A.O. Smith Corporation

Good day, ladies and gentlemen, and welcome to the AO Smith 2020 results conference call. At this time, our participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, the conference call is being recorded. I would now like to turn the conference over to your host, Ms. Patricia Ackerman, Senior Vice President, Investor Relations, CRS, and Treasurer. You may begin again.

Thank you, Julie. And I apologize to everyone on this call this morning. We had telephone problems. And so we will start over from the beginning so that you can hear all of our prepared remarks, and then we will go into questions and answers. I believe you heard the introduction that I gave, so I will turn the call over directly to Kevin Wheeler.

Okay, again, thank you, Pat, and our apologies for some technical difficulties here. This may be redundant, but we think it's important to start from the beginning. Before we begin discussing our results and outlook, I want to send my deepest gratitude to the thousands of A.O. Smith employees who have been working under less than ideal conditions and to continue to keep our operations running, offices open, and customers in hot and treated water. To recap 2020, better than expected fourth quarter results drove our 2020 performance above our expectations. North America water treatment grew 14% organically, driven by continued consumer demand for products promoting a safe home. The direct-to-consumer channel with our Aquasana brand, retail outlets with our A.O. Smith brand, and the dealer channel all contributed to solid 2020 growth. We believe industry shipments of US residential water heaters, including tankless, surged to a record, exceeding 10 million units or 8% growth over the prior year. This assessment is based on our strong December shipments. We believe the overall positive tone to new residential and safe at home remodel construction activity including an increase in proactive replacement demand, and channel inventory stocking related to extended industry lead times resulted in above-trend growth in 2020. Due to construction project delays and postponements in North America, as well as pandemic-related weakness in restaurant and hospitality new construction and replacement demand, we saw commercial water heater and boiler industry volumes decline by 8 to 10%. we maintained our market share in both of these categories. Progressive year-over-year improvement in consumer demand for our products in China continued in the fourth quarter. As a result of higher volumes and diligent efforts by our team to reduce costs and reorganize, high single-digit margins were achieved in the second half of the year. In North America, aside from the voluntary closure of our Mexican facility for several weeks in the second quarter, We remain operational throughout 2020 with no significant disruptions within our plants and our supply chain. Pandemic related safety protocols remain in place in our facilities and offices. Due to strong residential water heater demand, coupled with self quarantine related absenteeism, our lead times remain above normal. We continue to use temporary workers, swing shifts, and expedite logistics, in some cases to take care of our customers. All these efforts result in inefficiencies and incremental costs. To align our business with current global market conditions, we reduced headcount and incurred other restructuring costs, totaling approximately $6 million after tax in 2020. The majority of these actions took place in China. We published our second corporate responsibility and sustainability report in January. I'm very proud of our accomplishments since our first report. particularly in employee engagement, safety, resource reduction in our facilities, and a product portfolio that boasts some of the most efficient products in their respective categories. We introduced our first-ever public greenhouse gas emission goal. We strive to reduce GHG emissions by 10% by 2025. I will now turn the call over to Chuck, who will provide more details on the full year and the fourth quarter, beginning on slide five.

Thank you, Kevin. Full year sales of $2.9 billion declined 3% compared with 2019, largely due to significant weakness in the China business in the first half of 2020. As a result of lower sales, adjusted earnings declined 3% to $351 million or $2.16 per share compared with $370 million or $2.22 per share in 2019. Please turn to slide six. Sales in our North America segment of $2.1 billion increased 2% compared with 2019. Higher residential water heater volumes, growth in water treatment, as well as full year of water right sales were partially offset by lower U.S. commercial water heater volumes, lower boiler sales, and a water heater sales mix composed of more electric models which have a lower selling price. Rest of the world segment sales of $800 million declined 14% from 2019. Pandemic-related lockdowns and weak end market demand, primarily in China in the first half of the year, and a higher mix of mid-price products resulted in lower sales. Currency translation of China sales favorably impacted sales by approximately 9 million. Indian sales were also negatively impacted by pandemic-related economic disruption and declined to 31 million compared with 39 million in 2019. On slide 7, North America's segment adjusted earnings of $506 million increased 4% compared to 2019. The increase in earnings was driven by favorable impact to earnings from higher residential water heater volumes, growth in water treatment sales, a full year of water rights sales, and lower material costs. The impact to earnings from lower volumes of boilers and commercial water heaters and the mixed skew to electric water heaters partially offset these factors. Adjusted segment earnings exclude $2.7 million in pre-tax severance costs. As a result, adjusted operating margin of 23.9% was slightly higher than in 2019. Rest of the world adjusted segment earnings of $5 million declined significantly compared with 2019. In China, the unfavorable impact from lower sales and the higher mix of mid-priced products, which have lower margins than higher-priced products, more than offset reductions in SG&A costs and temporary waivers for required social insurance contributions. As a result of these factors, adjusted segment operating margin of 0.6% declined from 4.3% in 2019. Our corporate expenses of $52 million were higher than in 2019, primarily driven by lower interest income. Turning to slide eight, Record fourth quarter sales of 835 million increased 11% compared with the fourth quarter of 2019. The increase in sales is largely due to higher residential water heater volumes in North America and higher sales in China. As a result of higher sales and cost reduction initiatives earlier this year, fourth quarter earnings of 120 million or 74 cents per share increased significantly compared with 2019. Please advance to slide nine. Record fourth quarter sales in North America segment of $561 million increased 7% compared to the same period in 2019, primarily driven by higher residential water heater volumes. Rest of the world fourth quarter segment sales of $279 million improved 19% compared with the fourth quarter of 2019. Currency translation of China sales favorably impacted sales by approximately $14 million. Constant currency China sales improved 15% driven by mid-single-digit growth in end-market demand led by water treatment, replacement water treatment filters, and gas tankless water heaters, and a favorable mix between product categories compared with the fourth quarter of 2019. On slide 10, record fourth quarter North America segment earnings of $138 million. increased 7% from the same period in 2019. The increase in earnings was primarily driven by higher residential water heater volumes in North America and lower still costs. These factors were partially offset by logistic costs. As a result, fourth quarter segment margin of 24.6% was slightly higher than 24.5% in 2019. Rest of the world segment earnings of $31 million improved significantly from $1.5 million in the same quarter in 2019. In China, higher volumes, reductions in SG&A costs, and lower material costs drove higher earnings. As a result of these factors, fourth quarter segment margins improved to 11.2% compared with 0.6% in 2019. Our corporate expenses of $16 million in the fourth quarter were higher than in the same period of 2019, primarily due to an increase in long-term incentives and lower interest income in the 2020 fourth quarter. Advancing to slide 11, cash provided by operations of $562 million during 2020 was higher than 2019. Lower investments in working capital in 2020 were partially offset by lower earnings compared with the prior year. Our liquidity and balance sheet remains strong. Our cash balance has totaled 690 million at the end of 2020, and our net cash position was 576 million. At the end of 2020, our leverage ratio was 6%, as measured by total debt to total capital. We are in the process of refinancing our 500 million revolving credit facility, which expires at the end of the year. We currently have no borrowing on this facility. we expect to repurchase $400 million worth of shares in 2021 through a combination of 10B51 program and open market purchases. Recently, our board increased the authorized shares on our share repurchase authority by 7 million shares. Turning to slide 12, we introduced our 2021 EPS guidance this morning with a range of between $2.40 and $2.50 per share. The midpoint of our range represents an increase of 13% compared with our 2020 results. Our guidance assumes the conditions of our business environment and that of our suppliers and customers are similar in 2021 to what we have experienced in recent months and does not deteriorate as a result of further restrictions or potential shutdowns due to the COVID-19 pandemic. We expect cash flow from operations in 2021 to be between $450 and $475 million compared with $560 million in 2020, primarily due to higher earnings offset by higher investments in working capital than in prior year. In 2021, capital spending plans are between $85 and $90 million, and our depreciation and amortization expense is expected to be approximately $80 million. Our corporate and other expenses are expected to be approximately $51 million, slightly lower than in 2020. Our effective tax rate is assumed to be between 22.5 and 23% in 2021. Average outstanding diluted shares of $160 million assumes $400 million worth of shares are repurchased in 2021. I'll now turn the call back over to Kevin who will summarize our guidance assumptions beginning on slide 13. Kevin.

Thank you, Chuck. Our businesses and the countries in which we do business continue to navigate through pandemic related challenges, particularly in supply chain and logistics. Our outlook for 2021 includes the following assumptions. We project U.S. residential water heater industry volumes will be down 2% or 200,000 units in 2021. We are encouraged by the positive tone in the new construction market, although we believe some destocking will occur during 2021 as we expect industry lead times to improve throughout the year. The timing of the destocking is difficult to predict as we have two price increases announced, one effected in February and a second one in April. The stocking activity could be delayed until mid-year due to the pre-buy orders in advance of the price increases. Further note on the 2021 price increases. We have seen inflation across our supply chain, particularly steel and logistic costs. Steel has increased nearly 50% since we announced our February 1 water heater price increase of 5% to 9%. We announced a second price increase last week on water heaters affected April 1st. also between 5% and 9%, depending on the type of water heater. We expect commercial industry water heater volumes will further decline approximately 4% as pandemic impacted business delay or defer new construction and discretionary replacement installations. In China, it is encouraging to see consumer demand for our China products progressively improve in 2020 and into January of 2021. We accomplished much in China in 2020. which will allow us to productively grow in 2021. Those accomplishments include closing 1,000 stores in Tier 1 and 2 cities, while efficiently expanding in Tier 4 through 6 cities, implementing programs to save $30 million in SG&A, which will carry over into 2021. We've lapped the negative impact to earnings for mid-price products. We expect positive mix in 2021 from new products. and we executed programs resulting in stronger and more nimble distributors. We expect year-over-year increases in local currency sales between 14% and 15%. We assume China currency rates will remain at current levels, adding approximately $45 million and $3 million to sales and profits over the prior year, respectively. We expect our North America boiler sales will increase by mid-single digits in 2021. our expectations are based on several growth drivers. First, industry growth of three to 4%. We assume some pent up demand after the industry declined in the low teens levels in 2020. The CAGR for commercial condensing boilers, which is over 50% of the boiler revenue, was five to 6% prior to 2020. We believe replacement demand is still 85%. A potential government stimulus package targeting infrastructure investment may free up some jobs that were postponed or halted in 2020. The transition to higher energy efficient boilers will continue, particularly as commercial buildings improve their overall carbon footprint. In 2020, condensing boilers were 39% of the commercial boiler industry that represents our addressable market, which provides continued opportunity for our leading market share commercial condensing boilers. New product launches, including improvements to our flagship Crest commercial condensing boiler with a market differentiating oxygen sensor, which continually measures and optimizes boiler performance, and the introduction of a 1 million BTU light duty commercial night FTXL boiler. We project 13 to 14% sales growth in our North America water treatment products. We believe the mega trends of health and safe drinking water, as well as a reduction of single use plastic bottles, will continue to drive consumer demand for our point of use and our port of entry water treatment systems. We believe margins in this business could grow by 100 to 200 basis points higher than the nearly 10% margin achieved in 2020. And in India, fourth quarter sales were similar to the prior year. We project 2021 full year sales to increase over 20% compared with 2020 and to incur a small loss of $1 to $2 million. Advance to slide 14. We project revenue will increase by approximately 10% in 2021 as strong North America water treatment in China sales enhanced by growth in boiler sales more than offset expected weaker North America water heater volumes. Our 10% growth rate projection includes approximately $45 million of benefit from China currency translation. We expect North America segment margins to be between 23 and 23 and a half percent. rest of the world segment margins to be between seven and eight percent to slide 15 please 2020 was a challenging year we are pleased with our performance through the pandemic particularly these uncertain times we believe ao smith is a compelling investment for numerous reasons we have leading share positions in our major product categories we estimate replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes. We have a strong premium brand in China, a broad product offering in 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 are very excited for the opportunity we see in our North America water treatment platform. 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. That concludes our prepared remarks, and we are now available for your questions.

Ladies and gentlemen, if you have a question at this time, please press the star and then the number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Your first question comes from Jeff Hammond with KeyBank.

Hey, good morning. Morning, Jeff. Morning. So just on the China business, clearly you have a really easy comp in the first quarter. Just trying to get a sense of how you're thinking about seasonality. Is it back to normal? And then just on the margin cadence in rest of the world, you kind of were putting up high single digits even above your guidance. So maybe just talk about margin cadence through the year for rest of the world.

Yeah, sure, I can do that. We were really pleased with the fourth quarter, you know, back to double digits in Q4. Had a really nice favorable category mix. Had some decent online volume in China. So, you know, we were pleased with the fourth quarter. When we look at 2021, you know, I think we're back to a more normal cadence. You know, always Q1 is a challenge for us. So Q1 will be the lowest quarter. I would expect that we're going to progress progressively through the year like we have in the past. Maybe 2021 might be 45% of the revenue in the first half of the year, 55% in the back. And our best quarter will be Q4 again in 2021. So, you know, probably starting out the year, you're right, last year is not a, it was a pretty easy comp, right? So, you know, we would expect revenues in the first quarter to potentially double last year's revenues, low single-digit margins, and progress from there throughout the year.

Okay, that's helpful. And then just on North America, I guess your unit volume expectation is down in both commercial and res. I think your guidance maybe implies mid-single-digit growth. Is that largely a function of price, or are you baking any kind of share gains or mix within North America? Thanks.

What we're really baking in is that there will be some destocking, in the end of 2021. So, you know, we just came up a record year for the industry. And as we look forward, as we said in our comments, we're very excited about the new home construction market. We still think there's going to be quite a bit of proactive activity at the DIY level. But embedded in there is some inventory that as industry lead times kind of move back to normal, we see that declining and bringing the industry down from this last year by about a couple hundred thousand units.

Yeah, I mean, kind of the offset to that, a little bit of headwind on the destocking is, you know, we do have boilers projected to be favorable next year. In Kevin's comments earlier, we talked a little bit about some of the new products coming out, potential some help on infrastructure. We do see the industry with replacement being somewhat resilient. Maybe some of the work pushed back last year rolls into 2021. Water treatment, we project kind of a back-to-back 13% to 14% increase in water treatment overtopping that. And, yes, we do expect price rolling into next year. So we've got our steel costs particularly leading our costs for 2021, and we've got the two price increases, one February 1st and one April 1st rolling into next year.

Thank you.

Yep. Your next question comes from Matt Somerville with DA Davidson.

Thanks. Good morning. With respect to China, can you talk about the outgrowth you achieved in the fourth quarter relative to the market? I think you said you were up kind of mid-teens. constant currency, the market up mid-single digits, maybe parse out that gap to the upside in your business?

Yeah, I mean, there's a couple things. So if you look at kind of industry data and look at share and some of the other metrics out there, what they're not capturing is what's happening in our specialty stores. And we're really pleased with what kind of performance we had in our specialty stores in Q4. So That was strong. You know, consumer demand overall we saw in the mid-single digits, you know, strong mid-single digits. But the product category mix that we saw in Q4 was really helpful. So we had a higher product, you know, you get higher sales costs on gas tankless. Our water treatment product had a higher sales price. Decent commercial business in the quarter. So the mix between categories was very helpful to our growth. So that's probably the biggest pieces. I mean, we're really pleased about the fact that our mix, you know, we've talked in the past about some headwind on mix, and we really kind of lapped that, as we said in our comments, where we really wouldn't expect a negative headwind on mix in China going forward. We would expect it to be neutral or slightly positive. So we're kind of at a stabilized point, we believe, on the mid-priced products and positive to neutral going forward. I would just add a couple things onto that.

We've done a lot of work on our mid-price products and our cost structure and so forth. And quite frankly, we have some really terrific products that are going to be launching or have launched a high input in our electric water heater category. We're going to be the only brand out there with a category and grade one noise level in our tankless, which is a a huge factor for consumers in China. Noise is always an issue because it's inside the home. And our water treatment products have been doing quite well, and we have a number of new ones coming up that will continue to expand our higher flow rates, and along with providing hot water. So great work on the mid-price, but we haven't lost sight on our premium products because all three that I just mentioned are in the premium category.

And then with respect to the price increases you're putting in place, Kevin, does that cover you guys relative to where spot prices are today? If you just look at steel prices, they've gone parabolic. I'm sure you're well aware of that. So with this second increase you're putting in, are you effectively covered at today's spot prices, or do you need to contemplate later in the year maybe a third increase? Thank you.

Well, let me start out. Chuck's going to give you some of the details, but As you know, we tend to trail costs, but we always take action, and we have demonstrated that we can do that over time. But we are going to be trailing for a while, and maybe Chuck can give us some comments on how we see the price increases working their way through the market.

Yeah, I mean, our outlook and our guidance assumes that steel pricing stays kind of where it is for the index right now and carries throughout the end of the year. And then, of course, we talk about our price increases. You know, when we look at next year, we would see that those price increases are probably going to lag a little bit on what we're going to see in the cost. We get a little bit of a runway of 90 to 120 days, but to your point, steel pricing has gone up so dramatically so quickly that we're probably going to be chasing the margin a little bit as we go forward. You know, without commenting specifically on particular achievement of price, I would just say historically, you know, over time we've been able to cover that.

Great, thank you.

Your next question comes from Ethan Buckbinder with Citi.

Hi, good morning. Thank you for taking my question.

Good morning.

You mentioned stability and North America water heater manufacturing lead times. Can you talk about your visibility to the level of residential water heater customer inventory levels? due to the impact of lead times and potential pre-buy ahead of price increases? And how should we think about that affecting seasonality in 21?

Let me take that. I mean, the industry on residential is up about 8% over 2019. And I think you really kind of have to think about, or I think about the jumping off point in 2019, which is down about 2% from the trend line. So, I mean, the industry up in 2020 is really 6% to 8%. When we look at inventories, we think about the fact that it's probably half of that might be inventories that have built up. So, you know, if you're in that 3% to 4% of that increase is inventories in the channel, not all of that's going to come out of 2021, we don't think. So if it's 4% and a portion of that comes out of 2021, you know, we're maybe down to that 2% headwind that we see. helped a little bit by what we think will be encouragement in the housing offset of that. And we still see proactive demand on water heaters being pretty strong. So, you know, we kind of arrive at that 2%. When you think about kind of the cadence for the year, we don't believe the price increases that have been announced pulled much, if any, into sales into 2020. But, you know, the first quarter, you know, effective February 1st and effective April 1st, we would expect some increased demand on and the price increase driving some volume into Q1.

That's helpful. Thank you. And, you know, in Q4, China saw healthy growth, 15% constant currency. Can you give us an update about how the expected 500 store openings in Tier 4 to 6 cities are performing, and what are your expectations for store openings or closings in China during 21?

Well, let me touch on that, and then Chuck will give you some figures. One, when you start to look out in Tier 4 and 6 tier cities, I want to caution and make sure that we describe these are small counters, if you will. They're really not the type of stores that you're talking about and see Tier 1 and Tier 2 cities. So I just want to calibrate you as we open up those stores. They're really kind of counters with limited volume, but the ability to sell our product across those growing cities.

From a standpoint, Chuck, our forecast is... Yeah, so the Tier 4 to Tier 6 cities, we're kind of parsing their stores a little different than what we have in the past. So we've talked historically about 9,000 or 9,500 stores, and we're parsing it really Tier 1 and Tier 2, and then back to what Kevin said, Tier 4 through Tier 6. And the Tier 1 and Tier 2 cities, If you go back to 19, that would have been a little over 7,000 stores in those categories. And then the Tier 4 to 6 is around 2,000. So you kind of split it up into those two categories, and you get to the 9,000 and 9,500 stores. On the Tier 1 to Tier 2, our focus is really efficiency, looking at store efficiencies. And we've talked about closing 1,000 stores, and we have. So we went from About 7,400 stores at the end of 2019. At the end of this year, about 6,400 stores. So we've accomplished kind of where we were set out to do the closing of the 1,000 stores. You know, when we look into next year, not much change. We probably have a little bit. We're continuing to look and evaluate efficiency, but we did not expect much change in the Tier 1 to Tier 2 cities. Tier three, or I'm sorry, tier four through six, as Kevin said, it's a different selling model and our expectations are different. And how we're really measuring that is less about how many counters or footprints we have and more about the volume of sales going through there. So that's what we'll probably be talking about more going forward. We've opened up more than that 500 stores that are target. And when I say opened up, we've got relationships and counters and significantly more than the 500 stores And we're going to be just kind of looking at volumes through those stores going forward.

Thank you very much. I'll pass it along.

Thanks.

And your next question comes from Damon Arras with UBS.

Hi. Good morning, everyone.

Morning.

Morning. I wanted to ask you a follow-up question on the China business and rest of the world market in particular. Obviously making some really nice progress there, and you talked about some of the factors with mix starting to come back. Just wondering, kind of thinking longer term, you know, where you are in the business today. I mean, are there any structural reasons why you think you, you know, wouldn't be able to get back to kind of those low double-digit margins on a consistent basis, you know, You know, or is that achievable over time? And if so, kind of, you know, what's it going to take you to get there?

Well, I would tell you I believe, and we've talked about getting back to those mid to low team margins, and certainly we think we can get there. Structural changes, no. If you look at our strategy, our strategy is going to stay consistent. We're a premium brand. We use innovation. to drive products into the consumer's market. We invest in high service levels, we're a high quality company. That foundational part of our business is not gonna change. In fact, it'll continue to be enhanced. However, the market is changing. You have some online going, getting larger. You have some changes in the retail sector in tier one, tier two. And what we're gonna do is we're gonna remain nimble like we have. adjusting our model as far as store openings and how we go to market. You'll see a big part of digital be a big driver for us as we engage customers going forward. The day of having somebody in every store as a promoter we've talked about are probably going to be limited. And we'll use digital more and we'll continue to expand into the other markets that those four and six tier cities one day are going to be tier one, tier two, tier three cities. And we need to have a position there. So overall, I mean, our strategy, where we're at, getting to those type of margins we think are doable over time. And we've been taking the steps in 2020. We'll continue to take those steps in 2021 and beyond.

Yeah, I'll just add that volume really does matter. You know, Q4, we had decent volume, and we get that kind of volume. You know, we've got a double-digit margin in Q4. So, you know, over time, we would expect that we would continue to see consumer confidence driving demand and looking at kind of, you know, hopefully we get back to the point where we've got more trading up to more high premium products, which, by the way, this year, We saw some positive trading up in water treatment, and the water heating side was stable to up slightly. So we're optimistic about getting back to double-digit margins. Probably we're not. We don't have it in our outlook for next year, but we see a path.

Okay, got it. Thanks. And then you did a nice job kind of walking through your expectations for the U.S. presidential market. I was wondering if you could perhaps – give us a sense on how we should think about the cadence for the commercial market this year. I mean, that down 4%, are you sort of expecting declines through the year or maybe growth returning at some point? How should we think about that?

Well, the way I think about it and the way we think about it is we still need to see economies opening up. We need restaurants' capacities open up and in hotels and travel. So we have a 4% decline built into our model. We hope as the vaccine comes out and herd immunity starts getting closer and closer, we see the restrictions in those type of restaurants and hotels to be less and less. Companies start opening up and traveling. So if anything, we see more improvement maybe in the back half of the year than we do in the first half as we continue to, you know, work through the pandemic and, of course, the vaccines being transmitted to the number of people it needs to be.

Okay. Thanks so much. Good luck with it all. I'll pass it along. Okay. Thanks.

Your next question comes from David McGregor with Longbow Research.

Yes. Good morning, everyone. Just a question on the Good morning. Just a question on the inventories in North America, and you've provided quite a bit of color around that, so that's greatly appreciated. But what's the opportunity to sort of throttle up downstream kind of demand creation in 2021 as a way of kind of burn through that inventory surplus a little faster?

Well, I would tell you that the way the inventories are going to be burned through faster is really just when the economy opens up. And And again, we could see more improvement in the DIY side of the market where people are doing more to their homes as we saw in 2020. And, of course, new construction depending on labor in the market. There's a lot of things that can happen that can drive demand. One of the biggest challenges for the construction business has been labor. So those are two things. As things progress – And, again, I keep going back to you as the economy opens up and as, you know, we haven't had salespeople traveling for a year other than under emergency conditions where we're not spending time in the market as much as we like to. All that's going to matter as far as for us to drive demand, both from just the economic side but also from us looking at getting some share. So it's – there's more – there's more action to have to happen, but they also have to be some economic and some opening up of the economy for us to move that forward and bring the inventories down.

Okay, understood. Okay, thanks for that. And then secondly, just on the boiler business, and you walked through quite a bit of detail on why you were feeling confident in that mid-single-digit growth number for next year, so that as well is appreciated. But I just wonder if you could talk a little bit about what you're seeing in the backlog for that business that may be giving you confidence, or is this more just kind of assembling all these drivers in a theoretical construct and this has got to lead to a better growth? Are you seeing hard evidence in terms of orders and backlog now that's giving you that confidence?

Well, I can tell you what we're seeing today. We didn't see the delay in post-learner projects as we saw back in last year. That's number one. You know, number two, the activity in the market is lower, but there's still activity going on there. And so, you know, again, as we go forward, it's not just about some of the projects being released and the economy growing. There's a component of new product launches that we have that are going to be important to our growth. So it's a combination of those. But I would tell you, I mean, we're excited about the crust boiler with the O2 sensing technology. is an important part of what we're going to do. We actually introduced several new products in 2020 that kind of got lost in the mix of the pandemic that I believe are going to help our business as we go forward.

Yeah, and I would say with regard to your specific question on backlog, you know, our backlog is pretty similar to what it was at the end of last year before the pandemic. So, you know, the backlog is pretty solid. Okay.

And is there anything incremental to the distribution story on boilers that would be helping you next year?

Nothing specific. We still have strong distribution. Of course, we have our rep network, but I would say nothing that would be material to talk about today.

Right, right. Okay, thanks very much, gentlemen.

Thanks.

Your next question comes from Susan McLaury with Goldman Sachs. Thank you. Good morning.

Good morning, Susan.

My first question is on the water treatment side of things. You know, you highlighted that you expect some continued really elevated sales there over the course of 21. Can you talk a little bit about the margins? I know that, you know, you've made some progress there over the last couple quarters, but how you're thinking about that on a go-forward basis and, you know, any kind of pressures or benefits that we should be aware of in that?

No, we were pleased with the expansion of about 200 basis points of margin this year, so we're just under 10% in 2020. Going forward, with the help of leverage on some growth, so next year we kind of see that growth being the 13% to 14% again, and continued work on costs, we would expect margins to expand actually over the next couple of years in that 100 to 200 basis points. So we do expect forward progress on that as we continue to grow the base and continue to look at cost out.

I would just add, volume matters there too. So as that business continues to grow, we get to leverage our facilities, the operating leverage within them, which will also help us to improve margins on a long-term basis.

Okay, that's helpful. And then my second question is just, you know, you mentioned that you are restarting your share buyback program this year. I think you kind of earmarked $400 million or so for that. Any color in terms of, you know, the kind of cadence of that, how we should be expecting it to come through, and then, you know, kind of any appetite at the higher or the lower end of that $400 million?

No, I mean, I would peg it at 400 right now. I wouldn't really go higher or lower, and we're probably looking at throughout the year is what we're kind of thinking of it. So the cadence would be pretty evenly throughout the year.

And your next question comes from Brian Blair with Oppenheimer.

Thanks. Good morning, everyone.

Hey, Brian.

Good morning. Chuck, I'm I apologize if you've provided this detail. I have offered a lot. But if we keep other variables constant for the year, what's the margin impact of normalizing residential volumes in 2021? Just trying to parse that out, you know, that relative hit, knowing there are some offsets elsewhere.

Yeah, I mean, there are so many. I mean, it's hard to say that it's going to be stable, right? There's so many moving parts. Our costs have gone up so dramatically that in the last short period of time. And when you look at those costs going up, you look at, you're right, there's a little bit of a detrimental margin impact when you've got a couple hundred thousand units coming out of the industry. So yeah, there's some headwind there, but there are so many moving parts, it's hard to say. I think we're gonna, we're just gonna, we're gonna be chasing our costs a bit next year. As you said, the costs have gone up so dramatically. that there's going to be, at least in the first half of the year, a little headwind on North America margins.

Okay, understood. And great to see the momentum in your North American water treatment business. How is your M&A pipeline looking, particularly when it comes to targets to continue to scale that platform?

I would tell you that, as we always do, we try to be active, and we have certainly targets that we continue to stay close to and in contact with. The pandemic's made that a little bit more challenging, but we remain active in reaching out to the appropriate people. And as we come out of this pandemic, I think there's going to be some opportunity. But we're as active as we have always been and looking for the opportunities that make sense to our core business.

And your next question comes from Nathan Jones with Stifle.

Good morning, everyone. I just wanted to follow up a little bit on the rest of world margins. Comment there that you don't have double digit margins built into the model for 2022. I know in conversations we've had that you targeted getting the mid-price tier product margins in China up to the premium tier margins by the end of 2021. With volume returning pretty nicely in ROW, why isn't it that you could get to double-digit margins in 2022? And what are the top one or two things that would need to happen for you to achieve that double-digit margin in 2022?

Yeah, you know, the fourth quarter is always the strongest quarter in China. So if you kind of look at the fourth quarter, you take out currency, you multiply it by four, we're back to a billion-dollar business, and the year just doesn't play out that way. Q1 is always weaker, and so Q1 is just going to be challenged on that. So if you look at kind of the quarters building through the year, we're just not quite there yet on the volumes and on the cost out. Now, the margins, you're absolutely right. Our goal is to get the contribution margins back up to a similar percentage to the premium side of the product. That's going to take a little time. It takes a couple things. It takes cost out, which we're working on over time. We won't be in that position in 2021, but we are working on it, and it's going to take volume to help us kind of leverage that through the footprint in China.

And just a question on 4Q20 North America. You guys had anticipated some channel destocking in 4Q20. Doesn't look like that happened. Can you talk about what led to that happening? Was it just customers deferring destocking that because their new price increases were coming? Fundamental demand picked up, sell through picked up. Just any commentary you can provide on what changed between your assumptions when you were giving 4Q20 guidance.

Yeah, I'm not sure I could describe it better than you just did. When it's all said and done, you know, yeah, when we were talking about destocking, we didn't have a pricing piece coming up. And quite frankly, demand stayed there. And I think, you know, as we look back on it, our distributors probably want to be a bit heavy right now on their inventories just to make sure they can take care of their customer demand. So there's a few things that happened. You described them. We expect that sometime in 2021, probably in the latter half of the year, you start to see what we had said in the prior quarter actually happen.

Your next question comes from Scott Graham with Rosenblatt Securities.

Morning, Scott.

Scott, your line is open.

I'm here. Can you hear me?

We can hear you now.

Okay. Well, congrats on the quarter. Thank you. So first question is on China. Could you give us that percent of sales for the business, which I know you load up everything in there with the water treatment and everything, premium versus upper middle in the quarter?

Yeah, it really hasn't changed much. It's pretty consistent with what we've been talking about. So we still see the majority in the upper mid-priced part of the segment of the market, and not a lot has changed since the prior quarters.

Got it. Thank you. And then back to the North American business, I want to just try to square away some comments here and make sure I understand them. I think you said that last year residential was units, industry were up about eight, but you kind of called that a normalized six to eight percent and that the inventory build was maybe half of that, but that not all of that will come out this year. So sounds to me like a two minus, that's a two percent headwind. Is that fair?

Yeah, that's fair. I mean, we think we'll get a little bit of help on new construction potentially in that category, too. So, you know, that's exactly the way we're thinking about it in our outlook.

Right. Well, I only repeated your words. I just wanted to make sure I got it right. So those are very clear comments. But, I mean, the full-out question from that is, if I may, is, you know, if you're thinking that the industry is down, too, and it's essentially because of that reason that I guess I'm just wondering why you wouldn't expect sort of let's call it normalized. Why would you expect it to be only flat? Residential conditions are quite strong this year. I know you answered David's question earlier about, you know, labor and what have you. I mean, I think we've all experienced that. You try to get a contractor in your house, you know, you have to pay hard currency, you know, in advance kind of thing. I understand that. But is it a labor thing or are you just maybe being a bit conservative on that number?

You know, I guess I think of it, Scott, is that we would continue to expect to see some pretty decent consumer demand next year and proactive demand to be only down two. So this year being up six to eight, next year being down two, you still have that kind of baseline proactive replacement, strong residential replacement, some potential growth year over year, I think, in our numbers. So we do still expect it to be consumer demand fairly strong, relatively strong, similar to what we saw this year on that underlying proactive replacement. Scott, I would also tell you, we're coming off a record.

Even what we're forecasting is going to be one of the strongest years in the past decade. There's still a lot of optimism out there, but we just believe there's some stock that's going to come out that's going to make a difference.

Yeah, I mean, really the big variable on how we look at next year is that 2% destocking or 200,000 unit destocking.

Your next question comes from with Jeffrey.

Hi, good morning. Thanks for fitting me in.

Good morning.

Could you talk through what you're seeing in the tankless market in North America? And if you're seeing any other areas introduce legislation similar to California limiting gas use in residential homes and How could that impact tankless sales going forward?

Well, tankless had a good year. We believe it's going to be up low double digits. So kind of in line with the tank and so forth. So it's kind of what we expected in the tankless market and so forth. Now, as far as we talk about California, you're talking about decarbonization and so forth. And I'm not going to talk specifically about tankless. I would just talk about our position with regards to that. When you look at it for us, it's important that we are part of the conversation. We believe that, you know, GSD emissions in residential and commercial buildings, we want to be part of reducing those. We're constantly talking to policymakers just to make sure that, you know, They're keeping in mind the technologies, and there isn't a one-size-fits-all. You hear, like California, that they want to just go completely electric. We don't think a one-size-policy fit-all is the right way to go. We think multiple paths are there. So that's going to navigate its way through, and we're going to be part of the conversation to make sure that technologies are included, performance of the products included, and cost to the consumers included. And from an A.O. Smith perspective, I think we're positioned well. We have a full line of residential electric and commercial products in the market today. We have a full line of heat pump, residential and commercial, which are the highest efficient electric water heaters out on the market. And I never want to forget that we have leading positions in condensing products, gas condensing, which can make a big difference in lowering GHG emissions just by going from a standard to a high-efficiency model. So wherever the market's going to go, we're in position. Again, I would tell you we're part of the conversation, but we're also positioned well so we can be nimble in where the market goes. We have the products that can... can meet the demand for the consumer and, of course, the commercial market as well.

Thanks for that color. Then on the commercial, you talked about some uncertainty around that business, obviously forecasting it down for this year. Could you help us understand from a historical perspective, have there been many times where demand has declined two years in a row, and could this forecast prove conservative?

You know, I don't, Pat's taking a look at whether, and the answer is no. I mean, there probably hasn't been down two times in a year in a row, but I think the, you know, the pandemic and the impact to, I'll call it restaurant, hotel, some of the higher end, you know, the higher usage categories that we participate in, it's really spreading across two years, right? So it started Q2 and it's still going. So I think the down year over year is more related to pandemic than anything. And, you know, we may see, I mean, Kevin's comments earlier about how that might play out. I think we're going to have to wait and see what the back half of the year shows and where we're at in the pandemic disruption.

And your last question comes from Larry DeMaria with William Blair.

Hey, thanks. Hey, Larry. Hey, guys. Nice job. I know you talked about this kind of almost ad nauseum about the imagery he's talking, etc., But just to be clear, and then the potential pre-buy, are we expecting sales to comp up first half, comp down second half, or could we sort of get closer to a flat because of the price increases? Can you just kind of clarify that a little bit?

You know, I guess it's kind of hard to parse it out that way. I'll say we expect unit volume to be up in Q1, and that's because we do have the two price increases out there, and typically there's a pre-buy before that. And then historically, the back half of the year is stronger than the front half of the year. So, you know, when you kind of look at it that way, I think, you know, I think maybe that'll help kind of frame the model.

Okay. I guess perhaps. And then maybe that's mostly obviously residential, but it plays into North America. Commercial, some headwinds there, obvious. Is there a, you know, how do you think about that market situation? getting towards a bottom, is that potentially bottoming on a, just because if there's nothing else, easier comps later this year and start to think about maybe comping up off a low base? Or do we expect that to be down all year?

I think it's going to come down to how the economy opens up. There's been a lot of positive feedback from some governors that had been shutting down economies and realizing now that they have to open them up. But again, it comes down to Restaurants have to be opened up. They have to be more than 25% capacity. Hotels have to have people who are traveling. So I do think the pandemic is going to be a factor in how the commercial market returns. And we'll have to wait and see how that plays out throughout the year.

And I'm showing no further questions at this time. I would now like to turn the call back over to the host.

Thank you, everyone, for joining us today. We plan to participate in two virtual conferences in the first quarter, Citibank on February 18th and Robert W. Baird on February 23rd. Have a great day.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.