A.O. Smith Corp (AOS) — Q2 2022 Earnings Call Transcript

Good morning and welcome to the A.O. Smith second quarter conference call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer, and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency in the operating results for our business, we provided non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of non-operating, non-cash pension income and expenses. Reconciliation from GAAP measures to non-GAAP are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risk that could cause actual results to be materially different. Those risks include matters that we 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 for return. 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 the next slide.

Thank you, Helen. And good morning, everyone. Thank you for joining us today. I'm on slide 4 and our second quarter results. Our team performed well throughout the quarter despite an uncertain macro environment to deliver strong sales and EPS performance. Second quarter sales improved 12% year-over-year driven by our 2021 equation related pricing actions, the acquisition of Giant Factories late last year, as well as Water Treatment Boiler and Commercial Water Heater volume growth in North America. Our Rest of World segment performance decreased 30% year-over-year, driven by COVID-19 related lockdowns in China. However, we experienced sequential sales improvement in China through the quarter as restrictions began to ease. The acquisition of Giant Factories added $31 million to quarterly sales and $0.01 to EPS. We are pleased with the performance of the team, and our integration is on track. We saw quarter-over-quarter improvement in our supply chain in the second quarter, leading to higher boiler and commercial water heater volumes. Please turn to slide 5. Our global A.O. Smith team delivered second quarter of 2022 adjusted EPS of $0.82, a 14% increase that was driven in part by 12% increase in sales compared with the second quarter of 2021. Our strong second quarter performance resulted from our team's outstanding execution. Despite the backdrop of an uncertain macro environment, COVID-19 related lockdowns in China, and softness in the residential water heater industry. I am proud of how my A.O. Smith colleagues worked together to overcome many challenges to deliver value to our customers across the globe. Excluding the impact of Giant, North America Water Heater sales grew 19% in the second quarter of 2022 due to pricing actions implemented in 2021 in response to rising material and logistics costs. Lower sales of residential water heaters partially offset sales growth in the quarter. The residential industry saw record orders in the second quarter of 2021, creating a difficult comparison for 2022. With that said, we saw order rate softness as we exited the second quarter and into July as customers right-sized their inventories. We saw quarter-over-quarter improvement in our commercial gas water heater shipments, as supply chain constraints eased in the second quarter, as well as our sales of commercial electric water heaters greater than 55 gallons as order rates normalized after the regulatory change impacted orders at the beginning of the year. Our North America Boiler sales grew 27% in the quarter, driven by pricing increases to offset higher material and transportation costs and strong demand. We again ended the quarter with a significant backlog largely composed of commercial condensing boilers, and we continue to see stable order rates for these market-leading energy-efficient products. Our strategy to focus on innovation and decarbonization contributed to strong demand for our high-efficiency condensing boilers. North American Water Treatment sales grew 19% in the second quarter as our independent water quality dealers continue to outperform the market and gain share. We also benefited from strong demand in the wholesale channel. In China, sales decreased 40% in local currency compared to the second quarter of 2021, primarily due to the expected impacts of COVID-19 related lockdowns. Our sales improved sequentially through the quarter as lockdowns lessened and consumer demand improved. The steps that our China team has undertaken to right-size the business and manage discretionary spend paid dividends this quarter, as China held its operating margins flat to last year despite lower sales in the quarter. In the first half of July, we saw consumer demand down approximately 5% to 10% compared to last year, a sequential improvement from second quarter consumer demand levels. Please turn to slide 6. As I mentioned on our January call, one of our key strategic priorities in 2022 is to expand our water treatment business through innovation, new product development, and strategic acquisitions. In May, we launched our redesigned Aquasana Clean Water machine, the first power countertop water filter to combine a sleek compact no-install design with four different methods of advanced filtration technology. The new clean water machine is tested and certified to NSF standards for the removal of up to 99.9% of 77 contaminants including lead and the forever chemicals, such as PFAS and many more. Aquasana's patented Claryum filtration ensures industry-leading contaminant removal while retaining beneficial and naturally occurring minerals in water such as calcium, magnesium, and potassium for optimal hydration. In addition, we welcome Atlantic Filter Corporation to the A.O. Smith family last month. Atlantic Filter is the fifth acquisition we've made in the North America water treatment market since 2016. With a strong presence in Southern Florida, Atlantic Filter will expand our capabilities in this key area of the market. I'll now turn the call over to Chuck, who will provide more details on our second quarter performance.

Thank you, Kevin, and good morning everyone. I'm on slide 7, second quarter sales in the North America segment rose to $744 million, a 23% increase compared with 2021. Pricing actions largely on water heaters represented approximately 89% of the increase. Sales in the quarter also benefited from higher volumes of water treatment products, boilers, and commercial water heaters. That was more than offset by lower volumes of residential water heaters. Giant, acquired in October 2021 added $31 million to North America sales. North America's adjusted segment earnings of $163 million increased 17% compared with the same period in 2021. The earnings benefit of inflation-related price increases was partially offset by higher material and freight costs and lower residential water heater volumes. Adjusted segment operating margin of 21.8% declined compared with 2021 primarily due to higher material and logistics costs, plant inefficiencies, and the inclusion of Giant, which has lower margins than our legacy water heater business. Moving to slide 8, the rest of the world segment sales of $230 million decreased 13% year-over-year, lower sales volumes primarily driven by consumer demand headwinds in China related to COVID-19 related restrictions. Currency translation of China's sales unfavorably impacted sales by approximately $5 million. Sales in India grew 79% in the second quarter of 2022 on strong demand compared to last year, which was negatively impacted by the pandemic. We view India as a long-term growth opportunity given its attractive growth characteristics and changes in demographics. Rest of the World segment earnings of $18 million decreased 18% compared to segment earnings in the second quarter of 2021. In China, the impact of lower volumes was partially offset by lower selling, advertising, and engineering expenses. Rest of the World segment margin was 7.9%, down 60 basis points from the same period last year. Free cash flow of $24 million during the first half of 2022 decreased from the first half of 2021 due to higher 2022 earnings that were more than offset by lower customer deposits in China, higher incentive payments due to record 2021 sales and earnings, and greater cash outlays for increased levels of safety stock and higher costs inventory. Historically, we generate the majority of our cash in the second half of the year. Our cash balance totaled $459 million at the end of June and our net cash position was $161 million. Our leverage ratio was 14% as measured by total debt to total capital. Our strong annual free cash flow and solid balance sheet allow us to continue 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. We repurchased 2.9 million shares of common stock in the first half of 2022 for a total of $190 million. So I'll turn to slide 10. In addition to returning capital to shareholders, we see opportunities for organic growth, innovation, and new product development across all of our product lines and geographies. The strength of our balance sheet allows us to pursue strategic acquisitions even in the event of an economic downturn. We remain focused on identifying water heating and water treatment assets that meet our financial metrics, such as the recent acquisitions of Atlantic Filter and Giant Factories. Additionally, the strength of our balance sheet allows us to maintain a strong track record of delivering returns to shareholders. This has been done through both our dividends that we have increased for 30 consecutive years, as well as share repurchases that have totaled more than $550 million since 2021. Please turn to slide 11, and our 2022 full year earnings guidance and outlook. We reaffirm our 2022 outlook with an expected EPS range of $1.56 to $1.76 per share, and our adjusted EPS range of $3.35 to $3.55 per share. Our outlook is based on a number of key assumptions, including no further significant surges of COVID-19 cases in the U.S., and that COVID-19 related restrictions in China remain approximately at the level they are today and do not significantly impact our operations or our employees, customers or suppliers. Steel indices began to stabilize at the end of 2021 and have moderated towards the end of the second quarter. Our guidance assumes that the average steel price in the second half of 2022 will approximate the average steel prices in the second half of 2021. We continue to see elevated materials and transportation costs. We saw improvement in our supply chain in the second quarter; however, challenges still persist. We remain in close contact with suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks. But the environment remains unpredictable. We continue to see the benefits from multiple 2021 price increases compounded to approximately 50% for water heaters. We expect to generate free cash flow of approximately $450 million to $500 million. The range assumes that our inventories returned to year-end 2021 levels. For the year, CapEx is expected to be approximately $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 156 million at the end of 2022. Based on these assumptions, the midpoint of our adjusted EPS range remains an increase of 17% compared to 2021. I'll now turn the call back to Kevin who will provide more color on our key markets and our top line growth outlook and segment expectations for 2022, all those things on slide 11.

Thank you, Chuck. We project revenue growth for 2022 of 12% to 14%, which is lower than our outlook in April as a result of softening demand in residential and commercial water heating. Our sales assumptions include 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 heater industry unit volumes will be down approximately 4% to 6% from last year as industry demand normalizes. We project that commercial gas water heater industry shipments will be flat to slightly down for the year. However, we revised our full year outlook for the commercial water heater industry to be down 7% to 9% primarily due to weakness in the large electric grid greater than 55 gallons. The commercial industry started the year weaker than expected, primarily due to a regulatory change that temporarily impacted orders in that product category. COVID-19 related restrictions played out as we expected in the quarter. Therefore, we maintain our sales projection in China to be flat in local currency compared to last year as a result of the economic headwinds we are experiencing from COVID related restrictions. Due to our strong backlog and stable order rates, we have increased our full year boiler sales growth projection from 18% to 20% to 25% sales growth, driven by increased pricing in response to higher input costs and higher demand for our energy-efficient products. We project North America Water Treatment sales growth, inclusive of acquisitions to be approximately 50% in 2022 due to strong water quality dealer performance. Based on these factors, along with the full impact of our 2021 price increases, we expect our North America segment margin to be between 22.5% and 23%. The Rest of World segment margin is expected to be approximately 9.5% to 10% or 50 to 100 basis points higher than 2021. Please turn to slide 12. 2022 continues to present challenges that our global teams are meeting head on. We are a 148-year-old company that has continued to grow and innovate through all economic cycles. We believe A.O. Smith is a compelling investment because of our stable replacement business. Combined with exciting growth opportunities in North America Water Treatment business, as well as in China and India. We have premium brands and leading share positions in our major product categories. We estimate replacement demand represents 80% to 85% of U.S. water heater and boiler volumes. The strength of our balance sheet and free cash flow generation support our ability to continue investing for the long term in automation, innovation, new products and acquisitions, as well as returning cash to shareholders even in times of economic uncertainty. As we have demonstrated throughout our long history, we are able to be successful in all economic cycles. We are focused on meeting the needs of our customers. Our portfolio of strong brands combined with the investment in technology to drive innovation and new product development further enhances our market leadership. I'm confident in our ability to navigate the complex macro environment and capitalize on opportunities while continuing to execute our strategic objectives. With that, we conclude our prepared remarks, and we are now available for your questions.

Hey, good morning, everyone. A couple of questions here. First, on the China side, the margins and I think the demand proved relatively resilient versus the magnitude of the lockdowns, maybe just a little under the hood, how you think about the inventory levels there? How that tracked through the quarter, how you positioned in the back half of the year? And then just to comment on the capacity side, and the resiliency, the incremental space?

Sure. Good morning, Mike. This is Chuck. Yes, we're really pleased with how China performed for the quarter. We, on our last call talked a little bit about consumer demand being down 35% to 40% in April, and as you recall that was really during the hardest and most severe lockdowns in Shanghai and Beijing. But what we saw in consumer demand for the course of the quarter was consumer demand that was down about 20%. The first quarter was down around 10%. So second quarter average was down around 20%. And as we came out of the second quarter, and what we're seeing in July is we're down about 5% to 10%. So the consumer demand moved pretty well back to the first quarter levels. Then our assumption and guidance is that it stays at that level for the rest of the year. Inventories are flat to down a little bit in the channel, from the first quarter to the second quarter. So they are in a really good position. There's about three to four weeks in the inventory within the channel. And that's pretty normal for us; it's at a decently low point. And I'd say we're pleased with 9% in operating margins for the quarter at that lower volume. Some of that was helped by controlling discretionary spending, as we mentioned, that's probably about $3 million or so of help on discretionary spending. I'm talking about promotions, advertising, and very little travel for the quarter, as you can imagine in the lockdown situation. We would expect that through the second quarter or third quarters, we would have a similar ability to control discretionary spending, which we would probably turn back on in the fourth quarter as that's our largest kind of typical quarter in China. We would project to turn that back on, and we would hope for a strong fourth quarter similar to last year.

Great, super helpful. And then Kevin, I think you were talking about the last couple of years being awfully strong in the North America residential water heater side. And it makes a lot of sense that the volume side is down for this year against your comparison. What's the house view on what that run rates going to look like from an industry perspective? We're running high 9 million-ish kind of units right now. Do you guys have a sense from an industry perspective on where that settles in from a downside? And what that might look like?

Well, I think, as we talked about where we're forecasting the 4% to 6% downturn, and we truly believe, and we saw quite a bit of that in June, where we saw many of our customers reducing their inventories. And, again, as we go forward, this year, we look at it's starting to normalize beginning into August, September and the rest of the year. Where it goes forward, I think it's going to depend upon some new construction, but it's slowed down, but we think it’s going to come back. And it is going to normalize somewhere down towards the lower level of that 9 million I think over time. It's just a matter of working through some of the inventories and some of the economic disruptions that we're going through today. But still, you look at it, it's still going to be 80%, 85% replacement demand, and that's going to be very resilient. And there's always going to be potential upside on the new construction if we can get through this supply chain and interest rate issue that we're navigating through today as a country.

Yes, just a little more color on the tough comparison, right. So that Q2 shipments last year were, and I think Kevin mentioned on the call, record, but that's inclusive of 2006. So very strong 2021 Q2.

Good morning, everyone. Maybe just following up on Mike's question on the residential heated business in North America and related to the channel inventories, and you talked about customers taking their inventory down. Do you think that inventory has corrected? How long do you think it takes to correct?

Well, I think it's in the correction right now. Certainly, we believe there was a big correction in June. We're seeing some of it in July. And you step back right now; you look at overall in the industry, production has improved, lead times are down. So it's becoming a much more predictable environment. And so with that, I think all of our customers are going to reevaluate. I still think it'll take part of July and maybe a little bit of August, and then kind of normalize as we go through the balance of the year.

Yes, and just quantifying the lead times too because we came into the year at 25-day lead times, and we're pretty much on the residential side back to normal 15-day lead time. So kind of progression through the quarter, we went from 25 to 20 in Q1, and then at the end of Q2, we were at the 15-day range. So those normalizations have happened in the first half of the year.

Make sense. People would need less inventory under those circumstances. I guess my follow up question is going to be around steel prices and how that could impact the pricing on your products overall. Prices on water heaters are up a lot. They needed to be because steel was up a lot. Cold rolls and hot roll that down probably about 50% from peak prices now. Can you talk about your expectations for how price goes from here? Obviously, it'll go on a lag, that should be accretive to margins, just any comments you can have on how you're expecting that to go, if steel prices kind of stabilize from where they are now?

Yes, I mean just a little background color on this steel pricing, because yes, you're right; your reference of kind of the peak to where they've gone is a pretty big delta on steel pricing, but kind of the mechanics of what we see. What we see in cost is not necessarily the peak; it's kind of a weekly average, monthly average, quarterly average that we see 90 to 100 days later. So we're never really at the peak, we're probably never really at the trough. So those are a bit muted from kind of the highlights top and bottom end. And then we see that 90 to 120-day lag. So Q1, we had our highest cost; some of the improvement we saw in Q2 was the result of this little improved steel cost and steel pricing. We do expect that, as you noted, we've seen indexes come down. We pretty much know what steel will be for Q3, and we projected in Q4 it will be down a bit too, so we do expect to see some benefit from the steel pricing. It's a little muted from those peaks and troughs and comes a little delayed. And as far as pricing, we always consider the competitive nature in the marketplace and kind of look at abate in some pressure, not just for steel for other costs. And I'll just say kind of the other cost we're experiencing have been pretty resilient, pretty stable, that are still out there, including freight, logistics and delay.

Quite significantly, from flat down to down 7% and 9%. I think you said last quarter that you are seeing your order volume improve.

Hey, Andrew.

Yes. Can you hear me, okay?

No. You were muted for a while. So could you start over, please?

Yes, I have no problem.

Sorry about that.

Yes, no problem. So you changed your outlook for commercial water heater volumes. You are down 7% to 9%, as you said, and I think you said last quarter that you were seeing your order volume stabilize after the early regulatory change. So, can you give us more color into why the changing guidance? Are you seeing a more significant change in customer demand there? Or is it just a slow start to the year? Maybe destock there. Anymore color will be helpful.

Yes, I'll take that. As we mentioned, we still think commercial gas is going to be flat to slightly down. So that's moving along. But the regulatory change that we experienced in the first quarter — we’re seeing our orders normalize. But as we go forward, we believe of the 7% and 9% that we have forecasted being down almost 90% positive, it's going to be in that light service, commercial electric. We just don't see the industry rebounding from a slow start in a quarter. So that's the backdrop of why we're going down. The rest of the commercial businesses are quite strong and doing well. That said, the light service goes into homes and really small businesses. When you look at our commercial overall business, there's about a 4x or 5x to our commercial overall business excluding the light service when it comes to price. So it's on the lower end of our pricing curve, but it does drive volume. We just see now with better visibility that we need to bring the industry down from a unit standpoint, but feel pretty good about our commercial gas and condensing gas and where that's going.

Got it. That's helpful. And then Kevin or Chuck, maybe just I want to understand the puts and takes. Overall, you maintain your EPS guidance, but you did lower your revenue forecast a little bit, maintain margins in North America; China looks pretty good versus expectations. So what are the puts and takes here? What's the positives that you're seeing? Is it price versus cost that is the major offset to the lower volumes, any help there?

Yes, I’ll start out and Kevin may add on a little bit after that, but I mean, the puts and takes — it's price versus cost, and it's what we are seeing a bit of softening on the steel pricing. So we're getting a little bit of help there. But it's not just the water heating side, it's also pricing that we're going to have implemented in the fourth quarter on both the boiler side of the business and water treatment side of the business. So we've got some second quarter announced price increases that are in the market that should help us a bit in the back half with the margins. Also, we had a bit of destabilization during the quarter of water rates on the residential side. We expect that the plants probably will run a little bit smoother during the back half of the year. During the quarter, our water rates on the residential side expect that the plants probably will run a little bit smoother during the back half of the year. So we would expect a little bit of help there, and then there's a bit of mix opportunity, right, so residential is down in the quarter and residential, we see for the year down 4% to 6%. But as Kevin mentioned, we still feel good about commercial, particularly gas commercial product being strong for the back half of the year. Also, boilers and our backlog for boilers is still pretty resilient. We expect, and it’s typical, that the boiler business is strongest volume in the third quarter. So we would expect help on the mix side also.

Yes, the only thing I might add is even though China has gone through some COVID-related lockdowns, we've seen our new products do well. We've seen trade-up continue to grow. It’s been growing for the last couple of years. So we have some positive mix issues here. It's not only in North America, but we also see that in China.

Thanks. A couple questions. First on China. If you gave this, I apologize. But what is your best estimate on the revenue impact you experienced in the second quarter from the lockdowns? And where in did you see any sort of difference in out-the-door demand for water heaters versus water treatment in China? And then I have a follow-up.

Yes, I mean, it's hard to call out exactly what's COVID and what's the overall economy in China. So it's really hard to parse that but clearly, we were impacted negatively by COVID. And consumer demand out the door was down about 20%. So that was kind of out the door demand. I would say just kind of within our product categories, certainly the residential products were challenged most so I would say, electric water heaters and water treatment were probably the most challenged during the quarter, commercial water heating, commercial water treatment, the commercial side that's not sold through retail offset some of that 20% down, which we viewed as the number for overall sales volume.

Got it, and then just with respect to the boiler backlog, can you guys maybe put a finer point on that? How does that compare to prior peaks and prior cycles? And can you maybe talk about the magnitude of pricing you're looking for in boilers in treatment to what you just mentioned a couple of moments ago in the back half? Thank you.

Yes, I'll take the magnitude and maybe Chuck, you can jump in on any of the pricing side of it. Certainly, we haven't seen this type of backlog; we're in the three to four-month range, to be honest with you. And it's mainly commercial. What’s important to know here in our backlog is we actually have shift days for the vast majority of all our orders in house. There may be a put and take that we see where a job gets pulled in, and maybe gets kicked out a little bit. But overall, we see nothing that would cause a material change, the backlog is the — market remains very active, the jobs continue to move forward. Again, labor gets in the way a little bit. But overall, we have a lot of comfort in our backlog; primarily it's mostly commercial condensing products, which are the heart of our business.

And on the pricing side, on the water treatment side, going forward, in both for the boiler side and water treatment side, we expect to see it come in end of third quarter and in the fourth quarter, but water treatment kind of mid-single digits to 10% price increases depending on product category, similar for the boiler products in that 8% to 12% depending upon product category.

Good morning. I wanted to just explore further around the residential water heater business. And maybe some of the weaknesses you've seen there and I kind of think about that market as maybe at the risk of oversimplifying this a little bit as consisting of three buckets. You've got the construction, the replacement demand, and then of course, just changes in the channel inventory. It sounds like the channel inventory is fairly transitory. And you expect that, as you pointed out by August, you can see that kind of normalizing. New construction, I guess watch completions, and I'll give us a good sense of water heater consumption there. But let me just speak to replacement demand and what you're seeing there, and maybe not to be overly skeptical here. But to the extent you think you may have lost some share in replacement demand this quarter, what gives you confidence that your share position remains strong? Thank you.

Yes, okay. When we talked about replacement demand, there are two components of it — you have kind of the proactive replacement, and then you have the emergency replacement. The proactive side, which is renovation, has probably been pretty strong, we saw that, it's coming down a little bit, we test that every quarter and have a good read on that. As far as the overall emergency replacement, that will always remain resilient. I mean, people just don't go without hot water for any length of time. So yes, the residential visit has those components. Again, I just want to remind people that 50% of our business is in new construction. So even if it drops a little bit, it's pretty nominal for us. And but it’s nice upside as we go forward. But that's how it plays out. And we feel pretty comfortable with our 4% to 6%. And again, as I mentioned, a lot of the channel inventory adjustments would come out in June and July and a little bit of August. From a share perspective, we have really good data on that. We talked about this last year and into the quarter that we were a little bit behind. We really expected — I expected that it would normalize as production came up and lead times came down. And that's actually playing out really well on the residential side. I will tell you, we're slightly up moving towards our normal historic market shares. And I'll just throw in commercial, we're already back to our normal rates.

Good to hear. Thank you for that. And just as a follow up, I guess everyone's concerned right now about the slowing macro. And so I'm thinking about sort of where the strength lies in your businesses, it seems to be in the boiler businesses. It has always been sort of one of the stronger elements in the model. How cyclical is that business? How should we be thinking about kind of if 2023 is a soft year and we see pervasive weakness across the market? How stable should that business be?

Yes, historically, well we expect it to be pretty stable. I mean, the replacement component of that business is very similar to the water heater side, and that 80% to 85%. So the replacement piece continues to be resilient. Usually, the commercial side would typically lag the residential side; you've got projects in progress, and you’ve got quoting that's happening in advance. So it's a little more stable and longer. In the last recession, on the boiler side, which was 2006-2007, the boiler business was impacted, but not as much as the rest of the business, particularly because of some of the underlying growth drivers that you have on the replacement and high efficiency; most of our products are just as reminders, high efficient, energy-efficient products that are pretty resilient in downturns because of the energy efficiency nature and the continued demand for driving a replacement.

So just to be clear, when you say it's resilient in terms of the cyclicality, are you talking about units? Are you talking about profitability?

Both; they're very similar.

Hey, good morning. Just wanted to ask a similar question on, I guess Dave did on the water treatment business. It's a newer platform, and just trying to, it seems to be something maybe a little more discretionary than a water heater replacement. So just how you think that business would perform in a recession scenario?

Yes, I guess the first point of some of our water treatment is it's a much more affordable product. So this is our first time going through some type of cycle here. Certainly, there will be some discretion there with people, but the way we look at it is the penetration, the awareness is going to continue to go up. There's a consumable part that we have that continues to grow. It's about 50% of our business today. So we — it's not as — maybe not as resilient as water heaters; it's not a must-have. But it's got some built-in components that help offset some of the downturns, but just people becoming more aware of healthy and clean water. We think it's going to perform fairly well with any type of economic cycle.

Okay, and then seems like the new entrants in the water heater space finally got the plant open. And I'm just wondering if you're seeing them in the marketplace at all. And if you think there's any pricing disruption around that, particularly as input costs roll over. Thanks.

Yes, I'll quickly touch base on that. Nothing new from our perspective; yes, their plant is open, but their market activity from our perspective and what we're getting feedback hasn't changed. In fact, if anything, they're moving away from our customers, our retailers and wholesalers and trying to maybe look at more builders and that type of thing. Can't anticipate what the future is going to be with them? But right now it's kind of not a big change from what we saw other than they’re manufacturing a few products in their U.S. plant.

Hi, good morning. To an earlier question, Kevin, I was very interested in your view on the residential water heater market, kind of going from the 99 level, I think you said to the lower nines. I'm curious if you can add maybe a little more color from your perspective as the market leader. How much of that do you think is destock?

Again, that's going to be very speculative. The reason I feel confident in the water heater market is I still go back to, again, I'm not sure when it's going to normalize. But new construction, there's still a deficit out there. And that's going to continue to grow and move forward. So that's what gives me confidence in the market, a stable replacement side of it. And, yes, again, quite frankly, as things get a little tougher, people do more renovation. But I think if you look at our history, the growth rate in the residential water heater market has been at that couple percent range. And I think as I go forward, I just think it's going to adjust down; we were in a very hyper-inflated market, a lot of money out there, and everybody benefited from it. But I think over time, that's going to just normalize to a run rate that we've seen in the past. The great news of it, though, is that there are more water heaters out there today, and those are going to go out 10-14 years, which is going to play really well for the industry and for our company. So that's kind of the high level; it's really hard to get into much more detail than that, Scott.

It's fine. And that was helpful. Thanks. So in China, can you give us the sales split for the quarter in, I know you combine both water heaters and treatment, upper middle price point versus premium?

Sure. I mean, the premium I'll just — the premium side of the market is about, the low end is about 40% premium on the electric water heater side, the high end is nearing 50% premium on the water and the gas tankless, and then water treatment is kind of in between. So not a great deal of change, just a little uptick on the electric side; we introduced a couple of new products, a good dual tank, slimline product on the electric that we're hoping to get some traction on, which bumped that up a bit.

Okay, so you are seeing that number continue to incrementally progress.

Well, quarter-over-quarter for electric it was up and we think it's — it is due to some new products. It's hard to say there's a lot of movement. But when we track the upper part of the market and what the industry is telling us from a third party, still positive movement, so still an uptick from the last quarter. Not a large uptick, but only positive.

Yes, Scott, I echo that, we talked about it, it is about a couple of years now. And so a lot of our premium products have features and benefits that still consumers in China are willing to pay for. So we're very pleased with our new products. And we're really pleased to see the upper end continue to move in that northeast direction.

Got it, thank you. And just a follow up then on the share repurchases. I know you're still locked in at that $400 million. I'm just sort of wondering what the market weaker residential conditions, obviously sliding yet you're still having some fairly stable sales based on the replacement nature of them, including in China, good cash flow. What's holding you back from going higher on the share repurchases this year?

Yes, I mean, we did have enough $400 million, I think last year were 380-ish or something like that and change. So we're still a little bit of an uptick to historically. I think as we go into this cycle and we'll have to see how it plays out. But there could be some real opportunities on the M&A side; we want to make sure we're in a position to be able to capitalize on those opportunities. So that's one way to get it. The other is see we're projecting to be at that $400 million now, we don't have intentions to increase it on this call. But we'll continue to watch it as we have and see what the economy does and what our price does.

Yes, I’ll jump in here; that's almost a possibility. And so the way we looked at as we go into the year, and things have changed as this year started kind of evolved to where we're at today. The $400 million is pretty much a locked-in number for us. Each year, we evaluate where we like to go. So we'll take another look as Chuck said in 2023 but we do think there's some opportunity as we get into the back half of this year with a number of our M&A targets and things are changing, and we want to be prepared and have the balance sheet to take action if those opportunities come our way.

Hi, good morning, everyone. Thanks for all the detailed color around the market outlook. I have a follow-up question on margin; I was wondering if you could maybe just help us think about the bridge when you factor in some of the volume deleveraging for the lower steel and input costs. Is there a good way to think about the detrimental margin versus the price cost benefit? And I guess just any perspective you might be able to provide on additional margin you could capture later this year and next year if steel costs basically hold stable from here.

Yes, this is Chuck. I won't go beyond this year. But when you think about kind of the detrimental margins, we're really just talking about residential water heater detrimental margin, and then what Kevin mentioned, the light commercial; so you probably think of that in the 35% detrimental margin range. Steel costs, we've kind of got that visibility, and we have visibility into those costs through the third quarter for sure. We're starting to see visibility into second. We feel pretty good about that. So that’s probably the next largest driver. And then the stabilization of order rates, as we expect. We had a little bit of a disruption in the end of June and in July here on residential order rates; we would expect plants to perform a little bit better during the back half of the year, during the quarter; our water rates on the residential side expect that the plants probably will run a little bit smoother during the back half of the year. So we would expect a little bit of help there. And if you kind of think about the cadence for the back half of the year, our guidance is 22.5% to 23%, right? And we're kind of tracking below that right now, so we do expect a decent uptick in Q3, and then incrementally Q4 as some of those price increases I mentioned that are locked in and boilers come in. And we expect to see probably our most favorable steel for sure in the fourth quarter. So that's how we kind of think about that margin expansion.

Okay, that’s helpful. I want to ask you about your heat pump product. We're seeing heat pumps gain traction in the broader HVAC market kind of on the air side; that's really picking up. I was wondering if you could maybe talk a little bit about what you're seeing. I guess in theory, the economics have probably gotten a little bit worse just because of the steel inflation if you compare that product to the tankless. But maybe any ideas, maybe any thoughts on just how that is progressing? And do you think that the market is — that product could take off on its own? Or are you going to ultimately need some government stimulus?

Well, let me separate that to a residential heat pump versus a commercial heat pump because I think they’re both different markets. The residential heat pump is still an upsell product; it's one of the best value propositions we have in our company. But it's a 3x or 4x regular electric water heater, and there's some installation challenges. There are quite a bit of subsidies out there, whether it be up to state city, which is helping, and that's going to continue to grow. I mean, there's no doubt that it'll grow; it'll grow at a moderate pace, I believe, unless it's regulated in, but it's going to continue to grow. And it's going to be a long-term product for our company and our industry. But it's still a relatively small part of our overall volume. Commercial heat pump is even — there's a lot of activity out there. But that's trailing the residential side just because it does have some size to the installation. It requires a tank; there are a number of things that have to go along with it, and it's better for new construction than it is for retrofit. But we see that growing; we see activity in it. We obviously have products that we participate in, but I think both of those categories are going to grow at a percentage rate that’s pretty high, but as an overall volume still going to be more of an upsell product unless there's some regulatory changes that come.

Thank you for joining us today. Let me conclude by reminding you that our Global A. O. Smith team delivered strong sales and earnings in the second quarter despite many 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 four conferences in the third quarter: Northcoast on August 8, Jeffries on August 9, Stifel on September 7, and Davidson on September 22.