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. We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. On November 1, 2024, we acquired Pureit from Unilever for approximately $125 million, subject to customary adjustments. Pureit, a leading water purification business in South Asia, offers a broad range of residential water purification solutions. Pureit contributed $12 million to sales in the first quarter of 2025 and is expected to have annual sales of approximately USD $50 million for the full year 2025. The acquisition fits squarely in our core capabilities and doubles our market penetration in the South Asia region. In the first quarter of 2024, we acquired Impact Water Products, a privately-held water treatment company. The acquisition supports our geographic expansion and growth strategy by expanding the West Coast presence of our water treatment business. We continue to look for opportunities to add to our existing product portfolio in high growth regions demonstrated by our previous introductions of kitchen products and connected product technologies 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 North America 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 2024, we recognized restructuring and impairment expenses of $17.6 million. In China, severance expenses of $11.3 million related to the right sizing of that business for current market conditions. The remaining $6.3 million related to the restructuring of our water treatment business in North America as a part of a profitability improvement strategy that prioritizes improving our cost structure and emphasizes our more profitable channels. In our North America segment, we saw lower water heater volumes in the first quarter of 2025 against a difficult comparison in the same period last year. We believe that a pre-buy ahead of our March 2024 price increase pulled forward some demand into the first quarter of 2024. 2024 residential industry unit volumes were flat compared to the prior year and we project 2025 industry residential unit volumes will be flat as well. We anticipate that commercial water heater industry volumes will also be approximately flat in 2025 after minimal growth in 2024. In response to higher steel and other input costs, including tariffs, we announced price increases on most of our water heater and boiler products. We expect our boiler sales to grow between three and five percent in 2025 compared to 2024 as we continue to benefit from the transition to higher efficiency boilers. We anticipate sales of our North America water treatment products will be between $235 million and $245 million, a year-over-year decrease of approximately five percent as we de-emphasize certain channels and focus on our more profitable channels. In our Rest of World segment, our first quarter 2025 third-party sales in China declined four percent due to continued weak consumer demand. In 2025, we project our third-party sales in China to decrease between five to eight percent in local currency compared to 2024 as we expect consumer demand softness will persist in 2025. Combining all of these factors, we expect our 2025 consolidated sales to be approximately flat to up two percent compared to 2024. Given the uncertainty of the tariff environment, our guidance does not include our announced pricing which we project will offset, along with other actions, the current announced tariffs through the date of this filing. In addition to pricing, our other actions include footprint optimization, strategic sourcing actions and other cost containment initiatives. Our guidance also excludes the impacts from potential future acquisitions. 18 Table of Contents Results of Operations (dollars in millions) Three Months Ended March 31, 2025 2024 Net sales $ 963.9 $ 978.8 Cost of products sold 588.5 594.1 Gross profit 375.4 384.7 Gross profit margin % 38.9 % 39.3 % Selling, general and administrative expenses 192.6 192.2 Interest expense 2.9 1.0 Other income, net (1.2) (1.2) Earnings before provision for income taxes 181.1 192.7 Provision for income taxes 44.5 45.1 Net Earnings $ 136.6 $ 147.6 Our sales in the first quarter of 2025 were $963.9 million, and lower than the first quarter of 2024 sales of $978.8 million. Compared to the prior year quarter, our net sales decrease was primarily driven by lower residential and commercial water heater volumes in North America, lower sales in China, and an unfavorable currency translation of approximately $7 million due to the depreciation of foreign currencies compared to the U.S. dollar, which more than offset our higher sales of boilers and incremental sales related to the 2024 acquisition of Pureit that added approximately $12 million in the first quarter. Our gross profit margin in the first quarter of 2025 was 38.9 percent, down compared to 39.3 percent in the first quarter of 2024. The decrease in gross profit margin was primarily due to lower sales volumes. Selling, general, and administrative (SG&A) expenses in the first quarter of 2025 were essentially flat compared to the first quarter of 2024. Interest expense in the first quarter of 2025 was $2.9 million compared to $1.0 million in the same period last year. The increase in interest expense in the first quarter of 2025 was primarily due to higher debt levels. Other income, net was $1.2 million in the first quarter of 2025 and flat to the first quarter of 2024. Our effective income tax rate for the three months ended March 31, 2025 was 24.6 percent. The effective income tax rate for the three months ended March 31, 2024 was 23.4 percent. The change in the effective income tax rate for the three months ended March 31, 2025 compared to the prior year quarter was primarily due to a change in geographical earnings mix. We estimate that our annual effective income tax rate for the full year of 2025 will be approximately 24 to 24.5 percent. 19 Table of Contents North America Segment (dollars in millions) Three Months Ended March 31, 2025 2024 Net Sales $ 748.7 $ 766.3 Segment Earnings 185.2 198.7 Segment margin 24.7 % 25.9 % Sales in our North America segment were $748.7 million in the first quarter of 2025, or $17.6 million lower than sales of $766.3 million in the first quarter of 2024. Compared to the prior year quarter, our net sales decrease was driven by lower residential and commercial water heater volumes, which more than offset our higher boiler sales. North America segment earnings were $185.2 million in the first quarter of 2025, or $13.5 million lower than segment earnings of $198.7 million in the first quarter of 2024. Segment margins were 24.7 percent and 25.9 percent in the first quarter of 2025 and 2024, respectively. Lower segment earnings and margin in the first quarter of 2025 compared to the prior year quarter were primarily due to lower water heater volumes, lower volume-related absorption, and continued strategic investments, which were partially offset by higher boiler volumes. We estimate our 2025 North America segment margin will be approximately 24 to 24.5 percent. Rest of World Segment (dollars in millions) Three Months Ended March 31, 2025 2024 Net Sales $ 226.7 $ 226.9 Segment Earnings 19.7 17.2 Segment margin 8.7 % 7.6 % Sales in the Rest of World segment were $226.7 million in the first quarter of 2025, essentially flat to sales of $226.9 million in the first quarter of 2024. Compared to the prior year quarter, essentially flat sales were primarily due to lower volumes of our residential water treatment and gas water heater products in China and unfavorable currency translation of approximately $3 million that fully offset incremental sales related to our 2024 acquisition of Pureit that added approximately $12 million in net sales. Rest of World segment earnings were $19.7 million in the first quarter of 2025, or $2.5 million higher compared to $17.2 million in the first quarter of 2024. Segment margins were 8.7 percent and 7.6 percent in the first quarter of 2025 and 2024, respectively. The higher segment earnings and segment margin in 2025 compared to last year were primarily driven by cost controlling measures and benefits from our Q4 2024 restructuring actions which more than offset lower volumes in China. We estimate our 2025 Rest of World segment margin will be approximately eight to nine percent. Outlook We expect our consolidated sales in 2025 to be approximately flat to up two percent compared to 2024. Our projection is driven by expected flat industry residential and commercial volumes in North America. In our Rest of the World segment, after a challenging 2024, we expect consumer demand softness will persist in 2025 in China and a decline in third-party sales. We expect full-year earnings of between $3.60 and $3.90 per share. Given the uncertainty of the tariff environment, our guidance does not include our announced pricing which we project will offset, along with other actions, the current announced tariffs through the date of this filing. In addition to pricing, our other actions include footprint optimization, strategic sourcing actions and other cost containment initiatives. Our guidance also excludes the impacts from potential future acquisitions. 20 Table of Contents Liquidity & Capital Resources Our working capital was $540.0 million at March 31, 2025, compared with $495.7 million at December 31, 2024. The increase in working capital was primarily related to higher receivable balances, lower accounts payable and lower payroll-related accruals and was partially offset by lower cash balances. As of March 31, 2025, cash balances were positively impacted by $0.6 million due to changes in foreign currency during the quarter. Cash and cash equivalents used to fund our operations are primarily generated through operating activities and 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 from certain foreign subsidiaries. (dollars in millions) Three Months Ended March 31, 2025 2024 Cash provided by operating activities $ 38.7 $ 106.6 Cash used in investing activities (10.8) (71.2) Cash used in financing activities (95.1) (120.6) Cash provided by operations in the first three months of 2025 was $38.7 million and lower than $106.6 million in the first three months of 2024, primarily due to lower accounts receivable collections which resulted from lower prior quarter sales as well as lower current quarter earnings. Our free cash flow in the first quarter of 2025 and 2024 was $17.4 million and $84.6 million, respectively. We expect cash provided by operating activities to be between $600 million and $650 million in 2025. We expect free cash flow to be between $500 million and $550 million in 2025. Free cash flow is a non-GAAP measure described in more detail in the Non-GAAP Measures section below. Capital expenditures totaled $21.3 million in the first three months of 2025 compared with $22.0 million in the same period last year. We project 2025 capital expenditures will be between $90 million and $100 million and full-year depreciation and amortization expense will be approximately $80 million. In 2024, we renewed and amended our $500 million revolving credit facility ("renewed facility") which now expires on August 23, 2029. The renewed facility is with a group of nine banks and has an accordion provision that allows it to be increased up to $1 billion if certain conditions (including lender approval) are satisfied. Borrowing rates under the renewed facility are determined by our leverage ratio. The renewed 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, 2025, and expect to be in compliance for the foreseeable future. The renewed facility backs up commercial paper and credit line borrowings. At March 31, 2025, we had $113.3 million of borrowings outstanding under the renewed facility and an available borrowing capacity of $386.7 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 increased by $76.6 million in the first three months of 2025 as we used available cash to fund our stock repurchase program. Our leverage, as measured by the ratio of total debt to total capitalization, was 12.7 percent at March 31, 2025, compared with 9.3 percent at December 31, 2024. In the first quarter of 2025, our Board of Directors approved adding 5,000,000 shares of common stock to the existing discretionary share repurchase authority. Under the share repurchase program, the common stock may be purchased through a combination of 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. In the first quarter of 2025, we repurchased 1,794,694 shares at an average price of $67.19 per share and at a total cost of $120.6 million. As of March 31, 2025, there were 4,951,431 shares remaining on the existing repurchase authorization. Depending on factors such as stock price, working capital requirements, and alternative investment opportunities, we expect to spend approximately $400 million on stock repurchases in 2025 through a combination of any Rule 10b5-1 automatic trading plan and open market repurchases. On April 7, 2025, our Board of Directors declared a regular quarterly cash dividend of $0.34 per share on our Common Stock and Class A common stock. The dividend is payable on May 15, 2025, to shareholders of record on April 30, 2025. 21 Table of Contents Non-GAAP Financial Information We provide non-GAAP measures of free cash flow. We define free cash flow as cash provided by operating activities less capital expenditures. We believe that free cash flow provides useful additional information concerning cash flow available to meet future debt service obligations and working capital requirements. 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, 2025 2024 Cash provided by operating activities (GAAP) $ 38.7 $ 106.6 Less: Capital expenditures (21.3) (22.0) Free cash flow (non-GAAP) $ 17.4 $ 84.6 A. O. SMITH CORPORATION 2025 EPS Guidance and 2024 Adjusted EPS (unaudited) The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax): 2025 Guidance 2024 Diluted EPS (GAAP) $ 3.60-3.90 $ 3.63 Restructuring and impairment expense — 0.10 (1) Adjusted EPS (non-GAAP) $ 3.60-3.90 $ 3.73 (1) Includes pre-tax restructuring and impairment expenses of $11.3 million and $6.3 million, within the Rest of World segment and North America segment, respectively. 22 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, 2024. We believe that at March 31, 2025, 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: negative impact to the Company’s businesses from international tariffs, including any new or increased tariffs that could also trigger retaliatory responses from other countries, as well as, trade disputes and geopolitical differences, including the conflicts in Ukraine and the Middle East; further softening in U.S. residential and commercial 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 North American 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; the availability, timing or effects of China stimulus programs; potential 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; failure to realize the expected benefits of acquisitions or expected synergies; failure to realize the expected benefits, timing and extent, of regulatory changes; competitive pressures on the Company’s businesses; including new technologies and new competitors; the impact of potential information technology or data security breaches; negative impact of 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. A more detailed description of these risks is contained under the heading "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2024. 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.