A.O. Smith Corp (AOS) — Q2 2025 Earnings Call Transcript

Good morning, and welcome to the A. O. Smith Second Quarter Conference Call. I'm Helen Gurholt. Today, I'm joined by Stephen Shafer, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. Within today's presentation, we have provided non-GAAP measures. Free cash flow is defined as cash from operations, less capital expenditures. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A gentle 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 investor.aosmith.com. I will now turn the call over to Steve to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. We believe A. O. Smith has an outstanding foundation for profitable growth as a global water technology leader. I am both honored and excited to build on this foundation as the company's new CEO, and I'm confident in our company's future. This future will be powered by the many dedicated and capable A. O. Smith colleagues I have started to get to know over the past one and a half years, and I look forward to the journey we have in front of us together. Later in our prepared remarks, I will share some of my early thoughts on priorities going forward that I believe will be most impactful in delivering that bright future for us. But first, I would like to go through our second-quarter performance, our updated guidance for the year, and the announcement regarding our China business. Now turning to Slide 4 and our financial performance in the quarter. North America water heater sales decreased 2% in the second quarter, driven by lower volumes. Shipments in the first half of 2024 benefited from prebuy-related volumes ahead of an announced price increase. This year, we believe the industry once again bought ahead of price increases and tariff risk. We decided to take a more proactive approach by working closely with our customers to better align order rates to our strategy of smoothing production schedules in order to achieve greater operational efficiency. Like the overall industry, we still benefited in the quarter from a demand pull forward. However, our 2025 pull-forward impact was less pronounced compared to the demand pull forward we experienced in 2024, and we expect to gain operational efficiencies through the year because of these actions. Our North America boiler sales increased by 6% compared to the second quarter of 2024, led by higher volumes of our high-efficiency commercial boilers. North America water treatment sales increased slightly in the second quarter as growth in our priority channels, e-commerce, dealer, and direct-to-consumer continued to offset expected retail declines. In addition to the growth in these priority channels, we are pleased with the improved profitability it provided, which helped contribute to North America segment operating margin expansion in the quarter. In China, second-quarter sales decreased 11% in local currency as the ongoing economic challenges and limited availability of government subsidy programs outside of Tier 1 and Tier 2 cities resulted in lower volumes. We maintained our operating margin year-over-year despite lower sales due to our 2024 restructuring initiatives and other cost control measures. In addition to announcing our Q2 performance in China, we are also announcing today that we are initiating a process to further assess our China business in an effort to ensure that it is best positioned to compete and succeed in the future. We intend to evaluate a broad range of options in addition to further business improvements, including strategic partnerships and other alternatives. As we announced in Q4 of last year, given the market conditions, we have been working to optimize the operating structure in China and reduce costs to better position the business for the future. These initiatives are already delivering positive results. We are on track to achieve $15 million in annual benefits, which have resulted in sequential margin improvement quarter over quarter. Despite the current macroeconomic challenges, we believe the China market has substantial long-term potential. Our China business also has many competitive strengths, including a premium brand position, differentiated innovation capabilities, a well-established distribution network, and a talented local team. We are committed to realizing the full potential inherent in our China business for our company and our shareholders while benefiting our employees, valuable partners, and customers. We believe that the assessment announced today will allow us to properly understand the potential options available to realize the full potential of the business. As the review progresses, we will continue to deliver best-in-class products and service just as we always have. Please turn to Slide 5. I would now like to take a moment to discuss innovation at A. O. Smith. As a water technology leader, we continue to invest in and launch new-to-the-world differentiated products. I would like to highlight a few of those offerings today. We recently introduced the second product in our Adapt gas tankless line, the Adapt SC, which is our standard condensing product featuring industry-first integrated scale prevention technology. This product is positioned in the high-volume segment of the tankless market and is the latest proof point in our commitment to becoming the North American leader in tankless technology. We have also just launched our HomeShield Whole House Water Filter, which is certified to reduce PFAS to less than 4 parts per trillion for 500,000 gallons of water. In addition to taking whole house PFAS reduction performance to a new level, it is also easier to install and provides both economic and ecological benefits for the homeowner. Next month, we will introduce the Cyclone Flex, the next generation of our industry-leading commercial water heater that is smarter, more efficient and more flexible than ever. Staying the industry leader means never standing still, and this product is a continuation of our long history of cyclone enhancements and will help ensure we are best positioned for the 2026 regulatory change in the commercial market and remain the industry's number one specified commercial gas water heater. These are just a few examples of the exciting pipeline of new products we are bringing to market that has us confident in our future. I'll now turn the call over to Chuck, who will provide more details on our second-quarter performance.

Thank you, Steve, and good morning, everyone. We delivered sales of $1 billion in the second quarter of 2025, a decrease of 1% year-over-year. Earnings were $1.07 per share, a 1% increase compared to the prior period. Please turn to Slide 6. Second-quarter sales in the North America segment of $779 million decreased 1% compared to a difficult year-over-year comparison. Higher boiler sales were more than offset by lower volumes of water heaters. North America segment earnings of $198 million were essentially flat to last year. Segment operating margin was 25.4%, an increase of 30 basis points year-over-year, primarily due to mix benefits from our water treatment priority channel strategy as well as growth in high-efficiency water heaters. Moving to Slide 7. Rest of the World segment sales of $240 million decreased 2% compared to last year and included $16 million of sales from the Pureit acquisition. Sales in our legacy India business grew 19% in local currency. China third-party sales decreased 11% on a constant currency basis. Rest of the World segment earnings of $25 million were essentially flat year-over-year, as continued expense management offset lower sales in China. Segment operating margin was 10.5% compared to 10.6% in the prior period. The Pureit acquisition is progressing well; however, it will be a margin headwind in the near term as we focus on the integration. Please turn to Slide 8. We generated operating cash flow of $178 million and free cash flow of $140 million during the first six months of 2025, higher than the same period last year, primarily due to lower cash outlays for 2025 working capital needs that were partially offset by lower current year earnings. Our cash balance totaled $178 million at the end of June, and our net debt position was $126 million. Our leverage ratio was 14.1% as measured by total debt to total capital. Let's now turn to Slide 9. Earlier this month, our Board approved our next quarterly dividend of $0.34 per share. We repurchased approximately 3.8 million shares of common stock in the first six months of 2025 for a total of $251 million, an increase over the same period last year as we increased our planned full-year repurchase intentions from $306 million in 2024 to approximately $400 million of shares for 2025. We also opportunistically bought shares during the first half of the year. We are actively assessing strategic opportunities and have sufficient dry powder for suitable acquisitions. Our priority is on deals that strengthen our core business or help us build new growth platforms. Please turn to Slide 10 and our 2025 earnings guidance and outlook. We are raising the midpoint of our 2025 EPS outlook from a range of between $3.60 and $3.90 per share to a narrowed range of between $3.70 and $3.90 per share. The midpoint of our revised EPS range is an increase of 2% compared to our 2024 adjusted EPS. We have included the following key assumptions in our outlook. Our guidance assumes an approximate 15% to 20% increase in the cost of steel in the back half of the year as well as the full impact of currently announced tariffs, which minimally impacted the first half of the year. Other input costs outside of steel and tariffs are slightly higher than 2024 and ratable for the year. The tariff landscape remains uncertain. We have refined our estimate of the annualized tariff impact on total company cost of goods sold to be an increase of approximately 5%, which is inclusive of currently announced tariff rates as well as the mitigation efforts we have implemented. We estimate that 2025 CapEx will be between $90 million and $100 million as we continue to invest in engineering capabilities and prepare for the upcoming regulatory changes. We expect to generate free cash flow of between $500 million and $525 million. Interest expense is projected to be between $15 million and $20 million. Corporate and other expenses are expected to be approximately $75 million. Our effective tax rate is estimated to be between 24% to 24.5%, and we project our outstanding diluted shares will be 142 million at the end of 2025. I'll now turn the call back over to Steve, who will provide more color around our key markets, top line growth outlook, and segment expectations for 2025, remaining on Slide 10.

Thanks, Chuck. Key assumptions in our top line outlook include the following: We project that 2025 residential and commercial industry unit volumes will be approximately flat to last year, which is unchanged. As we expected, we believe there will be some pressure on our market share in the first half of the year as we managed our production levels despite the strong order rates we saw in response to tariff announcements and ahead of our May price increases. We anticipate a market share recovery in the second half of the year as we work through our backlog and our customers return to more normalized order patterns. In China, we believe the economy remains challenged, and we continue to project that our sales in China will decrease 5% to 8% in local currency. While the stimulus programs benefited sales in Tier 1 and 2 cities, where we saw relatively flat sales compared to last year, stimulus programs were inconsistently applied in other regions, particularly in smaller cities. Additionally, many regions have not yet resumed subsidies in the second half of the year. Our forecast assumes that the currency translation impact will be minimal in 2025. We continue to expect to realize annual savings of approximately $15 million from our 2024 restructuring actions. As a result, the China operating margin is projected to be in the 8% to 10% range for 2025, even with lower volumes. We remain cautious about the near-term market outlook, including the impact from the appliance discount trade-in program. However, we are pleased with how our China team continues to manage the challenging environment. We have raised our 2025 North America boiler sales projection from an increase of between 3% and 5% to an increase of between 4% and 6% compared to 2024. We are very pleased with our growth in the first half of the year. However, we believe we may have benefited from a minimal amount of prebuy related to price increases implemented in the second quarter. We continue to monitor the commercial markets closely. We have not changed our guidance that North America water treatment sales will decline approximately 5% in 2025 as we deemphasize the less profitable retail channel. We are pleased with the momentum we are seeing in our priority channels where we are seeing double-digit growth. We continue to project an operating margin expansion of approximately 250 basis points in 2025 for the North America water treatment business. Lastly, we continue to expect the addition of Pureit will add approximately $50 million in sales in 2025 and will not have a significant bottom line contribution this year as we work through integration. Based on our confidence in our ability to manage tariffs and other cost pressures and our expected improved relative market share performance in the back half of the year and our strong boiler sales in the first half of 2025, we have raised our full-year sales outlook from flat to 2% to an increase of 1% to 3% compared to last year. We continue to expect our North America segment margin will be between 24% and 24.5% and Rest of World segment margin will be between 8% and 9%. Please turn to Slide 11. As I reflect on my last 16 months, I have found that those first impressions have proven to be accurate. The company's dedication to its foundational values and doing business the right way, the Smith way, strongly resonates with me. The commitment of the entire global team to a strong culture of collaboration and innovation is evident. The quality of our businesses, where we are a leader in the markets that we serve with strong, trusted, and enduring customer relationships, is impressive. Our core North America water heater and boiler businesses provide a resilient base with stable 80% to 85% replacement rates, strong cash generation, and attractive regulation-driven growth tailwinds. Lastly, we have an outstanding set of strategic opportunities to lean into to build our bright future. As I now step into the CEO role, I'd like to highlight a few areas that my leadership team and I are focused on. First, operational excellence: we will remain focused on accelerating productivity and eliminating waste through the expansion of our AOS operating system. While A.O. Smith already has a great foundational culture of continuous improvement on the plant floor, I believe we can benefit from a renewed focus on the application of lean principles, not only to our manufacturing processes but to other processes as well. Another focal point for us will be technology, which will help us achieve new levels of productivity going forward, leveraging technology investments we have already made more effectively and investing in new technologies to help us advance the way we work. We also intend to build upon our great legacy of innovation at A. O. Smith. Our pipeline of innovative products is strong, and we have made significant investments to prepare for the future, both in terms of regulatory and technology shifts. Included in this investment is the recent commissioning of our brand new product development center in Lebanon, Tennessee. I look forward to the opportunity to advance A. O. Smith's innovation capability to the next level. I am pleased to announce that Dr. Ming Cheng joined the company earlier this month as our next Chief Technology Officer. I have personal experience both in deploying and running a number of operating systems in my career. I'm confident that Ming will help us achieve this next level of innovation capability. Lastly, our portfolio management will ensure that A. O. Smith is positioned well with a portfolio of businesses and products for future success. The assessment of the China business, as well as the restructuring actions we took in China and North America water treatment last year, are consistent with my commitment to continually evaluate our portfolio and take necessary actions for profitable growth. In conclusion, as we continue to navigate the tariff landscape and pursue our long-term strategic investments, I am pleased with our team's second-quarter performance. We executed well, both responding to a number of uncertain factors in North America with agility and discipline and resetting the business in China to address the ongoing challenging market environment. These actions have allowed us to continue to make sequential margin improvements in both the North America and Rest of World segments. We continue to see strong growth momentum in areas where we are expecting growth performance, including the North America boiler and India businesses as well as the prioritized channels in the North America water treatment business. I would like to thank all my A. O. Smith colleagues for your dedication and delivery. Our strong market leadership, recurring revenue from our core water heater and boiler businesses, and our solid balance sheet enable us to invest strategically and maximize shareholder return, even in the face of uncertainty. We are confident in our future and our proven ability to achieve profitable growth. With that, we conclude our prepared remarks, and we are now available for your questions.

Can we just start with the why now on the China side? What was it? Obviously, Steve, you're taking over the reins as maybe part of the catalyst. But why is this the right opportunity to start thinking about alternatives for China? How far are you in the process, and just kind of any incremental context? And maybe alternatives is the wrong word, but just trying to figure out what the next steps for that region are.

Yes. I think, Mike, we remain excited about the future potential of the market there. And as you know, we've been working through some changes within the business, taking some restructuring actions, making sure that we're positioning the business to compete and perform as the market goes through this challenging environment. I think we're just at the point where we want to broaden the horizon of options to explore. Our focus is completely and remains on how do we make this business most successful going forward. And so I think it was time for us to open the aperture, look at other options, and make sure that we're fully informed about what's the right path forward for the business.

Second, can you help me with margins as we get to the back half of the year? I have a twofold question. One, implied margins for Rest of World down back half of the year. Normally, they seem to be up back half of the year, so maybe just talk through the moving pieces there. And secondarily, just a discussion on price cost in North America and how you see that playing out for the rest of the year.

Yes, Mike. Rest of the World, I'll take that. We talked a bit about our China volumes this quarter being down 11% in local currency and full year being 5% to 8% down. So as we look at the back half of the year, we expect there will be some continued headwinds in China, and our cost reduction actions are working well. We do expect to realize that full annual savings of $15 million. However, the pressures we feel that we'll see with some inconsistencies within the application of the government subsidy program, we expect to continue a bit through the back half of the year, so we're not quite as bullish on the fourth quarter as we typically are from a seasonal cadence. But we are very pleased with the restructuring results. We expect China will be in that 8% to 9% operating margin for the year. On the North America side and price cost, as we walk into the back half of the year, we'll see steel costs going up 15% to 20%. We'll experience the full impact of tariffs. Tariffs will be about 5% for the full year. So when you take those two cost drivers together, as well as the pricing that we've implemented effective May 4, we believe we can offset those costs. However, we'll see a little headwind on North America margin in the back half because of those extra costs coming in.

Could you just talk through what you saw in residential and commercial water heater shipments in June and into July? It seems like industry shipments were running ahead of what maybe you saw due to market share. Can you provide any other color on the impact of the market share that you experienced in the first half and how that plays out as you go to the second half of the year as well?

I'll just follow up, Saree, on that. We expect that our share performance would be better in the back half of the year due to the smoothing and working with our customers we did on order management in the front half of the year. We believe our performance is a bit muted, so we would expect to pick up a bit of share in the back half of the year. Order rates in June and July are very typical and right where we expect them to be after a price increase pull forward.

Appreciate the color. And then I know you don't usually say much on pricing, but just the impact of price in the quarter and how much of the price increase did you realize in Q2 versus the remainder of the year?

Yes. I'll just talk about water heating because the water heating price increase was implemented in May. So essentially, there was very little pricing benefit that came into the second quarter. The price/cost relationship for the quarter from a tariff perspective roughly offset the increased cost and tariffs for the quarter.

I wanted to ask you about the North America water heater business and the volumes you saw in the second quarter. Could you give us a sense relative to last year where the volumes came in that you shipped? And how much of a prebuy headwind are you expecting now in the third quarter as a result of a little bit of the prebuy?

The industry volumes through May were relatively flat on the residential side. Commercial is up maybe a point. The industry is tracking very similar to last year. We're not tracking quite to that level because of our smooth production and management of orders. So we would expect to pick up a bit in the back half of the year relative to industry performance. Pull forward percentage is difficult to quantify, but we do know we had a benefit in the first half and in the second quarter for pull forward.

Okay. That's helpful. And then I wanted to ask you about the China water heater business. I appreciate that you are taking a look at options on what to do with that business going forward. But just looking at where some of the industry peers have been, it feels like you've been underperforming and maybe experiencing greater headwinds than the broader industry. Could you just help us to understand a little bit why that might be? Does it come down to your regional concentration, being more in the Tier 1 or Tier 2? Are you still seeing peers price more aggressively? Anything that could just help us understand why you're maybe trailing a little bit in that market in the exchange program?

Yes. We have many decades of strong performance in China. We're viewed as a market leader, a great brand known for innovation. However, we face a more challenging market now, with consumer confidence low and local competitors becoming much better. The gap in performance and innovation isn't what it used to be, making it more competitive and complex. We are pivoting to adapt by engaging more in digital efforts and addressing the shift to more connected and intelligent devices.

My first question is on the efforts that you mentioned to help better manage the pull forward of volumes in the first half. Can you just give a bit more detail on how you approached that? What was different relative to the past, and how you're thinking about efforts to continue to perhaps maintain that going forward?

The industry tends to buy ahead of anticipated changes like tariffs or price increases, leading to a lumpy operational flow. Previously, we served all incoming orders immediately, causing inefficiencies and underutilization. This year, we engaged proactively with customers to ensure they received necessary products without inducing operational strain during the production process. While Q2 did see some pull ahead, we managed operations better.

Okay. That's great color. And then maybe as you think about the business, Steve, when you come into this new role, can you talk a bit about other areas that might also be noncore or things that you'd like to deemphasize? Any areas or adjacencies that you're interested in building into and your thoughts on perhaps M&A or organic initiatives in those areas?

A high priority for me is portfolio management. We will continue to evaluate our portfolio regularly to ensure we hold the right assets. We will also invest in core businesses to maintain leadership positions. Building new business platforms is important and M&A will be a core component of that strategy. We have strategies in place to identify where we should expand.

Two questions. First, on the more recent point you made about building new business platforms, can you provide a deeper assessment, or maybe initial assessment, on the actionability and quality of A. O. Smith's current M&A pipeline? And then I have a follow-up.

Yes. Our M&A pipeline is active and we’re excited about a few spaces where we believe we can be good owners of businesses. While actionability may vary, we believe there are a few assets that could be actionable in the coming year. We remain disciplined in entering those opportunities.

As a follow-up, are you willing to consider something more transformational, maybe add another leg to the stool, so to speak? And just a quick one on the boiler business, can you help me understand what you're implying about the back half of the year, specifically to boilers?

On the first question regarding transformational M&A, we wouldn't rule it out. We're looking to expand our platforms, but with larger moves, there are additional risks and challenges involved. For our boiler business, while we like our growth performance in the first half, we're being cautious due to expected competitive headwinds.

I wanted to clarify the assessment of A. O. Smith China. As you're thinking about varying strategic opportunities, does this specifically relate to A. O. Smith China, or could your faster-growing India business be included in your strategic evaluation?

The announcement today is specific to China, focusing on options for our China business.

With North America water treatment, are you still tracking towards the 250 basis points margin expansion you had outlined before? And I guess, more importantly, with mix progressing towards your targeted more favorable mix, how should we think about incremental margins as you lap the retail declines and get back to growth?

Yes, we are tracking toward an increase of 250 to 300 basis points in our margin. Our business has performed well through the front half of the year. We expect the margin performance to continue in the second half as we pursue our channel strategy.

In addition to the prioritization strategies we've made, we're utilizing integration work to drive continued growth and margin performance, providing additional opportunities beyond just those strategies we've previously implemented.

Just wanted to clarify the market share comment, weaker first half, better second half. Is that just simply that your competitors didn't limit prebuy and maybe they saw more prebuy so that levels out? And then just more broadly on competitive landscape, maybe just speak to the new player in the market and the JV partnership.

Yes. We believe that the industry may have taken a more aggressive posture on fulfilling orders than we did. This is why we expect an uptick in our market share in the back half of the year. On the competitive landscape, while we take note of recent entrants, strong conviction, and full portfolio breadth are necessary to compete well in this market. Our long-standing investments put us in a solid position to navigate regulatory uncertainties and maintain market leadership.

I wanted to follow up on Mike's question of why now. I don't think anyone would debate the strength of your China business. However, sales are off peak and margin is well off peak. So is this more of an announcement that it's a look at the business to see which portions of it need to be significantly restructured? Could you talk to what some of the more favorable assessments within the options that you're talking about?

Our announcement today is not a decision made regarding the business. We're just initiating this assessment to explore full options. The goal is to ensure we position our China business for success and compete most effectively moving forward.

I guess I'm wondering if you might be rolling back pricing in some way given that the tariffs were rolled back.

No, we're not rolling back pricing. We expect the full impact of tariffs and steel costs to hit the second half of the year, and we will realize the benefits of pricing only gradually as we work through the backlog.

You mentioned steel costs up 15% to 20%. I was just hoping you could talk about what you're seeing with some of the other input costs and how those are moving directionally into the second half of the year.

Year-over-year other input costs outside of steel and tariffs are up slightly, but we don't see those moving up significantly in the back half. They are expected to remain ratable for the year.

Got it. Okay. And then the water treatment business had a good quarter overall. It sounds like retail business might still be a little weak there. Can you just talk a bit more about your outlook into the second half for that business?

We're making strong progress in the water treatment business, focusing on our priority channels is yielding positive results. We have undergone a reset to position ourselves competitively, and we are ready to return to growth.

The weakness in the retail channel is a proactive strategy that we undertook to deemphasize on-the-shelf retail. This strategic move has helped us strengthen our margins as we step into the year.

I wanted to know what has changed from a quarter ago with the China business? What more strategic options are on the table now that weren't before?

The shift is about broadening our evaluation of options to improve our competitiveness and success in the China market, ensuring we make the most informed decisions regarding the best path forward for that business.

For my follow-up on innovation, what are some of the specific innovations you're focusing on, whether it's in the U.S. market or Rest of World?

Innovation is key to our growth and maintenance of profitability. We're launching differentiated products that solve real problems, enhancing our systems for efficient product launches, and focusing on technologies relevant for the future. Embracing a culture of curiosity and risk-taking will also be instrumental.

Steve, I know you said you'll consider all alternatives regarding your balance sheet moving forward. But AOS has been sitting with what some call an underlevered balance sheet for some time. Do you think the company could get a bit more aggressive in general using its balance sheet?

We will prioritize finding attractive growth platforms. While protecting our core businesses, we need to use our strong balance sheet effectively to transform our portfolio over time. How we deploy capital will depend on actionable M&A targets and our overall strategies.

You raised your boiler forecast. I know you want to be conservative in the second half, but is your improved guidance based on continued traction on high-efficiency boilers? How would you rate the health of your commercial customers right now?

The boiler business is performing well, and our customers are looking for high-efficiency products. We have a healthy backlog, which supports our outlook for continued growth in this area.

When looking at our guidance of a 4% to 6% increase, we want to be cautious due to inventory in the channel and the benefits we received from the pull forward in the first half, but we're pleased with our overall performance in the market.

Thank you for joining us today. Let me conclude by reminding you that we are pleased with our EPS growth in the quarter. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at three conferences in the quarter: Seaport on August 18, Jefferies on September 3, and D.A. Davidson on September 18. Thank you, and have a great day.