A.O. Smith Corp (AOS) — Q2 2020 Earnings Call Transcript

Thank you, Michelle. Good morning, ladies and gentlemen, and welcome to A. O. Smith second quarter 2020 results conference call. Joining me today are Kevin Wheeler, Chairman and 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 and on slide 2. On slide 3, in order to provide improved transparency into the operating results of our business, we've provided non-GAAP measures: adjusted net earnings, adjusted earnings per share, and adjusted segment earnings that exclude the severance and restructuring charges related to aligning our business to current market conditions. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. Also, 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 4.

Thank you, Pat. Before I summarize the quarter and Chuck goes through the results, I want to express how proud I am of our global team. We faced challenges and complexities to our business that we have never faced before. Our number one goal was and remains to keep our employees safe while delivering our essential products to our customers. I say confidently that our team met and often exceeded my expectations. Thank you to the men and women in the A. O. Smith family around the world for your dedication and your spirit; you truly make A. O. Smith a remarkable company. The business performed in the second quarter is largely in line with what we saw in April. Continuing the pace of growth we saw in the first quarter, our North America water treatment business organically grew 19%. Direct-to-consumer and retail sales were particularly strong as consumers became more health-conscious during the pandemic and the shelter-in-place orders confined many of us to our homes. As expected, industry volumes of residential water heaters in the U.S. held up notably well. Based on our June shipments, we estimate industry volumes are flat to slightly less than the quarter compared to last year. Due to construction project delays and postponements in North America, we saw commercial water heater and boiler volumes decline in line with our estimates of the industry declines of 20% to 25% in the quarter compared with last year. Consumer demand for our products in China was flat to slightly positive compared to the second quarter of 2019, as restaurants and shopping malls reopened and retail foot traffic increased. We remained operational with no significant disruptions. Our Juárez Mexico plant, which we voluntarily closed in April, reopened in May and ramped up production in the latter portion of the quarter. We have taken numerous and meaningful steps to protect our employees, suppliers, and customers in the pandemic. These important steps, in many cases, reduced efficiencies include: continuous communication and training to our employees on living and working safely in a COVID-19 world; plant accommodations and reconfiguration to maintain social distancing; masks for all employees; implementation of sanitizing stations; temperature taking; and regular proactive deep cleaning and sanitization of our facilities. Our global supply chain remained operational. We continue to monitor and manage our ability to operate effectively as tariffs and the evolving nature of the COVID-19 pandemic and related stresses on the supply chain and periodic marketplace disruptions impact our operation. To align our business with current market conditions, primarily in China and to a lesser extent in North America, we reduced headcount and incurred other restructuring costs totaling $6 million in the second quarter. I will now turn the call over to Chuck, who will provide more details on the quarter beginning on slide 5.

Thank you, Kevin. Second quarter 2020 sales of $664 million declined 13% compared to the second quarter of 2019. The decline in sales was largely due to lower water heater volumes in China and lower commercial water heater and boiler volumes in North America driven by the COVID-19 pandemic. As a result of lower sales, second quarter 2020 adjusted earnings of $73 million and adjusted earnings per share of $0.45 declined significantly compared with the same period of 2019. Please turn to slide 6. Sales in our North America segment of $481 million declined 8% compared to the second quarter of 2019. Organic growth of approximately 19% North America water treatment sales was more than offset by lower commercial water heater volumes, lower boiler volumes, and a water heater sales mix composed of more electric models, which have a lower selling price. Rest of the World segment sales of $190 million declined 24% compared to the same quarter of 2019. China sales declined 20% in local currency related to a higher mix of mid-price products and further reductions in customer inventory levels. Consumer demand for our products in China was flat to slightly positive compared with the second quarter of 2019. China currency translation negatively impacted sales by approximately $6 million. Our sequential sales in China improved through the quarter and China was profitable in May and June. India sales declined significantly as the economy was shut down during the majority of the quarter to minimize the spread of the virus. On slide 7, North America adjusted segment earnings of $108 million were 12% lower than segment earnings in the same quarter in 2019. The decline in earnings was driven by lower volumes of commercial water heaters, lower boiler volumes, and a mixed skew to electric water heaters. Certain costs directly related to the pandemic, including temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, facility cleaning, paying benefits for furloughed employees, and other costs were $5.5 million in the second quarter. Adjusted earnings exclude $2.2 million in pre-tax severance costs. As a result, second quarter 2020 segment adjusted segment margin of 22.4% declined from 23.5% achieved in the same period last year. Rest of World adjusted segment loss of $2 million declined significantly compared with 2019 second quarter segment earnings of $22 million. The unfavorable impact to profits from lower China sales and a higher mix of mid-price products, which have lower margins, more than offset the benefits to profits from lower SG&A expenses. These results exclude $3.9 million in pre-tax severance and restructuring costs. As a result of these factors, adjusted segment margin was negative compared with 9% in the same quarter of 2019. Our corporate expenses of $10 million and interest expense of $3 million were similar to last year. Please turn to slide 8. Cash provided by operations of $179 million during the first half of 2020 was higher than $144 million in the same period of 2019 as a result of lower investment in working capital, including deferral of our April estimated federal income tax payment to July, which was partially offset by lower earnings compared with the year-ago period. Our liquidity and balance sheet remained strong. We had cash balances totaling $569 million and our net cash position was $288 million at the end of June. Our leverage ratio at the end of the second quarter was 14.5% as measured by total debt to total capital. We had $332 million of undrawn borrowing capacity on our $500 million revolver. Within the second quarter, our share repurchase activity continued to be suspended. During the first half of 2020, we repurchased approximately 1.3 million shares of common stock for a total of $57 million. Please advance to slide 9. We've introduced our 2020 adjusted EPS guidance this morning with a range of between $1.72 to $1.86 per share. Our 2020 adjusted EPS guidance excludes $0.03 per share in severance and restructuring costs that were incurred in the second quarter. Our adjusted guidance assumes that conditions of our business environment and that of our suppliers and customers are similar for the remainder of the year to what we are currently experiencing and does not deteriorate as a result of further restrictions or shutdowns due to the COVID-19 pandemic. We expect our cash flow from operations in 2020 to be approximately $350 million compared with $456 million in 2019, primarily due to lower earnings. Our 2020 capital spending plans are between $60 million and $70 million and our depreciation and amortization expense is expected to be approximately $80 million. Our corporate and other expenses are expected to be approximately $47 million in 2020 slightly higher than 2019, primarily due to lower interest income on investments. We expect our interest expense to be $9 million in 2020, compared with $11 million in 2019. Our effective income tax rate is expected to be between 23% and 23.5% since 2020. Our assumption is to assume no additional share repurchase, resulting in an average diluted outstanding shares in 2020 of approximately 162.5 million. I'll now turn the call over to Kevin, who will summarize our guidance assumptions beginning on slide 10.

Okay. Thank you, Chuck. Our outlook for 2020 includes the following assumptions: We project U.S. residential water heater industry volumes will be flat in 2020 driven by resilient replacement demand and similar levels of new construction as last year. We expect commercial industry water heater volumes will decline approximately 10% as job sites and business closures, due to the pandemic delay or defer new construction and discretionary replacement installation. It is encouraging to see consumer demand for our China product similar, if not a little higher than last year over the last four months. We are also seeing sequential quarterly improvement in market share both online and offline for water heater and water treatment products, driven by our mid-price range products. We took additional charges in Q2 for further restructuring of the business. We believe these restructuring charges are largely behind us. We continue to target closure of 1,000 existing stores, while targeting to open 500 small store relationships in Tier 4 through 6 cities. Cost actions and restructuring activity are projected to result in $35 million of savings in 2020 over 2019, $15 million of which will be realized in the second half of 2020. We expect year-over-year declines in local currency sales of 18% to 20% and protracted sequential quarter-over-quarter growth in the second half of the year as China appears to be making sustainable progress in reopening their economy and keeping the virus in check. We expect our North America boiler sales will decline approximately 10% for the full year. Commercial boilers represent 65% to 70% of our boiler sales. With many job sites temporarily closed during the second quarter, we believe as job sites reopen, the orders will sequentially improve in the second half of the year. We project 20% to 22% sales growth in our North America water treatment products, which include incremental water right sales. We ended 2019 with a $2.6 million loss in India and expect a similar loss in 2020 as a result of the pandemic. Please advance to slide 11. We project revenue will decline by 7% to 8% in 2020 as strong organic North America water treatment sales and resilient North America residential water heater volumes are more than offset by weaker North America commercial water heater and boiler volumes and lower China sales, largely due to the pandemic. We expect North America segment margin to be between 22.5% and 23% and Rest of World segment margins to be negative 1% to negative 2.5%. Please turn to slide 12. We believe particularly in these uncertain times A.O. Smith is a compelling investment for a number of reasons. We have leading share positions in our major product categories. We estimate replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes. We have a strong premium brand in China, a broad product offering in our key product categories, broad distribution, and a reputation for quality and innovation in that region. Over time, we are well-positioned to maximize favorable demographics in both China and India to enhance shareholder value. We have strong cash flow and balance sheet supporting the ability to continue to invest for the long term with investments in automation, innovation, and new products, as well as acquisitions and return cash to shareholders. We will continue to proactively manage our business in this uncertain environment. We see improving consumer demand trends emerge in China, where we were first impacted by the pandemic and see China operations pivot to profitability for the remainder of the year. In North America, as the economy begins to reemerge at the economic shutdown, persistent COVID-19 cases and related potential implications to returning to a more stable environment in the market workplace and supply chain will continue to be challenging throughout the remainder of the year. We have a strong and dedicated team, which has navigated successfully through prior downturns, and I'm confident in our ability to execute similarly through COVID-19. That concludes our prepared remarks, and we are now available for your questions.

Hi, good morning, everyone.

Good morning, Jeff.

Good morning, Jeff.

Just want to dig in on this China dynamic. Sales down 20% and I think you said consumer demand was flat. So just help me square those two things. I know you mentioned mix and destock just maybe parse those out. And what's the expectation for this mix dynamic and kind of inventory destocking to continue into the second half?

We’re down about 20%, and when excluding foreign exchange, that remains accurate for the quarter. There are two main factors contributing to this: mix and destocking. When analyzing the mix within that 20%, approximately one-third to less than half is due to the sales mix. The remainder is attributable to destocking and consumer demand. Inventories in the channel in China decreased again, which was somewhat unexpected. We do not anticipate this decline to continue. Currently, they are in the two to three-month range, and when we adjust our outlook for 2020, we believe they are at or near their lowest point; they might decrease further, but that’s our forecast.

And the mix dynamic in the second half, should that continue?

The mix dynamic in Q2 was somewhat unique. Our online sales were strong, comprising 30% of our total revenue in Q2 and showing a slight increase quarter-over-quarter. This puts a bit more pressure on the mid-price products since there is a higher concentration of mid-priced and upper mid-priced products available online compared to offline. We anticipate that there will be continued pressure on the mix moving forward, but we also hope to see sequential improvement in volumes and some growth in the offline market. However, we will need to monitor how that evolves.

It seems you need to achieve $30 million to $35 million in operating profit in the second half in China to reach your margin target. Is that purely due to volume improvement from this point forward, or are there other factors contributing to that profit increase?

Well, it's two things. There's some volume improvement. So we've seen sequentially China improve month-over-month and we expect it to continue quarter-over-quarter. So we do expect growth in the back half of the year. If you parse out the math, we expect China to grow year-over-year in low single digits maybe in that 5% range. And then on top of that, as Kevin mentioned, we've got cost reduction programs that we put in place. It's about $35 million for the year, and we expect $15 million of that to drop into the back half probably pretty even per quarter those savings.

Okay, great.

Yes. Hi, good morning to Kevin, Chuck, and Pat.

Good morning, Scott.

Good morning.

So, I just wanted to make sure; just, sort of, like a housekeeper. The COVID $5.5 million, you did not pull that out. That is in your North American 22.4%, right?

You are correct. It is reflected in our numbers. The only adjustment we made was $0.03 related to severance and restructuring.

Yeah, got it. I'm hoping you could maybe tell us a little bit more about the China percent of sales to premium in water heaters versus the percent to upper price point. I'm just wondering what that pie chart looks like right now?

Sure. Let me frame it. And as I mentioned just to Jeff, I mean it's a little unusual quarter because we got a little heavier mix on online. But just to, kind of, frame it let me go with the definition first though at mid-price as we're defining it for this information is on the electric; it would be less than RMB3,000 and then on the gas it would be less than RMB5,000. So that's what we're considering in this kind of calculation at mid-price. If you go back two years ago, the percent of our sales that would fall into that category below those two thresholds is in that 25% to 40% range. If you, kind of, walk it forward to a year ago, it is in that 35% to 55%. And then if you go to Q2, which again a little bit heavier online percentage than normal, it's in the 55% to 70% range. So it's grown because we've reintroduced products into that category, which we feel now we've got the full range of products filled in there.

Scott, I would just want to dovetail on what Chuck said. We've been working over a year plus to fill those mid-priced categories, and now we're there. So as we go forward, we look for our mix to hopefully move more towards our premium sector. But it was important for us from an overall perspective to compete both online and offline to have those mid-priced products, which by the way are the upper mid part of the range in our product offering. So again, going forward, I think as Chuck mentioned this is probably a low point when it comes to how many mid-price or a high point for mid-priced products should we look forward to see our mix shifting back maybe not to where it was in the past, but moving higher to premium products.

Thank you. Good morning.

Good morning.

My first question is just can you give us some color on the mix shift in the U.S.? I noticed in your press release you commented that that's kind of turned a bit negative more towards the electric side of things on the consumer business. Can you just give us some comments on how that has been coming together and your thoughts on the back half for mix?

Yes, this is Kevin. In our industry, we occasionally experience mix shifts for various reasons. From our viewpoint, the Northeast has been significantly impacted, particularly New York, New Jersey, and Massachusetts, which have faced the toughest COVID-related shutdowns. This region happens to be one of our strongest gas markets, which might explain part of the shift. Additionally, we've seen robust growth in India with our customer base in a more vibrant electric market, contributing to this temporary shift. However, when I look ahead, I haven't observed any significant systemic changes in the market. Over time, I expect our mix to normalize throughout this year or into the next.

Okay. That's helpful. And then just following up can you give us some color on raw material inputs? Steel prices seem to be a slight advantage for you in the quarter. But how should we think about that going out over the next few quarters as well?

Well, I mean if you look at steel and 70% of our steel is cold rolled, 30% is hot rolled, and we see kind of a delay in the cost of that 90 to 120 days. So if we kind of just take a data point of spot prices today and compare them to a year ago second quarter, we're down about 5%. So that kind of frames how to think about it. Steel has been lower, I guess for a couple of quarters now, but it has edged down a bit.

Good morning, everyone. Hope you are doing well?

Hi, Bryan.

Hey, Bryan. Same to you.

Chuck, I believe you've mentioned breakeven revenue for China in the $55 million $60 million per month range in recent past and being profitable in May and June would kind of validate that. Is that still the right range to think about? And then as we look forward beyond the structural savings that will come through in the back half, how should we think about incrementals as China revenue moves higher?

Yes, you are correct. The breakeven point is between $55 million and $60 million. We are pleased that we achieved this in May and June, and we expect to remain profitable moving forward. This range still holds. We need to keep examining the structure, and the restructuring charge of approximately $4 million in China should lead to savings in the future. The incremental margins are likely in the 40% to 45% range.

Okay. I appreciate that. And really nice growth in water treatment. Can you remind us of run rate profitability there? And structurally where you think margin can climb as that business continues to scale?

Yes. Run rate profitability Q1 we were at 9%; Q2 we're about 8%. We see it continuing to be that for the rest of the year. We're still looking at cost reductions. We've got a little SAP implementation happening this quarter. So there's some costs that are going to burden it a little bit in the back half, but we still see that just approaching 10% this year. So we're pleased with water treatment. The order rate has been strong. I mean we were up 19% to 20% for the quarter. And when we look into July, we see the same strength in orders. It's at that same rate.

Yes. I'd just make another comment on that as far as the growth has been strong and it looks to be continuing. And then just keep in mind there's a consumable part of this as we go forward and continue to put out our point-of-use in order entry type of products. That seeds the consumables as we go forward over the next few years. So there's a lot of positive trends in our water treatment business. And even as you look at it today, even softeners are starting to come back as our dealers are learning how to sell in a COVID environment and using digital and how they're installing and so forth. They've made a remarkable shift in their selling methods, and it's proven to be effective so far through July.

Thanks. I have a couple of questions. I want to revisit the electric impact. North America showed an 8% decline. Can you explain how that shift affected revenue and what the operating margin impact might have been?

Yes. We're just tracking down the impact of revenue. The percentage is really the same for gas or electric. So, I mean the percentage runs roughly the same. It's really just a step function as far as sales dollars and then margin dollars. I don't have a good answer on mix, but I mean it's probably in that 10% to 15% of the total decrease. When you look at the decrease in margin of the 8%, it's probably 10% to 15% of that.

And then have you begun to see in your order book as of late looking into June, July, any evidence that these delayed construction projects are indeed coming back online? Have you actually seen that take place in your order book?

I think it's too early to see that. When we consider Lochinvar boilers, the order quoting rate in the marketplace is slightly down. Although it is lower than before, there is still some activity, and I believe it's a bit premature to say that orders are fully coming back. However, when we focus on commercial water heating, we've observed a decline in the second quarter, but there's been a slight increase in order rates since then. Comparing Q2 to July, we've seen an uptick of about 4% to 5% in commercial orders. This suggests that some delayed replacements may be returning, and we anticipate this trend to continue. Overall, for both commercial water heaters and boilers, the first half of the year resembles the second half. We're down approximately 10%, with significant disruptions in boiler sales during the second quarter, but we expect some recovery, especially since our boiler season tends to be stronger in the fourth quarter.

Yes, I believe that's the main point here. As we approach the colder months, we see schools and businesses starting to activate their boilers again. It's still a bit early, but we have a solid backlog that we're working through, and we'll likely have a clearer picture soon. Our representatives on the ground indicate that they anticipate sites will reopen and projects will move forward, which is our assumption as we progress through the rest of the year.

Thanks for taking my question. I'd like to discuss the impact on your distribution channels considering the current situation. Many of your distributors are smaller businesses, which may lead to financial pressures. How has this affected your wholesale operations in terms of inventory management, payment terms, and similar aspects? Are there any developments as this situation evolves with the distribution channel?

Most of our customers in the channel are essential businesses that have remained operational, similar to us, often providing services like curbside pickup. Fortunately, they have generally managed to sustain their operations during these challenging times. We have not experienced noticeable changes in payment terms or our customers' ability to pay. Some of the smaller businesses may qualify for loans, which presents them with opportunities. Overall, we have managed well, and our customers have also fared well. However, on the commercial side, we have observed some destocking, with customers reducing their balance sheets and cutting back on inventory, especially for higher cost commercial products. We think that some of the changes in order rates might be affected by this, as well as adjustments in inventory across the industry.

Yes, I would just add on to that. I mean you talked about construction; you talked about reopening. And of course, all our distributors are also good at business and balancing their inventories. So, I would tell you that all of our distributors for the most part are managing through it. They've been through the financial crisis and they've come out of it. And at the same time they're going to adjust their inventories to the current demand. And so as we go forward and demand does pick up I would expect them to adjust those inventories appropriately going forward. So, overall, we have a tremendous customer base with legacies of 20, 30, 40 years, strong positions in the market and they're navigating through fairly well based on the information we're getting from our sales organization.

Got it. And then my follow-up was just really following up on the earlier discussion of water treatment. It really seems like you are building some pretty strong momentum there at this point in terms of the organic growth. Can you talk about just what is driving that? Is that more the market growth given all the PFOS concerns and lead and all that? Or is that share gain with your big box channel? I mean where is that growth coming from? If you can kind of give us some flavor there?

You summarized it well. The growth is coming from various factors you've mentioned. The pandemic has certainly increased people's awareness, but I also believe our water treatment team is performing exceptionally well. We have made updates to our websites and improved our consumer engagement process. Our telesales activity has also increased. We’ve implemented several foundational improvements to enhance our e-commerce capabilities and dealer network. In addition to consumer awareness regarding health issues, particularly in water treatment, we are executing at a higher level compared to last year, which is crucial for our progress. Our close rates have improved, which correlates with our sales performance. Overall, the water treatment business is thriving, but it is not solely due to market conditions; it is also about our execution. Although we lack the same level of data for water treatment as we do for water heaters, we do receive some information from the water quality association that tracks softener balance in tanks. This data is somewhat outdated due to pandemic-related delays, but it indicates that we are up more than 20% in the market, while previous data in February showed flat growth. We believe we are gaining market share, although we will need more time to validate that. Overall, we are doing well, driven by both market conditions and our team's enhanced execution compared to the past.

Yes. This is Chuck. I mean, I mentioned earlier that we've seen July demand continue strong and we've seen a better mix of some of our installed products as people are more comfortable with installers, dealers getting into home. So if you kind of look through kind of the end of June or July time frame, the softener mix in some of the larger products, we've just seen that come back a bit.

Hey, good morning, everyone.

Good morning.

Good morning.

I wanted to ask about Lochinvar. And you'd mentioned that quoting activity was down a little at this point, although, there's still some uncertainty, I suppose, with where that's going according to your comments. But under that situation or that scenario, one might sort of expect a higher level of competitive pricing pressure and just a more vigorous level of competition from some of the other players in the space. So, I wonder if you could just talk a little about what you're seeing on that side of the Lochinvar story? And also, to the extent you could talk about what you're seeing in terms of the mix of units sold within Lochinvar? And what might be changing there?

Well, as far as from a competition standpoint, we deal with that on a regular basis. We haven't seen much change from how we quote and how we can go to market. We’ve had to get a little creative about how we do sales calls and engineering calls on Zoom. But, overall, not much change there. We've had a nice mix towards some of our crest boilers, which are the higher BTU-type products, which are in larger applications. So we saw that come back this year, quite well. So, yes, overall, again, I go back to the business. We're heading into our stronger half of the year. There's still some uncertainties there that we've outlined, but we're in a position to capitalize as the markets do open up. And I think it's really important, as we've been working our way through the pandemic, we've kept our operations ready to be prepared to come out of it as sales grow and as the markets reopen. So, overall, operationally, we're in position to take care of our customers. And normally, there's a little bit of emergency activity that happens in the second half of the year, where people need things right away, and we're positioning ourselves to take care of that as well.

Maybe just a little more color on mix too. And Kevin is exactly right. We've seen some of the larger boilers a little heavier in the mix in the second quarter. We've talked before about residential being light. So when we look at residential in Q1, it was a warmer winter and it was pretty light for us in the industry. Second, July activity is really kind of hard to read. We typically, and we've done it this year again as we've got an early buy program. So, early buy program is specifically for residential boilers and that's running. We're seeing orders come in pretty well. We're fairly pleased with how that is typically playing out. So hard to read what's happening in July, but the residential orders on the early buy program might be running slightly less than last year, but it's not done yet, and we're pretty pleased with how that's playing out.

Okay. Thanks for that color. Just a second question on China. And you had mentioned the shift towards more medium price points. So thanks very much for providing the detail on that mix. I know it's something we've discussed in the past. I guess, the question is, with regard to capacity utilization rates, which I'm guessing right now, you've got plenty of headroom, but as you shift more to medium price point, what impact does that have on capacity and your need to invest CapEx in those facilities?

I can confirm that we have ample capacity and operating leverage moving forward. As you may be aware, we operate three large facilities in China. Compared to our top-line sales from a couple of years ago, we have more than enough capacity to accommodate our needs. Therefore, we do not foresee any necessity for additional capital investment in production for several years.

Good morning, everyone.

Good morning.

Good morning.

I just wanted to follow-up a little bit on Ryan's questions on water quality. That's a pretty fragmented market here in the U.S. Can you talk about where you think your market share is? What kind of market share targets you would have? And strategically thinking is this more of a build versus buy, an organic growth versus roll up the market? Or do you see opportunities here to go about consolidating this market? And are there big advantages to that scale?

It’s challenging for us to get a precise understanding of our market share since it’s a fragmented market. We estimate the addressable market to be around $2 billion, indicating a significant opportunity for us to enhance our position. In terms of strategy, we see potential in both building and buying. We have been focusing on leveraging the channels we operate in. This includes our direct-to-consumer channel through Aquasana, as well as our Amazon channel. Additionally, through the Water-Right and Hague acquisitions, we have access to the dealer channel. We’ve also introduced products into the wholesale market and retail. We plan to continue expanding within these channels over the next several years. We remain open to looking at mergers and acquisitions as well, believing there are opportunities in both approaches.

I'll just add a little more to that, it's Kevin here. Certainly on the M&A front, I think there's plenty of opportunity out there. It has to align with our strategy. Looking ahead, I've always mentioned in any call or investor meeting that the water treatment sector is an area where we intend to focus a lot of our efforts. There are opportunities available, and we still have ways to leverage and consolidate over the long term. A. O. Smith is committed to improving the industry, and we believe there will be ongoing opportunities to identify the right matches for our business.

Okay. Another question on China, I mean you guys have talked about the mid-tier priced products being lower margin than the premium tier product. That's a relatively new introduction for you into China. Is there an opportunity through operational improvement and ramping up the productivity of those lines for you to close that margin gap between the mid-tier and premium tier price products, without just leveraging volume?

Yes, there is opportunity. We're working on cost reduction programs within the product, also working on cost reduction programs within the manufacturing process. So certainly you're right, volume would help us but we're coming at it from multiple angles.

And just one quick one on capital allocation, you guys had started this year with a $200 million target for share repurchase. Based on your projections for the back half of the year cash flow, you're probably going to have about $500 million of cash on the balance sheet. So the balance sheet is going to be a little inefficient. Can you talk about when you think it would be appropriate to reinstate the share repurchase program? If that's next year would you look to kind of catch up a little bit of the 2020 spending to go along with the 2021 program, if we assume that the markets are in reasonable condition?

It's a bit too early for us to make a decision on that right now. We usually aim for that program to avoid growing cash. In this environment, we do have a cash projection, and we are pleased to project $350 million for the year. However, given the current uncertainty, we think it’s best to monitor the situation for the next quarter, and we’ll likely revisit this topic then.

Yes. I would just add on to that is we still believe there's better opportunities in the market. Acquisitions always are preferred method to invest in. I would like to see how things come out of the pandemic. And we're going to keep an eye on that. And again, we expect there'll be some opportunities. We want to be prepared from a cash position to capitalize, if they arise.

Hi Scott. Hello, Scott, are you there? Yeah, I apologize for that. I had muted myself.

Okay.

So just a follow-up question on China, so we're shrinking the number of sites there I think by about 1,000 this year. And here we are with the channel destocking unexpectedly. Could one be the cause of the other? How is that? And how are you managing that site reduction? How is that going?

I don't believe they're connected, Scott. The 1,000 stores we keep mentioning relate to underperforming locations, which we've addressed over the years by closing some and reopening others. This is largely a productivity issue, particularly considering the high costs associated with offline sales and promotions. The current economic climate has certainly influenced this, but evaluating our stores regularly and adjusting accordingly is something we do independently. Regarding inventory, it's really up to our distributors to decide what they need on hand. A change over the course of a quarter or a month shouldn't surprise us; it wasn't significant. We're maintaining an inventory range of about two to three months. What's crucial is that they stock the right products and that we drive sales to the consumer. Our distributors are in a stronger position now compared to six months or a year ago, and our sales are on the rise. As the economy recovers, there’s a solid opportunity to increase product sales. We have the capacity and lead times to manage this effectively. Therefore, the inventory situation is primarily a matter of our distributors managing their business, while we're focused on managing our retail operations efficiently to control sales costs.

Got you. And then last one on the North American business with commercial, which includes restaurant lodging. It does look like lodging, in certain areas, is coming back fairly strongly. However, I believe we will emerge from this with a smaller restaurant footprint for now. They tend to grow back in the following years. But is there a need to potentially return to North America and reduce costs on the commercial side for both water heaters and boilers given the post-COVID landscape? How are you approaching that?

Yes. I mean we think a lot of that demand that we're seeing in the second quarter and into July is postponement of some replacement going forward. I think it's a little early for us to predict if there's a great deal of change in the footprint of those types of customers. That's a portion of where our water heaters and boilers do go. But we'll continue to watch that. So we'll continue to watch it as it goes forward and see what happens. Right now we expect that's just delayed and there'll be replacement as those businesses start-up.

Yes Scott, I think it's a fair point, a fair question, but I think it's a little bit early. And so if you look at where our sweet spots are you'd be hitting restaurants and hotels and so forth. Certainly the closures have delayed some of that. But again going forward depending on how we reopen we'll have to see how that plays out. But again the replacement market will be there. And we'll have to see what size it is as we come out the other end.

Hey. Good morning, everybody.

Good morning.

On the water treatment guidance, I would like to clarify the expected sales growth of 20% to 22% for the full year. This seems to suggest a significant slowdown in the growth rate in the second half of the year. However, it appears that the organic growth in the second quarter is continuing into July. Many companies that have experienced strength in the DIY segment have indicated a slowdown, yet it remains quite strong. Additionally, it seems that products targeting contractors are improving. Therefore, I would like to know if there is a specific reason to anticipate a notable slowdown. Is there an element of conservatism in the guidance? I'm trying to piece everything together and understand the future outlook for water treatment.

Yes, that's a good question. We observed some solid strength entering the second quarter. We believe that part of this strength is due to increased consumer awareness and the shutdown prompting people to pay more attention to their water. The DIY channel has indeed been very strong. As we move into July, we continue to see a lot of activity and strength in water treatment. However, we will have to see if this momentum continues as people hopefully return to a more normal routine and get back to work. If you calculate the numbers, we anticipate a slight softening in the latter half of the year, and it may not match the current high order rates we are experiencing.

I wanted to clarify your earlier comments about the water heater shipments in June. Are you suggesting that the flat to slightly up trend applies only to June, or does it encompass the entire quarter? If it pertains to the full quarter, that would mean June was a strong month that compensated for the slower shipments we saw in April and May. Additionally, how do you think A. O. Smith has performed compared to the industry in the second quarter and into July?

Yes. That comment implies the full quarter. And again we did see a strong June. So that's the impetus going forward. And then as you look at it we've always felt people will do without a water heater for 24 hours; that's about it. So that replacement market is still going to be there. And then we've seen decent new construction still holding up over the various markets. So you put those two together that's why we came up with a forecast of residential volume being relatively the same as last year, but you're right, it comes off a strong June.

Strong June. And just orders carried forward into July, we still see that playing out similarly. So, residential orders have been healthy. And market share is the same. There's really no shift in market share.

Thank you. I have a few follow-up questions. Firstly, you mentioned that you are in the process of establishing 500 new store relationships in China. Can you provide more details on that? It seems to be focused on Tier 3 to Tier 6 cities. How does that compare with the 1,000 store closures you've implemented there?

The focus is on Tier 4 to 6 cities, which are experiencing significant growth. We are establishing relationships with our customers in these areas to ensure they have the appropriate selling tools and products for their environment. We believe that the Tier 4 and 6 cities will increasingly contribute to our new construction and housing business. It’s challenging to compare the 1,000 underperforming stores with the 500 new stores since the former are not recovering their costs. We are optimizing our operations by trimming the underperforming stores while continuing to expand the 500 stores in Tier 4 and 6 cities. Although the sales volume in these smaller stores will be less compared to Tier 1 and Tier 2 stores, our strategy involves pursuing growth in these regions while also focusing on cost control.

And so should we expect that they'll come online over the course of 2020? Or is that more of a 2021 impact in terms of the revenues coming through and some of the benefits?

We expect those to come on throughout 2020.

Thank you for joining us today. We plan to participate in two virtual conferences in the third quarter: Jefferies' on August 5th and D.A. Davidson's conference on September 22. Have a great day.