the China economy remains weak, and we have taken further action to rightsize the business while continuing to invest in innovation. We have a strong brand, broad product offering in our key product categories, broad distribution, and a reputation for quality and innovation. Over time, we are well-positioned to maximize favorable demographics in both China and India to enhance shareholder value. Our replacement markets remain stable, which we believe represents approximately 85% of North America water heater and boiler volumes. We have strong cash flow and balance sheet, providing an opportunity to continue to invest in ourselves, acquisitions, and return cash to shareholders. That concludes our prepared remarks. We are now available for your questions.

Just on China, I guess, just a lower expectation, your margin top line. Are you seeing that as more aggressive destock or weaker consumer demand? And then just on inventory, should we expect kind of first half '20 to still be under margin pressure as you guys continue to destock? And when do you think that kind of wraps up and gets back to normal?

Yes, this is Chuck. When we review the update from our previous guidance, we have observed a slight decline in consumer demand, with our sellout down a bit. It was previously running flat year-over-year, which was our assumption. We are now seeing a 5% to 8% weaker decline in demand. This has delayed our anticipated inventory reduction at the end of Q3. On a positive note, inventory levels did not increase. Normally, by the end of Q3, inventories would rise by about 12% to 15%, but this year they remained flat. Last year, inventories went up at the lower end of that range. As we move into the latter half of the year, we expect a somewhat weaker Q4 due to the diminished consumer demand and the inventory needs we still have. We anticipate that inventories will decrease by about a month, which will present a challenge. Regarding the end of the year, we expect to be around three months of inventory, whereas typically it falls within the two to three-month range. Therefore, we are facing a bit of a headwind as we head into next year.

Okay. You mentioned that the North America commercial sector improved and performed well in the quarter. Could you provide details on the core growth of water treatment and share your qualitative insights on the residential water heater segment?

I will address the residential water heater segment. In the third quarter, we anticipated a stronger recovery in residential sales than what actually occurred. While there was positive growth, it did not meet our expectations, particularly considering that the industry was down by 194,000 units through August. Looking at September, we do not expect much improvement based on incoming industry data. Overall, we adjusted our industry outlook downward by 50,000 units compared to our second-quarter call, and we do not believe we can make up this shortfall in the fourth quarter. However, it's important to note that there are 120 million households with around 132 million water heaters. Variations of 100,000 to 150,000 units can occur from year to year. We are coming off two consecutive years of over 4% growth, but this year seems to indicate a decline of about 1.5%. Overall, we remain optimistic about our water heater business, with our replacement market expected to stay strong. Thus, while it may be a slight down year for the residential sector, annual fluctuations are to be expected.

And on water treatments, on the water treatment side, the North America water treatment, that is, last year, we had a bit of a tough comp because we had some ramp-up going on with one of our major customers. But if you look at the base business, we grew at about 9% for the quarter. So the base business is growing nicely like the back half of the trajectory on growth as well as continuing to look at improvements in operations.

I appreciate the commentary on North America but wanted to see if you could dig into the results a little bit more. You talked about a 4% price increase back in August. How has this been received by the market? And are you seeing some more price increases from competitors? Or just in general, any changes in the competitive dynamic?

We're going to be very consistent here since we're the only public company. What I will say is we announced and implemented a 4% increase, as stated in August, and that's been implemented.

Okay. And then based on the 20% total headcount reduction in China, can you just confirm if that would be another 5% reduction in the fourth quarter? And maybe provide some color on where those headcount reductions are occurring, if you feel like the business will be rightsized for the 2020 market conditions at this point.

Yes, we have increased that percentage from 15% to 20% since the last quarter due to ongoing weakness in consumer demand. We will evaluate if this should be increased moving forward. Some of this will carry into Q1, and we expect to see the effects over the next two quarters. The impact has been widespread, but we have been careful to maintain our R&D and engineering capabilities and continue our investment in innovative products. We have not resorted to headcount reductions in those areas, but the cuts have been overall across the board.

Yes. To add some context, it’s crucial for us to make necessary adjustments for the current environment while ensuring that our business—be it in operations, manufacturing, or engineering—is positioned to ramp up quickly when the economy rebounds. Our strategy is very deliberate, and we are confident that the economy will recover; we just don't know the timeline. Therefore, we aim to align our cost structure with the current environment while also ensuring we can respond effectively when the economy improves, allowing us to provide our customers with the service they expect. It’s about finding the right balance, and we are examining it from every angle.

So just some thoughts on China here from a competitive dynamic, market share perspective. Last couple of quarters, you've given some good detail about how you think you're tracking versus the market, both at the high end as well as kind of overall. Maybe you can just give us an update there and then specifically talk about how you think you're performing versus the market as well as competitive situation.

Yes, this is Kevin. Let's discuss Q3, as we evaluate our performance on a quarterly basis, and there are fluctuations. In Q3, we maintained our market share in gas tankless products. However, in wall hung electric and water treatment, we experienced a slight decline of about 200 basis points. For electric water heaters, we have identified the regions where our share decreased, and we plan to take action in those areas. It's also important to note that in Q2, we increased our market share, so it’s natural to see some retraction. Nevertheless, these fluctuations are normal from quarter to quarter, and we don’t foresee any significant issues. We anticipate regaining our share over time and have the necessary products and distribution to support that. Regarding competition, China has been a challenging market for the past two decades, and we face competitors in the premium segment whom we must consistently engage with. The market is currently somewhat soft, yet our mid-priced products have performed reasonably well alongside our premium offerings that still deliver value to consumers. Overall, when we take a step back, our market share remains in line with our expectations, and minor fluctuations will continue to occur quarterly.

And I think, Mike, on your comments or your question about the high end of the market, the water treatment side, when we look at this year-to-date compared to 2018, we've seen it pretty stable. We haven't seen any decline, consistent with what I think we've talked about in the other quarters within the water heating side, both gas and electric. We saw the high end come down a couple of hundred basis points as far as the total market, percentage of market.

Okay. That makes sense there. And then the margins in the fourth quarter, I think, Chuck, you said about consistent with the third quarter. I think the math I ran was closer to breakeven. Just to confirm that one way or another. And then more importantly, just maybe talk about some of the puts and takes going into the fourth quarter to get to that margin profile. How much of this is just really volume deleverage versus maybe including severance or some of these other one-off kind of cost items? Any kind of color on the puts and takes and factors there would be helpful as well.

Yes. The Q4 volume is primarily driven by volume. Compared to last year, you can think of it as 50% due to channel inventory reduction impacting our volume, and the other 50% stemming from lower consumer demand. Regarding headcount reduction and associated costs, while we still have some expenses related to headcount reduction and severance in Q4, the benefits from these actions are greater than the incurred costs. There were also some inefficiencies at the plants which occurred at a lower rate. These factors somewhat balance each other out. However, the risks related to the Q4 forecast are more tied to consumer demand than channel inventory adjustments, as we anticipate a decrease in channel inventory by about a month. In terms of Q4 specifically, we see it as nearly a breakeven quarter in China.

I wanted to start off by, while we're on China, parsing out, if we can, sort of the difference between what you might have been seeing in your mid-price point product versus your premium price point product. And if we're able to talk about that four months of surplus inventory, are you able to parse out how many months are you in terms of just if we isolate the premium? Because it seems like the mid-price point is probably turning relatively well given where the markets migrated and maybe the concentration that might be in premium. So if it's four months on the aggregate inventory, what would it be on the premium?

Yes. I mean I'll say that right now, in Q3 and Q4, what we're seeing as sell into the channel is more heavily weighted towards the mid-price, lower-margin product. The channel does have more of the higher-price product that's taking longer to move in this sort of an environment. To parse it out and split it, we don't have that kind of clarity exactly right now. It looks like we see it changing over time because we know that we're selling mostly, and that's why our margins are lower in these two quarters, we're selling a larger percentage of mid-price product with lower margins. As far as the months, so we've got about four months of inventory, and I want to help define that a little bit. So four months, think of it in terms of the guidance we gave, so down 23% from last year. And we're thinking of four months as you take that number and divide it by 12, and that's roughly the number of dollars we kind of have in the inventory. So I wanted to frame it a bit because we're not looking at it as the next three months sellout. We're kind of looking at it as the 12-month average and working to get that down. So as the total year volume goes down, that's where we got a little bit more aggressive. But it's about four months looking to go to about three months by the end of the year.

Okay. And then, I guess, as a follow-up, just maybe talk about the boiler business. And I guess you've reduced guidance twice so far this year. Can you just talk about performance in the third quarter with maybe a little bit more granularity? And also, I guess, any color you can provide in terms of just the backlog dynamics? Are you seeing backlogs up or down in the boiler business? And just what does quoting activity look like in the boiler business?

The boiler business presents a somewhat mixed picture. Activity, including bidding and quoting, has been very active throughout the year, continuing from last year. We are witnessing a significant amount of activity leading to orders, even though many jobs are experiencing delays or postponements, possibly due to labor shortages. Despite this, we are anticipating a 5% growth and are gaining market share in most of our competitive categories. Our backlog of quotes has been released as expected, and while we foresee a gradual release over time, there is a longer delay between quoting and converting these into orders than we have experienced before. Overall, the commercial business appears strong, and we are capturing a good share of the jobs translating into orders. We expect this trend to persist into next year.

Can you hear me?

We can, Robert.

Yes. We can.

I think when considering China, it's clear there's a visibility issue with the channel and the ongoing developments, especially since you've consistently reduced your assumptions, particularly from the second to the third quarter. Next year is the year of the rat instead of the pig, with the New Year starting on the 25th. However, will you be able to provide detailed guidance or insight for the fourth quarter in China, given the current dynamic situation?

Let me address that. I've been asked multiple times if we're at the bottom, but we really don’t know. The data is somewhat ambiguous. We're coming off a challenging third quarter where consumer demand decreased, as previously mentioned. The fourth quarter will provide us insights for 2020. This market requires us to approach it month by month and quarter by quarter. Hopefully, there might be a Phase 1 of the China agreement that could assist as we enter 2020, but we can’t be certain yet. What we can do is share our best perspective based on the current data, and the fourth quarter is critical as we prepare for 2020. We are in the midst of our planning process now, but we need to see how the fourth quarter unfolds.

Moving on to North America, I understand there are some limitations on what can be shared due to competitive dynamics. However, could you provide insights on the growth rates for tank versus tankless systems in the near term? Have you noticed a significant shift, especially with some tankless applications and the decreasing overall costs, which may indicate a growing preference for them? Historically, tankless systems have demonstrated better growth rates. What information can you share on this, considering the different growth rates we've observed in North America? Additionally, it's worth noting that you missed the consensus numbers for the third quarter and adjusted your assumptions for the fourth quarter. Any visibility into potential significant changes in the fourth quarter would be appreciated.

Let me address that. There is no sea change. In the tankless segment of the business, growth is definitely faster than in the tank segment. The difference has changed significantly, with tank sales declining by about 1.6% while tankless sales are increasing by approximately 3.5%. This indicates a contraction between the two categories, but no meaningful change overall. Having been in this industry for 30 years, I can say that predicting fluctuations is challenging. A few hundred thousand units is relatively minor compared to the millions we sell. Nonetheless, we believe the North American tank replacement market is solid. We remain active in the gas tankless market, holding a low double-digit share that we continue to improve. We will be addressing gaps in the tankless category in 2020. Our distributors appear to be confident as we head into the upcoming quarter and next year. Overall, things remain fairly consistent with the start of the year.

Rob, I want to briefly return to China and discuss our visibility into the channel inventory there. We believe we have a clear view of the channel inventory, but we are facing challenges with sellout and consumer demand. This has led to a revision in our estimates from the previous quarter. It's important to note that we do not control the channel inventory; it is managed by our customers. We collaborate closely with them to help move the inventory through the channel, utilizing promotional programs. However, the significant change from our last forecast is primarily due to a decline in consumer demand.

I just wanted to ask about you filed an 8-K back earlier in October just looking at amendments to the articles of incorporation. And I was just wondering if you could just talk about the motivation for incorporating these various defensive measures.

If I may?

Sure.

David, this is Pat. The amendment was basically to bring our charter and bylaws up to our peers and current standard. So it was really just some benchmarking that we had done and looked at what best practices for shareholder proposals and for director nominees. So it really was benchmarking and best practices that drove the amendment.

Got it. I have a follow-up question. Last quarter, I asked you about the distribution between mid-price point and premium price point in China. You mentioned you would provide that information later. I'm wondering if we could revisit that question and get a clearer understanding of the proportions in the Chinese market. Additionally, is there anything you could consider in the long term to enhance the contribution margin on the mid-price point product besides simply increasing scale?

Yes, this is Chuck. We don’t have detailed information on the changes in mid-price points. We have launched additional products in the RMB 3,000 to RMB 5,000 range. As we mentioned before, the contribution margin for these products is not as high as for the high-end products. However, we are implementing cost reduction programs, as we always do, aimed at lowering product costs and enhancing productivity and process improvement. Currently, there is a heavier emphasis on the high end of the mid-price products since the channel currently has more higher-end items available than mid-priced ones. The newer models we’ve introduced are being well received in the market, and our customers are eager to adopt them. At the same time, we are diligently working to reduce channel inventory and manage some of the higher-priced models available.

There has been recent news about Haier entering the North American water heater market and building a plant. Can you discuss this? The market seems rational with a few players and good returns. What are you observing in the market, and what are your expectations regarding this new competitor?

What I can share is that it has been publicly announced that they are planning to enter the electric water heater market and that they have made a $60 million investment in South Carolina. We have not yet seen any products released, and we do not have much information beyond what has been published. Regardless, we always face competition. A.O. Smith has established long-term relationships with customers and offers the widest range of products in the market, along with advanced technology and high service levels. We also maintain strong market share. Ultimately, it seems there will be another competitor making a partial entry. They are suggesting this will happen next year in the fourth quarter, and we will address it just as we have with our other competitors. There is not much more to add beyond what has already been mentioned. We believe that our market share and diverse product offerings in both residential and commercial sectors position us well to continue advancing and succeeding in our markets.

Okay. Great. And then just back to the water treatment. Chuck, was the 9% that you mentioned excluding that large customer, or would that have included the tough comparison?

Yes. That excluded the load-in of ramp-up of the large customer because we had an unusually high ramp-up of a customer. So the 9%, we view as more as kind of the baseline growth of the base business.

Yes. No. I mean I guess a question I would have is can you give us any kind of updated embedded expectation for the relationship with Lowe's? And has anything changed there in terms of what is kind of translated into your guidance for this year and thinking about next year?

No, we cannot discuss specific customers moving forward, especially regarding their performance. Overall, our water treatment business continues to improve across all categories, including our dealer network, direct-to-consumer, retail, and wholesale. The business is on an upward trajectory, with increased productivity and improving margins as we expand into these market segments.

And then just a follow-up on the entrance of GE and Haier. I mean I guess it stands to reason though that it worked through a material price increase several years ago. It worked out. But that was in the context of, I guess, to pass an oligopoly. I mean clearly, do you think going forward, if it gets to a more competitive environment with more players, that does lead to lower return thresholds and definitely could put a cap or put some pressure on the North American margins? How do you think about trading profitability versus growth in North America going forward if the market changes?

I don't believe they are mutually exclusive, and we don't engage in trading. Let's consider this from a broader perspective. I'm not going to get into details about this potential competitor, but if you examine their announced investment of $60 million, I can assure you that our investment is ten times that amount. Competing effectively in this market requires significant investment, engineering, and strong sales organizations. We are confident in our position. Over the past 60 to 70 years, we have invested around $600 million in building this business. We feel optimistic about our future. We believe we have the necessary foundations in product, manufacturing, and engineering to compete moving forward, and that is our commitment. This has been our approach for the last 60 to 70 years, and we will continue this strategy going ahead.

We haven't discussed raw materials much during this call, but you mentioned in your prepared remarks and press release that they have positively impacted North American margins. Could you elaborate on how much that contribution could potentially increase? The steel markets have seen significant price decreases. It's unclear how much you're exposed to contracts versus spot pricing in the U.S., but it seems your indirect exposure might be favorable as well. How should we expect the margin contribution from raw materials to evolve as we progress through the fourth quarter and into the first half of next year?

For the fourth quarter, it's important to note that our steel costs are determined in advance. We typically experience a 90- to 120-day delay in seeing changes in steel costs, whether they increase or decrease. If we look back at the fourth quarter, we had our most favorable steel cost position for 2019. However, it’s crucial to consider the margin side of things, as we have some major retail clients with formula pricing that can also go in the opposite direction. While there is certainly a chance for margin expansion when steel prices decrease, there is also a corresponding challenge on pricing that can negate that benefit. As we approach the end of the year, we have our strongest steel position in the fourth quarter.

Thank you all for joining us on our call today. We will participate in several conferences over the course of the fourth quarter. The first is the Baird conference in Chicago. We will be there on November 5 and in the morning of November 6; and we will participate in the Stephens conference in Nashville on November 14. Have a great day.