SMITH A O CORP 10-Q

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world. Our supply chain has been relatively stable. However, we continue to monitor potential disruptions and increase our safety stock of key components when we believe it is warranted. We remain in close contact with our suppliers and logistics providers to resolve supply chain constraints as they arise. We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. In the first quarter of 2024, we acquired Impact Water Products, a California-based water treatment company. The acquisition supports our growth strategy by expanding the West Coast presence of our water treatment business. We also continue to look for opportunities to add to our existing product portfolio in high growth regions demonstrated by our previous introductions of kitchen products in China. We also recently introduced our internally designed and manufactured gas tankless water heaters in North America. In addition, we are expanding our commercial water heater capacity in preparation for the new efficiency rule for commercial water heaters that the Department of Energy (DOE) has adopted that will take effect in 2026. In our North America segment, we saw strong water heater demand in the first quarter that benefited from increased orders ahead of our March 1st price increases. We project 2024 industry residential unit volumes will be flat after approximately six percent growth in 2023. Proactive replacement has been above historical levels for the last several years and we project that will continue in 2024. We believe that new home construction remains in a deficit and will be flat compared to 2023. We anticipate that commercial water heater industry volumes will grow low single digits in 2024 compared to 2023 as demand for commercial electric water heaters greater than 55 gallon continues a positive trend toward pre-2022 levels. Sales of our boilers and water treatment products were negatively impacted by elevated channel inventories in 2023. We believe that channel inventories returned to near normal levels at the beginning of 2024 for both product categories. We expect to see an eight to ten percent increase in our sales of boilers in 2024 compared to 2023 as we continue to benefit from the transition to higher efficiency boilers. We anticipate sales of our North America water treatment products will increase approximately eight to ten percent in 2024, compared to 2023, as we continue our geographic expansion. In our Rest of World segment, we saw local currency third-party sales growth in China of six percent in the first quarter. We project our third-party sales in China will be flat to up three percent in 2024 in local currency compared to 2023 driven by innovative new products and resilient demand for our core products. Our guidance assumes an unfavorable currency translation impact on sales of approximately one percent in 2024. Combining all of these factors, we expect our 2024 consolidated sales to increase between three and five percent compared to 2023. Our guidance excludes the impacts from potential future acquisitions. 18 Table of Contents Results of Operations (dollars in millions) Three Months Ended March 31, 2024 2023 Net sales $ 978.8 $ 966.4 Cost of products sold 594.1 592.3 Gross profit 384.7 374.1 Gross profit margin % 39.3 % 38.7 % Selling, general and administrative expenses 192.2 187.2 Impairment expense — 15.6 Interest expense 1.0 4.0 Other income, net (1.2) (4.0) Earnings before provision for income taxes 192.7 171.3 Provision for income taxes 45.1 44.4 Net Earnings $ 147.6 $ 126.9 Our sales in the first quarter of 2024 were $978.8 million, or 1.3 percent higher than the first quarter 2023 sales of $966.4 million. Compared to the prior year quarter, the increased sales were primarily driven by a positive mix shift towards high efficiency commercial water heaters including heat pumps. In addition, our sales in the first quarter of 2024 were unfavorably impacted by approximately $9 million due to the depreciation of foreign currencies compared to the U.S. dollar. Our gross profit margin in the first quarter of 2024 was 39.3 percent and increased compared to 38.7 percent in the first quarter of 2023. The higher gross profit margin in the first quarter of 2024 compared to the same period last year was primarily due to lower steel costs. Selling, general, and administrative (SG&A) expenses in the first quarter of 2024 increased by $5.0 million compared to the first quarter of 2023. The increase in SG&A expenses in the first quarter of 2024 compared to the prior year period was primarily due to higher research and development expenses and higher employee costs from increased wages and management incentives. Impairment expense in the first quarter of 2023 was $15.6 million related to the sale of our business in Turkey. Of the $15.6 million impairment, $12.5 million was recorded in the Rest of World segment and $3.1 million in Corporate Expense. There was no impairment expense recorded in the first quarter of 2024. Interest expense in the first quarter of 2024 was $1.0 million compared to $4.0 million in the same period last year. The decrease in interest expense in the first quarter of 2024 compared to the same period last year was primarily due to lower debt levels. Other income, net was $1.2 million in the first quarter of 2024 compared to $4.0 million in the first quarter of 2023. The decrease in Other income, net was primarily due to higher foreign currency translation losses and lower interest income compared to the same period last year. The Company’s effective income tax rate for the three months ended March 31, 2024 was 23.4 percent. The effective income tax rate for the three months ended March 31, 2023 was 25.9 percent. The change in the effective income tax rate for the three months ended March 31, 2024 compared to the effective income tax rate for the three months ended March 31, 2023 was primarily due to the $15.6 million impairment expense recorded in the prior year period with no associated tax benefit. We estimate that our annual effective income tax rate for the full year of 2024 will be approximately between 24 and 24.5 percent. We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of the 2023 impairment expense. Reconciliations from GAAP measures to non-GAAP measures are provided in the Non-GAAP Measures section below. We believe that the measures of adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance. 19 Table of Contents North America Segment (dollars in millions) Three Months Ended March 31, 2024 2023 Net Sales $ 766.3 $ 752.7 Segment Earnings 198.7 188.6 Segment margin 25.9 % 25.1 % Sales in our North America segment were $766.3 million in the first quarter of 2024, or $13.6 million higher than sales of $752.7 million in the first quarter of 2023. Higher sales in the first quarter of 2024 were primarily driven by higher volumes of commercial water heaters and a positive product mix shift towards high efficiency water heaters, including heat pumps. North America segment earnings were $198.7 million in the first quarter of 2024, an increase of approximately 5.4 percent compared to segment earnings of $188.6 million in the first quarter of 2023. Segment margins were 25.9 percent and 25.1 percent in the first quarter of 2024 and 2023, respectively. Higher segment earnings and margins in the first quarter of 2024 compared to the prior year were primarily due to the benefits of the positive product mix shift toward high efficiency products, higher commercial water heater volumes, and lower steel costs that were partially offset by higher selling and advertising expenses. We estimate our 2024 North America segment margin will be approximately 25 percent. Rest of World Segment (dollars in millions) Three Months Ended March 31, 2024 2023 Net Sales $ 226.9 $ 219.1 Segment Earnings 17.2 5.3 Segment margin 7.6 % 2.4 % Sales in the Rest of World segment were $226.9 million in the first quarter of 2024, or $7.8 million higher than sales of $219.1 million in the first quarter of 2023. The increased sales in the first quarter of 2024 compared to 2023 was primarily due to higher volumes of kitchen products in China and increased inter-segment sales of approximately $8 million related to our recently introduced tankless water heaters manufactured in China and shipped to the U.S. market, partially offset by unfavorable foreign currency translation of approximately $9 million. Rest of World segment earnings were $17.2 million in the first quarter of 2024, compared to $5.3 million in the first quarter of 2023. Segment margins were 7.6 percent and 2.4 percent in the first quarter of 2024 and 2023, respectively. Higher segment earnings and segment margin in the first quarter of 2024 were primarily driven by the absence of the nonrecurring impairment expense of $12.5 million associated with the sale of our business in Turkey recorded in the first quarter of 2023. We estimate our 2024 Rest of World segment margin will be approximately ten percent. Adjusted segment earnings and adjusted segment margin in the first quarter of 2023 were $17.8 million and 8.1 percent, respectively. Adjusted segment earnings and adjusted segment margin in the first quarter of 2023 exclude the $12.5 million impairment expense. Outlook We expect our consolidated sales to increase in 2024 between three and five percent. Our sales projection is driven by continued end-market demand in water heating and the rebound that we expect in boiler and water treatment volumes after 2023 corrections in end-market inventories. In our Rest of the World segment, we expect overall growth in China driven by new products and resilient demand for core product offerings. We expect to achieve full-year earnings of between $3.90 and $4.15 per share. Our guidance excludes the impacts from potential future acquisitions. 20 Table of Contents Liquidity & Capital Resources Our working capital was $578.1 million at March 31, 2024, compared with $555.0 million at December 31, 2023. The increase in working capital was primarily related to higher inventory balances, lower accounts payable and payroll-related accruals partially offset by lower cash balances. As of March 31, 2024, cash balances were negatively impacted by $3.1 million due to changes in foreign currency during the year. Cash and cash equivalents used to fund our operations are primarily generated through operating activities and provided by our existing credit facilities. We believe our available cash and existing credit facilities are sufficient to cover our cash needs for the foreseeable future. We use a global cash pooling arrangement, intercompany borrowing, and some local credit lines to meet funding needs and allocate capital resources among various entities. We have historically made and anticipate future cash repatriations to the United States from certain foreign subsidiaries. (dollars in millions) Three Months Ended March 31, 2024 2023 Cash provided by operating activities $ 106.6 $ 119.9 Cash used in investing activities (71.2) (9.8) Cash used in financing activities (120.6) (97.5) Cash provided by operations was $106.6 million in the first three months of 2024 compared to $119.9 million in the prior year period, which decreased primarily as a result of higher incentive payments associated with record sales and profits earned in 2023 and higher inventory levels that more than offset higher earnings and accounts payable balances. Our free cash flow in the first quarter of 2024 and 2023 was $84.6 million and $109.2 million, respectively. We expect cash provided by operating activities to be between $640 million and $690 million in 2024. We expect free cash flow to be between $525 million and $575 million in 2024. Free cash flow is a non-GAAP measure described in more detail in the Non-GAAP Measures section below. Capital expenditures totaled $22.0 million in the first quarter of 2024 compared with $10.7 million in the same period last year. We project 2024 capital expenditures will be between $105 million and $115 million and full-year depreciation and amortization expense will be approximately $80 million. We have a $500 million revolving credit facility which expires on April 1, 2026. The facility is with a group of nine banks and has an accordion provision that allows it to be increased up to $850 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of March 31, 2024, and expect to be in compliance for the foreseeable future. The facility backs up commercial paper and credit line borrowings. At March 31, 2024, we had no borrowings outstanding under the facility and an available borrowing capacity of $500 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt decreased by $7.6 million in the first quarter of 2024 primarily due to debt repayments. Our leverage, as measured by the ratio of total debt to total capitalization, was 6.0 percent at March 31, 2024, compared with 6.5 percent at December 31, 2023. In the first quarter of 2024, our Board of Directors approved adding 2,000,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During the first three months of 2024, we repurchased 906,000 shares of our stock at a total cost of $74.5 million. At March 31, 2024, we had 4,595,462 shares remaining on the share repurchase authority. Depending on factors such as stock price, working capital requirements, and alternative investment opportunities, we expect to spend approximately $300 million on stock repurchases in 2024 through a combination of any renewed Rule 10b5-1 automatic trading plan and open market repurchases. On April 9, 2024, our Board of Directors declared a regular quarterly cash dividend of $0.32 per share on our Common Stock and Class A common stock. The dividend is payable on May 15, 2024, to shareholders of record on April 30, 2024. 21 Table of Contents Non-GAAP Financial Information We provide non-GAAP measures of free cash flow, adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense. We define free cash flow as cash provided by operating activities less capital expenditures. Our adjusted earnings, adjusted EPS, adjusted segment earnings, and adjusted corporate expenses exclude the impact of the 2023 impairment expense. We believe that free cash flow provides useful additional information concerning cash flow available to meet future debt service obligations and working capital requirements. We believe that the measure of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provides useful information to investors about our performance and allows management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance. A. O. SMITH CORPORATION Adjusted Earnings and Adjusted Earnings Per Share (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted earnings per share to adjusted earnings (non-GAAP) and adjusted earnings per share (non-GAAP): Three Months Ended March 31, 2024 2023 Net Earnings (GAAP) $ 147.6 $ 126.9 Impairment expense, before tax — 15.6 Tax effect on above items — — Adjusted Earnings (non-GAAP) $ 147.6 $ 142.5 Diluted Earnings Per Share (GAAP) $ 1.00 $ 0.84 Impairment expense per diluted share, before tax — 0.10 Tax effect on above items per diluted share — — Adjusted Earnings Per Share (non-GAAP) $ 1.00 $ 0.94 22 Table of Contents A. O. SMITH CORPORATION Adjusted Segment Earnings (dollars in millions) (unaudited) The following is a reconciliation of reported earnings before provision for income taxes to total segment earnings (non-GAAP) and adjusted segment earnings (non-GAAP): Three Months Ended March 31, 2024 2023 Earnings Before Provision for Income Taxes (GAAP) $ 192.7 $ 171.3 Add: Corporate expense (1) 21.9 18.6 Add: Interest expense 1.0 4.0 Total Segment Earnings (non-GAAP) $ 215.6 $ 193.9 North America $ 198.7 $ 188.6 Rest of World (2) 17.2 5.3 Inter-segment earnings elimination (0.3) — Total Segment Earnings (non-GAAP) $ 215.6 $ 193.9 Additional Information (1) Corporate expense $ (21.9) $ (18.6) Impairment expense, before tax — 3.1 Adjusted Corporate expense (non-GAAP) $ (21.9) $ (15.5) (2) Rest of World $ 17.2 $ 5.3 Impairment expense, before tax — 12.5 Adjusted Rest of World (non-GAAP) $ 17.2 $ 17.8 23 Table of Contents A. O. SMITH CORPORATION Free Cash Flow (dollars in millions) (unaudited) The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP): Three Months Ended March 31, 2024 2023 Cash provided by operating activities (GAAP) $ 106.6 $ 119.9 Less: Capital expenditures (22.0) (10.7) Free cash flow (non-GAAP) $ 84.6 $ 109.2 A. O. SMITH CORPORATION 2024 Adjusted EPS Guidance and 2023 Adjusted EPS (unaudited) The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax): 2024 Guidance 2023 Diluted EPS (GAAP) $ 3.90 - 4.15 $ 3.69 Restructuring and impairment expense — 0.12 (1) Adjusted EPS (non-GAAP) $ 3.90 - 4.15 $ 3.81 (1) Includes pre-tax restructuring and impairment expenses of $15.7 million and $3.1 million, within the Rest of World segment and Corporate expenses, respectively. 24 Table of Contents Critical Accounting Policies Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the U.S., which requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The critical accounting policies that we believe could have the most significant effect on our reported results or require complex judgment by management are contained in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the year ended December 31, 2023. We believe that at March 31, 2024, there was no material change to this information. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements in Note 1 – Basis of Presentation in the notes to our condensed consolidated financial statements included in Part 1 Financial Information. Forward Looking Statements This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance,” “outlook” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: softening in U.S. residential water heater demand; negative impacts to the Company, particularly the demand for its products, resulting from global inflationary pressures or a potential recession in one or more of the markets in which the Company participates; the Company’s ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to demand for the Company’s products, particularly commercial products, as a result of changes in commercial property usage that followed the COVID-19 pandemic; further weakening in U.S. residential or commercial construction or instability in the Company's replacement markets; inability of the Company to implement or maintain pricing actions; inconsistent recovery of the Chinese economy or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to the Company’s businesses from international tariffs, trade disputes and geopolitical differences, including the conflicts in Ukraine,the Middle East and attacks on commercial shipping vessels in the Red Sea; potential further weakening in the high-efficiency gas boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the Company’s businesses; including new technologies and new competitors; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; the inability to respond to secular trends toward decarbonization and energy efficiency and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.