Welcome to the A. O. Smith’s Third Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the call over to our first speaker for today, Helen Gurholt. Your line is now open.

Good morning, and thank you, everyone, for your patience while we dealt with our technical difficulties. Welcome to our A. O. Smith’s third quarter conference call. I’m Helen Gurholt, Vice President, Investor Relations and Financial Planning & 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 our 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 impairment charges, nonoperating noncash pension income and 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 this morning’s press release, among others. Also, as a courtesy to those 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.

Thank you, Helen, and good morning, everyone. I’m on slide 4 and will review a few of our third quarter highlights. I’m very pleased with the execution of our team across all of our businesses to deliver a strong third quarter EPS of $0.90. The performance of our North America segment was particularly strong. We saw resilient demand for our residential water heaters as well as year-over-year improvement in our operating margin. China’s new products drove year-over-year improvement as newly introduced kitchen appliance products were well received by the market. Innovative new products, combined with our strong brand, drove growth despite a continued challenging economic backdrop. India entered the year introducing a number of new products in both the water heating and water treatment categories and has delivered year-to-date sales growth of 17% in local currency. We also acquired Water Tec, a high-quality Arizona-based water treatment company. This acquisition aligns with our strategic growth aspirations to expand water treatment across the U.S. We welcome Water Tec team to the A. O. Smith family. Please turn to slide 5. North America water heater sales increased 13% in the third quarter as a result of continued strength in residential water heater demand. As you may recall, sales in the third quarter of last year were negatively impacted by channel inventory destocking of residential water heaters, primarily in the wholesale channel. Our North America boiler sales declined 18% in the third quarter against a difficult comp in 2022. In the third quarter last year, we worked down our backlog after making significant production and supply chain improvements. We believe channel inventories are approaching normal levels. Demand for our commercial high-efficiency condensing boilers, particularly our Hellcat CREST boilers remained steady in the quarter. North America water treatment sales increased 5% in the third quarter…

Thank you, Kevin, and good morning, everyone. I’m on slide 7. Third quarter sales in the North America segment were $710 million, a 9% increase over the same period last year. The increase was primarily driven by higher residential water heater volumes that were partially offset by lower boiler volumes. North America segment earnings of $170 million increased 28% compared with the adjusted segment earnings in the third quarter of 2022. Operating margin of 23.9% improved 350 basis points compared to adjusted segment operating margin in the third quarter of last year. The higher segment earnings and operating margin were primarily due to higher residential water heater volumes and lower steel costs, partially offset by lower boiler volumes. Segment pricing was relatively flat in the quarter compared to last year. Moving on to slide 8. Rest of the World segment sales of $233 million increased 1% year-over-year and 6% on a constant currency basis. Currency translation unfavorably impacted segment sales by approximately $11 million. Sales of newly introduced kitchen appliance products, higher commercial water treatment sales and a positive mix in China drove the sales increase in the quarter. India sales grew 13% in local currency in the third quarter compared to last year. Rest of the World segment earnings of $23 million increased 6% compared to segment earnings in the third quarter of 2022. Segment operating margin was 9.9%, an increase of 40 basis points compared to the same period last year, primarily as a result of higher sales of new products and a positive mix. Please turn to slide 9. We generated free cash flow of $396 million in the first nine months of 2023, more than 2 times the free cash flow generated in the same period last year. This was largely due to higher earnings and…

Thank you, Chuck. We have narrowed our 2023 sales outlook to grow approximately 2% compared to 2022, which was the high end of our previous guidance. Our outlook includes the following assumptions: Residential water heater orders remained strong through October. Therefore, we project 2023 residential water heater industry volumes will increase approximately 4% compared to last year. We continue to monitor proactive replacement and new housing completions, both of which remain favorable. Demand for commercial electric water heaters greater than 55-gallon continue to be robust. Our guidance for commercial water heater industry volumes to increase mid-teens compared to 2022 is unchanged. We maintain our guidance that our sales in China will grow 3% to 5% local currency in 2023. Our forecast assumes that the Chinese currency will devalue approximately 6% in 2023 compared to 2022. Our boiler business outlook of being down high single digits compared to last year is unchanged. As a reminder, 2022 is a difficult comp. We entered last year with a large backlog, which we worked down and exited the year with a normalized backlog, partially contributing to our boiler business growth of 28% in 2022. Our outlook for North America water treatment sales is to grow approximately 5% to 7% for 2023 also has not changed. We project that our sales in India will grow 15% this year. Please turn to slide 12. Again, we are very pleased with our performance in the first nine months of 2023. In North America, residential commercial water heater demand remained strong through the third quarter. The year is lining up to have a normalized split of approximately 52% of volume in the first half of the year and 48% in the back half of the year. As we expected, North America operating margin was down sequentially in the quarter, but remained strong relative to historical performance at 23.9%, even as we recognized higher steel costs in the quarter, compared to the first half of the year. In China, the team continues to execute very well across our various product lines through a balanced go-to-market channel strategy. New product introductions, continued growth in commercial water treatment and positive mix led to a 10% operating margin in the quarter. India continues to outperform the industry. We see great potential for our India business as it continues to deliver growth through new product introductions and premium customer service. Our focus remains on taking care of our customers as we continue to execute our key strategic objectives to advance our position as a global water technology leader. With that, we conclude our prepared remarks, and we are now available for your questions.

[Operator Instructions] Our first question comes from the line of Michael Halloran of Baird. Your line is now open. We will now move to our next question. Please stand by. Our next question comes from the line of Saree Boroditsky from Jefferies. Your line is now open.

Hi. Good morning. Congrats on the quarter. So just digging a little bit more about North America residential water demand, it obviously came in much stronger than you initially anticipated at the start of the year. What’s been the biggest surprise for you as you went from thinking volumes are going to be down 3% to 5% to now up 4%? And how does that set you up as we look into 2024?

Well, I’ll tell you -- and we’ve been talking about it each quarter, a biggest surprise has been the proactive replacement side of the business. That’s -- we thought that would moderate as we came into 2023. And quite frankly, it stayed strong and continues to be strong. And we’re very pleased with our number of completions that’s been positive as well. So you put those two together, a surprise, yes, but along with having that strong convergence in place. I mean, you put the two together, and it’s been a good year for water heater demand, and we see that continuing into the fourth quarter.

And then maybe just staying on that similar type of question. Obviously, North America margins have been stronger than you expected. It looks like price cost has been better. What was that contribution in the quarter? Is there anything else outside of higher volumes that we should think about with this year’s margin performance? And is it a good starting point as we think about 2024?

Yes. I mean, when you look at our organic growth for the North America segment -- this is Chuck, by the way. Good morning. The pricing contributed very little to segment growth. We had a little bit of incremental pricing on the boiler and water treatment side, a slight headwind on the water heating side. But most of the organic growth in North America was contributed to volume.

Is there any onetime items in this year that we should think about or is this a good starting point for -- as we think about 20242?

No, there’s nothing significantly -- nothing significant from a onetime item. We are pleased with how the quarter came out from a margin perspective. Margins remain fairly resilient.

Please stand by for our next question. Our next question comes from the line of Nathan Jones of Stifel. Your line is now open.

I just wanted to follow up on the proactive replacement side of the business, and just see if you can give any more color or any thoughts around why that continues to be so strong. I mean, I would have -- I know part of that is typically generated when you have sales in existing homes. Obviously, high interest rates discourage the sale of existing homes, but that business has continued to be really strong for you guys. Do you think there’s something that’s structurally changed in that market? Would you still expect it to go back to a more normal mix or a more traditional mix of the business? Just any more commentary you can give us on why you think that business is and continues to be so strong?

Well, you outlined many of the reasons right now. Certainly, people are staying in homes. There’s higher renovation. People aren’t moving, so they’re taking different actions. There’s some anecdotal here that we just have to be careful with. Really proactive replacement has been trending up since about 2019. And so, we don’t take one year as a trend. But we’re in our fourth year here, and it hasn’t really changed. And there’s some anecdotal evidence here that there’s some generational impact here. And so, where you look at a maybe a baby boomer would wait till it breaks, maybe the younger generation, Gen Zs and millennials indicate that they do a bit more proactive work than their predecessors. But, I would take that with a grain of salt right now, but it’s one trend that we watched now for a number of months, and it hasn’t changed, and it continues to be strong. So you put that together, is there a generational impact there? Maybe. But we’ll continue to monitor it. But right now, it’s held up surprisingly well now for 16 straight quarters.

That would be a nice tailwind, if it’s a structural change to the industry. I guess, my second...

I would tell you, we think that as well, but we’re not ready to say that. But again, it’s something we watch and the data that we use, we’ve been doing this for a decade-plus. So, it’s been a good guidepost for us long term. But again, we’ll see how it plays out. But right now, we see the proactive side of it holding up pretty well.

That’s good news. Second question on, I guess, your cost input. You guys had guided to seeing sequentially lower margins in the second half than the first half. And despite the outperformance you’re still are getting a bit lower margins in the second half than the first half, with higher-priced steel costs rolling through the P&L in the second half. We did see pretty significant declines in steel costs over the last six odd months before the last week. Should we expect to see that start rolling P&L in the first half of ‘24, and you should get some nice benefit from a price cost standpoint in the first half price of 2024?

[Technical Difficulty]

Please stand by for our next question. Our next question comes from the line of Bryan Blair of Oppenheimer.

To help us think about Rest of World segment profitability and your potential there, how does the contribution margin on your new China offerings compared to segment average? And what’s the run rate margin in India? And how does your team think about operating leverage there?

[Technical Difficulty]

That makes sense. Any quick color you’d offer on your M&A pipeline? You’ve executed some bolt-ons that are pretty down the middle in terms of your water treatment strategy. It’s been an interesting year with macro uncertainty in the rate environment and just that overall mosaic. Just curious how your deal funnel has progressed and how your team is thinking about actionability over the near term?

[Technical Difficulty]

Please stand by for our next question. Our next question comes from the line of Susan Maklari of Goldman Sachs.

Maybe to start with, I’m not sure if maybe it’s our line, but I think you broke up a little bit when you were talking about the previous question on raw materials and how we should be thinking about steel over the next coming quarters. Can you just maybe perhaps go back and reiterate some of those key points for us?

[Technical Difficulty]

No, you’re very clear right now.

[Technical Difficulty]

Okay. That’s very helpful. Thank you. And then, following up on the conversation earlier as well on thinking of proactive replacement versus the more nondiscretionary pieces of there. Can you give a bit more color perhaps on how you’re defining one versus the other? And as you’re thinking about that potential structural shift that’s coming through, any thoughts on what portion of the volumes today or the demand today is really sort of coming from that proactive replacement relative to the sort of nondiscretionary side of it?

[Technical Difficulty]

Thank you. Please stand by for our next question. Our next question comes from the line of Andy Kaplowitz of Citigroup.

Kevin and Chuck, can you give us more color into the components of China growth in terms of the strength in commercial water treatment and the new products growth you’re seeing as well as the mix benefit you’re getting? And then, how do you think about the durability of that growth going into ‘24?

[Technical Difficulty]

It’s very helpful. And then maybe shifting back to North America, commercial water heaters, you’ve kept up pretty impressive strength. Maybe the expected duration of that strength, have you still seen reasonably good quoting activity? Any sort of conversations you’re having, given the rise in rates lately? Any color would be helpful.

[Technical Difficulty]

Please stand by for our next question. Our next question comes from the line of Matt Summerville of D.A. Davidson & Company.

Can you guys hear me? Is it clear because every answer is really garbled on my end and that’s happening to at least one other sell-side counterpart that I’m aware of, just FYI.

[Technical Difficulty]

Yes, yes. No, I appreciate that. If this has already been asked, I completely apologize, but the channel inventories, can you give us kind of what you’re thinking as a year-end assessment, channel inventories will look like in North America in resi water heaters, commercial water heaters, boilers and treatment and how that may inform you as to the volume outlook for each, respectively, a level for next year?

[Technical Difficulty]

Yes, I can.

[Technical Difficulty]

Thank you. And then just as a follow-up, and again, my apologies if you answered this already. You’ve obviously kind of been benefiting from this product cycle, if you will, in China as it relates to your kitchen-related offering. When did those products launch? And how should we think about the duration of that cycle on the top line just in the context of the macro environment in China? Thank you.

[Technical Difficulty]

Thank you. Please stand by for our last question. Our last question comes from the line of Damian Karas of UBS.

I can hear you guys loud and clear now, but I do echo Matt’s comment, I literally haven’t been able to understand a lick of anything you said since we started the Q&A. I think what’s going on is like the analyst that asks the question can hear you, but it’s very kind of garbled for everybody else. So I do apologize for touching on ground you’ve already covered here, but I wanted to ask about the proactive replacement, just a follow-up. I’m just trying to think of like to what extent may be IRA and some of these efficiency credits are factoring in. So, I’m curious if you’re actually seeing any notable mix shifts on the efficiency scale in that proactive replacement or not really?

[Technical Difficulty]

Okay, great. That’s helpful. And just having seen steel prices move lower since where we started earlier in the year, how are you thinking about the next potential price cost impact from that? Just realizing that you do have some floating price but also index price.

[Technical Difficulty]

Thank you. This concludes the question-and-answer session. I would now like to turn the call back over to Helen Gurholt for closing remarks.

[Technical Difficulty]

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