A.O. Smith Corporation

Good day and thank you for standing by. Welcome to the first quarter 2022 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the conference over to Helen Gerholt. Ma'am, please go ahead.

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

Thank you, Helen, and good morning, everyone. Thank you for joining us today. I'm on slide four and our first quarter results. Our team performed extremely well throughout the quarter despite a turbulent macro environment and delivered strong sales and EPS performance. First quarter sales improved 27% year over year, driven by our 2021 inflation-related price increases and acquisition of the giant factories late last year and international volume growth. Excluding acquisitions, first-quarter sales grew 23 percent. Our rest-of-world segment performance was strong, with margins improving over 440 basis points year-over-year, driven by China improving its operating margins to over 11 percent. We delivered strong results despite supply chain challenges and component shortages throughout the quarter. Weather challenges and Omicron-related labor constraints impacted our North American production the first half of the quarter. However, shipments improved sequentially in the second half of February and in March, especially our residential water heater production where we saw supply chain improvement and as a result improved our lead times to customers. The acquisition of Giant added $32 million to the quarter sales and two cents to EPS. We are pleased with the performance of the team and the integration is on track. Please turn to slide five. Our global AO Smith team delivered first quarter 2022 adjusted EPS of 77 cents, a 31% increase that was driven in part by a 27% increase in sales compared with the first quarter of 2021. Our strong first quarter performance resulted from our team's outstanding operational and sales execution despite the challenging environment of component shortages, continued materials and transportation cost inflation, weather impacts, and surges in COVID-19. I continue to take pride in how my fellow AOSBIT employees are working together to overcome these challenges to meet market demand and deliver for our valued customers. Excluding the impact of Giant, North America water heater sales grew 28% in the first quarter of 2022. due to pricing actions implemented in 21, in response to rising material and logistic costs. Our full year outlook of the residential water heater industry remains unchanged as demand continues to track to our expectations. Our full year outlook for the commercial water heater industry is to be flat to slightly down. The commercial industry started the year weaker than expected, primarily due to a regulatory change that temporarily impacted orders of large electric commercial products greater than 55 gallons. Our first quarter commercial sales were also impacted by component shortages for certain gas products. We have seen demand for our large electric product improving since early in the quarter, and we expect component availability to improve in the second quarter. Our North America boiler sales grew 24 percent in the quarter, primarily driven by price increases to offset higher material and transportation costs and demand for our energy-efficient products. We ended the quarter with a record backlog, largely composed of commercial condensing boilers, and April continues to generate strong order rates for these market-leading, energy-efficient boilers, providing confidence in our outlook for the year. Our strategy to focus on innovation and decarbonization contributed to strong demand for our high-efficiency condensing boilers. North America water treatment sales grew 17% in the first quarter as we continue to pursue additional market share in this attractive market with a total addressable market value that we estimate to be $2.6 billion. Taking an omnichannel approach, our strategy is to grow our market share through innovation, product development, and acquisition opportunities. Our independent water quality dealers continue to play an important role in our growth by outperforming the market and gaining market share. In China, sales increased 12% in local currency compared to the first quarter of 2021, primarily due to favorable mix as our new product offerings continue to be well received, as well as higher sales of commercial water treatment products and replacement filters. During the first quarter, we proactively worked with our distributors to ship product into the market in advance of potential COVID-19 disruptions. which most recently is impacting transportation in certain regions. While our customers have ample inventory in place, our tracking of consumer demand in April across our portfolio and geographies is indicating a year-over-year reduction of 35% to 40%. Our outlook assumes the COVID-19-related shutdowns in China subside during the second quarter of 2022. Despite the economic headwinds to our business in China, I'm very pleased with the quarterly performance of our China team, who are taking great steps to right-size the business, manage discretionary spend, while investing in new product development. On slide six, please. I'd like to highlight two of our products in China that demonstrate our continued focus on innovation and product development. At the Red Top Awards ceremony in Tianjin, China, A.O. Smith earned two of the coveted high-end appliance awards for the quiet fresh range hood and soft water heating hot water boiler. Under the guidance of China Household Electric Appliances Association, our products were among hundreds of products evaluated for the awards every year with a focus on advanced technology, industrial design, market influence, energy conservation, environmental protection, and user experience. We take great pride in this recognition as yet another example of how our product set us apart as an innovative leader in the market. I'll now turn the call over to Chuck, who will provide more details on our first quarter performance. Thank you, Kevin.

Good morning, everyone. I'm on slide seven. First quarter sales in North America segment rose to $730 million, a 32% increase compared to 2021. Pricing actions, largely on water heaters, represented approximately 89% of the increase. Sales in the quarter also benefited from higher volumes of boilers and water treatment products. However, the sales increases were partially offset by lower volumes of commercial water heaters. Giant, acquired on October 19, 2021, added $32 million to North America sales. North America adjusted segment earnings of $154 million increased 21% compared with the same period of 2021. The earnings benefit of inflation-related increases was partially offset by higher material and freight costs and lower commercial volumes. Adjusted segment operating margin of 21.1% declined compared with 2021. Margin performance sequentially improved each month through the quarter as COVID-19 related absenteeism and supply chain constraints eased through the quarter. North America operating margins exited the quarter at the top end of our full year margin outlook for North America. Moving to slide eight, rest of the world segment sales of $256 million increased 15% year over year. Favorable mix from new product introductions in the premium segment of the market particularly our slimline electric wall-hung water heaters and water treatment products that deliver hot and ambient filtered water, as well as higher sales of commercial water treatment products and water treatment filters contributed to sales gains. As Kevin noted, sales in the first quarter were positively impacted by proactive measures to distribute product into the market in advance of potential COVID-19 disruptions in China. India continues to perform well and sales grew 36% in the first quarter compared to 2021. We view India as a long-term growth opportunity given its attractive growth characteristics and changes in demographics. The rest of the world's segment earnings of $25 million increased significantly over segment earnings in the first quarter of 2021. In China, the benefits from favorable mints, higher volumes, and lower advertising and selling expenses drove rest-of-the-world segment margins to 9.7%. Free cash flow of $4 million during the first quarter decreased from the first quarter of 2021 due to higher 2022 earnings that were more than offset by higher incentive payments due to record 2021 sales and earnings and higher cash outlays for higher levels of safety stock on higher-cost inventories. Historically, we generate the majority of our cash in the second half of the year. Our cash balance totaled $579 million at the end of March, and our net cash position was $284 million. Our leverage ratio was 14% as measured by total debt to total capital. Our strong annual free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return cash to shareholders. Earlier this month, our board approved our next quarterly dividend of $0.28 per share, which represents our 82nd consecutive year of dividend payments. We repurchased 1.5 million shares of common stock in the first quarter for a total of $108 million. Let's now turn to slide 10. In addition to returning capital to shareholders, we see opportunities for organic growth, innovation, and new product development across all of our product lines and geographies. We continue to target strategic acquisitions with a focus on water heating and water treating assets that meet our financial metrics of accretive earnings in the first year and return our cost of capital in three years. We have a proven track record of developing innovative new technologies and making prudent and focused acquisitions to drive shareholder value. Please turn to slide 11 in our 2022 full-year earnings guidance and outlook. We reaffirm our 2022 outlook with an expected EPS range of $1.56 to $1.76 per share and our adjusted EPS range of $3.35 to $3.55 per share. Our outlook is based on a number of key assumptions, which include no further significant surges of COVID cases in the U.S. and that COVID-related shutdowns in China subside during the second quarter of 2022 and do not significantly impact our operations, our employees, customers, or suppliers. Steel indices began to stabilize at the end of 2021, and steel fell briefly early in the first quarter of 2022. However, due to the international uncertainty on commodities availability and prices, in part due to the conflict in Ukraine, Steel market prices have risen again in recent weeks. Our guidance assumes that steel pricing in 2022 on an annual basis will approximate steel market pricing as of mid-April. We continue to see increases in non-steel materials and transportation costs. Supply chain challenges persisted in the first quarter. We remained in close contact with suppliers and logistic providers to troubleshoot, manage, and resolve bottlenecks, but the environment remains unpredictable. Our outlook assumes we continue to see the benefit from multiple 2021 price increases in the compounding to approximately 50% for water heaters, and continued resiliency and demand in North America for our water heating product categories, driven by replacement demand and new construction spending. As for other housekeeping assumptions, we expect to generate free cash flow of between $500 million and $525 million. For the year, CapEx should be between $75 million and $80 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be between 23.5 to 24%. And we expect to repurchase approximately $400 million worth of shares of our stock, resulting in outstanding diluted shares of $156 million at the end of 2022. Based on these assumptions, the midpoint of our adjusted EPS range represents an increase of 17% compared with 2021. I will now turn the call back over to Kevin, who will provide more color on our key markets and top-line growth outlook and segment expectations for 2022, all while staying on slide 11. Kevin.

All right. Thank you, Chuck. We project revenue growth for 2022 of 14% to 16%, which is lower than our outlook in January as a result of volume headwinds in China and a slower start to commercial water heating. Our sales assumptions include approximately 8 percent growth in each of the last two years, which is well above the historical average growth rate. We estimate U.S. residential water heater industry unit volumes will be down approximately 2 percent from last year as industry demand normalizes. While the commercial water heater industry demand has started the year slower than expected, our guidance assumes improvement in the remainder of the year. as we project the commercial industry volumes will be flat to slightly down compared to last year. We have reduced our sales growth projection in China from 5% growth in local currency to be flat compared to last year as a result of economic headwinds we are experiencing from COVID-related restrictions. We have increased our North America boiler sales growth projection from 10% to 18% to 20% sales growth driven by increasing increased pricing in response to higher input costs. Our outlook for North America water treatment sales growth of 13% to 14% for 2022 has not changed. Based on these factors, along with the full impact of our 2021 price increases, we expect our North America segment margin to be between 22.5% and 23%, and rest of our segment margins to be approximately 9.5% to 10%, or 50 to 100 basis points higher than 2021. Please turn to slide 12. 2022 continues to present challenges for our global teams, and we are meeting them head on. We believe AO Smith is a compelling investment for numerous reasons. We have leading share position in our major product categories. We estimate replacement demand represents approximately 80% to 85% of US water heater and boiler volumes. We have a strong premium brand in China, a broad product offering in key product categories, extensive distribution, and a reputation for quality and innovation in that region. We have rationalized the cost structure of our China business, streamlined our stores in Tier 1 and Tier 2 cities, and strengthened and extended our product offering in both the premium and upper mid-price sectors of the markets we serve. We are well positioned to maximize favorable demographics in China to enhance shareholder value. We continue to be very excited for the opportunity we see in our North America water treatment business. We have strong cash flow and balance sheet supporting our ability to continue to invest for the long term in automation, innovation, and new products as well as acquisitions and return cash to shareholders. We remain focused on serving our customers and continuing to meet their needs. Our strong brands across the portfolio, combined with investing in technology to drive innovation and new product development, will further enhance our market leadership. We are confident in our ability to capitalize on opportunities as we continue to execute our strategy. With that, we conclude our prepared remarks, and we are now available for your questions.

All right. Thank you, sir. As a reminder, to ask a question, you will need to press star 1 on your telephone keypad. To withdraw your question, you may press the pound key. Please stand by while we compile the Q&A roster. And we have our first question from Matt Somerville of DA Davidson. You may ask your question.

Thanks, Morning. First, maybe could you guys comment on what you think the market actually did from a volume standpoint in the U.S. for resi and commercial water heaters in Q1? and how you feel you performed relative to the market, just given that you guys experienced some COVID absenteeism, et cetera, and I would assume your competitors did as well. But if you could comment on that, that would be helpful, and then I have a follow-up.

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

And then just a follow-up on China. I think you mentioned sales tracking down 30%, 35% thus far in April. Is your guidance assuming and, well, I guess, what assumption do you think is most appropriate for us to be thinking about in Q2? Have you seen that 30% to 35% start to improve, or is it getting worse? I guess I'm trying to think about how to frame up China, you know, for the second quarter specifically, you know, to get to the full year kind of flat.

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

Got it. Thank you, guys.

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

Morning, Scott. Hey, good morning. Thanks for taking my question, all. So I can understand some of the puts and takes here on your slide 11. And essentially, if we were to take out the adjustment for the pension, your guidance is just – it's necessary just a little bit lower. I mean, that's just the math. And, like, if you had to kind of say, you know – You know, what are the larger swing factors in that? Would you essentially say, you know, China and slower starts of the year in North America? Or how would you frame that for us?

Yeah. Scott, I'd say our guidance or outlook on the adjusted EPS has not changed. So we're kind of staying tracked right on that. Kind of the puts and takes on that is, You know, certainly we're seeing the headwind in China. So we've got China where we were saying 5% up in local currency being roughly flat. And, you know, China for the first quarter starts out pretty strong. So first quarter, as we mentioned, we proactively put product into the channel. So that is expected to stay in the channel for the majority of the year just as kind of protection, make sure product is out there if there were any transportation interruptions. Also, discretionary spending in China ran pretty well. They're able to flex a bit better and be a little bit more nimble on spending since they've taken some cost out and restructured the business. So we expect that positive SG&A spending to be a lever we can pull going forward. So on the volume side, it's really largely China offset by a bit of spend that China can do. In North America, when we look at North America, we improved our margins 25 basis points on North America. The way we're thinking about that is, you know, we're coming out of the quarter at about that run rate in March. When residential production, you know, kind of hits a better pace when we've got components, we can perform pretty well. So, you know, the puts and takes are we've got China a little bit ahead when on sales. We've got a little bit better margin in North America. Our backlog is still strong on the boiler side. Kevin mentioned kind of the boiler condensing issues. product that's out there, larger product, good margin product. We've got a little bit of ground to make up on commercial water heating, so that should help our mix a bit. So as you kind of go throughout the year, we would expect that to be a bit of a help compared to Q1. We've talked a lot in the past, and we've noted in our comments the water heater pricing, but If you take outside of water heaters in North America and think about kind of the pricing on other product categories, we've got announced price increases, and I'll just make the range 2% to 12% out there that becomes effective as we go through the year that helps a bit on the margin side as we go kind of in the back half of the quarter. We still see commodity costs high. You know, we got a little relief on steel, but commodity costs made that up and increased. So our outlook, you know, we really haven't changed much on costs. We expected that to go up in our January outlook, and it has. So, you know, we're still seeing pressure on the cost side.

I got it. And, Chuck, my apologies. I am now looking at the quarter ago presentation, and that pension adjustment is in there. so guidance doesn't change. And thank you for that comprehensive response. That was awesome. Let me ask you a little bit about the supply chain. And, you know, and I know that you're always, you know, kind of loathe to comment on price cost. But, you know, your wording in North America suggests that you were kind of price cost positive here. And so if you can confirm that, great. And then secondly, You said the supply chain constraints are getting easier in North America. Can you explain that a little bit?

Let's talk about the supply chain first. As we frame it, it's stable. It has improved. We saw our residential components and so forth improve in the quarter. And we also see some improvement coming in in the second quarter on our commercial on particular components. But overall, it's been stable. It does improve, particularly on the material side. Components are still a bit unpredictable. So it's getting better, but we still wake up every day and still at times we'll have issues that we have to work through. But again, our teams are working very closely with with our suppliers. In fact, I think we know our suppliers better than we ever have now in the last couple of years. So it is moving forward. We're going to have these sporadic issues we have to deal with. But I think the key takeaway here is we just don't see any major disruptions. And before there's even a follow-up question, I just want to talk about Ukraine. We have no direct suppliers out of there. And we're seeing maybe some transportation issues, a small amount in Europe that we have to deal with. China, I think it's still a little early. We stay very close to China. Of course, we have a decent supply base there, particularly on some of our components. But nothing in the early term here that we see any issues with, and maybe some medium risk down the road. But again, no major disruptions in our supply chain that we can forecast at this time. So getting better, and all factories are running well. and that's in China as well, just to follow up on that. And we'll continue to work on some of our backlogs. We have large backlogs in boilers. We have large backlog in commercial water heating. We anticipate that second quarter we'll be able to make a dent in both of those, and they are certainly upsides for us as we go through the year, as Chuck mentioned.

Again, thank you very much for your comprehensive answers, both of you. I'll get back in the queue.

And speakers, we have our next question from Susan McClary of Goldman Sachs. You may ask your question.

Thank you. Good morning, everyone.

Good morning. Good morning.

I guess just staying on commercial for a bit, can you talk a little bit more about the regulatory changes that came through? And I know that you mentioned that you do expect that, you know, that will incrementally sort of catch up as we move through the next couple of quarters. Can you just give some details on, you know, the the relative changes that you're making there and how to think about some of those details?

Yeah, thank you for asking that question. I really think it needs some explanation. The regulatory change we're talking about was on the graded 55-gallon electric. And without getting into the details, the change raised the KW in wattage and requires a different SKU. What happened, though, our industry really did anticipate that going into effect. we were anticipating the old regulatory to be carried over and extended into the first part of this year. It wasn't. From our point of view, it caught the industry a bit flat-footed, not so much on the manufacturing side because we were all prepared, but I think from just understanding the regulatory change on the distribution side. So if you look at it, we had to get out there and kind of update our customers of what the new SKUs would be and so forth. So we saw January very slow. You know, we were working through the regulatory change being implemented and getting to our customers. We saw February improve. And then when I can just speak from our point of view, March, our run rate on greater than 55-gallon commercial electrics was basically at our run rate from prior year. So we look at this as kind of a temporary gap, if you will, that will close itself and more normalize as we get through the year. So it was just a situation where the industry had to kind of recover, but the fundamentals of the category, the fundamentals of the business are still there. That's why we're looking in the balance of year for that to stabilize and normalize. So that's a quick snapshot of what happened in that regulatory environment.

Yeah, no, that's very helpful. I appreciate all that color. And then I guess You know, on the residential side with the water heaters, appreciating that this is a bit further removed from you, but any commentary on inventories in the channel and just where those kind of sit given all the moving parts that the industry and yourselves obviously faced in the first quarter?

We don't have great view into the inventories in the channel, so what I'm going to tell you is anecdotal industry experience, that type of thing. On the commercial side, we believe the inventory is still a bit light in the channel. And that's indicated by our backlogs and just the activity that we're seeing there. So inventory, commercially, a bit light. We hope to make that up as we improve our production in the upcoming months and quarters. And I'll just probably add on residential. We probably think it's about where it needs to be. It may be even a bit heavy because... I think people are hedging themselves. Customers are hedging themselves in case of any further disruption. So that's our view. Again, residential is probably where it needs to be, a little heavy. Commercial is still some room. We take care of some production needs and get some products back into our customers' inventories.

Okay, great. Thank you, and good luck with everything.

Thank you.

And our next question from Nathan Jones of Steevil. You may ask your question.

Good morning, everyone. Good morning, Nathan.

Good morning.

I'll start off following up on the residential inventory there. Noted that it might be a bit heavy with safety stock. I think that's going to be one of the questions as we, not just for your business, but for a lot of businesses as we go forward is, Are customers holding safety stock and are they going to continue to hold that safety stock more permanently or will it normalize as customers have more confidence in their supply chains? Just interested to hear your opinion on that and what you're thinking about the potential inventory levels more over the long term at your customers.

Well, as I mentioned, I would agree with what you just said, quite frankly. I think, you know, as lead times come down and things normalize. Now, when that is, I'm not going to predict. But, you know, right now, yeah, there could be some. But, again, lead times are going to have to come down first. Things are going to have to be a lot more stable. I don't think it's heavy, you know, stock out there, safety stock out there. that we think, but it is a bit higher than maybe normal. But my view, probably most distributors whom I talk to will probably be a bit conservative in making sure they're going to lean in on having product and inventory to service their customers, considering the last year or so what they've gone through, what we've gone through. So that's our view. Again, we can't predict what's going to happen six, 12 months from now, but that's where we're at today.

Thanks for that. Maybe I could just ask, where are your lead times today? Where were they, you know, last year or late 2020 when they were at their highest? And what were they normally before COVID?

Are you talking North America or U.S. right now?

Yeah, North America, residential water heaters primarily.

Lead times today are about 20 days. that are our goal and what historically we've targeted is 15. And you look out back in the tougher times, there are probably 2x that or more. And we've just been able to bring those down, ramp up production, again, as materials and components became more available. On the commercial side, we target really the same type of lead times. Right now, our commercial lead times are elevated at least 2 to 3x.

That's great, Kyle, for me. Thank you very much for taking my questions. Thanks.

And our next question from Andy Kaplowitz of Citigroup. You may ask your question.

Good morning, everyone. Morning, Andy. Maybe we just talk a little bit more on China. Can you give us an update? into inventories in the channel. I know you said you put product in the channel. So how are you thinking about the channel itself, given it was sort of coming off five-year lows and maybe a little more color around your ability to drive self-help in China with new products, growing into those tier three to tier six cities? I think you mentioned SG&A cost out. How much could all that other stuff sort of help you as you go through this uncertain period?

Yeah, so a channel inventory in China, so most of the sales increase for the quarter was putting channel into the inventory, or putting inventory into the channel. The level at the end of Q1 is about a month and a half. You know, that's not really out of line compared to what it was, certainly higher than year end, which was at kind of a five-year low. Felt it was prudent to do that, make sure we had channel inventory available in case there was transportation interruption. So the way we're thinking about that in our outlook for the year is that, you know, most of that inventory will stay in the channel. We're not really bringing it back down to kind of the low level it was as we exited 2021. So we expect it to stay there just due to the uncertainty in, you know, COVID potential interruption, even though we Our outlook projects it'll subside a bit as we go through the rest of the year. Kind of the levers in SG&A, and the amount in the first quarter of SG&A discretionary spend that was mitigated, I guess, is in that $3 to $4 million. So we've taken out a large number of stores in Tier 1 and Tier 2, over 1,000 last year, and that reduces the cost, makes those stores more efficient. gives us a little more flexibility on how we spend SG&A. So those are kind of the inventory levels, the SG&A side. You know, the progress on Tier 3 through 6 cities, Tier 4 through 6 cities, is on track. You know, we continue to, the very low-cost model, continue to have, you know, think of those, again, as more counter space than they are storefronts in the Tier 1 and Tier 2 cities, but Largely on track, continue to add to those cities.

Appreciate the color. And then maybe just a little more color to the strength you're seeing in terms of your North American boiler business. Obviously, you increased guidance there, but how much of the improved outlook is your customers really focusing on these commercial condensing boilers, given their energy efficiency focus in a higher natural gas price environment? And could you see further inflection if gas prices stay high?

Well, again, this will be anecdotal. Again, we don't have any great data there, but it just would be natural as energy costs have gone up and a movement for decarbonization and reducing your footprint, that plays really well into our condensing boilers. So we feel there has to be some impact to that. Certainly the return on investment now on our condensing boilers is today versus they were just months ago are significantly better. So it's playing a role, and I think we see that because of just the order rate that we have on our condensing boilers coming in. I mean, our backlog has been high, continues to be high. We're shipping, doing quite well. That's why we raised the guidance. Activity in the institutional side, activity in the hospitality side, even still activity in the education side is good, and our quoting continues to be good. So overall, I think there's one, the market is maybe making up for lost time in the last couple years of COVID, but I do think there is a – a swing towards condensing high-end efficient products for, again, paybacks, but just as much for decarbonization. Appreciate the color.

And speakers, our next question from Damian Karras of UBS. He may ask your question.

Hi. Good morning, everyone.

Morning. Morning.

I wanted to ask you about pricing. Based on guidance, it doesn't seem like you've taken any further price actions since 2021, but you did mention some of the ongoing freight and other supply chain issues. So just wondering if there's, you know, anything else that you have executed or, you know, anything on the pricing front that, you know, is being planned at the moment?

Yeah, let me kind of frame our outlook on pricing or the way we were thinking about it. Back in January, we projected that our other material costs would continue to go up, and they have. So our assumptions going out in January were that they would, and we really have seen that play out on the other material costs. When we speak of that, that's kind of baked in already, and it hasn't changed our outlook much, although we continue to see the pressure on the other material costs, freights, and logistics. And the second part of that, again, I'm sorry. Does that answer your question, or was there a second piece?

Yeah, yeah. Basically, just was trying to get a sense if there's any pricing.

Oh, yeah, yeah. We did have other pricing. So when you just kind of park water heaters for a second and look at the rest of our businesses in North America, so water treatment, boilers, we've got a range of price increases on different products. It's a pretty broad range, but in that 2% to 12% price increases that we've announced beyond 2021 that are just coming into effect and will be effective in the back half of the year. and it was needed for those other material costs going up. So some of those pricing actions we'll see as we go through the rest of the year.

Okay, got it. That's helpful. And then could you maybe just elaborate on the weather impacts that you spoke of, maybe quantify that? I don't know. It just seems like these adverse weather events are a normal part of the business, thinking about the various floods and tornadoes, other things that have happened over the last – few years, but maybe you could just speak to what you experienced.

Yeah, I'll touch on that. It wasn't any floods and tornadoes, but it really comes down to the cold weather, snow, freezing rain, and it just impacted our plants, and particularly Tennessee. And again, if you look at it, you take a couple, three or four days off because of that, that just has a productivity issue for us going forward. So that's part of it. We had that happen in Q1 of 2021. It just seemed to spill over into 2022. We managed through that. And really, you know, I would tell you the quarter, the real impact we had from a plant standpoint was we had COVID. And we mentioned that in our January call, we had absenteeism in our factories about 7%. in COVID. And that, again, is a significant amount of people that we had to overcome. And then, again, as we got through January, people started to recover, get back to work. After February, we got back on track. So weather is part of it, but I would tell you COVID was probably the bigger part.

Understood. Thanks for the color. Best of luck. Thank you.

And our next question from David McGregor of Long Beach Longbow Research. You may ask your question.

Yes, good morning, everyone. I guess I just want to go back and maybe try and create a little more clarity around the pricing. You had talked about 50% price increase in 2021. Can you just remind us what the carryover pricing benefit is? I realize there's been some additional pricing initiatives in 2022, but Just how much of that 2021 50% carried over into 2022?

Yeah, you know, it's roughly half on the water heating side.

Okay. And you get the benefit of that just to be, I'm sorry, go ahead.

Yeah, I guess it was 50-50 roughly.

Right. And you get the benefit of that, just to be clear, you get the benefit of that from the beginning of the calendar year through the year.

It is largely at the beginning of the calendar year, yeah. The last one was announced effective November 15th of 2021. So with lead times, you know, it may be a little spill over into January. For the most part, it's running pretty much effective.

Okay, good. Thank you for that. And then just on the North American operating margins, the 21-1, how much of the 200 basis point decline was due to the lower commercial volumes?

You know, for Q1, it's about 50 basis points. So, you know, when we kind of look at Q1, 50 basis points on commercial water heating, yeah, it's about 50 basis points on Giant. You know, as we recall in the past, Giant's largely residential product, and so that's a little bit lower margin. So when you add that, you know, that brought it down a bit.

There's 100 basis points between the two. Thank you very much. Great. Thank you.

And again, if you would like to ask a question, you may press star one on your touchstone phone. And we have our next question from Jeff Hammond of KeyBank. You may ask your question.

Hey, guys. This is Mitch Moran for Jeff. Hey, Mitch. I was just wondering if you could walk us through your current expectations of margin cadence through the year, given all the moving pieces, and if... if you still have your expectation of one quarter being the trough for margins in 2022. Thanks.

Well, 2022, and let's just split it, you know, rest of the world separately from North America. And as kind of mentioned earlier, you know, China Q2 is going to be the, we believe in our outlook, the toughest quarter because of kind of where we're starting out in April. So I would say kind of cadence would be China would be, you know, a bit challenged in Q2. kind of start to normalize in Q, or really largely normalize in Q3, and then Q4 be the best quarter. North America, you know, if you think about kind of North America, we've got, you know, steel in the first quarter, just to remind everybody, steel was highest in the first quarter that we see throughout the outlook, so a bit of the margin pressure on that 21.1% in North America is a little higher steel. that kind of rolls off slightly as we go into the next quarters. But as I was mentioning, other commodity costs and other costs sort of fill that gap. But margins for the back half of the year, you know, sequentially Q3 and Q4 are a little bit stronger, and that's typically where we have kind of the strength in our boiler business. you know, the back half of the year, we kind of see the cadence of the year playing out fairly normal for the boiler side of the business, being kind of Q3, Q4 being a little stronger than the first half.

Okay, great. That's helpful. And then just on supply chain, I was wondering if you could give us some color on, you know, areas where you're seeing supply chain get better and if there's any differences, you know, commercial versus residential and NA versus the rest of the world. Thanks.

Yeah, right now we see our supply chain on the residential side improving, and that's really on the material side of it. And commercially, we expect Q2 to improve. We do have some really nice line of sight right now into some of the components that have been causing us some production issues, and they look like that they'll be resolved at least in Q2 as we go forward. So overall, again, I'd step back on our supply chain. it is unpredictable, but our teams managed it really well. And reaching out to the organizations and the companies that deliver to us, and then even our suppliers stepping up and doing the things they have. So we're getting better because our suppliers are getting better. Again, we'll work through some of the Ukraine issues and so forth that we talked about. But overall, I don't see supply chain being an issue for our business as we go forward, particularly in the second quarter on, just by... kind of the view that I've had from our procurement and supply chain group, we've managed through most of those challenges. And, again, anything's unpredictable. We can always be in change, but we feel pretty good where we're at. We don't see any of the supply chain issues disrupting our production or causing any issues throughout the year. Okay, great. Thanks for taking my questions.

Thank you.

And speakers, there are no more questions on cue. You may proceed.

Thank you, Catherine, and thank you all for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered strong sales and earnings in the first quarter despite many challenges. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at six conferences in the second quarter. Oppenheimer on May 4th, Goldman Sachs on May 10th, KeyBank on June 1st, Loop Capital on June 2nd, William Blair on June 7th, and UBS on June 8th. Thank you and enjoy the rest of your day.

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