A. O. Smith - Q2 2024
July 23, 2024
Transcript
Operator (participant)
Welcome to the 2024 second quarter A. O.Smith earnings call. At this time, all participants are in listen-only mode. After the speaker's presentation, there'll be a question-and-answer session. To ask a question during this session, you'll need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Helen Gurholt. Please go ahead.
Helen Gurholt (VP of Investor Relations)
Thank you, Marvin. Good morning, and welcome to the A. O Smith 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 plus 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 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 Wheeler (CEO)
Thank you, Helen, and good morning, everyone. I'm on slide 4, and 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 an 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-digit growth in local currency for the tenth 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 America 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 America 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%-10% for the year. Sales of our commercial boilers, particularly our Crest boilers with Hellcat technology, continue to outperform the market. North America 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 six. 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. Early 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, plant 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.
Chuck Lauber (CFO)
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 inter-segment 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 particular 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 $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 and our 2024 earnings guidance and outlook.
We narrowed our 2024 EPS outlook to an expected range of $3.95-$4.10 per share. The midpoint 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 of 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 to Juárez, 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 Juárez, the 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 Wheeler (CEO)
Thank you, Chuck. We reaffirm our outlook that 2024 sales will grow 3%-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 increase 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 U.S. residential industry unit volumes will be flat to last year.
Our projection that U.S. 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%-10% over last year. Our sales growth guidance from North America Water Treatment of an increase of 8%-10% is also unchanged.
Based on our 2024 assumptions, we expect our North America segment margin to be approximately 25%, and the rest of the 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 America 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 3 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.
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 3 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.
Operator (participant)
Thank you. At this time, we'll conduct the question-and-answer session. As a reminder, to ask a question, you'll need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Please stand by while we compile the Q&A roster. Our first question comes from the line of Matt Summerville of D.A. Davidson. Your line is now open.
Matt Summerville (Analyst)
Thanks. Couple 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.
Chuck Lauber (CFO)
Yeah. Good morning, Matt. Happy to. You know, if you look at the cadence for the back half of the year, clearly, we had a strong first six months. We mentioned what we believe to be a pre-buy in the North America market with our price increase. So as you're kind of looking at volumes of North America, 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, you know, where we were on Q2 in the fourth quarter with continued momentum on the tankless, gas tankless product. Margins will follow.
You know, the margin cadence in the third quarter will be challenged by the volume headwind in the third quarter. In China, you know, we're coming off, what I would say, a solid first half of the year. 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, July orders, both in China and in North America.
So a little bit of a slow start to the third quarter, and that'll probably translate into volume headwinds and it'll leave a little bit of an impact on the margins.
Matt Summerville (Analyst)
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 Wheeler (CEO)
... Yeah, hi, this is Kevin. I'll maybe touch base on inventories. They are pretty much where we expect them to be in that 4-6 week range. So, nothing that meaningful. You know, there's ups and downs as we go forward. What we mentioned is, you know, it, 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's managing it really well. Again, we don't chase every order. We're very selective in how we go to market.
And if you look at it overall, growing 2% in local currency in a very competitive market that has some consumer headwinds, I think our team's 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 know, you look at our kitchen products; they are doing well, commercial water treatment's doing well, and so is our HVAC part of the business. So being diversified as we are, you know, 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're at in China, and we'll keep managing it in the back half of the year.
Operator (participant)
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)
Hey, good morning.
Kevin Wheeler (CEO)
Good morning.
Chuck Lauber (CFO)
Good morning.
Jeff Hammond (Analyst)
Maybe just to start on the acquisition, just give us a sense of, you know, kind of profitability of the business or opportunity, you know, from a profitability standpoint, and, and kind of what the growth rate's been for the business, you know, the last five years?
Kevin Wheeler (CEO)
Well, I'll take the first part of it, and just to talk about the acquisition in general. First, I wanna go back to 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 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 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, but 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 gonna make a big difference. It's gonna make a difference in our scale. We're also gonna 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.
Chuck Lauber (CFO)
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 outside of the, or in Sri Lanka and Vietnam. But in total, roughly 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, you know, low to mid-single-digit profitability. Growth-wise, as a premium brand, you know, they've seen also very good growth in the region. Kevin mentioned 10 consecutive quarters of 15%+ growth, and you know, I believe they've seen very similar growth rates.
So we're pleased with the way the financial profile matches up, and as Kevin said, coming together, we would hope, you know, 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)
Okay. And then, just on working capital, it seems like you had much, a much bigger working capital build in the first half versus, you know, maybe, maybe the last couple of years. Just to—is, is that just timing? Do you expect to get a lot of that back in the second half?
Kevin Wheeler (CEO)
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 (participant)
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)
Thank you. Good morning, everyone.
Kevin Wheeler (CEO)
Morning, Susan.
Susan Maklari (Analyst)
My first question is, you know, you mentioned that boilers saw some growth or reverted back to growth in the quarter. Can you talk about, you know, 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 Wheeler (CEO)
Well, if you look at it, it's mainly on the commercial side of our business, Susan. And, and we came off a pretty difficult quarter last year, but still, our quoting's been active. You know, that transition from, you know, kind of standard models to high efficiency continues... So, you know, overall, we're about where we thought we would be. Our new products are doing well. I mean, the Crest boiler has always done well, but you add the Hellcat technology on top of that, that's just being really well received in the market. Order rates have been good. They continue to be good. Backlog is strong. So, yeah, overall, I just think the commercial segment's doing well. The overall industry is slightly up, and we're doing better than the industry.
And even on the residential side of the business, that's also a positive. So again, 8-10 coming off some easier comps, but the overall macro environment is good, and it plays really well into Lochinvar and our high efficiency focus that we've had over the years, and we're seeing some real benefits from that.
Chuck Lauber (CFO)
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 and fourth quarters. So we feel very comfortable with the 8%-10% growth.
Susan Maklari (Analyst)
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? You know, perhaps any impact there to North America over the coming quarters and just, you know, overall, the trend for pricing?
Chuck Lauber (CFO)
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, you know, our outlook has steel roughly flat year-over-year. As we mentioned, you know, steel went up in the second quarter compared to first quarter by about 20%. It was about 25% higher than Q2 last year. So you know, there was a bit of a ramp-up. Well, we've seen some softening in steel. As you recall, our lag is 90-120 days.
So as we kind of look at the back half of the year, we see, you know, quarter-over-quarter, Q2 to Q3, a little bit of relief. And then as we look into the fourth quarter, you know, we've with that lag, you know, 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 90-120 days out. So we do expect a little bit of relief in the fourth quarter, and it pegged kind of our outlook, very similar to what the index was issued for the month of June.
Operator (participant)
Thank you. One moment for our next question. Our next question comes from the line of Sari Brody of Jefferies. Your line is now open.
Saree Boroditsky (Analyst)
Good morning. Thanks for taking our question. You know, 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 this softer July rate?
Kevin Wheeler (CEO)
Yeah, and just to mention, we always give you an outlook, you know, 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, you know, in May and June into July. But I think, you know, 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 U.S. residential tank-type market through the balance of the year.
So it's a temporary lull, but I think just gets us back to where our forecast has been for the entire year.
Saree Boroditsky (Analyst)
Thank you. And then turning to tankless, you started to ship some in the second quarter. Now, what are you seeing from a demand perspective there? And then just on the modeling, you know, 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 Wheeler (CEO)
Well, I would tell you, again, we're coming from a low, a 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, you know, 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 Juárez 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 have Chuck touch on that, but, you know, having the tariff go away at the, in sort of 2025 is gonna make a big difference in how we view this from a margin perspective going forward.
Chuck Lauber (CFO)
Right. I mean, Sari, from a comp perspective, you know, it's all positive when we move to Juárez. We relieve ourselves of the 25% tariff. We take away 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 our production in Juárez, is a very positive upside to our tankless category.
Operator (participant)
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.
Andy Kaplowitz (Analyst)
Good morning, everyone.
Kevin Wheeler (CEO)
Morning, Andy.
Chuck Lauber (CFO)
Morning.
Andy Kaplowitz (Analyst)
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 at 10%. So my question is, how difficult is it to maintain that margin sort of guidance moving forward? What cost actions or anything else are you doing to sort of offset lingering price pressure?
Kevin Wheeler (CEO)
... Yeah, I'll touch on it first, and then maybe Chuck will jump in. You know, it's a tough market, and as we said, we're cautious about even our guidance. But our team's doing a terrific job balancing not only price and promotion, but also the cost of our business. You know, 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, in 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's evaluating it.
Again, I think we're taking a targeted approach. It's not gonna be easy, but we're confident in our China management that they can navigate the way through the second half of the year.
Chuck Lauber (CFO)
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 you know less profitable store store footprints, and feel pretty good about our position to be flexible as volumes challenge us a bit. So you know, 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 Wheeler (CEO)
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 in our HVAC side. So again, putting the combination together, challenging, but we think it's very doable.
Andy Kaplowitz (Analyst)
Got it. And I just wanna maybe ask the same question on North America again, like on terms of the margin, like, just to make sure I understand it. So you feel slightly better, you know, you're saying flattish versus a modest headwind, I think is what you previously said. But you also talked about Q3, you know, 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 costs, investments a little higher than expected? I know you said the 50 basis points, so any color would be helpful.
Chuck Lauber (CFO)
I mean, nothing new I don't think that we've talked, you know, that we haven't talked about before. You know, we'll-- I'll just mention that, you know, 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, three and four. 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 you're thinking about the back half of the year.
Operator (participant)
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)
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. Can you at all 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 through the second half.
Chuck Lauber (CFO)
Yeah, I mean, it really tracks closely with the volumes, right? So our cost structure on selling expense is largely based on a commission basis. So as we sell, you know, more product, we're gonna have a higher selling expense. We also emphasize different products, you know, 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 it does just kind of flat out expenses. We do mention, you know, the launch of tankless products, so we've got some initiatives within, you know, our launch of the tankless products that's driving that number just a little bit higher.
Kevin Wheeler (CEO)
Yeah, I just would add, I mean, we're excited about our tankless offering, being that it's internally designed. It's gonna be manufactured in North America. And we're gonna own the category and from our own perspective rather than from partnering with somebody. So we're gonna expend some, you know, we're gonna promote this product for the first part of the year, make sure we can get everybody to understand what the product does, training, some promotional activities. All those are really important for us 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.
You know, 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)
Got it. Thanks for that. And then as a follow-up on the boiler business, I mean, you've guided to up 8%-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?
Chuck Lauber (CFO)
Well, volumes being up certainly helps us. You know, when you look at the boiler business, it's largely commercial product that we're talking about being increased 8%-10%. So you know, it's an improvement when you've got growth in that segment or in that product category.
Operator (participant)
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)
Hey, good morning. Thanks for taking the questions.
Kevin Wheeler (CEO)
Hey, uh-
Scott Graham (Analyst)
Hey, so the, so the no change in the U.S. resi water heater industry, thinking of flat. You know, I know we talked about in quarters past, a couple quarters, that second half comparisons get a little bit tougher, so you wanna be careful with that number. You know, the first half year to date is up in resi, maybe even a little unexpectedly, certainly from this analyst'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, given your, you know, the last couple of months', sales volumes? Or are you kinda gonna hold the course with, you know, flat because the comps are tougher, and there's really—and you're not trying to message anything?
Kevin Wheeler (CEO)
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 at our emergency replacement, which is always gonna stay the same, proactive, new construction, again, whether it's new, you know, single family or multi-family, we felt that was gonna be relatively flat. You know, interest rates would probably keep it flat. So, we saw that the pre-buy, we're a little surprised on the 4% pull forward, a bit, that more than we had thought.
But when you, when you step back now, and you kinda look at how we started the year, kind of 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, you know, strong growth in gas tankless, and we're gonna 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)
Thanks for that, Kevin. So similar question. On the North American segment margin, you kinda, you didn't change that either, yet you're kinda calling for, some spot weakness here in the third quarter, no pun intended. I'm just wondering, is it that, is the 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?
Kevin Wheeler (CEO)
No, I wouldn't say we're more bullish. I mean, we still believe 25% is gonna be, you know, where we're at, well, where we'll end up. We were about at that in Q2 on some really nice volumes. So, you know, 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, you know, 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 midpoint of where we think we'll end up.
Operator (participant)
Thank you. One moment for our next question. Again, as a reminder, to ask a question, you'll need to press star one one on your telephone. Our next question comes from the line of Damian Karas of UBS. Your line is now open.
Hi, good morning, everyone.
Helen Gurholt (VP of Investor Relations)
Morning.
Kevin Wheeler (CEO)
Morning.
Scott Graham (Analyst)
Hey, Damien.
Damian Karas (Analyst)
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. You know, 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 the, you know, 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 Wheeler (CEO)
Yeah, I would tell you that, one, I always want to start with is just to calibrate, it's still 2% of the market, but it is a growing category, and it's very specific. And 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, you know, a 25%-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, you know, variety, so that's a good thing. Availability is everything.
So overall, the category continues to grow, albeit in certain states, but again, well above our growth 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 up front 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)
Great, that's good to hear. 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, and 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, you know, kind of sampling in your product, or is it sort of more of an, you know, 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 Wheeler (CEO)
Well, I would tell you, you described the market pretty well. And so, I think what we're hearing from our distributors, they'd like 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 and 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, you know, 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 gonna do very well. It's gonna take us several years to move that forward, but again, we control our own destiny now. We have great support from our distributors, and I look forward to what's gonna happen with our gas tankless line as you know, the next few years kinda develop.
Operator (participant)
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 (VP of Investor Relations)
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 twentieth, Stifel on September fourth, and D.A. Davidson on September nineteenth. Thank you, and have a great day.
Operator (participant)
Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.