Q2 2022 A O Smith Corp Earnings Call

July 28, 2022

The conference will begin shortly to raise your hand during Q&A you can dial star one one.

[music].

Yeah.

Good day and thank you for standing by welcome to the a O Smith second quarter 2022 earnings Conference call. At this time, all participants are in a listen only mode.

After the speaker's presentation, there will be a question and answer session to ask a question. During the session you will need to press star one on your telephone. Please be advised today's call is being recorded I would now like to hand, the conference over to your speaker today, Helen Gerhold Ma'am. Please go ahead.

Good morning, and welcome to the a O Smith second quarter Conference call I'm, Helen Gerhold, 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.

Order to provide improved transparency into the operating results of our business, we provided non-GAAP measures.

Free cash flow is defined as cash from operations less capital expenditures adjusted earnings adjusted earnings per share adjusted segment earnings and adjusted corporate expenses, excluding the impact of nonoperating noncash pension income and expenses.

Conciliations 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 for sure.

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 a O Smith Dot com.

I will now turn the call over to Kevin.

To begin our prepared remarks, please turn to the next slide.

Thank you Helen and good morning, everyone. Thank you for joining us today.

I'm on slide four in our second quarter results.

Our team performed well throughout the quarter, despite an uncertain macro environment to deliver strong sales and EPS performance.

Second quarter sales improved 12% year over year, driven by our 2021 inflation related pricing actions the acquisition of giant factories late last year as well as water treatment boiler and commercial water heater volume growth in North America.

Our rest of World segment performance decreased 13% year over year, driven by COVID-19 related Lockdowns in China.

However, we experienced sequential sales improvement in China through the quarter as restrictions begin to ease.

The acquisition of giant factories added $31 million to quarterly sales and <unk> to EPS.

We are pleased with the performance of the team and our integration is on track.

We saw quarter over quarter improvement in our supply chain in the second quarter, which led to higher boiler and commercial water heater volumes.

Please turn to slide five.

Our global a O Smith team delivered second quarter of 2022, adjusted EPS of <unk> 82.

A 14% increase that was driven in part by a 12% increase in sales compared with the second quarter of 2021.

Our strong second quarter performance resulted from our team's outstanding execution. Despite the backdrop of an uncertain macro environment COVID-19 related lockdowns in China and softness in the residential water heater industry.

I am proud of how my a O Smith colleagues worked together to overcome many challenges to deliver value to our customers across the globe.

Excluding the impact of giant North America water heater sales grew 19% in the second quarter of 2022 due to pricing actions implemented in 2021 in response to rising material and logistics.

Lower sales of residential water heaters, partially offset sales growth in the quarter.

The residential industry saw record orders in the second quarter of 2021, creating a difficult comparison for 2022.

With that said, we saw order rates softness as we exited the second quarter and into July as customers right size their inventories.

We saw quarter over quarter improvement in our commercial gas water heater shipments as supply chain constraints eased in the second quarter as well as our sales of commercial electric water heaters credited 55 gallons as order rates normalized after the regulatory change impacted orders at the beginning of the year.

Our North America boiler sales grew 27% in the quarter driven by pricing increases to offset higher material and transportation costs and strong demand.

We again ended the quarter with a significant backlog largely composed of commercial condensing boilers, and we continue to see stable order rates for these market leading energy efficient products.

Our strategy to focus on innovation and de Carbonization contributed to strong demand for our high efficiency condensing boilers.

North America water treatment sales grew 19% in the second quarter as our independent water quality dealer dealers continue to outperform the market and gain share.

We also benefited from strong demand in the wholesale channel.

In China sales decreased 14% in local currency compared to the second quarter of 2021.

Primarily due to the expected impacts of COVID-19 related lockdowns.

Our sales improved sequentially through the quarter as Lockdowns lesson and consumer demand improved the <unk>.

Steps with our China team have undertaken to rightsize, the business and manage discretionary spend pay dividends this quarter as China held its operating margins flat to last year, despite lower sales in the quarter.

The first half to July we saw consumer demand down approximately 5% to 10% compared to last year, a sequential improvement from second quarter consumer demand levels.

Please turn to slide six.

As I mentioned on our January call one of our key strategic priorities in 2022 is to expand our water treatment business through innovation, new product development and strategic acquisitions.

In May we launched our redesigned Aqua Sana clean water machine.

First power countertop water filter to combine a sleek compact no install design with four different methods of advanced filtration technology.

The new clean water machine is tested and certified NSF standards for the removal of up to 99, 9% of 77 contaminants, including led the forever chemicals, such as <unk> and many more.

<unk> patented clearly infiltration ensures industry, leading contaminant removal, while painting, the beneficial and naturally occurring minerals and water such as calcium magnesium and potassium for optimal hydration.

In addition, we welcomed Atlantic closer cooperation to the a O Smith family last month Atlanta.

Atlantic filter is the fifth acquisition, we've made in the North America water heater market since 2016.

With a strong presence in southern Florida Atlantic built to expand our capabilities in this key area of the market.

I'll now turn the call over to Chuck who will provide more details on our second quarter performance.

You, Kevin and good morning, everyone I'm on slide seven.

Second quarter sales in the North America segment rose to $744 million or 23% increase compared with 2021.

Pricing actions largely on water heaters represented approximately 89% of the increase.

Sales in the quarter also benefited from higher volumes of water treatment products.

<unk> and commercial water heaters that more than offset that was more than offset by lower volumes of residential water heaters giant acquired in October 2021 added $31 million in North America sales.

North America adjusted segment earnings of $163 million increased 17% compared with the same period in 2021.

The earnings benefit of inflation related price increases was partially offset by higher material and freight costs and lower residential water heater volumes.

Adjusted segment operating margin of 21, 8% decline compared with the 2021.

Primarily due to higher material and logistic costs plant production inefficiencies and the inclusion of giant which had lower margins than our legacy water heater business.

Moving to slide eight.

Rest of the World segment sales of $230 million decreased 13% year over year.

Lower sales volumes, primarily driven by consumer demand headwinds in China related to COVID-19 related restrictions.

Currency translation of China sales unfavorably impacted sales by approximately $5 million.

Sales in India grew 79% in the second quarter of 2022 on strong demand compared to last year, which was negatively impacted by the pandemic.

We view, India as a long term growth opportunity given its attractive growth characteristics and changes in demographics.

Rest of the World segment earnings of $18 million decreased 18% compared to segment earnings in the second quarter of 2021.

In China, the impact of lower volumes was partially offset by lower selling advertising and engineering expenses rest.

The rest of the World segment margin was seven 9% down 60 basis points from the same period last year.

Free cash flow of $24 million during the first half of 2020 to decrease from the first half of 2021 due to higher 2022 earnings that were more than offset by lower customer deposits in China.

Here incentive payments due to record 2021 sales and earnings and greater cash outflow outlays for increased levels of safety stock on higher cost inventory.

Historically, we generate the majority of our cash in the second half of the year.

Our cash balance totaled $459 million at the end of June and our net cash position was $161 million or.

Our leverage ratio was 14% as measured by total debt to total capital.

Our strong annual free cash flow and solid balance sheet allow us to continue to focus on capital allocation priorities and return cash to shareholders.

Earlier this month, our board approved our next quarterly dividend of <unk> 28 per share.

We repurchased two 9 million shares of common stock in the first half of 2022 for a total of $190 million.

So I will turn to slide 10.

In addition to returning capital to shareholders, we see opportunities for organic growth innovation, and new product development across all of our product lines and geographies.

The strength of our balance sheet allows us to pursue strategic acquisitions, even in the event of an economic downturn, we remain focused on identifying water heating and water treating assets that meet our financial metrics.

Such as the recent acquisitions of Atlantic filter and giant factories. Additionally.

Additionally, the strength of our balance sheet allows us to maintain a strong track record of delivering returns to shareholders. This has been done through both our dividend that we have increased for 30 consecutive years as well as share repurchases debt a total of more than $550 million since 2021.

Please turn to slide 11, and our 2022 full year earnings guidance and outlook.

We reaffirm our 2022 outlook with an expected EPS range of $1 56 to $1 76 per share and our adjusted EPS range of $3 35 to $3 55 per share.

Our outlook is based on a number of key assumptions, including no further significant surges of COVID-19 cases in the U S and that COVID-19 related restrictions in China remain approximately at the levels. They are today and do not significantly impact our operations or our employees customers or suppliers.

Steel indices began to stabilize at the end of 2021 and have moderated towards the end of the second quarter.

Our guidance assumes that the average steel price in the second half of 2022 will approximate the average steel prices in the second half of 2021.

We continue to see elevated materials and transportation costs.

We saw improvement in our supply chain in the second quarter, However challenges still persists.

We remain in close contact with suppliers and logistics providers to troubleshoot manage and resolve bottlenecks, but three months the environment remains unpredictable.

We continue to see the benefit from multiple 2021 price increases compounding to approximately 50% for water heaters.

We expect to generate free cash flow of approximately $450 million to $500 million. The range issue assumes that our inventories returned to year end 2021 levels.

For the year Capex is expected to be approximately $80 million.

Corporate and other expenses are expected to be approximately $55 million.

Our effective tax rate is estimated to be between 23, 5% to 24%.

And we expect to repurchase approximately $400 million of shares of our stock, resulting in outstanding diluted shares of $156 million at the end of 2022.

Based on these assumptions the midpoint of our adjusted EPS range remains an increase of 17% compared with 2021.

I'll now turn the call back to Kevin who will provide more color on our key markets and our top line growth outlook and segment expectations for 2022, all staying on slide 11, Kevin.

Chuck.

We project revenue growth for 2022 of 12% to 14%, which is lower than our outlook in April as a result of softening demand in residential and commercial water heaters.

Our sales assumptions include.

After approximately 8% growth at each of the last two years, which is well above the historical average growth rate.

We estimate U S residential water heater industry unit volumes will be down approximately 4% to 6% from last year as industry demand normalizes.

We project that commercial gas water heater industry shipments will be flat to slightly down for the year.

However, we revised our full year outlook for the commercial water heater industry to be down 7% to 9% primarily due to weakness in the large electric greater than 55 gallons.

The commercial industry started the year weaker than expected primarily due to a regulatory change that temporarily impacted orders in that product category.

COVID-19 related restrictions paid out as we expected in the quarter. Therefore, we maintain our sales projection in China to be flat in local currency compared to last year. As a result of the economic headwinds we are experiencing from COVID-19 related restrictions.

Due to our strong backlog and stable order rates, we have increased our full year boiler sales growth projection for 18% to 20% to 25% sales growth driven by increased pricing in response to higher input costs and higher demand for our energy efficient products.

We project North America water treatment sales growth inclusive of acquisitions to be approximately 50% in 2022 due to strong water quality dealer performance.

Based on these factors along with the full impact of our 2021 price increases we expect our North America segment margin to be between 22, 5% and 23% and rest of world segment margins to be approximately nine 5% to 10% or 50 to 100 basis points higher in 2021.

Please turn to slide 12.

2022 continues to present challenges that our global teams are meeting head on.

148, Youll company that has continued to grow and innovate through all economic cycles.

We believe a O Smith is a compelling investment because of our stable replacement business combined with exciting growth opportunities in North America water treatment business as well as in China and India.

We have premium brands and leading share positions in our major product categories.

We estimate replacement demand represents 80% to 85% of U S water heater and boiler volumes.

The strength of our balance sheet and free cash flow generation support our ability to continue investing for the long term.

And automation innovation, new products and acquisitions as well as returning cash to shareholders even in times of economic uncertainty.

As we have demonstrated throughout our long history, we're able to be successful in all economic cycles.

We're focused on meeting the needs of our customers our portfolio of strong brands combined with the investing in technology to drive innovation and new product development further enhance our market leadership.

I am confident in our ability to navigate the complex macro environment and capitalize on opportunities, while continuing to execute our strategic objectives.

With that we conclude our prepared remarks, and we're now available for your questions.

Thank you.

Quick question, you will need to press star one on your telephone please standby, while we compile the Q&A roster.

And our first question comes from the line of Mike Halloran with Baird. Your line is open. Please go ahead.

Hey, good morning, everyone.

Couple of questions here.

First on the on the China side.

The margins and I think the demand proved relatively resilient versus the magnitude of the Lockdowns, maybe just a little under the Hood. How you think about the inventory levels there how that track through the quarter, how you're positioned in the back half of the year.

And then just a comment on the capacity side.

The resiliency of the Incrementals. Please.

Sure sure good morning, Mike This is Chuck.

Yes, we're really pleased how China performed for the quarter.

On our last call talked a little bit about consumer demand being down 35% to 40% in April and as you recall that was that was really the heart of some of the severe lockdowns in Shanghai and Beijing.

But what we saw in consumer demand for the course of the quarter was the consumer demand was down about 20%.

First quarter was down around 10, so second quarter average are down around 20% and as we came out of the second quarter and what we're seeing in July as we're down about 5% to 10%. So the consumer demand went through pretty well to kind of back to the first quarter. So our.

Our assumption in guidance is that it stays at that level kind of for the rest of the year.

Inventories they are flat to down a little bit in the channel.

From the first quarter to the second quarter. So they are in a really good position.

Theres about three to four weeks in the inventory.

And the channel and Thats pretty normal for us it's at a decently low point.

And I'd say, we're pleased with 9% and operating margins for the quarter on that lower volume. Some of that was helped by discretionary spending as we mentioned thats, probably probably $3 million or so of help on discretionary spending and I'm talking about promotions advertising very little travel for the quarter as you can imagine in the lockdown situation.

We would expect through the second quarter or third quarter, similar ability to kind of demonstrate.

Controlling discretionary spending probably back to spending in the fourth quarter as you know that's our largest typical quarter in China and probably.

Our projection is to turn that back on.

We would hope for a strong fourth quarter similar to last year.

Great Super helpful and then.

Kevin I think you were talking about.

Last couple of years being awfully strong in the North America residential water heater side and makes a lot of sense of the volume side is down for this year against them.

Harrison.

What's the house view on what that run rate is going to look like from an industry perspective, we're running high 9 million ish kind of units right. Now do you guys have a sense from an industry perspective on where that settles in from a downside and what that might look like.

Well.

As we talked about we're forecasting a 4% to 6% downturn.

We truly we saw quite a bit of that in June .

Where we saw many of our customers, bringing inventories down.

And.

And again as we go go forward. This year, we look at is starting to normalize as we get into August September the rest of the year.

Where it goes.

Forward I think it's going to depend upon.

Some new construction, but it has slowed down but we think is going to come back and but it is going to normalize somewhere down towards the lower level of that $9 million I think over time.

It's just a matter of working through kind of some of the inventories in some of the economics disruptions that we're going through today, but still you look at it is still going to be 80% to 85% replacement merchant. She is going to be very resilient and there is always going to be potential upside on the new construction. If we can kind of get through the supply chain interest rate issue that were.

That we're kind of navigating through.

Today as a country.

Just a little more color on the tough comp right. So that the Q2 shipments last year were in <unk> and Kevin mentioned it on the call a record, but that's inclusive of 2006, so really strong 2021 in Q2.

Great really appreciate the color thanks, guys. Thanks.

Thanks, Matt.

Sure.

Thank you and our next question comes from the line of Nathan Jones with Stifel. Your line is open. Please go ahead.

Good morning, everyone.

Good morning, good morning.

Maybe just following up on Mike's question on the resi hated business in North America Erin.

Related to the channel inventories.

You talked about customers, taking their inventory down.

Do you think that inventories corrected how long do you think it takes to correct.

Well I think it's in the correction right now certainly we believe there was a big correction in June we're seeing some of that in July .

So you step back right now and you look at overall in the industry production has improved lead times are down so it's becoming a much more predictable environment.

So.

With that I think all of our customers are going to reevaluate.

I still think it will take part of July and maybe a little bit of August and then kind of normalized as we go through the balance of the year.

Just to quantify on the lead times two because we came into the year at 25 day lead times and we're pretty much on the residential side back to normal 15 day lead times.

Kind of progression through the quarter. We went from 25 to <unk> 20 in Q1, and then at the end of Q2, where we're in that 15 day range. So those normalization thats happened in the first half of the year.

It makes sense Pedro would need less inventory under those circumstances.

I guess my follow up question is going to be around steel prices and how that could impact the pricing on on.

On your products overall.

Prices on water heaters are up a lot they needed debate because scale was up a lot.

Cold rolled and hot rolled down probably about 50% from peak prices now.

Can you talk about your expectations for how price goes from here, obviously they'll go on a lag that should be accretive to margins. Just any comments you can have on how you're expecting that to go.

Steel prices stable from where they are now.

Yes, just a little.

Little background and color on the steel pricing because yes, you are right. Your reference of kind of the peak to where they have gone as a pretty big Delta on steel pricing, but kind of the mechanics of what we see and what we see in costs.

Not necessarily the peak, it's kind of a weekly average monthly average quarterly average that we see 90 to 100 days later, so we're never really at the peak, we're probably never really at the truck. So those those are a bit muted from kind of the highlights top to top and bottom head and then we see that 90 to 120 day lag so Q1.

We had our highest cost some of the improvement we saw in Q2 was the result of this.

Improved steel steel pricing.

And we do expect that to.

As noted we've seen index has come down we pretty much know what steel will be for Q3, and we projected in Q4, it will be down a bit too so.

We do expect to see some benefit on the steel pricing is a little muted from those peaks and trust.

It comes a little delayed in as far as pricing, we always consider the competitive nature in the marketplace and kind of look at a fade and some pressure not just for steel for other cost and I'll, just say kind of the other costs, we're experiencing have been pretty resilient pretty stable.

That are still still still out there, including freight logistics and a delay.

Thanks for taking my questions.

Okay.

Thank you and our next question comes from the line of Andrew Kaplowitz with Citi. Your line is open. Please go ahead.

Quite significantly.

From flat to down the down seven to nine I think you said last quarter that you are seeing your order volume.

Hey, Andrew.

Yes.

No.

You're muted for a while so could you start over please yes no problem.

Yeah No problem. So you changed your outlook for commercial water heater volumes.

Down seven to nine as you said and I think you said last quarter that Youre seeing your order volume has stabilized after the early regulatory change can you give us more color into why the change in guidance are you seeing more of a significant change in end customer demand there or is it just the slow start to the year, maybe a destock there any more color would be helpful.

Yes, I'll take that and as we mentioned, we still think commercial gas is going to be flat to slightly down so thats moving along but the.

The regulatory change that we experienced in the first quarter, we're seeing our orders normalize as we go forward, we believe of the 7% to 9% that we have forecasted being down almost 90% cost of it is going to be in that light service commercial electric we just don't see the industry.

Rebounding from a slow start in a quarter. So that's the that's the backdrop of why we're going down the rest of the commercial business is quite strong and doing well.

Maybe just kind of a reference point that the light service goes into homes, and really kind of small businesses and when you look at our commercial overall business.

There is about a four or five X to our commercial overall business, excluding the life service when it comes to price. So we'd say, it's on the lower end of our pricing curve, but it does drive volume and we just see now with better visibility that.

We need to bring the industry down from a unit standpoint, but feel pretty good about our commercial gas and condensing gas and where thats going.

Got it that's helpful and then Kevin Chuck maybe just I want to understand the puts and takes.

Overall, you maintained your EPS guidance, but you did lower your revenue forecast a little bit maintain margins in North America, China looks pretty good versus expectations. So what are the puts and takes here is it.

What's the positives that youre seeing is it price versus cost that is the major offset.

Two of them are lower volumes any help there.

Yes.

Start out and Kevin May add on a little bit after that but I mean, the puts and takes in its price versus cost and that's what we are seeing a bit of softening on the steel pricing so were getting a little bit of help there, but it's not just the water heater side. It's also pricing that we're going to.

Have implemented in the fourth quarter on both the boiler side of the business and water treatment side of the business.

So we've got some second quarter announced price increases that are in the market that should help us a bit in the back half with the margins also.

A bit of destabilization during the quarter of order rates on the residential side and we expect that the plants, probably will run a little bit smoother during the back half of the year.

During the quarter of order rates on the residential side and we expect that the plants, probably will run a little bit smoother during the back half of the year. So we would expect a little bit of help there and then theres a bit of mix opportunity right. So residential is down in the quarter and residential we see for the year down 4% to 6%, but as Kevin mentioned.

And we still feel good about commercial, particularly gas commercial product, our 4% to 6%, but as Kevin mentioned, we still feel good about commercial particularly gas commercial product.

<unk> strong for the back half of the year and then boilers.

Backlog for boilers is still pretty resilient.

And we expect and it's typical that the boilers are strongest in our boiler business is strongest volume in the third quarter. So we would help on that we expect health on the mixed side also.

Yes, the only thing I might add is even though China has gone through some COVID-19 related lockdowns, we've seen our new products do well, we see trade up continue to grow it's going for the last couple of years. So.

We have some positive mix issues here, it's not only in North America, but also we see that also in China.

I appreciate all the color guys.

Thank you and our next question comes from the line of Matt Summerville with D. A Davidson. Your line is open. Please go ahead.

Okay.

Thanks.

A question first on China.

Dave This I apologize but.

What is your best estimate on the revenue impact.

<unk> experienced in the second quarter from the Lockdowns and Varian did you see any sort of difference in out the door demand for water heaters versus water treatment in China in Manhattan.

Yes, it's hard to call out exactly what's COVID-19 and what's the overall economy in China. So it's really hard to parse it but clearly we were impacted negatively by COVID-19.

Consumer demand out the door was down about 20% so that that was kind of out the door demand.

I would say just kind of within within our product categories, certainly the residential products, where we're challenged most so I would say electric water heaters and water treatment, we're probably the most challenged during the quarter commercial water heater and commercial water treatment the commercial side thats not so.

Through retail kind of offset some of that 20% down which.

<unk> the number for overall overall sales volume.

Got it and then just with respect to the boiler backlog can you guys, maybe put a finer point on that how does that compare to prior peaks prior cycles.

And.

Maybe talk about the magnitude of pricing Youre looking for in boilers in treatment to what you just mentioned a couple of moments ago in the back half.

Yeah, I'll take the magnitude and maybe a check you can jump in on any of the pricing side of it.

Certainly we haven't seen this type of backlog we are in the three to four month range to be honest with you and it's mainly commercial so.

What's important to note here on our backlog as we actually have ship dates for the vast majority of all of our orders in house.

There may be a put and take that we see where job gets pulled in maybe gets kicked out a little bit but overall, we see nothing that would cause a material change to the backlog and the market remains.

Very active.

The jobs continue to move forward again labor gets in the way a little bit but overall, we have a lot of comfort in our backlog and primarily that it's mostly commercial condensing products, which are <unk>.

Part of our business.

And on the pricing side on the water treatment side going forward in both.

The boiler side in water treatment side kind of expect to see it come in end of the third quarter and in the fourth quarter, but water treatment kind of mid single digits to 10% price increases depending upon our product category similar for the boiler products in that 8% to 12% depending upon product category.

Got it thank you guys.

Yes.

And our next question comes from the line of.

David Macgregor with Longbow Research. Your line is open. Please go ahead.

Good morning.

I wanted to.

I wanted to just explore further around the residential water heater business.

Maybe some of the weakness that you've seen there.

Can you think about that market is maybe.

Maybe at the risk of oversimplifying this a little bit.

Three buckets, you've got too.

Construction replacement demand, we will of course, just changes in the channel inventory.

It sounds like the channel inventory is truly.

Truly transitory and do you expect that as you pointed out by August .

You could see that kind of normalizing new construction.

Yes.

We'll watch completions.

US a good sense of.

Water heater consumption, there, but maybe just speak to replacement demand and what youre seeing there and maybe.

<unk>.

We want to be able to be skeptical here, but to the extent you think you may have lost some share.

In replacement demand this quarter, what gives you confidence that your share position.

Remains strong thank you.

Okay.

When you talk about replacement demand.

There's two components of it you have kind of a proactive replacement and then you have the emergency replacement.

The proactive side, which is renovation partly driven by.

Kind of remote work had been pretty strong we saw it coming down a little bit.

Test that every quarter in and have a good read on that as far as the overall emergency replacement that will always remain resilient.

Just don't go without hot water for for any length of time so.

Yes.

The residential business has those components again, I just want to remind people that 15% of our business is that new construction. So even if it drops a little bit it's pretty nominal for us.

But it's a nice upside and as we go forward, but that's how it plays out.

Feel pretty comfortable with with our four to six.

Percent in and again as I mentioned I think a lot of the channel inventory.

Adjustments.

Good.

Come out in June and July and a little bit of August .

From a share perspective, we have really good data on that and we talked about this last year and ended the quarter that we were a little bit behind.

We really expected I expected that it would normalize.

As you know.

Yes.

<unk> came up and it will be.

<unk> came down and Thats actually playing out really well on the residential side I would tell you we're slightly up move.

Moving towards our normal historic market shares and I'll just throw in commercial the commercial we're already back to a normal rates.

Okay.

Good to hear.

Thank you for that and just as a follow up I guess.

Everyone's concerned right now about the slowing macro and so I'm thinking about sort of where the strength lies in your business. It seems to be in the boiler business has always been.

The stronger elements in the model.

Cyclical is that business, how should we be thinking about kind of just 2023 is a soft year and we see.

The base of weakness across the market.

How.

Stable should that business be.

Yes.

Historic well, we expect it to be pretty stable I mean, the replacement component of that business is very similar to the water heater side in that 80% to 85% so the replacement piece.

Continues to be resilient it usually the commercial side would typically lag the residential side you've got projects in progress we've got quoting that's happening in advance and so it's a little more stable than longer.

The last recession on the boiler side, which was.

2006 2007.

The boiler business was impacted but not as much as the rest of the business, particularly because of some of the underlying growth drivers that you have on the replacement and high efficiency most of our product just as a reminder, as high efficient energy efficient product that.

Pretty resilient in downturns because of the energy efficiency nature that it continues to want to.

Driver replacement.

So just to be clear when you say, it's resilient in terms of the.

Cyclicality you are talking about units are you talking about profitability.

So they are very similar.

Okay.

Thank you very much.

Thanks.

Thank you and our next question comes from the line of Jeff Hammond with Keybanc. Your line is open. Please go ahead.

Hey, good morning.

Jeff.

Just wanted to ask a similar question on.

I guess, Dave did on on the <unk>.

Water treatment business with newer platform and just trying to it seems to be something maybe a little more discretionary than.

Water heater replacement. So just how you think that business would perform in a recession scenario.

Yes.

The first point of some of our water treatment, it's much affordable much more affordable product.

So this is our first time going through some type of cycle here.

Certainly it will be some discretion there with people, but the way we look at it is.

The penetration of the awareness is going to continue to go up.

And there is a consumable part that we had that it's continued to grow as about 15% of our business today. So it's.

It's not is maybe not as resilient as water heaters is not a must have but its got some built in components that help offset some of the downturns, but just people, becoming more aware of having healthy and clean water. So we think it's going to perform fairly well.

So any type of economic.

Economic cycle.

Okay and then.

It seems like the new entrant in the water heater space kind of finally got the plant open and I'm just wondering if.

If youre seeing them in the marketplace at all and if you think theres any pricing disruption.

Around that particularly as his input costs rollover. Thanks.

Yes.

I'll quickly touch base on that.

Nothing new from our perspective, yes. Their plan is open but their market activity from our perspective, and what we're getting feedback hasnt changed in fact, if anything they are moving away from our customers, our retailers and wholesalers and trying to maybe look at more builders in that type of thing so.

Can't anticipate what the future is going to be with them, but right now.

It's kind of not a big change from what we saw other than they are.

A few products in.

And there are U S plant.

Okay. Thanks, guys.

Thank you and our next question comes from the line of Scott Graham with Loop capital. Your line is open. Please go ahead.

Yes, hi, good morning.

Good morning.

Earlier question Ken.

Kevin I was very interested in your view on the residential.

Water heater market kind of going from the nine nine level I think you said to the lower ninth so im curious if you can add maybe a little more color from your perspective as the market leader how much of that do you think is the destock.

Again, thats going to be very speculative the reason I feel confident in the water heater market as I still go back to and again I'm not sure when it's going to normalize but.

New construction, there is still a deficit out there.

And that's going to continue to grow.

And move forward.

So that's what gives me confidence in the market a stable replacement side of it.

And.

Again quite frankly as things get a little tougher people do more renovation, but I think if you look at our history the growth rate.

The residential water heater market its been at that.

<unk> percent range and I think as I go forward.

I just think it's going to adjust down we were in a.

Very hyper inflated market have a lot of money out there and everybody benefited from it but I think over time, that's going to just normalized to two kind of a run rate that we've seen in the past.

The great news that there is more water heaters out there today and thats going to <unk>.

You go out 10, 14 years is going to play really well for for the industry and for our company.

That's kind of.

The high level, it's really hard to give you much more detail than that Scott.

That was helpful. Thanks, So in China can you give us the sales split for the quarter.

In.

I know you combine both water heaters and treatment upper middle price points versus premium.

Sure sure I mean premium I'll, just premium side of the market.

So.

At the low end is about 40% premium on the electric quantity.

The high end is nearing 50% premium on the water and gas.

<unk>.

On the gas Tankless and then water treatment is kind of in between so not a not a great deal of change a little uptick on the electric side. We introduced a couple new products that are good dual tank Slim line product on the electric debt.

We're hoping to get some traction on which bumped that up a bit.

Okay. So you are seeing that number continue to incrementally progress.

Quarter over quarter for electric it was up and we think it is due to it is due to some new products.

Hard to say there are a lot of movement, but when we track the upper part of the market and what the industry is telling us from a third party.

Still positive movement, so still it's still an uptick from the last quarter not a large uptick but only only only positive Scott.

You talked about it it's been about a couple of years now and so a lot of our premium products have featured a benefit that still consumers in China are willing to pay for so we're very pleased with our new products and we're really pleased to see the upper end continue to move in that kind of northeast direction.

Got it. Thank you just a follow up then.

Share repurchases I know you're flying is still locked in at that $400 million I'm, just just sort of wondering what the market weaker resin conditions, obviously slot.

Slide <unk>.

Yet you're still having some fairly stable sales base.

The replacement nature of them.

Including in China, good cash flow.

What's holding you back from going higher on the share repurchases this year.

Yes.

We did have an uptick to $400 million I think last year were $3 80 ish or something like that unchanged.

We're.

We're still a little bit of an uptick to historically.

I think as we go into this cycle and we'll have to see how it plays out but there could be some real opportunities on the M&A side, we want to make sure. We're in a position to be able to capitalize on those opportunities. So that that's one weighed against it. The other is we're projecting to be at that 400 million now we don't have intentions to.

To increase it on this call, but we will continue to watch it as we have and see what the economy does and what our price does so.

Yes, Chuck I guess on that I guess my whole thinking of course is that it.

Not just about the cash flow, but it's also about the balance sheet you guys had been running in that cash position for like a decade.

It just seems like you have a lot of dry powder, there and can still increase the share repurchasing is that are you looking at a couple of large sized acquisitions is that kind of part of the equation.

Yeah, Hey, I'll jump in here.

Is.

That's always a possibility.

And so the way we've looked at as we go into the year.

But things have changed as this year started in kind of evolved to where we're at today the $400 million is pretty much a lot good number for us each year, we evaluate where we'd like to go. So we'll take another look as Chuck said.

In 2023.

But.

We do think Theres some opportunity as we get into the back half of this year with a number of our our M&A targets.

Things are changing and we want to be prepared and have the.

The balance sheet too to take action.

Opportunities come our way.

Okay. Thank you.

Thank you and again if you have a question at this time. Please press star one on your Touchtone telephone.

Our next question comes from the line of Damian purpose with UBS. Your line is open. Please go ahead.

Hi, good morning, everyone.

Turning.

Thanks for all the detailed color around the market outlook.

I have a follow up question on margins I was wondering if you could maybe just.

Help us think about the bridge when you factor in.

Some of the volume deleveraging, but the lower steel input costs is there a good way to think about the.

The decremental margin.

And as the price cost benefit.

And.

I guess, just any perspective, you might be able to provide on yes.

Yes additional margin you can capture.

Later, this year and next year.

It's sort of steel costs basically hold stable from here.

Yes. This is Chuck I won't go beyond this year, but when you think about kind of the decremental margins and we're really just talking about residential water heater decremental margin and then what Kevin mentioned the light commercial so.

Probably think of that in the 35% decremental margin range.

<unk>.

Steel cost.

Got those visibility we have visibility into those costs through.

Through the third quarter for sure.

Are you starting to see visibility in the second so we feel pretty good about that so thats, probably the next largest driver.

And then stable.

Stabilization of order rates as we expect we had a little bit of a disruption in the end of June and July here on residential order rates, we would expect plants to perform a little bit better during the back half of the year and the commercial mix is also favorable so we expect some help on commercial mix and.

If you kind of think about the cadence through the back half of the year.

We're going to where our guidance is 22, 5% to 23, right and we're kind of tracking below that right now so we do expect.

<unk> uptick.

In Q3 and then.

Incrementally Q4, as some of those price increases I mentioned in water treatment and lacking in boilers come in.

And as we see probably our most favorable steel for sure in the fourth quarter. So thats, how we kind of think about that margin expansion.

Okay. That's helpful.

And I wanted to ask you about your heat pump products.

We're seeing heat pumps gained traction in the broader HVAC market kind of on the air side, that's really picking up.

I was wondering if you could maybe talk a little bit about what youre seeing I guess I guess in theory, the economic that probably gotten a little bit worse.

Because of the steel inflation, if you compare.

That part of the Tankless.

<unk>.

Maybe any maybe any thoughts on just.

How that how that is progressing and do you think that the market that product to take off on its own or are you going to.

Ultimately need some government stimulus.

Well.

Let me separate debt to a residential heat pump versus a commercial heat pump because I think they're both different markets.

Residential heat pump is still an up sell product. It's one of the best value propositions, we have in our company, but its a three to four X irregular electric water heaters and there are some installation challenges there are quite a bit of subsidies out there whether it be at this stage city, which is helping and that's going to continue to grow I mean, there's no.

Doubt they will.

ROE.

It will grow at a moderate pace.

Pace I believe unless it's regulated in but its going to continue to grow and it's going to.

Our long term product for our company in our industry, but it's still a relatively small part of our overall volume.

Commercial heat pump is even.

Theres a lot of.

Activity out there, but that's that's trailing in the residential side just because it does have some size to the installation. It requires a tank theres a number of things that have to go along with it and it's better for new construction than it is for retrofit.

But we see that growing wishing activity in it.

Obviously have products that we participate in but I think both of those categories.

We're going to grow at a percentage rate pretty high but as an overall.

Volume is still going to be more of an upsell product unless there is some regulatory changes that com.

Got it that makes sense really appreciate it best of luck.

Thank you thanks for joining us.

I'm showing no further questions and I would like to hand, the conference back over to Helen <unk> for any further remarks.

Thank you for joining US today, let me conclude by reminding you that our global Ao Smith team delivered strong sales and earnings in the second quarter. Despite many challenges we have.

Look forward to updating you on our progress in the quarters to come.

In addition, please mark your calendars to join our presentations at four conferences in the third quarter.

Northcoast on August eight Jefferies on August 9th Stifel on September 7th and David said on September 22nd connect everyone have a great day.

This concludes today's conference call. Thank you for participating you may now disconnect everyone have a great day.

Okay.

The conference will begin shortly to raise Johan during Q&A you can dial one one.

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Yes.

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Yes.

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Yes.

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Good day and thank you for standing by welcome to the a O Smith's second quarter 2022 earnings Conference call. At this time all participants are in a listen only mode. After the speaker's presentation. There will be a question and answer session to ask a question. During the session you will need to press star one one on your telephone please.

Be advised today's call is being recorded I would now like to hand, the conference over to your speaker today, Helen Gerhart Ma'am. Please go ahead.

In order to provide improved transparency into the operating results of our business. We provided non-GAAP measures free cash flow is defined as cash from operations less capital expenditures.

Adjusted earnings adjusted earnings per share adjusted segment earnings and adjusted corporate expenses exclude the impact of nonoperating noncash pension income and expenses.

Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website.

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 chair.

If you have multiple questions. Please rejoin the queue.

You will be using slides as we move through today's call you can access them on our website at Investor a O Smith Dot com.

I will now turn the call over to Kevin to begin our prepared remarks, please turn to the next slide.

Thank you Helen and good morning, everyone. Thank you for joining us today.

Im on slide four in our second quarter results.

Our team performed well throughout the quarter, despite an uncertain macro environment to deliver strong sales and EPS performance.

Our rest of World segment performance decreased 13% year over year, driven by COVID-19 related Lockdowns in China. However.

However, we experienced sequential sales improvement in China through the quarter as restrictions begin to ease.

The acquisition of giant factories added $31 million to quarterly sales and <unk> <unk> to EPS.

We are pleased with the performance of the team and our integration is on track.

We saw quarter over quarter improvement in our supply chain in the second quarter, which led to higher boiler and commercial water heater volumes.

Please turn to slide five.

Our global a O Smith team delivered second quarter of 2022, adjusted EPS of <unk> 80 to a.

A 14% increase that was driven in part by a 12% increase in sales compared with the second quarter of 2021.

I am proud of how my a O Smith colleagues work together to overcome many challenges to deliver value to our customers across the globe.

Excluding the impact of giant North America water heater sales grew 19% in the second quarter of 2022 due to pricing actions implemented in 2021 in response to rising material and logistics.

Lower sales of residential water heaters, partially offset sales growth in the quarter.

The residential industry saw record orders in the second quarter of 2021, creating a difficult comparison for 2022.

With that said, we saw order rate softness as we exited the second quarter and into July as customers right size their inventories.

Our North America boiler sales grew 27% in the quarter driven by pricing increases to offset higher material and transportation cost and strong demand.

We again ended the quarter with a significant backlog largely composed of commercial condensing boilers, and we continue to see stable order rates for these market leading energy efficient products.

Our strategy to focus on innovation and de Carbonization contributed to strong demand for our high efficiency condensing boilers.

North America water treatment sales grew 19% in the second quarter as our independent water quality dealer dealers continue to outperform the market and gain share.

We also benefited from strong demand in the wholesale channel.

In China sales decreased 14% in local currency compared to the second quarter of 2021.

Primarily due to the expected impacts of COVID-19 related lockdowns.

Our sales improved sequentially through the quarter as Lockdowns lesson and consumer demand improved the <unk>.

In the first half to drive we saw consumer demand down approximately 5% to 10% compared to last year, a sequential improvement from second quarter consumer demand levels.

Please turn to slide six.

As I mentioned on our January call one of our key strategic priorities in 2022 is to expand our water treatment business through innovation, new product development and strategic acquisitions.

In May we launched our redesigned Aqua Sana clean water machine.

First power countertop water filter to combine a sleek compact no install design with four different methods of advanced filtration technology.

The new clean water machine is tested and certified NSF standards for the removal of up to 99, 9% of 77 contaminants, including led the forever chemicals, such as <unk> and many more.

In addition, we welcomed Atlantic filter Corporation to the a O Smith family last month Atlanta.

Atlantic filter is the fifth acquisition, we've made in the North America water heater market since 2016.

With a strong presence in southern Florida Atlantic built to expand our capabilities in this key area of the market.

I'll now turn the call over to Chuck who will provide more details on our second quarter performance.

You, Kevin and good morning, everyone I'm on slide seven.

Second quarter sales in the North America segment rose to $744 million or 23% increase compared with 2021.

Pricing actions largely on water heaters represented approximately 89% of the increase.

Sales in the quarter also benefited from higher volumes of water treatment products.

North America adjusted segment earnings of $163 million increased 17% compared with the same period in 2021.

The earnings benefit of inflation related price increases was partially offset by higher material and freight costs and lower residential water heater volumes.

Adjusted segment operating margin of 21, 8% decline compared with the 2021.

Primarily due to higher material and logistic costs plant production inefficiencies and the inclusion of giant which has lower margins than our legacy water heater business.