A.O. Smith Corp (AOS) — Q3 2022 Earnings Call Transcript

Thank you, Josh. Good morning, and welcome to the A.O. Smith third quarter conference call. I'm Helen Gurholt, Vice President of 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 into our operating results of 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 as well as legal judgment income and terminated acquisition-related expenses. Reconciliations from GAAP measures to non-GAAP measures 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 risks 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 per chart. 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. I'm on Slide 4 in our third quarter results. As we announced on October 13, we saw our customers reduce their North America residential water heater inventory levels, particularly in the wholesale distribution channel. This inventory destock activity was larger than we expected going into the third quarter. Based on market data, we believe this destock was industry-wide. As a result of the destock, our third quarter sales decreased 4% year-over-year due to lower residential water heater volumes, which more than offset our 2021 inflation-related pricing actions, incremental sales from our acquisition of Giant Industries late last year as well as commercial water heater and boiler growth in North America. Our Rest of World segment sales decreased 13% year-over-year as COVID-related lockdown headwinds persisted in China. Despite lower volumes, our China business achieved margin growth of 40 basis points in the quarter. The acquisition of Giant Factories added $25 million in 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, which led to higher commercial water heater and boiler volumes. Please turn to Slide 5. Our Global A.O. Smith team delivered third quarter 2022 adjusted EPS of $0.69, a 15% decrease that was driven in part by a 4% decrease in sales compared to the third quarter of 2021 as well as higher costs associated with production inefficiency and higher material costs. I commend the global A.O. Smith team for meeting the many challenges we faced in the third quarter, and taking the necessary steps to rightsize our production and meet current demands to improve efficiencies going forward. Excluding the impact of Giant, North America water heater sales decreased 9% in the third quarter of 2022. Due to greater-than-expected residential water heater destocking activity that more than offset pricing actions implemented in 2021, in response to rising material and logistic costs. The residential industry experienced greater than average growth in 2020 and in 2021. We began to see softness in our orders towards the end of the second quarter and into the third quarter. As our customers began to destock their inventories in response to our lead times returning to pre-pandemic levels. However, this destocking activity was prolonged and deeper than we originally expected. We have seen an increase in our orders in October. And while we expect higher residential water heater volumes in the fourth quarter compared to the third quarter, we do not expect volumes to be as robust as the fourth quarter of 2021. We again saw quarter-over-quarter improvements in our commercial gas water heater shipments as supply chain constraints continue to ease in the third quarter. Our North America boiler sales grew 27% in the quarter, mainly driven by previously announced price increases to offset higher material and transportation costs and higher volumes. We continue to see improvement in our supply chain in the third quarter, which allowed us to reduce lead times and begin to reduce our backlog. Our strategy to focus on innovation and decarbonization contributed to strong demand for our high-efficiency condensing boilers. North America water treatment sales grew over 4% in the third quarter, primarily due to pricing actions taken to offset higher input costs. Our water team business was also impacted in the quarter by customer destocking in the professional channels. In line with expectations, sales in China decreased 10% in local currency, compared to the third quarter of 2021, primarily due to the continued impact of COVID-19-related lockdowns. Our team in China continued to effectively manage discretionary spending in the quarter. In the fourth quarter, we forecast that consumer demand will be down approximately 15% compared to last year. Please turn to Slide 6. As I mentioned on our January call, one of our key strategic priorities in 2022 is to innovate and expand our decarb portfolio, including heat pump technology. In the third quarter, we launched our best-in-class Voltex AL residential heat pump water heater. The Voltex AL has industry-leading energy efficiency and provides peace of mind with new integrated leak protection technology. The Voltex AL also has 0 clearance design and versatile top inside water connections to ease installation for contractors. We believe the new Voltex AL is a market-leading product that puts us in a strong position to capitalize on the decarbonization and electrification megatrends. I'll now turn the call over to Chuck, who will provide more details on our third quarter performance.

Thank you, Kevin, and good morning, everyone. I'm on Slide 7. Third quarter sales in the North America segment were $653 million, a 1% decrease compared with 2021. Pricing actions largely on water heaters were more than offset by lower volumes of residential water heaters. Sales in the quarter also benefited from higher volumes of commercial water heaters and boilers. Giant acquired in October 2021, added $25 million to North America sales. North America adjusted segment earnings of $133 million decreased 11% compared with the same period of 2021. The earnings benefit of inflation-related price increases was more than offset by lower residential water heater volumes and related production inefficiencies as well as higher material and freight costs. Adjusted segment operating margin of 20.4% declined compared with 2021 operating margin, primarily due to the headwinds I mentioned and acquisition of Giant, which has lower margins than our overall legacy water heater business. Adjusted segment earnings and adjusted segment margin excluded a pretax gain of $11.5 million due to a judgment obtained against a competitor related to the infringement of one of our patents and pretax non-operating pension expenses of $2.6 million. Moving to Slide 8. Rest of the World segment sales of $230 million decreased 13% year-over-year. Lower sales volumes were primarily driven by consumer demand headwinds in China related to COVID-19-related restrictions. Currency translation unfavorably impacted segment sales by approximately $16 million, $12 million of which impacted China sales. Sales in India grew 16% in local currency in the third quarter of 2022 on strong demand for our water heating and water treating products. 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 $22 million decreased 19% compared to segment earnings in the third quarter of 2021. In China, the impact of lower volumes was partially offset by lower selling and advertising expenses. Rest of the World segment margin of 9.5% was down 70 basis points from the same period last year primarily due to the negative effects of foreign currency translation as well as higher advertising expenses to promote new products in India, partially offset by improvement in China operating margin. Cash flow from operations and free cash flow of $215 million and $164 million, respectively, during the first 9 months of 2022 decreased compared to the first 9 months of 2021 due to lower customer deposits in China, higher incentive accruals from 2021 due to record sales and earnings and greater cash outlays in 2022 for increased levels of safety stock on higher cost inventory that more than offset lower accounts receivable balances. Cash flow from operations and free cash flow reported today are each $34 million higher than the preliminary cash flows reported on October 13. As a result of separately reporting the impact of foreign currency exchange impacts on working capital. Our cash balance totaled $417 million at the end of September, and our net cash position was $129 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 return cash to shareholders. Earlier this month, our Board approved a 7% increase in our quarterly dividend rate to $0.30 per share. We repurchased 4.5 million shares of common stock in the first 9 months of 2022 for a total of $282 million. Let's now 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 times of economic uncertainty. As a result of our activities to identify water heating and water treating assets that meet our financial metrics, we recognized corporate expenses of $4.3 million related to costs associated with the terminated acquisition. These costs were excluded from adjusted earnings and adjusted earnings per share. The strength of our balance sheet allows us to maintain our strong track record of delivering returns to shareholders. This has been done through both our dividend that we have increased for 30 consecutive years as well as share repurchases that have totaled $650 million since the beginning of 2021. Please turn to Slide 11 and our 2022 full year earnings guidance and outlook. We maintain our 2022 outlook that we updated in conjunction with our October 13 press release with an expected earnings per share range of $1.29 to $1.39 per share our adjusted earnings per share range of $3.05 to $3.15 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 levels that they are today and do not significantly impact our operations, our employees, customers, or suppliers. Steel indices began to stabilize at the end of 2021 and have moderated through the current year. Our guidance assumes that average steel prices in the fourth quarter will be approximately 15% lower than the third quarter of this year. We continue to see elevated non-steel materials and transportation costs. We saw continued improvement in our supply chain in the quarter. However, challenges still persist. We remain in close contact with our suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks, but the environment remains unpredictable. We continue to see the benefit from multiple 2021 price increases, compounding to approximately 50% for water heaters. We expect to generate free cash flow of approximately $400 million to $425 million. For the year, CapEx is expected to be approximately $70 million to $75 million. Adjusted 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 $400 million worth of shares of our common stock, resulting in outstanding average diluted shares of $156 million for 2022. Based on these assumptions, the midpoint of our adjusted EPS range represents an increase of 5% compared to 2021. I'll now turn the call over back over to Kevin, who will provide more color on our key metrics and top line growth outlook and segment expectations for 2022, staying on Slide 11.

Okay. Thank you, Chuck. We project revenue growth for 2022 of 5% to 7%, which is lower than our outlook in July as a result of softer-than-expected demand in residential 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 12% to 13% on last year as customers rightsize their inventories and industry demand normalizes. We continue to 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 approximately 15%, primarily due to continued weakness in the electric product greater than 55 gallons. COVID-19-related restrictions in China played out as we expected in the quarter, and we expect continued headwinds for the remainder of the year. Therefore, we project our sales in China to be flat to slightly down 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 maintain our full year boiler sales growth projection of 25%, driven by increased pricing in response to higher input costs, prior demand for our energy-efficient products. We project North America water treatment sales growth, inclusive of acquisitions to be approximately 10% in 2022 as we continue to execute our water treatment business strategy. Based on these factors, along with the full impact of our 2021 price increases, we expect North America segment margin to be approximately 21.5%, and Rest of World segment margins to be approximately 10%. Please turn to Slide 12. The residential water heater industry adjustment that we experienced in the third quarter was disruptive. We have taken action to rightsize our production and we project lower steel costs, which we expect to lead to sequential improvement in profitability in the fourth quarter. Our company has a long history of the ability to navigate and innovate through all economic cycles. We believe A.O. Smith is a compelling investment with our premium brands and leading share positions in our major product categories, combined with exciting growth opportunities in North America water treatment business as well as in China and India. We estimate replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes. Our strong balance sheet and free cash flow generation allow us to continue investing for the long term in ourselves, and through acquisitions. We are focused on meeting the needs of our customers. Our portfolio of strong brands, combined with investing in technology to drive innovation and new product development, further enhance our market leadership. I'm confident in our ability to effectively manage the complex macro environment and capitalize on opportunities while continuing to execute our strategic objectives. That concludes our prepared remarks, and we are now available for questions.

A couple of questions. When do you guys expect price capture to peak for A.O. Smith in North America? And to that point, have you seen any impact as of yet from price paid associated with steel indices retreating off highs?

Yes. I mean let me address that. So for the quarter, you can see what we've presented on our walk forward that our pricing so far, which, just as a reminder, is fully in at the beginning of January. We're anniversarying our last price announcement coming up here in November. So pricing has been in the market for a while now. In the quarter, you can see we're covering costs well, covering costs plus our margin. We have seen steel costs moderate a bit. Over time, we typically see some fade on pricing as costs moderate. I want to just kind of remind everybody, though, that it's not just steel costs that we have as part of our pricing portfolio; it's also material costs. We've seen a broader basket of costs go up over time. And those costs have been pretty resilient. So with the lower volumes as we came into the third quarter, we're carrying a little extra inventory. We're a little bit more on safety stock than typical. Some of that is at a bit higher cost, including higher steel costs as we're working through buying still a little bit in advance of some of the volumes. And so we'll see an improvement in the fourth quarter. We expect margins to improve. Part of that is related to the price cost relationship. And as we exit the year, we expect to be working through the inventory as we exit the year, but we probably still have a little bit of carryover inventory going into next year.

And then maybe I was wondering if you guys could talk a little bit about the M&A transaction you were maybe looking at and ended up walking away from maybe a little bit of detail around the nature of the size and maybe ultimately, why that transaction was not consummated?

We're unable to provide details about that transaction due to an NDA. However, I can say that we followed our standard diligence process, assessing the strategic fit and financial metrics. We progressed significantly in the process, but we cannot disclose any specifics regarding that particular transaction.

Yes, probably may just make a couple more comments. I mean, we've talked about our M&A activity being pretty robust in the pipeline being fairly strong. Again, we always start with our core water treatment, water heaters, and boilers; we also have some adjacencies that we believe are meaningful to our business that we could leverage our markets and channels and customers and so forth. So that activity still remains. But I guess the big takeaway, I would say, is we went through that process we're talking about, but we remain financially disciplined and it's something we've always said that we were going to continue to do as a company through our M&A process.

I just wanted to follow up on the pricing commentary. Can you just talk a little bit about how we should think about the cadence of some of the price cost flowing through, just given all the different moving parts that you are seeing in there? And can you talk a little bit about the longer-term stability of some of the pricing? And how we should be thinking about that coming through the business over time?

Yes. I mean, the cadence is as we kind of look at the price/cost relationship, we entered the first quarter with our highest cost and pricing was not quite fully in the market. We kind of roll through the year, and I would say the relationship becomes a little better each quarter though we're pressured on non-steel costs as we went into the second and third quarters. We see some relief on steel as we go from the third to the fourth quarter. And so we do expect better margins in the fourth quarter on that cost price relationship. And as we exit the year, we're going to have to see where all the other material costs head into next year. But as we exit the year, we feel pretty good about our price cost relationship and margins.

And then following up, can you talk a little bit about the deceleration in water treatment there? You talked about destocking that's going on in the quarter. Can you give just some more color on where those inventories are? And how you're thinking about that going forward?

Yes, our water treatment business has been growing. It was the first to show growth during the pandemic and has performed well over the past couple of years, with growth of over 40 percent. The comment about professional destocking is related to our wholesale and professional dealer channels. It's worth noting that our professional dealers have experienced 10 consecutive quarters of strong growth. They faced similar inventory build issues, albeit not as severe as in our water heating sector, and we are starting to see reductions in inventory during the third quarter. We anticipate more of this as we move into the fourth quarter as well. Overall, the wholesale and dealer business is performing well, and our direct-to-consumer and retail channels are also doing well. There are some areas in exports and private label that are lagging behind, but this is likely just an adjustment as we return to normal levels in our water treatment operations. Overall, the business is performing well, we have introduced new products, and we expect to continue seeing double-digit growth in the near to midterm.

So on the residential side of things, North America water heaters, just thoughts on how long you think the destocking takes? Do you think it's mostly run its course here? And any thoughts on where you think the industry volumes kind of settle in that on a unit volume basis?

Yes, sure. Mike, let me just touch on that. One, we talked about it in our prepared remarks that it was deeper than we thought as we go forward. I mean we saw June, July and August some pretty good corrections. But as you step back and you look at it, I think the key driver has been our lead times have come back to pre-pandemic levels, where we can be counted on for on-time deliveries. There's some pressure on our wholesalers, particularly on inventory, the cost of inventory and probably wanting to exit maybe this year a bit conservative. But overall, I look at it, our orders have rebounded in October to a reasonable level. And it appears that we've just normalized back to an appropriate level. And that destock was really necessary as we kind of adjust to what is more of a normal level of orders and of sales. And then you step back and you look at our three segments, the replacement side of the business is resilient, continues to do that. Renovation and proactive replacement still elevated, but probably going to come down. And we've seen a bit of a slowness in the new construction residential part of the business, but that's probably just an adjustment to interest rates, but nothing like we saw back in '08 and '09. So I look at this, I think we're in a reset right now. We probably have had all the destocking or most of it in Q3, a little bit maybe left in Q4, and we should exit the year at the right levels as a water heater industry.

Yes. Just a couple of metrics around that, Mike, let me add to that. We've observed the industry increasing slightly, by 6% to 7% in Q4 compared to Q3. As Kevin mentioned, orders have shown some improvement. Overall, there's a small uptick in the industry. However, when we look at the fourth quarter, we expect the industry to be down approximately 20% from last year, which was a peak based on our tracking. Going back to the fourth quarters from five years prior to the pandemic, specifically from 2019 onwards, it is only a couple of percent lower than those years. It seems that as we conclude the year, we're moving towards a more normal range for the full year industry figures.

And then on the China side of things. Maybe talk to the resilience of the performance there. Obviously, the margin levels are coming in kind of quite nicely sequentially relative to what is a tough demand environment. But it feels like you guys are holding in really well on that side. So maybe talk to the inventory levels, what the channel partners are saying and how you think the share in your relative share is progressing in the market? It seems like it's doing pretty well right now.

Yes. I'll start with share. We feel that we're still where we've been. We haven't gained or lost. We're kind of still in that same leadership position in the mix. We are pleased with the quarter. We were down about 10%, right in line with what we expected. Very pleased with managing SG&A. So yes, being down that 10% in local currency and still being at about a 10% operating margin, real pleased with that at that level. The team is managing that well. So very steady performance as we kind of walk forward into the fourth quarter. We've got the fourth quarter up about 20% compared to the third quarter, but that's down a bit to last year because last year, if you recall, we had a really robust fourth quarter. A little bit of currency headwind will hit us, but that's just going to happen. And then SG&A, we're going to be spending more SG&A in the fourth quarter. So even though volumes go up, we're going to have a little improvement on the downside. But we really do want to lean into some advertising and selling as we exit the year. So we feel pretty good about the cadence of the business and how our channel inventories are right in line. If you recall, we added to inventory in the first quarter because of some concerns around pandemic and restrictions. That number hasn't changed. It's been steady through the year. We expect to exit the year steady. And that's in that 4 to 6 weeks' time frame.

Mike, I would like to add a couple more points regarding our margins. Our new products are performing well despite the challenging environment. We've introduced offerings in our core categories as well as in the premium sector, which continues to show growth. Although the premium sector is smaller due to some downturn, our premium customers are managing these challenges more effectively than others. I'm also pleased with our store productivity; we’ve implemented many actions over the past couple of years, and that is showing positive results, which is important for our spending execution. Overall, given the current environment, each segment of our business is performing as well as we could hope. We will continue to manage effectively and anticipate maintaining this into the fourth quarter, while also looking ahead to what 2023 may bring.

Starting with residential water heater volumes. You guys have been pretty consistent over the years talking about that residential water heater volumes being a 1.5% to 2% volume growth market, '20 was up 21 was up 8%, and you're looking at down 12% or 13% this year, which would probably get you back pretty close to that trend line. Do we have to pay back some of the demand pull forward? New construction is probably lower in '23 than '22. Wondering if like '23 baseline expectations for volume might be flat to down 5%? Or does your experience so you ought to be better or worse than that?

I can tell you that we haven't really calculated that yet regarding the possibility of having to pay some of it back. This reminds me of the situation in '08 and '09 when there was a significant drop, and many thought it was a major setback. We put in a lot of effort during that time. Currently, we have seen an 8% increase over the past few years, which translates to quite a few units. If we consider the total, there are likely over 120 million to 125 million houses, and we estimate that each house has about 1.2 water heaters. This gives us a base of around 150 million. We really don’t anticipate these one-off situations to have a long-term payback effect, especially considering replacements and renovation work. We’ve touched on housing, and while it may slightly decline, the overall increase is expected to stabilize over the next 5 to 25 years, which aligns with the lifespan of our water heaters. Therefore, we do not foresee any significant downturns in the short or long term.

Would flat to down a little bit, be a reasonable expectation for volumes next year?

We'll see how we exit Q4, and we'll let you know in January.

I wanted to follow up with my question on the commercial business. You've obviously had very strong demand there, but you've talked about lead times coming down and being able to clear some of the backlog. Does that present a potential issue where you might see some destocking in the commercial channels ahead, similar to what you've seen in residential in the back half of this year?

This is Kevin again. I would say yes and no, but I'll break that down a bit. On the gas side of the business, commercial gas, high efficiency is performing well; we mentioned it being flat to down, and that's tracking positively. Our backlogs are clearing, and the feedback from our customers indicates they are not overstocked with commercial gas water heaters. The downside to the commercial industry this year is mainly in the greater than 55-gallon electric category, which falls into semi-commercial water heaters since it also serves large residential and smaller commercial needs. The decline this year is largely due to the greater than 55 gallons, with almost all the decrease coming from that segment. In contrast, nearly all the increase in 2021 was from the greater than 55-gallon electric. It seems to me that the industry is normalizing to more traditional levels. Therefore, I don't anticipate a significant destocking issue; I believe it is already taking place with the greater than 55-gallon segment, and it will reach appropriate levels as we move out of Q4 2022.

Good morning, everyone. I want to revisit the topic of pricing. You mentioned the effect of your anniversary and the five price increases in 2021 at the end of this year. As I think about 2023, I understand you'll provide more details in January. However, from a planning perspective, it seems we are moving into a stagflationary environment. I'm curious about your thoughts on the potential for further price adjustments in an environment where demand is softening.

Yes. I mean we're not going to comment on forward pricing at all, just due to the competitive nature of this environment.

Is it possible to just address the question sort of theoretically in terms of pricing power or your ability or how confident you are in your ability to do something rather than specifics?

Yes. I would go back to how we've addressed this in the past. Historically, when we need to take pricing action, we've been able to do that given the appropriate amount of time to manage through that. And historically, we've been able to be successful at it. So if that was to occur, I think you just go back to the various times that we've taken those actions. And historically, I think it's appropriate that when needed, we have a track record of being able to execute.

And you talked about steel prices coming back, but could you talk about non-steel cost inflation and where you think that level may be?

Yes. I mean, if you kind of walk the year forward, we had in our outlook projections of non-steel cost going up throughout the year and that completely realized that. So the non-steel cost of foam, packaging, transportation, and freight being a very large one all sort of materialize and we really haven't seen relief on those. As we go forward, we would hope and expect that we would see relief on those. But right now, it's pretty resilient.

My second question, it really gets back to capital allocation. And just wondering, you've articulated a fairly definitive sort of set of priorities around capital allocation. I'm just wondering how those priorities may change in a recessionary environment? And to what extent maybe share repurchases become an increasing sort of priority for use of cash under those conditions?

Yes. We have been quite active in our share repurchases recently, amounting to $650 million from 2021 through the first nine months of 2022. Our priorities will remain unchanged. We will continue to invest in our business, ensure the protection of our dividends, and maintain our increasing dividend rate. Acquisitions will stay a priority, and we will consider repurchases as a subsequent option. We believe we are entering a favorable environment where our strong balance sheet positions us well for acquisitions. Overall, our priorities have remained consistent and on track.

I was wondering if you could maybe elaborate on how much cost actions you've taken in response to the softening of volumes in the North American residential market? And are those rightsizing and cost actions you've taken more structural in nature or somewhat more temporary?

Yes. Let me try to explain the cost actions. I mean the actions are really, I would say, rebalancing and aligning our manufacturing facilities to line up with what we see now as lower volumes. When we were going through the quarter, we expected volumes to come back quite candidly in the fourth quarter and as we exited the third quarter, which, as we mentioned, did not come back. So there was a bit of hiring churn to make sure we can meet demand. We're always going to make sure we're in a position from a labor perspective and component perspective to meet demand. So there was a bit of churn there. And as we exited the quarter, I'd say the rebalancing on the labor side, where we expect less churn in labor. We're in a good position. First half of the year, if you look back on demand, getting products out the door was a bit of a challenge. We're in a better position on preventative maintenance. All the components that make the plants run more smoothly. We're just set up a lot better going into the fourth quarter. And I mean to quantify that, I mean, certainly, you've got the volume piece, which clearly drops to the bottom line and a margin perspective. But just from an efficiency perspective, we think of it in terms of incrementally the fourth quarter from a plant efficiency being in that $5 million range better for the quarter.

And then just a follow-up on some of the pricing questions. I appreciate your comments on right, the track record you have with respect to pricing power and past inflationary and then subsequently raw materials deflationary cycles. I'm just curious, though, if you're getting any customer pushback on price, just given the magnitude of the 50% price increases and that sort of being unprecedented, is kind of the customer conversation, any difference in some of these past cycles?

I would say that not much has changed at the moment. I consistently focus on pricing and our global business relationships with customers. Our primary goal is to maintain competitiveness in the market, ensuring that our pricing and programs support our customers' growth and competitiveness. The discussions around this have remained fairly consistent, as Chuck has mentioned several times. Pricing has always been a key topic because of its volatility, while the rest of the business has remained relatively stable, which is encouraging. There are still pressures on pricing and costs affecting us and our distributors who supply products to customers and procure other materials. Overall, our conversations have not shifted significantly, which is positive for the industry, and we will continue to engage closely with our customers to help them remain competitive.

Your boiler business, particularly in commercial condensing boilers, appears to be quite resilient. Can you discuss the backlog you have in that area and your visibility moving forward? It's clear that you will face more challenging comparisons in 2023 for that segment, but energy efficiency seems to be a significant driver of demand.

I can tell you that the boiler market, especially in the commercial sector, has remained quite active. We are still experiencing strong demand from hospitality and institutional customers. A significant indicator of this is the steady quoting activity we have, which remains robust. Additionally, our industry still lacks sufficient inventory, so overall, the business is in great shape. We achieved two record months in the third quarter, and our supply chain has improved, enabling us to produce and ship at record levels. Order rates have stayed solid, indicating resilience in the industry, although historically it tends to lag behind residential markets by 12 to 18 months. Our backlog is currently elevated, at two to three times the levels we’ve seen in the past, but we are beginning to work through that, which is positive, and our production is on the rise. Overall, the business has been performing well, and we are optimistic about the fourth quarter. In fact, the resilience we are witnessing has exceeded our expectations at the beginning of the year.

I'd like to ask about your residential water heater business from a different perspective. You mentioned the industry is seeing a 6% to 7% increase in Q4 compared to Q3 and that volumes have been recovering in October. However, we are observing rising consumer mortgage rates. How much clarity do you have regarding the current quarter? In the past, you've mentioned that it's challenging to track inventories in the channel. What kind of insight do you have into the near term?

It really depends on the channel and the location in the country. Focusing on the U.S., we have a clear understanding of our retail segment and moderate insight into our wholesale operations. The market remains quite fragmented, with national and regional players alongside many local companies, making overall visibility limited. We do maintain conversations with our customers, but overall, the replacement model remains consistent at 80% to 85%. While destocking presented some challenges, the replacement business is stable and will continue. People will still need to replace water heaters and similar products. We're pleased to see an improvement in October's orders, which boosts our confidence that destocking is mostly complete. This shapes our perspective for the fourth quarter. It's important to note, as Chuck mentioned, that the fourth quarter will see a decline due to a tough comparison from the previous year. However, based on the first month's performance, we believe we are starting to return to the normalization we've discussed.

We have some thoughts on the housing market. You're right that mortgage rates have gone up and there's pressure on housing and new construction. However, our main focus is on project completions, and there is a delay between when construction begins and when installations like water heaters are finished. This lag could help support our performance throughout the year in the housing sector. We're going to closely monitor that figure as we move into 2023.

Last one covered here. I just want to hit on kind of what feedback you're getting or how you're thinking about kind of this IRA impact around heat pump water heaters. And just you mentioned kind of the new product introduction, just maybe level set us on how you think about market share in that space relative to kind of your traditional water heater market share?

I’ll discuss the IRA. I believe there is no downside for us regarding the IRA. It ultimately depends on what gets finalized and how it might provide incentives to transition to higher-efficiency products. On the heat pump side of the business, we are performing well, with a growth rate in the mid-double digits. This growth is building off a relatively small base. Currently, heat pumps represent about 2% of the market, but we expect that to increase. This is why we invested in the Voltex AL that we just mentioned. However, it still remains a small segment and will require some incentives and regulatory support to drive growth. Overall, I believe the IRA positions us well for the future, and in the long term, heat pumps will be one of our key technologies at A.O. Smith.

Thank you, Josh, and thank you, everyone, for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered solid execution in the third 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 two conferences in the fourth quarter, Baird on November 8 and Oppenheimer on December 14. Thank you, and have a great day.