A.O. Smith Corporation

Ladies and gentlemen, thank you for standing by, and welcome to the A.O. Smith First Quarter Results Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press Star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press Star 0. I would now like to hand the conference over to your speaker today, Ms. Ackerman, Senior Vice President, Investor Relations. Corporate Responsibility and Sustainability and Treasurer. Thank you. Please go ahead.

Thank you, Rache. Good morning, ladies and gentlemen, and welcome to the A.O. Smith First Quarter 2020 Results Conference Call. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer, and Chuck Lauer, Chief Financial Officer. Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. As a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have more than two questions, please rejoin the queue. I will now turn the call over to Kevin, who will begin our prepared remarks on slide three.

Thank you, Pat. Undoubtedly, these are unprecedented times. With safety and well-being of our employees as the highest priority, I am extremely proud of our entire team supporting our customers with essential water heating and water treatment products to combat this virus. As a result of the COVID-19 pandemic and in support of continuing our manufacturing efforts during this time, we have undertaken numerous meaningful, in some cases extraordinary steps in our manufacturing plans to protect our employees. These steps include plant accommodations and reconfigurations, to maintain social distancing, mask availability to all employees, deep cleaning, quarantine individuals with positive tests or potential exposure to the virus for 14 days, and restricting access to facilities, among others. While these steps result in lower manufacturing efficiencies in some cases, our focus is on safety first. The majority of our office personnel have been working from home and have done a great job and maintaining productivity and support of the business. As offices have reopened in China and will soon in other countries and in the U.S., we have implemented return-to-office protocols, which include bringing back office staff in waves over a two-month period, making masks available, more frequent cleaning of common areas, sanitizing stations throughout the office areas, and limited use of conference rooms for small group meetings to maintain social distancing. Our long-term relationships, in many cases decades long, and strength of our partners within various channels, including wholesale distributors, DIY retail, hardware stores, plumbing supply, and independent reps are particularly important as we provide the essential water heating and water treatment products critical to uninterrupted operations of hospitals, clinics, grocery stores, food service companies, and many more, including the households that many are now using to conduct business and education. Our global supply chain management team proactively monitors and manages the ability to operate effectively and identify bottlenecks. To date, we have not seen any meaningful disruption in our supply chain. We engaged in ongoing communication with our supply chain partners to identify and mitigate risk, including multi-sourcing and managing inventory at higher levels. Our recent implementation of SAP has provided improved management tools and visibility into our supply chain. Additionally, we have improved our manufacturing flexibility as a result of water heater tank standardization projects over the last five years. Standardization greatly improves our ability to shift manufacturing work from one plant to another should the need arise. The stability afforded by the replacement component in residential and commercial water heater and boiler demand, which we estimate at 85% of the U.S. unit volume, puts us in a position of strength as we navigate through this pandemic. We estimate replacement demand is 40% to 50% in China. While we are in a position of strength, similar to 2008 and 2009 timeframes, We expect to see lower demand for the majority of our products and have a proactive in managing costs. We have increased our cost reduction programs in China. We continue to monitor the North American environment and customer demand to potentially take further actions such as furlough programs and other restructuring. A.F. Smith is in a solid financial position with positive cash flow and a strong balance sheet. I will turn the call over to Chuck. who will elaborate on our cash and liquidity on slide four.

Thank you, Kevin. While A.O. Smith has a strong balance sheet and capital position, we are proactively managing our discretionary spend and cash position. To that end, we suspended our share repurchase program in mid-March. In addition, while we continue to focus on strategic investments, including new products and production efficiency, we have reprioritized and reduced our capital spend plans for 2020 by approximately 20%. Through April, we have completed $200 million of dividends out of China, and we have repatriated $125 million to the U.S. As of April 30, 2020, we had approximately $850 million in liquidity consisting of cash, cash equivalents, marketable securities, and borrowing capacity on our credit facility. which remains in place throughout 2020 and 2021, expiring in December 2021. We continue to focus on right-sizing the cost structure of our China business. We have achieved a 20% headcount reduction compared with December 2018, and we will continue to assess the need for additional workforce reduction. We are targeting 1,000 net store closures this year in China, along with further cuts in advertising and other costs. Total savings are expected to total $55 million, an increase of $10 million from our estimate in January, of which $30 million was achieved in 2019. Our debt maturity schedule is shown on slide five. The next major maturity date is at the end of next year, in December 2021, when our revolving credit facility expires. We are in compliance with all covenants in our credit facility, Our leverage ratio is 17.5% gross debt. The total capital at the end of March was significantly below the 60% maximum dictated by our credit and various long-term facilities. I'll begin comments about the first quarter on slide six. First quarter 2020 sales of 637 million declined 15% compared with the first quarter of 2019. The decline in sales was largely due to a 56% decline in China local currency sales driven by the COVID-19 pandemic. As a result of lower sales in China, first quarter 2020 net earnings of $52 million and earnings per share of $0.32 declined significantly compared with the same period in 2019. Please turn to slide seven. Sales in our North America segment of $533 million increased 2% compared with the first quarter of 2019. Incremental sales of $16 million from the Water Right acquisition purchased in April 2019, organic growth of 17% in North America water treatment products, and higher water heater volumes drove sales higher. These factors were partially offset by water heater sales mix composed of more electric models, which have a lower selling price and lower contractual formula pricing associated with a portion of water heater sales based on lower steel costs. Rest of the world segment sales of $110 million declined 53% in the same quarter in 2019. China sales declined 56% in local currency, related to weak consumer demand driven by the pandemic. China channel inventories declined slightly from the levels at the end of 2019 and remained in the normal range of two to three months. On slide 8, North America's segment earnings of $127 million were 10% higher than segment earnings in the same quarter in 2019. The improvement in earnings were driven by lower steel costs, incremental profit from water right, and improvement in the profitability of the organic water treatment sales. which were partially offset by the mixed skew to electric water heaters and lower contractual pricing. As a result, first quarter 2020 segment margin of 23.9% improved from 22.2% achieved in the same period last year. Rest of the world loss of $42 million declined significantly compared with 2019 first quarter segment earnings of $12 million. The unfavorable impact of profits from lower China sales and a higher mix of mid-priced products, which have lower margins, more than offset the benefit to profits from lower SG&A expense. As a result of these factors, the segment margin was negative, compared with 5.3% in the same quarter in 2019. Our corporate expenses of $15 million and interest expense of $2 million were essentially flat as last year. Our effective tax rate of 23.6% in the first quarter of 2020 was higher than the 20% tax rate in the first quarter of 2019, primarily due to geographical differences in pre-tax income. Please turn to slide nine. Cash provided by operations of $54 million during the first quarter of 2020 was higher than $22 million in the same period of 2019 as a result of lower investment in working capital including timing of certain volume incentive payments, which was partially offset by lower earnings compared with the year-ago period. Our liquidity and balance sheet remained strong. We had cash balances totaling $552 million, and our net cash position was $209 million at the end of March. During the first quarter of 2020, we repurchased approximately 1.4 million shares of common stock for a total of $57 million. I will now turn the call over to Kevin We'll begin on slide 10.

Thank you, Chuck. During April, we saw differing levels of impact from the pandemic across our major product lines and geographies. In North America, our average daily orders for residential water heaters declined low single digits compared with the first quarter pace. Commercial average order rates in April were down 30 to 35%. It is difficult to interpret order rates in April as customers are likely adjusting inventory levels as they manage their inventory investment dollars. In China, the pandemic had a significant impact on our volume in the first quarter. 50% of our sales volume occurred before the Chinese New Year shutdown on January 24th. With manufacturing, government offices, restaurants, and schools now largely reopened, and the majority of installers able to access apartments in China. We have seen sequential improvement in sellout and orders in April, compared with February and March. Consumers remain cautious, and it's too early to determine when consumers will return to normal levels in retail environments. A portion of the improvement could be pent-up demand. In North America, demand for residential boilers has remained soft following a warm winter. and we have delayed our early buy-in center program in this environment. Our commercial condensing boiler backlog has doubled from levels at this time last year, but some orders have extended delivery dates. With construction sites closed in some states, timing of delivery is difficult to project. Safety and security of drinking water is a high priority for consumers during this time. The North America water treatment in-market strength we saw in the first quarter continued in our direct-to-consumer product portfolio, which used to lower price, easier to install products. In April, we experienced some challenges in parts of the country with installed in-home products. In India, our water treatment products are considered essential, but our manufacturing plant is closed as worker transportation is difficult in this environment. We believe the current environment does not allow for the forecast of performance with reasonable precision. And as a result, we continue to suspend our 2020 four-year guidance. As the depth of the disruption and pace of recovery in our end markets become clearer, we look to return to our practice of providing a current year outlook. Please turn to slide 11. In Mexico, similar to other companies, We temporarily suspended operations as governmental agencies continue to sort through the industries designated as essential and allowed to continue to operate, as well as the conditions and safety measures under which businesses deemed essential are allowed to operate. We temporarily shifted manufacturing from Mexico to the US to minimize disruption of our customers. Each day, we move closer to an understanding of when we will resume production. and believe that we will be in a week or two and at a reduced manning incapacity. These lower rates coupled with U.S. output are expected to support demand for customers over the coming months. Our global supply chain team has been proactive from early in the first quarter and continues to monitor and manage availability of components. Again, to date, we have experienced minimal disruptions in our global supply chain. Our largest suppliers in Mexico, which are in different states than our Juarez plant, are now reopened, but at a reduced capacity. While the disruption has been minimal, we have experienced reduced safety stock levels on certain items, and our supply team is in ongoing communication with our suppliers to mitigate operational risk and manage inventory levels. We believe replacement demand for water heaters and boilers in the U.S. is approximately 85%. In 2006 through 2009, which captured the Great Recession peak to trough, industry shipments of residential water heater volumes declined 18%. The decline was primarily driven by a 1.5 million decline in new homes constructed. During that period, we were able to flex our operations to maintain margins. At 1.3 million new homes in 2019, we do not anticipate the new home construction impact will be as great as the Great Recession. The replacement base of our core U.S. products provides a stabilizing buffer to the economic downturn expected in the remaining three quarters of 2020. Please turn to slide 12. After being closed for several weeks in February in compliance with local orders, our three plants in China are open and operating. Foot traffic in our retail network in China remains low, and we are building to order at lower than normal operating capacities. Our suppliers are open, and we are not experiencing disruptions. Customers continue to prefer products with fewer features, continuing the trend we saw last year, as you would expect in this environment. Our mid-price products are positioned for this trend. Despite reduced headcount, retail footprint, and advertising costs, we continue to invest in R&D in the region. Product development continues with a focus on taking costs out of our most popular new products to improve contribution margins. Product development has been one of the pillars to our success in China, and we are committed to our investment in engineering resources in China and around the world. Please turn to slide 13. After a hard closure of the economy in the first quarter, China is slowly returning to business. While we have seen April orders and sales incrementally improve from February and March, it is too early to predict if the recent improvement is the result of pent-up demand or by consumers slowly returning to the market. In North America, we have previous experience in weathering through difficult economic conditions, most recently in the 2008 recession. However, with the massive and abrupt impact to jobs and in markets, like restaurants, hotels, and hospitals, it is difficult to predict if this current state of shelter-at-home and state-by-state closures will play out similarly to the 2008 recession. While we would expect that our replacement business in both water heating and boilers would provide a buffer in the same manner as we have seen before, the impact to construction and discretionary spend and closure of certain job site activity is difficult to predict for the remainder of 2020. In India, it is clear that our targets to break even in 2020 will be pushed out as the country battles COVID-19. Please turn to slide 14. We believe that, particularly in these uncertain times, A.O. Smith is a compelling investment for a number of reasons. We have leading market share in our major product categories. We estimate replacement demand represents approximately 85% of US water heater and boiler volumes. We have a strong premium brand in China, a broad product offering in our key product categories, broad distribution, and a reputation for quality and innovation in that region. Over time, we are well positioned to maximize favorable demographics in both China and India to enhance shareholder value. We have strong cash flow and balance sheet, supporting the ability to continue to invest for the long term with investments in automation, innovation, and new products, as well as acquisition and returning cash to shareholders. We will continue to proactively manage our business in this uncertain environment, as we've seen consumer demand trends emerge in China, where we were first impacted by the pandemic and now in North America as the current economy begins to reemerge after the economic shutdown. We have a strong team, which has navigated successfully through prior downturns, and I'm confident in our ability to execute through COVID-19. That concludes our prepared remarks, and we are now available for your questions.

As a reminder, to ask a question, you need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. And your first question line of Jeff Hammond with KeyBank.

Hey, good morning, guys.

Hey, morning, Jeff.

Morning. Really good color on April and the trends. And I just want to understand this China sellout. chart a little bit better. Is it fair to say that, like, the last five weeks' sellout has been kind of in line with prior year? And maybe how does that frame, you know, how you're thinking about 2Q for China versus the, you know, the steep drop you saw in 1Q?

Yeah, Jeff. Let me just kind of walk forward from January. I mean, Kevin said it on his remarks that half of our first quarter sales were before the holiday festival. So before January 24th, we had 50% of our Q1 sales already in. February was by far the weakest. Sequentially, March got a little bit better, and we've seen April get a little bit better. And that's just our sales. When you look at demand, what we've seen in April is demand is approaching, the sellout is approaching what we saw last year. So we're encouraged by it and think some of it could be pent-up demand. But we're encouraged by the way it's starting to track to last year.

Okay.

And we're encouraged by that. And on top of that, I just want to come back to channel inventories. You know, we saw channel inventories decrease slightly in the first quarter, too. So we're really building to demand, and we're pleased with that.

Okay. And then in North America... You know, kind of stark difference between the commercial water heater commentary and I think what you're saying about Lock and Bar, but it sounds like you expect Lock and Bar to see declines as well. Can you just maybe differentiate between those two and what you kind of expect?

Well, let me just take the North America water heating side of the market first. As we talked about, our orders were down a little bit on residential in April. In the commercial, I wouldn't read too much into April right now. Down 30%, 35% is, in our mind, probably our distributors kind of rebalancing inventory. Keep in mind that their largest investment is in our dollar amounts in our commercial products. So there's probably some rebalancing going on there. As far as Lock and Bar, again, Lock and Bar has had a very nice commercial start to the year. Again, some of those jobs are in New York and a few other states that have been suspended. But having a strong order book is really good. And we're still seeing, quite frankly, decent quote activity out there. So as we move forward, again, I think it's still too early to put a number on on what new construction will look like and when these jobs that have been postponed will be released. But, you know, overall, I like our position as we head into Q2, and then we're going to have to read and react as we see, you know, this market open up. It's very early right now.

Okay. Thanks, guys. I'll get back in queue.

And your next question, Matt Somerville with D.A. Davidson.

To that point, would it be possible, Kevin, to just talk about what you believe sell-through looks like in April in the commercial business versus sell-in where you indicated? And then as my follow-up, can you talk about how the new entrant into the residential water heater market later this year may impact or not market stability? I'd love to get your take on that. Thank you.

Well, I would tell you, when you start talking about North America and sell-in and sell-out, we don't really have great data there. So it would be more speculative on my part as we go forward. I still believe the 85% replacement market is going to hold up and continue. But the new construction is just too early for us to put kind of a number on that. knowing, again, as I've mentioned, a lot of the jobs being suspended and quite a bit of activity up in the northeast and so forth. So I'm not trying to dodge the question. It's just we really don't have that kind of visibility to give you a – or for me to give you a reasonable answer right now. And as it comes down to a competitor entering the market at the end of this year, again, as we've looked at it, A.O. Smith has dealt with competitors. for a long period of time. As we've mentioned on prior calls, we have very strong relationships with our distributors. As Abe mentioned in remarks, they go back decades. To be a full-time player in this market, you have to have a complete product line of residential, commercial, and on top of that, have excellent service levels. So we're going to focus on ourselves as we go forward and continue to do and provide value to our distributors as we've had over the last decades.

And your next question, the line of Scott Graham with Rosen Black Securities.

Hi, good morning. Hey, I was just hoping on slide four, the $55 million in China, is the math there as simple as assuming that $25 million drops into operating income this year?

It is. It is, Scott. You know, we were talking about $15 million on the January call, and we've increased that by 10.

Yes, gotcha. And then, you know, you have to look at each business individually and, you know, certainly within North America. But, you know, is there, you know, particularly with concerns out there about the speed of, you know, the release of the backlogs that are out there on commercial markets, for that to kind of start up again fully. I think that there's some concerns out there, and I guess my question is that, you know, does that preclude you? Like, does your backlog and your quoting preclude you from, you know, maybe taking some structural costs out there? And maybe more broadly, in North America, you know, what are the trigger points that you're maybe looking at to get more aggressive on the cost side in North America, again, more broadly?

Well, let me just take the high level, and I'll have Chuck fill in some of the blanks here. But if you look at it, demand, we have been able, and we've demonstrated it through 2008 in the recession, to be able to flex our plants appropriately. And so that's a skill set that came out of the Great Recession that we continue to use today. So that will be simply demand-driven, and we will adjust appropriately, whether it's in our water heater facility or in a boiler facility. And as far as, you know, costs right now, you know, the quarter came in, I think, pretty reasonable for us. We're continuing to watch demand. You know, some of the things we've already taken, we have our headcount on hold, traveling entertainment's down. But we haven't taken any major structural changes or decided to take any structural changes yet. We'll continue to look at it. We're prepared, if necessary, to execute. But we're just not in that position, and we'll continue to monitor demand in our customers as we head into Q2.

Yeah, I mean, the trigger point for us is really watching that demand. Back to your backlog question, I mean, we're pleased to have the backlog. We wish it was a little more predictable on when we were going to ship it. But that doesn't really preclude us from taking some of the actions that Kevin mentioned on taking some of the costs out as we watch the backlog.

Your next question line of David McGregor with Longbow Research.

Yes, good morning, everyone. Just a question on Chuck. I hope you're well. Yeah, you too. Yeah, thank you. Just a question on China. And I guess, you know, we've been talking now for a few quarters about the evolving mid-price point product that you've introduced into the Chinese market. And I guess I wanted to tie this in a little bit with what you're doing on SG&A because, you know, clearly you're making progress in terms of addressing the SG&A issue. But to the extent that you're relying more and more on mid-price point, one would presume that that's a more competitive segment of the market and, as a consequence, would require more in the way of ad support, market support, and And I'm just wondering if the migration into, you know, greater mass in the mid-price point constrains you in terms of what you're able to do in flexing SG&A?

You know, the products that we're introducing in that kind of upper mid-price point is really helping us a bit on the online. So as you might expect, in Q1, we saw our online business doing a bit better than we've seen in the past. You know, online historically has been 20% of our business last year, first quarter. This year it's approaching 30%. And the selling model is a little bit different on online after you make the sale than we do on the offline footprint. So some of the tie-in to kind of the mid-price products and some of the actions we're taking is looking at our store footprint. So the 1,000 stores that we talked about, You know, that's the area that we're really looking at, low-efficiency stores, trying to take some cost out. But, you know, it's really those mid-priced products help us a bit online as well as in the offline, and we're working on cost-reduction projects to continue to reduce the cost on those.

Yeah, I would just add that the cost of sale online is a little bit lower than offline in A lot of the action we're taking with stores, we're going to repurpose some of those investments towards our online activities. But I don't view it as being an incremental add to our marketing efforts. I look at it more of a repurposing of how we go to market.

Is there any chance we could get some sense of proportion from you in terms of what percentage of your business over there is mid-price point versus the kind of legacy premium price point?

We don't have that split percentage. handy right now. I would say, you know, certainly in this environment, we've seen a shift to more of the upper mid-priced and low end of the premium price product, but exact numbers we just don't have in front of us.

Okay. And my follow-up question is really on the water treatment. Some pretty impressive numbers there this quarter. Is this improved profitability? Is it really just being driven by scaling that business up, or is there a product mix or channel mix issue? If you could just talk about some of the progress you've made in water treatment.

Yeah, you know, it's all that. You know, it's some scale. It's some process improvement that we've had. You know, strong demand always helps. You know, the organic growth of 17% in the business really, really improves it. And we're very, very pleased with the addition of Water Right because Water Right has performed very, very well for us and helps that margin as we get more scale.

I guess just in this kind of environment where there's so many concerns about how the consumer discretionary spend might respond to the macro, are you seeing anything in April that would give you pause?

No. Actually, in our remarks, we talked about water treatment, and we had a very strong, in our minds, very strong Q1, and that really transferred over to April. You know, clean water is a critical element in the consumer's minds right now, and And having the ability for us, you know, one of the things in our water treatment, we have several channels that we market in. And this has proved to be a nice advantage for us, going through e-commerce, going through a dealer network, DIY, providing those opportunities to the various consumers played out really well in Q1 and we think will play out as we go forward into Q2.

Your next question, Robert McCarthy with Stevens.

Hey, good morning, everyone.

Good morning.

How are you doing? All right. So I guess, you know, first on China, could you just talk and amplify some of your existing commentary about the cost actions you took and the narrative in the back half of last year and the incremental cost actions you've taken now and how that's changed or what's accelerated, what's the difference? And then is there any granularity as to the negative margin you put up this quarter that that could give us a better sense of the components of the loss? Because that's a pretty sizable loss.

Yeah. So let me start with the cost actions. And I'll take it by kind of categories. So headcount reduction, when we were on January's call, we talked about the fact that we were targeting 20% to happen through the first half of the year. And we've achieved that 20%. And we're looking at some further headcount if necessary. So we're looking very closely at headcount as well as watching the consumer demand, we've really increased our selling and our advertising expense. So the increase there is with the 1,000 stores and we're looking at our footprint, we're targeting to take out further selling and offline infrastructure costs.

Okay, and then I guess as a follow-up on just the cash flow statement, Could you just give me a sense of what's really been the change in current asset liabilities for three months, 2020 versus 2019? Just give me some complexion around the conversion there in terms of what's going on in inventories and the receivables.

Yeah, inventories are up slightly. I'd say the biggest swing on cash flow is just some timing of some volume incentive payments that occurred in the first quarter last year that will occur in the second quarter this year. Let me go back to China for a second because you mentioned about the – I think you mentioned it was a pretty large decrement. You know, the volume really matters in China when you get to that level. So we've been kind of consistently talking about when volume goes down using a 50% decrement, and I think it falls in line pretty close to that. Q1 was, you know, not much time for the China team to react. Q1 was very abrupt. kind of leaving the spring festival holiday for the Chinese New Year, expecting to be back in a week and not returning for several weeks. So, you know, reacting on cost in Q1 was quite difficult, particularly paying employees and doing all the right things that we did for safety. So it was, you know, not easy to make quick action or take quick action in Q1. But the 50% decrement, you know, held pretty true in Q1. We curtailed all the advertising that we could in promotions because it just didn't make sense to promote while people were not in the retail environment. So, you know, as I mentioned earlier, you know, Q1, 50% before the festival and then sequentially better. So, you know, we're watching the orders in April very closely, and we're going to watch as we go into May to see, you know, kind of what we can expect as the year progresses.

And your next question, Ryan Connors with Bowen and Scattergood.

Great. Thanks for taking my question. Hope you're all well. You too, Ryan. Thanks. Yeah, I wondered if you could talk about the impact of all this on your channel partners and sort of the channel inventory situation in North America. I mean, many of your distributors are small businesses. Certainly the professional plumbers that they serve are small businesses, so presumably – you know, their financial wherewithal to hold inventory, you know, may have been compromised in many cases. So how does that impact you? You know, will there be some requirement that you utilize more of your balance sheet to finance inventory going forward or any thoughts on that?

Yeah. So many of our customers are also essential businesses in today's environment and continue to operate. You know, we know that their volumes are lower because they've had to adjust to curbside pickup in some cases and other other scenarios, which has hurt their business. Certainly water heaters are a very important part of their business, also a very important part of the replacement business. So that's more steady than some of the other discretionary spending that people would have for the other products that they carry. We're watching it close. If you go back to kind of the recession and use that as our experience level, we saw very, very little interruption during the recession. We would Hope and expect that some of the smaller distributors or customers that we serve would have been able to get some assistance through the government programs that are out there. But, you know, we're watching you very close. At this point in time, we haven't, you know, seen any indications of any slow-up or any issues in our channels, but we certainly are watching you close.

Okay, so you don't see any structural change in terms of, you know, you having to hold more inventory at your level as opposed to, the inventory capability of the channel itself.

Yeah, this is Kevin. You know, if anything, from 2008 when the Great Recession hit, there's been even more consolidation to some of our larger customers over that decade or so. And quite frankly, these are the same customers that navigated through the Great Recession. And they basically, almost every one of our customers has been deemed essential. and their customers have been deemed essential, so plumbers and so forth. Yes, some sales are down, but there's been – we've had to make no really adjustments to the way we do business with them other than making sure that they have product to serve the consumer and the commercial entities when necessary. And they've been navigating through it pretty well, and – Again, we stay close to them. Our sales force is virtually talking to them on a pretty regular basis. But as a whole, I think I would be very comfortable saying most of our distributors and retailers and even our dealers are navigating through this current environment. And again, we'll have to see how it plays out the rest of the year. But for the most part, everybody's doing business, a modified business, but nothing exceptionally different.

Your next question is from Susan McClary with Goldman Sachs.

Good morning.

Good morning, Lauren.

My first question is, can you talk a little bit to the decremental margins in North America, and especially as we think about it from a residential perspective as well as a commercial, just given the varying trends that you talked to there?

Yeah, I mean, when we look at the margin, incremental and decremental margins is about 30% roughly on the residential side. Commercial would be a bit higher. This is a little different, right, because some of this disruption is pretty abrupt. Some of it's stop-start. Some of it is a little bit more costly. But that's ballpark.

Okay, that's helpful. And then following up on that, you know, you mentioned that the rate of decline that you saw during the housing downturn in 2008. Can you talk to the mixed shift that you also see with that? And maybe how you're thinking about mixed shift in the U.S. coming through as we exit the virus and get into more of a recessionary period?

You know, back in that time, I don't believe we saw much of a mixed shift at all. There may have been a slight depending upon where the housing was located. Typically, some of the stronger markets are electric markets currently when you go to Florida and some of those other geographic areas. But we wouldn't expect a significant mix shift. It's typically a like-for-like exchange on the water heater side, on the residential side.

And your next question line of Cherie Brodowski with Jefferies.

Good morning. Thanks for taking my question. So you talked about the impact from construction site closures on commercial water heaters and boilers. Could you just provide any color on what you're seeing in regions with extreme shutdowns in North America, such as the Northeast, versus regions that are less impacted by the shutdowns?

Yeah, I would tell you – this is Kevin. We're seeing it – you just said up in the Northeast, New York, that area took aggressive measures to shut down a lot of their job sites there. We're seeing some of that on the West Coast as well in California. And so those are the areas, and quite frankly, we're starting to see some of those start to be released and coming back to work. But it was very regional and particularly very heavy in the areas, as you would expect, like New York, where the COVID-19 was having a serious impact.

Is there any way to quantify the decline seen there versus some other regions so we can kind of get a sense of what underlying demand could be versus COVID-19 impacts?

I don't think we can get that granular with you as far as, again, as we've talked about, even our backlog that we have, which is a nice backlog, those dates continue to move. We stay in contact with our customers and our buy-sell reps to kind of get the best view going forward. But it's really early. Until these key markets really open up, not just gradually open up, we're going to need to see some kind of run rate here before we can really give you a definitive response.

Our next question will end on Nathan Jones with Stifel.

Good morning, everyone. Good morning. Good morning. Just like to follow up to a comment you made, I think it was to Rob's question about reacting on costs in China and how difficult that was due to the abruptness of the shutdown and that it happened so quickly. Could you contrast that with your ability to adjust the cost structure in North America, depending on what we see going forward here?

Yeah, you know, the biggest contrast in my mind is that we wouldn't expect that big of a drop in North America because of the replacement business being a larger percentage of the business in China. So I want to just kind of start with that statement. And we've got a little bit more flexibility probably when you look at some of the programs that Kevin outlined as we go forward to make adjustments. So that would probably be our ability to maneuver a little quicker. In China, you know, we paid everybody 100% in Q1. It was a very, very difficult restart. The country was pretty hard closed for a longer period of time. And we're going to have to, I mean, we'll have to see what happens in the U.S. Hopefully we won't experience resurgence, and hopefully we'll see the country continue to open up.

Okay, that's helpful. And then a question on cash flow. Working capital for the remainder of the year, would you assume that that's going to be a source of cash, 2Q through 4Q, and any guidance you can give us on what you think the kind of cash conversion numbers are going to look like for 2020?

I'm not going to frame it from an amount, but working capital – You know, we're not going to pressure inventories a great deal right now in this environment. We're going to make sure we're carrying inventories adequately to cover our needs. We made an increase a bit in certain areas where we would like to make sure we've got safety stocks. You know, in China, we would expect that there would be some growth because we've got an expectation that we're going to see a little bit of growth over the course of the year or so. You know, not a firm number, but working capital, I wouldn't expect a lot of help on working capital for the back half of the year, but we'll watch it closely.

And your next question will come from the line of Robert McCarthy with Stevens.

Sorry, I'm a glutton for punishment. So I guess the next question is, maybe you just comment, you know, qualitatively. I know historically your gross margin in China has always been higher than than North America, even with the price increases we saw, you know, serially over the last four or five years. But, you know, clearly given what you've been seeing now, I mean, can you structurally still make that statement, or are we starting to see some material dilution in the gross margin in China?

Well, Q1, the gross margin in China was lower than our historical 40%. So Q1 certainly was, you know, there's a couple things driving it. It's the dramatic volume shift that's number one. and the cost associated with that. And, you know, we've been talking about some of the mid-price pressure on margin. We've introduced a lot of mid-price products or a number of upper mid-price products that we're very, very happy about that are being well-received. However, we've got some cost-out programs that are still yet to come on a couple of those. So, I mean, when you look at Q1, yeah, China actually was lower than our historical average gross margin, gross profits.

And do you think it's still credible? I mean, because I think you've been talking about the replacement cycle in China developing over time. And obviously, up until, you know, 18 months ago, you just had an incredible success story in China. But you talked about the replacement market kind of developing. And I think the replacement market, maybe, if memory serves, is in the, I don't know, 40 to 50%, maybe 40% of the market as of, I don't know, 12 to 18 months ago. But Given, you know, the intervention of this midsize product and what's going on, I mean, isn't it suffice to say that perhaps you're going to take a pause here, or is it even the right thing to think about a replacement market when you have this kind of switching to a lower-priced product?

I'll do my best to try to answer that. One, the replacement market is about 40% to 50%. So you're in line there. And 50% is in the Tier 1, Tier 2 cities. And you get out in the other lower tier cities, it's about 40%. And, again, I would go back to we still have, again, products for mid-price up to premium. And we continue to – drive both sides of the business and bring in new products to market, both in gas, electric, and, of course, water treatment. But on the water heater side, there is a strong preference for like-for-like, and that's no different than in the U.S. If you take out a product, you're probably leaning towards putting one similar in. So the way I look at the replacement market, it's, again, it's a nice buffer for us that we're not relying on new constructions and so forth. And we think it's going to be, today it's 50%. We believe it's going to be a real advantage for us as that continues to grow throughout the year. So I don't see the mid-price point and the premium price point at odds with each other. They're just surging. different types of consumers.

And there are no other questions. I will now turn the call back over to Patricia Ackerman.

Thank you, ladies and gentlemen, for joining us today. That concludes our session, and have a great day.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.