A. O. Smith Corporation (NYSE:AOS) Q4 2022 Earnings Call Transcript

A. O. Smith Corporation (NYSE:AOS) Q4 2022 Earnings Call Transcript January 31, 2023

Operator: Good day, and thank you for standing by. Welcome to the A. O. Smith Corporation’s Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. And I would now like to hand the conference over to your speaker today, Ms. Helen Gurholt. Ms. Gurholt, please go ahead.

Helen Gurholt: Good morning, and welcome to the A.O. Smith fourth quarter and full-year 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 provided non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings, and adjusted corporate expenses exclude the impact of non-operating, non-cash pension income and expenses, as well as legal judgment income and terminated acquisition-related expenses.

Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our Web site. 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 Web site at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks.

Please turn to the next slide.

Kevin Wheeler: Thank you, Helen, and good morning everyone. I’m on slide four and our full-year results. Our team delivered record-setting sales and year-over-year improvement in earnings on an adjusted basis despite lingering supply chain headwinds, inflation, and a significant U.S. wholesale residential channel inventory destocking activity that took place in the third quarter, and began to normalize in the fourth quarter. Residential industry volumes increased 15% in the fourth quarter compared to the third quarter. Despite the destocking activity, North America sales were up 11% compared to 2021 primarily due to inflationary pricing and strong demand for our commercial and residential boilers and water treatment products.

Our Rest of World segment delivered consistent performance in 2022 despite headwinds in the economy and currency exchange. Segment operating margins improved 120 basis points driven by our China team improving their full-year operating margins to almost 11%. In India, our sales grew 28% in local currency in 2022, and continued to be profitable. As expected, we settled the majority of our pension liabilities in December of 2022, which resulted in a non-cash pre-tax expense of $417 million or $1.60 of EPS. This expense is excluded from adjusted earnings and adjusted EPS. With our divided and share repurchases, we returned $581 million of capital to shareholders. Please turn to slide five. Our Global A. O. Smith team delivered record sales of $3.8 billion in 2022, and adjusted EPS of $3.14, a 6% increase over 2021.

We achieved this strong performance as a result of effective execution from our team. North America water heater sales grew 10%, in 2022, due to 2021 pricing actions implemented in response to rising material and logistic costs, and acquisition-related revenue that was partially offset by lower residential volumes. After two years of greater-than-average growth, residential unit industry demand decreased approximately 12% compared to 2021 primarily due to a wholesale channel inventory destocking that occurred during the second and third quarters. The order reduction we experienced from our customer was driven in part by our improved performance in delivering residential product and reducing our lead times. Commercial industry units decreased approximately 17% year-over-year.

A large portion of the decrease was due to a continued weakness in electric products greater than 55 gallon, which was impacted by a regulatory change at the beginning of 2022. We don’t expect that product category to rebound to pre-2022 levels. Despite the 2022 contraction in both the residential and commercial industries, we are pleased with our market share strength in both residential and commercial water heaters. Our North America boiler sales grew 28% driven by higher volumes and previously announced price increases to offset higher costs. Our supply chain improvement efforts allowed us to reduce our record backlog in the second-half of 2022. Our focus on innovation, efficiency in decarbonization contributed strong demand for our high-efficiency condensing boilers, particularly our Hellcat CREST boilers with O2 sensing technology.

North America water treatment sales grew 10% in 2022 due to pricing actions and higher volumes, particularly in our dealer and specialty wholesale channel. Our strategy is to pursue this market with an omni-channel approach as we work to grow our share through product development and acquisition opportunities. We view our independent water quality dealers have been outperforming the market and gaining market share. In China, full-year sales decreased 5% in local currency compared to 2021 due to impacts from COVID-19-related disruptions. Our core water heating products performed well in a down market. Our water treatment business, comprised of residential, commercial, and filter replacement consumables grew nearly 4% in local currency, and now represents almost 40% of our overall business, with repeatable consumable filter sales representing over 25% of overall water treatment sales.

For the year, operating margins in China were 10.7%. As a result of actions taken over the past several years to right-size the business and manage discretionary spending, China has achieved operating margins above 9% in each of the past seven quarters. I’m now on slide six. We released our third ESG report in December. We have made significant strides in our commitment to ESG, including progress towards our GHG emission reduction goal of 10% by 2025, preventing almost 500,000 metric tons of carbon emissions in 2021 through sales of our highly efficient water heaters and boilers, and WAVE verification, a process developed by The Water Council, as an initial step in creating a strategy to improve our water stewardship performance. ESG concepts are embedded within the foundation of our 149-year history.

The ESG report demonstrates our commitment to our values of being a good citizen, a good place to work, emphasizing innovation, and preserving our good name, and achieving profitable growth. I will now turn the call over to Chuck who will provide more details on our full-year and fourth quarter performance.

Chuck Lauber: Thank you, Kevin. Good morning, everyone. I’m on slide seven. Full-year sales in North America segment rose to $2.8 billion, an 11% increase compared with 2021. Pricing actions, largely on water heaters, were partially offset by lower volumes of residential water heaters. Higher volumes of boilers and water treatment products also added to segment sales growth. Giant acquired in October, 2021, added incremental sales of $94 million. North America segment adjusted earnings, of $611 million, increased 5% compared with 2021. The earnings benefit of inflation-related price increases and higher volumes of boilers and water treatment products was partially offset by higher material and freight costs and lower residential water heater volumes.

Adjusted operating margin of 21.7%, a decline of 120 basis points year-over-year, was driven by inflationary headwinds and volume-related production inefficiencies. We exited 2022 with our highest quarterly adjusted operating margins of the year at 23.3%. Moving to slide eight, Rest of the World segment sales, of $966 million, decreased 7% year-over-year and 2% in constant currency basis. Currency translation unfavorably impacted segment sales by approximately $49 million, $36 million of which impacted China sales. Our sales decrease was primarily driven by lower sales in China as consumer demand was negatively impacted by COVID-19-related restrictions. India sales grew 28% in local currency in 2022, compared to 2021, as we continued to outperform the market.

Rest of the World segment earnings, of $96 million, increased 5% compared to segment earnings in 2021. In China, the impact from lower volumes was more than offset by lower selling, advertising, and incentive expenses. Segment operating margin improved to 10%, an increase of 120 basis points compared to 2021, primarily as a result of improved management of discretionary spending in China. Please turn to slide nine. Turning to fourth quarter performance, we delivered sales of $936 million in the fourth quarter of 2022, down 6% year-over-year, driven by lower residential water heater volumes in North America and lower consumer demand in China that more than offset inflation-related pricing actions. Adjusted earnings in the fourth quarter were $0.86 per share, compared to adjusted earnings of $0.85 per share in the fourth quarter of 2021.

Please turn to slide 10. Fourth quarter sales in North America segment were $692 million, a 3% decrease compared to record sales in the fourth quarter of 2021. We saw quarter-over-quarter improvement of residential water heater demand; however, water heater volumes were still below the record industry levels in the fourth quarter of 2021. Our fourth quarter sales benefited from pricing actions and stronger boiler sales growth of 36% driven by backlog reduction. North America segment adjusted earnings, of $161 million, decreased slightly compared with 2021. The earnings benefit of inflation-related price increases, higher boiler volumes, and lower steel costs was offset by lower residential water heater volumes. And improved price-cost relationship resulted in higher adjusted segment operating margin of 23.3% compared with the 2021 adjusted segment margin of 23%.

Moving to slide 11, fourth quarter, rest of the world segment sale of $250 million decreased 13% year-over-year, primarily driven by the impacts of unfavorable currency translation and lower consumer demand in China due to COVID-19 related restrictions. Currency translation unfavorably impacted China sales by approximately $24 million. In local currency, China sales decreased approximately 7% year-over-year. India sales grew 16% in local currency in 2022 compared to 2021. Rest of the world segment earnings was $32 million, was slightly higher than Q4 2021 segment earnings. In China, lower incentives and selling expenses offset lower volumes and currency translation headwinds resulting in segment operating margin of 12.7%, a significant improvement over segment operating margin of 10.6% in the fourth quarter of 2021.

Please turn to slide 12. We generated free cash flow of $321 million during 2022; lower than in 2021 as higher adjusted earnings were offset by lower customer deposits in China, higher 2021 incentive payments made in 2022. And working capital cash outlays primarily related to higher inventory that more than offset the lower accounts receivable balances. Our cash balance totaled $482 million at the end of December. And our net cash position was $137 million. Our leverage ratio was 16.5% as measured by total debt to total to capital. Now turning to slide 13, in addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation, and new product development across all of our product line geographies. We continue to target strategic acquisitions that meet our financial metrics that are accretive to earnings, in the first year, return across the capital in three years.

Photo by RephiLe water on Unsplash

The strength of our balance sheet allows us to pursue a strategic acquisition even in times of economic uncertainty. Earlier this month, our Board approved their next quarterly dividend of $0.30 per share. We have increased our dividend for 30 consecutive years. We repurchased approximately 6.6 million shares of common stock in 2022 for a total of $404 million. The strength of our balance sheet also allows us to maintain our strong track record of delivering returns to shareholders. Over the past two years, we have returned $1 billion to shareholders through our dividend share repurchases. Please turn to slide 14, and our 2023 earnings guidance and outlook. As previously discussed, we terminated our defined benefit pension plan at the end of 2021.

The termination followed the strategy and measured glide path to derisk our fully funded exposure to pension liability. The plan which was previously sunset for benefits earned in December 31, 2014 represented over 95% of the company’s pension plan liability. The terminated plan’s pension liability was annuitized in 2022. The pension settlement, which we completed in the fourth quarter, accelerated the recognition of $417 million of non-cash pre-tax pension expenses. Tax benefits associated with the pension settlement were $168 million. And include amounts recorded at historical tax rates, and results in an after tax EPS impact of $1.60. We are pleased to introduce our 2023 outlook with an expected EPS range of $3.15 and $3.45 per share. The midpoint of our EPS range represents an increase of 5% compared with 2022 adjusted EPS.

Our outlook is based on a number of key assumptions including our guidance assumes that steel prices in 2023 on an annual basis will improve approximately 40% to 45% compared to 2022 including a sequential improvement of approximately 20% to 25% from the fourth quarter of 2022 to the first quarter of 2023. We have seen a flattening of the steel index. And therefore, our outlook does not project a further meaningful sequential reduction in steel costs through 2023. Regarding other costs outside of steel, we have generally seen flattening in cost at elevated levels. While we do expect a shift in buying power to move from neutral towards a buyers market as we progress through the year, our outlook does not assume significant improvement in non-steel material costs in 2023.

We saw continued improvement in our supply chain in the second half of 2022. While challenges still persist, disruptions are limited. We remain in close contact with our suppliers and logistics providers to manage and resolve supply chain issues as they arise. We expect to generate strong free cash flows 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 approximately 24%. And we expect to repurchase approximately $200 million of our shares of stock resulting in outstanding diluted shares of 150 million at the end of 2023. I’ll now turn the call back over to Kevin who will provide more color on our key markets and top line growth outlook and segment expectations for 2023 staying on slide 14.

Kevin?

Kevin Wheeler: Thank you, Chuck. We project 2023 sales to be approximately flat to 2022 at the midpoint with a range of plus or minus 3%, which includes the following assumptions. We’ll be the majority of our customers exited 2022 with near normal inventory levels. While we believe that new home construction remains a deficit, we expect it will be a headwind in 2023. Therefore we project that 2023 residential industry unit volumes will be down approximately 2% to 5% compared to last year. We project commercial water heater industry volumes to be flat to slightly up as supply chain constraints ease the market correction related to the regulatory change in commercial electric water heaters greater than 55 gallons is largely behind us.

In China, while we expect there could be COVID-19 related surges, related to Chinese New Year travel, we see the recent lifting of the Zero COVID Policy as a positive step to improve the economic environment. We believe they will take time the economy in China to improve and then weaken consumer confidence and a challenged real estate and housing market, we project that our sales in China will go 3% to 5% of local currency in 2023. Our guidance assumes volumes in China improved sequentially throughout the year. Our forecast assumes that the currency translation impact on sales will be similar to 2022. We expect our North America boiler sales will increase approximately 10% to 12% in 2023. Our expectations are driven by an industry growth of 3% to 4%.

The transition to higher energy efficient boilers will continue particularly as commercial buildings improve their overall carbon footprint. A year after launch, our CREST commercial condensing boiler with Hellcat Technology is quickly becoming the industry standard. We expect to see continued benefits from pricing actions implemented in 2022. Our boiler backlogs are at normal levels as we entered 2023. We project approximately 5% to 7% growth in sales of North America water treatment products, which is lower than our growth expectation of 10% per year, largely as a result of a reduced backlog as we exited 2022. We will have pricing benefits and the mega trends of healthy and safe drinking water, as well as reduction of single use plastic bottles will continue to drive consumer demand for our products.

Based on these factors, we expect our North America’s second largest will be approximately 23% and Rest of World segment margins to be approximately 10%. Please turn to slide 15. We remain focused on our key strategic priorities to advance our position as a leader in heating and treating water around the world. Those priorities are, expand and enhance our high efficiency product portfolio, including heat pumps for space and water heating, expand our global water treatment capabilities by investing in technologies, people and distribution, deploy capital effectively by investing in ourselves, acquisitions, and returning capital to shareholders. As we enter 2023, there are economic uncertainties ahead of us. However, there are positives. We believe the 2022 inventory adjustments in the wholesale residential market are behind us.

We expect more normalized unit volumes in 2023. Our fourth quarter 2022 North America adjusted operating margin, of 23.3%, improved over previous quarters as we exit the year with a favorable price-cost relationship and our plants are running more efficiently after the third quarter volume adjustments. In China, the lifting of Zero-COVID policy is a positive step to an improved economic environment. In 2023, we expect a strong rebound in free cash flow as China emerges from COVID-19-related disruptions and a dedicated focus on inventory reduction across our North American operations. We remain focused on servicing our customers. Our strong brands across the portfolio, combined with technology-driven innovation and new product development will enhance our market leadership.

We are confident in our ability to capitalize on opportunities as we continue to execute our strategy. With that, we conclude our prepared remarks. And we’re now available for your questions.

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Q&A Session

Operator: Thank you. Our first question will come from Saree Boroditsky of Jefferies LLC. Your line is open.

Saree Boroditsky: Good morning. So, just touching on the outlook for residential water heaters to be down to 2% to 5% this year, can you talk about how much of that is related to new home replacement, how are you seeing in — about proactive replacement this year? And then impact as we start to lap the housing downturn?

Chuck Lauber: Thanks. Good morning, Saree. This is Chuck. So, as we’re looking at next year, I mean we’re coming off a year where we’re down about 12% on the residential market with the inventory correction. Housing, we expect a headwind in housing of maybe 15% to 20%. Just — we’ve got an 80% to 85% replacement market, so housing is in that 15% to 20% range, which will be a headwind. And that’s kind of how you get down to the 2% down. Where we’re looking at for proactive replacement, it’s pretty strong on proactive replacement going into next year. We saw that tick up, historically proactive replacement as we measure it through a third-party survey, runs 20% to 25%. During the past couple years it’s been in that 30% to 35%. And our last survey still has it above 30%. So, we’re still projecting, going into next year, a fairly strong proactive replacement portion of the replacement market.

Saree Boroditsky: Great. And then, I guess, I know you guys don’t like to talk pricing a lot, but just on the residential water heater pricing in the retail channel, do you expect to see prices decline for the indexed contracts? And if so, how do you just think about the balance in pricing in retail versus the wholesale channel?

Kevin Wheeler: Well, hi. This is Kevin. When you look at both those channels, one, they’re — they are two different business models, but they compete for a lot of the same customers. And traditionally, you’re going to have some conflicts between the channels of a periodic — it’s kind of regional. But as we look at it and as we — as value at our pricing structure to both channels, we feel that they’re going to be competitive. Historically, at how we manager our pricing, hasn’t changed. So, again, we look at that both channels will be in the market competing at an equal level. So, that’s kind of where we’re at right now, and we’ll see how things play out the rest of the year.

Operator: Thank you. Our next question will come from Michael Halloran of Baird. Your line is open. Hello, Mr. Halloran, if your line is mute, please unmute your line.

Michael Halloran: I was muted; apologies. I gave this really enthusiastic hello too, so I was bummed I didn’t hear from anybody.

Chuck Lauber: Well, hello.

Michael Halloran: Yes. Thanks, everyone. Appreciate the time. So, first, on the guide and how you’re thinking about sequential, couple things. First, is the embedded assumption, relatively normal seasonal patterns as you work through the year? And then secondarily, when we think about kind of 1H load for second-half load, obviously the year-over-year comps get a lot easier in the back-half of the year. So, maybe talk about how you think growth cadences as we look through the year?

Chuck Lauber: Sure, Mike. We have it laid out in our outlook to be pretty much back to normal. When you look at the residential volumes, it’s usually 52%-48%; front-half of the year, 52%, back-half of the year, 48%. And we believe it’s going to get back to that normal cadence. Boilers, typically strongest in third quarter, so we have it laid out a bit like that, similar to prior cadence. China, we’ve got China starting out a bit slow with the COVID disruptions. As you know, the first quarter is always a challenge with the Chinese festival for volumes. And we just got — we got China a little bit lighter in the first quarter, but improving as we go through the year. And normal cadence again on China as fourth, the strongest, we would expect improvement on the COVID situation about fourth quarter, back to our normal routine of that being a strong retail quarter for us.

Michael Halloran: And might as well stay on China, then maybe just talk about how things are tracking from a competitive dynamic, share component to it, the market share component to it, but also how the high end of the market is performing versus the rest of the market? Feels like things are stable, but any commentary on the competitive landscape would be appreciated?

Kevin Wheeler: Yes, Mike, hi, it’s Kevin here. Share is always a difficult when we talked about how the omni-channel hedges go in together, we don’t have great visibility to all the different channels. But what I would tell you, that we believe we’re happy with our sales, we’re happy with our average pricing. We believe we’re getting our fair share of the market and continue to get that introducing new products, as we always do, and bringing products to the market that consumers are willing to pay for. When it comes to the high end of the market, it continues to have that sleeve that makes sense, and it keeps ticking up a little bit. But again, it’s still on a smaller base. We hope as we get through the Zero-COVID lifting and the consumer activity grows in the market, that will improve.

Consumers, right now in China, are — so, our record is — are saving the highest rate that they have ever. So, we look at there could be some pent up demand as we go forward. And again, just looking at China in general, there is some discussions about some consumer stimulus by the government; nothing specific today. Thanks for helping out some of the housing sectors to build up some of their inventory. So, that there’s a lot of positives, but again I think it will take some time as the consumer recovers from three years of, basically, inactivity and lockdown, and starts to get more comfortable. And that’s why, as Chuck pointed out, we’re looking at sequential improvement through the year, but there’s more positives than we’ve seen in a long time in our China market.

Chuck Lauber: And just to add to that, I — we said it in our prepared remarks, we’re really pleased with the consistency, as you noted, Mike, of our performance quarter-over-quarter, that the discipline towards managing our discretionary spend where our outlook for ’23 has us back in a growth mode on constant currency. So, we’re pleased to be — kind of hopefully turning a corner, growing in that 3% to 5% in local currency.

Michael Halloran: Great, really —

Operator: Thank you. Our next question will come from Jeff Hammond of KeyBanc Capital Markets. Your line is open.

Jeff Hammond: Hey, good morning, everyone.