Helen Gurholt:

Thank you, Marvin. Good morning, and welcome to the A.O. Smith second quarter conference call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures, adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of pension settlement income and restructuring and impairment expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning's press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks.

Chuck Lauber:

Thank you, Kevin, and good morning, everyone. I'm on Slide 7. Second quarter sales in the North America segment were $791 million, a 9% increase compared with 2023, driven by higher water heater and boiler volumes as well as year-over-year pricing actions. North America segment earnings of $198 million increased 2% compared with 2023 adjusted segment earnings. The higher segment earnings were primarily driven by increased volumes and pricing that were partially offset by higher steel costs and higher selling expenses to support our growth initiatives including the launch of our gas-tankless products. Segment margin was 25.1%, a decrease of 180 basis points year-over-year. The lower segment margin was due to the reasons I reviewed with regard to segment earnings, which more than offset higher volumes in the quarter. Moving to Slide 8. Rest of the World segment sales of $245 million were essentially flat to last year and included unfavorable currency translation of approximately $7 million, primarily related to China as well as intersegment sales associated with recently launched tankless water heaters. Segment third-party sales increased 3% on a constant currency basis. The increase was partially driven by higher sales of kitchen and HVAC products, partially offset by lower sales of residential water treatment products in China. India sales grew 16% in local currency in the quarter, driven by growth in both water heater and water treatment categories with particular strength in our e-commerce, retail and commercial end markets. Rest of the World segment earnings of $26 million decreased slightly compared to segment earnings in 2023, primarily due to the unfavorable product mix and sales promotions in China. Third-party segment operating margin was 11.5%, slightly lower than segment margin in 2023. Please turn to Slide 9. We generated free cash flow of $119 million during the first half of 2024, a decrease from the same period last year, primarily as a result of higher inventory and accounts receivable balance as well as higher incentive payments associated with record sales and profits last year, which more than offset higher earnings and higher trade payable balances. Capital expenditures increased $21 million year-over-year driven by our expansion projects. Our cash balance totaled $233 million at the end of June, and our net cash position was $93 million. Our leverage ratio was 6.8% as measured by total debt to total capital. Now let's turn to Slide 10. 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 lines and geographies. As Kevin mentioned earlier, we signed an agreement last week to acquire Pureit from Unilever for $120 million. Pureit offers a broad range of residential water purification solutions and has annual sales of approximately US$60 million, primarily in India. The addition of Pureit strengthens our leadership position as a global supplier of premium water treatment products and will double our market penetration in South Asia. The acquisition will also support our corporate strategy by enhancing our premium product portfolio and distribution footprint. Please turn to Slide 11 and our 2024 earnings guidance and outlook. We narrowed our 2024 EPS outlook to an expected range of $3.95 to $4.10 per share. The midpoint of our EPS range has not changed and represents an increase of 6% compared with 2023 adjusted EPS. Our outlook is based on a number of key assumptions, including our guidance assumes that our steel costs in the full year 2024 will be roughly flat to 2023. Our outlook assumes non-steel material costs that are similar in 2024 as they were in 2023. Our guidance also assumes a relatively stable supply chain environment, similar to what we experienced throughout 2023. We began shipping our internally designed and manufactured gas-tankless products in the second quarter. These products are being manufactured in our China facility until our North America capacity is completed in 2025. Associated import tariffs and other launch costs will impact North America margins by approximately 50 basis points in 2024. The tariff will be eliminated when production moves to Juárez, Mexico. For the year, CapEx should be between $105 million and $115 million, an increase over the last several years due to our capacity expansion projects, including our gas-tankless facility in Juárez, the expansion of our engineering capabilities in Lebanon, Tennessee and adding high-efficiency commercial water heating manufacturing capacity ahead of the 2026 regulatory changes. We expect to generate free cash flow of between $525 million and $575 million. Corporate and other expenses are expected to be approximately $65 million. Our effective tax rate is estimated to be approximately 24%. And we expect to repurchase approximately $300 million of our shares of stock, resulting in outstanding diluted shares of $147 million at the end of 2024. 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 2024, while staying on Slide 11. Kevin?

Operator:

Thank you. [Operator Instructions] Our first question comes from the line of Matt Summerville of D.A. Davidson. Your line is now open.

Chuck Lauber:

Yes. Good morning, Matt. Happy to. If you look at the cadence for the back half of the year, clearly, we had a strong first six months. We mentioned a bit of what we believe to be a pre-buy in the North America market with our price increase. So as you kind of look at volumes of North America, we look at Q3 as being a bit challenged because of some of that pre-buy and then Q4, probably looking very similar to Q2. So a little bit of headwind and the volumes in Q3 and a little bit of return back to where we were on Q2 in the fourth quarter with continued momentum on the tankless gas, tankless product. Margins will follow. The margin cadence in the third quarter will be challenged by the volume headwind in the third quarter. In China, we're coming off what I would say, a solid first half of the year, still see weakness in the economy, as Kevin mentioned. As always, our fourth quarter is expected to be the strongest as we go into the back half of this year. Third quarter also will be a bit challenged on the volume side, we believe. We've seen a bit of weakness, July orders, both on China and both -- within -- I'm sorry, within China and in North America. So a little bit of a slow start to the third quarter, and that will probably translate into volume headwinds, and it will leave a little bit of an impact on the margins.

Kevin Wheeler:

Yeah, hi. This is Kevin. Maybe I'll touch base on. Inventories are pretty much where we expect them to be in that 4 to 6-week range. So nothing that meaningful. There's ups and downs as we go forward. What we mentioned is it's a very competitive market. Consumer demand is weaker than it's been. And so the consumers are a bit cautious. So we're seeing a bit more I would say, promotional activities, we saw it in Q1, and that's kind of carried over into Q2 as well. I think our team is managing it really well. Again, we don't chase every order. We're very selective on how we go to market. And if you look at it overall, growing 2% in local currency in a very competitive market it has some consumer headwinds. I think our team has done a really nice job of balancing those competitive dynamics. I also want to remind people that we also have some areas in China that are growing well. You look at our kitchen products are doing well. Our commercial water treatment is doing well and so was our HVAC part of the business. So being diversified as we are on the water heating side and water treatment, but also having the other adjacencies has helped -- it made a difference in this difficult market. So overall, I'm very pleased that we're in China, and we'll keep managing it in the back half of the year.

Jeff Hammond:

Hey, good morning.

Helen Gurholt:

Good morning.

Kevin Wheeler:

Well, I'll take the first part of it and just to talk about the acquisition in general. First, I want to go back to our Indian business is performing really well. We have a terrific management team that's been executing for quarter after quarter. And we're looking to scale that business, both organically and inorganically. And Pureit plays a nice role in that business. It's a solid brand in the market. It complements our India business that we have today. They're stronger in e-commerce, have a nice retail presence - presence that also dovetails with our general trade and our retail presence. So overall, the business is doing well. It's a premium brand. We're not -- we do overlap. We're not exactly have products positioned right next to each other. So if you look at it, the overall, the brand, the product positioning, we're excited about bringing the team on, and doubling our business is going to make a big difference. It's going to make a difference in our scale. We're also going to be able to leverage our infrastructure and that we have on the ground there, whether it be logistics, manufacturing, you name it. So doubling our business is -- we're excited in doing with a premium company like Pureit and a premium brand really sets up nicely as we go forward after the close.

Jeff Hammond:

Okay. And then just on working capital, it seems like you had a much bigger working capital build in the first half versus maybe the last couple of years. Is that just timing? Do we expect to get a lot of that back in the second half?

Operator:

Thank you. One moment for our next question. Our next question comes from the line of Susan Maklari of Goldman Sachs. Your line is now open.

Kevin Wheeler:

Good morning, Susan.

Kevin Wheeler:

If you look at it, it's mainly on the commercial side of our business, Susan. And we came off a pretty difficult quarter last year, but still our quoting [ph] has been active. That transition from kind of standard models to high efficiency continues. So overall, we're about where we thought we would be. Our new products are doing well. I mean, the CREST boilers has always done well, but you add the Hellcat Technology on top of that. And that's just being really well received in the market. Order rates have been good. They continue to be good. Backlog is strong. So overall, I just think the commercial segment is doing well. The overall industry is slightly up, and we're doing better than the industry. And even on the residential side of the business, that's also a positive. So again, 8% to 10% coming off some easier comps, but the overall macro environment is good, and it plays really well into Lochinvar and our high efficiency focus that we've had over the years, and we're seeing some real benefits from that.

Susan Maklari:

Okay. That's helpful. And then turning to steel. We've seen that come down quite a bit recently. How do you think about the flow-through of that to the business, perhaps any impact there to North America over the coming quarters? And just overall, the trend for pricing?

Operator:

Thank you. One moment for our question. Our next question comes from the line of Saree Boroditsky of Jefferies. Your line is now open.

Kevin Wheeler:

Yes. And just to mention, we always give you an outlook for the month we're in on the call. But if you look at -- we talked about a pre-buy, we do believe there was a pull ahead, and we started to see a bit of softness in May and June into July. But I think July is also are one of our weaker months, and really, the third quarter is one of our weaker months because of the summer and the heat and so forth. So that's why we do think it's going to return as we get into August and September, and that's why we're holding a flat rate for the U.S. residential tank type market through the balance of the year. So it's a temporary low that I think just gets us back to what our forecast has been for the entire year.

Kevin Wheeler:

Well, I would tell you, again, we're coming from a low -- kind of a mid-single-digit market share. So we've had a very good launch. And I don't want to give you the numbers because they would sound really high. And they are for us. We're very pleased with the adoption by our customers. The -- and again, we launched the high-end condensing model first, and that's been well received by a number of customers, and it's easily hitting our expectations as we start to launch this product going forward. Again, we'll have two more products coming in by the end of the year, which will complete the line and then our factory in Juárez is on track, maybe a bit ahead of schedule, and we'll start to do some assembly to manufacturing towards Q4 and get ready in 2025. Maybe I'll help Chuck touch on that. But having the tariff go away at the start of 2025 is going to make a big difference in how we view this from a margin perspective going forward.

Operator:

Thank you. One moment for our next question. Our next question comes from the line of Andy Kaplowitz of Citigroup. Your line is now open.

Kevin Wheeler:

Good morning, Andy.

Andy Kaplowitz:

So you mentioned lingering pricing promotion pressure in China. I think you talked about margin there a little bit, but you obviously kept your guidance for Rest of the World margin 10%. So my question is how difficult it is to maintain that margin sort of guidance moving forward? What cost actions or anything else are you doing to sort of offset lingering price pressure?

Chuck Lauber:

Yes. We took quite a few cost actions over - within the COVID time frame in China like Kevin said, to change some of our cost structure to more variable take costs out of the business. Closed some very less profitable store footprints and feel pretty good about our position to be flexible as volumes challenge us a bit. So we'll continue to watch it. Right now, I think we've got China at about 11% for the year, very similar to last year. We anticipate being able to kind of work through it and continue to focus on cost and be at that percentage.

Andy Kaplowitz:

Got it. And I just want to maybe ask the same question on North America, again, like in terms of the margin, like just to make sure I understand it. And so steel [ph] slightly better. You're saying flattish versus a modest headwind, I think, is what you previously said. But you also talked about Q3 maybe being a little light or lighter in sort of volume. And I guess that's the incremental margin headwind holding you back. Is there anything else like launch costs, investments a little higher than you expected? I know you said the 50 basis points. So any color would be helpful.

Operator:

Thank you. One moment for our next question. Our next question comes from the line of David MacGregor of Longbow Research. Your line is now open.

Kevin Wheeler:

Yes. I mean it really tracks closely with volumes, right? So our cost structure on selling expense is largely based on a commission basis. So as we sell more product, we're going to have a higher selling expense. We also emphasize different products with a different commission level to drive initiatives from time to time. So somewhat variable, I think, is the best way to look at it, and it tracks closer to volumes than it does just kind of flat out expenses. We do mention the launch of tankless products. So we've got some initiatives within our launch of the tankless products that's driving that number, just a little bit higher.

David MacGregor:

Got it. Thanks for that. And then as a follow-up on the boiler business, I mean you guided to up 8% to 10% for the year. What's the right way to think about how profitability compares with last year and what you may have in your guidance?

Operator:

Thank you. One moment for your next question. Our next question comes from the line of Scott Graham of Seaport Research Partners. Your line is now open.

Kevin Wheeler:

Hey, Scott.

Kevin Wheeler:

Yes. I don't think we're really trying to message. We've always thought we came off a pretty strong year last year. And going forward, if you look, you look at our - our merchant replacement, which is always going to stay the same proactive new construction. Again, whether it's single-family or multifamily, we felt that was going to be relatively flat. Interest rates would probably keep it flat. So we saw that the pre-buy - we're a little surprised when the 4% pull forward a bit more than we had thought. But when you step back now and you kind of look at how we started the year, kind of a trending down to maybe give some back and then you look forward the next five months. We're just very comfortable as a flat year with strong growth in gas-tankless, and we're going to see some good growth in heat pump both residential and maybe even some commercial as well. So just trying to get back on track where we really think the market is, and we're very comfortable with that flat residential outlook just based coming off a very strong year.

Kevin Wheeler:

No, I would say we're more bullish. I mean we still believe 25% is going to be where we'll end up. We were about at that in Q2 on some really nice volumes. So Q3 will be a little more challenged on that because we will give back some of the volumes at least in our outlook, and then back to volumes that would drop to the bottom line. A little lower steel than our last assumption. So there is a little bit of opportunity on the steel side when we look at kind of our guidance from a quarter ago. But we're still feeling 25% is kind of the midpoint of where we think we'll end up.

Damian Karas:

Hi. Good morning, everyone.

Kevin Wheeler:

Morning, Damian.

Kevin Wheeler:

Yes. I would tell you that, one, I always want to start with is just a calibrate, it's still 2% of the market, but it is a growing category, and it's very specific. You just mentioned New York, California, other parts that are really promoting it. That continues to grow pretty nicely. I mean, we've kind of forecasted a 25% to 30% growth over the next several years, but we were north of that in Q2. So it still gets momentum. We have a great product line. We're having more and more distributors and retailers stock it in a broader variety. So that's a good thing, availability is everything. So overall, the category continues to grow, albeit in certain states. But again, it's well above our growth that we've had, and we see it continuing. It's a great product. We have a great product line. It has a nice payback story. It's just one that needs to be planned and so forth in the markets that are subsidizing it and putting money up front and helping with the purchase, it's growing quite well. So again, 25%, 30% going forward the next several years, and we had a nice Q2, there was several points above that.

Kevin Wheeler:

Well, I would tell you, you described the market pretty well. And so I think what we're hearing from our distributors, they have some optionality and they would like to buy from us. When you look at the commitments we have and the long-term relationships that we have with our distribution and be able to sell not only tank-type and commercial, but also tankless on there, I think, is really important. We still have to meet the market and be competitive and so forth, and we are. So overall, do I expect every one of our distributors to drop their current product lines? The answer is no. But I do look forward to adding a very competitive gas-tankless product line to their inventory and then let us compete in the market. And I think we're going to do very well. It's going to take us several years to move that forward. But again, we control our own destiny now. We have great support from our distributors. And I look forward to what's going to happen with our gas-tankless line as the next few years kind of develop.

Helen Gurholt:

Thank you, everyone, for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered record sales and strong EPS in the second 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 this quarter, Seaport [ph] on August 20, Stifel on September 4 and D.A. Davidson on September 19. Thank you, and have a great day.

Charles Lauber:

Thank you, Kevin, and good morning, everyone. I'm on Slide 6. First quarter sales in the North America segment were $766 million, a 2% increase compared with 2023 driven by higher commercial volumes and the benefits of mix shift towards high-efficiency water heaters, including heat pumps.

Kevin Wheeler:

Yes. Certainly, if you saw January and February AHRI data, and that was up and a portion of that was really due to a prebuy based on our price increase. We expect and see March coming in at a more normalized level and starting to get back to our forecast of a flat 2024 on the residential side of the business. We are -- we entered April with a really strong backlog, and we'll be working that down in the second quarter.

Unknown Analyst:

Got it. And I wanted to touch on the margin here. So I think you're now looking for North America segment margin to come in at a higher end of the range while like maintaining the steel cost expectation. So can you kind of provide more color on increasing your margin expectation for North America?

Michael Halloran:

Just want to clarify what you're talking to right there, Chuck. When you said pressure in the back half, you mean pressure sequentially versus front half, not year-over-year?

Michael Halloran:

So what you're essentially suggesting then is 1Q might be the high watermark? 2Q is still decent. Well, they're all decent margins regardless. And then back half just down a touch from front half, right?

Michael Halloran:

So then could you put the earnings seasonality in context and how you're expecting the earnings to flow through, is this a relatively normal seasonal year from your perspective? Or does some of these margin nuances shift that around a bit?

Operator:

Our next question comes from Susan Maklari with Goldman Sachs.

Kevin Wheeler:

Yes. I will tell you, based on the feedback that we have from our distributors, one, our distributors are all doing pretty well to even to slightly up. Inventories are basically in line. There's going to be some pull forward, but they'll work that off in the second quarter.

Charles Lauber:

Yes. I'll just add that some of the pull forward was within the quarter. You saw the strong data that came out on AHRI through February. For us, we saw a bit of moderation in March. as we kind of work through that price increase.

Kevin Wheeler:

I think there's a couple of points you're making with regards to commercial. One, there was a prebuy there as well. What was a bit different is if you look back to last year and the increase we had in the commercial market, a lot of it was that greater than 55-gallon electric. And in the quarter, we saw commercial gas up kind of mid-single digits, which was a nice positive surprise.

Operator:

Our next question comes from Matt Summerville with D.A. Davidson.

Charles Lauber:

Yes. So we did lower it a bit our guidance. We were saying 3% to 5%. And last year, we grew at 3% to 5%, Matt. And some of that is kind of what we've seen in demand through the first 4 months of the year. We've seen a bit of pressure on our core products as we've come in through the end of April.

Kevin Wheeler:

Yes, just maybe tie into that in Q1, we saw some heavy promotions, particularly in the March time frame. And we took an approach that we are very selective and targeted how we went to market on our approach. We have a premium brand there and really treated as much. So part of that softness we saw in some of the water heating and water treatment product had to do with that. We're not concerned about it. But as you look forward, there's a couple of big drivers there.

Matt Summerville:

Got it. And then as a follow-up, still sticking with China, what's your assessment of channel inventories in China? And then can you remind us how much of your China business today you feel is driven by replacement versus new?

Operator:

Our next question comes from Jeff Hammond with KeyBanc.

Charles Lauber:

Yes. I mean, that 50 basis points is a full year impact. It's kind of on an annualized basis. And production is scheduled mid-2025 roughly. We've broken ground. We've made good progress. We'll give updates as we go, but we're pleased with the start of the construction of the facility in Juarez.

Kevin Wheeler:

Maybe just to make a comment on this. We also limit the amount of prebuy that we have with our price increases. We realized that people are going to try to pull forward a bit. But it's going to be less than 30 days. And again, it's really difficult because business has been pretty good going through the first quarter. How much was prebuy, how much was just the need for the market. And I think it's going to wash itself out as we go into the next month or so. And that's why we've kept our flat U.S. residential industry volumes and where they're at. We don't think the prebuy is going to change our outlook at all.

Kevin Wheeler:

Yes. I would tell you the mix shift, I'll separate that from the gas side of the business, we've always been a high efficiency leader in and that continues to -- as people replace their existing lower efficient products that continues to replace those with higher efficiency. On the heat pup, rebates matter. And they're very regionalized to more on the West Coast and parts of the East. And they do matter. And -- but there's number of programs out there, certainly where we're going with the regulatory side of this in 2029.

Operator:

Our next question comes from Scott Graham with Seaport Research Partners.

Kevin Wheeler:

Well, what I said is we limit prebuys to 30 days. It doesn't mean that everybody pulls in 30 days. And so -- what I've mentioned in our scripted remarks and so forth, as we look out at March, we see March starting to become more normalized. The prebuy is in February, which everybody focused on. March will be as a percentage of an increase year-over-year will be going back down to more as a normalized level. So again, a prebuy is just a pull forward. It doesn't necessarily always mean that there's additional orders out there. And how we're looking at this as we get into the quarter as Chuck mentioned, some of it's already been shipped and maybe a bit is still to be shipped out in Q2.

Charles Lauber:

Yes. And I'll just add we've seen orders in April pretty strong on a relative basis. So we haven't seen a drop in that, Scott. So along with kind of managing, as Kevin said, the orders and then pushing some out and extending a bit of our lead times to manage the order rate. We've also seen decent order rates through April. So we feel pretty good about going into the second quarter.

Charles Lauber:

Yes, it was flat for the quarter. So if you recall last year, we had a pretty decent first quarter in boilers and then we really got a bit of a comp headwind on channel inventories coming down. We had worked down our backlog quite a bit in 2022. So we saw some challenges in boilers last year. So we've got easier comps as we go forward.

Operator:

Our next question comes from Andrew Kaplowitz with Citi.

Charles Lauber:

Yes. Sure, Andrew. I mean, first quarter is always a challenge for us in China on margins. It's usually our lowest margin quarter. And as you know, Rest of the World is largely China. So it wasn't out of line with what we expected for the first quarter. We haven't changed our full year outlook. You're right. We did lower our top line guide a bit. But the team in China has done a great job of taking a look at SG&A being more flexible, more variable on those costs and we have confidence that the team, even with a little lower volume is going to continue to manage the bottom line. So yes, a little bit of a headwind on the top line. First quarter is always a challenge, but we still feel good about that range for the full year.

Kevin Wheeler:

Yes. I think it certainly is a fragmented market. We're in five different channels. So the visibility is not as crystal clear as we would like. But if you look at it, the two things we highlighted was on the consumer demand side of it and just more average pricing for our orders in our consumer side of the business, just a little bit lower people being a bit more price cautious. And then also highlighted the water softeners and that just hasn't rebounded back from where we thought it was going to be.

Operator:

Our next question comes from Damian Karas with UBS.

Kevin Wheeler:

No. It's interesting, we watch that really closely because coming out, it's been elevated, and it's kind of normalized right now at that 30% level. We check it every quarter, and it's still holding up in that percentage. So no change. And with that, of course, our merchant replacement always remains consistent. And we also like what we're seeing in the new construction side, particularly on single-family housing.

Damian Karas:

Interesting. Good to hear. And then I have a follow-up question for you on North American tankless. Obviously, exciting, you're going to start shipping that product in the second quarter. I think you've been soliciting orders maybe since late last year. Any chance you can give us a sense on the level of orders that you've already been able to line up for that product? And how are you thinking about the potential sales impact for this year on that new product?

Adam Farley:

This is Adam Farley on for Nathan. I wanted a follow-up on the commentary around kitchen products in China. Just wondering if you could provide any detail on the percentage of revenue these products account for and maybe where you expect kitchen products in China to go over time?

Adam Farley:

And are these products accretive to Rest of World segment margins?

Operator:

Our next question comes from David MacGregor with Longbow Research.

Kevin Wheeler:

I'm assuming two step, you talked about our catalysts that we talked about during Investor Day?

Kevin Wheeler:

Again, it's been rolled out. We've done a number of pilots. We continue to roll it out to various customers. So I think right now, we're still in the early stages of it. The value proposition of it is outstanding. We're able to have a few models and be able to turn it into 25 different products immediately. So you don't -- when you are not capturing that inventory that you're tying up capital, but more importantly, your availability goes up and your customers are going to get served much, much better. So that continues to roll out. It's not going to be a program for everyone, but our larger stocking commercial accounts. This is a real benefit and a real separation of us in the market on the value proposition. So very pleased with it. Customers seem to be very pleased with it as well, and we'll continue to leverage that with the appropriate customer.

Charles Lauber:

Yes. I mean we've talked about kind of the lag that we see. So we've got -- we have visibility looking forward in kind of a 90- to a 120-day time frame. So you kind of look from April, we can see forward through that amount of time. So really fourth quarter is the biggest risk or opportunity for changes in index in steel as we kind of look forward to the rest of the year. So we've got a decent amount of the year covered from visibility.

Helen Gurholt:

Thank you, everyone, for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered strong sales and earnings in the first 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 four conferences this quarter

Helen Gurholt:

Thank you Abigail. Good morning everyone and welcome to the A. O. Smith’s full year and fourth quarter conference call. I’m Helen Gurholt, Vice President, Investor Relations and Financial Planning & 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 impairment charges, non-operating noncash 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 website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning’s press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today’s call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Chuck Lauber:

Thank you, Kevin, and good morning, everyone. I'm on slide 6. Full year sales in the North America segment rose to $2.9 billion, a 4% increase compared with 2022. Higher volumes of water heaters were partially offset by lower sales of boilers and pricing. North America segment earnings of $726 million increased 19% compared with 2022. Adjusted segment margin was 24.8%, an increase of 310 basis points year-over-year. The higher adjusted segment earnings and adjusted segment margin were primarily driven by higher water heater volumes and lower material costs. Moving to slide 7, the rest of the world's segment sales of $957 million decreased 1% year-over-year, including unfavorable currency translation of $44 million, primarily related to China. Segment sales increased 4% on a constant currency basis. Our sales increase was primarily driven by higher sales of kitchen products and water treatment products in China. India sales grew 15% in local currency in 2023, which is approximately three times the market. Rest of the world's segment earnings of $99 million increased 3% compared to segment earnings in 2022, primarily due to higher sales in China. Adjusted segment operating margin was 10.4%, an increase of 40 basis points compared to 2022. Please turn to slide 8. Turning to fourth quarter performance, we delivered sales of $988 million in the fourth quarter of 2023, an increase of 6% year-over-year led by higher water heater volumes in North America and higher kitchen product sales in China that more than offset lower boiler sales and pricing. Adjusted earnings in the fourth quarter were $0.97 per share compared with adjusted earnings of $0.86 per share in the fourth quarter of 2022. Please turn to slide 9. Fourth quarter sales in the North America segment was $738 million, a 7% increase compared to sales in the fourth quarter of 2022 as a result of higher water heating volumes partially offset by lower boiler sales. North America segment adjusted earnings of $173 million increased 8% compared with 2022. Adjusted operating margin of 23.5% increased 20 basis points compared to last year. The higher adjusted segment earnings and adjusted segment margin were primarily due to higher water heater volumes. Moving on to slide 10. Fourth quarter rest of the world's segment sales of $260 million increased 4% year-over-year primarily driven by sales of new products partially offset by unfavorable currency translation of $3 million in China. India sales grew 11% in local currency in 2023 compared to 2022. Rest of the world adjusted segment earnings of $30 million decreased 6% compared to Q4 2022 segment earnings. An adjusted segment margin of 11.5% decreased 120 basis points compared to segment margin in the same period last year. The decreases were primarily due to promotions and advertising supporting the launch of our dishwasher and steam oven products in China. Please turn to slide 11. We generated pre-cash flow of $598 million during 2023, an increase of 86% over 2022 primarily driven by higher earnings and lower working capital needs. In 2023, pre-cash flow conversion was 107%. Our cash balance totaled $363 million at the end of December and our net cash position was $236 million. Our leverage ratio was 6.5% as measured by total debt to total capital. Now turn to slide 12. As we detail at our investor day, 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 lines and geographies. We target strategic acquisitions that meet our financial metrics of the creative earnings in the first year and return our cost to capital in three years. The strength of our balance sheet allows us to continue to invest in ourselves through research and development and capital expansion while pursuing strategic acquisitions. Earlier this month, our board approved our next quarterly dividend of $0.32 per share. We have increased our dividend for over 30 consecutive years. We repurchased approximately 4.4 million shares of common stock in 2023 for a total of $307 million. We continue our strong track record of delivering return to shareholders. Over the last two years, we have returned over $1 billion to shareholders through our dividends and share repurchases. Please turn to slide 13 in our 2024 earnings, guidance, and outlook. We are pleased to introduce our 2024 outlook with an expected EPS range of $3.90 and $4.15 per share. The midpoint of our EPS range represents an increase of 6% compared with 2023 adjusted EPS. Our outlook is based on a number of key assumptions, including our guidance assumes that steel prices in 2024 will be a slight headwind compared to 2023. Relative to current steel prices, our projection includes a decline in steel price index in the second half of the year. Our outlook assumes non-steel material costs are similar in 2024, as they were in 2023. Our guidance also assumes a relatively stable supply chain environment similar to what we experienced throughout 2023. We are monitoring the situation in the Red Sea in Panama, and currently have not experienced any negative impacts. We launched our internally designed and manufactured gas tankless products earlier this month. As we mentioned at our investor day, these products will be manufactured in China facility until our North America capacity is completed in 2025. Associated import tariffs and other launch costs will impact North America margins by approximately 50 basis points. We are investing in manufacturing in Juarez, Mexico that will eliminate the tariff in the future. For the year, CapEx should be between $105 million and $115 million. An increase over the last several years due to capacity expansion projects related to our gas tankless manufacturing facility in Juarez, the expansion of our engineering capabilities in Lebanon and Tennessee, and an increase in high-efficiency commercial water heating manufacturing capacity to align with regulatory changes coming in 2026. We expect to generate strong pre-cash flow between $525 million and $575 million. Corporate and other expenses are expected to be approximately $60 million. Our effective tax rate is estimated to be between 24 and 24.5% , and we expect to repurchase $300 million of shares of our stock, resulting in our outstanding diluted shares of $147 million at the end of 2024. 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 2024, staying on slide 13. Kevin?

Operator:

Thank you. At this time, we will conduct the question and answer session. [Operator Instructions] Our first question comes from Michael Halloran with Baird. Your line is open.

Kevin Wheeler:

Good morning, Mike.

Kevin Wheeler:

We can. I hope you can hear us also.

Chuck Lauber:

Yes, I'll touch on that. We don't see much difference in 2024 as we forecasted in our guidance that 9.2 million new construction, whether it's single family or multifamily, continues to progress. And we see it flat. And the proactive replacement has stayed very resilient. It's been six to eight quarters now. We just received data from it recently, and it continues to move down that path. And, of course, the [emergency] replacement is a non-discretionary, and we expect that to continue. So, we look at really 2024 as having a very similar outlook as 2023.

Michael Halloran:

Got it. And just to be clear, the 6-ish percent was a 20 or 2023 reference point. Right?

Michael Halloran:

Yes, no, same page, me too. So second question, then, is just putting the North American margins in context. They certainly get the 50 basis point headwind from the investments you're making. Did you talk about why the confidence that down steel costs, the lower levels of inflation or limited inflation remaining, and then, maybe in the context of what you saw in the fourth quarter and how that will ramp through the year? I know a lot in there, but just looking for a little bit more color around that North America margin guide?

Operator:

One moment for our next question. Our next question comes from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Chuck Lauber:

Hey, Jeff.

Jeff Hammond:

Just trying to get a sense of feedback from the channel on the March pricing, you guys put through quite a bit. I think we were a little surprised to see a follow-on here, but maybe just speak to how the channels react into it and what's kind of supporting that price increase. Thanks.

Jeff Hammond:

Okay. And then just on the boiler, you've seen any kind of inflection in boiler demand or has this just growth off of easy comps?

Operator:

One moment our next question. Our next question comes from Susan Maklari with Goldman Sachs. Your line is open.

Kevin Wheeler:

Good morning, Susan.

Kevin Wheeler:

Yes. Again, we've been watching it and it's held pretty steady for a long time. Certainly, as we go forward and look at it, we still see housing renovation, even though things are going to be relatively flat, people are staying in the homes. We think housing renovation is still going to be a big part of how we go forward. And where it goes long term, we're still trying to get our arms around it. We talked a little bit about some generational issues that we've seen. But overall, right now in 2024, we're confident that the proactive replacement will stay steady. And we'll continue to monitor it as we continue over the years.

Kevin Wheeler:

Well, I'll start with North America water heating. We entered the year this year, pretty strong January. And I think we maybe had a little bit lower channel inventories coming into 2023. But we feel like we're in great shape, very normalized on North America water heating. On the boiler and water treatment side, I think we still feel a bit ahead when as we go through the end of 2023, but feel like we're going to exit the year in a good position of normalized inventories. In China, all the channel inventories are pretty much very normal kind of event for a while and kind of continue in that normalized zone.

Saree Boroditsky:

Hi. Good morning.

Saree Boroditsky:

Could you just go back and talk about what you saw from the water heater demand or market tier in the fourth quarter as shipments in October through November seem pretty strong versus the reported results and then any color on what you saw in January from a shipment perspective?

Saree Boroditsky:

Thanks. The rest of the world margins at 10% are flat from this year despite expectations for higher sales. So maybe just talk about some offsets that you expect to see there?

Saree Boroditsky:

Yes. On the rest of the world side, on the margin.

Operator:

One moment for our next question. Our next question comes from David MacGregor with Longbow Research. Your line is open.

Chuck Lauber:

Yes. I mean, so we've got a revenue guide. I'll just tie it back to the overall 3% to 5% growth on the top line. And, we're pleased that there's a number of drivers within that growth, and all of them are within the same amount, roughly. And if you kind of look at, just overall growth on tankless, heat pump, Kevin talked about pricing. We've got boilers growing kind of in that 8% to 10%. We've got North America water treatment growing 10% to 12%. And then, growth in China at 4%. And India, the ones that I mentioned are all very similarly sized. So it contributes in a meaningful way to growth, but it's not, it's not the largest part of growth in North America next year. We, I'll just kind of tie it back to that we were expecting $100 million on the top line over three years. So, when we get to 2026, we would expect to be incrementally there. It'd probably be a little lumpy as we start out, but we're looking for contributions in year one.

David MacGregor:

Got it. Thanks for that. And there's a follow up. I just wanted to ask about China, that the analysts meeting you outlined kind of a three segment, good, better, best market segmentation model. And what if you could just talk about what you're seeing in terms of demand dynamics across those three segments right now. I realize AI link is still pretty new. But if you could share what you're thinking, what you're seeing there?

Chuck Lauber:

Yes. I just put some numbers to that. So I mean, we define kind of the premium sector of the market, above 3000 RMB for electric water heating, and above 5000 RMB for gas water heating and water treatment, which are our core products in China. And the premium sector of the market that we sell, it's been in the 60% to 70% range, a little lower on water treatment, right around 50%. But it's been a nice zip code for quite a while now. So for probably the last couple of years. So we haven't seen a change, certainly hasn't decreased, but it's been pretty steady.

Unidentified Analyst:

Good morning. This is Adam [indiscernible] on for Nathan. My question relates to your balance sheet is in a very good position, significantly underlevered with a strong net cash position. So what are your plans to optimize the balance sheet? And maybe could you provide an update on your M&A pipeline? I'll leave it there. Thanks.

Kevin Wheeler:

I would just maybe add on to that. I mean, our pipeline is active, and we continue to look at spaces not only within our core, certainly water treatment, but geographic expansions, and even levering, potentially our customers and footprints that we have in various industries. So a lot of different spots on the board. We're engaged on a pretty regular basis with a number of companies. And again, just a matter of not it, but when the time comes about. But again, when we look at acquisitions, culture is exceptionally important for us in making sure that we find the right company that fits within A.O. Smith. On top of that, we are going to stay disciplined in making sure that we can return to our shareholders. So putting that all in context, we feel really good about the pipeline, and we'll see if we can bring some of those home in 2024.

Operator:

One moment for our next question. Our next question comes from Andy Kaplowitz with Citigroup. Your line is open.

Kevin Wheeler:

Hey Andy.

Andy Kaplowitz:

I just wanted to follow up on the 10% rest of world margin, 11% in China. You obviously spoke about it the investor day, 400 base points of improvement over the next several years. Do you need a better Chinese economy for that margin expansion to kick in, or do you start to dial down your advertising and promotion soon on the new kitchen products, and that will help? How does that work?

Andy Kaplowitz:

It's helpful color. And then just shifting gears, North American commercial water heater industry had a good year in '23, so maybe a difficult comparison in '24, but you've dialed in the low single-digit growth. So can you talk about the visibility you have to that end market holding up in '24?

Operator:

Thank you. [Operator Instructions] Our next question comes from [indiscernible] with UBS. Your line is open.

Kevin Wheeler:

Good morning.

Kevin Wheeler:

Yes. Details on pricing are really within our strategy here. We've always evaluated each time we bring a price increase to market. And early on, as we discussed, we make sure that we're addressing costs. We always make sure that we feel the cost before our customers is. And the bottom line we're at today is what's going to keep our customers competitive and that's really all we're going to say on the pricey side of this.

Kevin Wheeler:

Yes. Most of the growth that we see in 2024 relates to commercial business and water treatment, water treatment overall, particularly consumables. And then, we do see some growth in our kitchen products that are newly introduced. Overall, the core products were relatively flat year-over-year. I mentioned a little bit earlier about, we've kind of seen the stabilization of maybe what's being sold into the premium side. So, we think we're in a good spot for when the economy does come back, but we're looking at relatively year-over-year or flat for our core products.

Helen Gurholt:

Thank you, everyone, for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered record sales and earnings in 2023. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentation at three conferences this quarter. Citi on February 21, Barclays on February 22, and North Coast on March 7. Thank you and enjoy the rest of your day.

Helen Gurholt:

Good morning, and thank you, everyone, for your patience while we dealt with our technical difficulties. Welcome to our A. O. Smith’s third quarter conference call. I’m Helen Gurholt, Vice President, Investor Relations and Financial Planning & 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 our 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 impairment charges, nonoperating noncash pension income and expenses as well as legal judgment income and terminated acquisition-related expenses. We also provide total segment earnings. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning’s press release, among others. Also, as a courtesy to those in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today’s call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Chuck Lauber:

Thank you, Kevin, and good morning, everyone. I’m on slide 7. Third quarter sales in the North America segment were $710 million, a 9% increase over the same period last year. The increase was primarily driven by higher residential water heater volumes that were partially offset by lower boiler volumes. North America segment earnings of $170 million increased 28% compared with the adjusted segment earnings in the third quarter of 2022. Operating margin of 23.9% improved 350 basis points compared to adjusted segment operating margin in the third quarter of last year. The higher segment earnings and operating margin were primarily due to higher residential water heater volumes and lower steel costs, partially offset by lower boiler volumes. Segment pricing was relatively flat in the quarter compared to last year. Moving on to slide 8. Rest of the World segment sales of $233 million increased 1% year-over-year and 6% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $11 million. Sales of newly introduced kitchen appliance products, higher commercial water treatment sales and a positive mix in China drove the sales increase in the quarter. India sales grew 13% in local currency in the third quarter compared to last year. Rest of the World segment earnings of $23 million increased 6% compared to segment earnings in the third quarter of 2022. Segment operating margin was 9.9%, an increase of 40 basis points compared to the same period last year, primarily as a result of higher sales of new products and a positive mix. Please turn to slide 9. We generated free cash flow of $396 million in the first nine months of 2023, more than 2 times the free cash flow generated in the same period last year. This was largely due to higher earnings and lower working capital cash outlays, primarily related to lower inventory levels and lower 2022 incentive payments paid in 2023. Our cash balance totaled $342 million at the end of September, and our net cash position was $212 million. Our leverage ratio was 6.4%, as measured by total debt to total capital. Our free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return of cash to shareholders. Earlier this month, our Board approved a 7% increase to our quarterly dividend to $0.32 per share. We repurchased 2.4 million shares of common stock in the first nine months of 2023 for a total of $161 million. We expect to repurchase $300 million of our shares for the full year 2023. Let’s now turn to slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth through innovation and new product development across all of our product lines and geographies. The strength of our balance sheet also allows us to pursue strategic acquisitions along with organic growth. Please turn to slide 11 and our revised 2023 earnings guidance and outlook. We have increased our 2023 outlook with an expected adjusted earnings per share range of $3.70 to $3.80 per share. The midpoint of our adjusted earnings per share range represents an increase of 19% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, which include a stable supply chain with limited disruption. We have increased our North America full year margin guidance to be approximately 25% based on our full year outlook on volumes and price cost relationship. We forecast that our Q4 material costs will be similar to our Q3 material costs. Our Rest of the World margin guidance of approximately 10% remains unchanged. We expect to generate strong free cash flow of between $575 million and $600 million. For the year, CapEx should be approximately $65 million. Corporate and other expenses are expected to be approximately $60 million. Our effective tax rate is estimated to be approximately 24%. And with the expectation to repurchase approximately $300 million of shares of our stock, the resulting average outstanding diluted shares, is expected to be 151 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, top line growth outlook and segment expectations for 2023, staying on slide 11. Kevin?

Operator:

[Operator Instructions] Our first question comes from the line of Michael Halloran of Baird. Your line is now open. We will now move to our next question. Please stand by. Our next question comes from the line of Saree Boroditsky from Jefferies. Your line is now open.

Kevin Wheeler:

Well, I’ll tell you -- and we’ve been talking about it each quarter, a biggest surprise has been the proactive replacement side of the business. That’s -- we thought that would moderate as we came into 2023. And quite frankly, it stayed strong and continues to be strong. And we’re very pleased with our number of completions that’s been positive as well. So you put those two together, a surprise, yes, but along with having that strong convergence in place. I mean, you put the two together, and it’s been a good year for water heater demand, and we see that continuing into the fourth quarter.

Chuck Lauber:

Yes. I mean, when you look at our organic growth for the North America segment -- this is Chuck, by the way. Good morning. The pricing contributed very little to segment growth. We had a little bit of incremental pricing on the boiler and water treatment side, a slight headwind on the water heating side. But most of the organic growth in North America was contributed to volume.

Chuck Lauber:

No, there’s nothing significantly -- nothing significant from a onetime item. We are pleased with how the quarter came out from a margin perspective. Margins remain fairly resilient.

Nathan Jones:

I just wanted to follow up on the proactive replacement side of the business, and just see if you can give any more color or any thoughts around why that continues to be so strong. I mean, I would have -- I know part of that is typically generated when you have sales in existing homes. Obviously, high interest rates discourage the sale of existing homes, but that business has continued to be really strong for you guys. Do you think there’s something that’s structurally changed in that market? Would you still expect it to go back to a more normal mix or a more traditional mix of the business? Just any more commentary you can give us on why you think that business is and continues to be so strong?

Nathan Jones:

That would be a nice tailwind, if it’s a structural change to the industry. I guess, my second...

Nathan Jones:

That’s good news. Second question on, I guess, your cost input. You guys had guided to seeing sequentially lower margins in the second half than the first half. And despite the outperformance you’re still are getting a bit lower margins in the second half than the first half, with higher-priced steel costs rolling through the P&L in the second half. We did see pretty significant declines in steel costs over the last six odd months before the last week. Should we expect to see that start rolling P&L in the first half of ‘24, and you should get some nice benefit from a price cost standpoint in the first half price of 2024?

Operator:

Please stand by for our next question. Our next question comes from the line of Bryan Blair of Oppenheimer.

Kevin Wheeler:

[Technical Difficulty]

Chuck Lauber:

[Technical Difficulty]

Susan Maklari:

Maybe to start with, I’m not sure if maybe it’s our line, but I think you broke up a little bit when you were talking about the previous question on raw materials and how we should be thinking about steel over the next coming quarters. Can you just maybe perhaps go back and reiterate some of those key points for us?

Susan Maklari:

No, you’re very clear right now.

Susan Maklari:

Okay. That’s very helpful. Thank you. And then, following up on the conversation earlier as well on thinking of proactive replacement versus the more nondiscretionary pieces of there. Can you give a bit more color perhaps on how you’re defining one versus the other? And as you’re thinking about that potential structural shift that’s coming through, any thoughts on what portion of the volumes today or the demand today is really sort of coming from that proactive replacement relative to the sort of nondiscretionary side of it?

Operator:

Thank you. Please stand by for our next question. Our next question comes from the line of Andy Kaplowitz of Citigroup.

Kevin Wheeler:

[Technical Difficulty]

Kevin Wheeler:

[Technical Difficulty]

Matt Summerville:

Can you guys hear me? Is it clear because every answer is really garbled on my end and that’s happening to at least one other sell-side counterpart that I’m aware of, just FYI.

Matt Summerville:

Yes, yes. No, I appreciate that. If this has already been asked, I completely apologize, but the channel inventories, can you give us kind of what you’re thinking as a year-end assessment, channel inventories will look like in North America in resi water heaters, commercial water heaters, boilers and treatment and how that may inform you as to the volume outlook for each, respectively, a level for next year?

Matt Summerville:

Yes, I can.

Matt Summerville:

Thank you. And then just as a follow-up, and again, my apologies if you answered this already. You’ve obviously kind of been benefiting from this product cycle, if you will, in China as it relates to your kitchen-related offering. When did those products launch? And how should we think about the duration of that cycle on the top line just in the context of the macro environment in China? Thank you.

Operator:

Thank you. Please stand by for our last question. Our last question comes from the line of Damian Karas of UBS.

Chuck Lauber:

[Technical Difficulty]

Chuck Lauber:

[Technical Difficulty]

Helen Gurholt:

[Technical Difficulty]

Helen Gurholt:

Thank you, Eric, and good morning, everyone, and welcome to the A.O. Smith Second Quarter Conference Call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures, adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of impairment charges nonoperating noncash pension income and expenses as well as legal judgment income and terminated acquisition-related expenses. We also provide total segment earnings. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning's press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to 1 question and 1 follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investors.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Charles Lauber:

Thank you, Kevin, and good morning, everyone. I'm on Slide 7. Second quarter sales in the North America segment were $722 million, up 3% decline from the same period last year. The decrease is primarily driven by higher commercial and residential water heater volumes that were more than offset by lower boiler sales and pricing. Lower volumes contributed to approximately 1/2 of the organic growth decline. North America adjusted segment earnings of $194 million increased 19% compared with the second quarter of 2022. Adjusted operating margin of 26.9% improved 510 basis points from the segment adjusted operating margin in the second quarter of last year. The higher segment earnings and operating margin were primarily due to lower steel costs and higher volumes of commercial and residential water heaters partially offset by lower boiler volumes. Moving to Slide 8. Rest of World segment sales of $244 million increased 6% year-over-year and 12% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $14 million. Our sales increase was primarily driven by higher consumer demand and favorable mix in China, particularly for residential and commercial water treatment products. India sales grew 15% in local currency in the second quarter compared to last year. Rest of World segment earnings of $28 million increased 56% compared to segment earnings in 2022. Segment operating margin was 11.6%, and an increase of 370 basis points compared to the second quarter of last year, primarily as a result of higher volumes of water treatment products and positive mix. Please turn to Slide 9. We generated free cash flow of $236 million in the first half of 2023, higher than the first half of 2022 due to higher earnings and lower working capital cash outlays primarily related to lower inventory levels and lower 2022 incentive payments paid in 2023. Our cash balance totaled $410 million at the end of June, and our net cash position was $204 million. Our leverage ratio was 9.8% as measured by total debt to total capital. Our strong annual free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return of cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.30 per share. We repurchased approximately 1,075,000 shares of common stock in the first half of 2023 for a total of $70 million. We are committed to repurchasing $300 million of our shares for the full year of 2023. Let's now turn to Slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth driven by innovation and new product development across all of our product lines and geographies. We believe that our technology leadership and culture of innovation puts us in a strong position to capitalize on the mega trends of decarbonization and sustainability. The strength of our balance sheet also allowed us to pursue strategic acquisitions as we grow organically. Please turn to Slide 11 in our revised 2023 earnings guidance and outlook. We've increased our 2023 outlook with an expected adjusted EPS range of $3.45 and $3.60 per share. The midpoint of our adjusted EPS range represents an increase of 12% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including our outlook assumes a relatively stable supply chain with limited disruption. We remain in close contact with our suppliers and logistics providers to manage and resolve supply chain issues as they arise. We have increased our North America full year margin guidance to a range of between 24% and 24.25% based on our full year outlook on volumes and price cost relationship. We will have higher steel costs in the back half of the year, which will put some pressure on North America margin. We forecast that steel costs in the second half of the year will be approximately 20% higher than the first half of the year. Our guidance assumes that other costs outside of steel remain at current levels. Our Rest of the World margin guidance of approximately 10% remains unchanged. We expect to generate free cash flow of between $550 million and $600 million. For the year, CapEx should be between $70 million and $75 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be approximately 24%. And we expect to repurchase approximately $300 million of shares of our stock, resulting in an average outstanding diluted shares of $151 million at the end of 2023. We I'll now turn the call back over to Kevin, who will provide more color on our key markets and top line growth outlook for 2023, all staying on Slide 11. Kevin?

Operator:

[Operator Instructions]. And our first call comes from Matt Summerville with D.A. Davidson.

Charles Lauber:

Matt, this is Chuck. So when you kind of look at the front half, back half, I think of it in terms of 3 buckets, right? So you've got the price cost relationship to be compressed a bit by steel costs being up about 20%. That's probably the largest piece of the delta between first half and second half. Also the way the year is setting up on residential water heater, we've got the first half, and this is fairly typical, but maybe a little stronger than normal of residential and water heating at about 52.5% to 53% of the year, and then it is 47% to 47.5% in the back half. So there's a little bit of pressure on that because of the detriment of some volume on the residential side. And then the smallest piece, I would say, is kind of related to boilers in the mix, a little bit less mix on the higher end commercial boilers.

Kevin Wheeler:

That was quite a question, there's 4 of them in there. But let me just take the sellout. Sellout was good. It was double digits. We saw sellout improve in each of the months. And so that was a positive trend. Inventories are between that 1% and 2%.

Kevin Wheeler:

One to 2 months, excuse me. Thank you, Chuck. 1 to 2 months and maybe just a tab but nothing out of the ordinary. And as far as going back to water treatment, we just have some terrific products out there that we've introduced, and we mentioned it in our remarks on the hot water purifiers that we have in the high flow. They just continue to be well received in the market. Clean water is a priority for the Chinese consumer. So we see that continuing. And then you throw on top of that, our consumables that were really strong, up over 20-plus percent. And each time we sell a water treatment product, we have that potential of the ongoing consumable for the next several years. So that's gone really well. We continue to see that being a priority for the consumer going into the back half of the year. And as far as water heating and water treatment and electrics, they are tighter bit to some new housing foundations. So that's been under pressure for a while. But the electric side performed well, particularly some of our product that we introduced last year, and that continues to move in the right direction. So overall to be up the 50% in Q2 considering the challenges that the economy is having there, I think, is a positive statement of our premium products and how they're viewed in the market. And maybe the last thing is, if you look at the back half, there is talk about China with some targeted stimulus that's going forward. They've also kind of pulled back on homes as not being able to buy them for speculation. So Q3 may be a little bit tougher, but there's still some positive momentum in a number of areas, not only with our products, but hopefully, with some of the economic stimulus that should take effect in the back half of maybe Q3 and part of Q4.

Michael Halloran:

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

Michael Halloran:

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

Kevin Wheeler:

And maybe just throw in, the team is also doing an excellent job in vertically integrating and cost reductions. And that's going to continue as we go forward as well. We're -- if you recall, we've been a cause of some acquisitions. We're pulling the water treatment business together in 1 company and in 1 water treatment business and be able to leverage each of the locations and put production where it's the best cost for us. So overall, all the things that Chuck mentioned, and just a real strong focus on driving cost and continuous improvement has really benefited the organization. And I look at that continuing over the next 6, 7 months as well.

Joseph Nolan:

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

Operator:

Okay. Our next question comes from Susan Maklari with Goldman Sachs.

Charles Lauber:

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

Kevin Wheeler:

Well, let's just maybe break that down into, again, the replacement side. It's always going to be resilient. The emergency replacement that continues. When we look at right now where it's at, on the proactive side of the business, people are -- we look at -- renovation is still a priority for current homeowners and people are going to be staying in their homes, protecting their mortgage interest rates. So we think that's part of it as it continues to move forward, and we remain an important component of our volume. And then new construction, if you look at just completions have been pretty steady and moving up as well. So and then you look at new builder new builders are confident going forward. So overall, yes, we're up over the 2019, but we had a CAGR of 1.5% to 2% CAGR that you have to put on the 2019 number. And as you start to look at where we're ending up this year, what we think we're going to end up, it's going to be fairly in line with where the industry would have benefit. We didn't go through the ups and downs of the pandemic. So I think we get -- we had a little mixed up in 2021 and '22. And now we're starting to see things more normalize and the economy has been good, housing's been good, our renovations have been good. So if you look out in the next 12 to 24 months, I think we'll start to see more of the normalized growth rate coming out of our water heater business. And maybe just a tad more depending on where interest rates go and how the economy continues to progress.

Andrew Kaplowitz:

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

Andrew Kaplowitz:

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

Operator:

Thank you very much. And our next question comes from Nathan Jones with Stifel.

Charles Lauber:

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

Damian Karas:

So sorry if I missed this, but I was hoping you might be able to give us a sense for pricing in the second quarter in North America, kind of thinking about the 3 product categories, water heaters, boilers and water treatment, if you can maybe just give us a sense where pricing is trending? And is kind of the expectation as we get through the rest of the year, maybe a little bit of modest price fade in North America water heaters, just given kind of steel indexing, but no real formally announced price increases kind of in the wholesale channels?

Kevin Wheeler:

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

Kevin Wheeler:

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

Operator:

Thank you very much. And our last call comes from Jeff Hammond with KeyBanc Capital Markets.

Charles Lauber:

Yes. Let me talk about the industry first. And if we kind of look back and look back at our Q1, we talked about coming out of 2022 with inventories normal, and I think they might have been a little low. So we have got a little help in Q1 on volumes, building back some of the inventories in the industry that may have been depleted a bit. So kind of a little bit of help in that category. I think if you look at the full year though, and Kevin kind of described it, if you skip COVID, and you just go to 2019 and the 5 years before, and take an average of where we are in those 5 years and then look at the jumping off point of 2019, take a CAGR of 1.5%. And you're kind of in the ballpark of where we have the industry this year at flat to up a little bit. The industry ended last year in the tank side on residential, it may be and change. And if we're flat to that or a little bit up, that's a 1.5% CAGR jumping off between 2019. The other part of your question, could you remind me on that?

Charles Lauber:

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

Jeffrey Hammond:

Okay. And then last one, water treatment, I think you're kind of flat to slightly down first half, you're saying 5% to 7%. Is that just lapping tough comps? Or what's driving kind of the [indiscernible] there?

Operator:

Since I'm showing no further questions at this time, I will turn the conference back to Helen Gurholt for closing remarks.

Operator:

And this does conclude today's conference call. Thank you for participating. You may now disconnect.

Helen Gurholt:

Thank you, Eleanor. Good morning. And welcome to the A. O. Smith first quarter conference call. I am Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of impairment charges, non-operating non-cash pension expenses, as well as legal judgment income and terminated acquisition-related expenses. We also provide total segment earnings. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements, that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in our more -- 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 Kevin to begin our prepared remarks. Please turn to the next slide.

Chuck Lauber:

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

Operator:

Thank you. [Operator Instructions] Our first question comes from the line of Michael Halloran of Baird.

Kevin Wheeler:

Good morning, Mike.

Michael Halloran:

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

Michael Halloran:

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

Michael Halloran:

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

Saree Boroditsky:

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

Kevin Wheeler:

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

Chuck Lauber:

Yeah. We are not going to comment on future price increases. Just the commentary on its pricing in total and just to remind -- maybe remind everybody that, our last announced price increase was this November 2021. So we have kind of got a comp where full year 2022 pricing is in place. And so that just kind of wanted to remind everybody that it’s out there for the full year last year and it’s been -- we have anniversaried that price increase last fall. That was our final announced price increase.

Kevin Wheeler:

We just don’t comment on pricing forward looking.

Kevin Wheeler:

Yeah. I -- we talked about it in our prepared remarks, China really kind of played out to what we thought. We did see, January result was a very tough month with Chinese New Year and so forth and particularly coming off of COVID and opening up, but we saw a month-over-month improvement. April is playing out really well. We are seeing our sellout improve over March. So the way we view it, we should see month-over-month, quarter-over-quarter, and remember that the fourth quarter is our strongest month there. So, but it’s probably not the way we thought and as things settle in and consumers get a bit more comfortable, we are comfortable with our guidance of growth at 3% to 5% local currency.

Operator:

Please standby for our next question. Our next question comes from the line of Susan Maklari of Goldman Sachs. Your line is now open.

Kevin Wheeler:

Good morning.

Kevin Wheeler:

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

Kevin Wheeler:

Yeah. I would tell you, it’s -- one, the overall commercial market was up, but it was really driven by the commercial electric and the greater than 55-gallon. That really -- we thought that would not bounce back to pre-22 levels, and quite frankly, it did. So that’s driving much of the growth. But we are also seeing growth see low-single digits in the gas side of the business. So commercial held up well and that’s what gives us the comfort to move it up to that mid-single-digit growth rate.

Matt Summerville:

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

Chuck Lauber:

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

Kevin Wheeler:

Okay. When we look at China, overall, we have talked about this, there’s not a great market share outlet for us to -- we have to put pieces together. But when we look at our retail business, we look at our specialty store business, and overall, we are very comfortable that we are still one of the leaders in the market and we are getting our fair share of the business.

Kevin Wheeler:

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

Damian Karas:

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

Chuck Lauber:

Good morning.

Kevin Wheeler:

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

Kevin Wheeler:

I am not sure I would qualify it as any major changes. Rebates have been out there. They have been state. They have been local. Certainly, there’s the federal side of this now. So what I would tell you that, heat pump continues to grow. It’s coming off a very small base as we talked, is less than 2% of the overall water heater sold. But it’s growing at that double digits pretty regularly each quarter. The future, it’s going to continue to grow. It’s a very good high-efficiency green product that I think has a place long term and so -- but it’s going to continue to grow at a modest pace. Even with the incentives, we are probably going to need regulatory to really drive a fast increase in volume. But you can expect it to grow month-over-month, quarter-over-quarter for the foreseeable future. We are very high in heat pumps, both on the residential side and on the commercial side of the business. They are expensive. They do take a little bit to install. But from a consumer, from a commercial standpoint, they provide really good payback and a really good value proposition long term with the consumer or the business owner.

Andrew Kaplowitz:

Hey. Good morning, everyone.

Helen Gurholt:

Good morning.

Andrew Kaplowitz:

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

Andrew Kaplowitz:

Very helpful. And then, Kevin and Chuck, as REITs have continued to come up and given the volatility around the banks in March, doesn’t seem like you saw any hiccups, but did you -- when you are talking to your customers or channel partners, did you see anything that sort of worries you there, either in sort of core residential or commercial markets?

Operator:

Please standby for our next question. Our next question comes from the line of Jeff Hammond of KeyBanc Capital Markets, Inc. Your line is now open.

Kevin Wheeler:

Hey, Jeff.

Chuck Lauber:

Good morning.

Chuck Lauber:

Yeah. We are not really going to carve out the details around that. I will say, though, I mean, we are up on organic growth for the quarter. So the commercial growth -- residential growth outweighed the price. So we are pleased kind of with our margin expansion in Q1 knowing that we are going to see some pressure on steel in the back half of the year.

Jeff Hammond:

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

Operator:

One moment for our next question, please. Our next question comes from the line of David MacGregor of Longbow Research. Your line is now open.

Kevin Wheeler:

Good morning.

Chuck Lauber:

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

Kevin Wheeler:

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

Operator:

[Operator Instructions] Our next question comes from the line of David MacGregor of Longbow Research. One moment please.

Operator:

David, your line is live.

Kevin Wheeler:

Hey, David. You are pretty tough on the [Inaudible], so.

Kevin Wheeler:

Welcome back. Thanks. Thanks again back in the queue.

Chuck Lauber:

Yeah. So, for the quarter, I mean, water treatment is around 10% operating margin and as you know, we were at 10% and working our way up and our goal is still to expand those margins 100 basis points a year. We are a little behind the curve on that and trying to play a little bit of catch-up because of some of the cost price relationships there, which put a little pressure on operating margin. For the year, we are kind of looking at 11% operating margin. So we are looking to be a little bit better as we go through the year. But, yeah, we have a little catch-up to do on some cost increases.

Kevin Wheeler:

Yeah. I think it’s a combination of what you just mentioned. There will be some productivity. There will be some mix, because we are going to introduce some new products, particularly in our retail segment. So it will be a combination of productivity, mix and a few other things in that 100 basis point increase.

Kevin Wheeler:

Yeah. I just look at water treatment, and again, I didn’t say imminent, okay? I want to make sure that we are clear on that. But when you look at water treatment, it’s a very fragmented market. A lot of smaller acquisitions, we think we are going to be part of the roll-up and so that area is always a bit more active than maybe some of our core products. But there’s always opportunity there. We have to find the right fit, not only for us, but also for the people that would want to sell to us. But I think water treatment is going to be a primary focus and probably will have the most opportunity over the next few years for us. Not to say there’s not others, but that’s why it kind of singled out water treatment.

Helen Gurholt:

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

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.

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. 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?

Operator:

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

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.

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.

Michael Halloran:

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

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?

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?

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.

Operator:

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

Kevin Wheeler:

Good morning, Jeff.

Kevin Wheeler:

Well, steel has stabilized now for a while. So, and through the process it -- there's also been many non-steel related cost that as Chuck had mentioned in our remarks as stabilized. But, they haven't come down. So, we have made the appropriate adjustments there in both channels. And as we continue to reiterate, we are going to keep the channels competitive. Again, historically as I look back over the last year, we are managing our business as we have in the past. And we are a similar view as we go forward. So, our goal is to remain competitive in both channels. We do a lot of business with customers in both channels and that's our commitment. And again, we look at more of stabilization as we go forward since it looks like materials and steel have kind of plateaued and kind of stabilized. So, don't see a competitive issue between the channels or as we go forward into 2023. There is always some historic price paid. But, it's nothing different than we have seen in the past.

Kevin Wheeler:

Yes. I mean that's decline, I think I'll just going comment that if you would have stayed at that the peak, we would have probably been really challenged on the margin profile in North America. But what happened is we kind of grew into a little better margin profile as steel retreated a bit. And, we come out of the fourth quarter and steel does take another tick down maybe 20% to 25% in Q1. And then kind of flattens out. So, we had quite a bit of headwind in '22 on North American margin because of some of the higher steel cost earlier in the year.

Kevin Wheeler:

Yes. I mean where we are looking at is and we committed to $200 million as a buyback. And we are a little bit shy of our cash conversion target of 100% cash conversion in 2022, did that consciously, built inventories, worked our backlogs down. Pleased with that, now we will be working on reducing inventories in the next year. But as we entered 2023, we paid $200 million as the target that we are committed to. We are going to looking at kind of how '23 rolls out from really an acquisition perspective as we go through the year. We may revisit that as we go through the year. And as we work down inventories and see our cash potentially grow a bit. But, we are going to revisit it as we go through the year with the opportunities we think still to be out there on M&A.

Operator:

Thank you. [Operator Instructions] Our next question will come from Matt Summerville of D.A. Davidson. Your line is open.

Kevin Wheeler:

Yes. On the organic growth I mean just a couple of comments around that. So, we always invest in innovation, product development. From a capital perspective, some of those support new product developments. I would say when you get into the developments of the heat pumps, some of the other growth categories where we might have to support that.

Will Jellison:

Understood, okay. And then pivoting to capital allocation conversation to acquisitions, can you speak to actionability of the pipeline? What kind of things you are observing in the market for potential targets out there? And what's your overall thought is for how many of those could be acted upon in 2023.

Operator:

Thank you. And one moment please for our next question. And our next question will come from Susan Maklari of Goldman Sachs. Your line is open.

Kevin Wheeler:

Yes, good morning. Charles says, thank you. Can you help us out there?

Kevin Wheeler:

Yes, first to comment on Q4, we're really pleased where we came up in Q4 in North American margins is 23.3. And I do want to kind of call out the fact that we did have some pretty strong boiler volumes in that quarter. So, that's, that's coming off, we're pleased where we're coming off, but we got some help on some higher margin boiler, commercial boiler, product sales that helped us come out of that. So, the gains for the year on the margins is, it possibly expands a little bit, but we've got our outlook fairly even through the year, the way the balancing kind of occurs. And I talked a little bit earlier on the cadence that it's 52:48 for residential, a little lighter, we have boilers that are usually strongest in the third quarter. So, it's fairly smooth for the year we don't have non-steel costs in our assumption and outlook, coming down a great deal at the back half of the year, potential opportunity as we look at it, but we just, we see some opportunities, but we haven't got much of that opportunity baked into our outlook.

Kevin Wheeler:

Yes, I mean, we did had some great growth in 2022, on the boiler side, and again particularly in the fourth quarter was helped by drawing down our backlogs which we exited the year pretty normal, in that 10% to 12% growth that we see for next year, at 50% to 60% of that is price. So, carry over prices is a little over half of that 10% to 12%. The rest of the growth is on, it's on volume.

Operator:

Thank you. And our next question will come from David MacGregor of Longbow Research. Your line is open.

Chuck Lauber:

From a volume perspective, I would say no, we had some, starts and stops when you have some interruptions, particularly the front half of the year. But we've made all that up, we're back to normal these times on the residential side, we're back to a fairly normal backlog on boiler side and backlog is pretty normal on the North American Water Treatment side, too. So, don't think on a volume side, from a cost perspective a little bit harder to quantify some of those disruptions we saw in the fourth quarter an improvement in our plants operating efficiencies, and that's a result of less disruption in volume that we saw in Q3 and a bit on just more normal cadence to operating volumes.

David MacGregor:

Okay. And just with respect to the '22 impact, there isn't a way to sort of come up with some kind of an estimate on what it might have cost in terms of revenues, realize you're saying the 2023 impact is going to be de minimis, but the 2022 any?

Chuck Lauber:

Supply chain in us catching up on backlog carrying a little more inventory, it actually helped volumes a little bit on the boiler and water treatment side in 2022 because we couldn't work our backlog down with better supply chain.

Chuck Lauber:

Well, I'll tell you that a lot of variables right there. But I will tell you that from our perspective, thank you for the question by the way, just kidding with you. I will tell you, the number one is going to be volume. As we start to lift out of that Zero COVID. And the consumer activity increases and durable goods become more important as they get through all the restaurants and entertainment they're going to do in the first quarter now that they're out about. It's going to be volume related. And we've been volume challenged now for three years there. And we're positioned really well from a structural standpoint. But volume is new products, but it will come down to that consumer getting back in the market and feeling comfortable to start investing back in their homes and buying new home. So, from my perspective, it's one variable is going to be really volume, the rest of the business is really positioned well.

Lawrence De Maria:

Hey, thanks. Good morning, everybody. Just to follow-up in North American margin outlook, could you maybe distill it down into, what's driving it for '23, is essentially the positive carryover price and benefits of the exiting lower steel costs. Anything else in there, maybe mix and then related to that, how would you frame the downside risks to margins in '23 North America based on potential for a price concessions and is there much pushback yet? Thanks.

Lawrence De Maria:

Okay, that's helpful. Thank you. And then if I could just add one more then, the 5% to 7% water treatment growth, what's really underpinning that, it sounded like in your prepared comments, it's mostly price. But given the weakness in residential markets, just kind of curious how to build up their works?

Lawrence De Maria:

Okay, thank you, and good luck.

Andrew Kaplowitz:

Good morning, everyone.

Andrew Kaplowitz:

Can you give a little more color into how you're thinking about the commercial water heater market in '23? I know you mentioned flattop and regulatory overhang, mostly behind you in electric commercial water heaters, maybe sort of what's going on electric versus gas, what's your channel partners are telling you I think you answered about the commercial markets overall, hanging in there, but any more color would be helpful.

Andrew Kaplowitz:

Helpful. And then I know you introduced the Voltex heat pump in Q3, can you talk about your early penetration into the market with that particular heat pump and I know heat pump is still a small part of your business, but how might they become a factor later in '23 and '24 as IRA implications also impact the business?

Operator:

Thank you. This will end the Q&A portion of the conference. I would now like to turn the conference back to Ms. Helen Gurholt for closing remarks.

Operator:

This concludes today's conference call. Thank you all for participating. You may now disconnect and have a pleasant day.

Helen Gurholt:

Thank you, Josh. Good morning, and welcome to the A.O. Smith third quarter conference call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into our 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 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 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 1 question and 1 follow-up per chart. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Chuck Lauber:

Thank you, Kevin, and good morning, everyone. I'm on Slide 7. Third quarter sales in the North America segment were $653 million, a 1% decrease compared with 2021. Pricing actions largely on water heaters were more than offset by lower volumes of residential water heaters. Sales in the quarter also benefited from higher volumes of commercial water heaters and boilers. Giant acquired in October 2021, added $25 million to North America sales. North America adjusted segment earnings of $133 million decreased 11% compared with the same period of 2021. The earnings benefit of inflation-related price increases was more than offset by lower residential water heater volumes and related production inefficiencies as well as higher material and freight costs. Adjusted segment operating margin of 20. 4% declined compared with 2021 operating margin, primarily due to the headwinds I mentioned and acquisition of Giant, which has lower margins than our overall legacy water heater business. Adjusted segment earnings and adjusted segment margin excluded a pretax gain of $11.5 million due to a judgment obtained against a competitor related to the infringement of one of our patents and pretax nonoperating pension expenses of $2.6 million. Moving to Slide 8. Rest of the World segment sales of $230 million decreased 13% year-over-year. Lower sales volumes were primarily driven by consumer demand headwinds in China related to COVID-19-related restrictions. Currency translation unfavorably impacted segment sales by approximately $16 million, $12 million of which impacted China sales. Sales in India grew 16% in local currency in the third quarter of 2022 on strong demand for our water heating and water treating products. 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 $22 million decreased 19% compared to segment earnings in the third quarter of 2021. In China, the impact of lower volumes was partially offset by lower selling and advertising expenses. Rest of the World segment margin of 9.5% was down 70 basis points from the same period last year primarily due to the negative effects of foreign currency translation as well as higher advertising expenses to promote new products in India, partially offset by improvement in China operating margin. Cash flow from operations and free cash flow of $215 million and $164 million, respectively, during the first 9 months of 2022 decreased compared to the first 9 months of 2021 due to lower customer deposits in China, higher incentive accruals from 2021 due to record sales and earnings and greater cash outlays in 2022 for -- and greater cash outlays in 2022 for increased levels of safety stock on higher cost inventory that more than offset lower accounts receivable balances. Cash flow from operations and free cash flow reported today are each $34 million higher than the preliminary cash flows reported on October 13. As a result of separately reporting the impact of foreign currency exchange impacts on working capital. Our cash balance totaled $417 million at the end of September, and our net cash position was $129 million. 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 a 7% increase in our quarterly dividend rate to $0.30 per share. We repurchased 4.5 million shares of common stock in the first 9 months of 2022 for a total of $282 million. Let's now 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 times of economic uncertainty. As a result of our activities to identify water heating and water treating assets that meet our financial metrics, we recognized corporate expenses of $4.3 million related to costs associated with the terminated acquisition. These costs were excluded from adjusted earnings and adjusted earnings per share. The strength of our balance sheet allows us to maintain our 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 that have totaled $650 million since the beginning of 2021. Please turn to Slide 11 and our 2022 full year earnings guidance and outlook. We maintain our 2022 outlook that we updated in conjunction with our October 13 press release with an expected earnings per share range of $1.29 to $1.39 per share our adjusted earnings per share range of $3. 05 to $3.15 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 that they are today, and do not significantly impact our operations, our employees, customers or suppliers. Steel indices began to stabilize at the end of 2021 and have moderated through the current year. Our guidance assumes that average steel prices in the fourth quarter will be approximately 15% lower than the third quarter of this year. We continue to see elevated non-steel materials and transportation costs. We saw continued improvement in our supply chain in the quarter. However, challenges still persist. We remain in close contact with our suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks, but 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 $400 million to $425 million. For the year, CapEx is expected to be approximately $70 million to $75 million. Adjusted 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 $400 million worth of shares of our common stock, resulting in outstanding average diluted shares of $156 million for 2022. Based on these assumptions, the midpoint of our adjusted EPS range represents an increase of 5% compared to 2021. I'll now turn the call over -- back over to Kevin, who will provide more color on our key metrics and top line growth outlook and segment expectations for 2022, staying on Slide 11. Kevin?

Operator:

[Operator Instructions] Our first question comes from Matt Summerville with D.A. Davidson. Your may proceed.

Chuck Lauber:

Yes. I mean let me address that. So for the quarter, you can see what we've presented on our walk forward that our pricing so far, which, just as a reminder, is fully in at the beginning of January. We're anniversarying our last price announcement coming up here in November. So pricing has been into the market for a while. In the quarter, you can see we're covering costs, well covering costs plus our margin. We have seen steel costs moderate a bit. Over time, we typically see some fade on pricing as costs moderate. I want to just kind of remind everybody, though, that it's not just steel costs that we have as part of our pricing portfolio, it's also material cost. We've seen a broader basket of costs go up over time. And those costs have been pretty resilient. So with the lower volumes as we came into the third quarter, we're carrying a little extra inventory. We're a little bit more on safety stock than typical. Some of that is at a bit higher cost, including higher steel costs as we're working through buying still a little bit in advance of some of the volumes. And so we'll see an improvement in the fourth quarter. We expect on margin. Part of that is related to the price cost relationship. And as we exit the year, we expect to be working through the inventory as we exit the year, but we probably still have a little bit of carryover inventory going into next year.

Chuck Lauber:

Yes. We're bound by an NDA to not get into any details on that transaction. I would say, from a process perspective, it followed our normal diligence process. We look at from a diligence perspective, strategic fit. We look at kind of the financial metrics -- And due to the nature of the amount that we got to -- we got pretty far along in the process, but we're really not able to get into any details around that specific transaction.

Operator:

Our next question comes from Susan Maklari with Goldman Sachs. You may proceed.

Chuck Lauber:

Yes. I mean, the cadence is as we kind of look at the price/ cost relationship, we entered the first quarter with our highest cost and pricing was not quite fully in the market. We kind of roll through the year, and I would say the relationship becomes a little better each quarter though we're pressured on non-steel cost as we went into the second and third quarter. We see some relief on steel as we go third to fourth quarter. And so we do expect better margins in the fourth quarter on that cost price relationship. And as we exit the year, we're going to have to see where all the other material costs head into next year. But as we exit the year, we feel pretty good about our price cost relationship and margins.

Kevin Wheeler:

Yes, I would say if you look at our water treatment business has been growing -- it was the first to grow through the pandemic and has done quite well over the last couple of years. I think it's grown somewhere in the neighborhood of 40-plus percent. And the comment we made regarding some professional destocking, that really comes out of our wholesale channel and our professional dealer channel. And I would remind everybody on the call that our professional dealers have had 10 consecutive quarters of growth, really strong growth. And it faced similar but not as abrupt as our water heating, some inventory build, and we're starting to see some of that bleed off in the third quarter. And we expect to see a little bit more as we exit the fourth quarter as well. But overall, business on the wholesale quarter quality dealer side is doing well. Our direct-to-consumer is doing well, retail. And we have a couple of pockets or export in private label that are behind. But this is probably just an adjustment as we get back to some normal levels of cadence in our water treatment business. But overall, the business is doing well and has introduced some new products, we'll continue to do that as we go forward, and we still see double-digit growth in the near to midterm.

Michael Halloran:

So on the resi side of things, North America water heaters, just thoughts on how long you think the destocking takes? Do you think it's mostly run its course here? And any thoughts for where you think the industry volumes kind of settle in that on a unit volume basis?

Chuck Lauber:

Yes. Just a couple of metrics around that, Mike, let me just add to that. I mean we've got the industry kind of going up a bit, 6% to 7% in Q4 compared to Q3. As Kevin said, we've seen orders rebound a bit. So we've got a little bit uptick in the industry. Then if you look at that fourth quarter, we're down -- the industry will be down probably 20% from last year, which was an all-time high from when we've been tracking it. But if you go back to fourth quarters, and I'll say the five years pre-pandemic, so '19 back, it's only a couple of percent down from those years. So it really feels as when we exit the year we're getting more into a normal range for the full year industry numbers.

Chuck Lauber:

Yes. I'll start with share. We feel that we're already in where we've been. We haven't gained or lost. We're kind of still in that same leadership position and in the mix. We are pleased with the quarter. We were down about 10%, right in line with what we expected. Very pleased with managing SG&A. So yes, being down that 10% in local currency and still being at about a 10% operating margin, real pleased with that at that level. The team is managing that well. So very steady performance as we kind of walk forward into the fourth quarter. We've got the fourth quarter up about 20% compared to third quarter, but that's down a bit to last year because last year, if you recall, we had a really robust fourth quarter. A little bit of currency headwind will hit us, but that's just going to happen. And then SG&A, we're going to be spending more SG&A in the fourth quarter. So even though volumes go up, we're going to have a little improvement on the downside. But we really do want to lean into some advertising and selling as we exit the year. So we feel pretty good about the cadence of the business and how our channel inventories are right in line. If you recall, we added to inventory in the first quarter because of some concerns around pandemic and restrictions. That number hasn't changed. It's been steady through the year. We expect to exit the year steady. And that's in that 4 to 6 weeks' time frame.

Operator:

Our next question comes from Nathan Jones with Stifel. You may proceed.

Kevin Wheeler:

Well, I will tell you that let me start -- we haven't really calculated that. But as far as being able to have to pay some of that back. This kind of goes back to the '08, '09 when there was a deep drop and everybody thought that was a clip. We did a lot of work on that. And so -- this is an 8% grade over the last couple of years. That's about over , I think, in units. But again, as you look at it, it's going to be over 120 million to 125 million houses out there. We estimate that each house has 1.2 to believe it or not out there. So it's a base of 150 million. So we really don't see these type of one-offs having a longer-term payback effect just regard from replacement and the type of work that would be done on renovation. We talked a little bit about housing. We'll let that play out a little bit, it's probably going to be a little bit down. But the overall increase, I think, is going to feather out over the next 5 to 25 years, which is the length of life of our water heaters. So really no meaningful downturn that we could see anywhere in the near term or even in the long term.

Kevin Wheeler:

We'll see how we exit Q4, and we'll let you know in January.

Kevin Wheeler:

This is Kevin again. I would tell you, I -- yes and no, but it's -- I'm going to break that up a little bit. On the gas side of the business, commercial gas, high efficiency is doing well we talked to that being flat to down, and that's tracking really well. And our backlogs are clearing up. And all the feedback we have is our customers are not overstock when it comes to commercial gas water heaters. The negative part about the commercial industry this year is really all in that greater than 55-gallon electric. And that's a semi-commercial water heater, if you will, because it also goes into large residential and smaller commercial. And so if you look at what's been happening, all the decline this year is on that greater than 55 gallons, just virtually almost all of it. And then if you go back to 2021, almost all of the increase was the greater than 55-gallon electric. So it appears to me that the industry -- again, you're going to hear us say normalize probably more than once. But it appears that the overall commercial industry is normalizing to a more of a traditional level. So I don't think you'll see the destocking that we have. I think it's already occurring with the greater than 55-gallon and it will be at the appropriate levels as we exit Q4 of 2022.

David MacGregor:

Sorry about that. Technologically challenged. Good morning to everyone. Sorry about that. I wanted to just go back to the topic of pricing, if I could. And you talked about the impact on your anniversary and your 5 increases in 2021 at the end of this year. And so I'm thinking about 2023, and I realize you'll have more to say on that in January. But just as you -- from a planning standpoint, think forward, it would appear that we're heading into a stagflationary environment here. And I'm just wondering how you think about your opportunity to take further price actions in a softening demand environment?

David MacGregor:

Is it possible to just address the question sort of theoretically in terms of pricing power or your ability or how confident you are in your ability to do something rather than specifics?

David MacGregor:

And you talked about steel prices coming back, but could you talk about non-steel cost inflation and where you think that level may be?

David MacGregor:

My second question, it really gets back to capital allocation. And just wondering, you've articulated a fairly definitive sort of set of priorities around capital allocation. I'm just wondering how those priorities may change in a recessionary environment? And to what extent maybe share repurchases become an increasing sort of priority for use of cash under those conditions?

Operator:

Our next question comes from Damian Karas with UBS. You may proceed.

Chuck Lauber:

Yes. Let me try to explain kind of the cost actions. I mean the actions are really, I would say, rebalancing and aligning our manufacturing facilities to line up with -- what we see now is lower volumes. When we were going through the quarter, we expected volumes to come back quite candidly in the fourth quarter and as we exited the third quarter, which, as we mentioned, did not come back. So there was a bit of hiring churn to make sure we can meet demand. We're always going to make sure we're in a position from a labor perspective and component perspective to meet demand. So there was a bit of churn there. And as we exited the quarter, I'd say the rebalancing on the labor side, where we expect less churn in labor. We're in a good position. First half of the year, if you look back on demand, getting products out the door was a bit of a challenge. We're in a better position on preventative maintenance. All the components that make the plants run more smoothly. We're just set up a lot better going into the fourth quarter. And I mean to quantify that, I mean, probably think about operating. I mean, certainly, you've got the volume piece, which clearly drops to the bottom line and a margin perspective. But just from an efficiency perspective, we think of it in terms of incrementally the fourth quarter from a plant efficiency being in that $5 million range better for the quarter.

Kevin Wheeler:

I would tell you, right now, probably not much different. I always follow back on when it comes to pricing and doing business with our customers globally, quite frankly. Our job is to make sure that we keep that competitive. So that's our number one driver in the market, making sure the pricing that we have and the programs that we have allow our customers to grow and compete. So those conversations probably -- they haven't changed quite frankly, because -- and Chuck mentioned it a few times now, still used to be the major component we always talked about because it moved a lot -- the rest of the business kind of stayed relatively stable, that's really good. So there's still price pressures out there. There's still cost pressures out there. And it's not just for A.O. Smith, it goes down to our distributors as well who ship products to customers and, of course, buy other materials. So there's not a great deal of change in our conversations, which I think it's a good thing for the industry, and we'll continue to stay close to our customers and make sure that they stay competitive.

Andrew Kaplowitz:

So your boiler business and specifically commercial condensing boilers seems to be quite resilient. Maybe you could talk about the backlog you have there and what kind of visibility you have moving forward? And obviously, you've -- you'll have more difficult comparisons going into '23 in that segment, but it seems like energy efficiency is really driving that demand.

Andrew Kaplowitz:

If I could ask you a question on your residential water heater business in maybe a slightly different way. You said that you've got the industry up 6% to 7% in Q4 versus Q3. You mentioned volumes have been recovering in October. But we keep seeing sort of increasing pressure on the consumer mortgage rates are going up. So how much visibility do you have just into the quarter itself? Do you have -- you've said in the past, you can see inventories that are a little harder to see inventories in the channel. So what kind of visibility do you have into sort of the near term?

Chuck Lauber:

And just a commentary on how we think about housing. So you're correct. I mean there's mortgage rate increases. There's some pressure on housing and new construction. But for us, it's really completions, and we -- there's a bit of a lag when people start the construction process and then put in the war heater and finish out the construction process. So some of the some of the lag should help us carry through the year on housing. And we're going to really look at that number as we enter '23 on the housing side.

Jeffrey Hammond:

Last one covered here. I just want to hit on kind of what feedback you're getting or how you're thinking about kind of this IRA impact around heat pump water heaters. And just you mentioned kind of the new product introduction, just maybe level set us on how you think about market share in that space relative to kind of your traditional water heater market share?

Operator:

I would now like to turn the call back over to Helen Gurholt for any further remarks.

Operator:

This concludes today's conference call. Thank you for participating. You may now disconnect.

Helen Gurholt:

Good morning and welcome to the A.O. Smith second quarter conference call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency in the operating results for 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 on non-operating, non-cash pension income and expenses. Reconciliation from GAAP measures to non-GAAP 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 risk 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 return. 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 [email protected]. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Chuck Lauber:

Thank you, Kevin and good morning everyone. I'm on slide 7, second quarter sales in the North America segment rose to $744 million, a 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, boilers 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 to North America sales. North America’s 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 cost 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, plants in production and efficiencies and the inclusion of Giant which has lower margins than our legacy water heater business. Moving to slide 8, 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's 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 of the World segment margin was 7.9%, down 60 basis points from the same period last year. Free cash flow of $24 million during the first half of 2022 decreased from the first half of 2021 due to higher 2022 earnings that were more than offset by lower customer deposits in China, higher incentive payments due to record 2021 sales and earnings and greater cash outlays for increased levels of safety stock and higher costs 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. 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 returning cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.28 per share. We repurchased 2.9 million shares of common stock in the first half of 2022 for a total of $190 million. So I'll 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, 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 dividends that we have increased for 30 consecutive years, as well as share repurchases that have totaling 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 US, and that COVID-19 related restrictions in China remain approximately at the level 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 persist. We remain in close contact with suppliers and logistic providers to troubleshoot, manage and resolve bottlenecks. But the environment remains unpredictable. We continue to see the benefit from multiple 2021 price increases compounded to approximately 50% for water heaters. We expect to generate free cash flow of approximately $450 million to $500 million. The range 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 to 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 those things on slide 11. Kevin?

Operator:

[Operator Instructions] And our first question comes from the line of Mike Halloran with Baird.

Chuck Lauber:

Sure. Good morning, Mike. This is Chuck. Yes, we're really pleased now China perform for the quarter. We, on our last call talked a little bit about consumer demand being down 35% to 40%, in April, and as you recall that was really the hardest and the severe lockdowns in Shanghai and Beijing. But what we saw in consumer demand for the course of the quarter was consumer demand and it 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 is we're down about 5% to 10%. So the consumer demand went through pretty well to kind of back to the first quarter. So we're -- then our assumption and guidance is that it stays at that level, kind of for the rest of the year. Inventories, they're 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. There's about three to four weeks in the inventory -- in the channel. And that's pretty normal for us, it's at a decently low point. And I'd say we're pleased with 9% in operating margins for the quarter on that lower volume. Some of that was helped by discretionary spending, as we mentioned, that's probably $3 million or so of help on discretionary spending. I'm talking about promotions, advertising, and very little travel for the quarter, as you can imagine in the lockdown situation. And we would expect through the second quarter or third quarters, similar ability to kind of demonstrate this controlling discretionary spending, probably back to spending in the fourth quarter. As that's our largest typical quarter in China. And probably, our projection is to turn that back on. And we would hope for a strong fourth quarter similar to last year.

Kevin Wheeler:

Well, I think, as we talked about where we're forecasting the 4% to 6% downturn, and we truly believe, and we saw quite a bit of that in June, where we saw many of our customers can bring in inventories down. And, again, as we go forward, this year we look at it's starting to normalize beginning into August, September and the rest of the year. Where it goes forward, I think it's going to depend upon some new construction, but it's 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 and some of the economic disruptions that we're going through today. But still, you look at it still going to be 80%, 85% replacement emergency is going to be very resilient. And there's always going to be potential upside on the new construction if we can kind of get through this supply chain interest rate issue that we're kind of navigating through today as a country.

Operator:

And our next question comes line of Nathan Jones with Stifel.

Kevin Wheeler:

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 it in July. And you step back right now you look at overall in the industry, production has improved, lead times are down. So it's becoming a much more predictable environment. And so with that, I think all of our customers are going to reevaluate. I still think it'll take part of July and maybe a little bit of August, and then kind of normalize as we go through the balance of the year.

Nathan Jones:

Make sense. People 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 your products overall. Prices on water heaters are up a lot. They needed to be because steel was up a lot. Cold rolls and hot roll that down probably about 50% from peak prices now. Can you talk about your expectations for how price goes from here, obviously, it'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. If steel prices kind of stable from where they are now.

Operator:

And our next question comes from a line of Andrew Kaplowitz with Citi.

Kevin Wheeler:

Hey, Andrew.

Kevin Wheeler:

No. You were you were muted for a while. So could you start over, please?

Kevin Wheeler:

Sorry about that.

Kevin Wheeler:

Yes, I'll take that. As we mentioned, we still think commercial gas is going to be flat to slightly down. So that's moving along. But the regulatory change that we experienced in the first quarter, we're seeing our orders normalize. But as we go forward, we believe of the 7% and 9% that we have forecasted being down almost 90% positive, it's 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 backdrop of why we're going down, the rest of the commercial businesses quite strong and doing well. And 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's about a 4x or 5x to our commercial overall business, excluding the light service when it comes to price. So 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 that's going.

Chuck Lauber:

Yes, I'll start out and Kevin may add on a little bit after that, but I mean, the puts and takes. It’s price versus costa and it's what we are seeing a bit of softening on the steel pricing. So we're getting a little bit of help there. But it's not just the water heating 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 we had a bit of destabilization during the quarter of water 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, our water 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 there's 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, we still feel good about commercial, particularly gas commercial product being strong for the back half of the year. And then boilers and our 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 the -- we expect help on the mix side also.

Operator:

And our next question comes from the line of Matt Summerville with D.A. Davidson.

Chuck Lauber:

Yes, I mean, it's hard to call out exactly what's COVID and what's the overall economy in China. So it's really hard to parse that but clearly, we were impacted negatively by COVID. And consumer demand out the door was down about 20%. So that was kind of out the door demand. I would say just kind of within our product categories, certainly the residential products were challenged most so I would say, electric water heaters and water treatment were probably the most challenge during the quarter, commercial water heating, commercial water treatment, the commercial side that's not sold through retail, kind of offset some of that 20% down which viewed as the number for overall sales volume.

Kevin Wheeler:

Yes, I'll take the magnitude and maybe Chuck, you can jump in on any of the pricing side of it. Certainly, we haven't seen this type of backlog, we're in the three to four month range, to be honest with you. And it's mainly commercial. So what's important to know here in our backlog is we actually have shift days for the vast majority of all our orders in house. So there may be a put and take that we see where a job gets pulled in, maybe gets kicked out a little bit. But overall, we see nothing that would cause a material change, the backlog is 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 the heart of our business.

Operator:

And our next question comes from the line of David MacGregor with Longbow Research.

Kevin Wheeler:

Yes, okay. When we talked about replacement demand, there's two components of it, you have kind of the proactive replacement, and then you have the emergency replacement. The proactive side, which is renovation, probably driven by kind of remote work had been pretty strong, we saw that, it's coming down a little bit, we test that every quarter and have a good read on that. As far as the overall emergency replacement that will always remain resilient. I mean, people just don't go without hot water for any length of time. So yes, the residential visit has those components. Again, I just want to remind people that 50% of our business is that new construction. So even if it drops a little bit, it's pretty nominal for us. And but it's nice upside and as we go forward. But that's how it plays out. And we feel pretty comfortable with our 4% to 6%. And again, as I mentioned the, I think a lot of the channel inventory adjustments would come out in June and July and a little bit of August. From a shared perspective, we have really good data on that. We talked about this last year and into the quarter that we were a little bit behind. We really expected, I expected that it would normalize as production came up and lead times came down. And that's actually playing out really well on the residential side. I will tell you, we're slightly up moving towards our normal historic market shares. And I'll just throw in commercial, we're already back to our normal rates.

Chuck Lauber:

Yes, it's 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, and that 80% to 85%. So the replacement piece continues to be resilient. Usually the commercial side would typically lag the residential side, you've got projects in progress, and you’ve got quoting that's happening in advance. And so it's a little more stable and longer. And I, 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 products just as reminders, high efficient, energy efficient product that pretty resilient in downturns because of the energy efficiency nature that continues to want to drive a replacement.

Chuck Lauber:

Both, they're very similar.

Jeff Hammond:

Hey, good morning. Just wanted to ask a similar question on, I guess Dave did on the water treatment business. It's a newer platform and just trying to it seems to be something maybe a little more discretionary than a water heater replacement. So just how you think that business would perform in a recession scenario?

Jeff Hammond:

Okay, and then seems like the new entrants in the water heater space kind of finally got the plant open. And I'm just wondering if you're seeing them in the marketplace at all. And if you think there's any pricing disruption around that particularly as input costs rollover, thanks.

Operator:

And our next question comes from the line of Scott Graham of Loop Capital Markets.

Kevin Wheeler:

Again, that's going to be very speculative. The reason I feel confident in the water heater market is I'd still go back to and again, I'm not sure when it's going to normalize. But new construction, there's 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, yes, again, and quite frankly, as things get a little tougher people do more renovation. But I think it's, if you look at our history the growth rate in the residential water heater market, it's been at that couple 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 normalize to kind of a run rate that we've seen in the past. The great news of it, though, there's more water heaters out there today, and that's going to go out 10-14 years, that's going to play really well for the industry and for our company. So that's kind of the high level, it's really hard to get into much more detail than that, Scott.

Chuck Lauber:

Sure. I mean, premium I'll just, premium side of the market is so about, the low end is about 40% premium on the electric water heater side, the high end is nearing 50% premium on the water and the gas and the gas tankless and then water treatments kind of in between. So not a great deal of change of little uptick on the electric side, we introduced a couple new products, a good dual tank, slimline product on the electric that we're hoping to get some traction on, which bumped that up a bit.

Chuck Lauber:

Well, quarter-over-quarter for electric it was up and we think it's -- it is due to some new products. Hard to say there 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 an uptick from the last quarter. Not a large uptick but only positive.

Scott Graham:

Got it, thank you. And just a follow up then on the share repurchases. I know you're kind of still locked in at that $400 million. I'm just sort of wondering what the market weaker resi conditions, obviously sliding yet you're still having some fairly stable sales based on 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?

Scott Graham:

Yes, Chuck, I guess on that, I guess my whole thinking, of course, is that it's not just about the cash flow, but it's also about the balance sheet. You guys have been running in that cash position for like a decade. And 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?

Operator:

[Operator Instructions] Our next question comes from the line of Damian Karas with UBS.

Chuck Lauber:

Yes, this is Chuck. I won't go beyond this year. But when you think about kind of the detrimental margins, and we're really just talking about residential water heater detrimental margin, and then what Kevin mentioned, the light commercial, so you probably think of that in the 35%, detrimental margin range. Steel cost, we've kind of got those visibility, and we have visibility into those costs through the third quarter for sure. And we're starting to see visibility into second. So we feel pretty good about that. So that's probably the next largest driver. And then the stabilization of order rates, as we expect we had a little bit of a disruption in the end of June, and in 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 for the back half of the year we're going to, our guidance is 22.5 to 23, right. And we're kind of tracking below that right now. So we do expect a decent uptick in Q3. And then incrementally Q4 as some of those price increases, I mentioned that water treatment and lock-in and boilers come in. And as we see probably our most favorable steel, for sure, in the fourth quarter. So that's how we kind of think about that margin expansion.

Kevin Wheeler:

Well, let me separate that to a residential heat pump versus a commercial heat pump, because I think they're both different markets. The residential heat pump is still an upsell product, it's one of the best value propositions we have in our company. But it's a 3x or 4x regular electric water heater, and there's some installation challenges. There are quite a bit of subsidies out there, whether it be up to state city, which is helping, and that's going to continue to grow. I mean, there's no doubt that it'll grow. It'll grow at a moderate pace, I believe, unless it's regulated in, but it's going to continue to grow. And it's going to be a 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 there's a lot of activity out there. But that's trailing the residential side, just because it does have some size to the installation. And it requires a tank. There's 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 we see activity in it. We obviously have products that we participate in, but I think both of those categories are going to grow at a percentage rate pretty high but as an overall volume still going to be more of an upsell product unless there's some regulatory changes that come.

Helen Gurholt :

Thank you for joining us today. Let me conclude by reminding you that our Global A. O. Smith team delivered strong sales and earnings in the second quarter despite many challenges. 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 four conferences in the third quarter. Northcoast on August 8, Jeffries on August 9. Stifel on September 7, and Davidson on September 22.

Helen Gurholt:

Thank you, Catherine. Good morning and welcome to the A.O. Smith first quarter conference call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; Chuck Lauber, Chief Financial Officer. In order to provide improved transparency to our operating results, we provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Charles Lauber:

Thank you, Kevin. Good morning, everyone. I'm on Slide 7, first quarter sales in North America segment rose to $730 million, a 32% increase compared to 2021. Pricing actions largely on water heaters represented approximately 89% of the increase. Sales in the quarter also benefited from higher volumes of boilers and water treatment products. However, the sales increases were partially offset by lower volumes of commercial water heaters. Giant acquired on October 19, 2021 added a $32 million to North America sales. North America adjusted segment earnings of $154 million increased 21% compared with the same period of 2021. The earnings benefit of inflation related increases was partially offset by higher material and freight cost and lower commercial volumes. Adjusted segment operating margin of 21.1% declined compared with 2021. Margin performance sequentially improved each month through the quarter as COVID 19 related absenteeism and supply chain constraints eased through the quarter. North America operating margins exited the quarter at the top end of our full year margin outlook for North America. Moving slide eight, rest of the world segment sales of $256 million increased 15% year-over-year. Favorable mix from new product introductions in the premium segment of the market, particularly our slim line electric wall hung water heaters and water treatment products that deliver hot and ambient filtered water as well as higher sales of commercial water treatment products and water treatment filters contributed to sales gains. As Kevin noted, sales in the first quarter were positively impacted by proactive measures to distribute product into the market in advance of potential COVID 19 disruptions in China. India continues to perform well and sales grew 36% in the first quarter compared to 2021. 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 $25 million increased significantly over segment earnings in the first quarter of 2021. In China, the benefits from favorable events, higher volumes and lower advertising and selling expenses drove rest of the world segment margin to 9.7%. Free cash flow of $4 million during the first quarter decreased from the first quarter of 2021 due to higher 2022 earnings that were more than offset by higher incentive payments due to record 2021 sales and earnings and higher cash outlays for higher 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 $579 million at the end of March and our net cash position was $284 million. Our leverage ratio was 14% as measured by total debt to total capital. Our strong and annual free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return cash to shareholders. Earlier this month, our board approved our next quarterly dividend of $0.28 per share, which represents our 82nd consecutive year of dividend payments. We repurchased 1.5 million shares of common stock in the first quarter for a total of $108 million. Let's now 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. We continue to target strategic acquisitions with a focus on water heating and water treating assets that meet our financial metrics of accretive earnings in the first year and return our cost to capital in three years. We have a proven track record of developing innovative new technologies and making prudent and focused acquisitions to drive shareholder value. 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, which include no further significant surges of COVID cases in the US and that COVID related shutdowns in China subside during the second quarter of 2022 and do not significantly impact our operations, our employees, customers or suppliers. Steel indices began to stabilize at the end of 2021 and steel fell briefly early in the first quarter of 2022. However, due to the international uncertainty on commodities availability and prices, in part due to the conflict in Ukraine, steel market prices have risen again in recent weeks. Our guidance assumes that steel pricing in 2022 on an annual basis will approximate steel market pricing as mid-April -- as of mid-April. We continue to see increases in non-materials -- non-steel materials and transportation costs. Supply chain challenges persisted in the first quarter. We remain in close contact with suppliers and logistic providers to troubleshoot, manage and resolve bottlenecks, but the environment remains unpredictable. Our outlook assumes we continue to see the benefit from multiple 2021 price increases compounding to approximately 50% for water heaters and continued resiliency and demand in North America for our water heating product categories, driven by replacement demand and new construction spending. As for other housekeeping assumptions, we expect to generate free cash flow of between $500 million and $525 million. For the year, CapEx should be between $75 million and $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 worth 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 represents an increase of 17% compared with 2021. I will 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 2022, all while staying on Slide 11, Kevin?

Operator:

[Operator instructions] And we have our first question from Matt Summerville with D.A. Davidson. You may ask your question.

Kevin Wheeler:

Yeah, Matt, this is Kevin. I'll comment on that. We believe the market is going to be coming in on the residential side around that 2% range plus 2%. Commercial will be down I'm thinking somewhere in the 20% range and there's some reasons for that, that we outlined with regards to a regulatory change. So that's how the market we see coming in the first quarter in the US. How we did, we certainly got our fair share of both those markets. We performed again, we started out the year again with lot of COVID and weather. So as we outlined in our remarks the first month and a half were pretty tough. We had a really strong finish, particularly our residential teams did very well in the back half, particularly in March. So we feel we did well. Maybe a bit better than the market, but overall we certainly got our fair share, both the residential and the commercial business,

Charles Lauber:

Okay. Yeah. Hey Matt, it's Chuck. Yeah, China. So that 35% to 40% down in China, consumer demand, just to kind of frame that, that's April, that's what we're seeing in April, which is sequentially worse than what we saw in the first quarter. The way we think about it is and by the way that sector of what we're measuring here is consumers. So that's about 75% of our business. The commercial side does not fall into that metric. It's more the consumer spend that we're referencing there. Haven't really seen a change to that as we kind of look through the month of April, it's been fairly steady at that rate. In the first quarter, it was down in about to 10% range. So sequentially, it was worse. The way we think about it some pretty heavy lockdowns right now in April. So our assumption or our guidance is that that does subside as we go through the year. That does improve as we get, towards the end of the second quarter and sequentially, maybe the third quarter looks something like the first quarter, as far as consumer demand and then kind of get, gets more back to normal in the fourth quarter. So Q2 will certainly be the lowest quarter of the year for us when you think sequentially and Q4 once again normally is should be the best quarter of the year in China.

Operator:

And we have our next question from Scott Graham of Loop Capital Markets. You may ask your question.