A. O. Smith Q2 2024 Earnings Call Transcript

Presentation

[Operator]

Good day, and thank you for standing by. Welcome to the 2024 Second Quarter A. O. Smith Earnings Call. [Operator Instructions].

I would now like to hand the conference over to your first speaker today, Helen Gurholt. Please go ahead.

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

Thank you, Marvin. Good morning, and welcome to the A. O. Smith's second 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 pension settlement income and restructuring and impairment expenses. 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 we, that we described in this morning's press release among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com.

I will now turn the call over to Kevin to begin our prepared remarks.

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

Thank you, Helen, and good morning everyone. I'm on Slide 4, in our second quarter results. I'm very pleased with our second quarter performance and how we are tracking for the year. In the second quarter, our global A. O. Smith team delivered record quarterly sales of $1 billion and EPS of $1.06, a 5% increase over 2023 adjusted EPS. North American water heater and boiler sales increased 10%, due to higher volumes and pricing action.

China third-party sales grew 2% in local currency. India achieved double-digits growth in local currency for the 10th consecutive quarter. And last week, we announced that we signed an agreement to acquire Pureit, a leading water purification business in South Asia. We look forward to welcoming the Pureit team to the A. O. Smith family later this year.

Please turn to Slide 5. North American water heater sales grew 10% in the second quarter, due to higher residential and commercial volumes and pricing actions. We began shipping our internally developed and manufactured gas-tankless products in the quarter, and we are very pleased with market acceptance. Our North American boiler sales grew 10% compared to the second quarter of last year, driven by higher commercial volumes.

I am pleased to see a return to growth as channel inventory levels normalize and we are on track to achieve our boiler sales forecast of 8% to 10% for the year. Sales of our commercial boilers, particularly our CREST boilers with Hellcat technology continue to outperform the market. North American water treatment sales increased 8% in 2024, as acquisition-related dealer sales increases were partially offset by weakness in the retail channel.

In China, second quarter third-party sales increased 2% in local currency, as a result of sales of kitchen products, as well as HVAC products that were partially offset by lower volumes of residential water treatment. While markets for our core products remain challenged, we are pleased with our market share in the premium portion of the water heater and water treatment product categories. However, we have seen pricing and promotion pressures, particularly in the mid price sector of the market.

I'm now on Slide 6. This year, we are celebrating our 150th anniversary. It's a time to reflect on those 150 years of living our values of achieving profitable growth, emphasizing innovation, preserving our good name, being a good place to work and being a good citizen. It is also gratifying to be recognized for the continuation of those values. So far in 2024, our team has received several honors that reflect our employees' dedication to our core values.

Earlier this year, A. O. Smith was named one of the World's Most Ethical Companies by Ethisphere, a global leader in defining and advancing the standards of ethical business practices. In addition, our commitment to innovation and energy management has resulted in our Nanjing, China plan being selected as one of the 2024 Nanjing environment protection model enterprises, in recognition of our waste and emission reduction efforts.

We also received a 2024 Energy Star Sustained Excellence Partner of the Year Award from the EPA for the sixth year in a row, for our long-term commitment to energy management through our products. In addition, we were named 2024 U.S. News Best Companies to Work For in Manufacturing by U.S. News & World Report. While the reward is the satisfaction our team receives for doing the right thing and living our values, these honors validate our values as a differentiator for our employees and stakeholders.

I'll now turn the call over to Chuck, who will provide more details on our second 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 7. Second quarter sales in the North America segment were $791 million, a 9% increase compared with 2023, driven by higher water heater and boiler volumes as well as year-over-year pricing actions. North America segment earnings of $198 million increased 2% compared with 2023 adjusted segment earnings.

The higher segment earnings were primarily driven by increased volumes and pricing that were partially offset by higher steel costs and higher selling expenses to support our growth initiatives, including the launch of our gas-tankless products. Segment margin was 25.1%, a decrease of 180 basis points year-over-year. The lower segment margin was due to the reasons I reviewed with regard to segment earnings, which more than offset higher volumes in the quarter.

Moving to Slide 8. Rest of the World segment sales of $245 million were essentially flat to last year and included unfavorable currency translation of approximately $7 million, primarily related to China as well as intersegment sales associated with recently launched tankless water heaters. Segment third-party sales increased 3% on a constant currency basis. The increase was partially driven by higher sales of kitchen and HVAC products, partially offset by lower sales of residential water treatment products in China.

India sales grew 16% in local currency in the quarter, driven by growth in both water heater and water treatment categories with particularly strength in our e-commerce, retail and commercial end markets. Rest of the World segment earnings of $26 million decreased slightly compared to segment earnings in 2023, primarily due to the unfavorable product mix and sales promotions in China. Third-party segment operating margin was 11.5%, slightly lower than segment margin in 2023.

Please turn to Slide 9. We generated free cash flow of $119 million during the first half of 2024, a decrease from the same period last year, primarily as a result of higher inventory and accounts receivable balance as well as higher incentive payments associated with record sales and profits last year, which more than offset higher earnings and higher trade payable balances. Capital expenditures increased $21 million year-over-year, driven by our expansion projects. Our cash balance totaled $233 million at the end of June and our net cash position was $93 million. Our leverage ratio was 6.8% as measured by total debt to total capital.

Now let's turn to Slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation and new product development across all of our product lines and geographies. As Kevin mentioned earlier, we signed an agreement last week to acquire Pureit from Unilever for $120 million. Pureit offers a broad range of residential water purification solutions and has annual sales of approximately US$60 million, primarily in India.

The addition of Pureit strengthens our leadership position as a global supplier of premium water treatment products and will double our market penetration in South Asia. The acquisition will also support our corporate strategy by enhancing our premium product portfolio and distribution footprint.

Please turn to Slide 11, in our 2024 earnings guidance and outlook. We narrowed our 2024 EPS outlook to an expected range of $3.95 to $4.10 per share. The mid-point of our EPS range has not changed and represents an increase of 6% compared with 2023 adjusted EPS. Our outlook is based on a number of key assumptions, including, our guidance assumes that our steel cost in the full year 2024 will be roughly flat to 2023. Our outlook assumes non-steel material costs are similar in 2024, as they were in 2023.

Our guidance also assumes a relatively stable supply chain environment, similar to what we experienced throughout 2023. We began shipping our internally designed and manufactured gas-tankless products in the second quarter. These products are being manufactured in our China facility until our North America capacity is completed in 2025. Associated import tariffs and other launch costs will impact North America margins by approximately 50 basis points in 2024. The tariff will be eliminated when production moves towards Mexico.

For the year, capex should be between $105 million and $115 million, an increase over the last several years due to our capacity expansion projects, including our gas-tankless facility in Juarez, expansion of our engineering capabilities in Lebanon, Tennessee, and adding high efficiency commercial water heating manufacturing capacity ahead of the 2026 regulatory changes.

We expect to generate free cash flow of between $525 million and $575 million. Corporate and other expenses are expected to be approximately $65 million. Our effective tax rate is estimated to be approximately 24%. And we expect to repurchase approximately $300 million of our shares of stock resulting in outstanding diluted shares of $147 million at the end of 2024.

I'll now turn the call back over to Kevin, who will provide more color on our key markets and top line growth outlook and segment expectations for 2024, while staying on Slide 11. Kevin?

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

Thank you, Chuck. We reaffirm our outlook that the 2024 sales will grow 3% to 5% compared to 2023, which includes the following assumptions. Our outlook includes previously announced price increases in North America water heating of 4% on most of our water heater products. Price for heat pump products is 8%. We began to see realization of the price increases in the second quarter.

We believe that a pre-buy ahead of the price increases pulled forward some demand in the first half of the year for both residential and commercial water heaters. We have seen some softness in our orders in July. Due to normal seasonality in the pre-buy, we maintain our projection that 2024 US residential industry unit volumes will be flat to last year and our projection that US commercial water heater industry volumes will increase low single digits in 2024 is also unchanged. Our outlook assumes that new residential home construction and proactive replacement will remain at levels similar to last year.

In China, we believe the economy and consumer confidence remain weak. We continue to see headwinds in consumer demand. While we are cautious about the second half of the year, we maintain our 2024 third-party sales growth guidance to be between 0% and 3% in local currency. Our forecast assumes a negative currency translation impact of approximately 2% for the year.

We reaffirm that we expect our boiler sales to grow 8% to 10% over last year. Our sales growth guidance for North American water treatment of an increase of 8% to 10% is also unchanged. Based on 2024 assumptions, we expect our North America segment margin to be approximately 25%. And the Rest of World third-party segment margin to be approximately 10%.

Please turn to Slide 12. We are pleased with our performance in the first half of 2024. We saw strong growth in water heaters in the first half of the year, which we believe was partially driven by the pre-buy. We are pleased to see a return to growth in our North American boiler business as channel inventory levels normalize and we continue to benefit from the transition to higher energy efficiency boilers, particularly in commercial applications.

Our three capital expansion projects that will add capacity for key product categories in North America are on-track and will position us well for long-term growth. India remains on-track for another year of projected double-digit sales growth, and we're excited to complete the Pureit acquisition later this year, which will double our sales in the South Asia region. Pureit's strong brand and strength in the e-commerce channel will complement our premium brand, will make us the number three residential water treatment company in India.

Even as we celebrate our 150th anniversary and our rich history of innovation with employees, customers and partners, we remain focused on meeting the needs of our customers and executing our key strategic priorities to advance our leadership position in heating and treating water around the globe.

That concludes our prepared remarks, and we are now available for your questions.

Questions and Answers

[Operator]

Thank you. At this time, we will conduct a question-and-answer session. [Operator Instructions] Our first question comes from the line of Matt Summerville of D.A. Davidson. Your line is now open.

[Matt Summerville, Analyst at D.A. Davidson & Company]

Thanks. A couple of questions. I was hoping maybe you could spend a moment, Chuck, kind of talking about, how we should be thinking about the margin cadence in both North America and the Rest of the World in the back half of the year given some of the pluses and minuses you were describing?

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

Yeah. Good morning, Matt. Happy to. If you look at the cadence for the back half of the year, clearly, we had a strong first six months. We mentioned a bit of we, what we believe to be a pre-buy in the North America market with our price increase. So, as you kind of look at volumes in North America, we look at Q3 as being a bit challenged because of some of that pre-buy, and then Q4 probably looking very similar to Q2. So a little bit of headwind on the volumes in Q3, and a little bit of return back to where we were in Q2 in the fourth quarter with continued momentum on the tankless, gas-tankless product. Margins will follow. The margin cadence in the third quarter will be challenged by the volume headwind in the third quarter.

In China, we're coming off, what I would say a solid first half of the year. I still see weakness in the economy, as Kevin mentioned. As always, our fourth quarter is expected to be the strongest as we go into the back half of this year. Third quarter also will be a bit challenged on the volume side, we believe. We've seen a bit of weakness in July orders, both on China and both, within, I'm sorry, within China and in North America. So a little bit of a slow start to the third quarter and that will probably translate into volume headwinds, and it will leave a little bit of an impact on the margins.

[Matt Summerville, Analyst at D.A. Davidson & Company]

Got it. And then as a follow-up, could you maybe comment on what the channel inventory picture looks like in China? And I think in your prepared remarks, there was a mention about maybe seeing a little bit more price competition in the mid price point category. Can you elaborate on that a bit?

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

Yeah, hi. This is Kevin. Maybe I'll touch, touch base on, inventories are, are pretty much where we expect them to be in that four-week to six-week range. So, nothing that meaningful. Yeah, there's ups and downs as we go forward. What we mentioned is, it's a very competitive market. Consumer demand is weaker than it's been. And so the consumers are a bit cautious. So, we're seeing a bit more, I would say promotional activities. We saw it in Q1, and that's kind of carried over into Q2 as well. I think our team is managing it really well. Again, we don't chase every order. We're very selective on how we go-to market.

And if you look at overall, growing 2% in a, in local currency in a very competitive market and have some consumer headwinds, I think our team has done a really nice job of balancing those competitive dynamics. I also want to remind people that we also have some areas in China, that are growing well. You look at our kitchen products are doing well. Our commercial water treatment is doing well. And so was our HVAC part of the business. So, being diversified as we are, on the water heating side and water treatment, but also having the other adjacencies has helped and made a difference in this difficult market. So overall, I'm very pleased that we were out in China, and we'll keep managing in the back half of the year.

[Operator]

Thank you. One moment for our next question. Our next question comes from the line of Jeff Hammond of KeyBanc Capital Markets. 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]

Good morning, Jeff.

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

Good morning.

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

Good morning.

[Jeff Hammond, Analyst at KeyBanc Capital Markets]

Maybe just to start on the acquisition, just give us a sense of kind of profitability of the business or opportunity from a profitability standpoint and kind of what the growth rate has been for the business last five years?

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

Well, I'll take the first part of it, and just to talk about the acquisition in general. First, I want to go back to our, our Indian business is performing really well. We have a terrific management team that's been executing for quarter-after-quarter. And we're looking to scale that business both organically and inorganically. And Pureit plays a, plays a nice role in that business. It's a solid brand in the market. It complements our India business that we have today. They're stronger in e-commerce, have a nice retail presence, presence that also dovetails with our general trade and our retail presence.

So overall, the business is doing well, it's a premium brand. We're not, we do overlap, we're not exactly have products positioned right next to each other. So if you look at it, the overall, the brand, the product positioning, we're excited about bringing the team on and doubling our business is going to make a big difference. It's going to make a difference in our scale. We're also going to be able to leverage our infrastructure and that we have on the ground there, whether it be logistics, manufacturing, you name it. So doubling our business is we're excited in doing with a premium company like Pureit, and a premium brand really sets up nicely as we go forward after the close.

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

Yeah. And from a financial profile, it looks very similar to our India business today. I mean, Pureit business is the majority is in India, but it's also in Bangladesh and some shipments on outside of, in Sri Lanka and in Vietnam. But in total, roughly same, same size as our business around $60 million. Profitability-wise, very similar to what our India business has experienced in the last couple of years, meaning low, low to mid single-digit profitability.

Growth-wise, as a premium brand, they've seen also very good growth in the region. Kevin mentioned 10 consecutive quarters of 15-plus percent growth. And I believe they've seen very similar growth rate. So we're pleased with the way the financial profile matches up. And as Kevin said, coming together, we would hope to continue that growth momentum on a larger base and look for opportunities to leverage the bottom line as we go forward.

[Jeff Hammond, Analyst at KeyBanc Capital Markets]

Okay. And then just on working capital, it seems like you have much, a much bigger working capital build in the first half versus maybe, maybe the last couple of years. Is that just timing? Do we expect to get a lot of that back in the second half?

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

Yeah. We expect to get it back in the second half. It's timing. It's a little bit of tankless water heater inventory being built up, but for the large part it's timing.

[Operator]

Thank you. One moment 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 Goldman Sachs & Co. LLC]

Thank you. Good morning, everyone.

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

Good morning.

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

Good morning, Susan.

[Susan Maklari, Analyst at Goldman Sachs & Co. LLC]

My first question is, you mentioned that boilers saw some growth reverted back to growth in the quarter. Can you talk about what's driving that? And the sustainability of it? Just any comments on the comps that you face in the back half, and how you're thinking about the path from here?

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

Well, if you look at it, it's mainly on the commercial side of our business, Susan. And we came off a pretty difficult quarter last year, but still our quoting has been active. That transition from, from kind of standard models to high efficiency continues. So overall, we're about where we thought we would be. Our new products are doing well. I mean, the CREST boilers always done well, but you add the Hellcat technology on top of that. And that's just being really well received in the market. Order rates have been good. They continue to be good. Backlog is strong.

So overall, I just think the Commercial segment is doing well. The overall industry is slightly up. We're doing better than the industry. And even on the residential side of the business, that's also a positive. So again, 8% to 10% coming off some, some easier comps, but the overall macro environment is good, and it plays really well into the lock and bar in our high efficiency focus that we've had over the years, and we're seeing some real benefits from that.

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

And just to comment on cadence on the comps. So, I mean, we're up 8% this quarter, but the comps get easier quarter-over-quarter when we get to the third quarter and fourth quarter. So, we feel very comfortable with the 8% to 10% growth.

[Susan Maklari, Analyst at Goldman Sachs & Co. LLC]

Okay. That's helpful. And then turning to steel, we've seen that come down quite a bit recently. How do you think about the flow through of that to the business, perhaps any impact there to North America over the coming quarters and just overall the trend for pricing?

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

Yeah. I mean, the steel has come down a little bit. By the way, boilers grew at 10%, I said 8%. So I'll just correct that. It's a 10% growth for the second quarter. As we look at steel, we're thinking our outlook has steel roughly flat year-over-year. As we mentioned, steel went up in the second quarter compared to first quarter by about 20%. It was about 25% higher than Q2 last year. So, there was a bit of a ramp-up. We've seen some softening in steel. As we recall, our lag is 90 days to 120 days.

So as we kind of look at the back half of the year, we see quarter-over-quarter Q2 to Q3, a little bit of relief. And then as we look into the fourth quarter, with that lag, we haven't baked-in all of our indexes, because they haven't all been issued. As you know, it's a monthly index that sets the pricing as you look 90 days to 120 days out. So, we do expect a little bit of relief in the fourth quarter, and it pegged kind of in our outlook very similar to what the index was issued for the month of June.

[Operator]

Thank you. One moment for our next question. Our next question comes from the line of Saree Boroditsky of Jefferies. Your line is now open.

[Saree Boroditsky, Analyst at Jefferies Financial Group]

Good morning. Thanks for taking our question. You cited some softer orders in July on the water heater side. Could you just quantify this at all? And then does your guidance assume that demand stays in-line with the softer July rate?

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

Yeah. And just to mention, we always give you an outlook for the, for the month we're in on the call. But if you look at, we talked about a pre-buy, we do believe there was a pull ahead, and we started to see a bit of softness in May and June, into July. But I think July is also our one of our weaker months and really the third quarter is one of our weaker months, because of the summer and the heat and so forth.

So, that's why we do think it's going to return as we get into August and September. And that's why we're holding a flat rate for the US residential tank-type market through the balance of the year. So, it's a temporary low that I think just gets us back to where our forecast has been for the entire year.

[Saree Boroditsky, Analyst at Jefferies Financial Group]

Thank you. And then turning to tankless, you started to ship some in the second quarter. What are you seeing from a demand perspective there? And then just on the modeling, what is the impact from tankless to China sales this year? And does this create a challenging segment comp, when you do ship production to North America next year?

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

Well, I would tell you, again, we're coming from a low, kind of a mid single digit market share. So, we've had a very good launch. And I don't want to give you any numbers, because they would sound really high and they are for us. We're very pleased with the adoption by our customers. And again, we launched the high-end condensing model, first, and that's been well-received by a number of customers, and it's easily hitting our expectations as we start to launch this product going forward.

Again, we'll have two more products coming in by the end of the year, which will complete the line, and then our factory in Juarez is on track, maybe a bit ahead of schedule, and we'll start to do some assembly and manufacturing towards Q4 and get ready in 2025. Maybe I'll help touch, Chuck touch on that, but having the tariff go away at the start of 2025 is going to make a big difference in how we view this from a margin perspective going forward.

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

Right. I mean, Saree, from a comp perspective, it's all positive, and we move to Juarez. We relieve ourselves with the 25% tariff. We take away that the long logistics lead-time and some of the costs associated with bringing the product all the way back to North America from China. So, we're really viewing when we, when we start up production at Juarez is a very positive upside to our tankless category.

[Operator]

Thank you. One moment for our next question. Our next question comes from the line of Andy Kaplowitz of Citigroup. Your line is now open.

[Andrew Kaplowitz, Analyst at Citi Research]

Good morning, everyone.

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

Hi, Andy, good morning.

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

Good morning.

[Andrew Kaplowitz, Analyst at Citi Research]

So, you mentioned lingering pricing promotion pressure in China. I think you talked about margin there a little bit. But you obviously kept your guidance for Rest of World margin of 10%. So, my question is how difficult is it, is to maintain that margin sort of in guidance moving forward? What cost actions or anything else are you doing to sort of offset the lingering price pressure?

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

Yeah, I'll touch on it, first, and then maybe Chuck will jump in. It's a tough market. And as we said, we're cautious about even our guidance, but our team is doing a terrific job balancing not only price to promotion, but also the cost of our business. We talked way back when we went through the pandemic, a lot of our costs are now more variable than they are fixed. And so, we're just balancing it. Again, we're a premium brand.

So, we're in a different part of the market and a different clientele. But overall, it's still a tough environment. And most of the pressures that we're receiving are kind of in that mid to upper mid level, not on the higher level. And our team is evaluating it. Again, I think we're taking a targeted approach. It's not going to be easy, but we're confident in our China management that they can navigate the way through the second half of the year.

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

Yeah. We took quite a few cost actions over, within the COVID timeframe in China. And like Kevin said, to change some of our cost structure to more variable, take cost out of the business, close some very, lead less profitable store, store footprints. I mean, feel pretty good about our position to be flexible as volumes challenge us a bit. So, we'll continue to watch it right now. I think we've got China at about 11% for the year, very similar to last year. We anticipate being able to kind of work through it, and continue to focus on cost and be at that percentage.

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

Yeah. And we'll introduce a few new products in the back half of the year. Chuck had mentioned Q4 is our strongest quarter. And again, we're building some momentum in commercial water treatment. We're building momentum on our HVAC side. So again, putting the combination together, challenging, but we think it's very doable.

[Andrew Kaplowitz, Analyst at Citi Research]

Got it. And I just want to maybe ask the same question on North America again like in terms of the margin, like just to make sure, I understand it. So, you still slightly better, you're saying flattish versus a modest headwind, I think that is what you previously said. But you also talked about Q3, maybe being a little light or lighter in sort of volume. And I guess that's the incremental margin headwind holding you back. Is there anything else like launch cost investments a little higher than expected? I know you said the 50 basis points. So, any color would be helpful.

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

I mean, nothing, nothing new. I don't think that we've talked, that we haven't talked about before. We will, I'll just mention that the tankless launch does cause some pressure on margins that 50 basis points is sort of spread to the full year margin projection of 25%. So clearly, as we launch it, it's heavier weighted into Q2, Q3 and Q4. So, that's probably the only other area of a little bit of headwind on margins that I would say to take into account as we're thinking about the back half of the year.

[Operator]

Thank you. One moment for our next question. 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, and thanks for taking my questions. I guess, I wanted to focus in on the increased selling expense in North America. And can you, talk about how that North American selling expense compared year-over-year when you exclude the gas tankless rollout? And also, I guess, how we should be modeling that to the second half?

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

Yeah. I mean, it really tracks closely with volumes, right? So, our cost structure and selling expense is largely based on a commission basis. So, as we sell more product, we're going to have a higher upselling expense. We also emphasize different products with a different commission level to drive initiatives from time-to-time. So, somewhat variable, I think is the best way to look at it, and tracks closer to volumes than, than it does just kind of flat out expenses. We do mention the launch of tankless products, so we've got some initiatives within our launch of the tankless products that's driving that number just a little bit higher.

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

Yeah. I just would add. I mean, it, we're excited about our tankless offering being that is internally designed, it's going to be manufactured in North America. And we're going to, we're going to own the category and from a, from our own perspective rather than from partnering with somebody. So we're going to expend some, we're going to promote this product for the first part of the year and make sure we get everybody to understand what the product does, training, some promotional activities. All those are really important for us to, to get that product into the market, make sure people understand the features and benefits and how they really can benefit them going forward, and how we can compete long-term in this category. So, this is a one-time expense, but it's one that we're going to kind of lean into to make sure that we get the product off and off to a good start.

[David MacGregor, Analyst at Longbow Research]

Got it. Thanks for that. And then as a follow-up on the boiler business, I mean, you've guided to up 8% to 10% for the year. What's the right way to think about how profitability compares with last year? And what you may have in your guidance?

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

Well, volumes being up certainly helps us. When you look at the boiler business, it's largely commercial product that we're talking about being increased 8% to 10%. So, it's an improvement when you've got growth in that segment, or in that product category.

[Operator]

Thank you. One moment for our next question. Our next question comes from the line of Scott Graham of Seaport Research Partners. Your line is now open.

[Scott Graham, Analyst at Seaport Research Partners]

Hey, good morning. Thanks for taking the questions.

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

Good morning, Scott.

[Scott Graham, Analyst at Seaport Research Partners]

Hey. So the, so the no change in the US resi water heater industry making of flat. I know, we talked about in quarters past couple of quarters that second half comparisons get a little bit tougher. So you want to be careful with that number. The first half year-to-date is up in resi, on maybe even a little unexpectedly, certainly from this app's point of view.

Is your thinking on flat now maybe a little bit more leaning into the, maybe the market is, is in fact weakening on given your last couple of months sales volumes? Or, are you kind of going to hold the course with flat, because the comps are tougher and this really, and you're not trying to message anything?

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

Yeah. I don't think we're really trying to message, we've always thought we came off a pretty strong year last year. And going forward, if you look, you look at our merchant replacement, which is always going to stay the same proactive, new construction, again, whether it's new single-family or multi-family, we felt that was going to be relatively flat. Interest rates would probably keep it flat.

So we saw that the pre-buy, we're a little surprised when the 4% pull forward a bit, bit more than we had thought. But when you step back now and you kind of look at how we started the year, kind of a trending down to maybe give some back and then you look forward the next five months, we're just very comfortable as a flat year with a strong growth in gas-tankless and we're going to see some good growth in heat pump both residential and maybe even some commercial as well.

So just trying to get back on-track where we really think the market is, and we're very comfortable with that flat residential outlook just based coming off a very strong year.

[Scott Graham, Analyst at Seaport Research Partners]

Thank you, Kevin. So similar question, on the North American segment margin, you kind of, you didn't change that either, yet you're kind of calling for some spot weakness here in the third quarter, no pun attended. I'm just wondering, is that, is there no change in that margin, because maybe you left some wiggle room in there, and/or that you're actually seeing things that are making you more bullish on the fourth quarter margin, and if so, what?

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

No, I wouldn't say, we're more bullish. I mean, we still believe 25%, it's going to be, where we'll end up. We were about at that in Q2, and some really nice volumes. So Q3 will be a little more challenged on that, because we will give back some on the volumes, at least in our outlook and then back to volumes that would drop to the bottom line, a little lower steel than our last assumption. So you know, there is a little bit of opportunity on the steel side, when we look at kind of our guidance from a quarter ago. But we're still feeling 25% is kind of the mid-point of where we think we'll end up.

[Operator]

Thank you. One moment for our next question. [Operator Instructions] Our next question comes from the line of Damian Karas of UBS. Your line is now open.

[Damian Karas, Analyst at UBS Securities]

Hi. Good morning, everyone.

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

Good morning.

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

Good morning.

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

Good morning, Damian.

[Damian Karas, Analyst at UBS Securities]

I was wondering, if you might be able to give us a little bit of an update on what you're seeing for heat pump water heaters. I think we've seen states like New York and some others finalize their IRA allocations, a lot of those kind of really ramping up. So could you tell us that what you've been seeing with the heat pump product, how it's been trending and kind of expectations through the rest of the year into next year?

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

Yeah. I would tell you that, one, I always want to start with is just a calibrate, it's still 2% of the market, but it is a growing category, and it's very specific. You just mentioned New York, California, other parts that are really promoting it. That continues to grow pretty nicely. I mean, we've kind of forecasted 25% to 30% growth over the next several years, but we were north of that in Q2. So, it still gets momentum. We have a great product line. We're having more and more distributors and retailers stock it in a broader variety. So, that's a good thing. Availability is everything.

So overall, the category continues to grow. And albeit, in certain states. But again, it's well above our growth of, that we've had, and we see it continuing. It's a great product. We have a great product line. It has a nice payback story. It's just one that needs to be planned. And so far in the markets that are subsidizing it and putting money upfront and helping with the purchase, it's growing quite well. So again, 25%, 30% going forward next several years and we had a nice Q2 that was several points above that.

[Damian Karas, Analyst at UBS Securities]

Great. That's good to hear. And then maybe, if we could touch back just on the North American tankless. Congrats on getting that product rolled out. Now I know a lot of your wholesale distributors across the country for your tank products have relied on other manufacturers such as Rinnai, Navien, Rheem for tankless in the past. Could you just talk a little bit more about what you're seeing and hearing from your distributors? Are they kind of sampling in your product? Or is it, is it sort of more of an, an all or none type of switch that they would have to make? Any color you could give us just kind of on the receptivity and what your conversations have been like.

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

Well, I would tell you, you described the market pretty well. And so I think what we're hearing from our distributors is they have some optionality and they would like to buy from us. When you look at the commitments we have and the long-term relationships that we have with our distribution and be able to sell not only tank-type in commercial, but also the tankless on there, I think is really important. We still have to meet the market and be competitive and so forth and we are.

So overall, do I expect every one of our distributors to drop their current product lines. The answer is, no. But I do look forward to adding a very competitive gas tankless product line to their inventory and then let us compete in the market. And I think we're going to do very well. It's going to take us several years to, to move that forward. But again, we control our own destiny now. We have great support from our distributors. I look forward to what's going to happen with our gas-tankless line as the next few years kind of develop.

[Operator]

Thank you. I'm showing no further questions at this time. I would now like to turn it back to Helen Gurholt for closing remarks.

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

Thank you, everyone for joining us today. Let me conclude by reminding you that our global A. O. Smith team delivered record sales and strong EPS in the second quarter. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentations at three conferences this quarter; Seaport on August 20th, Stifel on September 4, and D.A. Davidson on September 19th. Thank you, and have a great day.

[Operator]

[Operator Closing Remarks]

Participants

Corporate Executives

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

Analysts

• Matt Summerville, D.A. Davidson & Company
• Jeff Hammond, KeyBanc Capital Markets
• Susan Maklari, Goldman Sachs & Co. LLC
• Saree Boroditsky, Jefferies Financial Group Inc.
• Andrew Kaplowitz, Citi Research
• David MacGregor, Longbow Research
• Scott Graham, Seaport Research Partners
• Damian Karas, UBS Securities