Third Quarter 2026 Earnings Call - SMITH A O CORP

Financial Performance:

• Q3 2026 total sales were $941 million (flat year-over-year); adjusted EPS was $0.93.
• North America segment sales grew 3% to $762 million (organic growth +1%); North America segment earnings were $180 million (flat YoY) with margins declining 60 bps to 23.6% due to input cost inflation.
• Rest of World segment sales decreased 7% to $193 million; earnings fell to $11 million with margins at 5.4%, driven by a 17% local currency decline in China.
• Year-to-date operating cash flow was $429 million; capital expenditures were $33 million lower than the prior year.
• Input costs are rising sharply, with steel and freight expected to increase 10-15% for the full year, negatively impacting margins by approximately 5% of COGS in North America.
• The balance sheet shows a debt-to-capital ratio of 27% (up from 9.2% YoY) due to the Leonard Valve acquisition, with $235 million in cash and net debt of $439 million.

Guidance and Future Outlook:

• Full-year 2026 sales excluding China are projected to grow approximately 4%; adjusted EPS is forecast between $3.42 and $3.52.
• Q4 is expected to be seasonally strong for boilers but moderated for water treatment due to manufacturing transitions.
• Full-year 2026 North America segment margin guidance remains flat at approximately 24%, despite Q4 cost pressures, as Q3 tariff refunds partially offset higher input costs.
• Boiler sales guidance for 2026 is raised to 10-12% growth (previously 6-8%); Water Treatment is lowered to 3-4% growth (previously 5-6%) due to consumer channel weakness and production transfer delays.
• Leonard Valve full-year sales are projected at $65 million (down from $70 million) due to project delays in the New York region.
• India sales (including PUREC) are expected to grow double digits in local currency for 2026.

Business Segments and Product Lines:

• Water Heaters: Residential sales declined 1% amid soft wholesale demand; commercial volumes remained resilient. A 9.5% price increase effective December is announced to offset rising steel and freight costs.
• Boilers: Driving strong growth with double-digit gains, fueled by high-efficiency product demand, share gains, and pricing actions.
• Water Treatment: Organic growth led by professional dealer channels (+30 new dealers YTD) and specialty wholesale; growth delayed in consumer channels due to manufacturing shifts from Groveport, Ohio.
• Leonard Valve: Contributed $15 million in Q3; mixing valve business performing well, while boiler controls (Heat Timer brand) face delays from energy efficiency project pauses in specific regions.
• China Business: Sold 81% stake to CPE for ~$400 million; A.O. Smith retains 19% equity and a multi-decade brand licensing agreement expected to generate ~$100 million in royalty value.
• Manufacturing: Ceased production at Groveport, Ohio facility to optimize footprint; expects near-term shipment delays but annual savings of $6-8 million.

Market and Competitive Landscape:

• China: Market characterized by weak consumer demand; strategic assessment concluded with the decision to sell to a local owner better positioned to compete.
• North America: Water heater industry volumes expected to decline low single digits; commercial water industry flat to 2025.
• Competition: Industry-wide pressure from steel and freight costs has led to widespread price increase announcements; competitors are expected to follow suit, validating the necessity of the December price hike.
• Market Share: A.O. Smith maintained water heater market share despite volume softness; gaining share in residential boilers as competitors exit the market.
• Macro: Residential replacement market faces headwinds from low housing transaction volumes, though proactive replacement rates remain stable at >30%.

Risks and Challenges:

• Cost Inflation: Significant and persistent increases in steel and freight costs (double-digit) creating margin pressure.
• Regulatory/Project Delays: Energy efficiency upgrade projects in New York and other regions are delayed, impacting Leonard Valve order timing.
• Currency: Favorable currency impacts in Q3 were specific to China; expected headwinds in Rest of World (excluding China) for 2026.
• Operational Transition: Manufacturing facility transfers in water treatment creating temporary shipment delays and backlog.
• China Uncertainty: Near-term results highly variable due to the strategic assessment and pending transaction closure.

Management Commentary and Tone:

• Strategic Focus: Management expresses confidence that divesting China simplifies the portfolio, creating a "higher margin, focused North American water platform" with an enhanced growth profile.
• Tone: Confident and decisive; acknowledges short-term cost headwinds but emphasizes disciplined pricing and cost management to protect margins.
• China Transaction: Viewed as a strategic necessity to unlock value and remove a drag on growth; optimistic about the future of the business under CPE ownership.
• Execution: Emphasis on "winning the heating season" and managing order patterns ahead of December pricing actions.

Analyst Questions and Answers:

• Guidance Bridge: Management declined to provide a direct walk from July guidance due to the structural change of removing China; ex-China results remain within original ranges.
• Price-Cost Parity: Full realization of the 9.5% price increase is expected to lag; management anticipates needing further price actions and cost savings to offset inflation in 2027.
• Boiler Growth Drivers: 2026 growth (10-12%) driven by high-efficiency portfolio, pricing, and share gains; normalized growth expected to settle at 4-6% over time.
• Capital Allocation: $350 million in after-tax proceeds (plus repatriated cash) from the China deal will be prioritized for share repurchases upon closing.
• Tariff Refunds: ~$10 million benefit recognized in Q3; no material refunds expected in Q4.
• Leonard Valve: Mixing valves performing well; boiler controls delayed due to regional policy decisions on efficiency upgrades, not structural business issues.
• China Cash: $80 million expected to be repatriated immediately; no material excess cash remains in China post-closing.

Other Key Points:

• Dividend: Announced a 6% dividend increase in Q3, continuing a long track record of annual increases.
• M&A Pipeline: Strong pipeline focused on core North American water business and growth platforms (water treatment, water management); remains disciplined on acquisitions.
• Share Repurchases: Increased full-year target to $300 million; expects to complete the program with ~$39 million remaining in Q4 before utilizing China proceeds.
• Strategic Shift: Excluding China would have resulted in 2025 revenue growth of 3% vs. flat reported, and an EBIT margin 200 bps higher.
• Upcoming Events: Management to present at Baird (Nov 10) and Goldman Sachs (Dec 2) conferences.