SMITH A O CORP Q2 2025 earnings call

Good morning, and welcome to the A. O. Smith Second Quarter Conference Call. I'm Helen Gurholt, Vice President, Investor Relations, and Financial Planning and Analysis. Today, I'm joined by Steve Shafer, Chief Executive Officer, and Chuck Lauber, Chief Financial Officer. Within today's presentation, we have provided non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. 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 Steve to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. We believe A. O. Smith has an outstanding foundation for profitable growth as a global water technology leader. I am both honored and excited to build on this foundation as the company's new CEO and am confident in our company's future. This future will be powered by the many dedicated and capable A. O. Smith colleagues I have started to get to know over the past year and a half, and I look forward to the journey we have in front of us together. Later in our prepared remarks, I will share some of my early thoughts on priorities going forward that I believe will be most impactful in delivering that bright future for us. First, I would like to go through our second quarter performance, our updated guidance for the year, and the announcement regarding our China visits.

Now, turning to slide four and our financial performance in the quarter. North America water heater sales decreased 2% in the second quarter, driven by lower volumes. Shipments in the first half of 2024 benefited from pre-buy-related volumes ahead of an announced price increase. This year, we believe the industry once again bought ahead of price increases and tariff risks. We decided to take a more proactive approach by working closely with our customers to better align order rates to our strategy of smoothing production schedules in order to achieve greater operational efficiency. Like the overall industry, we still benefited in the quarter from a demand pull forward. However, our 2025 pull forward impact was less pronounced compared to the demand pull forward we experienced in 2024. We expect to gain operational efficiencies through the year because of these actions.

Our North America boiler sales increased by 6% compared to the second quarter of 2024, led by higher volumes of our high-efficiency commercial boilers. North America water treatment sales increased slightly in the second quarter as growth in our priority channels, e-commerce, dealer, and direct-to-consumer, continued to offset expected retail declines. In addition to the growth in these priority channels, we are pleased with the improved profitability it provided, which helped contribute to North America segment operating margin expansion in the quarter. In China, second quarter sales decreased 11% in local currency as the ongoing economic challenges and limited availability of government subsidy programs outside of Tier 1 and 2 cities resulted in lower volumes. We maintained our operating margin year over year despite lower sales due to our 2024 restructuring initiatives and other cost control measures.

In addition to announcing our Q2 performance in China, we are also announcing today that we are initiating a process to further assess our China business in an effort to ensure that it is best positioned to compete and succeed in the future. We intend to evaluate a broad range of options in addition to further business improvements, including strategic partnerships and other alternatives. As we announced in Q4 of last year, given the market conditions, we have been working to optimize the operating structure in China and reduce costs to better position the business for the future. These initiatives are already delivering positive results. We are on track to achieve $15 million in annual benefits, which have resulted in sequential margin improvement quarter-over-quarter. Despite the current macroeconomic challenges, we believe the China market has substantial long-term potential.

Our China business also has many competitive strengths, including a premium brand position, differentiated innovation capabilities, a well-established distribution network, and a talented local team. We are committed to realizing the full potential inherent in our China business for our company and our shareholders while benefiting our employees, valuable partners, and customers. We believe that the assessment announced today will allow us to properly understand the potential options available to realize the full potential of the business. As the review progresses, we will continue to deliver best-in-class products and service, just as we always have. Please turn to slide five. I would now like to take a moment to discuss innovation at A. O. Smith. As a water technology leader, we continue to invest in and launch new-to-the-world differentiated products. I would like to highlight a few of those offerings today.

We recently introduced the second product in our ADAPT gas tankless line, the ADAPT SC, which is our standard condensing product featuring industry-first integrated scale prevention technology. This product is positioned in the high-volume segment of the tankless market and is the latest proof point in our commitment to become the North American leader in tankless technology. We have also just launched our HomeShield Whole House Water Filter, which is certified to reduce PFAS to less than 4 parts per trillion for 500,000 gallons of water. In addition to taking whole house PFAS reduction performance to a new level, it is also easier to install and provides both economic and ecological benefits for the homeowner. Next month, we will introduce the Cyclone Flex, the next generation of our industry-leading commercial water heater that is smarter, more efficient, and more flexible than ever.

Staying the industry leader means never standing still, and this product is a continuation of our long history of Cyclone enhancements, and it will help ensure we are best positioned for the 2026 regulatory change in the commercial market and remain the industry's number one specified yet commercial gas water heater. These are just a few examples of the exciting pipeline of new products we are bringing to market that has us confident in our future. I'll now turn the call over to Chuck, who will provide more details on our second quarter performance.

Thank you, Steve.

Good morning, everyone. We delivered sales of $1 billion in the second quarter of 2025, a decrease of 1% year-over-year. Earnings were $1.07 per share, a 1% increase compared to the prior period. Please turn to slide six. Second quarter sales in the North America segment of $779 million decreased 1% compared to a difficult year-over-year comp. Higher boiler sales were more than offset by lower volumes of water heaters. North America segment earnings of $198 million were essentially flat for last year. Segment operating margin was 25.4%, an increase of 30 basis points year-over-year, primarily due to mixed benefits from our water treatment priority channel strategy, as well as growth in high-efficiency water heaters. Moving to slide seven. Rest of the world segment sales of $240 million decreased 2% compared to last year and included $16 million of sales from the Pureit acquisition.

Sales in our legacy India business grew 19% in local currency. China third-party sales decreased 11% on a constant currency basis. Rest of the world segment earnings of $25 million were essentially flat year-over-year as continued expense management offset lower sales in China. Segment operating margin was 10.5% compared to 10.6% in the prior period. The Pureit acquisition is progressing well. However, it will be a margin headwind in the near term as we focus on the integration. Please turn to slide eight. We generated operating cash flow of $178 million and free cash flow of $140 million during the first six months of 2025. Higher than the same period last year, primarily due to lower cash outlays for 2025 working capital needs that were partially offset by lower current year earnings.

Our cash balance totaled $178 million at the end of June, and our net debt position was $126 million. Our leverage ratio was 14.1% as measured by total debt to total capital. Let's now turn to slide nine. Earlier this month, our board approved our next quarterly dividend of $0.34 per share. We repurchased approximately 3.8 million shares of common stock in the first six months of 2025 for a total of $251 million. An increase over the same period last year as we increased our planned full-year repurchase intentions from $306 million in 2024 to approximately $400 million of shares for 2025. We also opportunistically bought shares during the first half of the year. We are actively assessing strategic opportunities and have sufficient dry powder for suitable acquisitions. Our priority is on deals that strengthen our core business or help us build new growth platforms.

Please turn to slide 10 in our 2025 earnings guidance and outlook. We are raising the midpoint of our 2025 EPS outlook from a range of between $3.60 and $3.90 per share to a narrowed range of between $3.70 and $3.90 per share. The midpoint of our revised EPS range is an increase of 2% compared to our 2024 adjusted EPS. We have included the following key assumptions in our outlook. Our guidance assumes an approximate 15%-20% increase in the cost of steel in the back half of the year, as well as the full impact of currently announced tariffs, which minimally impacted the first half of the year. Other input costs outside of steel and tariffs are slightly higher than 2024 and ratable for the year. The tariff landscape remains uncertain.

We have refined our estimate of the annualized tariff impact on total company cost of goods sold to be an increase of approximately 5%, which is inclusive of currently announced tariff rates, as well as the mitigation efforts we have implemented. Our mitigation strategies include footprint optimization, strategic sourcing, and other cost controls. We estimate that 2025 CapEx will be between $90 million and $100 million as we continue to invest in engineering capabilities and prepare for the upcoming regulatory changes. We expect to generate free cash flow of between $500 million and $525 million. Interest expense is projected to be between $15 million and $20 million. Corporate and other expenses are expected to be approximately $75 million. Our effective tax rate is estimated to be between 24%-24.5%. We project our outstanding diluted shares will be 142 million at the end of 2025.

I'll now turn the call back over to Steve, who will provide more color around our key markets, top-line growth outlook, and segment expectations for 2025, remaining on slide 10. Steve?

Thanks, Chuck. Key assumptions in our top-line outlook include the following. We project that 2025 residential and commercial industry unit volumes will be approximately flat to last year, which is unchanged. As we expected, we believe there will be some pressure on our market share in the first half of the year as we managed our production levels despite the strong order rates we saw in response to tariff announcements and ahead of our May price increases. We anticipate a market share recovery in the second half of the year as we work through our backlog and our customers return to more normalized order patterns. In China, we believe the economy remains challenged, and we continue to project that our sales in China will decrease 5%-8% in local currency.

While the stimulus programs benefited sales in Tier 1 and 2 cities, where we saw relatively flat sales compared to last year, stimulus programs were inconsistently applied in other regions, particularly in smaller cities. Additionally, many regions have not yet resumed subsidies in the second half of the year. Our forecast assumes that the currency translation impact will be minimal in 2025. We continue to expect to realize annual savings of approximately $15 million from our 2024 restructuring actions, and as a result, China operating margin is projected to be in the 8%-10% range for 2025, even with lower volumes. We remain cautious about the near-term market outlook, including the impact from the appliance discount trade-in program. However, we are pleased with how our China team continues to manage the challenging environment.

We have raised our 2025 North America boiler sales projection from an increase of between 3% and 5% to an increase of between 4% and 6% compared to 2024. We are very pleased with our growth in the first half of the year. However, we believe we may have benefited from a minimal amount of pre-buy related to price increases implemented in the second quarter. We continue to monitor the commercial markets closely. We have not changed our guidance that North America water treatment sales will decline approximately 5% in 2025 as we de-emphasize the less profitable retail channel. We are pleased with the momentum we are seeing in our priority channels, where we are seeing double-digit growth. We continue to project an operating margin expansion of approximately 250 basis points in 2025 for the North America water treatment business.

Lastly, we continue to expect the addition of Pureit will add approximately $50 million in sales in 2025 and will not have a significant bottom-line contribution this year as we work through integration. Based on our confidence in our ability to manage tariffs and other cost pressures, our expected improved relative market share performance in the back half of the year, and our strong boiler sales in the first half of 2025, we have raised our full-year sales outlook from flat to 2% to an increase of 1%-3% compared to last year. We continue to expect our North America segment margin will be between 24% and 24.5%. Rest of World segment margin will be between 8% and 9%. Please turn to slide 11. As I reflect on my last 16 months, there were several things that led me to join the company in March 2024.

I found that those first impressions have proven to be accurate. First, the company's dedication to its foundational values and doing business the right way, the Smith way, strongly resonates with me. Second, the genuine commitment of the entire global team to a strong culture of collaboration and innovation. Third, the quality of our businesses, where we are a leader in the markets that we serve with strong, trusted, and enduring customer relationships. Our core North America water heater and boiler businesses provide a resilient base with stable 80%-85% replacement rates, strong cash generation, and attractive regulation-driven growth tailwinds. Fourth, an amazing set of strategic opportunities that we can lean into to build our bright future.

As I now step into the CEO role, I would like to highlight a few areas that my leadership team and I are focused on that I believe will play an important role in creating value at A. O. Smith as we go forward. First, operational excellence. We will remain focused on accelerating productivity and the elimination of waste through the expansion of our AOS operating system. While A. O. Smith already has a great foundational culture of continuous improvement on the plant floor, I believe we can benefit from a renewed focus on the application of lean principles not only to our manufacturing processes, but to other processes as well. I have personal experience both in deploying and running a number of operating systems in my career.

I believe the opportunity to expand our thinking of end-to-end processes and waste elimination can even further improve the operational and working capital efficiencies of our company. An example of our focus on this operational discipline is our initiative this year to work with our customers to smooth our production schedules in our plants, which we discussed earlier. I also see technology playing a big role in helping us achieve new levels of productivity going forward. Both leveraging those technology investments we have already made more effectively and investing in new technologies to help us advance the way we work. We are also going to build upon our great legacy of innovation at A. O. Smith. Our pipeline of innovative products is strong, and we have made a number of major investments to prepare for the future, both in terms of regulatory and technology shifts.

Included in this investment is the recent commissioning of our brand new product development center in Lebanon, Tennessee. Earlier, I shared some of the exciting new products we are introducing this year as examples of our powerful innovation capability. There is still much more we can do, and I look forward to the opportunity to advance A. O. Smith's innovation capability to the next level. I am pleased to announce that Dr. Ming Cheng joined the company earlier this month as our next Chief Technology Officer. I worked with him for over 10 years at 3M and developed great respect for his leadership, business sense, technical expertise, and great curiosity, all important attributes for an innovation leader. I'm confident that Ming will help us achieve this next level of innovation capability.

The third focus area I would like to mention is portfolio management, making sure that A. O. Smith is positioned well with a portfolio of businesses and products for future success. The assessment of the China business, as well as the restructuring actions we took in China and North America water treatment last year, are consistent with my commitment to continually evaluate our portfolio and take the actions necessary to position them well for profitable growth. M&A and strategic partnerships to build out our business platforms will likely be a critical lever to enable this portfolio work, and we have ample dry powder and management focus to help deploy it for the right targets. I look forward to sharing more information about these priorities as we lean into them and drive them forward to great value for A. O. Smith. Moving to slide 12.

In conclusion, as we continue to navigate the tariff landscape and pursue our long-term strategic investments, I am pleased with our team's second-quarter performance. We executed well, both responding to a number of uncertain factors in North America with agility and discipline and resetting the business in China to address the ongoing challenging market environment. These actions have allowed us to continue to make sequential margin improvements in both the North America and Rest of World segments. We continue to see strong growth momentum in areas where we are expecting growth performance, including the North America boiler and India businesses, as well as the prioritized channels in the North America water treatment business. In both our margin improvement and growth efforts, I would like to thank all my A. O. Smith colleagues for your dedication and delivery.

We also believe the strategic actions we are taking are positioning us well for the future. Leveraging the AOS operating system, re-energizing innovation, and driving our portfolio forward will be keys to our success. I am pleased to see our leadership team rallying around these priorities. Our strong market leadership, recurring revenue from our core water heater and boiler businesses, and our solid balance sheet enable us to invest strategically and maximize shareholder return even in the face of uncertainty. We are confident in our future and our proven ability to achieve profitable growth. With that, we conclude our prepared remarks, and we are now available for your questions.