A. O. Smith - Earnings Call - Q1 2025

Executive Summary

• Q1 2025 net sales were $963.9M (-2% YoY) and diluted EPS was $0.95 (-5% YoY); North America segment margin was 24.7% and Rest of World margin improved to 8.7% on cost actions, while North America sales rose 9% sequentially.
• Guidance maintained: FY2025 sales flat to up 2% ($3.8–$3.9B) and diluted EPS $3.60–$3.90; management excluded announced pricing from sales guidance given tariff uncertainty, but expects pricing and cost actions to offset tariff impacts to keep EPS within the range.
• Key operational callouts: North America boiler sales +10% in Q1; China sales -4% (local currency) but margins +200 bps; Pureit contributed $12M to sales; share repurchases front-loaded at $120.6M in Q1.
• Catalysts: clarity and timing on tariff implementation versus pricing realization (pricing 6–9% on most water heater products), accelerated tankless production transition to Juarez, Mexico, and stabilization in China demand and stimulus effectiveness.

What Went Well and What Went Wrong

What Went Well

• China margin expansion of 200 bps and Rest of World margin +110 bps YoY on cost reduction and restructuring, despite flat ROW sales; “we achieved a 200-basis point expansion in China margin compared to last year due to continued cost-saving efforts and benefits from our 2024 restructuring actions”.
• North America boilers grew 10% YoY, fourth consecutive quarter of growth; “our high-efficiency commercial boilers continue to outperform the market”.
• Sequential improvement: North America segment sales rose 9% QoQ as water heater volumes rebounded from Q4 levels; CEO highlighted “positive momentum from the sequential quarter-over-quarter growth”.

What Went Wrong

• Water heater volumes were lower YoY in North America due to tough comps and pre-buy ahead of 2024 price increase; NA margins fell 120 bps YoY to 24.7%.
• China sales declined 4% in local currency; management remains cautious about consumer confidence and expects China sales down 5–8% for FY2025.
• Free cash flow fell to $17.4M and cash from operations to $38.7M in Q1, driven by lower AR collections and lower earnings, versus $84.6M and $106.6M in Q1 2024.
• Tariff headwind: management estimated current announced tariffs could increase annual COGS by ~6–8% (ex-steel), creating a Q2 margin headwind before pricing catches up.

Transcript

Operator (participant)

Thank you for standing by, and welcome to the A. O. Smith Corporation's First Quarter 2025 earnings conference call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during this session, you'll need to press star 11 on your telephone. If your question has been answered and you'd like to remove yourself from the queue, simply press star 11 again. As a reminder, today's program is being recorded. Now I'd like to introduce your host for today's program, Helen Gurholt. Please go ahead.

Helen Gurholt (VP of Investor Relations)

Thank you, Jonathan, and good morning, everyone. Welcome to the A. O. Smith First 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; Steve Shafer, President and Chief Operating Officer; and Chuck Lauber, Chief Financial Officer. Within today's presentation, we have provided non-GAAP measures. Free cash flow is defined as cash from operations plus capital expenditures. 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 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. Please turn to the next slide.

Kevin Wheeler (Chairman and CEO)

Thank you, Helen and good morning. Before I review our first quarter performance, I'd like to take a moment to highlight our recent announcement that Steve will assume the role of President and Chief Executive Officer effective July 1st. Over the past year, Steve has worked closely with me and our leadership team to deepen his understanding of our business and identify opportunities to enhance performance and drive growth. I have full confidence in his ability to lead A. O. Smith and advance our position as a global water technology leader. As we have throughout this process, we will continue to ensure a smooth CEO transition over the next two months. I will remain actively engaged as Executive Chairman of the Board, continuing to support the company's strategic direction. Now, turning to slide four and our financial performance.

Our team delivered a solid performance in the first quarter, with volumes tracking our expectations. I'm pleased with our sequential quarter-over-quarter improvement. As anticipated, North America segment sales declined by 2%, as higher boiler sales were more than offset by lower water heater volumes. As a reminder, we had a very strong first quarter in 2024 for water heating, creating a challenging year-over-year comparison. Rest of world sales were essentially flat compared to last year. In China, third-party sales declined 4% local currency, reflecting ongoing economic weakness and soft consumer demand. In the quarter, we repurchased USD 121 million of our shares, front-loading a portion of our full-year 2025 repurchase outlook of USD 400 million. Please turn to slide five. North America water heater sales declined 4% in the first quarter, driven by lower volumes.

First quarter 2024 shipments benefited from pre-buy related volumes ahead of an announced price increase and a favorable commercial gas mix. In contrast, 2025 volumes reflected a more normalized annual cadence. One of our key initiatives for 2025 is to level load production across the year to ensure optimal plant efficiencies. We have maintained our planned production schedule despite stronger recent order rates, which appear to be in response to our announced price increases. Working closely with our customers, we are managing orders based on historical order rates and have adjusted lead times accordingly. We are continuing to monitor the situation closely. Our North America boiler sales increased by 10% compared to the first quarter of 2024, as our high-efficiency commercial boilers continue to outperform the market.

North America water treatment sales increased slightly in the first quarter, as growth in our priority channels—e-commerce, dealer, and direct-to-consumer—offset retail declines as we intentionally shift focus away from that channel. We are pleased with first quarter profitability, which is tracking in line with the full-year 250 basis point improvement we discussed during January's call. In China, first quarter third-party sales decreased 4% in local currency. Higher sales of electric water heaters and commercial water treatment products were more than offset by lower volumes of residential water treatment products and gas water heaters. Margin improved by 200 basis points in the quarter, driven by ongoing cost control efforts and benefits from our 2024 restructuring initiatives. I'll now turn the call over to Chuck, who will provide more details on our first quarter performance.

Chuck Lauber (CFO)

Thank you, Kevin. Good morning, everyone. We delivered sales of USD 964 million in the first quarter of 2025, a decrease of 2% year-over-year, and earnings were USD 0.95 per share, a decrease of 5% compared to the prior period. Please turn to slide six. First quarter sales in the North America segment were USD 749 million, decreased 2% compared to a tough comp last year. Higher boiler sales were more than offset by lower volumes of water heaters. North America segment earnings of USD 185 million decreased 7% compared to last year. Segment margin was 24.7%, a decrease of 120 basis points year-over-year. The lower segment earnings and segment margin were primarily driven by higher boiler sales that were more than offset by lower water heater volumes, lower volume-related absorption, and continued strategic investments, including tankless. Moving to slide seven.

Rest of the world segment sales of USD 227 million were essentially flat for last year, including sales from the Pureit acquisition of USD 12 million. China third-party sales decreased 4% on a constant currency basis. Lower sales in China were offset by the addition of Pureit. Rest of the world segment earnings of USD 20 million increased 15% compared to segment earnings in 2024, as expense management offset lower sales in China. Segment operating margin was 8.7%, an increase of 110 basis points compared to last year, driven by strong margin improvement in China. Pureit will be a margin headwind in the near term as we focus on integration. Turning to slide eight.

We generated operating cash flow of USD 39 million and free cash flow of USD 17 million during the first three months of 2025, which is lower than the same period in 2024, but is in line with historical first quarter cash flow, which typically is our lowest cash-generating quarter. The decrease was primarily due to lower accounts receivable collections as a result of higher sales in the first quarter of 2025 compared to the fourth quarter of 2024, as well as lower year-over-year earnings. Our cash balance totaled USD 200 million at the end of March, and our net debt position was USD 70 million. Our leverage ratio was 12.7%, as measured by total debt to total capital. I'll turn to slide nine. Earlier this month, our board approved our next quarterly dividend of 30 cents per share.

We repurchased approximately 1.8 million shares of common stock in the first three months of 2025 for a total of USD 121 million, an increase over the same period last year as we increased our planned repurchase intentions fom USD 306 million in the full year of 2024 to approximately USD 400 million of shares for the full year of 2025. We also weighted our share repurchases more heavily in the first quarter relative to our full-year outlook as we opportunistically bought shares during the quarter. We continue to cultivate an active acquisition pipeline and have adequate dry powder available for the right acquisition. As always, we remain focused on transactions that meet our financial metrics and expand shareholder value. Please turn to slide 10 in our 2025 earnings guidance and outlook. We maintain our 2025 EPS outlook with an expected range of USD 3.60-3.90 per share.

The midpoint of our EPS range is slightly higher than our 2024 adjusted EPS. We maintain our outlook on what has been a backdrop of uncertainty in tariff-related cost increases to our business. The tariff-related impacts that we considered in maintaining our outlook are based on what has been announced as of today. While our manufacturing footprint supports our in-country, for-country business model, our supply chain costs are impacted by not only our direct import of components, but also our suppliers' footprint and import strategies. We have confidence in our manufacturing and supply chain strategy and execution, as well as our suppliers' ability to manage in uncertain times. In a moment, Steve will discuss the actions we have taken to mitigate the tariff impact, including pricing, expense management, supply chain, and manufacturing initiatives. We have included the following key assumptions in our outlook.

Due to the uncertainty of the tariff environment, we have considered within maintaining EPS guidance, but excluded from our sales guidance the impact of announced tariffs and related offsetting actions. Based on the current announced tariffs, which could change in the future, we estimate that annual impact could increase our total cost of goods sold by approximately 6-8%, exclusive of mitigation efforts. Our guidance assumes that our annual steel and other input costs, exclusive of tariffs, will be similar to last year. This includes our projection that steel will increase in the second half of the year. We estimate that our 2025 CapEx will be between USD 90 million and USD 100 million as we continue to invest in engineering capabilities and prepare for the upcoming regulatory changes. We expect to generate free cash flow of between USD 500 million and USD 550 million.

Interest expense is projected to be between USD 15 million and USD 20 million. Corporate and other expenses are expected to be approximately USD 75 million. Our effective tax rate is estimated to be between 24-24.5%, and we project our outstanding diluted shares will be 142 million at the end of 2025. I'll now turn the call over to Steve, who will provide more color around tariffs, our key markets and top-line growth outlook, and segment expectations for 2025 on slides 10 and 11. Steve?

Stephen Shafer (President and COO)

Thank you, Chuck, and good morning, everyone. First of all, I would like to take a brief moment to let you all know how honored I am to be announced as the next CEO of A. O. Smith, effective July 1. It is a real privilege to be able to work with my dedicated and capable colleagues to help lead this iconic company into the future. I would also like to thank Kevin and his leadership and commitment to the company over the last 30-plus years, and for the trust and confidence that both you and the board have put in me. As Chuck mentioned, there is still uncertainty around tariffs, and while we are largely in-country for-country, our business is impacted by the changing tariff environment as we have certain components that are globally sourced.

We have mobilized cross-functional tariff response teams across our businesses to identify tariff and supply chain-related risks and to develop action plans to mitigate those risks. These teams meet regularly to address the evolving tariff impacts on each of our businesses to ensure that we continue meeting the needs of our customers while taking action to mitigate tariff-related costs. In North America, in response to tariff cost increases, as well as higher steel and other input costs, we have announced price increases of an average range of 6-9% on most of our water heater products. We have also announced price increases on our other product categories. Because of the uncertainty of the tariff environment, we have not included in our announced pricing in our top-line guidance. In addition to pricing, other mitigating actions include footprint optimization, strategic sourcing, and other cost containment measures.

Assuming the current tariffs go into effect as announced, we expect to begin seeing the benefits of our pricing actions by the end of the second quarter, while we are already experiencing tariff impacts as we enter the second quarter. In North America, the majority of our residential water heaters and all of our boilers and commercial water heaters are manufactured in the United States. Approximately 15% of our residential tank water heaters are produced in our Juarez, Mexico facility and are USMCA compliant. As previously planned, the production of our recently launched gas tankless products is being transitioned from our China facility to our recently completed tankless facility in Juarez. We are taking action to accelerate the transition given the current tariff environment. Key assumptions in top-line outlook include the following.

Our projection that 2025 residential and commercial industry unit volumes will be approximately flat to last year, which is unchanged. In China, we believe the economy remains challenged with low consumer confidence and a weak real estate market. While we see the stimulus programs as positive, we expect the program to act more as a stabilizer in the market as opposed to a meaningful catalyst for growth. We have not changed our full-year 2025 outlook and continue to project that our sales in China will decrease 5-8% in local currency. Our forecast assumes that the currency translation impacts will be minimal in 2025. We anticipate that our restructuring program in China will be substantially complete by the end of the second quarter, and we continue to expect to realize annual savings of approximately USD 15 million.

As a result, China operating margin is projected to be in the 8-10% range for 2025, even with lower volumes. I feel confident that our restructuring actions position us well for the market today and also to realize the benefits when the Chinese economy improves. We remain cautious about the near-term market outlook, including a level of sustainable impact from the appliance discount trading program, but we are pleased with how our China team continues to manage the challenging environment and maintain our premium brand position. We project our North American boiler sales will increase between 3-5% in 2025. While we are very pleased with our first quarter growth of 10%, we believe we may have benefited from a minimal amount of pre-buy from price increases to be implemented in the second quarter.

We are also cautious around the back half of the year and are monitoring the commercial market closely. We have not changed our guidance that North America water treatment sales will decline approximately 5% in 2025 as we de-emphasize the less profitable retail channel. We are pleased to see the strong start to the year in our priority channels and are looking to build on that momentum. We continue to project an operating margin expansion of approximately 250 basis points in 2025 for the North America water treatment business. We expect the addition of Pureit will add approximately USD 50 million in sales in 2025 and will not have a significant bottom-line contribution this year as we work through the integration of this business.

As I have noted, based on the significant volatility in the tariff landscape, we maintain our sales growth expectation of a range of flat to up to 2% pending further clarification on tariffs as we move through 2025. We expect our North American segment margin to be between 24% and 24.5% and Rest of World segment margin to be between 8% and 9%. Please turn to slide 12. While we expect 2025 to be a year of muted bottom-line growth as we navigate the volatile tariff landscape and continue to support our long-term strategic investments, as Kevin noted, we are pleased with our team's first quarter performance. I was particularly pleased with the following. Our manufacturing execution, as well as the steps taken to level load production and work with customers to manage order fluctuation caused by pricing actions.

Our cost containment actions, which resulted in nearly flat SG&A spend in the first quarter compared to first quarter last year, included increased SG&A expenses as a result of inflation and our Pureit acquisition. Our boiler sales growth of 10% in the quarter, the fourth consecutive quarter of growth for this category. Encouraging North American water heater sales, which, while lower relative to a tough comp last year, grew over 10% compared to the previous quarter. Both North America water treatment and China's profit improvement actions, we are on track to meet margin improvement goals through cost management and the benefits of restructuring. During the quarter, we also cut the ribbon and opened our world-class commercial R&D testing lab facility in Lebanon, Tennessee. This facility leverages our product development and engineering talent in one location, focused on continuing to drive our leadership in commercial water heating and boilers.

Lastly, but very important to us, for the second year in a row, A. O. Smith was recognized as one of the world's most ethical companies by Ethisphere, a global leader in defining and advancing the standards of ethical business practices. Living our values and doing business the right way is always front and center to how we operate, and it is great validation to be recognized by Ethisphere. We have confidence in our ability to navigate the volatile 2025 macro environment. Our leadership position in all the markets that we serve, the stable recurring revenue provided by our core water heater and boiler businesses, and our strong balance sheet allow us to continue to invest in ourselves, make attractive strategic acquisitions, and maximize shareholder return even in times of uncertainty.

As always, we are in close communication with our suppliers, customers, and other stakeholders as we navigate the challenging environment. We are deploying diligent cost management actions across our businesses to ensure that we maximize profitability during this time of cost volatility. We are committed to leading the industry forward and are confident that we will continue to build our long history of innovation and proven ability to drive profitable growth. With that, we conclude our prepared remarks, and we are now available for your questions.

Operator (participant)

Certainly. As a reminder, ladies and gentlemen, we ask that you please limit yourselves to one question and one follow-up. You may get back into the queue as time allows. Our first question for today comes from the line of Jeff Hammond from KeyBanc Capital Markets. Your question, please.

Jeff Hammond (Managing Director)

Hey, good morning, everyone. Kevin, congrats on a great run and Steve, for your promotion. Wanted to start here with, I guess you're not really changing anything in the assumptions, but I'm just wondering where you think you might see some demand destruction around incremental pricing actions and just the general uncertainty out there. On the price increases, would you expect to get margin on that price or just cover the incremental inflation? Thanks.

Chuck Lauber (CFO)

Hey, Jeff, let me start out on the margin question. Our assumption in 2025 is really EPS neutral. We're expecting to have pricing cover costs. We've kind of laid it out that way. If you kind of look at our pricing, we'll have probably a little bit of headwind in Q2 as we start incurring those costs before we have the pricing actions in place. I'd say a little bit of headwind relative to Q1. We're really pleased with 24.7% North America margins in Q1. With regards to demand destruction, we're really fortunate to have a replacement stable business with recurring revenue on the water heating side between that 80 and 85%. That certainly does stabilize our business. Our boiler business performed very well in the first quarter at 10% up.

As Steve noted, there may be a little bit of pricing pull forward there, but we're watching the commercial markets as we go through the year and have not increased our boiler guidance based on that. From our perspective, and it's early, it's certainly early in the year, but we haven't seen any negative activity. Orders and quoting have been pretty stable on the commercial side of the business, but again, it's pretty early in the year.

Jeff Hammond (Managing Director)

Okay, great. You mentioned that the tariff exposure, 6-8% of cost of goods sold. I'm just wondering if you could just unpack that a little bit. How much of that is steel inflation or steel tariffs and then any other kind of bigger buckets as you think about direct or indirect or purchase components?

Chuck Lauber (CFO)

Yeah, we kind of carve out steel separately when we think about tariffs. Even though there is steel tariffs, we've had those before. It is in our outlook, and we've got back half steel increases in our outlook. The tariffs themselves that I would say are more direct and more near-term and announced as of today, in that 6-8%, that's an annual number. We're looking at kind of annual volumes in the 6-8%. The largest component of that is bringing in product either through our suppliers or directly, including our tankless from the China market. We have talked a little bit about mitigating that through accelerating our tankless production as we've always planned to move from China to Mexico to mitigate that in the future. China is our largest piece of that.

Operator (participant)

Thank you. Our next question comes from the line of Mike Halloran from Baird. Your question, please.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Hey, just a clarification there, Chuck. I'm sorry. Did that include? You're saying the 6-8% does not include the steel inflation and is simply the tariff piece?

Chuck Lauber (CFO)

Our outlook includes the steel piece, but that 6-8%.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Got it. All right. Perfect.

Chuck Lauber (CFO)

Yeah.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Yeah. Got it. Just wanted to clarify.

Chuck Lauber (CFO)

It's very specific tariffs.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

Yeah. No, I appreciate that. Morning, everyone. Sorry about that. Congrats to everyone on the changes coming up. Could you just talk through how you think about then sequential as you work through the year? I understand the steel comments into the back half of the year, but from a demand perspective, as you sit here today, is this just kind of relatively normal seasonality as you work through the year? Are there any other nuances I should think about?

Chuck Lauber (CFO)

No. I mean, think about it in terms of what we talked about in January. 51%, 49% of residential product in the front half, back half. Orders have not fallen in quite that way. Steve talked about our initiatives to level load the plant. We could have pushed out more shipments if we had wanted to, but we really are working and very focused on managing the orders that have come in. Because of that, we would expect the cadence of the year to be much more normalized, even though we have some announced pricing out there. Think of it in terms of a fairly normal year as we lay it out, and we are working to try to do that so that we are most efficient as possible.

Stephen Shafer (President and COO)

Yeah, Mike, maybe another just a bit of color on that.

We've done quite a bit of inventory checks with our channel partners. Right now, we're in pretty good shape. Most channel partners are relatively flat to last year, even slightly down. It's a little bit different environment than we had last year as we exited Q1 of 2024.

Mike Halloran (Senior Research Analyst and Associate Director of Research)

That makes sense. Then follow-up, just maybe talk about the rebalancing or how much you feel like you need to rebalance some of the sourcing or some of the footprint for these changes. Obviously, the tankless coming over this way over the course of this year and into next year, that was well telegraphed. Maybe any of the other changes as you look at the network and how important that is, all else equal competitively or however you want to frame it.

Chuck Lauber (CFO)

Yeah. Mike, I'll take it as I mentioned the teams we've got that are working on this. There's shorter-term actions you can take relative to working with your suppliers where they have facilities that you can take advantage of. I mentioned even within our own supply chain network of getting tankless into Mexico faster. Teams are working on those things. There are longer-term items as well where there might be either a change in supply or requalification requirements. We're studying those, and some of them are harder than others. Obviously, some of them will be dependent upon what plays out in the year relative to tariffs. We have an understanding if things stay the way they are, certain actions we are working on and we would take. If they move, it might change those actions.

It is a pretty fluid state, and that is why we have got kind of these task forces set up so that it is not just executing a plan as the world is today, but it is helping us realign our supply chain as new information comes available.

Operator (participant)

Thank you. Our next question comes from the line of Saree Boroditsky from Jefferies. Your question, please.

Saree Boroditsky (Stock Analyst)

Hi. Thanks for taking the questions, and congratulations to Kevin and Steve on the new roles. You talked about pre-buy impacting the comps for water heaters last year on kind of a low single digit price increase. I was just curious on the pre-buying expectations given expected pricing actions in response to tariffs. I think you mentioned a difference in orders versus factory levels. Will you be delivering on lower-priced products into more of the year as a result? Thanks.

Chuck Lauber (CFO)

We really have been managing production to not pull in orders in the first quarter. We expect pricing to come into play later in the second quarter. The order rate from a price pull forward, we would expect to be pretty smooth from first to second quarter, kind of rounding out that 51, 49 perspective on units being shipped. I just say we work really closely with our customers on this. One of the ways we handle this is we float our lead times as we get orders coming in. We work with our customers in terms of an allocation of how to work through those orders so that we can actually provide some clarity around when the price transition occurs.

It is something we work closely with our customers on, and I think we are handling that through this year with the price changes and the uncertainty around tariff costs very effectively, both to serve our customers well, but also to run our plants efficiently. Maybe one other comment there. The whole key is we are just not pulling in a bunch of overtime in Q1 to pull it into Q1, but we are trying to be a bit more systematic about it. That is not going to change within the quarter how we are going to ship. We expect to be, as we said, to be through shipping through the quarter and then start to benefit from the back half of Q1 with the pricing.

It is just a little bit of timing, but it is narrow, but it makes a big difference to our factories, and it makes a big difference to our customers to make sure that they can order on a regular basis and have the stock in hand when their contractors need it.

Saree Boroditsky (Stock Analyst)

Appreciate the additional color. I'm sorry if this is just me being confused, but you have announced price actions, but I believe you've not included this in the guidance. I guess, would you expect those price increases to not go into effect if tariffs are not implemented in the current form? What would sales guidance be assuming announced price increases do go into effect? Thanks.

Chuck Lauber (CFO)

Tariffs are so volatile right now and unpredictable that we felt it was prudent to not include a top-line assumption of what may or may not be held into going forward costs or tariffs. EPS, we're very conscious of the tariffs that are in place today and the mitigating actions that Steve outlined, one of which includes pricing. We're comfortable with our EPS outlook and just where we fall within the USD 3.60-3.90, but we haven't decided. We just felt it was prudent to not try to put a top-line assumption out there. Yeah, I would tell you that those can go either way. I think we know where we're at today. We wanted to make sure you understood that we have taken action and that we're confident in how we're going to maintain EPS and our guidance on sales.

It is just really early because the equation changes sometimes literally every day. I think when we get a nice, better view of this, the takeaway here is we are prepared not only with our pricing, but all the other actions we have taken with regards to cost controls and so forth and optimizing our manufacturing that we are in good position to navigate through these tariffs regardless of where they end up.

Operator (participant)

Thank you. Our next question comes from the line of Bryan Blair from Oppenheimer. Your question, please.

Bryan Blair (Managing Director and Senior Analyst)

Thanks. Good morning, everyone. Echo the sentiment, Kevin and Steve. Congrats to you both. I wanted to just make sure that I'm understanding that 6-8% of COGS, potential tariff exposure, that does include the full run rate impact of tankless imports from China, correct? In extension of that, what would the pro forma figure be, assuming the full transition to Juarez production?

Chuck Lauber (CFO)

Yeah. I mean, there's a lot of moving parts to a pro forma number, particularly with us accelerating manufacturing from China to Mexico, meaning there'll be some trailing tariffs on components because we're probably going to have some components go into Mexico. Prior, we've been probably focused more on moving those to local sourcing. It's going to take a little bit of working through to kind of come up with that number, and we're certainly looking to mitigate it. The 6-8% includes tankless. It includes tankless at a volume of 2024. I think I talked about it on the last call. We have a meaningful amount of tankless inventory in place. That may not be quite that number in 2025, but from a full year perspective, tankless is the largest single component within the China import costs.

Bryan Blair (Managing Director and Senior Analyst)

Understood. Appreciate that detail. At a high level, just with regard to competitive positioning and strategy, I guess setting aside near-term price costs for the moment, maybe offer some color about how your team's thinking about the risks versus opportunities presented by all of the uncertainties around tariff, trade policy, etc.

Chuck Lauber (CFO)

I'd say anytime there's uncertainty, it's an opportunity to find a way to respond faster than your competitors, navigate it more successfully than others in the marketplace. I feel confident in our team's ability, the way we've rallied behind this, the way we've understood the dynamics. We've got our supply chain data pulled together. We've got experts within our organization that I think understand the dynamics well. I think we're very plugged in in terms of understanding some of the policy decisions that are out there today as well. I think from my standpoint, I'm confident that we can respond better than most because of the capabilities we've put in place. I think we just put it. One of the things, we're in country, for country, and that's on a global basis.

Being able to navigate this with our local teams, I think, is just an opportunity where maybe other companies do not have that luxury. Again, not being this low-cost producer, moving things around, being in country, for country with local management, I think it could make a difference for us as this thing plays out.

Operator (participant)

Thank you. Our next question comes from the line of Scott Graham from Seaport Research Partners. Your question, please.

Scott Graham (Senior Equity Research Analyst)

Hey, thank you. Good morning, Kevin. It's been a true pleasure working with you. We've spent some great time together and thank you for that. Steve and I wish you all the luck in the world and look forward to working with you. My questions are really around the residential water heater shipments assumption and then China. The residential macros to date have really not been overly optimistic, overly positive, particularly when you consider inflation impacting some of them. I was just wondering, what is your assumption for proactive this year within the industry on a year-over-year basis? Are you assuming proactive is flat, maybe even down?

Chuck Lauber (CFO)

Yeah. It's been interesting, Scott. We track this. I think we've talked about it many times for over a decade, and we just got the recent data last night, quite frankly, to be honest with you. Right now, the proactive and the emergency replacement is still tracking at that level that we came out of COVID. As we talked about, maybe this is just an embedded change in the industry. As we see it right now, we see proactive in the replacement, which is going to be 85% of our business, to be rather stable and resilient.

Scott Graham (Senior Equity Research Analyst)

Okay. Thank you for that. When you look at China, I know obviously with the stimulus over there targeting helping consumers, do you need a broader improvement in housing there to kind of get that business going? What are the things that you're looking for for that business to start to improve again?

Chuck Lauber (CFO)

I would characterize it as more we're looking for consumer confidence to build in China. I think with consumer confidence, and some of that is connected to the housing market, right, because there's a lot of wealth tied up for the Chinese middle class in their real estate. With that consumer confidence, you get both the benefit of how folks will invest in their real estate and/or invest in upgrade of their homes. With the upgrade of homes, you see the premiumization of appliances and kitchen updates that we can take advantage of. I would characterize it more as consumer confidence than the housing market. The housing market in China, it's got a ways to go, I think, to really recover, but it's that close connection to consumer confidence that we're watching.

Operator (participant)

Thank you. Our next question comes from the line of Andrew Kaplowitz from Citi. Your question, please.

Andrew Kaplowitz (Managing Director)

Good morning, everyone. Kevin and Steve, congratulations.

Chuck Lauber (CFO)

Thanks.

Andrew Kaplowitz (Managing Director)

Chuck, I'm just trying to understand the EPS cadence a little bit more for the year in tariffs versus pricing. If we think that the 6-8% of annualized cost of tariffs is going to be the headwind, do you see full impact in Q2 without much help from pricing yet? We need to forecast that in Q2. Do you end up covering more than the tariffs in the second half of the year under the transition costs from tankless later in the year? How does that cadence work?

Chuck Lauber (CFO)

Yeah. Let me start with we're very pleased with North America margins in Q1 at 24.7%. Cost containment measures and some of the other actions to level the plan have been very helpful to that margin. A reminder, our full year guidance is 24-24.5%. Q1 was a little bit better than that full year guidance. We haven't changed our full year guidance. From an EPS standpoint, from a margin profile standpoint, but from a North America margins, we would expect to be slightly down in Q2 because we are starting to see costs on tariffs. We're working to mitigate those costs, as Steve mentioned, working with our suppliers through the quarter, and we'll see pricing come in in June. There'll be a little bit of a headwind, and we haven't changed our full year guidance, 24-24.5%.

A lot to play out yet in the rest of the year. Q2, probably see a little bit of North America margin headwind, but for the full year, we're comfortable that EPS is kind of on track.

Andrew Kaplowitz (Managing Director)

Very helpful. Maybe just a follow-up on China for Kevin or Steve. Your sales started out only down 4%, which I think was slightly better than Q4. Did stimulus help at all? Can you give us more color on sort of what you see there? I know you continue to think about China as strategically important, but has it become at all more difficult to do business in China recently given what's going on?

Stephen Shafer (President and COO)

Yeah. Just regarding the start to the year, I think we're starting out kind of as we had expected to start the year, and we're cautious. I think we're cautious about how the year will play out, the economic conditions in China. We're watching it closely, but as we've said, we still think that the market recovery will take some time there. I think that's reflected in our guidance of how we proceed forward. Our focus really is making sure that we can maintain our competitiveness in China, maintain our premium brand position in China. That's what the team has been focused on, while at the same time right-sizing organization, I think, to the new market reality. I think we're off to a good start there, but we're very cautious as it relates to how the year will play out.

Regarding whether we're seeing a major shift in dynamic, I'd say the trends are very consistent to what we've seen over the last few years. It's a challenging macro environment, as we talked about. Consumer confidence is not where it needs to be to sort of drive growth. The trade-in program is stabilizing, but not really driving growth for us in the marketplace. Right now, we're looking to compete. Obviously, we have local competitors there. That means we've got to be really on our game. I think those conditions haven't changed. We haven't really seen a big shift relative to consumer sentiment around our products. We're in China for China, and we're well respected, and we have a great brand there. I think we still see that as the way in which we're competing and seen in the marketplace.

Operator (participant)

Thank you. Our next question comes from the line of David MacGregor from Longbow Research. Your question, please.

David MacGregor (Longbow Research)

Yes. Good morning, everyone, and congratulations to Kevin and Steve. I guess I wanted to start off by just asking you about capacity available to you in the United States, and specifically maybe how much excess capacity do you have in your Tennessee and Kentucky component plants and your ability to repatriate manufacturing to the U.S. I guess as part of that, how does an increase in the tariffs affect your thinking around vertical integration? I have a follow-up after that. Thanks.

Chuck Lauber (CFO)

Maybe I'll touch on that. In the water heater side, we're very vertically integrated already. Again, we're in country, for country. Repatriating, I don't think that's an issue because we don't have many products that come in from outside the United States. That's played out well for us, and it continues to play out well for us. I just don't see that being a major challenge for us. From a capacity standpoint, we do have capacity. We structure our plants appropriately, like we've been talking about, and making sure that we have the right run rates so we can optimize our efficiencies. We have the ability, we have three large residential plants. We have the ability to shift things around and move them where it's more optimal for our customers as well as for A. O. Smith from a margin standpoint.

No big plans to repatriate because we don't do that. I think our teams are working well together with Steve and the operating groups to make sure we're positioning ourselves well to kind of navigate this situation. That's where we're at. Again, it's playing out well. Our strategy for in-country, for country is playing out pretty well on a global basis considering the uncertainty and volatility in the market today.

David MacGregor (Longbow Research)

Okay. Good. Thanks for that. I guess secondly, just given all the changes that are taking place at the administration level in this country, I wanted to ask you about the 2026 change in regulatory requirements around the elimination of low-efficiency commercial gas product. Are you seeing anything at the federal level that would suggest that this might be delayed or would be reduced in scope? I think at one point you thought the changes would impact about 55% of units sold.

Chuck Lauber (CFO)

Yeah. I would tell you, I'm just going to take there's two major rulemakings out there. One is on the commercial rulemaking, which is October 26, and that's raising from non-condensing to condensing product in the commercial segment. Of course, there's what we refer to as NAECA 4, which is a little bit further out, and that's going to be in 2029. What I'll start with is both of these have gone through Congress, and they are law. Okay? It's going to be difficult to change any of those standards that we have there. What we're doing is we're simply preparing for that. The first step is going to be on the commercial side, and that'll be mainly in our McBee commercial facility, which we're taking steps there.

There is a lot of chatter out there with regards to this and regulatory, but we're proceeding until we see something really meaningful. We're proceeding as both of these rulemakings will go into effect at the appropriate time. If they do not, we're a pretty nimble company, and we can make adjustments. As of right now, again, they're law, and we're proceeding as if they're going to go into effect as scheduled.

Operator (participant)

Thank you. Our next question comes from the line of Damian Karas from UBS. Your question, please.

Damian Karas (Stock Analyst)

Hey, good morning, everyone. Hopping on the line late here, so apologies for any repetition. Morning, morning. I was just wondering if you could elaborate on the pricing actions for North America water heaters. Again, sorry if I missed this, but have your 6-8%—is this kind of already executed round of increases, or are there sort of some pending rounds of price changes that are going to take effect? I'm also just curious, I mean, thinking about the past, right, and the North American industry kind of construct, price increases have typically been similar happening at the same time, whether it was steel inflation or supply chain bottlenecks. This time is a little bit different just because of the very specific tariff factors and the fact that you have a different footprint from some of your peers.

Just curious if your price actions, if you're seeing anything kind of different in the market out there.

Chuck Lauber (CFO)

First off, on the pricing announcements, they have been made, and they are out in the marketplace, and we have been communicating with our customers around that. That is a step we have already taken. You are correct in that this is a little bit of a different dynamic as you think about tariffs versus other inflationary pressures that we have worked through in the past. Tariffs sort of have defined dates and supply chains, and we are all impacted a little bit differently across the different companies. I would say it comes down to we have really good relationships with our customers. We work through these things. Right now, obviously, we have to move forward with what we know and the best information we have available to us.

I think as that information changes, what might be different is we will continue to work with our customers around the implications that has in terms of our pricing.

Damian Karas (Stock Analyst)

Okay. Understood. I was wondering if you could maybe update us to the status of the Mexico capacity ramp. I'm curious if on the tankless side, if tariffs might actually present an opportunity to kind of accelerate your position in North American tankless. My understanding is that a lot of the North American market is still coming from overseas, ex-Mexico.

Chuck Lauber (CFO)

We are looking to accelerate our ramp up in Juarez. We have our premium condensing product that is launched there already. We have two more products that we were planning to launch through the course of this year to be ready for next year with the full portfolio. We are looking to accelerate those efforts so that we can get our products producing out of our Juarez, Mexico facility. Part of that acceleration is the economic case presented from the tariffs.

Stephen Shafer (President and COO)

Yeah, Damian, it has always been our intent to start production in China and move it to Juarez. This just accelerates the ability for us to start production in Juarez versus on the last two products, start up production in China.

Operator (participant)

Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Helen Gurholt for any further remarks.

Helen Gurholt (VP of Investor Relations)

Thank you, everyone, for joining us today. Let me conclude by reminding you that we are pleased with our quarter-over-quarter improvement, even in a challenging environment. We look forward to updating you on our progress in quarters to come. In addition, please mark your calendars to join our presentations at four conferences this quarter: Oppenheimer on May 5th, Nortcoast on May 6th, KeyBanc on May 28th, and Stifel on June 3rd. Thank you and enjoy the rest of your day.

Operator (participant)

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.