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A. O. Smith Q1 2023 Earnings Call Transcript


Listen to Conference Call View Latest SEC 10-Q Filing View Latest SEC 10-K Filing

Participants

Corporate Executives

  • Helen E. Gurholt
    Vice President Investor Relations, Financial Planning and Analysis
  • Kevin J. Wheeler
    Chairman, President, and Chief Executive Officer
  • Charles T. Lauber
    Executive Vice President and Chief Financial Officer

Presentation

Operator

Good day, and thank you for standing by. Welcome to the A. O. Smith First Quarter 2023 Earnings Conference Call. [Operator Instructions] I would like to hand the conference over to your speaker today, Helen Gurholt. Helen, please go ahead.

Helen E. Gurholt
Vice President Investor Relations, Financial Planning and Analysis at A. O. Smith

Thank you, Ellinor. Good morning, and welcome to the A. O. Smith First 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 provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures.

Adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of impairment charges, non-operating non-cash pension expenses as well as legal judgment income and terminated acquisition-related expenses. We also provide total segment earnings. 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 our -- this morning's press release, among others. [Operator Instructions] 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 J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Thank you, Helen and good morning, everyone. I'm on Slide four, and we'll review a few highlights of our first quarter results. Our team delivered record first quarter adjusted EPS of $0.94, driven by strong performance in North America with sales up 3% due to higher commercial and residential water heater volumes. In addition, we saw margin expansion across our water heating, boiler and water treatment product categories due to a more favorable price/cost relationship. Our Rest of World segment delivered consistent performance in the first quarter despite headwinds in the economy and currency exchange in China.

In India, our sales grew 28% in local currency in the first quarter due to strong demand for our water heating and water treatment products. Please turn to Slide five. North America water heater sales grew 3% in the first quarter of 2023 as we believe we outperformed the market and experienced resilient demand for our commercial and residential water heater products. Sales of commercial electric products were strong in the quarter as demand returned to pre-2022 levels. Last year, commercial industry shipments were negatively impacted by our regulatory change for commercial electric products greater than 55 gallons.

Our North America boiler sales grew 2%, driven by previously announced price increases to offset higher costs. Residential boiler volumes decreased year-over-year, primarily driven by elevated channel inventory levels coming off a particularly strong fourth quarter of 2022. We believe inventory levels have normalized by the end of the quarter. Demand for our commercial high-efficiency condensing boilers, particularly our Hellcat CREST boilers with O2 sensing technology remained strong. North America water treatment sales were flat in the first quarter of 2023 compared to a tough comp in 2022 as higher direct-to-consumer and e-commerce sales were offset by lower sales in our dealer and specialty wholesale channels.

Sales in the first quarter of 2022 benefited from strong shipments as supply chain constraints improved and we work down our order backlog. We believe the majority of our dealers and wholesale customers exited the first quarter with normal inventory levels. In China, first quarter sales decreased 10% local currency compared to the first quarter of 2022, primarily due to weakened consumer demand. We have seen sequential improvement through April and expect that improvement to continue through the year. We believe it will take time for the Chinese economy and consumer confidence to improve.

We saw a favorable price/mix in the quarter, particularly in our water treatment, as we recently introduced our large flow products that have been well received by the market. I'm now on Slide six. A. O. Smith has recently been named in 2023 ENERGY STAR Partner of the Year Sustained Excellence winner by the EPA and the U.S. Department of Energy. The ENERGY STAR award is given to companies that have made a long-term commitment to energy management through their products or services. This is the fifth consecutive ENERGY STAR Partner of the Year award A.O. Smith has received and the third time being named a Sustained Excellence partner.

These awards are a direct result of our strategic objective to expand and enhance our high-efficiency product portfolio, including heat pumps, as evidenced by the recent launch of our Voltex AL heat pump water heater. We are committed to continue development of sustainable water heating and water treating technology. I'll now turn the call over to Chuck, who will provide more details on our first quarter performance.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Thank you, Kevin, and good morning, everyone. I'm on Slide seven. Record first quarter sales in the North America segment rose to $753 million, a 3% increase compared with the same period last year. The increase is primarily driven by higher commercial and residential water heater volumes, partially offset by pricing. North America segment earnings of $188.6 million increased 22% compared with the first quarter of 2022. Operating margin of 25.1% improved 400 basis points from the segment adjusted operating margin in the first quarter of last year. The higher segment earnings and operating margin are primarily due to higher volumes of commercial and residential water heaters and lower steel costs.

Moving to Slide eight. Rest of the World segment sales of $219.1 million decreased 14% year-over-year and 8% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $17 million. Our sales decrease was primarily driven by lower sales in China as consumer demand was negatively impacted by COVID-19-related headwinds. We saw month-over-month improvement in consumer demand during the quarter. India sales grew 28% in local currency in the first quarter compared to 2022, as our new products have been well received by the market.

Rest of the World adjusted segment earnings of $17.8 million decreased 28% compared to segment earnings in 2022. Segment adjusted operating margin was 8.1%, a decrease of 160 basis points compared to the first quarter of last year, primarily as a result of lower volumes in China, partially offset by lower selling costs. Please turn to Slide nine. We generated free cash flow of $109 million in the first three months of 2023, higher than the same period in 2022, due to higher earnings and lower working capital outlays, primarily related to lower inventory levels and a lower 2022 incentive payments paid in 2023. Our cash balance totaled $496 million at the end of March, our net cash position was $155 million.

Our leverage ratio was 16% as measured by total debt to total capital. Our strong annual free cash flow and solid balance sheet enable us to focus on capital allocation priorities and return cash to shareholders. Earlier this month, our Board approved our next quarterly dividend of $0.30 per share, which represents our 83rd consecutive year of dividend payments. We repurchased approximately 821,000 shares of common stock in the first quarter of 2023 for a total of $53 million. We expect to repurchase $300 million of our shares in 2023, a $100 million increase from previous guidance. Let's now turn to Slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth driven by innovation and new product development across all of our product categories and geographies.

The strength of our balance sheet allows us to pursue strategic acquisitions even in times of economic uncertainty. During the quarter, we committed to selling our business in Turkey and recognized a non-cash impairment charge of $15.6 million. Primarily in anticipation of the liquidation of the cumulative foreign currency translation adjustment. The business model in Turkey is more project-based than our core consumer and commercial water treatment business and no longer fits our current strategy. Please turn to Slide 11 and our revised 2023 guidance and outlook. We've increased our 2023 outlook with an expected adjusted EPS range of $3.30 and $3.50 per share.

The midpoint of our adjusted EPS range represents an increase of 8% compared with 2022 adjusted EPS. Our outlook is based on a number of key assumptions, including -- we assume a relatively stable supply chain, while challenges 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've increased our North American margin guidance from approximately 23% to a range of between 23% and 23.5%. Based on a full-year outlook on volumes and price cost relationship, we have recently seen a meaningful rise in steel index pricing, which will translate into higher input costs and relative to the first quarter, put pressure on North American margins in the back half of the year. We forecast that our steel cost in the second half of the year will be approximately 20% higher than the first half of the year.

Our guidance assumes that other costs outside of steel remain relatively flat to our previous guidance, with favorable adjustments in our transportation cost outlook, offset by moderately higher costs outside of transportation. We expect to generate free cash flow of between $575 million and $625 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 as I noted earlier, we expect to repurchase approximately $300 million of shares of our stock, resulting in average outstanding diluted shares of $150 million at the end of 2023. I'll now turn the call back to Kevin, who will provide more color on our key markets and topline growth outlook and segment expectations for 2023, Staying on Slide 11. Kevin?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Thank you, Chuck. We revised our 2023 sales projection to be approximately flat to 2022 at the midpoint, with a range of plus or minus 2%, which includes the following assumptions. Residential water heater demand was resilient in the first quarter, and therefore, we are raising our projection for the 2023 residential water heater industry volumes to be approximately flat to last year. We continue to monitor proactive replacement and new housing completions. Demand for commercial electric water heaters greater than 55 gallons was strong in the first quarter and orders remained strong in April. We have raised our guidance for commercial water heater industry volumes to increase mid-single digits compared to 2022.

Our China business performed as expected in the first quarter. We believe it will take time for consumer confidence to strengthen and for the economy to improve in China. We reaffirm our guidance that our sales in China will grow 3% to 5% in local currency in 2023. Our guidance assumes volumes in China improved throughout the year. Our forecast assumes the Chinese currency will devalue approximately 2% in 2023 compared to 2022. We are adjusting our outlook for our boiler business. We believe channel inventory levels of residential boilers are more elevated coming into 2023 than what we assumed in our prior guidance. While commercial growth aligns with our previous guidance, the amount of inventory in the residential boiler market resulted in sluggish residential boiler sales in the first quarter, and guides us to an annual growth outlook of mid-single digits.

Demand for our energy-efficient custom commercial condensing boilers was steady in the first quarter, and job quoting remains active, particularly in the key institutional vertical. Our outlook for the North America water treatment sales growth of 5% to 7% for 2023 has not changed. Based on these factors, we expect our North America segment margin to be between 23% and 23.5% and Rest of World segment margins to be approximately 10%. Please turn to Slide 12. We are very pleased with our performance early in 2023. Demand for commercial electric water heaters rebounded to pre-2022 levels. We saw resilient demand for our residential water heaters.

Our first quarter 2023 North America operating margin of 25.1% will drive significant full-year margin improvement even as steel costs rise. In China, we saw sequential monthly improvement in our sales through April, and we expect that to continue through the year. We are pleased with our free cash flow through March, and we expect a strong rebound in free cash flow for the full year, as China emerges from COVID-19-related disruptions, and our dedicated focus on inventory reduction across our North America operations.

Our focus remains on meeting the needs of our customers as well as executing our key strategic objectives to advance our position as a leader in heating and treating water, globally. Our strong brands across the portfolio, combined with technology-driven innovation and new product development will enhance our market leadership. And with our strong balance sheet, we are confident in our ability to capitalize on opportunities as we continue to execute our strategy. With that, we conclude our prepared remarks, and we are now available for your questions.

Questions and Answers

Operator

[Operator Instructions] Our first question comes from the line of Michael Halloran of Baird.

Michael Halloran
Analyst at Robert W. Baird

Hey. Good morning everyone.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Good morning Mike.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Good morning.

Michael Halloran
Analyst at Robert W. Baird

Can you walk through what you're seeing on the water heater volume side, North America. Obviously, a lot of variability here. You had the destock period through last year, you look at December, January, February volumes are at least with AHRI. Those are tracking above $9 million annualized at this point units, seems a little hot maybe relative to what the run rate we've been talking about previously looked like. So maybe help understand what you think is going on underneath the hood. Are there some element of restocking? Do you expect some variability on those demand trends? And how do you think about that working through the year?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes, Mike, it's Kevin. Listen, I'm going to put it in four buckets for you. First, our emergency replacement demand is always going to be there. The one cold shower rule always applies and that will continue. What we've seen though is the proactive replacement continues to be above our normal levels. We just got updated on that just recently. So that's above average, so providing some additional volume. New construction completions were strong in Q1. So that also gave us a bump. And you mentioned about customers. We believe some, not all, a few customers maybe cut their inventories a little bit too low, and there was some replenishment going on with some of our customers. So you put those four together, that kind of drives our Q1 and then our forward-looking guidance of getting back to flat, to last year. We do expect Q1 to be down. We expect it to be down probably double digits. It's probably going to be in that low single-digit category. Just remember that Q1 was a very strong quarter. It was the strongest quarter that we had, and particularly March was the strongest month. So -- but overall, pleased with the volume, pleased with the industry and look for a kind of a flat 2023.

Michael Halloran
Analyst at Robert W. Baird

And then maybe also on the North America margins and how to think about modeling for the remainder of the year, 23%, 23.5% implies decent drawdown as we work through the year. Is that all back-half-weighted and is 2Q more comparable to 1Q and are there offsets to that decline as you think 1H to 2H that you're envisioning, whether incremental pricing or something else that might help that profile?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes. I mean we see steel costs, my kind of -- two sides. The lowest in the first half of the year, and they're going to be about 20% higher in the back half of the year. So while we started the year, which we're very pleased with our first quarter North America margins and our price cost relationship, steel by itself is going to be kind of a weight on the back half of the year. So we'll see margins lower in the back half. And then for the year '23, the 23.5% operating margins. We kind of -- we see volumes splitting the year and kind of the typical cadence is stronger in the first half and a little weaker in the back half 52% maybe it's typical in the front half and 48 in the back. We're a little stronger on our outlook here based on the strong Q1. We're probably more in the 53-47. And as you're aware, we've got a little bit easier comps in the second and third quarter based on kind of the destocking last year. Material costs, we see relatively flat. So kind of the puts and takes on margins would be strong first half, give back a bit in the second half and end up in that 23% to 23.5%.

Michael Halloran
Analyst at Robert W. Baird

Still good range.Thanks Charles, Thanks Kevin.

Operator

Please standby for our next question. Our next question comes from the line of Saree Boroditsky of Jefferies. Please standby.

Saree Boroditsky
Analyst at Jefferies Financial Group

The margin commentary, you talked about this being driven by higher steel costs in the back half. But within your guidance, are you baking in additional automatic retail pricing for this? So would that offset that?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

We haven't changed any -- Saree, this is Chuck. We haven't changed any of our pricing policy. So we do have some formula pricing that's out there, and that will flow kind of on the same leg as we've talked about before as steel costs go up and down. So haven't changed any of that. And along with kind of the steel price going up, some of that natural pricing through formulas will follow, either up or down as it moves, as it has historically.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes. I would say when you look at our pricing, it's about where we expected it. And Chuck just mentioned, we haven't changed the way that our process works within our company. And I go back to, we'll continue to monitor it, as we always do, and fall back to, we have a pretty good track record of adjusting the necessary.

Saree Boroditsky
Analyst at Jefferies Financial Group

But within your current guidance, do you bake in any additional price increases? Or do you stay at current levels?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes, we're not going to comment on future price increases. Just the commentary on this pricing in total, and just to remind -- maybe remind everybody that our last announced price increase was this November 2021. So we've kind of got a comp where full-year '22 pricing is in place. And so that -- just kind of wanted to remind everybody that it's out there for the full year last year. And it's been -- we've anniversaried that price increase last fall. That was our final announced price increase.

Saree Boroditsky
Analyst at Jefferies Financial Group

Okay. So just to be clear, I know we're not commenting on additional price increases going forward. So we can assume that additional price increases are not baked into guidance at this point. Is that fair?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

We just don't comment on pricing.

Saree Boroditsky
Analyst at Jefferies Financial Group

I have to try. And then just one last question. You mentioned China improving sequentially through the month. How did this trend in April? And how are you thinking about the cadence of growth through the year?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes. We talked about it in our prepared remarks, China really kind of played out to what we thought. We did see -- January is always a very tough month with Chinese New Year and so forth and particularly coming off of COVID and opening up. But we saw a month-over-month improvement. April is playing out really well. We're seeing our sellout improve over March. So the way we view it, we should see month-over-month, quarter-over-quarter. And remember that the fourth quarter is our strongest month there. So -- but it's probably not the way we thought. And as things settle in and consumers get a bit more comfortable, we're comfortable with our guidance of growth at 3% to 5% local currency.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes, being down in the first quarter, but we do expect, quarter-over-quarter, we would be up each of the quarters going forward.

Operator

Please standby for our next question. Our next question comes from the line of Susan Maklari of Goldman Sachs. Your line is now open.

Susan Maklari
Analyst at The Goldman Sachs Group

Thank you and Good morning everyone.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Good morning.

Susan Maklari
Analyst at The Goldman Sachs Group

My first question is around -- as you think about steel moving higher and the potential for some pricing to come through. Do you think there was any pull forward that is happening in the market today or in the first quarter as some of your customers perhaps try to position themselves.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

I guess we can expect a little bit. But as I outlined recently of how the quarter played out in the buckets that we saw, I really don't feel talking with our businesses that there was much pull forward. I think it was people, one, taking care of their customers, and number two, maybe balance out their inventory that was a bit light with some of our customers. But overall, I don't think there was any pull forward with regards to steel.

Susan Maklari
Analyst at The Goldman Sachs Group

And then can you give a bit more color on what you're seeing on the commercial side? There's obviously been some cross currents there as you think about the underlying market. I know you mentioned that you expect your -- the volumes to be up mid-single digits there so, but -- for the industry. How are you -- what are you seeing on the ground there? Any more color you can give.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes. I would tell you, it's, one, the overall commercial market was up, but it was really driven by the commercial electric and the greater than 55 gallon. That really -- we thought that would not bounce back to pre-'22 levels, and quite frankly, it did. So that's driving much of the growth. But we're also seeing growth, say, low-single digits in the gas side of the business. So commercial held up well, and that's what gives us the comfort to move it up to that mid-single-digit growth rate.

Operator

One moment for our next question. Our next question comes from the line of Matt Summerville of D.A. Davidson & Co. Your line is now open.

Matt Summerville
Analyst at D.A. Davidson & Co.

Thanks. A couple of questions. Can you talk about the context of your M&A pipeline and actionability therein and what the step-up in repurchase activity maybe says or maybe doesn't say about the outlook for A.O. Smith with respect to M&A specifically? And then I have a follow-up.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes, terrific. I'll take the M&A, I'll let Chuck comment on the repurchase. They're really not connected with regards to why we move them up. M&A pipeline continues to be, I'd say, active particularly, on the water treatment side of the business but in other areas. So that hasn't changed, and we continue to stay in close contact with our targets and looking for the right opportunities. So that's moving much like we thought it would be, and we hope we'll be able to deploy some capital in the near term.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes. With respect to the repurchase moving up $100 million, when we gave our outlook in January, we talked about our $200 million buyback outlook, and we also talked about $400 million being authorized by the Board, and we would kind of watch that through the year. Based upon our strong cash operations in Q1 and outlook for the year, we went ahead and moved that up to $300 million. So we felt very comfortable with that.

Matt Summerville
Analyst at D.A. Davidson & Co.

Got it. And then maybe with respect to China, can you talk about more recent market share trends in both water heaters and water treatment. What you're seeing from a mix perspective and then how you would characterize inventory levels? Thank you.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Okay. When we look at China overall, we've talked about this. There's not a great market share outlet for us to -- we have to put pieces together. But when we look at our retail business, we look at our specialty store business and overall, we're very comfortable that we're still one of the leaders in the market, and we're getting our fair share of the business.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes. The channel inventory is -- it's in a normal range, kind of in that four to six weeks.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

And coming back, just about the mix. The mix is holding pretty well. Our premium mix in all of our categories still continues to be moving up slightly in most of the categories. We talked a bit about our water treatment and how we introduced a new high flow product, which is in the premium sector. So it's been interesting to watch with the premium side of the mix and our premium customers continue to buy our products and we see that continuing through the rest of the year.

Operator

One moment for our next question please. Our next question comes from the line of Damian Karas of UBS. Your line is now open.

Damian Karas
Analyst at UBS Group

Hey, Good morning everyone. Congrats on the quarter.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Good morning.

Helen E. Gurholt
Vice President Investor Relations, Financial Planning and Analysis at A. O. Smith

Good morning.

Damian Karas
Analyst at UBS Group

So I wanted to ask you about your comments on channel inventories with North America pretty much being at normal levels exiting the quarter. You're already there for water heaters heading into 1Q, but it sounds like maybe boiler and water treatment caught you a bit by surprise, with respect to the inventory levels out there. Could you just maybe help us understand a little bit better on what you're seeing or hearing that gives you confidence that some of this more recent destocking is in fact flushed out?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Well, let me start with that, and Chuck can jump in. Boilers, I would say, a bit of a surprise. We kind of missed -- we had such a strong fourth quarter, and so that was a bit of a surprise which we had to sell through. The water treatment, I would say now, we knew there was still some inventory in the channel, particularly with our dealers and our specialty wholesalers and that works itself out. But the way I look at it right now, all of our channels, I think inventories are right where they really need to be, quite frankly. And the only area that may have a little bit of a gap, and we'll take care of that hopefully in Q2, would be on our commercial side of the business. But overall, other than the boilers, I think we saw our inventories where we thought they should be with our customers.

Damian Karas
Analyst at UBS Group

And I wanted to ask you about heat pumps, which is a topical subject matter at the moment. And I know, Kevin, you mentioned in the past, you're not expecting heat pumps to take over the water heater market anytime soon. There's still some cost and installation challenges. But I will say I've seen quite a bit of incentives out there related to IRA rebates on heat pump water heaters. So I'm curious if you started seeing any notable pickup in activity or maybe any changes in customer buying decisions as a result.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

I'm not sure I would qualify it as any major changes. Rebates have been out there. They've been state, they've been local. Certainly, there's a federal side of this now. So what I would tell you that heat pump continues to grow. It's coming off a very small base as we've talked, it's less than 2% of the overall water heater sold. But it's growing at that double digits pretty regularly each quarter. The future, it's going to continue to grow. It's a very good high efficiency green product that I think has a place long term. And so -- but it's going to continue to grow at a modest pace. Even with the incentives, we're probably going to need regulatory to really drive a fast increase in volume. But you can expect it to grow month-over-month, quarter-over-quarter for the foreseeable future. We're very high in heat pumps, both on the residential side and on the commercial side of the business. They are expensive. They do take a little bit to install. But from a consumer, from a commercial standpoint, they provide really good payback and a really good value proposition, long term, with the consumer or the business owner.

Operator

Please standby for our next question. Our next question comes from the line of Andrew Kaplowitz of Citigroup. Your line is now open.

Andrew Kaplowitz
Analyst at Smith Barney Citigroup

Hey Good morning,

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Good morning.

Helen E. Gurholt
Vice President Investor Relations, Financial Planning and Analysis at A. O. Smith

Good morning.

Andrew Kaplowitz
Analyst at Smith Barney Citigroup

Could you talk about margin performance in rest of the world? I know you didn't change the margin guide in the segment for the year. But it was a little low in Q1. Was that just sort of a weaker start to the year in China as you talked about already, I think you had mentioned that you were going to spend more money on marketing, advertising. Did you do that in Q1?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes, that's -- the Q1 is -- I mean it aligns with our expectations. It's a little lower than last year. I would say last year was a bit oversized and you kind of look at history in our Q1. Q1 in China is always a bit of a challenge. We really cut back on spending last year in Q1 to help that margin. But it was -- the margin in Rest of the World was aligned with our expectations this year. We will, though, I mean, we're calling out to be, I think, 11% operating margin in China, roughly for the year, and we expect the year-over-year growth in next quarters. And we do expect to spend more on SG&A to drive some of that growth. So that's why we're not expanding that a great deal, but we're really pleased that we're kind of back to a growth mode once we get out of Q1.

Andrew Kaplowitz
Analyst at Smith Barney Citigroup

And then Kevin or Chuck, as REITs have continued to come up and given the volatility around the banks in March, doesn't seem like you saw any hiccups, but did you -- when you're talking to your customers or channel partners, did you see anything that sort of worried you there? Either in sort of core residential or commercial markets?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

I would say that this is anecdotal, okay? But it's -- there's always concerns right now with rates moving up and what that's going to mean for the economy, particularly, the back half. So everybody has it online, but they're not changing behavior. They're watching inventories closely, but customer demand still seems to be moving along, both residentially and commercially. But there's this hint of a backdrop that the interest rates could cause some potential issues as we get into the back half of the year. We'll have to see how that plays out. That's more conversation than actually what's happening on the ground today.

Operator

Please standby for our next question. Our next question comes from the line of Jeff Hammond of KeyBanc Capital Markets Inc. Your line is now open.

Jeff Hammond
Analyst at KeyBanc Capital Markets

Hey, Good morning.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Hey Jeff.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Good morning.

Helen E. Gurholt
Vice President Investor Relations, Financial Planning and Analysis at A. O. Smith

Good morning.

Jeff Hammond
Analyst at KeyBanc Capital Markets

So I think you called out lower price in the first quarter. And I just want to understand maybe the magnitude, one, is this all kind of material price formulas? Or is there something more broad?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes. We're not really going to carve out the details around that. I will say, though, I mean, we're up on organic growth for the quarter. So the commercial growth -- residential growth outweighed the price. So we're pleased kind of with our margin expansion in Q1, knowing that we're going to see some pressure on steel in the back half of the year.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes, Jeff, I would just tell you a comment just a while back. Really on the pricing side, it played out as we expected, quite frankly. And so -- maybe even a little bit better, but it played out well, and we'll continue to -- just continue to evaluate and make sure that our customers are competitive. I've always said that over and over, in both channels and commercially. And we're pleased with the quarter, and we're pleased with the trend that we have today.

Jeff Hammond
Analyst at KeyBanc Capital Markets

And then I think there was an earlier question about the cadence of North America margins. Is it simply 2Q looks like 1Q and then we get a step down to kind of fall within the guidance?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

It's roughly that. We really see some of those costs on the steel side that go up 20% in the back half of the year, weighing in on Q3 and Q4, fairly evening on the quarter, at least when we look at it today.

Operator

One moment for our next question please. Our next question comes from the line of David MacGregor of Longbow Research. Your line is now open.

David MacGregor
Analyst at Longbow Research

Yes, Good morning everyone.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Goodmorning. [Speech Overlap]

David MacGregor
Analyst at Longbow Research

I wonder if I could just go back to China and ask you to just talk about that 3% to 5% guidance for 2023. Can you sort of separate out price versus volume? And help us just understand what's happening trend-wise there. And then also on China, if you could just talk about the extent to which you're expanding your distribution at this point and what that might represent in '23? And then I have a follow-up question.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes, it's mostly volume in China. There's a bit of price, but not nearly what we've seen in other parts of our businesses. So that 3% to 5% is based on what we believe with the opening in China and the COVID policies that we'll see a step up. We're comfortable kind of with the order rates that came in April. We feel good about that. So -- it's largely volume. Distribution wise, in China, we reduced some stores during the COVID period 2020 through 2021. But really distribution points are relatively stable. Not a lot of change on the distribution points, but we're comfortable with the outlets we have.

David MacGregor
Analyst at Longbow Research

And then just -- if I could just expand on China for a second. I do have a follow-up question, but just to build a little further on the China question. As you look for that volume recovery, is it mostly in your medium price point as opposed to your higher price point product. You mentioned earlier, premium was doing well. So I just wanted to get some clarity on that.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

No, I would say that we're going to see kind of a normal pattern coming out, maybe even leaning towards the premium a bit because we do have some new products that have come out. And we'll introduce additional products through the year. So I would say that our purchasing or the consumer purchasing behavior of A. O. Smith products will be very similar to what we've seen in the past and hopefully maybe a bit of a step up on the premium side as these new products enter the market.

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes, we've seen our mix move to positive based on the premium products introduced in the last, call it, 12 months. So that mix on new products is helping a bit on the growth.

Operator

Please standby. [Operator Instructions] Our next question comes from the line of David MacGregor of Longbow Research. One moment please.

David MacGregor
Analyst at Longbow Research

Hey, [Indecipherable]

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Hey, Welcome back.[Speech overlap]

David MacGregor
Analyst at Longbow Research

So I wanted to just ask about water treatment. And just there's kind of -- this is kind of a long conversation we've been having over the last few years about profitability within water treatment and just wanted to get a sense of how you're thinking about the margin outlook in water treatment this year? And just what the factors might be behind your thinking around that?

Charles T. Lauber
Executive Vice President and Chief Financial Officer at A. O. Smith

Yes. So for the quarter, I mean, water treatment is around 10% operating margin. And as you know, we were at 10% and working our way up, and our goal is still to expand those margins 100 basis points a year. We're a little behind the curve on that and trying to play a little bit of catch-up because of some of the cost price relationships there, which put a little pressure on operating margin. For the year, we're kind of looking at 11% operating margin. So we're looking to be a little bit better as we go through the year. But yes, we have a little catch-up to do on some cost increases.

David MacGregor
Analyst at Longbow Research

Is it mix and new products that drive that improvement? Are you just getting a little more progress around productivity and just what are the drivers behind that gradual improvement?

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes. I think it's a combination of what you just mentioned. There will be some productivity. There will be some mix because we are going to introduce some new products, particularly in our Retail segment. So it will be a combination of productivity, mix and a few other things in that 100 basis point increase.

David MacGregor
Analyst at Longbow Research

And then you mentioned in your M&A comment that water treatment, the opportunity looks perhaps a little more imminent.

Kevin J. Wheeler
Chairman, President, and Chief Executive Officer at A. O. Smith

Yes. I just look at water treatment. And again, I didn't say imminent, okay? I want to make sure that we're clear on that. But when you look at water treatment, it's a very fragmented market. A lot of smaller acquisitions, we think we're going to be part of the roll-up. And so that area is always a bit more active than maybe some of our core products. But there's always opportunity there. We have to find the right fit, not only for us, but also for the people that would want to sell to us. But I think water treatment is going to be a primary focus and probably will have the most opportunity over the next few years for us. Not to say there's not others, but that's why I kind of singled out water treatment.

Operator

At this time, I would like to turn it back to Helen Gurholt for any closing remarks.

Helen E. Gurholt
Vice President Investor Relations, Financial Planning and 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 strong first quarter performance and record first quarter EPS. We look forward to updating you on our progress in quarters to come. In addition, please mark your calendars to join our presentations at three conferences this quarter: Oppenheimer on May nine, KeyBanc on May 31 and William Blair on June six. Thank you, and enjoy the rest of your day.

Operator

[Operator Closing Remarks]

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