A.O. Smith Corp (AOS) — Q4 2021 Earnings Call Transcript

Thank you, Shannon. Good morning and welcome to the A.O. Smith fourth quarter and full year 2021 conference call. I'm Pat Ackerman, Senior Vice President, Investor Relations and Corporate Responsibility and Sustainability. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; Chuck Lauber, Chief Financial Officer; and Helen Gurholt, Vice President, Financial Planning and Analysis. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we have described in this morning's press release among others. Also as a courtesy to others in the question queue, please limit yourself to one question and one follow-up question. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to Slide 4.

Thank you, Pat and good morning, everyone. Thank you for joining us today. I'm on Slide 4 and our full year results. Our team delivered record-setting sales and EPS performance despite a turbulent macro environment. Demand for our products in North America was strong and unprecedented inflation-related pricing actions drove sales 19% higher over 2020. The Rest of the World segment performed well in 2021. China improved its operating margins to over 9%. We successfully navigated supply chain and transportation challenges and improved our delivery performance since the first quarter. We acquired Giant, a water heater manufacturer in Canada, expanding our market share in North America and welcoming a talented group of employees to the A. O. Smith family. With our dividend and share repurchases, we returned $537 million of capital to our shareholders. Please turn to Slide 5. Our global A. O. Smith team delivered record 2021 EPS of $3.02, a 42% increase that was driven in part by a record 22% increase in sales compared with 2020. Demand for our products was robust across geographies. We achieved this strong performance as a result of continued outstanding operational and sales execution from our team despite the challenging environment of component shortages, logistical bottlenecks and material and transportation cost inflation. I want to take the opportunity to thank my fellow A. O. Smith employees for their ongoing dedication and creativity as we work to overcome these challenges to meet strong market demand and deliver for our valued customers. North America water heater sales grew 21% in 2021 due to pricing actions implemented in response to rising material and logistic costs and strong demand for our products. Commercial industry demand increased approximately 11% due to the resumption of new construction and replacements in the hospitality market segment. Resident industry demand increased by approximately 8% in 2021 due to strength in new construction and strong replacement demand. Our North America boiler sales grew 13%, driven by new construction and replacement demand as well as the launch of new products. We ended 2021 with a record backlog, largely composed of commercial condensing boilers and January continues to generate strong order rates for these market-leading energy-efficient boilers providing confidence in our outlook for the coming year. Our strategy to focus on innovation and decarbonization contributed to strong demand for our high-efficiency condensing boilers. North America water treatment sales grew 14% in 2021 as we continue to pursue additional market share in this attractive fragmented market with a total addressable market value that we estimate to be $2.6 billion. Our strategy to pursue this market with an omnichannel approach has worked to grow our share through innovation, product development and acquisition opportunities. We believe our independent water quality dealers have been outperforming the market and gaining market share. In China, full year sales increased 24% in local currency compared to 2020 which was significantly impacted by the pandemic. Each of our major product categories grew year-over-year, including electric, gas tankless water heaters and residential and commercial water treatment products along with replacement filters. Our water treatment business comprised of residential, commercial and filter replacement consumables now represents approximately 30% of our overall business with repeatable consumable filter sales representing over 20% of overall water treatment sales. I'm now on Slide 6. We know the efficient operation of water heaters and boilers makes a significant impact on mitigating climate change, and we are committed to doing our part. Reduction in energy use and greenhouse gas emissions are often top priorities for both consumers and contractors. As a result, adoption of sustainable building guidelines, such as LEED and well-building certifications, continues to increase. I'd like to highlight some of our products that contribute to sustainable building practices and decarbonization efforts. Heat pump technology is a key consideration for many customers looking for a smart solution in both commercial and residential projects. A heat pump water heater harnesses the heat and the ambient air and transfers it to the water in the tank. We believe we are one of the technology and market share leaders in heat pump water heaters in North America and are well positioned to help our customers reduce their carbon footprints through innovative products. Adopting commercial and residential ENERGY STAR certified products can contribute to lowering greenhouse gas emissions and reducing negative environmental impact. A. O. Smith is proud to manufacture more than 1,000 models of ENERGY STAR certified products, many of which are eligible for incentives via national eco-rebate programs. The launch of our newest CREST commercial boiler with Hellcat combustion smart technology is a significant achievement for us as it enhances the energy efficiency of our existing highly efficient CREST condensing boiler. CREST boilers with Hellcat technology reduce start-up, maintenance and operating costs for our customers. I'll now turn the call over to Chuck, who will provide more details on the full year and fourth quarter performance.

Thank you, Kevin and good morning, everyone. I'm on Slide 7. Full year sales in North America segment rose to $2.5 billion, a 19% increase compared with 2020. Pricing actions largely on water heaters represented approximately 70% of the increase. Higher volumes of water heaters and boilers were driven by strong replacement and new construction demand, and higher volumes of water treatment products added to segment sales growth. Giant, acquired on October 19, 2021, added $23 million to North America sales. North America segment earnings of $591 million increased 17% compared with 2020. The earnings benefit of inflation-related price increases and higher volumes was somewhat offset by higher material and freight costs. Segment operating margin of 23.4% was a modest decline compared with the 2020 segment margin despite significant cost headwinds. Moving on to Slide 8. Rest of the World segment sales of $1 billion increased 30% year-over-year with approximately 60% of that increase attributed to higher volumes. Our sales increase was positively impacted by lower channel inventory reductions in 2021 as compared to 2020. Channel inventory levels at the end of 2021 were at the lowest level in five years. Currency translation of China sales favorably impacted sales by approximately $58 million. Growth in each of our major product categories in China contributed to local currency growth of 24% in 2021. New product introductions in the premium segment of the market, particularly our slim line electric wall hung water heaters and water treatment products that deliver hot and ambient filtered water contributed to sales gains. India sales grew 31% in 2021 compared to 2020. We remain committed to India as a long-term growth opportunity given its attractive growth characteristics and changes in demographics. Rest of the World segment earnings of $91 million increased significantly over breakeven results in 2020 which were adversely impacted by the pandemic. In China, the benefits from higher volumes and favorable mix were partially offset by employee incentives and higher advertising as well as the absence of social insurance waivers that were received in 2020. Segment operating margin improved to 8.8% compared to 2020, primarily as a result of improved operating leverage from higher volumes. Please turn to Slide 9. Turning to the quarter, fourth quarter performance, we delivered record sales of $996 million in the fourth quarter of 2021, up 19% year-over-year, driven by inflation-related pricing actions primarily in North America. Earnings in the fourth quarter were $0.87 per share which is an 18% increase compared with earnings of $0.74 per share in the fourth quarter of 2020. Please turn to Slide 10. Fourth quarter sales in North America segment rose to $715 million, a 27% increase compared against the strong comp in the fourth quarter of 2020. Pricing actions largely on water heaters and sales from Giant represented almost all of the increase. While volumes were strong relative to historical fourth quarter volumes, our 2020 fourth quarter was exceptionally strong, creating a difficult comp. North America segment earnings of $167 million increased 21% compared with 2020. The earnings benefit of inflation-related price increases was somewhat offset by higher material and freight costs and lower volumes. Pricing actions trailed rapidly rising steel costs which resulted in a lower segment operating margin of 23.3% compared with the 2020 segment margin of 24.6%. Moving to Slide 11. Fourth quarter Rest of the World segment sales of $288 million increased 3% year-over-year, primarily driven by favorable mix in China as consumers purchased our new higher-priced products with more features and benefits, which was offset by lower China volumes compared to the fourth quarter of 2020 which benefited from pent-up demand in China's economy emerging from the pandemic. Currency translation of China sales favorably impacted sales by approximately $9 million. Rest of the World segment earnings of $31 million were in line with Q4 2020 segment earnings and China favorable mix offset lower volumes. Segment operating margin was 10.6% compared to 11.2% in the fourth quarter of 2020, primarily due to lower volumes. Please turn to Slide 12. We generated strong free cash flow of $566 million during 2021, higher than 2020 due to higher earnings that were partially offset by a larger investment in working capital to support demand levels. Free cash flow conversion was 116%. Our cash balances totaled $631 million at the end of December and our net cash position was $435 million. Our leverage ratio was 9.7% as measured by total debt to total capital. Our strong free cash flow and solid balance sheet enables us to focus on capital allocation priorities and returning cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.28 per share which represents our 82nd consecutive year of dividend payments. We repurchased approximately 5.1 million shares of common stock in 2021 for a total of $367 million. Let's now turn to Slide 13. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation and new product development across all of our product lines and geographies. We continue to target strategic acquisitions with a focus on water heating and water treating assets that meet our financial metrics of accretive to earnings in the first year and return our cost of capital in three years. Please turn to Slide 14 and our 2020 earnings guidance and outlook. Adjusted EPS is introduced as a result of our termination of our defined benefit pension plan. The termination follows a strategy and measured glide path to derisk our fully funded exposure to pension liabilities. The plan which was previously sunset for benefits earned on December 31, 2014, represents over 95% of the company's pension liability. The terminated plans pension liability is expected to be annuitized in 2022. The pension plan settlement which we expect will occur during the fourth quarter will accelerate the recognition of a projected $445 million of noncash pretax pension expenses or an EPS impact of $1.73. In addition, in order to protect our pension plans funded status during 2021, we transitioned our pension plan assets to lower risk investments. The impact of this transition will result in a lower rate of return on pension investments and accordingly, higher pension expenses in 2022 compared to previous years. In order to provide transparency to the operating results of our business, in 2022, we will provide non-GAAP measures, adjusted net earnings, adjusted earnings per share and adjusted segment earnings that exclude the impact of noncash pension income and expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of the presentation and also on our website. We are pleased to introduce our 2022 outlook with an expected EPS range of $1.56 and $1.76 per share and our adjusted EPS range of $3.35 and $3.55 per share. The midpoint of our adjusted EPS range represents an increase of 17% compared with 2021. Our outlook is based on a number of key assumptions, including that the Omicron COVID-19 variant which is currently surging and impacting our production due to labor constraints. We currently have approximately 7% of our North America workforce out due to the COVID-19 surge. Our outlook assumes that the variant subsides in the first quarter and we return to the productivity levels that we operated at during the majority of 2021. Steel indices began to stabilize at the end of 2021 and we started to see the full benefit of our five announced 2021 price increases which had a cumulative effect on water heating prices of approximately 50%. Our guidance assumes that steel prices in 2022 on an annual basis will approximate steel market pricing at the end of 2021. We continue to see increases in non-steel materials and transportation costs. Multiple 2021 price increases compounding to approximately 50% for water heaters as we exit 2021. We assume that approximately 45% of the cumulative announced price increase was realized in 2021 and the remainder will be realized in 2022. Previously announced mid- to high single-digit inflation-related price increases in the remainder of our global portfolio, continued strength in demand and backlog in North America for all of our water heating product categories, driven by growth in replacement demand and new construction spending. While supply chain challenges have moderated as we move into 2022, we remain in close contact with our suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks. As the environment remains unpredictable, particularly with the current surge and the Omicron variant of COVID-19. The integration of Giant which we acquired in the fourth quarter of 2021 is on track and customer employee feedback is positive. We project the acquisition to achieve annual synergies of approximately $5 million over a two-year period. Giant added $0.01 to EPS in 2021 net of customary purchase accounting adjustments and one-time transaction expenses. We reaffirmed from our third quarter call that the acquisition is projected to add between $0.06 and $0.08 to EPS in 2022. As for other housekeeping assumptions, we expect to generate strong free cash flow of between $500 million and $525 million. For the year, CapEx is projected to be between $75 million and $80 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be between 23.5% to 24%. And we expect to repurchase approximately $400 million of shares of our stock, resulting in outstanding diluted shares of $157 million at the end of 2022. Based on these assumptions, the midpoint of our adjusted EPS range represents an increase of 17% compared to 2021. I'll now turn the call back over to Kevin, who will provide a little bit more color on our key markets and top line growth assumption outlook and segment expectations for 2022, while staying on Slide 14.

Thank you, Chuck. As Chuck noted, our outlook assumes the current surge of the Omicron variant subsides during the first quarter, it does not significantly impact productivity or significantly impact the end markets that we serve. With that assumption as a backdrop to 2022, we project revenue growth for 2022 of 16% to 18%, which includes the following assumptions: After approximately 8% growth in each of the last two years which is well above the historical average growth rate, we estimate U.S. residential water industry unit volumes will be down approximately 2% from last year as industry demand normalizes. We believe that commercial water heating industry volumes to be flat to slightly down as new construction and replacement installations level off. Our China business performance was strong and stable in 2021. We expect China sales to grow approximately 5% in local currency in 2022 driven by demand for our residential and commercial water treatment products, including our replacement filters as well as range hoods and cooktops. We expect that sales of our residential water heaters in China will be flat to slightly down compared to 2021. We expect our North America boiler sales will increase approximately 10% in 2022. Our expectations are based on several growth drivers; an industry growth of 3% to 4%, we believe replacement demand is 85%. The transition to higher energy-efficient boilers will continue, particularly as commercial buildings improve their overall carbon footprint. In 2021, condensing boilers were approximately 30% to 35% of the commercial boiler industry that represents our addressable market. We believe the potential for the condensing boiler market is to represent 60% to 65% of the total market over time, which provides continued opportunity for our leading market share commercial condensing boilers. And new product launches, including a full year of our improved flagship CREST commercial condensing boiler with Hellcat technology and the introduction of one million BTU light-duty condensing commercial Knight FTXL. We project 13% to 14% growth in sales for North America water treatment. We believe the megatrends of healthy and safe drinking water as well as the reduction of single-use plastic bottles will continue to drive consumer demand for our point-of-use and point-of-entry water treatment systems. We expect margins to improve by approximately 100 basis points in 2022 compared to last year. Based on these factors, along with the full impact of our 2021 price increases, we expect our North America segment margin to be between 22.25% and 22.75%, excluding pension expenses, and Rest of World segment margins to be approximately 10% or 100 basis points higher than 2021. Slide 15, please. As we begin 2022, I'm focusing on key strategic priorities to advance our position as a leader in heating and treating water around the world. First, innovate and expand our decarb portfolio, including heat pumps for space and water heating; expand our global water treatment capabilities by investing in technologies, people and distribution; deploy capital effectively by investing in ourselves, acquisitions and returning capital to shareholders. Thanks for the tremendous effort by our procurement and operation teams and their commitment to operational excellence which is part of our DNA, as nearly a 150-year-old technology leader in innovative manufacturing, our supply chain is stabilizing and our manufacturing lead times remain consistent. Through our focus and determination to serve our customers, we closed out the year on a high note and remain strong entering 2022. Our strong brands across the portfolio, combined with harnessing technology to drive innovation and new product development will enhance our market leadership. We are confident in our ability to capitalize on opportunities as we continue to execute our strategy. And finally, I have a bittersweet announcement. Pat Ackerman shared her plans to retire from her position as Senior Vice President, Investor Relations, Treasurer and Corporate Responsibility and Sustainability, effective March 31, 2022. In addition to her many responsibilities, Pat has been a key contact for new and existing investors since 2008, coordinating communication and effectively delivering our message to our investor base. We thank Pat for her dedication to A.O. Smith, her leadership and her steadfast commitment to the values and principles of our organization. Pat's many contributions and impact will be long-lasting. Please join me, Chuck, and the rest of the A. O. Smith family in wishing Pat the very best in her well-earned retirement.

Thank you, Kevin, for your kind words. I am fortunate to have spent my entire 39-year career at a terrific company in A.O. Smith and working alongside great people like many of you on this call today. I'm enthusiastic about retirement and one of the key reasons why is my Investor Relations successor, Helen Gurholt. With over two decades of progressively increasing finance experience at A.O. Smith, Helen most recently was Vice President and Controller and led our SEC reporting. You will find Helen to be knowledgeable and personable and I know you will enjoy working with Helen as much as I have. With that, we conclude our prepared remarks and we are now available for your questions.

Thanks and Congrats, Pat.

Thanks, Matt.

Couple of questions. How should we be thinking about North America in particular, kind of the quarterly revenue and earnings cadence given what's a pretty significant number of moving pieces, how you have incremental price rolling through, how you're thinking about volume across the different product lines? How should we be thinking about that for 2022?

Matt, this is Chuck. Looking ahead to 2022, the first quarter is likely to pose the greatest challenges in terms of margins and possibly volume. Historically, China sees the weakest performance in the first quarter due to festivals, with momentum building in the second and third quarters, while the fourth quarter tends to be the strongest. The dynamics in China may be straightforward since prices and costs have remained relatively stable. Shifting focus back to North America, we may see slightly reduced volume in Q1 due to some disruptions, including impacts from Omicron affecting parts of our labor force. Additionally, steel costs will peak in the first quarter as we have experienced increases, and given the usual lag in seeing these costs reflected, we expect steel prices to increase by around 15% to 20% from Q3 to Q4. Consequently, Q1 will be our most challenging quarter in terms of margins in North America, even with some pricing increases in place to help mitigate this. Moving through the second and third quarters, we anticipate some moderation in steel prices, and therefore, margins in North America should improve in the latter part of the year as price increases fully take effect. Overall, pricing on the water heating side is estimated to be effective at about 45%, with an additional 55% rolling in throughout 2022. I hope this gives you a clearer view of how the year may progress in North America.

Yes, it does. And just as a follow-up, you mentioned that inventory levels in China stand at the lowest level you've seen in five years. I guess, do you feel or do you expect to see inventory start to bleed higher? Or is A.O. Smith's objective going forward to really drive that number as low as possible so as to not have a repeat of some of the challenges you had in recent years?

Yes. Our goal is to always keep it at the leanest level that's appropriate to serve our customers in China. It's had a low watermark. We wouldn't expect it to go lower than that at the end of 2021. So as we've said before, we keep a close watch on it. It's at a level where we feel is about as low as it's going to go to make sure we're serving our customers.

Yes, hi, good morning. And hearty congratulations to you, Pat; you've been phenomenal in your job.

Thanks, Scott.

I have a couple of questions for you all. I guess the first one is on the North American business. It looked like the first two months of industry shipments in resi water heaters were up and your chart shows volumes down in North America for the quarter. Could you maybe give us a little more color on that?

This is Kevin. As we discussed in our Q3 call, we faced challenges in Q1, but we made progress through Q2 and Q3, and we expected that momentum to continue into Q4. However, it lagged slightly. What you are observing is not reflective of order rates or customer issues, but it did lag a bit. We anticipate picking it up as we enter 2022. I want to emphasize that our customer base is strong, with no issues or losses reported. Based on customer feedback, we provided excellent service throughout the pandemic, ensuring they received the products they needed. By the end of this year, as our supply chain began to stabilize, we lifted some allocations that had been in place for most of the year in December. This should potentially boost orders as we move into Q1. Overall, I believe we are in good shape. As the industry stabilizes and moves out of this turbulent period, we expect everything to revert to a more normal pace and steady output for us.

I have a couple of questions. I understand that you need to be cautious at the beginning of the year with your estimates, and that seems to reflect in some of the figures. When you mention that the commercial sector is expected to be flat or slightly down, I'm curious about the reasoning behind that. Given the ongoing situation with Omicron and the likelihood of a full year of reopenings, potentially even more than in 2021, I'm just trying to understand why you anticipate a flat market for your business.

I will address that and then have Chuck provide his input as well. In 2021, we experienced many reopenings and a very strong market. Looking ahead, we anticipate a more normalized environment. It's likely that some of the proactive replacements will not be present. Therefore, as we assess the strong performance of 2021, we expect a slight decline in 2022. However, coming off such a strong year, seeing flat growth is still a positive outcome.

Thank you. Good morning, everyone, and Pat, I'd like to add my congratulations as well to you.

Thanks, Sue.

Good morning. My first question is you mentioned that you have taken a lot of your customers off of allocation in North America in December. Can you just give us some color on where you think channel inventories sit? And how do you expect that your order rates could trend as those allocations have been removed?

Let me address that. We have strong visibility regarding our inventory in China, which allows us to be specific about it. However, in North America, our visibility isn’t as clear. Based on the feedback we’ve received from our customers, inventories appear to be mostly in line, though there are some gaps here and there. I believe that removing allocations will allow us to fulfill more orders, but I won’t provide a specific number. We have restricted some of our customers to ensure we can reliably deliver the right products on time. Overall, I see this as a positive development for our organization as we move into 2022, transitioning back to normal business operations. That's the current status, and I don’t have a specific number to add.

Got you. Okay, that's helpful. And then, as we do think about steel perhaps moderating or sort of coming off of this peak as we move through the year, how should we expect price will sort of trend with that? Do you think that as the volumes come off on the residential side potentially you'll have to give back any of this price? Or do you expect that it will be fairly sticky?

Yes, we've never experienced price increases like we've seen in the past year, which makes it challenging to predict future trends. Historically, we've been able to maintain our market share and margins and adjust to cost changes as needed. It's hard to gauge how things will unfold. While steel costs have dropped since our last call, we've encountered rising non-steel costs in logistics and freight, which have surged in the last quarter and offset some of the potential relief from the moderation in steel prices.

Hey, good morning, everyone. Congrats on the year. And Pat, best of luck in your retirement.

Thanks, Damian.

So I wanted to ask you about some of your comments on China. So you're expecting 5% sales growth there, but you mentioned water heater volumes flat to slightly down. Could you just talk about a little bit about your key assumptions driving your forecast there?

Sure, sure. Yes, I mean, water heater volumes in China have been flat to down. When we look at the full year demand and I'll just kind of talk about what the overall 2021 consumer demand as best we measure through our channel, it probably was up 1% to 2% the demand itself. So underlying demand when we get to the 5%, you can kind of think of it as 1% to 2%. There's a bit of pricing in China. We haven't nearly seen the cost pressures as we've seen in North America but that's perhaps another percent. And then when we think about kind of the new products, we've got some new products we've introduced. We've got the products I mentioned earlier in the statement on electric that are doing well and the gas products that are doing well, range hoods, cooktops, and commercial water treatment and water treatment overall, we feel pretty positive about which kind of fills that gap to get you to that 5%. Year-over-year currencies, we expect to be roughly flat, equal year-over-year. So that's kind of the bridge to kind of get up to that 5%.

Okay, great. That's helpful. And then on water heaters, specifically in China, maybe you could just help us understand a little kind of where mix is today compared to the pre-2019 peak levels, if you will. Obviously, kind of you mixed down after that. But maybe any color around kind of the mid- to premium price mix today relative to the past would be helpful.

Yes. We are not yet at the peak levels we experienced before 2019 when the premium segment made up a larger share of the market. However, we are coming out of the lowest point. We have a year-over-year improvement in mix planned for 2022, and Q4 showed positive momentum in mix. The introduction of our new products, which are positioned in the premium segment, is beneficial for our mix. While we haven't reached the peak, we are certainly above the trough and feel optimistic about the momentum and the new products entering the market.

Yes, I would just add that our new products across the electric line, gas tankless line, and water treatment have performed very well and continue to grow. Additionally, our commercial water treatment segment is doing well, exceeding $40 million. Chuck also mentioned that range hoods and cooktops are gaining momentum. Overall, we are still facing some COVID-related challenges and sporadic shutdowns that may set us back. There's still some risk to manage. However, looking at the fourth quarter, we came through it well. We have some excellent premium products that are just entering the market, which makes us optimistic about our product mix and our prospects for returning to 2019 levels soon.

Good morning, everyone. My congratulations to Pat and welcome to this part of the team to Helen. I did want to follow up on steel prices. I know you guys are talking about steel indices flattening out. But I think you have more exposure to coil steel prices which have actually come down pretty substantially. Is that a potential significant tailwind from margins as we get into maybe the second half of the year once you've run through the higher-cost steel and the inventory? And how is that balancing off against the inflation that you're continuing to see in other inputs?

Yes, our steel inputs consist of approximately 70% cold rolled and 30% hot rolled, and we are closely monitoring those indices. We've observed some moderation, although it hasn't decreased significantly. Year-over-year, our steel costs are projected to rise by 50% in 2022 compared to 2021, indicating continued pressure. Currently, at the beginning of the year, we are also tracking the rising costs of non-steel components and logistics, with no relief seen in that area. Looking ahead for the rest of the year, while we anticipate some moderation in steel prices based on the indices, the increase in non-steel costs will largely offset any potential savings. Our outlook suggests that Q1 will be the most challenging period, with margins expected to stabilize thereafter as we move past this quarter of elevated steel costs.

Good morning, everyone. Pat, thank you very much for your help over the years. It's been a pleasure working with you.

Thanks, Bryan.

Yes, I can do that. It's up about 100 basis points. We're looking to expand from 9% to 10%, primarily driven by volume and mix. The products we mentioned earlier contributed to this increase in volume and mix. We made some progress in 2021 to achieve the 9%, and now it's really about volume, mix, and leveraging the top line to reach 10%.

I would say on the residential side, probably not any tank momentum. Heat pumps have been growing year-over-year, becoming more popular. Obviously, there's more incentives out there and that's moving in the right direction. So we're in a good position there. And I would say, maybe on the commercial side, we're starting to see a bit more commercial heat pump up there. But let's step back, we still have a great decarbonizing footprint called condensing water heaters and condensing boilers. And that's also trending well because there's so many applications that you really need the output and the heat of a gas-fired product and being able to provide condensing boilers and condensing commercial water heaters, also priced opportunities. So commercial, I think you're going to continue to see just high efficiency growing and on both gas and on the kind of the heat pump side.

Thank you for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered strong sales and earnings despite many challenges in 2021. We are optimistic about our results in future periods based on a durable strategy, robust demand for our products as well as strong execution of our strategy despite an environment challenged by component shortages, logistical bottlenecks, inflation in both materials and transportation costs and pandemic-related challenges. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at three conferences next month; RW Baird on February 22, Citi on February 23 and Barclays on February 24. Thank you and have a great rest of your day.