A.O. Smith Corp (AOS) — Q1 2023 Earnings Call Transcript

Thank you, Eleanor. Good morning. And welcome to the A. O. Smith first quarter conference call. I am 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 into the operating results of our business, we provide 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 impairment charges, non-operating non-cash pension expenses, as well as legal judgment income and terminated acquisition-related expenses. We also provide total segment earnings. 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 our morning 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 turn. 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. I am on slide four and we will review a few highlights of our first quarter results. Our team delivered record first quarter adjusted EPS of $0.94, driven by strong performance in North America with sales up 3% due to higher commercial and residential water heater volumes. In addition, we saw margin expansion across our water heating, boiler and water treatment product categories due to a more favorable price/cost relationship. Our Rest of World segment delivered consistent performance in the first quarter, despite headwinds in the economy and currency exchange in China. In India, our sales grew 28% in local currency in the first quarter due to strong demand for our water heating and water treatment products. Please turn to slide five. North America water heater sales grew 3% in the first quarter of 2023 as we believe we outperformed the market and experienced resilient demand for our commercial and residential water heater products. Sales of commercial electric products were strong in the quarter as demand returned to pre-2022 levels. Last year, commercial industry shipments were negatively impacted by our regulatory change for commercial electric products greater than 55 gallons. Our North America order sales grew 2%, driven by previously announced price increases to offset higher costs. Residential boiler volumes decreased year-over-year, primarily driven by elevated channel inventory levels coming off a particularly strong fourth quarter of 2022. We believe inventory levels have normalized by the end of the quarter. Demand for our commercial high efficiency condensing boilers, particularly our Hellcat CREST boilers with O2 sensing technology, remains strong. North America water treatment sales were flat in the first quarter of 2023 compared to a tough comp in 2022 as higher direct-to-consumer and e-commerce sales were offset by lower sales in our dealer and specialty wholesale channels. Sales in the first quarter of 2022 benefited from strong shipments as supply chain constraints improved and we worked down our order backlog. We believe the majority of our dealers and wholesale customers exited the first quarter with normal inventory levels. In China, first quarter sales decreased 10% in local currency compared to the first quarter of 2022, primarily due to weakened consumer demand. We have seen sequential improvement through April and expect that improvement to continue throughout the year. We believe it will take time for the Chinese economy and consumer confidence to improve. We saw favorable price mix in the quarter, particularly in our water treatment as we recently introduced our large flow products that have been well received by the market. I am now on slide six. A. O. Smith has recently been named the 2023 ENERGY STAR Partner of the Year Sustained Excellence winner by the EPA and the U.S. Department of Energy. The ENERGY STAR award is given to companies that have made a long-term commitment to energy management through their products or services. This is the fifth consecutive ENERGY STAR Partner of the Year award A.O. Smith has received and the third time being named a Sustained Excellence partner. These awards are a direct result of our strategic objective to expand and enhance our high-efficiency product portfolio, including heat pumps, as evidenced by the recent launch of our Voltex AL Heat Pump Water Heater. We are committed to continued development of sustainable water heating and water treatment technology. I will now turn the call over to Chuck, who will provide more details on our first quarter performance.

Thank you, Kevin, and good morning, everyone. I am on slide seven. Record first quarter sales in the North America segment rose to $753 million, a 3% increase compared with the same period last year. The increase is primarily driven by higher commercial and residential water heater volumes, partially offset by pricing. North America segment earnings of $188.6 million increased 22% compared with the first quarter of 2022. Operating margin of 25.1% improved 400 basis points from the segment adjusted operating margin in the first quarter of last year. The higher segment earnings and operating margin are primarily due to higher volumes of commercial and residential water heaters and lower steel costs. Moving to slide eight. Rest of World segment sales of $219.1 million decreased 14% year-over-year and 8% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $17 million. Our sales decrease was primarily driven by lower sales in China as consumer demand was negatively impacted by COVID-19-related headwinds. We saw month-over-month improvement in consumer demand during the quarter. India sales grew 28% in local currency in the first quarter compared to 2022 as our new products have been well received by the market. Rest of the World adjusted segment earnings of $17.8 million decreased 28% compared to segment earnings in 2022. Segment adjusted operating margin was 8.1%, a decrease of 160 basis points compared to the first quarter of last year, primarily as a result of lower volumes in China, partially offset by lower selling costs. Please turn to slide nine. We generated free cash flow of $109 million in the first three months of 2023, higher than the same period in 2022, due to higher earnings and lower working capital outlays primarily related to lower inventory levels and a lower 2022 incentive payments paid in 2023. Our cash balance totaled $496 million at the end of March, our net cash position was $155 million. Our leverage ratio was 16% as measured by total debt to total capital. Our strong annual free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.30 per share, which represents our 83rd consecutive year of dividend payments. We repurchased approximately 821,000 shares of common stock in the first quarter of 2023 for a total of $53 million. We expect to repurchase $300 million of our shares in 2023, a $100 million increase from previous guidance. Let’s now turn to slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth driven by innovation and new product development across all of our product categories and geographies. The strength of our balance sheet allows us to pursue strategic acquisitions even in times of economic uncertainty. During the quarter, we committed to selling our business in Turkey and recognized a non-cash impairment charge of $15.6 million, primarily in anticipation of the liquidation of the cumulative foreign currency translation adjustment. The business model in Turkey is more project-based than our core consumer and commercial water treatment business and no longer fits our current strategy. Please turn to slide 11 and our revised 2023 guidance and outlook. We have increased our 2023 outlook with an expected adjusted EPS range of $3.30 per share and $3.50 per share. The midpoint of our adjusted EPS range represents an increase of 8% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including we assume a relatively stable supply chain. While challenges persist, disruptions are limited. We remain in close contact with our suppliers and logistics providers to manage and resolve supply chain issues as they arise. We have increased our North American margin guidance from approximately 23% to a range of between 23% and 23.5%. Based on a full year outlook on volumes and price cost relationship, we have recently seen a meaningful rise in steel index pricing, which will translate into higher input costs and relative to the first quarter, put pressure on North American margins in the back half of the year. We forecast that our steel costs in the second half of the year will be approximately 20% higher than in the first half of the year. Our guidance assumes that other costs outside of steel remain relatively flat to our previous guidance, with favorable adjustments in our transportation cost outlook offset by moderately higher costs outside of transportation. We expect to generate free cash flow of between $575 million and $625 million. For the year, CapEx should be between $70 million and $75 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be approximately 24%. And as I noted earlier, we expect to repurchase approximately $300 million of shares of our stock, resulting in average outstanding diluted shares of $150 million at the end of 2023. I will now turn the call back to Kevin, who will provide more color on our key markets, topline growth outlook, and segment expectations for 2023, staying on slide 11.

Thank you, Chuck. We revised our 2023 sales projection to be approximately flat to 2022 at the midpoint, with a range of plus or minus 2%, which includes the following assumptions. Residential water heater demand was resilient in the first quarter, and therefore, we are raising our projection for the 2023 residential water heater industry volumes to be approximately flat to last year. We continue to monitor proactive replacement and new housing completions. Demand for commercial electric water heaters greater than 55 gallons was strong in the first quarter and orders remained strong in April. We have raised our guidance for commercial water heater industry volumes to increase mid-single digits compared to 2022. Our China business performed as expected in the first quarter. We believe it will take time for consumer confidence to strengthen and for the economy to improve in China. We reaffirm our guidance that our sales in China will grow 3% to 5% in local currency in 2023. Our guidance assumes volumes in China improve throughout the year. Our forecast assumes the Chinese currency will devalue approximately 2% in 2023 compared to 2022. We are adjusting our outlook for our boiler business. We believe channel inventory levels of residential boilers are more elevated coming into 2023 than what we assumed in our prior guidance. While commercial growth aligns with our previous guidance, the amount of inventory in the residential boiler market resulted in sluggish residential boiler sales in the first quarter and guides us to an annual growth outlook of mid-single digits. Demand for our energy-efficient custom commercial condensing boilers was steady in the first quarter and job quoting remains active, particularly in the key institutional vertical. Our outlook for the North America water treatment sales growth of 5% to 7% for 2023 has not changed. Based on these factors, we expect our North America segment margin to be between 23% and 23.5% and Rest of World segment margins to be approximately 10%. Please turn to slide 12. We are very pleased with our performance early in 2023. Demand for commercial electric water heaters rebounded to pre-2022 levels. We saw resilient demand for our residential water heaters. Our first quarter 2023 North America operating margin of 25.1% will drive significant full-year margin improvement even as steel costs rise. In China, we saw sequential monthly improvement in our sales through April and we expect that to continue through the year. We are pleased with our free cash flow through March, and we expect a strong rebound in free cash flow for the full year as China emerges from COVID-19-related disruptions with our dedicated focus on inventory reduction across our North America operations. Our focus remains on meeting the needs of our customers, as well as executing our key strategic objectives to advance our position as a leader in heating and treating water globally. Our strong brands across the portfolio, combined with technology-driven innovation and new product development will enhance our market leadership. And with our strong balance sheet, we are confident in our ability to capitalize on opportunities as we continue to execute our strategy. With that, we conclude our prepared remarks and we are now available for your questions.

Hey. Good morning, everyone.

Good morning, Mike.

Good morning.

Hey. Can you walk through what you are seeing on the water heater volume side, North America, obviously, a lot of variability here? You had destock period through last year, you look at December, January, February volumes are at least with the HRI says. Those are tracking above $9 million annualized at this point units seems a little hot maybe relative to what the run rate we have been talking about previously looked like. So maybe help understand what you think is going on underneath the hood, are there some element of restocking, do you expect some variability on those demand trends and how do you think about that working through the year?

Hi, Mike. It’s Kevin. I’ll break it down into four main points. First, our emergency replacement demand will always be present. The one coal shallow rule consistently applies, and that won’t change. What we have noticed is that proactive replacement remains above our usual levels, and we recently received updates confirming this. Thus, we're experiencing additional volume. New construction completions were strong in the first quarter, contributing to our increase. Regarding our customers, we believe that some, though not all, may have reduced their inventories a bit too much, leading to some restocking among certain customers. When you combine these factors, they drive our first quarter results and our forecast of returning to flat compared to last year. We do anticipate that Q1 will see a decline, likely in the double-digit range, probably in the low single-digit category. It's important to note that Q1 was exceptionally strong, with March being our peak month. Overall, we are satisfied with the volume and the industry outlook, and we’re aiming for a flat performance in 2023.

Thanks for that. And then maybe also on the North American margins and how to think about modeling for the remainder of the year, 23%, 23.5% implies decent drawdown as we work through the year. Is that all back half weighted and is 2Q more comparable to 1Q and are there offsets to that decline as you think 1H to 2H that you are envisioning, whether incremental pricing or something else that might help that profile?

We observe two sides to steel costs. Initially, they were at their lowest during the first half of the year, but they're expected to rise about 20% in the latter half. While we are pleased with our first quarter margins in North America and the price-cost relationship, steel costs will impact margins negatively in the second half. As a result, we anticipate lower margins later in the year, ending with operating margins in the range of 23% to 23.5%. We expect volumes to be split typically, with a stronger performance in the first half and a softer showing in the latter half, usually around 52% for the first half and 48% for the second. However, our forecast is slightly more optimistic at 53% for the first half and 47% for the second half, thanks to a robust first quarter and easier comparisons from last year's destocking in the second and third quarters. Material costs are expected to remain relatively stable. In summary, we project strong margins in the first half, a slight decline in the second half, and ultimately reaching the 23% to 23.5% range.

Yeah. It’s still good range. Thanks, Chuck. Really appreciate it. Thanks, Kevin.

The margin commentary, you talked about this being driven by higher steel costs in the back half. But within your guidance, are you baking in additional automatic retail pricing for this, so would that offset that?

We haven’t changed any of our pricing policy. We have some formula pricing that will adjust similarly to what we've discussed before regarding fluctuations in steel costs. As steel prices increase or decrease, that formula-based pricing will also follow the trend, just as it has in the past.

Yeah. I would say when you look at our pricing, it’s about where we expected it, and Chuck just mentioned, we haven’t changed the way that our process works within our company. And I go back to, we will continue to monitor it as we always do and fall back to we have a pretty good track record of adjusting necessary.

But within your current guidance, do you bake in any additional price increases or do you stay at current levels?

We will not provide comments on potential future price increases. I would like to remind everyone that our last announced price increase occurred in November 2021, and the pricing for the full year of 2022 has been established since then. It’s important to note that we have already passed the anniversary of that price increase last fall, which was our most recent announcement regarding pricing.

Okay. So just to be clear, I know we are not commenting on additional price increases going forward. So we can assume that additional price increases are not baked into guidance at this point, is that fair?

We just don’t comment on pricing forward looking.

I have to try. And then just one last question, you mentioned China improving sequentially through the month. How did this trend in April and how are you thinking about the cadence of growth through the year? Thank you.

We discussed this in our prepared remarks. China has unfolded as we expected. January was particularly challenging due to the Chinese New Year and the transition from COVID, but we noticed an improvement month over month. April is performing well, with our sellout figures increasing compared to March. We expect to see consistent growth on a month-over-month and quarter-over-quarter basis, especially since the fourth quarter is typically our strongest. However, the situation hasn't developed quite as we anticipated. As consumers become more comfortable, we are confident in our growth guidance of 3% to 5% in local currency.

Being down in the first quarter, but we do expect quarter-over-quarter we would be up each of the quarters going forward.

Thank you. Good morning, everyone.

Good morning.

Good morning.

Good morning.

My first question is about the increase in steel prices and the possibility of some pricing adjustments. Do you believe there has been any advance purchasing happening in the market currently or in the first quarter, as some of your customers may be trying to position themselves?

I guess we can expect a little bit, but as I outlined recently of how the quarter played out in the buckets that we saw, I really don’t feel talking with our businesses that there was much pull forward. I think it was people, one, taking care of their customers, number two, maybe balance out their inventory that was a bit light with some from our customers. But, overall, I don’t think there was any pull forward with regards to steel.

Could you provide more insight into what you are observing in the commercial sector? There have been some mixed signals when considering the overall market. You indicated that you anticipate a mid-single-digit increase in volumes, but what is your perspective on the industry? What observations can you share from your experience on the ground?

The overall commercial market experienced growth, primarily driven by commercial electric and products greater than 55 gallons. We initially thought these segments would not recover to pre-2022 levels, but they have. This recovery is a significant factor in our growth. Additionally, we are seeing low single-digit growth in the gas sector of our business. Overall, the commercial segment performed well, which gives us the confidence to project mid-single-digit growth.

Thanks. A couple of questions. Can you talk about the context of your M&A pipeline and actionability therein and what the step-up in repurchase activity maybe says or maybe doesn’t say about the outlook for A.O. Smith with respect to M&A specifically? And then I have a follow-up.

Yeah. Terrific. I will take the M&A. I will let Chuck comment on the repurchase. They are really not connected with regards to why we move them up. M&A pipeline continues to be, I’d say, active particularly on the water treatment side of the business, but in other areas. So that hasn’t changed and we continue to stay in close contact with our targets and looking for the right opportunities. So that’s moving much like we thought it would be and we hope we will be able to deploy some capital in the near-term.

Yeah. With respect to the repurchase moving up $100 million, when we gave our outlook in January, we talked about our $200 million buyback outlook and we also talked about $400 million being authorized by the Board and we would kind of watch that through the year. Based upon our strong cash operations in Q1 and outlook for the year, we went ahead and moved that up to $300 million. So we felt very comfortable with that.

Got it. And then maybe with respect to China, can you talk about more recent market share trends in both water heaters and water treatment. What you are seeing from a mix perspective and then how you would characterize inventory levels? Thank you.

Okay. When we look at China, we have discussed that there isn't a significant market share opportunity for us, so we need to piece things together. However, in terms of our retail and specialty store businesses, we are confident that we remain one of the market leaders and are capturing our fair share of the business.

The channel inventory is in a normal range, typically around four to six weeks.

And coming back, just about the mix, the mix is holding pretty well. Our premium mix in all of our categories still continues to be moving up slightly in most of the categories. We talked a bit about our water treatment and how we introduced a new high flow product, which is in the premium sector. So it’s been interesting to watch with the premium side of the mix and our premium customers continue to buy our products and we see that continuing through the rest of the year.

Hey. Good morning, everyone. Congrats on the quarter.

Good morning.

Good morning.

So I wanted to ask you about your comments on channel inventories with North America pretty much being at normal levels exiting the quarter. You are already there for water heaters heading into 1Q, but it sounds like maybe boiler and water treatment caught you a bit by surprise, with respect to the inventory levels out there. Could you just maybe help us understand a little bit better on what you are seeing or hearing that gives you confidence that some of this more recent destocking is in fact flushed out?

Well, let me start with that and Chuck can jump in. Boilers, I would say, a bit of a surprise. We kind of missed. We had such a strong fourth quarter and so that was a bit of a surprise what we had to sell through. The water treatment, I would say now, we knew there was still some inventory in the channel, particularly with our dealers and our specialty wholesalers, and that works itself out. But the way I look at it right now, all of our channels, I think, inventories are right where they really need to be, quite frankly. And the only area that may have a little bit of a gap and will take care of that hopefully in Q2 would be on our commercial side of the business. But, overall, other than the boilers, I think we saw our inventories where we thought they should be with our customers.

Okay. Great. And I wanted to ask you about heat pumps, which is a topical subject matter at the moment, and I know, Kevin, you mentioned in the past, you are not expecting heat pumps to take over the water heater market anytime soon. There’s still some cost and installation challenges. But I will say, I have seen quite a bit of incentives out there related to IRA rebates on heat pump water heaters. So I am curious if you started seeing any notable pickup in activity or maybe any changes in customer buying decisions as a result?

I wouldn't classify it as major changes. Rebates have been available at state and local levels, and now there's federal involvement as well. I can say that heat pumps are continuing to grow, albeit from a small base—less than 2% of total water heater sales. However, they are experiencing consistent double-digit growth each quarter. Looking ahead, I expect this growth to continue at a moderate pace. Even with current incentives, we may require regulatory support to significantly boost volume. Nonetheless, you can anticipate monthly and quarterly growth in the foreseeable future. We have a strong focus on heat pumps for both residential and commercial applications. They are costly and installation takes time, but they offer excellent paybacks and substantial value for consumers and business owners in the long run.

Hey. Good morning, everyone.

Good morning.

Good morning.

Good morning.

Could you talk about margin performance in Rest of the World? I know you didn’t change the margin guide in the segment for the year. But was a little low in Q1, was that just sort of a weaker start to the year in China as you talked about already. I think you had mentioned that you were going to spend more money on marketing, advertising, did you do that in Q1?

Yes, the first quarter results align with our expectations, although they are slightly lower than last year. Last year's performance was somewhat inflated, and historically, the first quarter in China presents challenges. We significantly reduced spending in the first quarter last year to improve margins. However, the margins in the Rest of the World this year met our expectations. We anticipate an operating margin of around 11% in China for the year, along with year-over-year growth in the upcoming quarters. We do plan to increase spending on SG&A to support that growth. This is why we are not making substantial margin expansions now, but we are pleased to be returning to a growth phase once we move beyond the first quarter.

Very helpful. Kevin and Chuck, as REITs have continued to rise and considering the volatility surrounding the banks in March, it appears you did not encounter any issues. However, when speaking with your customers or channel partners, did you notice anything concerning in either the core residential or commercial markets?

I would say that this is anecdotal. However, there are concerns right now with interest rates rising and what that might mean for the economy, especially in the latter half of the year. Everyone is keeping an eye on it, but they are not changing their behavior. They are monitoring inventories closely, and customer demand appears to be steady in both the residential and commercial sectors. Nonetheless, there is a suggestion that rising interest rates could create potential challenges as we move into the second half of the year. We will have to wait and see how that unfolds. This is more of a conversation than a reflection of what is currently happening on the ground.

Hey. Good morning.

Hey, Jeff.

Good morning.

Good morning.

So I think you called out lower price in the first quarter and I just want to understand maybe the magnitude, one, is this all kind of material price formulas or is there something more broad?

We are not going to provide detailed information on that. However, I can say that we experienced organic growth for the quarter. The growth in the commercial sector surpassed the residential growth, which is encouraging for our margin expansion in Q1, even though we anticipate some pressure on steel prices in the latter half of the year.

Yeah. Jeff, I would just tell you a comment just a while back. really on the pricing side, it played out as we expected, quite frankly, and so maybe even a little bit better. But it played out well and we will continue to just continue to evaluate and make sure that our customers are competitive. I have always said that over and over in both channels and commercially. We are pleased with the quarter and we are pleased with the trend that we have today.

Okay. And then I think there was an earlier question about the cadence of North America margins. Is it simply 2Q looks like 1Q and then we get a step down to kind of fall within the guidance?

Yes, that's about right. We're noticing that costs in the steel sector are increasing by 20% in the latter part of the year, impacting the third and fourth quarters as we see it today.

Yes. Good morning, everyone.

Good morning.

I wonder if we could just go back to China. Yeah. Good morning. I wonder if I could just go back to China and ask you to just talk about that 3% to 5% guidance for 2023. Can you sort of separate out price versus volume and help us just understand what’s happening trend-wise there? And then also on China, if you could just talk about the extent to which you are expanding your distribution at this point and what that might represent in 2023? And then I have a follow-up question.

Yeah. It’s mostly volume in China. There’s a bit of price, but not nearly what we have seen in other parts of our businesses. So that 3% to 5% is based on what we believe with the opening in China and the COVID policies that we will see a step up. We are comfortable kind of with the order rates that came in April. We feel good about that. So it’s largely volume. Distribution wise in China, we reduced some stores during the COVID period 2020 through 2021, but really distribution points are relatively stable. Not a lot of change on the distribution points, but we are comfortable with the outlets we have.

Okay. And then just if I could just expand on China for a second. I do have a follow-up question, but just to build a little further on the China question. as you look for that volume recovery, is it mostly in your median price point as opposed to your higher price point product? You mentioned earlier premium was doing well. So I just wanted to get some clarity on that.

No. I would say that we are going to see it kind of a normal pattern coming out, maybe even leaning towards the premium a bit, because we do have some new products that have come out and we will introduce additional products through the year. So I would say that our purchasing or the consumer purchasing behavior of A.O. Smith products will be very similar to what we have seen in the past and hopefully maybe a bit of a step up on the premium side as these new products enter the market.

Yeah. We have seen our mix move to positive based on the premium products introduced in the last, call it, 12 months. So that mix on new products is helping a bit on the growth.

Thank you everyone for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered strong first quarter performance and record first quarter EPS. We look forward to updating you on our progress in quarters to come. In addition, please mark your calendars to join our presentation at three conferences this quarter, Oppenheimer on May 9th, KeyBanc on May 31st, and William Blair on June 6th. Thank you and enjoy the rest of your day.