A.O. Smith Corp (AOS) — Q2 2023 Earnings Call Transcript

Thank you, Eric, and good morning, everyone, 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 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 income and 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 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 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 investors.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'm on Slide 4, and we'll review a few highlights of our second quarter results. Our team delivered record adjusted EPS of $1.01 in the second quarter, driven by strong performance in our operating segment. We saw margin expansion in our North America segment, primarily due to a more favorable price-cost relationship as well as robust demand for our commercial and residential water heaters. Our Rest of World segment delivered improved performance in the second quarter even as headwinds in the economy and currency exchange continue in China. Both China and India delivered sales growth of 15% in local currency in the second quarter. Please turn to Slide 5. North America water heater sales decreased 2% in the second quarter of 2023 as higher volumes were offset by lower pricing. We saw continued resilience in residential water heater demand and year-over-year improvement in our commercial water heater business. Our North America boiler sales declined 13% in the second quarter compared to a tough comp last year, as lower volumes more than offset the benefits from pricing. Channel inventory levels of residential and light commercial boilers remain elevated in the quarter as a warmer-than-normal winter resulted in lower industry demand. We believe channel inventory levels are approaching normal levels at the end of the quarter. Demand for our custom commercial high-efficiency condensing boilers, particularly our Hellcat Crest boilers with O2 sensing technology, was steady in the quarter and continues to gain traction in the market. North America water treatment sales were down 2% in the second quarter of 2023 compared to another tough comp in 2022, as pricing and strong e-commerce sales were offset by lower sales in our specialty wholesale and dealer channels. Sales in the first half of 2022 benefited from strong shipments as supply chain constraints improved, and we worked out our order backlog. I'm particularly pleased with the margin improvement we have seen this quarter in our North America water treatment business. In China, second quarter sales increased 15% in local currency compared to the second quarter of 2022, which was negatively impacted by COVID-19-related shutdowns. Demand continued to improve for our products, particularly for residential and commercial water treatment products. Sales of water treatment consumables were particularly strong in the quarter. We also saw a favorable mix in our water treatment and electric water heater product categories this quarter, as recently launched products continue to be well received by the market. I'm now on Slide 6. According to our recent national consumer survey, nearly 9 out of 10 Americans have concerns about microplastics in their drinking water. Reducing plastic pollution has long been a priority for our North America water treatment business. Our North America water treatment products filter enough water to potentially eliminate over 1 billion single-use plastic bottles per year. I am pleased to announce that all of our countertop and undersink water filters are now independently certified to remove up to 99.6% of microplastics in addition to over 70 other contaminants, including PFAS and pesticides. We remain committed to leading the charge in identifying and becoming certified to remove harmful contaminants as they emerge. 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 were $722 million, a 3% decline from the same period last year. The decrease is primarily driven by higher commercial and residential water heater volumes that were more than offset by lower boiler sales and pricing. Lower volumes contributed to approximately half of the organic growth decline. North America adjusted segment earnings of $194 million increased 19% compared with the second quarter of 2022. Adjusted operating margin of 26.9% improved 510 basis points from the segment adjusted operating margin in the second quarter of last year. The higher segment earnings and operating margin were primarily due to lower steel costs and higher volumes of commercial and residential water heaters, partially offset by lower boiler volumes. Moving to Slide 8. Rest of World segment sales of $244 million increased 6% year-over-year and 12% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $14 million. Our sales increase was primarily driven by higher consumer demand and favorable mix in China, particularly for residential and commercial water treatment products. India sales grew 15% in local currency in the second quarter compared to last year. Rest of World segment earnings of $28 million increased 56% compared to segment earnings in 2022. Segment operating margin was 11.6%, an increase of 370 basis points compared to the second quarter of last year, primarily as a result of higher volumes of water treatment products and positive mix. Please turn to Slide 9. We generated free cash flow of $236 million in the first half of 2023, higher than the first half of 2022 due to higher earnings and lower working capital cash outlays primarily related to lower inventory levels and lower 2022 incentive payments paid in 2023. Our cash balance totaled $410 million at the end of June, and our net cash position was $204 million. Our leverage ratio was 9.8% 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 of cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.30 per share. We repurchased approximately 1,075,000 shares of common stock in the first half of 2023 for a total of $70 million. We are committed to repurchasing $300 million of our shares for the full year of 2023. 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 lines and geographies. We believe that our technology leadership and culture of innovation puts us in a strong position to capitalize on the mega trends of decarbonization and sustainability. The strength of our balance sheet also allows us to pursue strategic acquisitions as we grow organically. Please turn to Slide 11 in our revised 2023 earnings guidance and outlook. We've increased our 2023 outlook with an expected adjusted EPS range of $3.45 and $3.60 per share. The midpoint of our adjusted EPS range represents an increase of 12% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including our expectations of a relatively stable supply chain with limited disruption. 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 America full-year margin guidance to a range of between 24% and 24.25% based on our full-year outlook on volumes and price-cost relationship. We will have higher steel costs in the back half of the year, which will put some pressure on North America margin. We forecast that steel costs in the second half of the year will be approximately 20% higher than the first half of the year. Our guidance assumes that other costs outside of steel remain at current levels. Our Rest of the World margin guidance of approximately 10% remains unchanged. We expect to generate free cash flow of between $550 million and $600 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 about 24%. And we expect to repurchase approximately $300 million of shares of our stock, resulting in an average outstanding diluted shares of 151 million at the end of 2023. I will now turn the call back over to Kevin, who will provide more color on our key markets and top-line growth outlook for 2023, all staying on Slide 11.

Thank you, Chuck. We revised our 2023 sales projection to be a range of flat to up 2% compared to 2022, which includes the following assumptions. Residential water heater demand was resilient in the first half of the year. Therefore, we project 2023 residential water heater industry volumes to be flat to up 2% compared to last year. We continue to monitor proactive replacement and new housing completions, both of which remain strong. Demand for commercial electric water heaters greater than 55 gallons was strong in the first half of the year, which leads us to raise our guidance for commercial water heater industry volumes to increase mid-teens compared to 2022. We maintain our guidance that our sales in China will grow 3% to 5% in local currency in 2023. We believe it will take time for consumer confidence to strengthen and for the economy to improve in China. Our forecast assumes that the Chinese currency will devalue approximately 5% in 2023 compared to 2022. We have decreased our outlook for our boiler business from being up mid-single digits to being down high single digits compared to last year. Last year, our boiler business grew 28% compared to 2021, partially driven by our backlog reduction during the year. We believe channel inventory levels of residential and light commercial boilers were elevated coming into 2023. The mild winter and warm spring resulted in lower demand coming out of the heating season, which slowed channel inventory reduction efforts. Orders for our energy-efficient custom commercial condensing boilers remain steady. Our outlook for North America water treatment sales growth of 5% to 7% for 2023 has not changed. We project that our sales in India will grow 15% compared to last year. Please turn to Slide 12. We are very pleased with our performance in the first half of 2023. Demand for our commercial water heaters was strong. We saw resilient demand for our residential water heaters, as new housing completion and proactive replacement remain robust. Our second quarter 2023 North America adjusted operating margin of 26.9% was driven by an improved price-cost relationship and will lead to a full-year margin improvement even as our steel costs rise in the second half of the year. Our China business performed well in a weak economy in the second quarter, with sales growth of 15% and operating margins of over 12%. Market-leading products such as our high flow and hot water purifiers as well as dual tank electric water heaters led to a positive mix in the quarter. India continues to outperform the industry as our innovative new products drive market share gains. As a final note, the U.S. Department of Energy has recently issued its proposal to raise the minimum energy efficiency standards for residential water heaters that are targeted to be effective in 2029. As we review the DOE's proposal, we continue to dialogue with the DOE and other industry participants to offer guidance from our unique market leadership perspective to ensure the final proposal considers all factors that may impact consumers, including affordability, installation challenges, market adoption and consumer awareness, as well as state and local electrification regulations. As a leader in energy-efficient water heater solutions, we believe A.O. Smith is well-positioned to deliver a broad range of products that will meet or exceed the DOE requirements. And finally, our focus remains on meeting the needs of our customers as we continue to execute key strategic objectives to advance our position as a global water technology leader. With that, we conclude our prepared remarks, and we are now available for your questions.

A couple of questions. As we think about the first half, second half margin cadence in North America, how should we be thinking about how much margin compression is going to come from steel versus maybe some of the mix headwinds you might have given the change in your boiler outlook for North America? And then I have a follow-up.

Matt, this is Chuck. So when you kind of look at the front half, back half, I think of it in terms of three buckets, right? So you've got the price-cost relationship to be compressed a bit by steel costs being up about 20%. That's probably the largest piece of the delta between the first half and second half. Also, the way the year is setting up on residential water heater, we've got the first half, and this is fairly typical, but maybe a little stronger than normal of residential and water heating at about 52.5% to 53% of the year, and then it is 47% to 47.5% in the back half. So there's a little bit of pressure on that because of the detriment of some volume on the residential side. And then the smallest piece, I would say, is kind of related to boilers in the mix, a little bit less mix on the higher-end commercial boilers.

Got it. And then as a follow-up, just with respect to China, can you talk about the sustainability of water treatment demand there that you saw in the second quarter, perhaps maybe why the water heater business may be lagging a bit? And maybe also comment on sell-in versus sell-through and inventory levels overall in China.

That was quite a question; there are four of them in there. But let me just take the sellout. Sellout was good. It was double digits. We saw sellout improve in each of the months. And so that was a positive trend. Inventories are between that 1% and 2%.

One to two months.

One to two months, excuse me. Thank you, Chuck. One to two months and maybe just a tad, but nothing out of the ordinary. And as far as going back to water treatment, we just have some terrific products out there that we've introduced, and we mentioned it in our remarks on the hot water purifiers that we have in the high flow. They just continue to be well received in the market. Clean water is a priority for the Chinese consumer. So we see that continuing. And then you throw on top of that, our consumables that were really strong, up over 20-plus percent. And each time we sell a water treatment product, we have that potential of the ongoing consumable for the next several years. So that's gone really well. We continue to see that being a priority for the consumer going into the back half of the year. And as far as water heating and water treatment and electrics, they are tighter bit to some new housing foundations. So that's been under pressure for a while. But the electric side performed well, particularly some of our products that we introduced last year, and that continues to move in the right direction. So overall, to be up 50% in Q2 considering the challenges that the economy is having there, I think, is a positive statement of our premium products and how they're viewed in the market. And maybe the last thing is if you look at the back half, there is talk about China with some targeted stimulus that's going forward. They've also kind of pulled back on homes as not being able to buy them for speculation. So Q3 may be a little bit tougher, but there's still some positive momentum in a number of areas, not only with our products, but hopefully, with some of the economic stimulus that should take effect in the back half of maybe Q3 and part of Q4.

So just some help on the margins in North America here. If you look at the implied assumption in the back half of the year is kind of a historically high pullback in the margin levels, and the steel assumptions that you laid out seem a little steep relative to what the market pricing is today. So maybe just help add some context to why there's that magnitude after all, it was an awfully impressive front half of the year on the margin side, and how we should think about that normalizing for you?

Yes. The 20% increase in the second half compared to the first half is a result of a lag. Just to remind everyone, there is typically a 90 to 120-day delay regarding pricing. While steel costs have slightly decreased from their peak, we are still being assessed based on those costs, especially in the third quarter, drawing from the February time frame for the next couple of months. So even though there has been some moderation, we will still face that headwind. Additionally, the adjustments in the boiler outlook may be contributing more pressure than anticipated. Furthermore, considering the volume aspect I mentioned earlier, there is a bit of an impact. We had pricing for boilers and water heating in the second half of last year, which won’t be reflected in this back half. I hope that clarifies things.

Okay. Yes, it does. And then the second one is, I think Kevin in the prepared remarks, you squeezed any idea that you guys are pretty happy with the progression on the margins for your filtration business, water filtration business in the U.S. Just like some context there, is that scale, mix, operations, what are the moving pieces there?

We are pleased with the second quarter results for North America. The water treatment margins for the quarter are around 12%. Several factors contribute to this, including the pricing adjustments we implemented last year that are now in effect. Although there are still some cost pressures in our water treatment business, we are experiencing a slight relief in transportation costs. Additionally, our direct-to-consumer business performed strongly during the quarter, positively impacting our margins. We are satisfied with the operating performance, and volume is aligning with our expectations. We anticipate 5% to 7% growth for the year.

The team is doing an excellent job with vertical integration and reducing costs, and this will continue as we move forward. As you may remember, we have been involved in some acquisitions. We are consolidating the water treatment business into a single entity, allowing us to leverage our locations and optimize production costs. Overall, with a strong focus on cost reduction and continuous improvement, as Chuck mentioned, the organization has greatly benefited. I anticipate this trend will continue over the next six to seven months.

This is Joe Nolan on for David. I just have one quick follow-up on boilers. I think you talked about inventories approaching normalized levels kind of towards the end of the quarter. I guess if you could just talk a little bit more about order patterns and just when we might see those inventory levels officially get back to normalized levels and how you're thinking about approaching inventories in the back half of the year?

Yes, we exited the second quarter feeling that our inventories are nearing a normalized state. To break it down, on the boiler side, our larger commercial product is not really an inventory issue. The Crest O2 sensing product that Kevin mentioned is performing well, and those orders are stable. The larger products aren't facing any challenges related to inventory buildup. However, we are seeing some inventory issues with the smaller, lighter commercial boilers and residential units, but we believe we are mostly past that. As we approach the heating season next year, we will have a clearer view of our inventory situation, but we think we have largely managed through this challenge.

When we think about the change in the guide, especially as it relates to the boilers, is there anything also in there as it relates to price especially as you think about some of the changes in demand and perhaps some of the shifts in the steel costs over the last few quarters?

Our assumption, I'll just kind of summarize it is overall, our price/cost relationships are a bit improved, and that's driving a piece of that increase.

Okay. And then I guess if we think about the residential water heater demand, and the levels that it's been running for the industry and for yourselves through May, Europe really nicely versus 2019 even with the level of demand that we saw during the pandemic. Can you just on a higher level, perhaps talk about what are some of the core strengths of that demand, and how do you think about the sustainability of the current level of volumes of the industry and that yourselves are seeing in here as we look out over the next, call it, 12 or even 24 months?

Let's break that down, focusing on the replacement side, which remains strong. Emergency replacements are still ongoing. Currently, renovation continues to be a priority for homeowners, who are choosing to stay in their homes to protect their mortgage rates. This trend contributes to our volume. New construction is also steady, with builder confidence on the rise. Although we're up compared to 2019, it's important to note that we've experienced a compound annual growth rate of 1.5% to 2% since then. As we project for the end of this year, we expect our performance to align with industry trends. Unlike the pandemic's fluctuations, we faced some instability in 2021 and 2022, but now we're seeing a normalization as the economy and housing market improve, and renovations remain strong. Looking ahead to the next 12 to 24 months, we anticipate a return to a more stable growth rate for our water heater business, possibly influenced by interest rates and continued economic development.

Can you talk about the strength you continue to see in commercial water heaters here in North America, maybe the durability of that strength. You raised your forecast a little bit for the year. You've had easy comps, obviously, given the regulatory situation. But could you talk about, as financing costs have been slowly moving up, it still seems like the demand is quite strong in that business.

On the commercial water heater side, which is different from boilers, the profile resembles that of residential units, particularly with emergency replacements remaining strong. The comparisons have become a bit challenging due to the larger than 55-gallon electric units, as a regulatory change caused a downturn in early 2020. However, we are beginning to stabilize, and it seems that the larger electric units will return to their pre-regulatory change levels. We are also experiencing solid mid-single growth in commercial gas. From our viewpoint, we still have a backlog that we are working through, and we are making progress. The industry appears resilient, particularly in restaurants and hotels where we have historically performed well, and we are seeing increased usage of our units. Overall, the industry seems to be returning to a normal volume level. In 2021, we saw an 11% increase, in 2022, we experienced a 17% decrease, and now we are moving up to mid-teens. When everything is considered, we are getting back to a normal rhythm. Furthermore, we believe we have been outperforming the market in both our residential and commercial products in 2023.

That's helpful. And then you didn't change your Rest of World assumption for margin for the year, but you did see a nice step up in Q2, which I think you predicted. But I think you also suggested that you would see incremental margin improvement as the year went on. And again, you didn't change your overall year guidance. So are you seeing any incremental competitive pressure given the tough China market, or incremental supply chain headwinds? Or is it just kind of conservatism given the good Q2 results?

We are really pleased with Q2. China's margins were about 12%, and we are very happy with the results in China for the quarter. Looking ahead for the rest of the year, China drives most of the results in the Rest of the World. Q4 is the major holiday shopping and online shopping quarter, typically seeing our largest sales. We expect a volume growth of 3% to 5%. It will be important to invest in this area. We are waiting to see how Q3 plays out, which we anticipate will be fine but will not have a lot of volume. Investing in the growth in Q4 should keep the margins in line with that 10% to 11%. However, we are not concerned about any competitive pressures.

This is Adam Farley on for Nathan Jones. Most of my questions have already been answered, but I wanted to ask about your capital allocation; the balance sheet remains very strong net cash position. What are the priorities for putting this to work for shareholders? And are there any M&A opportunities out there to move this capital forward?

Yes. I mean capital allocation really hasn't changed. We're going to continue to invest in ourselves, making sure that we're investing in new product developments, plant automation and the efficiencies that we know we need to continue to drive. Our dividends, we continue to have an increasing dividend year-over-year, and we've declared the next dividend. So dividends would be a part of that for sure. We've got from a stock buyback; we certainly are in a good under-levered position. So we do expect to repurchase $300 million of shares this year, and that's expected to carry out. From an M&A perspective, I'd say it's still active. So we've talked in the past about looking at our priorities around water treatment. We still see opportunities to grow geographically in North America. We see opportunities to look to acquire maybe in the commercial space in water treatment. We also looked globally since that's a global technology and global product; other markets where we can see our positioning in a premium space are also of interest. So continue to be active, and we look to deploy capital.

So sorry if I missed this, but I was hoping you might be able to give us a sense for pricing in the second quarter in North America, kind of thinking about the three product categories, water heaters, boilers and water treatment, if you can maybe just give us a sense of where pricing is trending? And is kind of the expectation as we get through the rest of the year, maybe a little bit of modest price fade in North America water heaters, just given kind of steel indexing, but no real formally announced price increases kind of in the wholesale channels?

Yes, I have a few comments. We typically don't go into great detail on pricing. However, for this quarter, we have seen year-over-year improvements in boiler and water treatment pricing due to price increases announced at the end of last year. There has been some improvement in this area. In our overall analysis of North America, we've indicated a decrease in organic growth, with about half of that attributed to volume changes and the other half related to pricing. Overall, the North America segment has experienced similar pressures on organic growth. For the second half of the year, we've raised our guidance for North America margins, indicating some improvement in the region. Our overall outlook remains consistent.

Yes, just maybe another comment on this is, again, we're very consistent in how we manage our businesses and our pricing. There's not much difference from Q1 to Q2. We continue to have the underlying goals to keep our customers competitive. We look at both the markets that we're in and the boiler market; that's remained very consistent. So not a big change. Again, we sell on A. O. Smith value quality delivery, a number of other things that go forward that's been consistent for a number of years, and it's not changing as we enter the back half of the year.

Understood. And then, Kevin, I think you mentioned kind of getting back to normalized demand for residential water heaters. So I'm just curious how you're thinking today about what normalized demand is. I think historically, maybe you guys have talked about flattish to up a few points of volumes on an annual basis, plus a few points perhaps of price/mix. But how are you thinking about what that kind of framework is thinking of IRA, energy transition, other factors at play today?

Yes. I don't think about some of the industry as a whole has changed a whole lot. That 1% to 2% growth is pretty consistent, and it does move a bit when you have new construction. And again, we're in this economy right now; I mean the economy is still doing pretty well. GDP came out, still moving in the right direction. Housing were still at a deficit. You've heard us say that. I think how many years in a row. There's quite a bit of work to be done, maybe a few million homes that still need to be built. So I think the case is going to get back to that 1% or 2%, and probably the variable will be new construction in multifamily, how that continues to progress over the next couple of years. My guess is probably going to be a bit favorable to the industry and to our company.

Regarding the IRA Act, there are incentives for heat pump water heaters and high-efficiency water heaters, which is beneficial. However, we have not seen significant movement in consumer choices away from their current replacement decisions, which typically occur in emergencies, toward investing in energy-efficient products, even with IRA incentives. This presents a longer-term opportunity as we evaluate the situation.

Just on resi water heaters. So I wanted to come back to price because I think you said it was going to be similar, but I'm just wondering if some of the material price formulas flip into the second half with the steel up. And then just how should we think about your 0 to 2 industry number, given that it seems like first half was a little more resilient, destocking done and the comps, obviously, in the second half are really easy?

Yes. I mean as steel also follows what we see on anything we have with material price in the steel portion is that there's a 90- to 120-day lag. So that portion also sees pricing follow.

Yes. And that's baked into our guidance.

Our revenue in the second quarter in North America water treatment was flat to slightly down, you're saying 5% to 7%. Is that just lapping tough comps? Or what's driving kind of the consistency there?

It's certainly facing a challenging comparison. If you examine all our businesses, last year in Q2, we performed strongly. For instance, North America water treatment had an 18% increase in Q2 of 2022, which was solid. However, we are noticing some softness in different areas of the market as things begin to stabilize. Overall, our five core channels still show positive growth over time. So, despite the 2% compared to an 18% previous quarter, it still represents a good quarter for our water treatment business. Each of those channels experiences highs and lows; I've yet to see all five perform well or poorly at the same time. Nonetheless, the business remains in good shape. The underlying concerns regarding water quality are expected to increase, which is a crucial point. With issues like PFAS and varying chemicals, consumers will regularly question water quality. We have excellent solutions, whether under the counter, point of use, or point of entry, and we will capitalize on this trend as we have in the past.

Thank you, Eric, and thank you, everyone, for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered record second quarter performance and record EPS. We look forward to updating you on our progress in the quarters to come. Please mark your calendars to join our presentations at three conferences this quarter: North Coast on August 7, Stifel on September 6, and Davidson on September 21. In addition, we are very pleased to announce that we will host an Investor Day on Monday, November 6, in Chicago, Illinois. Invitations to register for our event will be forthcoming in September. Thank you, and enjoy the rest of your day.