A. O. Smith Q4 2023 Earnings Report

A. O. Smith EPS Results

• Actual EPS: $0.97
• Consensus EPS: $0.96
• Beat/Miss: Beat by +$0.01
• One Year Ago EPS: $0.86

A. O. Smith Revenue Results

• Actual Revenue: $988.10 million
• Expected Revenue: $985.89 million
• Beat/Miss: Beat by +$2.21 million
• YoY Revenue Growth: +5.60%

A. O. Smith Announcement Details

• Quarter: Q4 2023
• Date: 1/30/2024
• Time: Before Market Opens
• Conference Call Date: Tuesday, January 30, 2024
• Conference Call Time: 10:00AM ET

A. O. Smith (NYSE:AOS), based in Milwaukee, Wisconsin, is a leading manufacturer of water heating and water treatment products for residential and commercial applications. Since its founding in 1874, the company has built a reputation for producing reliable, energy-efficient water heaters, boilers and pressure vessels. Its product portfolio encompasses gas, electric, condensing and tankless water heaters, as well as specialty boilers designed to meet a variety of building and industrial needs.

The company operates through two primary segments: North America and Asia. In North America, A. O. Smith serves homeowners, contractors and building operators with well-established brands that deliver high performance, safety and long service life. In Asia, the company has expanded its presence with water heating and water purification solutions tailored to rapidly growing urban markets, leveraging local manufacturing facilities and an extensive sales network throughout China and parts of South Asia.

A. O. Smith has grown from its origins as a pump manufacturer into a global enterprise with production plants and research centers in the United States, China and India. The company’s emphasis on product innovation is supported by engineering teams dedicated to improving energy efficiency and reducing environmental impact. Patrick S. Decker has served as President and Chief Executive Officer since 2011, guiding A. O. Smith through periods of expansion and technological advancement.

With a long history of industrial manufacturing expertise, A. O. Smith continues to focus on sustainable solutions and customer support services. Its product offerings increasingly incorporate smart-control technologies and advanced materials to meet evolving regulatory standards and end-user expectations for safety, efficiency and durability.

A. O. Smith Q4 2023 Earnings Call Transcript

Key Takeaways

• Record 2023 performance: Global sales reached $3.9 billion and adjusted EPS was $3.81, up 21% year-over-year, driving a new free cash flow high of $598 million.
• 2024 outlook forecasts 3–5% revenue growth and an EPS range of $3.90–4.15 (a 6% increase at midpoint), supported by announced price increases and a $300 million share repurchase program.
• North America water heater strength saw residential demand up 6% and commercial up 15%, though boiler sales fell 12% due to channel destocking; segment margins are guided to 24.5–25%.
• Emerging markets growth: China sales rose 4% in local currency on new kitchen products and HVAC gains, while India grew 15% with new products representing 30% of sales, and further expansion is expected.
• Investment and expansion initiatives: include the March launch of in-house gas tankless units (50 bps near-term margin drag), $105–115 million in CapEx for capacity builds, and a net cash position of $236 million.

Presentation

[Operator]

Day, and thank you for standing by. Welcome to the A. O. Smith Fourth Quarter 2023 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, you will need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Helen Gurholt. Please go ahead.

[Helen Gurholt, VP of Investor Relations and Financial Planning & Analysis at A. O. Smith]

Thank you, Abigail. Good morning, everyone, and welcome to the A. O. Smith Full Year and Fourth Quarter Conference Call. I'm Helen Gurholt, 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 provided non-GAAP measures. Free cash flow is defined as cash from operations, less capital expenditures. Adjusted earnings, adjusted earnings per share, adjusted segment earnings, and adjusted corporate expenses exclude the impact of restructuring and impairment expenses, 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.

[Helen Gurholt, VP of Investor Relations and Financial Planning & Analysis at A. O. Smith]

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.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Thank you, Helen, and good morning, everyone. I'm on slide four in our full year results. 2023 was a record-setting sales and earnings year, driven by resilient water heater demand and excellent execution by our team. North America sales increased 4% and adjusted segment margin increased 310 basis points due to higher water heater volumes and improved price-cost relationship. Our Rest of World segment, sales grew 4% in local currency, as our recently introduced kitchen products in China were well received by the market. In India, our sales grew 15% local currency in 2023 and benefited from sales of new products, which represented 30% of our sales. Free cash flow grew to $598 million, primarily driven by record profit. We returned $490 million of capital to shareholders with our dividend and share repurchases.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Please turn to slide 5. Our global A. O. Smith team delivered record sales of $3.9 billion in 2023, and Adjusted EPS of $3.81, a 21% increase over 2022. North America water heater sales grew 6% in 2023 due to strong demand for our residential and commercial water heater products. The residential unit industry demand increased approximately 6% compared to 2022, as new construction and proactive replacement demand remained resilient. Commercial industry units increased approximately 15% year-over-year, as volume of commercial electric water heaters greater than 55 gallons rebounded and aligned closer to pre-2022 levels. We are pleased with our market share strength in both residential and commercial water heaters. Our North America boiler sales decreased 12% against a difficult comp of 28% growth in 2022.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

We worked down our backlog in 2022 after making significant production and supply chain improvements, which led to elevated channel inventories going into 2023. The resulting channel inventory destocking impacted our residential and small commercial boiler sales. Sales of our CREST commercial boilers with Hellcat technology increased over 50% in 2023. North America water treatment sales grew 2% in 2023, as higher sales in the e-commerce and direct-to-consumer channels were partially offset by lower sales in the wholesale and retail channels. Sales in the prior year benefited from strong shipments as supply chain constraints improved, and we worked down our order backlog, which resulted in elevated channel inventories in early 2023. In China, full-year sales increased 4% in local currency. We are pleased with our performance in a continued weak economy.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

In addition to the successful launch of our kitchen products, we saw double-digit sales growth of our HVAC and commercial water treatment product categories. Our core water heating and water treating products also performed well. As replacement approaches 60% of residential water heater sales, and residential water treatment sales, particularly consumables, remain resilient. I'll now turn the call over to Chuck, who'll provide more details on our full year and fourth quarter performance.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Thank you, Kevin, and good morning, everyone. I'm on slide six. Full year sales in the North America segment rose to $2.9 billion, a 4% increase compared with 2022. Higher volumes of water heaters were partially offset by lower sales of boilers and pricing.

[Chuck Lauber, EVP and CFO at A. O. Smith]

North America segment earnings of $726 million increased 19% compared to 2022. Adjusted segment margin was 24.8%, an increase of 310 basis points year-over-year. The higher adjusted segment earnings and adjusted segment margin were primarily driven by higher water heater volumes and lower material costs. Moving to Slide 7. Rest of the World segment sales of $957 million decreased 1% year-over-year, including unfavorable currency translation of $44 million, primarily related to China. Segment sales increased 4% on a constant currency basis. Our sales increase was primarily driven by higher sales of kitchen products and water treatment products in China. India sales grew 15% in local currency in 2023, which is approximately 3 times the market.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Rest of the World segment earnings of $99 million increased 3% compared to segment earnings in 2022, primarily due to higher sales in China. Adjusted segment operating margin was 10.4%, an increase of 40 basis points compared to 2022. Please turn to Slide 8. Turning to fourth quarter performance, we delivered sales of $988 million in the fourth quarter of 2023, an increase of 6% year-over-year, led by higher water heater volumes in North America and higher kitchen product sales in China, that more than offset lower boiler sales and pricing. Adjusted earnings in the fourth quarter were $0.97 per share, compared with adjusted earnings of $0.86 per share in the fourth quarter of 2022. Please turn to Slide 9.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Fourth quarter sales in the North America segment were $738 million, a 7% increase compared to sales in the fourth quarter of 2022, as a result of higher water heating volumes, partially offset by lower boiler sales. North America segment adjusted earnings of $173 million increased 8% compared with 2022. Adjusted operating margin of 23.5% increased 20 basis points compared to last year. The higher adjusted segment earnings and adjusted segment margin were primarily due to higher water heater volumes. Moving on to Slide 10. Fourth quarter Rest of the World segment sales of $260 million increased 4% year-over-year, primarily driven by sales of new products, partially offset by unfavorable currency translation of $3 million in China.

[Chuck Lauber, EVP and CFO at A. O. Smith]

India sales grew 11% in local currency in 2023 compared to 2022. Rest of the World adjusted segment earnings of $30 million decreased 6% compared to Q4 2022 segment earnings. An adjusted segment margin of 11.5% decreased 120 basis points compared to segment margin in the same period last year. The decreases were primarily due to promotions and advertising, supporting the launch of our dishwasher and steam oven products in China. Please turn to Slide 11. We generated free cash flow of $598 million during 2023, an increase of 86% over 2022, primarily driven by higher earnings and lower working capital needs. 2023 free cash flow conversion was 107%.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Our cash balance totaled $363 million at the end of December, and our net cash position was $236 million. Our leverage ratio was 6.5% as measured by total debt to total capital. Now turn to Slide 12. As we detailed at our Investor Day, 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 target strategic acquisitions that meet our financial metrics of accretive to earnings in the first year and return our cost of capital in 3 years. The strength of our balance sheet allows us to continue to invest in ourselves through research and development and capital expansion while pursuing strategic acquisitions. Earlier this month, our board approved our next quarterly dividend of $0.32 per share.

[Chuck Lauber, EVP and CFO at A. O. Smith]

We have increased our dividend for over 30 consecutive years. We repurchased approximately 4.4 million shares of common stock in 2023, for a total of $307 million. We continue our strong track record of delivering return to shareholders. Over the last two years, we have returned over $1 billion to shareholders through our dividends and share repurchases. Please turn to Slide 13 and our 2024 earnings guidance and outlook. We are pleased to introduce our 2024 outlook with an expected EPS range of $3.90-$4.15 per share. The midpoint of our EPS range represents an increase of 6% compared with 2023 Adjusted EPS. Our outlook is based on a number of key assumptions, including:...

[Chuck Lauber, EVP and CFO at A. O. Smith]

Our guidance assumes that steel prices in 2024 will be a slight headwind compared to 2023. Relative to current steel prices, our projection includes a decline in steel price index in the second half of the year. Our outlook assumes non-steel material costs are similar in 2024 as they were in 2023. Our guidance also assumes a relatively stable supply chain environment, similar to what we experienced throughout 2023. We are monitoring the situation in the Red Sea and Panama Canal and currently have not experienced any negative impacts. We launched our internally designed and manufactured gas tankless products earlier this month. As we mentioned at our Investor Day, these products will be manufactured in China, our China facility, until our North America capacity is completed in 2025.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Associated import tariffs and other launch costs will impact North America margins by approximately 50 basis points. We are investing in manufacturing in Juárez, Mexico, that will eliminate the tariff in the future. For the year, CapEx should be between $105 million and $115 million, an increase over the last several years due to capacity expansion projects related to our gas tankless manufacturing facility in Juárez, the expansion of our engineering capabilities in Lebanon, Tennessee, and an increase in high-efficiency commercial water heating manufacturing capacity to align with regulatory changes coming in 2026. We expect to generate strong free cash flow between $525 million and $575 million. Corporate and other expenses are expected to be approximately $60 million.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Our effective tax rate is estimated to be between 24% and 24.5%. We expect to repurchase $300 million of shares of our stock, resulting in our outstanding diluted shares of 147 million at the end of 2024. 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 2024, staying on slide 13. Kevin?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Thank you, Chuck. We project 2024 sales will grow between 3% and 5% compared to 2023, which includes the following assumptions. We believe the U.S. new home construction remains in a deficit, and we project it will be flat in 2023. We also assume that 2024 proactive replacement will remain at a level similar to 2023. Therefore, after an approximate 6% increase in the industry in 2023 compared to 2022, we project that 2024 residential industry unit volumes will be approximately flat to last year. We project U.S. commercial water heater industry volumes to increase low single digits, as demand for our commercial electric greater than 55 gallons continues its positive trend to pre-2022 levels. In addition, our outlook includes the announced price increases in North America water heating of 4% on most of our water heater products.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Price increase for heat pump products is 8%. These increases are projected to be effective late in the first quarter. In China, we believe it will take time for the economy to improve amid weakened consumer confidence and a challenged real estate and housing market, and we have not yet seen signs of significant improvement. Even with the continued backdrop of a weak economy, we project our sales in China will again grow 3%-5% in local currency in 2024, driven by resilient replacement demand, growth in demand for our water treatment products, and our recently released kitchen products. Our forecast assumes that the currency translation impact will be minimal in 2024. We expect to return to growth in our North America boiler business, with a projected sales increase of between 8%-10% in 2024.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

We expect to continue to benefit from the transition to higher energy-efficient boilers, particularly as commercial buildings look to improve their overall carbon footprint. We predict sales of North America water treatment products to increase approximately 10%-12%, as we expect to grow at 2 times the pace of the market. Based on our 2024 assumptions, we expect our North America segment margin to be between 24.5% and 25%, and Rest of World segment margin to be approximately 10%. Please turn to slide 14. I'd like to thank everyone who joined us at our Investor Day late last year, either in person or via webcast. A recording of the webcast is available on our website. The team and I enjoyed sharing the exciting growth opportunities that we see on the horizon for all of our businesses.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

A summary of the key topics that we covered are on slide 14. I look forward to sharing periodic updates on our initiatives, including the launch of our gas tankless products. As we look to 2024, we remain focused on our key strategic priorities to advance our position as a leader in heating and treating water around the, 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 geographic expansion. And deploy capital effectively by investing in ourselves, pursue our active acquisition pipeline, and returning capital to shareholders. We have many reasons to be optimism as we enter 2024.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

We see strong end market demand in North America for all of our product categories, and we expect to return to growth for boilers and North America water treatment, as we believe our customers exited 2023 with normalized channel inventories. We have begun several capacity expansion projects in North America that will support our growth in the long term. In China, we are projecting a second year of growth, driven by innovative new products and resilient demand for our core products. We expect to continue double-digit growth in India as our premium products and customer service are well received in the market. Finally, this year marks an important milestone for A. O. Smith as we celebrate our 150th anniversary.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

What began as a small machinist shop in Milwaukee, Wisconsin, in 1874, has grown into an innovative, industry-leading, global water technology company with more than 12,000 employees. A. O. Smith has a rich and proud history, and we are excited to celebrate it with employees, shareholders, customers, and partners across the globe. With that, we conclude our prepared remarks, and we are now available for your questions.

[Operator]

Thank you. At this time, we will conduct the question-and-answer session. As a reminder, to ask a question, you will need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. One moment for our first question. Our first question comes from Michael Halloran with Baird. Your line is open.

[Mike Halloran, Senior Research Analyst at Baird]

Hey, morning, everyone.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Morning, Mike.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Morning.

[Mike Halloran, Senior Research Analyst at Baird]

So, you know, I figured after last time where I had issues on my end getting through, I figured I'd give a pregnant pause there to make sure you guys could hear me.

[Chuck Lauber, EVP and CFO at A. O. Smith]

We can. I hope you can hear us also.

[Mike Halloran, Senior Research Analyst at Baird]

Yep. Yep. Sounds great. So two questions here, both on North America. First, could you give some context to how you're thinking about the moving pieces within the residential water heater business between discretionary replacement, new build, and then the nondiscretionary replacement pieces?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, I'll touch on that. We don't see much difference in 2024. As we forecasted in our guidance at $9.2 million, new construction, whether it's single family or multifamily, continues to progress, and we see it flat. And the proactive replacement has stayed very resilient. It's been 6-8 quarters now. We just received data from it recently, and it continues to move down that path. And of course, the emergency replacement is a nondiscretionary, and we expect that to continue. So we look at really 2024 as having a very similar outlook as 2023.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Maybe I'll just comment, Mike, that, you know, it, it's been a couple lumpy years, right? I mean, we've had COVID, been a bit of a correction last year. We think the industry this year will be up maybe in that 5.5%-6%. But if we kind of step back to 2019 and just look at a growth rate of 1.5%, we kind of - we, we end up at what we think our outlook is going to be for 2024, along with, you know, those assumptions that Kevin just mentioned. So it, it feels like a fairly stable residential market for us as we go into 2024.

[Mike Halloran, Senior Research Analyst at Baird]

Got it. And just to be clear, the 6-ish% was a 2023 reference point, right?

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, it was 2023 over 2022. I always trip up as we go into the next year here.

[Mike Halloran, Senior Research Analyst at Baird]

Yep. No, same page, me too. So, second question then is just putting the North America margins in context. I certainly get the 50 basis point headwind from the investments you're making. Could you talk about why the confidence in the down steel costs, the lower levels of inflation or limited inflation remaining, and then, you know, maybe in the context of what you saw in the fourth quarter and how that will ramp through the year? I know a lot in there, but just looking for a little bit more color around that North America margin guide.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah. So, you know, we see steel cost as a slight headwind as we go into the year. You know, steel costs have been kind of in that bandwidth, and I'll quote, cold rolled of $950-$1,350. I mean, it's been in that bandwidth, at the higher end of that bandwidth right now. So you know, as we come out of the fourth quarter, we're going to see a little bit of help on steel in the first quarter, and then we're going to see steel ramp up again in the back, you know, back three quarters, likely, although we're calling out slight relief in the back half of the year. You know, fortunately, we have pricing coming in when steel kind of comes in in the second quarter.

[Chuck Lauber, EVP and CFO at A. O. Smith]

So as we come out of 2023, we're looking at a, you know, a little bit better margin profile in the first quarter because steel is down slightly, and then get helped a little bit on pricing coming in with the higher cost steel. If we kind of look at the cadence for the year, kind of most quarters in North America are within that bandwidth of range, or at least pretty close in the twenty-four to, you know, in the twenty-four and a half to twenty-five percent bandwidth. I'd say Q1 has maybe a little more pressure. Then, of course, as you mentioned, we do have some headwinds.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Just, you know, launching our tankless product is about a 50 basis point headwind as we import out of China, through transportation and then, you know, continue to promote that product. One moment for our next question.

[Operator]

Our next question comes from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

[Jeff Hammond, Managing Director and Senior Research Analyst at KeyBanc Capital Markets]

Hey, good morning, everyone.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Hey, Jeff.

[Susan Maklari, Senior Equity Research Analyst at Goldman Sachs]

Good morning, Jeff.

[Jeff Hammond, Managing Director and Senior Research Analyst at KeyBanc Capital Markets]

Just trying to get a sense of feedback from the channel on the March pricing. You know, you guys put through quite a bit. I think we were a little surprised to see a follow-on here, but maybe just speak to, you know, how the channel's reacting to it and what's, you know, kind of supporting that price increase. Thanks.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, I would just tell you that, our philosophy has always been on pricing, that we feel the cost before our customers do. And so as much as steel bounces up and down, there's still other parts of components and other chemicals and so forth. And so our increase is always based on what we have to address going forward with our suppliers. So, and again, the cadence is. It's off a little bit. We pushed it out to March, and that's pretty rare, but it happens on occasion. Our goal has always been, and will continue to be, to keep our customers competitive, and the price increase, along with the timing, really reaches that goal for us.

[Jeff Hammond, Managing Director and Senior Research Analyst at KeyBanc Capital Markets]

Okay. Then just on the boiler, are you seeing any kind of inflection in boiler demand, or is this just growth off of easy comps?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, it's certainly some coming off some comps. You gotta remember, first quarter of last year was a pretty good year or a strong quarter for us on the boiler side, and we didn't see destocking until starting in the second quarter. But much of it has to do with coming off some comps, inventories coming down, our getting back to our regular cadence. And we always get a little tripped up on sell out versus sell in. You remember, our sell in was down, but our sell out, we felt we held our own in the market. So overall, the boiler market is slightly down on some quoting. Residential has been a headwind for us through most of the year that we look at turning that around in, you know, 2024.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

But overall, the market is a combination of comps and some of our new products. Our CREST with Hellcat technology continues to grow. We outlined how much it's growing this year or last year. So a combination of getting back to a normal cadence and some new product offerings is how we get to that 8%-10%.

[Operator]

One moment for our next question. Our next question comes from Susan Maklari with Goldman Sachs. Your line is open.

[Susan Maklari, Senior Equity Research Analyst at Goldman Sachs]

Thank you. Good morning, everyone.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Good morning, Susan.

[Susan Maklari, Senior Equity Research Analyst at Goldman Sachs]

My first question is going back to that discretionary demand on the residential water heaters. You've obviously seen that in the last several years. You've talked to that holding fairly flat for 2024. When we think about that relative to some other categories, you know, such as appliances, where we're seeing that discretionary demand has been weaker, just sort of across our building products coverage, what gives you the confidence that that will hold this year? And, you know, any additional thoughts on where that may trend over time?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, again, we've been watching it, and it's held pretty steady for a long time. Certainly, as we go forward and look at it, we still see housing renovation. Even though things are going to be relatively flat, people are staying in their homes. We think housing renovation is still gonna be a big part of how we go forward. And where it goes long term, we're still trying to get our arms around it. We talked a little bit about some generational issues that we've seen, but overall, right now, in 2024, we're confident that the proactive replacement will stay steady, and we'll continue to monitor it as we, you know, continue over the years.

[Susan Maklari, Senior Equity Research Analyst at Goldman Sachs]

Okay, all right. That's helpful. And then as we come into this year, any thoughts on where channel inventories are? Anything that you would highlight there or expectations as we move through the year on that?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Well, I'll start with North America water heating. You know, we entered the year this year, pretty strong January, and we think we maybe had a little bit of lower channel inventories coming into 2023. But we feel like we're in great shape, very normalized on North America water heating. On the boiler and water treatment side, I think we still feel a bit of headwind as we go through the end of 2023, but feel like we're going to exit the year in a good position on normalized inventories. In China, you know, all the channel inventories are pretty much very normal, kind of have been for a while, and kind of continue in that normalized zone.

[Operator]

One moment for our next question. Our next question comes from Saree Boroditsky with Jefferies. Your line is open.

[Saree Boroditsky, Equity Analyst at Jefferies]

Hi, good morning.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Good morning.

[Saree Boroditsky, Equity Analyst at Jefferies]

Could you just go back and talk about what you saw from the water heater demand or market share in the fourth quarter, as shipments in October through November seemed pretty strong versus the reported results? And then any color on what you saw in January from a shipment perspective?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Q4 came in a little bit stronger than we expected, and mostly on the residential side. We held our own and got our fair share of that. So that was a nice positive plus. I think we've talked about being up 4, I mean, that being close to 6 in the residential side of the business. I will see how that actually comes out specifically. I will tell you, January, it's early and you know, January was a pretty strong month, particularly on the water heater side of the business. But orders remain strong. I mean, it's

[Chuck Lauber, EVP and CFO at A. O. Smith]

... We continue to track towards our guidance. So in a one-month view, we feel pretty good about where we're at. And I would just tell you, orders are fairly strong across all of our businesses starting the year. Again, one month doesn't make a year, but we're off to a good start.

[Saree Boroditsky, Equity Analyst at Jefferies]

Thanks. The Rest of the World margins at 10% are flat from this year, despite expectations for higher sales. So maybe just talk about some offsets that you expect to see there?

[Chuck Lauber, EVP and CFO at A. O. Smith]

Offsets, for next year?

[Saree Boroditsky, Equity Analyst at Jefferies]

Yeah, on the Rest of the World side, on the margins.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, I mean, I'll, I'll speak to China. So China first, you know, we're expecting growth in China, 3%-5%. Next year looks very similar in our outlook, in that we're gonna be investing in new products, promoting new products, looking to have top line growth and kind of maintaining margins in China right around that 11%. So margin, operating margins in China year-over-year, roughly the same. I think we're, you know, we're really leaning on growth is in India. And maybe when you look at overall Rest of the World, and you look at our outlook for, for India, we, we continue to invest in growth. So we're gonna continue to put, kind of our... You know, certainly, we're pleased to be in a profitable position in India.

[Chuck Lauber, EVP and CFO at A. O. Smith]

We would like to continue to invest in growth and have, you know, growth outlooks of 15% in India next year.

[Operator]

One moment for our next question. Our next question comes from David MacGregor with Longbow Research. Your line is open.

[David MacGregor, Managing Director and Senior Research Analyst at Longbow Research]

Yes, good morning, everyone. Thanks for taking my questions. I wanted to start by asking you about the North American gas tankless business. You talked about, you know, its contribution to that 50 basis points and margin pressure. But could you talk about the top line impact? What do you expect in terms of timing and the size of the impact, in terms of, you know, the initial channel fill, and how are you thinking about that within the context of your revenue guide?

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, I mean, so we've got a revenue guide. I'll just tie it back to the overall 3%-5% growth on the top line. And, you know, we're pleased that there's a number of drivers within that growth, and all of them are within the same amount, roughly. And if you kind of look at, you know, just overall growth, growth on tankless, heat pump, Kevin talked about pricing. We've got boilers growing, kind of in that 8%-10%. We've got North America water treatment growing 10%-12%, and then, you know, growth in China at 4%.

[Chuck Lauber, EVP and CFO at A. O. Smith]

And India, you know, the ones that I mentioned are all very similarly sized, so it contributes in a meaningful way to growth, but it's not, you know, it's not the largest part of growth in North America next year. We'll just kind of tie it back to that we're expecting $100 million on the top line over three years. So, you know, when we get to 2026, we would expect to be incrementally there. It'd probably be a little lumpy as we start out, but we're looking for contributions in year one.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, just to add on, on the tankless side of it, we are building inventory as we speak, on the ground, and we'll launch in late March. We're already taking orders for it, and we're excited about it. One, that we own the technology, we're manufacturing, but more importantly, the first product that we're bringing to market, which is a condensing premix, has all the features that, quite frankly, we've been a little bit hamstrung with our product line. So two-inch vent, half-inch connection, better flow rates, all. Our team's excited about getting into market and being able to compete. So, we'll start in March. Early indications from a lot of customers are pretty excited about the product. We're excited about the product.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

But as Chuck mentioned, this will be a ramp that will start this year and continue to gain momentum over the next couple of years.

[David MacGregor, Managing Director and Senior Research Analyst at Longbow Research]

Got it. Thanks for that. And as a follow-up, I just wanted to ask about China. At the analyst meeting, you outlined kind of a three-segment, good, better, best market segmentation model. I wonder if you could just talk about what you're seeing in terms of demand dynamics across those three segments right now. I realize AI-Link is still pretty new, but if you could share what you're thinking and what you're seeing there.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, I'd-- I'll touch on that, maybe Chuck will jump in on it. We've not seen much change on our mix. And I would tell you that we're our good is premium good. And I mean, we're not down in the low end of the market, but throughout even the pandemic and even into last year and how we're looking going into 2024, our premium priced products, that premium sector of the market, has held up. It's not growing, but it's holding. And so our mix looks relatively the same as it has over the last several years. And we feel pretty good about that, considering the consumer is not as engaged as it needs to be, and that we look at that as being upside as the you know, consumer confidence grows a bit.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, I'll just put some numbers to that. So I mean, we define kind of the premium sector of the market, you know, above RMB 3,000 for electric water heating and above RMB 5,000 for gas, gas water heating and water treatment, which are, you know, our core products in China. And, you know, the premium sector of the market, that we sell, it's been in the 60%-70% range, a little lower on water treatment, right around 50%, but it's been in that ZIP code, for quite a while now, so for probably the last couple of years. So I haven't seen a change. Certainly hasn't decreased, but it's been pretty steady.

[Operator]

One moment for our next question. Our next question comes from Nathan Jones with Stifel. Your line is open.

[Adam Farley, Associate Analyst at Stifel]

Good morning, this is Adam Farley on for Nathan. My question relates to your balance sheet, is in a very good position, significantly under-levered with a strong net cash position. So, what are your plans to optimize the balance sheet? And maybe could you provide an update on your M&A pipeline? I'll leave it there. Thanks.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Sure. Good morning, Adam. Yeah, we are under-levered. We like the position that we're in going into, you know, an opportunity for M&A, which we'll talk about. You know, we continue to have kind of a balanced approach. I talked a little bit earlier about investing in ourselves, which are some of the three major expansion projects that we have going on with building manufacturing capabilities for gas tankless, for investing in commercial high efficiency capacity, and then continuing to invest in our R&D facilities in Lebanon, Tennessee. So we continue to, you know, make sure we're doing the right things to invest in ourselves and have three major projects going on. We're also doing a bit on the share buyback.

[Chuck Lauber, EVP and CFO at A. O. Smith]

You know, we've got $300 million of share buyback in our outlook for 2024. We continue to feel that that's an appropriate component of capital allocation as we're under-levered. And then we're reserving firepower for the opportunities within M&A. You know, we look forward to maybe some opportunities this year. It's always difficult to tell. Certainly investors' expectations always remain high. We feel like we're in a great position, though, to continue to kind of look for those opportunities as we go into 2024.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, I would just maybe add on to that. I mean, our pipeline is active, and we continue to look at spaces, not only within our core, certainly water treatment, but geographic expansions and even levering, you know, potentially our customers and footprint that we have in various industries. So, a lot of different spots on the board. We're engaged on a pretty regular basis with a number of companies. And again, just a matter of, not if, but when the timing comes about. But again, when we look at acquisitions, culture is exceptionally important for us and making sure that we find the right company that fits within A. O. Smith.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

And on top of that, we are gonna stay disciplined in making sure that we can return the right, you know, return to our shareholders. So putting that all in context, we feel really good about the pipeline, and we'll see if we can bring some of those home in 2024.

[Adam Farley, Associate Analyst at Stifel]

Thank you.

[Operator]

One moment for our next question. Our next question comes from Andrew Kaplowitz with Citigroup. Your line is open.

[Andrew Kaplowitz, Managing Director at Citi]

Good morning, everyone.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Hey, Andrew.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Good morning.

[Andrew Kaplowitz, Managing Director at Citi]

I just wanted to follow up on the 10% Rest of World margin, 11% in China. You obviously spoke about at the Investor Day, 400 basis points of improvement over the next several years. Do you need a better Chinese economy for that margin expansion to kick in, or do you start to dial down your advertising and promotions soon on the new kitchen products, and, you know, that will help? How does that work?

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, we need a better economic backdrop to achieve that. I mean, we really are in a situation now where we feel good about the costs we've taken out at the level we're at. Feel like we can leverage growth going forward, but we need to get the economy back. We need to get housing formation kind of reignited so that we've got a larger portion of the market that is growing in house formation. As you know, most of the water heaters go in when an individual moves into their home, even if it's a new construction.

[Chuck Lauber, EVP and CFO at A. O. Smith]

We're pleased we've got 60% replacement on the water heating side, so in the meantime, we're, we're very happy with the resiliency of the business at the levels we're at, but we will need some economic help to kind of achieve that, that expansion.

[Andrew Kaplowitz, Managing Director at Citi]

It's helpful color. Then just shifting gears. North American commercial water heater industry, you know, had a good year in 2023, so it may be a difficult comparison in 2024, but you've dialed in the low single-digit growth. So can you talk about the visibility you have to that end market holding up in 2024?

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

Yeah, it held up, and you have to go primarily back to, and we've mentioned a couple times, the greater than 55-gallon electrics. We went to a regulatory kind of change, and we had to get, the industry had to get its legs underneath, which it did, and we're starting to benefit from that. But of the growth of almost 70% came out of that category, and it's almost back to where it needs to be. But you look at that low single digits, it, a large majority of that growth is gonna be in that particular category as it gets back to a more normalized level that it exited in 2022. But overall, commercial business held up well. Gas business showed some growth. We break it down, small electrics versus large. Small electrics had growth.

[Kevin Wheeler, Chairman, President and CEO at A. O. Smith]

So each category is still growing, and we expect that to continue. There's still a very big part... We talk about residential replacement and discretionary you know, versus discretionary. Still, 85% of that business is replacement market for us, and we have a really nice market share in that particular category. And as you know, restaurants, hotels continue to come back online like they have been, our units are gonna get exercises like everybody else's, and that replacement should continue for the you know, foreseeable future.

[Operator]

Thank you. As a reminder, to ask a question, you will need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Our next question comes from Shrikanth Venjaramuri with UBS. Your line is open.

[Shrikanth Venkatramani, Analyst at UBS]

Good morning, guys. I'm on for Damian this morning.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Good morning.

[Shrikanth Venkatramani, Analyst at UBS]

Yep. So a quick question on North America pricing. So you announced a 4% increase in November and got pushed to March. I wanted to understand, what was the reason for pushing the price increase? Did you get some pushback? What, what's happening there?

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, no, the details on pricing are really within our strategy here. We always evaluate each time we bring a price increase to market, and early on, as we discussed, we make sure that we're adjusting costs. We always make sure that we feel the cost before our customer does. And the bottom line, where we're at today is what's gonna keep our customers competitive, and that's really all we're gonna say on the pricing side of this.

[Shrikanth Venkatramani, Analyst at UBS]

Cool. Okay. And as a quick follow-up on China, you seem to see most of the growth is coming from kitchen appliances and water treatment. So I just wanted to get your color on what you're seeing for water heater demand in China going into 2024.

[Chuck Lauber, EVP and CFO at A. O. Smith]

Yeah, most of the growth that we see in 2024 relates to commercial, commercial business on water treatment, water treatment overall, particularly consumables. And then, you know, we do see some growth in our kitchen products that are newly introduced. Overall, the core products were relatively, relatively flat year-over-year. I mentioned a little bit earlier about, you know, we've kind of seen the stabilization of maybe what's being sold into the premium side. So we think we're in a good spot for when the economy does come back, but we're, we're looking at relatively year-over-year flat for our core products.

[Operator]

Thank you. That does conclude the question and answer session. At this time, I would like to turn the call back to Helen Gurholt for closing remarks.

[Helen Gurholt, VP of Investor Relations and Financial Planning & Analysis at A. O. Smith]

Thank you everyone for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered record sales and earnings in 2023. 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: Citi on February 21st, Barclays on February 22nd, and Northcoast on March 7th. Thank you, and enjoy the rest of your day.

[Operator]

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Participants

Executives

• Chuck Lauber, EVP and CFO
• Helen Gurholt, VP of Investor Relations and Financial Planning & Analysis
• Kevin Wheeler, Chairman, President and CEO

Analysts

• Adam Farley, Associate Analyst at Stifel
• Andrew Kaplowitz, Managing Director at Citi
• David MacGregor, Managing Director and Senior Research Analyst at Longbow Research
• Jeff Hammond, Managing Director and Senior Research Analyst at KeyBanc Capital Markets
• Mike Halloran, Senior Research Analyst at Baird
• Saree Boroditsky, Equity Analyst at Jefferies
• Shrikanth Venkatramani, Analyst at UBS
• Susan Maklari, Senior Equity Research Analyst at Goldman Sachs