A.O. Smith Corporation

Good day, and thank you for standing by. Welcome to the A.L. Smith Corporation's fourth quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during that session, you will need to press star 1-1 on your phone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1-1 again. Please be advised that today's conference is being recorded, and I would now like to hand the conference over to your speaker today, Ms. Helen Gerholt. Ms. Gerholt, please go ahead.

Good morning, and welcome to the A.O. Smith Fourth Quarter and Full Year 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, and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations plus capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings, and adjusted corporate expenses exclude the impact of non-operating, non-cash pension income and expenses, as well as legal judgment income and terminated acquisition-related expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning's press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Thank you, Helen. Good morning, everyone. I'm on slide four and our full year results. Our team delivered record-setting sales and year-over-year improvement in earnings on an adjusted basis despite lingering supply chain headwinds, inflation, and a significant U.S. wholesale residential channel inventory destocking activity that took place in the third quarter and began to normalize in the fourth quarter. Residential industry volumes increased 15% in the fourth quarter compared to the third quarter. Despite the destocking activity, North America's sales were up 11% compared to 2021, primarily due to inflation-related pricing and strong demand for our commercial and residential boilers and water treatment products. Our rest of the world segment delivered consistent performance in 2022, despite headwinds in the economy and currency exchange. Segment operating margins improved 120 basis points, driven by our China team improving their full-year operating margins to almost 11%. In India, our sales grew 28% in local currency in 2022 and continued to be profitable. As expected, we settled the majority of our pension liabilities in December of 2022, which resulted in a non-cash pre-tax expense of $417 million, or $1.60 of EPS. This expense is excluded from adjusted earnings and adjusted EPS. With our dividend and share repurchases, we have returned $581 million of capital to shareholders. Please turn to slide five. Our global A.F. Smith team delivered record sales of $3.8 billion in 2022 and adjusted EPS of $3.14, a 6% increase over 2021. we achieved a strong performance as a result of effective execution from our team. North America water heater sales grew 10% in 2022 due to 2021 pricing actions implemented in response to rising material and logistic costs and acquisition-related revenue that was partially offset by lower residential volumes. After two years for greater than average growth, residential unit industry demand decreased approximately 12% compared to 2021, primarily due to a wholesale channel inventory destocking that occurred during the second and third quarters. The order reduction we experienced from our customer was driven in part by our improved performance in delivering residential product and reducing our lead times. Commercial industry units decreased approximately 17% year over year. A large portion of the decrease was due to a continued weakness in electric products greater than 55 gallons, which was impacted by a regulatory change at the beginning of 2022. We don't expect that product category to rebound to pre-2022 levels. Despite the 2022 contraction in both the residential and commercial industries, we are pleased with our market share strength in both residential and commercial water heaters. Our North America boiler sales grew 28%. driven by higher volumes and previously announced price increases to offset higher costs. Our supply chain improvement efforts allowed us to reduce our record backlog in the second half of 2022. Our focus on innovation, efficiency, and decarbonization contributed to strong demand for our high-efficiency condensing boilers, particularly our Hellcat crest boilers with O2 sensing technology. North America water treatment sales grew 10% in 2022, due to pricing actions and higher volumes, particularly in our dealer and specialty wholesale channels. Our strategy to pursue this market with an omni-channel approach as we work to grow our share through product development and acquisition opportunities. We believe our independent water quality dealers have been outperforming the market and gaining market share. In China, four-year sales decreased 5% in local currency compared to 2021. to the impacts from COVID-19 related disruptions. Our core water cleaning products performed well in a down market. Our water treatment business comprised of residential, commercial, and filter replacement consumables grew nearly 4% in local currency and now represents almost 40% of our overall business with repeatable consumable filter sales representing over 25% of overall water treatment sales. For the year, Operating margins in China were 10.7%. As a result of actions taken over the past several years to right-size the business and manage discretionary spending, China has achieved operating margins above 9% in each of the past seven quarters. I'm now on slide six. We released our third ESG report in December. We have made significant strides in our commitment to ESG, including progress towards our GHG emission reduction goal of 10% by 2025, preventing almost 500,000 metric tons of carbon emissions in 2021 through sales of our highly efficient water heaters and boilers, and achieving wave verification, a process developed by the Water Council as an initial step in creating this strategy to improve our water stewardship performance. ESG concepts are embedded within the foundation of our 149-year history. The ESG report demonstrates our commitment to our values of being a good citizen, a good place to work, emphasizing innovation, and preserving our good name and achieving profitable growth. I'll now turn the call over to Chuck, who will provide more details on our full year and fourth quarter performance.

Thank you, Kevin. Good morning, everyone. I'm on slide seven. Full year sales in North America segment rose to $2.8 billion, an 11% increase compared with 2021. Pricing actions, largely on water heaters, were partially offset by lower volumes of residential water heaters. Higher volumes of boilers and water treatment products also added to segment sales growth. Giant acquired in October 2021 added incremental sales of $94 million. North America segment adjusted earnings of $611 million increased 5% compared with 2021. The earnings benefit of inflation-related price increases and higher volumes of boilers and water treatment products was partially offset by higher material and freight costs and lower residential water heater volumes. adjusted operating margin of 21.7%. A decline of 120 basis points year over year was driven by inflationary headwinds and volume-related production inefficiencies. We exited 2022 with our highest quarterly adjusted operating margins of the year at 23.3%. Moving to slide eight, The rest of the world segment sales of $966 million decreased 7% year-over-year and 2% in constant currency basis. Currency translation unfavorably impacted segment sales by approximately $49 million, $36 million of which impacted China sales. Our sales decrease was primarily driven by lower sales in China as consumer demand was negatively impacted by COVID-19 related restrictions. India's sales grew 28% in local currency in 2022 compared to 2021 as we continued to outperform the market. Rest of the world segment earnings of $96 million increased 5% compared to segment earnings in 2021. In China, the impact from lower volumes was more than offset by lower selling, advertising, and incentive expenses. Segment operating margin improved to 10%, the increase of 120 basis points compared to 2021, primarily as a result of improved management of discretionary spending in China. Please turn to slide nine. Turning to fourth quarter performance, We delivered sales of $936 million in the fourth quarter of 2022, down 6% year-over-year driven by lower residential water heater volumes in North America and lower consumer demand in China that more than offset inflation-related pricing actions. Adjusted earnings in the fourth quarter were 86 cents per share, compared with adjusted earnings of 85 cents per share in the fourth quarter of 2021. Let's turn to slide 10. Fourth quarter sales in North America segment were $692 million, a 3% decrease compared to record sales in the fourth quarter of 2021. We saw quarter over quarter improvement of residential water heater demand. However, water heater volumes were still below the record industry levels in the fourth quarter of 2021. Our fourth quarter sales benefited from pricing action, and stronger boiler sales growth of 36% driven by backlog reduction. North America segment adjusted earnings of $161 million decreased slightly compared with 2021. Their earnings benefit of inflation-related price increases, higher boiler volumes, and lower steel costs was offset by lower residential water heater volumes. An improved price-cost relationship resulted in higher adjusted segment operating margin of 23.3%, compared with the 2021 adjusted segment margin of 23%. Moving to slide 11, fourth quarter risk of the world segment sales of $250 million decreased 13% year over year. primarily driven by the impacts of unfavorable currency translation and lower consumer demand in China due to COVID-19 related restrictions. Currency translation unfavorably impacted China sales by approximately $24 million. In local currency, China sales decreased approximately 7% year over year. India sales grew 16% in local currency in 2022 compared to 2021. Rest of the world segment earnings of $32 million were slightly higher than Q4 2021 segment earnings. In China, lower incentive and selling expenses offset lower volumes and currency translation headwinds, resulting in segment operating margin of 12.7%, a significant improvement over segment operating margin of 10.6% in the fourth quarter of 2021. Please turn to slide 12. We generated free cash flow of $321 million during 2022, lower than in 2021 as higher adjusted earnings were offset by lower customer deposits in China, higher 2021 incentive payments made in 2022, and working capital cash outlays, primarily related to higher inventories, that more than offset the lower accounts receivable balances. Our cash balance totaled $482 million at the end of December, and our net cash position was $137 million. Our leverage ratio was 16.5%, as measured by total debt to total capital. Now turning to slide 13. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation, and new product development across all of our product lines and geographies. We continue to target strategic acquisitions that meet our financial metrics of accretive earnings in the first year and return our cost of capital in three years. The strength of our balance sheet allows us to pursue strategic acquisitions even in times of economic uncertainty. Earlier this month, our board approved our next quarterly dividend of $0.30 per share. We have increased our dividend for 30 consecutive years. We repurchased approximately 6.6 million shares of common stock in 2022 for a total of $404 million. The strength of our balance sheet also allows us to maintain our strong track record of delivering returns to shareholders. Over the past two years, we have returned $1 billion to shareholders through our dividend and share repurchases. Please turn to slide 14 in our 2023 earnings guidance and outlook. As previously discussed, we terminated our defined benefit pension plan at the end of 2021. The termination follows a strategy and measured glide path to de-risk our fully funded exposure to pension liabilities. The plan, which was previously sunset for benefits earned on December 31st, 2014, represented over 95% of the company's pension plan liability. The terminated plan's pension liability was annuitized in 2022. The pension settlement, which we completed in the fourth quarter, accelerated the recognition of $417 million of non-cash pre-tax pension expenses. Tax benefits associated with the pension settlement were $168 million and include amounts recorded at historical tax rates and result in an after-tax EPS impact of $1.60. We are pleased to introduce our 2023 outlook with an expected EPS range of $3.15 and $3.45 per share. The midpoint of our EPS range represents an increase of 5% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including Our guidance assumes that steel prices in 2023 on an annual basis will improve approximately 40 to 45% compared to 2022, including a sequential improvement of approximately 20 to 25% from the fourth quarter of 2022 to the first quarter of 2023. We have seen a flattening of the steel index and therefore our outlook does not project a further meaningful sequential reduction in steel costs through 2023. Regarding other costs outside of steel, we have generally seen flattening in costs at elevated levels. While we do expect a shift in buying power to move from neutral towards a buyer's market as we progress through the year, our outlook does not assume significant improvement in non-steel material costs in 2023. We saw continued improvement in our supply chain in the second half of 2022. While challenges still persist, disruptions are limited. We remain in close contact with our suppliers and logistics providers to manage and resolve supply chain issues as they arise. We expect to generate strong free cash flow of between $550 million and $600 million. For the year, CapEx should be between $70 million and $75 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be approximately 24%. And we expect to repurchase approximately $200 million of our shares of stock resulting in outstanding diluted shares of 150 million at the end of 2023. I'll now turn the call back over to Kevin, who will provide more color on our key markets and top-line growth outlook and segment expectations for 2023, staying on slide 14. Kevin?

Thank you, Chuck. We project 2023 sales to be approximately flat to 2022 at the midpoint, with a range of plus or minus 3%, which includes the following assumptions. We believe the majority of our customers exit 2022 with near-normal inventory levels. While we believe that new home construction remains a deficit, we expect it will be a headwind in 2023. Therefore, we project that 2023 residential industry unit volumes will be down approximately 2% to 5% compared to last year. We project commercial water heater industry volumes to be flat to slightly up as supply chain constraints ease and a market correction related to the regulatory change in commercial electric water heaters greater than 55 gallons is largely behind us. In China, while we expect there could be COVID-19 related surges related to Chinese New Year travel, we see the recent lifting of zero COVID policy as a positive step to an improved economic environment. We believe it will take time for the economy in China to improve amid weakened consumer confidence and a challenged real estate and housing market. We project that our sales in China will go 3 to 5% in local currency in 2023. Our guidance assumes volumes in China improve sequentially throughout the year. Our forecast assumes that the currency translation impact on sales will be similar to 2022. We expect our North America boiler sales will increase approximately 10 to 12% in 2023. Our expectations are driven by an industry growth of 3 to 4% The transition to higher energy efficient boilers will continue, particularly as commercial buildings improve their overall carbon footprint. A year after launch, our Crest commercial condensing boiler with Hellcat technology is quickly becoming the industry standard. We expect to see continued benefits from pricing actions implemented in 2022. Our boiler backlogs are at normal levels as we enter 2023. We project approximately 5% to 7% growth in sales of North America water treatment products, which is lower than our growth expectation of 10% per year, largely as a result of a reduced backlog as we exited 2022. We believe that pricing benefits and the mega trends of healthy and safe drinking water, as well as reduction of single-use plastic bottles, will continue to drive consumer demand for our products. Based on these factors, we expect our North America segment margins to be approximately 23% and rest of the world segment margins to be approximately 10%. Please turn to slide 15. We remain focused on our key strategic priorities to advance our position as a leader in heating and treating water around the world. Those priorities are expand and enhance our high-efficiency product portfolio, including heat pumps for space and water heating. expand our global water treatment capabilities by investing in technologies, people, and distribution, deploy capital effectively by investing in ourselves, acquisitions, and returning capital to shareholders. As we enter 2023, there are economic uncertainties ahead of us. However, there are positives. We believe the 2022 inventory adjustment and the wholesale residential market are behind us. We expect more normalized unit volumes in 2023. Our fourth quarter 2022 North America adjusted operating margin of 23.3% improved over previous quarters as we exit the year with a favorable price-cost relationship, and our plants are running more efficiently after the third quarter volume adjustments. In China, the lifting of zero-COVID policy is a positive step to an improved economic environment. In 2023, we expect a strong rebound in free cash flow as China emerges from COVID-19 related disruptions and a dedicated focus on inventory reduction across our North American operations. We remain focused on servicing our customers. Our strong brands across the portfolio combined with technology driven innovation and new product development will 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're now available for your questions.

Thank you. As a reminder, to ask a question, please press star 1 1 on your phone and wait for your name to be announced. We ask you to please limit yourself to one question and one follow-up. To withdraw your question, please press star 1 1 again. Stand by as we compile the Q&A roster. And one moment, please, for our first question. Our first question will come from Sari Boroditsky of Jefferies LLC. Your line is open.

Good morning. So just touching on the outlook for residential water heaters to be down to 2% to 5% this year, can you talk about how much of that is related to new homes versus replacement? How are you thinking about proactive replacement this year and then any impact as we start to lap the housing downturn?

Good morning, Sari. This is Chuck. So as we're looking at next year, we're coming off a year where we're down about 12% on the residential market with the inventory correction. Housing, we expect a headwind in housing, maybe 15% to 20%. We've got a 80% to 85% replacement market, so housing is in that 15% to 20% range, which would be a headwind. And that's kind of how you get down to the 2% down. Where we're looking at for proactive replacement, it's pretty strong on proactive replacement going into next year. We saw that pick up, historically proactive replacement as we measure it through a third party survey runs 20 to 25%. During the past couple years, it's been in that 30 to 35%. And our last survey still has it above 30. So we're still projecting going into next year, a fairly strong proactive replacement portion of the replacement market.

Great. And then I guess I know you guys don't like to talk about pricing a lot, but just on the residential water heater pricing in the retail channel, you know, do you expect to see prices decline for the index contracts? And if so, how do you just think about the balance in pricing in retail versus the wholesale channel?

Well, hey, this is Kevin. When you look at both those channels, one, they are two different business models, but they compete for a lot of the same customers. And traditionally, you're going to have some conflicts between the channels periodically. It's kind of regional. But as we look at it and as we evaluate our pricing structures in both channels, we feel that they're going to be competitive. Historically, how we manage our pricing hasn't changed. So again, we look at that both channels will be in the market competing at an equal level. So that's kind of where we're at right now, and we'll see how things play out the rest of the year.

Thank you. One moment, please, for our next question.

Our next question will come from Michael Halloran of Beard. Your line is open. Hello, Mr. Halloran.

If your line is mute, please unmute your line.

I was muted. Apologies. I gave this really enthusiastic hello, too. I didn't hear from anybody.

Thanks, everyone. Appreciate the time.

So first on the guide and how you're thinking about kind of sequentials, You know, a couple things. First, is the embedded assumption relatively normal seasonal patterns as you work through the year? And then secondarily, when we think about kind of one-age load versus second-half load, obviously the year-over-year comps get a lot easier in the back half of the year. So maybe talk about how you think growth cadence is as we work through the year.

Sure, Mike. You know, we have it laid out in our outlook to be pretty much back to normal. You know, when you look at kind of the residential volumes, it's usually 52, 48, you know, front half of the year, 52%, back half of the year, 48. And we kind of believe it's going to get back to that normal cadence. Boilers, typically strongest in third quarter. So we have it laid out a bit like that, similar to prior cadence. China, you know, we've got China starting out a bit slow, you know, with the COVID disruptions. As you know, the first quarter is always a challenge with the Chinese festival for volumes. And we just got, we got China a little bit lighter in the first quarter, but improving as we go throughout the year. And normal cadence again on China's fourth quarter, the strongest we would expect, you know, improvement on the COVID situation by the fourth quarter. back to our normal routine of that being a strong retail quarter for us.

And might as well stay on China then. Maybe just talk about how things are tracking from a competitive dynamic share component to it, a market share component to it, but also how the high end of the market's performing versus the rest of the market. It feels like things are stable, but any commentary on the competitive landscape would be appreciated.

Yeah, Mike, hi, it's Kevin here. Share is always a difficult one. We talked about how the Omni channel has just blended together. We don't have great visibility to all the different channels, but what I would tell you that we believe we're happy with our sales. We're happy with our average pricing. We believe we're getting our fair share of the market and continue to get that. Introducing new products as we always do and bringing products to the market that consumers are willing to pay for. When it comes to the high end of the market, it continues to have that sleeve that makes sense, and it keeps ticking up a little bit. But again, it's still on a smaller base. We hope as we get through the zero COVID lifting and the consumer activity grows in the market, that will improve. Consumers right now in China, our records are saving at the highest rate that they have ever. So we look at there could be some pent up demand as we go forward. And again, just looking at China in general, there's some discussions about some consumer stimulus by the government, nothing specific today. Banks are helping out some of the housing sectors to build up some of their inventory. So there's a lot of positives, but again, I think it'll take some time as a consumer recovers from three years of basically inactivity and lockdown and starts to get more comfortable. And that's why, as Chuck pointed out, we're looking at sequential improvement through the year, but there's more positives than we've seen in a long time in our China market.

Just to add to that, we said it in our prepared remarks, we're really pleased with the consistency, as you noted, Mike, of our performance quarter over quarter, the discipline towards managing our discretionary spend. we're you know our outlook for 23 has us back in a growth mode on constant currency so we're pleased to be kind of hopefully turning a corner growing in that three for three to five percent and uh in local currency great really thank you one moment please for our next question

Our next question will come from Jeff Hammond of KeyBank Capital Markets. Your line is open.

Hey, good morning, everyone. Good morning, Jeff. Yes, so I just want to come back on price. I think your comment, Kevin, was both channels are going to be competitive, but just formulaically, I think you go negative on price with your material price formulas on the DIY side. So I'm wondering if your comment implies that you know, there's some pricing pressure on the wholesale side, or do we stick more there? And if we do, kind of, you know, what the upside is to maybe North America margins given the fall off in steel? Thanks.

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

Yeah, I mean, I understand the steel stabilization, but I think you mentioned 40% to 45% kind of decline. And I guess relative to past cycles, that's a much bigger kind of increase and then decrease. So I'm just wondering if the behaviors are any different.

Yeah, I mean, that decline, I guess I'll just kind of comment that if we would have stayed at the peak, we would have probably been really challenged on the margin profile in North America. What happened is we kind of grew into a little better margin profile and still retreated a bit. And, you know, we come out of the fourth quarter and still does take another tick down, maybe 20% to 25% in Q1, and then kind of flattens out, so. You know, we had quite a bit of headwind in 22 on the North America margin because of some of the higher steel costs earlier in the year.

Okay, and then just one last one. I think the last couple of years you signed up for $400 million buyback. I think you're stepping it down to $200 million. Just anything that informs kind of the lower buyback versus the past couple of years?

Yeah, I mean, where we were looking at it is when we're committed to 200 million as a buyback, and we, we are a little bit shy of our cash, you know, conversion target of 100% cash conversion in 2022. Did that consciously built inventories, you know, worked our backlogs down pleased with that now we'll be working on reducing inventories in the next year. But, you know, as we enter 2023, we pegged $200 million as a target that we're committed to. We're going to look at kind of how 2023 rolls out from really an acquisition perspective as we go through the year. You know, we may revisit that as we go through the year and as, you know, as we work down inventories and see our cash potentially, you know, grow a bit. But we're going to revisit it as we go through the year with the opportunities we think, you know, still to be out there on M&A.

Okay, thanks so much.

Thank you.

One moment, please, for our next question. Our next question will come from Matt Somerville of DA Davidson.

Your line is open.

Hi, good morning. This is Will Jellison on for Matt Somerville. I wanted to ask both questions today about capital allocation priorities and Starting off with organic growth, I was wondering if you could provide any more insight into what sorts of capital expenditure projects and investments you're considering making in 2023 and how those support the business and its growth moving forward.

Yeah, on the organic growth side, I mean, just a couple comments around that. So we're always investing in innovation, product development. You know, from a capital perspective, some of those support new product developments, I would say. when you get into the developments of heat pumps, some of the other growth categories where we might have to support that.

We break down the capital. We look at it from a growth perspective. Maintenance as well. We have some pretty large facilities that we have to invest back in. There's also a pretty large cost reduction component as we invest in automation, new technologies, and so forth, and efficiencies in our factory. Those are the three buckets that I would say that there's no specific major expense outside our normal, but there's a consistent span in all three categories in our company.

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

Well, let's just talk about the environment, which is a bit strange right now, you know, with some of the potential, you know, higher interest rates, the talk of a recession and so forth. And, you know, what I can tell you that multiples haven't really changed, maybe ticked down a little bit. But there's a lot of wait-and-see approach out there with, I would say, targets. So we're continuing to stay close to them. our potential targets and stay active in the pipeline. And we look at this as an opportunity as you get in uncertain times with our balance sheet, there could be some nice opportunities. But again, needs to play out a bit. We need to get through some of the uncertainty. But we feel good about our pipeline. We feel good about the companies that are in it. And we're going to continue to work on driving some of those to closure. As far as actionability, it always depends on the person saying yes as we go forward. And we'll keep working through there. We've made small acquisitions each the last few years. Hopefully, we'll be able to bring a couple of those across the finish line in 2023.

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

Hey, good morning, everyone. This is Charles Perron and for Susan this morning. Thanks for taking my question.

Good morning. Yeah, Charles, thanks. You helped us out there.

Yes. I guess my first question, I would like to go back to the North America margin outlook for 2023, and it's going to help us walk through the trajectory of the margins throughout the year. Obviously, we're going to have water heater volumes probably deleveraging in the first half and then coming back, obviously, gradually throughout the year, but also If you think about the price cost, you mentioned that non-sale categories should improve through 2023. So is it fair to expect maybe a gradual ramp in the margins throughout the year?

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

Gotcha. That's good color there. And then my follow-up on the boiler sales guidance for 23, 10% to 12% sales growth, that's impressive considering the significant growth you've seen in 22. Can you expand maybe on the drivers of the growth there, volumes versus price, and maybe the initiative supporting industry volume growth considering the weakening that we've seen in the commercial or non-residential indicators over the span of the last few months?

Yeah, I mean, we did have some great growth in 2022 on the boiler side. And again, particularly in the fourth quarter was helped by drawing down our backlogs, which we exited the year pretty normal. In that 10% to 12% growth that we see for next year, 50% to 60% of that is price. So carryover price is a little over half of that 10% to 12%. The rest of the growth is on volumes.

Yeah, I would just maybe add on to that. We came out some strong growth. Again, a lot of that had to do with bringing the backlog down, but our orders remain pretty stable. Quoting activity in the market is still strong, institutional, education. So we feel there's still a positive momentum in the boiler segment in 2023. And so far, as we've seen our orders come in over the last month, that's indicating that that's where we should be. Again, being stable. And what's really great is now our lead times are back to normal. We're able to, you know, get product out the door in a timely fashion. So, overall, we still feel really good about the boiler market. You know, the whole commercial side of the business tends to lag residential, so 2023 still seems like it'd be a solid year for our boiler business.

Thank you. One moment, please, for our next question. And our next question will come from David McGregor of Longbow Research. Your line is open.

Yes, good morning, everyone. My first question, just with respect to the supply chain and looking back on 2022, is there any way to estimate what supply chain disruptions cost you in 2022 in terms of revenue and EBIT? And does it become an incremental positive in 23? I mean, you mentioned the boiler backlogs have kind of normalized, but I'm just wondering if there's any kind of a throw forward benefit into 2023 from that normalization.

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

Yeah, I'll just add on to it that all of our plants throughout the year, really, supply chain did improve throughout the year, and we only had sporadic um outages that really didn't impact our productivity all that much the only exception was in china towards the fourth quarter but overall supply chain is is and is really kind of uh very much stabilized and we're chasing you know one and two items now not the entire portfolio okay and and uh just with respect to the 22 impact there isn't a way to sort of

come up with some kind of an estimate on what it might have cost in terms of revenues. I realize you're saying the 2023 impact is going to be the minimus, but the 2022, any?

Yeah, all I can tell you about 2022 is Q3 was a tough quarter for us on the residential water heater side just because of the drastic drop in volume. But overall, you know, we're building up those efficiencies. I don't see them being exceptionally different in 2023.

No, I mean, supply chain and us catching up on backlog, carrying a little more inventory, it actually helped volumes a little bit on the boiler and water treatment side in 2022 because we could work our backlog down with better supply chain.

Okay.

Yeah, that's interesting.

My second question is on China, and obviously a good quarter with rest of the world margins at 12.7%. With China, local currency sales down 4%, too, which is good. Obviously, a lot of work being done on managing costs. Can you just talk about the margin opportunity in China over maybe the next 12, 18, 24 months and what the specific drivers would be? And I'm guessing, you know, with progress in India and maybe some of these other smaller lines within ROW, it looks like you're now back to kind of that 12. You're approaching, anyway, the 12 to high 13s range that you last achieved in 2013, 2018. Is there a further upside or changes in price point mix and regional market mix and levels of competition just creates structural limitations that are going to hold you to those levels again.

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

Thank you. One moment, please, for our next question. And our next question will come from Lawrence DeMaria of William Blair. Your line is open.

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

Well, so our outlook, and you'll notice we didn't provide a range on North America margins for next year. We had 23% just as a kind of midpoint, as a point estimate. You know, we feel pretty comfortable with managing to that 23%. Carryover pricing, you know, there will be some, but not a great deal of carryover pricing in the water heater side next year. We've got our material costs holding fairly resilient going into next year. Conversion costs, we expect the plants to operate a little more smoothly, but just embedded in that are higher operating costs overall. The biggest puts and takes are we expect to continue to have a reasonable relationship on the price-cost relationship for the North America water heaters. We've had some carryover pricing in other parts of our business like boilers and water treatment in North America.

Okay, that's helpful. Thank you. And then if I could just ask one more then. The 5% to 7% water treatment growth, what's really underpinning that? It sounded like in the prepared comments it's mostly price, but given the weakness in residential markets, I'm just kind of curious how the buildup there works.

You are correct. It is mostly price going into next year. Again, a bit like the boiler side of the business, we brought our backlogs down. We saw a bit of inventory adjustment in the channel on the water treatment side of the business in 2022. So next year, I mean, we certainly have confidence in the underlying trends in North America water treatment. But most of the volume next year is driven by price. And we could potentially see some pressure on consumer spending as we head into 2023. Okay. Thank you and good luck.

Thank you. One moment, please, for our next question. Our next question will come from Andrew Kapellitz of Citi. Your line is open. Excuse me.

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

Yeah, well, again, we have it classed slightly up. Part of it is we still have lead times that are a little bit more extended than we'd like. So we normally like to be around 15 days. We're around 25. We, you know, we believe that the gas market and it's just, there's some inventory deficits out there. There's still some upside on some replacement. So we look at the market as just artificially, the 17% was just artificial because of the greater than 55 gallon. But underneath that, you know, the market was down mid single digits and that was with the supply chain issue and components and It's going to normalize, and we see it being slightly positive as we go through the year, particularly on the gas side of the commercial business.

Helpful. I know you introduced the Voltex heat pump in Q3. Can you talk about your early penetration into the market with that particular heat pump? I know heat pumps are still a small part of your business, but how might they become a factor later in 2023 and 2024 as IRA implications also impact the business?

Yeah, again, you look at it, as I talked about, one of our priorities is certainly on the heat pump side of the business, is both residential and commercial. And you are right. Residential heat pumps represents about 2% of the entire market today. It's got a really nice growth rate of 35% to 40%. And that's a positive trend, but it's going to take some time to move forward. There's some upfront costs to this that are expensive. There's some parts of the installation that are a bit more difficult than the normal replacement. But if you look out forward, a heat pump will become a bigger part of our commercial and residential portfolio. So that's going to move forward. Again, it's not going to go at the pace where it takes over the market next year or two, but long-term is one of the best value propositions. It's got a great decarbonization message. It's been promoted by a number of states. And of course, when you look at the Inflation Reduction Act, that's still working its way out, but there'll be a component there that will hopefully help and provide some stimulus as well. So overall, and then I would tell you our Voltex has been out a few months. It's done quite well, but it's a little early. We just feel a little good about the UEF of greater than four And the different features and benefits that it brings to the market, the zero clearance, it's a terrific product that can go into just about any application that it needs to. And so far, it's been received really well. But again, heat pumps in the early stages, but it will continue to grow at a greater accelerated rate year over year.

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

Thank you. Thank you everyone for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered record sales and strong adjusted earnings in 2022. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at three conferences this quarter. City on February 21st, Loop on March 14th, and UBS on March 23rd. Thank you and enjoy the rest of your day.

This concludes today's conference call. Thank you all for participating.

You may now disconnect and have a pleasant day.

The conference will begin shortly. To raise and lower your hand during Q&A, you can dial star 1 1. you Bye. Bye. Thank you. Thank you. you

Good day and thank you for standing by.

Welcome to the A.L. Smith Corporation's fourth quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during that session, you will need to press star 1 1 on your phone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1 1 again. Please be advised that today's conference is being recorded, and I would now like to hand the conference over to your speaker today, Ms. Helen Gerholt. Ms. Gerholt, please go ahead.

Good morning, and welcome to the A.O. Smith Fourth Quarter and Full Year 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, and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations plus capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings, and adjusted corporate expenses exclude the impact of non-operating, non-cash pension income and expenses, as well as legal judgment income and terminated acquisition-related expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning's press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks. Please turn to the next slide.

Thank you, Helen. Good morning, everyone. I'm on slide four and our full year results. Our team delivered record-setting sales and year-over-year improvement in earnings on an adjusted basis despite lingering supply chain headwinds, inflation, and a significant U.S. wholesale residential channel inventory destocking activity that took place in the third quarter and began to normalize in the fourth quarter. Residential industry volumes increased 15% in the fourth quarter compared to the third quarter. Despite the destocking activity, North America's sales were up 11% compared to 2021, primarily due to inflation-related pricing and strong demand for our commercial and residential boilers and water treatment products. Our rest of the world segment delivered consistent performance in 2022, despite headwinds in the economy and currency exchange. Segment operating margins improved 120 basis points, driven by our China team improving their full-year operating margins to almost 11%. In India, our sales grew 28% in local currency in 2022 and continued to be profitable. As expected, we settled the majority of our pension liabilities in December of 2022, which resulted in a non-cash pre-tax expense of $417 million, or $1.60 of EPS. This expense is excluded from adjusted earnings and adjusted EPS. With our dividend and share repurchases, we have returned $581 million of capital to shareholders. Please turn to slide five. Our global A.F. Smith team delivered record sales of $3.8 billion in 2022 and adjusted EPS of $3.14, a 6% increase over 2021. we achieved a strong performance as a result of effective execution from our team. North America water heater sales grew 10% in 2022 due to 2021 pricing actions implemented in response to rising material and logistic costs and acquisition-related revenue that was partially offset by lower residential volumes. After two years for greater than average growth, residential unit industry demand decreased approximately 12% compared to 2021, primarily due to a wholesale channel inventory destocking that occurred during the second and third quarters. The order reduction we experienced from our customer was driven in part by our improved performance in delivering residential product and reducing our lead times. Commercial industry units decreased approximately 17% year over year. A large portion of the decrease was due to a continued weakness in electric products greater than 55 gallons, which was impacted by a regulatory change at the beginning of 2022. We don't expect that product category to rebound to pre-2022 levels. Despite the 2022 contraction in both the residential and commercial industries, we are pleased with our market share strength in both residential and commercial water heaters. Our North America boiler sales grew 28%. driven by higher volumes and previously announced price increases to offset higher costs. Our supply chain improvement efforts allowed us to reduce our record backlog in the second half of 2022. Our focus on innovation, efficiency, and decarbonization contributed to strong demand for our high-efficiency condensing boilers, particularly our Hellcat crest boilers with O2 sensing technology. North America water treatment sales grew 10% in 2022, due to pricing actions and higher volumes, particularly in our dealer and specialty wholesale channels. Our strategy to pursue this market with an omni-channel approach as we work to grow our share through product development and acquisition opportunities. We believe our independent water quality dealers have been outperforming the market and gaining market share. In China, four-year sales decreased 5% in local currency compared to 2021. to the impacts from COVID-19 related disruptions. Our core water heating products performed well in a down market. Our water treatment business comprised of residential, commercial, and filter replacement consumables grew nearly 4% in local currency and now represents almost 40% of our overall business with repeatable consumable filter sales representing over 25% of overall water treatment sales. For the year, Operating margins in China were 10.7%. As a result of actions taken over the past several years to right-size the business and manage discretionary spending, China has achieved operating margins above 9% in each of the past seven quarters. I'm now on slide six. We released our third ESG report in December. We have made significant strides in our commitment to ESG, including progress towards our GHD emission reduction goal of 10% by 2025, preventing almost 500,000 metric tons of carbon emissions in 2021 through sills of our highly efficient water heaters and boilers, and achieving wave verification, a process developed by the Water Council as an initial step in creating this strategy to improve our water stewardship performance. ESG concepts are embedded within the foundation of a 149-year history. The ESG report demonstrates our commitment to our values of being a good citizen, a good place to work, emphasizing innovation, and preserving our good name and achieving a profitable growth. I'll now turn the call over to Chuck, who will provide more details on our full year and fourth quarter performance.

Thank you, Kevin. Good morning, everyone. I'm on slide seven. Full year sales in North America segment rose to $2.8 billion, an 11% increase compared with 2021. Pricing actions, largely on water heaters, were partially offset by lower volumes of residential water heaters. Higher volumes of boilers and water treatment products also added to segment sales growth. Giant acquired in October 2021 added incremental sales of $94 million. North America segment adjusted earnings of $611 million increased 5% compared with 2021. The earnings benefit of inflation-related price increases and higher volumes of boilers and water treatment products was partially offset by higher material and freight costs and lower residential water heater volumes. adjusted operating margin of 21.7%. A decline of 120 basis points year over year was driven by inflationary headwinds and volume-related production inefficiencies. We exited 2022 with our highest quarterly adjusted operating margins of the year at 23.3%. Moving to slide eight, The rest of the world segment sales of $966 million decreased 7% year over year and 2% in constant currency basis. Currency translation unfavorably impacted segment sales by approximately $49 million, $36 million of which impacted China sales. Our sales decrease was primarily driven by lower sales in China as consumer demand was negatively impacted by COVID-19-related restrictions. India's sales grew 28% in local currency in 2022 compared to 2021 as we continued to outperform the market. Rest of the world's segment earnings of $96 million increased 5% compared to segment earnings in 2021. In China, the impact from lower volumes was more than offset by lower selling, advertising, and incentive expenses. Segment operating margin improved to 10%, an increase of 120 basis points compared to 2021, primarily as a result of improved management of discretionary spending in China. Please turn to slide nine. Turning to fourth quarter performance, We delivered sales of $936 million in the fourth quarter of 2022, down 6% year over year, driven by lower residential water heater volumes in North America and lower consumer demand in China that more than offset inflation-related pricing actions. Adjusted earnings in the fourth quarter were 86 cents per share, compared with adjusted earnings of 85 cents per share in the fourth quarter of 2021. Let's turn to slide 10. Fourth quarter sales in North America segment were $692 million, a 3% decrease compared to record sales in the fourth quarter of 2021. We saw quarter over quarter improvement of residential water heater demand. However, water heater volumes were still below the record industry levels in the fourth quarter of 2021. Our fourth quarter sales benefited from pricing action, and stronger boiler sales growth of 36% driven by backlog reduction. North America segment adjusted earnings of $161 million decreased slightly compared with 2021. Their earnings benefit of inflation-related price increases, higher boiler volumes, and lower steel costs was offset by lower residential water heater volumes. An improved price-cost relationship resulted in higher adjusted segment operating margin of 23.3%, compared with the 2021 adjusted segment margin of 23%. Moving to slide 11, fourth quarter risk of the world segment sales of $250 million decreased 13% year over year. primarily driven by the impacts of unfavorable currency translation and lower consumer demand in China due to COVID-19 related restrictions. Currency translation unfavorably impacted China sales by approximately $24 million. In local currency, China sales decreased approximately 7% year over year. India sales grew 16% in local currency in 2022 compared to 2021. Rest of the world segment earnings of $32 million were slightly higher than Q4 2021 segment earnings. In China, lower incentive and selling expenses offset lower volumes and currency translation headwinds, resulting in segment operating margin of 12.7%, a significant improvement over segment operating margin of 10.6% in the fourth quarter of 2021. Please turn to slide 12. We generated free cash flow of $321 million during 2022, lower than in 2021 as higher adjusted earnings were offset by lower customer deposits in China, higher 2021 incentive payments made in 2022, and working capital cash outlays, primarily related to higher inventories, that more than offset the lower accounts receivable balances. Our cash balance totaled $482 million at the end of December, and our net cash position was $137 million. Our leverage ratio was 16.5%, as measured by total debt to total capital. Now turning to slide 13. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation, and new product development across all of our product lines and geographies. We continue to target strategic acquisitions that meet our financial metrics of accretive earnings in the first year and return our cost of capital in three years. The strength of our balance sheet allows us to pursue strategic acquisitions even in times of economic uncertainty. Earlier this month, our board approved our next quarterly dividend of $0.30 per share. We have increased our dividend for 30 consecutive years. We repurchased approximately 6.6 million shares of common stock in 2022 for a total of $404 million. The strength of our balance sheet also allows us to maintain our strong track record of delivering returns to shareholders. Over the past two years, we have returned $1 billion to shareholders through our dividend and share repurchases. Please turn to slide 14 in our 2023 earnings guidance and outlook. As previously discussed, we terminated our defined benefit pension plan at the end of 2021. The termination follows a strategy and measured glide path to de-risk our fully funded exposure to pension liabilities. The plan, which was previously sunset for benefits earned on December 31st, 2014, represented over 95% of the company's pension plan liability. The terminated plan's pension liability was annuitized in 2022. The pension settlement, which we completed in the fourth quarter, accelerated the recognition of $417 million of non-cash pre-tax pension expenses. Tax benefits associated with the pension settlement were $168 million and include amounts recorded at historical tax rates and result in an after-tax EPS impact of $1.60. We are pleased to introduce our 2023 outlook with an expected EPS range of $3.15 and $3.45 per share. The midpoint of our EPS range represents an increase of 5% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including Our guidance assumes that steel prices in 2023 on an annual basis will improve approximately 40 to 45 percent compared to 2022, including a sequential improvement of approximately 20 to 25 percent from the fourth quarter of 2022 to the first quarter of 2023. We have seen a flattening of the steel index, and therefore our outlook does not project a further meaningful sequential reduction in steel costs through 2023. Regarding other costs outside of steel, we have generally seen flattening in costs at elevated levels. While we do expect a shift in buying power to move from neutral towards a buyer's market as we progress through the year, our outlook does not assume significant improvement in non-steel material costs in 2023. We saw continued improvement in our supply chain in the second half of 2022. While challenges still persist, disruptions are limited. We remain in close contact with our suppliers and logistics providers to manage and resolve supply chain issues as they arise. We expect to generate strong free cash flow of between $550 million and $600 million. For the year, CapEx should be between $70 million and $75 million. Corporate and other expenses are expected to be approximately $55 million. Our effective tax rate is estimated to be approximately 24%. And we expect to repurchase approximately $200 million of our shares of stock, resulting in outstanding diluted shares of $150 million at the end of 2023. I'll now turn the call back over to Kevin, who will provide more color on our key markets and top-line growth outlook and segment expectations for 2023, staying on slide 14.

Kevin? Thank you, Chuck. We project 2023 sales to be approximately flat to 2022 at the midpoint, with a range of plus or minus 3%, which includes the following assumptions. We believe the majority of our customers exit 2022 with near-normal inventory levels. While we believe that new home construction remains a deficit, we expect it will be a headwind in 2023. Therefore, we project that 2023 residential industry unit volumes will be down approximately 2% to 5% compared to last year. We project commercial water heater industry volumes to be flat to slightly up as supply chain constraints ease and a market correction related to the regulatory change in commercial electric water heaters greater than 55 gallons is largely behind us. In China, while we expect there could be COVID-19 related surges related to Chinese New Year travel, we see the recent lifting of zero COVID policy as a positive step to an improved economic environment. We believe it will take time for the economy in China to improve amid weakened consumer confidence and a challenged real estate and housing market. We project that our sales in China will go 3% to 5% in local currency in 2023. Our guidance assumes volumes in China improve sequentially throughout the year. Our forecast assumes that the currency translation impact on sales will be similar to 2022. We expect our North America boiler sales will increase approximately 10% to 12% in 2023. Our expectations are driven by industry growth at 3% to 4%, The transition to higher energy efficient boilers will continue, particularly as commercial buildings improve their overall carbon footprint. A year after launch, our Crest commercial condensing boiler with Hellcat technology is quickly becoming the industry standard. We expect to see continued benefits from pricing actions implemented in 2022. Our boiler backlogs are at normal levels as we enter 2023. We project approximately 5% to 7% growth in sales of North America water treatment products, which is lower than our growth expectation of 10% per year, largely as a result of a reduced backlog as we exited 2022. We believe that pricing benefits and the mega trends of healthy and safe drinking water, as well as reduction of single-use plastic bottles, will continue to drive consumer demand for our products. Based on these factors, we expect our North America's segment margins to be approximately 23% and rest of the world's segment margins to be approximately 10%. Please turn to slide 15. We remain focused on our key strategic priorities to advance our position as a leader in heating and treating water around the world. Those priorities are expand and enhance our high-efficiency product portfolio, including heat pumps for space and water heating. expand our global water treatment capabilities by investing in technologies, people, and distribution, deploy capital effectively by investing in ourselves, acquisitions, and returning capital to shareholders. As we enter 2023, there are economic uncertainties ahead of us. However, there are positives. We believe the 2022 inventory adjustment and the wholesale residential market are behind us. We expect more normalized unit volumes in 2023. Our fourth quarter 2022 North America adjusted operating margin of 23.3% improved over previous quarters as we exit the year with a favorable price-cost relationship, and our plants are running more efficiently after the third quarter volume adjustments. In China, the lifting of zero COVID policy is a positive step to an improved economic environment. In 2023, we expect a strong rebound in free cash flow, as China emerges from COVID-19 related disruptions and a dedicated focus on inventory reduction across our North American operations. We remain focused on servicing our customers. Our strong brands across the portfolio combined with technology driven innovation and new product development will 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're now available for your questions.

Thank you. As a reminder, to ask a question, please press star 1 1 on your phone and wait for your name to be announced. We ask you to please limit yourself to one question and one follow-up. To withdraw your question, please press star 1 1 again. Stand by as we compile the Q&A roster. And one moment, please, for our first question. Our first question will come from Sari Boroditsky of Jefferies LLC. Your line is open.

Good morning. So just touching on the outlook for residential water heaters to be down to 2% to 5% this year, can you talk about how much of that is related to new homes versus replacement? How are you thinking about proactive replacement this year? And then any impact as we start to lap the housing downturn?

Good morning, Sari. This is Chuck. So as we're looking at next year, we're coming off a year where we're down about 12% on the residential market with the inventory correction. Housing, we expect a headwind in housing, maybe 15% to 20%. We've got a 80% to 85% replacement market. So housing is in that 15% to 20% range, which will be a headwind. And that's kind of how you get down to the 2% down. Where we're looking at for proactive replacement, it's pretty strong on proactive replacement going into next year. We saw that pick up, you know, historically proactive replacement as we measure it through a third party survey runs 20 to 25%. During the past couple years, it's been in that 30 to 35%. And our last survey still has it above 30. So we're still projecting going into next year, a fairly strong proactive replacement portion of the replacement market.

Great, and then I guess I know you guys don't like to talk about pricing a lot, but just on the residential water heater pricing in the retail channel, you know, do you expect to see prices decline for the index contracts? And if so, how do you just think about the balance in pricing in retail versus the wholesale channel?

Well, hey, this is Kevin. When you look at both those channels, one, they are two different business models, but they compete for a lot of the same customers. And traditionally, you're going to have some conflicts between the channels periodically. It's kind of regional. But as we look at it and as we evaluate our pricing structures in both channels, we feel that they're going to be competitive. Historically, how we've managed our pricing hasn't changed. So again, we look at that both channels will be in the market competing at an equal level. So that's kind of where we're at right now, and we'll see how things play out the rest of the year.

Thank you. One moment, please, for our next question.

Our next question will come from Michael Halloran of Beard. Your line is open. Hello, Mr. Halloran.

If your line is mute, please unmute your line.

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

Thanks, everyone. Appreciate the time.

So first on the guide and how you're thinking about kind of sequentials, You know, a couple things. First, is the embedded assumption relatively normal seasonal patterns as you work through the year? And then secondarily, when we think about kind of one-age load versus second-half load, obviously the year-over-year comps get a lot easier in the back half of the year. So maybe talk about how you think growth cadence is as we work through the year.

Sure, Mike. You know, we have it laid out in our outlook to be pretty much back to normal. You know, when you look at kind of the residential volumes, it's usually 52, 48, you know, front half of the year, 52%, back half of the year, 48. And we kind of believe it's going to get back to that normal cadence. Boilers, typically strongest in third quarter. So we have it laid out a bit like that, similar to prior cadence. China, you know, we've got China starting out a bit slow, you know, with the COVID disruptions. As you know, the first quarter is always a challenge with the Chinese festival for volumes. And we just got China a little bit lighter in the first quarter, but improving as we go throughout the year. And normal cadence again on China's fourth quarter, the strongest we would expect. you know, improvement on the COVID situation by the fourth quarter, back to our normal routine of that being a strong retail quarter for us.

And might as well stay on China then. Maybe just talk about how things are tracking from a competitive dynamic share component to it, a market share component to it, but also, you know, how the high end of the market's performing versus the rest of the market feels like things are stable.

um but any commentary on the competitive landscape would be appreciated yeah mike hi it's kevin here um share is always a difficult we talked about how the omni channel has just blended together we don't have great visibility uh to all the different channels but what i would tell you that um we believe we're happy with our sales we're happy with our average pricing we believe we're getting you know our fair share of of the market and and continue to uh To get that, introducing new products, as we always do, and bringing products to the market that consumers are willing to pay for. When it comes to the high end of the market, it continues to have that sleeve that makes sense, and it keeps ticking up a little bit. But again, it's still on a smaller base. We hope as we get through the zero COVID lifting and the consumer activity grows in the market, that will improve. Consumers right now in China are Our records are saving at the highest rate that they have ever. So we look at there could be some pent-up demand as we go forward. And again, just looking at China in general, there's some discussions about some consumer stimulus by the government, nothing specific today. Banks are helping out some of the housing sectors to build up some of their inventory. So there's a lot of positives, but again, I think it'll take some time as a consumer recovers from three years of basically inactivity and lockdown and starts to get more comfortable. And that's why, as Chuck pointed out, we're looking at sequential improvement through the year, but there's more positives than we've seen in a long time in our China market.

Just to add to that, you know, we said it in our prepared remarks, we're really pleased with the consistency, as you noted, Mike. of our performance quarter over quarter, the discipline towards managing our discretionary spend. Our outlook for 23 has us back in a growth mode on constant currency, so we're pleased to be kind of hopefully turning a corner, growing in that 3% to 5% in local currency. Great.

Thank you. One moment, please, for our next question. Our next question will come from Jeff Hammond of KeyBank Capital Markets. Your line is open.

Hey, good morning, everyone. Good morning, Jeff. Yes, so I just want to come back on price. I think your comment, Kevin, was both channels are going to be competitive, but just formulaically, I think you go negative on price with your material price formulas on the DIY side. So I'm wondering if your comment implies that you know, there's some pricing pressure on the wholesale side, or do we stick more there? And if we do, kind of, you know, what the upside is to maybe North America margins given the fall off in steel? Thanks.

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

Yeah, I mean, I understand the steel stabilization, but I think you mentioned 40% to 45% kind of decline. And I guess relative to past cycles, that's a much bigger kind of increase and then decrease. So I'm just wondering if the behaviors are any different.

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

Okay, and then just one last one. I think the last couple of years you signed up for $400 million buyback. I think you're stepping it down to $200 million. Just anything that informs kind of the lower buyback versus the past couple of years?

Yeah, I mean, where we were looking at it is when we're committed to 200 million as a buyback, and we, we are a little bit shy of our cash, you know, conversion target of 100% cash conversion in 2022. Did that consciously built inventories, you know, worked our backlogs down pleased with that now we'll be working on reducing inventories in the next year. But, you know, as we enter 2023, we pegged $200 million as a target that we're committed to. We're going to look at kind of how 2023 rolls out from really an acquisition perspective as we go through the year. You know, we may revisit that as we go through the year and as, you know, as we work down inventories and see our cash potentially, you know, grow a bit. But we're going to revisit it as we go through the year with the opportunities we think, you know, still to be out there on M&A. Okay, thanks so much.

Thank you. One moment please for our next question.

Our next question will come from Matt Somerville of DA Davidson.

Your line is open.

Hi, good morning. This is Will Jellison on for Matt Somerville. I wanted to ask both questions today about capital allocation priorities. Starting off with organic growth, I was wondering if you could provide any more insight into what sorts of capital expenditure projects and investments you're considering making in 2023 and how those support the business and its growth moving forward.

Yeah, on the organic growth side, I mean, just a couple comments around that. So we're always investing in innovation, product development. You know, from a capital perspective, some of those support new product developments, I would say. when you get into the developments of heat pumps, some of the other growth categories where we might have to support that.

We break down the capital. We look at it from a growth perspective. Maintenance as well. We have some pretty large facilities that we have to invest back in. There's also a pretty large cost reduction component as we invest in automation, new technologies, and so forth, and efficiencies in our factory. Those are the three buckets that I would say that there's no specific major expense outside our normal, but there's a consistent span in all three categories in our company.

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

Let's just talk about the environment, which is a bit strange right now, you know, with some of the potential, you know, higher interest rates, the talk of a recession and so forth. And, you know, what I can tell you that multiples haven't really changed, maybe ticked down a little bit. But there's a lot of wait-and-see approach out there with, I would say, targets. So we're continuing to stay close to them. our potential targets and stay active in the pipeline. And we look at this as an opportunity as you get in uncertain times with our balance sheet, there could be some nice opportunities. But again, needs to play out a bit. We need to get through some of the uncertainty. But we feel good about our pipeline. We feel good about the companies that are in it. And we're going to continue to work on driving some of those to closure. As far as actionability, it always depends on the person saying yes as we go forward. And we'll keep working through there. We've made small acquisitions each the last few years. Hopefully, we'll be able to bring a couple of those across the finish line in 2023.

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

Hey, good morning, everyone. This is Charles Perron and for Susan this morning. Thanks for taking my question.

Good morning. Yeah, Charles, thanks. You helped us out there.

Yes. I guess my first question, I would like to go back to the North America margin outlook for 2023, and it's going to help us walk through the trajectory of the margins throughout the year. Obviously, we're going to have water heater volumes probably deleveraging in the first half and then coming back, obviously, gradually throughout the year, but also If you think about the price cost, you mentioned that non-sale categories should improve through 2023. So is it fair to expect maybe a gradual ramp in the margins throughout the year?

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

Gotcha. That's good color there. And then my follow-up on the boiler sales guidance for 23, 10% to 12% sales growth, that's impressive considering the significant growth you've seen in 22. Can you expand maybe on the drivers of the growth there, volumes versus price, and maybe the initiative supporting industry volume growth considering the weakening that we've seen in the commercial or non-residential indicators over the span of the last few months?

Yeah, I mean, we did have some great growth in 2022 on the boiler side. And again, particularly in the fourth quarter was helped by drawing down our backlogs, which we exited the year pretty normal. In that 10% to 12% growth that we see for next year, 50% to 60% of that is price. So carryover price is a little over half of that 10% to 12%. The rest of the growth is on volume.

Yeah, I would just maybe add on to that. We came out some strong growth. Again, a lot of that had to do with bringing the backlog down, but our orders remain pretty stable. Quoting activity in the market is still strong, institutional, education. So we feel there's still a positive momentum in the boiler segment in 2023. And so far, as we've seen our orders come in over the last month, that's indicating that that's where we should be. Again, being stable. And what's really great is now our lead times are back to normal. We're able to, you know, get product out the door in a timely fashion. So, overall, we still feel really good about the boiler market. You know, the whole commercial side of the business tends to lag residential, so 2023 still seems like it'd be a solid year for our boiler business.

Thank you. One moment, please, for our next question. And our next question will come from David McGregor of Longbow Research. Your line is open.

Yes. Good morning, everyone. My first question, just with respect to the supply chain and looking back on 2022, is there any way to estimate what supply chain disruptions cost you in 2022 in terms of revenue and EBIT? And does it become an incremental positive in 2023? I mean, you mentioned the boiler backlogs have kind of normalized, but I'm just wondering if there's any kind of a throw-forward benefit into 2023 from that normalization.

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

Yeah, I'll just add on to it that all of our plants throughout the year, really, supply chain did improve throughout the year, and we only had sporadic outages that really didn't impact our productivity all that much. The only exception was in China towards the fourth quarter. But overall, supply chain is really kind of very much stabilized, and we're chasing one and two items now, not the entire portfolio.

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

Yeah, all I can tell you about 2022 is Q3 was a tough quarter for us on the residential water heater side just because of the drastic drop in volume. But overall, you know, we're building up those efficiencies. I don't see them being exceptionally different in 2023.

No, I mean, supply chain and us catching up on backlog, carrying a little more inventory, it actually helped volumes a little bit on the boiler and water treatment side in 2022 because we could work our backlog down with better supply chain.

Okay. Yeah, that's interesting.

My second question is on China, and obviously a good quarter with rest of the world margins at 12.7%. With China, local currency sales down 4% too, which is good. Obviously, a lot of work being done on managing costs. Can you just talk about the margin opportunity in China over maybe the next 12, 18, 24 months and what specific drivers would be? And I'm guessing, you know, with progress in India and maybe some of these other smaller lines within ROW, it looks like you're now back to the kind of that 12, you're approaching anyway, the 12 to high 13s range that you last achieved in 2013, 2018. Is there a further upside or changes in price point mix and regional market mix and levels of competition just created structural limitations that are going to hold you to those levels again.

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

Thank you. One moment, please, for our next question. And our next question will come from Lawrence DeMaria of William Blair. Your line is open.

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

Well, so our outlook, and you'll notice we didn't provide a range on North America margins for next year. We had 23% just as a kind of midpoint, as a point estimate. You know, we feel pretty comfortable with managing to that 23%. Carryover pricing, you know, there will be some, but not a great deal of carryover pricing in the water heater side next year. We've got our material cost holding fairly resilient going into next year. Conversion costs, we expect the plants to operate a little more smoothly, but just embedded in that are higher operating costs overall. The biggest puts and takes are we expect to continue to have a reasonable relationship on the price-cost relationship for the North America water heaters. We've had some carryover pricing in other parts of our business, like boilers and water treatment in North America.

Okay, that's helpful. Thank you. And then if I could just ask one more then. The 5% to 7% water treatment growth, what's really underpinning that? It sounded like in your prepared comments it's mostly price, but given the, you know, weakness in residential markets, just kind of curious how the buildup there works.

You are correct. It is mostly price going into next year. You know, again, a bit like the boiler side of the business, we, you know, we had broader backlogs down. We saw a bit of inventory adjustment in the channel on the water treatment side of the business in 2022. So next year, I mean, we certainly have confidence in the underlying trends in North America water treatment. But most of the volume next year is driven by price. And we could potentially see some pressure on consumer spending as we head into 2023. Okay. Thank you and good luck.

Thank you. One moment, please, for our next question. Our next question will come from Andrew Kapellitz of Citi. Your line is open. Excuse me.

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

Yeah, again, we have it classed slightly up. Part of it is we still have lead times that are a little bit more extended than we'd like. So we normally like to be around 15 days. We're around 25. We, you know, we believe that the gas market and it's just, there's some inventory deficits out there. There's still some upside on some replacement. So we look at the market as just artificially, the 17% was just artificial because of the greater than 55 gallon. But underneath that, you know, the market was down mid single digits. And that was with the supply chain issue and components and It's going to normalize, and we see it being slightly positive as we go through the year, particularly on the gas side of the commercial business.

Helpful. I know you introduced the Voltex heat pump in Q3. Can you talk about your early penetration into the market with that particular heat pump? I know heat pumps are still a small part of your business, but how might they become a factor later in 2023 and 2024 as IRA implications also impact the business?

Yeah, again, you look at it, as I talked about, one of our priorities is certainly on the heat pump side of the business. It's both residential and commercial. And you are right. Residential heat pumps represent about 2% of the entire market today. It's got a really nice growth rate of 35% to 40%. And that's a positive trend, but it's going to take some time to move forward. There's some upfront costs to this that are expensive. There's some parts of the installation that are a bit more difficult than the normal replacement. But if you look out forward, a heat pump will become a bigger part of our commercial and residential portfolio. So that's going to move forward. Again, it's not going to go at the pace where it takes over the market next year or two, but long term is one of the best value propositions. It's got a great decarbonization message. It's been promoted by a number of states. And of course, when you look at the Inflation Reduction Act, that's still working its way out, but there'll be a component there that will hopefully help and provide some stimulus as well. So overall, and then I would tell you our Voltex has been out a few months. It's done quite well, but it's a little early. We just feel a little good about, you know, the UEF of greater than four and And the different features and benefits that it brings to the market, the zero clearance, it's a terrific product that can go into just about any application that it needs to. And so far, it's been received really well. But again, heat pumps in the early stages, but it will continue to grow at a greater accelerated rate year over year.

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

Thank you, everyone, for joining us today. Let me conclude by reminding you that our global A.O. Smith team delivered record sales and strong adjusted earnings in 2022. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at three conferences this quarter. City on February 21st, Loop on March 14th, and UBS on March 23rd. Thank you and enjoy the rest of your day.

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