A.O. Smith Corporation

Ladies and gentlemen, thank you for standing by and welcome to the second quarter 2020 earnings call. At this time, all participants are in the 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 keypad. Please be advised that today's conference is being recorded. And if you require any further assistance, please press star 0. Now I would like to hand the conference over to your first speaker for today, Ms. Patricia Ackerman, Senior Vice President of Investor Relations, Corporate Responsibility, and Sustainability and Treasurer. Thank you. Please go ahead, Madam.

Thank you, Maike. Good morning, ladies and gentlemen, and welcome to A.O. Smith's second quarter 2020 results conference call. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer, and Chuck Lauber, 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 and on slide two. On slide three, in order to provide improved transparency into the operating results of our business, we provided non-GAAP measures, adjusted net earnings, adjusted earnings per share, and adjusted segment earnings that exclude the severance and restructuring charges related to aligning our business to current market conditions. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. Also, as a courtesy to others in the questions queue, please limit yourself to one question and one follow-up question per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Kevin, who will begin our prepared remarks on slide four.

Thank you, Pat. Before I summarize the quarter and check us through the results, I want to express how proud I am of our global team. We faced challenges and complexities to our business that we have never faced before. Our number one goal was and remains to keep our employees safe while delivering our essential products to our customers. I say confidently that our team met and often exceeded my expectations. Thank you to the men and women in the A.O. Smith family around the world for your dedication and your spirit. You truly make A.O. Smith a remarkable company. The business performed in the second quarter is largely in line with what we saw in April. Continuing the pace of growth we saw in the first quarter, our North America water treatment business organically grew 19%. Direct-to-consumer and retail sales were particularly strong as consumers became more health conscious during the pandemic and the shelter-in-place orders confined many of us to our homes. As expected, industry volumes of residential water heaters in the U.S. held up notably well. Based on our June shipments, we estimate industry volumes were flat to slightly less in the quarter compared to last year. Due to construction project delays and postponements in North America, we saw commercial water heater and boiler volumes decline in line with our estimates of the industry declines of 20 to 25% in the quarter compared to last year. Consumer demand for our products in China was flat to slightly positive compared to the second quarter of 2019, as restaurants and shopping malls reopened and retail foot traffic increased. We remained operational with no significant disruptions. Our Juarez Mexico plant, which we voluntarily closed in April, reopened in May and ramped up production over the latter portion of the quarter. We have taken numerous and meaningful steps to protect our employees, suppliers, and customers in the pandemic. These important steps, in many cases reduced efficiencies, include continuous communication and training to our employees on living and working safely in a COVID-19 world, planned accommodations and reconfiguration to maintain social distancing, masks for all employees, implementation of sanitizing stations, temperature taking, and regular proactive deep cleaning and sanitization of our facilities. Our global supply chain remain operational. We continue to monitor and manage our ability to operate effectively as tariffs and the evolving nature of the COVID-19 pandemic and the related stresses on the supply chain and periodic marketplace disruptions impact our operation. To align our business with current market conditions, primarily in China and to a lesser extent in North America, reduced headcount and incurred other restructuring costs totaling $6 million in the second quarter. I will now turn the call over to Chuck who will provide more details on the quarter beginning on slide five.

Thank you, Kevin. Second quarter 2020 sales of $664 million declined 13% compared to the second quarter of 2019. The decline in sales was largely due to lower water heater volumes in China and lower commercial water heater and boiler volumes in North America driven by the COVID-19 pandemic. As a result of lower sales, second quarter 2020 adjusted earnings of $73 million and adjusted earnings per share of $0.45 declined significantly compared with the same period in 2019. Please turn to slide six. Sales in our North America segment of $481 million declined 8% compared with the second quarter of 2019. Organic growth of approximately 19% in North America water treatment sales was more than offset by lower commercial water heater volumes, lower boiler volumes, and a water heater sales mix composed of more electric models, which have a lower selling price. Rest of the world segment sales of $190 million declined 24% compared with the same quarter of 2019. China sales declined 20% in local currency related to higher mix of mid-price products and further reductions in customer inventory levels. Consumer demand for our products in China was flat to slightly positive compared with the second quarter of 2019. China currency translation negatively impacted sales by approximately 6 million. Our sequential sales in China improved through the quarter, and China was profitable in May and June. India sales declined significantly as the economy was shut down during the majority of the quarter to minimize the spread of the virus. On slide 7, North America adjusted segment earnings of $108 million were 12% lower than segment earnings in the same quarter in 2019. The decline in earnings was driven by lower volumes of commercial water heaters, lower boiler volumes, and a mixed skew to electric water heaters. certain costs directly related to the pandemic, including temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, facility cleaning, paying benefits for furloughed employees, and other costs were $5.5 million in the second quarter. Adjusted earnings exclude $2.2 million in pre-tax severance costs. As a result, second quarter 2020 segment Adjusted segment margin of 22.4% declined from 23.5% achieved in the same period last year. Rest of the world adjustment segment loss of $2 million declined significantly compared with 2019 second quarter segment earnings of $22 million. The unfavorable impact to profit from lower China sales and a higher mix of mid-priced products which have lower margins more than offset the benefits to profits from lower SG&A expenses. These results exclude $3.9 million in pre-tax severance and restructuring costs. As a result of these factors, adjustment segment margin was negative compared with 9% in the same quarter of 2019. Our corporate expenses of $10 million and interest expense of $3 million were similar to last year. Please turn to slide 8. Cash provided by operations of $179 million during the first half of 2020 was higher than $144 million in the same period of 2019 as a result of lower investment in working capital, including deferral of our April estimated federal income tax payment to July, 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 $569 million, and our net cash position was $288 million at the end of June. Our leverage ratio at the end of the second quarter was 14.5%, as measured by total debt to total capital. We had $332 million of undrawn borrowing capacity on our $500 million revolver. in the second quarter and our share repurchase activity continues to be suspended. During the first half of 2020, we repurchased approximately 1.3 million shares of common stock for a total of 57 million. Please advance to slide nine. We reintroduced our 2020 adjusted EPS guidance this morning with a range of between $1.72 to $1.86 per share. Our 2020 adjusted EPS guidance excludes $0.03 per share in severance and restructuring costs that were incurred in the second quarter. Our adjusted guidance assumes the conditions of our business environment and that of our suppliers and customers is similar for the remainder of the year to what we are currently experiencing and does not deteriorate as a result of further restrictions or shutdowns due to the COVID-19 pandemic. We expect our cash flow from operations in 2020 to be approximately $350 million compared with $456 million in 2019, primarily due to lower earnings. Our 2020 capital spending plans are between $60 and $70 million, and our depreciation and amortization expense is expected to be approximately $80 million. Our corporate and other expenses are expected to be approximately $47 million in 2020, slightly higher than 2019, primarily due to lower interest income on investments. We expect our interest expense to be $9 million in 2020 compared with $11 million in 2019. Our effective income tax rate is expected to be between 23% and 23.5% in 2020. Our assumptions assume no additional share repurchase resulting in an average diluted outstanding shares in 2020 of approximately 162.5 million. I'll now turn the call over to Kevin who will summarize our guidance assumptions beginning on slide 10. Okay, thank you, Chuck.

Our outlook for 2020 includes the following assumptions. We project U.S. residential water heater industry volumes will be flat in 2020. driven by resilient replacement demand and similar levels of new home constructions as last year. We expect commercial industry water heater volumes will decline approximately 10% as job sites and business closures due to the pandemic delay or defer new construction and discretionary replacement installation. It is encouraging to see consumer demand for our China products similar, if not a little higher, than last year over the last four months. We are also seeing sequentially quarterly improvement in market share both online and offline for water heater and water treatment products driven by our mid-price range products. We took additional charges in Q2 for further restructuring of the business. We believe these restructuring charges are largely behind us. We continue to target closure of 1,000 existing stores while targeting to open 500 small store relationships in Tier 4 through 6 cities. Cost actions and restructuring activity are projected to result in $35 million of savings in 2020 over 2019, $15 million of which will be realized in the second half of 2020. We expect year-over-year declines in local currency sales of 18% to 20% and protract sequential quarter-over-quarter growth in the second half of the year as China appears to be making sustainable progress in reopening their economy and keeping the virus in check. We expect our North America boiler sales will decline approximately 10% for the full year. Commercial boilers represent 65 to 70% of our boiler sales. With many job sites temporarily closed during the second quarter, we believe as job sites reopen, the orders will sequentially improve in the second half of the year. We project 20 to 22% sales growth in our North America water treatment products, which include incremental water rights sales. We ended 2019 with a $2.6 million loss in India and expect a similar loss in 2020 as a result of the pandemic. Please advance to slide 11. We project revenue will decline by 7 to 8% in 2020 as strong organic North America Water treatment sales and resilient North America residential water heater volumes are more than offset by weaker North America commercial water heater and boiler volumes and lower China sales, largely due to the pandemic. We expect North America segment margin to be between 22.5 and 23%, and rest of the world segment margins to be negative 1 to negative 2.5%. Please turn to slide 12. We believe, particularly in these uncertain times, A.O. Smith is a compelling investment for a number of reasons. We have leading share positions in our major product categories. We estimate replacement demand represents approximately 80 to 85 percent of U.S. 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 acquisitions and return cash to shareholders. We will continue to proactively manage our business in this uncertain environment, We see improving consumer demand trends emerge in China, where we were first impacted by the pandemic, and see China operations pivot to profitability for the remainder of the year. In North America, as the economy begins to reemerge after the economic shutdown, persistent COVID-19 cases and related potential implications to return to a more stable environment in the market, workplace and supply chain will continue to be challenging throughout the remainder of the year. We have a strong and dedicated team, which has navigated successfully through prior downturns, and I'm confident in our ability to execute similarly 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 keypad. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Please stand by while we compile the Q&A roster. Your first question comes from the line of Jeff Hammond of KeyBank. Your line is open.

Hi. Good morning, everyone. Good morning, Jeff. Good morning, Jeff. Just want to dig in on this China dynamic, sales down 20, and I think you said consumer demand was flat. Just help me square those two things. I know you mentioned mix and destock. Just maybe parse those out and You know, what's the expectation for this mixed dynamic and kind of inventory to stock and to continue into the second half?

Okay. So we're down, you're right, it's about 20% when you take out the FX. So, right, for the quarter we're down 20%. There's two main pieces. One is mixed and the other, you're right, is the D-stock. If you just kind of look at the mix, you know, of that 20%, roughly a third, less than a half, is related to sales mix. So you kind of just get into that category of less than a half to maybe a third of that 20%. The rest is really destock and consumer demand. So it's, you know, inventories came down again in the channel inventory in China, so we were a little bit surprised they came down as much as they did. We don't project them to continue to decrease. They are now in the two- to three-month range when we recalibrate to kind of what we see 2020 to be at. So, you know, in our forward looking, we think they're about as low as they're going to go. They could go lower, but that's what our projection has.

The mixed dynamic in the second half, should that continue?

You know, the mixed dynamic is a little unique, I think, in Q2, right? So, we've got our online sales were strong. So, you know, if you look at our online sales, you know, they were 30% of our total revenue in Q2 and actually up. quarter over quarter slightly. So online sales put a little bit more pressure on the mid-priced products. As you know, there's more upper mid-priced products on the online than there is in the offline. You know, we would expect there to continue to be pressure on mix going forward, but we would also hope and we expect sequential improvement in volumes and would hope that the offline market would grow a bit. And it might be a little bit improved over that, but we'll have to kind of see how that plays out.

Okay. And then just it looks like you've got to do $30 million to $35 million in nonprofit in the second half in China to kind of get to your margin target. Is that strictly, you know, volume improvement from here, or is there something else that's driving that profit improvement?

Well, it's two things. There's some volume improvements. We've seen sequentially China improve month over month, and we expect it to continue quarter over quarter. So we do expect growth in the back half of the year. If you kind of parse out the math, we expect China to grow year over year in low single digits, maybe in that 5% range. And then on top of that, as Kevin mentioned, we've got cost reduction programs that we put in place It's about $35 million for the year, and we expect $15 of that to drop into the back half. Probably pretty even per quarter, the savings. Okay, great.

Your next question is from the line of Scott Graham of Rosenblatt. Your line is open.

Yes, hi. Good morning, Kevin Chuck. Morning, Scott. Good morning. So I just wanted to make sure, just sort of like a housekeeper, the COVID 5.5 million, you did not pull that out. That is in your North American 22.4, right?

You are correct. It is in our numbers. The only thing we adjusted out was $0.03 on severance and restructuring.

Yep, got it. I'm hoping you could maybe tell us a little bit more about the China – you know, sort of percent of sales to premium in water heaters versus the percent to upper price point. I'm just kind of wondering what that pie chart looks like right now.

Sure, let me frame it. You know, and as I mentioned just to Jeff, I mean, it's a little unusual quarter because we've got a little heavier mix on online, but just to kind of frame it, let me go with the definition first. So, you know, at mid-price as we're defining it for this information is, On the electric, it would be less than 3,000 RMB. And then on the gas, it would be less than 5,000 RMB. So that's what we're considering in this kind of calculation of mid-price. If you go back two years ago, the percent of our sales that would fall into that category below those two thresholds is in that 25% to 40% range. If you kind of walk it forward to a year ago, it is in that 35% to 55%. And then if you go to Q2, which, again, a little bit heavier online percentage than normal, it's in the 55% to 70% range. So, you know, it's grown because we've reintroduced products into that category, which we feel now we've got the full range of products kind of filled in there.

Yeah, you know, Scott, I would just want to dovetail on what Chuck said is we've been working over a year plus to fill those mid-price categories and And now we're there. So as we go forward, we look for a mix to hopefully move more towards our premium sector. But it was important for us from an overall perspective to compete both online and offline to have those mid-price products, which are by the way, are the upper mid part of the range in our product offering. So again, going forward, I think as Chuck mentioned, this is probably a... a low point when it comes to how many mid-price or a high point for mid-price products, and we look forward to see our mix shifting back, maybe not to where it was in the past, but mixing higher to premium products.

Your next question is from the line of Susan McLary of Goldman Sachs. Your line is open. Thank you. Good morning.

Morning.

My first question is just, you know, can you give us some color on the mix shift in the U.S.? I noticed in your press release you commented that that's kind of turned a bit negative, more towards the electric side of things on the consumer business. Can you just give us some comments on how that has been coming together and your thoughts on the back half for mix?

Yeah, this is Kevin. You know, if you look at our industry, we do have periodically some mix shifts for various reasons. The way we would look at this is, from our perspective, the Northeast has been one of the hardest hit. You go to New York, New Jersey, Boston, those areas, Massachusetts, have probably been the hardest hit when it comes to COVID and shutdowns. That just so happens to be one of our strongest gas markets. So that could be part of it. We've also had strong growth with our customer base in a stronger electric markets. So the two kind of... caused the shift, the temporary shift. If I look at it, though, and look forward, yeah, I don't see any real systemic changes in the market. And over time, I would expect that our mix would normalize over the year or into next year.

Okay, that's helpful. And then just following up, you know, can you give us some color on raw material inputs, steel prices seem to be a slight advantage for you in the quarter. But how should we think about that, you know, going out over the next few quarters as well?

Well, I mean, if you look at steel and, you know, 70% of our steel is cold rolled, 30% is hot rolled. And we see kind of a delay in the cost of that 90 to 120 days. So if we kind of just take a data point of spot prices today, And compare them to a year ago, second quarter, we're down about 5%. So, you know, that kind of frames how to think about it. Steel's been lower, I guess, for a couple quarters now. But it has edged down a bit.

Next question is from the line of Brian Blair of Oppenheimer. Your line is open.

Good morning, everyone. Hope you're doing well. Hey, Brian.

Same to you.

Chuck, I believe you've mentioned break-even revenue for China in the $55 million, $60 million per month range in recent past, and being profitable in May and June would kind of validate that. Is that still the right range to think about? And then as we look forward beyond the structural savings that will come through in the back half, how should we think about incrementals as China revenue moves higher?

Yeah, you know, so you're exactly right. I mean, that break-even point is in that 55 to 60. We're pleased that we saw it in May and June. We'd expect we're going to be profitable going forward. So, you know, we still see that as the range. We're going to continue to look at, you know, the structure, and we have taken a look at the structure. And the restructuring charge we took of about – it's about $4 million in China will result in some savings going forward. So the incrementals, so, you know, incrementals are probably in that 45 to 40 to 45% range, I would say.

Okay. Appreciate that. And really nice growth in water treatment. Can you remind us of run rate profitability there and structurally where you think margin can climb as that business continues to scale? Sure.

Yeah, we run rate profitability. Q1 we were at 9%, Q2 we were about 8%. We see it continuing to be that for the rest of the year. We're still looking at cost reductions. We've got a little SAP implementation happening this quarter, so there's some costs that are going to burden it a little bit in the back half, but we still see that just, you know, approaching 10% this year. So we're, you know, we're pleased with water treatment. The order rate has been strong. I mean, we were up 19 to 20% for the quarter, And when we look into July, we see the same strength in orders. It's at that same rate.

Yeah, I'd just make another comment on that as far as the growth has been strong and it looks to be continuing. And then just keep in mind there's a consumable part of this. As we go forward and continue to put out our point of use and border entry type of products, that seeds the consumables as we go forward over the next few years. So there's a lot of positive trends in our water treatment business. And even as you look at it today, even softeners are starting to come back as, you know, our dealers are learning how to sell in a COVID environment and using digital and how they're installing and so forth. They've made a remarkable shift in their selling methods, and it's proven to be effective so far through July.

Your next question is from the line of Matt Somerville of VA Davidson. Your line is open.

Thanks. A couple questions. I want to get back to the electric impact. North America was down 8%. Can you sort of parse out? what the impact of that shift was on revenue and what the operating margin impacts may have been there as well.

Yeah, we're just tracking down the impact on revenue. The percentage, you know, the percentage is really the same for gas or electric. So, I mean, the percentage runs roughly the same. It's really just a step function as far as sales dollars and then margin dollars. You know, Don't have a good answer on mix, but, I mean, it's probably in that 10% to 15% of the total, of the total decrease. When you look at the decrease in margin of the 8%, it's probably 10% to 15% of that.

And then have you begun to see in your order book as of late, looking into, you know, June, July, any evidence that these delayed construction projects are indeed coming back online? Have you actually seen that take place in your order book?

You know, I think it's too early to see that. You know, when we look at – and I'm thinking about lock and bar boilers at this point, but when you look at kind of the order quoting rate out in the marketplace, you know, it is down a bit. The quoting rate is lower than what it has been, but there's still activity out there. And orders coming back online, I think it's a little early. When we look at, though, just commercial water heating, Kevin talked about the decline in the second quarter. We have seen some uptick in order rates on commercial water heating. So if you look at Q2 compared to Q1, compared to what we saw in July, we see July up about 4% to 5% on commercial orders. So, you know, that probably is some delayed replacement that's coming back online, and we would expect that to continue. So, I mean, when you kind of think about commercial, and it's both commercial and water heater and boilers, you know, the front half of the year looks a lot like the back half of the year. We're down roughly 10% with a lot of disruption. A lot of disruption on boilers in the second quarter, but we expect some of that to come back online, particularly since our boiler season is a little stronger in the fourth quarter.

Yeah, I think that's the key takeaway here. As we get closer to the colder months and so forth, that's where we see, again, schools and businesses start to fire up their boilers. So it's a little early. We do have a reasonably strong backlog that we're still working through. And we'll probably have a better view. But if you talk to our reps who are on the ground, they'll tell you that they expect the sites to reopen. They expect to see some projects move forward. And that's kind of our assumption as we go forward in the rest of the year.

Your next question is from the line of Ryan Connors of Boining and Scattergood. Your line is open.

Hey, great. Thanks for taking my question. I wanted to actually talk a little bit about the sort of channel impact, channel situation, given everything that's going on. Obviously, many of your distributors are relatively smaller businesses, so in some cases, presumably, there could be some balance sheet pressures and other issues. How has that impacted your wholesale business in terms of your own need to hold inventory? payment terms, et cetera. Any impact there? Anything that's evolving as this goes on with the channel?

Well, you know, most of our customers, if not all of our customers in the channel, are essential businesses, remained open like we did and continue to operate, you know, maybe with curbside pickup and other activities. So we've been fortunate that most of our customers have fared pretty well, well from the perspective that they've been able to operate in a difficult time. We haven't seen significant impact on payment terms or any other ability of our customers to pay. Some of the smaller ones can qualify for loans, so there's opportunities for them to do that. So at this point, you know, we've fared pretty well. Our customers have fared pretty well. We have seen, particularly on the commercial side, some destocking. So we've seen our customers work on, you know, maybe – taking a little bit of their balance sheet down, cutting a little bit on the inventory side, particularly with the higher cost commercial product. And we believe some of what we've seen in order rates, and maybe it has been impacted by that, maybe in the industry too, just some adjustments within inventory within the channel.

Yeah, I would just add on to that. I mean, you talked about construction. We talked about reopening. And of course, All of our distributors are also good at business and balancing their inventories. So, one, I would tell you that all of our distributors, for the most part, are managing through it. They've been through the financial crisis and they've come out of it. And at the same time, they're going to adjust their inventories to the current demand. And so as we go forward and demand does pick up, I would expect them to adjust those inventories appropriately going forward. So overall, we have a tremendous customer base with legacies of 20, 30, 40 years, strong positions in the market, and they're navigating through fairly well based on the information we're getting from our sales organization.

Got it. And then my follow-up was just really following up on the earlier discussion of water treatment. It really seems like you are building some Pretty strong momentum there at this point in terms of the organic growth. Can you talk about just what is driving that? Is that more the market growth given all the PFAS concerns and lead and all that? Or is that share gain with your big box channel? I mean, where is that growth coming from, if you can kind of give us some flavor there?

Well, you actually outlined it pretty well. I think it's coming from all the things that you mentioned. Certainly, the pandemic has heightened people's awareness. But I would tell you at the same time, I believe our water treatment team is executing very well. Through the process, we've updated websites. Our consumer engagement process is much better. We have a telesales activity. So there's a number of foundational things that we've put in to improve e-commerce, to improve our dealer network. On top of the consumer becoming more aware of some health issues, particularly on water treatment, We're also executing, I think, at a higher level than we were last year, which I think is critical for us to go forward. And our close rates are up, and that kind of ties in with our sales as well. So, you know, overall, the water treatment business is doing well, but it's not just a combination of the market. It's a combination of execution as well. In water treatment, we don't have the data that we have, say, in water heaters. So, But if you look at, we do get some information on water quality from our Water Quality Association that tracks softener valves in tanks. Now, that data is a little old because of the pandemic. They haven't been able to update it. But we're up 20% plus, and the market at the time that we had the data, which is, I believe, in February, was flat. So we are taking, I believe we're taking some share. We'll need some more time to validate that. But yeah, it's going well, but it's a combination of market and our team executing at a much higher level than we had in the past.

Yeah, this is Chuck. I mean, I mentioned earlier that we've seen July demand continue strong, and we've seen a better mix of, you know, some of our install products as people are, you know, more comfortable with installers, dealers getting into homes. So, you know, if you kind of look through kind of the end of June or July timeframe, The softener mix and some of the larger products, we've just seen that come back a bit.

Your next question is from the line of David MacGregor of Longbow Research. Your line is open.

Good morning, everyone. Good morning. I wanted to ask about Lock and Var. You'd mentioned that quoting activity was down a little at this point, although there's still some uncertainty, I suppose, with where that's going, according to your comments. Under that situation or that scenario, one might sort of expect a higher level of competitive pricing pressure and just a more vigorous level of competition from some of the other players in the space. So I wonder if you could just talk a little about what you're seeing on that side of the Locker Bar story and also to the extent you could talk about what you're seeing in terms of the mix of units sold within Locker Bar and what might be changing there.

Well, as far as from a competition standpoint, we deal with that on a regular basis. We haven't seen much change from how we quote and how we can go to market. We've had to get a little creative about how we do sales calls and engineering calls on Zoom. But overall, you know, not much change there. We've had a nice mix towards some of our crust boilers, which are the higher BTU-type products, which are in larger applications. So we saw that come back this year quite well. So, you know, overall, again, I go back to the business. We're heading into our stronger half of the year. There are still some uncertainties there that we've outlined, but we're in position to capitalize as the markets do open up. I think it's really important, as we've been working our way through the pandemic, we've kept our operations ready to be prepared to come out of it as sales grow and as the markets reopen. So, overall, you know, operational, we're in a position to take care of our customers, and normally there's a little bit of – of emergency activity that happens in the second half of the year where people need things right away, and we're positioning ourselves to take care of that as well.

Maybe just a little more color on mix, too, and Kevin's exactly right. You know, we've seen some of the larger boilers a little heavier in the mix in the second quarter. You know, we talked before about residential being light, so when we look at residential in Q1, it was a warmer winter, and it was pretty light for us in the industry. Second, July activity is really kind of hard to read. Typically, and we've done it this year again, is we've got an early buy program. Early buy program is specifically for residential boilers. That's running. We're seeing orders come in pretty well. We're fairly pleased with how that is typically playing out. Hard to read what's happening in July, but the residential orders on the early life program might be running slightly less than last year, but it's not done yet, and we're pretty pleased with how that's playing out.

Okay. Thanks for that, Keller. Just a second question on China, and you'd mentioned the shift towards more median price points, so thanks very much for providing the detail on that mix. I know it's something we've discussed in the past. I guess the question is, you know, with regard to capacity utilization rates, which I'm guessing right now you've got plenty of headroom, but as you shift more to medium price point, what impact does that have on capacity and your need to invest CapEx in those facilities?

I would tell you right now there's – we do have plenty of capacity and operating leverage going forward. As you probably know, we have three large facilities in China. And being where we're at today from, you know, our top line sales where we were, say, a couple years ago, we have plenty of capacity to handle it. So we see no need for really additional capital from the production side of the business going forward for several years.

Your next question is from the line of Nathan Jones of Stiefel. Your line is open.

Morning, everyone.

Morning, Nick.

Good morning. I just wanted to follow up a little bit on Ryan's questions on water quality. That's a pretty fragmented market here in the U.S. Can you talk about where you think your market share is, what kind of market share targets you would have And strategically thinking, is this more of a build versus buy, you know, an organic growth versus roll up the market? Or do you see opportunities here to go about consolidating this market? And are there, you know, big advantages for that scale?

Well, I mean, it's tough for us to get a detailed handle on share, right? And you're right, it is a fragmented market. I mean, we think the addressable market, when we kind of look at it in a couple different ways, is about a $2 billion market. So clearly there's opportunity for us to continue to expand our position. It's both. You know, when you say is it a build versus buy, I think there's opportunities on both. You know, we've entered – our strategy is we've gotten into leveraging the channels that we're in. So, you know, we've got the direct-to-consumer channel through Aquasana and the Amazon channel through Aquasana. We've also – got the dealer channel through the Water Right acquisition along with the Hague acquisition. We've introduced product into wholesale, and we're in retail through low. So we've entered all the channels, and we would expect to continue to grow that out on channel expansion within those channels over the next several years. M&A, you know, it's certainly an area that we've got our eyes open and we're looking at. So we think there's opportunities in both. Yeah, I'll just add a little bit more on to that.

It's Kevin here. Certainly on the M&A front, I think there's plenty of opportunity out there. Again, it's got to fit to where we're taking our strategy. But if you look out, I've always said on any call or any industrial meeting that the opportunity on the water treatment front is, I think, an area that we're going to spend a lot of time in. There's opportunity there. And there's ways for us to leverage and consolidate over the long haul. And again, A.O. Smith is always looking to make the industry better and raise it up. And we think there's going to be opportunity over time to continue to find those right fits for our business.

Okay. Another question on China. I mean, you guys have talked about the mid-tier product being lower margin than the premium tier product. That's a relatively new introduction for you into China. Is there opportunity through operational improvement and, you know, ramping up the productivity of those lines for you to close that margin gap between the mid-tier and premium-tier price products without just, you know, leveraging volume?

Yeah, there is opportunity. We're working on cost reduction programs within the product. Also work on cost reduction programs within the manufacturing process. So certainly your right volume would help us, but we're coming at it from multiple angles.

And just one quick one on capital allocation. You guys had started this year with a $200 million target for a share repurchase. Based on your projections for the back half of the year cash flow, you're probably going to have about $500 million of cash on the balance sheet. So the balance sheet's going to be a little inefficient. Can you talk about when you think it would be appropriate to reinstate the share repurchase program? If that's next year, would you look to kind of, you know, catch up a little bit of the 2020 spending to go along with the 2021 program if we assume that, you know, the markets are in reasonable condition?

Yeah, I mean, it's a little early for us to reach out and make that call right now. I mean, we're watching... Well, we typically frame that program, you know, historically to not grow cash, you know. And then in this environment, we do have a cash projection. And you're right, you know, we're pleased with projecting $350 million for the year. And, you know, we feel that right now, though, there's enough uncertainty out there that we want to just watch it for the next quarter. And we'll be back probably talking about it next quarter.

Yeah, I would just add on to that is we still believe there's better opportunities in the market. Acquisition is always our preferred method to invest, and I would like to see how things come out of the pandemic, and we're going to keep an eye on that. And again, we expect there'll be some opportunities, and we want to be prepared from cash position to capitalize if they arise.

Your next question is from the line of Scott Graham of Rose and Lott. Your line is open.

Hey, Scott.

Hello, Scott, are you there? Yeah, I'm sorry about that. I was on – I muted myself. So just a follow-up question on China. So we're shrinking the number of sites there, I think, by about 1,000 this year. And here we are with the channel destocking unexpectedly again. Could one be the cause of the other? And how are you managing that site reduction? How is that going?

Well, I don't think they're related, Scott, to be honest with you. One, the 1,000 stores that we keep referring to, it has to do with unproductive stores. And we've done that over the years, but we've had to close some stores, reopen other stores, and so forth. So, That, to me, is a productivity market issue because there's a heck of a lot of cost into offline sales and with promoters and so forth. So because of the economic environment there, certainly it's enhanced this. So that's an independent thing that we do on a regular basis, evaluate our stores and close and open appropriately. As far as the stocking, it's really up to our distributors to determine what they – They needed their inventory. And again, I don't think a quarter a month is something we should really be surprised at some shift. It wasn't a big shift. We're still in that two to three month range of inventory. And what's important is that they have the right products in stock and that we're driving business to the consumer to sell. And we're in great position. I think our distributors are in a significantly better position than they were, say, six months to a year ago. and our sales are growing. The opportunity to sell more products as the economy reopens is positive. We have the capacity and the lead times to take care of that. So, again, I think the inventories are just more of a separate business management by our distributors, and we're taking care of the retail stores because it's the right way to manage our cost of sales.

Gotcha. And then last one on... Back to the North American business with, you know, commercial, which includes, you know, restaurant lodging. It does look like lodging, certainly in spots, is coming back fairly strongly. But I think you have to emerge from this with – we're going to emerge with a smaller restaurant footprint, at least for the time being. They always seem to grow back in the out years. But is there a need here to maybe – come back to North America and cut some costs on the commercial side, both water heaters and boilers, given that, you know, on a post-COVID basis? How are you looking at that?

Yeah, I mean, we think a lot of that demand that we're seeing, you know, in the second quarter and into July is postponement of some replacement going forward. You know, I think it's a little early for us to predict if there's a great deal of change in the footprint of, you know, those types of customers. That's a portion of where our water heaters and boilers do go. But we'll continue to watch that. So we'll continue to watch as it goes forward and see what happens. Right now, we expect it's just delayed and there'll be replacement as those businesses start up.

Yeah, Scott, I think it's a fair point, a fair question, but I think it's a little bit early. And so if you look at where our sweet spots are, you've hit restaurants and hotels and so forth. Certainly the closures have delayed some of that. But, again, going forward, depending on how we reopen, we'll have to see how that plays out. But, again, the replacement market will be there, and we'll have to see what size it is as we come out the other end.

Your next question is from the line of Kevin Hostbar of North Coast Research. Your line is open.

Hey, good morning, everybody. On the water treatment guidance, I guess I want to understand a little more for the full year, 20% to 22% sales growth. It seems to imply a fairly sizable slowing in the growth rate in the back half of the year, but it sounds like the DIY, well, the organic growth in the second quarter seems to be carrying forward into July, and a lot of companies that have seen DIY strength have seemingly said that that's slowing but, you know, still quite robust and carrying forward. And it sounds like the contractor-based products seem to be getting a bit better. So I guess I just want to understand what – is there a reason to assume that there should be a sizable slowing? Is there some conservatism in there? Just trying to connect the dots there and understand, you know, the guidance there going forward for water treatment.

Yeah, that's a good question. I mean, we saw some fair strength coming into the second quarter. You know, we think a lot of that or some of that, and we talked a little bit, Kevin talked a little bit before about the strength in the business is consumer awareness and maybe the shutdown, people thinking about their water a little bit more. The DYI channel, you're right, has been very, very strong. So, you know, the second quarter and into July, we see a lot of a lot of activity on water treatment, a lot of strength. Will that continue as people kind of hopefully get back to a little bit more normal and back to work? We'll have to see how that plays out. So you're right. I mean, if you kind of do the math, we're expecting it to soften a bit in the back half and not be exactly that 20% to high order rates that we're seeing in the current environments.

I guess I just wanted to clarify in the opening comments, I think you guys mentioned that based on where you see your water heater shipments in June that you think the industry is flat, slightly up. Was that just a month of June comment or was that the full quarter? Because I guess if it's the full quarter, it would imply June was quite a robust month to offset the slowness in April and May's AHRI shipments. And curious how you felt A.O. Smith has done versus the industry, you know, in the second quarter and into July.

Yeah, that comment applies to the full quarter. And, again, we did see a strong June. So that's the impetus going forward. And then as you look at it, we've always felt, you know, people will do without a water heater for 24 hours. That's about it. that replacement market is still going to be there. And then we've seen decent new construction still holding up over the various markets. So you put those two together, that's where we came up with a forecast of residential volume being relatively the same as last year. But you're right, it comes off a strong June.

Strong June and just orders carried forward into July, we still see that playing out. So residential orders have been healthy. And market share, you know, market share is the same. You know, there's really no shift in market share.

Your next question is from the line of Susan McLary of Goldman Sachs. Your line is open. Thank you.

I just have a few follow-up questions. The first is you mentioned in your commentary that you're in the process of establishing 500 new store relationships in China. Can you just give us a little more color on that? It sounds like it's in the Tier 3 to Tier 6 cities. And then how does that kind of balance against the 1,000 store closures that you've done there?

Well, it's Tier 4 to 6 cities, and that's where a lot of the growth is. And we have... I know those are much smaller stores, but, you know, they're in the areas that are growing. So we're working with our customers to establish those relationships to make sure they have the right selling tools and products for that particular environment. And we see the four- and six-tier cities playing a bigger role, particularly in the new construction part of the business and housing. So that's moving. Comparing the 1,000 to the 500 is difficult because, again, there's really not a comparison. The 1,000 are underproductive stores, not performing, not covering their costs, and so forth. So we're just leaning up that part of our business where the 500 stores, which we've been expanding in Tier 4 and 6 cities for a while now, are addition opportunities. They will be certainly less. sales volume going through a tier four, six city store than obviously in a tier one, tier two specialty store or retail store. So they're really two separate actions on our part. One's more growth and one's more cost control.

And so should we expect that they'll come online over the course of 2020 or is that more of a 2021 impact in terms of the revenues coming through and some of the benefits?

We expect those to come on throughout 2020.

I am showing no further questions at this time. I would now like to turn the conference back to Ms. Patricia Ackerman.

Thank you for joining us today. We plan to participate in two virtual conferences in the third quarter, Jeffrey's on August 5th and D.A. Davidson's conference on September 22nd. Have a great day.

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